THE FISCAL BLUE PRINT
WITH COACH JEFF MONTGOMERY
Episode 19: Q&A- Roth IRA 5 Year Rules; Options for Custodial Accounts for Minors & more!
(1:00) Disclaimer: Please do not take advice from me on this show. As a licensed Fiduciary I am only allowed to give advice to clients. Unless you’re a client I can’t give you advice because I don’t know you. Think of this as helpful hints and education only! And please, before implementing any information or ideas you hear on this show always consult your legal adviser, your tax adviser, and your financial adviser.
(3:15) Practical Planning Segment: First question today came via a phone call; We will protect the anonymity of the caller and simply call him ‘Bob.’ Bob had a question that comes up often about saving for a minor. He specifically asked: what are his options to set up an account for his one-year old grandson? How does all that work?
My first question is always: what is the goal for the money? College, grand parental gifting, or simply just want to figure out the best way to give the child a good start in life. The answer to this question will guide what type of account to use.
(5:30) College– it may make sense to set up a 529 college saving plan for the minor. But there are some pros and cons. Briefly…. because we could spend an entire show on 529 plans, I will go over some of the pros and some of the cons.
529 plans are named for Section 529 of the federal tax code but are sponsored by the states and operated by financial services companies. Money deposited into a 529 savings plan can be invested and if used properly, no taxes are payable on any of the earnings or withdrawals. “Used properly” means that the withdrawals are spent on certain “qualified” higher education expenses such as tuition, fees, room and board, books and supplies and a few other expenses incurred at a qualified university
(7:00) The Pros:
Tax-free withdrawals: A major benefit these plans have is the tax-free nature of withdrawals used for college expenses.
Adult control: The owner of the plan is usually a parent of the student named as beneficiary. The owner controls the account. Junior will not be able to empty the account to buy a sports car on the way to campus. Parental ownership is also better when it comes time to apply for financial aid because parental assets are treated differently than student assets.
Geographic freedom: You can use the savings plan of any state regardless of which state you live in or in which state the student attends college.
Family flexibility: If the beneficiary does not attend college or use all the funds in the plan, the beneficiary can be changed to a family member of the beneficiary. There is no deadline as to when money in a 529 savings plan must be used. If there are funds remaining, it should be possible to avoid tax and penalties by continuing the plan and using the funds for a new beneficiary. This flexibility is important because not using the money for higher education results in high rates of tax. Because “family member” is defined quite broadly, the potential for a 529 savings plan to be used for more than one student or even more than one generation is significant.
Flexible gifting plus gift/estate tax advantages: Anyone can open a 529 savings plan and the plan can accept contributions from anyone. This makes these plans handy for families who have multiple members wanting to contribute. Those who wish to make larger contributions of $15,000 or more in a year can utilize the 529 plan’s unique five-year gifting feature which allows up to $75,000 (five years’ worth of gifts) to be made in one year without gift taxes.
(14:00) The Cons:
Taxes and penalties: If you do withdraw earnings that are not used for qualified expenses at a qualified institution, the earnings are taxable plus a 10% penalty applies. To avoid this, you should keep records of exactly what was spent on college and be careful not to withdraw more than needed during the tax year. Some states have “recapture” rules. If you take a state income tax deduction and subsequently transfer the funds to a better plan in a different state, the state in which the deduction was taken can reclaim those deductions.
Limited investment flexibility: In some ways, 529 plans resemble a typical 401(k) plan. You are limited to the investment options within the plan. In the better plans, these options are low cost and sufficient in number to build a good mix of investments. However, unlike a 401(k) in which you can usually make changes whenever you like, the frequency of changes to the selections in a given 529 plan are limited. If an additional change is desired, you would need to move the funds to another state’s plan. Bottom line: Shop around for the best plans!!
What was also a PRO by some may considered a CON: The amount you can contribute has its limits. 15k per year or the 5 yr gifting feature mentioned earlier. IF you’re a Grandparent that wants to contribute more than those amounts, you cannot.
(19:10) Another option to consider for minors are UGMA’s or UTMAs; Uniform Gifts to Minors Act (UGMA) and Uniform Transfers to Minors Act (UTMA) are custodial accounts that adults can set up for minor recipients. They effectively serve as a trust that holds the assets during the recipient’s childhood.
Depending on what state you’re living in the actual definition of a minor can vary since the “age of majority” will be different depending on the state. In some states you become an adult at the age of 18, others the age is 21.
With a custodial account of just about any type the adult will control the account until the minor reaches adulthood, at which time the account legally becomes theirs and they can do with it as they see fit.
A few important things to consider with these types of accounts:
- This is an irrevocable transfer. Once you deposit funds into a custodial account under either of these laws, you cannot access or withdraw the money.
- It becomes the property of the minor recipient. The recipient also cannot access the money until they come of age.
- You cannot specify a purpose for the account after the recipient comes of age. The money becomes theirs free of all encumbrances and conditions.
