Investors have different accounts they use to build a retirement.
Most use a traditional IRA or a 401(k); some use a Roth IRA (Individual Retirement Account).
The Roth IRA is quickly becoming one of the most popular choices because of the tax advantage when either used as income or inherited by a named beneficiary.
The big difference between the Roth IRA and other retirement accounts is that rather than receiving a tax break for monies placed into the account, you receive the tax break when you withdraw the money.
Why is this difference significant? Like any other choice based around tax issues, the more funds that have a tax advantage, the better the net results. Using a Roth IRA’s long-term accumulation allows for blending this tax-free income with other assets which may have more tax liability.
In your earning years, you can afford more tax, funds paid into a Roth IRA are not allowed a deduction as would be the case in a traditional IRA. The difference between a traditional IRA and a Roth IRA is about these deductions. A traditional IRA allows for the participant to deduct contributions BUT income removed at a later date is fully taxable as income. The Roth IRA adds the dimension of no decoctions but a completely tax-free income when removed from the account.
When you retire, you want every penny you can get tax free. Put simply, pay your tax as you go while you’re working, not taxes when you retire.
The Internal Revenue Service has recently allowed investors to convert traditional retirement accounts to Roth IRAs. Until just recently only employer-sponsored (403 (b), 401k and governmental 457 (b) retirement plans could be converted to a Roth IRA. This was allowed for investors who had funds in a former employer’s plan or those aged 59½ or older.
The American Taxpayer Relief Act of 2012 relaxed conversions to make transfers for all kinds of retirement accounts legal and easy. Faced with the possibility of a giant tax bill in converting a traditional IRA to a Roth IRA can seem overwhelming, but the benefit is the conversion is a tax-free income later in life.
Also, conversions from the traditional IRA can also be spread over several tax years, thus reducing the burden across the time span. This conversion requires a small amount of management, but it is easy to accomplish. Your current IRA custodial can assist you in the transfer.
The “hold” rule should also be considered. To qualify for the tax-free and penalty-free withdrawal of earnings, a Roth account must meet the five-year holding requirement which means the funds must be held for 5 years before income is removed.
To tax now or tax later, that is the question. The answer is fundamental and depends on your situation. A general rule of thumb is if you have at least 10 years before accessing income, it makes sense to consider the conversion.