Posts Tagged ‘roth ira


IRA to IRA to IRA Rollover in one year?

Why surfing the interwebz, we’ve run into some potentially misleading information.  Well, it most definitely can be interpreted as being misleading, but the intent of the individuals is unknown.  Of course, the point of this blüg is to make sure people don’t use this misleading information.  So, regardless of what someone’s intention is, we hope people walk away with more knowledge than they did before they invested a few minutes in what we have written.

Over at Retire by 40’s blüg, “Ray” gave some advice in the comments that certainly deserves an asterisk.  And, we put that asterisk in the comment section.  But, here is what “Ray” said which could be misleading.

What people don’t understand is you can roll it over to say Vanguard and if you don’t like them, then roll it over to Etrade and if you don’t like them, roll it over to Schwab etc.

Usually from start to finish it’s no more than 7-10 business days if you do it right…

The implication here is that you can just rollover whenever you please.  Which is true, but not without consequences.

Continue reading ‘IRA to IRA to IRA Rollover in one year?’


misconception about roth IRA first time home buyer distribution

Well, with April here, spring in the air, flowers blooming and tax time looming, we thought we would dispel a misconception about the Roth IRA first time home buyer’s reduction in earnings while taxes are fresh in the mind of half the population.

We’ve seen this lately being mentioned as an advantage of a Roth IRA here, here and here.  And, we’ve attempted to alert some of them to the complexity of this acrobatic maneuver they suggest.  Some willing to learn, but mostly with us being shrugged off.  So, we thought we would move it to a stage where we can fully (at least attempt to) explain this complex tax move.

First, we should point out, that we think using an IRA for anything else other than retirement is a mistake.  GASP!  A blanket statement.  They are powerful tools which help people to retire.  In an indirect way, yes, buying a home does help one to retire, or paying for a child’s college education (if that is an expense you decide to bear) does help you to retire.  But, there are other ways to help you save for those things.  Look at it this way, you only get $5000/yr (under current rules) to contribute.  Maxing this out year after year will barely get you into retirement, if ever.  Use a wrench to turn nuts & bolts, and a hammer to pound nails.  So, even if you read through what we are about to say and still think saving for a home in a Roth IRA is a good idea, you certainly don’t have our endorsement.  But, our opinion is worth what you paid for it (should we set up a paypal link for some luv?).

The origin of the Roth IRA first time home buyer’s earnings distribution misconception is the interwebz.  It is undoubtedly true that you can withdraw from a Roth IRA, an amount up to $10,000 for the purchase of a primary residence to be your “first” home (usually if you haven’t owned a home in two years, you are a born again “first” time home buyer).  We would certainly hope everyone would due their do diligence (why do we feel like we messed something up there?).  And, if you want a great summary of why most people think this is an easy peasy tax move, read Publication 590, page 62, bottom right of the page.  It is right there, plain as day under big bold words that say, “What are Qualified Distributions”:

One that meets the requirements listed under First home under Exceptions in chapter 1 (up to a $10,000 lifetime limit).

And if you’re looking at the Pub 590 document that we link to, page 62 and you click on the hyperlink of “first home,” then it takes you to the part where it defines who you can buy a home for, what defines a “first” home and even points out that you and your spouse can both do this for the same home!

This is a qualified distribution, so the normal roth ordering rules don’t apply (rules which say when there is a non-qualified distribution that you first take out your contributions, then conversions-this has a few caveats-and then earnings).  Being a qualified distribution, you can take from the earnings.  If you think you can have your cake and eat it too by keeping your contributions as an emergency fund and reducing your earnings for the home purchase you are WRONG!  You will have to reduce your basis (or contributions) by the amount of earnings you withdrew the prior year for a first time home purchase, up to $10,000.

Sounds confusing, well it is.  Let’s look at some tax forms.  To do this, we must go back to 2010 so you can see how this works.  For our example we’ll assume you have $30,000 in a Roth IRA, $10K of earnings and $20k of contributions.  Let’s say you want to tap that $10k of earnings for a home in 2010.  First off, you must have a Roth IRA account at least 5 years old.  Withdrawing anything before that can trigger taxes and penalties.  But, what is so lucrative about using the earnings instead of the contributions?  The main reason is so in our example, you could take all $30k out for a home purchase, tax and penalty free.  But, if you aren’t going to completely wipe out the account, you are not gaining anything (and some would argue you are loosing things).

