Backdoor Roth IRA Conversions: Read the Fine Print

Roth-IRA-401kI was recently chatting on Facebook with my cousin who is a successful financial advisor, and we were discussing the “backdoor” Roth IRA conversion.  The backdoor Roth IRA conversion is a strategy that allows some high income earners who participate in employer sponsored retirement plans to also make indirect contributions into a Roth IRA, in spite of IRS contributions limits.  The way the backdoor strategy works is you make a non-deductible contribution to a traditional IRA and then immediately convert it to a Roth IRA.  Sounds pretty easy right?  Unfortunately, there is a lot of IRS fine print that must be understood before trying this trick at home.

The backdoor Roth IRA conversion is a great strategy for transferring a non-deductible tax-deferred IRA contribution into a Roth IRA if (1) you have no other traditional IRA funds, or (2) the value of your other IRAs are less than or equal to the basis in your IRA accounts.  However, very few people own non-deductible IRAs exclusively.  Usually, investors will open a deductible IRA first, and then when their employer offers them a better retirement plan, they stop funding their deductible IRAs and begin participating in their employer’s plan.  Or, they will rollover a previous employer’s retirement plan into a deductible Traditional IRA when they change jobs.

Later on when the investor’s income is large enough to max out their contributions to their employer plan (as well as disqualify them for a deduction in their traditional IRAs), they pursue investing their supplementary funds into a non-deductible Traditional IRA.  The non-deductible Traditional IRA won’t help reduce a current year tax liability, but it will allow investors to defer the taxes on the growth of the non-deductible contributions.  Non-deductible IRAs are complex, requiring investors to file an 8606 Form with their taxes, as well as keep accurate records of which contributions were deductible and which were non-deductible.  From a tax perspective, funding a non-deductible IRA is easy; however, taking distributions in retirement and accurately paying the taxes on those distributions (some taxed, others not taxed) can be a real pain.

Because non-deductible Traditional IRAs are difficult and Roth IRAs are easy, there is a lot of incentive to replace non-deductible IRAs with Roth IRAs.  Initially, Congress disallowed high income earners from participating in Roth IRA conversions; however, in 2010 Roth IRA conversions were made available to everyone regardless of income.  As a result, financial planners saw an opportunity for high income earners to participate in Roth IRAs as well.  This is where the backdoor conversion came to fruition.

There are two flies in the ointment investors should consider before using the backdoor Roth IRA conversion.  Nothing that comes out of Congress is simple or even intuitive, and backdoor Roth IRA conversions are no exception.  If you don’t own any Traditional IRAs where you took a tax deduction, no problem.  However, if you own ANY Traditional IRAs where the values exceed the contributions you made to the IRAs, you will be subject to the IRA Aggregation Rule under IRC Section 408(d)(2).  This rule stipulates that when a Roth conversion occurs, the taxpayer must calculate the income tax consequences of a Roth conversion by aggregating together all of the taxpayer’s IRAs; therefore, if you own any other Traditional IRAs, they will complicate the tax consequences of the “contribute-then-convert” strategy.  For example:

Assume Steve contributes $5,500 to a non-deductible IRA with the intention of converting it to a Roth IRA.  However, Steve also has a $100,000 IRA funded from earlier pre-tax IRA contributions and two prior 401(k) rollovers.  When Steve converts his newly created $5,500 non-deductible IRA, he cannot simply convert at a tax cost of $0.  Instead, the IRA aggregation rule applies as follows: $5500 (all non-deductible IRA contributions/ ($100,000 (all IRA assets) + $5500 (newest non-deductible contribution ) = 5.213% or $286.73.  In other words, Steve will have to pay taxes on $5213.27, thus making the conversion about as enjoyable as chewing on tinfoil.

To get around the aggregation rule, some investors choose to roll their existing IRAs with pre-tax contributions into their employer plans.  By not having a Traditional IRA with pre-tax contributions, there is nothing to aggregate, thus the annual backdoor Roth IRA conversions are much simpler; however, not all 401(k)s offer investments as robust and diverse as a self-directed traditional IRA; therefore, investors will need to determine if losing their options and flexibility by rolling their Traditional IRAs into their employer’s plan will be offset by the advantages of funding their Roth IRAs annually.

