By LITA EPSTEIN
May 13, 2020
You might think that the only thing you need to know about a Roth IRA is that your contributions are limited to $6,000 if you are under age 50 and $7,000 if you are 50 or over (at least for 2020).1 Well, it’s a little more complicated than that. Here are 11 common errors that people with Roth IRAs are likely to make, and a few suggestions on how to avoid those mistakes.
Quick Recap: Roth vs. Traditional IRA
First, though, a quick refresher on the key differences between a Roth IRA and a traditional IRA. Contributions to a Roth IRA are not tax-deductible when you make them. However, the distributions can be tax-free. This untaxed status for distributions applies to both the original investments and the gains on them, assuming you’re over age 59½ when you withdraw the funds and that the account is at least five years old (see rule No. 5, below).2
In contrast, contributions to a traditional IRA are tax-deductible.1 However, when it comes time to withdraw the funds, you'll have to pay taxes on them at your current income-tax rate.3 What’s more, you have to take required minimum distributions (RMDs) on traditional IRAs starting when you reach the age of 72. Roth IRAs are not subject to RMD requirements until the death of the account holder (see rule No. 10, below).4
Also, if you don't need the money, you can leave the account to your heirs. However, in 2020, the Internal Revenue Service (IRS) changed the mandatory distribution rules for heirs of IRAs. All funds in the beneficiary's account must be distributed by the end of the 10th year after the death of the original IRA owner. There are exceptions, such as for spouses, minor children, disabled or chronically ill people, and those not more than 10 years younger than the IRA owner.5
Below are the mistakes to avoid.
1. Not Earning Enough to Contribute
You cannot contribute more to a Roth IRA than you received in earned income for the year. This income can come from wages, salaries, tips, professional fees, bonuses, and other amounts received for providing personal services. You can also count earnings from commissions, self-employment income, nontaxable combat pay, military differential pay, and taxable alimony and separate maintenance payments.1
So-called unearned income—such as dividends, interest, or capital gains—are not included in calculating the allowable Roth contribution.
You can contribute to a Roth up to allowable limits for both yourself and your spouse as long as you file your taxes jointly and one of you makes enough eligible income to fund the contributions.6
2. Earning Too Much to Contribute
You can earn too much overall to contribute to a Roth IRA. Whether you're eligible is determined by your modified adjusted gross income (MAGI). When calculating your MAGI, your income is reduced by certain deductions, such as contributions to a traditional IRA, student loan interest, tuition and fees, and foreign earnings.
The income limits for Roth IRAs are adjusted periodically by the IRS. As of 2020, people who are married filing jointly or a qualifying widow(er) must make less than $196,000 to be able to make the maximum contribution. If you earn between $196,000 and $206,000, you may be able to contribute some money, but the amount is reduced. With earnings above $206,000, no contribution is allowed.
Taxpayers in 2020 who are filing as single, head of household, or married filing separately (who did not live with their spouse at any time during the year) can contribute to a Roth IRA as long as they earn less than $124,000. The allowed contribution starts phasing out if they earn $124,000 or more and is eliminated entirely above $139,000.6
What if you’re married and live with your spouse, but file taxes separately? If you earn more than $10,000, you cannot contribute to a Roth IRA at all. If you made less, you might be able to make a reduced contribution. Only those who are completely separated can make a substantial contribution, as delineated above.6
3. Not Contributing for Your Spouse
As rule No. 1 said, you can’t contribute more to a Roth than you’ve earned in a given year. But there’s an important exception for non-working spouses, as long as you’re legally married and file a joint tax return.
However, there's no such thing as a joint IRA. A spousal IRA allows a non-working spouse to establish an account, and then have the working spouse make contributions to it as well as to their own. Of course, the working spouse’s income has to be enough to cover both contributions. But increasing—perhaps even doubling—your annual contributions is certainly not the worst idea in the world, and could significantly increase a family's retirement savings over time.
