They're considerable, when it comes to taxes
- Contributions are the money you deposit into an IRA while earnings are the profits you receive on those IRA contributions.
- Earnings in IRAs grow tax-free while in the account.
- If you have a Roth IRA, you pay taxes when you deposit your contributions. You never pay taxes on contributions, and none on earnings after age 59½.
- If you have a traditional IRA, you get a tax deduction on your contributions. When you withdraw the funds, you pay taxes on both your contributions and all the earnings they have made over the years.
IRA contributions and earnings sound very similar. Both represent money flowing into your account. But if you ask the IRS, they aren’t similar at all. If you don’t know the difference, you could find yourself with a hefty tax bill.
An IRA contribution is money that you deposit into an IRA account. That could be automatic deductions from a paycheck or transfers from your bank account if you’re contributing, say, freelance earnings. The money you’re allowed to put into an IRA has to be earned: employment or business income. You can’t have made it from, say, investments.
The IRS sets limits on how much you can contribute to your IRA each year. In 2019, you can contribute up to $6,000 if you’re under the age of 50 or $7,000 if you’re 50 or older. Why do you get an extra $1,000 if you’re 50 and older? The IRS calls these catch-up contributions. If you’re of an age when there are fewer years ahead of you than behind you until retirement, and your account balance isn’t where you’d like it to be, you can “catch up” by contributing more into your account.
IRA contributions might be tax-deductible depending on the type of IRA you have. Roth IRA contributions are not tax-deductible, but contributions to a traditional IRA generally are, at the state and federal level.
How much of your contribution to a traditional IRA is deductible might be limited if you or your spouse are part of a retirement plan from an employer. You might also be limited based on your annual income. Roth IRA income eligibility limits are not affected by whether you (or your spouse) has an employer retirement plan.
If you have a Roth, here’s the other important thing about tracking your contributions: Because your contributions are already taxed before they enter a Roth IRA, you can withdraw those contributions (or, strictly speaking, an amount equivalent to them) at any time without a penalty or paying taxes on the funds again.
Traditional IRAs are more complicated. You can withdraw non-deductible contributions tax- and penalty-free at any time, but other contributions are hit with taxes and penalties if taken before age 59½. Certain exceptions apply in certain circumstances.
The reason you deposit money into investment accounts is to get that money earning for you. Your earnings include the income or interest paid by your investments and the profits you make from selling them.
Earnings generated in either a Roth or traditional IRA grow tax-free, as long as they remain in the account. And in both accounts, you can only withdraw earnings on or after age 59½; if you take them before that, you are subject to a penalty of 10% of the withdrawn sum—the distribution, in IRS-speak— along with regular tax due on them, unless certain exceptional situations apply.
But after age 59½, the tax treatment diverges, based on what sort of account you have. In a traditional IRA, both earnings and contributions are taxed at your income tax rate at the time of withdrawal. In a Roth IRA, no tax is due on the earnings, if the account is at least five years old. You get the break because you paid upfront, so to speak: when you made the after-tax contribution that generated those earnings.
How They Affect Taxes
When deciding between a traditional or Roth IRA, the earnings portion is where you should put the most thought. Do you believe that your earnings will be considerably higher once you reach retirement age—along with your tax bracket? If you do, a Roth IRA might be a better choice.
The reason: Paying taxes at your current tax rate might be a smaller tax burden than waiting until later in life when you’re in a higher tax bracket. Also, if you believe that state and federal governments will increase tax rates in the future, you might want to pay the taxes at the current rates.
On the other hand, if you think your income, and your income tax bracket, will be substantially less in your retirement years than it is now, the traditional IRA might be the way to go. Pay the tax man when the tax bite is smaller.
Important: Traditional IRAs mandate required minimum distributions (RMDs) starting at age 70½. Counting as taxable income, they can bump you into a higher tax bracket.
The Bottom Line
IRAs aren’t completely free of tax. The IRS taxes all income, sooner or later. The key question is when it collects—on the front end or the back end. If you pay taxes on contributions to an account, as you do with a Roth IRA, you don’t pay them on distributions from that account. Conversely, when you don’t pay taxes on contributions to an account, as with traditional IRAs, then the bill comes due on the distributions from that account.
It’s only a matter of when the taxes are due, but the timing of those withdrawals can represent large differences in the amount of tax you end up paying.