For many investors, Roth individual retirement accounts (IRAs) are a sweet opportunity to set aside money for retirement and let it grow and compound, tax-free. Though investors pay money on their annual Roth contributions, qualified withdrawals, or distributions, are not taxed--which means that a Roth's investment earnings are safe from the IRS. However, a Roth IRA isn't the ticket for everyone--the devil is in the details.
Unpredictable Tax Rates
As a rule of thumb, tax professionals encourage you to put off paying a tax as long as legally possible--why hand that money over to the IRS if it could be put to work for you now? This is sometimes true for a Roth IRA, which requires you to pay taxes upfront to get savings down the line. If you think you will be in a higher income bracket when you retire, a Roth IRA is a good idea because your tax rate is lower now. But if you end up making less in retirement, your taxes will have been higher than necessary.
Early Distribution Penalties
If you want to withdraw Roth IRA funds before you turn 59 1/2, you may be responsible for paying a 10-percent penalty on the Roth's earnings--as opposed to your contributions, which are never penalized. Roth IRAs are also subject to the five-year rule, which stipulates that you cannot take a qualified distribution until the account has been open five years, even if you turn 59 1/2 in the meantime. The same is also true for funds you roll over to a Roth IRA--you must let them sit for five years.
It sounds morbid, but it's something to consider: you could die without ever seeing a tax benefit from your Roth IRA. At least with a traditional IRA, you can take a tax write-off for your contribution the year you make it. With a Roth IRA, you usually need to wait until retirement to get your hands on those tax-free earnings.
Conversion Tax Blues
A 2010 loophole that eliminates income limits for Roth IRA conversions has many people scrambling to roll over their traditional IRAs and 401ks to Roth accounts. It may be a good opportunity to save money, but there is a costly downside: conversions are taxed at the account owner's income tax rate. This means that, if you decide to convert, you could have a very large tax bill if your investment portfolio is large.