11 Mistakes to Avoid With Your Roth IRA

Don’t lose tax-free benefits by contributing too much or making other errors

Individual retirement accounts (IRAs) are a great option for anyone who wants to save up for retirement, whether the saver chooses a traditional or a Roth version. You may think that the only thing that you need to know is the contribution limit for the year.

It’s a bit more complicated than that but you do need to know the annual contribution limits, so here goes:

  • The IRA contribution limit for the 2022 tax year is $6,000. If you are age 55 or older, you can contribute an extra $1,000 as a "catch-up contribution."
  • The IRA contribution limit for the 2023 tax year rises to $6,500. The catch-up contribution remains at $1,000.
  • Starting in 2024, the allowable catch-up contributions will be indexed to inflation.

Meanwhile, there are 11 common errors that people with Roth IRAs can make. Here's to avoid them.

Key Takeaways

  • Contributing to a Roth individual retirement account (Roth IRA) may seem like a great idea, but there are complications that you must avoid.
  • You can’t contribute more to a Roth IRA than you’ve earned in income.
  • Exceeding the Roth IRA contribution limit will result in a yearly 6% penalty on the excess until the money is removed from the account.
  • IRA rollovers must be done carefully and within 60 days to avoid taxes and penalties.
  • Not naming beneficiaries and not taking distributions from an inherited Roth IRA are other common mistakes.

Roth vs. Traditional IRA

First, a quick refresher on the key differences between a Roth IRA and a traditional IRA.

Contributions to a Roth IRA are taxed before you deposit them in the account. But the money is usually tax-free when you withdraw it. That applies to both the original contributions and the gains on them, assuming you’re over age 59½ when you withdraw the funds and the account is at least five years old.

Contributions to a traditional IRA, on the other hand, are not taxed when you deposit the money. When it comes time to withdraw the funds, you’ll pay the taxes due at whatever your income tax rate is at that time.

As of 2023, you have to take required minimum distributions (RMDs) on traditional IRAs every year beginning April 1 of the year after you reach the age of 73. The age will be pushed back to 75 starting in 2033.

Roth IRAs are not subject to RMD requirements until the death of the account holder.

If you don’t need the money in a Roth account, you can leave it to your heirs. But due to a 2020 rule change, all funds in the beneficiary’s account must be withdrawn by the end of the 10th year after the death of the original IRA owner. There are exceptions for spouses, minor children, disabled or chronically ill people, and those who are not more than 10 years younger than the IRA owner.

Below are the mistakes to avoid.

1. Not Earning Enough to Contribute

You cannot contribute more to a Roth IRA than you received in earned income for the year. This income can come from wages, salaries, tips, professional fees, bonuses, and other amounts received for providing personal services.

You can also count earnings from:

  • Commissions
  • Self-employment income
  • Nontaxable combat pay
  • Military differential pay
  • Taxable alimony
  • Separate maintenance payments

You can contribute to a Roth up to the allowable limits for both yourself and your spouse as long as you file your taxes jointly and one of you makes enough eligible income to fund the contributions.

So-called unearned income, such as dividends, interest, or capital gains, are not allowed as part of your Roth contribution. Rental income or income received from a partnership in which you do not play an active role is also considered unearned income.

2. Earning Too Much to Contribute

You can earn too much overall to contribute to a Roth IRA. Whether you’re eligible is determined by your modified adjusted gross income (MAGI). When calculating your MAGI, your income is reduced by certain deductions, such as contributions to a traditional IRA, student loan interest, tuition and fees, and foreign earnings.

If your income is below the ranges listed below, you can contribute the full amount to a Roth. If it's within the range, you can contribute a reduced percentage. If it's above the range, you can't contribute to a Roth.

The income limits for Roth IRAs are adjusted annually for inflation. They are as follows:

  • For the 2022 tax year, the income phase-out range for singles and heads of households is between $129,000 and $144,000. For married couples filing jointly, the range is between $204,000 and $214,000. The phase-out range for a married individual filing a separate return is $0 to $10,000.
  • For the 2023 tax year, the income phase-out range increases to between $138,000 and $153,000 For married couples filing jointly, the phase-out range increases to between $218,000 and $228,000, The phase-out range for a married individual filing a separate return remains at $0 to $10,000.

