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Published On

June 9, 2020

Roth IRA contributions and conversions come with plenty of rules: contribution rules, withdrawal rules, safe harbor rules, pro-rata and aggregation rules. In this episode, we explain these rules, and how they apply to both traditional retirement plans, and to accounts like SEP IRAs and thrift savings plans (TSP). Plus, understanding small-cap, mid-cap, large-cap, value, and growth asset classes when it comes to investing.

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Show Notes

(00:57) Estimated Taxes, the Safe Harbor Rule, Roth Conversions, and Capital Gains
(07:26) The Five Year Roth Withdrawal Rules and Steps to Do a Roth Conversion
(19:32) Clarification: Paying Taxes on a Roth Conversion From a TSP
(26:47) Are Excess Roth IRA Contributions Taxable?
(27:51) Will IRA Annual Contributions Ever Increase?
(28:47) Asset Classes: Understanding Small-Cap, Mid-Cap, Large-Cap, Value, and Growth
(37:14) Pro-Rata and Aggregation Rules for Roth Conversions, ERISA Protections, and RMDs

Free resources:

YMYW LIVE WEBINAR | With live, open Q&A with Joe Anderson, CFP®, especially for YMYW listeners! Wednesday, June 10, 12pm Pacific / 3pm Eastern.

Explaining Value Stocks vs Growth Stocks

LISTEN | YMYW Podcast #237: Mad at the Roller Coaster? Then You Don’t Understand the Ride (an investing primer)

LISTEN | YMYW Podcast #262: What’s the Right Retirement Asset Allocation for You?

Listen to today’s podcast episode on YouTube:

Transcription

If you’re listening to this episode on the day it was released, congrats! That means you still have time to register for tomorrow’s live YMYW webinar, happening at noon Pacific, 3pm Eastern. Once again Joe and Big Al will answer your money questions live on camera for free and just for YMYW listeners. Sign up in the podcast show notes – click the link in the description of today’s episode in your podcast app to get there. Today on Your Money, Your Wealth®, we’re talking all about Roth rules: contribution rules, withdrawal rules, safe harbor rules, pro-rata and aggregation rules. Joe and Big Al will explain them and how they apply to both traditional retirement plans, and to accounts like SEP IRAs and thrift savings plans (TSP). Plus, the fellas break down the small-cap, mid-cap, large-cap, value, and growth asset classes, and we wrap up with a giant derail about getting a haircut. I’m producer Andi Last, and here are the hosts of Your Money, Your Wealth®, Joe Anderson, CFP® and Big Al Clopine, CPA.

Estimated Taxes, the Safe Harbor Rule, Roth Conversions, and Capital Gains

Joe: We’ve got David from NYC. He writes in. “Hi all. I have a question about paying estimated federal income taxes and the Safe Harbor Rule. My situation is brief.” As he writes us a full page.

Al: 1, 2, 3 paragraphs.

Joe: “I’m retired and getting Social Security, 85% of which is taxable and my wife is still working. With those two income streams plus cap gains, dividend distributions and interest, minus deductions, our taxable income was about $130,000 so we’re in the 22% tax bracket for 2020 because during the first three months of this year I did a little over $20,000 conversion almost all fully taxable due to the pro-rata rule. And because I expect much larger capital gain distributions from some actively managed mutual funds in our taxable account thanks to the volatility this year and the ongoing outflows, our taxable income should end up just about at the top of the 22% tax bracket or a tiny bit above, at $171,000 and some change. Based on my wife’s pay stubs it’s easy to figure out roughly what her 2020 federal withholdings will be. If the Safe Harbor for our tax liability for 2020 is paying at least 110% of the 2019 tax, it seems the estimated tax would be a simple calculation of the difference between 110% times 2019 tax minus projected 2020 federal withholding paid equally over 4 quarters. But what if those cap gain distributions are much higher than I expect and taxable income ends up closer to $190,000? In some years like this distributions have been ridiculously high, that’s why I’m trying to transition out of active funds. Am I still protected against an IRS penalty by relying on that simple formula? By the way, I have New York state and city income taxes to worry about too. But I’ll leave those aside for now. Hope I’ve provided enough info to get your sage advice.” Thought I was gonna say sage.

Al: Sage.

Joe: Sage.

Al: Sage. We’re sage advisors.

Joe: “Thanks. I’ve been listening to your podcast for a year or so now and I always find it informative and fun.” Thank you David from NYC. Hopefully you’re safe in the epicenter.

Al: Right. Well, let’s break this down a little bit. So what David is saying is he thinks his income tax will be higher this year because of his Roth conversion and maybe higher capital gains taxes. So he’s wondering if he can rely on that rule that we’ve talked about which is to base your estimated payments and/or withholdings on last year’s tax. And so the rule is pretty simple. You take last year’s tax and if you have enough in withholdings, you’re fine. Now if your income is over $150,000 which it appears that David’s is based upon his taxable income numbers then you have to take it times 110%. So what that means is let’s just say your taxes are $20,000 times 110% so $22,000 is your number. If your withholding is $15,000 just to make up a number so you’re short $7000. David what you said is exactly right. Take that $7000 divided by 4 quarterly payments and that’s what you make over the rest of the year. That’s regardless of your capital gains. Your capital gains could be $2,000,000. It doesn’t matter. As long as you paid in 110% of last year’s tax you’re covered. Now certainly you do owe the tax on April 15th of next year so be ready for that big liability but you don’t necessarily have to pay it early.

