There are many different types of retirement plans, and one of the main ways to choose among them is to ask: How do they treat you at tax time? Let’s just say the Roth IRA is really very polite.
How Roth IRA taxes work
Although you pay taxes on the money you put into a Roth IRA, the investment earnings in the account are tax-free. Also, when you reach age 59½ and have had the account open for at least five years, withdrawals are tax-free.
No 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).
Roth IRA taxes on withdrawals
The other 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.
» Like the sound of tax-free retirement income? Find out how and where to open a Roth IRA.
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.
Still, there are at least a couple of situations where a traditional IRA might be a better bet for you than a Roth IRA:
If you’re pretty sure your taxes are going to be lower in retirement than they are right now, then it makes sense to delay taxes until then.
Don’t forget that Roths offer more flexible withdrawals, plus don’t require distributions in retirement, the way traditional IRAs do. Like we said, Roths are downright polite.