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Roth IRA Tips, Tricks and Twists

There are several extraordinary methods to maximize the advantages of these accounts.

You no doubt are aware of the basic benefits of the Roth IRA. First, any future investment earnings and interest are sheltered from taxation. Then when the client reaches age 59½ withdrawals are (generally) tax-free, and there are no mandatory withdrawals while the Roth IRA owner is alive, even after she turns 70½.

However, there are several lesser-known features to the vehicle that could save your clients taxes and trouble in good times and bad. Here are some hidden ways that Roth IRAs can be used to boost your clients’ financial well-being.

Special Occasions

Roth IRA contributions can be withdrawn at any time for any reason with no taxes or penalties whatsoever. The IRS lets the Roth IRA owner designate withdrawals as “contributions,” until the amount taken out equals the amount deposited. But, any earnings withdrawn that exceed the contributed amount can get hit with taxes and a 10 percent penalty if the Roth IRA owner is under 59½. However, there are a few circumstances that allow Roth IRA owners under age 59½ to avoid the 10 percent penalty (not including taxes) on distributions of Roth IRA earnings, as well.

The first is to pay for qualified higher education expenses incurred by the Roth IRA owner or eligible family members. Unreimbursed medical expenses also qualify if the expenses exceed 7½ percent of the Roth IRA owner’s adjusted gross income. Finally, if the Roth IRA owner is unemployed, he can avoid the 10 percent penalty on the earnings withdrawal if he uses the Roth IRA funds to pay for health insurance premiums.

For more information on the exceptions, check Topic 557 at

Turning Losses Into Tax Savings

Clients who see a decline on the investments within their Roth IRAs can use those losses to cut their taxes—if they’re willing and able to jump through a few hoops.

First, they have to liquidate all of their Roth IRA accounts. The potentially realizable loss is the total withdrawn, minus the amount contributed. That loss isn’t a typical capital loss. Instead, it’s a miscellaneous itemized deduction, which is then added to the client’s other miscellaneous itemized deductions for that particular tax year. The amount of those deductions that exceeds 2 percent of the client’s adjusted gross income is deductible, assuming the clients itemize instead of taking the standard deduction.

There are some key drawbacks to this strategy. Besides the issues with the deductions, the clients will be challenged to rebuild their Roth IRA accounts through contributions, especially if they either don’t have any earned income or their earnings exceed the limits for making contributions.

One Just for Junior

Assets invested for minors are often held in UTMA/UGMA accounts that are managed by an adult (usually a parent), until the minor reaches adulthood and can take control over the money. In the meantime, calculating the taxation of any capital gains and interest generated within the accounts can be an annual nightmare. Worse yet, if the child goes to college and applies for financial aid, up to 25 percent of the UTMA/UGMA account will be included in the Expected Family Contribution (EFC), the amount required for the family to pony up before any need-based financial aid is awarded.

However, if the child in question has a job (and income), both of these problems can be solved. The UTMA/UGMA assets can be sold, and the proceeds can be used to fund a Roth IRA for the child, in an amount up to the lesser of the kid’s annual earnings, or $5,500. The federal and institutional financial aid formulas usually don’t count assets in Roth IRA accounts in the EFC, so the money won’t reduce any need-based financial aid. However, since Roth IRA contributions can be withdrawn at any time for any reason with no taxes or penalties, the student’s Roth IRA can still be tapped relatively pain-free for higher education expenses (or any other urgent need).

Social Security Savings

Technically, Social Security payments are tax-free to retirees. However, there is a “means test” that can turn those payments into federally taxable (and maybe state-taxable) income in a hurry.

The determining formula requires recipients to start with their AGI, add “non-taxable interest” (i.e., from municipal bonds) and finish by adding in half of their Social Security income. But, distributions from Roth IRAs aren’t included in the formula. So, clients could take an infinite amount of money from their Roth IRA, and it still wouldn’t affect the taxation of their Social Security income.

However, note that money converted from an IRA to a Roth IRA will be included as taxable income to the client in the year of conversion; therefore, it will also figure in the means-testing formula that determines if their Social Security payments are taxable. Hence, you and your clients may want to make any IRA-to-Roth IRA conversions before initiating their Social Security retirement payments.

Family Finances

You probably work with some older IRA owners who are in a low-or-no income tax bracket and have named younger higher-income family members as the beneficiaries of the accounts. Once the IRA owners pass away, the inheritors, generally, have to begin taking distributions from the accounts and pay income taxes on the withdrawals. Therefore, the older generation may want to convert some or all of their IRAs to Roth IRAs now, so that their tax bill now will (hopefully) be less than what the inheritors will pay. Better yet, the older clients will be done with required minimum distributions (RMDs) on the amount converted. On the Roth IRA owner’s death, the beneficiaries will have to take the RMD amount each year, but that will be tax-free. They can also take more than that amount out if they wish to forego the advantage of any future earnings being sheltered from taxation.

In fact, it’s such a good deal for the beneficiaries that they should be convinced to pay the taxes on the conversion out of their own pockets.

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