How to make the most of a retirement strategy that involves a thrift savings plan, Roth IRA conversions, and charitable giving from a donor-advised fund. (Or maybe a QCD instead.) Also, how to calculate multi-year Roth conversions, and do you lose compound interest when doing Roth conversions? Plus, Joe and Big Al’s thoughts on closed-end funds, a variable annuity rescue plan, and Social Security benefits when working vs. not working.

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Show Notes

(00:45) Retirement and Charitable Giving Tax Strategy: TSP, Donor Advised Funds, Roth Conversions and QCDs (Michael, Sioux Falls, SD)
(10:50) What is Your Opinion on Closed-End Funds? (Paul, MN)
(18:54) Variable Annuity Rescue: How to Work Into the Drawdown Phase of a Variable Annuity? (Kevin, Inver Grove Heights, MN)
(25:03) How Should I Do Multi-Year Roth Conversions? (David, 65657)
(31:58) Understanding Capital Gains and Capital Losses (Ed)
(33:53) Am I Losing Compound Interest If I Do a Roth Conversion? (Paul, Orange County)
(41:38) Social Security Benefits: Working vs. Not Working (Dan)

Free resources:

WATCH | YMYW TV S.5 E.10: Charitable Giving That Gives Back (donor-advised funds)

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Transcription

Today on Your Money, Your Wealth® podcast #317, Joe and Big Al spitball for Michael in South Dakota, who wants to make the most of his TSP, donor-advised fund and Roth conversion retirement strategy. David in the 65657 wants to know about calculating multi-year Roth conversions, and Paul has a very good question too: do you lose compound interest when doing Roth conversions? The fellas also offer their thoughts on closed-end funds and a variable annuity rescue plan for another Paul and for Kevin, respectively, and Dan wants to know about Social Security benefits when you’re working or not working. I’m producer Andi Last, and here are the hosts of Your Money, Your Wealth®, Joe Anderson, CFP®, and Big Al Clopine, CPA.

Retirement and Charitable Giving Tax Strategy: TSP, Donor Advised Funds, Roth Conversions and QCDs

Joe: Michael from Sioux Falls, South Dakota, writes in. Sioux Falls, South Dakota.

Al: Wow.

Joe: How’d he find us?

Andi: What, do you think they don’t have internet there?

Joe: That’s not what I was saying. That’s rude, Andi. That’s Sioux Falls, kind of- I like South Dakota- WalDrug-

Al: WalDrug? That’s what you know about South Dakota?

Joe: I know that. I know the Badlands-

Al: Badlands. Mount Rushmore.

Joe: Deadwood.

Al: Yeah.

Joe: Yeah. Calamity Jane and Wild Bill Hickock.

Al: Got it. Ok.

Joe: Jack McCall, I believe, was the name that killed Bill Hickock? The Dead Man’s Hand? Aces and 8s? Come on, what else?

Al: You know, a lot about it.

Joe: What else you got?

Al: It’s cold in the winter, that’s what I got.

Joe: “To Joe, Big Al and Andi.” He’s very proper. Greetings from the frozen plains of South Dakota.”

Al: It must be winter as he wrote this question.

Joe: “I continue to love your podcast, but unfortunately, it is only a weekly event. I have tried many other podcasts, but most are like those boring instructors we had in school.”

Al: Do you remember this?

Joe: That’s right, Michael. We’re not boring here. “I drive a 2018 Ford F150.” Of course you do- Midwestern. “Do not have any pets, and I’m horrible at writing limericks. However, I have been hitting on Florida Smitty’s wife while he’s out delivering bread.”

Al: Wow, that’s a long drive.

Joe: Oh, I get it. “I continue to keep my garage refrigerator stocked with beverages waiting for your spontaneous drop-in.” This dude is awesome. Michael, you gave me goosebumps. Look at him, Smitty’s wife, out delivering bread. Smitty. You better watch out with your new golf cart too there in the – where’s- like I read something- we lost her again.

Al: Yeah, I forget the town.

Joe: It’ll come to me.

Al: Yeah.

Joe: It’ll come to me. The- like that it’s the oasis for retirees, there’s like 10 women to every guy.

Al: Oh, there you go, right?

Joe: That’s why Smitty’s delivering bread there.

Al: He meets a lot of people down there.

Joe: The- not The Bridges- The-

Al: I don’t remember.

Joe: Alright, whatever. “I’m presently 64 and file jointly with my 62-year-old wife, retirement is about 2 and a half years from now. I have been government employed the past 3 and a half years, thus having FERS, federal employment retirement system, coming and a TSP. I contribute about $40,000 per year to the TSP includes match and hope to have $250,000 in the TSP by retirement.” That is thrift savings plan. “My federal employment retirement will contribute about $1000 a month, which will cover insurances. Our annual income is $250,000 and as of now I look to our retirement needs of $160,000 per year, most likely overestimate. Our savings are $60,000; IRAs, $2,200,000; Roth $300,000. I’m presently maxing out $24,000 bracket with Roth conversion, which is about $100,000 annually. I plan on delaying Social Security till 70, which will provide $4000 a month. We will have some land-” Oh, he’s got some raw land “- providing $1000 a month. Our only debt is our home at $120,000 with 2.5% interest rate.” All right. You got all that, Al?

