Roth Clarifications

[moda0306]

I have been back and forth on this issue, and it's written about very poorly, so let's clarify.

It gets lost in the articles out there that don't understand a Roth, but you CAN withdraw the principal (what you put in) at any time without penalty or taxes.  If you make a contribution, you can take it back out with NO 5 year rule.  The earnings are another story, but given this the Roth IRA (probably not your Roth 401(k)... these plans don't allow you most of the time).

This creates a really amazing vehicle IMO.  Especially considering the FAFSA implications, if one were to contribute $5,000 per year starting when their kid was born, they'd have $90,000 in cash basis tax sheltered but easily distributable by the time their kid graduated high school.  $180,000 if the other Parent does the same thing.

I love the flexibility of this.  It's almost like having your cake and eating it, too.  You get tax deferral on all that income, but if you really need it, the principal is right there for the taking.  So between I-bonds and Roth IRA's, (and gold's very nature as a non-income producing item), the options people have are amazing to pay extremely limited taxes on their income.  I know it's nice to have money you can't touch for some people, but I personally will take the flexibility ANY DAY.  I really don't like having my hands tied by tax considerations.

http://www.fairmark.com/rothira/taxfree.htm
http://retireplan.about.com/od/irawithd ... othira.htm
http://www.obliviousinvestor.com/roth-i ... wal-rules/

PS, for some of the younger, healthier members on here (especially young professionals in the 25%+ tax bracket), HSA's are GREAT options to defer/eliminate taxes.  If one is in the 30% federal/state bracket, another 7.65% in FICA/Medicare is not paid by you in taxes if your HSA contributions are made through your employer.  That's 37.65%!  That savings account (other investment options too) is more flexible than an IRA as it is usable for medical expenses for your lifetime, but still converts to a retirement account at age 70 and has no RMD's (if memory serves).

[foglifter]

You highlighted 2 very good points: although both Roth IRA and HSA accounts have amassed a lot of press in the last few years, some of their advantages remain less known. I max out Roth IRA for myself and my wife and I also took advantage of a 2010 Roth conversion so I can spread the income over 2011 and 2012. Nobody knows what's gonna happen with taxes come 2012. And I also like the fact that if needed I can withdraw contributions from Roth.

I also use HSA and max it out annually (~6K for a family plan). Although my employer doesn't contribute, this is still a great deal as I pay 0 from my wages in insurance premiums (HDHP works for me as I don't have that many medical expenses). My daughter started her first professional job in a major medical insurance company last year and I was surprised to know that her employer offers ONLY HDHPs. But her benefits are much better - she gets HSA contributions from the employer and some extra $$$ if she passes the "wellness" test. As to her retirement plan, surely, I advised her to choose Roth 401(k) option as it's a no-brainer for her age.

Another myth that results from misunderstanding is that HSA is somehow tied to your insurance plan or your employer, which is not true. IRS clearly states that to be able to contribute to HSA one should be covered by HDHP. Which doesn't mean you have to open your HSA through your insurance company or employer. You can open it in any financial institution and as far as I can witness banks don't even ask for a proof of HDHP coverage. Now, there is one special scenario when the account may have to be opened through employer - if you're getting employer contributions and the insurance plan requires that you open it in a designated bank. Well, as with IRAs, you can have more than one HSA - just make sure you don't exceed the IRS contributions limit for a year.

I normally pay all my medical expenses with a credit card (earning cash back) and then at the end of the year I write myself a check fro the total amount of my expenses. But this is not required, if the HSA rate is good or if you decided to invest your HSA balance then obviously it's better to allow that money to grow and pay your expenses out-of-pocket. Again, if at some point you need cash, you can withdraw money for a several years of expenses. Of course it's a good idea to keep the receipts and track your medical expenses in some sort of a log in case IRS ever questions your withdrawal.

A word of caution with regards to HSA: make sure to check if your state offers tax deduction for HSA contribution and/or interest. many cash-strapped states (like California) don't - so every year I have to dig up the last-year HSA interest number from the bank and put it into my state tax return.

Last but not least: since HSA contributions are limited some banks offer pretty high rates. Last year I moved my HSA to Adirondack Trust and I'm still getting 5% APY. Alas, last week I was informed the rate would go down to 3% as of May 1st. Which is still a pretty good deal for tax-free FDIC-insured account. I consider my HSA balance as a part of my PP cash portion.

For those interested here's a list of banks/CUs offering HSAs. BH forum also has a great Wiki section on HSAs. Some banks offer investment options also, although fees might be too high for this added convenience.

[moda0306]

How do you people get such good rates on your HSA's... I don't know mine but I think it shares the sub-1% interest of most savings accounts.

[moda0306]

If one has a couple kids, the FAFSA implications of having a lot of your wealth in tax-deferred accounts is huge... plus your ability to pull principal from your Roth once your kids start college accomplishes two things:

1) You can now pay for whatever FAFSA doesn't cover.  This "distribution" from your Roth doesn't show up on your tax return either

2) To further increase your chances of significant aid, (and since maybe at this point in your life you're in a reasonably high bracket), you can heavily contribute to your IRA/HSA/401(k) ($5k, $3k, and $15k about respectively per parent, equalling $46,000 total open for contribution).

