The Tax Benefits of Roth IRAs
Roth IRAs might not seem so great at first glance because you can claim a tax deduction for retirement savings contributions that you make as you can with a traditional IRA. You must pay taxes on the money you contribute in the year you save it to your Roth. But this earns you some nice tax perks further down the line. You can take that money back tax free in retirement because you already paid income tax on it when you made the contributions. Better yet, all the growth and income resulting from that money can be tax free as well, if you meet certain rules that aren’t that prohibitive. You don’t have to begin taking out the money and paying taxes on it when you reach a certain age, as is the case with traditional IRAs.
When Do You Pay Taxes on Roth IRA Withdrawals?
The Internal Revenue Code (IRC) does include a good many rules and limits that can affect the tax-free treatment of Roth IRA earnings. First, your withdrawals must be “qualified” in order to escape taxation.
The Tax on Nonqualified Withdrawals
A withdrawal is considered qualified if at least five years have passed since you first contributed to your Roth IRA, and at least one more circumstance must exist:
You take the money after you’ve reached age 59½,You withdraw up to $10,000 for a first-time home purchase,You become disabled, orThe money passes to a beneficiary in the event of your death.
You’ll also be charged a 10% tax penalty on the amount of the withdrawal if you’re younger than age 59½ unless you meet at least one of several other circumstances. Many of these can also apply to ordinary taxation of the Roth IRA’s earnings:
The distribution is taken in equal payments spread out over the course of your life expectancy,You’ve been receiving unemployment compensation for at least 12 consecutive weeks and you use the money to pay for health insurance premiums,You use the money for qualified higher education expenses,The distribution is taken due to your disability or death, orYou take up to $10,000 for a qualified first-time home purchase. This amount is a lifetime limit.
Withdrawals that qualify as reservist distributions can dodge the tax penalty bullet as well.
The Excise Penalty Tax on Excess Contributions
A 6% tax penalty will apply if you contribute more money to your IRAs than you’re entitled to save during any given tax year. Contribution limits are $6,000 per year as of 2022, or $7,000 if you’re over age 50, increasing to $6,500 or $7,500 in 2023. These limits apply to all your IRA contributions added together if you contribute to more than one account in the same year. You have a short window of time to correct the situation if this happens to you. You can withdraw the money and any earnings on the contribution by the due date for your tax return for that year. This deadline includes any extensions of time that you might ask for to file your return.
Modified Adjusted Gross Income (MAGI) Limits
Your modified adjusted gross income (MAGI) must be below certain thresholds to contribute the full $6,000 or $7,000 to your accounts annually. These thresholds are set by filing status. You’re limited to a MAGI of less than $129,000 in 2022 if you’re single, head of household, or a married taxpayer filing a separate return, provided that you didn’t live with your spouse at any time during the tax year. You can contribute a lesser portion if your income falls between $129,000 and $143,999. You can’t contribute at all if your MAGI is $144,000 or more. These limits increase if you’re married and filing a joint return, or if you’re a qualifying widow(er). They decrease to $10,000 if you’re married and filing a separate return and you lived with your spouse at any time during the tax year.
The “Backdoor” Roth IRA
“Backdoor” Roth IRAs can work around the problem of MAGI limits. You can make a nondeductible contribution to a traditional IRA that isn’t subject to any income limits, then transfer or convert that money into a Roth account, even if you earn more than the Roth IRA MAGI limit for your filing status. This earns you those Roth IRA tax perks on your money and its growth when you take distributions, although you would have to pay income tax on any earnings realized between the time you make the initial contribution to a traditional IRA and the date of the conversion. Congress lifted the income restrictions for Roth IRA conversions in 2010, although they still apply to contributions. The Tax Cuts and Jobs Act (TCJA) continued to allow this workaround when that law went into effect in 2018. The Build Back Better Act, introduced in 2021, proposed to eliminate this strategy from the tax code, at least for wealthy taxpayers. But this provision was eliminated when the Act was scaled back and passed as the Inflation Reduction Act in August 2022. Want to read more content like this? Sign up for The Balance’s newsletter for daily insights, analysis, and financial tips, all delivered straight to your inbox every morning!
