Paying for a college education continues to be a challenge.  Not only is there tuition to consider, but the cost of books, lab fees, travel expenses, housing and meals, and a spending allowance.   Most families will seek some sort of financial aid to help cover the costs.  Since financial aid is need-based, families who have saved and invested well over the years to pay for college may find that they don’t qualify for financial aid when the time comes: they make too much money, or they have too much savings.  In that instance, financial aid will go to families who did not plan quite so well.  There is a way, however for a family to save the money they need for college and still qualify for financial aid:  start a Roth IRA.

Roth IRA as a College Fund

If you start making Roth IRA contributions when your child is small, a significant sum can accrue by the time the child is ready for college.  Since you’ve already paid the taxes on contributions you made to a Roth IRA, your funds can be left in the Roth account, earning interest tax-free.  You can use your Roth IRA to pay for all of your school-related expenses, as long as they are “qualified education expenses.”  Qualified education expenses include books, tuition, fees, supplies, and tuition that are paid to a properly accredited institution.  For room & board, you’re on your own: you can’t pay living expenses with your Roth IRA funds.  You can also use the funds to pay for yourself, your spouse, your children, your spouse’s children, your grandchildren, or your spouse’s grandchild. 

Financial Aid Considerations

Financial aid formulas usually do not take retirement savings into account, so any funds in the Roth will not be considered when applying for financial aid.  Other college savings options, like a Coverdale Education Savings Account or a state 529 savings account are considered for financial aid purposes.  A parent who has saved for college using a Roth IRA (all other things being equal) is much more likely to qualify for financial aid than a parent who saved using a Coverdale.

Of course, things are rarely as simple as they seem, and there is one flaw in using a Roth as a college savings vehicle: withdrawals from the account may be considered unearned income.  A boost in a family’s income affects their ability to qualify for financial aid.  Individuals should consult with their financial planner to develop a strategy for using Roth funds to pay for college.

The Federal Reserve has gotten much press lately from its’ announcement that consumers slashed their credit card debt by more than 7 billion dollars in May 2010.  That sounds like good news; at first glance, perhaps the economy is not as bad as it seems.  After all, 7 billion dollars is a lot of money for consumers to fork over to pay down credit card debt.  If only it were true.

Closer analysis of the facts reveals a less auspicious outlook.  The reason that credit card balances are declining isn’t because consumers are paying them off, it’s because banks are writing off delinquent balances as the borrowers default.  During the first quarter of 2010, credit card balances declined by 19.5 billion dollars; 18.7 billion dollars was written off by the banks.  Since the end of 2008, balances have dropped by over 127 billion dollars, much of that being written off by the banks.

Debts Don’t Go Away

Banks write off debt because they are required to do so by the Federal Reserve.  To do otherwise would distort a bank’s balance sheet by showing a large receivables asset that was actually not an asset at all, because it is uncollectable.

Debtors who have had balances written off are not out of the woods regarding payment of the debt.  Banks routinely sell written-off receivables for pennies on the dollar to collection agencies, who continue to try to collect the debt.  When a collection agency buys a debt, they become the owner of the debt and assume all rights of ownership, including the right to sue for payment.  Collection agencies can sue for payment up to the statute of limitations of the home state.

Your Roth IRA May Be At Risk

The Employee Retirement Security Income Act (ERISA) completely protects employer-sponsored plans from creditors (except former spouses and the IRS).  IRA’s are not covered by ERISA.  In a bankruptcy proceeding, the first one million dollars of an IRA can be exempt from creditors (depending on the source of the funds) but for anything short of bankruptcy, state law prevails.  There is no consistency in state laws regarding the vulnerability of IRA funds.

Most states exempt 100 percent of the funds while they are in the account; that is the case in New York, New Jersey, and Connecticut.  Laws vary regarding whether withdrawals are covered, and whether protections extend to heirs and former spouses.  Other states limit how much of the account is exempt; Nevada caps the account at five hundred thousand dollars, while other states – like California – exempt only what is “reasonably necessary” to support the account owner and dependents.  The “reasonably necessary” wording is problematic because it is open to interpretation and an invitation to lawyers to sue.

Put the Roth in a Trust

Financial advisors suggest that placing the Roth account into a trust can protect the account from creditors.  The time to take this action is before there is any sign of creditor problems on the horizon; otherwise the action could be deemed a fraudulent conveyance and be reversed.   As usual, such decisions are complex, and applicable laws will vary from state to state.  Individuals concerned about protecting their Roth from attacks by creditors should seek qualified advice.

