Putting money into an individual retirement account not only gives you some hefty tax benefits, but it also can simplify your life when it comes to filing your income taxes. For example, if you invest in a certificate of deposit with your local bank, you must keep track of how much interest you earned every year, report it to Uncle Sam and pay taxes on it. Not so with a CD held in your Roth IRA.
Individual Retirement Account
An individual retirement account is not an investment. It is a special type of custodial or trustee account that holds your retirement investments. With only a few exceptions the IRS doesn't care what kind of investments your IRA holds. You can put stocks, bonds, real estate or bank certificates of deposit in your IRA. Once those investments go into your IRA, the IRS treats any income or growth produced by those investments exactly the same.
Roth IRA CD
There is no real difference between how a regular CD and a Roth IRA CD work. For example, if you have your Roth IRA with your local FDIC-member bank and you use the money in your Roth account to buy a certificate of deposit, that CD will earn the same rate of interest as a comparable CD in your regular bank account. Both CDs are insured by the Federal Deposit Insurance Corporation. The only difference between the two types of CDs is how you report the interest.
Roth IRA Reporting
You don't get to claim a tax deduction for your Roth IRA contributions, so you don't report your contributions to the IRS when you file your federal income tax return. All of the earnings on investments held by your Roth IRA, including any interest from CDs, grow on a tax-deferred basis, so you don't report earnings produced inside your Roth IRA. Qualified distributions are free from federal income taxes, so you don't report them on your federal income tax report either. The only time you have to report any Roth IRA transaction is if you take a nonqualified distribution.
If you withdraw the earnings portion of your Roth account before you have had the account for at least five years and are 59 1/2 years old, the IRS considers the withdrawal to be a nonqualified distribution and taxes it as ordinary income. Interest on your Roth IRA CD is taxed the same as capital gains from real estate sales and dividends from stocks held in the account. All of the nonqualified distribution is lumped together and taxed as ordinary income. With a few exceptions, you'll also get hit with an additional 10 percent early withdrawal penalty. Since all nonqualified distributions are taxed the same, you don't report the CD interest separately.
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.