When saving for retirement, a Roth IRA offers the distinct advantage of simplicity. Although contributions to a Roth IRA is not tax-deductible, you can compound your investments and withdraw your money free of taxes, and you are not required to withdraw a minimum amount when you retire. Annual contribution limit is $5,500 ($6,500 if you are over 50). However, despite these benefits, investors can also encounter potential pitfalls and incur unintended tax liabilities.
Here are the eight common Roth IRA mistakes to avoid.
1. Not maximizing (or not contributing at all) your Roth IRA contributions per year. If you contribute the maximum of $5,500 a year for 30 years assuming an annual investment return of 5%, you can make $1.1 million in 30 years. Let us say, you hold back and contribute only $5,000 per year, the difference of the $500 per year at a 5% return for 30 years due to compounding amounts to almost $100,000! Also, if you earn enough money to cover the Roth IRA contributions for you and your non-earning spouse, you can max out the contributions each year for both of you.
Here are the eight common Roth IRA mistakes to avoid.
1. Not maximizing (or not contributing at all) your Roth IRA contributions per year. If you contribute the maximum of $5,500 a year for 30 years assuming an annual investment return of 5%, you can make $1.1 million in 30 years. Let us say, you hold back and contribute only $5,000 per year, the difference of the $500 per year at a 5% return for 30 years due to compounding amounts to almost $100,000! Also, if you earn enough money to cover the Roth IRA contributions for you and your non-earning spouse, you can max out the contributions each year for both of you.
2. Avoid contributing because you exceed the earnings limit. The IRS prevents high earners to contribute directly to a Roth IRA – in 2014, the earnings limit is $191,000 for a married couple filed jointly and $129,000 for single people or the head of household. One way to circumvent this problem is to contribute to a Traditional non-deductible IRA and then promptly convert to a Roth IRA before the cash earns any returns or else you will be subject to mandatory minimum distributions and ordinary income taxes upon withdrawals.
3. Contributing too much. If you contribute more than your allowed amount, you can incur a penalty of 6% per year on the excess contribution. For example, you forget that you have already contributed earlier in the year, or you continue to contribute even after age 70 ½ or for a diseased individual. You can resolve this by taking out the excess money before filing your taxes or carrying forward the contribution to the next year with proper documentation to the IRS.
4. Breaking the rule for rollover. You can move from one IRA account to another or take distributions from a 401K account after you leave a job without incurring taxes as long as you do this within 60 days. Starting 2015, you can do this rollover once during a 365-day period, not a calendar year. More importantly, you can only use this 60-day rollover once per year even if you have five IRA accounts. If you break the rule, you can lose your entire IRA benefits.
5. Messing up the rollover. Avoid taking the money out from one IRA account to yourself before you roll over to another. It is best to do a custodian-to-custodian transfer. However, you have to be meticulous about the transfer to make sure the money is actually rolled over into the correct IRA account and not a regular investment account. Otherwise you will lose the entire IRA tax shelter.
6. Not knowing the order of Roth IRA withdrawals. Normally, you can withdraw your original contributions and conversion amounts from your Roth IRA tax-free and penalty-free when you reach age 59 ½ and provided you wait for five years. However, each IRA conversion you make is treated separately and is subject to its own five-year waiting period, or you will incur a 10% early withdrawal penalty.
7. Not paying attention to fees and investments in the IRA account. Discount brokers typically charge no fees when hosting your Roth IRA account and so make sure you do not pay any annual hosting fee. Also when choosing your investments in the IRA account, think about the expenses you are paying in mutual funds. Go for no-load mutual funds or low-cost exchange-traded funds. Also make sure you track regularly how your investments have done over time (at least once a year) and rebalance among cash, stocks, and bonds periodically. Also check whether you have the right mix between value and growth stocks, domestic versus international investments, to make sure you reach your financial goals upon retirement.
8. Forgetting to take required minimum distributions (RMD) from an inherited Roth. If you are lucky enough to inherit a Roth IRA from someone who is not your spouse but forget to take the RMD as per the IRS rules, you can still incur a penalty of 50% of the money not distributed. Seeking advice on an inherited Roth IRA will save you headaches down the road.
