Roth contributions can be beneficial because the EARNINGS associated with those contributions can be withdrawn tax free. Imagine! Money that is never taxed by the federal government! Sounds great? It can be. However, not all earnings associated with Roth contributions are eligible for this favorable tax treatment. Know the rules before you distribute!
First, let's differentiate between Roth contributions and Traditional contributions. Traditional or "pre-tax" contributions are made to your qualified retirement plan on a pre-tax basis, meaning that they are deducted from your gross pay before the taxes you owe are calculated. This is great because it reduces your taxable income so that the amount of tax that you pay each paycheck is less. With traditional contributions, those pre-tax dollars grow tax deferred until you withdraw them. When you take a withdrawal, however, your original contributions plus any earnings become taxable income to you. Got it? No taxes at the time of contributions but taxes are due on the full amount when withdrawn. Roth contributions work in the reverse. With Roth contributions, you pay taxes with each contribution you make because the contributions are deducted from your pay AFTER your taxable income is calculated. However, when the contributions are withdrawn, it is possible for your full withdrawal including any earnings you have accumulated to be withdrawn tax free. Of course, you have already paid taxes on your original contributions, but being able to withdraw your earnings tax free is one of the most significant advantages of making Roth contributions.
What conditions have to be met to be able to withdraw your Roth account tax free? A qualified distribution is generally a distribution that is made at least 5 years after your first Roth contribution to your Plan and is either:
- Made on or after the date you attain age 59½, or
- Made after your death, or
- Attributable to your being disabled.
Given these rules, in order to get the full benefit of making Roth contributions, it is important to wait to withdraw the Roth portion of your account until after you reach age 59 1/2 or at least 5 years after you started making Roth contributions, if later. When you make withdrawals, be sure to consider these factors when you decide when to take a distribution and, if possible, what source of money (pre-tax or Roth) you choose to withdraw first.