7 mistakes to avoid with your Roth IRA

The Roth IRA is a powerful retirement savings tool. It offers tax-free investment growth and tax-free distributions if certain conditions are met and the ability to withdraw contributions anytime. But the Roth IRA also has unique rules and restrictions. Failure to abide by them can reduce the account’s long-term financial benefits. Knowledge is power. Knowledge of mistakes to avoid with your Roth IRA can help you reach your retirement goals.

Common Roth IRA mistakes to avoid

Before you invest in a Roth IRA, understand the common mistakes investors make and how to avoid them.

1. Withdrawing earnings early

While you can withdraw Roth IRA contributions anytime tax- and penalty-free, the same isn’t true of earnings. Withdrawing Roth IRA earnings early can be costly. “Withdrawing earnings prematurely not only diminishes the potential for compound growth but may also result in penalties and taxes if you withdraw before age 59½ and don’t meet certain exceptions,” said Cameron Burskey, the managing director of Cornerstone Financial Services. Roth IRA earnings are subject to a five-year rule. For a withdrawal of earnings to be tax- and penalty-free, it must be made at least five years after your first Roth IRA contribution. One of the following must also be true:

• You’re 59½ or older.
• You’re disabled.
• You’re the beneficiary of the account, and the owner has died.
• You’re withdrawing no more than $10,000 for the purchase of your first home.

A withdrawal of earnings that does not meet the above requirements or qualify for an exception will be subject to income tax and a 10% early withdrawal penalty.

Tip: Exceptions such as qualified education expenses, unreimbursed medical bills and health insurance premiums while you’re unemployed may help you avoid the penalty but not the tax.

2. Contributing too much

The IRS generally limits contributions to tax-advantaged accounts. The Roth IRA is no exception. In 2023, you can contribute the lesser of the following:

• $6,500, or $7,500 if you’re 50 or older.
• Your earned income for the year.

If you overcontribute to your Roth IRA, you have until the tax filing deadline, including extensions, to fix the mistake by withdrawing the excess contributions and any income they earned. Otherwise, they are taxed at 6% per year for each year they remain in your account.

3. Contributing when your income is too high

The IRS limits who can contribute directly to a Roth IRA based on their income. In 2023, single filers with an income of less than $138,000 and married joint filers with an income of less than $218,000 can contribute up to the limit. Once you pass those income thresholds, your contributions may be reduced or eliminated. Single filers with an income of $153,000 or more and married joint filers with an income of $228,000 or more cannot contribute at all. If you make Roth IRA contributions despite your income being too high, they are subject to a 6% tax for each year they remain in your Roth IRA. You may be able to avoid that penalty by withdrawing the excess contributions or recharacterizing them as traditional IRA contributions by the tax filing deadline, including extensions. “If you are above the income limit, you cannot contribute directly to a Roth. But you can still use a backdoor strategy,” said Kendall Meade, a certified financial planner with SoFi. A backdoor Roth IRA allows you to make nondeductible contributions to a traditional IRA, which doesn’t have income limits, and then convert it to a Roth IRA. As long as you didn’t take a tax deduction and your contributions haven’t accrued earnings, you won’t pay taxes when you make the conversion.

4. Not taking advantage of a spousal IRA

You generally must have taxable income to contribute to a Roth IRA. But a non-wage-earning spouse can open and contribute to a Roth IRA if the other spouse works and the couple files a joint tax return. Each spouse can contribute up to the limit as long as their combined contributions do not exceed the wage-earning spouse’s earned income. Missing out on a spousal IRA because you don’t know you can contribute as a non-wage earner is a big mistake. First, it reduces the amount you and your spouse can contribute to tax-advantaged accounts as a couple. Second, and perhaps more importantly, it prevents you from having your own investments and forces you to rely on your spouse for your retirement savings.

5. Assuming a Roth IRA is the best option

The Roth IRA is a popular retirement savings tool often touted as the best option for young workers. But every tax advantage has a trade-off, which means Roth IRAs may not be right for everyone. Roth IRAs offer no tax benefits in the year you contribute. But you can get tax-free withdrawals during retirement if certain conditions are met. That means Roth accounts are best suited for individuals who are in a lower tax bracket today than they will be in retirement. “When you contribute to a Roth IRA, you are making a bet that your taxes will be higher in the future than they are today,” said Kelly Palmer, a chartered financial analyst and the founder of the financial planning firm The Wealthy Parent. Before you assume that a Roth IRA makes sense for you, run the numbers based on your current tax rate and what your tax rate may be in retirement to see whether a traditional IRA could be more tax-efficient. “Don’t immediately discount the power of the traditional IRA,” Palmer said. “If possible, consider contributing to both Roth and traditional accounts to diversify your tax risk.”

Tip: Remember that the contribution limits — $6,500, or $7,500 if you’re 50 or older — apply to the total contributions you make each year to all your traditional and Roth IRAs.

6. Not understanding the consequences of a Roth conversion

If you have a traditional IRA, a Roth IRA conversion could help you take advantage of a Roth IRA’s benefits. This strategy allows you to move money from a pretax account to a Roth IRA, which is an after-tax account. But some people fail to consider the potential consequences of a Roth IRA conversion. First, assuming you received a tax deduction for your traditional IRA contribution, you’ll pay income tax when you convert the funds to a Roth IRA. Second, the conversion will be subject to a five-year holding period. If you withdraw the converted principal before those five years are up, you could face a 10% early withdrawal penalty.

7. Forgetting to invest the money in your Roth IRA

Perhaps the most serious and costly mistake you could make with your IRA is not investing the money. In most cases, that doesn’t happen automatically. “A Roth IRA is just a container. It’s essential to invest the funds within it,” Burskey said. “Leaving money in cash or not actively managing your investments can result in missed growth opportunities.” When you contribute to your Roth IRA, the money likely sits in a cash account until you direct your brokerage firm to invest it. If you fail to do so, you could find yourself earning a meager amount of interest — or none at all.