﻿Alright, everybody, I’m Logan Allec, I’m a CPA, and in this video I want to share with you fifteen
Roth IRA warnings and pitfalls because everybody loves Roth IRAs, right, until they don’t.
Everybody loves Raymond unless you haven’t seen it, everybody loves ice cream unless you’re
lactose intolerant, and everybody loves Roth IRAs until they screw theirs up. Roth IRAs do have
major tax benefits, I have a Roth IRA, I helped my wife set up a Roth IRA, I set up Roth IRAs for my
kids, and there are benefits to the Roth IRA with the major one being that you can put money in your
Roth IRA today, invest it, and that growth and any income you earn from your investments in the Roth
IRA, you can tap into tax-free starting when you turn fifty-nine and a half years old, so unlike a
Traditional IRA where you get a tax deduction for your contribution now assuming you’re eligible to
the deduction, unlike the Traditional IRA where you get a deduction now but the growth in your
account is merely tax-deferred, with the Roth IRA the growth is truly tax-free assuming you play
by the rules. That is the major benefit of the Roth, there are others, but that is the big one.
I have another video on the channel comparing and contrasting Roth IRAs to Traditional IRAs,
link to that video is at the top of the screen as well as in the description below, but in this
video I want to talk about Roth IRA warnings and pitfalls if you will, so let’s get right into it,
before we do, I do want to say that this video is sponsored by my Prosper course, in this course I
basically share with you all the knowledge I’ve gained over the years about investing and building
wealth both personally and professionally as a CPA, there is a coupon code to that course
in the description below. But let’s get right into these fifteen Roth IRA warnings and pitfalls.
Pitfall number one is not exploring other investment options and assuming it’s Roth or bust.
Even if a Roth IRA does make more sense for you than a Traditional IRA, there are other kinds
of investments you may want to consider before jumping into a Roth, such as perhaps real estate.
Now, throughout my 20s I was fortunate enough to be in a position where I could both max out
my IRAs as well as save for a down payment on my first piece of real estate, which was a four-unit
property in a rural part of Los Angeles County where I live. I lived in one of the units and
rented out the other three, I also rented out the bedroom in my unit as well and slept on a
mattress on the floor that my then-girlfriend, now-wife gave me -- let’s just say that back then
I was definitely a minimalist, not for the sake of minimalism, but for the sake of investing as much
as possible. I was able to purchase this property with an FHA loan with only three-point-five
percent down, and it has turned out to be a great investment. My property manager has increased the
rents over the years, and I currently collect four thousand, four hundred and thirty-five dollars
a month in rent, and we’re actually going to increase the rents on one of the units next month,
while my monthly mortgage payment, which includes principal, interest, taxes, and insurance is two
thousand, nine hundred and eight dollars. So the rents I collect are one thousand, five hundred and
twenty-seven dollars more than my monthly payment, of course repairs and capital expenditures and
vacancies come up from time to time so that’s not necessarily my cash flow every month, but this
asset still generates cash flow for me every month and it’s also appreciated hundreds of thousand of
dollars since I purchased it, and my initial investment was only around fifteen thousand
dollars because A) this was years ago when the market was cheaper and B) I only put three
point five percent down, so in twenty, thirty years, I’m going to be sitting on a paid-off
piece of property worth seven figures that cash flows possibly five figures a month, obviously
inflation may make those figures not quite as impressive in 30 years, but that’s still a great
return on a fifteen-thousand-dollar investment. I don’t want to make this a real estate video,
but my point is if you’re willing to do something like this, it might be worth while you’re young
to forego the Roth for a few years and get into a rental property with a low down payment. Obviously
this is not investment advice, all investment carries risk, and when you borrow to invest, that
just amplifies your risk, so please keep that in mind. But my point is don’t just assume that it’s
Roth or bust, ideally you could do Roth and real estate, but I know that’s not an option
for everybody, and of course keep in mind that if you do forego the Roth to invest in real estate,
that deal may never come and you will have missed your opportunity to contribute to
your Roth. Or what you could do is contribute to your Roth and withdraw your contributions tax-free
when you do find that rental property because you can withdraw Roth contributions at any time,
that is perhaps one of the only times that I would be comfortable with somebody taking money out of
their Roth to put into another investment, just keep in mind if the market tanks and your Roth
value goes down, that may get in the way of having enough for that down payment. So there’s a lot to
think about here, I’m not a financial adviser, I don’t give investment advice,
but I just want to get those gears turning in your head so you start thinking about these things
so you can build a lifetime of wealth for yourself and your family. Pitfall number two:
Contributing to a Roth IRA without earned income. Unlike a taxable brokerage account,
you need earned income to contribute to a Roth IRA or a Traditional IRA for that matter,
there is an exception for spouses, which I’ll talk about later, but in general the most you can
contribute to an IRA for the year is the smaller of the statutory limitation which for this year is
six thousand dollars or seven thousand dollars if you’re age fifty or older by the end of the year
so the lesser of that amount or your earned income for the year. What is earned income? Generally
speaking, in layman’s terms, it’s money you make for doing stuff, so your wages from your job,
self-employment income, and it’s net self-employment income that you report on Schedule
C less the the deduction for contributions made on your behalf to business retirement plans like
a SEP and less the deduction for one-half of your self-employment tax liability for the year.
