Meyers Wealth Management

Roth IRAs are getting to be more and more popular, and for good reason.  We have no certain knowledge about future tax rates, but it seems quite likely that they've no place to go but up.  With a Roth IRA, you pay taxes now on the money that goes in, and in the future, that money -- and whatever it's grown to -- comes out tax free.

But wait, there's more!  Unlike traditional IRAs or other pre-tax employer-based retirement plans, there are no Required Minimum Distributions from a Roth IRA.  Once you turn 70-1/2, you must start taking money out of traditional IRAs -- and paying taxes on those distributions.  But since the government gets no taxes from Roth IRA distributions, the government has less incentive to require you to take those distributions.

And Roths are great for estate planning, too!

We're convinced.  Roth IRAs are great.  So how much money can you put into a Roth IRA, and who can put money into one?

First, how much?  If you are contributing directly to an IRA and/or a Roth IRA, your annual direct contributions to them may be no more than (a) your earned income and (b) $5000 per year (or $6000 if you are over age 50, and they call that extra $1000 a "catch-up" contribution).  We'll get to the income limits in a moment, but regardless of those income limits, and assuming your earned income is enough, that maximum total applies to the combination of contributions to both a traditional IRA and a Roth IRA.  You may put, say, $3000 in the Roth and $2000 into the traditional, but you could not put $5000 into each of them.

So who can contribute?  Nowadays, pretty much everyone can, though it's not always obvious how, exactly, one would go about doing it due to some income limits and possible conversion tax implications.

Regular, simple, direct contributions are the easy path.  If your Adjusted Gross Income (AGI) is below a certain threshold, and you (and/or your spouse) have earned income (ie. wages rather than investment income), you may simply contribute directly to a Roth IRA.  If you are married filing jointly, and your AGI is below $167,000 (in 2010), you may contribute the full $5000 ($6000 if you are over 50) directly to a Roth IRA.  If you are single, and your income is below $105,000, you may contribute the full $5000 (or $6000) directly to a Roth IRA.  If your income is above those levels, there is a phaseout range which reduces the amount you may put into a Roth IRA, and if your AGI is above $177,000/$120,000, you may not contribute directly to a Roth IRA at all.

So what if you do have income above those limits?  Until 2010, you were out of luck.  At of the beginning of 2010, the rules changed.  There is another way to get money into a Roth IRA now.  You may not be able to contribute directly to the Roth IRA, but now you may make a traditional-to-Roth IRA conversion. Until 2010, conversions were also not allowed if your AGI was above $100,000 but that limit is now gone.  Anyone with a traditional IRA may now convert all or part of it to a Roth IRA.  So here's the trick - if your income is above the direct-contribution limits for Roth IRAs, you may make a direct contribution to a traditional IRA and then immediately convert that amount from the traditional to the Roth IRA.

So what's the catch?  Naturally, there's a catch.  It has to do with the way conversion may be taxed.  If you already have assets in a traditional IRA, when you convert that balance to a Roth IRA, you may have to pay income taxes on some or all of the amount converted.  How much of the conversion will be taxable depends on how much money is in the traditional IRA (and that means the sum of all traditional IRA accounts you have, not the amount in that particular account from which you make the conversion) and how much or whether you deducted those contributions on your income taxes in the years in which you made the contributions.  This may appear a little bit messy, so we'll use an example with some made-up numbers to help clarify.

Suppose you made deductible contributions to a traditional IRA for several years, perhaps when you were a bit younger and were making less and were able to deduct them.  Over the course of several years, between the deductible contributions you made, plus the growth of the investments, you now have $20,000 in that traditional IRA.

If you convert any of that IRA to a Roth IRA, the entirety of the conversion will be taxable income.  In other words, if you converted $10,000 of the $20,000 balance, you'll owe income taxes on that $10,000.  You'll end up with a traditional IRA with $10,000, a Roth IRA with $10,000 and, hopefully you paid the taxes with money you had outside the IRA.  You almost certainly do not want to have to cash out any of the IRAs to pay those taxes.