Have you ever done something that you later wished you hadn’t done?  As children, we could invoke the powerful “take-back” rule to reverse a poor decision.  As adults, we rarely have the luxury of a “take-back”.  When the economy is uncertain, the tax code is the size of a telephone book, and financial advisors sometimes misinterpret the rules, it’s easy to make a financial mistake.

IRA’s Now Have a “Take-back” Rule

IRA’s have a built-in take-back rule.  You can switch your IRA contribution from one type of IRA to another, or undo a conversion.  You can go from Roth to traditional or from traditional to Roth, subject to some restrictions.  You can use this rule to recover from a failed conversion, or simply because you changed your mind. You can even use this rule to reduce your taxes by reversing a conversion following stock market losses.

When to Use the Rule

Keep these uses in mind; you never know when you may need them:

• Failed conversion:  Let’s say that you converted a regular IRA to a Roth in February.  Later in the year, it becomes apparent that your income will exceed the allowed limit.  You can set up a new traditional IRA to replace the Roth, and it will be treated as if the original conversion was simply a rollover to a new traditional IRA.

• Unable to pay the taxes:  If you make the conversion and find that you can’t pay the taxes, or that the increased income will jeopardize your Social Security or other entitlement, you can set up a traditional IRA to replace the Roth IRA, and the unwanted conversion disappears.

• Stock market losses after conversion:  If you converted your traditional IRA when the stock market was doing well, then you paid a lot of taxes on the converted funds.  If the market then took a dive and you lost money, you can reverse the conversion, and then do a new conversion later.  You will pay fewer taxes on the conversion. 

• Regular contribution to traditional IRA. If you make a contribution to a traditional IRA and then wish you had contributed that money to a Roth IRA instead, you can substitute a Roth IRA for the traditional IRA as the recipient of that contribution.  This also works in reverse; you can change your Roth contribution to a traditional IRA contribution.

It’s rare that the IRS will let you reverse a decision; they are quick to add interest and penalties when someone makes a mistake.  In this instance, though, the ability to recharacterize an IRA is built into the tax code.  Thanks to Congress for realizing that in an uncertain economy, taxpayers need a “take-back” rule.

Discussion continues as to the better retirement vehicle: a traditional IRA or a Roth IRA.  Much of the disagreement centers around future tax rates; will they go up, or will they go down?  And, how will changes in the tax code affect IRA’s of either type?  Economists can’t seem to agree.  The following axiom regarding economists holds true in this situation:

• For every economist’s opinion, there exists an equal and opposite economist’s opinion.

Two Schools of Thought

The adversaries in this discussion fall into two camps: those who believe that you should invest in a Roth IRA because taxes will certainly go up, and those who believe that the future is uncertain, so take what you can get now.  Let’s have a look at their arguments.

Taxes Will Go Up, So Invest in a Roth

Proponents of the “taxes will go up” position state that in the future, tax rates will almost certainly go up.  Currently, they say, there are multiple financial crises to be concerned with: health care, increased unemployment benefits, hard-hit pension funds, under-funded social security, and an expensive war.  Somehow, all of this must be paid for, so it is inevitable that taxes will go up.

If tax rates go up, investors who have contributed funds to a traditional IRA with the hope that their tax rate will be lower when they retire are in for a big disappointment.  They may, in fact, be paying more tax on their future withdrawals instead of less tax.

The solution, according to this camp, is to pay the tax on your contributions now while rates are low.  Then, when the money is withdrawn, there will then be no tax due at all on the withdrawals.   Having a Roth, they say, removes any uncertainly about what future tax rates will be, because there will be no tax on withdrawals at all.  With a traditional IRA, you have no choice but to start making withdrawals at age 70 ½ and pay whatever the prevailing tax rate is.

The Future is Uncertain, So Take What You Can Get Today

The proponents of the “uncertain future” position say that knows one knows what the future will bring, so take what you can get today, i.e., an income deduction for your contributions to a regular IRA.  The thinking here is similar to the “eat, drink, and be merry, for tomorrow we die” philosophy in its fatalism: the only thing we can be certain about is today.

Income taxes could increase, or not.  Capital gains tax could increase, or not.  The US could institute a national sales tax, of a VAT tax, or a flat-rate tax.  Or not.  Who knows?  Everyone’s crystal ball seems to be broken.

It’s the uncertainty of future tax policy that prompts this camp to preach in favor of the traditional IRA.  Take the tax deduction today.  Let tomorrow take care of itself.

The Middle Ground

The truth is that future changes in the tax code could increase or decrease the value of either type of account, say those who assume the middle ground.  Middle-of-the-roaders recommend investing in several different retirement vehicles, according to one’s personal circumstances and attitude toward risk.

