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Investing Blog Roundup: Tracking Roth IRA Basis — Save Your Form 5498!

Recently I’ve received emails from a few different readers on the topic of tracking basis in a Roth IRA. That is, with a Roth IRA, you can remove contributions tax-free and penalty-free at any time, but how do you know (and how can you prove to the IRS) how much you have contributed over the years?

The easiest answer is to keep the Form 5498 that the brokerage firm sends you every year. It reports all the contributions and conversions for the year in question.

Recommended Reading

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Does a 401(k) Rollover Count as a Pension for the Social Security Windfall Elimination Provision (WEP)?

A reader wrote in recently with the following story/question:

For the last several years of my wife’s work before retiring, she had worked for a government agency and no SS had been collected. However, she did have a 401(k) which she contributed to. I knew that she fell under the WEP/GPO provisions.

Subsequent to my wife retiring but before she applied for SS, we rolled her account into an IRA. Two different representatives from SSA told me that if we had not rolled it over, we would NOT have been subject to the WEP. We were allowed by my wife’s plan to keep our funds there and they actually had some very good investment choices. If I had known that and if it was true, I would never have moved the account. And if I understand correctly, the WEP would not come into play and we could have had a considerably higher benefit over the years until we had started to use it.

I had read that the WEP only comes into play when you receive a pension or a lump-sum retirement distribution from a job that was not covered by Social Security. I had taken “distribution” to mean cashing out the 401(k), not rolling it over into an IRA, but I am guessing from what the SSA is saying, that is not the case.

If we had known that we could “let it ride” in the 401(k) and delaying being subject to the WEP, I would have jumped at the chance. This would seem to be another way to significantly increase your benefit if you were in the right circumstances.

So I would appreciate your view of this. I am assuming I can’t do anything for myself, but hopefully for others.

The SSA employees are correct that a rollover does count as a payment/withdrawal from the plan. Therefore, if:

  1. The plan itself counts as a pension, and
  2. The payment counts as a pension payment from that plan…

…then the rollover would trigger the WEP.

And, you are correct that in some cases the effect of the WEP can be delayed as a result of delaying a rollover (and also delaying any other payments, including payments from a defined benefit plan, if any).

So those are the two questions we have to answer:

  1. Does the plan count as a pension at all?
  2. Does this particular payment count as a pension payment? (Sometimes the plan can count as a pension, but this individual payment does not count.)

Does the Plan Count as a Pension?

To determine whether the plan counts as a pension for the sake of triggering the windfall elimination provision, we first have to know whether the worker paid Social Security tax at the job in question. If so, then the plan will not trigger the WEP.

If the worker did not pay Social Security tax (i.e., the job was “noncovered employment”), then we need to know whether the plan includes employer contributions. If it does, then it’s a pension. If it does not include employer contributions, then it’s only a pension if it is the primary retirement plan.

Does the Payment Count as a Pension Payment?

A withdrawal of the employee’s contributions + interest will not count as a pension payment if the employee is not yet eligible to receive a pension and the employee forfeits all rights to the pension.

If the employee is already eligible for the pension, any payment from the plan will count as a pension. Or, if the payment included any amounts that were employer contributions, the payment will count as a pension — regardless of whether the employee is eligible to receive a pension.

What does it mean to be “eligible” for a pension? An individual becomes eligible for a pension the first month he or she meets all requirements for payment except stopping work and applying for the payment. The pension-paying agency, not the SSA, determines pension eligibility and entitlement.

So just to summarize/reiterate the key points here: in some cases a distribution (including a rollover) from a defined contribution plan such as a 401(k) can trigger the windfall elimination provision. And in such cases, delaying taking any distributions (including rollovers) might allow you to delay applicability of the WEP, thereby allowing you to receive a larger Social Security benefit for a period of time.

Want to Learn More about Social Security? Pick Up a Copy of My Book:

Social Security cover Social Security Made Simple: Social Security Retirement Benefits and Related Planning Topics Explained in 100 Pages or Less
Topics Covered in the Book:
  • How retirement benefits, spousal benefits, and widow(er) benefits are calculated,
  • How to decide the best age to claim your benefit,
  • How Social Security benefits are taxed and how that affects tax planning,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"An excellent review of various facts and decision-making components associated with the Social Security benefits. The book provides a lot of very useful information within small space."

Investing Blog Roundup: “Cookie Cutter Retirement Plan” Presentation

As I mentioned a couple of weeks ago, I recently gave a presentation for the Detroit and Minnesota Bogleheads groups about the “Cookie-Cutter Retirement Plan” concept.

Here is the link to the Zoom recording.

