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 may not be appropriate 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 arrangement account — is a tax-advantaged retirement plan that individuals can set up with brokerage firms and other financial institutions like commercial banks, investment companies, and credit unions.
Unlike aworkplace 401(k) plan, Roth IRAs aren’t sponsored by an employer. Instead, you open and manage the account yourself, which gives you a greater variety of investment options.
Read more:What is a Roth IRA?
Roth IRA contributions aren’t tax-deductible. Unlike contributions to other tax-advantaged 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
A Roth IRA can be a helpful tool to help you save for retirement. These accounts have a few key benefits: tax-free investment growth, flexible and tax-free withdrawals, early withdrawals of your contributions, and no required minimum distributions.
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 ordinaryincome and capital gains taxes.
Consider this: Ordinary income tax rates range from 10% to 37%, depending on your income.1Meanwhile, capital gains tax rates range from 0% to 20%.2 When investing in a taxable brokerage account, you would be subject to these 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 later, you will eventually pay taxes when you withdrawthose dollars. With the Roth IRA, on the other hand, you’ll never pay taxes when you withdrawthose dollars again as long as you follow the withdrawal guidelines.
Roth IRA flexible, tax-free withdrawals
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 yourRoth IRA withdrawals, you must meet a couple of requirements. Though your Roth IRA contributions can be withdrawn at any time — we’ll talk more about that in the next section — the same can’t be said about your investment earnings.
To withdraw your earnings tax-free and penalty-free, you’ll have to meet the following requirements:
- It’s been at least five years since the start of the year in which you first contributed to the Roth IRA
- One of the following is true:
- You’ve reached age 59 ½
- You’re permanently disabled
- You’re the beneficiary of the account, and the owner has passed away
- 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 a10% early withdrawal penalty.3
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 periodic payments (SEPP)
- Taking a qualified reservist distribution
Early withdrawals of contributions
Unlike your Roth IRA investment earnings, your 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 the same $5,000 next year without any tax consequences.
The reason for this flexibility is that you’ve already paid taxes on your Roth IRA contributions. This isn’t the case with your earnings or with the contributions to other tax-advantaged retirement accounts.
It’s not advisable to make regular withdrawals of your Roth IRA contributions — if you withdraw your contributions, they won’t be able to grow and help you retire. However, it’s an option that’s available in a financial emergency.
No required distributions
A final important benefit of a Roth IRA is you won’t be subject to anyrequired 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 reachage 73 (or age 72, if you turned that age on or before December 31, 2022).4
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 like Roth 401(k)s, 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 the 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 thesame contribution limit: $7,000 in 2024, and an additional $1,000 catch-up contribution for those 50 and older.
Additionally, bothTraditional and Roth IRAs have penalties for withdrawals before age 59 ½, except for withdrawals of contributions, in the case of Roth IRAs.
However, these accounts also have some important differences when it comes to their taxation. First, Traditional IRA contributions are made pre-tax. You can deduct any Traditional IRA contributions you make for the year on your income tax return. Those contributions directlyreduce your taxable income.
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 for 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 Traditional IRA or a pre-tax 401(k).
The benefit of a pre-tax account 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. 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. When making backdoor Roth IRA contributions, you must file IRS Form 8606 to ensure that future withdrawals are not subject to taxation.
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 higher during retirement than it is today, then a Roth IRA might be the better choice.
Finally, know that you don’t necessarily have to choose one or the other. Many investors appreciate having some tax diversification in their portfolios. You could choose to invest a portion of your money in a Traditional IRA and a portion in a Roth IRA. You would get to deduct some of your contributions now, as well as receive some tax-free income during retirement.
If you choose this strategy, just know the $7,000 contribution limit applies to both accounts. You can contribute $7,000 total across both accounts, not $7,000 to each account.
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 on your investment growth or withdrawals. And there are some ways you can minimize your tax burden further.
Avoid early withdrawals
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.
The penalties for early withdrawals of your earnings are significant. You’ll pay a 10% early withdrawal tax, as well as ordinary income taxes, which don’t normally apply to Roth withdrawals.
Additionally, though you can withdraw your Roth IRA contributions at any time, it’s more tax-advantageous to leave them in the account. The best way to maximize tax-free investment growth is to allow as much of your balance as possible to grow in the account for as long as possible. By withdrawing your contributions early, you’re limiting your tax-free growth.
Utilize a Roth IRA conversion
Another 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 conversion, you move money from your Traditional IRA to your Roth IRA. You’ll pay income taxes on any money you convert that you haven’t already paid taxes on, including pre-tax contributions and investment earnings. This creates a significant upfronttax liability, but then you can enjoy tax-free growth and withdrawals from the Roth IRA.
A Roth conversion may be particularly beneficial if you do it during a very low tax year. You’ll pay the income taxes in a year when your tax liability is low and then enjoy tax-free withdrawals later when your income tax rate is higher.
Before moving forward with a Roth IRA conversion, be sure to consult a tax professional to ensure you do the conversion correctly and that a Roth IRA conversion is the right choice for you.
Consult with a tax professional
One of the best ways to lower your tax liability, both relating to your Roth IRA and overall, is to work with a tax professional. These individuals know the ins and outs of the tax code and are aware of the best ways for investors to reduce their tax burden.
Reporting Roth IRA on taxes
In most cases, you won’t need to report your Roth IRA on your income tax return (Form 1040) because your contributions are made after taxes. You also won’t have to report your investment growth. Finally, you don’t need to report any withdrawals that are a return of your contributions on your tax return
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 a tax professional. 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, including 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.
If you’re investing for retirement and are wondering if a Roth IRA would be a good tool for doing so, seek advice from a financial advisor who can assess your situation and offer personalized recommendations.