So if you have a job, if you have a small business that sustains your living expenses and all that,
it’s presumably more than six thousand dollars so you can contribute the max. And this is why
although a Roth IRA is a great option for kids, many kids can’t contribute to a Roth because they
don’t have earned income, obviously if they have a job or a side hustle they can, but most kids
don’t have earned income so they’re not eligible to contribute to an IRA. Pitfall number three:
contributing directly to a Roth IRA with too much income. So the IRS has rules in place that say,
“If you make more than this amount for the year based on your filing status,
then you can’t contribute directly to a Roth IRA.” Here’s the IRS’s table that shows these
amounts by filing status for 2021, but basically let’s say you’re married filing jointly and your
and your spouse’s modified adjusted gross income for the year, which for simple filers is just how
much they make, is greater than or equal to two hundred and eight thousand dollars, then both
spouses are ineligible to directly contribute to a Roth IRA for 2021. If they make at least
one hundred and ninety-eight thousand dollars but less than two hundred and eight thousand
dollars they are eligible to contribute a reduced amount to a Roth IRA than the six
thousand dollar or seven thousand dollar amount based on their age, but if they make less than
one hundred and ninety-eight thousand dollars they can directly contribute the maximum amounts for
the year to a Roth. And if you do that, you pay a six percent excise tax to the IRS every year your
excess contribution remains in your Roth. And I’ve seen this happen a lot of with clients who make
less than the threshold amounts here, and so they frontload their Roth at the beginning of the year,
they contribute the maximum, but then they get a large bonus or they did day trading or something
and that took their income over the limits, well now what do you do? Well, the good news
is you can fix it, no harm, no foul by your tax return deadline for the year, typically April 15,
you can simply take the money out along with any earnings attributable to those overcontributions,
so that’s one thing you can do, or you can recharacterize the contribution as a Traditional
IRA contribution, which may not be the best answer based on your situation. But the best thing to
do is to simply avoid getting in this situation in the first place by utilizing a backdoor Roth IRA,
using a backdoor Roth IRA, you can contribute to a Traditional IRA and then convert that Traditional
IRA money into a Roth IRA and you can get around the Roth IRA income limitations in this way,
I have a video I made a few years ago on how to do this with Vanguard, so a link to my video on how
to do a backdoor Roth IRA at Vanguard is at the top of the screen as well as in the description
below. On that note, pitfall number four is not taking into account the pro-rata rule for backdoor
Roth IRAs if you have existing Traditional IRA balances. This topic can get complicated
and probably warrants its own video, but for now let me just break it down like this. If you have
existing Traditional IRA balances and you took tax deductions for this traditional IRA contributions,
then the IRS views your traditional IRA balances as one big lump and when you go to do a backdoor
Roth IRA even if you just want to do it for this year’s Traditional IRA contribution that you
aren’t going to take a tax deduction for, the IRS says, “Uh, uh, uh. You need to group your
current year Traditional IRA contribution with your previous Traditional IRA contributions and
calculate, pro rata, how much of your conversion is taxable vs. non-taxable.” To make things easy,
let’s say you have a Traditional IRA balance of ten thousand dollars that you took deductions for
previously and you want to backdoor six thousand dollars this year. Well, the IRS says that what
you have to do is divide your “old” Traditional IRA balance of ten thousand dollars over your
total Traditional IRA balance after you’ve made the backdoor contribution to the Traditional IRA
but before you convert it to a Roth and that’s the percentage of your backdoor contribution that’s
taxable. So in this case we’d divide ten thousand dollars, that’s the “old” Traditional IRA balance,
by sixteen thousand dollars, that’s the “old” plus the “new”, let’s call it, and that
percentage is sixty-two point five percent. So when you backdoor that six thousand dollars