Joe: So the estimated taxes is always if it’s over $150,000 of income- taxable income or adjusted gross?

Al: Adjusted gross.

Joe: So then if as long as they pay 110% of last year’s-

Al: Yes.

Joe: -and they could have triple the income this year.

Al: Doesn’t matter.

Joe: As long as they pay 110%. And pay the tax due on April 15th, they’re good.

Al: Right. And so the IRS doesn’t care if it’s a withholding or an estimated payment. They’re indifferent. That’s why you look at those together. So you take the 110% times your tax, that’s your number. Then you look at what your expected withholding is. If your withholding is more than 110% your tax, you’re done. If your withholding is less than 110% of your tax, then you take the difference and divide it by 4 and pay that in quarterly payments. The only exception to that is if your taxes are actually going down as opposed to going up. So in other words if 2020, your taxes will be lower than 2019, now you can base it on the current year as long as you’re paying 90% of the current year. But I almost hate to say that rule because people get too confused. But that’s only when your taxes are lower for the current year.

Joe: So what’s the deal like when people are getting penalized because certain income shows up at certain parts of the year?

Al: Oh that’s a good point. That is true. So let’s say you do your Roth conversion now. So we’re recording this in May. So your next estimate of payment in May is June 15th. But what if you just did it then you didn’t know about it in April 15th then you just fill out the IRS penalty form next year with your return, it’s Form 2210, and you use what’s called the annualization method to show when your income spiked. And so basically if you did a conversion now then you’d basically have to make a double estimated payment in June as the catch-up. But you’ll still avoid penalty. And then you’ll make a regular estimated payment for the 3rd and 4th quarter. That makes sense?

Joe: Not even close.

Al: Well here’s my tip for you. After we’re done, rewind the tape, listen to it slowly.

Joe: Because before you said you could just divide it by 4-

Al: Well yeah you can. But if you’re into the year and you’ve already missed the 1st payment, you have to have a little bit different method. That’s why this gets so confusing.

Joe: Got it. Got it.

Al: Then when I throw in the 90% this year’s tax, people stop listening; including you.

Joe: Yes.

The Five Year Roth Withdrawal Rules and Steps to Do a Roth Conversion

Joe: Now people are getting kind of creative with the names here.

Al: I’ve noticed that. I like it.

Joe: I don’t know if I care for that much.

Al: I like it.

Joe: So we got Elwood Blues.

Al: That’s perfect.

Andi: You know the crazy thing is he’s from Missouri, not Chicago.

Joe: Exactly.

Al: Yeah.

Joe: Maybe Elwood moves, maybe to Missouri.

Al: To Missouri, on his road trip.

Joe: Was Elwood Belushi? Or was that Aykroyd?

Andi: I don’t remember.

Al: I think it was Belushi, but I- that’s a 50/50 guess.

Andi: It was Jake and Elwood, right? Wasn’t that their names?

Joe: Yeah, I’m just trying to think of the tattoos on their hands.

Al: Yeah, maybe. Maybe it was Aykroyd then, if it was- I don’t know. Who knows?

Joe: I think it was Aykroyd.

Andi: It was Aykroyd, yeah. I just looked it up.

Al: And you’ve got a- he’s got another name for you too.

Joe: I understand. I just saw that right now. “Hello Big Al, Miss Andi and cousin Eddie, I mean Joe.” What the hell’s cousin Eddie coming from?

Al: I don’t know.

Joe: I’m gonna come to his house with a trailer- with a RV.

Al: You should, right?

Joe: And dump my RV right in his-

Al: Right. You gonna show up at Christmas with no presents?

Joe: Exactly.

Al: – with the kids?

Joe: Well I might give them a nice white pair of shoes. Real potato ketchup Eddie? Nothing but the best.

Andi: Apparently you are cousin Eddie.

Al: He still liked that turkey even though it was so overdone. I do remember that.

Joe: When the thing just exploded?

Al: -exploded and they were all eatin’ the bones.

Joe: It’s a little dry. Little dry. “I have a question for you and I will try to give you as much detail as I can. All I ask is that you shorten it up. Or word it a little better if you use it on the podcast which I hope you do.” Well there Elwood-

Al: I don’t think we did.

Joe: We’re not shortening this thing up and I’m going to butcher the hell outta this. And we’re gonna go. We’re gonna do it. Together. “On January 1st, 2021 my company will be stopping our current pension plan and offering the lump sum pay of which I will take.” So he’s taking the lump sum versus the annuity which would be an income stream. “I don’t know the exact number, but let’s just assume $300,000. I will have it transferred to my IRA and keep making contributions. One question is when I do finalize- when I- one question is when I do have this finalized in the IRA, can I then make the $6000 contribution for 2021 on top of it?” Yes of course. The question is, he’s going to roll the lump sum into an IRA. Since a lump sum is $300,000, Elwood here is curious if he can still continue to make his annual contribution into the IRA. Or does the lump sum count as a contribution amount?

Al: Yes and it doesn’t. So you’re right. So you can go ahead and make that $6000 contribution and the lump sum payout will be in 2021 so you can do the IRA contribution for 2021.