Now let's return to the person who currently makes too much to contribute directly to a Roth IRA.  We'll start with the same situation - you've got $20,000 in a traditional IRA which was funded entirely with deductible contributions.  That means if you convert even $1 from that IRA to a Roth IRA, you'll owe taxes on the amount converted.  If you make a $5000 non-deductible current contribution to that traditional IRA, you now have a traditional IRA with a balance of $25,000 and a $5000 "basis".  Basis here refers to the amount in the account on which you've already paid taxes.  If you then wanted to convert $5000 from that traditional IRA to a Roth IRA, the rules require you to prorate the basis in the conversion.  This is the catch.  You cannot convert only the $5000 you've just added. Any amount you convert will be proportionally considered to be existing  money in the IRA plus the non-deductible amount you've just added.  And this happens even if the new contributions are  made to a new account.  Your IRA and its basis applies across all of your IRA accounts.  You cannot isolate it by having a separate account.

So in this case, to recap, you have $20,000 in the traditional IRA, which was funded with regular deductible contributions.  You add $5000 now, as a non-deductible contribution.  Now you have $25,000 in the traditional IRA with a basis of $5000.  You convert $5000 to a Roth IRA.  Since the proportions in the traditional IRA had you at $5000/$25,000 of it in after-tax money, 1/5 of the conversion is considered to be conversion of after-tax money and 4/5 of the conversion is taxable.  After the $5000 conversion, you now have a traditional IRA worth $20,000 with a $4000 basis, a $5000 Roth IRA -- and you owe income taxes on $4000.  I'll repeat that last bit:  you owe income taxes on $4000 -- because 4/5 of the conversion was deemed to have come from the part of the traditional IRA on which you'd never before paid taxes.

So how can this be useful to someone who currently earns too much to contribute to a Roth IRA but wants to use conversions to make it happen?  If you do not already have an IRA which was funded with pre-tax money, then you can make the conversion with no new taxes due.  In the example immediately above, the problem was that the person already had made deductible contributions to a traditional IRA.

If your only existing retirement accounts are employer retirement plans like a 401(k) or 403(b) or a qualified profit-sharing plan, and you have no existing traditional IRA at all, you've got an opportunity to get money into a Roth IRA without paying any taxes on the conversion.  The trick is that you have to first open up a traditional IRA account.  If you make a non-deductible contribution to a traditional IRA account and you do not already have any money in a traditional IRA account, your basis is exactly equal to the amount you contributed.  So it looks like this:  you have no traditional IRA at all.  You open the traditional IRA and make a non-deductible $5000 contribution.  You now have a traditional IRA worth $5000, with a basis of $5000.  Now you convert $5000 to a Roth IRA.  100% of the conversion is a conversion of money you've already paid income taxes on (because it was a non-deductible contribution).  After the conversion, you have $zero in the traditional IRA (and zero basis, because you converted the entire thing), and you have a Roth IRA with $5000, and you owe no new additional taxes.  You do not get to take any tax deductions -- your traditional IRA contribution was non-deductible.  But in the future, any distributions from that Roth IRA after you retire will be tax-free.

As you can see, by keeping the income-limit for direct contributions to Roth IRAs, but allowing conversions for anyone, the government has made it possible for high-income folks to put money into a Roth IRA -- but potentially with a substantial tax on the conversion if they already have IRAs.  For folks who don't already have substantial traditional IRAs, it's a great opportunity to fund Roth IRAs without any additional taxes.  For folks who do already have substantial traditional IRAs, though it's a much more complex decision as to whether it's worth paying taxes on the conversions.

In an earlier News and Notes article here, we discussed credit card rewards programs.  The bottom line at that time was that generally, the best deals are cash back.  Nobody has blackout dates on cash, you can use it in small increments, cash doesn't expire.  And on a dollar-for-dollar basis, some of the most generous programs were cash programs (ie. when you come up with reasonable estimates for what points of various sorts are worth were you to buy with cash whatever those points got you).

