Patience, they say, is a virtue. And for investors, the Roth IRA may be the best proof – provided you follow the rules.
First introduced in 1998, these accounts not only offer tax-deferred growth, but also the ability to make tax-free withdrawals after the age of 59½. If you earn less than the yearly income limit – $133,000 for single filers and $196,000 for married couples in 2017 – it’s one of the most potent retirement planning tools at your disposal.
But in order to enjoy the full benefits of a Roth, you’ll want to avoid some of the missteps that tend to trip up investors. Here are six common ones.
1. Avoiding a Roth Since You Have a 401(k)
The original goal of the IRA was to provide an investment vehicle for Americans who didn’t have a retirement plan through their employer. But there’s nothing in the regulations preventing you from using both.
In fact, financial planners often suggest funding a Roth IRA once you’ve maxed out the employer’s contribution to your 401(k) – provided you’re getting a match of some sort. At that point, Roth IRAs often have clear upsides, like more investment options and greater tax flexibility in retirement.
For 2017, you can contribute $5,500 a year to a Roth, or $6,500 if you’re age 50 or older. What you put into your 401(k) doesn’t diminish that amount.
2. Not Contributing for Your Spouse
In most cases, you can’t contribute more than you’ve earned in a given year. But there’s an important exception for non-working spouses.
A spousal IRA allows them to have an account much like their working spouse. As long as you’re married and file a joint tax return, your spouse is eligible to participate. As a couple, that extra $5,500 – or $6,500, if your spouse qualifies for the catch-up provision – can significantly increase your tax benefit over time.
3. Contributing Too Much
The annual contribution limit applies to the total amount you invest in Roth IRAs, even if you have more than one. If you go over the cap, you’ll be hit with a 6 percent penalty each year on any excess funds that you contribute. Ouch!
There’s hope if you catch the mistake early enough, however. You can avoid the penalty if you discover the excess contribution before filing your taxes and pull the appropriate amount from your account. Or, you can carry the extra contribution over to another tax year, as long as you notify the IRS.
4. Doing Too Many Rollovers
It used to be that you could perform an IRA rollover only once in a calendar year, but that changed in 2015. Now, the government restricts you from doing more than one rollover in a 365-day period – even if they occur in two different years.
It’s a rule you’ll want to pay attention to because too many rollovers can mean a loss of your IRA. There are some exceptions, as is the case with 60-day rollovers from a Traditional IRA into a Roth IRA. So if you’re hoping to do a second rollover, you might want to do a little research first.
The 365-day rule does not apply to the direct transfer of funds between two IRA trustees, which the IRS does not consider a rollover.
5. Pulling the Money Out Early
In order to enjoy tax-free withdrawals, a Roth IRA owner has to be 59½ years of age and have owned the account for at least five years. If you pull the money out before those two milestones, you could face some pretty negative consequences.
While you can withdraw up to the amount you contributed without incurring additional taxes – it was made with after-tax dollars, after all – you may have to pay income taxes and a 10 percent penalty on any earnings you accrue in the meantime (if you withdraw them too).
In some limited cases, you can avoid the early withdrawal penalty (although not the applicable taxes). You can, for example, pull money out to cover the costs of certain education expenses or to pay for a first-time home purchase. Follow the rules carefully if you want to take advantage of these exceptions.
6. Forgetting the Beneficiary List
All too often, Roth IRA owners forget to list primary and contingent beneficiaries for their account – and that can be a huge mistake. It’s likely that money in the account will be made payable to the IRA owner’s estate, which means it goes through probate. Translation: more complications and bigger attorney fees.
Once you name a beneficiary, make sure to update your paperwork if you want to make any changes. That’s especially true if you and your spouse part ways. A divorce decree by itself won’t prevent a former spouse from getting the assets if he or she is still listed as a beneficiary.