8 Common Roth IRA Mistakes to Avoid

These Roth IRA mistakes can have costly tax consequences

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A Roth IRA is a type of retirement account where you contribute after-tax money. Since you've already paid taxes on these funds, you can withdraw them tax-free in retirement. Unlike other retirement funds, you aren't required to take minimum distributions from a Roth IRA, although beneficiaries who inherit these IRAs must do so. This means you can let your money grow tax-free for as long as you want.

This type of account can be a great way to save for retirement. To make sure you're getting the most from your account, let's look at the most common mistakes people make with Roth IRAs. Avoiding these missteps can help you keep more of your money.

Key Takeaways

  • A Roth IRA allows you to invest after-tax dollars and take tax-free withdrawals in retirement.
  • There are several common mistakes people make with their Roth IRAs. These errors can be costly and lead to missed opportunities.
  • To avoid making these mistakes, it's essential to understand the rules and regulations for Roth IRAs.

Why Invest in a Roth IRA?

Compared to other types of retirement plans, a Roth IRA has several advantages. Since you've already paid taxes on the money you contribute to your account, you can withdraw money tax-free when you retire. This reduces your tax liability.

Additionally, you can name a beneficiary for your Roth IRA. When you die, the money in your account would go to the person listed without going through probate. Contributions you've made are a tax-free inheritance for them as long as the money has been in the account for at least five years at the time the account holder dies. But if the Roth IRA was less than five years old at the time of the original owner’s death, they'll owe taxes on any earnings they withdraw.

Because of these and other advantages, a Roth IRA is a good choice for many people. For example, let's say you're in your 20s and just getting started in your career. You know you need to save for retirement, but you don't have a lot of money.

You can make small monthly contributions to your Roth IRA. Since you're in a lower tax bracket now, it makes sense to contribute with after-tax dollars. This way, you won't have to pay taxes on your withdrawals when you retire, when you’re hopefully in a higher bracket.

You can also use your Roth IRA to help you meet other financial goals, such as buying your first home or paying for your children’s college expenses.

8 Common Roth IRA Mistakes to Avoid

If you want tax-free dollars to enjoy in your retirement years, make sure you're investing in a Roth IRA correctly. Otherwise, you could end up paying taxes and penalties when you withdraw funds. 

To help you keep more of your money, here are the top Roth IRA mistakes to avoid.

1. Skipping a Roth IRA Because You Have a 401(k)

If you have a 401(k) already, you might be tempted to skip a Roth IRA. After all, you're already saving for retirement, right?

But you shouldn't pass up on the chance to open a Roth IRA just because you have a 401(k). When used together, a 401(k) and a Roth IRA are a powerful retirement savings combination that can help you accumulate a significant nest egg.

One way to maximize both types of retirement plans is to take advantage of any employer 401(k) match. Once you're contributing enough to get the full employer match, you can open a Roth IRA and fund it.

2. Trying to Contribute When You Don’t Qualify

For 2022, you can contribute to a Roth IRA if your modified adjusted gross income (MAGI) is $144,000 or less as a single filer, or $214,000 or less as a married couple filing jointly. If your income is above these amounts, you’re not eligible to contribute directly to a Roth IRA. To make matters more complicated, there’s also an income range in which you can contribute a reduced amount to a Roth IRA.

If you make contributions when you don't qualify, it’s considered an excess contribution. The IRS will charge you a 6% tax on the excess amount for each year it stays in your account.

If you’re close to the income limits for reduced or eliminated contributions, one way to avoid the extra tax penalty is to wait until you’re about to file your taxes, said Jessica Goedtel, a certified financial planner and financial advisor at Pavilion Financial Planning, in an email to The Balance.

“You’ve got until the April filing deadline to make [contributions],” she explained. “Let your accountant know that you still want to make a Roth IRA contribution. They’ll let you know how much you can contribute, if anything.” 

Using this strategy helps ensure you don’t contribute less than you’re eligible to—or overcontribute and wind up paying unexpected taxes. 

Under the law, you have until the day your taxes are due, without extensions, to fund the previous year’s IRA.

3. Contributing Too Much

Similarly, if you deposit more than you’re allowed to contribute to your Roth IRA, you’ll face the same excise tax of 6% on those extra funds.

And this isn’t just a one-time tax—it’ll be assessed every year until you correct the overage. This error can be costly if you don’t notice this Roth IRA mistake for a few years. 

