With a Roth IRA, you pay taxes on your contributions, so you don't have to pay later when you take qualified withdrawals. However, not all Roth IRA withdrawals are tax-free. If you take out the earnings before they are qualified, you'll owe income taxes and a penalty.
A Roth individual retirement account shares one significant feature with a traditional IRA. Both types of accounts allow any investment held in the account to grow tax-deferred. As long as the investment remains in your IRA, you don't have to pay any taxes on the growth, regardless of how it is achieved. Interest income, dividend payments and capital gains all receive the same tax deferral.
You can use the money in your Roth IRA to buy a variety of investments, from bank certificates of deposit to individual stocks. You can buy and sell investments inside a Roth IRA, similar to how you trade investments in a regular cash account, with one major difference. If you sell a security for more than you paid for it in your cash account, you have a taxable capital gain. If you have the same transaction in a Roth IRA, the gain is not taxed.
Return of Contributions
Because you have already paid taxes on the money you contribute to a Roth IRA, you can withdraw an amount equal to your contributions at any time for any reason without creating a taxable event. For example, you might contribute $5,000 to your Roth IRA and use the money to buy stock. If the market value of the stock increased to $6,000 you could sell the stock and withdraw $5,000. The IRS would consider the $5,000 withdrawal a nontaxable return of your contributions, so you would not be taxed on this capital gain.
"Qualified withdrawal" refers only to the investment gains in your Roth IRA. You must have had the account for at least five years and meet one of the other Internal Revenue Service qualifications before your earnings become qualified. The most common additional qualification is reaching age 59 1/2. However, you can also take qualified withdrawals if you are using the money to buy a first home or if you are disabled. Qualified withdrawals are free from federal income taxes, regardless of how the growth was earned.
If you withdraw Roth IRA earnings before they become qualified, they will be taxed as ordinary income and may be subject to an additional 10 percent penalty, regardless of how the earnings were produced. For example, you might contribute $5,000 to your Roth IRA and use that money to buy stock. If the market value of that stock increased to $6,000 and you sold your stock, you could make an early withdrawal of $6,000 from your IRA. The IRS would consider $5,000 of this withdrawal to be a nontaxable return of contributions. The remaining $1,000 would be taxed as ordinary income, even though it was earned as a capital gain. You may have to pay an additional 10 percent tax penalty on the $1,000.
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.