Is a Roth IRA a Pre-Tax Investment?

Learn how taxation on a Roth IRA account works

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Roth IRAs (individual retirement accounts) are designed to offer you tax advantages to help you save for retirement, but you do not use pre-tax funds for them. 

Instead, contributions to Roth IRAs must come from taxed income, but then you can make withdrawals tax-free, including on earnings, in your retirement years. 

Let’s take a look at how taxation works with contributing to and withdrawing from Roth IRAs, as well as how taxes apply to other types of retirement accounts.

Key Takeaways

  • Roth IRA contributions are made with after-tax funds, not pre-tax funds. 
  • You can use pre-tax income to contribute toward traditional 401(k) and traditional IRA accounts. 
  • Roth IRA accounts offer tax advantages in your retirement years, when you can withdraw your contributions and any earnings tax-free.   

Roth IRA Contributions Are Post-Tax, Not Pre-Tax

Roth IRA contributions are made with income that has already been taxed and the contributions are not tax deductible. That means, investments in these accounts are not pre-tax investments.

The tax benefit of Roth IRAs is that you don’t pay tax on any dividends or capital gains on the funds in the account while saving for retirement, and on qualified distributions. 

Qualified distributions are distributions of investment income that meet certain requirements, such as if you receive them after your retirement age, which the IRS sets at 59½. You can also receive qualified distributions if:

  • you’ve had the account for more than five years
  • you are disabled
  • distributions are being made to a beneficiary
  • you were affected by a qualified disaster
  • you are using them to build or buy your first home (up to $10,000)

If you take a nonqualified distribution, you must pay a 10% penalty, but that only applies to investment earnings, not what you originally contributed. Contributions to a Roth IRA can be withdrawn at any time.

Keep in mind that the IRA has limits on how much you can contribute to Roth IRAs. As of 2022, you can contribute $6,000 per year and $7,000 per year if you are over 50. The IRS often changes the contribution limit, but not necessarily annually.

The IRS also imposes an income limit on Roth IRA contributions, so if you earn too much, you can’t contribute. For 2022, if you report more than $204,000 on a joint tax return or more than $144,000 on a single/head of household return you can’t make contributions.

If your income is too high to contribute, one way to get the benefits of a Roth IRA is to use a Roth conversion, or a “backdoor” strategy. With a conversion, retirement accounts such as 401(k)s or traditional IRAs can be converted to a Roth even if the account balance is more than the annual contribution limit. 

How Pre-Tax Retirement Accounts Works

If you’d prefer the tax-advantages of a pre-tax retirement account, which provide more immediate tax benefits, you have several options to consider. Let’s go over how different types of pre-tax qualified retirement accounts work. 

401(k)

Traditional 401(k) plans. as well as 403(b) and 457(b) plans, are defined contribution plans sponsored by employers. Typically, the employee makes a contribution into the plan and the employer matches a portion or all of the contribution. Contributions to the plan are made pre-tax, and then the withdrawals in retirement are subject to taxation.

Roth 410(k) plans are employer-sponsored plans in which contributions are made with taxed income, but then the earnings can be withdrawn tax-free in retirement.

Traditional IRAs

Traditional IRAs are similar to Roth IRAs in that they are held by individuals, but traditional IRAs take pre-tax contributions and then your distributions in retirement are taxed. Traditional IRAs have the same annual contribution limits as Roth IRAs. If you withdraw funds early, you must pay income taxes plus a 10% early withdrawal penalty. 

Is a Roth IRA the Best Retirement Account for You?

Should you put your retirement savings in a Roth IRA or a retirement account that offers more immediate tax benefits? Let’s go over the pros and cons of each. 

When After-Tax Accounts Work Best

Roth IRAs are generally recommended for younger people who have longer investing horizons. That’s in part because they have more time to establish significant earnings, which they can withdraw tax-free in their retirement years. Their longer investing horizon means they can better leverage the power of compounding to help their earnings grow more quickly.

Younger people also generally earn lower incomes than older people, so their tax rate is lower. As they age and earn more income, they tend to move to a higher tax bracket and their earnings are taxed more. So, paying taxes now may be more beneficial for them.

Let’s say you make $80,000 per year, which puts you in the 22% tax bracket. If you contribute $6,000 now, the tax would be $1,320. If in later years, you have an income of $130,000 you would be in the 24% bracket, so you would pay $1,440 on $6,000. You can see paying taxes earlier may make more sense for some people. 

When Pre-Tax Accounts Work Best

You may prefer a pre-tax account if you would like to take advantage of tax breaks sooner. For example, you may be on a tight budget and need the tax advantage immediately. 

You may also benefit from using a retirement account that takes pre-tax funds if you are earning a significant amount of money now, and expect to earn much less in retirement. 

Best of Both Worlds

If you’re not sure exactly which type is best, you can consult a financial advisor for guidance on your personal situation. They may recommend one type of retirement account or they may suggest that you split the difference. For example, you can invest in a Roth IRA to grow earnings for future tax-free withdrawals, while also contributing to a 401(k) plan at work to take advantage of matching funds.

No matter which strategy you choose when it comes to retirement savings, the earlier you start, the better. 

Non-qualified retirement accounts

Qualified retirement accounts offer incredible tax benefits, but you can also use other types of investment accounts toward saving for retirement. Investing using traditional brokerage accounts that have no tax breaks allows you to remove the money without early penalties. You can also invest more because there are no contribution limits. 

You may need more money to fund your retirement than what you can save in a tax-advantaged retirement account like a Roth IRA. If you invest in a side account, you’ll build up your savings while also keeping money liquid if you need it to invest in a business or real estate. 

Frequently Asked Questions (FAQs)

How much tax do you pay on a Roth conversion?

Roth conversions are taxed at your marginal income tax rate. In the year that you do the conversion, you’re required to report the full account balance as income on your tax return. You can do the conversion over several years to limit each year’s tax payments. This is especially helpful if you know what years you will have higher income.

How does a Roth IRA affect your tax return?

A Roth IRA would only affect your tax return if you do a conversion in that tax year or make a nonqualified distribution. In that case, you would report the amount on your tax return. The conversion would be taxed at your marginal rate and the distribution would have a 10% penalty.

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