To avoid this problem, always track your contributions carefully. If you accidentally put in too much, you can withdraw the excess without penalty until your tax filing deadline. However, you’ll also have to withdraw the interest or other income earned from those extra funds. 

4. Missing Out on a Backdoor Roth IRA

If you make too much money to contribute directly to a Roth IRA, there’s another option: You can use a backdoor Roth IRA. This process allows you to make after-tax contributions to a traditional IRA. Once the money is invested, you can convert it to a Roth IRA. 

However, converting a traditional IRA to a Roth IRA can have tax consequences. Since the money you put into your traditional IRA was pre-tax, you’ll need to pay income tax on it when you do the conversion. It’s possible that this additional income could even bump you up into a higher tax bracket.

Because there are so many possible implications, it’s a good idea to talk to your accountant or a financial planner before contributing to a backdoor Roth. They can help you decide if this strategy makes sense for your financial situation. 

5. Not Contributing for Your Spouse

To put money into a Roth IRA, you must have earned at least as much income as the amount you contribute. But there’s a loophole if you’re married and file a joint return: the taxable income can be earned by either you or your spouse, and one of you can contribute to a spousal IRA on the other’s behalf. For example, if you earned taxable compensation in 2021 and your spouse did not, you could contribute to both your own Roth IRA and to a spousal Roth IRA—as long as your income can cover those amounts.

Depending on your income, your maximum contribution to this type of Roth IRA is $6,000 each. When you reach age 50, the per-person limit increases to $7,000. So if you’re 48 years old and your spouse is 52, you can contribute up to a total of $13,000. If you’re both over 50, you can contribute a maximum of $14,000.

6. Doing Rollovers Wrong

A rollover is when you withdraw money from one retirement account and deposit it into another. You can do a rollover from your 401(k) to a Roth IRA, but you must follow certain rules. If you don’t, you may face tax consequences.

If you request a distribution from a retirement plan like your 401(k), you have 60 days to complete the rollover by depositing the funds into your Roth IRA. If you don’t deposit the full amount into your Roth IRA within 60 days, the IRS will treat it as a taxable distribution and may also assess a 10% additional early-distribution tax.

You can also choose a direct rollover or trustee-to-trustee transfer, neither of which will result in taxes being withheld from the rollover amount. 

Another rule to be aware of is the once-per-year IRA rollover limit. You can typically only do one rollover per year, so you’ll want to plan accordingly.

If you elect to do a direct rollover, taxes won’t be withheld on the spot. However, your contributions to a 401(k) or traditional IRA were pre-tax, so when you roll them into a Roth IRA, they’ll count as income in the year you made the rollover.

7. Forgetting to Name Beneficiaries

When you pass away, your beneficiaries receive the benefits of your Roth IRA. But if you don’t have a living beneficiary named on your account, this money typically ends up in your estate. Once there, your Roth IRA must go through probate before your heirs can access it.

When your Roth IRA goes into probate, it’s lumped together with your other assets. Then, before it gets distributed to your heirs, all your debts are paid. This means your heirs might not end up with as much money as you wanted them to. 

To avoid this problem, regularly review all of your accounts to ensure your named beneficiaries are up to date.

8. Not Investing Your Funds

“It’s not enough just to open the account,” Goedtel explained. “I see a lot of people who open an account, make a contribution, but then just leave it in cash. That’s like putting all the ingredients together for a cake and never baking it. The best part of a Roth IRA is the tax-free growth. It’s not growing if it’s sitting in cash.”

In addition to simply funding your account, you need to decide how you’re going to invest those funds. If you aren’t sure of a good investment strategy, consider reading up on the subject or asking a financial professional for help. Otherwise, you’ll miss out on the magic of compound interest and your money won’t be as helpful when you retire.

Frequently Asked Questions (FAQs)

How do you set up a Roth IRA?

When you're ready to start saving for retirement with a Roth IRA, you'll need to pick a financial institution that offers this type of investment. Then you'll provide some personal information about yourself to open an account. Finally, you'll start funding the account and investing the money.

How do you withdraw contributions from a Roth IRA?

You can withdraw your contributions from a Roth IRA at any time, for any reason, without paying any taxes or penalties. To do this, you'll need to contact the financial institution where you have your Roth IRA and request a withdrawal. Note that this is different from withdrawing earnings, which may incur taxes and penalties depending on factors like your age and how long you’ve had your Roth IRA.

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