Question:  

Quincy, my mom is 70 yrs.  She doesn’t make very much money.  I was wondering if i opened up an account in her name can I work or manage the account? Instead of my handing her the cash in the account, would this be beneficial to us both?  I’m also thinking about converting her IRA to a Roth IRA.

Answer:  

There could be substantial benefits in doing so.  The good news is that her contributions to the account may be removed at any time tax and penalty free, regardless of her age or the length of time the account has been open.  She may not contribute more than her earnings, so you will have to be careful there.  She can make the contribution all the way up until April 15 of next year for this year.  Because she can withdraw the contribution amount at any time, contributing money to a Roth IRA is a great way for your Mom to save.  Because she is over 59 ½ there would never be a penalty for removing funds from the Roth IRA.  However, if she removed more than her contribution amount (in other words, she took her profits) before she has had a Roth IRA established somewhere for her benefit for at least 5 tax years, the distribution may be taxable even though it is from a Roth IRA.  The magic happens once she has satisfied the 5 year aging requirement.  At that point all distributions are completely tax free.  If she doesn’t end up withdrawing all of the money before she passes away and you inherit the Roth IRA, then you can take tax and penalty free distributions from the account for the rest of your life, regardless of your age.  The bottom line is that in my mind, at least, there would be benefits to both of you if you helped her open and work a Roth IRA.  The key to the benefit is that you actually work the account and not just let it sit there doing nothing. 

Let me know if we can help any further.  Have a great day!

Question:

I have a situation where I bought a rental property with 2 step loan. The first loan is IRA loan, actually from Entrust client. Then when it comes to refinance, it seems like I might have a problem that I could not be qualified for loan. So, I am wondering if I set up IRA, could I use that money to pay off the first loan?

Answer:

Unfortunately, the answer to your question is no, you cannot.  It is a prohibited transaction to use your IRA for your personal benefit right now, as opposed to taking distributions from the IRA when you retire.  If you are under age 59 ½ you can take a distribution from your IRA to pay off the mortgage, but of course that would mean you would have to pay a 10% premature distribution penalty in addition to any taxes owed if the IRA were a traditional or other pre-tax plan.  If you are over age 59 ½ the only issue is whether or not the distribution is taxable, which depends on what type of IRA it is and whether you have any after tax basis in the account.  As you already know, you can use your self-directed IRA to loan money to other investors, but not to yourself or any other disqualified person.

Top Ten Mistakes I See People Make With Their Self-Directed IRAs

1) Not understanding the “self-directed” part of self-directed IRAs.

Unlike more traditional brokerage style IRAs, self-directed IRAs do not come with any tax, legal or investment advice, nor do self-directed custodians and third party administrators offer or endorse investment products.  Self-directed means just that – it is self-directed and you must find your own investments and decide how you want to structure those investments.  If you make a million dollars in your self-directed IRA all the glory belongs to you, but if you lose everything you have there is no one to blame but yourself.

2) Not investing in what they know best, but rather investing in something they know nothing whatsoever about.

One of the primary benefits of a self-directed IRA is that it allows you to invest in what you know best, especially if that is not the more traditional IRA investments like stocks, bonds, mutual funds or annuities.  Some people get very excited about the idea of self-direction and invest in something they know nothing about, which often leads to an investment disaster.  Most of my mistakes in investing have been because I have strayed from what I know how to do best.

3) Not understanding the disqualified persons and prohibited transaction rules.

Disqualified persons are those persons who are deemed to be too close to make a transaction within your IRA an arms-length transaction, which means these persons cannot enter into transactions with your IRA nor can they benefit from those transactions, either directly or indirectly.  Prohibited transactions are what your IRA cannot do with any disqualified person.  The penalty for entering into a prohibited transaction is DEATH (of the IRA that is) along with taxes and penalties.  If you have a self-directed IRA you must have a good basic understanding of these rules as they apply to your investing strategy.

4) Not vesting assets correctly – all assets in self-directed IRAs should be vested as follows:  “Entrust Retirement Services, Inc. FBO Your Name IRA #Your IRA Number.”

