Disadvantages of Roth IRAs: What to know before you invest

Key points

• Roth IRAs offer unique benefits but also have drawbacks like income restrictions.
• Consider a Roth IRA if your tax bracket will be higher in retirement than it is today. 
• Investing in a mix of Roth and traditional IRAs and 401(k)s can provide flexibility and security.

Roth IRAs are like the cool kids at the investing party. Everybody seems to love them. Why? The tax-free growth and withdrawals, lack of required minimum distributions, and ability to contribute at any age make Roth IRAs a crowd-pleaser.

But before you get swept away by the allure of this retirement account, remember that there’s no one-size-fits-all investment strategy. Every investment vehicle has pros and cons. The Roth IRA is no different.

Let’s explore the disadvantages of Roth IRAs. The knowledge you gain will empower you to make the best decisions for your unique circumstances. 

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What is a Roth IRA? And how does a Roth IRA work?

The Roth IRA is an individual retirement account available to workers under a certain income threshold. Its unique selling point lies in the tax benefits it offers. Unlike traditional IRAs, which allow you to make contributions that grow tax-deferred until you withdraw them in retirement, Roth IRAs allow you to make post-tax contributions that grow tax-free. Withdrawals in retirement are also tax-free.

Roth IRAs also offer flexibility. You can withdraw your contributions — but not your earnings — at any time tax- and penalty-free. That isn’t the case with traditional IRAs. 

In a nutshell, Roth IRAs are tax-advantaged retirement accounts that allow you to pay your tax bill upfront and then sit back, relax, and enjoy tax-free growth and withdrawals. That sounds appealing, right? Well, don’t forget that every silver lining has a cloud. Roth IRAs are no exception.

Roth IRA contribution rules and income limits

Navigating the Roth IRA contribution rules and income limits can be overwhelming. But this topic is key to understanding some of the disadvantages of Roth IRAs.

There are no age restrictions on Roth IRA contributions. Whether you’re 18 or 80, you can contribute if you have taxable compensation. 

So how much can you contribute? For 2024, the maximum you can contribute to all your traditional and Roth IRAs combined is $7,000, or $8,000 if you’re 50 or older.

Remember that Roth IRA contributions are made with money that has already been taxed, meaning you don’t get immediate tax benefits. But the trade-off is that you get tax-free withdrawals in retirement.

But there’s a caveat: Your income plays a role too. Your modified adjusted gross income, or MAGI, must be under certain limits for you to contribute to a Roth IRA.

Roth IRA contribution limits for 2024

If your income exceeds these limits, you can still access a Roth IRA using a backdoor strategy.

“In the backdoor Roth strategy, you contribute the money to a traditional IRA and then immediately convert that to a Roth IRA,” said Kendall Meade, a certified financial planner at SoFi. “As long as the money has not been invested in the interim, there are no tax consequences.”

Disadvantages of Roth IRAs

One potential pitfall of Roth IRAs is that they might disadvantage high earners. Because contributions are made post-tax, savers in higher tax brackets could find themselves paying more now than they would in their retirement years, when their tax brackets might be lower.

How does that break down?

Let’s take Jane, for example. She earns $140,000 per year, putting her in the 24% tax bracket. She can max out her contribution to her Roth IRA at $7,000 for 2024 at her income level. 

• Given that Jane is in the 24% tax bracket, the pretax income she needs to earn to contribute $7,000 is about $9,211 ($7,000 / [1 – 0.24]).

Now, fast-forward to Jane’s retirement. Let’s assume her income has decreased, and she falls into the 12% tax bracket. If Jane had chosen to contribute to a traditional IRA instead of a Roth IRA, she would have deferred taxes until retirement, when she would have paid the lower rate of 12% upon withdrawal.

• A withdrawal of $7,000 would be taxed at 12%.

• Using the above calculation, the pretax income that a $7,000 contribution would represent in retirement is about $7,955 ($7,000 / [1 – 0.12]). 