Another consideration is the “Step Transaction Doctrine,” which permits the IRS to disallow strategies such as the backdoor Roth IRA conversion if they can prove the only economic value you received from opening a non-deductible Traditional IRA before converting to a Roth was to avoid the prohibition of funding a Roth IRA directly.  The problem with the step transaction doctrine is the IRS applies the rule arbitrarily on an individual basis.  That means some people might get away with it, and others might get hammered.  There is no way for certain to know if they will use the Step Transaction Doctrine to slap you with a 6% excess contribution penalty sometime in the future after you have been converting for decades and your Roth IRA has grown hefty.  Therefore, backdoor at your own peril.

While the backdoor Roth conversion strategy might be a good opportunity, I recommend meeting with your financial planner and tax advisor first to discuss how the aggregation rule and the step transaction doctrine might affect you.  With long-term capital gains and dividends currently taxed at 15% for most investors (high income earners will pay more) many clients may prefer investing in a taxable account or real estate with their supplementary investment dollars rather than go through the hassle of a backdoor conversion of non-deductible Traditional IRAs.

Teach Your Children Well

kid counting pennies_425425x283One of the fascinating experiences of growing older is watching other people’s children become adults.  For the last 20 years, I have observed children in my community grow up in a consumer culture, and how different choices made by different children in similar situations have had a profound impact on their future financial outcomes.  Here are 3 things I have witnessed:

1) The wealth of a child’s parents has proven to have little impact on a child’s future ability to manage money.  I have seen children raised in humble surroundings grow up to be remarkable financial stewards, and I have seen children of the wealthy develop into spendthrifts.  There is zero correlation between a parent’s balance sheet and their children’s future ability to manage their own finances.

2) Parents who pay 100% of their children’s college tuition don’t help them become better future money managers (and children who go to college on full scholarships don’t manage money much better).  College is often the first place a young adult learns to make choices about necessities (i.e., rent, food, utilities).  Many parents of means feel it is reasonable  to pay their children’s college expenses, expecting their children will have more time and energy to focus their attention on academics; however, I haven’t seen any evidence that children who don’t earn money during college get better grades.  Upon graduation, those students who worked through college and paid for at least some of their expenses, have demonstrated better money management skills and more lucrative work prospects than those who  completed college without part-time work.

3) Parents who intentionally teach their children about money management before middle school tend to produce better future money managers.  Bar none, intentional financial instruction by both parents has produced the greatest number of children who grow up to be good financial stewards.  It is critical that age-appropriate basic financial principles be taught at a young age before the children are old enough to get their money cues from the culture.  Many parents require their children to tithe, save, and invest, before spending.  For others, shopping becomes a learning opportunity to drive home important money principles.  Many of my clients who have raised financially savvy adults asked me years ago to partner with them in teaching their children about saving, investing, and goal setting.  By saving money starting in high school, these children have built a relationship with a financial professional whose money values are similar to their parents.

There are a couple of caveats to my observations.  Even though parents may teach all their children the same sound money principles, not every child will heed them.  Some strong-willed children will reject sage advice, much to their parents’ disappointment.  Secondly, if one parent is good with finances and another a free spirit with the family’s money, the children will tend to follow the example of the less disciplined parent.  Parental unity on money management is critical for ensuring children don’t get mixed messages.

We all want our children to be happy adults.  By teaching them while they are young age appropriate skills and values of good stewardship, we can ensure they are equipped to survive in a consumer culture.

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What to do when Junior or Sissy Move Back Home

LivingWithParentsMillennials, those born after 1982 and between the ages of 18 and 31, are living with mom and dad in record numbers.  More than any other adult generation alive today, Millennials have the lowest employment rates, the highest standards for the kind of work they are willing to do, and the greatest job turnover.  For many Millennials, moving back in with mom and dad allows them to save money for school, take more time to locate the perfect job, regroup after getting bloodied in the adult world of self-reliance and personal responsibility, or take refuge from a painful emotional experience.  Labeled the “boomerang generation,” Millennials are coming home by the millions, and parents are at wit’s end on what to do.