A lot of time is spent in attempting to get clients, title companies, and investment providers to understand that all assets must be vested in a specific way in order to be held within a self-directed IRA.  Common errors include failing to vest in the name of the custodian or administrator at all, or only putting the client name after the “FBO” so that it appears we are holding the asset on behalf of the individual instead of the individual’s IRA.  Another common mistake is where the client attempts to use their own Social Security Number instead of that of the IRA or the administrator or custodian’s trust tax identification number.

5) Failing to submit proper paperwork to allow smooth opening of IRAs and processing of transactions.

Another large time waster is chasing down paperwork from improperly completed documents for opening the IRAs, for transferring money into the IRAs and for transactions.  This leads to a frustrated client and frustrated staff.  Taking the time to learn how to properly submit paperwork and allowing yourself enough time to do so is critical in successfully navigating the self-directed IRA world.  Remember, it is better to ask questions in advance than to submit incorrect paperwork and cause a delay.

6) Not understanding what they are investing in.

This is a big one.  It is almost incomprehensible to me how some people don’t have any understanding of what they are investing in at all.  For example, a person called the other day and thought she had a note and an option agreement.  Instead, she had a simple option where she had paid $28,000 for an option to buy 50% of the property for $10.  This was meant to help the owner out of foreclosure. The homeowner had the right to buy back the option at a profit to the IRA of about $5,000. The good news is that it worked for a time period and the homeowner got to stay in the house for an extra two years.  The bad news is that the homeowner still wasn’t fiscally responsible and the IRA lost every dime when the lien holder foreclosed. Since all the IRA had was an option (not a note as she thought) she could not even sue to recover some of her money, and even if she had exercised her option her IRA would have only owned half of the house.

7) Not understanding Unrelated Business Income Tax and how it may affect your IRA.

IRAs may be taxed in three circumstances.  First, if it runs a business, either directly in the IRA or indirectly through a non-taxed entity such as a partnership or LLC.  Second, if the IRA owns and rents out personal property (rents from real property are exempt from this tax).  Third, if the IRA owns debt-financed property, again either directly in the IRA or indirectly through a non-taxed entity such as a partnership or LLC.  Just to be clear, it is not necessarily all bad to make investments which cause your IRA to pay tax, especially within a Roth IRA or other tax free account, but it is something you should understand up front.

Trusting someone with your hard earned IRA money without doing proper due diligence and proper paperwork.

Let me give you a hint – con men are very good at what they do.  Make sure you understand what you are investing in, and do your due diligence on the investment and on the person you are investing with before making an investment decision.  Also, make sure you have proper paperwork.  I wouldn’t loan money to my own mother without proper documentation!  Proper paperwork protects both your IRA and the person your IRA is investing with.  Think about what would happen if either you died or the person you invested with died.  Would either party’s heirs understand what the investment was all about?  Even if you trusted the person you invested with absolutely, would their heirs know about your handshake deal and honor it?  Probably not!  An excellent rule of thumb in investing is that if it sounds too good to be true it probably is.  Also, a common thread in scams is that it must be done NOW or you will miss out on this incredible opportunity!  This is an attempt to draw you in without allowing you time to think about or due diligence on the investment.

9) Failing to follow proper strategy when loaning your IRA to other investors.

There are at least 10 simple rules to follow when lending your IRA money out (or even your personal money).  They are:

a)         Do not loan on something you wouldn’t be excited to own if the borrower defaults.

b)         Generally, do not advance money for repairs until the repairs are done, and then inspect the repairs before advancing the funds.

c)         Do not loan to someone you would feel uncomfortable foreclosing on!

d)         If the loan goes into default, do not delay – take action immediately!

e)         Collect interest monthly so you will know if the borrower is getting into trouble.

f)          If you are unsure about a loan, hire a professional to help you evaluate the deal (at the borrower’s cost, of course!).

g)         Get title insurance on your loan.  If done at closing the incremental cost to the borrower is very small.

h)        Verify that hazard and, if necessary, flood and wind insurance are in place naming your IRA as an additional insured.

i)          Insist on evidence that taxes, homeowners association dues and hazard insurance are paid when they come due during the term of the loan.

j)          Get a personal guarantee when lending to a non-individual borrower or a weak borrower.

