I’m a big fan of the Roth IRA and investors that understand it’s massive tax-free benefits are also.
Recently a reader sent in this question about it:
Thanks for your questions Debbie! Before we answer your question, let’s do a quick refresher on the Roth IRA rules.
What is a Roth IRA?
A Roth IRA is a type of individual retirement account (IRA) that allows you to contribute after-tax money and withdraw it tax-free in retirement. It is named after Senator William Roth, who sponsored the legislation that created the account. Now I don’t know personally know Senator Roth – but this man deserves an award for creating the greatest savings tool ever!
The main difference between a Roth IRA and a traditional IRA is the way they are taxed. Contributions to a traditional IRA may be tax-deductible, but withdrawals in retirement are taxed as ordinary income. With a Roth IRA, contributions are not tax-deductible, but withdrawals in retirement are tax-free.
What are The Benefits of a Roth IRA?
Roth IRAs have a number of benefits, including:
- Tax-free growth: The money in your Roth IRA grows tax-free, which can result in a larger balance over time.
- Tax-free withdrawals: Withdrawals from a Roth IRA in retirement are tax-free, which can be a significant advantage if you expect to be in a higher tax bracket in retirement.
- Flexibility: You can withdraw your contributions (but not any earnings) from a Roth IRA at any time without penalty.
- No RMDs: Unlike traditional IRAs, Roth IRAs do not have required minimum distributions (RMDs) during the account holder’s lifetime.
There are some income limits and contribution limits for Roth IRAs, and you may not be eligible to contribute if your income is too high.
Can You Lose Money in a Roth IRA?
Yes, you absolutely can. You first need to understand the Roth IRA is NOT an investment. It’s an investment vehicle geared for retirement and you get to decide the best investments that go inside the Roth IRA. Now we have that clear, here’s some ways you could lose money in a Roth:
1. Market Fluctuations
Like any investment, the value of your Roth IRA can fluctuate due to changes in the stock market or other economic conditions. If you have invested in stocks, mutual funds, or other securities, the value of your Roth IRA may go up or down depending on the performance of these investments. It’s important to remember that investing always carries some level of risk, and you could potentially lose money in a Roth IRA if your investments don’t perform well.
2. Early Withdrawal Penalties
If you withdraw money from your Roth IRA before you reach age 59 1/2, you may have to pay a 10% early withdrawal penalty in addition to any taxes owed on the withdrawal. While there are some exceptions to this rule, such as for certain qualified education expenses or first-time home purchases, it’s important to understand the potential costs of taking money out of your Roth IRA before you are eligible to do so.
3. Over Contribute to a Roth IRA
There are limits on how much you can contribute to a Roth IRA each year. According to IRS.gov for 2023, the contribution limit is $6,500 per year for those under age 50, and $7,500 per year for those age 50 and over. If you exceed these limits, you may have to pay a 6% excess contribution penalty on the excess amount.
4. Roth IRA Conversion Taxes
If you want to convert a traditional IRA or 401(k) to a Roth IRA, you may have to pay taxes on the amount you convert. If you are in a high tax bracket when you convert, you may end up paying a significant amount in taxes, which could reduce the overall value of your Roth IRA.
5. Required minimum distributions (RMDs)
Unlike traditional IRAs, Roth IRAs do not have required minimum distributions (RMDs) during the account holder’s lifetime. However, if you inherit a Roth IRA, you may be required to take RMDs from the account. If you don’t take the required amount, you may have to pay a 50% penalty on the amount you should have withdrawn but didn’t.
6. ACAT or Transfer out Fees
When you open a retirement account with any broker they will typically charge you an IRA custodial fee ($30-$75). If you decide to transfer your IRA out they will ding you with the annual custodial fee and a transfer-out fee. Every firm charges a different amount. As an example, Edward Jones currently charges $95 to transfer an IRA from them. So you would have to pay $135 ($40 annual account fee + $95 termination of account fee).
What Type of Investments Can Go Into a Roth IRA?
You can invest your Roth IRA in a wide variety of assets, including:
- Stocks: You can invest in individual stocks or mutual funds that hold a basket of stocks.
- Bonds: You can invest in individual bonds or bond mutual funds that hold a diversified portfolio of bonds.
- Exchange-traded funds (ETFs): ETFs are investment vehicles that hold a basket of assets, such as stocks or bonds, and trade like stocks on a stock exchange.
- Certificates of deposit (CDs): CDs are low-risk investments that pay a fixed interest rate over a set period of time.
- Money market funds: Money market funds are mutual funds that invest in short-term, high-quality debt instruments, such as government securities and commercial paper.
It’s important to consider your investment goals and risk tolerance when deciding how to invest your Roth IRA.
How Safe is a Roth IRA?
In general, a Roth IRA can be a safe way to save for retirement because it provides tax-free income in retirement and allows you to withdraw your contributions at any time without penalty. However, like any investment, a Roth IRA carries some risk. The value of your Roth IRA may fluctuate due to changes in the financial markets, and there is always the possibility that you could lose money.
When choosing the right brokerage for your Roth IRA, consider the fee structure, account minimums, and investment options. Some brokerages have no account minimums and charge low fees, while others have high account minimums and charge higher fees. Additionally, some brokerages offer a wide variety of investment options, while others offer only a limited number of options.
Make sure they have SIPC coverage and it’s always best to choose a financial advisor that is a fiduciary.
It’s important to diversify your investments and consider your risk tolerance when deciding how to invest your Roth IRA. You may want to speak with a financial advisor or tax professional to determine the best strategy for you.
The Bottom Line – Roth IRAs and Losing Your Money
Roth IRA’s are a great way to save for retirement, but like any investment, there is the chance of losing money. If you are considering investing in a Roth IRA, be sure to do your research and understand the risks involved.
Also, be sure to have a solid plan for how you will use the money you save in your Roth IRA, in case you do lose some of your investment.
FAQ’s Can Roth IRAs Lose Money?
Yes, you can lose your entire Roth IRA. If you make a withdrawal from your Roth IRA account before you reach the age of 59 1/2, you will have to pay a penalty tax of 10 percent on the amount withdrawn. In addition, you may also have to pay income taxes on the amount withdrawn.
And this doesn’t include the investments you choose for your Roth IRA. If you choose risky investments and they lose all their value, you will lose your entire Roth IRA.
If the stock market crashes, the value of your Roth IRA may decline if you invested in stocks or other investments affected by the market downturn (this could include ETFs, mutual funds, managed portfolios, etc). It’s important to remember that investing in the stock market carries some level of risk, and it’s not uncommon for markets to experience fluctuations.
If you are freaking out about a stock market crash on your Roth IRA, seek guidance from a financial advisor that can walk you back from the edge. They can help you review your investment strategy and make any necessary adjustments to help you reach your long-term financial goals.
It’s also important to remember that contributions to a Roth IRA are made with after-tax dollars, so you won’t be required to pay taxes on any withdrawals, even if the value of your account has dropped. This is a significant advantage in retirement, as it allows you to access your money tax-free when you need it. Gotta love tax-free money!
Cited Research Articles
- IRS.gov – Retirement Topics Contribution Limits https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-ira-contribution-limits
- SIPC.org – What SIPC Coverage protects https://www.sipc.org/for-investors/what-sipc-protects