In this month’s edition of “Money Matters,” Scott discusses tax-free strategies and ROTH IRAs to help maximize your financial portfolio.

Money Matters: ROTH IRAs & Tax-free Wealth Strategies

0:00:00.0 CJ: WTIP is pleased to bring you another edition of Money Matters, a monthly feature intended to help us understand more about managing our finances. Scott Oeth is a certified financial planner and adjunct professor, works with many individuals and has taught our retirement planning and wealth management strategies to hundreds of financial professionals, and he's joining us now by phone. Welcome, Scott.

0:00:22.7 Scott Oeth: Good morning, CJ.

0:00:24.1 CJ: Good morning to you. So, you said you have some ideas on tax-free wealth strategies with Roth IRAs to talk about this morning. What have you got for us?

0:00:34.3 SO: Yeah, I love this topic, CJ. You and I have talked about Roth IRAs in the past. This is the type of individual retirement account where if you follow the rules and the stipulations and the holding period requirements and all that good stuff, the earnings are tax free. Who doesn't love tax free? Right.

0:00:49.9 CJ: Exactly.

0:00:52.0 SO: So, and there are many techniques. I just wanted to touch on a few here, but it is important. The rules are complex and the phase outs and the income limitations and the contribution limits, they change every year, sometimes even more often than if there's a tax law change. So, people really need to consider the ideas that we're talking about, but then do their own research to see if this actually makes sense for them and if they qualify. Okay.

0:01:18.9 SO: So, I'm going to keep things a bit general from that stance, but one of the things, CJ, with the Roth IRA is, like I said, if you follow the rules, the earnings grow tax free. So, if the Roth IRA is part of your overall investment plan, let's say you've done well and happily, maybe you have money in an employer retirement plan, maybe you have some other money, maybe some came from an inheritance and Roth is a piece of it. One idea that can make a lot of sense is instead of looking at the Roth IRA and thinking about the investments in there as an entire portfolio, what you might want to do is take a look at, say, out of your household's portfolio, what is the highest expected return type holding that you'd want, and overload the Roth IRA with that to really get the most bang for the buck out of that Roth IRA.

0:02:10.6 SO: I view it as kinda the difference between, a scoop of grandma's hot dish where everything's in there, the peas, the corn, the tater tots, all that the chicken all in one, or do we want to just maybe pull out the tater tots and put those in the Roth IRA because there's a big difference if we look at something historically, it depends on the time period. Like small company stocks have had a much higher return over the long haul than bonds and even a higher return than large company stocks. So in some cases it can really make sense to piece that out and say, let's put our highest opportunity set in the Roth IRA to really take advantage of capturing that tax free gain. So that's one thing, CJ, but the other side of the coin that maybe applies to a lot more people, especially when they're just starting out, is maybe they've heard of a Roth IRA, but they're thinking, well, I'm just getting going.

0:03:03.2 SO: I really need to work on building up some emergency savings, some safe money in case the car breaks down or I get laid off, or Roth IRAs for rich people only. Well, not exactly and take a look at it. Even with a modest dollar amount, a small dollar amount, you have a coupon each year for an amount that you can put into a Roth IRA and if the year goes by, that's it. You don't get to go backwards and get credit for that. But it's important I think for people to keep in mind there's a difference between the account type, which is the Roth IRA or traditional IRA, and the investments in that account type.

0:03:42.2 SO: So if you're in that point where, maybe you don't have a lot of excess cash and the priority really should be building up some safe stable type holdings, you can still do that inside the Roth IRA and that way at least you're taking advantage of that annual coupon to get some money into the Roth IRA and you can choose to invest it in something like say maybe a money market account or even a certificate of deposit at the bank, if that makes sense in your situation to have that safe, stable money, but have it in a tax-free environment.

0:04:13.9 SO: And if time goes on and you build up your overall portfolio and you get more earnings on that, well, you can always then change the investment. At least you've started putting some money into the Roth IRA and there's some other reasons there also around, a five year holding period, starting the clock running on that. So in either way, I think... Think specifically about what type of holding makes sense and not just view it as the account type and that it needs to be a long-term plan.

0:04:44.9 CJ: Okay. So, okay, long-term focus is what we want to get as much bang for the buck from the Roth IRA, but they can also be a safety bucket. But should we be switching the types of holdings often?

0:04:57.3 SO: Not usually. CJ in most cases where I've seen or where I'm managing the account, I think it usually makes sense to choose an appropriate holding something that really fits with the overall financial plan and investment strategy, and largely stick with it. And in fact, there's some pretty good research showing that many people unfortunately probably most end up shooting themselves in the foot, so to speak, by switching their holdings too often, you and I about a year ago I brought up this concept of a study that the big research for Morningstar puts out there, they call the Mind the Gap study, where they find that investors miss out on a lot of returns because they get caught up in that psychological trap of chasing the hot return, what did well last year and selling out of something that did poorly.

