5 Costly Roth IRA Mistakes
Hey everyone, Henry here at Disruptive Money Management, and today we’re going to be talking about the five most costly mistakes you can make with your Roth IRA.
That’s right; the Roth IRA is often touted as the single most powerful vehicle available when it comes to investing for retirement. And that is with good reason. Currently, the Roth IRA is the only full investment vehicle that allows an individual investor to invest for retirement, and upon retirement, withdraw money TAX-FREE. That’s right, folks… tax-FREE. Now, I don’t know about you, but every year the tax man cometh, and every year my wife and I drown ourselves in a bottle of wine after having met with our CPA to file our taxes. So, to be able to have a retirement vehicle for TAX-FREE withdrawals in retirement...it’s a no-brainer.
Supercharge your path to financial freedom with a Roth IRA.
So, two things I want to start with very early on are eligibility requirements and terminology.
First off, to open a Roth IRA, you must be age 18 or over, and to fund the Roth IRA, you must have eligible earned income. That means you ought to be a W-2 employee or a 1099-independent contractor and filing a tax return. Cash coming from under the table without any pay stubs and tax returns will not work. Now, I know you’re like, “Duhhh Henry, who doesn’t file taxes?” But you’ll be surprised. I grew up in the heart of San Francisco, and being Chinese American; I was extremely embedded into the local Chinese community there. There are so many that were paid under the table, and all they were able to do were just really deposit it into bank savings account because they didn’t have the opportunity to invest in qualified instruments.
Secondly, the Roth IRA is just an underlying investment VEHICLE. Not an investment but an investment vehicle. I often hear people asking, “Hey, what’s your Roth IRA return?” The Roth IRA doesn’t generate any returns, the investments within it do. Think of the Roth IRA just as a basket and that basket holds stocks, bonds, ETFs, and mutual funds. Also, keep in mind that the I in Roth IRA stands for individual. These accounts are all tied to specific social security numbers, so for joint households, you can do two of these-one for you and your spouse or significant other.
Costly Mistake #1
Not investing and just sitting in cash.
I’m going to preface that this is an all too common mistake. Sitting in cash happened to a client of mine a few years back. At the time, I was already managing the bulk of his retirement assets and making sure he was sticking to his financial plan. The start-up Roth IRA was just a small portion of his nest egg, so we decided to have my client try investing on his own. Quite frankly, there’s no better way to learn unless you’re doing it yourself, right? So off he went to establish his account at Charles Schwab and fund the account.
So fast forward a year later to our annual review, and after having gone through our managed assets, I asked about his Roth and how it was performing. He looked pretty crestfallen and said with disappointment that it wasn’t doing that great. In comparison to what everything else was doing, his Roth IRA was struggling and seemingly hadn’t made anything.
I was in shock. S&P 500 as a whole had double-digit returns that years, so I was very concerned that while he had opened and funded his Roth IRA, he may not have gone in and bought any securities. I relayed my concerns and asked for a statement to review. Sure enough, when the statement arrived, his account held approximately $7,000 and change in the money market.
Leaving funds in your Roth IRA within a money market may be safe but the lack of growth may hamper its growth relative to inflation.
So, mistake number one is not investing the money. Having a Roth IRA is not an investment, you still need to provide the custodian (which is the place where you have the Roth IRA account at) the direction on how to have it invested. It could be as simple as picking an S&P 500 index fund or buying stocks, but whatever it is, you have to initiate that transaction. Generally speaking, you have to tell them how to invest the cash you have already deposited. More importantly, if you’re making automatic deposits every month into the account, to tell them how to invest those monthly contributions or else they’ll sit there in cash.
Another consideration with mistake number one is investing your Roth IRA directly with depository bank branches and credit unions. Roth IRAs opened at a traditional brick and mortar bank or credit union typically only provides money market assets or CDs. These are no good for retirement investing because the bank rates are much too low! Bank CD and money market rates are just like keeping it in cash. So make sure that if you’ve opened a Roth IRA at a local branch office and if you did not meet with a licensed investment advisor who talked to you about how to invest and what those investments hold, you’re probably in a bank CD.
Bank CDs within a Roth IRA may seem safe and secure but the low interest rates can barely keep up with the cost of living adjustments.
You know, one of the things I hate most about mistake number one is how catastrophic it can be. Far too many times, I have met with individuals who have left their accounts in cash or bank CDs because they were misguided into thinking they just needed a Roth IRA or any retirement account. And listen, I get it, time passes, and you forget, but I have too many horrific experiences with people just sitting in those products for years on end.
Costly Mistake #2
The number two most costly Roth IRA mistake is investing in bonds and extremely conservative government assets like treasuries. Before I jump into this, I ought to put it out there that there is nothing wrong with going to cash or going into government securities if you’re objective is to limit downside risk exposure. Early on this year in February and March, moving to cash or government securities to limit extreme downside volatility is smart, but staying in conservative investments like bonds for the long-term, especially in a Roth IRA, is not.
The Roth IRA is a retirement vehicle, and more importantly, it has the advantages of not having RMDs (Required minimum distributions), which means you don’t need to take withdrawals at age 72. Again, this is why it is one of the most potent retirement accounts you can have.
FYI, if you haven’t checked out my comparison on the Traditional IRA versus the Roth IRA, please check it out for a more in-depth guide on Roth IRA strategies.
Because of the much longer amount of time that you can invest in a Roth IRA without forced withdrawals, you can take a more growth-oriented approach to invest. This approach allows you to take a higher level of risk to maximize your return potential. Again, shy away from the bonds and stick with growth-oriented equities in your Roth IRA.
