There are many advantages of saving your money in a Roth IRA (individual retirement account). 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, just as traditional IRAs do. But if you play by the rules, you also won’t pay taxes when you take the money out of a Roth IRA.
Here is some of the most important information that 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 individual retirement account (IRA).
- Contributions to a Roth IRA are made with after-tax dollars, which means that 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 limit for 2023 was $6,500. (The deadline for making them was April 24, 2024.) You could put in up to an additional $1,000 if you were age 50 or older. In 2024, the limit is $7,000. The cap on catch-up contributions remains $1,000.
There are phaseout amounts based on your modified adjusted gross income (MAGI) if you want to invest in a Roth IRA. If you’re still working on your 2023 tax return, the phaseout amounts for 2023 are as follows:
- $138,000 to $153,000 for singles and heads of households
- $218,000 to $228,000 for married couples filing jointly
- $0 to $10,000 for married individuals who file separately and lived together at any time during 2023
In 2024, the phaseout amounts are as follows:
- $146,000 to $161,000 for singles and heads of households
- $230,000 to $240,000 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, not a tax-free account.
Roth IRAs do not benefit from the same up-front tax break that traditional IRAs receive. The contributions are made with after-tax dollars. Thus, a Roth IRA doesn’t reduce your tax bill for the year when you make contributions. Instead, the tax benefit comes at retirement, when your qualified withdrawals are tax-free.
42%
The percentage of households in the United States that have an IRA, according to a report from the Investment Company Institute published in Feb. 2024.
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
Earnings in your Roth IRA grow tax-free no matter how large your profits are. 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 that 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 from a Roth IRA at any time, for any reason, with no tax or penalty. You’ve already paid taxes on them, and the Internal Revenue Service (IRS) treats all of it as your money.
Withdrawals of earnings work differently. Only qualified withdrawals are tax- and penalty-free. The IRS considers a withdrawal to be qualified if you are at least 59 ½ years old and you’ve had a Roth IRA–any Roth IRA, not necessarily this one–for at least five years
If you’ve met the five-year rule but are not at least 59 ½, withdrawals of earnings will be taxable unless you.
- Have a permanent disability
- Have died and the withdrawal is by a beneficiary
- Use the withdrawal 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 several factors. Note that this 10% withdrawal tax only applies to earnings. Contributions to a Roth IRA may be withdrawn for any reason at any time without tax or penalty. The earnings portion of a non-qualified distribution from your Roth IRA is included in your MAGI to determine Roth IRA eligibility
The earnings portion of a non-qualified distribution from your Roth IRA is included in your 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 |
| 59½ or older | Yes | Tax- and penalty-free | N/A |
| 59½ or older | No | Tax on earnings but no penalty | N/A |
| Younger than 59½ | 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 59½ | 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 Should You Choose?
Traditional and Roth IRAs are both 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.
That 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 that you have to forgo 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 when 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.
Can I Avoid Paying Taxes by Converting a Traditional Individual Retirement Account (IRA) to a Roth IRA?
Unfortunately, no. If you decide to convert your traditional individual retirement account (IRA) to a Roth IRA, the taxes that would be due when you take a distribution would be due instead when you convert it to the Roth IRA. If you are in a period when you fall into a lower tax rate or the market is down, this could be a good time to execute the conversion. The tax bite would be smaller. Then you’d able to allow earnings to continue to grow tax-free and, once qualified, eventually to be withdrawn tax-free.
Do I Pay Taxes on Traditional IRA Earnings?
Yes, but only when you withdraw them from the IRA. In the meanwhile, earnings grow tax-deferred. In contrast, Roth IRAs offer tax-free growth of your initial contribution and of qualified earnings.
Traditional IRAs save you money on your taxes in the year when you invest, but when you start taking distributions, you’ll be taxed on your contributions and your earnings.
Can I Deduct My Contributions to a Roth IRA on My Taxes?
No. Since you contribute to a Roth IRA with after-tax money, no deduction is available in the year when you contribute. If you need to lower your taxable income, consider a traditional IRA.
The Bottom Line
Opening and funding a Roth IRA is one of the best ways to lower the amount of tax that you will pay on your investments over the long haul. While Roth IRAs don’t lower your taxes when you contribute, they allow your money to grow tax-free indefinitely. Eliminating the taxes from your earnings can make a significant difference in your investment balance over time.
Retirement Security Rule: What It Is and What It Means for Investors
The new Retirement Security Rule, also known as the fiduciary rule, is intended to protect investors from conflicts of interest when receiving investment advice that the investor uses for retirement savings. You might get investment advice for your IRA.
The rule was issued by the U.S. Department of Labor (DOL) on April 23, 2024. It takes effect on September 23, 2024 However, a one-year transition period will delay the effective date of certain conditions to 2025.
If an advisor is acting as a fiduciary under the Employee Retirement Income Security Act (ERISA), they are subject to the higher standard–the fiduciary best-advice standard rather than the lower, merely suitable advice standard. Their designation can limit products and services they are allowed to sell to clients who are saving for retirement.
