The Roth IRA is a powerful retirement savings tool. For young people especially, it’s the best way to take full advantage of compound interest while minimizing your tax exposure. The money you contribute grows tax-free, and most people can withdraw funds in retirement tax-free, too. However, make some wrong moves along the way and you could face unnecessary taxes and penalties. Here are Roth IRA mistakes to understand, so that you can let your retirement nest egg grow to its full potential.
Ignoring the annual contribution limits
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The annual contribution limit for a Roth IRA in 2023 is $6,500 if under age 50, and $7,500 if 50 or older. Some don’t realize that these contribution limits apply to the grand total contributions you make each year to all your traditional and Roth IRAs.
Attempting to contribute more than the annual limit will result in a 6% penalty tax on the excess amount unless promptly removed. If you exceed the Roth IRA contribution limits, you have until the tax filing deadline, plus extensions, to withdraw the excess contributions and any income they earned.
On the flip side, don’t neglect the fact that you can and should max out those limits, if possible.
Not knowing the income limits
There are income limits to eligibility for contributing to a Roth IRA. In 2023, the phase-out range for singles is $138,000 to $153,000. For married couples filing jointly, it’s $218,000 to $228,000. Contributing above these limits can lead to re-characterization or removal of excess contributions.
Withdrawing earnings too early
Sure, you can withdraw your initial Roth contributions at any time tax and penalty-free. However, withdrawing any earnings before age 59 1/2 will trigger taxes and penalties on those distributions. There are exceptions for circumstances like disability, death, or a first-time home purchase, but in most cases you’ll face an early withdrawal penalty.
Not planning for required minimum distributions
Unlike a traditional IRA, there are no required minimum distributions (RMDs) during the account owner’s lifetime for a Roth IRA. However, upon inheritance, beneficiaries other than a spouse must take RMDs from the inherited Roth account. Failing to take RMDs results in a 50% penalty on the amount that should’ve been withdrawn.
Not naming beneficiaries
Failing to name beneficiaries for your Roth IRA account could force the funds to go through probate upon your death. And if your estate is the beneficiary, your heirs may have to deplete the entire account within five years. Be sure to fill out a beneficiary form and review it periodically.
Rolling over from a 401(k) incorrectly
When rolling money from a 401(k) plan into a Roth IRA, it’s important to avoid triggering taxes. Consult with a financial advisor to determine the best way to rollover the funds. Strategies like direct rollovers and setting up substantially equal periodic payments can allow for tax-free conversions. If you know you have retirement funds out there ready to be consolidated, here’s our guide to finding your old 401(k) savings from previous jobs so you can maximize your retirement savings.
Understanding these potential Roth IRA mistakes is key to maximizing your tax-free growth potential. All in all, where you put your money matters for hitting your different savings goals, so here’s our guide to all the different saving accounts you need.