A Roth IRA (individual retirement account) is a retirement investment vehicle into which workers contribute after-tax dollars. Since workers have already paid taxes on their income, their earnings grow tax-free. They can also withdraw the money without paying additional taxes.
However, a common Roth IRA mistake is having insufficient earned income to put into an IRA. Earned money includes commissions, bonuses, and self-employment income. Workers cannot deposit any income they did not actively earn into a Roth IRA account, such as rental income from a property they're not managing.
Over-contribution is also possible. Exceeding the limit—$146,000 to $160,000 for individuals and $230,000 and $240,000 for couples—attracts a 6 percent penalty on an account. Over-contribution may happen when workers hold more than one IRA. An unexpected rise in income can also lead to it.
One way to rectify the mistake is to catch it before filing tax returns and withdraw the excess contributions plus any resulting earnings. Another option is to roll over the excess contribution to the next tax year.
Speaking of rolling, converting a previous employer's contributions into a Roth IRA is possible. However, any rollover after the 60-day rollover grace period is taxable. Likewise, more than one rollover within 365 days attracts a tax. Exceptions exist, such as converting a traditional IRA (contributions made with pre-tax dollars) into a Roth IRA.
Two types of rollovers are direct and indirect. In a direct rollover, the money is transferred from one account to another automatically or via a check in the name of the Roth IRA. In an indirect rollover, account holders withdraw the money from the old account and put it in the Roth IRA. One of the most common mistakes workers make is missing the 60-day rollover window after using the money elsewhere.
Account holders can withdraw from a Roth IRA at any time and age since they contribute with after-tax dollars. It's only a problem if they withdraw before age 59 and a half or before they've held the account for at least five years. Early withdrawals attract a 10-percent penalty on earnings withdrawn, not to mention income tax.
The only exception to the 10-percent penalty rule is when the account holder withdraws to cover education expenses or a first-time home purchase. They'll, however, still pay the ordinary income tax.
Another Roth IRA mistake is not naming a beneficiary. Failure to name a beneficiary means that the court may become involved after the account holder dies, a process called probate. Probate costs money, delays, and complications, and the court may not distribute the funds as the account holder wishes.
Another common mistake is not withdrawing from an inherited Roth IRA. Beneficiaries must empty a Roth IRA within 10 years of the account holder's death. Spouses are exempt from this rule. After year 10, withdrawals are subject to a 25-percent penalty.
Some Roth IRA mistakes, like not taking advantage of a spousal IRA to contribute to a non-wage-earning spouse, only deny individuals a chance to maximize their retirement savings. However, the mistakes can be costly. Hiring a financial planner experienced in retirement planning can help one navigate the tax and penalty traps associated with Roth IRAs.
