Roth IRAs are one of the many great investment tools out there. Several financial experts out there consider a Roth IRA to be the best investment tool that anyone can use. It’s taxed-advantaged in a different way than a traditional IRA and due to its tax advantages, many consider it to be the best type of retirement account.
Roth IRAs sound great and because so many people out there recommend Roth IRAs as the best investment tool that anyone can have, we often forget about the rules that apply to these accounts despite their tax advantages.
Rules that although some are not written, following them would be of a great benefit to us as individuals and would help us know which mistakes to avoid with a Roth IRA.
Below I’ll be going over 7 different mistakes to avoid with a Roth IRA that could end up costing you thousands and more often than not, MILLIONS of dollars in the long-run.
Let’s get on with it…
Mistake #1: Skipping a Roth IRA because you already have a 401k
401ks are a great investment tool, and if your employer offers a match, you’re basically getting free money. 401ks can be a very lucrative investment tool but due to some of these account’s high ROIs people often believe that’s all that they need.
Or maybe people are simply not aware that this doesn’t have to be their only investment tool. By opening a Roth IRA account while also having a 401k you maximize the number of returns you can have during the age of retirement.
No law prevents you from opening both, a 401k and a Roth IRA. In fact, several financial professionals often suggest that you invest within a Roth IRA once you’ve reached the match limit on your 401k (if your employer offers a match).
As said before, by having both of these accounts open you immediately open up more opportunities for you to reach your retirement goals faster, or, surpass the original goal that you had.
Mistake #2: Keeping Cash in a Roth IRA
Roth IRAs are investment tools!
Having large sums of cash within a Roth IRA is a complete waste of space in your account because you only have a $6k max per year (2020 tax year).
The lump sum of money should be going into investments like stocks, ETFs, Index Funds, Mutual Funds, and other valuable investments that can bring a high return. Having cash lying around in your Roth IRA defeats its purpose.
And I know some people out there might be thinking right now: “well, my cash is earning interest for me because it’s saved in a CD and the other portion is saved in a Money Market Account”.
Keeping your money in “investments” like these is almost the same as leaving your money as cash.
CD’s, Money Markets, High Yield Savings accounts are all examples of what you should be avoiding when you’re putting money into a Roth IRA, especially if you’re young. You can be using these vehicles outside of a retirement account, but it’s really only wasting space in a retirement account when these are your main vehicles.
As a young person, you have so much time to recover from the volatility of riskier investments.
If the market declines and you’re 20 years old, this is a perfect time to buy more of those investments because they’re at a discount and you have several of years to recover from the bear markets!
You shouldn’t be trying to avoid risky investments when you still have 20+ years ahead of you to recover from an economic downturn. That being said, you should do your in-depth research on specific investments prior to making any official investment decision to take a well-calculated risk.
Mistake #3: Making Early Withdrawals
Roth IRAs have a very particular perk that people like to commonly take advantage of… this perk is: you can make withdrawals on the money you’ve contributed to the account completely tax and penalty-free. Even if you’re under the age of 59.5.
But pay close attention to what I said, you can withdraw money tax and penalty-free from contributed funds. This means that if you invest $4,000 into your account and it makes a 100% return, you now have $8,000 total in your account. $4,000 is from your contributions and $4,000 from the return your investments have made.
From these $8,000, you can only withdraw the amount you’ve contributed, which is only $4,000 tax and penalty-free if you’re under the age of 59.5. The other $4,000 which is only what your investments have made within the account will be penalized at 10% if withdrawn before the age of 59.5.
Due to this advantage of Roth IRAs, people often like to use their contributed funds for emergencies when they arise. They think: “well it’s tax and penalty-free and I really need the money right now, so this is a perfect time to withdraw it”. This is wrong!
Roth IRAs are intended to be for retirement. By withdrawing funds from the account you completely miss out on the high tax-free returns that those investments can bring. In the long-run, these returns could certainly add up to millions of dollars!
Millions of dollars that you’ve completely missed out on because you made this early withdrawal on the account.
This is why you should always have a fully funded Emergency Fund before making any investments. Should an emergency arise, you now have that emergency fund to take care of you and you allow the contributions in your Roth IRA to stay within it so that their growth can be fully maximized.
Mistake #4: Contributing more than the limited Amount
You can have more than one retirement account opened at a time. Whether it’s more than one Roth IRA account or a Roth IRA and a Traditional IRA opened at the same time…
However, don’t let this throw you off when it comes to the contribution limit. You have a limited amount of $6,000 to contribute to your accounts in total. This means that if, for example, you have two separate Roth IRA accounts opened, you can’t contribute $6,000 to one and $6,000 to the other.
The total has to come to $6,000. This could be $3,000 in one account and $3,000 in the other, or $4,000 in one and $2,000 in the other. Whatever the variation is, don’t let the total of your contributions for both add up to more than $6,000.
If you do and you file your taxes while being above the contribution limit, the excess cash is penalized at 6%.
So be cautious to not contribute more than $6,000 total, but if it happens by accident you can avoid the penalty if you discover the mistake before filing your tax returns. You can take the excess contributions, plus any earnings on it out of the account without a penalty as long as you catch it on time.
