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Retirement need

Tax-advantaged savings plans to the rescue

Boosting your retirement income
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|> About Money 101

investing 101

  Tax-advantaged savings plans to the rescue
Think of 401(k)s and IRAs as Uncle Sam's gifts to enhance your retirement years.

If someone offered you free money, would you walk away from it? Of course not. But that's just what you'd be doing if you don't contribute the max to one or more tax-advantaged retirement savings plans like 401(k)s and IRAs. You would also be giving up the chance to turbocharge your savings and dramatically boost the value of your retirement nest egg.

Let's start with the most powerful option: the 401(k). Sticking a portion of your paycheck into a 401(k), as some 27 million Americans now do, can give you three compelling benefits: an immediate tax deduction, the possibility of a matching contribution from your employer, and tax-deferred growth on your savings. Your employer sets the maximum contribution as a percentage of your salary (usually 6 percent to 8 percent, although it can be higher), and up to $10,000 of what you sock away is excluded from your taxable income. Most employers also match a portion of what you save each year, typically 50 cents on each dollar of the first 6 percent you put in. The money in your 401(k) grows free of income taxes, until you withdraw it. Pull out money before age 59 1/2, however, and you'll owe an additional 10 percent. This penalty is waived for certain early withdrawals, such as those made to pay medical expenses in excess of 7.5 percent of gross income.

Add up these benefits, and you come away with some impressive numbers. If you contribute 6 percent of a $50,000 annual salary and your employer matches half of what you save, you would stash away $4,500 a year ($3,000, plus $1,500 from your employer). You would also save $930 in taxes, assuming you're in the 31 percent combined federal and state tax bracket. In other words, your employer and Uncle Sam would effectively be footing $2,430 of your $4,500 401(k) contribution, or more than half of it! Oh, and since your 401(k) compounds without the drag of taxes, your money also grows faster than it would in a taxable account.

In lieu of a 401(k) -- or possibly even in addition to it -- you should consider one or more of the several versions of IRAs available. If you have no retirement plan at work, you can invest up to $2,000 in a traditional IRA -- and deduct the entire $2,000 from your taxes. (A nonworking spouse can also invest a fully deductible $2,000, if the couple's combined income is at least $4,000.) If you have a 401(k) or other retirement plan at work, you may qualify for a full or partial deduction if your adjusted gross income is below $40,000, if you're single, or below $60,000, if you're married. (If you're not covered by a retirement plan, but your spouse is, you may still qualify for a full or partial deduction if your joint income is $150,000 or less.) As with a 401(k), your money grows tax-deferred until you withdraw it at retirement. IRAs face the same early withdrawal penalties as 401(k)s. Even if you don't qualify for a deduction, however, you can still invest up to $2,000 in a nondeductible IRA. You miss out on the $2,000 write-off, but the earnings in your account still grow tax-deferred.

Another alternative is a Roth IRA. As with a traditional and nondeductible IRA, you can invest up to $2,000. Instead of getting a tax deduction, however, your money grows tax free--that's right, it's not taxed at all when you withdraw it. You can qualify for a Roth IRA even if you participate in another retirement plan at work, as long as your adjusted gross income is less than $110,000 (for singles) or $160,000 (married couples).

So which of the three IRAs is best for you? The nondeductible is the least attractive, so take it only if you can't qualify for the other two. The choice between a deductible and a Roth is more difficult, but generally you're better off in a Roth if you expect to be in a higher tax bracket when you retire and you don't expect to withdraw your IRA money within a few years after retiring. Besides tax-free returns, another benefit of the Roth is that you aren't required to begin making mandatory withdrawals from your account by April 1st after the year you turn 70 1/2. That's a valuable feature for anyone planning to leave money to heirs.

Finally, if your adjusted gross income is less than $100,000, you might also look into converting existing IRAs to Roths so that your retirement savings can grow tax-free. If you convert, however, you'll have to pay taxes on the earnings in your IRA, as well as the contributions, if you deducted them. Deciding whether to convert involves serious number crunching. But given the potential benefits involved, it's worth it. So if you're considering the move, check out one of the many Roth calculators available on the Web or, if that prospect sounds too uninviting, consult a financial adviser.

Next: Boosting your retirement income


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