10) Attempting to figure out how to get around the rules to get a benefit for themselves or other disqualified persons rather than simply investing within the rules.

It seems to be very tempting for people to want to use their own IRAs to make money or obtain some other benefit for themselves or other disqualified persons right now instead of letting all the benefits go to the IRA so that they have a nice retirement.  To make matters worse, a lot of gurus are teaching how to hide the fact that you are violating the rules instead of teaching people how to use the rules properly to their advantage.  My personal motto is, use the law to your advantage but don’t abuse the law.  After all, the “R” in IRA stands for Retirement. It is not an INA (or Individual NOW Account)!  To make money now, use OPI (Other People’s IRAs), and to make money for your retirement, use your own self-directed IRA.

11) Attempting to use a “checkbook control LLC” to get their hands on their IRA funds without having to deal with all that pesky paperwork and those silly prohibited transaction rules without understanding the extreme danger involved.

This is popular but is not wise.  However, to explain it fully would take a full weekend with me, Dyches Boddiford and CPA David Worley.  Come to think of it, we are explaining it all in August in Atlanta, Georgia if anyone is interested.

By:      H. Quincy Long

            Good news!  You can buy real estate in your traditional, Roth, SEP, or SIMPLE IRA, your 401(k), your Coverdell Education Savings Account for the kids, and even in your Health Savings Account.  Even better, your IRA can borrow the money for the purchase or even take over a property subject to existing financing.  What could be better than building your retirement wealth using OPM (Other People’s Money)?  However, there are some restrictions which you must be aware of when using your IRA to purchase debt financed real estate.  Below I answer a series of frequently asked questions regarding the purchase of debt financed real estate in an IRA.

Q.        Is it really legal to buy real estate in an IRA?

A.        Yes.  Even the IRS agrees that real estate is a permitted investment.  In its answer to the question “Are there any restrictions on the things I can invest my IRA in?” the Internal Revenue Service states “IRA law does not prohibit investing in real estate but trustees are not required to offer real estate as an option.”

Q.        Can my IRA buy real estate with a loan or take over a property subject to an existing loan?

A.        Yes.  An IRA may borrow money to acquire real estate or take over a property subject to an existing loan, provided that the loan is non-recourse to the IRA and to any “disqualified person.”  This means that typically the lender may only foreclose on the property in the event of a default.  Even if there is a deficiency, the lender cannot come after the rest of the IRA’s assets, nor can the lender come after the IRA owner or any other disqualified person.  Neither the IRA holder nor any other disqualified person is permitted to sign a personal guarantee of the debt.

Q.        Where can I get a non-recourse loan for my IRA?

A.        There are at least four sources for financing which do not violate the non-recourse requirements for IRA’s.  First, there is seller financing.  Most sellers understand that if the loan goes into default they get the property back anyway, so asking for the loan to be non-recourse should not be too difficult to negotiate.  Second, there is private financing from financial friends.  If you cultivate a reputation as a professional real estate investor, there should be no reason that your financial friends would not loan your IRA money on a non-recourse basis, either from their own funds or from their own IRA’s.  I have seen IRA’s borrow the money for both the purchase and the rehab on a non-recourse loan!  Third, there are banks and hard money lenders.  Non-recourse loans are not the norm, so many banks will turn you down.  However, there is at least one bank that lends in all 50 states, and in Houston I have had at least 3 local banks and 2 hard money lenders make non-recourse loans to IRA’s.  Finally, as mentioned above, you could take over a property subject to an existing loan, provided the originator of the loan is not you or another disqualified person.

Q.        Is there any tax effect of having an IRA own debt financed real estate?

A.        Yes.  Income and gains from investments in an IRA, including real estate, are normally not taxed until the income is distributed (unless the distribution is a qualifying distribution from a Roth IRA, a Coverdell Education Savings Account, or a Health Savings Account, in which case the distribution is tax free).  However, if the IRA owns property subject to debt, either directly or indirectly through an LLC or a partnership, it may owe tax on the net income from the property or partnership.

Q.        If the profits from an investment are taxable to an IRA, does that mean it is prohibited?

A.        Absolutely not!  There is nothing prohibited at all about making investments in your IRA which will cause the IRA to owe taxes.