Some personalities complement each other quite well, and having an adult child move back in the house need not always be stressful.  On the contrary, having an extra set of adult hands to help with cooking meals, doing lawn care, and running errands can be a blessing.  Socially, it is nice having adult conversations with someone besides a spouse around the dinner table or while washing dishes.  Some kids naturally appreciate their parents and communicate their affection quite regularly.  Unfortunately, many Millennials moving back home are chronologically 25 years old but emotionally still teenagers, and oftentimes the reason they  move back into their parents’ home is they are not quite ready for independence.  Many desperately want the freedom to make their own lifestyle choices, and it is a bonus when mom and dad financially subsidize those choices.  When the reason adult children move back home is because they still need more maturing, it is a good idea to have a plan to ensure they are being equipped to eventually launch successfully back out on their own.

If it looks like one of your kids might be moving back home, here are some things to consider before you start moving their things into the downstairs bedroom:

Charge Rent  Even a small rent is a good idea.  Some families have established a system where they charge a nominal rent the first month, and then incrementally raise the rent every month until the rent equals 30% of what they could earn if the child applied themselves.  This serves as an incentive for the child to find work, any work.  Some families save this rent and give it back to the child when they finally launch.  Other parents use their child’s rent as repayment for their college financing or to provide additional funds for their own retirement.  The point here is to equip the child with the skills necessary to pay for their own room and board.

Assign Chores  Unless you enjoy running a charity bed and breakfast, your adult child should pitch in to complete household chores like mowing the lawn, shoveling snow, emptying the dishwasher, and cleaning the bathroom.  These chores should be part of the contract mentioned below, and they should include the standard of excellence you expect (e.g., grass cut once per week before 5:00pm on Saturday, dishwasher completely emptied every morning before 8:00am, etc.).

Create Employment Expectations  Many Millennials have employment standards so high they can’t find a job.  This can be frustrating for parents who cut their own teeth on entry-level positions in their formative years.  It is not unreasonable for parents to expect their adult children to be working a minimum of 40 hours/week, even if this means holding two or more jobs they may not necessarily enjoy.  Some families require adult children to either be working, and/or looking for work, a minimum of 40 hours/week.

Establish and Monitor Financial Goals  The reason most Millennials move home is they run out of money.  While they are living at home it is crucial they be working towards being financially secure.  Help your adult child establish realistic financial goals (i.e., save $5000, pay off student loans, etc.), and hold periodic meetings to ensure the child is working towards meeting those goals.

Have Children Pay Their Own Bills  A majority of Millennials get financial help from their parents.  To be prepared for the responsibilities of unsupervised adulthood, have your child pay their own bills, such as automobile insurance, cell phone charges, and health insurance premiums.  Even if you are providing financial support for some of the bills, the child should be writing the checks.  Too many Millennials avoid moving out because they are intimidated by the bill paying responsibilities of adulthood.  By giving them an opportunity to build their own relationships with insurance companies, auto mechanics, cell phone companies,  etc., you are removing a major hurdle that prevents so many Millennials from living independently.

Mark a Move-Out Date on the Calendar  It is important there be an expected launch date.  This will encourage the child to find employment, save money, and look for a place of their own.  Make sure the launch date is far enough in the future to ensure the child has a reasonable chance of meeting their financial goals.  For example, if the goal is to save $5000, giving the child 10 months (save $500/mo) is reasonable.

Bring in a Third Party to Arbitrate Disputes  If Mom and Dad experience difficulty seeing eye to eye on goals and expectations for their adult children who move back home,  get help!  Meet periodically with a family therapist, spiritual leader, or respected family friend who can offer objective guidance on how to help Junior or Sissy launch back into the world of adulthood.  Sometimes a third party who is not emotionally involved can see the situation more clearly than the parents, and their suggestions may ensure established expectations and goals for the child aren’t too lenient or too harsh.

Create a Contract  If you and your spouse disapprove of drugs or alcohol, loud music, profanity, or questionable moral choices, make sure you write down your rules in the form of a contract and have your child sign.  If you expect common areas like the kitchen, bathroom, and living spaces to be clean and tidy, put those in the contract as well.  If your child has accumulated furniture and other household items, make sure you consider where they will be stored, and if your child has a car, you will have to determine where it will be parked.  Clearly state in the contract that failure to comply with any provisions will be grounds for eviction.  Additionally, poor attitudes, unwillingness to work towards financial independence, or refusing to work 40+ hours per week should also be grounds for premature launch.