Now, according to a Wall Street Journal article, a study has just quantified how infrequently folks can actually use those frequent flier miles to get "free" plane tickets:

From the article: A study testing the availability of free seats showed that Southwest Airlines Co. could fulfill 99.3% of requests for award seats requiring standard mileage levels, and Alaska Air Group Inc.'s (NYSE: ALK , news) Alaska Airlines offered choices on 75% of requests. US Airways Group Inc. could fulfil just 10.7%. Delta Air Lines Inc. was among the stingiest, too, with awards requiring the lowest mileage available for only 12.9% of requests made by IdeaWorks Co., a consulting firm.

In other words, as stingy as the actual value of the frequent flier miles really scale up, that's not necessarily the worst of it.  Assuming you've accumulated enough of them, you're still unlikely to actually be able to use them on a flight you want on the most popular airlines.

And it's only going to get worse if and when more of the bigger airlines consolidate (such as the recently announced United and Continental merger) and they cut back on certain routes and try to get more efficient.

Here's a link to the Wall Street Journal article, hosted on Yahoo's Finance site: http://finance.yahoo.com/family-home/article/109543/the-road-to-redemption

We're still big fans of cash-back cards.  Rewards are only worth something if they're rewards you are actually going to be able to use.  It appears that the Schwab 2% cash-back card is no longer being issued, but Fidelity's still got a great cash-back card deal.  Chase has replaced their old cash-back card with their new "Sapphire" card which is almost as good as the old deal.  And American Express's "Blue Cash" card is worth looking at as well.

We'd love to hear from folks who have good credit card rebate programs, especially cash-back ones.  Let us know how it's worked for you - have you gotten as much back as you'd hoped, have you had good customer service experiences, etc.

May 1, 2010 - the Treasury has announced the new interest rates for I-Bonds.  The fixed-rate attached to all newly issued I-Bonds for the next six months is 0.20%.  The semiannual inflation-rate, used in computing the interest on all outstanding I-Bonds, is 0.77%.  These two rates are combined into a composite earnings rate for newly issued I-Bonds of 1.74%.

Some background:

US Treasury Savings Bonds.  We've all heard of them, and many of us got them as gifts when we were young.  The old versions were paper certificates with a face value on them which was twice the price that folks paid for them.  The computation of their values was complex and required lookups in government tables, usually at a local bank.

Unlike traditional bonds, US Savings Bonds are non-marketable Treasury securities.  That means that you cannot sell them to someone else - they may be redeemed (usually, again, at a local bank), or they can be held.  One of the consequences of this is that they are not subject to the same kind of interest-rate risk that typical bonds are subject to.  Whether rates go up or down, it doesn't affect the price or redemption value directly, since there is nobody you can sell them to, and when you redeem them, you generally get back all your principal plus accrued interest.

Savings Bonds have been around since 1935 and have been offered in a variety of series, the earliest ones were A, B, C, and D.  The Series E bonds was first offered in 1941 and became the famous "War Bond" during WWII - and became the world's most widely held security.  Bear in mind that back then, very few people (relative to how widespread it is today) owned stocks or mutual funds.  Nobody had an IRA or a 401k.  Folks had savings accounts at their local banks, paid off their homes, and bought savings bonds.

The Series E bonds had an original term of 10 years, though they were set to earn interest for as much as 30 or 40 years.  In 1980, it was replaced with the Series EE bond and the last Series E bonds will cease earning interest this year, in 2010.  EE bonds are still being issued.  Over the years, there have been other series as well: F, G, J, K, H, HH and most recently, the innovative Series I bond.  In addition to the changes in the series of bonds, how their interest was calculated, how long they interest,  changes to how these bonds were bought, held, and redeemed have taken place.  Millions of people bought them through the Payroll Savings Plan, folks bought them in person at their local banks, and as of a few years ago, they became available in pure electronic form through the Treasury Direct program (which already existed as a way for people and institutions to buy traditional Treasury bonds electronically).

The I bonds represent a departure from other Savings Bonds in that the interest rate is built of a combination of a fixed "real" rate, fixed at the day of purchase and for the life of the bond - and a floating "inflation" rate which is adjusted every 6 months and based on the CPI-U, a measure of inflation published by the BLS.  Other Savings Bonds have their interest rates set based on averages of the yields of regular Treasury securities.  The idea here is that an I-Bond will protect the value of your investment from inflation.