Q.        But if an investment is taxable, why do it in the IRA?

A.        That is a good question.  To figure out if this makes sense, ask yourself the following key questions.  First, what would you pay in taxes if you made the same investment outside of the IRA?  The “penalty” for making the investment inside your IRA, if any, is only the amount of tax your IRA would pay which exceeds what you would pay personally outside of your IRA.  Unlike personal investments, the IRA owes tax only on the portion of the net income related to the debt, so depending on how heavily leveraged the property is the IRA may actually owe less tax than you would personally on the same investment.  Second, does the return you expect from this investment even after paying the tax exceed the return you could achieve in other non-taxable investments within the IRA?  For example, one client was able to grow her Roth IRA from $3,000 to over $33,000 using debt financed real estate in under 4 months even after the IRA paid taxes on the gain!  Third, do you have plans for re-investing the profits from the investment?  If you re-invest your profits from an investment made outside of your IRA you pay taxes again on the profits from the next investment, and the one after that, etc.  At least within the IRA you have the choice of making future investments which will be tax free or tax deferred, depending on the type of account you have.

Q.        If the IRA pays a tax, and then it is distributed to me and taxed again, isn’t that double taxation?

A.        Yes, unless it is a qualified tax free distribution from a Roth IRA, a Health Savings Account (HSA) or a Coverdell Education Savings Account (ESA).  The fact is that you still want your IRA to grow, and sometimes the best way to accomplish that goal is to make investments which will cause the IRA to pay taxes.  Keep in mind that companies which are publicly traded already have paid taxes before dividends are distributed, and the value of the stock takes into consideration the profits after the payment of income taxes.  In that sense, even stock and mutual funds are subject to “double taxation.”

Q.        If the IRA makes an investment subject to tax, who pays the tax?

A.        The IRA must pay the tax.

Q.        What form does the IRA file if it owes taxes?

A.        IRS Form 990-T, Exempt Organization Business Income Tax Return.

Q.        What is the tax rate that IRA’s must pay?

A.        The IRA is taxed at the rate for trusts.  Refer to the instructions for IRS Form 990-T for current rates.  For 2005, the marginal tax rate for ordinary income above $9,750 was 35%.  Capital gain income is taxed according to the usual rules for short term and long term capital gains.

Q.        Is there any way to get around paying this tax?

A.        Yes.  In some ways it may be considered a “voluntary” tax, since investments can often be structured in such a way as to avoid taxation.  Some ways to structure your IRA investment to avoid taxation include loaning money instead of acquiring the real estate directly or purchasing an option on the real estate, then assigning or canceling the option for a fee.  These techniques have a disadvantage in that they may not result in as much profit to the IRA, but will generally be free of tax.  There is also an exemption from this tax for 401(k)’s and other qualified plans in certain circumstances.

Q.        Where can I find out more information?

A.        Visit our website at www.EntrustTexas.com for more information.  Also, Unrelated Business Taxable Income and Unrelated Debt Financed Income are covered in IRS

Publication 598, which is freely available on the IRS website at www.irs.gov.  The actual statutes may be found in Internal Revenue Code §511-514.

            There is one general truth that applies both inside and outside of an IRA – you can do more with debt than you can without it.  Despite the increased risk from debt and the taxes due on income from debt financed property, a careful analysis may lead to the conclusion that having your IRA pay taxes now may be the way to financial freedom in your retirement.  Be sure to have your IRA pay the tax if it owes it, though.  As I always say, “Don’t mess with the IRS, because they have what it takes to take what you have!”

By: H. Quincy Long           

            How would you like to have tax free income when you retire?  Would you like to have the ability to leave a legacy of tax free income to your heirs when you die?  The great news is that there is a way to achieve these goals – it is through a Roth IRA.

            Historically, because of income limits for contributions to a Roth IRA and for converting a Traditional IRA into a Roth IRA, high income earners have not been able to utilize this incredible wealth building tool.  Fortunately, the conversion rules are changing so that almost anyone, regardless of their income level, can have a Roth IRA.  But is it really worth converting your Traditional IRA into a Roth IRA and paying taxes on the amount of your conversion if you are in a high tax bracket?  For me, the answer is a resounding yes.  I firmly believe it is worth the pain of conversion for the tremendous benefits of a large Roth IRA, especially given the flexibility of investing through a self-directed IRA.

