Roth IRAs are popular tools for investing for retirement. One of their best benefits is tax-free growth on investments. Your profits can compound indefinitely, and you won’t have to pay taxes on them when you withdraw them in your retirement years.
Roth IRAs are not necessarily for everyone. If you don’t use a Roth correctly, you could end up with a smaller nest egg than you’d like in retirement. Here are some risks to using Roth IRAs and how you can minimize them.
- Roth IRA contributions are made with post-tax funds, and there is no tax on qualified distributions such as those made in your retirement years.
- If you make nonqualified distributions such as withdrawing before your retirement age, you’ll face a tax and a 10% penalty on earnings.
- Traditional IRAs and employer-sponsored plans such as 401(k)s are alternatives to Roth IRAs and may be better retirement account choices for some.
What Is a Roth IRA?
A Roth IRA, or individual retirement account, is a qualified retirement account in which your investments can grow and won’t be taxed when you withdraw them in retirement.
Unlike with a traditional IRA, the contributions to a Roth IRA are taxed before you contribute. With a traditional IRA, your contributions are tax deductible.
How a Roth IRA Works
You can contribute up to $6,000 of post-tax income, or $7,000 if you are over age 50, in 2022. (The IRS often changes this limit.) Then, you can make withdrawals tax-free in retirement, including on earnings.
Contributions to a Roth IRA can be withdrawn anytime with no penalties. However, investment earnings can only be withdrawn if you’ve reached the IRS retirement age of 59½ or if you’re buying your first residence, have a certain level of medical expenses to pay, or are disabled.
If you withdraw your earnings before your retirement age or without meeting one of the special requirements, you’ll face a 10% tax penalty.
Risks of Roth IRA Investing
Investing in a Roth IRA does have risks. Let’s take a closer look at some of the more common risks of using this type of retirement account.
Choosing the Wrong Investments
A Roth IRA is essentially a brokerage account with tax benefits. It isn’t like a savings account at a bank, where interest is automatically paid on your deposits.
With an IRA, you choose investments, so there is a risk you could choose investments that do not perform well or do not align with your investing goals. You could even suffer financial losses.
You can use specific investment strategies to reduce your risk. For example, you can increase diversification to spread risk and reduce the chance that any one stock’s losses would significantly affect your portfolio.
Or you could increase your exposure to fixed-income investments as you near retirement to prioritize protecting your principal over achieving aggressive growth.
Penalties are another risk to using a Roth IRA. If you don’t use these retirement accounts according to IRS rules, penalties can reduce your gains. For example, if you withdraw investment earnings before they are qualified distributions (such as when you turn 59½), you will face a 10% penalty.
Additionally, even if the investment earnings would otherwise be qualified (such as if you are older than age 59½ or are disabled), they can’t be withdrawn until five years after the first contribution to the account.
Roth IRAs also have income limits. In general, you can only contribute to a Roth IRA for 2022 if you have taxable income and you make less than $214,000 if you’re married and filing jointly, or $144,000 if you’re single, head of household, or married and filing separately (if you haven’t lived with your spouse that year).
If you do contribute when you are not qualified, or if you contribute more than the IRS limit, you can incur a 6% tax penalty each year until you correct the error.
You May Not Live Long Enough
The tax advantages of Roth IRA funds, namely tax-free withdrawals on earnings, are generally not available until you turn 59½. So if you pass away before that age, then you paid taxes on money without ever getting the tax benefit.
Your beneficiaries can still get tax benefits on the money. Depending on their relationship to you, they can inherit a Roth in several ways, including taking a lump-sum distribution and establishing a new IRA then transferring the assets.
Not Having Other Investments
The maximum Roth IRA contributions are between $6,000 and $7,000, depending on your age, as of 2022. If you max out a Roth each year and make no other investments, you still may not have enough saved for your retirement.
In addition to a Roth, other investments can help you meet your financial goals in retirement:
- Buying a home or investing in real estate
- Contributing to an employer-sponsored plan such as a 401(k)
- Investing additional funds in a brokerage account
Roth IRAs also carry an opportunity cost risk. Your contributions can be withdrawn at any time, but not your investment earnings. If you invest well, your account will include investment earnings. The opportunity risk is that those earnings can’t be put to other uses, like for investments in private businesses or complex real estate transactions, without a penalty.
Your investment choices within a Roth IRA are important to helping you maximize gains. Holding more high-growth investments in a Roth and more conservative investments in a taxable account can potentially help you reduce your total tax liability.
“Since growth in a Roth is tax-free, you generally want to hold your most aggressive assets there,” Matt Bacon, a financial advisor with Carmichael Hill, told The Balance via email. “Think growth equities here. …You want your Roth in overdrive mode.”
Alternatives to a Roth IRA
Roth IRAs are just one type of retirement investing account. Employer-sponsored 401(k) plans and traditional IRAs are other options.
401(k) plans are defined contribution retirement plans sponsored by employers. They have mostly replaced defined benefit (pension) plans. With a 401(k), you contribute pretax earnings that are deducted from your paycheck automatically, and your employer may match all or a portion of the funds.
If your employer offers matching funds, you’ll typically want to try to contribute to a 401(k) at least up to their limit so you’re not leaving free money on the table. You can also contribute to a 401(k) plan if you earn too much money to qualify to contribute to an IRA.
Traditional IRAs are similar to Roth IRAs but your contributions are made with pretax income. In retirement, your distributions are taxed at your marginal income tax rate.
Generally, it’s better to use a Roth IRA if you think your tax rate will be lower now than in retirement. You may want to use a traditional IRA if you expect your tax rate will be higher now than in retirement.
Are Roth IRAs Good Investment Tools?
A Roth IRA can be a good investment tool if you use it correctly. If you save well, choose investments that align with your financial goals, and leverage the tax benefits, a Roth IRA can save you a significant amount of money on taxes.
Frequently Asked Questions (FAQs)
How much interest does a Roth IRA earn?
Roth IRA accounts don’t earn interest automatically like savings accounts do. However, you can choose to hold assets in your Roth IRA that pay interest, such as bonds. Dividend stocks held in a Roth IRA can also provide interest-like regular returns.
When can you access your Roth IRA?
You can access your contributions to a Roth IRA anytime without penalty (although there may be a fee from the custodian of the account). Withdrawing investment earnings before they are qualified would result in a 10% penalty. For withdrawals to be qualified, you need to be over age 59½ or qualify as disabled unless the funds will be used to purchase your first residence or pay medical bills over a certain amount.
Is a 401(k) better than a Roth IRA?
A 401(k) plan and a Roth IRA plan have different advantages. Employer-sponsored 401(k) plans often include an employer match, which can provide more investment funds, and their contribution limit is higher. A Roth IRA may provide more investment options and offer tax-free withdrawals on earnings in retirement. You can also invest in both types of accounts.
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