A Roth IRA is a tax-exempt retirement savings account that holds investments that you choose using after-tax money. Roth IRAs offer many benefits, 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.
- One disadvantage is that contributions to a Roth is limited by your household income, and contributions for those with eligible incomes is capped at $6,000 a year.
- Another drawback is that if you withdraw your earnings before it's been at least five years since you first contributed to a Roth, you could owe taxes and a 10% penalty.
Roth vs. Traditional IRA
Roth and traditional IRAs are excellent ways to stash money away for retirement. They share the same contribution limits. For 2020, 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 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 these aren't necessarily deal-breakers, here are the disadvantages of Roth IRAs.
Roth IRA Income Limits
One disadvantage of Roth IRAs 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. Here's a rundown of the Roth IRA income and contribution limits for 2020:
|2019 Roth IRA Income and Contribution Limits|
|Filing Status||MAGI||Contribution Limit|
|Married filing jointly|
|Less than $196,000||$6,000 ($7,000 if age 50+)|
|$196,000 to $205,999||Begin to phase out|
|$206,000 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 $124,000||$6,000 ($7,000 if age 50+)|
|$124,000 to $138,999||Begin to phase out|
|$139,000 or more||Ineligible for direct Roth IRA|
*Married filing separately and head of household can use the limits for single people if they have not lived with their spouse in the past year.
Roth IRA Tax Deduction
The biggest difference between traditional and Roth IRAs is when you pay taxes. With traditional IRAs, you can deduct your contributions the year you make them. This provides an immediate tax break that can leave you with more money to invest—or to pay down debt. The downside is that you pay taxes on your 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 have less money around tax time 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 59 1/2 years old and it's been at least five years since you first contributed to a Roth IRA—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 59 1/2 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 there are no required minimum distributions (RMDs) starting at age 72—that it can be easy to overlook any 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.