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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!"

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!"

2021 Tax Brackets, Standard Deduction, and Other Changes

The IRS recently published the annual inflation updates for 2021. If you have questions about a particular amount that I do not mention here, you can likely find it in the official IRS announcements:

Single 2021 Tax Brackets

Taxable Income
Tax Bracket:
$0-$9,950 10%
$9,950-$40,525 12%
$40,525-$86,375 22%
$86,375-$164,925 24%
$164,925-$209,425 32%
$209,425-$523,600 35%
$523,600+ 37%

 

Married Filing Jointly 2021 Tax Brackets

Taxable Income
Tax Bracket:
$0-$19,900 10%
$19,900-$81,050 12%
$81,050-$172,750 22%
$172,750-$329,850 24%
$329,850-$418,850 32%
$418,850-$628,300 35%
$628,300+ 37%

 

Head of Household 2021 Tax Brackets

Taxable Income
Tax Bracket:
$0-$14,200 10%
$14,200-$54,200 12%
$54,200-$86,350 22%
$86,350-$164,900 24%
$164,900-$209,400 32%
$209,400-$523,600 35%
$523,600+ 37%

 

Married Filing Separately 2021 Tax Brackets

Taxable Income
Marginal Tax Rate:
$0-$9,950 10%
$9,950-$40,525 12%
$40,525-$86,375 22%
$86,375-$164,925 24%
$164,925-$209,425 32%
$209,425-$314,150 35%
$314,150+ 37%

 

Standard Deduction Amounts

The 2021 standard deduction amounts are as follows:

  • Single or married filing separately: $12,550
  • Married filing jointly: $25,100
  • Head of household: $18,800

The additional standard deduction for people who have reached age 65 (or who are blind) is $1,350 for each married taxpayer or $1,700 for unmarried taxpayers.

IRA Contribution Limits

The contribution limit for Roth IRA and traditional IRA accounts is unchanged at $6,000.

The catch-up contribution limit for people age 50 or over does not get inflation adjustments and therefore is still $1,000.

401(k), 403(b), 457(b) Contribution Limits

The salary deferral limit for 401(k) and other similar plans is unchanged at $19,500.

The catch-up contribution limit for 401(k) and other similar plans for people age 50 and over is unchanged at $6,500.

The maximum possible contribution for defined contribution plans (e.g., for a self-employed person with a sufficiently high income contributing to a solo 401(k)) is increased to $58,000.

Child Tax Credit

The child tax credit ($2,000 per child) and the related phaseout threshold ($200,000 of modified adjusted gross income, $400,000 if married filing jointly) do not get inflation adjustments. The portion of the credit that can be refundable (up to $1,400 per child) does receive inflation adjustments, but it is still $1,400 for 2021.

Capital Gains and Qualified Dividends

For 2021, long-term capital gains and qualified dividends face the following tax 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.

Alternative Minimum Tax (AMT)

The AMT exemption amount is increased to:

  • $73,600 for single people and people filing as head of household,
  • $114,600 for married people filing jointly, and
  • $57,300 for married people filing separately.

Estate Tax

The estate tax exclusion is increased to $11,700,000 per decedent.

Pass-Through Business Income

With respect to the 20% deduction for qualified pass-through income, for 2021, the threshold amount at which the “specified service trade or business” phaseout and the wage (or wage+property) limitations begin to kick in will be $329,800 for married taxpayers filing jointly, $164,900 for single taxpayers and people filing as head of household, or $164,925 for married people filing separately.

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!"

Using a Roth IRA for a Home Down Payment

A reader writes in, asking:

“What do you think about using a Roth IRA for a home down payment?”

This is a topic that generates endless disagreement, in part because when somebody asks this question, they can actually be asking either of two completely separate questions:

  • What do you think about taking money out of a Roth IRA, to use it as a down payment on a home?
  • For money that is already intended to be used as a down payment on a home, what do you think about contributing it to a Roth IRA (as opposed to simply leaving it in a taxable account)?

Let’s tackle the first question first, then the second. But before directly addressing either of those questions, we need to talk about the actual rules: how are distributions from a Roth IRA treated, when used for a home down payment?

Tax Treatment of Roth IRA Distributions When Used for a Home Purchase

Money that you contribute to a Roth IRA can come back out of the account at any time, free from tax and penalty. (Note: this is only for amounts that were contributed directly to the Roth IRA. For amounts that were contributed to a traditional IRA, then moved to a Roth IRA as a conversion, see this article.)