Mistake #5: “Investing” in Penny Stocks
I always emphasize this in several articles on this website. Investments are calculated risks that assure the safety of principal and an adequate return after thorough analysis. Stock investments are for the long term, not the short term.
If you’re not familiar with penny stocks, they are common shares of small public companies that trade for less than one dollar per share. People like to take “short-cuts” and buy $1,000+ in penny stocks in the hopes that the value of that purchase grows from a few cents per share to several dollars per share.
I can confidently tell you that 95% of the time that you try this, you are going to lose your money. If you lose money in a Roth IRA there’s no “restart” button”, you’ve lost the money.
In a Roth IRA, you should go for long-term stable investments in which you take a reasonable amount of calculated risk. I’ve personally never liked penny stocks, but if you really want to make these purchases, do it outside of a Roth IRA. You’ll be grateful you did later in life.
Buying penny stocks is equivalent to buying a lottery ticket. Your chances of losing are very high and there’s no reason to take that level of risk into your Roth IRA where you only have a very limited amount of funds that you’re allowed to contribute.
Mistake #6: Investing in Short-Term Bonds
As I’ve said multiple times throughout this article, Roth IRAs are for the long-term. Since they’re meant for the long term, they are usually meant for more volatile investments like stocks, index funds that follow a stock market, or mutual funds that hold stocks.
If you don’t want to be too risky with your money and don’t mind a possible lower return, that’s fine. You can minimize the amount of volatility by placing a higher proportion of your money into bonds… but don’t make these short-term bonds. Though short-term bonds offer lower risk than long-term bonds, their yields are very low in comparison.
Since short term bonds pay very low interest. Placing tax-free money into a short-term bond deteriorates the value that tax-freedom that a Roth brings.
Compared to a mutual fund or index fund that focuses on stocks or even long-term bonds, short-term bonds basically don’t give you anything. By having a very low rate of return with short-term bonds, you’re not taking advantage of compound interest to its full extent.
This is similar to putting your money in a CD or a high yield savings account within a Roth IRA. It’s fine if you want to do that, but it’ll be better to put your money in these securities outside of a Roth IRA so that you can maximize the value of the money going into your Roth IRA and take full advantage of compound interest.
On a side note, don’t make investments within a Roth IRA that are tax-deferred, for example, annuities. You aren’t going to get “double tax benefits” by doing this. Take advantage of tax-deferred investments but do it outside of a tax-advantaged account.
Mistake #7: Waiting to invest within a Roth because you “have time”
Let me make this crystal clear: it is NEVER too soon to start contributing to your Roth IRA. The sooner you start, the better.
You might be 18 years old right now and think it will be better to wait it off until later so you can enjoy the moment now.
If you do this, by the time you hit your 40s or 50s you will be playing the catch-up game and regret not starting early. If you put it off for later now, you’re going to continue to do that until it becomes an emotional priority.
By starting now, you not only get to take advantage of making more volatile investments and having a higher return, but you also have a lot more time to take advantage of compound interest!
And since you’re young, you don’t necessarily have to max out your contribution amount if you can’t afford it right now. Since you have several years to contribute to the account, you won’t be rushed to try to max it out every year.
That being said, if you have important short-term goals that you need to take care of first, make those a priority, but try your hardest to start investing within a Roth IRA account as soon as possible. The earlier the better.
Several people think “I’m probably not even going to be alive by the time I would hit 60” but I’ll let you in on a very important fact. Life expectancy in America is increasing as technology and medicine advances. There’s a very high chance that you’re going to live for a while and probably going to outlive your parents and grandparents in terms of the number of years in the long run.
Once you hit that age, you’re going to regret not having anything to rely on for retirement and you’ll probably have to play the catch-up game and it’s not a fun game to play.
These mistakes aren’t listed in any specific order of importance. They are all equally important and should be avoided so that you can maximize your return on your contributions.
Even if you’re someone who plans on retiring early, having this by the time you’re 60 years old will certainly be a benefit to you because by that point it’ll be extra money; and since it’s tax-free, it won’t count as part of your taxable income by the time you hit your 60s.
With all this being said, it’s important to consult with a financial advisor to help you look for specific investments that you can make within the Roth IRA but you must make sure that your advisor has your best interest and is not looking to fill his/her pockets with fat commissions by selling you certain investments.
Though not all financial advisors who get paid by commission are “scandalous” it’s important to be careful that they aren’t trying to sell you things like an insurance policy on your Roth IRA when you don’t even make enough yet to max out all your retirement accounts like a 401k with a match along with a Roth IRA.
Advisors also charge fees so make sure that those fees are going toward them so that they do something that you wouldn’t be able to do. Don’t get an advisor to do something that you can easily do yourself and have them charge you a fee for it.
Financial advisors are a great resource and can be an amazing help. But you have to double down on making sure that they have your best interest at hand and not trying to fatten their pockets.
With all this said, stay away from these mistakes and watch your money grow into the millions by the time you hit your 60s. You’ll be happy that you stuck with it for the long term.
If you have any questions at all on anything I’ve said or think I’ve missed a mistake that you might’ve done, please comment down below and let me know! I’ll be more than happy to reply to each one of you.