Who knows what the future will hold?  No one, but everyone has an opinion.  Just ask any economist.

Anyone wanting to get a good understanding of retirement plans should have lots of time on their hands, some good reading glasses, and some aspirin.  The number of retirement plans available is overwhelming; there are individual retirement plans (IRA’s), and employer-sponsored retirement plans (Defined Benefit, Defined Contribution, 401K’s, Profit-Sharing plans, ESOP plans, Simple plans, Money-Purchase pension plans, and SEPs.)

Let’s take a look at the two Individual Retirement Plans (IRA’s), and see how they compare.

Traditional Individual Retirement Plan (IRA)

Regular IRA’s were created in 1975, and are no longer offered. Traditional IRA’s have been around since 1986.  They have always been a popular investment product, because the contributions made (up to $5,000 in 2010; $6,000 if you are over 50) are deductible from your income for tax purposes.  If you earn $85,000 in 2010 and contribute $5,000 to your IRA, your taxable income drops to $80,000.  The $5,000 drop saves you not only the tax on the $5,000 ($1,400 @ 28%), it drops you to a 25% marginal rate which can save you up to $14,000 in taxes, depending on your filing status and other factors.

Traditional IRA’s are a good tactical maneuver if you want to drop into a lower tax bracket.  Since no taxes have been paid on the deposit, you will have to pay taxes when the money is withdrawn.   Withdrawals must be made starting at age 70 ½.  When withdrawn, the money is taxed as if it was ordinary income.  Most retirees are in a lower tax bracket at retirement age, so the theory is that the withdrawal will be taxed at a lower rate than if taxes were paid prior to deposit.

Roth IRA

Roth IRA’s were established in 1997.  The tax structure of a Roth is substantially different from that of the Traditional IRA.  Taxes on contributions made to a Roth are paid prior to depositing the money.  Consequently, the account owner has better access to his account funds, and the investment of funds can be done either by an account custodian or the account owner (self-directed).  Further advantages of a Roth IRA over a Traditional IRA are:

• Direct contributions can be withdrawn tax-free at any time
• Up to $10,000 in earnings can be withdrawn for the purchase of the account owner’s first home
• Assets can be passed on to heirs
• There are no age-based distribution rules.  Funds can be withdrawn once the account is five years old.

Growth is Not Guaranteed

Both the Traditional IRA and the Roth IRA are investment-based retirement accounts.  The key word here is “investment”.  Investment’s don’t always earn money, even when they are invested in blue-chip, stable companies.  Markets and economies can crash, and your investment could suffer.

Each person’s circumstances will vary, and it is difficult to choose wisely unless all of the circumstances are known.  Choosing an IRA account is always a wise decision; which one is best for you is between you and your financial advisor.

The Roth IRA is famous for its ability to earn compound interest tax-free.  Less well known is the fact that an investor doesn’t have to have his IRA administered by a financial institution; they can administer their account themselves by selecting the “self-directed” option when the account is set up.

You Control the Account Money

With a self-directed IRA, one simply sets up an LLC which holds the account funds.  One-hundred percent of the capital gains from investments and the profits from business transactions stay in the LLC account, with no taxes due on the profits.

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Investors are often confused about what they can and can’t do with their Roth IRA.  The Roth is so flexible compared to other retirement vehicles that much is written – sometimes incorrectly – about how the IRA funds can be withdrawn.  Here’s a quick look at which distributions are qualified, and which are not.  For further clarification, see you Roth IRA professional.

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Probate is the mechanism whereby estates are settled.   When you die, the value of everything you own and everything you owe is added up, the debts subtracted from the assets, and the balance distributed to your heirs.  If there is insufficient money to pay all the debts and taxes, your property is sold, generally at auction, to raise cash so that the final bills can be paid.  The process is controlled by an estate executor, appointed by you in your will, or by the probate court if you don’t have a will.

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Mark Twain said it best: “buy land, they’re not making it anymore.”  Indeed.  It’s estimated that around 80% of the wealth in the US today is in the value of real estate.  Real estate has always offered an excellent opportunity for long term growth.  Even today, with the real estate market in a slump, there are significant opportunities to be found, and using your Roth IRA to fund your investments can bring a better-than-average rate of return if handled properly.

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Death & Taxes

The Estate Tax debate rages on in the United States.  Temporarily on hold for 2010, the tax will come roaring back in 2011.  As Presidential administrations change and Congress turns over, no one knows what the future of estate taxes will be.  One thing is for sure:  the government needs money and will take it wherever they can get it.

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