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3 Big Problems With Roth IRAs

Todd Campbell, The Motley Fool

In the 1980s, 60% of employees were offered pensions by their employers. Today, that figure is less than 5%. The decline has shifted the responsibility of saving for retirement to workers, many of whom are turning to Roth IRAs. Over one-third of U.S. households owned a Roth IRA in 2016, and if you're thinking of joining them this year, you have until the tax-filing deadline in April to make a contribution for 2017. Investing in a Roth IRA can be smart, but there are drawbacks you should know about beforehand. These three problems with Roth IRAs could make saving for a retirement in a traditional IRA a better option. 

No. 1: Roth IRAs have income limits

If you're a high-income household, you might be surprised to learn that you're not allowed to save money in a Roth IRA.

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Image source: Getty Images.

Roth IRAs come with income restrictions, and eligibility begins phasing out when modified adjusted gross income exceeds specific thresholds. For the 2017 tax year, the phase-out begins at $118,000 for single tax filers and $186,000 for married couples. In the 2018 tax year, it begins at $120,000 for singles and $189,000 for married couples.

Unfortunately, if your income is above those thresholds, the amount you can sock away in a Roth IRA will be reduced, and if your modified adjusted income was above $133,000, for single filers, or $196,000, for married filing jointly, last year, you won't be able to contribute anything to a Roth IRA for 2017.

Roth IRA Income Phase-Out Limits
Tax filing status 2017 Income limits 2018 Income limits
Single $118,000-$133,000 $120,000-$135,000
Married, filing jointly $186,000-$196,000 $189,000-$199,000

Data source: Vanguard.

The income limit is disappointing, but you still have an option. Traditional IRAs don't tie the ability to contribute to income, so you can contribute after-tax money to one as long as you earn reportable income and you're younger than 70.5 years old. In some cases, you can even convert your traditional IRA contribution into a Roth IRA via a process called a backdoor Roth IRA. These conversions can be tricky, though, so make sure to discuss this option with your tax advisor first.

No. 2: Roth IRA benefits can be limited

Roth IRA contributions are made with money that's taxed up front so that money can be withdrawn tax-free in retirement. That's the opposite of traditional IRAs, which give savers a tax break up front but tax withdrawals in retirement.

The tax-free withdrawals feature is one of the big benefits offered by a Roth IRA, but savers won't enjoy the full benefit of that feature if they pass away young -- especially if they're single and without heirs. According to the U.S. Department of Health and Human Services, about 1 in 5 people will die younger than age 70, and over 1 in 10 people will pass away prior to age 60.

Despite the mortality risk associated with a Roth IRA, it can still make sense to contribute to one for the benefit of your beneficiaries. A Roth IRA's tax-free withdrawal benefit can be passed on to others; however, heirs might still owe estate taxes, depending on the size of their inheritance. 

Regardless, if you're considering a Roth IRA, assess your life expectancy realistically before deciding if it makes more sense to capture tax benefits up front through a traditional IRA or delay them through a Roth IRA.

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Image source: Getty Images.

No. 3: The time value of money can be hard to beat

A common financial theory is that money today is better than money tomorrow. That's because money today can earn a return. For example, if $10,000 earns a 10% return in one year, then giving up that $10,000 now only makes sense if someone gives you more than $11,000 one year from now. 

Because you have to pay taxes on Roth IRA contributions up front, saving in a Roth IRA reduces the amount of money that can be invested today. In essence, a Roth IRA trades the benefit of having more money today for the future benefit of tax-free withdrawals.

That might not be the best choice. For instance, if you're in the 24% income tax bracket in 2018 and you contribute $5,500 to a Roth IRA this year, then you'd pay $1,320 in taxes on those contributions. Alternatively, if you contribute to a traditional IRA and qualify for a deduction, then you could invest your tax savings. Investing an extra $1,320 every year and earning a hypothetical 6.5% average annual return could increase your savings by $51,249.41 in 20 years. 

For 2017, a traditional IRA's up-front tax deduction phases out above $99,000 for someone filing jointly who is covered by a workplace retirement plan, such as a 401(k) plan. The phase-out begins at $186,000 for someone who is uncovered by a workplace plan but has a spouse who is covered by one. If neither spouse is covered, then the deduction can be taken in full, regardless of income.

Investors should also keep in mind that a traditional IRA's tax break is in the form of a deduction to income, not a credit against taxes owed. As a result, the up-front savings associated with a traditional IRA may not match up dollar for dollar to the taxes owed on a Roth IRA contribution, depending on your situation.

Regardless, a deduction due to a traditional IRA contribution could put you in a lower tax bracket or below income levels that allow you to qualify for other tax deductions or tax credits, such as the student loan interest deduction. In those cases, the up-front tax break could be even more valuable.

What's the best option?

The primary benefit of a Roth IRA is tax-free withdrawals in retirement. That's a great benefit, but don't assume your income tax rate in retirement will be higher than it is today. The average retired worker is receiving only $16,848 in Social Security this year and a $1 million retirement account would only supplement that amount by $40,000, if you follow the common advice not to withdraw more than 4% per year in retirement. In 2018, that would result in an effective tax rate that's below 12% for most married couples filing jointly.

Overall, deciding between a traditional IRA and a Roth IRA can be difficult. What's best for you might not be best for someone else. Therefore, if you're uncertain which option makes the most sense, it may be time to chat with a tax advisor.

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