Advanced Diploma of Financial Planning (ADFP) Practice Test

How do distributions from a Roth IRA differ from those of a traditional IRA?

1. Roth IRA distributions are taxable

2. Roth IRA distributions are generally tax-exempt

3. Traditional IRA distributions are never taxed

4. Roth IRA distributions can only be made after age 70

The correct answer is: Roth IRA distributions are generally tax-exempt

The rationale behind the choice that Roth IRA distributions are generally tax-exempt lies in the fundamental tax treatment of Roth IRAs compared to traditional IRAs. Contributions to a Roth IRA are made with after-tax dollars, meaning that the money you contribute has already been taxed. As a result, when you withdraw funds from a Roth IRA in retirement, those distributions are typically tax-free, provided you meet certain requirements, such as having the account for at least five years and being at least 59½ years old at the time of withdrawal. This tax-free nature of distributions is a key advantage of Roth IRAs, as it allows individuals to withdraw their contributions and earnings without facing additional tax liabilities. This characteristic contrasts sharply with traditional IRAs, where contributions may provide tax deductions in the contribution year, but withdrawals are subject to income tax since those contributions were made with pre-tax dollars. The other options suggest misconceptions about the taxation and rules surrounding IRA distributions. Some may imply that traditional IRA distributions are always taxed or that Roth IRA distributions are subject to age limits similar to those found in traditional IRAs, which further highlights the unique features of Roth IRAs that make them appealing for tax planning purposes.