Overlooked aspects of Roth accounts

“Tax free earnings”- that sure has a nice ring to it!  Roth IRAs and Roth accounts in retirement plans such as 401(k)s and 403(b)s 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 pre-tax retirement account to a Roth, and reversing or “recharacterizing” a conversion. These rules can be tricky. Based on reader questions from our Q&A columns, we know many aspects of Roths are often overlooked. Below we share six often overlooked features:

1. Tax Free Withdrawals Before Age 59 ½

Unlike traditional IRAs, you can get money out of a Roth IRA prior to age 59 ½ 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.

With a traditional IRA, you cannot simply take out after-tax contributions.

Conversions less than 5 years old may incur a 10% penalty and earnings would generate both taxable income and a 10% penalty if a withdrawal is made. Access to Roth accounts in other retirement accounts such as 401(k)s and 403(b)s 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.

2. No Required Minimum Distributions (RMDs)

Roth IRA accounts can continue to grow past age 70 ½ in two ways traditional IRAs cannot. First, Roth IRAs are not subject to RMDs at age 70 ½. 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 70 ½ as long as you receive taxable compensation such as wages. Contributions to a traditional IRA post 70 ½ are prohibited. Note: RMDs usually apply to Roth accounts in other retirement plans.

3. 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.

4. 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. (See: Should I Convert to a Roth IRA?) 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.

Remember, with a Roth conversion, taxes are paid now so none are paid later.

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% 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 59 ½, the amount withheld is considered a distribution and can be subject to a 10% penalty.

NOTE: Due to the tax code changes that went in effect beginning in 2018, conversions made in 2018 and later can no longer be recharacterized. Only contributions can be recharacterized.

5. Recharacterizations Are Allowed

“Do-overs” are allowed. 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)s.

The tax code offers a great one (a “do-over”), called a “recharacterization.”

There is still time. You have up until the deadline for extended returns (typically October 15th) of the year after the year of conversion to recharacterize. This means that if you converted anytime in 2014, you could undo the transaction as late as October 15, 2015. This can be done even if no extension was filed, taxes were paid, and a 2014 return was filed by the normal April 15 deadline. If you are contemplating a conversion in 2015, you have until October 17, 2016 to recharacterize because October 15th is a Saturday.

6. Losing Investments Can Be Recharacterized.

gg-btc-do-over-buttonRoth IRAs allow you the ability to recharacterize losing investments. Say you convert $50,000 of all pre-tax 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.

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

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:


1 Roth IRA 2 Roth IRAs Difference
Value on Conversion $50,000 $50,000
Value of Roth IRA $50,000 $50,000
Value of Traditional IRA after conversion $0 $0
Ordinary Income Recognized $50,000 $35,000 ($15,000)
Ordinary Income Tax at 25% $12,500 $8,750 ($3,750)


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. 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 59 ½, a new five year clock starts for each conversion separately from other conversions (see #1 above).

Low bracket taxpayers have the problem of 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.

Roth IRAs and Roth retirement accounts can be powerful tax planning tools when used prudently. To achieve the most benefit, we are happy to navigate the minefield of rules and employ strategies which best fit our client’s financial plans.

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Moisand Fitzgerald Tamayo, LLC is an Orlando, Tampa and Melbourne, Florida based fee-only financial planner serving central Florida and clients across the country. Moisand Fitzgerald Tamayo, LLC specializes in providing objective financial planning, retirement planning, and investment management to help clients build, manage, grow, and protect their assets through all phases of one’s life and the many transitions in between. If you have any questions or would like to discuss anything further, please give us a call or send us a note. If you are not a client and wish to receive emails notifying you of new posts – no more than once per month – fill out the subscription information in the sidebar to the right. For more frequent updates, follow us on FacebookLinkedIn, or Twitter.  

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About Dan Moisand

Dan Moisand is a fee-only financial advisor with Moisand Fitzgerald Tamayo, LLC. He is a regular contributor for multiple outlets, including Florida Today, MarketWatch, and The Wall Street Journal. His writing and financial advice have also been featured in Financial Planning, Investment Advisor, Wealth Manager/Advising Boomers, Forbes, Smart Money, and The New York Times, among other publications. He is the only two-time winner of the Journal of Financial Planning’s “Call for Papers” competition and has been named a top financial planner and advisor by multiple publications. Investment News named Dan one of the “twenty most influential men and women” in the history of financial planning. He currently serves on the Board of Directors for the CFP (Certified Financial Planner) Board.


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