Retirement accounts offer tax relief

Rules for IRAs, 401(k)s, and other plans vary, so plan wisely.

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Last week, my column reviewed strategies Americans can employ to lower their income-tax bill. Today's focus is on year-end retirement issues.

Retirement planning begins the moment you take a job and continues throughout your employment. Whether you work for someone else or are self-employed, decisions on funding retirement accounts can have a substantial effect on how much money you have when you retire. Many decisions must be done carefully as they are difficult to reverse without penalty, so it's best to consult with a tax adviser before making any significant moves.

IRAs and 401(k)s

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For 2008, those below age 50 may contribute up to $5,000 to an individual retirement account and those 50 and over may contribute up to $6,000. If you contributed this year to an employer-sponsored retirement plan, deductions for a traditional IRA begin to phase out if your modified adjusted gross income (AGI) is greater than $53,000 for single filers or $85,000 for those married filing jointly. If your spouse has an employer-sponsored retirement plan such as a 401(k), but you do not, deductions begin to phase out at $159,000. You must have taxable income to contribute to a traditional IRA.

Unlike a traditional IRA, contributions to a Roth IRA are not tax deductible. But withdrawals are free from federal taxes if the account has been held for at least five years and you have reached age 59-½. Maximum contributions to a Roth are the same as those for traditional IRAs, but the contribution phase-out stage begins when AGI is $101,000 for single filers and $159,000 for married couples filing jointly. Unlike a traditional plan, you can make contributions after age 70-½.

Taxpayers are allowed to contribute to both a 401(k) and an IRA in the same year, subject to income limitations. For employer-sponsored 401(k) plans, the maximum contribution is $15,500 in 2008. If age 50 or older, you can make an additional $5,000 catch-up contribution.

IRA conversions

Converting a traditional IRA to a Roth IRA requires you to pay ordinary income tax on any converted amount. If the value of your IRA is down this year, the tax consequences would be less, based on the depreciated value of the plan at the time of the conversion. When your investments appreciate in value in future years, the growth won't be subject to tax – particularly attractive if tax rates increase in future years. Tax year 2008 may well be the ultimate time to do a Roth IRA conversion.

Two caveats: Calculate whether the taxable distribution from the conversion jumps you into a higher tax bracket; your AGI must be $100,000 or less to convert to a Roth.

Self-employed plans

With unemployment at a 14-year high, many Americans have become increasingly interested in establishing their own businesses. For them, tax considerations are of particular importance this time of year. "A self-employed person should establish a retirement plan by the end of 2008 in order to take the tax deduction on their 2008 income tax return and optimize savings of potentially thousands of dollars," says Hal Burstein, a CPA at Burstein & Associates, LLC. "They can fund their retirement plan in 2009."

Self-employed individuals may generally contribute the lesser of $46,000 or 20 percent of their net self-employment income to plans such as solo 401(k)s or SEP IRAs. Solo 401(k) plans must be set up in 2008, whereas a SEP IRA must be established and funded in 2009 at the time taxes are filed. Each has their advantages. Depending on your self-employment income level, a solo 401(k) may potentially allow greater retirement contributions and maximized tax deductions than a SEP IRA. But there may be greater administrative responsibilities and fees.

Older individuals may consider establishing an S corporation to take advantage of higher contribution limits. An S corp is a business whose profit and losses are reported and taxed on the shareholder's tax returns. Established in 1958 to enable small family corporations to get started, some 4 million S corps now operate in the United States.

"The silver lining in this down economy is the new entrepreneurship that is being created. Entrepreneurship is alive and well and growing like a weed. It is an important component in restoring the economy and business activity," says Brian Reardon, executive director of the S Corporation Association of America.

For an owner of an S corporation without other employees, the preference is to establish a defined-benefit plan, as it has higher limits than a 401(k) or other defined contribution plans and you can make contributions in years in which you don't receive income. Its limits are $46,000 or 25 percent of earned income.

Dr. Kathleen Connell is a professor at Haas Graduate Business School, University of California, Berkeley.

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