r-CAREERS-large570While much has been written about the difficult employment opportunities available to Millennials, that has not been my observations.  Not a week goes by where I don’t see opportunities I would have jumped on thirty years ago if I needed the money.  With the struggling Millennials I have counseled, their unwillingness to do unpleasant work makes it nearly impossible for them to find any employment to their liking.  Even when they find work, they are not always interested in working much beyond 20 hours a week. This makes it difficult to pay off student loans or save enough funds to get their own apartment or pay their own bills.   The reason why many Millennials are having difficulty growing up and moving out is they have been spared the adversities earlier generations experienced in their own early adulthood.  When Millennials move back home, it is important they learn the skills necessary to succeed in adulthood.  Moving back home may be just the opportunity for Mom and Dad to properly equip Junior and Sissy with the tools necessary to develop them into happy and productive citizens.

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On Social Entrepreneurship

I recently shared lunch with a young friend home from college for the holidays who is engaged in a social entrepreneurship project at his university where teams of global participants compete for grant money.  These teams will be judged on their “social entrepreneurship.”  While I have seen the term social entrepreneurship in print media, I didn’t really know much about it until I started doing some research.  My conclusion is social entrepreneurship is nothing more than a 21st  century label used for marketing purposes.

triple-bottom-line-environment-2-mar11According to Wikipedia: “Social entrepreneurship is the process of pursuing innovative solutions to social problems.  More specifically, social entrepreneurs adopt a mission to create and sustain social value.  They pursue opportunities to serve this mission, while continuously adapting and learning.  They draw upon appropriate thinking in both the business and nonprofit worlds and operate in all kinds of organizations: large and small; new and old; religious and secular; nonprofit, for-profit, and hybrid.”

After several hours researching social entrepreneurship, the only distinction I can see that separates the social entrepreneur from the conventional entrepreneur is WHO appreciates the entrepreneur.  Those who are deemed champions of social entrepreneurship seem to have one thing in common; they tend to be left leaning liberals who are quite vocal about their social passions.  You are not going to find many WASP Republicans in the social entrepreneur’s hall of fame, even if they donate millions (e.g., Chik-fil-A) to worthy social causes.  If a successful entrepreneur is not overtly liberal in their social and political leanings, they are often vilified as being greedy capitalists; however, if they have earned billions of profits as capitalists but actively support liberal causes such as gay marriage, environmental issues, or wealth redistribution, they are awarded the more respected moniker of social entrepreneur.

I can’t think of three entrepreneurs who have done more to improve society than John D. Rockefeller (cheap oil), Andrew Carnegie (cheap steel) and Bill Gates (cheap computing); however these three icons of innovation and positive social change evidently aren’t studied, emulated, or valued by those who hand out the social entrepreneur certifications.  On the contrary, industrialists who grow wealthy enough to give billions to worthy social causes are often vilified by those who hold social entrepreneurs in high esteem.

You don’t even have to be very effective at positive social change to be lauded as a social entrepreneur, you just have to make the people supporting you (customers and employees) feel good about doing so.  Take for example the appropriately named company FeelGood.  FeelGood is an organization recently highlighted in Forbes as a social entrepreneurial success, and since 2005, has logged 128,000 volunteer hours handing out 150,000 grilled cheese sandwiches from 25 locations for the purpose of raising money (in their case, $1.5 million) for the goal of eradicating world hunger.  While $1.5 million seems like a lot, when you start doing the math, it would have been more economically effective if those volunteers had just worked as waiters at Applebee’s or the Olive Garden (not deemed socially entrepreneurial) and donated their tips.  I know dozens of businesses who have given away more than $1.5 million since 2005, and they didn’t have the manpower resources that FeelGood has at its disposal.  In contrast, The Economist estimates the Catholic church donated $171 billion towards social causes in 2010 alone, and practically every Mormon church in the world is more effective at food distribution than FeelGood, so what is so entrepreneurial about FeelGood?

triple bottom line SeptemberTo me, the social entrepreneur labeling phenomenon is a 21st century marketing ploy to attract Millennial customers, investors, and employees who choose feeling good over being good.  As another young friend recently said about his generation:

“It is very important that we feel good about our social contributions, even though we aren’t necessarily interested in DOING the difficult things necessary to bring about positive change.

