The Main Event: Traditional IRA v. the Roth IRA v. the Self-Directed IRA

032_rowboats_NOVThere has been a lot of discussion concerning Roth IRAs lately among those planning for retirement. One reason may be because new federal tax laws have changed the limitations placed on converting to a Roth. Plus, the December 31st deadline to convert your traditional IRA into a Roth is fast approaching. Remember, we are talking taxes here, so converting your IRA into a Roth is doable, it is just not simple. Knowing the benefits that come with a Roth should help you decide if it is the right IRA for you. For this reason, I have explained in this week’s Perspective, the pros and cons involved with traditional IRAs, Roths and the somewhat uncommon self-directed IRAs.


Traditional IRA


We all know that traditional IRAs are used to save pre-tax dollars for retirement. Both traditional and Roth IRAs have significant tax advantages, but depending on your circumstances, one may be better than the other. The primary benefit of a traditional IRA is that in most cases, the contributions are made on a pre-tax basis. This means that when you contribute to your IRA throughout the year, you can deduct that amount from your taxable income when tax time arrives. For 2009 and 2010, the maximum you can contribute tax-free to a traditional IRA in one year is $5,000 if you are under 50 years old. Those who are 50 and older can make catch-up contributions up to $6,000. Unlike a Roth IRA, in 2009, traditional IRAs have no income limitations.


 In addition to receiving the tax deduction up front, the money in your IRA is allowed to grow tax-deferred. Any interest or capital gains from the investments in your IRA are not taxed when the gains are realized. Instead, they are deferred until you make withdrawals from your IRA, at which point the withdrawal amounts are taxed as ordinary income. Many who are just beginning to save for retirement find the traditional IRA to be the best match because they are not required to pay any taxes up front.


There are two major disadvantages with traditional IRAs and both concern making withdrawals. First, account holders are forced to take at least the required minimum distribution (RMD) each year starting at age 70 ½. If the RMD is not met, the account holder is subject to stiff penalties. The second potential disadvantage is only a problem if you are forced to make withdrawals prior to turning age 59 ½. If you are forced to make early withdrawals, you will be subject to early-withdrawal penalties.


IRAs are subject to different treatment under state and local tax laws. Therefore, as with all retirement accounts, do not hesitate to consult a qualified advisor.


Roth IRA


You might find converting a traditional IRA to a Roth is the best option for you, but it is important to know the rules restricting such conversions. For 2010, the IRS decided to lift the rule that restricts taxpayers who make more than $100,000 a year from converting their traditional IRA into a Roth. The contribution limits, however, will continue to be dictated by your adjusted gross income (AGI).


The Roth IRA is still the only retirement account that allows for tax-free withdrawals after you retire. Currently, investors who hold devalued assets are converting to Roth IRAs because the government taxes conversion amounts as ordinary income rather than as capital gains or dividends. If you hold devalued securities that you believe will bounce back, then converting to a Roth IRA might be an option to consider. Investors are also being prompted to convert to a Roth in order to take advantage of the current low tax rates. The recent government spending frenzy will have to be paid back, so taxes are likely to increase.


It should be noted that conversions for 2009, which still have income limitations, have to be in before the year’s end. But, if you plan on using an investment advisor, it will take them about a week to process the paperwork I recommend you get the conversion moving in early December. To determine if you qualify for a conversion, your investment advisor will need to review any additional traditional IRA contributions, estimates for your 2009 adjusted gross income and other basic financial information.


 The last major benefit of converting to a Roth is your option to “recharacterize” your account if you become unhappy with the conversion. A recharacterization will return your assets to a traditional IRA and the taxes you paid on your Roth will be refunded. You typically have until the due date of your return, which would be April 15th the following year, or if you file an extension, October 15th. This option acts as a fallback for any investor that comes to regret their decision to convert.


Self-Directed IRA


Self-directed IRAs are for investors who want to create wealth using their knowledge of investments outside of stocks, bonds and certificates of deposit (CDs). Many investors prefer self-directed IRAs because they feel that they can reduce risk by investing in assets that they know and understand. There are specific rules regarding self-directed IRAs that you should be familiar with before considering the vehicle as an investment option because there are transactions that are prohibited. Most important are the transactions that the IRS classifies as “self dealing,” which encompasses investing in properties with which you or your family members have had prior ownership.


Many banks and brokerage firms stand to make financial gains when you select to invest your IRA money in stocks and CDs. Therefore, many custodians will focus solely on those investments instead of highlighting your options to invest in real estate or other assets. Therefore, although investing in real estate with IRA money has been allowed for more than 30 years, self-directed IRAs are still fairly unannounced. If you are looking to diversify your retirement portfolio, combining real estate and your IRA can be very powerful. But, because of the many tax regulations that come with self-directed IRAs, it is important to choose a registered investment advisor who has prior experience with them.


All My Best,


Thomas J. Powell


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 This report was prepared only to provide a brief comparison of a few of the many different retirement accounts that exist. The discussion of investment strategies in this article should not be considered an offer to buy or sell any investments. For all financial decisions, it is important to consult a professional.





About TomPowell

Senior Managing Partner of Resolute Capital Partners. As chief strategist I combine my education and proven expertise in raising private capital, innovative deal structure, risk mitigation, portfolio management, and distressed debt recovery to lead the Resolute Capital team in building a cross-pollination program of Foreign Direct Investment between Asia and the United States. In 1999, I founded and led the growth of ELP Capital, Inc, a mortgage banking investment company. In addition I served as the Senior Managing Director for ELP Capital’s affiliated investment company - ELP Capital Advisors, a Registered Investment Advisor for the ELP Capital Family of Funds, Institutional Investors, and wealthy individuals. I began my career with Wells Fargo Bank when I was recruited in 1988 for a management position in business banking for the Silicon Valley market. I was instrumental in the architecture, development, and initial application of Wells Fargo's Officer Sales Training programs, led two separate branch offices to top 5 overall rankings, and in 1990 was named as one of the youngest Vice Presidents in the Company’s 140-year history. I am a widely sought after speaker, international guest lecturer, and am an Instructor in the Office of Executive Education at Harvard University. In addition, I publish a weekly economic newsletter and podcast The Powell Perspective. I am involved in numerous community and industry groups. Specialties:An innovative investment manager with particular expertise in credit risk analysis, distressed debt recovery, and deal structure. I understand the practical application of money management in response to risk on both Wall Street and Main Street.
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