Ric Edelman has some strong arguments against the Roth IRA. Joe & Big Al, aka “The Roth Brothers,” offer their thoughts. Plus, understanding basis when it comes to Roth conversions. And what happens if you’ve already contributed, but by the end of the year you’ve exceeded the income limitation for Roth contributions? Can you open a Roth for your 12-year-old whose raking in the babysitting bucks? What happens to your Roth when you die? It’s an all Roth IRA episode!

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Show Notes

(00:47) What Do You Think of Ric Edelman’s Opinion on Roth IRAs? (video)
(14:36) What Happens If My Income Exceeds the Roth IRA Contribution Limits After I’ve Already Contributed?
(18:29) How Does Basis Work for Roth Conversions?
(24:22) How to Factor Taxes Into Big Al’s Quick Retirement Calculation Guide
(27:23) What Happens to Our Roth IRA When We Die?
(29:47) Can I Open a Roth IRA for My 12-Year-Old Daughter? (video)

Transcription

You may recall back in Your Money, Your Wealth® episode 184, Joe and Big Al mentioned that they’ve been called “The Roth Brothers” in the past. Today on Your Money, Your Wealth® episode 212, they’re going to show us why – it’s an entire episode of your Roth IRA questions! The fellas explain the mechanics of basis when it comes to Roth conversions. Plus, what happens if you’ve already contributed to your Roth IRA for the year, but by the end of the year you’ve exceeded the income limitation for Roth contributions? Can you open a Roth IRA for your 12-year-old daughter whose raking in babysitting bucks? And what happens to your Roth IRA when you die? But first: not everyone agrees that the Roth IRA is a great thing. Ric Edelman has some strong arguments against it. Here with their thoughts are “The Roth Brothers” themselves, Joe Anderson, CFP® and Big Al Clopine, CPA.

:47 – What Do You Think of Ric Edelman’s Opinion on Roth IRAs?

Joe: This is a question that we have received a few times in the past, Alan. And this is from April from Illinois. We used to do a full segment on this, didn’t we usually? What is Ric Edelman saying?

Al: (laughs) Yeah that was a long time ago.

Joe: She’s like, all right well, “what do you think of Ric Edelman’s opinion of Roth IRAs?” So, first disclosure, I’m a big fan of Ric. Al and I know Ric personally.

Al: Yeah we do.

Joe: That’s a name drop.

Al: (laughs) If you’re not in the industry you probably don’t know what we’re talking about. But if you’re in the industry, you go, “oh, those guys know Ric Edelman. That’s pretty good.” I know him by name. (laughs) How about that? And he knows he knows by me by name when he looks at my name tag at conferences I go to. (laughs)

Joe: (laughs) I think there’s a difference of opinions in some of the planning that we do versus what his firm does.

Al: Yeah I would say there are probably more similarities than differences, but we do have differences.

Joe: I think our investment philosophies are almost right on. Pretty close there. I think when you look at Social Security benefits strategies or claiming strategies, to pension, to life insurance. All of it. But when it comes to taxes, we differ.

Al: Yeah I agree with that.

Joe: And here’s the reason why I believe, is that we are a smaller boutique Registered Investment Advisor with CPAs on staff. We have a very strong financial planning process that monitors all the financial planning that goes through, and we spend a lot of money, basically, on very good talent to make sure that we provide a phenomenal product in regards to planning.

Al: Right, which includes a huge emphasis on income taxes, which most firms don’t really do – including Ric’s firm.

Joe: And I think there’s liability there.

Al: Yes. There is. Right. We’re taking a chance. (laughs)

