The biggest benefit of a Roth IRA is that you get to take tax-free withdrawals in retirement. You contribute with after-tax income, that money gets invested in your account, and your entire balance (including earnings) can be withdrawn without owing any taxes in retirement. And because there are no capital gains taxes in a Roth IRA, your money can get compounded tax-free until retirement.

But can a Roth IRA lose money, and what happens to your account and tax situation if you end up with a losing portfolio?

How a Roth IRA works

To learn how a Roth IRA can lose money, let’s first quickly look at how a Roth IRA works once you put money into your account.

After-tax contributions: With a Roth IRA, you contribute money into the account with after-tax income (income you’ve already paid taxes on). Once the money is in your account, you get to choose how that money gets invested. Typical investment options are traditional assets like individual stocks, bonds, mutual funds, and ETFs. You can also invest in alternative assets through special self-directed IRAs.

Tax-free compounding: You don’t pay any taxes on the gains you make from these investments. All profits can get reinvested, giving you the advantage of tax-free compounding. A Roth IRA is different from other retirement accounts because you’re allowed to withdraw the contributions made into your account at any age without penalties. However, to withdraw earnings from your account, you have to wait until you reach 59½ years of age, plus your Roth IRA must be at least 5 years old.

Tax-free withdrawals: The biggest advantage of a Roth IRA is tax-free withdrawals in retirement. No matter how large the earnings from your investments may be, you can withdraw everything without any taxes owed to the IRS. This is different from a traditional IRA where you fund the account with pre-tax income, receive a tax deduction, but have to pay ordinary income taxes when you withdraw in retirement.

For example, if you’ve contributed a total of $50,000 into your Roth IRA over the years and it grew to a balance of $5 million through your investments, you would be able to withdraw the entire $5 million from your account completely tax-free.

Also read: Roth IRA Vs Traditional IRA: Key Differences & Similarities

Can a Roth IRA lose money?

Yes, a Roth IRA can lose money in the same way your personal investing account can lose money. Roth IRAs are not a risk-free investment and there is always the potential that your investments will underperform.

A Roth IRA does get special tax treatments, like tax-free compounding, that could help you grow your money faster, but that doesn’t necessarily shield you from bad investment decisions or volatile market conditions. Like all forms of investing, a Roth IRA requires smart portfolio management in order to make money over the long-term.

How can a Roth IRA lose money?

There are several different ways that a Roth IRA can lose money, the main one being if your investments lose money. Other money losers like penalties are not impactful enough to turn a wining portfolio into a losing one on their own, but are still worth mentioning here.

Your investments in your Roth IRA can lose money

Because your Roth IRA funds get invested into stocks, bonds, mutual funds, or ETFs, it’s entirely possible that your investments lose money, especially if you’re taking on bigger risks in volatile market conditions.

If you’re trying to actively trade and beat the market, you have a higher risk of underperforming as even the best mutual fund managers have difficulty consistently outperforming the market. However, your risk is usually reduced if you passively invest into index funds and ETFs to match market performance, and not try to beat it. While the market can be volatile year to year, it consistently returns around 10% per year if you invest long-term.

Some people even choose to invest their Roth IRAs into higher risk assets like crypto and real estate using a self-directed Roth IRA.

Early withdrawal penalties can put a dent in your account value

As mentioned earlier, a Roth IRA lets you withdraw contributions made into your account at any age without penalties. However, you can’t withdraw any earnings from your account until your Roth IRA is at least 5 years old, and you reach 59½ years of age. If you withdraw earnings early, you would be hit with a 10% early distribution penalty and income taxes on the withdrawn amount.

Going back to the previous example, if you contributed a total of $50,000 into your Roth IRA over the years and it ballooned into a balance of $5 million due to smart (lucky?) investments, you would be allowed to withdraw the $50,000 in contributions made at any age without penalties or taxes. However, that leaves $4.95 million in your account that can’t be withdrawn until your Roth IRA is 5 years old, and you’re at least 59½ years of age.

