The Facts

• If your employer doesn't offer a retirement plan such as a 401k, or you choose not to participate, contributions to a Traditional IRA are generally tax-deductible, regardless of your income. If you are covered by an employer's plan, the amount of your IRA contribution that is deductible begins to phase out as your income rises. If your income is above certain amounts, IRA contributions can't be deducted at all (the amount varies depending on your filing status).
  
  

Function

• The earnings in a Traditional IRA grow tax-deferred, regardless of whether contributions are deductible. You will be taxed on distributions you take from the IRA, but if you make nondeductible contributions, you won't pay taxes on a portion of your distribution, to avoid being taxed twice. In some cases, it may be preferable to contribute to a Roth IRA, rather than make nondeductible contributions, but individuals making above a certain amount are ineligible to participate in Roth IRAs.
  
  

2010 Law Change

• Contributions to Roth IRAs are also nondeductible. But, unlike Traditional IRAs, contributions and earnings may be withdrawn tax-free. As stated earlier, though, there are income limits to participation. But beginning in 2010, you will be able to begin making rollovers from Traditional to Roth IRAs regardless of income level, paying taxes only on the earnings. Assuming the law is not changed, higher-income individuals will be able to begin participating in Roth IRAs and enjoy tax-free withdrawals in retirement.
  
  

Considerations

• Although earnings in a Traditional IRA are tax-deferred, when funds are withdrawn, they are taxed as ordinary income. Depending on your tax bracket, this can be as much as 35%. Earnings held in a taxable brokerage account are taxed at the lower capital gains rate. Although you won't pay taxes on earnings and dividends in a Traditional IRA as your account grows, the difference in tax rate when you take the money out may make a taxable account a more attractive option.
  
  

Warning

• Be sure to keep accurate records when making nondeductible IRA contributions. You must file IRS Form 8606, which details the nontaxable portion of your IRA. You will pay a penalty if you don't file the form, and if you don't have a record of your nondeductible contributions, you face the possibility of being taxed twice on the same contributions. The formula for figuring out the portion of your withdrawal that is taxable is complicated and confusing, and you'll probably want to consult an accountant or other tax preparer for advice.