- The custodian can also withdraw funds to cover expenses related to the welfare or education of the minor recipient. You can name yourself custodian of the account, although that does not change the irrevocable nature of the transfer
(22:00) Tax Implications of UGMA vs. UTMA Accounts
UGMA and UTMA accounts are not tax-deferred assets. All gains on investment properties are taxed as normal, and the creator of the account may choose to pay these capital gains taxes on behalf of the recipient.
The parent or guardian may have to file a tax return on behalf of the minor and/or dependent child if the returns on the UGMA or UTMA account exceed the IRS’ income threshold.
There are potentially some tax benefits to UGMA and UTMA accounts though. The details of the recipient’s dependency status and income define how the assets in UGMA and UTMA accounts are taxed.
However, in many — if not most — cases, any returns in the account are taxed at the recipient’s tax threshold. Since the recipient is a child, this can translate to significant tax savings compared to if those gains were taxed at the parent’s (presumably much higher) income bracket.
(23:40) The Bottom Line
UGMA and UTMA accounts are types of custodial accounts, which allow an adult to store and protect assets for a minor until he or she reaches the age of majority. There are potentially some tax-related upsides to UGMA and UTMA accounts, but remember that these are not tax-deferred assets like some other types of college savings vehicles.
(24:40) NEXT QUESTION! The Roth IRA 5 Year Rules: https://www.rothira.com/roth-ira-5-year-rule
(26:50) The Basics Before reviewing the 5-year rules, there are three basic guidelines for the withdrawal of funds from a Roth IRA that you need to keep in mind:
- At age 59½ you may withdraw both contributions and earnings with no penalty, provided your Roth IRA has been open for at least 5 tax years.
- If you are under 59½, you can withdraw contributions with no penalty.
- Exemptions allow you to withdraw funds before the age of 59½ with no penalty. These exemptions include a first-time home purchase, college expenses and several others.
The use of the term “tax years” above with regard to 5 year rules means that the clock starts ticking January 1 of the tax year when the first contribution was made. A Roth IRA contribution for 2018 can be made on April 15, 2019, for example, but it counts as if it were made on Jan. 1, 2018. In this case, you could begin withdrawing funds without penalty on Jan. 1, 2023—not April 15, 2024.
(29:50) Rule One
The first Roth IRA 5-year rule is used to determine if the earnings (interest) from your regular Roth IRA are tax-free. To be tax-free, the earnings must be withdrawn:
- On or after the date on which you turn 59½; after the original IRA owner dies (if you are a beneficiary); or for a qualified first-time home purchase.
- At least 5 tax years after the first contribution to any Roth IRA you own.
The second bullet raises an important point: The 5 year clock starts with your first contribution to any Roth IRA—not necessarily the one from which you are withdrawing funds. The clock rule also applies to conversions from a traditional IRA to a Roth IRA. (Rollovers from one Roth IRA to another do not reset the 5 year clock.)
Once you satisfy the 5 year requirement for a single Roth IRA, you’re done. Any subsequent Roth IRA is considered held for 5 years.
(32:20) Rule Two: Roth Conversions
The second Roth IRA 5-year rule determines whether distribution of principal from the conversion of a traditional IRA to a Roth IRA is penalty free. (You pay taxes upon conversion.) As with contributions, the 5-year rule for Roth conversions uses tax years but the conversion must occur by Dec. 31 of the year in which the conversion occurs.
Each conversion has its own 5-year period, but IRS rules stipulate that the oldest conversions are withdrawn first. The order of withdrawals for Roth IRAs are contributions first, followed by conversions and then earnings. If you are under the age of 59½ and take a distribution within 5 years of the conversion, you will pay a 10 percent penalty unless you qualify for an exemption.
(36:15) Rule Three: For Beneficiaries
Since death is an exception, when a Roth IRA owner dies, beneficiaries who take a distribution will not pay a penalty—no matter whether the distribution is principal or earnings (interest).
Death does not, however, eliminate the 5 tax-year rule for earnings to be tax free. If you, as a beneficiary, take a distribution from an inherited Roth IRA that was not held for 5 tax years, the earnings will be subject to tax.
Thanks to the withdrawal order mentioned under Rule Two, you may owe no taxes since earnings are the last part of the IRA to be distributed.
It’s always wise to seek advice from a trusted financial adviser before withdrawing funds, converting from one type of IRA to another or beginning the process of taking a distribution from an inherited IRA.
(37:45) So as a final word……………… keep those questions coming in; 3 ways to get questions to us:
#1 Record a question directly from our podcast page. You’ll see an orange button that says start recording. Click that button and you can record your voice and send in a question. Make sure you give us permission to play your question on the next podcast.
#3 give us a call to 855-97-coach …..which is 855-972-6224
We appreciate you joining us today for this episode of The Fiscal Blueprint. Be sure to visit fiscalblueprint.com to access the most recent content available including all past shows.
Remember it’s not about the money but about your life! Having a mindset and living a life of abundance rather than scarcity will change the direction of your life forever!! Enjoy the Journey!!!