How the I-Bonds work:

Every six months, in addition to adjusting the inflation portion of the interest rate for all I-Bonds, the Treasury adjusts the fixed-rate which will apply to all the I-Bonds to be issued for the next six months.  Whatever the fixed-rate was on the day one buys an I-Bond, that fixed-rate will be used, in combination with the semiannual inflation rates released every six months, to compute the interest that the I-Bond will earn over the following six months.  When you buy an I-Bond, you lock in that fixed-rate for as long as you choose to hold your I-Bond.

When the I-Bonds were first issued, that fixed-rate was as much as 3 to 3.6% between 1998 and 2001.  The fixed rate now is 0.20%.  It's actually been as low as zero % (for six months in 2008).

The actual interest earned on an I-Bond is computed as follows:

Composite rate = [Fixed rate + (2 x Semiannual inflation rate) + (Fixed rate x Semiannual inflation rate)]

Tax considerations:

There are some great tax advantages that Savings Bonds offer.  Interest earned on them is subject to the federal income tax, but the tax is generally deferred until redemption.  That means that if you hold a Savings Bond, you don't have to pay taxes on the interest each year.  Instead, the interest accrues and compounds and until you redeem the bond, you don't pay any taxes on that earned interest.  All of the accumulated interest you earned is only taxed when you finally redeem the bond.  This is a powerful tax advantage similar to the tax advantage offered by a deferred annuity or a non-deductible IRA contribution.  And this is quite different from TIPS, the marketable Treasury Inflation Protection bonds (on which taxes must be paid annually, and which generally ought to be held in IRAs because of that).  Savings Bonds get tax deferral without having to put them into any kind of special account.

Moreover, interest on Treasury Savings Bonds is generally not subject to state income taxes.  This is especially nice in high-income-tax states like California.

Finally, under certain conditions the interest may be excluded from federal income taxes when the bond owner pays qualified higher education expenses (college) with the money.  (This is a little messy, as there are phaseouts which depend on the taxpayer's modified adjusted gross income).

Redeeming the bonds:

Savings Bonds generally may be redeemed no sooner than 12 months after purchase.  You should probably not  buy them if you have any reason to think you're going to need your money back sooner than 12 months.  After that, if you redeem these bonds less than 5 years after purchase, you lose 3 months of accrued interest (which may not be a big deal if the rate on them is low and you have a better alternative at that point).

So should I buy savings bonds?

As usual, it depends on an individual's specific situation.  Savings Bonds in the context of an asset allocation decision are a very low-yielding cash-like investment.  The closest similar thing is a CD, as the money is locked up for a limited period of time after which it may either be cashed out or left in place.  The lockup is actually tighter than a CD for those first 12 months during which the Savings Bond cannot generally be redeemed at all, but after that, the cost to get out of it is fairly small.

Note, however, that CD rates right now (May, 2010) with maturities of one year or less generally have rates lower than current composite yield (1.74%) on newly issued I-Bonds.  You have to look at 18 month or 2 year CDs to get rates higher than that, and those are still subject to state income taxes and do not get the tax deferral that I-Bonds get.

The fixed-rate on these bonds right now locks one into a very low real rate of return.  And no matter what happens to interest rates or inflation, that fixed-rate won't change for the life of these bonds.  If one were to buy them today with the very low 0.20% fixed rate, it might well be worth forgoing the 3 months of interest (and paying income taxes on accrued interest) to cash them out and buy new I-Bonds as soon as a year from now if the Treasury raises the fixed-rate (and you can tolerate a new 12 month lockup period). 

Nevertheless, given the low total return on these right now, it may be worth looking at alternatives such as a short-term investment grade bond fund which has higher liquidity (no 12 month lockup) and higher current yields.  The downsides to a short-term investment grade bond fund are that if rates go up, the fund may lose a little value (this is moderated by it being only short-term bonds), or if corporate defaults go up, the spread may widen (again, similarly moderated by the short term of the bonds), and of course, there are tax consequences and potential trading costs as well.

