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Andi Last

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Published On

March 24, 2020

If you’re in the 22% tax bracket, does 22% of what you make go to the IRS? How does capital gains tax work with ordinary income tax? Joe & Big Al explain how tax brackets work and they answer your Roth contribution and Roth conversion questions: like what’s the point of a Roth conversion if you’re just leaving the money to your kids? Plus some Mega Backdoor Roth talk, spousal Roth contributions and more.

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Show Notes

(00:53) How Do the Tax Brackets Work?
(06:50) Capital Gains Tax vs. Ordinary Income Tax
(16:07) I’m Fully Funding Roth. Should I Convert the Employer Match From Traditional to Roth?
(20:13) Why Contribute to Roth in States that Don’t Tax Withdrawals?
(28:08) What’s the Purpose of Roth Conversions If I’m Just Leaving the Money to My Kids?
(35:43) The Different Paths to Roth Conversion
(42:41) Can My Spouse Contribute to her Existing Roth IRA?
(45:28) 529 Plan Overseas Withdrawal Strategy: Would I Owe Tax and Penalty?

Resources mentioned in this episode:

WATCH: What is the Qualified Business Income Deduction (QBI)?

Click here to Subscribe to Pure Financial Advisors on YouTube for weekly market updates and commentary from Joe Anderson, CFP® and Brian Perry, CFP®, CFA.

Click here to Subscribe to Your Money, Your Wealth® podcast and TV show on YouTube

Read Pure Financial Advisors’ COVID-19 Response

LISTEN | YMYW podcast # 257: No Tax on 401(k) Withdrawals in My State – Should I Ignore the Roth?

IRS Guidance: 2019 Tax Deadline Extended to July 15, 2020

YMYW Discussion of the Mega Backdoor Roth Strategy:

LISTEN | YMYW podcast # 249: I’ve Maxed Out My 401(k). Can I Contribute to a Roth IRA or Roth 401(k)?

LISTEN | YMYW podcast # 255: Does the Pro-Rata Rule Apply for In-Plan Roth Conversion to Roth 401(k)? Mega Backdoor Roth Contributions

LISTEN | YMYW podcast # 238: Do Spouse’s Accounts Count in Roth Conversions? Mega-Backdoor Roth

LISTEN | YMYW podcast # 265: Roth Rollover Consequences

LISTEN | YMYW podcast # 263: Should I Go All Roth Contributions and Should I Start Converting Now?

LISTEN | YMYW podcast # 251: Can I Contribute to My Traditional IRA After Retirement Accounts?

Listen to today’s podcast episode on YouTube:

Transcription

Until further notice, we’re sheltering in place here in California, thanks to the COVID-19 Coronavirus. Luckily we have answers to lots of your questions that we were able to record before all hell broke loose. So Today on Your Money, Your Wealth®, Steve in San Diego, Cole in your Hyundai Elantra, Shea in New York, David in Chicago, Chris in Texas, Margaret in Virginia, Tennessee Dave, and Sunil, your questions are being answered in this episode. If you’re in the 22% tax bracket, does 22% of what you make go to the IRS? Joe and Big Al will break it down for you. After that, it’s all Roth conversions and contributions, and we’ll wrap it up with a question about taxes and penalties if you take the 529 money and run! I’m producer Andi Last. We’ve got no Steve Miller here, but we do have the hosts of Your Money, Your Wealth®, Joe Anderson, CFP® and Big Al Clopine, CPA.

How Do the Tax Brackets Work?

Joe: We got Steve. He writes in from San Diego. “Hi, Joe and Al (and Andi.)” Did you put that in Andi?

Andi: Nope. Steve does that because you say that every time.

Joe: That you put it in parentheses?

Andi: He adds it so that I get kudos.

Joe: Oh I got it. So props. “I hope you get to stay on the radio as the show just keeps getting better and better.” Oh thanks, Steve. We get one more of those one-star reviews versus 5 stars –

Al: We fold.

Joe: Yeah. So 5 stars we’re on, one stars, we’re out. I’m just letting people know.

Andi: Yeah. Okay.