One of the hard sells of Roth IRA’s are their flexibility.  And they are the Gumby of retirement investment vehicles because contributions can be tapped, tax and penalty free.  If you like this about a Roth, here is why you need to be cautious with this first time home buyer deal.  Let’s assume you take the $10k of earnings in our example above in 2010 for the purchase of your first home.  You would fill out the 2010 form 8606 like so…

That’s it.  You can download this 2010 8606 form here.  The 2010 form is a little more complicated than other years because of being able to allocate taxes due on conversions over two years, but all that is in Part III.

So, in 2011 (or any year into the future), let’s say you want to take out the $20k of contributions, for whatever reason.  Let’s fill out your form 8606 in 2011.  This is what it would look like (oh, and you’ll need the instructions, linked here for your pleasure).

WHOA! What just happened?  How did you end up with taxable money in line 36?  Should line 22 be $10,000?!  OR $20,000?  As they say, the devil is in the details.  Let’s look at those instructions for the 2011 8606, line 22.

Figure the amount to enter on line 22 as follows.

  • If you did not take a Roth IRA distribution before 2011 (other than an amount rolled over or recharacterized or a returned contribution), enter on line 22 the total of all your regular contributions to Roth IRAs for 1998 through 2011 (excluding rollovers from other Roth IRAs and any contributions that you had returned to you), adjusted for any recharacterizations.
  • If you did take such a distribution before 2011, use the chart on page 9 to figure the amount to enter.

We hop to page 9 and find the following chart.

So, using this chart on page 9 of form 8606 instructions for 2011, if we took a distribution for a first time home buyer in a prior year, we must take that off of our Roth basis in the following year (2010 8606 line 29 less line 26).  Essentially, the Roth ordering rules are restored and the Roth basis (contributions) is reduced by the amount used for the home buyer’s distribution in any following year you take a distribution.  You can find the 2011 8606 form here.

If you were planning on having an emergency fund and use a home buyer distribution within your Roth accounts, it would be wise to treat the home buyer distribution as being from the basis.  In fact, it would be wise, if you aren’t wiping out the entire amount of Roth funds, to take from the basis and save yourself not only a headache, but your lifetime $10,000 home buyer  distribution from any IRA.  The wisest thing you could do, however, is not touch your retirement accounts until needed in retirement.

And you should check out our legalese page to know we are not professionals at anything, except maybe at barking.  H&R block won’t even hire us to prepare 1040EZ’s.  So, talk to them or a real tax professional.  


Roth IRA = Traditional IRA, a case for thoughtful Roth consideration

One of the most frustrating things to read in the blüg-o-sphere is how much better the Roth IRA is than a traditional IRA.  Heck, there is even a website fully dedicated to Roth IRA’s.  People seem to get caught up in paying fewer taxes and tax free growth.  These are all things which a Roth IRA offers, but is the Roth always better?  No, more times than not, it is not better.

It depends on what your definition of “better” is.  If your main goal in life is to stick it to Uncle Sam and pay the absolute minimum in tax, then yes, a Roth IRA is always better.  But, we propose this is not what the average working stiff who has retirement in mind wants.  We think everyone should look at after-tax dollars, not the amount of taxes paid, to weigh their options.

By definition, a Roth IRA has taxed contributions and earnings (growth and dividends) which are never again taxed (people with a year supply of ammunition in their fallout shelter may refute this).  Regardless of your conspiracy theories, the equation for computing after-tax return on an investment in a Roth IRA is:

By definition, a traditional IRA has pre-tax money used for the contribution and earnings which aren’t taxed until distribution, at which time they are taxed as ordinary income (but not FICA).  The equation to compute your after tax dollars of a traditional IRA is:

You see where we are going with this?  If you start out with the same principal investment (“P“), have the same return (“r“, they are the same because you would invest them the same) and you have the same taxes in retirement as you do now (“t“), then these equations leave you with the exact same after-tax dollars.

Of course, if you pay the taxes before compounding, it will be less than paying the taxes after compounding.  So, you do pay fewer taxes with a Roth than a traditional investment vehicle, but the after tax value is the same if the tax rates are the same at contribution time vs in retirement.  It should also be pointed out, that it may be appropriate to apply one’s effective tax rate at distribution time if they are completely in pre-tax dollars.

