Boost Your Retirement Savings

Saving for retirement is one of the best and easiest ways to reduce your tax bill while building a future nest egg. If you are among the 44 million Americans who participate in their company's 401(k) plan, you can contribute up to $15,500 this year and, if you are 50 or older, you can stash an extra $5,000 in catch-up contributions for a total of $20,500 in 2007. (The limits are the same for 2008.) Every dollar you contribute to the plan escapes federal and state income taxes (although that money is still nicked by the payroll tax for Social Security and Medicare—7.65% of the first $97,500 of wages in 2007, then 1.45% for any additional wages). If your combined federal and state income tax rate is 30%, for example, you save $300 in taxes for every $1,000 you contribute to your 401(k). So, that $1,000 contribution reduces your take-home pay by just $700.

Some employers offer matching contribution, maybe 50 cents on the dollar. If your boss is one of them, make sure you contribute at least as much as needed to capture your employer's match. Otherwise, it's like walking away from free money. Any employer match does not count toward the contribution limit cited above.

Similar tax-deferred retirement plans, such as 403(b) plans for teachers and employees of nonprofit organizations and 457 plans for state and local employees, and the federal government's Thrift Savings Plan have identical annual limits on contributions.

Your Own Boss

If you are self-employed, you can stash even more into a tax-deferred retirement account because you contribute as both an employee and an employer.

With a solo 401(k) plan, available only to self-employed business owners with no employees (other than a spouse), you can contribute up to $15,500) to your tax-deferred retirement account as an employee plus 25% of your compensation (if your business is incorporated) up to a maximum combined contribution of $45,000 in 2007. If your business is not incorporated, you can kick in 20% of your self employment income (which is total business income minus half of your self-employment tax) up to the same limit. And, if you are 50 or older, you are eligible for an additional $5,000 in catch-up contributions for a total of $50,000 in 2007.

Another retirement savings option is a SEP IRA, which is good for both self-employed people and those who have side jobs in addition to their regular careers. Assuming you max out your 401(k) at your day job, you cannot take advantage of the $15,500 limit again with a solo 401(k). But you can open a SEP IRA for your small business or sideline business and save up to 20% of your self-employment income (or 25% of your compensation if your business is incorporated) up to $45,000 for 2007. Although no catch-up contributions are allowed, the SEP IRA offers one advantage over the solo 401(k): you can set one up at the last minute. You have until your file your income taxes for the previous year to establish and fund your SEP. With a solo 401(k), you must establish your plan by December 31 but you have until you file your tax return to fund it.

If you have employees (other than your spouse), you aren't eligible for a solo 401(k,) but you do have other options. Consider a SIMPLE IRA, which stands for Savings Incentive Match Plan for Employees. In 2007, you can save $10,500 of your self-employment income and your business can kick in another 3%. People age 50 and older can tack on an extra $2,500 in catch-up contribution.

On Your Own

You can also save for retirement on your own with an individual retirement account (IRA). If you don't participate in a retirement plan at work, or even if you do and your income falls within eligibility limits, you can make tax deductible contributions of up to $4,000 to a traditional IRA in 2007, plus an additional $1,000 in catch-up contributions if you are 50 or older. For 2008, the annual limit regardless of age rises to $5,000, and the catch up addition for those 50 and older remains at $1,000.

If you participate in a workplace-based retirement plan, you can still make tax-deductible contributions to an IRA if you are single and your income is less than $52,000 in 2007. If you income is between $52,000 and $62,000, you qualify for a partial deduction. If you are married filing a joint return, the phase out limit for deductible IRA contributions begins at $83,000 in 2007 and the write-off disappears once your income tops $103,000. (For 2008, the phase-out zone for singles rises to between $53,000 and $63,000; for married couples the deduction will phase out as income on a joint return rises from $85,000 to $105,000.)

If you don't participate in a retirement savings plan at work, but your spouse does, you can make tax-deductible contributions to an IRA if your adjusted gross income on your joint return is $150,000 or less. You can claim a partial deduction if your income is between $156,000 and $166,000. You can't deduct your IRA contribution once your income tops $166,000. (For 20087, this phase-out zone will be between $159,000 and $169,000.)

The Roth Option

While most retirement savings plans are based on upfront tax breaks, with the understanding that your withdrawals will be fully taxable in retirement, the Roth IRA offers an opposite approach. You get no initial tax break, but all future earnings and withdrawals are tax-free as long as your account has been open at least five years and you are at least 59-1/2 years old. Plus, since you contribute after-tax dollars, you are able to withdraw you contributions (but not your earnings) at any time, tax-free and penalty-free.

Roth IRAs are a great option for anyone interested in tax-free retirement income, and are particularly good for young workers who could benefit from decades of tax-free growth. Roths are also good for anyone who expects to be in a higher tax bracket in retirement. However, there are eligibility limits. For 2007, single taxpayers can contribute up to $4,000 to a Roth IRA, or up to $5,000 if you are 50 or older, only if your income is $114,000 or less. You can make a partial contribution to a Roth IRA if your income is between $99,000 and $114,000. Once your income tops $114,000, you are ineligible to contribute to a Roth IRA. For married couples, $4,000 or $5,000 contributions can be made for each spouse, in income is under $166,000; the right to make contributions is gradually phased out as income rises between $156,000 and $166,000. (These phase-out zones increase in 2008. The opportunity to contribute to a Roth will evaporate as income on a single return rises between $101,000 and $116,000; for joint returns, the phase-out zone will be between $159,000 and $169,000.)

But if the idea of tax-free income in retirement appeals to you, and your income is too high to qualify, there's a backdoor entrance to the Roth IRA. Under current law, you can convert a traditional IRA to a Roth IRA only if your adjusted gross income is $100,000 or less. But that $100,000 income limit on conversions will disappear in 2010. But you don't have to wait that long to hop on the Roth IRA bandwagon.

You can start making nondeductible contributions to a traditional IRA now and build up a lump sum that you can convert to a Roth IRA in 2010 when the income limits on conversions disappear. If these nondeductible contributions represent your only IRA money, then you will just owe taxes on the earnings when you convert to a Roth IRA. However, if you have other IRA money funded with deductible contributions, only a portion of the converted amount will escape taxes since all conversions must be done on a pro rata basis based on the total balance in all of your IRAs.

Employers are now allowed (but not required) to offer a Roth option for their 401(k) plans. Like the Roth IRA, contributions are made with after-tax dollars and future withdrawals will be tax-free as long as you adhere to the rules. If your employer has added the Roth option, seriously consider whether you would be better off foregoing the immediate gratification of a tax break today for the delayed gratification of tax-free income in retirement. You can choose to split your contributions between a traditional 401(k) and the new Roth version as long as your combined contributions do not exceed the annual limits.

Updated for tax year 2007