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IRA Battle: Roth vs. Traditional

It is a new year and tax time is coming sooner than you think. It is always a good time of year to evaluate your possiible tax savings for next year. One way to lower your tax liability is to contribute money to tax-deferred retirement savings, including 401(k)/403(b) or individual retirement accounts (IRAs). Coupled with medical benefit premiums and flexible spending accounts, these tools let you take a big stab at your adjusted gross income (AGI). However, you may be best served by paying taxes now, and skipping them later by contributing to after-tax retirement accounts, like a Roth IRA.

In 1929, total government spending (federal, state, and local combined) was only about ten percent of the gross domestic product (GDP). Today, government spending is about 20 percent for federal, and ten percent for state and local, amounting to about 30 percent of the gross domestic product. Given this trend, along with our relatively low tax brackets, do you think that you are likely to be in lower tax bracket when you retire? Shake the magic eight ball... doubtful.

What are we to do? Well, many companies sponsor 401(k) plans that accumulate pre-tax funds. When you draw on these funds, you will pay taxes in your current tax bracket. Many financial advisors claim that you are likely to be in a lower tax bracket when you retire, as your expenses will be less. But, as we have witnessed, this may not be the case. Our only option is to diversify our retirement earnings between pre-tax and after-tax plans. Enter the Roth IRA.

You may be familiar with the Roth IRA, you may not. Roth IRAs are different from Tradional, or Contributory, IRAs in one fundamental way: it is created with after-tax funds. So, instead of taking a deduction today for your contributions, you pay your taxes and then contribute. This has some obvious downsides, but one nice advantage: you never pay any taxes on your withdrawals. You already paid taxes on your contributions, so now you get to keep your returns tax free as well.

In addition, there is now a Roth 401(k) that is being offered by some companies. However, I would not put all of my eggs in one basket. You need something to keep your taxes low today, as well as something to keep them low tomorrow. Stick with a traditional 401(k), up to your employers point of match, and anything you would like to contribute beyond that, put it in a Roth IRA.

Currently, 401(k) accounts have an annual limit of $15,000 (for 2006, up $1,000 from 2005). IRA accounts have an annual limit of $4,000, through 2007. Get the free money that your employer offers with the 401(k), deduct your benefit premiums, and setup a flexible spending account. Then, use after-tax funds and setup a Roth IRA.

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