Al: Yeah, I’ve got it.

Joe: So he’s got $2- uh- 2, 3, 4, call it $2, –

Al: He’s got about-

Joe: $2,800,000?

Al: Yeah, $2,800,000, I guess when you add the- you’re adding the future TSP. Call it about $3,000,000. We’ll round it to $3,000,000. Easy.

Joe: Good enough. And then he’s going to have $120,000- so roughly about $130,000 in fixed income, $1000 a month there. $48,000 or $52,000 in Social Security plus $60,000 of pension. He’s flush there.

Al: He’s in pretty good shape.

Joe: He needs roughly let’s call it $30,000, $40,000 from the portfolio. Back-of-the-envelope-spit balling here.

Al: Which is no problem. $3,000,000.

Joe: Yeah. What’s that percentage? That’s 1%?

Al: That’s about 1.5%.

Joe: Got it. Thank you. So he’s got some questions, Michael does. “Using a donor-advised fund, I plan on using IRA monies for this. So when it comes out of an IRA, is it income to me and then I get a deduction on my taxes, there’s basically no charge? And what my taxable income is? Like if I take $40,000 out of an IRA, is it basically a wash other than $40,000 less in my IRA account? Does the amount affect the amount I can convert to Roth?” So let’s answer that. So you cannot put IRA dollars directly into a donor-advised fund, you would have to take a distribution, so the $40,000 comes out as income.

Al: That’s right.

Joe: And then you place it in the donor-advised fund and then you get a tax deduction.

Al: That’s right. So I would say, Michael, if you already are itemizing your deduction, what you’re saying is basically true. There’s $40,000 of income in the IRA. There’s $40,000 of additional deduction because you’re itemizing your deduction. Your taxable income will be the same. Your adjusted gross income will be a little bit different. So you may be subject to more limitations, maybe more of Social Security would be taxable, although you’re not receiving it right now. So but here’s the problem, Joe, is a lot of people that, right now, the married standard deduction is, call it $25,000, roughly $25,000, and you’re limited to $10,000 in property taxes and state taxes. So for folks that have in this case, he’s got a mortgage of $120,000, call it 3% less, let’s say $3000 or $4000 a year, something like that. $10,000 in taxes. And let’s say he’s contributing another $2000 in contributions right now.

So if you just take those numbers, that’s about, call it $15,000 just to make the math easy.

Joe: He’s using the standard deduction is what you’re saying.

Al: He’s using the standard deduction. By the time you do the $40,000 IRA money into donor-advised fund, the- from $15,000 of what you’re currently itemizing to $25,000, that just basically gets you to where you start itemizing. So the first $10,000 is wasted, is my point. So it doesn’t always work out as nicely as you’d want to. And because of that, what some people do, if you like this strategy, is maybe instead of $40,000, they do a much bigger number to really take advantage of it, do a big Roth conversion in that year, and then you don’t do donor-advised funds in other years because you’ve probably got to itemize _________ standard deduction.

Joe: But the problem is, is that he wants to use his retirement money to do this. So let’s say if you do $100,000 donor-advised fund, you’re pulling $100,000 from your retirement account. It’s going to show up as your adjusted gross income. So that’s going to be the wash. You’re not going to be able to do a large enough conversion because the deduction is basically wiping out the $100,000 distribution to put in the donor-advised fund. And then you want to do a conversion on top of that. I don’t think the math works.

Al: Well, yeah it does. Because $100,000 in a donor-advised fund, but you only get to deduct $90,000, let’s say, because you’re filling up your standard deduction. You have $100,000 of income. You get $90,000 of deduction.

So, yeah, you didn’t get dollar for dollar, but you got a lot of it. So maybe you could convert $90,000 and be in the same spot.

Joe: Here’s what I do. Michael, wait till you’re 70 and then do a QCD. So then you just take it directly from your retirement account to a qualifying charity. It doesn’t show up on your tax return. Then you can do conversions. It doesn’t mess up with your AGI or anything like that. If you want to give to charity, please give to charity. But if you want to do a larger donor-advised fund to kind of play with tax deductions, wait till 70 and then you can do a qualified charitable distribution. “Also, is there any advantage of keeping my TSP in retirement or would there be preference to transferring it to an IRA once retired?” Me personally, I would transfer it into my IRA just for convenience that I only have one IRA. The TSP is probably a heck of a lot cheaper in regards to I don’t know what funds that you have. TSP is less- I think the IRA you have a little bit more flexibility, but the TSP is a great plan, so that’s a personal preference there. “Thanks so much and let me know if you’re running short on bread or Coors Lite.” This guy is hilarious. I want Michael to write it every week. This guy is awesome. Thank you very much, Michael. You made my day.

Sorry to Schmidty who delivers bread in Florida from episode 309, and Smitty in his golf cart in the VILLAGES from just about every other episode, Joe got ya’ll confused, but Michael didn’t. Anyway, learn more about donor-advised funds and other tax-efficient charitable giving strategies: watch the YMYW TV episode, Charitable Giving That Gives Back, and before you file your 2020 taxes, download the 2021 Tax Planning Guide from the podcast show notes at YourMoneyYourWealth.com. Click the link in the description of today’s episode in your podcast app to go straight there. In the show notes you’ll also find the transcript of today’s episode, and a big banner that says Ask Joe and Al On Air. You know what to do.