While the 10% early distribution penalty usually won’t be a big enough hit to turn a profitable portfolio into a losing one, it can still eat into your account asset value and push you towards a loss if your investments are falling in value.

How to avoid losing money in a Roth IRA

Diversify and invest long-term

There are many different styles of investing that you can choose to invest your Roth IRA funds, and it all depends on your risk profile and goals. Some people have higher risk profiles than others and might actively trade stocks to try and beat the market. Riskier investors tend to find higher-risk, higher-reward investments and put a large percentage of their portfolio into a single position.

However, even the best fund managers have difficulty beating the market every single year. Markets can be volatile and unpredictable from year to year, but has consistently returned an average of around 10% per year when investing long-term.

To reduce your chances of safest investment strategy that would reduce your chances of losing money in your IRA is to diversify your portfolio, aim to match the market (not beat the market), and invest long-term.

Also read: The Average Stock Market Returns Over The Past 10, 20, 30, and 40 Years

Avoid early withdrawal penalties

As mentioned earlier, you can withdraw your contributions only from your Roth IRA at any age without any penalties or taxes. To withdraw earnings, you must wait until your Roth IRA is at least 5 years old (5 years must have passed since your first contribution) and you must be at least 59½ years old. Early withdrawals of earnings before you’re eligible can result in a 10% penalty plus income taxes.

Avoid high trading fees

You will incur different trading fees (in the form of an expense ratio) depending on what you choose to invest in. Actively managed mutual funds will have higher fees of around 0.5% to 2%, while ETFs and passively managed index fund fees can be as low as 0.05%. While a 1% fee might sound small, this is a yearly expense charged as a percentage of your position in the fund. For example, with a $1 million portfolio, a 1% would result in a $10,000 annual fee.

Fortunately, higher expense ratios are usually only found in actively managed mutual funds that try and beat the market. Your expense ratios will be lower if you’re just investing in index funds and ETFs through passively managed funds that aim to match the market.

Also read: Average Expense Ratios for Mutual Funds, Index Funds, and ETFs

What do people typically invest in with their Roth IRAs?

A Roth IRA can get invested into most traditional assets. Popular IRA investments include stocks, bonds, mutual funds, ETFs, REITs, and target-date funds.

Some higher-risk profile investors may choose to diversify their portfolios by investing in alternative assets (like crypto and real estate) using a self-directed IRA. These often come with higher fees in exchange for access to special asset classes not accessible through your typical brokerage.

Also read: Index Funds vs ETFs vs Mutual Funds: Which One Should You Choose?

Is a Roth IRA safe?

A Roth IRA gives you a number of tax advantages including:

  • Tax-free compounding: You don’t have to pay any capital gains tax on your investment gains and can reinvest all profits.
  • Tax-free withdrawals in retirement: Once eligible, you can take money out of your account completely tax-free no matter how large your account has grown.
  • Withdraw contributions at any time: This isn’t really a tax advantage, but it’s still a convenient option to have if you’re in need of emergency funds.
  • No RMD: Most retirement plans require that you start taking distributions once you turn 73 years old. A Roth IRA has no RMD rules and can keep compounding until the account holder is alive.

But even with the benefits that come with a Roth IRA, you’re still at risk of losing money if your investments lose money. A Roth IRA can be a safe investment if you build a diverse portfolio, avoid early withdrawal penalties, and invest long-term. In other words, don’t put 100% of your Roth IRA into speculative plays like GameStop and pray it’ll moon overnight.

Because of the power of compound interest, a Roth IRA is most effective when compounded over a long period of time. Anyone with earned income can open and contribute to a Roth IRA, as long as you don’t exceed the Roth IRA income limits. Even children can start compounding money from an early age through a custodial IRA.

For example, here’s the difference in portfolio growth at age 65 if you start maxing out your Roth IRA at age 13 versus age 21.

Start investing early, take advantage of compound interest, and let time and the power of compounding do its thing to build wealth into retirement.