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The overlooked benefits of Roth investment accounts

Tax-free earnings. That sure has a nice ring to it. Roth individual retirement accounts and Roth accounts in retirement plans, such as 401(k) plans and 403(b) plans, are increasingly popular because earnings can be exempt from taxes if you follow the many rules.

Rules apply with regards to contributing to Roth accounts, converting funds in a traditional IRA or other pretax retirement account to a Roth, and reversing or "re-characterizing" a conversion. These rules can be tricky, and many aspects of a Roth investment are often overlooked. Below we share six features savers should keep in mind. (For more, see Youth and Roth IRA Equals a Solid Retirement Plan.)

ROTH IRA
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Unlike traditional IRAs, you can get money out of a Roth IRA prior to age 59½, tax- and penalty-free. Distributions from a Roth IRA are taken based upon ordering rules. Regular contributions ($5,500 in 2015) and catch-up contributions ($1,000 in 2015 for persons age 50 and older) come out first, followed by amounts converted more than five years ago. These funds have already been taxed and can be received tax- and penalty-free.

Conversions less than five years old may incur a 10 percent penalty, and earnings from the account would generate both taxable income and a 10 percent penalty if a withdrawal is made. Access to Roth accounts in other retirement accounts, such as 401(k) plans and 403(b) plans, are subject to additional access limitations.

With a traditional IRA, you cannot simply take out after-tax contributions. A pro-rata rule applies, which will result in only a portion of a distribution from an IRA being excluded from taxation.

Roth IRA accounts can continue to grow past age 70½ in two ways traditional IRAs cannot. First, Roth IRAs are not subject to required minimum distributions at age 70½. Converting funds to a Roth will end RMDs on the funds converted. Second, if your total income is under certain limits, you can make contributions (up to $6,500 in 2015) to a Roth IRA past age 70½ as long as you receive taxable compensation such as wages. Contributions to a traditional IRA post 70½ are prohibited. Note: RMDs usually apply to Roth accounts in other retirement plans.

Flexible distributions. The beneficiaries of your Roth IRA can choose to take the funds and place them in an inherited IRA instead of taking a lump sum. This allows beneficiaries to keep most of the funds in the Roth structure and continue to accumulate earnings tax-free.

Heirs would only be required to take out a minimum amount each year (also tax-free) based upon their life expectancies. If heirs ever need more than the minimum, they can take additional amounts at any time.

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Conversions available. Roth conversions are available to anyone with an IRA, regardless of age or income. Whether or not one should convert is another matter. The government would love high-income earners to convert and pay the taxes at their high tax rates.

Remember, with a Roth conversion, taxes are paid now so none are paid later. Conversions make sense when the taxes paid by the person converting would be less than the taxes that would be paid on a distribution from a traditional IRA or retirement account by whomever takes the distribution in the future.

Conversions are not as attractive if you do not pay the taxes with non-retirement account monies. Say a person converts $20,000 while in the 25 percent tax bracket — $5,000 in taxes are due. If that is paid from a non-retirement account, such as an ordinary checking account, all $20,000 can grow tax-free. If the taxes are paid by withholding, only $15,000 remains in the Roth account. Plus, if you are under age 59½, the amount withheld is considered a distribution and can be subject to a 10 percent penalty.

Do-overs are allowed with a Roth investment. Did you ever play a game as a child and someone would call for a "do-over" when something didn't go right? The tax code offers a great one, called a recharacterization. If you regret a conversion to a Roth IRA for any reason, you can recharacterize all or any portion of the conversion. The recharacterized funds are put back in the traditional IRA, and your taxes are adjusted as though the conversion never happened. Note: Recharacterization is not allowed for so-called in-plan conversions inside other retirement plans, such as 401(k) plans.

"Recharacterization allows the luxury of applying perfect hindsight to go back in time and unwind a tax strategy. That is a rarity in life."

There is still time. You have up until the deadline for extended returns (typically, October 15) of the year after the year of conversion to recharacterize.

Roth IRAs also give you the ability to recharacterize losing investments. Say you convert $50,000 of all pretax IRA money and put half in investment A and half in B. A year later, A is worth only $10,000 and B is worth $40,000. Do nothing and you have $50,000 in income from the conversion and $50,000 in a Roth IRA ($10,000 in A and $40,000 in B).

Because recharacterization calculations are based on each account, you could have instead converted $25,000 to a new Roth IRA holding investment A and converted another $25,000 to a second new Roth IRA account entirely invested in B. In this case, you would only recharacterize the conversion to the Roth with the investment in A, wiping out $25,000 of taxable income. You could then reconvert the $10,000.

The end result: The same $50,000 balance, which resulted from the first scenario, is now split between two Roth IRAs. The bigger difference is, this was obtained by paying tax on just $35,000 of income ($25,000 on the conversion to the account with Investment B and $10,000 on the second conversion to Investment A). The table below shows the difference.


Recharacterizing Roth IRAs

1 Roth IRA
2 Roth IRAs
Difference
Value on conversion $50,000 $50,000 $0
Value of Roth IRA $50,000 $50,000 $0
Value of traditional IRA after conversion $0 $0 $0
Ordinary income recognized $50,000 $35,000 ($15,000)
Ordinary income tax at 25% $12,500 $8,750 ($3,750)
Dan Moisand, Moisand Fitzgerald Tomayo

Recharacterization allows the luxury of applying perfect hindsight to go back in time and unwind a tax strategy. That is a rarity in life.

As with many elements of tax planning, this strategy is not a no-brainer. But while the law allows you to have as many IRAs and Roth IRAs as wanted, multiple accounts increase complexity. Each conversion is accounted for separately and over multiple tax years.

Year one logs the conversion. In year two, as late as October 15, a recharacterization is filed. Then you must wait until the year after the original conversion or 30 days after the recharacterization, whichever is later, to perform the second conversion of the Roth account holding investment A. Investments are volatile, and any rise in A reduces the tax savings. For those under age 59½, a new five-year clock starts for each conversion separately from other conversions.

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Low-bracket taxpayers have the additional issue: When they recharacterize, taxable income from a low-income year is removed. When the losing Roth IRA is converted again, the loss in that IRA needs to be substantial or the tax bracket low enough in that particular year to keep from increasing the tax bill.

Despite the complexity, Roth IRAs and Roth retirement accounts can be powerful tax-planning tools when used prudently.

(Editor's note: This guest column originally appeared on Investopedia.)

— By Dan Moisand, principal/senior financial planner of Moisand Fitzgerald Tamayo www.moisandfitzgerald.com