Is the Roth IRA Taxed Prior to Taking Money Out?

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    Identification

    • As a W-2 employee, your Roth IRA contributions would have already been taxed at the federal and state level directly out of your paycheck. As a self-employed individual, however, you may owe taxes on Roth IRA contributions when you report them as part of your taxable income. After buying investments for the Roth IRA, you will not be responsible for paying taxes on capital gains, interest earnings and dividend payments as they occur within the account. At retirement, you can withdraw money from your Roth IRA---without paying any taxes at that point. A Roth IRA is the mirror image of a traditional IRA. The Traditional IRA allows for tax-deductible contributions, but your withdrawals will be taxed as ordinary income.

    Contribution Limits

    • As of 2010, you are generally limited to $5,000 worth of combined annual contributions into Roth and traditional IRA accounts. In some cases, your Roth IRA contributions may be further limited due to relatively high levels of reported modified adjusted gross income. As a single filer, your Roth IRA contribution limits are reduced when you report a modified AGI above $105,000. You cannot make any contributions into a Roth IRA---if you report a modified AGI of more than $120,000.

    Roth IRA Withdrawals

    • You can withdrawal your Roth IRA investment principal at any time---without penalty. Your investment gains, however, may be subject to an additional 10 percent penalty if you take money out of your account before age 59 ½. For example, you may put $1,000 into a Roth IRA this year to buy Mutual Fund Z. After two years, your investment grows to $1,500 by the time you turn 30. At that point, you sell off Mutual Fund Z and withdraw your entire Roth IRA balance. You would then owe a tax penalty on $500 worth of gains.

    Investment Strategy

    • You should consider integrating a Roth IRA alongside a 401(k) and taxable brokerage account within your overall financial plan. The 401(k) plan shares a similar structure with the traditional IRA, where contributions deductible and withdrawals are taxed as ordinary income. Your 401(k) plan through work is likely to provide for an employer match---where your company also puts money into the account on a dollar-for-dollar basis with your own contributions. 401(k) and Roth IRA retirement plans, however, are limited in terms of their flexibility. With a taxable brokerage account, you can save more money for retirement and also access cash at any time---without an additional tax penalty.

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