What Are the Risks of a Roth IRA?

And how do you avoid them?

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Roth IRAs provide a popular tool for investing for retirement. One of their greatest benefits is tax-free growth on your investments. You can take advantage of tax-free compound growth indefinitely, including that from dividends, interest payments, and capital gains. You won't have to pay taxes on these gains when you withdraw funds in retirement.

But Roth IRAs are not necessarily for everyone. You could end up with a smaller nest egg than you’d like in retirement if you don’t use a Roth correctly. Here are some risks to using Roth IRAs and how you can minimize them.

Key Takeaways

  • Roth IRA contributions are made with post-tax money.
  • There's no tax on qualified distributions, such as those made in your retirement years.
  • You’ll face a tax and a 10% penalty on your earnings if you make nonqualified distributions, such as taking withdraws before your retirement age,
  • Traditional IRAs and employer-sponsored plans such as 401(k)s are alternatives to Roth IRAs and may be better retirement account choices for some people.

What Is a Roth IRA?

A Roth individual retirement account (IRA) is a qualified retirement account in which your investments can grow. They won’t be taxed when you withdraw them in retirement.

Unlike with a traditional IRA, the contributions to a Roth IRA are taxed before you contribute. With a traditional IRA, your contributions are tax deductible.

How a Roth IRA Works

You can contribute up to $6,000 of post-tax income, or $7,000 if you are over age 50, in 2022. The Internal Revenue Service (IRS) often changes this limit to keep pace with inflation and it increases to $6,500 and $7,500 respectively in 2023. You can then make withdrawals tax free in retirement, including your earnings.

Note

Contributions to a Roth IRA can be withdrawn at any time with no penalties. But investment earnings can only be withdrawn if you’ve reached the IRS retirement age of 59½ or if you’re buying your first residence, have a certain level of medical expenses to pay, or are disabled.

You'll face a 10% tax penalty if you withdraw your earnings before your retirement age or without meeting one of the special requirements.

The Risks of Roth IRA Investing

Investing in a Roth IRA does have its risks. Let’s take a closer look at some of the more potential problems with using this type of retirement account.

Choosing the Wrong Investments

A Roth IRA is essentially a brokerage account with tax benefits. It isn’t like a savings account at a bank, where interest is automatically paid on your deposits.

You choose your investments with an IRA, so there's a risk that you could choose investments that don't perform well or don't align with your investing goals. You could even suffer financial losses.

Note

You can use specific investment strategies to reduce your risk. You can increase diversification to spread risk and reduce the chance that any one stock’s losses would significantly affect your portfolio.

You could increase your exposure to fixed-income investments as you near retirement age to prioritize protecting your principal over achieving aggressive growth.

Incurring Penalties

Penalties are another risk to using a Roth IRA. Penalties can reduce your gains if you don’t use these retirement accounts according to IRS rules.

For example, you'll face a 10% penalty if you withdraw investment earnings before they're qualified distributions, such as when you turn 59½. Additionally, your investment earnings can’t be withdrawn until five years after your first contribution to the account. even if the earnings would otherwise be qualified because you're older than age 59½ or you're disabled.

Roth IRAs also have income limits. You can only contribute to a Roth IRA for the 2022 tax year if you have taxable income and you make less than $214,000 if you’re married and filing jointly, or $144,000 if you’re single, head of household, or married and filing separately and you haven’t lived with your spouse at any time during the year. These income limits increase to $228,000 and $153,000 respectively in 2023.

You can incur a 6% tax penalty each year until you correct the error if you contribute when you're not qualified to do so, or if you contribute more than the IRS limit.

You May Not Live Long Enough

The tax advantages of Roth IRA funds, namely the tax-free withdrawals on earnings, are generally not available until you reach age 59½. You'll pay taxes on money without ever getting the tax benefit if you pass away before that age.

Note

Your beneficiaries can still receive tax benefits on the money. They can inherit a Roth in several ways depending on their relationship to you, including taking a lump-sum distribution and establishing a new IRA then transferring the assets.

