Considering getting a Roth IRA for the first time? Anyone with earned income can start contributing to a Roth IRA. Even minors can start compounding their money tax-free from an early age through a custodial Roth IRA. However, a Roth IRA is a retirement account, meaning you’re putting money in an account that ideally should only be taken out years or decades in the future when you reach retirement. If you try to withdraw early, there could be penalties.
If you’re trying to decide whether to start contributing to a Roth IRA, or are wondering what its advantages and disadvantages are compared with other retirement plan options, here’s everything you need to know.
Roth IRA pros and cons overview
|Roth IRA Pros||Roth IRA Cons|
|No capital gains tax on any investment profits. All earnings can get reinvested.||You must use after-tax income to put money into your account. This is the tradeoff you make in exchange for tax-free withdrawals in retirement.|
|Withdrawals in retirement are completely tax-free no matter how large your investments have grown.||A Roth IRA has a lower contribution limit than most retirement plans.|
|Withdraw contributions only at any age without penalties or taxes.||Roth IRA income limits restrict high income earners from making contributions.|
|No RMD means you can keep your money compounding longer, as long as you’re alive.||Withdrawing earnings from your Roth IRA has a 5-year rule. In addition to being over the age of 59½, your Roth IRA must also be at least 5 years old.|
|Leave tax-free money to your heirs. Your beneficiaries can withdraw from an inherited IRA tax-free and they’ll have 10 years to withdraw the entire amount.||You don’t get any tax breaks when you contribute to a Roth IRA.|
|If your income exceeds the Roth IRA income limits, the backdoor Roth IRA is an easy workaround.|
|Because withdrawals are tax-free, it acts as a hedge against future tax hikes. You can also withdraw without owing hefty taxes if you’re in a high tax bracket in retirement.|
|A Roth IRA is more accessible than other retirement plans since anyone with earned income can contribute.|
8 Advantages of a Roth IRA
1. Tax-free compounding
There are no capital gains tax on any profits you make from your investments. 100% of the profits go straight back into your Roth IRA where it can be reinvested, allowing your money to grow faster. This tax benefit isn’t unique to the Roth IRA as most popular retirement accounts offer it as well.
2. Tax-free withdrawals
The biggest benefit of a Roth IRA is that withdrawals in retirement are completely tax-free no matter how large your investment gains. For example, Peter Thiel invested in PayPal using his Roth IRA using just a little over $2,000. Overtime, his Roth IRA grew to a balance of over $5 billion. Because the funds were in a Roth IRA, the entire amount can be withdrawn with zero taxes owed to the IRS.
3. Ability to withdraw your contributions
You can withdraw only your contributions made into your Roth IRA at any age without penalties or taxes. For example, if you contributed $20,000 to your Roth IRA over the years and your assets have grown to a value of $200,000, you could withdraw the $20,000 in contributions tax-free at any time.
4. No RMD rules
Most retirement plans have required minimum distributions (RMD). Starting at the age of 73, you’re required to start taking distributions from your retirement plan each year until the account is emptied. A Roth IRA has no RMD, meaning you can keep compounding your money tax-free while you’re still alive.
5. Leave tax-free money to your heirs
A Roth IRA is one of the best vehicles to pass money after you pass because the tax benefits carry over. Once your beneficiaries inherit your Roth IRA, they can withdraw contributions at any age without taxes or penalties, and can withdraw earnings from the account as long as the Roth IRA was established at least 5 years ago. The Roth IRA is allowed to keep compounding tax-free, but the entire amount of the IRA must be withdrawn within 10 years.
6. Ability to do backdoor Roth conversions
One of the disadvantages that we’ll get to in a minute is income limits of a Roth IRA. If you make too high of an income, you cannot make contributions to a Roth IRA for that tax year. However, one of the pros of a Roth IRA is that there’s a really simple workaround to this restriction called a backdoor Roth IRA.
If you make too much money and are restricted from making Roth IRA contributions, you can contribute to a traditional IRA instead, and then immediately convert the funds into your Roth IRA. Since the income limit only applies to contributions, and not rollovers, this is a legal workaround that many people take advantage of each year.
7. Protected from future tax hikes
Since a Roth IRA can be withdrawn completely tax-free in retirement, you’re protected against future hikes of tax rates from the IRS, or from being in a high tax bracket. Withdrawals from other pre-tax retirement accounts (like a traditional IRA) are taxed as ordinary income based on your tax bracket and tax rates at the time of withdrawal. Roth IRA distributions are not taxed as regular income so you don’t need to worry about your tax bracket or tax rates when you want to take qualified distributions from your account.
8. Anyone with earned income is eligible
Many retirement plans have stricter eligibility requirements to open an account and make contributions. For example, a solo 401k can only be opened by business owners and self-employed people with no employees. A 401k requires that you work for an employer that offers a plan for their employees. A Roth IRA can be opened by anyone with earned income at any age. Even children can start contributing to their accounts from an early age through a custodial Roth IRA.
Also read: How Does a Roth IRA Grow Over Time?
4 Disadvantages of a Roth IRA
1. Required to pay taxes upfront
With a traditional IRA, you make contributions with pre-tax income and receive a tax deduction in the amount of your contribution. The downside of a Roth IRA is that you don’t get any tax deductions on your contributions since contributions are made with after-tax income.
For example, let’s pretend you made $50,000 in income this year and want to contribute $5,000.
- With a traditional IRA, the $5,000 contribution would get deducted from your taxable income and you would only have to pay income tax on $45,000 in income. Withdrawals in retirement are taxed as regular income.
- With a Roth IRA, there is no tax deduction. You pay income tax on the $50,000 and make contributions with after-tax income. Withdrawals in retirement are tax-free.
2. Low contribution limit
A Roth IRA has a low contribution limit compared to other retirement plans. For 2023, you can only contribute up to $6,500 if you’re under 50 years of age, and up to $7,500 if you’re 50 years of age or older. In comparison, a 401k has a contribution of $22,500 ($30,000 if age 50+) and a solo 401k has a contribution limit of $66,000 ($73,500 if age 50+).
3. Income limits
While anyone with earned income can contribute to a Roth IRA, income limits restrict high income earners from making contributions.
For 2023, your income must be under $138,000 in order to contribute the maximum amount. If your income is higher than $138,000 but less than $153,000, you can still make contributions, but your limit gets reduced. If you make over $153,000, you cannot contribute at all.
- If your income is $138,000 or less, you can contribute up to the maximum Roth IRA contribution limit of $6,500 ($7,500 if age 50+).
- If your income is over $138,000 but less than $153,000, your contribution limit gets reduced.
- If your income is over $153,000, you cannot contribute at all.
As mentioned earlier, you can still do a backdoor Roth IRA conversion if your income is too high to contribute for the tax year.
4. There is a 5-year rule for withdrawals of earnings
With most retirement accounts, you can start taking qualified distributions once you reach the age of 59½. Any withdrawals before the age of 59½ are considered early distributions and will be hit with a 10% penalty plus income taxes.
A Roth IRA has an additional withdrawal rule for earnings. While you can withdraw contributions from your Roth IRA at any age without penalties or taxes, withdrawing earnings requires that you’re at least 59½ years of age PLUS your Roth IRA must be at least 5 years old. This is known as the 5-year rule and is a requirement for Roth retirement accounts.
Even if you’re over the age of 59½, if your Roth IRA is not at least 5 years old, you cannot take qualified distributions of earnings without a 10% penalty.
Also read: Benefits & Tax Advantages Of A Roth IRA