If you were lucky or smart enough to buy I-Bonds back in the period between 1998 and 2000, consider them as part of your asset allocation and unless you really have other needs for that money, consider hanging on to them as long as you can.  The fixed rates from back then were quite high, and between then and now, you've accrued substantial interest -- which is continuing to compound tax-deferred.  It was difficult in 1999 to believe that a 3% real rate of return was incredibly attractive, while the stock market was soaring and the internet bubble was inflating.  But it was a fantastic opportunity and those who took advantage of it should be quite pleased with that choice.  In contrast, today, with a real fixed-rate of 0.20%, they don't look nearly as attractive now as they did then.

Some helpful links:

Treasury Direct

Treasury Direct's I Savings Bonds Frequently Asked Questions

I Savings Bonds Rates (current and historical)

Savings Bond Calculator (finds the value of EE, E, and I Bonds you already own)

Roth IRAs, Traditional IRAs and Taxable investments

Lately there's been a lot of talk about Roth IRAs, particularly about the possibility of converting traditional IRAs into Roths.  The trigger for much of this discussion is the fact that as of the beginning of 2010, many more people are now eligible to make the conversion.  Until now, the law allowed conversions only for folks whose income was below $100,000.  That cap has now been lifted, so suddenly many folks who previously couldn't consider conversions now can.

Before we talk about conversions, however, and the potentially complex calculations which can go into figuring out if doing a conversion makes sense, we'd like to talk about traditional and Roth IRAs themselves.

And before we talk about any IRAs, however, let's explore briefly the tax consequences of regular, old-fashioned taxable savings, starting with one's earnings. The cycle goes like this:

1. Earn money

2. Pay income taxes

3. Invest that money - buy stocks, bonds, or stick it in a savings account

4. Each year, pay income taxes on some of the investment's earnings (interest payments, dividends, etc)

5. Sell off or otherwise liquidate the investment

6. Pay taxes again on the gains in that investment (assuming you sell it for more than you paid in the first place)

7. Spend the money

As you can see, there are several stages along the way during which taxes are paid.  Depending on which stage and how often, that tax drag can be quite substantial.  Let's do an example with a pretty unfortunate case - suppose the investment was simply to put the money into a savings account which throws off fully taxable interest.  For this example, we are going to make several assumptions - about tax rates, the investor's income level and the rate of interest paid by the bank.  We are going to leave out State income taxes because it varies a lot by state, though in certain states, it can make a huge difference (e.g. CA has a 9.3% tax on most income!)  Moreover, to keep it very simple, we are going to assume that those rates do not change, and we will follow the life-cycle of a specific chunk of earned money.

1. Earn money:   $5000

2. Pay income taxes (25% of $5000 is $1250): $3750

3. Put $3750 into a savings account which earns 2% (Note that current savings account rates are less than that, but they've varied a lot over the years)

4. After a year, our savings account earns us $75 interest, on which we pay 25% income taxes of $18.75, so we actually only earn, after taxes, $56.25.  Add that to our savings account, which now has $3806.25

[repeat this cycle for however long the investment is left alone.  We will assume 25 years].  We end up with $5441.05

5. Since this is a savings account, there is nothing to sell - it's already cash.

6. There is no capital appreciation, so no capital gains taxes, and we've paid taxes on the interest each year along the way.  No taxes due.

7. We have $5441.05 to spend.

One more thing to note about this is we make no allowance for inflation - in reality, after inflation, this saver has probably lost purchasing power, even though he diligently allowed his savings to compound for 25 years.

Let's do this same exercise with the purchase of some stock.  We will buy just one single company, assume no commissions on the purchase and sale, assume the stock throws off a taxable dividend of 2%/yr (current div yld. of S&P500), further, we will assume that the dividend is reinvested with no commissions, and that the dividend and the stock price both grow together at 7%/yr.  This is pretty close to the long-term returns of the S&P500, though note that it ignores  volatility - it's not like the real thing clocks in that return year-after-year.  In real life, it's gone up and down a lot.  This is a very rough, back-of-the-envelope assumption made only for the sake of demonstrating some tax issues.  One more thing, we're going to use 2010 tax rates.  In 2011, assuming Congress doesn't change things, they are quite different - in 2011, some brackets go up, and the tax rates on dividends go back to being the same as your normal income taxes, rather than lower as they are now.