this year, sixty-two point five percent of it, or three thousand, seven hundred and fifty dollars,
of it is taxable. So you really gotta track this stuff. And again on that note, pitfall
number five, and this is a quick one, but pitfall number four is not completing Form 8606 with your
tax return when you do the backdoor Roth or do Roth conversions or even take distributions from
your Roth IRA. Pitfall number six is missing the deadline to contribute to a Roth IRA. I see this
every year, people think they have until the extended due date of their return for a given
year to make an IRA contribution for that year, and that’s not the case. Extensions don’t count
when it comes to the IRA contribution deadline. The deadline to contribute to an IRA for the year
is the original tax filing deadline for that years, so for example, the deadline to contribute
to a 2021 IRA, unless the IRS extends it for some reason like it did for the 2020 deadline,
but apart from that the deadline to contribute to an IRA for tax year 2021 is Friday, April 15,
2022. You can file an extension of time to file your deadline to file your tax return by six
months, but that doesn’t extend your deadline to contribute to an IRA for tax year 2021. And of
course you can contribute to an IRA for a given year as early as the first day of that year,
so the first day to contribute to a 2021 IRA was January 1, 2021, and the last day apart from the
IRS extending the deadline, is April 15, 2022. Pitfall number seven is contributing to a Roth
IRA when a Traditional IRA makes more sense. Obviously given how the Roth and the Traditional
are essentially converses of each other in terms of tax benefits, to know for certain
which is better for you right now you’d have to know a number of things about the future that are
impossible to tell right now, you’d have to look through the corridors of time and see if Congress
changed up any of the rules between Traditional and Roth IRAs by the time you retire, you’d have
to know what tax rates will be like in the future, you’d have to know what your income will be like
when you retire, so it’s impossible to say for certain, for absolutely certain what the future
holds, but in general, the higher your income, the higher your current tax rate is especially as
compared to your projected tax rate in retirement, and the closer you are to retirement, the more the
Traditional IRA might make more sense. Just think about it for a second. Let’s say this year you’re
fifty-five years old and you’re in the thirty-two percent tax bracket and you’re going to retire in
five years and you’ll be in the twelve percent tax bracket throughout your retirement, let’s say you
knew that for sure somehow, crystal ball. And you want to contribute to an IRA for the first time
and start taking distributions right when you start retirement. Does it make sense to forego
a thirty-two percent deduction today to avoid a twelve percent tax in five years? Probably not,
right? Unless the returns in your IRA are astronomical over that short time period or
something like that, right? So my point is that the Roth isn’t always the right answer, it really
depends on your situation. But generally speaking, if you’re young and in a low tax bracket,
Roth generally speaking looks more attractive, but if you’re in a higher tax bracket and closer to
retirement, Traditional generally speaking might start looking more attractive. Pitfall number
eight is not investing the money in your Roth IRA. I was on Instagram the other day and there
was a financial influencer talking about how her Roth IRA has had great returns the past few years,
which makes sense because, well, just look at the market, and somebody commented on that Instagram
post someone commented, “Wait what!? I have a Roth IRA and have gained almost nothing in 8 years.”
That is tragic, that is absolutely tragic, I don’t know this person who commented but I’m
almost certain that the reason her Roth IRA “gained almost nothing in 8 years”
is basically she didn’t invest the money in her Roth. She might have put money into her Roth
but she didn’t actually select investments for the money in her Roth to invest it.
And that’s absolutely tragic given that this was during the longest bull market in history. What
should you invest in? I’m not a financial adviser, this is not financial advice, but personally my
Roth IRA is mostly in low-cost index fund ETFs, if you want to learn more about my personal investing
philosophy, check out my Prosper Course, link with a coupon code is in the description below.