            For Traditional to Roth IRA conversions in tax year 2009, the Modified Adjusted Gross Income (MAGI) limit for converting to a Roth IRA is $100,000, whether you are single or married filing jointly.  However, the Tax Increase Prevention and Reconciliation Act (TIPRA) removed the $100,000 MAGI limit for converting to a Roth IRA for tax years after 2009.  This means that beginning in 2010 virtually anyone who either has a Traditional IRA or a former employer’s retirement plan or who is eligible to contribute to a Traditional IRA will be entitled to convert that pre-tax account into a Roth IRA, regardless of income level.

            Even better, for conversions done in tax year 2010 only you are given the choice of paying all of the taxes in tax year 2010 or dividing the conversion income into tax years 2011 and 2012.  If you convert on January 2, 2010, you would not have to finish paying the taxes on your conversion until you filed your 2012 tax return in 2013 – more than 3 years after you converted your Traditional IRA!  One consideration in deciding whether to pay taxes on the conversion in 2010 or dividing the conversion income into 2011 and 2012 is that 2010 is the last tax year in which the tax rates are at a maximum of 35%.  Tax rates are scheduled to return to a maximum tax rate of 39.6% in 2011, and other tax brackets are scheduled to increase as well, so delaying the payment of taxes on the conversion will cost you some additional taxes in 2011 and 2012.  The benefit of delaying payment of the taxes is that you have longer to invest the money before the taxes need to be paid, whether the payment comes from the Roth IRA or from funds outside of the Roth IRA.

            The analysis of whether or not to convert your Traditional IRA to a Roth IRA is a complex one for most people, because it depends so much on your personal tax situation and your assumptions about what might happen in the future to your income and to tax rates, as well as how you invest your money.  From my own personal perspective, I make the simple assumption that tax free income in retirement is better than taxable income.  I can afford to pay my taxes now (not that I like it), and I would like to worry less about taxes when I retire.  I also don’t believe that tax rates will be going down in the future.  For me, the decision comes down to whether I want to pay taxes on the “acorn” (my Traditional IRA balance now) or the “oak tree” (my much higher IRA balance years in the future as I make withdrawals). 

            The way I analyze whether or not to convert to a Roth IRA is to calculate my “recovery period” – that is, the time it takes before my overall wealth recovers from the additional taxes I have to pay on the conversion.  If I can recover the cost of the taxes on the conversion before I might need the money in the Roth IRA, then I say it is worth doing, especially since the gains after the conversion are tax free forever.  Fortunately, with a self-directed IRA you are in total control of your investments, and the recovery period can be quite short.  There may also be a benefit if you are able to convert an asset now that may have a substantial increase in value later.

            Using my own situation as an example, I have been planning on doing a conversion in 2010 ever since the passage of TIPRA was announced in 2006.  My first step was to immediately begin making non-deductible Traditional IRA contributions.  Even though I am covered by a 401(k) plan at my company and earn more than the limits for making a deductible Traditional IRA contribution, this does not prevent me from making a non-deductible contribution since I am under age 70 ½.  The main reason I have been making non-deductible contributions to my Traditional IRA is to have more money to convert into a Roth IRA in 2010.  The best thing about this plan is that only the gains I make on the non-deductible contributions to the Traditional IRA will be taxed when I convert to a Roth IRA, since I have already paid taxes on that amount by not taking the deduction.

            I plan on converting approximately $100,000 in pre-tax Traditional IRA money in 2010.  The actual amount converted will be more like $150,000, but as I noted above my wife and I have been making non-deductible contributions to our Traditional IRAs since 2006, so the actual amount we pay taxes on will be less than the total conversion amount.  This means that my tax bill on the conversion will be $35,000 if I pay it all in tax year 2010 or $39,600 divided evenly between tax years 2011 and 2012, assuming I remain in the same tax bracket and Congress doesn’t make other changes to the tax code.