4. Contributing Too Much
If you have more than one IRA, or your income gets an unexpected boost, you can easily make the mistake of contributing more than the allowable maximum. (Remember, the annual limit of $6,000 or $7,000 including the catch-up provision is for all your IRAs total, not per account.) Exceeding the limit can cost you a penalty of 6% on the excess each year until you rectify the mistake.1
You can avoid the penalty if you discover the mistake before filing your tax return and take the excess contribution, plus any earnings on it, out of the account. (Actually, you can withdraw some or all of your Roth IRA contributions up to six months after the original due date of the return, but you then must file an amended return.) You can also carry over the excess contribution to another tax year, but unless that’s done simultaneously with the correction, it might trigger the penalty.2
5. Pulling out Earnings Too Early
The withdrawal rules for Roth funds can be a tad complicated. You can withdraw the amounts you contributed any time, at any age—those contributions were made with after-tax dollars, after all. But you may owe income taxes and a 10% penalty on any earnings you withdraw. In order to enjoy tax- and penalty-free withdrawals on any profits or income the investments generated, a Roth IRA owner must be 59½ years old and have owned the account for at least five years (the "5-year rule").1 If you pull the money out before those two milestones, you could face some costly consequences.
In some limited cases, people under 59½ can avoid the early withdrawal penalty (although not the applicable taxes) on earnings. You can, for example, pull out money to cover the costs of certain education expenses or to pay for a first-time home purchase.
6. Breaking the Rollover Rules
It used to be that you could do an IRA rollover only once in a calendar year, but that changed in 2015. Now, the government restricts you from doing more than one rollover in a 365-day period—even if they occur in two different years.7
It’s a rule you’ll want to pay attention to because too many rollovers can trigger a big tax bill. “Some people can lose their entire IRA because they did two rollovers in a year and didn’t realize it," says Ed Slott, author of "The Retirement Savings Tax Bomb...and How to Defuse It."8
There are some exceptions, as in the case of 60-day rollovers from a traditional IRA into a Roth IRA.7 Also, the 365-day rule doesn’t apply to the direct transfer of funds between two IRA trustees, which the IRS does not consider a rollover.7
7. Rolling Over the Money Yourself
There are two basic ways to rollover funds from one qualified retirement savings account, like a traditional IRA or a 401(k), into a Roth: direct and indirect.
In a direct rollover, your money is transferred from one account to another electronically, or you receive a check made out in the name of the new account and deliver it. With an indirect rollover, you take possession of the money from the old account and deposit it into the new one yourself.
It's best to avoid this latter move because so many things can go wrong. The most common mistake people make is missing the 60-day deadline to roll over the money because they used the cash for something else and didn’t have enough to make the full contribution on time. Sometimes, people simply forget.
If you do choose to do it yourself anyhow, be meticulous about documenting the rollover in case the IRS questions it. If you can’t prove you deposited the money in time, you'll have to pay taxes and penalties on it.9
8. Not Considering a Backdoor Roth IRA
If you make too much money to contribute to a Roth, all is not lost. You could instead contribute to a nondeductible IRA, which is available to anyone no matter how much income they earn. (This contribution is made with after-tax dollars, money that has already been taxed.) Then, using a tax strategy called a backdoor Roth IRA, you convert that money into a Roth IRA.
To avoid tax complications, you should quickly convert the nondeductible IRA into a Roth IRA before there are any earnings on the money. Advisors recommend that you deposit the money into a low-interest-earning IRA account initially to minimize the chance it will earn much before you transfer it.10
There is also another tax trap you need to consider. If you have a traditional, deductible IRA or a 401(k) with your employer, you could end up with a hefty tax bill due to the complicated rules on converting other IRAs to Roths.
You also have the option of converting an existing 401(k) or a traditional IRA to a Roth IRA, using the same backdoor strategy. The advantage of converting is that any earnings after the Roth conversion will no longer be taxable when you withdraw money during retirement. The disadvantage is that you must pay tax based on your current earnings for any money you convert.11 12
“In general, the longer the time horizon and the higher the likelihood for a higher projected income tax bracket in retirement, the more likely a conversion will work in an investor’s favor,” says Mark Hebner, founder, and president of Index Fund Advisors, Inc., Irvine, Calif.