Joe: “I think we know- I think it would be helpful for you guys to go into some detail about the income tax ladder structure. Up until recently, I thought that if your income goes into the next tax bracket you have to pay the higher rate on your whole income. A few months ago I was listening to another radio show and they mentioned that only the amount in each bracket gets taxed at the bracket’s rate. Is this correct?” Why you cheatin’ on us, Steve?

Al: Because we’re not talking about this.

Andi: Because you’re not on 24 hours a day. He’s got to listen to something else on the radio.

Joe: It’s just heartbreaking. “Could you break down the detail of the tax structure of the brackets for those who make let’s say $50,000 to $200,000 annually? Thanks.” That’s kind of a big gap, Steve. But sure.

Al: Well I could make $50,000 or I could make $200,000. Let’s say I made $50,000. OK let’s say I made $200,000.

Joe: So are you- is Steve single? Do we know if Steve single? Or if he’s married?

Andi: I don’t know that.

Al: So I will go- I’ll just go single, since that’s the first one I got in front of me. So the single bracket, the 10% bracket goes to $9875. By the way that’s taxable income.

Joe: Taxable income line 10 on your tax return.

Al: It’s not gross income. It’s after your standard deduction or itemized deduction, whichever is higher.

Joe: So $10,000, line 10 taxable income. Anything under that. So let’s say you make $30,000 but your taxable income’s $10,000, $20,000 is non-taxable. And so then the $10,000 is going to be taxed at the 10% rate.

Al: Pretty much. $9875 is taxed at 10% and $125 is taxed at 12%. And so that’s his question. It’s like what if I go $1 over into the next bracket is the whole thing taxed at the higher bracket? The answer is No. It’s just the extra amount or the incremental amount or the- whatever went over into the next bracket, that gets taxed at a higher amount. And I do think a lot of people have a misconception about this. And that’s true, like let’s say you’re single and you make I don’t know, $518,000-

Joe: He said $50,000 to $200,000.

Al: Yeah, but now $500,000 now you’re 35%- now you’re over 30%- you’re 37% bracket at $518,000.

Joe: Where’re your glasses?

Al: I think the print is way too small. This is for a 40-year-old, not a 60-year-old. Anyway, I’m just going to say $500,000. You go with that? I’ll round it. So that means some of your income is taxed at 10%, some at 12%, some at 22%, some at 24%, some at 32%, some at 35%, and $5001. I’m using that as a round number. That $1 is taxed at 37%. But not the whole thing.

Joe: So that’s why we always talk about line10. We used to always say line 43, but since they changed the tax returns, line 10 is taxable income.

Al: It’s actually different for 2019.

Joe: They already changed it. It’s line what?

Al: I don’t know. But it’s not 10.

Joe: Because they got such a backlash of how bad that tax return was?

Al: You know why? Because they took a perfectly good tax return that was on 2 pages and they made it 8 pages to try to simplify it. And because they had 2 pages that fit on a postcard. And then they had-

Joe: 15 pages.

Al: -but they had all the same laws. So they had to have 6 supporting schedules for all of the lines that were omitted. So then people didn’t like that. So now they said we’re going to make the postcard a little bit bigger. And they eliminated 3 pages. So now it’s still the postcard which is bigger than a postcard that no one is ever going to put in because of your Social Security number’s on there. But that’s a whole ‘nother point. But anyway, there’s 3 schedules instead of 6.

Joe: Look at taxable income. And then from there then like because we talk about Roth IRA conversions quite a bit it’s like how much should I convert? Should I convert all of it? Should I just convert this? How much? So we look at what tax bracket are you in? And what tax bracket do you think you’re going to be? And then convert to the top of that bracket. So if Steve is single and let’s say he wants to convert to the top of the 22% tax bracket. I’m guessing that’s going to be roughly about $80,000.

Al: $85,000.

Joe: So if he’s making $50,000, you’ve got $35,000 to stay in that 22% tax bracket. If you get all of a sudden a raise or you get a bonus of $5000, you still convert $35,000. But then all of a sudden $5000 jumps into the 24%. Well, not everything is going to be taxed at 24%; just the $5000 additional would be taxed at that bracket.