Joe: Yes. And then so you can make the 2020 contribution as well and all the way to April of next year.

Al: Which I think is his next point.

Joe: So he could do both.

Al: He can do both.

Joe: He can do the 2021, April of next year. And do the $300,000 roll from the defined benefit plan into the IRA.

Al: Yeah exactly. Which is a good idea. I agree.

Joe: Here’s the other part of this. “I also have a Roth IRA opened 5 years ago. Am I able to make this transfer into the traditional IRA but then have some of it transferred to the Roth IRA? I understand I won’t have to pay taxes on this amount but is it possible? And if so, am I able to take the money from the Roth let’s say a month later for whatever?” So he’s got a Roth IRA. He’s concerned about the 5-year clock. And so what the 5-year rule is on a Roth IRA, is that the money that you put in a Roth IRA has FIFO tax treatment, first in first out, so the dollars that he’s made as contributions can be pulled out. The 5-year clock really has to do with 59 and a half. So I don’t know how old Elwood Blues is but if he’s using the Blues Brothers and Cousin Eddie-

Al: He’s probably under 50 because he’s using a $6000 contribution.

Andi: He says, if you read a little further down he says he’s age 44, married, gross income $125,000.

Al: Oh, there it is.

Joe: Thank you Andi.

Andi: Sombody’s gotta read them.

Joe: I suppose we could have probably been prepared and read the whole email before we go live on this. So no, he’s 44. So the 59- he could take contributions only. So just FYI, he wants to do a conversion of this money. He can do a conversion of the money, but no, he can’t have access to the converted money for 5 years. So if you convert under 59 and a half, you have a 5-year clock on each of the conversion dollar until you turn 59 and a half. So they don’t want you to convert and then take money out the next year because then that avoids the 10% early withdrawal penalty. So they want you to season the money in the Roth from a conversion for 5 years. Your contributions are available right away. The growth on the Roth IRA dollars is 5 years or 59 and a half, whichever is longer. So if you do a conversion and you need the money you have to wait 5 years until you’re 49 to take the converted dollars. And then you’ve got to wait till 59 and a half to take the earnings out.

Al: Yeah that’s right. But let’s just say you’ve done $40,000 in prior contributions-

Joe: He’s got access to that.

Al: You can take that anytime. In fact as soon as you do a contribution you can take it out the next day. No problem. Any age. It’s just that conversion you got to wait 5 years and then the income part, as you said Joe, 59 and a half.

Joe: “If this is possible, could you please go over these steps with some detail how to make this happen? I count on pay the taxes when putting them on in the Roth. Can you transfer any amount into the Roth if you’re willing to pay the taxes on it?” Yes. The conversion amount is unlimited. So let’s say the $300,000 you get from your lump sum you roll that into the IRA. You make another $12,000 contribution on top of that. And then you want to do a Roth IRA conversion. You can do the conversion up to any dollar amount. Just know that the taxes will be owed the next year. You don’t want to withhold taxes from doing a Roth conversion, especially when you’re under 59 and a half, because you’re 44, if you withhold taxes by doing a conversion. For instance you convert $100,000 and withhold 20% or $20,000 to pay the tax, well that $20,000 is also going to be assessed a 10% penalty because that doesn’t qualify as a legal distribution if you will or a qualified distribution from a retirement account because you’re taking that out to pay taxes on a conversion.

Al: So you pay tax on the $20,000 plus a penalty on the $20,000, both; and federal and state.

Joe: So that’s a huge blow up. So you’ve got to be really careful about how you do these conversions. We’ve seen a lot of different mistakes throughout the years. So you want to do a straight conversion and then just pay the tax outside. So if you’re willing to pay the tax then by all means, go for it. But what confuses me I guess with Elwood Blues here is that he wants to make $12,000 contributions to IRAs, maybe he does a $12,000 to Roth IRAs.

Al: I was just thinking the same thing. That’d be much smarter and do a smaller conversion. That way you have access to that $12,000 if you need it. If something happens.

Joe: “So current age 44, married, my gross income $125,000-” so gross income depending on- yeah, with that type of income too, I’d do Roth IRA. “Wife, substitute teacher maybe $10,000-” I do have a 401(k) at work and started maxing out about 3 years ago, pension buyout could be around $300,000, but he’s got $235,000 in a traditional IRA. The remaining into the Roth IRA minus taxes. When can I have access to the money in the Roth?”

Andi: So he’s saying the pension buyout, he wants to put $235,000 in the Traditional and the rest into the Roth.

Joe: Oh, so $300,000- put $235,000 in the Traditional IRA and the remaining in the Roth IRA minus taxes. No, don’t do that, Elwood. You’re gonna blow yourself up, brother. Even though you’re call me cousin Eddie, I just saved you probably like $30,000 in unnecessary tax.

Al: Agreed. I don’t know about Missouri taxes but in California if you were to do this you’d pay the federal and state tax plus penalty to feds and penalty to state. For a lot of people it comes out to about 50% in taxes, when you add all this together. It’s just a complete waste of money.

Joe: You’ll blow yourself up. Do not withhold taxes by doing this- say well here, with this $300,000 but I’m going to put $235,000 in this, oh withhold some taxes and then put the rest in the Roth IRA. No, absolutely not. That will- because the withholdings is what’s going to blow you up and then the next year you’re going to have penalties and then pay tax on the tax. It would be a nightmare.