0:05:45.3 SO: And so they're continuously in this cycle of selling low and buying high as opposed to what we want do is the opposite. We want to buy things low, we want to buy quality holdings when they're out of favor and they're cheap ideally and sell them when they're high. But Morningstar found that they updated this long running Mind the Gap study and they found that on average investors miss out on earning nearly one fifth of the return. And what they're doing is they're comparing the average return of the funds, the holdings, and then what the investors are actually earning. So, let's take a 17% less return, 1.7% on average over a 10 year period. So no, CJ in general, we want to think about what makes sense overall. Choose quality holding, low cost holding, diversified holding and largely stick with it.

0:06:33.1 CJ: Okay. You also said you had some thoughts on how one could share the love with Roth IRAs and help family members. What strategies should we know about that?

0:06:43.8 SO: This is great. We love IRA. We love Roth IRAs, and hopefully we love our family members.

0:06:51.4 SO: If we're doing well, there's things that we can do to really help spread the wealth here and extend and maximize the power of the Roth IRA. Just to touch on a few, if you're in a position where things are going very well, you have excess cash, you're looking to extend it, you might want to look into what's called a backdoor or mega backdoor Roth IRA. This makes sense for some high earners in certain situations where they can use non-deductible IRAs or their company retirement plan to get extra dollars in and then convert to a Roth IRA. That's one idea to extend it for yourself. But a big one that a lot of people miss is what's called a spousal IRA, CJ.

0:07:29.8 SO: And so if a couple is married and one person is not working and the other is, and they're not covered by a company retirement plan they might be able to fund a spousal IRA essentially saying, here there's money that the other spouse can put into the Roth IRA on their behalf and have their own account. As a household, it's a way that you could increase the amount that goes into this really powerful tax free account type. It works with, sideways with spouses, children is another big opportunity. So kids, if they have earned income, even if they're under age 18, they can have a custodial Roth IRA and they can contribute dollars, even small amounts, to really begin that fantastic tax-free wealth compounding in a Roth IRA. It's a great way to help teach kids about investing. It's a great way to really help them maximize their earnings a big step up from the piggy bank.

0:08:27.2 SO: And start talking about investing and maybe build some dollars that hey, contributions can be taken out tax free, they could be used for college, they could be used to help start a business, buy that first house. There's... There are rules around all these things you want to look into, but very versatile account. Not to mention just long-term retirement. So kids, if they have earnings, earned income, they can do this. If they have earned income. Something that we've talked about many times with parents, it's maybe the parents want to essentially match what their kids are earning. If they make some money in a summer job, it's tough to say to that kid, "Hey, you need to put that all away in a Roth IRA."

0:09:04.6 SO: But maybe the parent is in a position where they can do so, they can say, "Okay, you earned $1000 this summer, why don't I give you $500 or $1000, gift that to you, and you put that in a Roth IRA because you've qualified with that earnings." That's a great strategy and one that's related to that CJ is family businesses. If there's some type of business where you can legitimately employ the kids and they can do some meaningful work, they can make their earnings there in the family business, maybe build some work skills and learn about that and use those earnings to fund the Roth IRA. So I think those are great ways to help build that financial acumen and give the kids a head start and really get them going with Roth.

0:09:47.5 CJ: And when you're talking about children, you're talking about underaged children correct?

0:09:53.4 SO: Exactly, and that's most... A lot of people don't really realize this, but under age 18, you can work with a custodian set what's called a custodial IRA, and the parents can help the kids set that up. In cases little kids, if they're actually doing meaningful work in say family business or certainly teenagers with summer jobs, this can apply with their putting money into Roth IRA with their earnings.

0:10:22.0 CJ: All right. Wow. Lots to cover there. Lots to think about. Is there anything else you want us to know about Roth IRAs this morning, Scott?

0:10:32.4 SO: Well, there's a lot we could talk about CJ. We could go on all day. There's many stories, many strategies since the club. Maybe one other thing in the family being, grandparents or parents who are... If they're in a position where they're in retirement, they're feeling good about their financial position, they're living comfortably, they have enough and feeling pretty good about that, and they're starting to think about legacy planning. There's some great ideas around Roth IRAs for the senior generation if they're... How do we smartly pass on some of this to our kids or to our grandkids? Roth IRAs make a fantastic inheritance vehicle because those gains are tax free. They can even stay in the account for up to 10 years after someone has passed on.

0:11:19.4 CJ: Really? Okay.

0:11:20.1 SO: And they leave... Yeah. It can... You might get a whole nother sort of turn of the crank there with a compounding cycle with the money in the Roth IRA.

0:11:30.5 SO: Sometimes people, even if they've done well in retirement, they're in a relatively low tax bracket, their adult children might be in a higher tax bracket as a intergenerational estate planning, wealth transfer strategy. It can make sense for grandparents or that senior generation to go ahead and pay taxes on IRA money 403B money, 401K money and convert it into a Roth IRA at their lower tax rate so that the kids don't have to pay a tax on it at a higher rate in the future. One more idea there, I guess to throw in.

0:12:06.7 CJ: Wow. Nice. Okay, well, we're going to have this on our website, and I'm sure you will as well. Thank you, Scott Oeth. We've been talking finances with Scott, and we do that on the first Wednesday of the month on North Shore Morning.