This article takes a look at the mistakes to avoid with your Roth IRA.
Building a Million-Dollar Roth IRA
According to a survey by The Charles Schwab Corporation (NYSE:SCHW), individuals think they need at least $1.8 million to live a comfortable retirement. Based on the figure, it is safe to say that the average American, who has only $120,300 saved up for their retirement, is in for a bumpy ride if they don’t start saving up. Thankfully, there are quite a few ways through which an individual can stack up a million dollars in retirement. One such example is through a Roth IRA.
A Roth IRA is a special type of Individual Retirement Account (IRA) in which an individual pays taxes on their contributions, and then receives all future withdrawals tax-free. Many individuals believe that contribution limits imposed by the IRS make it difficult to build up a fat nest egg for retirement through such accounts. However, that’s where they are wrong. This is because with consistency, and with the power of compounding, it is quite easy to be a retirement millionaire yourself.
So how is it possible to raise over a million dollars in your Roth IRA? More importantly, why is a million-dollar Roth IRA so attractive to retirees? The answer lies in its tax-free withdrawals. Since a Roth IRA requires after-tax contributions, an individual who has amassed over a million dollars in retirement will be able to enjoy it tax-free in their retirement years. However, there are many things that can go wrong with a Roth IRA. For this reason, we have compiled a list of all the mistakes to avoid with your Roth IRA. Before we move on to that, let’s get back to the question: how to build a million dollar Roth IRA account?
Which Stocks to Add to Your Retirement Portfolio
We at Insider Monkey recently compiled a list of the Best Growth Stocks to Buy and Hold in 2024. To compile the list of the top 5, we ranked the holdings of Vanguard Growth ETF by the number of hedge funds that had bought the shares in Q4 2023 and chose the top 5. These top stocks were chosen based on hedge fund sentiments, where the top consensus stock picks outperformed the S&P 500 Index by more than 140 percentage points over the last 10 years.
Why are we interested in the stocks that hedge funds pile into? The reason is simple: our research has shown that we can outperform the market by imitating the top stock picks of the best hedge funds. Our quarterly newsletter’s strategy selects 14 small-cap and large-cap stocks every quarter and has returned 275% since May 2014, beating its benchmark by 150 percentage points (see more details here).
Based on our list, the top five growth stocks to buy and hold on to are NVIDIA Corporation (NASDAQ:NVDA), Alphabet Inc. (NASDAQ:GOOGL), Meta Platforms, Inc. (NASDAQ:META), Amazon.com, Inc. (NASDAQ:AMZN), and Microsoft Corporation (NASDAQ:MSFT). The top growth stock to buy and hold is Microsoft Corporation (NASDAQ:MSFT), the world’s largest personal computing operating system provider. The company boasts strong financials and significant growth potential, with Azure, AI integration, and its diversified business model being the key drivers of the company’s revenues and profitability. Undoubtedly, the stock is a strong buy and hold, with shares having popped up 35% since May 2023. Posting its Q3 2024 earnings, the company’s revenue rose by 17% year-over-year to $62 billion, $1 billion higher than analyst expectations.
Methodology
To compile a list of mistakes to avoid with your Roth IRA, we consulted a number of sources such as The Charles Schwab Corporation (NYSE:SCHW), Bankrate, Investopedia, and District Capital Management, to name a few. A consensus approach was adopted to choose the top 11 mistakes to avoid with your Roth IRA, with one point awarded each time it was recommended by a source. Mistakes have been ranked in an ascending order based on the number of times recommended.
At Insider Monkey we are obsessed with the stocks that hedge funds pile into. The reason is simple: our research has shown that we can outperform the market by imitating the top stock picks of the best hedge funds. Our quarterly newsletter’s strategy selects 14 small-cap and large-cap stocks every quarter and has returned 275% since May 2014, beating its benchmark by 150 percentage points (see more details here).
