Top 20 Roth Mistakes to Avoid
Here are the top 20 Roth IRA mistakes to avoid, ranked in order of importance from least to most costly (at least, as I see it).
Some of these are mistakes I’ve made and others I’ve managed to avoid.
20) Contributing to a Roth Account When You Should Contribute to Traditional
On one hand, this may not be that costly. Usually, if you’re on the fence because you’re not sure that your income tax bracket will be higher or lower in retirement, it’s not going to make a huge difference either way.
On the other hand, if you’re contributing to a Roth while in a high-income tax bracket or contributing to a traditional while in a very low income tax bracket, you may be paying far too much in unnecessary taxes.
For more on making this decision, see this post about Roth vs Traditional or check out the video below.
19) Owning Municipal Bonds in a Roth
Because Roth IRAs enjoy completely tax-free earnings, there’s no reason to own a tax-efficient investment like a municipal bond in your Roth IRA account.
It’s like trying to double-dip your tax savings, but you can only get it once. Save your muni bonds for a taxable brokerage account.
18) Owning Your Most Conservative Investments in Roth
Piggybacking on the previous mistake, you also shouldn’t own your most conservative investments in a Roth IRA.
Again, because Roth accounts enjoy tax-free earnings and withdrawals, combined with the fact that Roth assets are the ones you will probably want to hang on to the longest, you would be best served to hold your high-growth assets, like stocks, in a Roth IRA.
Now, depending on your asset allocation you may not be able to avoid owning some more conservative assets in a Roth and that’s totally fine. Just make sure your assets with the highest growth potential are in the Roth first.
17) Not Diversifying Roth Investments
This mistake really applies to almost any account.
Someone I know once bought an individual stock in their Roth IRA and it did very well. So well in fact that their asset allocation was way overweight in this one stock.
Instead of selling some of the stock and redistributing the earnings to other assets, he held onto his star stock and watched it fall all the way back down to what he paid for it.
That was dumb. Don’t be like me…um…I mean him.
I’m not saying you can’t own a little stock in your Roth but keep it in reason. Many financial advisers recommend holding no more than 10% of your assets in a single stock.
I think that’s a little high, but I know some people just want some money to kind of play with.
Just make a commitment to keep things in line if you do really well in a single pick.
16) Spending Roth Before Traditional
When you begin making withdrawals from your retirement accounts, you’re going to want to start with Traditional or Tax-Deferred assets before you withdraw from your Roth.
That’s because Roth dollars don’t have any future tax obligations, so it’s more valuable to let them grow than those in a tax-deferred space.
Of course, there may be a long-term tax planning strategy that could call for you to use some of your Roth money before you’ve exhausted your traditional accounts; but, in general, try to save the Roth as long as you can.
15) Ignoring Spousal Contributions
One fundamental requirement for being eligible to make Roth contributions is that you must have earned income.
The exception to this is a non-working spouse whose husband or wife has enough earned income for both spouses to contribute.
So, if you want to contribute to an IRA but don’t work a normal job, but your spouse does, look into a Spousal IRA.
14) Ignoring the Backdoor Roth IRA
Another fundamental requirement of being eligible to make Roth contributions is that your income not exceed the annual maximum income restrictions in place for higher-income individuals and families.
Here’s a table with those limitations for 2024 below.
Basically, if you make more than this, you can’t contribute to a Roth IRA…directly.
But you can fund a Roth IRA by using the Backdoor Roth IRA method. In summary, by contributing to an after-tax IRA, and then converting that contribution to a Roth you can fund a Roth IRA by using an extra step.
There is a potential tax bomb to avoid, however. We’ll get to it later in our list.
13) Ignoring the Mega-Backdoor Roth
In the same vein, if you have a high income and you’re looking for a way to get more money into a Roth account, you could use the Mega-Backdoor Roth method.
Because 401(k) plans have much higher after-tax contribution limits (Up to $69,000 in 2024, $76,500 for 50+) you can get much more into a Roth by using your 401(k) instead.
Just contribute whatever amount you want up to the limit, then convert it to Roth within the 401(k) or take an in-service distribution and roll it over to your Roth IRA.
Your 401(k) plan may or may not allow you to do this, so you’ll need to check your plan documents to be sure.
12) Excess Contributions
Contributing too much to a Roth IRA happens more often than you might think. Typically, it catches people who have a sudden increase in income or receive some sort of taxable windfall that disqualifies them after they’ve begun making contributions.
It’s reasonably easy to fix, but if you fail to remove an excess contribution the IRS will penalize you 6% each year you leave the excess funds in your account.
11) Forgetting to Update Your Beneficiaries
Most of us will rarely, if ever, make changes to the beneficiaries listed on our Roth accounts because there’s rarely a need to.
Unfortunately, that makes this responsibility easy to overlook and all the more painful when it happens.
There are a lot of rather tragic stories of inheritances that should have gone to the current spouse or children of a decedent, but instead end up in the hands of an ex because the beneficiaries were never updated on the account.
You should update your beneficiaries on an annual basis or any time you have a change in the status of one of your beneficiaries.
10) Forgetting the Five-Year Rule
Another rule of Roth IRAs is that funds must sit in the account for at least 5 years before they are withdrawn.
This means you must have a Roth IRA open for at least 5 years before you can begin making qualified withdrawals at any age or you’ll have to wait 5 years after a conversion to make withdrawals unless you reach age 59.5 first.
Each Roth conversion gets its own 5-year clock, but they all expire at 59.5 assuming the account was open for at least 5 years first.
The point is, if you plan to make a Roth withdrawal within the next five years you need to be sure you satisfy the five-year rules. This can be a little confusing, but we also have a post about the five-year rule to help explain it.