Working with a tax or financial advisor on backdoor Roth IRAs and other complicated retirement plan strategies can potentially help you avoid expensive mistakes.
9. Forgetting Your Beneficiary List
All too often, Roth IRA owners forget to list primary and contingent beneficiaries for their account—and that can be a huge mistake. If the account is simply made payable to the IRA owner’s estate, it will have to go through the probate process. In other words, you have more complications, greater delays, and bigger attorney fees.
Once you name beneficiaries, be sure to review them periodically and make any changes or updates. That’s especially important if you and your spouse part ways. A divorce decree by itself won’t prevent a former spouse from getting the assets if they are still listed as a beneficiary.13
10. Failing to Withdraw Inherited Roth Money
This is the new 10-year rule that applies to IRA beneficiaries. Unlike the original owner of a Roth IRA and their spouse, other beneficiaries must take required minimum distributions (RMDs). For non-spousal beneficiaries, they must withdraw 100% of the funds within ten years of the owner's death.5
In the past, RMDs were allowed to be spread out over the beneficiary's life expectancy, which helped reduce the tax burden. However, as of 2020, all of the money must be withdrawn within the ten-year period following the original owner's death.5
In other words, if you inherit a Roth IRA from someone besides your spouse, you will have to start making withdrawals from it, similar to those of a traditional IRA or 401(k). The good news is that no tax is due on the money if the account is over five years old.14
The tax penalty for not following the RMD rules can be as high as 50% of the amount that was supposed to have been taken out.13
11. Skipping a Roth Since You Already Have a 401(k)
The original goal of the IRA was to provide an investment vehicle for Americans who didn’t have a retirement plan through an employer. But there’s nothing in the laws preventing you from using both. In fact, financial planners often suggest funding a Roth IRA once you’ve contributed enough to your 401(k) to get your employer’s full-matching contribution.
One advantage of IRAs over 401(k) plans is that, while most 401(k) plans have limited investment options, IRAs offer the ability to invest in many types of mutual funds, stocks, and other opportunities.
The Bottom Line
Having a Roth IRA can provide a bonanza of retirement benefits for both you and your heirs. But pay attention to the rules, so you don't jeopardize your account's tax-free status.
- IRS. "Retirement Topics—IRA Contribution Limits, Feb. 2020." Accessed April 10, 2020
- IRS."Publication 590-B (2019), Distributions from Individual Retirement Arrangements (IRAs), Feb. 2020." Accessed April 10, 2020.
- IRS. "IRA FAQs—Distributions (Withdrawals), Jan. 2020." Accessed April 10, 2020.
- IRS. "Retirement Plan and IRA Required Minimum Distribution FAQs, March 2020." Accessed April 10, 2020.
- AARP. "Did the SECURE Act Kill the Stretch IRA? Feb. 2020." Accessed April 10, 2020.
- IRA. "Amount of Roth IRA Contributions That You Can Make for 2020, Jan. 2020." Accessed April 10, 2020.
- IRS. "Rollovers of Retirement Plan and IRA Distributions, Feb. 2020." Accessed April 10, 2020.
- Ed Slott. "The Retirement Savings Time Bomb." Penguin Books, 2007.
- IRS. "Retirement Plans FAQs relating to Waivers of the 60-Day Rollover Requirement, Jan. 2020." Accessed April 10, 2020.
- Charles Schwab. "Income Too High for a Roth IRA? Try These Alternatives, March 2019," Accessed April 10, 2020.
- Charles Schwab. "Roth IRA Conversion Calculator, 2020." Accessed April 10, 2020.
- Charles Schwab. "Considering a 401(k) rollover? Consider your options first, 2020." Accessed April 10, 2020.
- IRS. "Publication 590-B (2019), Distributions from Individual Retirement Arrangements (IRAs), Feb. 2020." Accessed April 10, 2020.
- Charles Schwab. "Inherited IRA withdrawal rules, 2020." Accessed April 10, 2020.