Al: And we do get that question all the time. Oh, what if I go $1 over? We don’t want to do that. And I have to say well that $1 gets taxed another couple pennies. But that’s it.

Joe: That’s it. So great question Steve. Hopefully, that helps. So look at taxable income. Then you can really start mapping out and planning your tax strategy. So we do talk about that kind of often and I’m surprised, you were probably listening to some other-

Al: We haven’t talked about in a while though.

Joe: Yeah it’s been about an hour. Just go ahead and listen to some other show. Missed it.

Capital Gains Tax vs. Ordinary Income Tax

Joe: So we actually got a voice recording. Who do we got?

Cole: Hello, my name is Cole and I was just calling to ask you a question for the podcast. So, I haven’t really listened for too long, I mostly just started like about a week ago, but I’ve listened to about 10 or so, so far just on my way to work, in my black Hyundai Elantra.

So right now, I have a lot of money that I’ve been investing into a Roth IRA and into my TSP, also in Roth, because I’m in the Air Force. But I was wondering, I wanna start investing even more than the maximum contributions for both Roth TSP and my Roth IRA, which I’m currently maxing out both. And I want to start contributing to my own brokerage account through Vanguard.

So, I was wondering how that works with capital gains tax with your regular tax. So, for example, if I make $50,000 a year now, and I make let’s say $20,000 worth of capital gains tax, I know that it’s a separate tax rate, but does it affect the $50,000 that I currently make on the bottom or on the top?

And what I mean by that is like if I make $50,000 a year and let’s say that that was theoretically taxed at 20% versus if I was bumped up to $70,000, then taxed at 25% because of that, does come to the bottom or the top?

That made no sense but hopefully, you get the idea of what I’m saying because I didn’t really and I just kind of called off the cuff. So thank you so much I appreciate it and I love watching the podcast – well, listening to it – and have a wonderful day.

Joe: Awesome. I know exactly what Cole is talking about.

Al: I do too. Let’s explain it.

Joe: Because- Well first of all Cole thank you for your service. And thank you for letting us know what kind of car you drive because that just made us feel like we were going-

Andi: We don’t know where he is.

Joe: Yeah, where the hell are ya Cole? Where are you driving your Hyundai Elantra?

Al: He’s in the Air Force. He’s in the air all the time.

Joe: He’s flying. He’s Maverick.

Al: Anyway. I know what he’s asking too. But you go ahead.

Joe: So when he’s asking is it on the top or the bottom- because a capital gain has a different tax rate. It could be zero, could be 15% or could be 20% depending on what your adjusted gross income is or what your taxable income is. What he’s saying is that I make $50,000 a year of ordinary income. And if I have $20,000 of capital gains does the capital gains start at the bottom and then all of a sudden push my $50,000 up into the higher tax brackets? Or does the $50,000 stay? And let’s say he’s taxed at a little bit at 10% and a little bit at 12%. And then do the capital gains sit on top of the $50,000? And then from there, those are taxed at capital gains rates. So he can use the bottom brackets the 10% and the 12% or the 22% bracket with ordinary income and then would the additional capital gains sit on top of that? So it doesn’t push his other income into those higher brackets.

Al: Yeah that’s exactly the question.

Andi: Now I actually understand it. I did not know what he meant.

Joe: Is it up or bottom? Is it in? Is it out?

Al: And Cole, you’re going to like the answer because the capital gains always sit on top of ordinary income. So it does not push the ordinary income up into a higher bracket. So let’s just use your numbers of $50,000. Let’s say you’re single. We don’t know that for sure but let’s just say you’re single. So if you make $50,000 a year and with a standard deduction of about what, $12,000 that puts you about $38,000 taxable income which is about the top of the 12% bracket. So that means your salary is going to be- you’re going to pay 10% and 12% regardless of how many capital gains that you have. Now your capital gains sit on top and because your capital gains would effectively push you into the next bracket, which is the 22% bracket. Those are taxed at 15%. So your ordinary income is taxed at the lower brackets. The capital gains because you’re above that 12% bracket is taxed at the capital gains rate of 15%.

