The Internal Revenue Service provides a lot of documentation surrounding taxes, retirement and Roth IRAs. That documentation is usually very long and can be quite confusing to decipher.
One of the most significant benefits of using Roth IRAs is tied in with income taxes. Understanding how your Roth IRA will affect your tax return is critical.
Are Roth IRA Contributions Taxed?
You don’t pay a tax on your Roth IRA contributions at the time you contribute the funds to your Roth IRA. However, your contributions come from your post-tax income so you have already paid taxes on them. The tax benefit you get comes at retirement, when you don’t have to pay any taxes on the money you withdraw from your Roth IRA.
Roth IRA Tax Break
Roth IRAs do not receive the tax break that pre-tax retirement accounts, such as Traditional IRAs and 401(k) plans, receive. As long as you contribute the legal amount, the money you put into a pre-tax retirement account lowers the amount of your income that is subject to income tax. However, when the funds are withdrawn in retirement, you will pay taxes at your ordinary income tax rate.
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. If you lock in paying a certain rate today and your personal tax rate is higher at retirement, using a Roth IRA will have saved you money.
With or without a tax break, another benefit of using a Roth IRA over pre-tax investment vehicles like Traditional IRAs is that you can withdraw your contributions (not your earnings on those contributions) at any point without paying taxes or fees.
Are Roth IRA Withdrawals Taxed?
Whether or not your withdrawal from a Roth IRA is taxed depends on a few factors. To avoid being taxed, the funds must have been in the Roth IRA for at least five years before they can be withdrawn. Additional factors include:
- How old you are when the withdrawal is made
- Whether the withdrawal is from contributions alone or if it includes earnings
- What purpose the withdrawal is made for
Withdrawals made after age 59½ are normal retirement withdrawals and are not taxed. You paid tax on that income when you first contributed to the Roth IRA.
If the withdrawal is made before age 59½ and is only up to the amount that has been contributed to the Roth IRA, then no income tax is charged. Withdrawals of contributions are tax-free.
If the withdrawal was made before age 59½ and includes more than what you contributed (your investment earnings), then you may have to pay tax. There are certain situations under which the IRS will allow you to withdraw without penalty. Funds can be withdrawn 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.