1. Earn money: $5000

2. Pay taxes:  $3750

3. Invest in stocks:  $3750

4. After a year, our stock has grown in value to $4012.50, and it's thrown off a taxable dividend of $75.  We pay income taxes (at 2010 rates, that's 15% on most stock dividends) on that dividend, leaving us with $63.75 cash to reinvest in that stock.  We buy more stock with that cash, so now we have $4076 worth of stock and a cost basis of $3813.75 (the after-tax amount we spent on the stock = the original $3750 + 63.75).

We'll repeat this process 25 times on a spreadsheet.  The result is stock worth $30,183 with a cost basis of $8915.

5. We sell that stock for $30,183 of which $21,268 is a capital gain and $8,915 is a return of our cost basis.

6. Pay taxes on the gain: $21,268 is taxed at 15% ($3190)

7. We have $26,993 to spend.

Now, that's an astonishingly larger amount at the end of 25 years than one had in a savings account.  The lesson here, however, is not that you should just buy lots of stocks - there are other considerations such as volatility and risk to consider.  This was just to demonstrate how the taxes drag on the investment.  For a much more apples-to-apples comparison, suppose that instead of paying a 2% dividend, the stock was a pure growth stock and paid no dividend.  We'll assume the same overall theoretical stock return -- we'll assume that the stock price grows at 9% (in the previous example, the stock price grew by 7% and paid a dividend of 2%, so the total return is the same 9%).  This will show the impact of those taxes you pay along the way on those dividends:

1. Earn money: $5000

2. Pay taxes:  $3750

3. Invest in stocks:  $3750

4. After a year, our stock has thrown off no taxable dividend, so we pay no taxes.  The stock price goes up by 9%, so now we have $4088 worth of the stock, and since we didn't get a dividend to re-invest, we made no new purchase and our cost basis remains the same $3750 from our original stock purchase.

We'll repeat this process 25 times on a spreadsheet.  The result is stock worth $32,337 with a cost basis of $3750.

5. We sell that stock for $32,337, of which $28,586 is a taxable capital gain, and $3750 is the return of our cost basis

6. Pay taxes on the gain: $25671 is taxed at 15% ($4288)

7. We have $28,049 to spend.

You can see that the effect of paying taxes along the way before re-investing those dividends has a substantial drag on the end result.  Note further that in this example, those dividends were taxed at the same low rate as capital gains.  They haven't always been taxed at the same rate.  In 2011, unless Congress does something about it, the dividends will be taxed at a higher rate than cap-gains, and the advantage of not paying taxes on dividends along the way is even more powerful.

Let's run this same example with a high-dividend paying stock, with the same total return of 9%.  This time, the stock pays a 4% dividend, and the share price grows by 5%/yr:

1. Earn money: $5000

2. Pay taxes:  $3750

3. Invest in stocks:  $3750

4. After a year, our stock has grown in value to $3937.50, and it's thrown off a taxable dividend of $150.  We pay income taxes (at 2010 rates, that's 15%) on that dividend, leaving us with $127.50 cash to reinvest in that stock.  We buy more stock with that cash, so now we have $4065 worth of stock and a cost basis of $3877.50.

We'll repeat this process 25 times on a spreadsheet.  The result is stock worth $28,168 with a cost basis of $13,634.

5. We sell that stock - our gain is $19,098.98, and we get our $8,006 basis back.

6. Pay taxes on the gain: $14,535 is taxed at 15% ($2180)

7. We have $25,988 to spend.

The difference between a tax-efficient stock which throws off no dividends and a stock with precisely the same pre-tax total return but which throws off substantial dividends is quite large.  On an original investment of $3750, the difference after 25 years is more than $2000.  Tax efficiency is important!

To whet your appetite for our discussion of traditional and Roth IRAs, without going into all the details here, here are the results of taking that $5000 that we've earned and investing it in that same stock in a traditional and in a Roth IRA.  We are sticking with the same assumptions:  9% total return on the stock (note that now it makes no difference whatsoever whether it pays dividends or not - since we don't pay any taxes along the way in either Roth or traditional IRAs), 25% income tax rate:

Traditional IRA:  We end up with $32,337 to spend.

