Roth individual retirement accounts, or IRAs, are popular investment accounts because of their tax advantages. You pay taxes on the money upfront in exchange for tax-free growth and withdrawals later on. You won’t pay taxes on Roth IRA gains, whether they’re short term or long term.
Find out more about how taxes work for Roth IRAs. Learn why a Roth IRA is a great way to invest when you’re trying to minimize your future tax bill.
- A Roth IRA is never subject to short-term or long-term capital gains taxes.
- Because a Roth IRA is funded with after-tax dollars, you can withdraw your contributions tax free and penalty free at any time.
- If you withdraw your earnings before age 59 ½, or it’s been less than five years since you opened the account, you could owe income taxes plus a 10% penalty.
Roth IRAs Don’t Tax Any Gains
Your Roth IRA gains are never taxed as long as you follow certain rules. This applies to short-term capital gains on investments you hold for a year or less, which are typically taxed as ordinary income. It also applies to long-term capital gains on investments you hold for over a year, which are normally taxed at lower rates.
When Roth IRA Funds Are Taxed
You fund a Roth IRA with money you’ve already paid income taxes on. As long as you wait until you’re 59 ½ and you’ve held the account for at least five years, your gains are tax free. You can withdraw your Roth IRA contributions without paying taxes or a penalty at any time. But if you tap into the earnings early, you’ll pay income taxes plus a 10% penalty on the earnings portion.
You won’t pay capital gains taxes on traditional IRA gains, either. However, because you contribute pretax dollars, your withdrawals from those accounts are taxable as ordinary income.
Best Investments for a Roth IRA
Because the tax benefits are so generous, the best investments for a Roth IRA are those that you expect to deliver the biggest returns. Lower-yielding investments are better options for taxable accounts.
A Roth IRA is a good option for investing in stocks and index funds in fast-growing sectors. High-yield dividend stocks are also good options because dividends aren’t taxed in a Roth IRA. You can reinvest your dividends to fuel your returns even more.
If you own both exchange-traded funds (ETFs) and actively managed mutual funds, prioritize using your Roth IRA for the actively managed funds. The frequent rebalancing that occurs in actively managed funds creates more taxable events. But because growth in a Roth IRA is generally tax free, you can avoid the tax bill altogether.
Penalty Taxes and Other Pitfalls To Avoid
It’s important to follow the Roth IRA rules to avoid owing income taxes and possibly a 10% penalty on your withdrawals. If you need to withdraw money before you’ve reached age 59 ½ and met the five-year rule, try to limit your withdrawal to the contribution portion, because earnings will be taxed. You can also avoid the 10% penalty under some circumstances, such as when you’re using the money for a first-time home purchase, college, or expenses related to childbirth or adoption. However, you’ll still pay income taxes on early withdrawals of earnings.
Overfunding a Roth IRA because your income exceeded the limits or you simply contributed too much also could result in a tax bill.
If you discover the overfunding error before you’ve filed your tax return for the year, you won’t pay a penalty on the contributions; however, you may owe taxes and a 10% penalty on the earnings if you’re under age 59 ½.
If you realize your mistake after filing your return and don’t take action to correct it, a 6% penalty tax will apply each year until the matter is resolved.
Frequently Asked Questions (FAQs)
How do you set up a Roth IRA?
You can open a Roth IRA at the financial institution of your choice, either online or in person. You’ll need to provide some basic information, like your Social Security number, address, date of birth, and employment information. Once you’ve set up the account, you’ll need to deposit money and decide how to invest it.
How much can you contribute to a Roth IRA?
The maximum Roth IRA contribution is $6,000 for people under age 50 in 2022. If you’re 50 or older, you can make an extra $1,000 catch-up contribution. You can’t contribute more than your taxable compensation for the year. Income limits also apply.