Not Having Other Investments

The maximum Roth IRA contributions are between $6,500 and $7,500 as of 2023, depending on your age. You still may not have enough saved for your retirement if you max out a Roth each year and make no other investments.

Other investments can help you meet your financial goals in retirement in addition to a Roth:

  • Buying a home or investing in real estate
  • Contributing to an employer-sponsored plan such as a 401(k)
  • Investing additional funds in a brokerage account

Roth IRAs also carry an opportunity cost risk. Your contributions can be withdrawn at any time, but not your investment earnings. Your account will include investment earnings if you invest well. The opportunity risk is that those earnings can’t be put to other uses without paying a penalty while they're in your Roth IRA account, such as for investments in private businesses or complex real estate transactions.

Note

Your investment choices within a Roth IRA are important to helping you maximize gains. Holding more high-growth investments in a Roth and more conservative investments in a taxable account can potentially help you reduce your total tax liability.

“Since growth in a Roth is tax free, you generally want to hold your most aggressive assets there,” Matt Bacon, a financial advisor with Carmichael Hill, told The Balance via email. “Think growth equities here...You want your Roth in overdrive mode.”

Alternatives to a Roth IRA

Roth IRAs are just one type of retirement investing account. Employer-sponsored 401(k) plans and traditional IRAs are other options.

401(k) Plans

401(k) plans are defined contribution retirement plans sponsored by employers. They have mostly replaced defined benefit (pension) plans. You contribute pretax earnings to a 401(k) that are deducted from your paycheck automatically, and your employer may match all or a portion of the funds.

You’ll typically want to try to contribute to a 401(k) at least up to their limit if your employer offers matching funds so you’re not leaving this "free money" on the table. You can also contribute to a 401(k) plan if you earn too much money to qualify to contribute to an IRA.

Traditional IRA

Traditional IRAs are similar to Roth IRAs but your contributions are made with pretax income. Your distributions are taxed at your marginal income tax rate in retirement.

Note

It’s generally better to use a Roth IRA if you think your tax rate will be lower now than it will be in retirement. You may want to use a traditional IRA if you expect your tax rate will be higher now than in retirement.

Are Roth IRAs Good Investment Tools?

A Roth IRA can be a good investment tool if you use it correctly. A Roth IRA can save you a significant amount of money on taxes if you save well, choose investments that align with your financial goals, and leverage the tax benefits.

Frequently Asked Questions (FAQs)

How much interest does a Roth IRA earn?

Roth IRA accounts don’t earn interest automatically like savings accounts do, but you can choose to hold assets in your Roth IRA that pay interest, such as bonds. Dividend stocks held in a Roth IRA can also provide interest-like regular returns.

When can you access your Roth IRA?

You can access your contributions to a Roth IRA anytime without penalty (although there may be a fee from the custodian of the account). Withdrawing investment earnings before they're qualified would result in a 10% penalty. For withdrawals to be qualified, You must be over age 59½ or qualify as disabled for withdrawals to be qualified unless the funds will be used to purchase your first residence or pay medical bills over a certain amount.

Is a 401(k) better than a Roth IRA?

A 401(k) plan and a Roth IRA plan have different advantages. Employer-sponsored 401(k) plans often include an employer match, which can provide more investment funds, and their contribution limit is higher. A Roth IRA may provide more investment options and offer tax-free withdrawals on earnings in retirement. You can also invest in both types of accounts.

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Sources
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
  1. Securities and Exchange Commission. “Individual Retirement Accounts (IRAs).

  2. IRS. "Retirement Topics—IRA Contribution Limits."

  3. IRS. “Publication 590-B, Distributions From Individual Retirement Arrangements (IRAs)."

  4. Securities and Exchange Commission. "Diversify Your Investments."

  5. IRS. "Amount of Roth IRA Contributions That You Can Make for 2023."

  6. IRS. “IRS Announces Changes to Retirement Plans for 2022.”

  7. IRS. “Publication 590-A, Contributions to Individual Retirement Arrangements (IRAs)."

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