What is Your Opinion on Closed-End Funds?

Joe: Let’s go with Paul from Minneapolis. “Hi, Andi, Joe and Al. Love your podcast. Drive a 2014 Jeep Grand Cherokee. And I don’t own a dog. Unfortunately, I’m a lifelong and diehard Minnesota Viking fan. Joe can relate, I’m sure. I’m 62 and married. My wife and I both have been retired for 3 years, I have a $60,000 a year pension, $450,000 in a Roth IRA and $600,000 in a traditional IRA. I plan to wait until 70 to collect Social Security. I have aggressively- aggressively done Roth conversions over the last 3 years. I have a general question. I have been considering investing in closed end funds-” CEFs.

Al: Yes, for sure.

Joe: Yes, I like it. “- which may pay dividends ranging from 6% to 10% a year. Many pay the dividends monthly, which would be a good source of monthly income to bridge the gap until Social Security kicks in. I’ve never heard you discuss CEFs, closed end funds, in your podcast. I’m wondering what your opinion is here on these. Thanks and Go Vikes.” All right, Paul.

Al: Yeah. What’s your opinion on this? What is it first of all?

Joe: Closed End Fund. Well, let’s first explain a mutual fund. Mutual fund is an open-ended fund. So a mutual fund manager purchases- oh man, we don’t- we’re going to blow up the clock on this.

Al: That’s alright. We’ll just do a short segment after.

Joe: OK, mutual fund. A mutual fund manager buys stocks. And then when you buy- stocks or bonds and a whole mix of ______ portfolio within the mutual fund. And then when you buy into that mutual fund, you’re buying shares of the overall fund.

Al: Which owns a bunch of other stocks or bonds, whatever.

Joe: A Closed End Fund is that you have a strategy that’s closed. So it trades. You’re not buying the stocks inside the overall fund. It’s closed. So the manager can do a lot of unique things within the fund. So they can put options on it. That can put leverage on it. They could do all sorts of things within the fund because the fund then just trades on the exchanges.

Al: Because there’s not new money going in or out. So they know what they have. So they’ve got the ability to-

Joe:- do whatever they want to do-

Al:- with these some of these other strategies, which can be more risky.

Joe: A lot of times they are more risky.

Al: Which is why they can pay more.

Joe: Absolutely.

Al: And you could lose more too.

Joe: Yes. And so, no, we’re fans of all different types of investments, but you just have to understand what you’re getting into. So, Paul here, I’ve reached out to Paul because he’s from Minneapolis. All my Minneapolis people, I’ll reach out personal.

Al: Oh very good.

Joe: And I said, hey, Paul, why don’t you help me out here? What are you looking at? You want to buy something that’s 10%. Let me do some little research for you.

Al: Yeah, OK.

Joe: So he sends me like 3 ticker symbols. Or maybe it was a little bit more than that. But I was only expecting- he might gave me 6 but I only looked up 3. Because it’s free.

Al: And what do you find?

Joe: So the 3 that he looked at that were paying 10%, you looked at the underlying asset. What do you think they were?

Al: Well, let’s see- I’m going to say they were stocks, but there were options and leverage in there. This would be my guess.

Joe: Good guess. They were high yield bonds. ____ to 2008, Alan?

Al: Yes.

Joe: Credit default swaps? Remember those?

Al: Oh yeah. Yeah. Derivatives, all that stuff. None of us knew what was.

Joe: Yes. I mean- they’re paying- exactly. So they are paying 10% but they’re extremely volatile and they’re extremely risky. So when you- anytime you see 10% dividend, I’m not saying it’s fake, of course, they’re paying it. It’s a good investment company that’s offering these. But you just have to take a little bit deeper dive. Why would it be paying 10%? OK, if I have sub-subprime loans.

So if I have a subprime loan that I’m purchasing, what does that mean? The interest rate is already high, because someone that purchased that loan-

Al: – they couldn’t get a normal loan from a bank-

Joe: – they couldn’t get 2% that they’re given now. They’re paying 8%.

Al: Yeah. There’s a reason why they have to pay that much interest.

Joe: Exactly. It could be like a jet ski loan from an 18 year old. So they bundle all this stuff together. And so already interest is fairly high and then you add leverage to it.

Al: So now you control more with less money.

Joe: Exactly.

Al: Which can work both ways, just like real estate. When you own real estate and have a loan on it, if it goes down, you lose a lot more because it’s related to your down payment.

Joe: Exactly. Usually closed-end funds will have options on them as well. Puts, calls, they’ll use leverage. But let me just illustrate leverage real quickly.

Al: Ok, that’d be helpful.

Joe: So let’s say you have $1,000,000 and that $1,000,000 generates 7%. And so that’s $70,000 of income. But then you’re like, you know what? I’m pretty good. That 7%, I can continue to get that 7%. So let’s get some leverage going. So then you leverage and you take out a $400,000 note. 40% leverage. So now I’m investing not $1,000,000 Alan, I’m investing $1,400,000.

