3 Costly Mistakes People Make With Roth IRAs

Roth IRAs allow people to invest after-tax income and then make tax-free withdrawals in retirement. But reaping the rewards requires investors to avoid some expensive blunders.

Joel Baglole
Joel Baglole
Feb 24, 2019 at 9:47AM
Investment Planning

Roth IRAs continue to gain popularity as vehicles for retirement savings. That stems from the fact that Roth IRAs offer tremendous tax breaks. Not only do they shelter your investments from capital-gains taxes and dividend taxes, but they allow you to withdraw your funds in retirement without paying income tax on them.

However, taking full advantage of a Roth IRA means avoiding several mistakes that can cost you money in the form of taxes, penalties, and attorney fees. Here are three common and costly mistakes to be aware of and avoid.

Money stuffed in an envelope marked "Roth IRA."

Roth IRAs come with rules that need to be followed. Image source: Getty Images.

1. Over-contributing

In 2019, workers under age 50 can contribute a maximum of $6,000 to a Roth IRA. People over age 50 can contribute a maximum of $7,000. However, if your income exceeds a certain amount, then you may not be able to contribute the full amount -- or anything at all. To make the maximum annual contribution, you must have a gross income below $122,000 if you're a single tax filer or $193,000 if you're half of a married couple filing jointly. The amount you can contribute declines as your income exceeds these amounts. Once your income exceeds $137,000 as a single filer or $203,000 as a married couple filing jointly, you're not eligible to contribute to a Roth IRA at all.

Should you contribute more to a Roth IRA than you're allowed, you'll have made what is known as "an ineligible excess contribution," which can result in tax penalties. Specifically, the penalty for ineligible contributions is 6% of the ineligible amount. You pay this penalty when you file your income tax return using Form 5329. To avoid the 6% penalty on excess funds, it's important to know whether you're eligible to contribute to a Roth IRA and how much money you can put in the account each year based on your age and your income. Over-contributing is an easy mistake to make, especially if a recent increase in your income has suddenly made you ineligible to contribute the same amount you did before.  

2. Pulling money out early

Pulling money out early can be a pitfall with many investments. But it can be particularly costly if that investment is held in a Roth IRA. If you withdraw money from a Roth IRA before you're 59 1/2 years old, the amount withdrawn may be subject to a 10% penalty, as well as income tax on any "accrued earnings." Any money you withdraw beyond the amount of your original contributions to a Roth IRA is viewed as "earnings," and it's subject to income tax.

The good news is that there are some notable exceptions to this rule. For example, if the funds go toward the purchase of your first home, or if they're distributed to your beneficiaries upon your death, then the withdrawal will not be subject to penalties or taxes. There are also some breaks available to people using a Roth IRA withdrawal to help pay college expenses. You must also remember the "five-year rule," which requires that your Roth IRA be open for at least five years before you withdraw any funds, lest you face income tax and penalties.

Given the stiff penalties and taxes involved, it's advisable to withdraw money from a Roth IRA only as a last resort in an emergency. And bear in mind that the IRS has good reasons for putting these restrictions on your withdrawals: That money is meant to help you stay financially secure in retirement, not cover near-term expenses.

3. Forgetting to list primary and contingent beneficiaries

When you're setting up a Roth IRA, it's important to pay attention to the fine print and fill out all the forms and paperwork properly. This includes listing primary and contingent beneficiaries for the account. Forgetting to name beneficiaries of your Roth IRA can cause big headaches for your heirs. The money in your account will be made payable to your estate, which means it will go through probate. And probate can be a complicated process that requires your heirs to pay hefty attorney fees to gain access to the money.

Remember to name beneficiaries when you first set up a Roth IRA, and be sure to update the paperwork associated with the account if you'd like to add or remove beneficiaries. For example, if you get divorced, you may want to remove your ex-spouse as a beneficiary, and if you have grandchildren, you may decide to leave some of the money to them.

Roth IRAs are great investment vehicles. But, like most retirement savings instruments, they come with their share of rules and procedures. Failure to follow the rules can lead to expensive problems.