Roth IRAs haven't been around as long as other retirement plans, but they have a unique feature that most other tax-favored retirement accounts don't offer. Roth IRAs don't give you an up-front tax deduction, but they let you make withdrawals tax-free in retirement. What that means is that as long as you meet the qualifications for the tax break, Roth IRAs let you earn interest and other investment income without ever having to report it on your tax returns. The only exception is if you don't meet all the qualifications that Roth IRAs require. Read on to learn more about the benefits of Roth IRAs and when you have to be careful.
Why Roth IRAs are special
For decades, deferred compensation programs allowed retirement savers to put off having to pay income tax on their earnings. By contributing to a traditional IRA, 401(k) plan, or other retirement account, you could reduce your taxable income in the year in which you made the contribution. In exchange, however, you had to agree to pay income tax on the money when you withdraw it in the future. That's how the IRS gets its fair share back.
Roth IRAs changed the rules, turning the tables on the deferred income concept. Roth IRA contributions are made with after-tax money, so you don't get any deferred tax benefit from the initial contribution. Roth IRAs do enjoy tax-deferred growth on the investment income that your contributions generate, so they are similar to traditional IRAs in that respect.
Yet what makes Roth IRAs unusual is that having given up that up-front tax break, they give you an even better tax break in retirement. No matter how much your money has grown, you don't have to pay income tax on Roth IRA withdrawals.
When you break the Roth IRA rules
There is one situation in which you might have to report interest from a Roth IRA on your taxes. That's when you fail to meet the requirements for tax-free treatment of your Roth IRA.
This can happen for a couple different reasons. First, qualified distributions only include those made after the five-year period that begins when you first make a contribution to a Roth IRA. Therefore, if you take money out of your Roth that represents investment income, then it will be taxable and you'll have to report. Also, you'll have to pay tax if you take earnings out of your Roth before you reach age 59 1/2 and don't qualify for another exception, such as being disabled or using up to $10,000 for a first-home purchase of up to $10,000.
Note that because of the ordering rules, you're deemed to withdraw your Roth IRA contributions before you touch earnings. As a result, it's rare to have to include Roth IRA interest as taxable income even if you don't qualify, unless you close out your entire account.
Roth IRAs are extremely valuable, and you typically won't have to report anything about them to the IRS. However, if you break the rules governing Roths, then you might have to report your interest income after all.
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