A popular and efficient way to stretch your retirement dollars is to take advantage of the tax benefits offered by Roth individual retirement accounts (IRAs). However, to maximize these advantages, you need to know how Roth IRAs are taxed. Here’s a breakdown of taxation for Roth IRA contributions, earnings and withdrawals; and a comparison with taxation for traditional IRAs. A financial advisor could also guide you in other retirement planning decisions.
Understanding Roth IRA Taxes
Unlike other retirement accounts, Roth IRAs have a unique feature: They operate with after-tax dollars, meaning you’ve already settled your tax dues on the amount you invest into the account.
The Internal Revenue Code (IRC) sets rules for Roth IRAs. Here are five things you should know about Roth IRA taxes:
-
Contributions: Since you contribute to a Roth IRA with money that you’ve already paid income tax on, your contributions are not tax-deductible in the year you make them.
-
Tax-free growth: Once the money is inside the Roth IRA account, it grows tax-free. This means you won’t owe any taxes on the earnings, dividends, or capital gains generated within the account as long as you follow IRS rules.
-
Qualified withdrawals: The main advantage of a Roth IRA is that qualified withdrawals in retirement are tax-free. To be considered qualified, the withdrawal must be made after age 59½ and the account must have been open for at least five tax years. If you meet these requirements, both your contributions and your earnings will be tax-free.
-
Non-qualified withdrawals: If you withdraw money from a Roth IRA before meeting the qualifying criteria (before age 59½ and before the account has been open for at least five years), the earnings portion of the withdrawal may be subject to income tax and an additional 10% penalty tax. Some exceptions can be applied, if you withdraw the money for certain medical expenses or first-time home purchase.
-
No required minimum distributions (RMDs): Unlike traditional IRAs and other retirement accounts that compel you to withdraw from your retirement accounts at age of 73, Roth IRAs do not mandate minimum distributions at any age. This means you can leave the money in the account to continue growing tax-free for as long as you want during your lifetime.
Understanding Roth IRA Contribution Taxes
Paying taxes on Roth IRA contributions upfront might seem counterintuitive. But in the long run, this strategy could pay off big as both your contributions and withdrawals will be tax-free (refer to IRS rules in the section above again for requirements).
So if you make consistent annual contributions of $6,500 starting at age 25, and see a 6% annual return, this can grow to over $1 million tax-free dollars by age 65.
Another common reason to open a Roth IRA account early: If you’re currently in a lower tax bracket and expect to make more money later on, then it could make more sense for you to contribute to a Roth IRA now.
In this scenario, if you are in the 22% tax bracket during your work life and foresee a jump to the 32% bracket by the time you retire, you could benefit from that lower tax rate on your contributions now then if you made contributions later on.
Roth IRA Taxes vs. Traditional IRA Taxes
Understanding the key tax differences for both Roth and traditional IRAs will help you strategize when to use either account.
For traditional IRAs, you can get a tax deduction for contributions made today and pay income taxes on withdrawals later. For Roth IRAs, you can pay taxes on contributions upfront, and benefit from tax-free growth and withdrawals during your retirement.
Here’s a table with a fuller tax breakdown for each account:
Aspect |
Roth IRA Taxes |
Traditional IRA Taxes |
---|---|---|
Contributions |
Made with after-tax dollars, not tax-deductible |
Made with pre-tax dollars, may be tax-deductible |
Taxation of Growth |
Earnings grow tax-free within the account |
Investments grow tax-deferred, taxes paid upon withdrawal |
Withdrawals |
Qualified withdrawals (after age 59½, account open 5+ years) are tax-free, including contributions and earnings |
Subject to ordinary income tax rates upon withdrawal, including contributions, earnings and deductible contributions |
Required Minimum Distributions (RMDs) |
No RMDs during the original account holder’s lifetime |
RMDs must begin by age 73 |
Penalty on Early Withdrawals |
Earnings portion of non-qualified withdrawals subject to income tax and an additional 10% penalty, unless exceptions apply |
Withdrawals before age 59½ may be subject to income tax and an additional 10% early withdrawal penalty, unless exceptions apply |
Bottom Line
Roth IRAs can offer tax-free growth and withdrawals, no minimum distributions and other tax benefits that can be particularly advantageous for those who expect to be in a higher tax bracket in retirement. However, you should carefully consider your individual tax situation and retirement goals when deciding on a Roth or traditional IRA.
Tips for Tax Planning
-
A financial advisor who specializes in taxes can help you properly plan for certain tax situations while making a long-term tax plan. This can save you money and open up new investment opportunities. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
-
You can also use a federal income tax calculator to estimate how much tax you might owe for the upcoming tax year.
Photo credit: ©iStock.com/Dean Mitchell, ©iStock.com/izusek, ©iStock.com/Hirurg
The post How a Roth IRA Is Taxed appeared first on SmartReads by SmartAsset.