There are four kinds of IRAs with various benefits. Traditional and Roth IRAs are established by individuals, whereas Simplified Employee Pensions (SEPs) and Savings Incentive Match Plan for Employees (SIMPLE) are sponsored by employers. Regardless of the type you choose, all IRAs are “fully vested.” This means all of the contributions you make and earnings you accumulate belong to you, including the contributions made by your employers. If you are considering opening a Roth IRA, here is what you need to know.
First, how a typical IRA works
An Individual Retirement Account (or IRA), is basically a type of investment account for retirement that offers special tax advantages. For instance, you are not required to pay taxes on the earnings from an IRA. Instead, those earnings are reinvested and compounded so the account can grow as much as possible, tax free. Then, after you have reached retirement age, you can begin taking withdrawals from your IRA. At that point, there are three factors that will affect the possible tax consequences. Those factors include the type of IRA you have, the amount of your present income and the amount of the withdrawal you ultimately make.
The different types of IRAs
There are generally four different types of IRAs and each type has its own benefits. Traditional IRAs and Roth IRAs are the two types of IRA accounts that are opened by individuals. Simplified Employee Pension (SEP) and a Savings Incentive Match Plan for Employees (SIMPLE) are the types of IRAs that are made available through an employer. Every one of these IRAs are considered “fully vested,” meaning that all of the contributions and earnings belong to the individual, even the contributions made by their employers.
How is a Roth IRA different from other kinds of IRAs?
Each type of IRA has its own specific eligibility requirements. Those requirements are generally based on the amount of the account holder’s income. If you need to make contributions to a traditional IRA, you must have earned income and be younger than 70½-years-old. On the other hand, a Roth IRA will only allow you to make contributions when your income fits within certain limits. Earned income is basically the money you are paid to work. That includes your wages, salaries, tips, bonuses, commissions, and self-employment income.
There are different tax incentives for traditional and Roth IRAs
Contributions that are made to traditional IRAs can be deducted from your taxes at both the state and federal level. These deductions must be made during the same year the contribution was made. On the other hand, withdrawals made during your retirement are taxed at the ordinary income tax rates. Roth IRAs do not provide a tax break on contributions. Instead, the earnings and withdrawals are tax-free, which means you can avoid taxes when you deposit money into a traditional IRA, and you avoid taxes when you withdraw money from a Roth IRA during retirement.
Consider converting to a Roth IRA
Even if you already have a traditional IRA, you may not realize that you have other options available, such as converting your traditional IRA to a Roth IRA. You can also make this conversion with an employer-sponsored IRA. In fact, it is rather easy to make this conversion and there are so many benefits in doing so. Regardless of whether you are looking to transfer your entire retirement account balance or just a portion of the funds, here is what you need to know about converting to a Roth IRA.
Common reasons to consider converting to a Roth IRA
Converting a traditional IRA to a Roth IRA can be a wise choice, especially when you anticipate that your tax rate might increase in the future. If your earnings are too high for you to be eligible to contribute to a Roth IRA directly, you might be able to use the conversion of your Roth IRA as a method of providing tax free retirement income.
How to complete a conversion to a Roth IRA
The easiest way to convert to a Roth IRA is to create a direct trustee-to-trustee transfer from one financial institution to another. An even easier way, if you keep the Roth IRA at the same investment firm or institution as the other, is to simply request that the traditional IRA be re-designated as a Roth IRA. That keeps you from having to open a new account. The same can be done with a 401k or an employer-sponsored retirement plan. Be sure, though, that the funds are transferred directly without any distributions being made. Otherwise, there will likely be penalties.
If you are issued a check for the account proceeds, as part of the conversion, then the financial institution is required to withhold 20% of that amount for tax purposes. On the other hand, as long as you deposit the entire amount, including the 20%, back into a new Roth account within 60 days, there shouldn’t be a penalty. If you cannot make the deadline, any funds that are not rolled over into a Roth IRA will be subject to the 10% early withdrawal penalty if you are younger than age 59 1/2.
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