A Roth IRA allows you to pay the taxes on your retirement savings while you are still working. There are specific rules regarding how much you can contribute and how to become eligible for tax-free withdrawals in retirement. If you don’t carefully follow the rules, you might need to pay taxes or penalties on the investment earnings.
When saving in a Roth IRA, you’ll want to know:
— How much you can contribute to a Roth IRA.
— What happens while the money is in the Roth IRA.
— How to take tax-free Roth IRA withdrawals.
— When you will have to pay taxes on earnings.
[See: 10 Reasons to Save for Retirement in a Roth IRA.]
Contribute After-Tax Funds to a Roth IRA
While traditional IRAs allow you to defer paying income tax on your retirement savings, you depot after-tax funds in a Roth IRA. “Contributions are not deducted from current year income taxes, so you are still paying those taxes,” says Jeff Wright, president and wealth advisor at Wright Wealth in Atlanta.
The limit on how much you can put into an IRA is $6,500 in 2023. If you are 50 or older, the limit is $7,500. Your filing status and level of income could impact the contributions you’re allowed to make. Eligibility to make Roth IRA contributions is phased out if you earn more than $138,000 in 2023 as a single filer and $218,000 as a married couple. If you make more than $153,000 as a single filer or $228,000 as a couple filing jointly, you won’t be able to directly contribute to a Roth IRA.
For those who exceed the income limits and want to fund a Roth IRA, there is a back door conversion option. “The way the back door conversion works is that you can make a non-deductible contribution to a traditional IRA, which has no income limits on non-deductible contributions,” says Joseph M. Favorito, managing partner at Landmark Wealth Management in Melville, New York. Then you convert the traditional IRA contribution to the Roth IRA right away. “Since you took no deduction on the contribution, there is no taxable income on the conversion to the Roth IRA,” Favorito says. “In addition, there are no income limits on the Roth conversions.”
Making a Roth IRA contribution or conversion earlier in your career could lead to long-term benefits. “Roth IRA contributions and conversions are beneficial for investors in lower tax brackets if they expect to be in a higher tax bracket at the time of withdrawal,” Wright says. “In this case, the investor is paying lower income taxes now than they otherwise would in the future if withdrawing from a traditional IRA.”
[Read: How to Open a Roth IRA.]
No Taxes Due While the Money Is in the Roth IRA
Once you’ve made a contribution to a Roth IRA, you won’t have to pay taxes on the money in the account. “The funds grow completely tax-free,” Favorito says. The funds can continue to grow in the account for years or decades.
An event such as an emergency could lead you to look for ways to access funds early. “You have full access to withdraw your contributions at any time, with no penalty,” says Cody Lachner, director of financial planning at BBK Wealth Management in Lafayette, Indiana. However, taxes and penalties could apply to early withdrawals of investment earnings.
Roth IRA Withdrawals in Retirement Are Typically Tax-Free
The IRS has requirements that must be met for you to take out the earnings in a Roth IRA without penalty. “The Roth IRA needs to be open for at least five calendar years,” Lachner says. You’ll also need to be at least 59 1/2 years old when you start to take funds from the Roth IRA. If you meet these criteria, you won’t pay taxes on the withdrawals of investment growth.
If you choose to leave the funds in the account, you can do so without penalties. This is different than a traditional IRA, which has required minimum distributions after age 73 in 2023.
[See: How to Pay Less Tax on Retirement Account Withdrawals.]
When You Need to Pay Taxes on the Roth IRA Investment Earnings
If you withdraw earnings from the Roth IRA within five years of opening the account or before age 59 1/2, you’ll have to pay taxes on the withdrawal. You could also face a 10% early withdrawal penalty on the earnings withdrawn if you are younger than age 59 1/2.
However, if you go through a financially challenging time and meet certain requirements, you could take funds out without having to pay a penalty. Exceptions to the Roth IRA early withdrawal penalty include:
— You use up to $10,000 from the account to pay for a first-time home purchase.
— You need the funds for qualified education expenses.
— You access up to $5,000 to help cover expenses related to a birth or adoption.
— You are disabled.
— You withdraw to pay for significant medical expenses that aren’t covered by insurance.
The tax savings from Roth IRAs can help you build a tax efficient retirement plan. “Having access to a bucket of money that is not subject to income tax means that a person can be very strategic with how they structure their retirement income,” Lachner says. Money in retirement that comes from pensions, Social Security, traditional IRAs and 401(k)s can increase taxable income. Roth IRA withdrawals can be a tax-free source of retirement income as long as the criteria are met.
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IRA Contribution Limits for 2023
How Roth IRA Taxes Work originally appeared on usnews.com
