The Washington Post reported on Friday that the move would signal a handing over of responsibility of dealing with Iraq from the Pentagon to the State Department.
The mission will help coordinate efforts to hold elections and usher in a democratic government in the country.
"The real challenge for the new embassy, so to speak, or the new presence will be helping the Iraqi people get ready for their full elections and full constitution the following year," Secretary of State Colin Powell told The Post in an interview this week.
"That's going to be a major effort on our part."
One of the first steps would be resuming diplomatic relations between Washington and Baghdad.
Although the United States is the occupying power in Iraq, the two countries have still not resumed diplomatic relations, which were severed after Iraq's 1990 invasion of Kuwait.
The US embassy in Egypt has a larger presence with more than 7,000 personnel but this includes many non-diplomats from other US agencies, including, for example, two members of the US Library of Congress who collect foreign books.
The Baghdad embassy will have the largest US diplomatic staff anywhere in the world, The Post quoted State Department officials as saying.
The United States is planning to build a new embassy, it added, with construction expected to take three to five years.