roth ira - The Finance Gourmet

Understanding How Beneficiaries Work

As a financial advisor, I used to review client’s paperwork when they came in for an appointment. Among many other things, I always made sure to go over was to review beneficiaries of my client’s accounts. Or, more to the point, I TRIED to review the beneficiaries on my client’s accounts. All too often, they had no idea who the beneficiaries were, or how to find out. Even worse, they often just decided to assume that they knew the beneficiaries on their accounts.

Out of date beneficiaries is one of the most common financial problems people have when they start financial planning.

What Are Beneficiaries

When someone dies, there are a series of laws that determine exactly how your assets get dispersed among the living. These laws are long and complex. They are collectively referred to as estate law, and it is complicated enough to be an entire specialty for attorneys. The primary instrument for distributing your assets as you see fit, rather than as how the law dictates, is your will. However, there are several kinds of accounts that do not fall under this process, unless you do not properly designate your beneficiaries.

In this context, a beneficiary is the person who will receive some, or all, of the money or assets contained within certain kinds of accounts. The special thing about beneficiaries is that they are not subject to the traditional estate process. This is what many people do not understand. Your designated beneficiaries have nothing to do with your will, your trustee, or any sort of probate at all. They will receive the assets completely outside of this process.

In other words, a beneficiary designation trumps normal estate law.

In order to ensure a full grasp of what this means, some examples are helpful.

Beneficiary Example 1: A man has $500,000 in total assets. $300,000 are in an account with beneficiaries and $200,000 are in various other financial accounts. The first account has the man’s son listed as the only beneficiary. The man’s will says that all of his assets should be split 3-ways between his three children. How much does each child get?

Under the terms of the will, you might thing that each child gets one-third of the $500,000 in total assets. However, this is not what happens. Having a beneficiary takes those assets out of the estate process altogether. So, in this case, the will splits up only the $200,000 that remains. The three children split that money equally. The son listed as the beneficiary gets not only his one-third share of $200,000, but all of the $300,000 account he is listed as a beneficiary on.

The son listed as the beneficiary gets $300,000 + 1/3 of $200,000 ($66,667) = $366,667
The other two children get $66,667

Is that what you expected?

Beneficiary Example #2: A woman has an account with $100,000. The beneficiary is her husband. Years later, she divorces him and remarries. The woman visits her attorney and updates her will to state that none of her assets go to her ex-husband and that her current husband should inherit everything.

When the woman dies, the $100,000 still goes to her ex-husband, and there is nothing the current husband can so or do about it. The named beneficiaries of an account takes precedents what the will stipulates.

Beneficiary Example #3: A man has an account that lists his two children, Steve and Jane, as beneficiaries in equal amounts. Steve dies before his father. The father never updates the account. When the father dies, how much does Jane receive?

This is where it gets really complicated, because there are different types of beneficiaries.

Not updating beneficiaries is one of the major mistakes people make when doing financial planning. The problem is that people don’t think about beneficiaries unless they are doing estate planning, which focuses on the drafting of wills and trusts. Ensure that you review all of your account beneficiaries regularly and share that information with your financial planner and estate attorney so that everything happens the way you desire.

Smart to Use Roth IRA For College

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Should I use my Roth IRA for college?

As a former financial planner, I would often get these questions from clients who read something somewhere. Much like patients asking doctors about drugs they heard about on TV, such questions rarely ended up being a good idea. Still, it is possible to use a Roth IRA to pay for college, but it only makes sense in very specific circumstances.

First, you probably know that a Roth IRA is designed for retirement savings, so that is what it is best used for. The corresponding vehicle for parents saving for college is a 529 college savings plan. In general, the best way to save for college is in a 529 plan versus a Roth IRA. That being said, a Roth IRA can be used, and may be clever in certain circumstances.

Can I Use Roth IRA for College

Let’s start with CAN you use a Roth IRA to pay for college. We’ll look at SHOULD you use a Roth IRA for college next.

As you may know, a Roth IRA offers tax-advantaged growth for investments within the account. This creates two kinds of money inside of a Roth IRA. The first kind of money is contributions. Contributions are the monies directly deposited into the account. They do not include any dividends, interest or gains on investments. If you put $5,000 in a Roth IRA for 10 years, then your contributions are $50,000, no matter what the account is actually worth. Any amount above $50,000 is earnings.

There are two features of a Roth IRA that allow for its use to fund college without paying penalties. First, all contributions can be withdrawn without penalty or taxes. In other words, in the case above, the taxpayer could use $50,000 to pay for college (or anything else for that matter) without taxes or penalties.

The second feature is that there is an exception allowing Roth IRA funds to be used to pay for qualified college expenses. Basically, if you are deliberately trying to stretch what “college expenses” means, it probably counts. Tuition, fees, books, supplies and equipment, at an institution with the word university or community college in the name are pretty much all covered. (Typically, non-degree programs like a coding bootcamp, or writers retreat don’t count.) You are allowed to pay such expenses for yourself, your spouse, your children, and their descendants (that means grandkids and great-grandkids are included).