Al: We in almost all cases don’t want people to withhold on a Roth conversion but especially when you’re under 59 and a half. It makes virtually no sense.

Joe: Virtually- yes. Zero sense. So put everything into the IRA. And then you take a look at $125,000. He’s got room, he’s got $50,000 of room if he wanted to do a $50,000 conversion in that 22% tax bracket. So then convert $50,000 and just know you’re going to owe $10,000 next April by doing the $50,000 conversion. So you want to make sure that you have $10,000 or something like that of liquid cash to do it or change your withholdings or something like that. If the tax bite is too high then you’d probably do something lower, right?

Al: Here’s a thought. Why not instead of making the Roth contribution, just keep that money for the taxes. You’re paying the taxes with that same money. You’re getting $50,000 in instead of $12,000.

Joe: So in other words you’ve got $12,000 right now that you were going to put an IRAs, keep the $12,000 in cash and convert $50,000. Take the $12,000 that you were going to put in the Roth, just pay that to the IRS to get the $50,000 in.

Al: Use that same $12,000 to get $50,000 in. I like the math there.

Joe: You’re leveraging the taxes. So I hope this makes some sense. “And I would be- there a lot of people that might run out with companies getting way of their pensions.”

Andi: I think that was “bet. I would bet-”

Joe: Elwood, I don’t know, maybe he was a little buzzed when he wrote this e-mail to us. Doesn’t Elwood like to sip on the little candy sauce?

Al: Is that what Missourians use?

Joe: I don’t know. I could go for some candy sauce right now.

Elwood, if you haven’t yet downloaded our Guide to the Five Year Rules for Roth IRA Withdrawals, do it now. It lays out the confusing 5-year Roth clocks and tells you what you can and can’t do in an easy-to-read format based on your age and circumstances. Then pass it on to someone else and tell ‘em you got this great information from Joe and Big Al and that they really should subscribe to the Your Money, Your Wealth® podcast. To download the 5 year Roth clock guide, click the link in the description of today’s episode in your podcast app to go to the show notes at YourMoneyYourWealth.com and click on the banner that says “The 5 Year Rules for Roth IRA Withdrawals” If you still have questions, that’s perfectly understandable! Click the banner that says “Ask Joe and Al On Air” and send in your question as a voice message or an email.

Clarification: Paying Taxes on a Roth Conversion From a TSP

Joe: We have Tim. He writes it from San Diego, Al.

Al: OK. Let’s hear it.

Joe: He goes “Hi Joe and Big Al. The last response I heard from you regarding the rollover caused me some concern. Maybe I just misheard it. I transferred a portion of my TSP IRA to my bank and the next day took a check to the custodian of my Roth. Did I hear correct that the IRS may consider that I touched the funds and get some sort of big penalty? Even though I put the funds into my Roth in much less than 60 days. Some history, for 2018 I did an electronic transfer from my TSP to my Roth late in the year around September but the TSP would not withhold taxes so the IRS sent me a penalty bill which I appealed and won. For 2019 I thought ah, lesson learned and I had the TSP transfer enough to stay within the 24% tax bracket to my bank. TSP withheld taxes then I took a check to put the after-tax remainder in my Roth in less than 60 days. Sorry for the lengthy question. I enjoy the TV and webcast.” So TSP has some funky rules in regards to distributions from the overall TSP. And what Tim is doing is a 60-day rollover in regards to the TSP. But I have no idea how old he is and I’m not sure why he’s doing it this way. Because the TSP won’t go to the Roth component of it. So he’s saying I’m just going to take a distribution and I’m going to roll it back within 60 days. But he’s withholding taxes.

Al: So he has to get other money to make it whole. So I actually think this works.

Joe: Yeah it’s fine. But if he doesn’t- but why- he’s withholding taxes to pay for the conversion but now he’s got to pay the IRA back to make him whole and if he’s under 59 and a half he’s going to get a 10% penalty.

Al: That would be true-

Joe: -and taxable.

Al: Yeah and taxable.

Joe: So he’s doing a conversion and he’s withholding 24% with the conversion. So let’s just say $100,000, roughly $24,000 he’s withholding. $76,000 is what he’s putting into the Roth IRA. Even though he took a distribution on $100,000. If he’s under 59 and a half, he’s rolling the $76,000 back into the Roth within the 60-day period which he can do. But he’s then withholding taxes on the conversion. And then if he’s under 59 and a half, that $24,000’s got a 10% penalty.

Al: But don’t you think it doesn’t because, he got the whole amount back into the Roth-

Joe: He’s not putting the whole amount. He’s not putting$100,000 into the Roth.

Al: That’s how I read it. I think he’s using other money to put the whole amount back into the Roth. And that would be OK.

Joe: Yeah. I don’t think he’s doing that.

Al: Well let’s just pretend. Just humor me. If he was.

Joe: Why would he withhold taxes though?

Al: Well don’t you have to? Out of a TSP? On a withdrawal?

Joe: Good point.

Al: Like a 401(k)? So I think that’s what he’s doing.

Andi: He’s nodding by the way, for the listeners who can’t see Joe nodding at Al.

