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; comprehension of how your Roth IRA will affect your tax return is critical.
Are Roth IRA Contributions Taxed?
Roth IRA contributions are not taxed at the time you contribute the funds to your Roth IRA. However, your contributions come from post-tax income. You pay taxes on your income today, but not in the future.
Roth IRA Tax Break
Roth IRAs do not receive a tax break that pre-tax retirement accounts such as Traditional IRAs and 401k plans receive. Pre-tax retirement accounts are funded with income that has not been taxed. These plans avoid paying tax today, but must pay income tax when he funds are withdrawn in retirement.
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 chance personal income tax rates will increase. If you lock in paying a certain rate today and your personal tax rate is higher at retirement then 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 you can withdraw your contributions (not earnings) at any point without paying taxes or fees.
Are Roth IRA Withdrawals Taxed?
Whether or not your withdrawal from a Roth IRA is taxes depends on a few factors. First, the funds must have been in the Roth IRA for at least five years before they can be withdrawn. Additional factors include:
- When the withdrawal was made
- Whether the withdrawal was from contributions alone or if it included earnings
- What purpose the withdrawal was made for
Withdrawals made after age 59 and 1/2 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 59 and 1/2 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 59 and 1/2 and includes amounts above what you contributed (your investment earnings) then you may have to pay tax. There are certain situations where 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.