A Roth individual retirement account (IRA) is a retirement savings account that a person can contribute to each year and, under certain circumstances, funds can be withdrawn tax-free.
The money saved in a Roth IRA can be invested in financial instruments, such as equities, bonds, or a savings account. Contributions to a Roth IRA are made with after-tax money, meaning the contributions are made after income taxes have been withdrawn from the person’s paycheck.
Roth IRAs offer a long-term tax benefit since withdrawals of contributions and investment earnings are not taxed in retirement. However, Roth IRAs may not be the right retirement account for every individual. Although there are benefits to Roth IRAs, there are also distinct disadvantages that should be considered.
Key Takeaways
- Roth IRAs offer several key benefits, including tax-free growth, tax-free withdrawals in retirement, and no required minimum distributions., but have drawbacks as well.
- One key disadvantage: Roth IRA contributions are made with after-tax money, meaning there’s no tax deduction in the year of the contribution.
- Another drawback is that withdrawals of account earnings must not be made before at least five years have passed since the first contribution.
- This five-year rule may make Roths less good to open if you’re already in late middle age.
- Roth IRAs’ tax-free distributions may not be advantageous if you’re in a lower income-tax bracket when you are retired.
Roth vs. Traditional IRA
Roth and traditional IRAs are both excellent ways to stash money away for retirement. However, there are annual contribution limits.
For 2021 and 2022, individuals can contribute a maximum of $6,000 each year, or $7,000 if they’re age 50 or older.
To contribute to either, you must have earned income, which is money earned from working or owning a business. Also, individuals cannot deposit more than what was earned in a given year.
Despite these similarities, the accounts are actually quite different, and below are the disadvantages to Roth IRAs.
Roth IRA Income Limits
One disadvantage of the Roth IRA is that you can’t contribute to one if you make too much money. The limits are based on your modified adjusted gross income (MAGI) and tax filing status. To find your MAGI, start with your adjusted gross income—you can find this on your tax return—and add back certain deductions.
In general, you can contribute the full amount if your MAGI is below a certain amount. You can make a partial contribution if your MAGI is in the “phase-out” range. And if your MAGI is too high, you can’t contribute at all.
Below is a rundown of the Roth IRA income and contribution limits for 2021.
Roth IRA income and contribution limits for 2022:
Married filing separately and heads of household can use the limits for single people if they have not lived with their spouse in the past year.
The Backdoor Roth IRA
There’s a tricky but perfectly legal way for high income-earners to contribute to a Roth IRA even if their income exceeds the limits. This is called a backdoor Roth IRA and it entails contributing to a traditional IRA and then immediately rolling over the money into a Roth account.
Needless to say, this must be done strictly by the IRS rules.
Roth IRA Tax Deduction
The biggest difference between traditional and Roth IRAs appears when the taxes are due.
With a traditional IRA, you deduct your contributions the year you earn them. This provides an immediate tax break that leaves you with more money in your pocket. The downside is that income taxes are due on both your contribution and the money it earns when you make withdrawals during retirement.
Roth IRAs work the opposite way. You don’t get an upfront tax break, but withdrawals in retirement are generally tax-free.
That sounds good, but it can actually be a disadvantage for some investors.
You make Roth IRA contributions with post-tax dollars, so you don’t get the upfront tax break that traditional IRAs offer.
Here’s why. No upfront tax break means you’ll get less money in your paycheck to spend, save, and invest.
And, tax-free withdrawals in retirement are something to look forward to—unless you’ll be in a lower tax bracket in the future than you are now.
Depending on your situation, you could benefit more from a traditional IRA’s upfront tax break, and then pay taxes at your lower rate in retirement. It’s worth crunching the numbers before you make any decisions since there’s potentially a lot of money at stake.
Roth IRA Withdrawal Rules
With a Roth, you can withdraw your contributions at any time, for any reason, without tax or penalty. And qualified withdrawals (which include contributions and account earnings) in retirement are also tax-free and penalty-free. To be qualified, the withdrawals happen when you’re at least 59½ years old and it’s been at least five years since you first contributed to a Roth IRA—also known as the five-year rule.
If you don’t meet the five-year rule, any earnings you withdraw could be subject to taxes or a 10% penalty—or both, depending on your age:
- Age 59 and under: Withdrawals of earnings are subject to taxes and a 10% penalty. You may be able to avoid the penalty (but not the taxes) if you use the money for a first-time home purchase or for certain other exemptions.
- Age 59½ and over: Withdrawals of earnings are subject to taxes but not penalties.
The five-year rule can be a disadvantage if you start a Roth later in life. For example, if you first contributed to a Roth at age 58, you have to wait until you’re 63 years old to make tax-free withdrawals.
The Bottom Line
Roth IRAs offer many benefits—tax-free growth, tax-free withdrawals in retirement, and no required minimum distributions (RMD) starting at age 72. However, there are potential drawbacks.
Typically, individuals benefit from saving for retirement in an IRA. Whether the better option is a traditional or Roth IRA depends on several factors, including your income, age, and when you expect to be in a lower tax bracket—now or during retirement. Please consult a tax expert, financial planner, or financial advisor to help you make a more informed decision so that your retirement plan is customized for your specific financial situation.