Pitfall number nine is withdrawing money too early because look, you contribute to a Roth
with after-tax money, you don’t get a deduction for the amounts you put in, so you can withdraw
your contributions at any time, tax-free and penalty-free, and while that’s true,
I wouldn’t do that in most cases, if you find a killer small multifamily you can get
in for FHA low down payment and the numbers still work, OK, maybe. But other than that,
the truth is that you’re very limited in how much money you can contribute to a Roth IRA every year,
and on your investments in your Roth IRA you can enjoy tax-free growth for decades and decades and
decades, so why would you want to take branches off that money tree? Look, I understand things
comes up, life happens, but this is why you really want an emergency fund to cover those things so
you don’t have to raid your retirement accounts. And the same logic here applies to the exceptions
that can allow you to withdraw money out of a Roth IRA before fifty-nine and a half,
there’s a list of them, maybe I’ll cover those in another video, but one of them is if
you’re a qualified first-time homebuyer, you can withdraw up to ten thousand dollars from your Roth
IRA to purchase a home and you can avoid the ten percent penalty on earnings, OK, yes, just because
you can do that doesn’t necessarily mean you should. It might make sense for some people, but
in general, I want you to enjoy as much tax-free growth in your Roth IRA as possible and not take
any money out before you need to. Pitfall number ten is not listing a beneficiary for
your account. So this is super easy to do if you set up a Roth IRA through a big online brokerage
like Fidelity or Vanguard or Schwab, and the point of adding a beneficiary to your account
is it just makes it easier for when you pass for your account to go to whom you want it to go to.
On all my wife’s and my accounts, we are each other’s beneficiary. I’m not an estate planning
lawyer, so obviously this is not legal advice, if you have questions about whom you should list as a
beneficiary and contingent beneficiaries on your retirement accounts, consult with an attorney.
Pitfall number eleven is not considering Roth conversions, taking that pre-tax Traditional IRA
and converting it, possibly piecemeal to not knock you into another tax bracket,
into a Roth IRA. This can make sense especially if you’re looking at having a low-income year,
you’re taking a year off or something like this
so you can make that money permanently tax-free by paying the conversion tax when you’re in a low tax
bracket. The analysis is much more involved than this, Roth conversions probably warrant their own
video, but the pitfall here is not considering conversions because depending on your situation,
they might be worth it. Pitfall number twelve is holding the wrong assets in a Roth,
I had a client once, and he was super conservative with his portfolio, and somewhere along the line
he heard that he should invest heavily in municipal bonds, also known as muni bonds.
And in general, interest earned on muni bonds is tax-free at least at the federal level,
with states it gets a little trickier because different states have different rules, but this
guy was in Florida, no personal income tax. The tradeoff of course you get with muni bonds is
in the long run you’re not going to get nearly the kinds of returns you’re going to get on stocks,
right. But he had his Roth all in muni bonds. And this guy was young too, well he wasn’t like a kid,
but he was in his 40s, decades from retirement, and I told him, look, I’m not a financial adviser,
I don’t give investment advice, but bro, these muni bonds are tax-free for you anyway,
why are you holding them in a Roth, maybe consider investing your Roth in a more aggressive way
than municipal bonds. So just like your asset allocation matters, your asset location matters
as well, really think and be smart about what kind of assets you want to hold in your Roth or other
tax-advantaged retirement accounts vs. in taxable accounts. Pitfall number thirteen is ignoring the
five-year rule, or should I say, rules. So there are a few 5-year rules for Roth IRAs, first one
is that for your earnings in your Roth IRA to come out tax-free once you reach the age of fifty-nine
and a half, at least five years must have passed since you made your first contribution to any Roth
IRA in your name. This obviously isn’t a problem if you opened up your Roth in your twenties,
but for some folks who get started later in life, they can bump into that issue. There’s also a
five-year rule for Roth conversions, which is that you have to wait five years before withdrawing any
converted balances. It’s important to note that in both cases your five-year period begins on
January First of the year of your first Roth contribution or the year of your conversion.
Pitfall slash warning number fourteen is it’s possible that in the future Congress will change
the Roth IRA rules because that’s something they can do. For example, current House Ways and Means
Chair Richard Neal, Democrat from Massachusetts, recently said that he has directed Ways and Means
to draft a bill that “will stop IRAs from being exploited”...to “consider...limiting the total
amount of money that can be saved in tax-preferred retirement accounts.” Now, in his statement, Neal
also seemed to imply that the ultra-wealthy are the ones being targeted here, not necessarily just
average people like you and me, but who knows what will happen over the years and decades to
come. So keep that in mind. And finally pitfall number fifteen is not opening a Roth IRA at all,
while Roth IRAs don’t necessarily make sense for everybody and you may want to prioritize, say,
buying your first rental property, I can tell you that Roth IRAs make a lot of sense
for lots of people, especially younger people who are in lower tax brackets. I do have a video right
over here explaining the differences between Traditional and Roth IRAs as well as my video
on investing for beginners right down here, and if you want a more in-depth explanation from me about
investing and taxes and retirement accounts and budgeting and wealthbuilding,
be sure to check out my Prosper course, link to that course is in the description below
with a coupon code for my loyal YouTube audience, I’ll see you there, buh-bye.