This may drain your income to what may seem to be an unacceptable level, but if you're simultaneously withdrawing from your roth accounts whatever principal you need to keep your income high enough, it can probably really help on the FAFSA form to have your income down by up-to $46,000.

Keep in mind, doing this will probably wreap great FAFSA results if you're in the right income range.  I don't know all the calculations, but using the Roth shelter as both a source of income (to reduce your FAFSA taxable income), and also using it as a wealth shelter where FAFSA doesn't penalize you nearly as much for having it, meanwhile being a great tax-deferral vehicle that's extremely flexible in allowing you to withdraw contributions, and you've got yourself one awesome package.

Other strategies to reduce income in your kids' college years are also probably smart moves.

[foglifter]

How do you people get such good rates on your HSA's... I don't know mine but I think it shares the sub-1% interest of most savings accounts.

Have a look at those 2 links in my post above, just make sure you set up the filters so you see both nationwide and local banks. The thing is some banks and CUs are only shown with "local" option checked, but in fact they might accept deposits from other states. For example, NY-based Adirondack Trust is shown as local, but I was able to open an account from California.

From what I see there are several places that offer around 3% APY, which is not bad. And these rates can go up if the Fed rate starts crawling up at some point - I remember when I first opened my first HSA back in 2005 with Patelco they offered 5.12% (not anymore).

[TripleB]

...if one were to contribute $5,000 per year starting when their kid was born, they'd have $90,000 in cash basis tax sheltered but easily distributable by the time their kid graduated high school.  $180,000 if the other Parent does the same thing.

I have a few points that need clarifying in your plan:

Please explain how both parents could contribute to their child's Roth IRA for $5k in one year without exceeding the $5k annual contribution limit.

Please explain how you will justify to the IRS that your child has earned income of $5k+ to allow the Roth IRA contribution. The IRS requires a person to have earned income up to the level of the contribution made to an IRA.

Did you take into account the Self Employment Taxes that your child will pay on this earned income in your calculation? A sample example would be to pay your child $5k to do chores. You issue the child a 1099 and he/she must pay $750 in Self Employment Tax.  Only then is the child eligible for a Roth IRA contribution.

How will you prevent your child from withdrawing the IRA on their 18th birthday to buy a sports car/vacation to Europe/boat/etc.?  This is an IRA, not a trust, so you cannot set restrictions on withdrawals.

Do you have any ethical dilemmas with purposely sheltering assets to obtain government handouts?

[moda0306]

Maybe I wasn't clear, but I'm not saying to put these assets in your child's name.  I'm saying that they'd stay in your and your wife's name but be used to pay your kids' education, or at least help your assets and income be in a range where your kids more easily qualify for aid.  In fact, wealth in your childs name is penalized more by FAFSA if I remember right.

I don't think there are any ethical issues with what I've proposed. 

[TripleB]

Maybe I wasn't clear, but I'm not saying to put these assets in your child's name.  I'm saying that they'd stay in your and your wife's name but be used to pay your kids' education, or at least help your assets and income be in a range where your kids more easily qualify for aid.  In fact, wealth in your childs name is penalized more by FAFSA if I remember right.

How do you contribute assets into your child's Roth IRA, "in your name?"

Are you confusing a Roth IRA with a 529?

[moda0306]

It is your roth Ira.  It has nothing to do with your kid other than you are using t to help with your fafsa claim and maybe help you pay for their college if you so choose.

[TripleB]

It is your roth Ira.  It has nothing to do with your kid other than you are using t to help with your fafsa claim and maybe help you pay for their college if you so choose.

I understand now. In your example, the parents are currently not contributing anything to an IRA, and instead putting $5k per year into a taxable account for their child's educational savings. Then they can gain advantage by instead putting that $5k each into a Roth IRA.

[moda0306]

The parents could have been doing whatever before.  All I was saying is that one may initially think of their and their wife's Roth IRA as an "untouchable retirement account" and treat it as such.  I was saying that if they were to load it up fully (as opposed to loading up into an IRA or taxable funds), it would help come fafsa time in both wealth reduction (you don't get as penalized for tax-deferred accounts) and income reduction (making traditional 401k, IRA and HSA contributions during that time while taking distribution from one's Roth can give the appearance (legally) of lower income).

Parents could also contribute to a 529 to help them even further.  In fact I'd suggest it.  But the Roth, if used correctly, can really change your "FAFSA score" whether or not you're helping your kid pay for college or if you've saved up in a 529.  I'm no fafsa expert, but this is based on what I've heard about how fafsa scores your wealth and income.

The Roth, especially when looked at through the financial aid lense, is really a case of having your cake and eating it too.  You get all the benefits of tax-free income & growth (makes rebalancing easy), protection during bankruptcy or lawsuit, FAFSA tests, etc., but you can still look at the principal as liquid money in case of emergency or opportunity.  For some this may be bad (probably why it's not a well advertised feature), but for most on this board liquidity is never a bad thing.