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5 Roth IRA Misunderstandings That Could Cost You

By Selena Maranjian – Nov 13, 2016 at 4:43AM

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A Roth IRA is a surprisingly powerful way to save for retirement. Relatively modest regular contributions can total hundreds of thousands of dollars in your golden years -- and they can all be tax-free!

If you're ready to sock money away for retirement via a Roth IRA -- or you're already doing so -- bravo! Making the most of a Roth IRA can considerably improve your financial condition in retirement. Just be sure that you're not suffering from any costly misunderstandings about Roth IRAs and how they work. Here are some common misunderstandings, cleared up.

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Not true: You'll get an immediate tax break

If you're thinking that Roth IRAs are great because they give you a nice upfront tax break, you're wrong. You're thinking of traditional IRAs, where you get to deduct the amount of your contribution from your taxable income, thereby paying less tax. With a Roth IRA, you get no upfront tax break. But if you play by the rules, you'll get to withdraw funds from your Roth IRA tax-free! That can be quite meaningful if the investments in your Roth IRA grew substantially over time.

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Not true: The contribution limit doesn't change

Many people don't realize that the contribution limit for an IRA changes over time. It doesn't necessarily change every year, but it does slowly rise with inflation. If you're thinking that the limit is $5,000, for example, you haven't been keeping up. It was $5,000 for 2008 through 2012, but since then it has been $5,500. And on top of that, those aged 50 or older can chip in another $1,000, bringing their limit to $6,500. Note, too, that the limit applies to all your IRAs in this way: It's the total limit you can contribute to them all combined. If you have three different IRAs, for example, you don't get to enjoy three $5,500 limits. You can contribute up to $5,500 to any one of them or you can distribute that sum between two or three of them.

Not true: You have to invest in mutual funds (or stocks)

Another misunderstanding that many people have about Roth IRAs (and traditional ones, too) is that they restrict you to only invest in, say, mutual funds -- or stocks. IRAs actually can hold a wide range of securities. If you open an IRA with a mutual fund company, you may indeed be limited to just that company's funds. But if you open an IRA with a brokerage, you can fill it with shares of a wide range of mutual funds, including bond funds, and/or you can invest in individual stocks and other securities with it. This is an advantage that IRAs have over 401(k) plans, which typically offer a much more limited range of investments -- though if one or more inexpensive broad-market index fund is among them, that can be all you really need.

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Not true: All IRA providers are pretty much the same

They may all be able to create a Roth IRA account in your name and permit you to choose investments to park in it, but IRA providers can vary considerably in various ways, with some able to serve you better than others. As you look into your options, know that all major brokerages and many smaller ones will offer IRA accounts. So will many mutual fund companies, and perhaps even your bank. Find out what you will be able to invest in through that account. If you want to invest in individual stocks, for example, will you be able to? Look into the fees charged. Some brokerages will charge $7 or less per trade, while others might charge $25. If you're going to buy or sell very infrequently, a little difference won't matter much, but frequent traders should look for low fees. Some providers charge no commission fee at all if you invest in any of hundreds or thousands of mutual funds. Find out whether a provider will charge an annual service fee, too, or an "inactivity" fee if you don't trade much. See what the account minimum is, and if you can meet that. If you'd like a brick-and-mortar location to visit now and then, opt for a provider that has an office near you.

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Not true: Roth IRAs are helpful, but not super powerful

Finally, don't let yourself assume that a Roth IRA can only be a minor player on your retirement savings team. Being able to sock away just $5,500 per year may not sound like it will amount to gobs of money, but it can. Contribute $5,500 annually to a Roth IRA for 25 years, and if it averages annual growth of 8%, it will eventually top $430,000! (Note, too, that 25 years of $5,500 contributions totals $137,500 -- so roughly $300,000 of that nest egg is pure gain -- and from a Roth IRA, it can be withdrawn tax-free!)

Go ahead and plow money into your 401(k) at work and into any other retirement savings accounts you might have, but don't overlook the power of a Roth IRA. And be sure to clear up any misunderstandings you might have about Roth IRAs, because they could cost you.

Longtime Fool specialist Selena Maranjian, whom you can follow on Twitter, owns no shares of any company mentioned in this article.  We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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