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How do Roth IRA taxes work?

glass jar used for saving US dollar bills and notes for IRA retirement fund

Individual retirement accounts, commonly known as IRAs, are a tax-friendly way to build retirement savings. A Roth IRA has unique benefits, especially compared to a traditional IRA. Understanding IRA contribution limits, tax implications, and withdrawal rules will help you understand321c3e9b-e4bd-45c3-9784-0cd774161185 how this financial tool can support you in retirement.

A Roth IRA is a retirement savings account offered by brokerage firms, banks, credit unions, and insurance companies. You fund the account with earned income that’s invested in the market. It grows and compounds over time, and you can then make withdrawals to provide retirement income.

A key benefit of a Roth IRA is the potential tax savings, particularly on investment earnings and distributions.

Roth IRA contributions are not tax deductible because you fund the account with money that has already been taxed — so you don’t get the up-front benefit of lowering your taxable income like you do when making pretax contributions to a traditional 401(k) or 403(b) employer-sponsored retirement plan. With a Roth, the tax benefits come later.

Generally, you can open a Roth IRA and make contributions at any time up until the deadline for filing your income tax return. For example, you could contribute to your Roth IRA for the tax year 2023 until April 15, 2024. There are limits to how much money you can put in your Roth each year, so it’s important to stay on top of your contributions.

Money in an IRA can sit and earn interest without being subject to a capital gains tax. This is different from mutual funds, exchange-traded funds, or money market funds, where you’re taxed on capital gains even if you didn’t sell shares.

Long-term capital gains tax is usually 15% of the earnings but could be more or less based on your taxable income. This cost can eat into your retirement savings, especially over the long term. Maximizing your Roth IRA contributions can lower your tax liability because of its tax-free growth.

When you withdraw money from your Roth IRA, it’s not deductible. But — and this is key — you won’t pay income taxes on it in retirement, subject to certain rules.

You can access your Roth IRA contributions at any time, tax-free. But withdrawals of earnings must be qualified to avoid taxes or penalties. Qualified distributions are made when you are at least 59 ½ and have had the Roth account for at least five years.

You may still qualify for a tax-free withdrawals before turning 59 ½ in certain situations, like if you're a person with disabilities or you’re using the funds toward a first-time home purchase. Otherwise, nonqualified payments from a Roth IRA may be subject to a federal income tax and a 10% early withdrawal penalty.

Put simply, if you contribute to a Roth IRA during your working years, when you retire you can withdraw the money as tax-free income.

For 2024, you can contribute up to $7,000 to an IRA — up to $8,000 if you’re 50 or older making catch-up contributions. This is an increase from the $6,500 limit in 2023 ($7,500 for those 50 or older).

However, not everyone can contribute the maximum due to the Roth IRA income limits. The maximum contribution for your household could be lower than the annual limit depending on your modified adjusted gross income (MAGI) and filing status.

Both a traditional and Roth IRA allow your retirement savings to grow tax-free, but there are three major differences between these accounts worth noting.

Roth IRA contributions are not tax deductible, but eligible withdrawals are tax-free.
Traditional IRA contributions may be tax deductible, but you’ll pay ordinary income tax on distributions.
Traditional IRAs have required minimum distributions (RMDs), so you’ll have to start withdrawing from the account by age 73.
A Roth IRA does not have RMDs — you can leave the money in as long as you’re alive.

A traditional IRA provides an immediate tax break by lowering your taxable income. With a Roth IRA, your tax advantage comes later during withdrawals. The type of IRA account you choose depends on your eligibility, goals, and tax needs. You may choose both to balance the impact of taxes on your overall retirement plan.

You do not pay taxes on qualified distributions from a Roth IRA. Generally, distributions are qualified once you’re 59 ½ and have had the IRA open for a minimum of five years. Nonqualified distributions could be subject to income tax and an additional 10% early withdrawal tax.

Yes. A Roth IRA is funded with after-tax dollars, so you can contribute money you’ve already paid taxes on. It’s possible to transfer untaxed dollars to a Roth IRA with a Roth IRA conversion. But you’ll likely have to pay taxes on any type of rollover that involves an untaxed amount.

Distributions from a Roth IRA should not put you in a higher tax bracket if they’re qualified because qualified distributions from a Roth IRA are tax-free and penalty-free.

You could pay an income tax and an additional 10% penalty for nonqualified distributions. Nonqualified withdrawals are made before you turn 59 ½ or before your IRA is five years old.

Yes. Money in a Roth IRA grows tax-free. You can also withdraw your earnings tax-free and penalty-free as long as it’s a qualified distribution, generally meaning you’re at least 59 ½ and have had an IRA for a minimum of five years.

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