A Roth IRA (Individual Retirement Arrangement) is a retirement savings account that allows you to pay taxes on the money you put into it upfront. With Roth IRAs, you pay taxes upfront, and qualified withdrawals are tax-free for both contributions and earnings.
This means with a Roth IRA, contributions are not tax-deductible, but earnings can grow tax-free, and qualified withdrawals are tax- and penalty-free.
Roth IRA Tax rules vary depending on your age and how long you’ve had the account and other factors. In this article, we shall go through how ROTH IRA taxes work.
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HOW DOES ROTH IRA TAXES WORK
Of all the advantages Roth IRAs offer—and there are many—the most significant are the tax benefits. Roth IRAs offer tax-free growth on both the contributions and the earnings that accrue over the years. If you play by the rules, you won’t pay taxes when you take the money out.
In 2021 and 2022, the contribution limits are set at $6,000, and an additional $1,000 may be contributed by those who are age 50 or older.
If you want to invest in a Roth IRA there are phase-out amounts based on your modified adjusted gross income (MAGI). In 2020, the phase-out amounts are $124,000 to $139,000 for singles and heads of households.
For married couples who file joint taxes, the AGI phase-out range is $196,000 to $206,000. These figures are slightly up from 2019 when the AGI phase-out on a Roth was $193,000 to $203,000 for married couples. And $122,00 to $137,000 for heads of household and singles.
In 2022 these phase-out amounts go up to 125,000 to 140,000 for singles and heads of households. For married couples who file jointly the phase-out amounts are $198,000 to $208,000.
ROTH IRA TAXES VS. TRADITIONAL IRA TAXES
The way Roth IRAs are taxed is basically the opposite of how traditional IRAs and regular 401(k)s are. With those retirement plans, you put your money in before you pay taxes on it.
That helps trim your tax bill in the year you make the contribution, which itself is a valuable tax benefit.
In other words, you might get a tax deduction for putting money into a traditional IRA, reducing your taxable income by the amount of the contribution. That’s all well and good while you’re enjoying that tax break, but keep in mind that you’re delaying the pain.
When it comes time to pull your money out in retirement, that money will be subject to income taxes.
Read: WHAT IS ROTH IRA AND HOW DOES IT WORK?
ROTH IRA TAXES ON EARNINGS
One thing about Roth IRA taxes is that Roth IRAs offer one of the sweetest tax benefits you can find for your retirement savings:
You’ll never pay tax on any investment returns you earn in your account, as long as you play by the Roth IRA withdrawal rules and don’t withdraw your investment earnings early.
While you can withdraw your contributions at any time without tax or penalty, you need to leave your investment earnings in the account until at least age 59½ — or face a fairly steep 10% penalty plus income tax on what you withdraw (though there are some exceptions).
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ROTH IRA TAXES ON WITHDRAWALS
One thing about Roth IRA taxes is that you get the benefit of tax-free withdrawals in retirement — although, technically, that’s not so much a blessing as it is delayed gratification.
While your investment earnings grow tax-free, it’s also true that with a Roth IRA you have to pay taxes upfront on your contributions.
That is, your Roth IRA contributions are made with money you’ve already paid tax on, and then you get entirely tax-free withdrawals in retirement.
Why is paying taxes now a good thing? Because if you think about it, retirement is potentially the worst time to be facing big tax bills. By definition, you’re not working.
So getting those taxes out of the way long before retirement, when you’re still collecting a paycheck, is not a bad idea.
QUALIFYING FOR A TAX DEDUCTION IN ROTH IRA
Only in very rare situations can you deduct losses in your Roth IRA account. To qualify for the deduction, you must close all of your Roth IRA accounts, including Roth IRA accounts that have profits.
Your traditional IRAs need not be closed, as they are treated separately, and the value of your Roth IRA from the previous year or at any point during the time the account was open does not matter. You must show a loss from your tax basis in the account.
FIGURING YOUR TAX DEDUCTION IN ROTH IRA
Your deduction is equal to the amount by which your tax basis exceeds your total withdrawals from your Roth IRAs. Your tax basis is the total amount of your contributions to the Roth IRA because these contributions are made with after-tax dollars.
For example, if over the years you have contributed $25,000 to your Roth IRA but receive $15,000 when you close the account, you would have a net loss of $10,000.
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REPORTING YOUR TAX DEDUCTION IN ROTH IRA
The deduction for Roth IRA losses is an itemized deduction, which means you must itemize on your tax return and cannot claim the standard deduction. If you are already itemizing, this is not significant.
