Roth IRA

The Importance of Financial Education

Photo Credit: Edwin Andrade, Unsplash

It’s a well-known fact that America has a huge financial literacy problem. The causes of this lack of financial knowledge are often cited as a deficiency of personal finance education in schools or at home. Personally, I would love to see personal finance as a mandatory senior year high school course. I think it would reduce the rate of debt mismanagement in college – both credit card and student loan debt; start young adults on a path to good credit early; and decrease the anxiety of knowing how to handle money as young adults.

A Course in Personal Finance
Recently, I was asked to teach a personal finance class at a local college. I was thrilled for the opportunity and worked diligently on the syllabus, the curriculum, and the slides for the four summer classes. 16 students signed up for the course, 6 of whom need the credit for their MBA degree. The average age of the students is 28, and mostly women.

The most surprising aspect of my experience is the enthusiastic response from the students to the subject matter. The first class focused on personal budgeting and retirement plans. To get these young people thinking critically about their spending, I had them read an ebook I wrote called the Happiness Spreadsheet (a free copy can be downloaded from my website). The book espouses the idea that if you think consciously about the relationship between your spending, what you value, and your happiness, it is easier to create a budget that will stick. Many students had never looked at their spending habits in this way, and it inspired them to do the work.

Learning About Retirement Plans
When it came to retirement savings plans, I was less surprised by the elementary knowledge of the majority of the students. Earlier in the class, I asked them to rank their financial literacy from 1- 10. The average response was 5. I was encouraged when two of the students immediately acted and opened up Roth IRA’s the following week, and others expressed greater interest in how their 401(k) was invested.

In the second class, I focused on credit and debt.

Some of the students had already experienced credit woes. One woman misused credit cards in college but was able to dig herself out and rebuild her credit. She has a credit score over 700 now. Another got into credit trouble after a divorce. She managed to bring her score up from the low 600’s to 700 by diligently going through her credit report to get joint accounts paid off and closed. Another student has stellar credit with an over 800 score. Her goal is to buy a house and has asked for help in reaching this goal.

Future classes will focus on investments and retirement planning. In the end, I will be happy if the students learn 3 concepts from the course:

1. The tax benefits and flexibility of the Roth IRA.
2. The benefits of saving early and the power of compounding.
3. How important it is to build good credit.

Of course, there is so much more to having a successful financial life, but if acted upon, these three concepts will lay a great foundation.

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Smart and Savvy Roth IRA Strategies Updated for 2018

 

Roth IRA’s are a great savings tool. Contributions aren’t deductible like with traditional IRAs, so Roth contributions don’t lower your tax bill immediately. However, the tax-free nature of any earnings, no required minimum distributions (RMD’S) and ability to withdraw your at any time, tax and penalty free, make them an excellent planning and savings tool.

Before any discussion about Roth IRA strategies it’s important to be aware of the income and contribution limitations:

Income Limits

In 2018, for single taxpayers, there are phase-outs between modified AGI of $120,000 and $135,000 and over $135,000 Roth contributions aren’t allowed. For married taxpayers the phase-out range is from $189,000 to $199,000 and over $199,000 is disqualifying.

Contribution Limits

In 2018, the total amount individuals can contribute $5,500. People over 50 can contribute an additional $1,000 for a total of $6,500.

Here are some features of Roth IRA’s that highlight their unique saving and planning advantages:

1. You Can Open A Roth For Your (Employed) Children

As soon as your child has taxable earned income and regardless of age, you can contribute to a Custodial Roth IRA for them up to their earnings, or a maximum (in 2017) of $5500.00, whichever is less.

As a parent, you retain control of the account until your child turns 18 (or 21 in some states). What a great way to start a nest egg for your children and teach them something about money at the same time!

2. High Earners can contribute to a Roth 401(k)

High earners can work around the income limits noted above by contributing to a Roth 401(k) if their company plan allows it. No income limits apply to Roth 401(k) contributions so it can make good sense for big earners to contribute to a Roth 401(k) or split contributions between a traditional and Roth 401(k). Total contributions cannot exceed the 2018 limit of $18,500 (or $24,500 for those 50 and older).

3. Roth Conversions

Seven years ago income limits on Roth conversions lifted so that anyone no matter how much money they make can convert a traditional IRA to a Roth in any given year. High-earners may not want to take the tax hit that a conversion would trigger while earning the big bucks, but if there is a year where income is lower (i.e., a sabbatical year, quitting a salaried job, first years of retirement before RMD’s,  to work at a start-up) a Roth conversion may be a good move.

