Archives for July 2021

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Investing Blog Roundup: Which Bond Fund?

This week Jim Dahle did a great job answering the question of which bond fund you should use in a portfolio. Perhaps my favorite thing about the article though is the introduction, in which he makes it clear that this isn’t a critically important question.

Which bond fund to use is an important question in the sense that, when constructing a portfolio, you do have to pick something(s) to use for fixed-income (unless you’re going with an all-stock allocation). But your likelihood of meeting your financial goals is extremely unlikely to be significantly affected by whether you use a Total Bond fund or, for example, an intermediate-term Treasury fund. It’s not even close to one of the most important financial planning decisions.

Recommended Reading

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Roth IRA Withdrawal Rules

Mike’s note: In talking to people about Roth conversions, it has become clear to me that people have a lot of misunderstandings about the general rules for Roth IRA distributions. So today’s article is something of a back-to-basics post.

Types of Roth IRA Distributions

Withdrawals from a retirement account are known as “distributions.” The way a distribution from a Roth IRA is taxed depends on what type of money is being distributed. Specifically, a Roth IRA can consist of (up to) three types of money:

  1. Contributions,
  2. Amounts converted from a traditional IRA or other retirement plan, and
  3. Earnings.

An important point to note here is that earnings are not considered to be “earnings on contributions” or “earnings on converted amounts.” They’re simply earnings.

Example: In Year 1 Kevin contributes $6,000 to a Roth IRA. In Year 2 Kevin contributes another $6,000 to the Roth IRA. He also converts $30,000 from his traditional IRA to his Roth IRA. At the end of Year 2, Kevin’s Roth IRA is worth $50,000. That $50,000 is considered to be a) $12,000 of contributions, b) $30,000 from conversions, and c) $8,000 of earnings. It does not matter whether the earnings are the result of growth from the converted amounts or growth from the contributed amounts. Earnings are simply earnings.

Another important point here is that distributions from a Roth IRA are considered to happen in the order listed above. That is, distributions are considered to first come from contributions, then from converted amounts, then from earnings.

Distributions of Contributions

The tax treatment of distributions of contributions is simple: contributions can come out at any time, tax-free and penalty-free.

Example: Kelly is 24 years old. She opens her first Roth IRA and contributes $3,000. Two weeks later, she takes the $3,000 back out. Kelly does not owe any tax or penalty.

Distributions of Converted Amounts

Distributions of converted amounts are not subject to ordinary income tax.

Distributions of converted amounts are subject to a 10% penalty, unless (at least) one of the following is true:

  • The distribution is occurring at least 5 years from January 1 of the year in which the conversion occurred,
  • The distribution is of a converted amount that was not taxable in the year of the conversion,
  • The distribution is for a “qualifying reason” (listed below), or
  • One of the “other exceptions” to the 10% penalty (also listed below) applies.

Distributions of converted amounts are considered to occur on a first-in-first-out basis. That is, if you do a Roth conversion in Year 1 and another in Year 2, distributions will be considered to come from the Year 1 conversion first. And for a given conversion, if it was partially taxable and partially nontaxable, the taxable portion (i.e., the portion of the conversion that was taxable in the year of conversion) is considered to be distributed before the nontaxable portion.

Qualifying Reasons

The following are the “qualifying reasons” for a distribution from a Roth IRA:

  • You have reached age 59½.
  • The distribution was made to your beneficiary after your death.
  • You are disabled.
  • You use the distribution to pay certain qualified first-time homebuyer amounts.

Other Exceptions to 10% Penalty

The following are the “other exceptions” to the 10% penalty:

  • The distributions are part of a “series of substantially equal payments.”
  • You have unreimbursed medical expenses that exceed 7.5% of your adjusted gross income.
  • You are paying medical insurance premiums during a period of unemployment.
  • The distributions are not more than your qualified higher education expenses.
  • The distribution is due to an IRS levy of the account.
  • The distribution is a qualified reservist distribution.
  • The distribution is a qualified birth or adoption distribution (up to $5,000 per parent per birth/adoption).
  • The distribution was a “qualified coronavirus-related distribution.”

