Archives for January 2022

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Qualified Charitable Distributions from an IRA with Basis

A reader writes in, asking:

“I’ve seen articles about how to calculate the taxable amount of an RMD when the distribution from the Traditional IRA contains both pre-tax and post-tax dollars.

I’ve seen articles about how taking a QCD from your Traditional IRA reduces the taxable amount of your RMD to be reported to the IRS.

But I have not seen anything (and research has come up empty) about taking QCDs from a “mixed” Traditional IRA.  Specifically, (a) how to calculate the taxable amount of the RMD to be reported on Form 1040 and (b) how to calculate the remaining basis of the Traditional IRA.”

First, let’s give a bit of background on what this reader is asking about. Qualified charitable distributions (QCDs) are distributions from an IRA directly to a charity. And despite being a distribution from a traditional IRA, they are not taxable. (See “Qualified Charitable Distributions vs. Donating Appreciated Stock” for more details.)

And, the other topic in question here is how distributions work from a traditional IRA when you have basis (i.e., when you have made nondeductible contributions to your traditional IRA). When you have basis in your traditional IRA, a portion of each distribution is nontaxable. Specifically (when there’s no QCD also involved), that nontaxable percentage is calculated as:

  • Nontaxable percentage of the distribution = Your basis in the traditional IRA ÷ (traditional IRA balance at the end of the year + distributions/rollovers/conversions out of traditional IRA during the year).*

When we add a qualified charitable distribution into the mix as well, then the first thing to know is that the QCD is always nontaxable. And, provided that your non-basis amounts in the IRA exceed the amount of the QCD, then:

  • The QCD does not reduce your basis, and
  • For the sake of calculating how much of the other distributions are taxable/nontaxable (and how much basis is left in the IRA afterwards), it’s as if the QCD amount was gone from the IRA before the year even began.**

This is because the QCD is not included at all on Form 8606 as a distribution. (On the line for reporting distributions, the form itself explicitly says: “do not include […] qualified charitable distributions.” The instructions say the same thing.)

Let’s Walk Through an Example

Imagine that you only have one traditional IRA, and at the beginning of the year, the account balance is $100,000 and you have $12,000 of basis in the IRA (from having made $12,000 of nondeductible contributions). During the year you make a qualified charitable distribution of $7,000 and you take other distributions of $6,000. At the end of the year, the IRA balance is $90,000.

First things first: the QCD is nontaxable. Because those are just the rules for QCDs.

Then to calculate how much of the $6,000 of other distributions are taxable, we follow our math from above:

  • Nontaxable percentage = basis ÷ (balance at the end of the year + distributions/rollovers/conversions out of the account during the year).
  • Nontaxable percentage = 12,000 ÷ (90,000 + 6,000) = 12.5%.

Remember, we exclude the QCD from this math. That’s why the denominator is $96,000 rather than $103,000.

So, 12.5% of the $6,000 distribution is nontaxable ($750). The remaining 87.5% of the $6,000 distribution is taxable ($5,250). In total, $13,000 of distributions were made from the IRA, and $5,250 is the amount that would be taxable. And at the end of the year, you would have $11,250 of basis in the IRA (because $750 of the basis was distributed tax-free this year).

*If you have multiple traditional IRAs, they are considered to be one IRA for this purpose.

**If the amount of the distribution to charity exceeds your non-basis amounts in traditional IRAs, then the QCD is limited to your non-basis amounts, because QCDs are limited to the amount that would otherwise be taxable. For example, imagine that your traditional IRA balance includes $6,000 of basis from nondeductible contributions and $2,000 of earnings — and that’s it. And you have $5,000 distributed directly to a charity. The QCD is limited to $2,000 because it’s only the earnings that would normally be taxable. The rest of the distribution ($3,000) is still nontaxable, but it’s considered to be nontaxable distribution of basis rather than QCD.

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Investing Blog Roundup: The Impact of Impact Investing

A recent paper from Jonathan Berk and Jules H. van Binsbergen took a look at “The Impact of Impact Investing” (a.k.a. ESG investing or socially responsible investing).

