What Are the Tax Advantages of a Roth IRA?

IRS balances Roth IRA tax advantages with several rules to comply with

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A Roth IRA is an individual retirement account that provides some tax perks that traditional IRAs don’t share. The account must be set up as a Roth to qualify for these advantages.

But the IRS balances the tax advantages of these accounts with a fair number of rules you must abide by to qualify. You can’t earn too much, but you must earn at least some taxable income. Contributions are capped at a certain amount annually, based on your filing status. Penalties can apply if you don’t follow the rules.

Key Takeaways

  • Savings contributed to a Roth IRA grow tax-free. You can withdraw your contributions and their earnings without paying income or capital gains taxes, if your distributions are “qualified.”
  • Your money saved to a Roth IRA is taxed at the time of contribution because you can’t claim a tax deduction for it.
  • You don’t have to take required minimum distributions (RMDs) from a Roth IRA as you must with a traditional IRA. You can leave your contributions in place and let your money keep earning for as long as you like.
  • Roth IRAs can be subject to some penalty taxes if you don’t meet all the rules.

Tax Advantages of Roth IRAs

Your money won’t sit stagnant in your Roth IRA until you need it in retirement. It’s invested for you so it will grow, earning dividends, interest, or both. It then can be subject to some advantageous tax treatment.

Tax-Free Withdrawals 

You’ve been saving for decades, and now it’s time to retire. The IRS lets you withdraw your contributions to your Roth IRA tax-free because you’ve already paid income tax on that money at the time you made the contributions, unlike with a traditional IRA.

You can claim a tax deduction for contributions to a traditional account, but then you must pay the tax on that money in retirement when you take it back again. You don’t get a tax deduction when you contribute to a Roth account, so you’re effectively paying those taxes upfront.

Tax-Free Earnings

Earnings on a traditional IRA are tax-deferred. You’ll pay tax on this money eventually when you begin taking distributions in retirement. This isn’t necessarily the case with a Roth IRA. This growth isn’t taxable, although some rules do apply. Your distributions from the account must be “qualified” to receive this special tax treatment.

Access to Your Money  

The rules for withdrawing your money and its earnings are much more lenient with a Roth IRA. You’ve already paid taxes on that money, so the IRS is more generous about not imposing penalties when you tap into the account, although there can be some, along with fees.

Required Minimum Distributions

You must begin taking RMDs from a traditional IRA at age 70½ or age 72, depending on your year of birth. Remember, you haven’t paid taxes yet on that money, so the IRS doesn’t let it sit there forever untaxed.

Roth IRAs aren’t subject to RMD rules. Your invested money can keep earning for you as long as you like. You can pass this asset to your heirs free of income tax if you don’t use all the money during your lifetime.

Contributions to traditional IRAs were once subject to an age cap. You were not permitted to save after age 70½. This rule was lifted in 2020. There’s no longer any age limit for contributing to either a Roth or a traditional IRA.

When Do You Pay Taxes on Roth IRA Funds?

Contributions to a Roth IRA are taxed at the time you earn the money. This is what allows those tax-free withdrawals, and it earns you the perk of tax-free growth as well.

Say you want to contribute $40,000 to your Roth IRA during your working years. It grows to $60,000 by the time you’re ready to retire. That $20,000 in earnings is tax-free as well. You’ve paid income tax on the original $40,000, but the entire $60,000 can come back out again unaffected by income or capital gains taxes, as long as the distribution is qualified.

Your earnings are qualified if you’re at least age 59½ and you’ve held your Roth IRA for a minimum of five years. Withdrawals are also qualified if they’re the result of your death or total and permanent disability, even if you haven't yet met the age and ownership rules.

The IRS provides a handy tool on its website that will tell you how much, if any, of your Roth earnings are taxable at the time of withdrawal, based on these rules. It’s an interactive quiz that takes about 15 minutes.

Avoid Penalty Taxes on Roth IRAs

There are two circumstances under which you might take a bit of a tax hit on Roth IRA contributions and distributions. Both involve making mistakes that prevent you from meeting the rules.

Nonqualified Withdrawals

You must pay income tax on any portion of your distributions that represent earnings if your withdrawals don’t qualify for tax-free treatment because you’re younger than age 59½ or you haven’t yet held the account for five years. But, again, this rule doesn’t apply to your Roth IRA contributions because you’ve already been taxed on that money. They weren’t tax-deductible at the time you made them.

Unfortunately, you’ll also be hit with a 10% penalty tax if you take your money back before age 59½, from either a Roth or a traditional IRA. This is over and above income tax on your account’s earnings.

But Roth accounts offer some options for avoiding this penalty-tax hit. You can set up distributions as substantially equal periodic payments over the course of your life expectancy. You can also take up to $10,000 for a first-time home purchase if you’re younger than age 59½, and you can take money for higher-education expenses regardless of your age.

You can withdraw an amount equal to health insurance premiums you’ve paid if you’ve received unemployment compensation for 12 consecutive weeks (or you could have received unemployment, except you’re self-employed), or for unreimbursed medical expenses that exceed a percentage of your adjusted gross income.

Excess Contributions

Contributions to all your IRAs, both traditional and Roth, are capped at $6,000 a year as of 2022, or $7,000 if you’re age 50 or older. This is a collective limit that applies to all your IRAs combined, if you have more than one.

Your Roth contributions can be limited to less than these thresholds if you earn too much. An excess contribution tax penalty of 6% per year applies if you exceed these limits until you take the money back out again.

This penalty doesn’t apply if you withdraw your excess contribution and its earnings before the due date of that year’s tax return.

Frequently Asked Questions (FAQs)

How do you pay taxes on a Roth IRA conversion?

A Roth IRA conversion involves moving money from a traditional IRA or other retirement savings account into a Roth IRA. You’ve already claimed a tax deduction for the contributions to the traditional account, so you have to pay income tax on that money and its earnings when moved. But the 10% tax penalty for early withdrawals from a traditional IRA doesn’t apply if you’re transferring the money to another IRA.

What tax forms do you need when using a Roth IRA?

You don’t have to report contributions to your Roth IRA on your tax return because they’re not tax-deductible. But you do have to file IRS Form 5329 with your tax return, in most cases, if you take an nonqualified withdrawal.

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