Distributions of Earnings

Distributions of earnings will be subject to ordinary income tax unless they are “qualified distributions.” In order for a distribution to be a qualified distribution:

  • It must be for a “qualifying reason” (listed above), and
  • The distribution must not occur any earlier than 5 years from January 1 of the year in which you first established and contributed to a Roth IRA. (For example, if you first opened and contributed to a Roth IRA on May 18, 2019, this 5-year rule would be satisfied as of January 1, 2024.)

And distributions of earnings will be subject to a 10% penalty unless:

  • The distribution is for a “qualifying reason” (listed above), or
  • You meet one of the “other exceptions” to the 10% penalty (also listed above).

The following flowchart summarizes tax treatments of distributions of earnings from a Roth IRA:

All Roth IRAs Are Viewed as One

When applying the above rules, the IRS views all of your Roth IRAs together as one big Roth IRA. For example, distributions from a Roth IRA will not count as distributions of earnings until you’ve withdrawn an amount greater than the total of all of your contributions to all of your Roth IRAs.

Example: In 2018, you contributed $2,000 to a Roth. In 2019, you opened a Roth IRA with a different brokerage firm and contributed $3,000 to it. By 2021, each Roth has grown to $5,000. You could withdraw $5,000 from either (but not both) of the two Roth IRAs without having to pay taxes or penalties because your total contributions were $5,000 and because the IRS considers them to be one Roth IRA for these purposes.

What if You Have Rolled a Roth 401(k) or 403(b) into Your Roth IRA?

If you have rolled assets from a designated Roth account in an employer plan (i.e., what we would typically refer to as a Roth 401(k) or Roth 403(b)) into your Roth IRA, those rollover amounts are separated into contributions and earnings — and then lumped into the appropriate category along with regular Roth IRA contributions and earnings.

Of note: at least in theory, this information should be transmitted from the administrator of the employer plan to the administrator of the Roth IRA. But it’s best if you keep records of your own, to be able to demonstrate the portion of the rollover that is attributable to contributions.

Example: Over the course of a few years, you contribute $50,000 to your Roth 401(k). After leaving that employer, you roll the entire Roth 401(k), which is worth $80,000 at the time of the rollover, into your Roth IRA. For the sake of applying the distribution rules discussed above, the $50,000 is treated as if it were regular Roth IRA contributions (i.e., it can be withdrawn from the Roth IRA tax-free and penalty-free at any time). And the additional $30,000 will be treated just like any other earnings in the Roth IRA (i.e., it will be treated in keeping with the rules shown in the flowchart above).

Investing Blog Roundup: Long-Term Care Needs

Long-term care is one of the trickiest topics in financial planning. The potential costs are quite high, yet the available insurance products leave something to be desired.

Three researchers with the Center for Retirement Research at Boston College recently sought to answer a few of the questions that you have likely asked yourself: how likely are you to need long-term care? And how likely are you to need a severe level of care as opposed to a more minor level of care? And how long is your need for care likely to last?

Recommended Reading

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Roth Conversion Planning: A Step-By-Step Approach

A reader writes in, asking:

“Can you describe exactly the steps you would take to determine whether a Roth conversion makes sense? I understand conceptually that they are advantageous when your tax rate is low, but can you elaborate on how exactly you would figure that out, as well as how to determine how large of a conversion to do?”

What follows is my process for retirement account distribution planning, including Roth conversions.

There are two broad stages to the process:

  1. Creating a “dummy” plan (or maybe you could call it a “default” plan), and
  2. Making improvements to that plan.

Making a Dummy Plan

By a “dummy” plan, I mean a plan in which every year you:

  • Do no Roth conversions.
  • Spend first from wages/earnings, required minimum distributions, Social Security, pension income, dividends/interest coming from holdings in taxable accounts, and only then from further distributions from tax-deferred accounts.
  • Take just enough out of retirement accounts in order to a) satisfy your RMDs and b) provide sufficient dollars to satisfy the desired level of spending, after considering taxes.

