Roth IRAs are a fairly new investment vehicle when it comes to retirement accounts. Traditional IRAs started back in 1974 as a tax-deferred way for people to save for retirement, even if their employers offer pension plans. Roth IRAs appeared many years later when the Taxpayer Relief Act of 1997 created these new retirement plans. Roth IRAs allow for tax-free rather than simply tax-deferred growth. The account was named after the senator from Delaware that proposed this type of plan and it has been the preferred investment vehicle since then.
How is a Roth IRA different from the much more common traditional IRA? Traditional IRAs are tax deferred, allowing most people to take a tax deduction, depending on eligibility, when a contribution is made. When you reach retirement, distributions from the traditional IRA are included in ordinary income at that time. If you are eligible to make a contribution to a Roth IRA (check with your CPA or tax advisor to find out), you do not get a tax deduction for that contribution. However, this means the distributions in retirement are tax-free and not included in your income. Essentially, with a Roth IRA you pay taxes on the seed (contribution), but the plant (or growth) is tax-free.
If you are ineligible to make a contribution to a Roth account, you are not precluded from taking advantage of the benefits of a Roth IRA. If you have funds in a traditional IRA or similar account (SIMPLE, SEP, 401(k)), you can move the funds in those accounts to a Roth IRA through a conversion. A conversion to a Roth IRA is a taxable event, which generates a 1099R form that is sent to the IRS the year the conversion is made. It is important to note that the taxes cannot be paid by the retirement account. A conversion is taxed to you personally as ordinary income in the year the conversion is made. However, moving forward, the account grows tax-free!
Is a Roth IRA better than a traditional IRA? Will paying taxes now be better than paying them later? Should I convert the entire amount in my traditional IRA to a Roth IRA? All of these questions have different answers depending on your current income, your current tax bracket/rate, your expected tax bracket/rate in retirement, and how close to retirement you are. You should seek the advice of your CPA or tax advisor to find out if a conversion is right for you. Don’t wait until tax season to visit your CPA, though. The deadline for 2014 to convert funds to a Roth IRA is December 31st. Many people don’t see their CPA until January or February and by then, it is too late perform a Roth conversion for the previous year.
If you would like to learn more about the advantages and disadvantages of converting your retirement funds to a Roth IRA, join us for one of our many upcoming events on this subject.
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