If you have earned income from a job or other paid work, opening a Roth IRA is one of the more effective strategies for securing long-run financial freedom. Money deposited to a Roth IRA has already been taxed, which means you’ll enjoy tax-free growth and earnings up to and through retirement. Since the Roth offers you a limited amount of tax-exempt space, you’ll want to avoid making any of the common mistakes.
Here, we’ll review four of the more common Roth IRA mistakes and offer guidance on how to avoid them.
1. Not opening one
You can’t invest in a Roth IRA if you don’t have one. Most online brokerage services like Vanguard, Fidelity, and Schwab offer zero-cost Roth IRAs that can be opened in a matter of minutes. If you have questions during the account-opening process, help is also available for free by calling any of their customer service centers.
The opportunity cost of avoiding a Roth IRA is substantial. A simple $6,000 annual investment compounded at 8% for 30 years would yield nearly $735,000 entirely tax-free — not to mention the immense psychological benefit in knowing that your retirement savings account contains no embedded tax liability (like a pre-tax 401(k)).
2. Not investing your contributions
Money contributed to a Roth IRA will initially sit in your IRA’s money market, or cash account. While you won’t lose any money in the stock market this way, you will lose out to inflation over time, which has the effect of diminishing your purchasing power. What’s more, you’ll lose out on valuable compounding by forgetting to invest your money.
Since you only have a limited amount of tax-exempt investing space, making sure you actually put your money to work is a far-too-often-overlooked piece of the Roth IRA process. Once you contribute money to your Roth IRA, take the active step to invest your money in accordance with your broader financial plan.
3. Contributing too much
The annual contribution limit for Roth IRAs in 2022 is $6,000 ($7,000 if you’re over 50), or your total earned income if it’s less than that amount. This is set to increase to $6,500 and $7,500, respectively, in 2023. Note that these amounts don’t include Roth conversions or 401(k) rollover amounts; contribution limits only apply to new money invested.
If you do contribute more than the maximum allowed, you’ll need to remove the excess contribution (and associated earnings) before the tax-filing deadline. This can create a tax mess, especially if you let excess contributions linger for too long or make the same mistake repeatedly for several years in a row.
The good news is that your broker may not allow excess contributions beyond the IRS-prescribed limits, which helps protect all parties involved.
4. Investing too conservatively
You may have heard of Peter Thiel’s $5 billion Roth IRA, which resulted from an aggressive investment in PayPal (NASDAQ: PYPL) in its early years. While you don’t need to make the same type of bet to be considered successful, you might consider using your Roth IRA for your highest-growth opportunities.
Recall that your Roth IRA is entirely tax-exempt, and the contribution limits are fairly low in the context of today’s rapidly increasing prices. Your Roth IRA remains tax-exempt for life, so the more growth you can harness from the account, the better. Again, all investment growth and earnings will be entirely tax-free, so the more you can “go for it” in this account, the more you stand to benefit.
Don’t lose out on Roth IRA benefits
Because the Roth IRA offers a limited amount of tax-free investing space, make sure to use all of it to its fullest extent. First, make sure to have one open in the first place. Next, remember to invest the money you contribute, and be willing to place your highest-growth assets in it.
Today’s economic environment only offers so many opportunities to get ahead of the game. It’s now as important as ever to take advantage of the ones that do exist, even if the contribution limits aren’t particularly high. Make an investment in your future this year and repeat the process in 2023.
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