Al: So that’s what I think. I think he’s trying to make it whole with other money and he can’t get around a withholding. He tried to get around the withholding the year before and the IRS got all over him, I guess.

Joe: Tim, move the money into an IRA and then convert the IRA to the Roth.

Al: Yeah.

Joe: But don’t withhold taxes on the conversion.

Al: I agree with that.

Joe: Because then it doesn’t- the conversion’s probably not gonna make sense. If you need to pay the tax from the- all logistics aside, because what he’s doing is a 60-day roll over into a Roth and I don’t believe he’s making the Roth whole. I believe he doesn’t have outside money to pay the tax.

Al: That could be. But whenever you do a conversion you should have outside money to pay the tax. You have to come up with that somehow.

Joe: He’s paying the tax within his retirement account.

Al: But I do agree it’s cleaner to go from TSP to IRA because then there’s no withholding because that’s a direct transfer from one fund to the other and then you could do a Roth conversion. Obviously there’s no withholding and then you just pay the tax when it’s due. That would be cleaner. The 60-day rule, I think technically it works. But here’s the problem is you can only do it once a year. And if you did it this year on April 2nd and next year you do it on February 28. It’s like you’ve blown it.

Joe. Interesting. This is where people get into problems.

Al: I know. They hear they hear snippets and then they start doing stuff.

Joe: And then they’re like I’ll show them and I’ll work this way around- because the other guy totally blew up that we were talking about before.

Al: I remember one.

Joe: He took a full distribution and he was like I don’t know what the big deal is I keep taking these distributions- and he’s trying to do 60-day rollovers but he did multiple of them that disqualified him.

Al: Yeah. Because the rule is you can only do one every 365 days. So in other words, if you do an April 1st then you have to wait till April 2nd the following year to do the next one.

Joe: So this is where- what the 60-day rollover- when he’s trying to do a conversion makes very little sense to me.

Al: It’s just- it’s more dangerous.

Joe: It’s way more dangerous. So I’m not sure why he’s doing it that way. I’m guessing he’s withholding taxes because he doesn’t have outside money to pay the tax. He’s paying the tax within the conversion.

Al: Well if he’s doing that-

Joe: Stop.

Al: – and if he’s under 59 and a half yes, stop, even over 59 and a half. There’s not a lot of situations where we recommend that.

Joe: Unless there’s millions-

Al: Unless there’s millions and you got no other money and you’re going to be at such a high tax bracket.

Joe: So let’s say if Tim has got millions in a retirement account in this TSP. And he’s also got a pension of like $150,000. And his wife’s got another pension of another $50,000- So very high fixed income. Super high retirement balances. No other outside assets.

Al: No non-retirement assets, then I could- and you’re over 59 and a half. So I could see it then. And we had recommended in that situation, but it’s unusual.

Joe: Right. We talk about conversions quite a bit. Most people think you’re Dr. Roth?

Al: Yeah, Dr. Roth. That’s what my-

Andi: The Roth Brothers.

Joe: The Roth Brothers. Wow.

Al: -my fellow church practitioner, no parishioner, is that what you call it? Parishioner.

Joe: You practice church?

Al: Yeah. I’ve been practicing for a long time. Anyway, that’s what he calls me, Dr. Roth.

Joe: Got it.

Al: Although he is- no, I won’t say it.

We got another one about Roth. So this is in regards to excess contributions to a Roth IRA.

Are Excess Roth IRA Contributions Taxable?

Joe: Richard writes in. Question on excess contributions to a Roth IRA. “If I’m over 59 and a half, do the earnings on my excess contributions to a Roth, will that be taxable? I don’t think it should be taxable because it’s coming out of the Roth.”

Al: It’s taxable.

Joe: It’s excess contributions. You put too much money in.

Al: Because if you weren’t allowed to put it in, the earnings are not allowed either. That’s why. So that takes care of that.

Joe: This is BS.

Al: I think you guys are wrong.

Joe: Yes. So the whole term of excess contribution is- ok Richard, it’s like you putting in as a contribution $50,000 and letting the $50,000 grow.

Al: All that growth should be tax free because it’s in a Roth. No, not if the $50,000 was-

Joe: But the rule is only $7000 contribution and you made a $50,000 contribution, you don’t think the excess growth is taxable?

Al: It’d be cool if it could be. We’d all be doing $1,000,000 contribution every year if we had it.

Joe: All day long.

Will IRA Annual Contributions Ever Increase?

Joe: Are IRA annual contributions ever going up to $7500. Preston writes in. Sure.

Al: The answer is yes. I actually- just for fun I did a little analysis. IRA contributions started, the limit, in 1974 the first year you could do it, was $1500. And it stayed that way to ’81 then it was $2000 for a long time till 2001. Then it was $3000, $4000, $5000, $5500. $6000 started in 2019. The catch-up only started in 2002. So that’s- anyway yeah, it’s always going up; not every year, but over time.

Joe: That’s kind of an oddball question. Been always waiting my whole entire life to put $7500 versus $7000.

Al: I want to put $8000.

Joe: Cool.

Asset Classes: Understanding Small-Cap, Mid-Cap, Large-Cap, Value, and Growth

Joe: Wow, we got Marcus writes in. We haven’t heard from Marcus in a while, have we?

Al: We have not. Tennessee. Where’d we think he was-?

