The Internal Revenue Service provides a lot of documentation on Roth IRA taxes, tax issues, and withdrawals. That documentation can be quite confusing to decipher.
But understanding how your Roth IRA will affect your income tax return is critical, since one of the most significant benefits of using Roth IRAs involves the tax breaks you get.
Are Roth IRA Contributions Taxed?
In a sense, yes. Roth IRAs do not receive the upfront tax break that other retirement accounts, such as Traditional IRAs and 401(k) plans, receive. With these plans, technically known as pre-tax retirement accounts, your contributions—the money you deposit, up to the limit allowed—lower the amount of your gross income that is subject to taxes, thus effectively lowering the amount of tax you owe, in the year you make them. However, when you start withdrawing funds from these accounts after your retirement, you will pay taxes on those funds, at your ordinary income tax rate at that time.
In contrast, Roth IRA contributions are made with after-tax dollars. That is, they don’t reduce the amount of your gross income, or your tax bill, the year you make them. The tax benefit you get comes at retirement, when you don’t owe any income tax on the money you withdraw from your Roth IRA—because you already effectively paid it, back when you made the contribution.
Roth IRA Tax Break
Despite the lack of a tax break today, a Roth IRA may end up being a great investment vehicle to minimize your taxes over a long period of time. The further out your retirement date, the greater the chance that personal income tax rates will increase (either because your income will have increased, or the federal government will have imposed higher rates, or both). If you pay at a certain rate today and your tax bracket is higher at retirement, using a Roth IRA will have saved you money.
Another benefit of using a Roth IRA over one of the pre-tax retirement accounts is accessibility: The rules for withdrawing funds are a lot more liberal, compared to those for Traditional IRAs or 401(k)s. In fact, to a certain extent, you can do so without paying taxes or penalties. Let’s look at the regs more closely.
A third benefit is that you pay no taxes on the money your Roth IRA earns over the years that you have the account. With a Traditional IRA, you do pay income taxes on both your contributions and their earnings when you start withdrawing money at retirement.
Are Roth IRA Withdrawals Taxed?
Whether or not your Roth IRA withdrawal—officially known as a distribution—is taxed depends on a few factors. In general, you can withdraw your contributions (that is, a sum equivalent to the amount you’ve invested in the Roth IRA) at any time without tax or penalty. Where it gets tricky is if your withdrawal digs into the account’s investment earnings (anything above the sum total of your contributions: interest, dividends, capital gains, etc.). Additional factors include:
- How old you are when the withdrawal is made
- How long the funds have been in the Roth IRA
- The purpose of the withdrawal
Withdrawals of contributions made after age 59½ are considered normal “qualified distributions” and are not taxed. We said it before and we’ll say it again: You paid tax on that money when you first contributed to the Roth IRA. Distributions that include earnings are free of tax too; however, the Roth IRA must have been established for at least five years before they can be withdrawn.
If the withdrawal is made before age 59½ and doesn’t exceed the amount that has been contributed to the Roth IRA over the years, then no income tax is charged. As stated earlier, withdrawals of contributions are tax-free.
If the withdrawal is made before age 59½ and includes earnings, then you may have to pay both income tax and a 10% penalty. There are certain situations under which the IRS will allow you to withdraw without penalty, however. Funds can be distributed for higher education expenses or to buy a home. Certain hardship circumstances, such as permanent disability, also allow funds to be withdrawn tax- and penalty-free.