The Common Mistakes You Should Avoid When Building Your Tax-free Nest Egg

Roth IRA. (Jason York/Shutterstock)

A Roth IRA is a fantastic vessel for anyone wanting to save for retirement. One of the best things about a Roth IRA is that while your contributions are not tax-deductible, your contributions grow tax-free.

While a Roth IRA is an excellent way for future retirees to set themselves up for a better tax situation when it comes time to distribute, there are some common mistakes you should avoid when building your tax-free nest egg.

Earning Too Much or Too Little

You cannot contribute more money towards a Roth than you acquired in earned income for the year. Earned income comes from wages, salaries, and tips received from providing services.

It should be noted that you must have earned income to be eligible to contribute to a Roth IRA.  If you only have unearned income—for example, income from dividends or capital gains—you are not eligible.

Earning Too Little

If you earn too little—for instance, if you earn less for a year than you anticipated— you could overfund your Roth IRA.

As of 2022, Roth IRA contribution limits allow up to $6,000 annually, plus an additional $1,000 if you are over 50 years old. You can bump up your Roth contribution limits by filing taxes jointly with your spouse. If you are married and filing jointly, your joint contribution could be as much as $12,000 (or $14,000, if you are over 50).

Earning Too Much

You can also earn too much to contribute to a Roth. The parameters for eligibility are determined by your modified adjusted gross income (MAGI). There are deductions when calculating your MAGI, such as any contributions you make towards a traditional IRA.

A Roth owner who is 59 1/2 and has owned the account for at least five years can withdraw funds—both contributions and earnings—without incurring costly penalties.

Not Understanding the Rollover

Rollover rules changed in 2015. While you used to be able to do one IRA rollover per calendar year, you now can only do one rollover within a 365-day period. The clock does not restart when the new calendar year begins. A full 356 days must pass between rollovers to not incur a penalty. This often overlooked rule can prove detrimental, as rollovers can trigger a significant tax bill.

Another common mistake people tend to make with rollovers involves the process of rolling the money over itself. When you directly roll over the money, it is either transferred electronically or via check from your account to the new account. But you can also do an indirect rollover: you are given the money and entrusted to deposit it into the new account.

The mistake people make involves the indirect rollover. There is a 60-day deadline to deposit the money, but people may miss this deadline. They do this because they either forget or use the cash elsewhere. Because of this human error variable, it’s best to have the money directly transferred to your new account.

Not Utilizing the Backdoor Roth

Perhaps the biggest mistake on this list involves the backdoor Roth, a severely underutilized strategy. A backdoor Roth is available to anyone, regardless of their earned income. This strategy allows you to take funds from a traditional IRA or a 401(k) and convert them to a Roth IRA via the backdoor strategy. When converting, any earnings after the Roth conversion won’t be taxable upon disbursement.

The process of doing a backdoor Roth conversion can be complicated, but it is absolutely worth it when you consider the massive tax implications and what you stand to save. Make sure that your advisor is competent and can navigate the process accordingly.

Conclusion

A Roth IRA can be a stellar tool in your retirement planning. However, Roth IRAs can become costly endeavors if you are ill-informed or do not pay attention to certain attributes like contribution limits (which change annually). Pay attention to the rules, so you don’t jeopardize an otherwise excellent retirement planning tool.

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