Roth IRA: Pay the IRS Now for a Tax-Free Retirement. Here’s How It Works

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When you’re transitioning into retirement, the last thing you want is to get hit with a giant tax bill. Fortunately, you can avoid this if you save your money in a Roth IRA.

Roth IRAs are tax-advantaged retirement savings accounts to which you contribute after-tax dollars. Since you pay taxes on your contributions upfront, you don’t have to pay taxes on withdrawals during retirement. In fact, you can withdraw both your contributions and earnings tax-free after age 59 ½, as long as you’ve held your account for at least five years.  

Learning about the tax advantages of a Roth IRA now can help you build your retirement plan for the future. Here’s how Roth IRA taxes work.

Tax Advantages of a Roth IRA Account

Roth IRAs offer a sweet tax break to retirement savers. Your money grows tax-free, and you’ll never pay taxes when you withdraw it in retirement, as long as you play by the Roth IRA rules. 

Since you contribute after-tax dollars to a Roth IRA, you can also withdraw your contributions at any time without penalty, but experts strongly argue not to do that.

These tax rules are more or less the opposite of the rules around a traditional IRA. With a traditional IRA, you contribute pre-tax dollars and pay taxes on both your contributions and earnings in retirement. 

Along with these tax advantages, Roth IRAs have another perk: No required minimum distributions, also known as RMDs, in retirement. This means there are no mandatory withdrawals so you can keep your money in a Roth IRA as long as you like. If you’d prefer to leave your money untouched, you can pass it down to your heirs without penalty. 

How are Roth IRA Contributions Taxed

When you save your money in a Roth IRA, you contribute after-tax dollars, or money that has already been taxed at your current tax rate.

Roth IRAs also have a maximum annual contribution limit. For the 2022 year, the maximum amount you can contribute to a Roth IRA is $6,000, or $7,000 if you’re 50 or older, and in 2023, you’re free to contribute $6,500 if you’re under 50, and $7,500 if you’re 50 and older.

These contribution limits begin to phase out at certain income thresholds, which vary depending on your filing status. Your contribution limit will be reduced if you make between, 

  • $129,000 and $144,000 as a single filer or head of household  
  • $204,000 and $214,000 as a married couple filing jointly
  • $0 and $10,000 as a married individual filing separately who did not live with your spouse during the year 

Individuals who exceed those income limits are not eligible to contribute directly to a Roth IRA account without doing a backdoor Roth IRA. A backdoor Roth IRA still lets you contribute to a Roth IRA but you have to open a traditional IRA and convert it to a Roth IRA.

How are Roth IRA Withdrawals Taxed

Since you pay taxes on your Roth IRA contributions upfront, you don’t need to pay taxes again on your withdrawals in retirement, assuming you meet Roth IRA conditions of having the account open five years. Even if your contributions earn a massive return on investment, you can withdraw the money tax-free. This is why experts love and swear by Roth IRAs as a great retirement vehicle.

“Withdrawals are not taxed — that’s the beauty of it,” says Sonja Breeding, CFP and vice president of investment advice at Rebalance, an investment firm. “Because they’re not taxed, we typically recommend letting the contributions grow as long as possible.”

Pro Tip

Since you contribute after-tax dollars to a Roth IRA, you don’t have to pay taxes on withdrawals during retirement, as long as you play by the Roth IRA rules.

As mentioned, tax-free withdrawals on your earnings are allowed once you’ve turned 59 ½ and have been contributing to the account for at least five years. There are a few other instances when you can withdraw your money tax-free as long as you meet the five-year rule, including: 

  • First-time home purchase
  • Medical bills
  • Health insurance while you’re unemployed
  • Qualified education expenses 
  • Permanent disability

Keep in mind that if you don’t meet any of these criteria, you will have to pay taxes on the amount plus a 10% penalty. Experts also strongly recommend not taking money out of a Roth IRA for any exception, including the ones above.

Draining your retirement account usually isn’t advised, however, as it could leave you without enough savings in retirement. Plus, the longer amount of time your money has to grow in your account, the greater return you could see due to the power of compound interest