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Investing Blog Roundup: What’s Next?

It’s been one heck of a week, to follow what was, by any measure, one heck of a year.

In finance, one thing you eventually have to accept is that it’s impossible to predict what’s going to happen next. Lots of events look obvious, in hindsight. But lots of potential events that didn’t happen would have looked obvious in hindsight as well.

That feeling — unsure what’s about to happen, recognizing that some of the potential outcomes are dramatically different than other potential outcomes — feels particularly acute right now.

As always, thank you for reading, and I wish you well.

Recommended Reading

Retirement Tax Planning Error: Not Planning for Widow(er)hood

One of the most common retirement tax planning errors I see is specific to married couples: not accounting for the tax changes that will occur once one of the two spouses dies.

For example, using data from the SSA’s 2017 Period Life Table, we can calculate that, for a male/female couple both currently age 60 and in average health, there will be, on average, 11.3 years during which only one spouse is still alive. (That is, the expected period for which both spouses will still be alive is 17.4 years, while the expected period for which either spouse will be alive is 28.7 years. The difference between those two lengths of time, 11.3 years, is essentially the expected duration of “widow(er)hood” for the couple.)

Why This Is Important for Tax Planning

When one of the two spouses dies, there is generally a decrease in income, but it’s typically somewhat modest as a percentage of the household’s overall income — especially for retired couples who have managed to accumulate significant assets. What generally happens is that the smaller of the two Social Security benefits disappears when one spouse dies*, but the portfolio income is largely unchanged (unless the deceased spouse left a significant portion of the assets to parties other than the surviving spouse).

And, beginning in the year after the death, the surviving spouse will only have half the standard deduction that the couple used to have. In addition, there will only be half as much room in each tax bracket (up to and through the 32% bracket), and many various deductions/credits will have phaseout ranges that apply at a lower level of income.

In other words, there’s half the standard deduction and half as much room in each tax bracket, but the surviving spouse is left with more than half as much income. The result: their marginal tax rate generally increases, relative to the period of retirement during which both spouses were alive.

The tax planning takeaway is that it’s often beneficial to shift income from those later (higher marginal tax rate) years forward into earlier (lower marginal tax rate) years. Most often that would be done via Roth conversions or prioritizing spending via tax-deferred accounts.

It’s tricky of course because, as with anything dealing with mortality, we don’t know the most critical inputs. To put it in tax terms, how many years of “married filing jointly” will you have in retirement? And how many years of “single” will you (or your spouse) have in retirement? We don’t know. We can use mortality tables to calculated expected values for those figures, but your actual experience will certainly be different.

So it’s hard (or rather, impossible) to be precise with the math. But it’s very likely that a) there will be some years during which only one of you is still living and b) that one person will have a higher marginal tax rate at that time than you (as a couple) had earlier. So, during years in which both spouses are retired and still alive, it’s likely worth shifting some income forward to account for such.

Often the idea is to pick a particular threshold (e.g., “up to the top of the 12% tax bracket” or “before Social Security starts to become taxable” or “before Medicare IRMAA kicks in”) and do Roth conversions to put you slightly below that threshold each year. But the specifics will vary from one household to another. And the decision necessarily involves a significant amount of guesswork as to what the future holds.

*This is a simplification. There can be various factors (e.g., government pension) that would make the total household Social Security benefit fall by an amount more or less than the smaller of the two individual benefits.

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Can I Retire Cover

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  • How to calculate how much you’ll need saved before you can retire,
  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • Click here to see the full list.

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Investing Blog Roundup: Rich as I Say, Not as I Do

This week I particularly enjoyed an article from Nick Maggiulli pointing out something that’s not frequently mentioned about personal finance experts:

“Many of them have gotten wealthy by selling advice to others rather than by using their own advice. […] The people telling you how to build wealth did not, in fact, build their wealth in that same way.”

Other Recommended Reading

Thanks for reading, and Happy New Year!

I wish you happiness and health in 2021.

Estimated Tax Payments and Roth Conversions

A reader writes in, asking:

“I was wondering if you’ve discussed taxes on Roth conversions before. Specifically, I’m really confused on whether or not I would need to make estimated tax payments to the IRS. Does it matter when I do the conversion, January vs. December, for instance? Would I make a single estimated payment, or would I have to make four during the year? I do NOT currently make estimated payments. My wife and I file jointly and have taxes withheld from our paychecks and typically may owe a few grand at most in taxes in April.

Maybe a post about estimated taxes in general would be helpful.”

Yes, a Roth conversion could cause you to need to make estimated tax payments.

There are two ways to avoid penalty for underpayment of estimated taxes.

First, you will not owe any penalty if your total tax for the year, minus your withholding, minus your refundable credits is less than $1,000.

Second, you will not owe any penalty if:

  1. Over the course of the year, you paid (via withholding and/or estimated tax payments) at least the smaller of:
    • 90% of your total tax for the year or
    • 100% of your total tax for last year (110% if your adjusted gross income from last year was at least $150,000),
  2. And your estimated tax payments were each of the required amount and were each made by the applicable deadline.

Estimated Tax Deadlines

The applicable deadlines are April 15, June 15, September 15, and January 15 of the following year. It’s important to note that this isn’t every three months, despite often being referred to as “quarterly” payments. If you make your first payment on April 15, then make your second payment three months later, that second payment is going to be a month late.

