Traditional IRAs and retirement plans sponsored by employers are great retirement investment tools. While there are benefits associated with these types of retirement accounts, Roth IRA benefits should also be considered before determining which type of plan is right for you. In reality, the benefits of converting to a Roth IRA may be even better. You can choose to either transfer all or some of your existing retirement account to a new Roth IRA, and you can do so without regard to your income.
What is an IRA and how does it work?
An IRA is essentially an investment account with several tax advantages that provides a reliable way to save money for retirement. Whether you have a traditional or Roth IRA, you will not be required to pay taxes on any earnings for the retirement account. Instead, the earnings can be reinvested and compound on a tax-deferred basis to experience even more growth. Once you reach retirement age and begin to make withdrawals from your IRA, your tax obligation will depend on three factors: the type of IRA you have, your present income and the amount of your withdrawals.
The different types of IRAs
There are four different types of IRAs, each with its own benefits. The first two, Traditional IRAs and Roth IRAs, are created by individuals. Both a Simplified Employee Pension (SEP) and a Savings Incentive Match Plan for Employees (SIMPLE) are made available through an employer. All IRAs are “fully vested,” which means that all contributions and earnings belong to the individual, including those contributions made by their employers.
How is a Roth IRA different?
Each type of IRA has its own eligibility requirements based on certain income limits. Anyone with earned income who is younger than 70 ½-years-old can make contributions to a Traditional IRA. With a Roth IRA, however, there are income limitations on your ability to make contributions. For single filers in 2017, that income threshold starts at $118,000 (up from $117,000) and ends at $133,000 (up from $132,000). In that range, your contribution is limited, eventually reaching zero. For married filers in 2016, that income threshold starts at $186,000 (up from $184,000) and ends at $196,000 (up from $194,000). “Earned income” refers to the money an individual is paid to work, which includes wages, salaries, tips, bonuses, commissions, and self-employment income.
Basic Roth IRA benefits
If there is a chance that your income tax rate may increase in the future, then converting to a Roth IRA should be considered. When your earnings are currently too high to qualify for making contributions to a Roth IRA, you can accomplish the same goal by converting to a Roth IRA instead. There are no income limitations on Roth IRA conversions. Roth IRA benefits mean you can enjoy tax free retirement income – an obvious benefit.
One consideration, though, is whether the amount you plan to convert, when coupled with your current year’s income, will create a significant tax burden. In other words, if the conversion will cause you to be placed in a higher income tax bracket, or subject you to unnecessary taxes, then you may want to reconsider.
How to convert to a Roth IRA
The easiest way to convert a retirement account to a Roth IRA is to make a direct trustee-to-trustee transfer between financial institutions. Or, if you keep the retirement account at the same investment firm, you would simply request that your traditional IRA is re-designated as a Roth IRA. That way you do not need to open a new account.
If you are issued a check by your financial institution, you must withhold 20% of the amount for tax purposes. As long as you deposit all of the funds, including amount withheld, into the new Roth account within 60 days, you will not incur any penalty. Otherwise, you may be subject to a 10% early withdrawal penalty, if you are younger than 59 ½ and no exception to the early withdrawal penalty applies. The penalty will be imposed in addition to the income taxes you already owe on the entire converted balance.
Differences in Tax Incentives between Traditional and Roth IRAs
Traditional IRA contributions are tax deductible during the year you make the contribution. However, withdrawals from a Traditional IRA, during retirement, are taxed at ordinary income tax rates. Roth IRAs do not provide a tax break on contributions, but instead, the earnings and withdrawals are tax-free. So, you can avoid taxes when you contribute to a traditional IRA, while you avoid taxes when you withdraw from a Roth IRA during retirement.
It is never too late to start planning for your retirement. It could be a mistake to rely solely on your Social Security benefits to provide a comfortable retirement. Be proactive and make a comprehensive retirement plan now, so that you can relax in your golden years.
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