Let’s take a look at how taxation works with contributing to and withdrawing from Roth IRAs, as well as how taxes apply to other types of retirement accounts.
Roth IRA Contributions Aren’t Pre-Tax
Roth IRA contributions are made with income that’s already been taxed. Your contributions are not tax deductible, so investments in these accounts are not considered to be pre-tax investments. Qualified distributions are those that meet certain requirements, such as if you receive them after retirement age, which the Internal Revenue Service (IRS) sets at 59½. You can also receive qualified distributions if:
You’ve held the account for more than five years.You’re disabled.Distributions are made to a beneficiary.You were affected by a qualified disaster.You’re using the money to build or buy your first home (up to $10,000).
You must pay a 10% penalty if you take a nonqualified distribution, but this only applies to your investment earnings, not to the money you originally contributed. Contributions to a Roth IRA can be withdrawn at any time because you’ve already paid tax on that money. Keep in mind that the IRS places limits on how much you can contribute to IRAs. As of 2022, you can contribute $6,000 per year or $7,000 if you’re over 50. The changes these contribution limits periodically, but not necessarily every year. They do increase to $6,500 and $7,500 in 2023, however. One way to get the benefits of a Roth IRA if your income is too high to contribute is to use a Roth conversion or “backdoor” strategy. Retirement accounts such as 401(k)s or traditional IRAs can be converted to a Roth even if the account balance is more than the annual contribution limit, although you have to pay tax on the funds in the year of the conversion.
How Pre-Tax Retirement Accounts Work
You have several options to consider if you’d prefer the tax advantages of a pre-tax retirement account. They provide more immediate tax benefits.
A 401(k)
Traditional 401(k) plans. as well as 403(b) and 457(b) plans, are defined contribution plans that are sponsored by employers. The employee makes a contribution into the plan and the employer matches a portion or all of the contribution. Contributions to the plan are pre-tax, so the withdrawals in retirement are subject to taxation.
Traditional IRAs
Traditional IRAs are similar to Roth IRAs in that they’re held by individuals, but they take pre-tax contributions. Your distributions in retirement are therefore taxed. Traditional IRAs have the same annual contribution limits as Roth accounts. You must pay income taxes plus a 10% early withdrawal penalty if you withdraw funds early.
Is a Roth IRA the Best Retirement Account for You?
Should you put your retirement savings in a Roth IRA or a retirement account that offers more immediate tax benefits? Let’s go over the pros and cons of each.
When After-Tax Accounts Work Best
Roth IRAs are generally recommended for younger people who have longer investing and saving horizons. That’s in part because these individuals have more time to establish significant earnings, which they can withdraw tax free in their retirement years. Their longer investing horizon means they can better leverage the power of compounding to help their earnings grow more quickly. Let’s say you make $80,000 per year, which puts you in the 22% tax bracket. The tax would be $1,320 now if you contribute $6,000. You’ll have an income of $130,000 in retirement so you’d be in the 24% bracket. You would pay $1,440 on that $6,000. Paying taxes earlier may make more sense for some people.
When Pre-Tax Accounts Work Best
You may prefer a pre-tax account if you want to take advantage of tax breaks sooner. You may be on a tight budget and need the tax advantage immediately. You may also benefit from using a retirement account that takes pre-tax funds if you’re earning a significant amount of money now and expect to earn much less in retirement.
The Best of Both Worlds
You can consult a financial advisor for guidance on your personal situation if you’re not exactly sure what type of account is best for you. They might recommend one type of retirement account or they might suggest that you split your money and contribute to both. You can invest in a Roth IRA to grow earnings for future tax-free withdrawals while also contributing to a 401(k) plan at work to take advantage of matching funds.
Non-Qualified Retirement Accounts
Qualified retirement accounts offer incredible tax benefits, but you can also use other types of investment accounts toward saving for retirement. Investing using traditional brokerage accounts that have no tax breaks allows you to remove the money without early penalties. You can also invest more because there are no contribution limits. You may need more money to fund your retirement than what you can save in a tax-advantaged retirement account like a Roth IRA. You’ll build up your savings if you invest in a side account while also keeping money liquid if you want it to invest in a business or real estate. 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!