However, if you were not planning to itemize, make sure that the total amount of your itemized deductions is greater than your standard deduction.
To claim the deduction, you must file your taxes using Form 1040 and report the deduction on Schedule A. Report the amount of your Roth IRA loss as a miscellaneous deduction.
This amount is added to your other miscellaneous deductions and then you must subtract 2 percent of your adjusted gross income to ascertain your deduction value.
For example, if your Roth IRA loss is the only miscellaneous deduction, you claim a $5,000 loss and your adjusted gross income is $50,000, you would subtract $1,000 (2 percent of $50,000) from $5,000 to find that your deduction would be $4,000.
ROTH IRA CONVERSIONS AND TAXES
If you have a 401(k) from a former employer and are interested in the advantages offered by Roth IRAs, you can convert your 401(k) into a Roth IRA directly.
However, you’ll owe taxes on the number of pretax assets you convert.
Roth conversions and RMDs
If you are 72 or older and must take required minimum distributions (RMDs) from your Traditional IRA, bear in mind that you must take any RMDs that are due before the conversion, and failing to do so may result in penalties. RMD amounts cannot be included in the converted amount.
The amount you choose to convert will be taxed as ordinary income. This additional income, therefore, can push you into a higher marginal federal income tax bracket.
The total taxable amount is affected by whether the underlying contributions to the IRA were deductible.
Deductible contributions and any gains on them are taxed at their full current value—so if your Traditional IRA has only deductible contributions, you’ll pay tax on the full amount.
Nondeductible contributions have a nontaxable portion, which you’ll calculate using cost basis on IRS Form 8606.
Ways to pay the tax
The federal tax on a Roth IRA conversion will be collected by the IRS with the rest of your income taxes due on the return you file in the year of the conversion.
The ordinary income generated by a Roth IRA conversion generally can be offset by losses and deductions reported on the same tax return.
It’s usually considered a good idea to avoid using the funds that are being converted from within your Roth to pay the tax on the conversion.
By doing so, you will have less left in the account to potentially grow tax-free and, if you are under 59½, you’ll also incur the 10% penalty on the amount you don’t convert to the Roth IRA.
You may be required to make estimated tax payments in the year of the conversion before you do your return.
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TAXES ON QUALIFIED DISTRIBUTIONS
First of all, distributions of Roth IRA assets from regular participant contributions and from nontaxable conversions can be taken at any time, tax- and penalty-free.
However, distributions on taxable conversion amounts may be subject to the 10% early distribution penalty.
Distributions of earnings that are part of a non-qualified distribution are taxable and may be subject to an additional 10% early-distribution penalty.
- There is a distinction regarding which distributions are qualified and are thus exempt from taxes and penalties. To be qualified, a distribution must meet both of the following two categories of requirements:
- It occurs at least five years after the Roth IRA owner established and funded their first Roth IRA.
- It is distributed under one of the following circumstances:
- The Roth IRA holder is at least age 59½ when the distribution occurs.
- The Roth IRA holder is disabled when the distribution occurs.
- The beneficiary of the Roth IRA holder receives the assets after the owner’s death.
- The distributed assets will be used toward the purchase, building, or rebuilding of a first home for the Roth IRA holder or a qualified family member. This is limited to $10,000 per lifetime.2 Qualified family members include the Roth owner, their spouse, their or their spouse’s children, grandchildren, parents, or other ancestors.
HOW NON-QUALIFIED DISTRIBUTIONS ARE TAXED
The tax implications of a non-qualified distribution depend on the source of the Roth IRA assets.
There are four possible sources of Roth IRA assets:
- Regular participant contributions and rollover of basis from designated Roth accounts.
- A Roth conversion or rollover of taxable assets (pretax assets from traditional IRAs, SEP IRAs, SIMPLE IRAs, and employer plans such as qualified plans, 403(b), and governmental 457(b) plans.) These assets are taxed when converted or rolled over to the Roth IRA.
- A Roth conversion or rollover of nontaxable assets (basis amounts in traditional IRA and after-tax assets from employer plans such as qualified plans and 403(b) plans). These assets are not subject to income tax when converted to a Roth IRA.
- Earnings on all Roth IRA assets and rollover of earnings from a non-qualified distribution from a designated Roth account.
IN CONCLUSION
Always remember that Roth IRAs allow you to pay taxes on money going into your account and then all future withdrawals are tax-free.
With a Roth IRA, you contribute after-tax dollars, your money grows tax-free, and you can generally make tax- and penalty-free withdrawals.
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