One easy way to become a more tax-efficient investor is to utilize tax-advantaged accounts such as individual retirement accounts (IRAs), which come in two varieties—traditional and Roth. These special accounts allow you to enjoy either tax-deferred or tax-free growth of your investments.

Tax deferral can lead to significant savings over time. Let's assume two investors each start with $10,000 and earn a 10% annual return for 30 years. One has 100% of her gains tax-deferred, while the other realizes the full amount of his capital gains each year and pays a 20% tax on those gains. Under this scenario, the tax-deferred investor ends up with almost $75,000 more at the end than the investor with the taxable gains.

IRAs can be invested in any type of publicly traded security, including stocks, bonds, and mutual funds. Generally, there's no limit to switching investments or money managers within an institution, although there could be tax penalties involved if you switch between different types of IRA accounts. Some institutions tack on fees for switching accounts to another firm.

Traditional IRAs
When you contribute to a traditional IRA, the IRS allows you to take an income tax deduction up to the amount of the contribution, subject to income limitations. In addition, dividends and capital gains earned inside a traditional IRA are not subject to tax until withdrawal.

However, there are some important limitations to remember. First, you must be age 70 1/2 or under with earned income to contribute to a traditional IRA. Second, the annual contribution limit is $4,000 from 2005 to 2007. The limit rises to $5,000 in 2008, and thereafter can be adjusted in $500 increments to account for inflation. If you are age 50 or older, you can make additional "catch-up" contributions of $500 in 2005 and $1,000 from 2006 onward. Finally, you must begin mandatory withdrawals when you reach age 70 1/2. Withdrawals made before you turn 59 1/2 are taxed and may be subject to an additional 10% penalty.

Roth IRAs
As with traditional IRAs, interest income, dividends, and capital gains accumulate tax-free. However, the main feature of Roth IRAs is that they are funded with aftertax dollars (contributions are not tax deductible). The upside of this is that qualified distributions from a Roth IRA are exempt from federal taxation.

The Roth IRA has the same annual contribution limits and "catch-up" provisions as a traditional IRA, but you must meet certain income requirements to contribute to a Roth IRA. Generally, single filers with modified adjusted gross income up to $114,000 and joint filers with income up to $166,000 (in 2007) are eligible to make annual contributions to a Roth IRA. Contributions to a Roth IRA can be withdrawn at any time without paying taxes or penalties, but withdrawal of earnings may be subject to income taxation and a 10% early withdrawal penalty if made before you turn 59 1/2.

In addition, the distribution must also be made after a five-tax-year period from the time a conversion or contribution is first made into any Roth IRA. So, if you open your first Roth IRA and make your first contribution on April 15, 2005, for the 2004 tax year, your five-year period starts on Jan. 1, 2004. Assuming you meet the other requirements, distributions made in this case after Dec. 31, 2008, from any Roth IRA will receive tax-free treatment.

Return to Glossary