Top 10 Mistakes to Avoid With Your Roth IRA

You may think the only thing you have 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 2019). Well, it’s a little more complicated than that. Here are the 10 most common mistakes people with Roths are likely to make – and how to avoid them.

But, first, a quick refresher on the key difference between a Roth IRA and a traditional IRA. Contributions to a Roth IRA are not tax-deductible when you make 'em. But the distributions are tax-free: both the original investments themselves and the gains on them (assuming you're over age 59^1/2 when you withdraw). In contrast, contributions to a traditional IRA are tax-deductible; it's the distributions that are taxed. What's more, you have to take required minimum distributions on traditional IRAs when you hit age 70^1/2. You never have to withdraw funds from Roth IRAs.

All set? Let's move onto the mistakes.

You cannot contribute more to a Roth IRA than you actually earned in income. This income can come from wages, salaries, tips, professional fees, bonuses and other amounts received for providing personal services. You can also consider earnings from commissions, self-employment income, nontaxable combat pay, military differential pay, and taxable alimony and separate maintenance payments. If your earnings come from other types of income – such as dividends, interest or capital gains – they cannot be used to determine your allowable Roth contribution. You can contribute to a Roth up to allowable limits for both you and your spouse as long as you file jointly and one of you makes enough eligible income to fund the contribution.

The IRS uses Modified Adjusted Gross Income (MAGI) to calculate what you can contribute. When calculating MAGI, income is reduced by certain deductions such as contributions to a traditional IRA, student loan interest deduction, tuition, and fees deduction, or foreign earnings deduction. If your income level is close to your planned Roth contribution, be sure to review IRS rules for MAGI to make sure you stay under the limit. Because...

You can earn too much to contribute to a Roth IRA. Income limits are adjusted each year by the IRS. As of 2019, people who are married filing jointly or a qualifying widow(er) must make less than $193,000 to be able to make the maximum contribution. If you earn between $193,000 and $203,000 you may be able to contribute some money but the amount will be reduced. With earnings above that, no contribution is allowed.

Taxpayers in 2019 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 $122,000. If they earn above $120,000 but no more than $137,000, their allowable Roth contribution is reduced. With earnings of $137,000 or higher, no Roth contribution is allowed.

If you're married and live with your spouse (even if you cohabitated for only part of the year), filing taxes separately can be costly in many ways. You lose all types of deductions, or at least the full benefit of them – and exhibit A is the Roth. If you earned more than $10,000, you cannot contribute to a Roth IRA at all. The reason: the IRS doesn't want married couples gaming the system by filing separately. If you made less than $10,000, you may be able to make a reduced contribution. Only those who are completely separated can make a substantial contribution, as delineated above.

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 $6,000/$7,000 annual limit is for all your IRAs total, not per account.) This can cost you a penalty of 6% on the excess each year after that mistake. You can avoid the penalty as long as you discover the mistake before filing your tax return and take the excess contribution, plus earnings, 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 that contribution to another tax year, but unless that's done simultaneously with the correction, it might trigger the penalty.

Beginning in 2015, IRA rollover rules changed so you can only roll money from one IRA into another IRA once over a 365-day period. This affects all the IRAs you hold, so be very careful when you are planning to make a change. Previously, the rule was once a year, but now the year it occurs does not matter. It is based solely on a 365-day period. “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.

You may not realize it, but there are many different ways to roll over an IRA and small technical mistakes can result in penalties or an unnecessary tax hit. Various errors can be made with each type of rollover, especially if you choose the wrong type for your individual financial situation. The details are too complicated for this brief overview, so be sure to get advice (see Mistake #7) before choosing any particular rollover.

Given the potential mistakes of choosing the wrong rollover, it’s always best to seek financial advice either from a fee-based financial advisor or from your IRA trustee. Always avoid rolling over the money yourself (taking out the money by check and then depositing it somewhere else). So many things can go wrong.

The most common mistake is missing the 60-day deadline to roll over because you used the cash for something else and then didn’t have enough to make the full contribution on time. If you do choose to do it yourself, be sure to be meticulous about documenting the transfer in case the IRS questions it. If you can’t prove you made the transfer, you will pay taxes and penalties on the money transferred. Your best bet is to do a custodian-to-custodian (also called trustee-to-trustee) transfer, then make sure the funds have been transferred into the type of IRA you chose.

If you make too much money to contribute to a Roth, all is not lost. You may be able to contribute to a non-deductible IRA, which is available to anyone no matter how much they make. This contribution is made with after-tax dollars, money that has already been taxed, and there are no limits on the amount that can be contributed or the income you are permitted to have.

You must immediately convert this non-deductible 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 (so you don’t raise any questions about transferring earnings). You could be stuck with a tax bill if you have another traditional IRA or a 401(k) with your employer, so get financial advice before trying this backdoor Roth IRA strategy. 

You do have the option of converting a 401(k) or traditional IRA to a Roth IRA. The advantage of this move is that any earnings after the conversion will no longer be taxable. The disadvantage is that you must pay tax based on your current earnings for any money converted. “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. If you do plan to use this strategy, work with a financial advisor to be sure you don’t make a mistake.

The market will rise and fall over the many years that you’ll hold your IRA. Start by settling on an allocation that fits your tolerance level for the ups and downs. Generally, advisors recommend that the growth portion of your portfolio should be 110 or 120 minus your age. So if you are 30, the percentage of your portfolio in growth stocks should be 80% or 90%. It’s wisest to have a mixture of stocks from companies of different sizes and of investments in different industries. Mutual funds can help you get the proper mix if you have a small portfolio or you don’t have the time to research and pick stocks. 

As the market shifts, you may find that you’ve made too much money in one area and your portfolio is no longer balanced among the assets as you planned. Rebalancing is the periodic adjustment of your asset allocations to conform with your investment goals or to accommodate changes in them. It’s a good idea to review your asset allocation once or twice a year (not more frequently because you don’t want to react to short-term market swings). Remember that account holders and their spouses don’t pay taxes on the income from their Roth investments.

Money withdrawn from Roth IRAs is generally not taxable, but that’s only true for the original owner of the IRA and his or her spouse. If you inherit an IRA from someone who is not your spouse, you will have to take required minimum distributions (RMDs), similar to those of a traditional IRA or 401(k).

“A non-spousal beneficiary who decides not to take RMDs from an inherited Roth IRA will then have to liquidate the entire account by December 31st of the fifth anniversary of the original account owner’s death,” says Hebner. “Unless there is an immediate need for the funds, the beneficiary is essentially removing the tax-exempt growth that is allowed for Roth IRAs, which is not optimal.”

The IRS penalty for not following the RMD rules can be as high as 50% of the money that was supposed to have been taken out. So if you are lucky enough to inherit a Roth IRA, be sure to review the withdrawal rules with your financial or tax advisor. 

Having a Roth can provide a bonanza of retirement benefits for yourself and your heirs. Don’t undermine those perks by tripping up on the many rules that determine who can have a Roth and how account holders have to manage the funds. If you're looking to get started funding an IRA, Investopedia has created a list of the best brokers for IRAs.