'Mellody's Mail': Tax-Smart Retirement

— -- Q U E S T I O N: How much of your current income should you target at retirement and are there any ways to keep that tax-free?

A N S W E R: This is an excellent question. If you have an employer-sponsored retirement plan, such as a 401(k) plan, if you can you should aim to contribute the maximum amount allowed by your plan. The maximum amount you can contribute each year is the lower of (a) the highest percentage of your salary which your plan allows you to contribute or (b) $13,000 for 2004 (this amount increases to $14,000 in 2005 and $15,000 in 2006).

For example, if your employer allows you to contribute up to 10 percent of your salary each year to your 401(k) plan, and you earn $40,000, the maximum amount you can contribute is $4,000 annually. Keep in mind, if you are age 50 or older, you also may be eligible to contribute an additional $3,000 to your 401(k) plan if your employer permits such contributions.

There are several tax advantages to contributing to an employer-sponsored retirement plan. Specifically, your contributions are made with pre-tax dollars, meaning you taxable income is reduced by the amount you contribute. For example, if you earn $40,000 per year and defer 5 percent of your salary ($2,000) to your 401(k) plan, you would only be taxed on the remaining $38,000.

An additional benefit to a 401(k) plan is tax-deferred growth, meaning you do not have to pay taxes on the contributions or earnings until you make withdrawals. You become eligible for withdrawals at age 59½, at which point your withdrawals are subject to ordinary income taxes. In retirement, your income will likely be lower thus reducing the amount of taxes you would have to pay — an important benefit of deferring your investment related taxes.

In addition to investing in an employer-sponsored retirement plan, you can also invest in a Traditional IRA or Roth IRA. If you meet the income requirements, I would recommend a Roth IRA which allows you to save an additional $3,000 for your retirement in 2004. To participate in a Roth IRA, your adjusted gross income cannot exceed $95,000 for single filers and $150,000 for joint filers. Unlike contributions to a 401(k) plan, contributions to a Roth IRA are made with after-tax dollars.