Don’t Do This with Your Roth
If you have read many of the posts on martinmoney.com or watched the videos on our YouTube channel, you know what a big fan I am of Roth IRAs.
There’s a certain degree of freedom that you get from the tax-free earnings and withdrawals of a Roth account that isn’t available through tax-deferred investing.
In tax-deferred accounts, the government still has a declared interest in your future earnings and withdrawals because you’ll owe taxes when you begin removing the money in retirement.
Ultimately, the decision to use a Roth or Tax-Deferred investing strategy depends on your marginal tax rate now versus when you retire and I don’t have time for that in this post. (But you can read about it here.)
Instead, I’m going to focus on several things you shouldn’t do with a Roth account in hopes of helping you avoid common Roth pitfalls that many fall into.
1) Don’t Under or Over Contribute
This may sound like it would be easy enough to avoid. The annual contribution limits for Roth IRAs are listed in the table below.
If you stay within the lines here, then there’s nothing to fear but this catches more people than you might think, myself included.
Where this gets challenging is for those whose modified adjusted gross income falls very close to the income limitations.
If you start the year assuming your income will fall below the limit, and you want to contribute, then you probably will.
But what if you receive a raise or a bonus that nudges you over the mark?
That’s not a bad thing. It’s just unexpected. And if you’ve already made contributions, you’ll have a bit of a mess to untangle.
On the other hand, what if you decide not to contribute until the end of the year and you miss out on a full year of earnings because you were sitting on the sidelines?
Well, when in doubt I would go ahead and make the contributions. If it turns out the contributions aren’t allowed, they can be removed or redirected into a taxable brokerage.
You will owe income tax on any earnings, but if you remove the disallowed contributions before the end of the next tax year you won’t be penalized.
For more details, read this post about contributing too much to a Roth or watch the YouTube version.
I’ve made this mistake before and it was a little bit of a headache to clean up, but your brokerage sees this happen all the time. They can walk you through the fix.
2) Don’t Choose Roth 401(k) over Roth IRA
If you have access to both a Roth IRA and Roth 401(k) you might wonder if it makes any difference which account takes preference for your contributions.
Well, it does depend on your situation, but there are a few reasons the IRA is typically a better choice than the 401(k), and one reason the opposite may be true.
First, you are in complete control of your IRA. You get to pick the account custodian and select the investments. This isn’t true through an employer-sponsored 401(k).
Having this level of control allows you to choose investments that better fit your asset allocation goals and have lower expense ratios.
Next, the contributions you make to a Roth IRA can be removed at any time, tax and penalty free.
That is not the case with Roth 401(k)s.
I’m actually about to deter you from raiding your Roth for cash, but if you have a significant emergency, you can break the seal on that Roth and pull out your contributions.
The one reason you might prefer a Roth 401(k) over a Roth IRA is legal protection. In many states, 401(k)s enjoy a higher degree of protection from lawsuits or bankruptcy than IRAs do.
But don’t take my word for this. You should consult with an attorney or research the laws in your own state to be sure.
3) Don’t Use Your Contributions
So, like I just said, even though you can remove your Roth IRA contributions tax and penalty-free, you should avoid doing so if at all possible because it will cost you.
As an example, let’s assume you contributed $5,000 to a Roth IRA 5 years ago and it has provided an average annual return of 8% since that time and is now worth $6,298.56.
You decide you could use a vacation and that $5,000 would fund a nice weeklong experience for you and a loved one, so you pull out your contributions and leave the earnings to grow for another 25 years when you plan to retire.
The good news it the earnings of $1,298.56 grow to $8,893.16. That’s almost a seven-fold increase.
However, if you had left the $5,000 in the Roth it would now be worth $43,135.53.
That means your $5,000 vacation actually cost you $34,242,37.
Ouch.
Yes, having Roth contributions as a “last resort” type emergency fund is handy, but that doesn’t mean there aren’t drawbacks.
If at all possible, do not remove Roth contributions. You can never put them back and the long-term impact is significant.
4) Don’t Make Early Withdrawals
As you may be aware, you cannot remove funds from a Roth IRA or 401(k) until age 59.5.
If you tap into your Roth early you will owe a 10% early withdrawal penalty for anything you take out and you can’t put it back.
For perspective, 10% would be a very good year of earnings for your investments.
Combine that with the opportunity cost I just explained when I was addressing removing conversions, and you can understand how early withdrawals can be incredibly costly.
The good news is there are a couple of ways around the minimum withdrawal age for Roth IRAs and 401(k)s.
First, if you retire from the employer that manages your Roth 401(k) at age 55 or later, you can remove Roth funds from that account tax and penalty free.
It’s called the Rule of 55 and it is a good one to keep in mind in case you want to retire in your late 50s.
Another strategy is called a Roth Conversion Ladder.
As we’ve mentioned a couple of times now, Roth contributions can be removed at any time tax and penalty free.