Al: So that I got that $1,000,000 but I bought $1,400,000 of stock because I borrowed $400,000.

Joe: Exactly.

Al: Got it.

Joe: So then if I get that same 7% that’s close to $100,000. That’s $98,000.

Al: Yeah. So now that feels like 10%, doesn’t it? Because of leverage.

Joe: So you divide that into the $1,000,000, which is my principal is 10% rate of return, roughly.

Al: Got it.

Joe: But then you got to take out the cost of leverage and these big funds, their cost is pretty minimal. And they probably hedge their cost by selling shares to the short sellers and things like that to cover that kind of cost. So it could net out to, let’s say, not 10%, but close to 9%, 8.5%. But it’s still a lot higher than 7%. So that’s leverage. But how about if it goes down 7%?

Al: OK, so now it’s worth, call it. $900,000. Well, I guess your $1,400,000, at that point is now worth, let’s call it $1,200,000. It’s a little more than that. But $1,200,000.

Joe: Right. So it works the same exact way on the other side of the equation.

Al: So now you lost $200,000 on your $1,000,000 investment. So it went down 7%, but you lost 20%. And the numbers are wrong, but you get the concept. It magnifies your gain and magnifies your loss.

Joe: Yes. So when markets are good, leverage is great. It’s like, well, the real estate boom, everyone was giving these liar loans. And then, you know what, the big short, you have these very respectable individuals that they work in a dark place with polls. Buying like, 15 different homes. The Domino’s Pizza guy is buying a $1,000,000 home. Because of the leverage. As markets go up, leverage is great because you only have to put a little bit down and all of a sudden the valuation of that asset is increasing and you only have a little bit of skin in the game. But then also, when that market turns on you, you just have to understand what you’re buying I guess.

Al: Yeah, I think that’s a good point. Some of these closed-end funds, I mean, it’s not just dividends. It’s capital gains, in some cases, even return of capital. So just look and see what you’re getting in terms of that payout.

Joe: Because they’re not going to read the fine print. They’re going to say 10%. 10% sounds good. But how about if that’s, like you said, return of principle? Well, you’re just getting your own money back.

Al: That’s not income.

Joe: Yeah. You get 10%. We made 2%. But we gave you 8% of your money back.

Variable Annuity Rescue: How to Work Into the Drawdown Phase of a Variable Annuity?

Joe: Kevin writes in from Inver Grove Heights. You know where that is, Al?

Al: I do not.

Joe: That’s in the good state of Minnesota.

Al: Really?

Joe: Oh yeah. I’ve been to Inver Grove Heights many, many times.

Al: What’s the distinguishing feature?

Joe: I have no idea.

Al: Trees?

Andi: Apparently there’s no beer there.

Joe: There’s plenty of beer.

Andi: Ok.

Al: Cold in the winter?

Joe: Yeah, it’s like a suburb outside of Minneapolis or St. Paul. It’s kind of in the middle there. “Big fan of the show. The past year was a wild ride, pandemic scare, the Minneapolis St. Paul rioting and sudden early retirement package. Side note, got a call in June from Minnesota IRS investigators about a townhouse that I rented a few years ago from a jailed Minneapolis police officer asking about how I got paid.

Al: Wow.

Joe: Wow.

Al: Full investigation going on.

Joe: Interesting. Wow.

Al: Ever got a call from the IRS on some sort of criminal investigation?

Joe: Never.

Al: Yeah, me neither.

Joe: But I don’t think the IRS calls you.

Al: Well, maybe- I think the IRS-

Joe: This isn’t like-

Al: Well, not what we think of the IRS, but the IRS probably does have investigators that help other departments. Department of Justice.

Joe: I wonder who he was renting his place to.

Al: Yeah, that’d be interesting.

Joe: “Just retired in July at age 62. Rolled over my 401(k) to an IRA $800,000; Roth $500,000; brokerage $500,000; cash $100,000; now collecting $2400 a month pension; holding off Social Security to 68. How would I work into the drawdown phase of a variable annuity of $450,000? $250,000 is principle. I bought this in ‘07 from a family adviser that handled my mother’s finances I inherited and suggested it to me. He was a New York life insurance agent disguised as a financial adviser. He also tried to sell me some magic beans, but I was smart enough for that. But too stupid to understand about annuities. Several years ago, I heard from Ken Fisher say on one of his commercials that he would die and rot in hell before he sold someone annuity. I thought, uh oh, I have one. I did some digging and I found out that it was a pretty pricey type of investment that I really didn’t need. 2017 was the year that I took my finances seriously and started to educate myself about fees and taxes by hitting the Internet and taking control of my money.” All right, Kevin. Well, good for you. You’ve done a great job of accumulating some wealth here. So he’s looking at, what do I do with this variable annuity? $450,000, $250,000 of it is principal. So how variable annuities work in regards to taxation is that it’s first- last in, first out. So what that means is that the principal comes out last and the earnings come out first.

Al: So if you just take a lump sum, it’s going to be all taxable until that $200,000 gain is gone.

