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Why a Traditional IRA Might Not Be Worth the Last Minute Tax Savings


With the tax filing deadline of April 17 fast approaching you might be looking for a last minute way to decrease your 2011 tax bill. Opening a traditional IRA seems like a good idea, you get a two-fer, tax savings and a little more padding for your retirement cushion. But before you rush off to capture a tax deduction, make sure you know as much as you think you do about IRAs.

Simply put, there are a lot of ways to trip yourself up if you don't have all the facts. For example, establishing an IRA with an insurance company and purchasing an annuity contract may not be a smart move. Since the IRA is a tax-deferred account, when you invest your IRA funds in an annuity, you are putting a tax-deferred investment vehicle (the annuity) inside a tax-deferred account (IRA). You get no benefit from the annuity being tax-deferred, explains Elaine Bedel, president of Bedel Financial Consulting. Annuities can also have high expenses that eat away at investment return. Instead, establish an IRA with a brokerage custodian and investing in mutual funds that are suited for your desired asset allocation.

Similarly, investing IRA funds in municipal bonds is a waste because muni bond interest is tax-free. Regardless of that tax characteristic, all earned income distributed from an IRA is considered taxable. Therefore, the IRA owner would pay income taxes on interest income that would have been tax-free if it weren't housed in the IRA.

While you can tap your 401k, you can't borrow from your IRA, so if you want to help your child purchase a house or start a business, that's not the place to turn because the "loan" would be considered a distribution, meaning income tax would be due and if you're under age 59 1/2, you'll get hit with a 10% penalty.

Know too that, whether you want to or not, with a traditional IRA at the end of age 70 1/2 you're required to make minimum distributions. Realize there are regulations to distributions. There are no joint IRAs and each taxpayer must take distributions based on their individual account balances and age, says Scott Halliwell, a certified financial planner with USAA. If you don't take your RMDs in a timely fashion Uncle Sam will ding you with a 50% penalty. You also want to be sure that you take the right withdrawal amount.

An IRA may not be the best way to leave money to your children. Why? Often children are in a higher tax bracket than their retired parents and leaving them IRA money is the wrong thing to do, warns David Shucavage, president of Carolina Estate Planners. Quite frankly, some financial planners call IRAs the worst wealth transfer vehicle.

IRAs do not pass through a will. You need to name a beneficiary, otherwise your IRA assets could be subject to probate, a big time suck and potentially a costly affair to boot. Then too, if you incorrectly name IRA beneficiaries, it gets complicated. "While there can be specific reasons to do so, naming a trust or your estate as the IRA beneficiary can wipe out the potential tax deferral benefits of the IRA by forcing the beneficiaries to take required distributions over a much shorter time frame," cautions Kevin Dorwin, a certified financial planner with Bingham, Osborn & Scarborough.

Consistency counts. Not contributing enough or consistently defeats the purpose -- building a retirement nest egg. You miss the tax advantages by contributing less than the maximum allowed by law or by skipping a year in favor of other priorities, points out David Geller, author of Wealth & Happiness. Contribution limits are set by law and have changed over the years and some are adjusted for inflation every year.

Assess whether a Roth IRA might be better for you. Though if you go the Roth IRA route you won't get a current year income tax deduction, but if you meet eligibility requirements, you can enjoy tax-free investment growth on the investments in your retirement fund. If you make less than $110,000 as a single filer, or $173,000 as a joint filer, you can contribute to a Roth. You won't get a tax deduction, but this account is far more valuable in retirement as future withdrawals are tax free, says Dorwin.

What's the moral of this story? In your last minute search for tax savings, be savvy.


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