Wednesday, February 15, 2012

Tax-time retirement strategies


Putting aside a little extra money toward retirement in an individual retirement account, or IRA, would seem to be a no-brainer for the vast majority of middle-class Americans. Yet relatively few people contribute to them each year.
Although most households were eligible to make contributions to IRAs, only 14 percent of them did so in 2010, according to data from the Investment Company Institute. Just 39 percent of households own an IRA, even when you count all the IRAs created by rollovers of 401(k) assets and SEP-IRAs for the self-employed.
With tax day approaching -- the deadline for making a 2011 IRA contribution -- it's better to be among those who contributed than among those who blew it off. After all, you don't need to run the numbers on one of those ubiquitous retirement calculators to realize that every little bit helps.
Say, for example, that you're 45 now, and you put aside just $1,000 in an IRA. By the time you retire at 65, that $1,000 will be worth nearly $4,000 (assuming a 7 percent annual return). Set aside $1,000 a year from age 45 to 65, and when you retire you'll have more than $40,000 -- a tidy sum. (If you're 35 now, or 25, those numbers will come out much higher.)
While the vast majority of opportunities to get deductions for 2011 expired at year-end, you can contribute to an IRA or SEP until April 17, 2012. "You still have the opportunity to get deductions for IRAs and SEPs," says Bill Smith, managing director of the national tax office for CBIZ MHM, an accounting and management consulting company. "It's a good tax benefit and a great deferral, and if you think you are eligible, you have plenty of time to run the scenarios to see what it's going to save you in taxes."
If that has you thinking about contributing, here's what you need to know:
- How much you can contribute. The tax rules generally let you set aside $5,000 in a traditional deductible IRA or a Roth IRA; you can also split this contribution between the two in whatever proportion you like. If you're age 50 or older, you can put away an extra $1,000 for a total of $6,000 because of the rules on so-called "catch-up" contributions.
There are income limitations that prohibit high-income taxpayers with retirement plans at work from making contributions. But those income limits are higher than they used to be, so don't assume you won't qualify until you look at the numbers. If you're married and have a 401(k), for example, your ability to invest in a traditional IRA begins to phase out above adjusted gross income (AGI) of $90,000; for a Roth, the phase-out begins at AGI of $169,000. You can run your numbers on an online calculator, such as this one from Wells Fargo (
- Traditional IRAs vs. Roth IRAs. The difference between a traditional IRA and a Roth IRA is all about the tax. With a traditional IRA, you make your contributions with pre-tax dollars, and you'll owe taxes when you withdraw the funds. For tax purposes, it's the same concept as your 401(k). With a Roth IRA, you pay the taxes when the money goes in; but neither you -- nor your heirs, assuming you don't need to spend all that money in retirement -- will ever again have to pay income taxes on that money or the money that it earns within the Roth.
Which is better for you? For most people, the Roth has the advantage over the long term. That's mainly because you won't owe tax when you withdraw the funds, at which point your savings should be substantially higher. The longer your time horizon --because you're still decades from retirement or because you expect to have funds to pass on to your kids -- the better a Roth is. It will also be more valuable if your taxes in retirement are higher than they are today.
The caveat to the Roth is that you must be able to come up with the money to pay that tax hit up front. For a $5,000 contribution in the 28 percent tax bracket, that's an extra $1,400. If you'll need to raid your retirement funds to pay the tax man, it isn't worth it.
- The other Roth option. If you are covered by a retirement plan at work, you may be offered the choice of a Roth 401(k)-- an option that's been gaining ground slowly since it was introduced in 2006. For tax purposes, the basic concept of the Roth 401(k) is the same as for the Roth IRA, but the contribution limits ($17,000 for 2012) and employer matching contributions work like a regular 401(k). That means you can sock away money a whole lot faster.
If you're not sure whether your tax rate will be higher or lower in retirement than it is today (and, frankly, who is?), one smart strategy is to put part of your retirement funds in the regular 401(k) and part of them in the Roth. That way you've played both sides of the tax debate and left yourself some nice options for when it's time to retire and actually start using the money you will amass.