When it comes to retirement planning, it is never too late to start. The truth is, you be able to safely rely on your Social Security benefits. Instead, you should be proactive and create your comprehensive retirement plan now. That way, you can relax and enjoy your retirement the way you always hoped you would. One easy way to get started is by opening Individual Retirement Accounts which can help you start saving and investing in your future. One valuable type of IRA is a Roth IRA. Here is what you need to know.
What is an IRA and how does it work?
An Individual Retirement Account, or IRA, is basically an investment account that provides tax advantages along with a reliable way to save money for retirement. IRAs do not require you to pay taxes on the investment earnings from the account. Instead, these earnings can be reinvested and compounded so that your account will experience as much growth as possible. Then, after you reach retirement age and start making withdrawals from your IRA, the tax consequences depend on three factors. Those factors include the type of IRA you have, your present income and the amount of your withdrawals. In 2016, the maximum contribution for a Roth IRA is $5,500, for individuals under the age of 50. For those over age 50, the limit is $6,500.
Types of IRAs from which you can choose
There are essentially four different kinds of IRAs, each with its own advantages. Traditional IRAs and Roth IRAs are opened by individuals, as opposed to Simplified Employee Pension (SEP) and a Savings Incentive Match Plan for Employees (SIMPLE) are made available through employers. Regardless, all IRAs are considered “fully vested.” This means that all contributions and earnings belong to the individual, even those contributions made by their employers.
How is a Roth IRA different from a traditional one?
A traditional IRA is different from a Roth IRA because it is funded with “pre-tax” dollars. That means you do not pay any taxes on your contributions or the interest those contributions earn until you start taking withdrawals during your retirement. At that point, each withdrawal you make is taxed as ordinary income.
On the other hand, a Roth IRA is funded with “after-tax” dollars. A Roth IRA does not provide any tax benefits relating to contributions. But, the earnings and withdrawals from Roth IRAs are generally tax-free. A major benefit of a Roth IRA is that, not only are your earnings allowed to increase tax-free, but when you retire and begin receiving withdrawals, you do not pay income taxes. Essentially, you can avoid taxes when you contribute to a traditional IRA, but you avoid taxes with a Roth IRA when you withdraw money at retirement.
Why you should consider converting to a Roth IRA
Converting to a Roth IRA can be an attractive option, especially if you expect your tax rate to increase in the future. Another benefit is that, when your earnings are too high to allow you to contribute to a Roth IRA directly, you may be able to use a Roth conversion as another means to provide tax free retirement income.
When should you make the conversion?
Typically, those whose income is too high to contribute to a Roth IRA in a particular year, but who anticipate being in a higher tax bracket when they retire, benefit the most from converting to a Roth IRA. Something else to consider is how much you intend to convert, in addition to your income for the current year. You need to make sure the combined amount will not result in a substantial tax burden. If the conversion results in placing you in a higher tax bracket or subjecting you to additional taxes then it may not be the best idea.
The process of converting to a Roth IRA
The easiest way to convert is by making a direct trustee-to-trustee transfer from one financial institution to another. If you intend to keep the retirement account at the same investment firm, on the other hand, you can request that your traditional IRA be re-designated as a Roth IRA, as opposed to opening a new account. You can do the same thing with a 401(k) or an employer-sponsored plan. However, be sure that the funds are transferred directly from one financial institution to the other.
If you have questions regarding estate planning needs, contact the Northern California Center for Estate Planning and Elder Law for a consultation, either online or by calling us at (916) 437-3500.