Joe: Tennessee/Alabama. Yeah that’s right.

Andi: That’s him. Yep.

Joe: “Hello Joe. Al, Andi. I have a very, very, very important question for Big Al. Big Al, do you think Carol Baskin killed her husband?

Al: That’s reference to Tiger King.

Joe: Thank you.

Al: Honestly Marcus, I only watched like 3 episodes and I sort of got bored. So I would say she’s a little off. So it could be. I but I’m not going to say yes or no.

Joe: Alan have you seen those signs with Baskin-Robbins? It’s like no relation to Carol. It’s pretty funny.

Al: Right.

Joe: Apparently not. “Just kidding, don’t have to answer that one. Here’s my real question. Could you all explain large cap, mid-cap and small cap? Can a mid-cap company eventually become a large cap company? Next, please explain growth and value. When does a value stock not become a value stock anymore? I’m trying to logically understand the composition of value funds and why they tend to perform better in the long term. Lastly, how does let’s say a small cap S&P 600 index fund differ from a small cap S&P 600 value index fund? They both should contain the same 600 companies, right? Thank you again for an informative, funny and real podcast. Looking forward to multiple episodes of Your Money, Your Wealth® per week.”

Andi: He’s been advocating for that for a long time.

Al: He has. I remember that. Well let’s start with small cap, mid-cap-

Joe: You can do the large cap, mid cap and small cap and I’ll do the value and growth.

Al: That just refers to the value of the company which they call capitalization of the company. So in other words, if a company is worth a 1,000,000,000 in terms of market value that’s its capitalization.

Joe: Just the number of shares outstanding times the stock price.

Al: To figure out the price per share. And so when you’re thinking of a- I’ll go with a mid-cap. A mid-cap is generally considered to be $1,000,000,000 of value capitalization to $5,000,000,000. Although some people actually think it’s a little bit more but we’ll just go $1,000,000,000 to $5,000,000,000. That’s mid-cap, large cap is above that. So those are larger companies, small cap is below that. Very simple. Can one change from one to the other? Sure, as companies grow they can go from one category to the other. And there are times then these funds that get reconstituted like the S&P value index type fund. A couple of times a year they may be kicking out funds that grow past the- now they’re mid-cap and so they should no longer be in that particular fund. So yeah that does happen all the time.

Joe: So value versus growth, real quickly on that. I guess there’s a few different measures that some people look at to determine what is a value stock versus a growth stock. I think we look at price per book value-

Al: -price to book value.

Joe: And so what that means is that a company, you have a market value and then you also have a book value. So there are two different values. What is- a market value is the perceived value that the overall market- the stock market believes that your company is worth. The book value is that, what’s your inventory?

Al: What are your assets worth?

Joe: What’s your assets? You have a balance sheet? I have desks, computers and blah blah blah blah blah. So there’s-

Al: – and maybe you have technology that you capitalized or maybe you bought some other companies and so you got that capitalized. So all that stuff added together is your book value and then you sort of compare that to the market value.

Joe: So if the market value is lower than the book value, that’s a value stock. If it’s higher, it is a growth stock.

Al: That’s oversimplification but that gives you the idea. And so another way to think about this as a value company is one that the stock price is beaten down for whatever reason.

Joe: So if everything is liquidated you know the assets themselves are worth more than the overall stock price that’s trading on the exchange.

Al: And if you think about like a value stock, that’s like a stock on sale. And that’s where Warren Buffett likes to make his money. He buys value stocks when they’re in sale. He doesn’t like to pay full price or excess price.

Joe: So that’s why you will see over time and this is not true in all cases in all timeframes as we’ve experienced value stocks have underperformed growth stocks. But over a longer period of time value stocks will outperform growth just because there’s more risk associated with those types of companies and you’re compensated for that risk.

Al: There’s a reason why the stock price is lower. So it’s more risky to invest in that company. Hopefully it does a big turnaround. And interestingly enough because the stock prices are cheaper if you look at a basket or an index fund that has a whole bunch of companies they tend to outperform over the long term. But you’re right. I mean we’ve had 5, 6, 7 years straight where that’s not been true. Growth stocks have outperformed. But over the long term value stocks because there’s more risk performed better.

Joe: So there’s called mean reversion. So what that means is, let’s say you have a company that is doing poorly or an industry that’s doing poorly. So what happens with that industry is that all of a sudden a lot of the companies that are in that industry go out of business and then all of that business goes to the strong that survive. And what do you think happens to that stock price over time? It goes up because it made it past everything, all the BS. But everything is true on the other side too. So there’s a certain industry that is gaining a lot of interest and people are making a ton of money in a certain area. What happens? They create more competition. As more competition is created, what happens to that stock price? It will go down. So that’s why we believe in indexing. Just so you’re buying all the companies because it’s very difficult to determine who’s going to make it and who’s not, like airlines. Who would have predicted the pandemic? And then all of a sudden you look at is American Airlines- are they going to make it through? If there was no government bailouts, who knows? Alaskan Airlines. Spirit. Who knows what the fallout is going to be? And then so to go back to your S&P 500 value index versus growth index, is it the same companies? It could, but it’s how that index or how that ETF- and I’m not sure if he’s looking at an index fund or an ETF-

Al: Well he says index, but I don’t know. He says- it says “small cap S&P 600 and a small cap S&P 600 value index funds”.