In addition, a distribution of earnings is free from the 10% penalty if it is a “qualified first-time homebuyer distribution.” And if you have satisfied the 5-year rule, the distribution will be free from regular income tax as well.

For a distribution to be a qualified first-time homebuyer distribution:

  • It must be used within 120 days of the distribution…
  • to pay “qualified acquisition costs”…
  • on a “principal residence”…
  • for a “first-time homebuyer.”
  • And the homebuyer in question must be yourself, your spouse, one of your (or your spouse’s) ancestors, or one of your (or your spouse’s) descendants.
  • Also, qualified first-time homebuyer distributions are limited to $10,000 over your lifetime. (Though if you’re married, your spouse gets his/her own $10,000 limit.)

As far as definitions:

  • “Qualified acquisition costs” means what you would expect: costs of acquiring, constructing, or reconstructing a residence. And it includes any usual or reasonable settlement, financing, or other closing costs.
  • “Principal residence” also means what you would expect: your main home. If you have more than one home, the IRS takes a “facts and circumstances” approach to determining which one is your main home. (You can find more information in Treasury Regulation 1.121-1(b) if you’re interested.)
  • A “first-time homebuyer” is anybody who had no present ownership interest in a principal residence during the 2-year period ending on the date of acquisition for the home in question. If you are married, your spouse must also meet this requirement in order for you to qualify.

Using Money from a Roth IRA for a Home Down Payment

The decision of whether to buy a home obviously has many factors involved, many of which are not financial at all. Let’s assume that that decision has already been made and that you do intend to buy a home, so the question remaining is simply whether you should use money from a Roth IRA for the down payment.

When it comes to using assets for a home down payment, the general order of preference is as follows:

  • Best to use taxable money (i.e., assets that are not in a retirement account at all — just regular checking/savings accounts and taxable brokerage accounts),
  • Next-best to use “qualified first-time homebuyer distributions” from a Roth IRA,
  • Next-best to use distributions of contributions from a Roth IRA — or distributions of converted amounts if those distributions would not be subject to the 10% penalty (e.g., because the conversion has satisfied its 5-year period or because the conversion was not taxable),
  • Next-best to use other distributions (e.g., distributions of earnings) from a Roth IRA, distributions from a traditional IRA, or distributions from an employer-sponsored plan such as a 401(k) or Roth 401(k).

So the question then is: how much taxable money is there? If you have sufficient money in taxable accounts that you can cover the down payment that you want to make (while still having an emergency fund), then it’s an easy decision: don’t take money out of your Roth IRA for the down payment. Use the taxable assets instead.

If, on the other hand, you do not have sufficient assets in taxable accounts to fund the down payment, then the question is essentially: should you use Roth IRA money or delay the home purchase? On the financial side, whether waiting would pay off depends on:

  • Whether another home comes available for sale that meets your criteria and which is approximately as affordable.
  • What rate of return you earn on the assets that stay invested in the Roth IRA while you wait to build up your savings.
  • Whether interest rates move upward or downward (because you will be getting a mortgage in the future, at those future interest rates, rather than at today’s rates).

And again, there are of course an assortment of non-financial factors that could, quite reasonably, affect your decision as to whether to wait or go ahead and buy the home in question now.

Contributing to a Roth IRA to Save for a Down Payment

A separate but related scenario is the case of somebody who plans to buy a home in the not-so-distant future, and they want to know whether it makes sense to put money into a Roth IRA when that money is likely to be used for a down payment. In other words, the question is basically “make Roth IRA contributions or do not make Roth IRA contributions.”

And the answer here is generally to go ahead and make the contributions, even if the money in question is intended to be used for a home down payment rather than retirement. There are a few reasons for this:

  1. There’s not much of a downside from a tax perspective, given the way that distributions are treated when used for a first-time home purchase.
  2. Making Roth IRA contributions may allow you to qualify for the retirement savings contribution credit.
  3. And perhaps most importantly, if you later change your mind about the home purchase (or decide to delay it for other reasons), you will not have missed out on your Roth contributions for the year(s) in question.

There are two related points to note here.

First, if the money in question is intended to be used in the relatively near-term future, it should of course be invested conservatively.

Second, this general concept does not apply to Roth 401(k) contributions. If you have money that you intend to use in the near future for a home down payment, do not contribute it to a 401(k) — even a Roth 401(k). In some cases you won’t be able to get money out of a 401(k) at all until you have left the employer in question. And the special tax treatment (discussed above) that sometimes applies to distributions from an IRA when used for a home purchase does not apply to distributions from a 401(k) (whether Roth or not).

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!"

