Roth IRAs boast big tax advantages
- You make Roth IRA contributions with after-tax dollars.
- Unlike traditional IRAs, there’s no upfront tax break when you contribute to a Roth IRA.
- You can withdraw your contributions at any time, for any reason, without owing taxes or penalties.
- Earnings in your account grow tax-free.
The Internal Revenue Service (IRS) provides a lot of documentation regarding Roth IRA taxes, tax issues, and withdrawals. The rules, however, can be difficult to decipher.
But understanding how your Roth IRA affects your taxes is critical. That’s because 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 don’t get the upfront tax break that other retirement accounts, such as traditional IRAs and 401(k) plans, receive.
These other plans are pre-tax retirement accounts. Your contributions—the money you deposit, up to the limit allowed—lower the amount of your gross income that’s subject to taxes. That effectively lowers the amount of tax you owe for that year. When you start withdrawing funds from these accounts after your retirement, however, you’ll pay taxes on those funds at your ordinary income tax rate.
In contrast, Roth IRA contributions are made with after-tax dollars. 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. You don’t owe any income tax on qualified distributions from your Roth IRA. That’s because you already effectively paid it, back when you made your contributions.
Roth IRA Tax Breaks
Despite the lack of a tax break today, a Roth IRA may end up being a great investment vehicle to minimize your taxes over the long-term.
The further out your retirement date, the greater the chance that personal income tax rates will increase. While it’s hard to predict, your income could be higher and income tax rates could change. If you pay a certain rate today and your tax bracket is higher at retirement, using a Roth IRA will save you money.
Another perk: You don’t pay taxes on the money your Roth IRA earns over the years that you have the account. That means your earnings grow tax-free. With a traditional IRA, you pay income taxes on both your contributions and earnings when you start withdrawing money at retirement.
Are Roth IRA Withdrawals Taxed?
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. In fact, to a certain extent, you can do so without paying taxes or penalties.
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 at any time without tax or penalty. Where it gets tricky is if your withdrawal digs into the account’s investment earnings. That’s anything above the sum total of your contributions, including 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
The 5-Year Rule for Roth IRAs
Withdrawals of contributions made after age 59 ½ are considered normal “qualified distributions.” These aren’t taxed because you paid tax on that money when you first contributed to the Roth IRA. Distributions that include earnings are free of tax too, as long as the account is at least five years old (the “5-year rule”).
If you withdraw money before you’re 59 ½ and it doesn’t exceed your total contributions, you won’t owe taxes (withdrawals of contributions are always tax-free).
If you withdraw earnings before age 59½, you may have to pay both income tax and a 10% penalty. The IRS allows you to withdraw money without penalties in certain situations. 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.