In most cases, you are already familiar with traditional IRAs and Roth IRAs, but you are not sure exactly how they differ and how they are the same. Here’s a quick breakdown of Roth vs. traditional IRAs.
Traditional IRAs offer tax deductions and tax-deferred growth until you withdraw the money. Withdrawals are subject to ordinary income tax at that time. The contribution to a Roth IRA does not qualify for a tax deduction. The funds also grow tax-deferred, but qualified distributions are tax-free. In general, a qualified distribution is not subject to tax or penalty. If a Roth IRA distribution is made by someone over age 59.5 (or meets the penalty exceptions such as death, disability, or purchasing their first home), it is considered qualified. Investing in a Roth IRA can be appealing to many investors for this reason. With our $30 trillion debt, it’s hard to imagine our tax rates won’t rise in the future, making tax-free income even more important.
Despite Roth IRAs’ popularity, their distribution rules can be complicated. A few important rules govern Roth IRA withdrawals, conversions, and interest earned.
- Roth IRA Contribution Withdrawal
Whenever you take a distribution from a Roth IRA, your contributions come out first. Even if you aren’t 59.5 and your Roth is less than five years old, you can withdraw all your contributions without penalty or tax.
2. Roth IRA Conversions
Regardless of age or income, anyone can convert a Roth IRA. Many people are confused by this. A contribution can only be made by those who meet the income requirements and maximum contribution limits. Anyone can convert their traditional IRA to a Roth IRA, regardless of income level.
During your conversion from a traditional IRA to a Roth IRA, the amount you convert is added to your gross income. The increase in your gross income occurs only during the tax year in which the IRA is converted. As a result, your income increases, and you pay your ordinary tax rate. If you have had your Roth IRA for less than five years or are under the age of 59.5, you may still be subject to a 10% early withdrawal penalty.
3. Roth IRAs and Tax Treatment of Earnings
Roth IRAs can be tax-free if you have held them for at least five years and are over the age of 59.5; the earnings on the account can be tax-free.
4. Required Minimum Distributions (RMDs)
RMDs are not required for Roth IRAs, unlike traditional IRAs. Non-spouse beneficiaries require RMDs of Roth IRAs. For most beneficiaries, these RMDs won’t be necessary until after the beneficiary’s 10th year following the death of the Roth IRA owner. If the original owner took RMDs, inherited traditional IRAs require an RMD each year, but Roth IRAs do not require an RMD until the end of the 10th year after the original owner’s death.
5. Inherited Traditional IRA Conversion
An inherited traditional IRA cannot be converted to a Roth IRA, but an inherited employer retirement plan can be converted.