Beware of Tax Planning “Cliffs”

A tax cliff occurs when one additional dollar of income beyond a certain threshold causes a sudden increase in your tax bill (or, in some cases, health insurance costs).

Most tax provisions don’t include tax cliffs. Instead, the effect of additional income is “phased in” over time. For example, with the American Opportunity Credit (for higher education expenses), you can claim the full credit if your income falls below a given threshold ($80,000 if single, $160,000 if married filing jointly). Then, as your income passes that threshold, the amount of credit you can claim is gradually reduced (“phased out”) until it reaches zero.

But with provisions that include tax cliffs, the change happens all at once. You either get the full deduction/credit or no deduction/credit. There’s no room in between. In such situations, that one dollar of income that puts you beyond the threshold can cost you hundreds or even thousands of dollars.

For example, all of the following provisions include cliffs:

There are many at the state level as well.

Avoiding Tax Cliffs

When possible, the goal is to avoid a situation where you end up just barely on the wrong side of a given cliff threshold.

The area in which people are most likely to have flexibility (i.e., ability to adjust income on demand, in order to avoid a cliff) is with regard to retirement accounts (i.e., by adjusting the balance of Roth/tax-deferred contributions if still working or distributions if no longer working).

A tricky point, however, is that the income being measured varies from one provision to another.

  • The retirement savings contribution credit is concerned with your adjusted gross income;
  • The tuition and fees deduction is concerned with modified adjusted gross income;
  • ACA premium tax credit and cost-sharing reductions are concerned with household income;
  • IRMAA is concerned with modified adjusted gross income (but the “modifications” to adjusted gross income are different than they are for the tuition and fees deduction); and
  • The EITC cliff is concerned with investment income.

Using tax prep software can be a helpful way to test for such cliffs. For instance, it can be helpful to prepare a hypothetical return in advance (e.g., using the 2019 version of the software to prepare a hypothetical return now, for 2020). See what your projected tax bill would be, then see how it would change if, for instance, you made an additional $1,000, $2,000, $3,000 etc. of tax-deferred contributions. At some point you might find that there’s a sharp decrease in the projected tax bill.

To be clear though, that method is not perfect, for a few reasons. Firstly, it won’t catch cliffs that affect something other than your taxes (e.g., IRMAA or Affordable Care Act cost-sharing reductions). In addition, it’s imprecise given the fact that you’d be using 2019 software for a 2020 return, and the relevant thresholds can change from one year to the next. And in situations in which major tax legislation has been passed, the exercise could be entirely off the mark.

Still, it’s often useful as an easy way to do a quick check.

More broadly though, it’s helpful to develop an awareness of which provisions involve cliffs, and then to be mindful of the one(s) that are most likely to affect you, so that you can look up the relevant threshold(s) when necessary. (For instance, if you buy health insurance on the exchange, you generally want to have Affordable Care Act subsidies in mind when making any tax-related decisions.)

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!"

Inherited HSA Rules

A reader writes in, asking:

“After last week’s article discussing the rules for inherited IRAs, I would be interested to hear about the rules for inherited HSA accounts. We have been using my HSA effectively as a ‘third retirement account’ contributing the max each year regardless of likely medical expenses, since we can take no-penalty distributions for any purpose after age 65. So there’s a good chance that the account will outlive me…or even both of us.”

This is an easy one.

There’s no such thing as an inherited HSA — at least not in the sense that there is with an inherited IRA (in which a beneficiary can continue to own the inherited IRA, with its own set of special rules, for many years).

That is, after you die:

  • If your spouse is the beneficiary of your HSA, the account just becomes his/her HSA. (That is, it’s not an “inherited HSA.” It’s just a normal HSA, now owned by your surviving spouse.)
  • If somebody other than your spouse is the beneficiary of your HSA, the account is no longer an HSA. It just becomes a regular taxable account, and the full value of the account is taxable as income to the beneficiary in the year of your death.*
  • If your estate is the beneficiary of your HSA, the account ceases to be an HSA, and the value of the account is included as income on your final tax return.

There are two primary financial planning implications here:

  1. If you’re married, name your spouse as the beneficiary of your HSA!
  2. It’s a good idea to prioritize spending down this account (to the extent of your qualified medical expenses, and potentially beyond that extent once you reach age 65) rather than retirement accounts, because your children (or other non-spouse heirs) would rather inherit a retirement account than an HSA that immediately becomes fully taxable.

*If, within 1 year of the date of death, your non-spouse beneficiary (other than your estate) pays any of your qualified medical expenses that were incurred before your death, the amount of those expenses is subtracted from the amount that is taxable to the beneficiary.

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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