Joe: Correct. So he’s got $200,000 roughly of gain. So if he takes $200,000 out, it’s all taxed at ordinary income. The other $200,000 is tax-free. So you want to treat this Kevin, just like an IRA or- first off what I would do, I would shop different variable annuities. There’s a lot of very inexpensive variable annuities that you can now roll your money into without the high fees and cost and everything else. It’s like a variable annuity rescue is what we call it. So there’s products out there that are very inexpensive. But still you’re in the product. So the taxation is what’s the issue now.

Al: Yeah, because if you just- if you surrender right now, you’ve got a $200,000 ordinary income gain. So that’s no fun.

Joe: So but he can 1031 exchange-

Al: 1035.

Joe: 1035. 1031 is real estate, Alan.

Al: Yes, right.

Joe: -1035 exchange that annuity into a low cost priced annuity which I would highly recommend that he do first and then look at a strategy to say, what’s my tax bracket? And then slowly start bleeding those out, depending on what tax bracket that he’s in. So if he’s in the 12% tax bracket, it’s just like a conversion strategy. We would convert IRAs or retirement accounts, let’s say, to the top of the 12% or the 22% tax bracket to get it out of the retirement account into the Roth. In this case, it’s a non-qualified variable annuity. So I would just look at your tax bracket and then start bleeding these dollars out up to a certain tax bracket that you feel comfortable paying tax on.

Al: Yeah, that makes sense. Or you could annuitize it and then roughly half of your payment is taxable and half is not. But you want to first get into probably a better annuity that’s lower cost.

Joe: Yeah, really good point Al, that he could annuitize the contract and then let’s say it’s $1000 a month, hypothetically, of course, $500 would be tax-free. $500 would be- well it’s not exact. But whatever that the pro-rata is within the annuity.

Al: Yeah. It’s roughly half.

Joe: Thank you.

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How Should I Do Multi-Year Roth Conversions?

Joe: David writes in. I don’t know what the numbers represent, Andi.

Andi: That’s his zip code. He actually listed his zip code as the place he was from. And no, I didn’t look it up.

Joe: Yeah, you he did.

Andi: But he does say at the very bottom that he’s got the ugliest cat in the Ozarks. So apparently his zip code is someplace in the Ozarks.

Joe: David, 65657. “Dear Andi, Big Al and Jim.” Oh, I knew this guy was a- oh boy. “I want to do a multi-year Roth conversion on a $500,000 IRA. I need to know the optimal amount to convert. The host of a competing podcast advised me to convert the maximum possible while staying in the 0% tax bracket. This amount usually equals the standard deduction. While doing this, the IRA increased from $450,000 to $510,000 and it looks like a tax time bomb is developing. Could you tell me a sweet spot for my Roth conversion or recommended software that calculates multi-year Roth conversions? I’m 64, my only income is $17,000 in Social Security, no dependents. I am a minimalist, living in the Ozarks where the cost of living is low. My total spending last year was $12,000.” I think Alan spent $12,000 this morning. “I have other funds and could afford to make a much larger conversion even to the top of the 12% tax bracket or higher, if that would be the optimal long term strategy. I will always be in a low tax bracket, but my ____ marginal tax bracket is 22% or higher. I drive a 2005 Honda Accent and feed two feral- feral-”

Andi: – feral-

Al: – feral-

Joe: What the hell’s feral cat?

Andi: Wild.

Al: Wild.

Andi: Stray.

Joe: Thank you.

Al: Non-domesticated.

Joe: “- one of which is the ugliest cat in the Ozarks.” All right. So David 65657, is hanging out with ugly- ugliest cats in the Ozarks.

Andi: In his Hyundai Accent.

Joe: And spends like $2 a day.

Al: Right.

Joe: OK. So his only income is $17,000. What does he do, Al? I would say convert to the top of the 12% tax bracket and I don’t know what competing podcast that you’re listening to, but 12% is pretty cheap. You could- his RMDs are not going to be that much but he- if his income is $17,000, he’s 62 years old and he’s got $500,000 in the retirement account. If he doesn’t do anything with the money until he turns 72,10 years, it could double. So now he’s got $1,000,000.

Al: Yeah. It could.

Joe: And his required distribution at that point will be roughly $40,000. So if I look at $40,000 plus $17,000, that’s $57,000 minus let’s say the standard deduction will be, I don’t know, call it $20,000, in 10 years?

Al: Yeah, well, we don’t know if he’s single or not. Probably single.

Joe: Well, it’s David 65657. Come on here. He hangs out with ugly-ass cats.

Al: OK, I’ll go with that- he’s single. So. Right. Yeah, call it $15,000. We’ll say the taxable Social Security will be $15,000. $40,000 plus $15,000 is $55,000 minus $15,000. So $40,000 is the taxable income which right now is the top of the 12% bracket which will become 15% in 2026. So it seems to me at the 12% bracket’s actually a pretty good deal.

Joe: So hopefully you caught that, David. You just want to look at if- he doesn’t need the money, if you just let it grow in 10 years, let’s say it doubles depending, of course, how it’s invested. We’re just using the rule of 72 here. So now it’s $1,000,000. Roughly your required distribution is 4% of that. So that’s $40,000 that is mandatory that you have to distribute out of the plan. Plus your Social Security or half of your Social Security will be taxed, or 85% of it.