Here are the 11 Mistakes to Avoid with Your Roth IRA:
11. Contributing too much
Is there anything like contributing too much in retirement? Apparently, there is. Putting too much in your Roth IRA will result in tax penalties, which exist to ensure compliance with the contribution limits set by the IRS. When you put more in your Roth IRA than the set amount, it will trigger a 6% tax penalty on the excess amount until the mistake is corrected. These contribution limits exist so that such tax-advantaged retirement accounts are used equitably amongst taxpayers, ensuring that the benefits of Roth IRAs are available to taxpayers within the prescribed limits. So how much should you contribute to your Roth IRA? The Roth IRA contribution limit for tax year 2024 is $7,000 for those below 50, and $8,000 for those aged 50 and above.
10. Withdrawing Savings Early
Another mistake to avoid with your Roth IRA is withdrawing your savings early. Roth IRAs are special retirement accounts where your contributions are taxed, while all withdrawals made in the future are tax-free. However, it’s important to remember that only qualified withdrawals are tax-free and penalty-free. Roth IRA contributions can be withdrawn tax-free since their taxes are already being paid for. However, withdrawals on the earnings may be subject to taxes and penalties depending on age and the duration you’ve held the account. In the case of a Roth IRA, a qualified withdrawal will be one where earnings are withdrawn only if you’re over 59 ½ years old, and the retirement account itself is at least 5 years old. However, there are exceptions to this rule.
9. Funding More IRAs
You can open up as much Roth IRAs as you want. However, you can’t contribute more than the IRS limit across all your IRAs. The contribution limit for a Roth IRA in 2024 is $7,000, so make sure you don’t contribute more than this amount across all your IRAs combined. While having multiple IRAs doesn’t allow one to contribute more, they may add to complexity and fees. However, many people do hold multiple IRAs for tax-minimization and access to more investment choices.
8. Failing to Utilize a Spousal IRA
Another mistake to avoid with your Roth IRA is missing out on the opportunity to open a spousal IRA. While opening and funding an IRA does involve earned income, the IRS allows for certain exemptions for the spouses who don’t work. Provided income requirements are met, an individual can cover contributions for both themselves and their spouse, and file a joint return. In 2024, an individual can contribute for them and their spouse IRA up to a maximum of $16,000 if over the age of 50.
“The IRA for nonworking spouses is often overlooked, but it’s important to take advantage if you can. Keep in mind that a spousal IRA is a separate account (not a joint account), and each spouse can choose a traditional IRA, Roth IRA, or both. Over time, the account can help you invest more for retirement and take advantage of potential tax savings”.
-Hayden Adams, The Charles Schwab Corporation (NYSE:SCHW)
7. Navigating a Roth Conversion on Your Own
Another major mistake that an individual can make related to a Roth IRA is converting a traditional IRA into a Roth without planning out the details. Often times, individuals with too high incomes use a “backdoor Roth IRA”. A backdoor Roth IRA is somewhat a loophole to a Roth IRA. A backdoor Roth allows high-earning individuals to open a Roth IRA despite of the income limits imposed by the IRS. This involves converting tax-deferred funds, such as those in a traditional IRA or a 401(k), to a Roth IRA. Since such a conversion is quite complicated and one needs to be careful with all the rules, doing it on your own is one mistake to avoid. You may incur unnecessary taxes, face an early withdrawal penalty, or even push yourself into a higher tax bracket. Once you convert, there’s no going back.
6. Contributing to a Roth IRA when Ineligible
You may have contributed more to your Roth IRA in the case when you’ve earned less than what you originally anticipated. An individual can contribute the maximum allowed to a Roth IRA in a tax year, or the amount of their compensation, whichever is less. In turn, your income may have taken an unexpected jump, in which case you may be ineligible for a full, or any contribution at all, to your Roth IRA. Whether or not you can contribute to a Roth IRA in case of high income depends on your MAGI-Modified Adjusted Gross Income. In 2024, a single filer must make less than $146,000 for making a full Roth IRA contribution. Joint filers must make under $230,000 to make the full contribution.
