Please note: This article may contain outdated information about RMDs and retirement accounts due to the SECURE Act 2.0, a law governing retirement savings (e.g., the age at which individuals must begin taking required minimum distributions (RMDs) from their retirement account will change from 72 to 73 beginning January 1, 2023). For more information about the SECURE Act 2.0, please read this article or speak with your financial consultant. (1222-2NLK)
A Roth IRA can offer potential tax benefits if you use it to its full advantage—among them the ability to make qualified tax-free withdrawals in retirement. But it's important to avoid costly pitfalls that can minimize those tax advantages, as well as your nest egg.
"When it comes to investing in a Roth IRA, it pays to know the rules, plan ahead, and get help if you need it," says Hayden Adams, CPA, CFP, and director of tax planning and wealth management at the Schwab Center for Financial Research. "This can help you avoid some of the most common mistakes, which may be difficult—if not impossible—to undo after the fact."
Here are six mistakes to steer clear of if you want to get the most out of a Roth IRA.
Mistake #1: Withdrawing earnings too soon
Original contributions to a Roth IRA are treated differently than earnings (growth) you make on investments in your account. In general, you can withdraw Roth IRA contributions any time without tax or penalty.1 But to withdraw any earnings tax-free, you must be 59½ or older and have had your account for at least five years. If you withdraw them before this time, you may owe a 10% penalty and ordinary income tax on the earnings.
That said, the IRS does allow some exceptions for investors under 59½. For example, you might qualify for an early withdrawal without tax or penalty if you use the money for a first-time home purchase (up to $10,000 lifetime maximum), for adoption expenses, or if you become disabled.2
"While it might be possible to take an early withdrawal, we generally recommend leaving Roth IRA assets alone as long as possible," says Hayden. "That way, your money will have longer to potentially benefit from tax-free growth."
Mistake #2: Contributing too much
It's also up to you to make sure you don't overcontribute to your Roth IRA. Putting more than the allowed amount into your account can trigger a 6% penalty on the excess contribution each year, until you correct the mistake.
In 2022, the maximum allowed contribution across all of your IRAs is $6,000—or $7,000 if you're 50 or older. But you can make too much—or too little—to contribute the maximum.
- If your modified adjusted gross income (MAGI) is…
- You can…
If your modified adjusted gross income (MAGI) is…Less than $129,000>You can…Contribute up to the maximum>
If your modified adjusted gross income (MAGI) is…$129,000 or more, but less than $144,000>You can…Make a partial contribution>
2022 Roth IRA Contribution Income Limits: Married Couples Filing Jointly
If your modified adjusted gross income (MAGI) is…$144,000 or more>You can…No longer contribute for the given year>
- If your modified adjusted gross income (MAGI) is…
- You can…
If your modified adjusted gross income (MAGI) is…Less than $204,000>You can…Contribute up to the maximum>
If your modified adjusted gross income (MAGI) is…$204,000 or more, but less than $214,000>You can…Make a partial contribution>
If your modified adjusted gross income (MAGI) is…$214,000 or more>You can…No longer contribute for the given year>
In addition to meeting Roth IRA income limits, your total IRA contributions generally can't exceed your earned income for the year. For example, if your earned income is $5,000 for the year, the most you can contribute across your IRAs is $5,000. If you don't have earned income, you won't be eligible to make IRA contributions that year.3
What if you inadvertently overcontribute?
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You can usually correct the mistake by withdrawing the excess amount (plus any earnings tied to it) by the due date of your tax return for that year. But in most cases, you'll still owe taxes on the earnings, and potentially a 10% penalty for early withdrawal.
"Overcontributing can cost you, even if you catch the mistake quickly and correct it," Hayden says. "The best approach is to know the rules and plan carefully to stay under the contribution limits."
Mistake #3: Missing out on a spousal IRA
While you usually need earned income to open and fund an IRA, the IRS allows exceptions for spouses who don't work outside the home. If you meet the income requirements, can cover contributions for you and your spouse, and file a joint return, you can each have IRAs. This is significant, since married couples filing jointly can contribute a combined $12,000 in savings for 2022 ($14,000 if you're both 50 or older).
"The IRA for nonworking spouses is often overlooked, but it's important to take advantage if you can," Hayden says. "Keep in mind that a spousal IRA is a separate account (not a joint account), and each spouse can choose a traditional IRA, Roth IRA, or both. Over time, the account can help you invest more for retirement and take advantage of potential tax savings."
Mistake #4: Doing a Roth conversion on your own
If your income is too high to contribute to a Roth IRA, you might find yourself considering a Roth conversion or a "backdoor" Roth at some point.4
Both of these options involve converting tax-deferred funds, such as a traditional IRA or 401(k), to a Roth IRA. This can sometimes give you more flexibility in retirement and help minimize taxes, but you need to be careful because the rules can be difficult to navigate without a clear plan.
