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Stated simply, if you invest money in a Roth account, you can withdraw 100% of the amount you invest and all of the earnings associated with that investment tax-free*. This includes federal and state income taxes in most cases.

When you think of your retirement accounts – regardless of Roth – think about holding two buckets. Bucket #1 in your right hand holds your contributions to the retirement account. Bucket #2 in your left hand holds the overflow from Bucket #1, or the earnings you have (hopefully) made on those contributions. In the case of “traditional” (read regular 401k / 403b) retirement accounts, the IRS says that it will give you a break by not taxing you on the money you put into Bucket #1 (your contributions). That is why these contributions are called “pre-tax” – the IRS treats them as if you never even earned them in the current tax year. But with traditional retirement accounts, the IRS will nail your hide to the wall at retirement by taxing every last penny you withdraw from both of your buckets (your contributions and earnings) at your income tax rate during retirement. And what your income tax rate will be at retirement is anyone’s guess since tax rates have the tendency to change over time.

For Roth accounts, however, the IRS says that it will tax you now on your contributions (Bucket #1) since the money you contribute to Roth accounts has already hit your checking account and is considerd by the IRS as “earned income” for the current tax year. This means that all of the money you contribute to Bucket #1 in your right hand has already been taxed and the government will allow you to withdraw this amount and its associated earnings – Bucket #2 in your left hand – at retirement tax-free.

Now, you are probably asking yourself, “why did he place that little asterisk (*) at the end of that first sentence of this section? I know what that means. That means there are strings attached. Ok, what is the catch?”

You’re right – there is a catch. In order to get all of your money tax free from a Roth account, you must play by the “Roth rules” so that your distribution is “qualified”. If you don’t follow the rules, the IRS referees will blow the whistle and declare your distribution “nonqualified”. But most of the Roth rules are fairly reasonable.

To better understand the IRS rules defining what is and is not a qualified distribution, check out this related post.