Joe: Are they the same 600- ? To be honest with you, they could. But I doubt it.

Al: I doubt it too because the one- I think that one is going to have all value funds and the other one is probably going to have some growth in it.

Joe: I still think it’s not going to have all value. I think it’s going to be tilted.

Al: It’s maybe titled.

Joe: And then it’s gonna look at the market cap of the overall of those companies and that’s how they’re going to construct the ETF.

Al: You’d have to go to the specific index or fund because everyone’s going to be a little bit different.

Joe: There’s your elementary version of value versus growth and large versus small. Good to hear from you again Marcus. Hopefully that answers your question. Keep them coming. I always like to- hey, has Marcus joined the webinar? I don’t think I’ve-

Andi: Yes, he has.

Joe: Oh yes. All right. Well very cool.

Register for tomorrow’s live YMYW webinar, happening at noon Pacific, 3pm Eastern. Check out our blog post on value stocks vs growth stocks in the podcast show notes at YourMoneyYourWealth.com, where you’ll also find links to previous relevant episodes of YMYW, including a primer on the basics of investing and an explanation on determining the best asset allocation for your retirement portfolio – in other words, how much of those small, mid and large-cap and growth and value stocks you should have in your portfolio. Click the link in the description of today’s episode in your podcast app to access all the free financial resources you’ve heard mentioned, and to read the full transcript of the episode as well. You know that helps sometimes when you’re trying to make sense of Joe and Big Al.

Pro-Rata and Aggregation Rules for Roth Conversions, ERISA Protections, and RMDs

Joe: Andy writes in.

Andi: No I don’t.

Al: Different Andy.

Andi: Yeah.

Joe: He goes “Hey folks. Hope you are safe and we are exiting the pandemic. Three comments, hopefully I’m not wrong. Number one. This was an interesting add to the Roth conversion discussions. If your spouse or you have only IRAs, no SEPS, no IRAs from old 401(k)s, 403(b)s, mainly non-deductible IRAs, your exposed balance using the aggregation breakdown may not produce as much of a tax load especially in a down market. Thus for me with some SEPS or unique IRAs it makes it wiser to convert more of hers versus as her tax load is lower.” Did you follow that?

Al: I think he’s talking about the aggregation rule and the pro-rata rule. And so it sounds like his wife/spouse has less tax consequence of converting and yeah absolutely, then convert that first.

Joe: But here’s- let’s just make sure that people understand the aggregation and pro-rata rule. And it’s not based on couples. IRAs are individual retirement accounts.

Al: And I think maybe that was kind of a breakthrough for him. He didn’t realize that. So each one stands alone for purposes of this rule.

Joe: So let’s say Andy has IRAs that are all non-deductible. And so he was like what I found interesting is that because markets went down my account balance went down. But I still have the non-deductible contributions. So if I did the conversion- let’s say he did $50,000 of non-deductible IRA contributions and the account balances was worth $60,000. The market went down now it’s worth $52,000. He still has $50,000 of basis even though it-

Al: There’s no change there.

Joe: So when you convert now he’s only paying tax on $2000 let’s say versus $10,000. So you are absolutely right there but the aggregation of pro-rata rules from a non-deductible standpoint of what’s tax and what’s not is based on you Andy, and your spouse.

Al: Separately.

Joe: Separately. So let’s say the Andy spouse has all SEP or pre-tax dollars, Andy has all basis in his or her retirement account. Don’t aggregate the two spouses together. Just separate them and I think your math will turn out pretty tight.

Al: I’m agreeing with that comment.

Joe: Because it- but does it- It makes it wiser-

Al: -to convert more of hers first as her tax load is lower. So whichever spouse, whether it’s you or her.

Joe: But why is it-

Al: Well you started by saying if your spouse or you. That’s why it got confusing. Which one is it?

Joe: If your spouse or you- maybe Andy doesn’t have any. He goes “no SEPS, no IRAs from old 401(k), 403(b), mainly my deductible IRAs. Your exposed balance using the aggregation breakdown may not produce as much of a tax load, especially in a down market, thus for me with some SEPS or unique IRAs-” I don’t know what a unique IRA is.

Al: I guess he’s saying SEP is a unique IRA. So it still counts as an IRA.

Joe: So the spouse has the non-deductible IRAs. That’s it, and he-

Al: Or a 401(k) or 403(b).

Joe: Got it. So yes, convert that-

Al: -first.

Al: Ok, we got that one.

Joe: We got it. If the next two are like this it’s gonna be painful.

ERISA Protections

“Maintaining your funds in an old 401 can be benefit with ERISA protection for some specialties. Of course this assumes satisfactory investment options and fee. Some states do allow lawsuits to tap IRAs and certain values.” We don’t talk about this enough and there was a comment I think in our webinar too, or maybe it was maybe one of my webinars that I did or something like that, was like really good content but you’re missing some protection laws. So 401(k)s and IRAs, there’s ERISA protection, if you get sued. So there’s two different types of protections. One if you get sued and the one if you file bankruptcy.

Al: And they’re two different things.

Joe: Two different things. So retirement accounts are protected under bankruptcy. So if you rolled a 401(k) into an IRA you still have the same protections up to $2,000,000.

