If you’ve given thought to your retirement, you may already be familiar with the Roth IRA. As a form of an Individual Retirement Account, the Roth IRA is a self-directed investment vehicle where you choose which assets to invest in. Once you contribute your after-tax dollars, you can sit back and watch your savings grow tax-free!
It’s well-suited for young people in their 20s-30s who are launching their careers and make less than they expect to in the future. By paying taxes upfront today, you help your future self live a better life — with less taxes.
Opening mine was a big milestone in my investing journey and I recommend my friends and family to open their own. With such an awesome deal, are there any downsides to having your own Roth IRA?
Like any investment vehicle, understanding the pros and cons of a Roth IRA will help you decide if it will work for you and your investing strategy.
- A Roth IRA is one of the most advantageous accounts to invest in as its returns are withdrawn tax-free in retirement.
- Its pros include freedom to invest how you want, tax diversification, no RMDs, and an exception to help home buyers.
- Its cons include income thresholds, low contribution amounts, and paying tax upfront.
- High-income earners can bypass the income limitations by doing a backdoor Roth conversion.
- Coupling your Roth IRA with a pre-tax employer-sponsored plan is optimal for most people to accrue the benefits of each account’s differing tax treatment.
Freedom to Set Your Strategy
With an IRA, you can invest with stocks, bonds, mutual funds, futures, commodities, etc. You can build and control your investing strategy with a larger array of options than what you would find in an employer-sponsored plan. Setting the right asset mix and strategy can help you make the most of your tax-free money!
With my retirement accounts, I tend to be more conservative but I lean a little more aggressive with my Roth IRA. I invest in index funds, ETFs, leveraged ETFs, individual stocks, and a splash of crypto. Ask me how I’m doing in the next bull market. I hold more of my money in index funds, which stabilizes my portfolio during volatile periods like the one at this article’s time of writing. In your Roth, you can tailor your strategy to match your risk tolerance, diversify, or go for larger swings if you are inclined.
A few years ago, I bought into a crypto fund and held for three days and saw large returns – something I would not be able to do in my 401k.
No Penalty to Take Out Roth IRA Contributions
You are allowed to withdraw your Roth contributions penalty-free at any time. If you are in a tough financial spot or have other needs for the money, you could withdraw your contributions. Although, note that you cannot make early withdrawals on your investment earnings without paying a 10% penalty and taxes.
First Time Home Buyer Exception
The Roth IRA offers a neat option if you are an aspiring first-time homeowner and can be useful, especially if you are a young worker. You can withdraw all of your contributions and up to $10,000 of tax-free growth penalty-free — if you meet the following conditions:
- Had the Roth IRA for at least 5 years
- Buying a home for the first-time
- For people who haven’t had a home as a primary residence for at least 2 years
- Must use withdrawn funds within 120 days of receipt for expenses tied to home purchase
The $10,000 earnings limit is a lifetime cap, so you can only withdraw up to that amount of growth. However, I caution against any type of early withdrawals as they could disrupt your retirement plan. It is better to build and use an emergency fund, sinking funds, or other savings for your near-term financial needs. As Certified Financial Planner (CFP) Shon Anderson says in this CNBC article, “You can obtain a loan for a home, car, business venture, college tuition … but no one will ever receive a loan to retire.“
If you are 50 or older, you can contribute an extra $1,000 each year on top of the $6,000 annual cap. This additional contribution helps you generate more tax-free money to add to your retirement investments. If you are adding more money at 50 or older, it is advised to pursue a more conservative position.
Because you pay taxes upfront, your withdrawals are tax-free in retirement. The tax advantages are for when you’re ready to cash out and manifest in two ways. You can save on taxes if you expect to be in a higher tax bracket in retirement than you are today. Tax rates today are historically lower than they have been 40-50 years ago. Given how much the government is spending recently, I’m factoring in an increase in tax rates by the time I retire. To me, it means that paying taxes upfront is a bargain compared to paying them in the future.
The accompanying benefit is in adding tax-free income to your mix of retirement income sources. In retirement, you can make money from a variety of sources including Social Security income, rental income, 401(k) withdrawals, profits from another investment account, etc. If you have one of these or other income sources, you will pay tax on your withdrawals and profits.
Extra Roth IRA income helps you allocate which sources you pull your retirement income from so you can avoid a larger tax bill. This is especially useful if you are close to the border of your tax bracket. In this case, the Roth IRA acts like a strategic reserve you can tap for tax-free withdrawals when needed.
No Required Minimum Distributions (RMDs)
With a 401(k) or traditional IRA, you are required to take RMDs at age 72, but this is not the case with the Roth IRA. The lack of RMDs gives an investor flexibility for when they want to deploy this money.
You can start withdrawing without penalty at 59 1/2. Some may opt to not withdraw and pass down their Roth holdings to their heirs without tax consequences.
Backdoor Roth IRA Conversions
Contributing to a Roth IRA is subject to income limitations, so high-income taxpayers can be out of luck. We cover the income limits more in-depth below, but there is a legal way to bypass them, which we overview here.
Traditional to Roth
1. Open a Traditional IRA and Make After-Tax Contributions to It
Set up a traditional IRA and make your contributions up to the $6,000 (or $7,000) annual contribution limit. You can build up this IRA over several years if you wish, but the contributions must come from after-tax money.