5. Mishandling Rollover Rules
When you switch a job, you can convert your old 401(k) into a traditional or a Roth IRA in order to take advantage of tax-free withdrawals. However, these rollovers are tax and penalty free only if the 60-day rule is followed. The rule states that individuals must deposit all of their funds into a new retirement account within 60 days of the distribution. Failure to meet the 60-day deadline will result in income taxes on the retirement funds. Early withdrawal penalties also apply in case the individual is under 59 ½. This is called an indirect rollover. A better way to move funds in this case is to do a direct rollover or a trustee-to-trustee transfer.
“This can be helpful in a couple of ways—first, no taxes will be withheld directly from the money you roll over. And second, you won’t risk missing the 60-day rollover window, which could result in penalties if you’re under age 59½.”
-Hayden Adams, The Charles Schwab Corporation (NYSE:SCHW)
Moreover, individuals can’t do more than one rollover in a 365-day period, triggering a bigger tax bill. The two rollovers that are subject to this rule is an IRA to IRA and a Roth IRA to a Roth IRA.
4. Withdrawing an Inherited IRA after the deadline
A Roth IRA don’t have required minimum distributions as long as the owner of the Roth IRA is alive. Owners need not withdraw money during their lifetime, allowing their investment to continue to grow tax-free. However, these rules change in the case of an inherited Roth IRA. This is because inherited Roth IRAs carry required minimum distributions and an owner must withdraw money within a specified time. The general rule is that owners of an inherited IRA must empty the account within 10 years of the death of the original owner. This rule applies to Roth IRAs inherited in the year 2020 or later.
3. Failing to Name Beneficiaries
A Roth IRA can easily be inherited by a beneficiary if they were already designated. However, one big mistakes Roth IRA owners usually make is failing to name their beneficiaries. In such a case, heirs may be subject to greater delays, complications, and higher attorney fees in order to inherit the Roth IRA. This is why naming beneficiaries is very important in a Roth IRA. Once the beneficiaries have been named, one must also make sure to periodically review, and make changes, if any. This can be important in case an individual parts ways with their spouse. In case of a divorce, a former spouse who is listed as a beneficiary will end up inheriting the Roth IRA.
2. Not Working with a Financial Planner
Opening and managing a Roth IRA isn’t that simple. There are many investments, tax strategies, and timings of your contributions that can impact your account and even its tax-free status. This can cause additional taxes and penalties, which is why it’s the one major mistake to avoid with your Roth IRA. A certified financial planner can help individuals set up and maintain a Roth IRA to the best of its potential. They can also help individuals avoid costly financial mistakes.
1. Failing to Invest Your Roth IRA Funds
Based on our methodology, one major mistake to avoid with your Roth IRA is failing to invest your Roth IRA funds. A Roth IRA is an Individual Retirement Account where an individual contributes their after-tax dollars. However, many individuals believe contributing to a Roth IRA is an investment in itself when it is not. Just because an individual contributes to a Roth IRA doesn’t mean that the money is automatically invested. In fact, an individual must go into the account, select the investments, and then manage them. This is the best advice for a Roth IRA. Some popular investments for Roth IRAs are stocks, bonds, mutual funds, Exchange-traded Funds (ETFs), Target-date Funds (TDFs), and Real estate investment trusts (REITs). However, it is not allowed to invest in collectibles in a Roth IRA. This includes automobiles, artwork, stamps, rugs, and other items.
At Insider Monkey, we delve into a variety of topics, ranging from the best places to retire to the best AI travel apps; however, our expertise lies in identifying the top-performing stocks. Currently, Artificial Intelligence (AI) technology stands out as one of the most promising fields. If you are looking for an AI stock that is more promising than NVDA but that trades at less than 5 times its earnings, check out our report about the cheapest AI stock.
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