Joe: (laughs) We’re not taking a chance. It’s like we’re giving value that most firms don’t necessarily want to, because it’s like, well here, they can get tax advice from their CPA. They could get their tax advice from their enrolled agent, or whatever. They can do it on their own. We don’t want to get in that business. We’re in the business of helping them build their wealth via through asset management. 90% of their focus is more or less investment management. You can get a financial plan through Edelman or any of these other fine really fine financial planning firms for maybe a couple hundred bucks. It’s not a financial plan, in my opinion, it’s a cash flow analysis just to see if you’re on track or not. They might run a couple Monte Carlos, and it’ll take them 15 minutes to put together. And it really helps them to identify how many other assets that you have, really to see OK, well what can we do and how much money can we manage. And I think that’s a fact with a lot of firms, and there’s nothing wrong with that because they’re helping them, A, create a network statement, which is key. And then looking at well, what do they need to do with the net worth to help them grow? And if their firm is helping them build wealth, well, God bless them. We take a little bit different stance to say OK, well yes, building wealth is key, but how can you also build wealth from things that you can control. And taxes, in our opinion, are a huge thing that you can control. And so the biggest emphasis that we made since day one with Pure Financial Advisors is that, all right, we want to have the coordination of different professionals, CPAs, attorneys, CERTIFIED FINANCIAL PLANNERS™, money managers, all sitting around the same table looking at things with an objective viewpoint. And I think that’s what made us what, one of the fastest-growing financial planning firms here in the nation.

April from Illinois, she had sent us a little excerpt from I think Ric Edelman’s… and then did they change his name too, is it now “Edelman Financial Engines?” Is that the official name?

Al: That I don’t know.

Joe: OK. April sent that to us about his opinion on Roth IRAs. if you’ve ever listened to our show before, you probably have gathered that Al and I are pretty large fans of Roth IRAs. And so she wanted to get our opinion. And so let me read this real quick of what Edelman says about Roths, and then we can rebuttal here. From Edelman, he’s like, “First ask yourself what’s the goal of investing? Why put money into an IRA in the first place? Obviously, the goal is to accumulate wealth, as much wealth as you possibly can on an after-tax basis. The question then becomes what type of IRA produces more wealth, the traditional or the Roth? The answer might surprise you,” says Edelman. “If you run the numbers on a spreadsheet, which isn’t hard to do, you’ll quickly discover the answer is neither. It’s a wash. There’s no difference. If you convert to a Roth, you trigger a tax immediately. But converting won’t increase your wealth. So why pay a tax right now that you don’t have to pay?” Let’s stop there, Al. Let’s break this down. What’s he talking about?

Al: All right. So he’s saying, so you pay the tax now and then you’ve got less to invest. Or you don’t pay the tax, you’ve got a higher balance, but then you pay the tax later – a higher tax. But when you do the math, all things being equal, you end up with the same net number.

Joe: So for instance, if I had $100,00 in an IRA, and let’s say I had $25,000 outside of my IRA. So I had $125,000, total.

Al: OK. So that’s your net worth.

Joe: That’s my net worth – $100, 000 in an IRA, $25,000 in a brokerage account. And if I decided to convert that $100,000 into a Roth IRA, the hundred grand of the IRA goes into the Roth. Now I have $100,000 in a Roth. But I have to pay tax to get the $100,000 in and let’s assume I’m the 25% rate. So that cost me $25,000 in tax. Is that fair? Does that make sense?

Al: It does. So you did the Roth, and so now your net worth is only $100,000 because you lost $25,000 to tax.

Joe: Correct.

Al: So you immediately went backwards.

Joe: I went backwards. It’s like why in the hell would you do this?? (laughs) So $125,000 is my net worth. And then if I did the Roth conversion, I had to pay the tax upfront to get that money to grow tax-free. So now I have $100,000 in the Roth. But let’s say you go 10 years out, and the money doubles – it grows at 7%. So now that $100,000 is worth $200,000, but it’s all tax-free. That’s pretty cool.

Al: In the Roth, yeah.

Joe: Ric Edelman’s point is this, he’s like, “let’s say you don’t do anything. You keep the $100,000 in the IRA. You keep the $25,000 in your brokerage account, and you invest them the same. And let’s assume they get a 7% rate of return over the 10 years. And then with that, it will double.

Al: Yes. OK. So that’s $250,000.

Joe: So yeah. That $100,000 is now $200,000 and then the $25,00 is now $50,000.

Al: Yeah. So your total net worth went from $125,000 to $250,000.

Joe: So you’re thinking, “well the $250,000 is a lot more money than the $200,000 in the Roth.” But what are we forgetting?

Al: Yeah. When you take the money out of the IRA you gotta pay tax.

Joe: So if I take the $200,000 out of the IRA, what do I truly net?

