Find out more about how taxes work for Roth IRAs. Learn why a Roth IRA is a great way to invest when you’re trying to minimize your future tax bill.
Roth IRAs Don’t Tax Any Gains
Your Roth IRA gains are never taxed as long as you follow certain rules. This applies to short-term capital gains on investments you hold for a year or less, which are typically taxed as ordinary income. It also applies to long-term capital gains on investments you hold for over a year, which are normally taxed at lower rates.
When Roth IRA Funds Are Taxed
You fund a Roth IRA with money you’ve already paid income taxes on. As long as you wait until you’re 59 ½ and you’ve held the account for at least five years, your gains are tax free. You can withdraw your Roth IRA contributions without paying taxes or a penalty at any time. But if you tap into the earnings early, you’ll pay income taxes plus a 10% penalty on the earnings portion. Note that you’re paying income taxes for an early withdrawal on your Roth IRA earnings rather than capital gains taxes. Capital gains taxes never apply to Roth IRA withdrawals.
Best Investments for a Roth IRA
Because the tax benefits are so generous, the best investments for a Roth IRA are those that you expect to deliver the biggest returns. Lower-yielding investments are better options for taxable accounts. A Roth IRA is a good option for investing in stocks and index funds in fast-growing sectors. High-yield dividend stocks are also good options because dividends aren’t taxed in a Roth IRA. You can reinvest your dividends to fuel your returns even more. If you own both exchange-traded funds (ETFs) and actively managed mutual funds, prioritize using your Roth IRA for the actively managed funds. The frequent rebalancing that occurs in actively managed funds creates more taxable events. But because growth in a Roth IRA is generally tax free, you can avoid the tax bill altogether.
Penalty Taxes and Other Pitfalls To Avoid
It’s important to follow the Roth IRA rules to avoid owing income taxes and possibly a 10% penalty on your withdrawals. If you need to withdraw money before you’ve reached age 59 ½ and met the five-year rule, try to limit your withdrawal to the contribution portion, because earnings will be taxed. You can also avoid the 10% penalty under some circumstances, such as when you’re using the money for a first-time home purchase, college, or expenses related to childbirth or adoption. However, you’ll still pay income taxes on early withdrawals of earnings. If you discover the overfunding error before you’ve filed your tax return for the year, you won’t pay a penalty on the contributions; however, you may owe taxes and a 10% penalty on the earnings if you’re under age 59 ½. If you realize your mistake after filing your return and don’t take action to correct it, a 6% penalty tax will apply each year until the matter is resolved.