Roth IRA:  We also end up with $32,337 to spend.

Note two things:  (1) with the given assumptions, you end up with precisely the same amount of money to spend; and (2) it's more than with the taxable account regardless of the tax-efficiency (i.e.. the dividends paid along the way) of the investment.

We'll delve deeper into traditional IRAs, Roth IRAs and non-deductible IRAs in another article soon.  Then we'll be ready to talk about IRA conversions.

Thanks for following along.  As always, we'd love to hear from you with comments, criticism or questions.

A question often comes up amongst folks of a certain age regarding UGMA/UTMA accounts.  Namely, since many of our parents used them for us about a generation ago, are they still tools that we should be considering for our college savings for our kids today.  Or, perhaps of slightly greater complexity, if they already have a UGMA or UTMA account for their kids, what, if anything, should they do with them?

So what are UGMA/UTMA accounts, anyway?  UGMA stands for the Uniform Gifts to Minors Act, which was passed in 1956 to provide a uniform set of rules which individual States could adopt to make it more convenient for folks to transfer assets to minors.  In 1986, the UTMA, or Uniform Transfers to Minors Act expanded the kinds of assets which could be so transferred to minors, and the UTMA has been adopted by most States since.

In both cases, the account created under UTMA or UGMA is called a Custodial Account, and it has some characteristics in common with a trust.  Like a trust, it's a container into which assets may be placed for the benefit of one person (the child), but under the control of someone else (the custodian - usually the parent - in this case, rather like a trustee).  Similarly, like a (irrevocable) trust, once assets are transferred into the account, it is considered a completed gift for gift and estate tax purposes.  Unlike a trust, however, the rules for the use of the custodial account and assets are not as customizable by the creator of or donor to the account.  In particular, the custodian may take money from the account specifically for the benefit of the child - it may be used to pay for private school, for example.  It may not be used for things which are already the obligation of the parent, such as food and shelter.  And lastly, the control over the assets and account usually automatically goes to the child when the child reaches the age of majority, usually 18 or 21, though some states allow for a little more flexibility in this.  That means that if you set up a UTMA account for a child and the child doesn't go to college or otherwise spend the assets in the account according to your wishes, when the child reaches that specified age, he or she may use the money for anything he or she wants.  The traditional example of this is the kid blowing the money on a sports car.

So why did folks set up these custodial accounts so often?  One, as mentioned above, to get the assets out of the estate.  Two, because the child's tax bracket is likely lower than the parents', so to the extent that the assets produce income, that income may be taxed at that lower rate.  Three, asset protection -- if the parent gets sued, the child's assets are not vulnerable.  Of these, the primary driver was generally the taxation and in the years since then, that benefit has been whittled away mainly by what's called the kiddie tax.  The kiddie tax rule makes it so that unearned income belonging to the child and exceeding fairly low limits gets taxed at the parent's rate rather than the kids rate.

The downsides to the UGMA/UTMA accounts, however, are substantial.  As mentioned above, the kid may blow the money on anything he or she wants once he or she reaches a certain age.  But that's not the only downside!  Also as mentioned above, the tax advantages are a lot smaller than they used to be.  The accounts still generate taxable income, whether it's at the child's tax rate or, if large enough, via the kiddie tax, at the parent's rate.  Moreover - and this may be a big one, too - at least according to the current federal financial aid rules, assets in a UGMA account which belong to the child are counted, not surprisingly, as assets belonging to the child when computing the family's expected contribution.  Assets belonging to the parent are expected to be contributed towards college costs at a 5.64% rate while assets belonging to the student are expected to be contributed at a 20% rate.

529 plans, on the other hand, suffer from few of these problems.  Assets in a 529 plan grow fully tax-deferred and if used for educational expenses, the growth is actually tax-free.  That's vastly better than the tax treatment of UGMA/UTMA assets.  Assets in a 529 plan remain under the control of the owner of the account (usually the parent) regardless of the child's age or whether it's used for college or not -- and if the child doesn't go to college, the beneficiary may be changed so that someone else such as a brother or cousin may use that money for college or, ultimately, if not used for college, could be returned to the donor (subject to tax and penalty).  UGMA/UTMA assets, once given, are gone.  As far as the other benefits - 529s also get assets out of the estate as well, and provide some protection in case of lawsuit or bankruptcy as well.  Finally, 529 assets are considered parental assets in the federal financial aid formula, so the expected family contribution due to 529 assets is considerably lower than if the assets were owned outright.