Al: Yeah. 25% tax rate, $50,000 tax. So now you end up with $200,000 net, which is the same as what you had in the Roth.

Joe: But how about that $25,000 to $50,000 though? I have to pay tax on that too, right?

Al: Yeah, if there’s gain, you bet.

Joe: Well it did gain, right? It did 25 to 50, so I’ve got to pay a capital gains tax on that. So I think Ric’s math is off a little bit too, here.

Al: Well and plus I mean, that’s like, I don’t know, like a lab textbook case. There are so many other variables that make this so much better. But that’s our starting point.

Joe: So he’s thinking, all right, well it’s a wash. If you pay off your mortgage, do you increase your net worth?

Al: No.

Joe: No.

Al: Because you took one asset and reduced a liability so you’ve got the same net worth.

Joe: When we look at Roth conversions, that’s how we look at it, is that we’re paying off a mortgage. We’re buying our partnership back from the IRS.

Al: Yeah. Because you’ve gotta look at your IRA as though it’s not all yours, because there’s a tax component when you withdraw the funds.

Joe: So there’s a mortgage on the overall IRA. So you’re trying to figure out what’s the best way to get rid of the mortgage or reduce the mortgage as much as you can. So by having money in a Roth IRA, and having money in a traditional IRA, there are many more benefits than just looking at a straight line Excel spreadsheet evaluation.

Al: Sure. Yeah, I agree with that.

Joe: One of the biggest, in my opinion, is that you now have control on your distribution. How much that you pull from an IRA, and then how much that you can pull from the Roth. Maybe you do a 50/50 split. Hey, I’m gonna pull 50% from my IRA, 50% from my Roth IRA. That could keep me in a very low tax bracket, even though I have very high cash flow.

Al: Right. So you’re managing your distributions to keep out of the higher tax brackets.

Joe; That’s one. Two: there is no required minimum distribution on Roth IRAs. So that money can continue to compound for my life, spouse’s life, kids life. Pretty good. Number three: asset location. So if I manage my affairs effectively from an asset location, I will probably have investments in my Roth IRA that have a higher expected rate of return than I would in its standard IRA. Because all of the growth now is going to grow tax-free.

Al: Yeah. So then you have your lower expected return assets in your IRA and you end up with a lot more after-tax money.

Joe: So when I’m considering, now, the tax code itself, of the tax reform, has reduced marginal rates, what, five of the seven marginal rates now are lower? And some of them by a fairly large margin?

Al: Tax rates are cheaper right now.

Joe: So does it make sense for me to pay a cheaper rate today than wait and pay a more expensive rate in the future? That makes sense to me. So that’s another, I think, a win for doing Roth.

Al: Especially right now because very few taxpayers are subject to Alternative Minimum Tax, which substantially increases the tax rate. Plus, we have lower rates. Then, Joe, you combine that with – there are other tax planning strategies that you can do to lower your taxable income that allows you to do Roth conversions in yet a lower tax bracket. You just have to know what they are. And if you put all of these things together, and you do the same mathematics, you come out much better doing the Roth IRA. I will say, if Congress, our government, decides to tax Roth IRAs?

Joe: Well let let let me finish what you wrote here. He goes, “You also asserted that the Roth avoids the requirement to take distributions starting at 70 and a half.” So I’m reading back to Ric’s here. “Can you count on that forever? Be aware that President Obama inserted language in the 2015 budget that would require distributions from Roths at age 70 and a half just as with traditional IRAs.” So Ric is saying, “hey you know what, you like the fact that there is no RMDs? No, they’re going to change it. Barack Obama tried, but he failed. But maybe Trump can do it, or whoever is next.” “So that’s one of my fears about Roths,” says Ric. “The government could change the rules at any time, and do it retroactively. If you won’t reach age 70 for another 20 years, you’ll go through 10 Congresses and maybe five presidents. Are you sure they won’t ever change the rules? Consider that Roths will hold trillions of dollars by then. Money that’s currently tax-free. That’s a pretty tempting target for a legislator trying to generate tax revenue.” All right. So what do you think? Changing the rules on RMDs, Al?