3. Not Contributing for Your Spouse

You can’t contribute more to a Roth than you’ve earned in a given year. But there’s an important exception for nonworking spouses as long as you’re legally married and file a joint return.

There’s no such thing as a joint IRA, but you can get a spousal IRA. This option allows a working spouse to contribute to his or her own account as well as that of the non-working spouse. The working spouse’s income must be enough to cover both contributions.

Increasing, perhaps even doubling your annual contributions, is not the worst idea in the world, and could significantly increase a family’s retirement savings over time.

4. Contributing Too Much

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. Exceeding this limit can cost you a 6% penalty on the excess each year until you rectify the mistake.

You can avoid the penalty if you discover the mistake before filing your tax return and take the excess contribution, plus any earnings on it, out of the account.

You can actually withdraw some or all of your Roth IRA contributions up to six months after the original due date of the return, but you must file an amended return.

You can also carry over the excess contribution to another tax year, but unless that’s done simultaneously with the correction it might trigger the penalty.

5. Withdrawing Earnings Too Early

The withdrawal rules for Roth funds can be a tad complicated. You can withdraw the amounts that you contributed at any time, at any age, since those contributions were made with after-tax dollars. But you may owe income tax and a 10% penalty on any earnings that you withdraw.

To enjoy tax- and penalty-free withdrawals on any profits or income that the investments generated, a Roth IRA owner must be 59½ years old and have owned the account for at least five years. (This is known as the five-year rule). If you pull the money out before those two milestones, you could face costly consequences.

People under age 59½ can avoid the early withdrawal penalty, but not the applicable taxes on earnings, for certain exceptions. You can take out money to cover some education expenses or to pay for a first-time home purchase.

6. Breaking the Rollover Rules

You used to be able to do an IRA rollover only once in a calendar year, but that changed in 2015. The government now restricts you from doing more than one rollover in a 365-day period—even if they occur in two different calendar years.

It’s a rule that you’ll want to pay attention to because too many rollovers can trigger a big tax bill. “Some people can lose their entire IRA because they did two rollovers in a year and didn’t realize it,” said Ed Slott, author of The New Retirement Savings Time Bomb.

There are some exceptions, as in the case of 60-day rollovers from a traditional IRA into a Roth IRA. Also, the 365-day rule doesn’t apply to the direct transfer of funds between two IRA trustees, which the IRS does not consider a rollover.

7. Rolling Over the Money Yourself

There are two basic ways to roll over funds from one qualified retirement savings account, like a traditional IRA or a 401(k), into a Roth: direct and indirect.

In a direct rollover, your money is transferred from one account to another electronically, or you receive a check made out in the name of the new account and deliver it. With an indirect rollover, you take possession of the money from the old account and deposit it into the new one yourself.

It’s best to avoid the latter move because so many things can go wrong. The most common mistake that people make is missing the 60-day deadline to roll over the money because they used the cash for something else and didn’t have enough to make the full contribution on time.

If you do choose to do it yourself, be meticulous about documenting the rollover in case the IRS questions it. If you can’t prove that you deposited the money in time, you’ll have to pay taxes and penalties on the money.

8. Not Considering a Backdoor Roth IRA

If you make too much money to contribute to a Roth, all is not lost. You could instead contribute to a nondeductible IRA, which is available to anyone no matter how much income they earn. Then, using a tax strategy called a backdoor Roth IRA, you convert that money into a Roth IRA.

To avoid tax complications, you should quickly convert the nondeductible 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 initially to minimize the chance that it will earn much before you transfer it.

Another Tax Trap

There is another tax trap that you need to consider: If you have a traditional, deductible IRA or a 401(k) with your employer, you could end up with a hefty tax bill due to the complicated rules on converting other IRAs to Roths. 

You have the option of converting an existing 401(k) or a traditional IRA to a Roth IRA, using the same backdoor strategy. The advantage of converting is that any earnings after the Roth conversion will no longer be taxable when you withdraw money during retirement. The disadvantage is that you must pay income tax based on your current tax bracket for any money that you convert.

“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 in Irvine, Calif.

