A common question surrounding the Roth IRA (individual retirement agreement) is when do you pay taxes on the money ou are contributing to the account. It is somewhat simplistic and yet somehow involved at the same time to elaborate on the answer. This post will hopefully make it plain and clear what is the true answer to this question.
To begin, we must understand that this entirement agreement is subject to the laws and rules laid out by the IRS. If you want to try to wade through that, feel free to check the IRS website. It is quite involved, so I will try to separate the wheat from the chaff. A Roth IRA is different than a traditional IRA in two key areas (hint, they both have to do with taxes!). First, all the money contributed to a Roth comes from after tax money. In essense you are paying your state, local and federal taxes as you would for all the other take home money you are using to pay your cell phone bill, mortgage, car payment, and so forth. All the money you use to contribute to your Roth comes from this after tax pool of money we all earn.
So the question then becomes why should I go this route when I can contribute pre tax money in a standard IRA and have more to give with less pain? The answer lies in the fact that once you contribute to a Roth with your after tax money you don’t have to give the government any more of your money ever again from this portion of your portfolio. The money grows in the account completely free and clear from any taxes. Once you withdraw the money in retirement it also comes out tax free so you don’t need to pay any taxes there. It is a great way to lower your tax burden when you are enjoying your retirement.
Now, there is one caveat. In order for the government to make this a reality they hammer you pretty hard with penalties and taxes if you are inclined to take the money out before retirement age. If you are age 59.5 or less and you want to take out your money in your Roth account you are going to incur a 10% penalty on any earnings in the account as well as pay federal, state and local taxes based on income on those same earnings. The nice part being that any money you contributed can be withdrawn at any time without penalty or tax implications. You just need to worry about the earnings on that money.
So there you have it, a quick and dirty lesson on when you pay taxes on a Roth IRA.