Their conclusion:

“We conclude that at current levels impact investing is unlikely to have a large impact on the long-term cost of capital of targeted firms. A substantial increase in the amount of socially conscious capital is required for the strategy to affect corporate policy. [Mike’s note: elsewhere in the paper, they estimate that in order to cause a 1% change in the cost of capital, impact investors would need to control more than 80% of all investable wealth.] Given the current levels of socially conscious capital, a more effective strategy to put that capital to use is to follow a policy of engagement. By purchasing the stock in targeted companies rather than selling the stock, socially conscious investors could potentially have greater impact by exercising their rights of control through the proxy process or by gaining a majority stake and replacing upper management.”

This is the case I have been making for years. But from a purely financial point of view, it’s clear that investing in broadly diversified low-cost mutual funds (rather than buying a handful of individual stocks) is the best decision. And unfortunately when we invest via mutual funds, we give up our voting rights in the underlying shares. The fund company gets to vote those shares instead (or not vote them).

Nearly 20 years ago (December 2002) Jack Bogle argued to the SEC that mutual fund shareholders should have a right to know how fund managers vote the fund’s shares. Unfortunately, the availability of such information is still quite limited.

Other Recommended Reading

Thanks for reading!

Social Security Made Simple: 2022 Edition

Just a brief announcement for today: the 2022 edition of Social Security Made Simple is now available (print version here and Kindle version here).

Relative to the prior (2019) edition, various figures have of course been updated.

And with this year’s large COLA, one of the questions I received repeatedly was whether a person has to have filed for their retirement benefit already in order to receive the COLA. So I’ve added an explanation that you get the annual cost-of-living adjustment beginning at age 62, regardless of whether you have filed for benefits.

There’s also a new example in the chapter on spousal benefits that illustrates another topic that has been a source of question for years: how is a person’s total monthly benefit calculated if they a) start their own retirement benefit early and then b) later start to receive a spousal benefit? (In short, the dollar-value reduction to your retirement benefit that was applied due to filing early continues to apply after your benefit as a spouse kicks in.)

For anybody who has not read the book, the outline is as follows:

Part One: Social Security Basics
1. Qualifying for Retirement Benefits
2. How Retirement Benefits Are Calculated
3. Spousal Benefits
4. Widow(er) Benefits
Part Two: Rules for Less Common Situations
5. Social Security for Divorced Spouses
6. Child Benefits
7. Social Security with a Pension
8. The Earnings Test
Part Three: Social Security Planning (When to Claim Benefits)
9. The Claiming Decision for Single People
10. When to Claim for Married Couples
11. The Restricted Application Strategy
12. Age Differences Between Spouses
13. Accounting for Investment Returns
Part Four: Other Related Planning Topics
14. Social Security and Asset Allocation
15. Checking Your Earnings Record
16. How Is Social Security Taxed?
17. Do-Over Options
Conclusion: Six Social Security Rules of Thumb
Appendix A: Widow(er) Benefit Math Details
Appendix B: Restricted Applications with Widow(er) Benefits
Appendix C: The File and Suspend Strategy

You can find the print version here and Kindle version here.

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Investing Blog Roundup: How Do Household Finances Change After Children Leave?

I hope that you enjoyed your holiday season. I’m looking forward to 2022, and I hope you are as well.

Recommended Reading

As always, thanks for reading!

Professional Financial Advice: How Much Should You Pay?

In the realm of financial planning, advisors are often encouraged to use “value-based” pricing — and to determine the value of their services by comparing the results the client would get with those services to the results the client would get without those services. For example, an annual advisory fee equal to 1% of your assets under management is reasonable if the financial planning and portfolio management services provided for that fee can collectively improve your results by more than that amount. (And Vanguard’s “Advisor Alpha” research or David Blanchett and Paul Kaplan’s “Gamma” research is often used to make this case.)

But that only makes sense if this financial professional is the only financial professional with whom you could work.

If you’re at the Toyota dealership, considering purchasing a RAV4, the decision you’re making isn’t “Toyota RAV4 as compared to walking everywhere.” You’re evaluating the RAV4 against other vehicles.

