Recent changes in the tax laws allow you to put in more money each year to either your Roth IRA or "traditional" IRA. But if you're going to take full advantage of these new, higher contribution limits, you need to select the right vehicles with which to fund your IRA. In picking these investments, consider mutual funds — they can offer you some significant advantages.
Before we look at the benefits of placing mutual funds within an IRA, let's look at the new contribution limits. Until 2002, you could invest up to $2,000 a year in either a Roth or a traditional IRA. But now, thanks to the Tax Relief Act of 2001, you can put in up to $3,000 a year to either IRA — and this limit will eventually rise to $5,000 per year, starting in 2008.
Both types of IRA can help boost your retirement savings. Depending on your income level, your contributions to a traditional IRA may be tax-deductible — and, even if they're not, all your earnings grow on a tax-deferred basis. Roth IRA contributions are not deductible, but all earnings grow totally tax-free, provided you've had your account at least five years and you're at least 59 1/2 when you start making withdrawals.
Now, let's see how mutual funds can help you maximize your IRA:
• Diversification — As you know, every mutual fund is made up of many individual assets. You can buy funds composed of stocks or bonds or government securities or other types of investments. Many funds contain a mixture of all these vehicles. Consequently, all mutual funds offer a vital element of diversification to your portfolio — and diversification is still the most important element of long-term investment success.
• Professional management — Mutual funds are run by professional portfolio managers, who make decisions on which securities their funds should buy and sell. So, when you put mutual funds in your IRA, you've got experienced money managers working for you. Of course, before you invest in any mutual funds, you'll want to make sure you understand the fund managers' investment philosophy, and you should also explore their track record. (Keep in mind, though, that a fund's past performance will not guarantee future results. Also, be aware that the investment return and principal value of your mutual fund will fluctuate; your shares, when redeemed, may be worth more or less than their original cost.)
• Potential tax advantages — During the past couple of years, many mutual fund owners have discovered, to their chagrin, that they owed capital gains taxes on funds that had actually declined in value. How was this possible? It's because fund managers, in the course of their regular trading, may sell individual holdings that have appreciated over time. The fund will then make capital gains distributions to shareholders like yourself — and you'll be responsible for the accompanying capital gains taxes. But if you hold mutual funds within a traditional IRA, then these taxes will be deferred — and they'll be avoided entirely in a Roth IRA.
An IRA is a great way to create income for the retirement lifestyle you've envisioned. And the best way to get the most out of your IRA is to fund it with the right investments — so give mutual funds some strong consideration.