The IRS collects taxes on the money you earn, even the deferred amounts such as retirement account contributions, eventually. With a traditional IRA, you defer taxes on the amount you save in the IRA until you begin withdrawing from the IRA after your retirement. A Roth IRA allows you to pay taxes on your contributions now and withdraw them later tax-free. You can also convert existing IRAs to Roth IRAs, though you'll pay taxes at the time of conversion.
Now or Later
Whether it's better to pay now or letter depends on your tax situation. If you think you'll be in a lower tax bracket when you retire, paying later makes sense. But if you worry about ever-rising taxes and think you could end up paying more if you wait, opening a Roth IRA could be the better bet. In a traditional IRA, you'll pay taxes on the money your IRA has earned since you deposited it, while with a Roth IRA, the money in your IRA grows tax-free. Online calculators allow you to compute the advantages and disadvantages of converting under different scenarios to determine the most beneficial move for you.
If you decide to convert your traditional IRA to a Roth IRA, contact the financial institution that holds your traditional IRA. You can open a Roth IRA with that institution or with a different financial institution. In either case, the financial institution that holds the traditional IRA should take care of transferring the funds to your Roth IRA.
The amount of the IRA you convert adds to your adjusted gross income for the year. You pay taxes according to the tax bracket into which you fall. To estimate the tax you owe, multiply the amount of the IRA you plan to convert, plus any additional contributions you intend to make to the Roth this year, by your tax amount. If the amount you convert pushes you into a higher tax bracket, you'll end up paying more. Don't forget you'll owe state taxes on the amount you convert also, if you live in a state with state income tax.
In 2010, the IRS allowed taxpayers who converted regular IRAs to Roth IRAs to split the tax bill and pay it out in 2011 and 2012. This benefit has not yet been extended to other tax years, but it could be, so consult the IRS or a tax professional about the rules for your tax year. Report your conversion on Form 8606 -- Nondeductible IRAs.
Cynthia Myers is the author of numerous novels and her nonfiction work has appeared in publications ranging from "Historic Traveler" to "Texas Highways" to "Medical Practice Management." She has a degree in economics from Sam Houston State University.