It does make sense to first ask the question: do I want to buy a vehicle? Depending on your mobility, where you live, and so on, you may be able to save a lot of money by walking, biking, and using public transportation. Similarly, not paying for financial advice can be perfectly prudent for lots of people in various stages of their lives.

But for a particular vehicle to be the right one to purchase, it has to not only improve your life relative to no vehicle, it has to improve your life relative to the other vehicles you could purchase.

The same goes for financial advice. Even if a financial professional could, for example, improve your results by $20,000 per year relative to not working with a financial professional (and that’s a tall order to fill), that doesn’t mean that any price less than $20,000 per year is a good deal. You might be able to find an equally qualified professional who can provide the same service for less.

There Are Substitutes

Since starting this blog in 2008, I have had the pleasure of meeting and corresponding with lots of super smart financial professionals. But I have never met a single one whom I thought to be the only person who could handle a particular financial planning situation.

And to be clear, that’s 100% true for me as well. I believe I do a good job advising clients about retirement tax planning, Social Security, and a few other topics. But Jim Blankenship, for example, knows at least as much about those topics as I do. And so do plenty of other professionals who don’t happen to write a blog or books.

Many parts of financial planning are complicated. But they’re not that complicated. There’s nothing for which you need a one-in-a-million genius-level IQ. No matter which area(s) of financial planning you want help with, there are more than a few people qualified to help.

What Services Do You Want?

When considering working with a financial professional, the first step should be to ask yourself what services you want.

A critical question here is whether you want advice (i.e., financial planning), portfolio management (i.e., somebody who will actually place the buy/sell orders for you, to keep your portfolio at its intended allocation), or both.

If all you want is portfolio management, you can get it very cheaply through Vanguard or other robo-advisors. (Or you can get a very basic version by simply using an all-in-one fund.)

If all you want is advice, you would likely appreciate working with an “advice-only” professional (i.e., one who does not even provide portfolio management, and who will therefore not be trying to sell you such services).

If you want both advice and portfolio management, that’s where the financial planning firms that charge based on assets under management might be a good fit. But even then, not necessarily. There are flat-fee firms as well (e.g., Bason Asset Management, which charges a flat $5,100 per year as of this writing). And depending on the size of your portfolio, a flat fee could be a lot less than an asset-based fee.

Typical Costs

For advisors charging hourly, a 2020 Kitces Research survey found that the median cost for hourly financial planning was $250. A 2020 survey from Envestnet/MoneyGuide found the hourly average was $257. (I’ll be interested to see the extent to which these fees change in the next iteration of the surveys, given the inflation over the course of 2021.)

For firms charging a flat retainer fee, the Kitces Research survey found that the median annual amount was $4,000.

As far as asset-based fees for financial planning combined with portfolio management, the Kitces Research survey found that “median fees were 1.0% of [assets under management] up to $1 million. The median fee then dropped to roughly 0.9% at $2 million and 0.8% at $5 million.” The Envestnet/MoneyGuide survey found a mean asset-based fee of 1.04%.

More Than Just Costs

The point here isn’t to automatically choose the advisor who can provide the rock-bottom cost. You want to be aware of costs — and check to see if there’s an equally-good option that costs much less. But in many cases the advisor who turns out to be the best fit for your needs will not be the very least expensive option.

It’s important to determine whether this particular advisor has the particular expertise you’re seeking. Do they often work with people in circumstances similar to yours? For instance, Jon Luskin works with DIY investors. Meg Bartelt focuses on working with women in tech. Cody Garrett works with families with “FIRE” goals. Sotirios Keros works especially with healthcare professionals.

And there are other questions about the firm that could be important. For instance, some people may prefer to work with a solo advisor, while others may prefer to work with a larger team, such as the hourly-only firm Timothy Financial. A team can likely provide deep expertise on a broader range of topics than an individual can. In addition, a team can provide better accessibility. (If a solo advisor is on vacation, the firm is on vacation. If one person in a team firm is on vacation, the team is still operating.)

And there are subjective considerations as well: does this person/team feel like a good fit? Do you trust them? Do they communicate in a way that makes sense to you, or does it feel like they’re speaking another language?

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