IRAs primarily come in two flavors: traditional IRAs and Roth IRAs. The biggest difference between the two types of IRAs is when the money funding the account is taxed. With traditional IRAs, you pay no taxes on the money you put into the account, but you do pay taxes when you take money out. Roth accounts are the other way around; you pay taxes on the contributions you make, but not on the money as you take it out (assuming you're at least 59 1/2 and have had the account for at least five years). Roth IRAs have one other significant benefit: Unlike traditional IRAs, there are no required minimum distributions from a Roth IRA. That means you can choose to take the money out on your own schedule, not the IRS's.
Deciding which type of IRA is best for you hinges largely on whether you will get a better deal by being taxed on the money going in, or on the money coming out. Sometimes, a traditional IRA will look like a better idea at first, but then you'll realize that you are better off with a Roth IRA instead. In that case, there's a simple fix: Convert your traditional IRA to a Roth IRA.
With both types of IRAs, the funds are taxed at your income tax rate for the year. Thus, if you think you are at a higher (taxable) income level now than you will be when you retire, a traditional IRA is a better choice. However, if you think you'll be in a higher tax bracket after retirement, a Roth IRA would save you money on taxes. And there's another factor to consider: Social Security benefits may or may not be taxed depending on how much taxable income you have during the year. If you're taking distributions from a Roth IRA, you're much less likely to end up paying tax on your Social Security benefits than if you're taking distributions from a traditional IRA.
If you've decided to convert your traditional IRA to a Roth IRA, the next question to ask is when to do it. Because you haven't paid taxes yet on the money that's now sitting in your traditional IRA, you'll have to pay taxes on that money when you convert the account to a Roth IRA. If you have a lot of money in your IRA, this can result in a significant tax bill.
Ideally, you should time the conversion for a year when you can afford to pay the taxes and when it will have minimal impact on your overall tax situation. For example, moving thousands of dollars from a traditional to a Roth IRA might well push you into a higher tax bracket and force you to pay even more extra taxes that year. Or, the extra income might make you ineligible for certain deductions and credits you'd planned to claim. If you're careful about timing the conversion, you can avoid these kinds of problems.
Another option is to convert the funds over several years. You don't have to do the entire account at once; you can open a new Roth IRA and slowly move the money from the traditional to the Roth account, thereby spreading out the tax impact over a few years. However, do keep in mind that the sooner the money's in the Roth IRA, the more time it has to grow tax-free.
Before you decide to convert to a Roth IRA, you should be aware of one important limitation on these accounts. In order to make contributions to a Roth IRA, your income must be below a certain amount based on your filing status (single, married filing jointly, etc.). You can still convert a traditional IRA to a Roth IRA if you're above this income level, but you won't be able to make direct contributions to the Roth IRA in the future unless your income drops below the limit. Of course, you always have the option of opening a new traditional IRA and putting your contributions there instead. Indeed, having both types of IRAs can give you considerable flexibility with distributions and tax management -- really, it's the best of both worlds.
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