How Roth IRA Taxes Work

There are many advantages of saving your money in a Roth IRA (individual retirement account). The most significant ones are the tax benefits. Roth IRAs offer tax-free growth on both the contributions and the earnings that accrue over the years. If you play by the rules, you won’t pay taxes when you take the money out.

Here is some of the most important information that you’ll need to know before you decide to contribute to a Roth IRA.

Roth IRA Contributions and Phaseouts

The contribution limit for 2023 is set at $6,500. You can put in an additional $1,000 if you are age 50 or older. In 2024, the limit is $7,000, and catch-up contributions remain at $1,000.

There are phaseout amounts based on your modified adjusted gross income (MAGI) if you want to invest in a Roth IRA. The phaseout amounts for 2023 are as follows:

• $138,000 to $153,000 for singles and heads of households
• $218,000 to $228,000 for married couples filing jointly
• $0 to $10,000 for married individuals who file separately and live together at any time during the year

In 2024, the phaseout amounts are as follows:

• $146,000 to $161,000 for singles and heads of households
• $230,000 to $240,000 for married couples filing jointly
• $0 to $10,000 for married individuals who file separately and live together at any time during the year

How Roth IRA Contributions Are Taxed

Contributions to a traditional IRA are made using pre-tax dollars and may be tax deductible, depending on your income and if you or your spouse are covered by a retirement plan at work.

If you are eligible to deduct your traditional IRA contributions, it will lower the amount of your gross income that’s subject to taxes. And that effectively lowers the amount of tax you owe for that year.

When you start withdrawing from these accounts after your retirement, you’ll pay taxes on those funds at your ordinary income tax rate. That’s why the traditional IRA is called a tax-deferred account.

Roth IRAs do not benefit from the same up-front tax break that traditional IRAs receive. The contributions are made with after-tax dollars. Thus, a Roth IRA doesn’t reduce your tax bill for the year when you make contributions. Instead, the tax benefit comes at retirement, when your withdrawals are tax-free.

Despite the lack of a tax break today, a Roth IRA can be a great way to minimize your taxes over the long term. That’s because the earnings will grow tax-free. This is true no matter what type of investment you hold in your Roth IRA, be it a mutual fund, stock, or real estate (you’ll need a self-directed IRA for that).

Traditional IRA vs. Roth IRA

Earnings in your Roth IRA grow tax-free no matter how large your profits are. If your contributions over the years earn $100,000 in profits—or $1 million, for that matter—the earnings still grow tax-free. And you have already paid the income taxes on the contributions that you made.

By comparison, you pay income taxes on both the contributions and the earnings in a traditional IRA. If you contributed to a traditional IRA and earned that same $100,000 in profits, you would owe taxes on both the contributions and the earnings at your ordinary income tax rate when you make a withdrawal.

This is the key distinction between Roth and traditional IRAs.

How Roth IRA Withdrawals Are Taxed

You can withdraw contributions from a Roth IRA at any time, for any reason, with no tax or penalty. You’ve already paid taxes, and the Internal Revenue Service (IRS) considers it your money.

Withdrawals of earnings work differently. Only qualified withdrawals are tax- and penalty-free. The IRS considers a withdrawal to be qualified if you’ve had a Roth IRA for at least five years and the withdrawal is taken:

• Because you have a permanent disability
• By a beneficiary or your estate after your death
• To buy, build, or rebuild your first home (a $10,000 lifetime maximum applies)

Withdrawals that don’t meet these conditions are considered non-qualified distributions. You may be on the hook for income taxes and a 10% early withdrawal penalty, depending on several factors. Note that this 10% withdrawal tax only applies to earnings; contributions to a Roth IRA may be withdrawn for any reason at any time without tax or penalty. Those factors include:

• How old you are when you take the withdrawal
• How long it has been since you first contributed to a Roth IRA
• How you intend to use the money
• Whether you qualify for an exception

Here’s a rundown of the rules for Roth IRA withdrawals:

Which Should You Choose?

Traditional and Roth IRAs are both tax-advantaged ways to save for retirement. While the two differ in many ways, the biggest distinction is how they are taxed.

Traditional IRAs are taxed when you make withdrawals, and you end up paying tax on both contributions and earnings. With Roth IRAs, you pay taxes upfront, and qualified withdrawals are tax-free for both contributions and earnings.

This is often the deciding factor when choosing between the two.

Converting a Traditional IRA to a Roth IRA

If you are strapped for cash, the Roth IRA option may be a tougher commitment to make. The traditional IRA takes a smaller bite out of your paycheck because it reduces your overall tax liability for the year.

Even if you feel that you have to forgo the Roth option for now, you might consider converting your account from a traditional IRA to a Roth IRA in a few years, when you’re more financially comfortable. But be aware that all the taxes you were deferring in the traditional IRA will come due in the year when you do the conversion.

A Roth IRA is generally the better choice if you think you will be in a higher tax bracket after retiring. Income tax rates could increase. Or your overall income could be higher due to a variety of factors, such as Social Security payments, earnings on other investments, or inheritances.

If you’re considering converting from a traditional IRA to a Roth IRA, you may be able to lessen your tax liability if you time the conversion right. Consider making the move when the market is down (and your traditional IRA has lost value), your income is down, or your itemizable deductions for the year have increased.

The Bottom Line

Opening and funding a Roth IRA is one of the best ways to lower the amount of tax that you will pay on your investments over the long haul. While Roth IRAs don’t lower your taxes when you contribute, they allow your money to grow tax-free indefinitely. Eliminating the taxes from your earnings can make a significant difference in your investment balance over time.