So the bottom line is that for most folks nowadays generally will benefit very much more from a 529 than from the old UGMA/UTMA accounts.

Here's the final chapter in our story.  If you have already established a UGMA/UTMA account for your child, you cannot just take that money back and open up a new 529 account owned by you with that money.  Sure, in theory, the money's for the same purpose.  But in fact, a 529 owned by you gives you substantially more long-term control over the assets than a custodial account because, unlike the custodial account, you may change the beneficiary or even take the money back, whereas a custodial account is the child's asset and in the long run, belongs to the child to do with as he or she likes.

So what's the solution for folks who already have a UGMA/UTMA account?  The 529 providers allow you to create a "custodial 529" account.  That is, the UGMA/UTMA provisions still wrap around the 529, but instead of the UGMA/UTMA investing in regular assets, the UGMA/UTMA invests in a 529.  The owner of this 529 is now the child, rather than the parent as would be typical with normal 529s.  And because of the UGMA/UTMA restrictions, the custodian may not change the beneficiary - the child must remain the beneficiary.  And finally, when the child reaches age of majority, the child may take control over the 529 and liquidate it (and pay taxes and penalties if not used for education) or, at that point, change beneficiaries to someone else.  So it still suffers a little bit of the downside of regular UGMA/UTMA accounts.  But it still keeps the 529 tax benefits, which are potentially enormous.  And the final cherry on top, should you have a UGMA/UTMA and are considering moving it into a custodial 529 -- for financial aid formulas, it's treated as a parental asset, rather than the student's asset.  That final twist makes it a rather large exception to the general rules of financial aid, and is very much a benefit for those for whom financial aid may ultimately be a consideration.

Bear in mind that everyone's individual situation is unique and that there is no simple rule which necessarily applies to everyone.  We hope the above notes help clarify the situation regarding custodial accounts, 529s, and the hybrid, custodial 529s.  As always, we invite questions and corrections.  And we remind you that the above notes are for informational purposes is not to be construed as professional personalized advice.

One last note, we remind you to review our other note about 529s and, in particular, to be aware of the costs associated with 529 plans and the difference between buying a 529 directly from the provider as opposed to buying into a 529 through a broker  (the unfortunately sadly named "advisor-sold" plans), which often have very much higher fees.

Okay, I know we're here mainly to talk about financial issues, but due to a recent event, I'm reminded -- and feel a need to remind everyone I know -- of the importance of good backups.

There is a financial component -- one of the things that comes up frequently when talking to folks about their finances is records and record-keeping.  While the topic of what to keep and for how long will be addressed another time, the point here is that nowadays, many of us keep more and more records on our computers.  Banks and brokerages and credit card companies are trying especially hard to get us all to "go paperless" and use their online access to get our statements, for example.  Many of them also let you not only view the statements online, but also download PDF copies of them.  While these things are nowhere near as irreplaceable as, say, your family photos, it still would be unfortunate to lose them.  Moreover, some folks keep detailed records in programs like Quicken which would be very painful to reconstruct if one's computer hard drive were lost.

So many of us now have digital cameras, too, and no longer have film or negatives at all.  A hard drive crash could cost folks their only copies of some precious images.

So I'm saying it again - BACK UP YOUR COMPUTER HARD DRIVE!

There are many many ways to do this, from saving copies on CDs to fancy online services, but the fastest way I know is to keep an external hard drive and simply copy over to it all your important data.  There are also great programs specifically for making backups which will carefully copy only things which have changed since the last backup, and there are programs which let you "clone" your computer's hard drive to a fully bootable backup.  I highly recommend this last approach (perhaps in addition to others, like burning CDs with the family photos and storing those CDs in the safe or at another family member's house).  Nevertheless, no matter how you choose to do it, I can't encourage you more strongly - do it - do it today - back up your computer hard drive!