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Tax Planning

Retirement Savings

IRAs, 401(k) plans and their extended family are so entrenched that no President or Congress is likely to undermine them; the trend has actually been to expand and improve these breaks. This year, for example, maximum allowable IRA contributions rise by $1,000, to $5,000, for those younger than 50 and to $6,000 for those 50 and older.

When you open an IRA, the biggest decision you need to make is whether to feed a Roth (if you are eligible) or a standard IRA. To qualify for a Roth, your income can't exceed $169,000 if you are married or $116,000 if you are single. With the Roth, you pay taxes on your contributions but none on the earnings or withdrawals. With the traditional IRA, you may or may not get a tax deduction on your contributions, and taxes on your gains will be deferred until you begin withdrawing money.

But the standard IRA has a built-in flaw: It converts the earnings you make as your investments grow into ordinary income when you withdraw money. The Roth is free of this blemish, which is why it can also make sense to convert all or part of a traditional IRA to a Roth. The downside is that you must pay taxes at ordinary rates on the amount you convert. (If you convert in 2010, however, when the $100,000 income ceiling on conversions ends, you can spread the tax bill over 2011 and 2012.)

If you're in the 28% tax bracket now (the maximum for being eligible to start a Roth IRA) but expect to retire on a shoestring, you might decide that starting a new Roth or converting to one is too costly. Online calculators (such as our own at kiplinger.com/tools) can help you decide. But if you believe that your tax rate at retirement will be higher than your tax rate today, a Roth becomes more attractive.

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There are other practical reasons to like Roths. One is that you can withdraw your contributions (but not earnings) at any time for any reason and pay no tax. A second is that Roths, unlike regular IRAs, are exempt from the requirement to begin making withdrawals at age 70½. You do have to be at least 59½ to avoid a 10% penalty on withdrawals of gains, but that is the most you'll have to pay the Treasury to get your hands on the earnings early.

Frankly, the worst you can say about a Roth IRA is that you can't contribute enough to finance your entire retirement. That means you'll also want to invest in a 401(k) (or its equivalent for public employees and the self-employed). You can sock away $15,500 in a 401(k) in 2008 if you're younger than 50 and $20,500 if you're 50 or older. Employers usually match your contributions up to the first few percentage points of your salary -- an utterly tax-free bonus.

A 2006 law created a Roth option for the 401(k). If your employer allows, you can designate all or part of your 401(k) savings as a Roth account, which means you pay tax on the money you contribute but can withdraw it and the earnings tax-free in retirement. You are still subject to the other rules of 401(k)s and are limited to your plan's investment choices.

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