5 simple rules for investing in an IRA

Investing for retirement doesn't have to be complicated. One of the simplest and most effective approaches is to set aside money each year in an IRA, which offers tax advantages on retirement savings so you can potentially accumulate more money over time.

Here are 5 simple rules for managing your IRA assets:
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The biggest mistake you can make with an IRA is not to contribute. For the 2010 and 2011 tax years, the maximum annual contribution amount is $5,000 if you're under age 50, or $6,000 if you're 50 or older. (If you earned less than these amounts, your contribution limit would be equal to your earned income for the year.) These limits apply to your combined contributions to all IRAs you hold. If you're married, your spouse can make an IRA contribution too, even if he or she doesn't have earned income.

And just because the calendar has flipped to 2011 doesn't mean you can't make a contribution for the 2010 tax year. You have until April 18, 2011, to do so, and you can go ahead and make a contribution for 2011 as well. Just be sure to specify the tax year for which you're contributing.

Choosing the right type of IRA hinges on the question of when you want to pay taxes—now or later.
With a traditional IRA, your contributions may be tax-deductible if you meet certain eligibility requirements.

Your earnings can then grow tax-deferred until you begin taking withdrawals, at which point you'd be taxed at whatever rate you're subject to at the time (which could be higher or lower than your current rate). With a Roth IRA you're contributing after-tax money, so you don't get an immediate tax deduction, but your earnings grow tax-free, assuming they meet certain requirements.

For many investors, the appeal of a Roth IRA is obvious: tax-free growth, no lifetime requirements for required minimum distributions (RMDs), and the opportunity for tax diversification. This comparison chart can help you decide.

If you can't contribute to a Roth IRA because your income exceeds the allowable limit, you may be able to take advantage of what's sometimes known as a "back door" Roth IRA.

It works like this: You fund a nondeductible traditional IRA and then immediately convert it to a Roth. You're essentially making a contribution to a Roth IRA, and there may be little or no tax impact from the conversion.

But be careful: This strategy works best if you don't have other traditional IRA assets, because federal law requires you to aggregate all your IRA assets (regardless of which assets you actually convert) for tax purposes. (For example, if you have $50,000 in total IRA assets and you want to convert the $10,000 in your nondeductible IRA, your conversion amount will be treated as though four-fifths of it—$7,500—comes from your pre-tax assets, and that amount will therefore be taxable.) So, if you have significant IRA assets that were funded with pre-tax contributions (from an employer plan rollover, for example), you'll want to consider the potential tax bite before taking any action.

For most investors, a nondeductible IRA no longer makes much sense as part of a long-term retirement plan. Although such an account may grow tax-deferred, contributions aren't deductible, and any earnings will ultimately be subject to taxation when you're making withdrawals.

As long as you're eligible to contribute, a Roth IRA is probably a much better choice. But if high income keeps you from contributing to a Roth and a back door Roth strategy (see item 3 above) isn't an option, consider tax-efficient investments in nonretirement accounts as an alternative to a nondeductible traditional IRA.

Market performance isn't the only thing that affects your IRA's bottom line. Investment costs can have a significant "drag" on your long-term retirement savings. And unlike market returns, which can be positive one year and negative the next, operating expenses keep eating away at your account in good years and bad.

That's why it's important to keep an eye on what you're paying your investment provider. Here's a very rough guideline: If your IRA costs you 1% of assets per year over 30 years, you'll end up "giving away" nearly 30% of what you would have had if those fees hadn't been deducted. (Learn more about why costs matter.)

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