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Roth IRAs: The Complete Guide
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How Roth IRA Taxes Work

Know the rules to take full advantage of the tax perks

There are many advantages of saving your money in a Roth IRA. 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 you'll need to know before you decide to contribute to a Roth IRA.

Key Takeaways

  • There are many advantages of saving your money in a Roth IRA.
  • Contributions to a Roth IRA are made in after-tax dollars, which means 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 and there are no taxes on qualified distributions.
  • You may want to convert your traditional IRA to a Roth IRA when you're in a better financial situation.

Roth IRA Contributions and Phaseouts

The contribution limits for 2021 and 2022 are set at $6,000. You can put in an additional $1,000 if you are 50 or older.

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 2021 are:

  • $125,000 to $140,000 for singles
  • $125,000 to $140,000 heads of households
  • $198,000 to $208,000 for married couples filing jointly
  • $0 to $10,000 for married individuals who file separately and live together at any time during the year

The phaseout amounts for 2022 are:

  • $129,000 to $144,000 for singles
  • $129,000 to $144,000 heads of households
  • $204,000 to $214,000 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 upfront tax break that traditional IRAs receive. The contributions are made with after-tax dollars. So, a Roth IRA doesn't reduce your tax bill for the year that you make contributions. Instead, the tax benefit comes at retirement, when your withdrawals are tax-free.

10%

The percentage of taxpayers in the United States that have a Roth IRA, according to the Tax Policy Center. 

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 Internal Revenue Service (IRS) considers it your money.

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)

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:

  • 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

The earnings portion of a non-qualified distribution from your Roth IRA is 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.

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 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.

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.

Article Sources

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