Of all the advantages Roth IRAs offer—and there are many—the most significant 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. 

In 2020 and 2021, the contribution limits are set at $6,000, and an additional $1,000 may be contributed by those who are age 50 or older.

If you want to invest in a Roth IRA there are phase-out amounts based on your modified adjusted gross income (MAGI). In 2020, the phase-out amounts are $124,000 to $139,000 for singles and heads of household. For married couples who file joint taxes, the AGI phase-out range is $196,000 to $206,000. These figures are slightly up from 2019 when the AGI phase-out on a Roth was $193,000 to $203,000 for married couples and $122,00 to $137,000 for heads of household and singles.

In 2021 these phase-out amounts go up to 125,000 to 140,000 for singles and heads of households. For married couples who file jointly the phase-out amounts are $198,000 to $208,000.

Key Takeaways

  • Contributions to a Roth IRA are made in after-tax dollars. That is, you pay the taxes upfront.
  • You can withdraw your contributions at any time, for any reason, without tax or penalty.
  • Earnings in your account grow tax-free. No taxes are owed on qualified distributions.

How Roth IRA Contributions Are Taxed

Contributions to a traditional IRA are made with pre-tax dollars and may be tax-deductible, depending on your income and if you or your spouse is 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, however, 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.

24.9 million

The number of households in the United States that have a Roth IRA, according to the Investment Company Institute. 

Roth IRAs do not benefit from the same upfront tax break that traditional IRAs receive. The contributions are made with after-tax dollars. So, a Roth IRA will not reduce your tax bill for the year that you make contributions.

Instead, the tax benefit comes at retirement, when your withdrawals are tax-free.

Roth IRA Earnings Grow 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

It is also true no matter how large your profits. 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 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 at any time, for any reason, with no tax or penalty. You've already paid taxes, and the IRS considers it your money.

Withdrawals of earnings work differently. The IRS considers a withdrawal to be "qualified"—and therefore, tax-free and penalty-free—if you've had a Roth IRA for at least five years and the withdrawal is taken:

  • When you're age 59½ or older
  • 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).

If you make a withdrawal that does not meet these conditions, it is considered a non-qualified distribution. You may be on the hook for income taxes and a 10% early withdrawal penalty, depending on:

  • 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.

If you take a non-qualified distribution from your Roth IRA, the earnings portion will be included in your modified adjusted gross income (MAGI) to determine Roth IRA eligibility.

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

Roth IRA Withdrawal Rules
Your Age 5-Year Rule Met Taxes and Penalties on Withdrawals Qualified Exceptions
59 ½ or older Yes Tax-free and penalty-free n/a
59 ½ or older No Tax on earnings but no penalty n/a
Younger than 59 ½  Yes Tax and 10% penalty on earnings. You may be able to avoid both if you have a qualified exception
  • First-time home purchase
  • Due to a disability
  • Made to a beneficiary or your estate after your death
Younger than 59 ½  No Tax and 10% penalty on earnings. You may be able to avoid the penalty but not the tax if you have a qualified exception
  • First-time home purchase
  • Qualified education expenses
  • Unreimbursed medical bills
  • Health insurance premiums while you're unemployed
  • Due to a disability
  • Made to a beneficiary or your estate after your death
  • Substantially equal payments
  • Due to an IRS levy

Which You Should Choose

Traditional and Roth IRAs both are 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.

The Conversion Option

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 bill for the year.

Even if you feel you have to forego 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 you do the conversion.

In general, a Roth IRA is 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.