Well you must know by now, it’s not really a safe gamble to fully count on Social Security to fund your retirement years. Anyone with even a bit of financial sense starts planning early for retirement, and diversifies his or her options for the maximum results in old age. That means combining your efforts: Social Security, pension, Individual Retirement Account, and maybe even a little bit of part time work after retirement. You simply can’t be too prepared!
Individual Retirement Accounts (IRAs)
That’s why more and more people are starting IRAs. IRA stands for Individual Retirement Account. It’s a savings account that has a tax-favored status given by the IRS, to encourage Americans to save for retirement.
The tax-favored element comes in two forms, depending on the type of IRA you choose. The type of IRA you choose depends on your current tax bracket and the tax bracket you expect to have once you retire.
Choosing is probably the hardest part of starting an IRA. The rest is easy, aside from choosing how you’d like to invest that money. But these days most financial companies offering IRAs offer target retirement IRAs, to make the choosing easy. But don’t worry if you choose the wrong type of IRA. You can use IRS form 8606 to convert to a Roth IRA.
A Roth IRA is not tax deductible but when you take distributions from it in retirement, those payments will be tax-free. So, if you don’t want to be paying any income tax on your withdrawals when you retire, a Roth IRA might be a good idea.
There are Roth IRA limits: if you are single then you can’t make more than $110,000 in a year. If you are married filing jointly then the Roth Income limit is $183,000. There’s a phaseout period between $173,001 and $183,000.
If however you really need the tax deduction right now, a Traditional IRA might be a worthy consideration. You can deduct the amount of your annual contribution (there is a contribution limit of around $5000 or so, increasing every year). But the tradeoff is that when you take distributions once you retire, you’ll have to pay taxes on the amount you withdraw, as if it were income. But, if you are in a relatively high tax bracket right now and expect to be in a lower tax bracket upon retirement, a Traditional IRA might be for you.
IRS Form 8606 For a Roth Conversion
Now, sometimes you change your mind. If you want to convert from a traditional IRA to a Roth IRA, it’s easy with IRS form 8606. It’s also used if you are rolling your employer-sponsored Traditional IRA to a Roth.
When you roll your money from the traditional IRA to a Roth, you’re moving money that was comprised of pre-tax contributions. That means you haven’t paid any income tax on that money. Therefore, you’ll have to pay income tax on your previous traditional IRA or employee-sponsored IRA contributions if you want to covert them to Roth status.