The organizer accidentally forgot to start recording until a few minutes into the presentation. (She had a lot going on, as she was also in charge of admitting people into the meeting from the waiting room, as well as administering a poll regarding the makeup of the audience.) But none of the important information was cut off.

Essentially all you miss is me explaining that I hope you can use the material either as:

  1. A sort of rough-draft plan for your own retirement planning — with adjustments then made as needed based on your personal circumstances, or
  2. As material to draw from whenever friends or family ask for input about any of the topics covered.

Other Recommended Reading

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Predicting Tax Legislation is Harder Than Timing the Market

Timing the stock market is hard. It’s so hard, in fact, that there’s a reasonably broad consensus that it’s unwise to even try.

And that’s in spite of the fact that, when attempting to time the stock market, you’re really only trying to predict one thing: what will the market do next? And there are only three possible outcomes: go up, stay flat, or go down.

Trying to predict specific changes to our tax law in any way that is useful for tax planning is far, far harder than trying to time the stock market.

Take one example: will distributions from Roth IRAs be made taxable in the future? And how should a person adjust their tax planning based on that possibility?

People ask me about that (and other similar topics) all the time. And it doesn’t seem like it should be that complicated — either some law gets passed that makes Roth IRA distributions taxable or no such law gets passed. Two possible options, right?

Unfortunately, no. There’s also the possibility that it would work like taxation of Social Security benefits. That is, we could see a change where Roth distributions remain nontaxable, unless your income is over a certain threshold. And this third possibility is itself an unlimited number of possibilities, because the threshold could be set at any level. And the calculation (for what percent of your Roth distributions are taxable, based on the amount by which your income exceeds the chosen threshold) could work in any number of different ways.

In other words, you could make a prediction that a bill will be passed that causes Roth distributions to be taxable. And you could be right about that prediction, but you have to get the details right too. If you get the details wrong, any tax planning decisions that you make based on your prediction are as likely to be harmful as helpful.

And if you do somehow manage to get the details right?

Well, there’s still the issue of timing.

You might precisely predict what this new provision in our tax code looks like — but be off by ten years as to when the legislation gets passed. And if that is the case, then you’re again in a situation where any tax planning decisions that you make based on your prediction are as likely to be harmful as helpful.

And even if you are right as to the details of how the new provision works and you are right as to the timing, there’s yet another problem: tax legislation never changes just one thing. Most pieces of tax legislation are hundreds of pages long.

Even if you accurately predict the details of the provision in question and when it will be implemented, some other change made by the same legislation could completely mess up the math in your analysis. And once again you’re left in a situation where any tax planning decisions that you make based on your prediction are as likely to be harmful as helpful.

A vague sort of prediction that “marginal tax rates for people with high incomes might be higher later than they are now” is pretty reasonable. But trying to guess at the specifics of any particular change — and then make specific tax planning decisions accordingly — is just not worth the time and effort.

For More Information, See My Related Book:

Book3Cover

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"

Investing Blog Roundup: Upcoming Bogleheads Event

Next Saturday (3/27), I’ll be giving a presentation for the Detroit and Minnesota Bogleheads groups. But, since it’s via Zoom, anybody is welcome. The topic will be the “Cookie-Cutter Retirement Plan” concept. It will be from 10:30am – 12:30pm (ET), which will include plenty of time for questions/discussion.

If you’re interested, you can find the details on the Bogleheads event calendar page.

Recommended Reading

Thanks for reading!

Marginal Tax Rate: Not (Necessarily) The Same As Your Tax Bracket

News note: The American Rescue Plan Act of 2021 that was passed last week covers a lot of ground. If you’re interested in a summary, I’d recommend this one from Alistair Nevius or this more thorough write-up from Jeffrey Levine.

A reader writes in, asking:

“I wonder if you can write about the ‘marginal tax rate is not necessarily the same thing as your tax bracket’ concept for people who are still working. My spouse and I got caught in this situation for the first time in the tax year 2020 because we will be subjected to the ‘Investment income tax’. We will be addressing this by changing part of our Roth 403b contribution to regular 403b contribution for 2021 and beyond (i.e. to keep our MAGI as a married couple to < $250,000).”

As we’ve discussed many times in prior articles, your marginal tax rate is often higher than just your tax bracket. Most often, I’m discussing that concept in the context of retirees, due to the way Social Security benefits are taxed and the way Medicare premiums are determined. But it can apply to people in their working years as well.

Things that can cause such an effect for people still working would include:

  • The 3.8% net investment income tax, as the reader above noted.
  • Any credit or deduction that phases out based on income level.
  • The way in which long-term capital gains and qualified dividends are taxed. (Other income can push LTCGs/QDs into a different tax treatment.)