Al: Yeah, right. Probably 85%.

Joe: Then you can take out the standard deduction to kind of guesstimate where your tax bracket is going to be.

Al: Yeah, that’s really the way to think about this, is what’s it going to be when I hit age 72. That helps you decide what tax bracket to convert right now. The tricky part about this, Joe, is the $17,000 that he’s receiving, actually SSDI, his taxed Social Security Disability Income. It’s tax-free. Well, it’s tax-free currently. Because there’s not enough income. But when you add a Roth conversion, then up to half or even up to 85% of that’s taxable. So you kind of have to maybe run some projections. If you really want to get this right, David, me being a CPA, an accountant, I would go buy Turbo Tax and at look at how much tax at different levels and play around with it. Because what you’re- and then when you figure out how much tax you’re paying, divide that into the amount of the Roth conversion to figure out your effective rate.

Joe: Because if he converts to the top of the 12% tax bracket, his tax rate’s not 12%.

Al: It’s going to be higher isn’t it? But because he’s going to have more income, that’s all of a sudden now taxable.

Joe: Exactly.

Al: So that’s the hard part about this.

Joe: So that’s probably why the compete- we don’t have competition here, first David.

Al: We just have a chat show.

Joe: Yeah. I mean, they’re probably way better than us. We’re on the bottom of the barrel. Well, thank you for saying that we’re competing with someone else. That’s probably why they said just go to the standard deduction because they didn’t want to get in all the minutia that you just did.

Al: Yeah, exactly.

Joe: They went, I’ll just go to the standard deduction.

Al: That’s what I- if I was wanting to do this right, that’s what I would do. I would buy Turbo Tax and play around with this and see what the different levels come out to. You probably don’t want to convert in the 22% bracket because you’re not going to be in that bracket anyway. So I wouldn’t do that. So 12% bracket or lower.

Joe: Yeah, without question. But the 12%, when he gets his tax bill he’s going to be like, well I thought those guys said I’m going to pay 12%. But no, every dollar that you add of taxable income, it makes one dollar or, you know, added to tax of your Social Security that is currently tax-free depending on where you fall in those thresholds.

Al: Yeah, that’s right. Because when you don’t make any other income, the Social Security is generally 100% tax-free. But as you have other income, in some cases half of it’s taxable, in other cases, 85% is taxable. So when you get to a certain level, you add another dollar Roth conversion and all of a sudden, oops, now I’m going to add another 50% of Social Security, which now is taxable. That’s why this is tricky. That’s why if you really want to do this right, you get maybe some software, maybe Turbo Tax or some related software and just play around with it. But don’t go into the 22% bracket. You don’t need to.

Joe: Yeah. Have fun with your feral cats, David.

Al: Feral.

Joe: Feral. Feral?

Al: Feral.

Andi: Feral.

Joe: Like Will Ferrell?

Al: Yes.

Joe: Got it.

Al: Yeah, he’s feral.

Joe: He’s definitely feral.

Understanding Capital Gains and Capital Losses

Joe: We got Ed writes in. “I sold a big stake in one of my stocks in 2020 for an $80,000 loss. I had no other gains or losses in 2020. I plan on using $3000 towards ordinary income in my 2021 tax return. If I sell another stock in 2021 for a big gain, let’s say $65,000, can I apply what’s left of my $80,000 loss for my 2020 against the $65,000 gain? Thank you.”

Al: The answer is yes, very simply. So when you have a capital loss then the IRS allows you to use that loss against any other capital gain. And once you’ve done that, and in this case, there are no gains for 2020, you get to take $3000 against ordinary income. You carry over $77,000 loss Ed, and that whole loss is available towards 2021 capital gains. So you get the answer that you want. Which is why we talk about a concept called tax loss harvesting, which is when you have a loss position, go ahead and sell it, buy something similar, so you’re still in the market, create that loss, because you never lose it. It carries forward for the rest of your life and you at least get to take $3000 deduction against ordinary income and you get to take dollar for dollar against any future capital gains in any future year until it’s all used up. So it’s a good deal.

Joe: Very good. Thanks, Ed. Just FYI, we like to know where you’re writing from- kinda failed and didn’t follow directions.

Al: We don’t know the car. We don’t know the dog’s name.

Joe: Yeah. If he’s got- what do they call them? feral?

Al: Feral cats?

Andi: Feral cats?

Al: Right. You never heard that term?

Joe: Never.

Al: Ok.

Joe: Never.

Andi: It’s used pretty commonly in Australia to actually refer to humans as being feral.

Al: Well, that sounds right.

Joe: See? I learn just as much on this show.

Al: As we all do.

Joe: It’s a give and take. It’s a give and take.

Al: Yeah, you’re right. We all learn on the show.

Joe: Not much, but we do learn.

Am I Losing Compound Interest If I Do a Roth Conversion?

Joe: Paul from Orange County writes in. “Hello, Joe, Al and Andi. Got a Roth conversion question for you.”

Andi: Imagine that.

Joe: I can feel the excitement, all the way from OC. “I’m 47 years old, earning about $55,000 a year. After expenses deductions, I normally end up in the 12% tax bracket. Thank God for my Prius that gets 57 miles to the gallon.” 57 miles to the gallon.

