But Roth IRAs are not necessarily for everyone. You could end up with a smaller nest egg than you’d like in retirement if you don’t use a Roth correctly. Here are some risks to using Roth IRAs and how you can minimize them.
What Is a Roth IRA?
A Roth individual retirement account (IRA) is a qualified retirement account in which your investments can grow. They won’t be taxed when you withdraw them in retirement. Unlike with a traditional IRA, the contributions to a Roth IRA are taxed before you contribute. With a traditional IRA, your contributions are tax deductible.
How a Roth IRA Works
You can contribute up to $6,000 of post-tax income, or $7,000 if you are over age 50, in 2022. The Internal Revenue Service (IRS) often changes this limit to keep pace with inflation and it increases to $6,500 and $7,500 respectively in 2023. You can then make withdrawals tax free in retirement, including your earnings. You’ll face a 10% tax penalty if you withdraw your earnings before your retirement age or without meeting one of the special requirements.
The Risks of Roth IRA Investing
Investing in a Roth IRA does have its risks. Let’s take a closer look at some of the more potential problems with using this type of retirement account.
Choosing the Wrong Investments
A Roth IRA is essentially a brokerage account with tax benefits. It isn’t like a savings account at a bank, where interest is automatically paid on your deposits. You choose your investments with an IRA, so there’s a risk that you could choose investments that don’t perform well or don’t align with your investing goals. You could even suffer financial losses. You could increase your exposure to fixed-income investments as you near retirement age to prioritize protecting your principal over achieving aggressive growth.
Incurring Penalties
Penalties are another risk to using a Roth IRA. Penalties can reduce your gains if you don’t use these retirement accounts according to IRS rules. For example, you’ll face a 10% penalty if you withdraw investment earnings before they’re qualified distributions, such as when you turn 59½. Additionally, your investment earnings can’t be withdrawn until five years after your first contribution to the account. even if the earnings would otherwise be qualified because you’re older than age 59½ or you’re disabled. Roth IRAs also have income limits. You can only contribute to a Roth IRA for the 2022 tax year if you have taxable income and you make less than $214,000 if you’re married and filing jointly, or $144,000 if you’re single, head of household, or married and filing separately and you haven’t lived with your spouse at any time during the year. These income limits increase to $228,000 and $153,000 respectively in 2023. You can incur a 6% tax penalty each year until you correct the error if you contribute when you’re not qualified to do so, or if you contribute more than the IRS limit.
You May Not Live Long Enough
The tax advantages of Roth IRA funds, namely the tax-free withdrawals on earnings, are generally not available until you reach age 59½. You’ll pay taxes on money without ever getting the tax benefit if you pass away before that age.
Not Having Other Investments
The maximum Roth IRA contributions are between $6,500 and $7,500 as of 2023, depending on your age. You still may not have enough saved for your retirement if you max out a Roth each year and make no other investments. Other investments can help you meet your financial goals in retirement in addition to a Roth:
Buying a home or investing in real estateContributing to an employer-sponsored plan such as a 401(k)Investing additional funds in a brokerage account
Roth IRAs also carry an opportunity cost risk. Your contributions can be withdrawn at any time, but not your investment earnings. Your account will include investment earnings if you invest well. The opportunity risk is that those earnings can’t be put to other uses without paying a penalty while they’re in your Roth IRA account, such as for investments in private businesses or complex real estate transactions. “Since growth in a Roth is tax free, you generally want to hold your most aggressive assets there,” Matt Bacon, a financial advisor with Carmichael Hill, told The Balance via email. “Think growth equities here…You want your Roth in overdrive mode.”
Alternatives to a Roth IRA
Roth IRAs are just one type of retirement investing account. Employer-sponsored 401(k) plans and traditional IRAs are other options.
401(k) Plans
401(k) plans are defined contribution retirement plans sponsored by employers. They have mostly replaced defined benefit (pension) plans. You contribute pretax earnings to a 401(k) that are deducted from your paycheck automatically, and your employer may match all or a portion of the funds. You’ll typically want to try to contribute to a 401(k) at least up to their limit if your employer offers matching funds so you’re not leaving this “free money” on the table. You can also contribute to a 401(k) plan if you earn too much money to qualify to contribute to an IRA.
Traditional IRA
Traditional IRAs are similar to Roth IRAs but your contributions are made with pretax income. Your distributions are taxed at your marginal income tax rate in retirement.
Are Roth IRAs Good Investment Tools?
A Roth IRA can be a good investment tool if you use it correctly. A Roth IRA can save you a significant amount of money on taxes if you save well, choose investments that align with your financial goals, and leverage the tax benefits. Want to read more content like this? Sign up for The Balance’s newsletter for daily insights, analysis, and financial tips, all delivered straight to your inbox every morning!
