When are Roth IRA earnings taxable?

One of the benefits of using a Roth IRA to save money for retirement is the tax benefits you receive. Generally, a Roth IRA is funded with after-tax dollars, and you won't pay taxes on withdrawals if you take qualified distributions. While you won’t pay taxes when you withdraw the portion of your Roth IRA contributions, you may owe taxes when you withdraw your Roth IRA earnings.

If you take a non-qualified distribution of Roth IRA earnings, you will pay taxes on the distribution at your tax bracket rate and a potential 10% penalty tax if you are below age 59 ½. However, if you take a qualified distribution of Roth IRA earnings, the withdrawal won’t count as an income, and hence, you won’t owe taxes or penalties on the distribution.

How Roth IRA is taxed

A Roth IRA is a type of IRA to which you contribute post-tax dollars. This means that the contributions you make to a Roth IRA are taxed already when they go into the account, and you won’t get a tax deduction on the contributions. The Roth IRA contributions grow tax-free over the years, and you get a tax benefit in form of tax-free withdrawals when you retire.

If you take a qualified distribution of both the contributions and earnings, you won’t pay taxes on the amount withdrawn. For a distribution to be deemed qualified, you must have completed at least five years since the first contribution, and be 59 ½ or older. However, if you don’t satisfy these requirements, the distributions you take from the Roth IRA will be taxed at your income tax rate. If you are below age 59 ½, the distribution may also be subject to a 10% tax penalty on early withdrawals.   

How are Roth IRA earnings taxed?

Any earnings in your Roth IRA will grow tax-free, regardless of the type of investments you hold in your IRA. You can earn investment income from holding stocks, mutual funds, bonds, etc.

While you can withdraw your Roth IRA contributions at any time, there are different rules for Roth IRA earnings. If you want to take a tax-free distribution of the Roth IRA earnings, at least five years must have elapsed since the first contribution. If you withdraw your earnings before you have completed the five-year period, your withdrawals will be taxed at your income tax bracket rate.

You must be at least 59 ½ or older to make tax-free withdrawals of your Roth IRA earnings. If you are below 59 ½, the withdrawals will be subject to a 10% penalty tax for early withdrawals. However, there are certain exemptions to the 10% penalty tax for Roth IRAs, and the penalty may be waived if you qualify for these exemptions. Some of these exemptions include taking distributions in substantially equal periodic payments, withdrawing funds to pay for college, and withdrawing up to $10,000 for a first-time home.  

If you die, the Roth IRA beneficiaries won’t be subject to the 10% penalty tax as long as the 5-year rule is satisfied.

How are traditional IRA earnings taxed?

While a Roth IRA offers tax-free growth of your contributions and earnings, traditional IRA contributions and earnings grow tax-deferred until when you take a distribution. However, if you have a traditional IRA, you won’t pay tax on your contributions; you will only pay taxes when you make a withdrawal from the account. If you withdraw the portion of your contributions and earnings, you will pay income taxes at your tax bracket, and an additional 10% penalty tax if you are below 59 ½.

Roth IRA Ordering Rules

When you take a Roth IRA distribution, you must follow the order of distribution for non-qualified withdrawals. The distributions follow a specific order depending on whether they are contributions, conversions, or investment earnings.

Roth IRA contributions come out first in the order of distributions. Contributions are distributed tax-free and penalty-free, regardless of the number of years you have held the account or your age.

Roth IRA conversions come second in the order of distributions. Generally, the taxable conversions are distributed first, followed by the non-taxable portion of converted assets. The converted assets are subject to the 10% penalty, and the five-year period starts counting from the time you convert to a Roth IRA. If you withdraw the converted pre-tax assets before the five-year period, the withdrawals will be subject to the 10% penalty tax.

Earnings are distributed last, after contributions and conversions. If you take a qualified withdrawal of the earnings, you won’t pay taxes or penalties on the distribution. However, non-qualified withdrawal of earnings attracts taxes and penalties.