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4 Things Everyone Gets Wrong About Roth IRAs

4 Things Everyone Gets Wrong About Roth IRAs

4 Things Everyone Gets Wrong About Roth IRAs

You probably know that a Roth IRA is a great way to save for retirement on top of an employer-sponsored retirement plan. You've no doubt heard about the sweet tax advantages, too: Forgo a tax break today, watch your money grow tax-free for a few decades, and then get a source of income in retirement that the IRS can't touch. Roth IRAs also have a lot of flexibility. For example, unlike a 401(k) or a traditional IRA, you can withdraw your contributions before you're 59 1/2 without owing taxes or a 10% penalty.

But there are a few big misconceptions about how Roth IRAs work. Here are four things you need to know that everyone else gets wrong.

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1. Who can contribute

Generally, you need earned income to contribute to any kind of IRA, and you have to choose a traditional IRA if your earnings exceed the Roth IRA income limits. But there are work-arounds to both of these rules.

If you're working but your spouse isn't (or vice-versa), you can contribute to a spousal IRA as long as you file a joint tax return. It's a regular Roth IRA or traditional IRA, but it's funded for a non-working spouse using the other spouse's earnings. When your income is too high to make Roth IRA contributions, you can use a backdoor Roth IRA strategy, in which you contribute to a traditional IRA. Then you immediately convert it to a Roth IRA. Just be prepared to pay any applicable taxes by the tax deadline for the year you do the conversion.

2. When the five-year rules apply

To avoid paying income taxes when you withdraw your earnings, the Roth IRA five-year rules apply. One of those rules says that even when you can avoid the 10% penalty on withdrawals -- like if you're 59 1/2, or you're using the money for a qualified home purchase or higher education --- you'll usually owe income taxes if you haven't had a Roth account for at least five years.

But these rules apply only to your earnings, not your contributions. Your contributions are always yours to access at any time, 100% tax- and penalty-free.

There's also a second five-year rule that governs conversions from traditional retirement accounts to Roths. For each Roth conversion, if you take money out before five years, you'll owe the 10% penalty on withdrawals unless you're already 59 1/2 or meet other exceptions.

Again, taking money from your Roth IRA for non-retirement purposes is only something you should do if you've considered other options. But the flexibility to withdraw your contributions at any time can make using your Roth IRA in an emergency a better option than turning to a traditional retirement account.

3. The RMD rules

If you're wondering when you have to start withdrawing that Roth IRA money, the answer is: never. Unlike other retirement accounts, Roth IRAs don't have required minimum distributions (RMDs). You can withdraw as much or as little as you want tax-free -- or you can choose not to spend a cent of it in your lifetime. The only people who have to worry about RMDs on Roth IRAs are those who inherit them from someone else.

4. Who counts as a first-time homebuyer

You're allowed to use up to $10,000 of your Roth IRA earnings for a first-time home purchase without paying taxes or a penalty, as long as you've had the account for five years. If you're married, you're each allowed to take $10,000 from your Roth IRAs, so you can take $20,000 total.

But you don't really have to be a first-time homebuyer. The IRS will consider both you and your spouse to be first-time homebuyers if neither of you has owned a home in the past two years. Bear in mind that $10,000 is a lifetime cap, so you can't use $10,000 of Roth IRA earnings for a home purchase and then do it again a few years later.

Also, just because you're allowed to use a Roth IRA to purchase a home doesn't make it a great idea, because you're missing out on compound growth. Making a smaller down payment, saving more, or buying a less expensive house are often better options than withdrawing Roth IRA money.

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