Roth IRAs: Common Mistakes to Avoid
Saving money for one’s future is relatively straightforward. Money goes in when you are younger, and money comes out as needed when you are older. Saving into a Roth IRA is strongly recommended when you are younger as it provides tax-free savings. But there are certain rules to adhere to and sometimes, common mistakes can occur. Here a few examples of what to look for and how to best address them.
Contributions from Earnings
Contributions can only be made to the lesser of the contribution limit ($6,000 if you are under 50 or $7,000 if you are 50+) or earned income. Earned income, by IRS standards, can come from wages, salaries, tips, bonuses, etc. If, for example, you earn only $4,000 from wages, then your Roth IRA contribution limit will be $4,000.
A common situation encountered in this area is not earning enough or anything at all and using unearned income such as dividends, interest, or capital gain distributions to try to contribute to a Roth IRA. You should make sure there is at least some amount of earned income before considering a direct contribution to a Roth IRA.
Earning Too Much to Contribute
Earning too much income can pose a bit of an issue when trying to contribute to a Roth IRA. The IRS has set Modified Adjusted Gross Income (MAGI) thresholds that can prevent you from making a full contribution. Starting in 2021, if you are married filing jointly, you must make less than $198,000 to make a full contribution or less than $125,000 if you are filing single. Our earlier blog post covers these income limits thoroughly.
If you do find yourself in a situation where your income is too high and are ineligible to make a direct contribution, then considering a backdoor Roth IRA contribution can be the best option for you.
The rules for withdrawing from a Roth IRA are tricky if you have not met certain requirements. While you can withdraw any amounts directly contributed at any time and at any age, the rules change when it comes to withdrawing the earnings portion of the account. The worst-case scenario is that you may end up paying taxes and an additional 10% penalty on the earnings you withdraw. In our previous blog post, we discuss these rules further.
If you do find yourself in a situation where you may need funds, looking towards other sources of funds before dipping into a Roth IRA may be way to go.
Roth IRAs are mostly a blessing with a few caveats as mentioned above. Understanding the rules can take some time but the benefits, namely tax-free growth, clearly outweigh the work it takes to understand this type of account. Having a fee-only financial advisor on your side who understand the rules and help you automate savings can go a long way to reach your goals.
Weingarten Associates is an independent, fee-only Registered Investment Advisor in Lawrenceville, New Jersey serving Princeton, NJ as well as the Greater Mercer County/Bucks County region. We make a difference in the lives of our clients by providing them with exceptional financial planning, investment management, and tax advice.