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Use disability payments for annuity or Roth?

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Dear Liz,
I receive disability and I have some money from a workers’ compensation award that I want to put toward retirement. I had to use my IRA money to stay afloat and have no retirement. Now I have $10,000 to $20,000 to invest, but should I buy an annuity or start a Roth? What are my choices?
— Nancy

Dear Nancy,
You should consider buying an annuity only after you’ve exhausted other tax-advantaged ways to save for retirement.

Contributions to annuities don’t get any tax breaks, while gains withdrawn in retirement are taxable as income. Also, annuities can come with high costs and surrender charges that limit their appeal.

Fortunately, you may have better options. You don’t have access to a workplace retirement plan such as a 401(k), which is typically the best choice for retirement contributions, but you may be able to contribute to a deductible IRA or a Roth IRA.

Contributions to IRAs require that you have taxable, earned income, but disability payments received before retirement may qualify, says Mark Luscombe, principal analyst for tax research firm CCH Tax and Accounting North America.

“The IRS does include in the definition of earned income taxable long-term disability payments received before reaching minimum retirement age that are reported in box 1 of Form W-2 as taxable compensation,” Luscombe says.

Contributions are limited to $5,500 a year, or $6,500 for those 50 and over. Regular IRA contributions will give you a deduction upfront, while withdrawals are taxable as income. Roths offer no upfront deduction, but money withdrawn in retirement is tax-free, making them a good option for those who expect to be in the same or a higher tax bracket in retirement.

You can make your contributions over a few years to invest all your award money, or you can set up a regular taxable brokerage account with the excess funds and invest through that. If you hold investments in a taxable account for at least a year, you’ll qualify for favorable capital gains tax rates.

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