However, this Roth IRA distribution exception only applies to the penalties that would ordinarily be due. The withdrawal does still count as taxable income. This can be a double whammy, because not only do you owe taxes on these funds, but it also increases your income for purposes of financial aid. Since financial aid takes into account your income, artificially inflating it by taking funds from your Roth IRA may not be a good strategy.

Is It Smart To Use Roth IRA for College?

Additionally, you are literally stealing from your retirement in order to pay for a child’s college. Not only is that money not available for your retirement, but that money is not able to grow while you are still working. At 8% growth over 20 years, that $50,000 withdrawal isn’t just $50,000 gone from your retirement, but $234,500 gone from your retirement.

One of the running themes on this blog is that despite what might be “best” mathematically isn’t necessarily what is right for each of us as unique humans with emotions. For parents who really want to help their kids with college, but who don’t have any other money saved up, a Roth IRA offers a tempting, if non-optimal, way to tap into some funds. That being said, keep it as minimal as possible, ideally, no more than the total amount of your contributions to avoid additional taxes.

Remember, as unappealing as student loans sound, there is no such thing as retirement loans. Consider if you are better off helping your child pay back students loans over time, rather than raiding your retirement savings to send them to college.

If you, or your child, is already looking to pay for school, the Roth IRA is an option, if not the best one. If, however, you are thinking of how, or where to save, consider setting up a 529 plan instead and save money specifically for college.

What Is a Roth IRA?

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What is a Roth IRA, and is a Roth IRA the best way to save for my retirement?

Even the basics in financial planning aren’t always so basic, and the basics of IRA plans, is one of those times.

IRA stands for Individual Retirement Account. As you may imagine, that means it is an account for an individual (versus a group like a 401k plan is for) to use in order to save for retirement. As an enticement to actually save for your own retirement, the government gives you tax advantages for using an IRA for retirement planning. As a way to keep you from pulling money out for other things besides retirement, there is a penalty if you use it for something else.

Roth IRA versus Traditional IRA

With a traditional IRA, or just IRA, you get a deduction from your taxes today, unless your income is too high, and tax deferred growth on the money in the account. When you start taking the money out, you owe taxes on both the contribution and the gains. (If you earn too much money to take the tax deduction on your contributions, then you do not have to pay taxes on those funds again when you withdraw them.)

With a Roth IRA, you get no tax deduction today, but the earnings grow tax-free inside the account, and you pay no taxes on either the withdrawal, or the earnings when taken in retirement.

Both types of IRAs require you to be age 59 1/2 to make a qualified non-penalized withdrawal, unless you meet certain, very specific exceptions. If you are not 59 1/2 years old when you withdraw money, it will be subject to both ordinary income tax and a 10 percent penalty.

Roth IRA Rules

There are Roth IRA income limits that prevent certain high-income tax payers from contributing to a Roth IRA. Although such taxpayers can do a Roth conversion to convert a regular IRA account into a Roth IRA account.

After that, the most important thing to understand about a Roth IRA and the rules for Roth IRAs is that you do not get a tax deduction for contributions. That means any money you put into a Roth IRA has already been taxed and will not be taxed again. The other thing you must understand is that this is NOT true for any dividends or gains in the account. If you grasp these two concepts, then understanding the Roth IRA is easy.

Because you already paid taxes on your contributions, you can withdraw them at any time — even before age 59 1/2 — without paying taxes or penalties. But, all money above and beyond the contributions are fully taxable and subject to penalties.

So, if you put $5,000 into an IRA for 10 years, that is $50,000 in contributions. If during that time, your investments have done well such that the total value of the account is $110,000, then, you could withdraw up to $50,000 with no taxes or penalties. However, money withdrawn after that would be subject to taxes and penalties unless you are over age 59 1/2 unless you meet one of the following exceptions:

Disability (as defined by the IRS)
Certain qualified first-time home buyer distributions
Certain medical insurance premiums while unemployed
Certain unreimbursed medical expenses above a percentage of income
Due to certain IRS levies
Qualified reservist distributions
Distributions as part of a series of substantially equal period payments for life (This is a neat exception for some people. I’ll have to cover it in detail elsewhere, but you can start taking money whenever you want if you essentially calculate an annuity amount and take the calculated amount every year.)
Distributions for certain higher education expenses.

Note the above exceptions are still taxable, but are not subject to the 10% penalty. In other words, if you took $10,000 out of your Roth IRA to pay tuition, that $10,000 still counts as income (and is taxes as such) but there is no $1,000 (10%) penalty. Of course, the whole amount is tax and penalty free if it was part of your contributions to the account.

