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 contributions and earnings. And if you play by the rules, you won't pay taxes when you take the money out. In 2019 and 2020, contribution limits are set at $6,000 and an additional $1,000 may be contributed if you 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 AGI 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.
- 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.
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—contributions are made with after-tax dollars. So a Roth IRA will not reduce your tax bill 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 earnings always 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.) It is also true no matter how large your profits. 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 would 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 thus 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||
|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||
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 are 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 will 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:
- Job earnings
- Social Security
- Investment earnings
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.