9) Unqualified Distributions
Unqualified withdrawals from a Roth IRA are basically any made before age 59.5, unless it is for one of the few exceptions available like a first-time home purchase or college tuition.
The penalty for an unqualified distribution is 10% and you can’t replace the money later. Once it’s out of the account, it’s out for good.
So, you’ll lose 10% of your money and any tax-free earnings you would have gained by leaving the money in the account.
The larger the distribution, the more painful this would be.
8) Failing to Convert Traditional to Roth
Roth Conversions are a great way to reduce your tax liability before you reach the age of required minimum distributions (RMDs).
RMDs are a way the government ensures that they’ll get a chance to collect taxes on your tax-deferred savings by forcing you to remove money from the accounts.
By converting traditional IRA assets to Roth in low-income tax years you can reduce the amount of money you’ll have exposed to taxes later while paying for conversions at a potentially lower tax rate.
Failing to take advantage of conversions when you can could lead to painful tax years after RMDs hit.
The best time to convert is usually after retirement, but before you reach RMD age of 72 to 75 depending on when you were born.
7) Triggering Tax on a Bungled Rollover
If you leave an employer and decide to roll over an existing Roth 401(k) to a Roth IRA, you could potentially realize an unqualified distribution if you’re not careful.
There are a couple of ways to carry out a rollover.
The best way is a direct rollover where your 401(k) custodian sends a check or the assets in the account to your Roth IRA custodian, and you never handle any of the money.
The riskier way is to have the 401(k) custodian send you a check, requiring you to send the check to your IRA custodian yourself. You’ll have 60 days to move this money from one account to the other or you’ll be hit with a 10% early withdrawal penalty on any earnings in the account.
I’ve never heard of a good reason not to do a direct rollover, so just remove all the risk and stay out of it if you can.
6) Using Your Roth IRA to Fund Conversions
We spoke earlier about conversions from Traditional IRAs to a Roth IRA.
You need to keep in mind when you do this that it is a taxable event, meaning you’ll owe income taxes on the amount you convert.
That’s because Traditional IRA assets have never been taxed and Uncle Sam has to collect before the money goes into the Roth.
There are perfectly good tax reasons to do a conversion, but be sure you have enough cash on hand to fund the conversion so you don’t have to cannibalize the IRA in the process.
Again, you can’t replace the money you pull out of an IRA so it would be a shame to use it to pay for your conversions.
5) Using a Backdoor Roth IRA While Forgetting the Pro Rata Rule
We also shared a bit earlier about Backdoor Roth IRAs but stopped short of telling you about a potential tax headache they can create.
Because the IRS sees all of your non-Roth IRAs as one, if you make a conversion using after-tax or pre-tax IRA funds, you’ll owe tax on a pro-rata or proportional basis depending on how much of your IRA money hasn’t already been taxed.
In other words, if you convert to a Roth IRA, you’ll owe taxes proportional to all of your pre-tax IRA funds.
So, if you have $20,000 in IRAs and $15,000 of it is pre-tax, you’ll owe income tax on 75% of your conversion because 75% of your IRAs are pre-tax.
You don’t get to single out the after-tax money for your Backdoor Roth IRA.
To avoid this, you could possibly roll your traditional IRA dollars into a 401(k) if your plan allows.
That means they wouldn’t be IRA assets anymore and the pro rata rule wouldn’t have any pre-tax assets to capture.
4) Removing Contributions
One potentially handy feature of Roth IRAs is that you can remove your contributions at any time, tax and penalty free because contributions have already been taxed.
The problem with this is you can never replace those contributions once they’ve been removed.
You’ll be forfeiting years of future earnings and interest that you can never get back.
Instead of raiding your Roth IRA, be sure to build up a sufficient emergency fund to cover unexpected expenses and sudden cash needs.
3) Forgetting to Withdraw Inherited Roth Assets
Named beneficiaries of Inherited Roth IRAs have up to 10 years to remove Roth assets from the account completely.
This means for a decade they get to have an extra Roth IRA.
However, if the assets sit in the Inherited Roth IRA for more than 10 years, they’ll have to pay 25% for each year the Inherited Roth is left funded.
This can potentially be reduced to a 10% penalty, but that would still be quite painful.
There is a lot of wisdom in leaving those funds in the inherited Roth as long as possible, but be sure and set a reminder so you don’t blow it on penalties later.
2) Buying Expensive Investments
This is the death by 1000 cuts Roth mistake that you could potentially make in any investment account.
Expense ratios for most common mutual fund or exchange-traded fund investments can range from nearly 0 to 5% annually.
In a previous post we wrote for our website, we illustrated how an expense ratio of 0.9% could cost nearly $120,000 for an average investor over a period of 35 years.
Expense ratios are a bit like dead weight on a race car. The more you carry, the more it slows you down.
Do yourself a favor and buy low-cost index funds. Studies show they perform better over time than active management anyway.
1) Not Contributing Early and Often
It may seem a bit cliché to have not contributing as the biggest mistake, but if you think about it none of the previous mistakes could exist without this one.
Besides, the only way to build a small fortune in Roth IRAs is by contributing the annual maximum and giving it many years to grow through compounding interest.
I also want to especially challenge young people who are just getting started in their careers. Your income is probably as low now as it will ever be, meaning your tax liability is as low now as it will ever be.
Take advantage of this time by filling up those Roth accounts.
This is something my wife and I focused on heavily in our early years and we are really getting to experience the benefits of that almost 20 years later.
Conclusion
So, now you know most of what to avoid with those Roth Accounts.
We’ve got lots more on our website and YouTube channel about Roth IRAs. I invite you to follow the links above to our other posts and videos about these topics.
