The Disadvantages of Roth IRAs Every Investor Should Know

A Roth Individual Retirement Account (IRA) is a retirement savings account that a person can contribute to each year. In certain circumstances, funds can be withdrawn tax-free.

Money saved in a Roth IRA can be invested in financial instruments, such as stocks, bonds, or savings accounts. Roth IRA contributions are made with after-tax money, meaning contributions are made after income taxes have been deducted from the account holder’s paycheck.

Roth IRAs offer long-term tax benefits because contribution withdrawals and investment gains are tax-free in retirement. However, Roth IRAs may not be the right retirement account for everyone. While there are advantages to Roth IRAs, there are also various disadvantages to consider.

Key findings

  • Roth Individual Retirement Accounts (IRAs) offer several key benefits, including tax-free growth, tax-free withdrawals in retirement, and no required minimum distributions (RMDs). However, they also have drawbacks.
  • One key drawback: 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 earnings from the account must not be made until at least five years have passed since the first donation.
  • This five-year rule can make Roths less useful to open if you’re already in late middle age.
  • Tax-free distributions to Roth IRAs may not be beneficial if you are in a lower income tax bracket when you retire.

Roth vs. Traditional IRA

Roth and traditional IRAs are excellent ways to stash away money for retirement. However, there are annual contribution limits.

For 2023, people can give a maximum of $6,500 each year, or $7,500 if they are 50 or older.

To contribute anything, you must have earned income, which is money earned from working or owning a business. Also, you cannot deposit more than you have earned in a given year.

Despite these similarities, the accounts are actually quite different. Below are the disadvantages of a Roth IRA.

Roth IRA Income Limits

One downside to a Roth IRA is that you can’t contribute to one if you make too much money. Limits are based on yours modified adjusted gross income (MAGI) and tax return status. To find your MAGI, start with yours adjusted gross income (AGI)— you can find this on your tax return — and add back certain deductions.

Generally:

  • You can contribute the full amount if your MAGI is below a certain amount.
  • You can make a partial contribution if your MAGI is within the phase-out range.
  • If your MAGI is too high, then you cannot contribute at all.

Below is a brief description of Roth IRA income and contribution limits for 2022 and 2023.

Roth IRA Income and Contribution Limits for 2022
Submission status MAGGIES Contribution limit
Married filing jointly or qualifying widow(er)
Less than $204,000 $6,000 ($7,000 if you’re over 50)
$204,000 to $214,000 Phase out the range
$214,000 or more Not eligible for a direct Roth IRA
Married, filing separately
Less than $10,000 Phase out the range
$10,000 or more Not eligible for a direct Roth IRA
Single or head of household
Less than $129,000 $6,000 ($7,000 if you’re over 50)
$129,000 to $144,000 Phase out the range
$144,000 Not eligible for a direct Roth IRA
2023 Roth IRA Income and Contribution Limits
Submission status MAGGIES Contribution limit
Married filing jointly or qualifying widow(er)
Less than $218,000 $6,500 ($7,500 if over 50)
$218,000 to $228,000 Phase out the range
$228,000 or more Not eligible for a direct Roth IRA
Married, filing separately
Less than $10,000 Phase out the range
$10,000 or more Not eligible for a direct Roth IRA
Single or head of household
Less than $138,000 $6,500 ($7,500 if over 50)
$138,000 to $153,000 Phase out the range
$153,000 or more Not eligible for a direct Roth IRA

Married taxpayers filing separately can use the single/head of household limits if they did not live with their spouse at any time during the tax year.

Backdoor Roth IRA

There is a difficult but perfectly legal way for high earners to contribute to a Roth IRA even if their income exceeds the limits. This is called a backdoor Roth IRAwhich involves contributing to a traditional IRA and immediately rolling the money into a Roth account.

This transaction must be done strictly according to Internal Revenue Service (IRS) rules..

Roth IRA Tax Deductibility

The biggest difference between traditional and Roth IRAs comes when taxes are owed.

A traditional IRA deducts your contributions in 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 you earn when you make withdrawals during retirement.

Roth IRAs work the other way around. You don’t get upfront tax relief, but retirement withdrawals are generally tax-free.

That sounds good, but it could be a drawback for some investors.

You contribute to a Roth IRA with after-tax dollars, so you don’t get the initial tax break that IRAs traditionally offer.

Here’s why: No upfront tax relief means you’ll get less money in your paycheck to spend, save and invest. And tax-free retirement withdrawals are something to look forward to – unless you’re going to be in a lower tax bracket in the future than you are now.

Depending on your situation, you could take advantage of more of the traditional upfront tax benefits of an IRA and then pay taxes at your lower rate in retirement. It pays to crunch the numbers before making any decisions, as a lot of money is potentially at stake.

Roth IRA withdrawal rules

With a Roth IRA, you can withdraw your contributions at any time, for any reason, without tax or penalty. In addition, qualified withdrawals (which include contributions and account earnings) at retirement are also without taxes and penalties. To qualify, withdrawals must be made when you’re at least 59½ years old and at least five years have passed since you first contributed to a Roth IRA — also known as five-year rule.

If you don’t meet the five-year rule, then any winnings you withdraw may be subject to taxes or a 10% penalty – or both, depending on your age:

  • Age 59 and under: Withdrawals of winnings 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 either a first home purchase or certain other exemptions.
  • Aged 59½ and over: Withdrawals of winnings 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 to make tax-free withdrawals.

Can I withdraw installments without triggering the five year rule?

yes Your contributions can be withdrawn at any time without penalty or taxes. Only earnings are subject to the five-year rule.

What is my modified adjusted gross income (MAGI)?

Your modified adjusted gross income (MAGI) is your adjusted gross income (AGI) with a few deductions added back. Re-applied deductions include half of self-employment tax, deductions for student loan interest, rental losses, and more.

Do Roth and traditional Individual Retirement Accounts (IRAs) have the same income limits?

No. There are no income limits for contributing to a traditional Individual Retirement Account (IRA). Roth IRAs base your ability to contribute a maximum of $6,500 for 2023 on your MAGI. People over the age of 50 can give an additional $1,000 catch-up contribution. However, the deduction for your traditional IRA contributions may be limited if you or your spouse are covered by a retirement plan at work and your income exceeds certain levels.

The bottom row

Roth IRAs offer many benefits; tax-free growth, tax-free retirement withdrawals and no required minimum distributions (RMD) starting at age 72. However, there are potential drawbacks.

People typically benefit from saving for retirement in an IRA. However, whether a traditional or Roth IRA is better depends on several factors, including your income, age, and when you expect to be in a lower tax bracket—now or in retirement. Please consult a tax expert, financial planneror financial advisor to help you make a more informed decision so that your retirement plan is tailored to your specific financial situation.

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