How Do Taxes on Roth IRAs Work?

Having a forward-looking tax plan is a critical consideration when it comes to wealth management. If you’re not careful, taxes can quickly destroy the financial wealth you’ve worked so hard for. It’s important to understand how your income sources are taxed, so today we’re going to review taxes on Roth IRAs.

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One of our managing directors, Bud Kasper, CFP®, AIF®, was once asked to give his top-three pros of Roth conversions—which is the process of converting a traditional IRA to a Roth IRA. It only took him a few seconds to compile his list.

No future tax.
No future tax.
No future tax.

What’s Not to Like About Tax-Free Growth?

If there are no future taxes on Roth IRAs, that wraps up this article on taxes on Roth IRAs, right? Well, there’s a little bit more to it than that. Make no mistake about it, the tax-free growth on earnings of Roth IRA contributions and Roth IRA qualified distributions can be a game-changer in retirement depending on your situation. But even as a self-proclaimed Rothaholic, Bud acknowledged that there are reasons not to convert to Roth IRAs.

When making a contribution to a Roth IRA, you’re required to pay tax on those dollars before the earnings begin to grow tax-free. It’s the same principle with Roth conversions, as you’re required to pay tax on the funds that are being converted before capturing the tax-free growth. If you don’t have enough money to pay tax on a Roth conversion, that’s an obvious reason not to convert to a Roth IRA. To see specific examples of when Roth conversions do and don’t make sense, download a copy of our Roth Conversion Case Studies.

Roth Conversion Case Studies

Ordering Rules for Roth IRA Distributions

Roth IRA distributions can consist of contributions, converted funds, and earnings—or any combination of the three. To determine what your distribution is, you must use “ordering rules,” which dictate the order in which these categories of Roth IRA money must be withdrawn.₁ All Roth IRAs are considered one Roth IRA for distribution purposes.

A Roth IRA distribution will consist first of any Roth IRA contributions. If there are no contributions or those amounts are completely exhausted, the next funds out are converted funds. Once all converted funds have been exhausted, the remainder of the distributions will consist of earnings.

1. Are You Withdrawing a Qualified Contribution?

Roth IRA contributions are the annual amounts that you contribute to a Roth IRA account. A qualified distribution of Roth IRA contributions will always be both tax and penalty free.

2. Are You Withdrawing Converted Amounts Before Age 59½?

Converted funds are never subject to income tax. However, they will be subject to the 10% penalty for early distributions (unless an exception applies) if you are under 59½ and they have been in a Roth IRA for less than five years. Each conversion starts its own 10% penalty five-year clock.

3. Are You Withdrawing Converted Amounts After Five Years or Age 59½?

A distribution of converted funds after five years or after age 59½ will be entirely income tax and penalty free.

4. Are You Withdrawing Earnings Before Age 59½?

Earnings withdrawn prior to age 59½ are generally subject to income tax regardless of how long they’ve been in a Roth IRA account. Earnings withdrawn prior to age 59½ are also generally subject to the 10% penalty for early distributions unless an exception applies.

5. Are You Withdrawing Earnings After Age 59½ and Five Years?

Earnings withdrawn after age 59½ are never subject to the 10% penalty. They may, however, be subject to income tax. If you have held a Roth IRA for more than five years, your earnings are tax-free. If not, they are taxable at ordinary rates.

Do You Have Questions About Taxes on Roth IRAs?

We understand the impact taxes can have on a retirement plan and are well-versed in minimizing taxes on retirement savings and income. Our CPAs work closely with our wealth managers to help design a proactive tax plan and to prepare tax returns for pre-retirees and retirees.

It’s important to understand that tax preparation and tax planning are two different things, though. Tax preparation is tax compliance that reports on the previous tax year. Tax planning looks at your current AND future tax rates and assesses how you to go about paying as little tax over your lifetime rather than on a year-by-year basis. Having money in Roth accounts and having tax diversification can play a big role in that.

If you have any questions about taxes on Roth IRAs and how Roth IRAs can be a part of your forward-looking tax plan, start a conversation with our team below.

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Taxes on your retirement income aren’t something that you want to overlook during the retirement planning process. Our financial planning team is ready to build you a personalized financial plan that considers your current and future tax situation so that you have more confidence that you’re doing the right things with your money, freedom from financial stress, and time to do the things you love.

Taxes on Roth IRAs : Watch Guide

00:00 – Introduction
01:24 – Difference Between Roth and Traditional 401(k)s and IRAs
03:08 – Taxation and Income Limits on Traditional & Roth IRAs and 401(k)s
06:08 – Breaking Down the 5 Year Rules
18:49 – Create a Plan for Your Roth Accounts
21:25 – What We Learned Today

Resources Mentioned in This Article

Articles and Videos

Past America’s Wealth Management Show Episodes

Downloads

Roth Conversion Case Studies

Other Sources

[1] https://irahelp.com/slottreport/roth-ira-distribution-ordering-rules/

Investment advisory services offered through Modern Wealth Management, LLC, an SEC Registered Investment Adviser.

The views expressed represent the opinion of Modern Wealth Management an SEC Registered Investment Adviser. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Modern Wealth Management does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.