Disadvantages of the Roth IRA

Since their inception in 1998, Roth IRAs have exploded in popularity. Roth IRAs offer tax-deferred investment growth as well as tax-free distributions, provided you meet certain eligibility requirements. In addition, there are no RMDs on Roth IRA accumulations, so you can hold the account value for life, making it a meaningful part of your estate planning strategy.

While the advantages of a Roth IRA are more easily understood and promoted, the disadvantages are rarely discussed. Not all of these downsides are dealbreakers, but they are high on any financial advisor’s list when thinking about how a Roth IRA fits into the context of the wholistic planning strategy for an individual or family. It’s worth noting upfront that the value of a Roth IRA is unlocked only when you make money in the account. If you lose money over the long-term, you’d have been better off in a taxable brokerage account.

Downsides to the Roth IRA

A Roth IRA has a number of disadvantages:

1. Contributions are not tax deductible

2. Contribution and income limitations

3. No capital loss deductions

4. Complicated distribution rules

5. Early distribution taxation

6. 10% Penalty taxation

Disadvantage #1: Contributions are not tax deductible

Roth IRA contributions are not tax deductible, so you won’t reduce your income taxes by funding one. Compared to a Traditional 401(k) contribution at an identical savings target, you’ll have less cashflow due to the income tax burden. The higher marginal tax bracket you’re in, the more taxes you’ll pay upfront by foregoing a Traditional 401(k) for a Roth IRA.

Disadvantage #2: Income Limitations

For 2022, you can only put $6,000 into a Roth IRA (or $7,000 if you’re at least age 50). In addition, Roth IRAs have maximum Modified Adjusted Gross Income (MAGI) limitations, which are discussed here. If you make more than the upper end of the Roth IRA MAGI limit, you can’t contribute to a Roth IRA.

There is a technique called a Backdoor Roth IRA that allows you to circumvent the MAGI limitations; however, it requires the care and skill of a professional to avoid violating the IRS’ Step Transaction Doctrine. The Step Transaction Doctrine basically says if you take a series of steps to get to the same result as you would have gotten with a single transaction, you’ve effectively made the single transaction.

Disadvantage #3: No Capital Loss Deductions

The IRS lets you annually deduct up to $3,000 of net capital losses against your other income for the year, where any excess beyond $3,000 can be carried forward to the next tax year. This deduction is an above-the-line deduction, making it even more valuable. But losses in a Roth IRA do not receive this tax treatment.

There is one exception to this rule. If you close all of your Roth IRAs, you can report any aggregate loss on the total basis as an itemized deduction on Schedule A. I’ve never heard of anyone ever doing this, but it does technically exist.

Disadvantage #4: Complicated Distribution Rules

Distributions from a Roth IRA are assumed to be taken in the following order:

1. Contributions first

2. Conversions second

3. Growth third

Having contributions come out first is actually an advantage to the account because it allows you to remove the principal without taxation; but if you’re going to make a distribution, it behooves you to have exact records of what dollars amounts in the account belong to what category. Otherwise, you’re likely to miscalculate your tax liability.

Disadvantage #5: Early Distribution Taxation

Tax-advantaged growth in a Roth IRA is very appealing, but the requirements for distributing that growth aren’t always straightforward. Generally speaking, there are two requirements and BOTH must be met to avoid ordinary income taxes on distributions from a Roth IRA:

1. Your earliest-existing Roth IRA is at least 5 years old

2. You are at least age 59.5, disabled, buying your first home ($10,000 limit), or inheriting the Roth IRA.

Disadvantage #6: 10% Penalty Taxation

Note that the above requirements don’t apply to the 10% additional penalty taxation, which is a second level of tax that can occur on a Roth IRA (yes, you can be taxed twice). You’ll incur a 10% additional withdrawal penalty unless you meet at least one of the exceptions. A few of the more common exceptions include:

• At least age 59.5

• Disabled

• $10,000 for a first home

• Death of the owner (inherited)

• Education expenses

• Medical premiums for unemployed

• Medical expenses beyond 7.5% AGI

• Substantially equal period payments

Example: Billy opened his first Roth IRA in 2020 with a $6,000 contribution, which is now worth $7,000 in 2021. He withdraws the full value of the account to pay for college. Because Billy didn’t have the Roth IRA for 5 years and education expenses aren’t one of the four ordinary income tax exceptions, Billy will pay ordinary income tax on the $1,000 of growth. But he won’t owe the 10% additional penalty tax on the $1,000 of growth because educational expenses are an exception.