"One of the most important things to know about converting tax-deferred funds to a Roth IRA is that the money you withdraw for the conversion is considered taxable income," says Hayden. "One implication of this is that you'll need to pay taxes on it in the year of the conversion—and in most cases, you'll want to pay the tax from a cash account so that you don't eat into your retirement savings, incur unnecessary taxes, or trigger an early withdrawal penalty."
Another potential tax consequence of withdrawing tax-deferred funds—even if you're planning to move it right into a Roth IRA—is that you could push yourself into a higher tax bracket.
"A financial planner or tax adviser can help you determine how to time your conversion for a potentially better tax outcome," says Hayden. "In some cases, this could mean converting smaller amounts over multiple years, waiting until your income is lower to convert, or deciding a conversion isn't right for you after all."
Given the complexity, potential costs, and recent law changes that no longer allow you to "undo" (or recharacterize) a Roth conversion, Hayden recommends talking to a financial planner or tax advisor before you start to convert.
Mistake #5: Overlooking how a rollover works
When you leave a job with a 401(k), you have several options. One of them is to roll assets from your old 401(k) into a traditional IRA or a Roth IRA. Many choose to convert their assets to a Roth IRA to take advantage of tax-free withdrawals in retirement.
If your old employer-sponsored account is a Roth 401(k), you won't usually owe taxes on the money you roll over to a Roth IRA because both accounts are funded with after-tax dollars. But if you're converting a traditional pre-tax 401(k), you'll owe income taxes on all contributions and earnings from your old account. These taxes are due the year of the rollover—and can be substantial.
The method you use to move money between retirement accounts also matters.
"It's generally best to move your assets using a direct rollover or trustee-to-trustee transfer, rather than taking the money out and redepositing it yourself (often called a 60-day rollover)," says Hayden. "This can be helpful in a couple of ways—first, no taxes will be withheld directly from the money you roll over. And second, you won't risk missing the 60-day rollover window, which could result in penalties if you're under age 59½."
The Roth IRA five-year rule also applies. In most cases, you'll need to have your Roth IRA open for at least five years before you start withdrawing earnings on the funds you rolled over. Withdrawing them before the five-year mark could trigger ordinary income tax, plus a 10% penalty.
Hayden says, "While the rules can be complex and there are costs, a rollover can sometimes make sense. Talking to a tax or financial professional before you start the process can help you avoid mistakes and choose the course that's right for you."
Mistake #6: Misunderstanding inherited IRA rules
Another common scenario that can result in unnecessary taxes or penalties is inheriting an IRA. If you inherit a Roth IRA, you won't typically owe taxes on the inherited funds. But you will be subject to certain withdrawal rules and deadlines.
Your options for accessing the money will depend on when you inherited the IRA, your relationship to the original owner of the account, and other personal factors.
For example, only surviving spouses have the option to transfer the assets into their own existing or new IRA. But all beneficiaries of an inherited IRA can generally choose to take a lump sum distribution or disclaim the inherited account. Other options and limitations may apply, depending on your particular circumstances.
"Inherited IRA rules and tax outcomes can vary widely depending on your specific situation," says Hayden. "As with all investment transactions, make sure you clearly understand your options and how they'll impact your taxes and larger financial picture—both now and down the road."
1, 4 Any funds that you convert to a Roth IRA will be subject to specific rules, including a separate five-year holding period for each Roth conversion (see IRS publication 590-B). If you withdraw money from a converted Roth IRA before you've held it in the account at least five years, you may owe additional penalties and taxes. In addition, earnings that are withdrawn before age 59½ are subject to an early withdrawal penalty.
2See IRS publication 590-B for early withdrawal rules, and consider consulting with a tax professional before making an early withdrawal.
3 This rule does not apply to a spousal IRA, which allows a nonworking spouse to make IRA contributions without having earned income.
Depending on the type of IRA account you have, there are different rules for withdrawals, penalties, and distributions. Please understand these before opening your account.
Roth IRA earnings can be withdrawn tax-free after age 59½, if you've held the account for at least five years. If you take a distribution of Roth IRA earnings before you reach age 59½ and before the account is five years old, the earnings may be subject to taxes and a 10% federal tax penalty.
A rollover of retirement plan assets to an IRA is not your only option. Carefully consider all of your available options, which may include but not be limited to keeping your assets in your former employer's plan; rolling over assets to a new employer's plan; or taking a cash distribution (taxes and possible withdrawal penalties may apply). Prior to a decision, be sure to understand the benefits and limitations of your available options and consider factors such as differences in investment related expenses, plan or account fees, available investment options, distribution options, legal and creditor protections, the availability of loan provisions, tax treatment, and other concerns specific to your individual circumstances.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for their own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
Investing involves risk, including loss of principal.
This information does not constitute and is not intended to be a substitute for specific individualized tax, legal, or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner, or investment manager.1222-2L6Z