Roth IRAS – What You Need to Know
Roth IRAs are tax-favored accounts to which qualified taxpayers can make after-tax contributions. Contributions to a ROTH IRA account can grow tax-free, and neither the contributions nor the earnings on them are subject to tax when a Roth IRA owner receives a qualified distribution from the account. Although a Roth IRA is designed to help a taxpayer save for retirement, it is inaccurate to characterize a Roth IRA as just a retirement savings vehicle.
Roth IRAs offer several advantages over traditional IRAs.
•Distributions can be made completely tax free, as long as they are qualified distributions (generally, distributions made more than five years after the contribution that are made after the owner has attained age 59½, died, or become disabled, and distributions for certain special purposes, including the purchase of a first home).
•The owner is not required to take lifetime distributions, so the tax-free buildup can continue throughout the owner’s life.
•Distributions of contributions are always tax free, no matter when they are made.
A taxpayer that decides to take lifetime distributions can benefit from the same favorable tax treatment accorded to Roth IRAs. Like traditional IRAs, Roth IRAs provide for tax deferral on the earnings. However, since no tax is imposed as long as the distribution is a qualified distribution, as discussed above, this benefit is increased.
Because tax-free distributions of earnings can occur only after the five-year requirement is satisfied, to take full advantage of this (as well as to maximize the amount of earnings on which tax is deferred), contributions to a Roth IRA should be made as soon as possible. In fact, parents or grandparents may want to consider setting up and funding a Roth IRA for their children or grandchildren as soon as the children or grandchildren have enough earned income from part-time or summer jobs. This will ensure that the five-year requirement is met when the individual for whom the Roth IRA is established is ready to make a withdrawal to buy a home, for example.
Before making a contribution to a traditional IRA (or other retirement plan), it generally is important to be sure that you can afford to be without the funds for some period of time, since tax and often heavy penalties are imposed when amounts are withdrawn. However, in the case of a Roth IRA, withdrawals before the five-year requirement is satisfied are tax free as long as they consist only of contributions. As a result, a Roth IRA can act as an emergency fund since you can make tax-free withdrawals from the account to the extent of the contributions made to the account.
For example, assume you contribute $3,000 to a Roth IRA in 2020, 2021, and 2022. In October 2023, when the account is worth $11,000 (contributions plus earnings), you need $5,000 for an emergency. Since you’ve made contributions to the Roth IRA equal to $9,000, you would be able to withdraw the $5,000 tax-free from the Roth IRA. In applying this rule, distributions from a Roth IRA are treated as coming from contributions first. You must keep accurate records of the contributions made to a Roth IRA so that if a withdrawal is made from the account, you can show that the withdrawal is coming from contributions and is, therefore, tax free.
The fact that you can withdraw the annual contributions made to the Roth IRA at any time during retirement without incurring any tax means that these accounts can serve financial planning goals that cannot be served by a traditional IRA.