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Posted: February 03, 2009

Reduce your 2008 taxes with an IRA: SEP, traditional and Roth

A look at three popular retirement plans

Wayne Farlow

Are you still looking for ways to reduce your 2008 taxes? Funding an IRA between now and April 15 is one of the few remaining methods to reduce last year’s taxable income. Let’s look at three popular IRAs to determine if a year-end contribution is appropriate for you.

For someone who is self-employed, a SEP IRA is often the best way to reduce your taxable income and save for retirement. If your company is an S or C Corporation, you can contribute up to 25% of your W-2 income to a SEP IRA. With a sole proprietorship or an LLC your maximum contribution is 20% of your income. In either case, the maximum annual contribution is $46,000 for 2008. If you have any employees, you must contribute the same percentage of income for any employee that is over 21, has worked for you for at least 3 years and receives at least $550 in annual compensation.

If you have no self employment income, you may be able to contribute to a traditional, deductible IRA or to a Roth IRA. To determine if you qualify for an IRA contribution, let’s look at the rules for each type of IRA.

To contribute to a traditional IRA, you must be under 70½ years old and you (or your spouse) must have earned income. In 2008, your maximum IRA contribution is $5,000 ($6,000 if you are over age 50). If you are covered by a company retirement plan, you can deduct the maximum amount when your Adjusted Gross Income (AGI) is no more than $53,000 as a single tax payer or $85,000 as a joint filer. If your spouse has no earned income, he or she can contribute the maximum amounts to their own IRA, even when you are covered by a company retirement plan, as long as your AGI is under $159,000.

To contribute to a Roth IRA, your Adjusted Gross Income (AGI) must be less than $101,000 as a single filer or $159,000 as a joint tax filer. Your maximum Roth IRA contribution is $5,000 ($6,000 if you are over age 50). However, if you make any traditional IRA contributions, the maximum Roth contribution amount is reduced by the amount that you contributed to the traditional IRA.

Based on IRS rules, the decision on which IRA to fund is often obvious:
1. If you are not covered by a company retirement plan and, as a single filer have an AGI over $101,000 or as a joint filer have an AGI over $159,000, you can only fund a traditional IRA.
2. If you are covered by a company retirement plan and your AGI is over $85,000 but less than $159,000 as a joint filer or over $53,000 but less than $101,000 as a single filer, you can only fully fund a Roth IRA.
3. If you are over 70½ and have earned income, you can only fund a Roth IRA.
Funding a Roth IRA has the following advantages over a traditional IRA:
1. When buying your first home, a Roth IRA allows the withdrawal $10,000 of growth and income plus all of your contributions, with no taxes or penalties on the withdrawal. 
2. For people under age 40, the tax free growth and withdrawal of funds during retirement often make Roth IRA contributions a better, after-tax choice.
3. When funds are required before age 59½, a Roth IRA typically allows the withdrawal of Roth contributions with no taxes or penalties on the withdrawal.
4.  A Roth IRA in your estate is an excellent method of passing tax free funds to younger generations.

If there are no compelling reasons to chose a Roth over a traditional IRA, decide on whether you wish to reduce your current taxes with a traditional IRA or reduce your taxes during  retirement with a Roth IRA.

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Wayne Farlow is the founder of Financial Abundance, LLC, a Registered Investment Advisor firm.  He is a Certified Financial Planner (CFP®), focusing on Retirement Planning, Investment Management, Small Business Owner Planning and Sudden Wealth/Inheritance Planning.  His book, “Financial Abundance Guide,” is available free at www.farlowfinancial.com .  He can be reached at wayne@farlowfinancial.com or at 303-554-0309.

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