Al: (laughs) I would say changing the rules on a Roth to have RMDs, that could happen. But if it does happen, then that money comes out tax-free. You would have a little bit less control, but still, for all the reasons that we already mentioned, you come up in a much better place. I think the bigger concern is, will they change the whole structure and say, “you know what, Social Security never used to be taxable, and Roths are not taxable. Now, Social Security is taxable. Let’s make Roths taxable.” And I would say that’s highly unlikely for that, just because whenever they made changes in the retirement code before, they’ve always grandfathered the old stuff in.

Joe: You know, last comment on this is that most of the younger generation, the millennials, are putting most of their dollars into Roth IRAs. And so his argument here of saying, “hey, you know, in 10, 20, 30 years from now, there will be trillions of dollars in Roth IRAs, you don’t think they’re going to change it?” But Ric, guess who’s trillions of dollars that is? It’s the people that are going to be in Congress.

Al: And who are they supporting? The people that have all the Roth IRAs that are not gonna stand for that.

Joe: They’re not going to hurt themselves.

If you’ve got money questions, go to YourMoneyYourWealth.com, scroll down and click “Ask Joe and Al On Air” and send us a voice recording or an email. We’ll respond here on the show, and we might even send you a video of our answer! And to learn how to Keep the Volatile Stock Market from Wiping Out Your Retirement Savings, watch the Your Money, Your Wealth TV show online at YourMoneyYourWealth.com and click “Special Offer” to download our white paper, Pursuing a Better Investment Experience. After this there are only two episodes left in season 5 – subscribe on YouTube so you don’t miss ’em! Now let’s get to more of your money questions. Or more specifically, let’s get to your Roth IRA questions!

14:36 – What Happens If My Income Exceeds the Roth IRA Contribution Limits After I’ve Already Contributed?

Joe: We got Bill from Maryland, he wrote in this week. He said, “thank you for the informative podcast. Of course, I have a Roth IRA question. 2018, my wife and I have a joint income that is close to the limit of us allowing for Roth contributions. Then I contribute the full $5,500 during 2019, and by the end of the year 2019, our income exceeds the limit for contributing to a Roth. What happens next?” So Bill, your question is, if you contribute to a Roth IRA and then you find out that you exceeded the limit for 2018 for a married couple – what is that, $199,000, I think, for 2019 it’s $203,000 or $206,000?

Al: Yeah for 2019 I got it in front of me, it’s $203,000 for joint, $137,000 for single. I think it was maybe $2-3,000 less for 2018.

Joe: Yeah $198,000 to $199,000. So Bill’s question is that he contributed to the Roth IRA and then maybe he gets a big bonus at the end of the year and then his income exceeded that threshold where he is no longer able to put money into the Roth IRA, even though he already made the Roth IRA contribution.

Al: Yeah, and that’s pretty common. I mean, that happens all the time because at the time you make the contribution you think, “well, I’m going to be under the limit.” And then by the time the year ends you’re over the limit. So the IRS has to allow your way to undo it.

Joe: Well, it’s called jail, Bill. (laughs)

Al: Actually no, that’s not true. (laughs)

Joe: You committed fraud, and you will be escorted to the local county facility. (laughs) No, it’s called recharacterization. You just recharacterize those monies out of the Roth IRA so you can take those monies back out of the overall account, no harm, no foul. There will be issues though with the gain.

Al: Yeah, you have to re-characterize that also.

Joe: That would be a taxable event. So let’s say you put the $5,500 in, you get $6,000. It’s in a Roth IRA, you over-contributed to the overall account. So $5,500 is re-characterized out of the account. You could put it in an IRA if you wanted to. And then what would happen there – that’s what I would do. I would re-characterize it back into an IRA. And then now I have the $5,500, I would have full basis in that, and I would just convert it back into the Roth.

Al: Yeah later. Yeah, why not?

Joe: Or the next day.

Al: That’s the workaround innit? And by the way the re-characterization-

Joe: Unless Bill has other IRAs, then you have to follow the pro-rata and aggregation rules.

Al: Yes you do. So I was going to say, timing. So you have to do this by the due date of your return, which would be April 15th unless you extend, it would be October 15th.

Joe: So I mean Bill, if you’re close, why don’t you just wait until January, February, March of the following year to make those contributions?

