Roth individual retirement arrangements were devised to offer after-tax savings and provide the biggest benefits to people who anticipate paying a higher tax rate in retirement. Whether the earnings from the Roth IRA increase your taxable income depends on whether you are taking the distributions, and, if so, whether you are eligible for a qualified distribution.
Earnings in Account
Roth IRAs act as a tax-shelter for money in the account, so your Roth IRA earnings won't increase your taxable income as long as the money stays in the account. For example, say you fall in the 33 percent tax bracket and you earn $12,000 in interest in your Roth IRA. In a taxable account, you would owe $3,960 and keep only $8,040. However, since it is in a Roth IRA, the entire $12,000 remains in the account to continue growing.
If you take a qualified withdrawal from your Roth IRA, you'll get all the earnings -- and all your contributions -- out tax-free. To qualify, you must be either 59 1/2 years old or older, permanently disabled or using no more than $10,000 for a first home. In addition, the Roth IRA must be open for five years, counted from the first day of the first tax year you made your first contribution. For example, say you made your first Roth IRA contribution during the 2011 tax year -- it doesn't matter what date you made the contribution -- your five years starts counting on Jan. 1, 2011.
If you aren't taking a qualified withdrawal, taking out earnings from your Roth IRA will count as taxable income that year. However, before you touch your earnings, you are allowed to remove all your contributions tax-free and penalty-free. If your Roth IRA has $70,000 in contributions and $28,000 in earnings, the first $70,000 of non-qualified withdrawals would come out tax-free and penalty-free. However, any distributions above $70,000 would count as taxable income.
If you are taking a non-qualified withdrawal from a Roth IRA, you will pay not only taxes but also a 10 percent early withdrawal penalty on earnings taken out. For example, if you take out $3,500 of earnings, expect to pay $350 in tax penalties on top of the income taxes. However, you can avoid the early withdrawal penalty if you qualify for an exception, including college or grad school costs and medical expenses exceeding the minimum percentage of your adjusted gross income.