A Roth IRA is a retirement savings account that holds investments that you choose using after-tax money. Roth IRAs offer many benefits, and the greatest of them is the fact that your retirement money and its earnings will never be taxed again. But they're not the right choice for every investor. If you're thinking about opening an account, consider the disadvantages of Roth IRAs first.
- Roth IRAs offer several key benefits, including tax-free growth, tax-free withdrawals in retirement, and no required minimum distributions.
- An obvious disadvantage is that you're contributing post-tax money, and that's a bigger hit on your current income.
- Another drawback is that you must not make a withdrawal before at least five years have passed since your first contribution.
Roth vs. Traditional IRA
Roth and traditional IRAs are both excellent ways to stash money away for retirement. They share the same contribution limits. For 2021, that's $6,000, or $7,000 if you're age 50 or older.
To contribute to either, you must have earned income. That's strictly the money you get from working or owning a business. And you can't deposit more than you earn in a given year.
Despite these similarities, the accounts are actually quite different. While they aren't necessarily deal-breakers, here are the disadvantages of Roth IRAs.
Roth IRA Income Limits
One disadvantage of the Roth IRA is that you can't contribute to one if you make too much money. The limits are based on your modified adjusted gross income (MAGI) and tax filing status. To find your MAGI, start with your adjusted gross income—you can find this on your tax return—and add back certain deductions.
In general, you can contribute the full amount if your MAGI is below a certain amount. You can make a partial contribution if your MAGI is in the "phase-out" range. And if your MAGI is too high, you can't contribute at all.
Below is a rundown of the Roth IRA income and contribution limits for 2021.
|2021 Roth IRA Income and Contribution Limits|
|Filing Status||MAGI||Contribution Limit|
|Married filing jointly|
|Less than $198,000||$6,000 ($7,000 if age 50+)|
|$198,000 to $207,999||Begin to phase out|
|$208,000 or more||Ineligible for direct Roth IRA|
|Married filing separately*|
|Less than $10,000||Begin to phase out|
|$10,000 or more||Ineligible for direct Roth IRA|
|Less than $125,000||$6,000 ($7,000 if age 50+)|
|$125,000 to $139,999||Begin to phase out|
|$140,000 or more||Ineligible for direct Roth IRA|
Married filing separately and heads of household can use the limits for single people if they have not lived with their spouse in the past year.
The Backdoor Roth IRA
There's a tricky but perfectly legal way for high income-earners to contribute to a Roth IRA even if their income exceeds the limits. This is called a backdoor Roth IRA and it entails contributing to a traditional IRA and then immediately rolling over the money into a Roth account.
Needless to say, this must be done strictly by the IRS rules.
Roth IRA Tax Deduction
The biggest difference between traditional and Roth IRAs appears when the taxes are due.
With a traditional IRA, you deduct your contributions 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 it earns when you make withdrawals during retirement.
Roth IRAs work the opposite way. You don't get an upfront tax break, but withdrawals in retirement are generally tax-free.
That sounds good, but it can actually be a disadvantage for some investors.
You make Roth IRA contributions with post-tax dollars, so you don't get the upfront tax break that traditional IRAs offer.
Here's why. No upfront tax break means you'll get less money in your paycheck to spend, save, and invest.
And, tax-free withdrawals in retirement are something to look forward to—unless you'll be in a lower tax bracket in the future than you are now.
Depending on your situation, you could benefit more from a traditional IRA's upfront tax break, and then pay taxes at your lower rate in retirement. It's worth crunching the numbers before you make any decisions since there's potentially a lot of money at stake.
Roth IRA Withdrawal Rules
With a Roth, you can withdraw your contributions at any time, for any reason, without tax or penalty. And qualified withdrawals in retirement are also tax-free and penalty-free. Those happen when you're at least 59½ years old and it's been at least five years since you first contributed to a Roth IRA—also known as the five-year rule.
If you don't meet the five-year rule, any earnings you withdraw could be subject to taxes or a 10% penalty—or both, depending on your age:
- Age 59 and under: Withdrawals 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 a first-time home purchase or for certain other exemptions.
- Age 59½ and over: Withdrawals 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 years old to make tax-free withdrawals.
The Bottom Line
Roth IRAs offer so many benefits—tax-free growth, tax-free withdrawals in retirement, and no required minimum distributions (RMD) starting at age 72. But don't overlook the potential drawbacks.
Most investors will benefit from saving for retirement in an IRA. Whether the better option for you is a traditional or Roth IRA depends on your income, your age, and when you expect to be in a lower tax bracket—now, or during retirement.
Internal Revenue Service. "Traditional and Roth IRAs." Accessed Oct. 29, 2020.
Internal Revenue Service. "Income Ranges for Determining IRA Eligibility Change for 2021." Accessed Oct. 29, 2020.
Internal Revenue Service. "Publication 590-A Contributions to Individual Retirement Arrangements (IRAs)," Pages 5–6 & 39. Accessed Oct. 29, 2020.
Internal Revenue Service. "Retirement Topics - IRA Contribution Limits." Accessed Oct. 29, 2020.
Internal Revenue Service. "Amount of Roth IRA Contributions That You Can Make for 2020." Accessed Oct. 29, 2020.
Healthcare.gov. "What to Include as Income." Accessed Oct. 29, 2020.
Internal Revenue Service. "Publication 590-A Contributions to Individual Retirement Arrangements (IRAs)," Page 39. Accessed Oct. 29, 2020.
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