Al: Yeah that is one way to go. But on the other hand, it’s nice to make your Roth contribution early to get a full year of growth tax-free, if you, in fact, do qualify. So that would be the advantage of doing it that way. But then you just have to check and see where you’re at at year end. And then if you do have to re-characterize, make sure you do it timely.

Joe: So you re-characterize, and then the gains that come out will be a taxable event to you.

Al: Yeah. And if you don’t do this timely, then you get excise taxes and other penalties. So just be aware of that.

Joe: Yeah. If you keep it in the Roth when it shouldn’t be in the Roth, It’s what, 6% per year excise tax of the balance. So yeah. And you know, the IRS is getting a lot better at looking at balances and with the new 5498 form.

Al: Yeah. They’re getting more information from the custodian. So yeah, I would agree, I think they are getting better.

18:29 – How Does Basis Work for Roth Conversions?

Joe: We got David from North Carolina. The Tar Heel State. “Hi guys. I have a question about federal taxes on non-deductible traditional IRA contributions and moving money from a 401(k) to a Roth. I’m going to use roundabout numbers to try to simplify my example.” All right David, what do you got? “Let’s say I have made $20,000 of non-deductible traditional IRA contributions.” So first of all, what a non-deductible IRA contribution is, is that anyone can contribute to a traditional IRA. And if you make too much income, you can no longer take the tax deduction. It’s about $66,000 if you’re single, about $120,000 if you’re married – something like that.

Al: Yeah you are in the ballpark. So for 2019, $123,000 married, $74,000 single is the upper limit as to what you can deduct.

Joe: OK. So he’s assuming he’s going to make this $20,000 IRA contribution, does not take the deduction.

Al: Sure. Because his income was too high.

Joe: “The account has no net gain or loss and still worth $20,000. This is the only IRA money I have. I also have a 401(k) plan with $200,000 and I’m no longer working. I would like to gradually migrate that 401(k) money to a Roth. Also assume this 401(k) account has no net investment gain or loss over the coming years.” All right. “I could roll the entire $200,000 into an IRA and then convert $20,000 of it each year. My understanding is that the first year, about 91% of the $20,000 would be treated as taxable income. The second year 90%, down to 50% when the IRA has $40,000, and no taxable income in the final year when it has $20,000. If my math is right, in total, about $141,000 of the $220,000 of the two accounts will be treated as taxable income.” Ah, no. Your math is – I don’t know David where you’re getting your math from.

Al: Let’s stop there, because I do know how he got it, and it’s not correct, unfortunately. So what he’s doing Joe, is he is taking the $20,000 basis and keeping that flat the entire time.

Joe: Yes, he’s keeping the $20,000 basis flat.

Al: So here’s what you’re missing, David, is that first year when you do that conversion, so $20,000 is basis, $220,000 is the total. So you divide the 20 into 220 and you get 9%. So in other words 91% is taxable, 9% tax free. That’s the way that that works. In round numbers it’s about $2,000, just to keep it like super simple. So the next year, now your basis is $18,000, not $20,000 – you have to relieve your basis on what went over to the Roth tax-free so that your 91% will stay fixed all the way through the whole thing, assuming that the account didn’t grow.

Joe: Right. So I guess David – because he said that, right? “My account’s not going to grow. So let’s just assume that.” It’s going to be 91% the entire time.

Al: The whole time, and in the last year, when you have $20,000 left, you’ll only have $2,000 of basis. So that’s the math. But I like the creativity. Which now means the next paragraph is N/A.

Joe: “Alternatively, each year I could roll over into the IRA only the $20,000 I intend to re-characterize to my Roth-” here, David, why are you making this so hard? If this were actually a true statement, that you have a 401(k) plan and you have $20,000 of basis in a non-deductible IRA, convert the IRA right now.

Al: Yes, because there’s no tax at all.

Joe: There would be zero tax. The $20,000 goes directly into the Roth, all future growth of that $20,000 will grow 100% tax-free. Then you convert from the 401(k) to the Roth IRA each year, depending on your tax bracket.

