Disadvantages of Roth IRAs Every Investor Should Know

A Roth individual retirement account (IRA) is a retirement savings account that a person can contribute to each year. In certain circumstances, funds can be withdrawn tax free.

The money saved in a Roth IRA can be invested in financial instruments, such as stocks, bonds, or savings accounts. Contributions to a Roth IRA are made with after-tax money, meaning that the contributions are made after income taxes are deducted from the account holder’s paycheck.

Roth IRAs offer a long-term tax benefit since contribution withdrawals and investment earnings are not taxed during retirement. However, Roth IRAs may not be the right retirement account for everyone. While there are advantages to Roth IRAs, there are also distinct disadvantages that should be considered.

Key Street Shops

  • Roth individual retirement accounts (IRAs) offer many important benefits, including tax-free growth, tax-free withdrawals during retirement, and no required minimum distributions (RMDs). However, they also have disadvantages.
  • One major disadvantage: Roth IRA contributions are made with after-tax money, meaning there is no tax deduction in the year of contribution.
  • Another disadvantage is that withdrawals of account earnings cannot be made until at least five years have passed since the first contribution.
  • This five-year rule may make opening Roths less beneficial if you are already in late middle age.
  • Tax-free distributions from Roth IRAs may not be advantageous if you are in a lower income tax bracket in retirement.

Roth vs. Traditional IRA

Roth and traditional IRAs are great ways to save for retirement. However, there are annual contribution limits.

For 2023, individuals can contribute a maximum of $6,500 per year or $7,500 if they are 50 years of age or older.

To contribute to either, you must have earned income, that is money earned from working or running a business. In addition, you cannot deposit more than you earned in a given year.

Despite these similarities, the accounts are actually very different. Below are the disadvantages of Roth IRAs.

Roth IRA Income Limits

One downside to the Roth IRA is that you can’t add 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 (AGI)—this can be found on your tax return—and add back certain deductions.

Generally:

  • 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 phased out range.
  • If your MAGI is too high, you cannot contribute at all.

Below is a breakdown of Roth IRA income and contribution limits for 2022 and 2023.

2022 Roth IRA Income and Contribution Limits
Filing Status Magi Contribution Limit
Qualifying Married or Widowed Filing
Less than $204,000 $6,000 ($7,000 if age 50+)
From $204,000 to $214,000 Step out the range
$214,000 or more Ineligible for a direct Roth IRA
Married Filing Separately
Less than $10,000 Step out the range
$10,000 or more Ineligible for a direct Roth IRA
Individual or Head of Family
Less than $129,000 $6,000 ($7,000 if age 50+)
From 129,000 to $144,000 Step out the range
$144,000 Ineligible for a direct Roth IRA
2023 Roth IRA Income and Contribution Limits
Filing Status Magi Contribution Limit
Qualifying Married or Widowed Filing
Less than $218,000 $6,500 ($7,500 if age 50+)
From $218,000 to $228,000 Step out the range
$228,000 or more Ineligible for a direct Roth IRA
Married Filing Separately
Less than $10,000 Step out the range
$10,000 or more Ineligible for a direct Roth IRA
Individual or Head of Family
Less than $138,000 $6,500 ($7,500 if age 50+)
$138,000 to $153,000 Step out the range
$153,000 or more Ineligible for a direct Roth IRA

Married taxpayers filing separately can use the single/head of household limits if they do not live with their spouse at any time during the tax year.

Backdoor Roth IRA

There is a trivial 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, which means contributing to a traditional IRA and having the money rolled into a Roth account immediately.

This transaction must be conducted strictly in accordance with Internal Revenue Service (IRS) rules.

Roth IRA Tax Deduction

The biggest difference between a traditional IRA and a Roth can be seen when the taxes are due.

A traditional IRA deducts your contributions in 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 your contribution and the money it earns when you make withdrawals during retirement.

Roth IRAs work the other way around. You don’t get a tax break up front, but withdrawals during retirement are usually tax-free.

That sounds good, but it can be a disadvantage for some investors.

You make Roth IRA contributions with after-tax dollars, so you don’t get the upfront tax break that traditional IRAs offer.

Here’s why: Any upfront tax break means less money in your paycheck to spend, save and invest. And tax-free withdrawals in retirement are something to look forward to—unless you’re in a lower tax bracket in the future than you are now.

Depending on your situation, you may benefit more from a traditional IRA upfront tax break and then pay taxes at your lower rate in retirement. It’s worth crunching the numbers before you make any decisions as there could be a lot of money involved.

Roth IRA Withdrawal Rules

With a Roth IRA, you can withdraw your contributions at any time, for any reason, without tax or penalty. Additionally, qualified withdrawals (including contributions and account earnings) during retirement are tax-free and penalty-free. To qualify, the withdrawals must be made 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:

  • 59 years of age and younger: Withdrawal of earnings is subject to taxes and a 10% penalty. You may be able to avoid the penalty (but not the taxes) if you use the money to buy a first home or for certain other exemptions.
  • Age 59½ and over: Withdrawal of earnings is 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 must wait until age 63 to make tax-free withdrawals.

Can I Withdraw Contributions Without Triggering the Five Year Rule?

Yes. Your contributions can be withdrawn at any time without penalty or taxes. Only earnings are subject to the five-year rule.

What is My Adjusted Gross Income (MAGI)?

Your modified adjusted gross income (MAGI) is the same as your adjusted gross income (AGI) with some deductions set aside. Deductions reinstated include half the self-employment tax, deductions for student loan interest, rental losses, and more.

Do Roth and Traditional Individual Retirement Accounts (IRAs) Have the Same Income Limits?

There are no income limits for contributing to a traditional individual retirement account (IRA). Roth IRAs establish your ability to add the maximum $6,500 for 2023 to your MAGI. People over the age of 50 can make an additional $1,000 contribution as a result. However, the deduction for your contributions to a traditional IRA may be limited if you or your spouse are covered by a retirement plan at work and your income exceeds certain levels.

The Bottom Line

Roth IRAs offer many advantages; tax-free growth, tax-free withdrawals in retirement, and no required minimum distributions (RMDs) starting at age 72. However, there are downsides.

Typically, individuals take advantage of retirement savings in an IRA. However, whether a traditional IRA or a Roth is better depends on several factors, including your income, age, and when you expect to be in a lower tax bracket—now or in retirement. Consult a tax expert, financial planner, or financial advisor to help you make a more informed decision so that your retirement plan is tailored to your specific financial situation.

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