It’s very likely that you’ve thought about saving (or converting existing savings) to a Roth IRA or 401k. It may have been recommended to you by someone, a friend, family member, advisor, your bank or a colleague. You’ve almost certainly seen, if not read, an article about the benefits of a Roth.
All retirement savings accounts are designed to help you save money on taxes. Roths can be a particularly great way to reduce your tax burden.
What is Roth?: A Roth is a retirement savings account. With a Roth, you pay taxes on the money you contribute to the account. The trade-offs (and the reasons they’re so popular) are that your money grows tax-free, withdrawals aren’t taxed, and you’re not required to take minimum distributions at any given age. (Learn more about the benefits of a Roth.)
(With a 401k or traditional IRA, your savings contributions are tax-deferred. You don’t pay taxes on the money you save.)
Roths can be great, but they are not always right for everyone and big mistakes can be made. Here are 15 mistakes to avoid with Roth accounts.
1. Not opening a Roth because you already have a 401(k)
There are two main types of retirement savings accounts: individual savings accounts (traditional and Roth) and employer-sponsored retirement accounts such as 401ks (traditional and Roth), SEPs, 403bs, etc.
If you’re saving in a retirement plan at work, you’re still allowed to save in an IRA or Roth IRA, and if you have the cash flow, you probably can.
You are allowed to contribute to both a Roth IRA and an employer-sponsored retirement plan.
The maximum contributions to IRAs (Roth and traditional) for 2024 are $7,000 plus an additional $1,000 in catch-up contributions if you’re 50 or older.
The maximum annual 401k contribution is $23,000 for 2024, plus a catch-up contribution of $7,500 if you’re 50 or older.
2. Not taking advantage of the Roth because you make too much money
That’s right, there are income limits when it comes to contributing to a Roth account. In 2024, you can save in a Roth only if your modified adjusted gross income (MAGI) is below a certain threshold. Check the latest Income limits Established by the IRS.
However, the income limit shouldn’t prevent you from taking advantage of Roth accounts. While you can’t save directly in a Roth, you can save in a traditional IRA and roll that money over to a Roth. This is often referred to as “back door” Roth savings.
Learn more about backdoor Roths.
3. Convert money to a Roth without following the rules
When converting money from a traditional retirement savings vehicle to a Roth, you need to follow the conversion rules. You can do the following:
- roll over: A rollover is when you take a distribution from your traditional IRA and make sure that money is deposited into a Roth account within 60 days.
- Transfer of trustee to trustee: This is where you direct the institution that holds your traditional IRA to transfer funds to a different institution where your Roth account is held.
- Transferring the same guardian: In this case, both your traditional and Roth accounts are at the same institution, and you direct them to make the conversion.
If you simply withdraw money from your retirement plan and place it in a Roth IRA, the early distribution tax may be assessed at 10%.
4. Withdraw Roth converted funds too early
The beauty of the Roth is that the money grows tax-free. So, in general, you want time for the account to grow after doing a Roth conversion.
More specifically and most importantly, it is very important to know that the converted Roth funds must remain in your Roth IRA for at least 5 years before withdrawal.
Withdrawing funds before 5 years will result in a 10% early withdrawal penalty.
5. Contribute a lot to the Roth
As noted above, there are limits to how much you can contribute to a Roth. The IRS will charge you a 6% penalty tax on any investments that exceed the limits. The penalty is assessed for each year in which the necessary measures were not taken to correct the error.
6. Not having the cash flow to pay taxes on a Roth conversion
Unlike contribution limits, there are no limits on the amount you can convert to a Roth. However, you must be able to pay the taxes due on the transfer.
Your conversion may be limited to the amount of tax you can withstand in any given year.
The transferred funds will be treated by the IRS as income and taxed as such.
7. Improper planning of when to make transfers
Timing Roth conversions is tricky.
What can get complicated is timing how much to do and when. There are several important factors to consider:
- Your income (current and future)
- Your tax bracket (current and future)
- Future changes in tax law
- How much money you will have in traditional accounts and the amount of your required minimum distributions (RMDs) when you reach age
- Cash available to pay taxes on transfer
- How much time between the transfer and the time you will start withdrawing funds
- The rate of return you will earn on your Roth funds
- Your goal for making the transfers: For example, do you want to minimize taxes over your lifetime? Stay under a certain tax or IRMAA threshold? Maximize the value of your real estate?
