Rollover to a Roth IRA

Rollover to a Roth IRA: For you and your children’s prosperous future

Rollover to a Roth IRA: A Quick History…

The contribution limit for individuals to IRAs–Roth and traditional-was risen to $3,000 for 2002 and 2003.  It’s going up to $4,000 per individual from 2005 to 2007 and $5,000 after 2008. In addition, the contribution levels will be indexed for inflation from 2008, starting from a $5,000 basis.  Help your children take maximum advantage of these changes-from the moment they’re old enough earn income-and you should be able to shelter just about all of your children’s accumulated wealth by the time they apply for college.  In this way, you can minimize or even eliminate any adverse impact their growing wealth will have on financial aid eligibility.

Rollover to a Roth IRA:Shift Your Kids’ UGMAs and UTMAs into a Roth for Greater Benefits

Is your child starting to work part-time yet?  Whether it’s mowing neighbors’ lawns, working for a local business or working for you in your business, if they’ve got formal income, you should open a Roth for them right now.

I go over the key benefits of the Roth for kids in the Seeds of Wealth program, but let me recap them briefly here: With a Roth, your child can…

  • Enjoy 100% tax-free income, growth and withdrawal
  • Get greater compounded returns without taxes on gains or dividends
  • Better maintain financial aid eligibility for college
  • Have access to over $100,000 of his IRA by age 30, long before retirement
  • Build wealth simultaneously in an easily accessible non-sheltered account as well

Review pages 223-228 in the Seeds of Wealth program to see specifically how a Roth can deliver these benefits.  But for this update, let me tell you how you can legally transfer money from your child’s non-IRA account into a Roth.

Rollover to a Roth IRA: Pulling the Ole Switcheroo

The IRS Code doesn’t allow you to shift money from a regular investment account into an IRA.  You have to fund your IRA from earned income.  Well, here’s how you legally get around that.

In essence, you don’t switch anything.  You let your child spend money from his UGMA or UTMA investment account and have him save that much more from his earned income.  Those savings now go into the IRA.

If this seems like semantics, to an extent it is.  But you’re dealing with the IRS.  And if you try to transfer money directly from an UGMA or UTMA account to a Roth IRA, the custodian (that is the broker holding the IRA account, such as Scottrade) won’t allow it.

So here’s how it might look when you do it right…

Let’s say your 12-year-old child earns $3,000 in a year (about $60 a week) mowing lawns.  Let’s say he also receives $1,000 in non-taxable gift money in the form of allowance, gift money, holiday money and household chore money.  So, from the Seeds of Wealth point of view, your child has taken in a total of $4,000 for the year and should save half, or $2,000.

Let’s also say, that at the same time, he has $1,000 accumulated in an UGMA or UTMA account-set up before he was working and thus before he was able to have a Roth IRA.

Now, the IRS says your child can’t put that $1,000 into the Roth.  That’s a transfer.  No good.  But here’s what you can do.  Cash out the account and let your kid spend the $1,000.  In exchange, you now just ask him to save $3,000 from his total income of $4,000 this year, instead of $2,000.

Since his formal earned income was $3,000, he, in fact, can deposit up to $3,000 into the Roth IRA.  So, from your child’s point of view, nothing has really changed.  He made $4,000, and saved and invested $2,000.  Those $2,000, combined with the $1,000 he already had in the UGMA or UTMA, make up a total of $3,000.  And that, indeed, is what he now has in investments too-$3,000.  But it’s all in his IRA!

Now, if we imagine the same scenario but instead of $1,000 currently in an UGMA or UTMA, your child has $2,000 in that UGMA or UTMA, then it may take you two years to effect the transfer without, really “transferring” it.

You won’t be able to transfer the full $2,000 right away because that would put him over the annual IRA contribution limit of $3,000.  You’d have the $2,000 from new savings plus $2,000 from the old account amounting to $4,000-and that’s beyond the IRA annual contribution limit of $3,000. What’s more, even if the annual contribution limit were higher, the $1,000 he earned around the house in allowance, chore money, etc. is not a permissible source of IRA funds.  It has to be “earned” income.

Rollover to a Roth IRA: Getting Bigger in 2008

But by repeating what you did in the first example, you’d still be able to move all of his prior account into the IRA.  It would just take you another year before you got it all over to the IRA.

And if you’ve got more still in a non-sheltered minor’s account-say $5,000 or $10,000?  Well, take note that the IRA contribution limit went up to $4,000 and up to $5,000 in 2008 and then will be indexed to inflation after that. So you may be able to shelter more of your child’s money from taxes and minimize or eliminate the impact his growing wealth might otherwise have on financial aid eligibility.

And, of course, because IRA rules allow you to withdraw capital contributions five years after you’ve opened the account, he can also have access to a good deal of his money as a young adult, should he need it.  But it’s doubtful he would-since he’ll also be building wealth outside the IRA in a non-sheltered account once he is working and in his 20s.

So there you have it in a nutshell.  Depending on your child’s particular situation (exactly how much he currently has in an UGMA or UTMA, how much he’s earning in a formal job, etc.), you can very probably move some or all of your child’s non-sheltered funds into a Roth IRA while abiding by IRS rules…

Rollover to a Roth IRA: Take Full Advantage of the Roth IRA

For most savers and investors, Roth IRAs will remain the real option going into the college years.  And that’s why the recent IRA contribution limit hikes have been important.  This was the first time Congress increased the IRA contribution limit since IRAs were introduced. It was long overdue. It’s possible the limit may be increased again by the time your kids go to school–providing them even a little more shelter.  However, we can’t count on that yet, so here’s another technique you can use:

If you think your child will easily shelter $12,000 in Roth IRAs but won’t have enough additional funds to make it worthwhile to consider using those additional non-sheltered funds as a down payment on a home for your child during college years, there is another option to shelter the rest-say just $5,000 or so.

That option is to keep roughly that portion of your children’s non-sheltered investment accounts in your name until the child finishes college. You should hold the non-dividend-paying, lowest turnover part of their portfolios in your account in order to negate or minimize any potential tax impact on you.  Later, after college, you can begin to gift these mutual fund shares to your children (up to $11,000 a year per child in gifts tax-free).  If you’re the parents (not the grandparents), holding these shares in your name will still affect financial aid eligibility but not as much as assets held directly in the child’s name.

Also, make full use of the 11 ways we speak about in the program to reduce the cost of a first class education by as much as 70%.

Finally, if after these techniques you end up losing a little in financial aid eligibility, that’s a cost you’ll have to live with. There is always a price for success. After all, you can’t qualify for unemployment if you have a job. But I wouldn’t suggest you quit your job just to get a free check from the government.


By Justin Ford,
Author, Seeds of Wealth