Al: And you can roll from the 401(k) to an IRA, but you have to wait till next year. In other words it’s your total IRA balances at year end that determine how much is taxable versus tax-free. So you do the conversion right now, $20,000, no tax. Next year you can roll your 401(k) to an IRA if you want to and then continue your conversions, although you’ll pay tax on whatever you convert. That’s the right answer. But you can see where he’s coming from. He was coming from, “hey, I found this loophole where I could just keep this and keep getting to use it over and over again,” and that’s not the way the IRS looks at it.

Joe: So I don’t think I’ve got to read anymore.

Al: We already answered it because the alternative is incorrect too.

Joe: Right. So, sorry David. Hopefully that helps. But if you wanted to continue to work, let’s say, or work part time, I would still tell you to keep your money in the 401(k) plan because then what you could do is, you could continue to do the non-deductible IRA contributions and then continue to convert them year after year after year with zero tax because you still have bases in that IRA. Everything else is in the 401(k). The IRS is not going to look at the pro-rata and aggregation rules. So if you want to double check Al and I’s answer via the code, just look at that the pro-rata and aggregation rules of conversions with basis. So then that will give you a better idea too if you don’t fact check us.

Al: But I do love the creativity.

Andi: I love the fact that at the end he says, “Thanks, I enjoy the podcast.”

Joe: Well thank you, David.

24:22 – How to Factor Taxes Into Big Al’s Quick Retirement Calculation Guide

Joe: We got Ted from San Diego. Ted says this, “Hey, thanks for the quick retirement calculator guide, Alan. My question is, in step one the tool uses net income as a guide, but that would not factor taxes on deferred income, pension or Social Security. Would it be safe to multiply step one by 1.4 for California if one wanted to have $120,000 per year net?” So break this down for us in a minute or two. What the heck Ted is talking about.

Al: (laughs) Well, Ted is talking about a calculator I put down, but which by the way, is on our website. It’s the quick retirement calculation guide. YourMoneyYourWealth.com?

Andi: It’s at YourMoneyYourWealth.com go into the Financial Resources, it’s one of our white papers.

Al: So what’s on that is, you you estimate your living expenses in retirement. You use an inflation factor to get to what that is, you subtract your fixed income, and then you end up with a shortfall. You multiply that shortfall by 25, and that gives you an approximate idea what your savings should be. That’s what that is. Now, this calculator is meant to be just a simple thing to see if you’re in the ballpark.

Andi: Keyword quick. (laughs)

Al: Yeah, quick. But I guess to answer the question, yeah, if you add the tax component that’s probably better. Probably 1.4 is a little bit high. I might divide it by .75 and I might get like closer to $160,000. But it depends upon your tax bracket and whether you’re married. All kinds of stuff, really. So it’s it’s just a quick guide.

Joe: Yeah. And Ted, I guess maybe to piggyback off that is that Al and I see individuals often that really don’t understand the math of how much money that they need to create the income that they’re accustomed to. You know what I mean? So it’s like, hey I’m used to spending – like Ted here wants to spend let’s say $120,000 a year. So let’s say Ted comes into the office and says, “Hey Big Al. Here’s my plan. I want to spend a $120,000 a year, my Social Security benefit is maybe $20,000, so $100,000 needs to come from the overall portfolio. And I have half a million dollars saved.” And we would say, you know what, that’s not enough because you’re short. So this helps people just to say, “All right well am I close, am I on track, am I not on track, do I have to save a heck of a lot more money?” Or, “you know what, I’m feeling pretty confident with my spending levels and the amount of assets that I have plus my fixed income.”

Check the show notes for today’s podcast at YourMoneyYourWealth.com to download that Quick Retirement Calculator Guide and the Roth IRA Basics guide. And hey, key words here are “quick” and “basic.” They’ll give you an overview of these concepts. Another key word is “free” – these resources are free for you to download, just for listening to Your Money, Your Wealth®.

If you need more help with your situation, you could always schedule a free 2 meeting assessment with a certified financial planner just by clicking the free assessment button at YourMoneyYourWealth.com, or you could scroll down the page to “Ask Joe and Al On the Air” and send the fellas a voice recording or an email, just like Michael did:

27:23 – What Happens to Our Roth IRA When We Die?