For many, the lowest tax years of post-20’s life may be the years in between retirement and the beginning of Required Minimum Distributions (RMD’s) at age 70 ½ – this is also a good time to consider converting some IRA money to a Roth.

4. The Backdoor Roth

At about the same time the rules on Roth conversions were changed, a strategy developed called the Backdoor Roth. People who hit the income limits for Roth contributions instead contribute to a non-deductible IRA and then immediately convert it to a Roth IRA.

However, it’s not that simple because of the pro-rata rule. If the person converting has other traditional IRA assets, the taxes due on the conversion will depend on the ratio of IRA’s that have been taxed to those that haven’t. There is a workaround to the pro-rata rule: roll traditional IRA assets into a company plan such as a 401(k) or solo 401 (k) before attempting the back-door Roth, taking them out of the pro-rata equation. This move makes sense if the company plan has decent investment choices and low fees.

Due to the wide array of tax outcomes that could occur while applying these strategies, it would be wise to get a second opinion from your financial advisor or tax accountant.

Do you want to manage your money (and life!) better?

The Happiness SpreadsheetIf you want to think differently about the relationship between your spending, your values and your happiness, then sign up to get your FREE copy of The Happiness Spreadsheet.

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3 Things You May Not Know About the Roth IRA

Here are 3 features of Roth IRA's that highlight the unique saving and planning advantages of the RothRoth IRA’s are a great savings tool. They are different from traditional IRA’s in that they aren’t deductible, so Roth’s don’t lower your tax bill immediately.

However, the tax-free nature of any earnings, no required minimum distributions (RMD’S) and ability to withdraw your contributions at any time tax and penalty free, make them a great planning tool as well as savings tool.

Before any discussion about Roth IRA’s it’s important to be aware of the income limitations for contributions.

In 2015, for single tax-payers there are phase-outs between modified AGI of $116,000 and $131,000 and over $131,000 Roth contributions aren’t allowed. For joint tax-payers, the phase-out range is from $183,000 to $193,000 and over $193,000 is disqualifying.

Here are 3 features of Roth IRA’s that highlight the unique saving and planning advantages of the Roth:

1. You Can Open A Roth For Your (Employed) Children

As soon as your child has taxable earned income and regardless of age, you can contribute to a Custodial Roth IRA for them up to the amount they earn or a maximum (in 2015) of $5500.00, whichever is smaller.

As a parent you retain control of the account until your child turns 18 (or 21 in some states). What a great way to start a nest egg for your children and teach them something about money at the same time!

2. High Earners can contribute to a Roth 401(k)

High earners can work around the income limits noted above by contributing to a  Roth 401(k) if their company plan allows it.

No income limits apply to Roth 401(k) contributions so it can make good sense for big earners to contribute to a Roth 401(k) or split contributions between traditional and Roth 401(k). Total contributions cannot exceed the annual limit of $17,500 ($23,000 for those 50 and older).

3. The Back-Door Roth and Pro-Rata Rule

Five years ago, income limits on Roth conversions lifted so that anyone no matter how much money they make can convert a traditional IRA to a Roth. At that time, a popular strategy developed called the back-door Roth.

This is how it works: people who hit the income limits for Roth contributions instead contribute to a non-deductible IRA and then immediately convert it to a Roth IRA.

However, it’s not that simple because of the pro-rata rule. If the person converting has other traditional IRA assets, the taxes due on the conversion will depend on the ratio of IRA’s that have been taxed to those that haven’t.

There is a workaround to the pro-rata rule: roll traditional IRA assets into a company plan such as a 401(k) or solo 401 (k) before attempting the back-door Roth, effectively taking them out of the pro-rata equation.

Due to the wide array of tax outcomes that could occur while applying these strategies, it would be wise to get a second opinion from your financial advisor or tax accountant.

Do you want to manage your money (and life!) better?

The Happiness SpreadsheetIf you want to think differently about the relationship between your spending, your values and your happiness, then sign up to get your FREE copy of The Happiness Spreadsheet.

Like this post?

If you found this blog post useful or inspirational, please share it on your favorite social media network!

If you found this information interesting, please share it with a friend!

3 Things You May Not Know About the Roth IRA Read More »

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