What are Roth IRA taxes & how do they work?

What are Roth IRA taxes & how do they work?

01.05.2024

Investing is one of the best ways to prepare financially for the future, but it also comes with some tax consequences. The good news is that retirement accounts tend to come with certain advantages that aren’t available for other brokerage accounts.

Roth IRAs have unique tax benefits for investors, including tax-free growth and withdrawals. But because they don’t have the upfront tax benefits that some accounts offer, they aren’t right for everyone. Keep reading to learn more about how Roth IRAs work, their tax benefits, and how they compare with other tax-advantaged retirement accounts.

What is a Roth IRA

A Roth IRA — short for individual retirement account — is a tax-advantaged retirement plan that individuals can set up with brokerage firms and other financial institutions.1

Read more: What is a Roth IRA?

Roth IRA contributions are not tax-deductible. Unlike contributions to other retirement accounts, you won’t get an upfront tax benefit from those to your Roth IRA. However, once you’ve contributed the money to the account, you won’t be subject to any additional taxes.

Roth IRA tax benefits

Roth IRAs have three key benefits: tax-free investment growth, flexible and tax-free withdrawals, and no required minimum distributions.

Read more: The advantages of an IRA

Roth IRA tax-free investment growth

One of the key benefits of a Roth IRA is that you’ll never pay taxes on your investment growth. When compared to a taxable brokerage account, a Roth IRA can save you hundreds of thousands of dollars over the years in income and capital gains taxes.

Consider this: income tax rates range from 10% to 37%, depending on your income.2 Meanwhile, capital gains tax rates range from 0%  to 20%.3 When investing in a taxable brokerage account, you would be subject to taxes when you earned interest or dividends on an investment or when you sold one of your investments for a gain. But with a Roth IRA, you avoid these taxes altogether.

By avoiding taxes, you allow your entire investment portfolio balance to stay intact and continue to grow. As a result, you’ll see your investments grow more quickly than you would outside of a tax-advantaged retirement account.

It’s important to note that pre-tax retirement accounts such as traditional IRAs and 401(k)s also have tax-free investment growth. However, as we’ll talk about in a later section, you will eventually pay taxes on those dollars. With the Roth IRA, on the other hand, you’ll never pay taxes on those dollars again as long as you follow the withdrawal guidelines.

Roth IRA flexible, tax-free withdrawals4

Another key benefit of Roth IRAs, and the reason they have become so popular among investors, is they provide tax-free retirement income. Unlike pre-tax retirement accounts, Roth IRA contributions are made with dollars you’ve already paid taxes on. As a result, you won’t pay any income taxes on the money you withdraw from your account.

However, to avoid taxation on your Roth IRA withdrawals, you’ll have to meet a couple of requirements.

First, your Roth IRA contributions can be withdrawn tax-free from the account at any time. In other words, you could contribute $5,000 to your Roth IRA this year and then turn around and withdraw that same $5,000 next year without any tax consequences

However, the same can’t be said about your investment earnings. To withdraw your investment earnings tax-free and penalty-free, you must meet the following requirements:

  1. It’s been at least five years since the start of the year in which you first contributed to the Roth IRA.
  2. One of the following is true:
    1. You’ve reached age 59 ½
    2. You’re permanently disabled
    3. You’re the beneficiary of the account and the owner has passed away
    4. You’re withdrawing no more than $10,000 to purchase your first home.

If you withdraw your investment earnings without meeting these requirements, you’ll pay income taxes on the portion of your withdrawal that is earnings (but not the portion that’s contributions). Additionally, you’ll pay a 10% early withdrawal penalty.

There are also some situations where you can avoid the 10% early withdrawal penalty, including:

  • Paying for unreimbursed, deductible medical expenses
  • Paying for health insurance while you’re unemployed
  • Paying for higher education expenses
  • Taking a series of substantially equal payments
  • Taking a qualified reservist distribution

No required distributions5

A final important benefit of a Roth IRA is you won’t be subject to any required minimum distributions (RMDs).

When you invest in a pre-tax account, the IRS isn’t able to collect taxes on your contributions or investment earnings. But eventually, it wants to collect that tax revenue, and that’s where RMDs come in. RMDs are a specific percentage of your retirement account balance that you’re required to withdraw each year once you reach age 73 (or age 72, if you turned that age on or before December 31, 2022).

RMDs do a few things. First, in the case of pre-tax accounts, they require you to pay income taxes on the money you’re required to withdraw. Additionally, the money is no longer in your retirement account, benefiting from tax-free investment growth.

The good news is that Roth IRAs — and other Roth accounts, starting in 2024 — are not subject to RMDs. You can leave the money in your account indefinitely to use later in retirement or to pass along to your beneficiaries after you pass away.

Traditional IRAs vs. Roth IRAs

A Roth IRA is one of two popular types of individual retirement accounts widely available to investors. The other is the traditional IRA. The two accounts have a few things in common. First, both have the same contribution limit ($7,000 in 2024, and an additional $1,000 catch-up contribution for those 50 and older).6

Additionally, both traditional and Roth IRAs have penalties for withdrawals before age 59 ½, except for withdrawals of contributions, in the case of Roth IRAs.

But these accounts also have some important differences when it comes to their taxation. First, traditional IRA contributions are made pre-tax. You can deduct on your income tax return any traditional IRA contributions you make for the year. Those contributions directly reduce your taxable income.7>

For example, if you have $50,000 of income in 2024 and contribute $7,000 to your traditional IRA, you only have $43,000 of taxable income.