Paying a few dollars more for a product or service to a company that promises to use some of its profits to protect the Amazon rain forest or eradicate poverty in Bangladesh seems like a fair tradeoff to feel good, particularly if it doesn’t deprive us of anything or require any effort on our part to promote sustainable social improvement.  The sticky point is, more social good would probably come from buying less expensive products or services from companies not deemed socially entrepreneurial and donating the difference to worthy causes.  However, like my young colleague stated, it is easier just to pay more for the social entrepreneur’s product, feel good about it, and not have to do any unpleasant check-writing, volunteering, or rainforest-saving ourselves.

In the same way food companies are ethically and unethically attempting to secure hormone-free beef stamps or organically grown vegetable certifications, companies are working hard to impress Millennial customers, investors and employees with their social entrepreneurship credentials.  The next generation of consumers wants to feel good about the products they are buying or the companies where they are working.  Millennials have grown up having the cash to pay more than market price for the goods and services that make them feel good, and earning less wages from a social entrepreneur employer is often offset by parents paying for many of their living expenses (housing, cell phone, car insurance, etc.).  

Even colleges and universities have gotten on board, offering entrepreneurship degrees at the undergraduate and graduate level for the purpose of attracting Millennial students more interested in good feelings than good outcomes, especially when someone else is paying the tuition.  (I really shouldn’t be so hard on Millennials;  it isn’t their fault they are being played by older college recruiters and professors who are appealing to the naiveté’).

Many of the participants in my young college friend’s social entrepreneurship project come from third world countries where rule of law, free market capitalism, freedom of speech, and limited government are merely pipe dreams.  It is very difficult to apply business solutions to social problems when corrupt and immoral governments aren’t interested in reducing bureaucracy, opening new markets, or supporting free trade.  There is very little incentive for aspiring entrepreneurs to succeed in business for the purpose of positive social change when local thugs, constables, and government bureaucrats are allowed to shake them down for extortion money whenever they earn a few bucks.  Until an environment exists where entrepreneurs (social or otherwise) can prosper without fear of losing the fruits of their efforts to corruption, usury, and outright theft, there will be little incentive for entrepreneurs to bring positive social change to their respective communities.

When I shared with my young college friend at lunch my cynical views on social entrepreneurship, he asked me what I thought was a better alternative.  First of all, I recommended he study and apply the principles of limited government, free markets, and federalism as they were understood at the time of the U.S. Constitution’s ratification.  The more liberty a citizenry has, the more innovation and economic security a society will enjoy.  Secondly, I told him the most effective positive social change always comes from individuals with indomitable spirits, creative minds, proper knowledge, and most importantly, good hearts.  As a student of a prestigious university, others will naturally expect his leadership upon his graduation; therefore, if work towards positive social change is his life calling (which should be the calling of all of us), I encouraged him to: 1) seek truth, 2) study hard to be the best businessman, lawyer, teacher, doctor, leader, whatever, and 3) continually work on having a good heart.  Finally, I encouraged him to run, not walk, away from any college classes, departments, or degrees that specialize in social entrepreneurship, lest he be distracted from taking classes that will legitimately equip him for the important work of finding workable solutions to society’s biggest challenges.

History shows the greatest social contributions come from individuals who are focused on doing good rather than merely feeling good.  Labels like: Social Entrepreneur aren’t catalysts for positive social change; in fact, such labels are divisive, distracting, and wasteful.  Instead, positive social change comes from people who systematically give more than they take from every personal and corporate relationship.  If we want to positively change the world via business style innovation, wealth creation, and leadership processes, then we should focus on innovating, creating wealth, and leading effectively, and avoid wasting our time pursuing fancy labels.

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Be the Smartest Person In the Room Without Going to College

Before I lead you to a wrong impression, I want to publicly state I believe education is extremely important.  In fact, I will even go so far as saying education is one of the most worthy of pursuits; however, I think we tend to confuse college with education.

The purpose of this post is not to argue for or against the value of a college degree, and I will say that I believe everyone should consider attending the best college they can afford without borrowing money.  My real purpose is to share some excellent ways to get a college level education without paying tuition or moving into a dormitory.

