How Roth IRA Taxes Work and When You Pay
There are many types of pension plans, and one of the main ways to choose among them is to ask yourself: How do they treat you at tax time? Let’s just say the Roth IRA is really very polite.
How Roth IRA Taxes Work
Although you pay tax on the money you put in a Roth IRA, the investment income in the account is tax-exempt. Plus, when you turn 59 and a half and your account has been open for at least five years, withdrawals are tax-free.
No Roth IRA Taxes on Income
One thing about Roth IRA taxes is that Roth IRA offer one of the most attractive tax benefits you can find for your retirement savings: you will never pay tax on the returns on investment you earn on your account, as long as you play Roth IRA Withdrawal Rules and don’t withdraw your investment income prematurely.
While you can withdraw your contributions at any time without tax or penalty, you must leave your investment income in the account until at least 59.5 years of age – or you incur a fairly steep penalty of 10% plus income tax on what you withdraw (although there is some exceptions).
Roth IRA taxes on withdrawals
The other aspect of Roth IRA taxes is that you benefit from tax-free withdrawals in retirement – although, technically, that’s not so much a blessing as it is a deferred gratification. While your investment income grows tax free, it’s also true that with a Roth IRA, you have to pay taxes up front on your contributions.
In other words, your Roth IRA contributions are made with money you have already paid taxes on, and then you get completely tax-free withdrawals in retirement.
Why is paying taxes now a good thing? Because come to think of it, retirement is potentially the worst time to face big tax bills. By definition, you are not working. So eliminating those taxes long before retirement, while you are still collecting a paycheck, is not a bad idea.
Roth IRA Taxes Versus Traditional IRA Taxes
The way Roth IRAs are taxed is basically the opposite of how traditional IRAs and regular 401 (k) are. With these retirement plans, you invest your money before paying taxes on it. Who helps reduce your tax bill in the year in which you pay the contribution, which in itself constitutes a significant tax advantage.
In other words, you could get a tax deduction for putting money into a traditional IRA, by reducing your taxable income by the amount of the contribution. That’s all well and good while you take advantage of this tax break, but keep in mind that you are delaying the pain. When the time comes to withdraw your money in retirement, that money will be subject to income tax.
Still, there are at least a few situations where a Traditional IRA might be a better bet for you than a Roth IRA:
If you are fairly confident that your taxes will be lower in retirement than they are now, then it makes sense to defer taxes until then.
Remember, Roths offers more flexible withdrawals and does not require distributions at retirement like traditional IRAs do. As we said, the Roths are downright polite.