Traditional IRAs enjoy tax-free growth, just like Roth IRAs do. But when you take withdrawals during retirement, you’ll have to pay income taxes on them. And depending on your income tax rate, that could eat into anywhere from 10% to 37% of your distributions.

Of course, that’s not to say there’s no tax consequence of investing in a Roth IRA or that a Roth IRA is better for everyone. In fact, some investors will see far more benefit from a pre-tax account like a traditional IRA or 401(k).

The benefit of pre-tax accounts is that your contributions are tax-deductible. In other words, they reduce your tax burden in the current year. For someone with a high income and, therefore, in a higher tax bracket, the upfront tax benefit could outweigh the tax benefit later on.

Additionally, not everyone is eligible to contribute to a Roth IRA. The IRS places income limits on who can make Roth IRA contributions. In 2024, you can no longer contribute to a Roth IRA once your income reaches $161,000 for single individuals and $240,000 for married individuals.8 There’s also a phase-out range for lower-earning taxpayers who may only be able to make partial contributions.

Of course, there is a way around this restriction. A strategy known as a backdoor Roth IRA allows you to make non-deductible contributions to a traditional IRA and then immediately recharacterize them as Roth dollars to enjoy the benefits of a Roth IRA.9

Read more: What a backdoor Roth IRA is and how to use it

While there’s a lot more that goes into it, the simplest way to decide whether a traditional or Roth IRA is right for you is to compare your income and tax rate today to your income and tax rate during retirement.

If you expect your income and tax rate to be lower during retirement than it is today (which may be the case if you’re a high earner), then a traditional IRA might be right for you. On the other hand, if you expect your income and tax rate to be lower during retirement than it is today, then a Roth IRA might be the better choice.

Strategies to minimize Roth IRA taxes

Roth IRAs already have some powerful tax benefits that mean you won’t have to worry about tax liabilities. However, there are some ways you can minimize your taxes further.

First, the most important way to minimize your Roth IRA taxes is to avoid taking early withdrawals of your investment earnings. Though you can withdraw your contributions at any time, withdrawals of earnings before 59 ½ — or in other select situations — will result in income taxes.

Another way to achieve the full tax benefits is to leave your contributions in the account. Yes, you can withdraw your contributions at any time with no income taxes. However, the best way to maximize the tax-free investment growth is to allow as much of your balance as possible to grow in the account. By withdrawing your contributions early, you’re limiting your tax-free growth.

Finally, a way to reduce your taxes over the long term is to use a Roth IRA conversion. A Roth conversion allows you to convert money from a traditional IRA to a Roth IRA. You can do this as a backdoor Roth IRA, as we discussed earlier. But you can also do it in future years on traditional IRA contributions you’ve already deducted.

To do a Roth IRA conversion, you move money from your traditional IRA to your Roth IRA. You’ll pay income taxes on the money you convert, which creates a significant upfront tax liability. However, you’ll then enjoy the tax-free growth and withdrawals the Roth IRA has to offer.10

Before moving forward with a Roth IRA conversion, be sure to consult a tax professional, both to ensure you do the conversion correctly and to ensure a Roth IRA conversion is the right choice for you.

Reporting Roth IRA on taxes

In most cases, you won’t need to report your Roth IRA on your income tax return. Because your contributions are made after taxes, you won’t report those on your tax return. You also won’t have to report your investment growth. Finally, you don’t need to report on your tax return any withdrawals that are a return of your contributions.

However, there are a couple of situations where you’ll need to report your Roth IRA on your taxes. First, you’ll have to report any withdrawals that aren’t a return of your contributions. For example, if you withdraw $10,000 of investment earnings before you reach 59 ½, you’ll have to report that money as income on your tax return.

You’ll also have to report any Roth conversions you make. A Roth conversion is when you convert pre-tax dollars to Roth dollars. All money you convert that you haven’t already paid taxes on will be subject to income taxes.

When in doubt about whether something needs to be reported, consult an accountant. The last thing you want is to neglect to report something you should have and then be in trouble with the IRS.

The bottom line

A Roth IRA is one of the most popular retirement savings tools available, and it’s easy to see why. This account offers powerful tax benefits that include tax-free investment growth, tax-free retirement income, and no required minimum distributions.

 

Roth IRAs aren’t right for everyone, especially high earners looking to reduce their tax liability as much as possible today. However, there’s a place for a Roth IRA in many people’s retirement savings strategies, and it’s worth considering how one might fit into yours.

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  1. IRS. “Roth IRAs.” November 2023.
  2. IRS. “IRS provides tax inflation adjustments for tax year 2024.” November 2023.
  3. IRS. “Topic No. 409, Capital Gains and Losses.” November 2023.
  4. IRS. “Publication 590-B (2022), Distributions from Individual Retirement Arrangements (IRAs).” November 2023.
  5. IRS. “Retirement Topics — Required Minimum Distributions (RMDs).” November 2023.
  6. IRS. “401(k) limit increases to $23,000 for 2024, IRA limit rises to $7,000.” November 2023.
  7. IRS. “Traditional IRAs.” November 2023.
  8. IRS. “401(k) limit increases to $23,000 for 2024, IRA limit rises to $7,000.” November 2023.
  9. IRS. “IRA FAQs.” November 2023.
  10. IRS. “IRA FAQs.” November 2023.

The Currency editors

Staff contributors

The CurrencyTM, a publication from Empower, covers the latest financial news and views shaping how we live, work, and play. We keep you current on ways to plan, save, and invest for life.

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