Required Amount per Estimated Tax Payment

The required amount for each estimated tax payment is generally 25% of the required annual payment. In other words, if a) you make the same size payment for each of the four estimated tax due dates, b) you make each payment on time, and c) you meet the percentage requirement described above (i.e., 90%, 100%, or 110%), then you won’t owe any penalty.

However, in cases in which your income is earned unevenly throughout the year, the required amount for a given estimated tax payment may be less than 25% of the annual amount.

As a very simplified example, imagine that you have no taxable income whatsoever for the first 11 months of the year. Then in December you do a very large Roth conversion. In such a case, if you make a sufficiently large estimated tax payment by Jan 15 of the following year, you would owe no penalty, despite not having made any estimated tax payment for any of the first three periods.

Form 2210 and its instructions walk you through the details. (Pay particular note to Schedule AI for situations in which income varies considerably throughout the year.)

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: How America Invests

For many years, Vanguard has published an annual study (“How America Saves“) that looks at investor behavior within employer-sponsored plans. Last week, Vanguard released a new study: “How America Invests,” which looked at the portfolios and transactions of Vanguard clients in more than 5 million retail households from 2015 through the first quarter of 2020.

There’s a lot of material, but one thing that strikes me — and which is in keeping with the data from the annual employer-plan studies — is that individual investors (at least, those who are Vanguard clients) aren’t the dummies they’re often made out to be.

For instance, most Vanguard clients don’t jump in and out of the stock market at inopportune times, because most Vanguard clients don’t really do very much at all, other than simply buy more of whatever it is that they already own (which happens to be quite a good investment strategy, in my opinion, hence the name of this blog).

Here’s one such piece of data:

Fewer than one-quarter of Vanguard households trade in any given year, and those that do typically only trade twice. [Mike’s note: they’re defining trading here as moving money from one investment option to another within an account.] Most traders’ behavior is consistent with rebalancing or is professionally advised. […] Twenty-two percent of households traded in the first half of 2020—a rate typical of trading for a full calendar year. Despite the increase in trading, less than 1% of households abandoned equities completely during the downturn, while just over 1% traded to extremely aggressive portfolios. The net result of the portfolio and market changes was a modest reduction in the average household equity allocation, from 63% to 62%.

Other Recommended Reading

Thanks for reading!

Marginal Tax Rate or Effective Tax Rate?

A reader writes in, asking:

“I am tentatively starting to think how taxes affect retirement especially for the ACA purposes, in case it somehow survives the latest current court fight. So, which kind of tax should we be concerned about? When I google this, I can find someone saying ‘marginal tax’ whereas somebody else saying ‘effective tax rate’. So, which is it? Could you direct me to some easy to understand tutorial about it? I certainly cannot plan anything (e.g. 401k to an IRA and then Roth IRA conversions) and staying under ‘the cliff’ unless I understand the basics on this subject.”

Broadly speaking:

  • Effective tax rate is useful for budgeting;
  • Marginal tax rate is useful for tax planning.

For example, if you’re considering taking a new job and you want to know how much actual take-home pay you would have, given a certain level of gross salary, you’d need to know your effective tax rate. (“How much total tax would I be paying on my total income?”)

But for almost every tax planning decision, we want to know marginal tax rate. For instance, if you were considering a Roth conversion, you’d need to know the applicable marginal tax rate. (“How much tax would I pay on this income?”)

With tax planning, we’re generally trying to decide “should I do X or should I do Y?” And we want to know how the tax bill changes as a result of doing X instead of doing Y. That is, we want to know the marginal tax rate.

This is the case whenever we’re trying to determine the value of a potential deduction (e.g., additional deductible charitable contributions). And it’s the case whenever we’re trying to determine the tax-cost of potential additional income (e.g., additional distributions from tax-deferred accounts). It’s also the case when trying to determine when it’s best to recognize a certain piece of income (e.g., doing a Roth conversion this year as opposed to in a later year).

In all of those cases, marginal tax rate is what we want to know.

What’s Your Marginal Tax Rate?

An important point about marginal tax rates is that there’s more to it than just looking at what tax bracket you’re in. Your actual marginal tax rate for a given type of income could be significantly higher or lower than your tax bracket. This is often the case when additional income causes you to lose out on a particular tax break for which you currently qualify (e.g., your income becomes too high to qualify for a given credit, or a greater percentage of your Social Security benefits become taxable). And the opposite can happen with deductions. That is, in some cases a deduction will cause not only the anticipated amount of savings (i.e., the amount of the deduction times your tax bracket) but also additional savings because now your income is low enough to qualify for some other tax break.

In addition, certain types of income (most importantly, qualified dividends and long-term capital gains) are taxed at different tax rates than ordinary income. Also, when doing the eligibility calculation for various tax breaks, some types of income/deductions count, while others do not — and it varies depending on which deduction/credit we’re talking about.

In my opinion, the best tool for people doing their own tax planning is tax preparation software. You can create a hypothetical return, look at the total tax due, then adjust one factor (e.g., “what if I took another $1,000 from my traditional IRA this year?”). When you see how much your total tax would change, you know your actual marginal tax rate for that hypothetical income/deduction.

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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