How a Roth IRA Works

Functionally, a Roth IRA works just like a regular IRA. You open an account with an IRA custodian, typically a bank or brokerage, and deposit money into the account. Within the account, you can invest in stocks, bonds, mutual funds, and other investments. Those investments pay dividends, have capital gains, and the like. Since the Roth IRA is a tax-advantaged account, you do not pay taxes on those dividends or capital gains, or anything else, so long as it is in the account.

Every year, you will get a Form 5498 from your IRA custodian. Since a Roth IRA does not give you a tax deduction, you really don’t do anything with the Form 5498, other than stick it in your folder of tax documents. (The purpose of the form is to let the IRS know about the contribution. You are just getting a copy.)

When it comes time to make a withdrawal, you follow your bank or brokerage’s procedure. It may be as simple as filling out a form, or even doing an online transfer. When you start making withdrawals, you will get a Form 1099-R from your custodian. It will report the amount of the distribution, but that distribution will not be taxable, unless you are under 59 1/2.

Using Roth IRAs for Other Stuff

A lot of the difficulty understanding Roth IRAs comes from the fact that you can use them for other stuff by withdrawing your contributions, even if that isn’t necessarily the best idea.

Consider, for example, you want to save money for a vacation home. As your second home, you can’t use the first-time homebuyer exception, but you could use your contributions.

It would work something like this:

Every year, you and your spouse contribute $5,000 into a Roth IRA, or $10,000 total.
After 5 years, you have $50,000 in contributions, and some amount of earnings. Let’s say you have $10,000 in earnings, or $60,000 total account balance.
You withdraw $50,000 for the down payment, and leave the remaining $10,000 in the Roth IRA to grow for retirement.

This isn’t necessarily the best move. After all, you’ve just raided your retirement account. Theoretically, if you had plenty of money elsewhere for retirement, say a pension, or you’ve contributed a ton to a 401k account, then maybe this makes sense. However, if you aren’t already feeling pretty solid for retirement, this kind of thing is only setting you back.

myRA IRA Review – Safe and Legit

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No matter how helpful the government could potentially be to its citizens, it typically won’t/can’t get involved in finance because there are huge lobbying dollars behind financial services companies. For example, it would be relatively trivial for the IRS to create a free, online, auto-filing system that would work for most taxpayers, increase tax collections, and be a win-win for everyone involved. Everyone, that is, except for TurboTax, who, obviously, spend millions of dollars each year keeping such a system away from its lucrative tax software business.

This is why I was surprised to find out about myRA, a no-cost government Roth IRA program aimed at people who might otherwise have a hard time getting started saving for retirement.

What Is myRA and Is It Safe and Legitimate?

The myRA account is a government run Roth IRA. As such, it follows all of the same rules as a regular IRA. There is a maximum Roth IRA contribution amount allowed each year. This year, it’s $5500, with an additional $1,000 “catch-up” contribution allowed for people 50 or older.

So, what’s the benefit of using the myRA program?

The myRA IRA has no start up cost, no IRA annual fees, and just as important no minimum contribution or starting balance. So, you can literally start saving $2 per month, if you like. The idea behind the program is to overcome the initial obstacle so many people have where just getting an account started is too costly, too much work, or too confusing. To sign up for a myRA, you just need a Social Security Number, a Driver’s license, and the name and date of birth of someone to be the beneficiary on the account — that’s who gets the money if you die.

One key difference between the myRA and other IRAs is that there are no investment choices in the myRA. All funds are deposited into the Government Securities Fund, which is a risk-free fund of U.S. Government Treasuries. This fund is very much like the Government Securities Fund available in the 401k plans of government employees. This fund has historically earned just over 2%. For people just getting started for retirement, this is a good way to get started. Most funds or investments in an IRA require a minimum investment, but with myRA, you can literally start with $1 and still earn better than a savings account.

As a Roth IRA, you can withdraw your contributions (the money you put in) at anytime without taxes or penalties. That makes using your Roth IRA as an emergency fund a good way to put money aside for retirement, while still having savings available if you ever need them. Note: You cannot withdraw the earnings (interest) until you are 65, or you will pay a penalty and taxes on the withdrawal.

To contribute to a myRA, you can setup a payroll deduction with your employer, or link it to a checking account. From there, you can initiate regular, recurring transfers, or one-time contributions. According to the website, you will also be able to directly contribute from your tax refund on Form 1040 by sending your refund to a myRA account instead of getting the money back as a check or ACH deposit.

Before you go worrying that the government is actually going to start standing up to the financial industry in order to make things easier for citizens, don’t fret. The myRA comes with strict limits that ensure it will only be used by those that the banks and brokerages can’t profit from. The maximum balance allowed in a myRA is $15,000. After that, you have to transfer it to a private-sector Roth IRA account.

Overall, the myRA is a great way for people without a 401k plan to get started saving for retirement right away.