            To help analyze the conversion, I made some calculations of how long it would take me to recover the money I had to pay out in taxes at various rates of return, assuming a taxable conversion of $100,000 and a tax bite of $35,000.  I calculated my recovery period based on paying the taxes with funds outside of the IRA (which is my preference) and by paying taxes from funds withdrawn from the Roth IRA, including the early withdrawal penalty I would have to pay since I am under age 59 ½. 

            If I pay taxes with funds outside of my Roth IRA and can achieve a 12% return compounded monthly, my Roth IRA will grow to $135,000 in only 30 months, at which point I will have fully recovered the cost of the conversion.  A 6% yield on my investments will cause my recovery period to stretch to 60 months, while an 18% yield will result in a recovery period of only 20 months!  Of course paying taxes with funds outside of the IRA reduces my ability to invest that money in other assets for current income or to spend it on living expenses.  But if I have to withdraw the money from the Roth IRA to pay taxes and the early withdrawal penalty, the recovery period for my Roth IRA to achieve a $39,000 increase ($35,000 in taxes and a $3,900 premature distribution penalty) increases to 50 months at a 12% yield and 99 months for a 6% yield.  Paying the taxes from funds outside of my Roth IRA will result in a much larger account in the future also since the full $100,000 can be invested if taxes are paid with outside funds, while only $61,000 remains in the Roth IRA after withdrawal of sufficient funds to pay the taxes and penalties.

            I believe that since my IRAs are all self-directed I can easily recover the cost of the conversion (i.e. the taxes paid) in less than 3 years based on my investment strategy.  From that point forward I am building tax free wealth for me and my heirs.  How can I recover the taxes so quickly?  It’s easy!  Self-directed IRAs can invest in all types of non-traditional investments, including real estate, notes (both secured and unsecured), options, LLCs, limited partnerships and non-publicly traded stock in C corporations.  With a self-directed IRA you can take control of your retirement assets and invest in what you know best.

            In my retirement plan I invest in a lot of real estate secured notes, mostly at 12% interest with anywhere from 2-6% up front in points and fees.  I also own some stock in a 2 year old start up bank in Houston, Texas which is doing very well, and a small amount of stock in a Colorado bank.  As the notes mature I plan on purchasing real estate with my accounts, because I believe now is the best time to buy.  In some cases I may purchase the real estate itself and in other cases I will probably just purchase an option on real estate.  The bank stock will be converted at the market price in 2010, but when the banks sell in a few years I expect to receive a substantial boost in my retirement savings since banks most often sell at a multiple of their book value.  In the meantime, the notes and the real estate will produce cash flow for the IRA, and if I have done my investing correctly the real estate will also result in a substantial increase in my Roth IRA when it sells in a few years.

            Note that I have written this article from the perspective of someone who is in a high tax bracket.  A lower tax bracket will reduce the recovery period and is an even better bargain, especially if you can afford to pay the taxes from funds outside of the Roth IRA.  If you take advantage of the opportunities afforded to you by investing in non-traditional assets with your self-directed Roth IRA, you can truly retire wealthy with a pot of tax free gold at the end of the rainbow.

            H. Quincy Long is Certified IRA Services Professional (CISP) and an attorney and is President of Entrust Retirement Services, Inc., with offices in Houston and Dallas, Texas.  He may be reached by email at QLong@EntrustTexas.com.  Nothing in this article is intended as tax, legal or investment advice.

By H. Quincy Long

            Most people want a Roth IRA once they understand the tremendous tax benefits.  You do not receive a tax deduction for contributing money to a Roth IRA, but qualified distributions are TAX FREE FOREVER.  Essentially the concept of a Roth IRA is that you pay taxes on the “acorn” (the initial contribution) instead of the “oak tree” (the potentially large amount in the Roth IRA after many years of tax deferred accumulation).  This is especially beneficial in a truly self-directed IRA, which can invest in real estate, notes, options, private company stock, LLCs, limited partnerships and other non-traditional asset

            Unfortunately, there are income limits for contributing to a Roth IRA or converting money from a Traditional IRA to a Roth IRA.  For contributions, a married couple filing jointly may not contribute if they have Modified Adjusted Gross Income (MAGI) of more than $176,000 for 2009.  For single individuals the MAGI limit is no more than $120,000 for 2009 to be able to contribute to a Roth IRA.  The news is even worse if you want to convert assets from a Traditional IRA to a Roth IRA.  Whether married or single, you are not eligible to do a Roth conversion if your MAGI is more than $100,000.