Just to give you an example of hypothetical growth, if you were to invest $6000 into your Roth IRA in growth equities with an annualized return of only 6% over ten years, you would have an account balance of $79,800. If you contrast that with a bond portfolio of 3%, you’ll have an account balance of $68,900 during that same period. That is a difference of $10,900 that you’re missing out on by being too conservative!
Costly Mistake #3
The third most costly mistake is on the other side of the spectrum which is investing in penny stocks.
Penny stocks are what I consider the high risk with low to no reward. Penny stocks, for those needing a refresher, are stocks that are traded under five bucks, with most of the penny stocks trading for under a dollar. Penny stocks have this allure that you can buy a bunch of penny stocks, and when they increase in value, you’ll instantaneously be rich because of the sheer volume of shares that you are holding.
And it’s easy to become misguided when it comes to penny stocks. People that pitch penny stocks will often talk about it being the next big thing in pharmaceuticals or the next big tech company that is unknown now but will become a significant player shortly. They’ll offer up penny stocks because it’s easier to buy more of it with your money. They’ll compare that with a $1,000, you could probably only buy a few shares of Apple or a partial percentage of Google, but with penny stocks, you can have over a thousand shares for the same cost, and when that penny stock soars, you’ll be making bank!
Well, let me let you in on something… they don’t work! Penny stocks are considered pennies for a reason. The companies they represent are typically smaller companies that are banking on one product or one scientific breakthrough. The lack of transparency and fundamental strength of the underlying company is what makes these investments a VERY BAD idea!
Costly Mistake #4
The fourth most costly Roth IRA mistake is thinking that you cannot contribute because you are over the income threshold. You can contribute up to $6,000 if you’re under age 50 and an additional $1,000 if you’re age 50 and above. The Roth IRAs have an income knock-out provision. The IRS states that if you, in the year 2020, make more than $124,000 as a single-filer or over $196,000 as a joint household, you are ineligible to contribute the maximum to a Roth IRA if your income is above $139,000 as a single-filer or $206,000 joint then you cannot contribute AT ALL.
And they would be right, but if you are in that category fret not because the IRS has a tax loophole that allows for an indirect contribution to the Roth IRA for all you high-income earners out there.
The Backdoor Roth IRA is a way for high income-earners to sidestep the income limits so that they can contribute to this tax-free account. I am a big fan of this strategy and use it for many of my clients who are above the income limits.
I’ll have a separate segment that explains the backdoor Roth in detail, along with some pointers on how to do it correctly and as cost-effective as possible.
However, the short version of the Backdoor Roth is putting after-tax money into a Traditional IRA without taking the deductions and then converting the Traditional IRA balance over to a Roth IRA account. In essence, you need both a Traditional IRA and a Roth IRA to do this, and ideally, you would not want to do this at a mutual fund company to reduce cost. Again, more in-depth segment Backdoor Roth IRA explained, check it out!
Costly Mistake #5
The fifth most costly Roth IRA mistake is using the money early and not for retirement. I started this segment by calling the Roth IRA the single most potent investment vehicle you can have because of the tax-free withdrawals. The Roth IRA allows you to withdraw your contribution money at any time without being subject to penalties. The growth or earnings is tied to age 59-½ and a 5-year rule to bypass tax penalties.
Let me explain this in two parts: contributions and earnings. The earnings are simple enough to understand. If I contribute $6,000 to my Roth IRA and let’s say one year later that Roth IRA account balance is at $$6,500. I can, without penalties, withdraw my $6,000, which is considered principal without facing any tax penalties. So, again, money deposited by me has no penalties for withdrawals. It doesn’t matter if you’re 25, 35, 45, whatever. No penalties.
The investment earnings, however, are subject to withdrawal rules. So using the above example, the $500 in investment earnings must be held until age 59-½, and the account must have been opened for at least five years before there are no penalties. Withdraws before meeting those two conditions are subject to taxes and penalties.
There are exceptions to this such as:
buying your first home, you can use up to $10,000 for that,
Qualified higher education, otherwise known as college expenses, for yourself and your direct family or,
Unreimbursed medical expenses
So, going back to withdrawal rules. Keep in mind the 5-year rule needs to be in place in addition to the age 59-½ rule. I get this all the time from clients nearing retirement. They’ll start funding a Roth IRA in the final years of employment and then try to turn around and start withdrawing from it immediately in retirement. They assume that because they are over age 59-½, they won’t have any penalties, but if that 5-year rule has not been met, you’ll be paying penalties for it.
Just to re-iterate if you’re under age 59-½ and you withdraw that $500 in earnings, you’ll be paying both ordinary income taxes and an additional 10% penalty on that $500.
If you’re over age 59-½, but your Roth IRA is not at least five years old, any income you take will be subject to a 10% penalty. That means if you funded a Roth IRA at age 58, you could not withdraw the investment earnings until five years later!
I know this can get a little bit confusing, which is why I recommend you speak to your CPA before initiating any withdrawals. Taking withdrawals from a Roth IRA too early will just hurt your retirement plan. I have seen so many instances where people were sold on a Roth IRA because of the tax-free portion, and their financial advisor told them they could withdraw the money at any time. Worst yet, some have even been described to consider the Roth IRA as a better form of a savings account because you can invest in it. And then, suddenly, an emergency comes, and they need to withdraw from the Roth IRA, thereby effectively destroying their financial plan. Like I said in my previous episode, I highly encourage you to think of this account as out-of-sight and out-of-mind when it comes to withdrawals. Don’t go starting the Roth IRA until you have your debt paid off, and your emergency fund stashed away.
And that’s it for today, my dear listeners. The Roth IRA is the single most potent investment vehicle you can have, and if you avoid these five costly mistakes, you are well on your way to financial independence. Until next time, stay healthy, stay safe, and invest wisely.