Effects of Phase-Outs

As stated above, any deduction or credit that phases out based on your income can cause your marginal tax rate to be something other than just your tax bracket.

A common example would be the American Opportunity Credit, for people paying higher education expenses for somebody in their first 4 years of higher education. For a single person it phases out from $80,000-$90,000 of MAGI, which means that across that $10,000 window of income a $2,500 credit disappears — meaning the marginal tax rate is whatever it would otherwise be, plus 25%! And the credit is per student. For a single person who has, for example, a freshman and a junior in college, their marginal tax rate across that range of income would be whatever it would otherwise be, plus 50%!

For a married couple filing jointly, the phaseout range is from $160,000-$180,000, which means that the increase in marginal tax rate is only half as severe (i.e., an additional 12.5% per eligible student), but it applies across a range of income that is twice as large.

Also of note: beginning in 2021, the Lifetime Learning Credit has the same phaseout range.

Another common example is the premium tax credit for anybody buying insurance on the exchange (which is relevant for self-employed people, people whose employers don’t provide health insurance, and pre-Medicare retirees). The amount of the credit steadily decreases as your “household income” approaches 400% of the federal poverty level, which means that your marginal tax rate is, again, higher than just your tax bracket.

And when your household income passes 400% of the FPL, the premium tax credit disappears entirely, which makes the marginal tax rate extremely high for the $1 of income that pushes you across the threshold. (Important exception: for 2021 and 2022 specifically, the premium tax credit will be allowed to people with income above 400% of the federal poverty level due to American Rescue Plan Act of 2021, passed just last week.)

The student loan interest deduction phases out from $70,000-$85,000 of MAGI ($140,000-$170,000 if married filing jointly). That’s limited to $2,500, and it’s a deduction rather than a credit. And the window of income is broader. So, all of those effects combined means that the effect of such is not so dramatic, but it’s still one more thing causing marginal tax rate to be greater than the applicable tax bracket.

The list goes on and on — child tax credit, child and dependent care credit, earned income credit, retirement savings contribution credit. If it phases out based on your income, it can cause your marginal tax rate to be higher than just your tax bracket.

Long-Term Capital Gains and Qualified Dividends

Long-term capital gains and qualified dividends are taxed at a lower rate than ordinary income. Rather than being taxed according to your tax bracket, they are taxed at the following rates:

  • 0% tax rate if they fall below $80,800 of taxable income if married filing jointly, $54,100 if head of household, or $40,400 if filing as single or married filing separately.
  • 15% tax rate if they fall above the 0% threshold but below $501,600 if married filing jointly, $473,750 if head of household, $445,850 if single, or $250,800 if married filing separately.
  • 20% tax rate if they fall above the 15% threshold.

Example: Bob is single. Excluding his qualified dividends and long-term capital gains, his taxable income for 2021 is $38,000. He also has $4,000 of long-term capital gains. His first $2,400 of long-term capital gains (i.e., those that fit under the $40,400 threshold) will be taxed at a 0% rate, and the remaining $1,600 will be taxed at a 15% rate.

But here’s where things get tricky. With total taxable income of $42,000, Bob is in the 22% tax bracket. But if his ordinary income increases by $1,000, his income tax for the year will increase by $270 (i.e., a 27% marginal tax rate).

That’s because the 12% bracket extends up to taxable income of $40,525. And, excluding LTCGs, Bob’s taxable income is below that threshold. However, his taxable income excluding LTCGs is now $39,000 rather than $38,000. So we have 12% regular income tax on this $1,000 of additional income (i.e., $120 of tax).

But there’s another effect going on as well. There is now only $1,400 of space for LTCGs before hitting the $40,400 threshold. That is, this $1,000 of additional ordinary income is also causing another $1,000 of his long-term capital gains to be above the $40,400 threshold and therefore taxed at a 15% rate, so that causes another $150 of income tax.

So we have $120 + $150 = $270 total dollars of tax being caused by this $1,000 of income. A 27% marginal tax rate, despite a taxable income that is in the 22% bracket.

In Summary

Even for me — having written about this concept for years — these effects are not usually intuitive.

This is why I often discourage people from trying to do tax projections using nothing but Excel. It’s hard to account for all of the different thresholds. (This is especially true when we remember that the thresholds in question apply to different income calculations! Some look at taxable income, the premium tax credit looks at “household income,” and many look at modified adjusted gross income — which itself has several different definitions.) Much better, in my opinion, to use actual tax software that automatically accounts for everything.

For More Information, See My Related Book:

Book3Cover

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"
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My new Social Security calculator (beta): Open Social Security