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Individual retirement account (IRA)

Planning for the future is never a bad idea, especially when it has to do with your finances and retirement. Whether retirement is 10 years away, or 50 years away, putting money aside for the years after work is now more important than ever. An Individual Retirement Account (IRA) may be just the type of investment account that could help you plan for a secure future. There are several different types of IRAs: Traditional IRA, Roth IRA, SEP-IRA, SARSEP-IRA, and SIMPLE-IRA. Traditional IRAs are broken down into Regular and Rollover IRAs. The best part about an IRA is that your investments grow tax-free until you take the money out at retirement.

Traditional IRA
A traditional IRA is a tax-deferred personal retirement fund. You can contribute up to $4,000 for 2007, and $5,000 in 2008. Catch-up provisions for those age 50 or older are an additional $1,000 a year. Depending on how much you earn and your marital status, the money you invest may be tax-deductible. Although the annual contribution limit is the same for both traditional and Roth IRAs, the difference in the two IRAs is in the tax treatment. For traditional IRAs, you may qualify for a tax deduction in any year that you make a contribution, but the amount of interest that accrues in your account will be taxable when you retire. This type of IRA may make sense for you if you anticipate that your income tax bracket when you retire will be much less than it is currently.

Roth IRA
A Roth IRA is a tax-deferred retirement account that turns the traditional IRA formula on its head: although retirement contributions are taxed up front, withdrawals can be made completely tax-free once you reach age 59 1/2 and have had a Roth IRA for five years. For some people, paying taxes now to enjoy tax-free income later may actually make more financial sense in the long term. For one thing, the Roth IRA allows investors to effectively shelter more money for retirement. Although the annual contribution limit is the same for both traditional and Roth IRAs, because your Roth contribution is made with after-tax income, the full amount, including the catch-up contributions, can compound substantially over the years — without incurring any future tax liability.

The amount you can contribute to a Roth IRA may be reduced or eliminated depending on your filing status and your adjusted gross income level.

Whether the Roth IRA is a better option really depends on your expectation of your future tax rate. In the past, retirees routinely moved into a lower tax bracket. However, with more people maintaining high levels of income even in retirement, it may make more sense to pay taxes on your contribution today, while you're still employed.

Although investors can certainly open both a traditional and a Roth IRA, most financial advisers suggest that you convert your existing account to take full advantage of the Roth's long-term benefits. But before converting, consider these factors:

  • You can only convert if your adjusted gross income is not more than $100,000 for the year the conversion occurs.
  • More importantly, you'll have to pay taxes — which can be substantial depending on how much you've amassed in your current IRA — on all deductible contributions and earnings. To avoid being hit with penalties, you must pay these taxes with non-IRA money. In fact, tax experts caution that if you don't have other cash handy to pay the tax, you're probably better off with a traditional IRA.

Am I eligible to participate in an IRA?
Are you self-employed or employed by someone else in an activity for which you receive earned income or compensation? If so, then you are eligible to make a contribution to either a traditional or a Roth IRA. If you have earned income and are under age 70 1/2, then you may make a contribution to a traditional IRA. The only question is whether that contribution will be deductible.

Traditional IRA Eligibility
That depends on your income tax filing status and whether you (or your spouse) participated on any day in the year in an employer's qualified retirement plan. In general, if neither you nor your spouse participated in a 401(k) or other qualified retirement plan, your contribution will be fully deductible. If you (or your spouse) did participate in an employer-sponsored retirement plan, then your contribution to a traditional IRA might be deductible, depending on your modified adjusted gross income (AGI). (Modified AGI for most folks is the same as the adjusted gross income on the last line of the first page of Form 1040.)

The amount of a traditional IRA contribution that is deductible declines to zero between certain AGI ranges, as follows (for 2008 contributions):

  • $101,000 to $116,000 for single or head of household filers
  • $159,000 to $169,000 for joint filers

Example: If you're single and your AGI for 2008 is $100,000, you will be able to fully deduct your traditional IRA contribution. If your AGI iss $105,000, you would be able to deduct part of your contribution. If your AGI iss $116,000 or higher, you will not be able to deduct your contribution at all.

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