When do you pay taxes on a Roth IRA? Retirement planning calls for a delicate balance between making the most of your investment both today and for the future. Knowing when you pay taxes on an investment is a vital part of that balance.
What is a Roth IRA account?
The two basic types of IRAs are Roth IRAs and traditional IRAs, and you can choose either one as an investment vehicle when you're planning for your retirement. With a Roth IRA account, there are restrictions based on your income, and if you make more than a certain amount, you cannot contribute. But the biggest difference between a traditional IRA and a Roth IRA is the tax structure, which makes this difference important.
When do you pay taxes on a Roth IRA?
The primary difference between a Roth IRA and a traditional IRA is when you pay taxes. A traditional IRA is a tax-deferred account. That means that you don't pay taxes until you withdraw your funds. With a Roth IRA, you pay your taxes upfront, which means your Roth IRA contributions are made with regularly taxed income.
Why does it matter when you pay taxes on a Roth IRA account?
This big difference is important for two reasons: one, it assumes you'll be paying taxes at a time when you can better afford it; two, you can plan ahead for a fixed tax liability instead of guessing what it might be down the road.
In a traditional IRA or other investment vehicle, you pay taxes when you withdraw the funds. That means that, in 40 years, or however long it is until you withdraw funds, you have to pay taxes on every penny you withdraw. If you contribute $4,000 annually, but that cash turns into $8,000 or even $10,000 by the time you withdraw it, you have to pay taxes on the entire amount, effectively penalizing you for your investment growth. Likewise, if you deposit $4,000 annually, but want to withdraw $40,000 in a lump sum, you'd have to pay taxes on that entire amount, potentially at a tax rate higher than it would have been at the time of deposit.
With a Roth IRA, you pay taxes on your deposit as regular income today. This means that it's taxed at your regular income tax rate, and you calculate it with your normal tax return. If you deposit $4,000 today, and that turns into $8,000 by the time you withdraw it, you won't pay an extra penny; you'll only have paid taxes on the initial $4,000. Depending on your tax bracket when you make the deposit and when you withdraw it, you'd potentially pay fewer taxes at deposit than at withdrawal, making a Roth IRA account a more efficient investment vehicle.
How much can I put in my Roth IRA? The amount will adjust for inflation every tax year, but you might not be able to contribute the maximum if your income is too high.
How much do you need to start an IRA? You may need at least $1,000, or you can enroll in a program with a smaller minimum investment as long as you agree to make regular contributions.