2. Use an Existing Roth IRA or Open One
Create a Roth IRA or use an existing one and contact the brokerage service teams for each IRA and inform them you want to do the transfer. Tell them you want to do an IRA conversion to your Roth.
3. Do the Conversion and Transfer Holdings
As you do the conversion process, each broker will check to confirm accurate account details, have you file the appropriate paperwork, and specify what assets you want to transfer over. They will also state which tax documents you need to keep an eye out for when you file the next year. Then, the broker will transfer over your assets within a few weeks to complete the process. Voila — enjoy the totally tax-free growth!
With this overview here, you can get started but know more nuances involving potential tax impacts. You can best navigate them with the support of your brokerage services team or financial advisors.
Roth-401(k) to Roth IRA
If you have a leftover employer-sponsored retirement plan with an after-tax component, you can convert those holdings too. At my prior employer, I had a Roth-401(k), where I could make both pre-tax and after-tax contributions. I had the tax benefits of both accounts, but I had a limited set of funds to choose from. After I quit, I transferred my after-tax contributions and growth to my Roth IRA account to gain access to more investment options and to simplify my account tracking.
I worked with three brokerages to set up the transfer in a process like the one above. I moved my after-tax money to my Roth IRA and sent my pre-tax money to my Rollover IRA.
Side Note: A Rollover IRA works like a Traditional IRA, so further contributions are tax-deductible.
Along the way, I learned about the potential tax consequences and nuances that I could incur. I learned the best way is to do a trustee to trustee transfer, where the funds are sent from one financial institution to the next and never come into your custody. When you pay taxes next year and report the transaction you will have less paperwork to file and less chance of an IRS inquiry.
No Tax Deduction
Because you put in after-tax money, there is no immediate tax break for having a Roth IRA. This IRA is designed for those who expect to have a higher tax bracket in retirement than they do today, so you owe taxes today and expect the tax-free Roth IRA withdrawals in the future.
If you want a tax deduction, then you can use a 401(k) or traditional IRA to get one while building your retirement savings.
There are taxable income limits that prohibit contributing to a Roth account once they pass them. The point of phasing for high-income earners depends on their Modified Adjusted Gross Income (MAGI) and filing status. For simplicity, here are two examples of the rules for 2022.
If you are filing single:
- Contribute up to the max if your MAGI is less than $125,000
- Phase-out is between $125,000 to $139,000
- Making $140,000 or more excludes you
If you are married filing jointly:
- Contribute up to the max if your MAGI is less than $198,000
- Phase-out is between $198,000 to $208,000
- Making $208,000 or more excludes you
These income limits can be circumvented by doing a Roth conversion, which we cover above. Determining if you fall within these income tax bracket limits is up to you and your financial advisor, with the help of tax software.
In 2022, you can contribute up to $6,000 to all of your IRAs, including your Roth IRA (or up to $7,000 if you are 50 or older). Compared to other retirement accounts like the 401(k) and its $20,500 maximum contribution limit, you can only contribute a fraction of that to your IRAs. Since you can only fund your Roth with after-tax money, you have to intentionally budget, save, and transfer those funds to retirement savings account for something decades away.
Since this is take-home money, people would be using that money for living expenses or saving for near-term needs. By saving for your Roth IRA you are sacrificing a bit of your quality of life today for your future retirement life.
For middle-class people and their families, the choice to contribute or use the money for living expenses is a very real tradeoff that they must think through – especially in this economic environment.
See the Backdoor Roth IRA process above to bypass the income limit.
Roth IRAs require more self-management on your part than a 401(k) as you have to open, manage, and contribute to the account on your time. I’ve found that making a budget that includes a monthly Roth contribution and making an automatic transfer simplifies the process.
In contrast, some employers automatically enroll all their employees in a 401(k) plan and the money is taken out before taxes so workers never miss the money. Though I view self-management as a pro because I get the freedom to set my strategy and select from a wider array of assets to pursue a chance at higher returns.
Although, with the passing of the SECURE Act 2.0 in the House, it is becoming likely that all employers will be required to automatically enroll all eligible employees in their 401(k) plans and set a minimum contribution.
The Verdict – How the Pros and Cons of a Roth IRA Balance Out
At the end of the day, is a Roth IRA worth it? Yes
The upsides of a Roth IRA exceed the downsides. Advantages such as penalty-free contribution withdrawal, freedom to invest how you want, and exception for home buyers offer flexibility to an investor not seen in other investment accounts. Though the downsides like low annual contribution limits, income restrictions, and no tax deductions limit the potential you can get from it.
Most people benefit from having an employer-sponsored pre-tax plan and a Roth IRA to lower their tax bills in the present and the future. Investing through a 401(k) allows you to create value from your tax savings — an advantage that should not be overlooked.
Once I started working, I began to invest in my Roth IRA. I find having this exposure early on was valuable as I learned how to manage my investments and test out different strategies and asset classes. The main lesson I’ve gained is that investing involves risk and that savvy investors build wealth by using the tools at their disposal to diversify their holdings and manage their risk.
Roth IRAs are one tool to help you do that, but your larger investing strategy is what ultimately gets you closer to financial freedom. It’s best to work with a financial advisor to fine-tune your retirement savings plans and to receive investment advice tailored for your situation.