Of all the benefits Roth IRAs offer—and there are many—the most significant is the way the taxes work. Roth IRAs offer tax-free growth on contributions and earnings. And if you play by the rules, you won't pay taxes when you take the money out. 

Key Takeaways

  • You make Roth IRA contributions with after-tax dollars.
  • You can withdraw your contributions at any time, for any reason, without tax or penalty.
  • Earnings in your account grow tax-free, and qualified distributions are tax-free.

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.

24.9 million

The number of households in the U.S. that have a Roth IRA. 

Roth IRAs don’t get the same upfront tax break that traditional IRAs receive—contributions are made with after-tax dollars. So, they don’t reduce your tax bill the year you make them. 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 earnings always grow tax-free.

That's 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). It's also true no matter how large your profits are. If you contribute $10,000 and earn $100,000—or $1 million for that matter—the earnings still grow tax-free.

By comparison, you pay income taxes when you withdraw contributions or earnings from a traditional IRA. If you contributed $10,000 to a traditional IRA and earned that same $100,000, you'd owe taxes on those earnings at your ordinary income tax rate. This is a 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.

You can always withdraw your Roth IRA contributions without owing taxes or penalties.

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, or
  • To buy, build, or rebuild your first home (a $10,000 lifetime maximum applies).

If you make a withdrawal that doesn't meet these conditions, it's 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's been since you first contributed to a Roth IRA
  • What you'll use the money for
  • If 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

The Bottom Line

Traditional and Roth IRAs are tax-advantaged ways to save for retirement. While the two differ in many ways, the biggest distinction is how they're taxed. Traditional IRAs are taxed when you make withdrawals, so 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.

In general, a Roth IRA is the better choice if you think you'll be in a higher tax bracket during your retirement years. While it's impossible to predict, income tax rates could increase. Also, your income could be higher due to a variety of factors, including:

If you have a traditional IRA now and are concerned about future taxes, you can convert it to a Roth IRA. But be aware that all the taxes you were deferring in the traditional IRA will become due as soon as you do the conversion.

Still, you may be able to lessen your tax liability if you time the conversion for when the market is down (and your traditional IRA has lost value), your income is down, and your itemizable deductions for the year have increased.