Thus, by choosing a Roth IRA while in a higher tax bracket, Jane paid approximately $1,256 more in taxes than she would have had she chosen a traditional IRA. 

Beyond the tax structure, there are a few other speed bumps on the Roth IRA road. Eliza Arnold, founder of retirement savings platform Arnie, said some of the most significant “hitches” of Roth IRAs are:

• Income caps: Roth IRAs have income ceilings. If your earnings are high, you might not qualify.
• Limited contributions: The cap on yearly IRA contributions is substantially lower than the cap on yearly 401(k) contributions.
• Penalties on early withdrawals: You can withdraw your contributions tax- and penalty-free. But early withdrawals of earnings could trigger taxes or penalties if you’re younger than 59½ or the account is less than five years old.
• No upfront tax perks: Unlike traditional IRA contributions, Roth IRA contributions aren’t tax-deductible.

While Roth IRAs have plenty of benefits, they also have a fair share of limitations. The trick is to align these pros and cons with your unique circumstances, ensuring the investment vehicle you choose is the best fit for your retirement journey.

Who should open a Roth IRA?

With the ins and outs of Roth IRAs on the table, the next question is, who can gain the most from this retirement account?

“Typically, younger individuals who are in a lower tax bracket now but anticipate earning more — and being in a higher tax bracket — in the future stand to benefit greatly,” Arnold said. “Those who value tax diversification in retirement may also find a Roth IRA appealing.”

Roth IRA withdrawal rules also offer flexibility that could appeal to people needing to access their savings before age 59½. You can withdraw Roth IRA contributions — but not earnings — at any time, tax- and penalty-free. This feature could come in handy as a safety net for unforeseen circumstances.

So, to bring it all home, a Roth IRA could be just the ticket if you’re earning a steady paycheck, hanging out in a lower tax bracket, and looking for a retirement plan with the flexibility to pull contributions without taxes or penalties. By contributing to a Roth IRA, you’re securing a tax-free future while retaining access to your savings along the way.

Other ways to save for retirement

While Roth IRAs can be fantastic retirement savings vehicles, they’re far from the only show in town. Retirement savings is more like a bustling marketplace, offering various options to cater to different financial situations and retirement goals. Let’s take a closer look at a few alternatives.

Traditional IRA

The traditional IRA is a sibling to the Roth IRA. Like its Roth counterpart, a traditional IRA is an account you set up independently to save for your golden years. But the tax structure of a traditional IRA is essentially the opposite of the tax structure of a Roth. 

With a traditional IRA, you make pretax contributions, lowering your taxable income in the year you contribute. This feature could be particularly attractive if you’re in a high tax bracket. The trade-off? You’ll pay income taxes on your withdrawals in retirement at whatever your tax rate is at the time.

Traditional 401(k)

Let’s shift gears to employer-sponsored plans, starting with the traditional 401(k). This retirement plan lets you sock away a chunk of your pretax salary into investments. The advantage is that you reduce your taxable income now. The money you invest grows tax-deferred until you take distributions in retirement. 

While it doesn’t offer the tax-free withdrawals of a Roth IRA, a traditional 401(k) typically comes with a significant perk: employer matching. This is essentially free money that can supercharge your savings. 

Furthermore, ​​you can contribute $23,000 across your 401(k) accounts in 2024 or $30,500 if you’re 50 or older. This is significantly higher than the IRA contribution limit.

Roth 401(k)

Lastly, let’s talk about the Roth 401(k). This option is a hybrid of sorts. Like a Roth IRA, a Roth 401(k) allows you to make post-tax contributions, meaning you enjoy tax-free withdrawals in retirement. 

Unlike a Roth IRA, a Roth 401(k) doesn’t have income limits. And like a traditional 401(k), a Roth 401(k) is an employer-sponsored plan, meaning you could benefit from employer matching. You will also benefit from the higher contribution limit we mentioned above.

“Each of these options caters to different financial situations and goals, and the best choice often involves a combination of these accounts for optimal tax diversification,” Arnold said.