Tax-free earnings are an overlooked benefit of Roth investment accounts

Tax-free earnings are an overlooked benefit of Roth investment accounts
Tax-free earnings are an overlooked benefit of Roth investment accounts

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.


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