A Roth IRA is an individual retirement account that is funded with after-tax income. Roth IRA contributions are NOT tax deductible, you receive no tax breaks for contributing to the plan. This is the trade off you make in exchange for getting tax-free withdrawals in retirement.
If you’re looking for a tax deduction on your IRA contribution, you would instead want to make contributions to a Traditional IRA.
In a Traditional IRA, you make contributions with pre-tax income rather than after-tax income. This gives you a tax deduction in the amount of the contribution. But because you don’t pay taxes up front, your withdrawals in retirement get taxed as regular income, based on the tax rates and your tax bracket at the time of withdrawal.
Also read: Benefits & Tax Advantages Of A Roth IRA
Contributing
Let’s pretend you made $80,000 this year and decide to contribute $5,000 to a Traditional or Roth IRA, here’s what that would look like:
Roth IRA: You pay full taxes on the $80,000 in income and then contribute $5,000. You receive no tax deductions for your contribution.
Traditional IRA: Your $5,000 contribution gets deducted from your taxable income and you now only pay income tax on $75,000.
Also read: Roth IRA Vs Traditional IRA: Key Differences & Similarities
Investing
Money that you put into a traditional or Roth IRA gets invested, usually into traditional assets like stocks, bonds, ETFs, and mutual funds. What you invest in is up to you and you could either choose to make your own investments, invest through a mutual fund, or use a robo-advisor to build you a portfolio based on your risk profile and financial goals (like Carry’s no-fee robo-advisor). You can pick and choose what percentage of your portfolio to allocate to each type of asset class.
You could even choose to invest in alternative assets like precious metals, crypto, real estate, or even startups. These would need to be made through a special type of IRA called a self-directed IRA. However, note that these types of IRAs come with higher fees in exchange for access to alternative assets that aren’t typically available with major brokerages.
Investments and your investment options are the same whether you invest through a Traditional or Roth IRA.
Investment growth
Once your money is invested, it grows tax-free. In other words, you don’t pay any capital gains tax on your investment profits and all your earnings can go straight back into your account where it can be reinvested. Compound interest allows your money to grow exponentially faster over time, which is one of the biggest advantages of investing through a retirement account like a Traditional or Roth IRA.
Investment growth is also the same whether you invest through a Traditional or Roth IRA.
Withdrawals
Withdrawals is where you’ll notice a major difference between a Roth or Traditional IRA.
With a Roth IRA, you didn’t get any tax deductions when you contributed money into your account since you paid with after-tax income. However, your withdrawals in retirement are completely tax-free, no matter how much your account has grown from your investments. In other words, because you already paid income taxes on your contribution, you’re not required to pay them again when you take withdrawals in retirement.
With a Traditional IRA, you didn’t pay any income taxes on your contributions. Instead, you received a tax deduction. Therefore, when you take withdrawals in retirement, it gets taxed as regular income. For example, if you made $50,000 in the year of withdrawal, and you decide to withdraw $50,000 from your Traditional IRA, your new taxable income would now be $100,000. Therefore, withdrawing from a Traditional IRA requires more calculations so that you’re not putting yourself in a high tax bracket and losing a majority of your account balance in tax payments.
On the other hand, it doesn’t matter if you withdraw from your Roth IRA in a lump sum since it doesn’t affect your taxable income and you don’t owe any taxes regardless of how much it is.
Withdrawal example
Let’s go back to the earlier example. Let’s pretend that the $5,000 you contributed grew into a balance of $500,000 by the time you retire.
With a Roth IRA, you would be able to withdraw the entire $500,000 all at once (although it may make more financial sense to only take out what you need and leave the rest to keep compounding tax-free). You wouldn’t owe any taxes on the $500,000 withdrawal because you already paid taxes on the $5,000 contribution.
With a Traditional IRA, you would owe income taxes on whatever amount you withdraw. Obviously, withdrawing the entire $500,000 in a single lump sum would put you in the highest tax bracket possible and you would lose nearly 50% to tax payments. Therefore, you might decide to only take out just enough to stay in a lower tax bracket and leave the rest in your account. Because you didn’t pay taxes when you contributed the $5,000 you now owe taxes when you withdraw your balance, which has now grown to $500,000.
Are Roth IRA losses tax deductible?
Okay, so now we know that contributions to a Roth IRA are not tax deductible. But you might be wondering, what about losses in your Roth IRA? What if your Roth IRA investments lose money? Are you able to get a write off?
In this article, we only gave examples of what happens if your Roth IRA made money. But a Roth IRA could just as easily lose money if you’re not careful with your investments or during volatile market conditions.
You CANNOT deduct losses from your Roth IRA on a year-to-year basis. For example, if you contribute $5,000 to a Roth IRA and you lose $4,000 by the next tax year, you cannot deduct a $1,000 loss, per IRS rules.
The only way to deduct losses from your Roth IRA is if you close all of your Roth IRA accounts (if you have multiple), including ones that have profits. Obviously, this is a rare case because it doesn’t make financial sense to do this purposely strictly to write off a loss. You’re completely ending your tax-free growth, which would hurt you more in the long run.
Conclusion
Roth IRA contributions are not tax deductible, as all contributions must be made with after-tax income. You don’t receive any tax breaks when you contribute in exchange for tax-free withdrawals in retirement.
If you want to receive a tax deduction from your IRA contribution, you would instead need to contribute to a Traditional IRA. Contributions to a Traditional IRA are made with pre-tax income and get deducted from your taxable income for the tax year. However, unlike a Roth IRA, your withdrawals in retirement will get taxed as regular income.
One other thing to note is that your contributions to your Roth IRA can be withdrawn at any age without any taxes or penalties. However, to withdraw earnings from your account, you would need to be at least 59½ years of age, and your Roth IRA must be at least 5 years old (known as the 5-year rule). With a traditional IRA, you cannot withdraw contributions or earnings until you reach 59½ years of age. Early distributions before you’re eligible for withdrawals would result in a 10% early distribution penalty plus income taxes on the amount withdrawn.
Also read: The Pros and Cons of a Roth IRA