Al: And if you have an IRA that was originally an IRA, in California, it’s a little under $1,400,000 that you get protection on. That’s on bankruptcy.

Joe: Bankruptcy.

Al: Only.

Joe: So 401(k), you roll into an IRA, it still follows that, that protection rule from 401(k) dollars.

Al: So we’re talking bankruptcy now.

Joe: If you get sued because you ran over someone’s dog-

Al: – or like as he say, certain specialty- certain professions you’re more than likely to be sued. You know like a doctor for example.

Joe: Or CPA.

Al: Yeah, right. And so then it’s a different answer. With the ERISA plans you get protection, IRAs you don’t.

Joe: Depending on the state.

Al: Depending upon the state. And basically as I understand it, I am not an attorney, so take this for what it’s worth. My understanding is the courts will determine what’s fair in terms of how to divvy that up in a judgment.

Joe: Yes. And it’s complicated.

Al: And it could be anything. There is a danger.

Joe: There’s a risk.

Required Minimum Distributions (RMDs)

Joe: “My understanding is that 1) some banks will use your funds to produce a steady drawdown and 2) some mutual fund families or 401(k) sponsors will coordinate RMD distributions which allow you an income stream without losing them into an annuity product which is lost when you or your spouse passes. Thus, wouldn’t your only wild card be isolated IRAs with individual RMDs? Couldn’t you just consolidate these to ease RMDs?” Yes. Consolidate to ease the required minimum distributions. If you have multiple IRAs, you can take one required minimum distribution and satisfy the required minimum distribution just out of one IRA from multiple. If you do have multiple accounts such as a 401(k)- let’s say you have three 401(k)s, and an IRA, you’re gonna have to take required minimum distributions out of each of those different accounts.

Al: And I think that’s confusing to a lot of folks- so IRA- is no matter how many you have, you can pretend they’re one account, take an RMD from one account. 401(k)s, 403(b)s, that sort of thing, gotta take an RMD from every single one you have. So if you had six employers and you kept all those 401(k)s or 403(b)s, you have to take an RMD out of each one. So it’s a good idea to consolidate those at some point.

Joe: So I’m not sure why he’s saying “some banks will use your funds to produce a steady drawdown.”

Al: I don’t know what that means either. Because he’s suggesting if you don’t take enough out then the bank’s going to put it into annuity. I’ve never heard of such a thing. Right? Is that how you read that?

Joe: Unless he’s still talking about protection. Because of the overall retirement account because it’s still gonna be a state by state and are they’re looking at what income and retirement account produces?

Al: Maybe but he specifically says it that puts them- putting them into an annuity product-

Joe: Well I guess if you convert your IRA to an annuity that’s an income stream versus an asset. So some people trying to skirt certain things because you’ve got asset laws and income laws. And so you can’t- so I don’t know what he’s really asking there.

Al: I’m not sure either. We don’t know what state too. So we can’t- every state’s a little different.

Joe: That’s why it’s imperative you let us know where you’re calling from, folks. Because we can just-

Al: And if you’re from California we can help you. And if you’re not, we’ll just do our best.

Joe: “Your insight comments make this subject easier to understand. My wife now takes her walk listening to podcasts-” He doesn’t really say our podcasts. “-so she gets more familiar with financial terms. Essentially when I wax on it’s not Greek to her. Wash your hands frequently and don’t touch your face.” But what the hell’s Andy doin’ with his wife- “-when I wax on-“?

Andi: When he goes on and on about finance, his wife actually understands better because she listens to this podcast, is what he’s saying.

Joe: Oh, wax on- I was thinking of something else.

Andi: Waxing philosophical, you know?

Al: Yeah, that’s how I-

Joe: If I’ve ever said wax on, it’s not that I’m talking a lot. Using Mr. Miyagi. Wax on. Wax off.

Al: Maybe that’s slang for wherever Andy lives.

Joe: Keep waxing on she could get familiar. Because the way he writes, man I feel bad. She needs to listen to this podcast. Because if he talks like he writes-

Andi: She’ll probably have a better understanding of you because her husband is kind of talking in circles like you do.

Joe: I’m not talking- the reason why people say I’m talking in circles is because I’m reading verbatim of what the hell they’re writing to us.

Andi: Right Joe. That must be it. Yeah.

Al: And your answer is rock solid. Tight.

Joe: Dude. Read this-

Andi: Did you just say dude?

Joe: I just- get me all fired up. I was waxing on.

Al: I’m gonna start using that. ‘On, it’s just Joe waxing on again.’

Joe: ‘What are ya doin’?’ ‘I’m waxing on. Leave me alone.’

Al: ‘I’m talking to myself. I’m waxin’ it up.’

Joe: Oh boy. Yeah. Wax on. Wanna wax on a little bit?

Al: This is good. We could have a whole new dialogue here.

Joe: Oh God. I’m sweating now.

_______

Stick around for that big ol’ Derail I mentioned, that is, if you don’t mind giving up four minutes and 23 seconds of your life that you’ll never get back.

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Pure Financial Advisors is a registered investment advisor. This show does not intend to provide personalized investment advice through this broadcast and does not represent that the securities or services discussed are suitable for any investor. Investors are advised not to rely on any information contained in the broadcast in the process of making a full and informed investment decision.