In 21st century America, if you have a laptop, tablet, or cell phone and you are uneducated, it is because you have made the choice to be ignorant.  There are dozens of ways to get a college level education these days, and many of them are low-cost and even free.  For those who are interested in lifelong learning, here are some venues I use and enjoy on a fairly regular basis:

TGC1. The Great Courses  Produced and distributed by The Teaching Company, the Great Courses are college-level audio and video courses available on CD, DVD, MP3 and MPEG-4 download formats.  These courses are taught by top-notch, award-winning professors selected for their teaching excellence.  The courses range from 6 to 84 lectures, and there are nearly 500 courses offered covering many different subjects: the arts, philosophy, business, history science and mathematics, religion, and better living.  While the courses at first glance are rather pricey ($50-$500), every course goes on sale at least 70% off at least once a year.  I have never paid full listed price for any course, and I have purchased a half a dozen or so for $9.95

The courses are outstanding, and if I have an addiction, it is the Great Courses.  I own a couple of dozen of them and I own some in every format.  While the streaming courses are the least expensive, they are also the most irritating.  Occasionally a bad wi-fi connection affects the streaming quality.  Not a big issue when I am watching them by myself on my Nexus 7 tablet, but rather frustrating when I watch them with Linda on the big flat screen.  Each course comes with an informative class outline with lecture notes and bibliographies.  For those who are dedicated life long learners, I encourage you to check out The Great Courses.  It is even fun to get your friends interested and  swap courses back and forth.

iTunesU2. iTunes U  Apple has teamed up with dozens of English-speaking colleges and universities offering hundreds of college and graduate level course on just about every subject imaginable.  While the quality isn’t quite as good as the Great Courses, the courses offered on iTunes U are free.  I have taken three courses online via  iTunes U: a finance course and a game theory course from Harvard, and  a Greek history course from Yale.  While the material was good, the professors were not as engaging or interesting as with the Great Courses; then again, the courses were 100% free.

Because I am not a big Apple fan, I am frustrated I can’t get access to iTunes U on my Nexus, but I have watched courses successfully on my HP laptop.  For those of you who are Apple aficionados, there is a mobile app available that makes downloading iTunes U courses really easy.  Check them out; if you don’t like the feel of a course, the only thing you spent was your time.

KA3. Khan Academy  Khan Academy is a not-for-profit whose goal is to improve education by providing world-class education for anyone anywhere.  Originally designed to teach math, science, and computers, Khan Academy has branched out into economics, finance, history, and American civics. Khan Academy courses are also free.

Khan Academy’s format is a little different from the other two I mentioned.  Rather than teach a semester course with multiple lectures like most schools, Khan Academy offers 5-7 minutes of instruction on a specific concept or topic, with the goal for the student to master the concept or topic before moving on to the next video.  The methodology is brilliant, allowing the student to work at their own pace, ensuring that essential material is not only presented to the student but also mastered.  Khan Academy is geared for all ages, from elementary school through college.  For those who are interested in learning the nuts and bolts of a particular subject, Khan Academy is excellent.  I took a banking course, and it was very well done.  The Khan Academy’s format lends itself to learning concepts rather than entertaining the student; therefore, you might want to use the Great Courses and iTunes U for learning the humanities and Khan Academy for math and science; or, you might want to use the Khan Academy to supplement what you are learning via the online lectures of other venues.

It should be noted, none of the above listed programs offer college credit; therefore, proving you have taken and mastered these courses can be a challenge.  (For self-employed folks like me, this isn’t a requirement).  If proving your education is necessary,  you will need to keep accurate records of your work. When I homeschooled my college-aged son, I kept records of the classes he completed via the Great Courses and iTunes U, as well as the homework assignments I had him complete.  I can’t speak for all employers, but I personally would consider a prospective employee who could prove they educated themselves via the three venues I listed.  Anyone who has the wherewithal to organize their own education, the discipline to complete the courses and record their coursework, and show proof of their work in  a second job interview, would probably get a few extra brownie points from me over the candidate who went to college conventionally.  (However, I tend to be an outlier, so proceed with caution if you choose to work for a conventional boss).

In addition to becoming more knowledgeable, the online courses I mentioned above have enriched my life.  From philosophy to physics, and economics to religious studies, I have been able to get a world-class education without ever needing to fill out a college application or find parking on campus. I encourage everyone to take advantage of the inexpensive educational opportunities that are available online to anyone.

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