AH HA!  You wouldn’t take the taxes out of the Roth investment, P*t, instead you would invest the entire amount, P?  Well, that could very well be the case, but, you still have P*t to invest somewhere if you go the traditional route.  So, where do you put it?  Top off your 401(k), or maybe you top off a traditional IRA?  If you do this, you use the exact same equations above and end up in the exact same place as above.

What if you are able to max a 401(k) and an IRA and choose the traditional route?  You have no other tax advantaged accounts to invest in.  The difference would have to go into a taxable account.  If the tax rates are the same, the after tax dollars will favor a Roth investment vehicle.  But, it should be noted that there are other qualitative benefits to having money in a taxable account oppose to a tax advantaged account – liquidity of the money being probably the biggest benefit.

All this can be summed up in the following table which is an output of our nifty spreadsheet found at the bottom of this article.

The table above shows investments made in Roth investment vehicles, Traditional tax advantaged investment vehicles and taxable accounts.  The big surprise is the difference between Roth accounts and some of the traditional accounts is nothing!  It is no surprise that the Roth yields more than a traditional account with taxable accounts.  Even less surprising should be growth in a taxable account is more tax efficient than dividends (wink, wink young dividend investors).  But, don’t forget the qualitative characteristics of having taxable money.

Remember to compare apples to apples and oranges to oranges.  It isn’t fair to compare a Roth where the taxes haven’t been taken out of the principal to a straight traditional IRA where taxes are taken out at distribution and not invest the taxes to be paid for a Roth.

And for curiosity sake, what does the output look like if taxes are less in retirement than working?

Just as if taxes went up in retirement the Roth would be heavily favored, the traditional comes out ahead if taxes decrease.  What is interesting (wink, wink young dividend investors) is if you invest totally in dividends, you are better off in a Roth!

The choice to invest in a Roth should be based on the following:

  1. Income and source of income in retirement
  2. What tax rates will be in retirement
  3. “Intangibles” (e.g. using a Roth for estate planning, having a taxable account for liquidity)

Generally speaking, most people’s income in retirement will be less than what they were bringing home pre-retirement.  Very few people will be able to bring in more than their working income.

We think the Roth investment vehicles are very powerful, especially for those in lower marginal tax rates.  It is not, however, automatic or a “slam dunk” to always invest in a Roth.  We would by no means suggest anyone over the current 25% marginal tax bracket be a shoe in for investing after-tax money in a Roth account.  Yes, you pay fewer taxes now, but you are more than likely to be in a lower tax bracket in retirement, thus your after tax returns will be less.   Roth conversions or maxing out Roth 401(k) & Roth IRA’s are usually best utilized by younger workers (who hopefully have many years of income growth ahead of them), but regardless of age, one should always beware of what their income will be in retirement compared to their income today, their outlook on future tax structure and other “intangibles” such as estate planning or liquidity of other types of accounts.

What we didn’t look at

We aim to provide information applicable to the general readership.  We did not apply any state income or LTCG/Dividend tax.  Also, we assumed in some scenarios that all earnings are from dividends, and this is more times than not completely true.  Therefore, the scenarios in which we did this carry a bit of “penalty,” as some earnings will be growth and taxed at the time of distribution.  Also, tax loss harvesting is not accounted for in taxable accounts (people say that like tax loss harvesting is a good thing).

We’ve attached our spreadsheet for your pleasure (really, so someone doesn’t say, what about this or what about that).  As always, this was created by us, and is therefore our property.  We appreciate a little linky love if used to generate any published material (or if you just think it is cool).



Taxes going up! Taxes staying the same! Taxes going down!

Welcome! from our blüg’s tax research dawghouse based in a sunny spot here in the Milky Way.  Last week, we posted that taxes are more than likely to decrease in retirement.  And, a Grumpy, wisely gave us some push back.  Each and every one of us can toss about conjecture when it comes to future tax rates.  Personally, we like to look at our tea leaves every day to get a reading on future tax rates.

Regardless of who’s kool-aid you’re drinking, prudent retirement planning will require some sort of tax rate assumption.  So, what assumption do we use?  Well, let’s take a look at what you would have paid from 1913 all the way up to 2011 to have some sort of historical foundation to base our guess on.