Working with a tax or financial advisor on backdoor Roth IRAs and other complicated retirement plan strategies can help you avoid expensive mistakes.

9. Forgetting Your Beneficiary List

Roth IRA owners often forget to list primary and contingent beneficiaries for their account—and that can be a huge mistake. If the account is simply made payable to the IRA owner’s estate, it will have to go through the probate process. In other words, there are more complications, greater delays, and bigger attorney fees for your heirs.

Once you name beneficiaries, be sure to review them periodically and make any changes or updates. That’s especially important if you and your spouse part ways. A divorce decree by itself won’t prevent a former spouse from getting the assets if that person is still listed as a beneficiary.

10. Failing to Withdraw Inherited Roth Money

This is the new 10-year rule that applies to IRA beneficiaries. Unlike the original owner of a Roth IRA and that person's spouse, other beneficiaries must take distributions. Any beneficiary other than the spouse must withdraw 100% of the funds within 10 years of the owner’s death.

In the past, RMDs could be spread out over the beneficiary’s life expectancy, which helped to reduce the tax burden. However, under the SECURE Act of 2019, but all of the money must be withdrawn within the 10-year period following the original owner’s death.

In other words, if you inherit a Roth IRA from someone besides your spouse, you will have to start making withdrawals from it, similar to those of a traditional IRA or 401(k). The good news is that no tax is due on the money if the account is more than five years old.

The rules are slightly different if the beneficiary is a surviving spouse of the account owner. Starting in 2024, a surviving spouse has the option of postponing their RMDs until the year that the original owner would have started taking distributions, according to the SECURE 2.0 Act of 2022. In other words, under the law, a surviving spouse would be treated the same as the original owner.

The tax penalty for not following the RMD rules can be as high as 25% of the amount that was supposed to be taken out. If the error is corrected in a timely manner, that penalty can be dropped to 10%.

One advantage of IRAs over 401(k) plans is that, while most 401(k) plans have limited investment options, IRAs offer the opportunity to put your money in many types of mutual funds, stocks, and other investments.

11. Skipping a Roth Since You Already Have a 401(k)

The original goal of the IRA was to provide an investment vehicle for Americans who didn’t have a pension plan through an employer. But there’s nothing in the law that prevents you from using both.

In fact, financial planners often suggest funding a Roth IRA once you’ve contributed enough to your 401(k) to get your employer’s full matching contribution.

I'm Near Retirement Age. Should I Roll Over My Money Into a Roth IRA?

There is no age limit for contributing to a Roth individual retirement account (Roth IRA).

However, you will need to think carefully about your intended use for the funds. If you expect to need the money in the next five years, you will be unable to access that money without paying a penalty.

The five-year rule is in place for each rollover that you make. So, if you make one in the current tax year and another one the next year, you can withdraw the funds from the first in five years and the next in six years.

Rolling over funds into a Roth IRA has benefits if you expect to leave the money in the account to your heirs. You will not be subject to required minimum distributions (RMDs), as with a traditional IRA, and you can leave the balance to your heirs.

What Are the Roth IRA Contribution Limits for 2022 and 2023?

The contribution limit for an IRA, whether it's a Roth or a traditional version, is $6,000 in 2022, plus $1,000 for those ages 50 and older.

The limit in 2023 increases to $6,500 plus $1,000 for people ages 50 and older.

What Are the Roth IRA Income Phaseout Ranges for 2022 and 2023?

The income phaseout ranges for 2022 are as follows:

  • Married filing jointly and qualifying widow(er): $204,000 to $214,000
  • Single, head of household, and married filing separately (living separately the entire year): $129,000 to $144,000
  • Married filing separately (not living separately the entire year): $0 to $10,000.

The income phaseout ranges for 2023 are:

  • Married filing jointly and qualifying widow(er): $218,000 and $228,000,
  • Single, head of household, and married filing separately (living separately the entire year): $138,000 and $153,000
  • Married filing separately (not living separately the entire year): $0 to $10,000.

The Bottom Line

Having a Roth IRA can provide a bonanza of retirement benefits for both you and your heirs. But pay attention to the rules, so you don’t jeopardize your account’s tax-free status. If you’re looking to start funding an IRA, Investopedia has a list of the best brokers for IRAs.

Article Sources
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