Roth IRA Contributions Are Not Tax-Deferred
Roth IRA contributions are made with income that has already been taxed. Your contributions cannot be deducted from your taxes, so investing in these accounts is not considered a tax-deferred investment.
Qualified distributions are those that meet certain requirements, such as if you receive them after retirement age, which the Internal Revenue Service (IRS) defines as 59 and a half. You may also receive qualified distributions if:
- You have maintained the account for more than five years.
- You are disabled.
- The distributions are made to a beneficiary.
- You were affected by a qualified disaster.
- You use the money to build or buy your first home (up to $10,000).
Note: The tax benefit of a Roth IRA is that you do not have to pay taxes on any earnings or capital in the account while saving for retirement or on qualified distributions. You will have to pay a 10% penalty if you take an unqualified distribution, but this applies only to investment earnings, not to the money you originally contributed. Contributions to a Roth IRA can be withdrawn at any time since you have already paid taxes on that money.
You should keep in mind that the IRS imposes limits on the amounts you can contribute to individual retirement accounts. As of 2022, you can contribute $6,000 annually or $7,000 if you are over 50 years old. These limits change periodically, but not necessarily every year. However, they will increase to $6,500 and $7,500 in 2023.
Note: The IRS also imposes an income limit for eligibility to contribute to a Roth IRA. You cannot contribute if you earn a significant amount. Your modified adjusted gross income (MAGI) must be $214,000 or less if you are married and filing a joint tax return for 2022, or $144,000 if you are head of household or filing as an individual. These limits increase to $228,000 and $153,000 in 2023.
One way to benefit from a Roth IRA if your income is too high to contribute is to use a Roth conversion or “backdoor” strategy. Retirement accounts like 401(k) or individual retirement accounts can be converted to Roth even if the account balance exceeds the allowed annual contribution limit, although you will have to pay taxes on the money in the year of the conversion.
How Do Tax-Deferred Retirement Accounts Work?
You have several options to consider if you prefer the tax benefits of tax-deferred retirement accounts. These options provide more immediate tax benefits.
401(k)
Traditional 401(k) plans, as well as 403(b) and 457(b) plans, are defined contribution plans that are funded by employers. The employee contributes to the plan, and the employer matches part or all of the contribution. Contributions to the plan are tax-deferred, so withdrawals are taxed in retirement.
Traditional Individual Retirement Accounts
Traditional Individual Retirement Accounts are similar to Roth IRAs in that they are owned by individuals, but they take pre-tax contributions. Your distributions in retirement are taxed. Traditional IRAs have the same annual contribution limits as Roth accounts. You must pay income taxes as well as a 10% early withdrawal penalty if you withdraw funds early.
Is a Roth IRA the Best Retirement Account for You?
Should you place your retirement savings in a Roth IRA or in a retirement account that provides more immediate tax benefits? Let’s review the advantages and disadvantages of each.
When
Do after-tax accounts work better?
In general, Roth IRA accounts are recommended for younger individuals who have longer investment and savings horizons. This is partly because these individuals have more time to achieve significant gains, which they can withdraw tax-free in retirement years. The longer investment horizons mean they can better leverage the power of compounding to help their earnings grow faster.
Note: Generally, younger individuals earn lower wages than those nearing retirement, so they have a lower tax rate. They tend to move into a higher tax bracket and are taxed more on their earnings as they age and increase their income, so paying taxes now may be more beneficial for them.
Suppose you earn $80,000 annually, placing you in the 22% tax bracket. The tax would be $1,320 now if you contribute $6,000. You would have an income of $130,000 in retirement, so you would be in the 24% tax bracket. You would pay $1,440 on that $6,000. Paying taxes earlier may be more convenient for some people.
When do pre-tax accounts work better?
You might prefer a pre-tax account if you want to take advantage of tax deductions sooner. You might be on a tight budget and need the immediate tax benefit.
You might also benefit from using a pre-tax retirement account if you are currently earning a high income 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 which type of account is best for you. They may recommend one type of retirement account or suggest you split your funds and contribute to both. You can invest in a Roth IRA to increase earnings for future tax-free withdrawals while contributing to a 401(k) plan at work to take advantage of matching funds.
Note: Regardless of the strategy you choose regarding retirement savings, the earlier you start, the better.
Non-qualified retirement accounts
Qualified retirement accounts provide incredible tax benefits, but you can also use other types of investment accounts to save for retirement. Investing through traditional brokerage accounts that do not offer tax advantages allows you to withdraw money without incurring early withdrawal penalties. You can also invest larger sums since there are no contribution limits.
You may need more money to fund your retirement than you can save in a tax-qualified retirement account like a Roth IRA. You will build your savings if you invest in a side account while keeping funds liquid if you want to invest in business or real estate.
Frequently Asked Questions (FAQs)
How much tax do you pay on a Roth IRA conversion?
Roth IRA conversions are subject to income tax at your marginal tax rate. You must report the full account balance as income on your tax return in the year you make the conversion. You can spread the conversion over several years to reduce tax payments each year. This is particularly helpful if you know the years you will have higher income.
How does a Roth IRA affect your tax return?
A Roth IRA will affect your tax return only if you made a conversion in that tax year or had an ineligible distribution. You will report the amount on your tax return in these cases. The conversion will be taxed at your marginal tax rate, and there will be a 10% penalty on the distribution.
Do
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Sources:
The Balance only uses high-quality sources, including peer-reviewed studies, to support the facts presented in our articles. Read our editorial process to learn more about how we fact-check and ensure the accuracy, reliability, and credibility of our content.
Internal Revenue Service (IRS). “Publication 590-A, Contributions to Individual Retirement Accounts (IRAs).”
Internal Revenue Service (IRS). “Retirement Topics – IRA Contribution Limits.”
Internal Revenue Service (IRS). “The Amount of Contributions You Can Make to Roth IRAs for 2023.”
Internal Revenue Service (IRS). “The Amount of Contributions You Can Make to Roth IRAs for 2022.”
Source: https://www.thebalancemoney.com/is-roth-ira-a-pre-tax-investment-5225577
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