Understanding How Roth IRAs Affect Your Taxes

Learn how investing in a Roth IRA can help reduce your taxes and provide tax-free growth for both contributions and earnings.

Understanding How Roth IRAs Affect Your Taxes

Roth IRAs are a great way to save for retirement, as they allow you to pay taxes on the money you enter your account upfront, and then all future withdrawals are tax-free. Contributions to the Roth IRA are not taxable because the contributions you make to them are usually made with money after taxes and you can't deduct them. The Internal Revenue Service (IRS) also considers the earnings you have accrued in your traditional pre-tax IRA. When you convert after-tax money from a traditional IRA to a Roth IRA, the amount is tax-free because you have already paid taxes on those funds.

Earnings should be treated as ordinary taxable income. A Roth IRA differs from a traditional IRA in several ways. Contributions to a Roth IRA are not deductible (and you don't report contributions on your tax return), but qualifying distributions or distributions that are a return of contributions are not taxable. To be a Roth IRA, the account or annuity must be designated as a Roth IRA when established.

For more information on contributions to the Roth IRA, see Topic No. While you pay taxes on the money you deposit into a Roth IRA, the earnings from investing in the account are tax-free. In addition, when you turn 59 and a half and have had your account open for at least five years, withdrawals are tax-free. It is important to keep good records of all your contributions to the IRA, as your IRA custodian is not required to do so.

Roth IRAs offer tax-free growth in both contributions and earnings that accrue over the years. Because you contribute after-tax money to a Roth IRA, no deduction can be applied in the year you contribute to the account. Unlike a traditional IRA, you can withdraw sums equal to your Roth IRA contributions, penalties and tax-free, at any time, for any reason, even before age 59 and a half. For withdrawals or distributions of earnings to qualify as tax-free, you must have had a Roth account (any Roth account) for at least five years. If you are considering converting from a traditional IRA to a Roth IRA, it may be possible to lower your tax liability if done correctly.

While your investment earnings grow tax-free, it's also true that with a Roth IRA you have to pay upfront taxes on your contributions. If an excess contribution is made to a Roth IRA and then eliminated, this contribution cannot be used to determine the five-year period for qualifying distributions. Opening and funding a Roth IRA is one of the best ways to reduce the amount of tax you'll pay on your long-term investments. A Roth IRA is usually the best option if you think you'll be in a higher tax bracket after retirement. Keep in mind that withdrawals from contributions to a Roth IRA are always tax-free because that money has already been taxed. This is the most important information you'll need to know before deciding whether or not to contribute to a Roth IRA.

The other thing about Roth IRAs is that you get the benefit of tax-free withdrawals in retirement, although technically this isn't so much of an advantage as it is delayed gratification. This is true regardless of what type of investment you have in your Roth IRA - whether it's mutual funds, stocks or real estate (you'll need a self-directed IRA for this).