Al: That’s pretty good.

Joe: I guess I don’t ever know-

Al: You don’t check?

Joe: No.

Al: Doesn’t your car tell you miles per gallon? You’ve got one of those new cars with all the bells and whistles, right?

Joe: No.

Al: It’s one of- just push the button-

Joe: I don’t know what button to push.

Al: – on the dash and it’ll tell you.

Joe: Absolutely no idea. I don’t push any buttons, Al. The only button I push is start.

Al: Got it. Mine is about 23.

Joe: Gas guzzler.

Al: It’s not a- well it’s not 15, but it’s not 57.

Joe: “I’m in the beginning years of gradual Roth conversions. Currently, I’ve got $390,000 in my rollover IRA and about $50,000 converted to a Roth. Is there any advantage in keeping at least some cash in the traditional IRA? Or is it recommended that I just keep converting gradually, say, $15,000, 20,000 per year until it’s all sitting in the Roth for when I retire in my 60s? Am I losing any compound interest dollars by doing this? Thank you all for the great information. I’ve been learning a ton.” Really interesting point. So what he’s saying is that, if I do the conversion, am I losing compound interest? Because maybe it’s a lower balance because he had to pay some cash on it.

Al: Sure, some tax.

Joe: What’d I say?

Al: Cash.

Joe: Yeah, well, taxes- you pay your tax with cash. So let’s say if I have $100,000 and I convert and now I only have let’s say $80,000 because it costs me $20,000 in tax to do the conversion. Am I losing money here? Am I- is the compounding effect- Am I hurting myself by doing this? This is a fairly common question I think we get sometimes. What’s the answer?

Al: Well, the answer- the straight mathematical answer- although you’ve got intangibles to add to it- the straight mathematical answer is if you’re in the same tax bracket today that you’re going to be in retirement, it’s same same. The numbers work out the same. Yeah, you’ve got a lower balance and less to grow, but you don’t have to pay tax on it. So when you do the math, it works out exactly the same. So if you end up converting in a higher tax bracket then you will be in retirement. Then I would concur. You might be hurting yourself in the long term. But there’s other intangibles, such as when you don’t convert, you have more dollars. And you just- the thing is the tax savings, you generally end up spending anyway. So you kind of can end up in a worse position. That’s kind of one of the intangibles that go along with this.

Joe: This is what people have to realize. They have to take a look at their retirement accounts after tax, but they never do that. So he’s saying, hey, I have $400,000 in my IRA. If I convert that- but he doesn’t have $400,000.

Al: Yeah. Its after-tax, so let’s call it $300,000. Yeah. Whatever the number is.

Joe: Because he’s going to have to pay tax on those dollars regardless. It says $400,000 on your statement today, but you cannot spend $400,000. Is the point. Because you have to pay tax out of that and let’s say yeah, it’s $100,000 embedded tax, that you just don’t see. But then he’s like well I’m not paying tax on that. So that embedded tax is growing for me. So but the longer it grows, you’re still going to have to pay tax on those dollars. Does that make sense?

Al: Yeah, it does. It does. And I think if it- if another way to think about this is, is if by doing a Roth conversion today, you’re in the 22% bracket and you’re going to be in the 12% or even 0% bracket, then you-

Joe: – don’t do it.

Al: – you pay too much tax in the 22% to avoid paying basically a 12% bracket later. See that’s the calculation- this is why it’s important that we tell people you don’t have to convert 100% of your balance. In fact, that’s probably not the right answer for most people. When you count Social Security, that makes it more complicated. And we won’t really get into that. But just the simplicity is if you’re in a higher bracket today than you’re going to be in in retirement, then think carefully about over-converting.

Joe: So I want to do this. We haven’t done this calculation in a while. Real simple, because I want to help Paul out. Let’s say Paul, just to make- because you already made fun of my math skills, I’m going to keep the math really easy. So let’s say that I have $100,000 and I’m in the 25% tax bracket. And that $100,000 is in a retirement account and I pull the $100,000 out of the retirement account. I have to pay 25% in tax or $25,000 in tax. So I’m left with $75,000. That’s my real money there. That’s what I can spend. That’s my net dollar. So let’s say I convert that $100,000 and I move it into my Roth IRA and I have to pay that 25% in tax. So what do I have in my Roth? $75,000. So it’s same same. But now the Roth is going to grow with 100% tax-free. But they’re saying wouldn’t $100,000 grow faster and aren’t I losing compound interest because I have $100,000 over here versus the $75,000 over here. I get it. So let’s not convert. So that $100,000 grows and it doubles. So now I have $200,000. So that’s one Paul- and then now I take the $200,000 out. I paid 25% in tax. What do I pay in tax?

Al: $50,000.

Joe: So my net is $150,000. So- this is boring to you, isn’t it Alan?

Al: Yeah, it is. But that’s because I’ve heard this 1,000,000 times.

