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Tax Strategies
Doreen Griffith
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Retirement planning can help you save on taxes
HOW financially prepared are you for retirement? Did you know that saving for retirement may help you save taxes, either today or in the future?
Individual retirement accounts (IRAs), Roth IRAs and 401(k) plans are three common savings plans individuals can use to save for retirement and reduce their tax liability today. Contributions to IRAs and Roth IRAs are allowed by April 15, 2007, to count for 2006.
A traditional IRA allows an individual to make tax-deductible contributions to the account now for use in the future. Tax savings are maximized if individuals are in lower tax brackets at retirement.
For 2006 and 2007, traditional IRA contributions are limited to the lesser a taxpayer's compensation or $4,000. Taxpayers age 50 and over can make an extra $1,000 catch-up contribution. Also, the taxpayer's compensation will be applicable for both husband and wife, which allows a stay-at-home parent to have IRA benefits.
If in the 25 percent tax bracket now, a $4,000 tax-free contribution to an IRA will save $1,000 in taxes (25 percent times 4,000). An IRA contribution effectively reduces your taxable income and will grow tax deferred until you begin to make withdrawals.
Withdrawals can begin at age 59 -- with no penalties. Additionally, contributions cannot be made once the individual is over 70, and distributions must start at this time.
Tax-deductible contributions to a traditional IRA are further limited if you also participate in an employer-sponsored retirement plan. Deducting your IRA contribution is phased-out when adjusted gross income (AGI) exceeds $85,000 for married filing jointly and $60,000 for single filers.
ROTH IRAs operate differently from traditional IRAs. Contributions to Roth IRAs are not tax deductible. However, the tax advantages of Roth IRAs occur at distribution. With contributions made with after-tax dollars, distributions (contributions and earnings) are tax free. If you expect to be in a high tax bracket at retirement, a Roth IRA offers future tax savings.
As with the traditional IRA, there are limitations to contributions for higher income taxpayers. No contribution is allowed for single filers whose AGI exceeds $110,000 and married filing jointly taxpayers with AGI exceeding $160,000. Contributions to Roth IRAs are subject to traditional IRA contribu- tion limitations, and are further reduced by contributions made to all other retirement plans.
For example, Malia's compensation is $40,000 and has both a traditional IRA and a Roth IRA. She contributed $3,000 to her traditional IRA during the tax year. According to the traditional IRA contribution, her contribution limit is $4,000. Her Roth IRA contribution limit is $1,000 ($4,000 minus $3,000) -- the traditional IRA limit less contributions to other retirement plans.
Also different from a traditional IRA, individuals can continue to make contributions to Roth IRAs beyond the age of 70.
AN employer plan such as a 401(k) plan is another way to save for retirement and reduce current taxes at the same time. An employee can elect to have compensation deferred and placed in the 401(k) savings account. A 401(k) plan operates similarly to a traditional IRA, by effectively reducing taxable salary and tax liability today.
Contributions to 401(k) plans are subject to an annual limit that is indexed for inflation. The 2006 annual limit is $15,000, much higher than both traditional IRAs and Roth IRAs.
Contributions are made tax free and withdrawals (including contributions and earnings) are taxed at the time of distribution, offering greater tax savings if in a lower tax bracket at retirement.
Additional advantages of a 401(k) plan may include employer matching and borrowing opportunities.
With the holiday season just passing us, it is time to start the new year thinking of our future. What better way than to start planning for retirement.
Doreen Griffith is managing partner for the Honolulu office of Grant Thornton LLP. She can be reached at
Doreen.Griffith@gt.com