First off, we should give credit, where credit is due.  The Tax Foundation did some of the heavy lifting for us.  And you can download the same data which we built our tool around here.  We also did some high level research into the Tax Foundation’s data and found it to be accurate to a degree suitable for understanding trends in Federal income taxation.  Furthermore, if you are into minutiae like we are, you should see why the Tax Foundation’s numbers will differ slightly from the IRS’.

Second, we should clear up a common misconception about how American’s are taxed.  The U.S. has a progressive tax system, meaning the more you make, the more you pay.  And more often than not, at a higher tax rate.  If an individual(s) is in the 25% tax bracket, that does not mean you multiply their income by 25%.  All American’s pay the same amount of tax on their first $10,000 (or insert whatever number you like) regardless of what their marginal tax bracket is, so on and so forth.  If this is unknown to you, please see this Wikipedia article, which even includes a sample calculation under the obvious heading.  Now that we all know our marginal tax rate is the amount of tax we pay on our next dollar, not our entire ordinary income, we can proceed.

But why is knowing our marginal tax rate helpful?  For those working stiffs like ourselves, it helps one to determine if the effort of making more income is worth the after tax payout.  It can also help in making decisions such as how much money you should convert to a Roth IRA.  These two reasons are by no means exhaustive.  Let’s pop some incomes into our handy tool and see what poops out the other end.  For this article, we are using $50k, $100k and $200k in 2011 dollars (so, your 2011 $50k spending power was the same in 1913) and a Married Filing Jointly status.

We learn a couple of things from this chart.  First, as stated previously, the more money you make, the higher your marginal tax rate.  And historically, we learn two things: 1) The tax structure changed dramatically in 1941.  We are not history buffs, but there was a war around that time.  We just merely wish to point out this change associated with major events, not to discuss every reason why this change came about (and knowing why is applicable, but a different conversation).  We would not suggest using any tax rate before 1941 for tax planning purposes.  And 2) the late 80’s early 90’s had a “rate bubble,” where higher incomes actually had a marginal tax rate less than some lower incomes.

It is also interesting to note, that for a family making $50k, the marginal tax rate has not changed for the last 25 years!  And the highest it’s ever been is 29% in 1945 and 28% in 1981.  A couple’s effective (or total dollar paid) peaked in 1945 when they had to pay $12,077 (2011 dollars) in taxes for an effective tax rate of 24%.  Oddly enough, the marginal tax rate dropped in 1954 to 22% and held there for 10 years, but less tax was paid in 1981 (marginal tax rate of 28%).

While there is an effective rate localized maximum in 1981, it is interesting that it is less than the 35 year period of 1942 to 1976.  And in fact, a couple has paid approximately 20% to 30% less in taxes the last 35 years than they would have the 35 years prior!

What about those couples making $100k and $200k?  Well, here is a chart with their marginal and effective tax rates.

The conclusion we draw from this chart is, the lower your income, the less variability for effective tax rates.  Also, as you are less likely to have significant tax increases, you also are less likely to have significant tax decreases (we all knew that already, this is just the history to prove it).

If we were to look at even higher incomes, the variability would be even higher!  So, this is another reason to keep your expenses low, you are less likely to experience large variations in your income tax.

So, what to use for your retirement tax rate assumption?  The real risk is a significant change during retirement, not during the accumulation phase.  Most people will be able to react, tack on a few years of saving to account for changes during the accumulation phase.  We suggest entering your income into our tool below to see what you would have paid historically.  And make sure there is enough wiggle room in your plan to cover the highest tax rate since 1941, plus a few percentage points (more if you are a “high” earner).  And if you often sport a tin foil hat, perhaps a few more.  There is some point where enough is enough and you’ll have to accept some risk, unless you want to work into the grave.  We’ll go over how to build in wiggle room in another post (psst…it doesn’t always mean accumulating more).

What we don’t account for

Tax deductions.  We input no tax deductions.  So an interesting exercise would be to compare your annual effective tax rate in these years and see how much you are reducing your taxes through deductions.  If you have dependents or large deductions (e.g. mortgage interest), we would caution you from extrapolating straight into retirement, as those will (HOPEFULLY!!) go away.  State income tax is something we didn’t look at either.  Doing 40 something states didn’t seem like too much fun.  And, there are other ways the gubmint can tax individuals.  Social Security is a prime example and one which is not included in our tool.  Long term capital gains and dividends are not covered and in our opinion, deserve their own post.  Also, some years, for REALLY high income earners, there is a max effective rate that we did not put into our tool (sorry uber rich!).