It can be difficult trying to figure out how much to transfer and when. Many people find it better to spread out conversions and have a multi-year conversion strategy.
Here are some resources to help you figure out how to optimize Roth conversions:
NewRetirement Roth Conversion Explorer
Explorer is part of NewRetirement’s PlannerPlus. The tool helps take the guesswork out of if and when you should make transfers. Explorer will use your plan and run thousands of scenarios to determine personalized strategies for you to convert based on an objective of your choice.
Modeling transfers in the new pension scheme
As described above, the Roth Conversion Explorer suggests conversions based on the goal you choose. However, you may have other Roth conversion scenarios you want to consider. You can model any potential conversion in the NewRetirement Planner and instantly see the impact on your lifetime tax expenses and your incremental tax expenses for the year you convert. Or evaluate it in terms of future cash flow. What is the impact of the conversion on required minimum distributions? And more…
Advice from a fee-only financial advisor
How to save? How much should be saved? If you should convert? These may seem like simple questions, but the truth is that they are complex and it can be reassuring to work with a professional to get the answers that are right for you.
If you’re interested in a customized Roth conversion strategy and want professional expertise, work with a Certified Financial Planning Professional™ from NewRetirement Advisors to set and achieve your goals. Book a free discovery session.
8. Not investing appropriately
Tax-free growth is the name of the Roth IRA game. As such, you want to make sure that your money in a Roth IRA is invested for growth appropriate for your age and risk tolerance.
9. Use a Roth when you’re in your highest tax bracket
If you’re in your highest-income years, you’ll likely make better traditional contributions than a Roth during those years.
And if you think your taxes will be lower in the future, a Roth conversion probably isn’t right for you now.
The NewRetirement Planner can give you insight into your tax bracket for all the years ahead. This can help you see opportunities for Roth conversions.
10. Not modeling your future income
Many people believe that their income will decrease in retirement and that taxes will not be a factor.
However, this may not be true, especially if you have significant retirement savings. Required minimum distributions (RMDs) may push your income levels into higher tax brackets.
Modeling future income allows you to understand whether Roth savings or a Roth conversion is a good idea for you.
The NewRetirement Planner enables you to model your future income and the system automatically analyzes your RMDs. This can help you see future tax brackets and liabilities.
11. Overlooking your husband’s opportunities to save
For better or worse, oftentimes one partner will be more involved in the family’s financial health than the other — even if you both bring in the income. Sometimes this imbalance means that the financially savvy partner is making all the right moves with his money, but is not necessarily taking advantage of the partnership opportunities.
If your spouse has income, make sure he saves in the most beneficial vehicle, which may be a Roth account.
12. Overlooking savings opportunities for your wife (even if she has no income)
In general, you must have income in order to save in tax-advantaged savings vehicles.
However, if you are married and filing a joint return, you can take the maximum Roth IRA for each spouse using a spousal IRA. You can contribute on their behalf and the annual individual contribution limits are the same.
So, if you’re married, over 50, filing a joint return, and only one spouse has income, you can still contribute a maximum of $16,000 to your household. ($7,000 plus an additional $1,000 in catch-up contributions for each of you.)
13. You think you’re too old or too young to contribute to a Roth
There are no age restrictions for contributing or converting funds to a Roth IRA.
The real factor to consider is your tax liability for one type of savings vehicle or the other.
14. Failure to name and update beneficiaries
This is not necessarily limited to Roth accounts, but not naming and updating the beneficiaries of the accounts is a mistake often made. It is very closely related to Roth accounts.
Not having a beneficiary or having the wrong beneficiary will seriously derail your estate plans.
15. Not considering savings and Roth conversions in light of a comprehensive financial plan
No financial decision should ever be made without understanding the pros and cons regarding your current and future overall financial picture.
There are several considerations that will affect the true benefit (or downside) of making the transfer. For example, your family and potential inheritance can be affected by whether or not your savings are in a Roth.
Maintaining a comprehensive written financial plan is a great way to model the impact of your decisions.
NewRetirement Planner is the most comprehensive tool available online. The easy-to-use system helps you make better decisions, enjoy improved financial results, and experience more peace of mind about your money.
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