            For people who exceed these income limits, it might at first appear that they are left out in the cold when it comes to Roth IRAs.  Fortunately, this is not actually true.  There are at least 3 ways in which a person who exceeds the income limits may end up with a Roth IRA.  The key phrase is “end up with” in the preceding statement.

            The first method of acquiring a Roth IRA if you exceed the income limits is to inherit one.  There is no age discrimination for contributing to a Roth IRA, unlike the Traditional IRA.  Anyone with earned income within the limits can contribute.  Earned income is generally income on which you must pay Social Security and Medicare taxes.  Passive or investment income, including rents, interest and dividends do not count as earned income, but it is not that hard to create earned income.  An elderly relative or friend may be able to help in your business in some way, for example, and your payment to them for their assistance would be earned income.  They may even be predisposed to name you as their beneficiary in the event of their death.

When a Roth IRA is inherited, the new account owner must take required minimum distributions from the IRA, unless the inheritor is a spouse.  Required minimum distributions are not required for the original account owner.  However, this does not mean that the balance in the account cannot be invested, and it is easy, at least with a self-directed IRA, to create income which exceeds the yearly required minimum distributions.  Even better, if the person who died had a Roth IRA for at least 5 tax years, distributions from the account are tax free, even if the inheritor is under age 59 ½.  There is never a 10% premature distribution penalty either, since the distribution is due to death.

            A second method to acquire a Roth IRA has to do with excess contributions.  Many people do not really know whether their income will exceed the limits when they make their Roth IRA contribution, especially if they contribute early in the year.  This is certainly true of self-employed persons.  So what happens if you make a mistake by contributing early and it turns out your income exceeded the MAGI limit for the year? 

If you take action before your tax filing deadline, including extensions (generally October 15), you can recharacterize the contribution to a traditional IRA as long as you are under age 70 1/2, along with all of the net income attributable (NIA) to the contribution.  You may also remove the contribution from the Roth IRA, along with any net income attributable.  In this case the only penalty which you might have to pay is on the income attributed to the contribution, not on the contribution itself.  If you remove the contribution after your tax filing deadline plus extensions, it is unclear from the regulations whether you must also remove the net income attributable from the Roth IRA.  A third choice is to leave the contribution in the Roth IRA and pay a penalty on the excess contribution.  In many circumstances this may be the wisest choice.

If you leave the money in your Roth IRA, you are required to pay a penalty of 6% of the amount of the excess contribution for each year that the excess remains in the Roth IRA.  For example, if you make an excess contribution $4,000 to a Roth IRA and your MAGI exceeds the limit, your penalty is only $240 for each year the excess remains in the account.  This is the penalty regardless of how much money you make in the Roth!  Since the penalty only applies for as long as the excess contribution remains in the Roth IRA, you will no longer have to pay the penalty if you qualify for a Roth in a future year and do not contribute or if you remove the contribution.  Once you have a Roth IRA, the account may continue to be invested regardless of your current year income. 

            Finally, in 2010 the $100,000 MAGI limit for converting assets from a Traditional IRA to a Roth IRA is eliminated.  Although a person who exceeds the MAGI limit will still not be able to contribute to a Roth IRA, in 2010 and future years anyone may convert assets in a Traditional IRA to a Roth IRA, no matter what their income level.  The amount converted is generally added to your taxable income for the year of conversion to extent it exceeds any non-deductible contributions in the account.  For conversions in the year 2010 only, however, the person converting has the choice of paying 50% of the taxes on the conversion in 2011 and the other 50% in 2012.  You have 3 years to pay taxes on Roth conversions done in 2010!

            As I always say, there are worse things than not qualifying for a Roth IRA, such as qualifying for a Roth IRA!  Whether by inheriting a Roth IRA, through an inadvertent excess contribution, or by conversion in 2010, even those who are fortunate enough not to qualify for a Roth IRA due to income exceeding the MAGI limit may end up with a Roth IRA.  Even a small Roth IRA can be built into a large IRA with careful investing, which means that even the wealthy can have a substantial amount of tax free retirement income.