Our tool can be downloaded here.  Just remember, it was created by us and is therefore our property.  If you use the tool for any calculations or to generate any charts which will be published, we would appreciate a little linky love.  And as always, we are human dawgs, so we can make mistakes.  Please let us know of any errors or improvements that can be made.


401(k) dividend confussion

The Beating Broke blüg recently fielded a reader question asking about why they weren’t seeing dividends on their 401k statements.  The age-old high schooler debate tactic of going on a verbose diatribe without actually explicitly answering the question was employed.  BB, however, did provide some excellent information, albeit a bit jumbled.

Beating Broke did cover that a 401(k) is a tax-advantaged investment vehicle where, regardless if the money is contributed as traditional (pre-tax) or Roth (after-tax), the growth and dividends aren’t taxed until withdrawal (traditional) or never (never say never) again (Roth).  There is actually a third “category” available at an employer’s discretion, if one contributes over the annual limit the contribution is made after-tax and will be taxed again at distribution (stinky).  Since it doesn’t matter when growth and dividends occur or are made (because you get taxed at contribution or distribution or both and not anytime in between), some companies simply capture dividends in a broad “earnings” category.

For example, Mlle Rhodesian Ridgeback currently has a 401(k) plan with a simple and cheesy “statement” simply listing “contribution” in one column and “gain/loss” in another (and a few other columns which are not pertinent for this discussion). Her funds are not open to the publick and don’t carry a ticker symbol.  La Mlle used to work for a company who’s 401(k) plan was administered by Vanguard.  La Mlle liked this much better and she could actually see when and the amount of dividend distributions for each fund, but that wasn’t the main reason she liked her Vanguard plan (a whole ‘nother story).

So, to some degree, it doesn’t matter if you see the dividend distribution or not.  La Mlle knows she is getting dividends in her current 401(k) because she is invested in a S&P 500 index.  Sure it’s nice to see when dividends are paid, but if they are just added to the funds growth, it doesn’t really matter.  It’s not clear to us if “trading” between investment options is always allowed within a 401(k) plan, but if one desired to have dividend distributions sent into other investment options within the plan, they can either move funds around within the plan or change their contribution allocation.

Where the plot thickens is if you invest in an IRA.  Typically, and it is highly suggested, that people go to a reputable mutual fund company (not insurance) for their IRA needs.  Their mutual funds (with ticker symbol and all) can be invested in taxable accounts or tax-advantaged accounts.  Because taxable accounts care (well, really the IRS cares) when the dividend distribution is made and other things like when stocks are sold (turnover), the fund company tracks this for all of their customers.  And that is why you will see dividends on the IRA accounts, but may not see them in a 401(k) (although they are there).

Other things we like that Beating Broke mentioned

BB suggested to contribute to a 401(k) to maximize the company match, then an IRA, then back to top off the 401(k) if one is able.  We generally agree this is the advice most savvy investors should follow.  It’s difficult, however, to understand everyone’s situation.  BB recommended a Roth IRA, and that may not be for everyone.  And in fact, any type of IRA may not be appropriate at all depending on income and/or the goals an individual has.  There are other considerations for foregoing the IRA as well.  M. Bichon Frise has a friend who refuses to invest in an IRA because of the ERISA protections offered to a 401(k).  While not a very valid reason in most people’s mind as no one plans to be sued and we don’t know anyone who knows anyone who has been sued.  But this is what helps this individual take his dawggie naps at night.

What we didn’t like

Generally speaking, we are very conservative with our investments.  We understand that the stock market has faltered, but we also believe it will provide returns in the future.  At least that is what our tea leaves told us this morning.  BB mentioned in a comment that he recommended such things starting a business, real estate investment and lending club to increase yield over stock market returns.  We would not recommend these to any family member (even of a different dawg breed), friends or cats who simply desires to invest for long-term savings.  Our view is these are risks that don’t need to be taken for potential and a little additional yield.  Not to mention time, if that is important to you.  But, that is the philosophy in our dawghouse and it’s like arguing over Beggin’ Strips being better than Milkbones (of course, anything with bacon is much better).