What we want to know is what your marginal tax rate (for ordinary income) would be in each of the next several years, under such a “dummy” plan. Note that we are concerned with your actual marginal tax rate, not just the tax bracket that you’re in.

The software I use for this process is Holistiplan, which I think is excellent, but it is priced based on the assumption that it’s being used in an advisory capacity for many clients rather than for an individual household. For most individuals doing DIY planning, a reasonable option is to use tax prep software to prepare hypothetical returns. (Note though that if you do not have experience preparing your own returns, there’s going to be quite a learning curve.) I sincerely do not think that a spreadsheet is a good tool for calculating your marginal tax rate, as it’s quite a challenge to create a realistic tax model that includes all the relevant factors.

For each year, you’re going to create a scenario/return in your tax modeling software, and then start recording the results in a spreadsheet.

For each year, see if you have enough after-tax income to satisfy your desired level of spending. (So this calculation is basically: wages/earnings, plus RMDs, plus Social Security/pension income, plus investment income from taxable accounts, minus taxes — and compare that to your desired level of spending.) If that level of income isn’t enough, increase tax-deferred distributions until it is enough. Remember, we are not yet including any further distributions from retirement accounts.

Then repeat the process for each of the next few/several years. (As I’ve mentioned previously, I don’t think there’s much value in going very many years into the future.) For each year, be sure to include any appropriate adjustments for changes in circumstances, such as:

  • The larger standard deduction for people age 65+,
  • Wage/self-employment income ending/declining due to retirement or partial retirement,
  • Social Security income starting, or
  • Selling your home.

If you’re married, it’s important to also run “only one spouse alive” scenarios under the dummy plan as well, to see what the marginal tax rate would be after one of the two of you dies.

Note that this whole analysis requires making some guesses and estimates. For instance, you’ll have to decide whether to assume the tax bracket structure is allowed to revert back to pre-Tax Cuts and Jobs Act levels at the end of 2025, or whether the current structure will be extended. And you’ll have to make assumptions as to portfolio performance, for the sake of determining RMDs.

Making Improvements to the Plan

With this “dummy” plan in place, take a look at how your anticipated marginal tax rate changes over time. A pattern that is very common for people in almost-retired or recently-retired scenarios is something along these lines:

  • Marginal tax rate falls once income from work stops,
  • Marginal tax rate increases once Social Security begins,
  • Marginal tax rate increases further once RMDs begin, and
  • (For married couples), marginal tax rate increases further once one of the two spouses dies.

From here, the goal is basically to “smooth out” your marginal tax rate. That is, we want to move income out of years in which you have a higher marginal tax rate and into years in which you have a lower marginal tax rate. The tools with which we can shift income from one year to another are:

  • Shifting income earlier by doing Roth conversions, or
  • Shifting income later by satisfying spending in earlier years via Roth accounts or liquidating taxable holdings with significant basis.

For years in which it makes sense to do Roth conversions, you have to decide how much to convert. To do this, first identify the next few thresholds (for the year in question) at which your marginal tax rate would increase. These could be the top of a tax bracket, an IRMAA threshold, the thresholds for Social Security benefit taxation, the bottom of the phaseout range for a particular deduction/credit, or the threshold at which the 3.8% Net Investment Income Tax kicks in.

Then determine exactly what your marginal tax rate would be after hitting that threshold. If that higher marginal tax rate is higher than the marginal tax rate you expect to face later, then you want to do Roth conversions up to (but not beyond) that threshold. If the marginal tax rate beyond that threshold is still below the marginal tax rate you expect to face later, then you probably want to do Roth conversions up to the next threshold. Of note, this is something of an iterative process, because as you do more and more conversions in the earlier years, it can result in your marginal tax rate in the later years being reduced (because RMDs will be smaller).

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