Roth IRA distributions are tax free (as long as you’ve met the requirements.) Earnings on your Roth are tax free. If you die, your heirs inherit the money tax free. I just love things that are tax free!
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I write about ROTH IRAs quite a bit, but someone recently asked me to explain ROTH IRAs so here we go:
A ROTH IRA is best defined by how it’s different from a regular (Traditional) IRA. Here are the differences:
- You cannot deduct contributions to a ROTH IRA, so whatever money you invest into a Roth—you’re going to pay income tax on the year you invest it.
- If you satisfy the requirements, your ROTH distributions are tax-free.
- You can still make contributions to a Roth IRA even after you reach age 70 and ½.
- You can leave your money in your Roth IRA as long as you live. (This is important for people who want to leave behind money for their heirs. It also means you don’t have any required minimum distributions (RMDs) like you have with Traditional IRAs. )
- You must designate the IRA as a Roth when you set it up (the default IRA setting is for a Traditional IRA.)
So why am I so gung ho about Roth IRAs? I like things that are tax free. The distributions are tax-free, the earnings are tax-free, and if you die, they go to your heirs tax-free. That’s a lot of tax-free going on there.
Here’s another thing I really like about the Roth IRA—not only are the distributions tax-free, but the distributions don’t count towards your Adjusted Gross Income. I realize I’m going into Tax Geek Speak here, but hear me out, because this is important.
Let’s say you’ve got a kid in college. You haven’t saved enough money for tuition and you need $10,000 for the tuition payment. Now you can take that money out of your Traditional IRA and not pay a penalty (because you won’t pay the penalty for early withdrawals when you use it for tuition), but you’ll still have to pay the regular income tax on it. So if you’re in the 25% tax bracket, you’ll pay an additional $2500 in taxes to take that $10,000 out of your Traditional IRA.
Now, if you need the whole $10,000 then you’ll need to actually take $13,333 out and withhold $3,333 in order to have the $10,000 and still pay your taxes on it. Plus, the IRA money that you take out goes on your tax return as income. So if you’re applying for financial aid, your aid will be reduced because you’re showing $13,333 more in income than if you didn’t take any money out of your IRA. (And you could use the financial aid—you couldn’t afford the tuition, right?)
Now, if you had a Roth IRA, you’d take out that $10,000 tax-free. The $10,000 wouldn’t have an impact on your tax return and therefore, wouldn’t have the same negative impact on your FAFSA application. See why I like the Roth IRA?
Here’s another example of where it’s useful. Let’s say you’re retired and receiving Social Security income. If your money is all in a traditional IRA or pension, your extra income can make your social security taxable—up to 85% of your Social Security income can be taxed. But if you take money out of your Roth IRA, that will have no effect on whether your Social Security gets taxed or not. The more you have in your Roth IRA, the more opportunity you’ve got to maneuver.
If you’re looking for a place to put some retirement money, my first choice is a Roth IRA. Start saving today, you’ll be glad you did.
For more information about Roth IRAs, here’s a link to the IRS website: http://www.irs.gov/Retirement-Plans/Traditional-and-Roth-IRAs
Hi Gil,
No they are not! Only the earnings on the ROTH IRA that are distributed would be taxable but since it’s for college even those aren’t taxed!
That’s one of the reasons I love ROTH IRAs! Plus, let’s say you put $10,000 into your ROTH IRA and it’s not worth $12,000. If you only take out the $10,000 you’re not taking out the earnings so you’re still not taxed. Gotta love it.
Hi Jan,
Are early distributions from a Roth IRA (before 59.5 yrs old) taxable, even if they are used for college tuition?
Thanks
Gil
Hi Canda,
It’s odd because if you have ‘tax free” income in the United States–as I understand it, you do not pay tax on it in India. Sadly, if you have tax free income in India, you still pay tax on it in the United States. And you will also want to report that account on an FBAR form also.
I would recommend that you report the interest every year, even though you do not get to draw it out for 15 years. Here’s why: your current income is low enough that you are not required to file. So, I’m thinking that this additional income won’t be taxable to you either.
But, if you waited for the 15 years and reported it all in one fell swoop, not only would you pay taxes on it, it would also kick you into a higher tax bracket making the tax effect even worse.
But by claiming that interest every year, you’ve documented that you’ve included it in your taxable income. This is a double win for you in my opinion. (No or very little tax now and no tax later versus no tax now and a lot of tax later.)
I am a resident Alien from India and my income comes only from India. My wife and I are both above 65 and we intend to file this year for our foreign income consisting of Pensions and interest. Our combined income is is less than filing limit but just so. My wife has a PPF account in India from which she gets interest at the end of every year which is deposited in the account. PPF is called Public Provdent Fund and income is Tax free in India. Her contributions to PPF limited to Rs. 70,000 (about $ 1130) per year can be deducted out of her taxable income. However she cannot withdraw any money for 15 years extendable to 20.
This appears similar to Roth IRA. My question is whether we need to show this income as interest income in our Tax Return 1040, even though we dont get income distribution till 15 years. Further do we report redeemed money including collected interest at the end of 15 years and do we pay tax on that in USA? There is no tax in India either on deposits or on interest when we close the PPF.
I shall be grateful for any advice.
candca