Joe: Michael. “Hello Joe and Al.” Thank you Michael for putting me first. (laughs) “Could you explain about the Roth IRA, what happens to the money after we die? We will leave about a million dollars in a Roth.” So a couple of bullet points here. “Does the beneficiary have to distribute the money within five years or suffer a penalty? Does five years start from the time they receive the inheritance?” Okay. Let’s answer that one first. Michael, it depends on who you named as your beneficiary is going to determine how the money is going to be distributed out. With a Roth IRA at death with no designated beneficiary, the five year rule applies. What does the beneficiary need the do? So now he’s saying that there is a beneficiary. So the beneficiary needs to change the title on the account.

Al: Yeah and I think this is most important. And so how should the beneficiary change the title?

Joe: It’s going to say “Michael, deceased on whatever date Michael died, for the benefit of his children”.

Al: So Michael’s name is still in there, right?

Joe: Yes.

Al: Deceased with the date for the benefit of the child. Something like that.

Joe: So then they are now the beneficial owners of that overall account. They will have to take a required minimum distribution based on their life expectancy. Even though it’s a Roth IRA, it’s a beneficiary IRA. It’s a stretch IRA. They’re going to have to take an RMD based on their life. “Finally, our children will not need the money to live on, how can they leave it to their heirs?” They can disclaim it. They don’t have to take it, they can disclaim that overall asset and disclaim it to their beneficiaries. That gets extremely complicated because we’re talking about a Roth IRA, and we can answer that in a little bit. We love your show. We watch all your shows through YouTube. Joe, you remind us of Dennis the Menace. Classic TV show we once enjoyed watching. Thank you and God bless.”

Al: I never thought is Dennis the Menace, but now I can see it.

Joe: Dennis the Menace, Michael.

Al: Troublemaker.

Andi: That’s why that’s your middle name.

Joe: Dennis the Menace. I don’t know if that’s a compliment.

Andi: It’s absolutely compliment.

Joe: Great questions Michael.

Al: Dennis the Menace – a bit of a rebel. That’s you.

Andi: Definitely a menace.

Joe: Yes.

29:47 – Can I Open a Roth IRA for My 12-Year-Old Daughter?

Joe: All right. So we’ve got a couple of emails from people that didn’t want to leave a name.

Al: Anonymous. That’s a name.

Joe: Thank you. “Can I open a Roth IRA in my daughter’s name? She is earning money from babysitting. She is twelve years old. Thank you.” Yeah. If she’s got earned income.

Al: Yeah. She’s gonna have to report it though.

Joe: She’s gotta file a tax return.

Al: Not everyone reports their babysitting income. Did you?

Joe: I’ve never babysat a day in my life. (laughs) Well, I babysit every single day of my life, actually, I’ve got 78 babies that I look after.

Al: 78?

Joe: isn’t it? 78 or 80? How many people we got here?

Al: Oh, at Pure? Yeah. Okay, I got it. I suppose you report that income though. (laughs)

Joe: (laughs) Yes I do. I do report that income. It’s not enough. How does someone do it, I guess, is the question.

Al: Yeah okay. Well first of all, so a Roth IRA, it’s a retirement account that you contribute to and you do not get a tax deduction. But the money grows tax-free in the account, and so when it’s withdrawn later, presumably in retirement, then all the proceeds are tax-free. So there is no age limit – somebody that’s twelve and has babysitting income could open an account. They probably don’t have the resources to do it, but Grandma’s thinking maybe she’ll do it, or Mom will do it, whatever. So in that particular case, yes, that can be done. So the Mom or the Grandma opens the account in the daughter’s name. And so it’s a Roth IRA. I guess, would it be a minor account? I’ll ask you that question, probably, huh?

Joe: Yeah.

Al: So a minor Roth account. I’ve never actually done one but that seems like that’s what it would be probably.

Joe: Yeah we’ve done them a few times because we have that program 40 under 40. And so we’ve had some custodial, I guess is what they’re really called, for the technical name.

Al: Okay. Got it.

Joe: But just from a legality or tax standpoint, as long as there is earned income up to $5,500, she can contribute up to $5,500 but she’s got to prove that she made $5,500. So she’s got to file a tax return even though she probably is not going to be taxed on that $5,50 because the standard deduction is going to be more than that.

