Financial Planning in Your 20s and Controlling Income Taxes

Joe Anderson, CFP® and Big Al Clopine CPA answer personal finance questions about real estate investments, financial planning in your 20s, retirement, and controlling income taxes from Investopedia in episode 58 of the YMYW podcast. Original publish date August 20, 2016 (hour 2). Note that content may be outdated as rules and regulations have changed.

02:49 – “I have 2 town home units, 9 & 10. I lived in #10 since 2006 and rented #9. I want to sell both and buy a new larger home using capital gains. I will have approximately $200,000 from #10 and $150,000 from #9 in capital gains. The new home will cost approximately $500,000. If I use these gains as down payment for a new home, do I qualify for capital gain exclusion under Taxpayer Relief Act of 1997?”

Answer: To qualify for the 121 tax exclusion you must pass two tests, the use test and the ownership test.  You must live in your primary residence 2 out of the last 5 years to qualify. You can exclude up to $250,000 if you are married and up to $500,000 if you are married.  Since you lived in #10 for at least two out of the past five years and that $200,000 is under $250,000, you do qualify for the capital gain exclusion for that home. However, rental #9 is unfortunately fully taxable at capital gain rates. You could do a 1031 exchange on #9 and buy another rental, but it has to be a rental for a rental – it can’t be a rental for a residence. There’s really no way to roll a gain from a rental into a principal residence.

07:21 – “If you’re in a divorce situation and this applies to you, you want to be careful how you do the property selling.”

08:10 – “How do I become financially strong and independent at 22 years old? I have one full time job ($10,800 annually before taxes). I am 22 years old, single, and have no kids. I have no establish credit. I need to buy my first car and get an apartment or trailer before 2016 ends. Where should I start investing with $1,000? Should I put it in savings or look into binary options?”

WATCH | Financial Strategies for Your 20’s & 30’s

Answer: You are already taking a step in the right direction by taking initiative with your finances, so great job. There are many steps you can be taking right now that can kick start your financial future. Here’s my recommended order of saving: 1) save in 401(k) to employer match, if applicable. 2) Save up to $5,500 into a Roth IRA (Roth IRA is an after-tax retirement account where all future growth is tax-free). 3) Go back to 401(k) and contribute up to max. 5) Save in non-retirement accounts. Set goals for yourself to make sure you save. I recommend saving 15% of your income every year and slightly increase that rate whenever you receive a raise, you will build up a substantial nest egg for retirement.  Make sure you set aside the money you want to use for your apartment and car, don’t invest this money if you plan on using it. Keep in mind that when you build your investment portfolio, you have the opportunity to take on more risk since you have years and years for that money to grow and recover from any setbacks.

09:38 – “Try to set aside 15% of your income at any age and keep doing that throughout your career; you’ll have plenty of money when you retire.”

11:39 – “My mother-in-law is in her 70’s. She will live comfortably on her monthly social security check and has 1/3 of her assets in the bank. She will come into the other 2/3 when she sells her home. What do you suggest she does with the money she gets from the sale? Should she get an inflation hedge and some appreciation while being conservative at her age?”

Answer: Yes, you need some kind of inflation hedge. In terms of how much inflation is a different question. It’s never a good idea to have all your money subject to market risk since you don’t know if you’ll need that money for medical expenses or a long-term care stay .  It’s also not a good idea to have all your money setting in cash or cash equivalents.  What you need to do is take a look at what the money is for, the income need and find the target rate of return to accomplish all of your financial goals.  Then build a portfolio with the least amount of risk to achieve that target rate of return.

15:52 – “A lot of times, people put investments in front of the planning, and that’s where they fall into problems.”

16:53 – “My father sold a piece of property that he inherited in order to pay for assisted living expenses. He passed away the year of the sale. His income was less than $15,000. Does his estate pay capital gains on the property, which gained $144,000 in value from the date of inheritance?”

Answer: It depends upon whether the house he sold was his primary residence or a rental property.  If it was his primary residence and he lived in the property 2 out of his last 5 years of life, he would or his estate would qualify for the 121 exclusion and he can exclude up to $250k in gain.  Since the gain was 144k he would not pay tax.  However it this was a rental property or a 2^nd home there would be a capital gains tax, the capital gains tax gets paid for on his final individual tax return and the tax itself will be paid by the estate. Since his income was only 15K some of the capital gain would be tax few.  There is no capital gain tax treatment for individuals in the 10 and 15% tax brackets.

24:05 – “Do I qualify for backdoor Roth IRA?” I own a 403b, 457b, and DCP account. Do these count towards the pro-rata rule?”

Answer: No, because a 403b, 457b and DCP account are employer-sponsored plans. The pro-rata rules apply for IRAs ONLY this includes SEP IRA’s and Simple IRAS as well if you are self employed.  The Back Door Roth Strategy is used for individuals when there income is too high, you can’t do a normal Roth IRA contribution . Since you own a 403b, 457b and DCP account, those are non-IRAs so they don’t count towards this aggregation and pro rata rule. The phase-out range for Roth IRA contributions if you’re single is $116,000-132,000 and if you’re married filing jointly it’s $184,000-194,000. If you’re below those ranges you can contribute $5500 directly into a Roth each year that you have earned income or your spouse has earned income (if you’re over 50 it’s $6500). If your income exceeds the limit you can’t do a Roth contribution, but you can do a backdoor Roth IRA contribution. You must first put the money into a non-deductible IRA and then you can convert those dollars. Since you originally did not get a tax deduction from contributing the money into the IRA, you won’t have to pay money on the conversion. The problem with this is if you have other IRAs, you have to do the proration or aggregation rule.

For more info on the pro-rata rule, you can read this article: https://purefinancial.com/backdoor-roth-ira/

27:36 – “How should I manage my extraordinary tax year?”

Answer: It depends what the value of the stock is. You might not have to do the NUA this year – I’d double check to make sure you’re getting the right information from the right people on that. Whatever the plan document says is the law. There are many combinations of strategies that you can do, but bottom line is see what the appreciation of that stock is and if it’s worth it to do the full $100,000. You don’t necessarily want to do it if there’s not a large enough gain. You also need to consider your tax bracket, salary, one-year severance and possible charitable strategies to lower your taxes. You do not have to do the entire 100k NUA you could do something less that may make sense depending on what you tax bracket is going to fall.

35:40 – “Unfortunately, tapping your nest egg comes with all sorts of new rules but also opportunities if you understand the strategies.”

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