Roth IRAs have only been around since 1997, but they’re a popular investment option for retirement planning and with good cause. In many cases, distributions – money withdrawn from a Roth IRA – are tax-free, regardless of whether that money represents a return of contributions made or interest income the account earned.
The Internal Revenue Service wants you to save for retirement, so the tax code offers all sorts of perks to encourage you to do so. You lose those perks in most cases if you don’t leave the saved money and its earnings in place until retirement.
When you invest in a Roth IRA, you must leave your money there for at least five years. The five-year period begins on Jan. 1 of the year in which you open the account and make your first contribution. The account must be designated a Roth IRA, not a traditional IRA, when you set it up, and you can’t take tax-free withdrawals until you reach age 59 1/2.
When you do get around to taking withdrawals, they’re first considered to be a return of the contributions you made to the account over the years. Technically, you would only be withdrawing interest after those principal amounts have been depleted.
Taxation on Withdrawals
Assuming you’re at least age 59 1/2 and you’ve held your Roth IRA for at least five years, you can take withdrawals tax-free and without reporting them on your tax return, both from the principal portion and, eventually, from the interest portion of the account. You don’t even have to meet these rules to take your contributions back tax-free, but when you reach the interest accumulation in the account, that’s a whole different story. That money is taxable and reportable if you haven’t met all the rules.
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No Tax Deduction for Contributions
The IRS is so generous with Roth IRAs because it has already collected taxes on this money or at least on the principal. You can take tax deductions for contributions made to traditional IRAs in the year you make them, but this isn’t the case with Roth IRAs. When you open a Roth account, you do so with money that’s subject to income tax. When you make traditional IRA tax-deductible contributions, the IRS collects its tax at the other end when you withdraw the money in retirement.
If you dip into the interest portion of your Roth IRA before reaching age 59 1/2 or before you’ve held the account for at least five years, you have to report this income on your tax return. The money is taxable.
The key word here is “earnings” – the interest earned by the principal contributions. That’s the portion of the account that’s taxed. Withdrawals are considered to come out of your principal first, so you might have to take a significant withdrawal before you need to worry about reporting and paying taxes on the interest. If you do end up dipping into the interest portion of the account, it’s possible that you could also end up owing the IRS a 10-percent penalty.
Exceptions to the Rules
You can sometimes dodge taxes and the 10-percent penalty if you make withdrawals for certain reasons that are approved under the tax code. You’re permitted to take withdrawals if you become permanently disabled or to pay for higher education costs. You can take up to $10,000 to buy your first home if you’ve passed the five-year mark. The IRS says you’re a first-time homebuyer if you haven’t owned a home in the last two years. Just be sure to keep documentation to prove how you spent the money.