When You Shouldn't Start an IRA

By Dan CaplingerMarketsFool.com

If you want to save for retirement, then IRAs are almost always a great way to get started. The tax benefits that IRAs offer give you a leg up on saving money in a regular taxable account, and their flexibility in terms of investment options makes them more attractive to many investors than 401(k)s and other employer-sponsored plans. Yet in some limited cases, it actually makes sense not to start an IRA.

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Situation 1: You can't deduct your IRA contribution and don't want to use the back-door Roth strategy

The clearest situation in which an IRA doesn't make sense is when you make too much money to qualify for the upfront tax deductions that traditional IRAs offer. As long as neither you nor your spouse have access to an employer-sponsored retirement plan at work, then no income limits to deductible IRAs apply, and you can make a full contribution.

Those who do have access to an employer-sponsored retirement plan like a 401(k) have to deal with income limits. The chart below gives the phase-out range for deductions, with the lower limit showing when the maximum deductible amount starts getting reduced, and the upper limit showing when deductions disappear entirely.

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Data source: IRS.

If you're above these limits, then you can still open an IRA, but it would have to be a nondeductible IRA. Nondeductible IRAs are generally a poor retirement planning option, as they take what would often be tax-favored capital gains or dividend income and turn it into ordinary income for tax purposes when you withdraw it from your IRA in retirement. However, some savers can immediately take their new nondeductible IRA and convert it to a Roth IRA with no adverse tax consequences. This is known as the backdoor Roth strategy, but it only works well if you don't have previously existing traditional IRAs for which you did get a tax deduction when you first contributed to them.

Image source: Getty Images.

Situation 2: You need all your available retirement savings to get an employer match

Many employers offer matching contributions when you participate in a 401(k) or other retirement plan at work. If that's the case, then you might well not have enough money to contribute both to your 401(k) and to an IRA. Because the matching contribution is essentially free money toward your retirement, you'll almost always want to give 401(k) contributions priority, at least up to the maximum amount of the match.

Once you've maxed out the match, then it can make sense to consider IRA contributions rather than putting more money in a 401(k). The best answer for you depends on whether your 401(k) plan offers you good investment options that have low fees and let you build up a well-diversified portfolio. Sometimes, the fund choices within a 401(k) are actually better than what you'd get on your own, because your employer has more in retirement assets and can sometimes get access to lower-cost institutional mutual fund classes. On other occasions, though, your 401(k) might have inferior investment options, and that's when using an IRA makes sense to deploy any savings you have available above what's necessary to maximize the match.

IRAs are generally smart vehicles for saving for retirement. But in a few limited cases like the ones above, it might not make sense to start an IRA. Be sure to take a close look at your specific situation in order to decide whether IRAs are right for you.

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