Well, as it happens any amounts you convert from a Traditional IRA to a Roth IRA receive the same treatment as contributions after five years have passed since the conversion.
So, if you want to get at your Roth a little early, you can begin rolling over your tax-deferred IRA funds five years before you want to tap your Roth for access to penalty-free Roth dollars.
You do need to keep in mind that Roth Conversions are a taxable event, so make sure you have enough cash to fund the conversions before you start.
5) Don’t Contribute While In a High Tax Bracket
I did say I wouldn’t dive into the whole Roth versus Traditional debate in this post and I’m going to keep my promise by just addressing one side of the issue.
If you have a high income, Roth accounts are probably not for you.
That’s because Roth contributions do not receive tax deductions meaning you are forgoing a deduction at a very high income tax rate when you contribute to a Roth.
If you expect to be in even higher brackets in retirement, then by all means, Roth away.
However, most people find themselves in lower brackets in retirement meaning it’s a better value to take the deduction when the contribution is made.
Generally, I recommend contributing to a Roth if your combined state and federal income tax rate is below 25%. If it’s over 30%, I’d probably go with a tax-deferred contribution.
If it’s in between I’d hedge and do a little of both, though I confess that I lean toward Roth a little.
6) Don’t Convert Everything to a Roth
You might think that since all the money in Roth accounts has a completely tax-free future, you’d want as much money as possible in Roth accounts.
However, there are a few cases where having some money in a tax-deferred or taxable space is more tax-efficient.
The primary example is giving.
If all of your money is in a Roth account, then gifts that would normally receive a tax deduction won’t earn you any deductions because you won’t have any taxable income from which to make a deduction.
Another common example is benefactors who convert as much of their financial legacy to Roth IRAs as possible.
I understand the sentiment. Inheritances in a Roth account are hard to beat.
But what if you pay a bunch of taxes converting a Traditional IRA to a Roth for your kids, but when you die they’re all in lower tax brackets than you?
In that case, they would have received more money after taxes if they had inherited a Traditional IRA.
Or what if you have one kid in a higher bracket and another one in a lower bracket?
It can get complicated, right? That’s why I say manage your retirement funds for your retirement. Your beneficiaries can figure out the taxes after you’re gone.
Finally, if you’re not careful you could overpay for Roth Conversions by paying taxes for the conversions at tax rates that are higher than you find yourself in later on.
If you have a lot of money in tax-deferred accounts and large Required Minimum Distributions are in your future, then you should definitely consider Roth Conversions. But keep in mind that there is a breakeven point, after which conversions cease to make much sense.
7) Don’t Forget the Pro Rata Rule
Speaking of conversions, one popular Roth IRA hack for those with incomes that are too high to make direct contributions is to use a Backdoor Roth IRA.
Here’s how it works…
Anyone with earned income can make after-tax contributions to a Traditional IRA, even with very high incomes.
Anyone is also allowed to convert those contributions to a Roth IRA without any penalties or taxes other than those owed for earnings between the time of the contribution and the conversion.
So, if you do just those two things, you have successfully completed the Backdoor Roth IRA maneuver.
But there’s a significant catch.
The IRS’ pro-rata rule states that you must pay taxes on a pro rata or proportional basis for all of your IRA accounts.
For example, if you have $5,000 in an IRA on a tax-deferred basis and $5,000 in a Traditional IRA on an after-tax basis, 50% of the conversion is subject to income tax because 50% of the balance of all of your non-Roth IRAs is subject to income tax.
In other words, if you have a significant tax-deferred IRA balance, it may be costly to make the conversions to a Roth through the back door.
8) Others
Here are a few other “don’ts” for Roth accounts that may apply to a smaller cross-section of people…
- Don’t Forget to Withdraw Inherited Roth – You have 10 years to completely liquidate an inherited Roth IRA. The good news is, in the meantime, you can use it as an extra Roth IRA, continuing to invest the assets within the account.
- Don’t Forget Your Beneficiaries – Make sure you check on this at least once a year so you don’t accidentally bequeath your Roth account to someone who pre-deceased you or, maybe worse, to an ex-spouse.
- Don’t Do Indirect Rollovers – If you roll an old employer-sponsored retirement plan into a Roth IRA, try to have the custodian transfer the funds to your Roth IRA directly so you don’t have to handle anything. If a check is sent to you, you’ll have 60 days to get it into your Roth before it’s considered a taxable distribution which could also be subject to early withdrawal penalties.
- Don’t Forget the Five-Year Rule – Your Roth account must be open for at least five years before you can remove any earnings from the account without penalty, even if you’re over 59.5. The five-year rule also applies to each Roth conversion in the laddering strategy I proposed earlier and to any inherited Roth IRAs that haven’t been open for at least five years.
Wrap Up
In summary, the tax-free earning and withdrawal benefits of Roth accounts make them difficult to beat, but you can mess them up if you’re not careful.
Take care of your Roth and it will take care of you.
For more about Roth accounts, check out our Roth playlist on YouTube.