Joe: But if I have $75,000. I did the conversion. I convert that, now $75,000 that doubles. What do I have? $150,000. It’s the same, same, same. I don’t lose any compound interest whatsoever because of the taxes that- the IRS wants you to keep it in the retirement account because then they get more tax. Instead of them getting $25,000 in tax, what did they get? They got $50,000 in tax. But if my money’s now sitting in a Roth IRA, how much more flexibility do I have if tax rates go sky high? If I want to take a lot more money out because I want to go on vacation and go buy a new Prius or whatever that I want to do, I’m not going to be stuck. I’m taking the uncertainty of taxes out the window.

Al: Yeah, that’s true. And the key to that example is the tax rate is the same at the beginning versus the end. So this is what we’re talking about. If your tax rates higher now than it’s going to be in retirement, then think twice about Roth conversions. If it’s going to be the same, well, you end up in the same place, but you got more flexibility. If it’s going to be lower- I’m sorry- if your tax rate’s going to be higher in retirement, then I’d be converting all day to try to equalize that out.

Joe: All right. Thanks a lot for the question.

Social Security Benefits: Working vs. Not Working

Joe: We got Dan writes in. “Hi. I’ve been watching and listening to you guys. I have a question. The projected monthly payments go about 6% per year from 62 to 67 and then 8% from 68 to 70.” I think he’s referring to Social Security here, Al.

Al: Yeah, that’s what it would sound like.

Joe: “But I think that assumes I continue to work until I begin withdrawing. If I stop working and stop contributing to Social Security at age 62, would my projected payments still be increased at those same rates? I think I can figure it out with the Social Security website, but that will take me a while to plug in all the information. I was hoping to get a quick answer from you guys. Thanks a bunch.”

Al: Yeah, we might have an answer, right?

Joe: We might. I don’t know. I would probably just go to Social Security, is probably a better answer.

Andi: He’s waited long enough for the answer. He could have gone- he could have walked there-

Joe: I know- like he wrote in, in like 1999. We’re finally getting to it.

Al: We’re a couple of decades behind. He’s been receiving Social Security for 15 years at this point.

Joe: Exactly.

Al: Anyway Dan, so the way this works – so full retirement age right now, depending upon what year you were born, is going from age 66 to 67. So, from age 62, which is the first age that you can receive your benefits all the way to- let’s just say your full retirement age is age 67. It does increase. I think it’s a little bit more than 6%, but roughly 6% per year. Then after that, it’s 8% a year from full retirement age to 70. So what happens is if you stop working, then your benefits stop accruing and you won’t necessarily receive what’s on your Social Security statement because it presumes you’re going to be working until a full retirement age, which is let’s call it age 67. But the truth is, if you stop at 62, whatever that benefit is at that time, that will grow 6%. It’s just not what’s on your statement.

Joe: Well, another way to say it is that if you take it at 62, you’re just taking a permanent haircut. If you’re full retirement age is 66, you take it at 62, it’s a 25% reduction of benefit. So that’s how you have to look at it. It’s a reduction of benefit. And then once you reach full retirement age, then you receive a delayed retirement credit. I think what his answer is- or what his question is, is that- let’s say- because they take a look at 40 years of work history. So, when you look at your statement, they’re going to say here’s 40 years of work history. And so, I’m not sure how old Dan is. Let’s say Dan’s 50. And he doesn’t have 40 years of work history. So, they’re going to assume that Dan is going to continue to work. But I don’t know if they calculate it to full retirement age or to age 60.

Al: I’m pretty sure they calculate the full retirement age on the statement.

Joe: OK, well, that’s- we’re close. Your statement is not going to be exact anyway.

Al: Well, see, what I think the question is, is if I stop at 62 working and I don’t take Social Security, will it still grow at 6%? And the answer is yes, whatever your benefit was and you kind of said it the other way. If you wait till 67- Joe: – you’ll get your full benefit-

Al: – you’ll get roughly 25% more, a little bit more than that now, since full retirement age is 67, but you get your full benefit at retirement age. You get a reduced benefit at 62 whether you’re still working or not.

Joe: So, if he takes it- OK, we could go in the weeds on this now. If he takes it at 62 and he’s still working, then he’s going to receive a reduction in the overall payment depending on how much income that he makes.

Al: That’s true.

Joe: So, you don’t want to make the- you don’t want to take your benefit at 62 if you’re making more than roughly, what, $30,000?

Al: But the point is, whenever you stop working and whatever that benefit is and if you reach age 62 and you don’t take it at that point, it will continue to grow into the next year at roughly 6%.

Joe: But your understanding is this, I’m going to retire Alan, at 46 years old. And I’m not going to work anymore. I’m looking at my Social Security statements today.

Al: Yes.

Joe: You’re assuming that on the statement that Social Security is assuming that I’m going to work at that same level of income until age 67?

Al: Yeah, that’s what it says on the statement. Look at your statement.

Joe: Is it 67 or is it 60?

Al: It’s whatever your full retirement age. I’ll have to pull that out at the break to make sure.

Joe: Well, you’re the one that’s collecting Social Security. I have like 25 years until I collect mine.

Al: Let me clarify. I’m not collecting Social Security, but I am eligible. Put it that way.

Joe: Dan- You should have went to Social Security. You should-

Al: Actually, I aced the answer. Just listen to my answer.

_______

Stick around for the “feral” Derails at the end of the episode.

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