Al: Yeah except she might have to pay self-employment tax on that, which is part of it. And you just alluded to one of the keys here. Because a lot of times when you’re younger and you’re doing babysitting, even though technically you’re supposed to report it as income, does that happen? Not regularly. (laughs) Just being honest. And so if you want to open up an IRA for your daughter, granddaughter, whatever, then they’re going to have to file a tax return and show earned income for you then to contribute into a Roth IRA in their name.

Joe: So it’s worth it.

Al: Yeah. And the way it works: so let’s just say she made $2,000 babysitting income, then you could open up a Roth IRA for $2,000. You can’t do anymore. You could do less. The maximum is $5,500. And so if she earned up to that amount you could max it out, but otherwise you’re limited to the earned income.

Joe: So get her to file a tax return. And then she can file the higher of the two: $5,500 or $6,000 2019, or her earned income.

Al: Yeah. Now sometimes what folks do, if they have a business, so they get their kids on the payroll – as long as they can justify the kid is earning wages. Doing something for that wage. And it’s appropriate pay. Kid can’t show up for one hour and get paid $10,000. It’s not gonna fly with the IRS. So they actually have to be doing something bonafide and getting fair pay for that. But once they do that, so it’s income to the child who’s in a low tax bracket, it’s a deduction to you as the business owner, and now the child has earned income that you could open up a Roth account for them. This is particularly important, I think Joe when kids are in college or close to college. You put your kids on the payroll, you get a tax deduction, and then they pay tax on it, but they have a low tax rate. And then they take the money that they’re making from the business and they use it to pay for college. And in a roundabout way, you sort of pay for college expenses and get a tax deduction that way.

Joe: Yeah. I mean this only applies to small businesses, and there have been all sorts of ideas that come across our desk. “I’m going to create an internet business (laughs) that’s not really a business. And we’re going to create the expenses and then I’m going to put the family on the payroll and we’re gonna create the payroll and run it through…”

Al: Right. No, we see that, yeah. So you have to have a profit motive. And the way to show a profit motive is actually to make some sales, right?

Joe: So how many years, what’s the leniency here for me being a really bad business owner? Let’s say, “hey, I started my business.” So what, two years? And then it’s a hobby? Is that the rule?

Al: Well, it could be. So the rule is this: you’re supposed to show a profit 3 out of five years. Otherwise, the hobby loss rules could come into play. But as a longtime CPA watching the IRS administer this rule, you could be a great business owner and lose money for 10 years because you’re developing a technology, or like some of the drug companies that are trying to discover a new miracle drug, it may be 20 years before they actually make a profit. So that really is not so much the issue. The issue is that if you are not making a profit in three out of five years, you better be able to show that you have a business. In other words, it can’t be, “Oh, I’m a coin collector and I going to make money selling coins.” And five years go by and you’ve never had a sale. That’s what they’re trying to get at.

Joe: Right. Well, we have a client that does very well collecting buttons. Right?

Al: Yeah. That’s true, you’re right about that. So it can be done.

Joe: I mean these are pretty rare buttons. (laughs) First time we heard it we’re like, “buttons? I thought, like, really? Buttons? (laughs) “Yeah!” And then all of a sudden it’s like, wow, yeah, you can make a lot of money, apparently.

Al: Who knew, right?

Joe: Yeah she’s killing it.

Al: I need a button on one of my suits. It broke, need to call her up.

Joe: Well that would be kind of cool.

Andi: Might be a really expensive button. (laughs)

Joe: Might be a $10,000 button on Big Al’s suit.

Al: I’d make her year. (laughs)

Joe: Yeah. And it’d make you look like a d-hole.

Al: Well, and that suit has, gosh, it has two coat buttons and it probably has four buttons on each sleeve.

Joe: And you lost them all?

Al: No, just one. But I want to get a matching set. Might cost $100,000.

Andi: And if you get fancy buttons then you have to worry about them falling off too.

Al: True, yeah.

Joe: Okay, that’s it for us, we’ll see you again next week. For Big Al Clopine, I’m Joe Anderson, the show is called Your Money, Your Wealth®.

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