Joe: And then plus the state which you didn’t give us.

Al: Well he’s in the air. So it changes.

Andi: In his Elantra.

Joe: It changes. I have a question for you. Because if Cole stays in the 10% or 12% tax bracket, then the capital gains is actually tax-free. So let’s say he’s married now.

Al: OK perfect. So now let’s just say married. And that’s all the income they make and they get it- they double up on the standard deduction. So I’m just going to say it’s $30,000 taxable income just to be simple. And the top of the 12% bracket is about $80,000. Which means now Cole, you could have $50,000 of capital gains to get to that $80,000. And now since you’re in, even combined, on a 12% bracket, the capital gains are tax-free, as long as they’re long term. And a lot of people don’t realize this. When you’re in the lowest two tax brackets, 10% and 12%, capital gains rate is zero at least for federal, not for the state, but at least for federal. And some people ask me, my taxable income is $79,000. So what if I have $100,000 capital gain? Is that all tax-free? No. Only $1,000 of it to get you to the $80,000. Everything else then is at 15%.

Joe: So on the other side though too, because your tax bracket is so much higher because he had that $100,000 capital gain even though your taxable income of ordinary income is still in the 12% tax bracket. People get a little bit confused there as well. It’s like oh well now do I still get at least the $1000 tax-free? Just because my taxable income is so much higher because of all of the capital gains that I receive. But you would still get the $1000 tax-free.

Al: Yeah you would. And so for tax geeks out there let me give you the formula. So figure out your ordinary income and your ordinary deductions like your standard deduction. That’s your ordinary tax. Look at the tax table, figure the tax. Then you add your capital gains on top of that at capital gains rates to figure out what that is.

Joe: How about this? So there’s that net investment income tax comes in right at $200,000 single; $250,000, if I’m married.

Al: And that’s adjusted gross income.

Joe: Adjusted- AGI. And so let’s say that I have $251,000 of adjusted gross income. $100,000 of that was capital gains. So does $1000 dollars get the additional net investment income tax? Or does the entire $100,000 get the 3.8%?

Al: Yeah. Just $1000, if you’re married. Because it’s $250,000. Everything above $250,000- so it’s the lower of the excess amount or the passive income; in this case the capital gains, the passive income. Now if you’re single and the floor is $200,000 and you were at, what did you say? Like $256,000? So then $56,000 is subject to the 3.8% tax, but not the whole $100,000.

Joe: So with just about every tax situation, let’s say if I had a taxable income of $100,000 and I would be- if I was married, let’s say, I’d be in the 22% tax bracket. So some people think, well then all of my income is taxed at 22%.

Al: So I pay $22,000 to the feds.

Joe: But it’s stair steps. A little bit is taxed at 10% and this and that. And once I’m in that bracket, that’s all I’m paying tax on. The same thing is true for capital gains. The same thing is true for net investment income tax. So once you break those thresholds then the only the additional above those thresholds would be taxed at those different rates.

Al: That’s exactly right. And the IRS generally tries to do that so you’re not penalized for going $1 over and have all this giant extra tax. There are exceptions though.

Joe: Yes. What?

Al: One is the ACA credit.

Joe: Medicare premiums.

Al: Yeah. And Medicare. And Social Security taxability. So there are some exceptions there.

Joe: Anything else? Medicare. Social Security. Subsidies.

Al: Yeah. Subsidies. If you lose money on rental properties, you start- as you add income, you also lose losses at the same time. So yeah there are some problems. I’m forgetting the name of it- the 20% small business deduction-

Andi: QBI.

Al: Yeah. Thank you. QBI. Yeah, there are some cliffs there.

Check the podcast show notes for more on QBI, the Qualified Business Income Deduction. John in South Carolina, Andy in Cincinnati, PV, Greg in Florida and our good friend Marcus, we’ve got your questions on deck to be answered next week. I hope all of you are staying safe and healthy, wherever you are in the world. Check out YourMoneyYourWealth.com to learn what we’re doing here at Pure Financial Advisors to keep our employees and clients safe and healthy, and subscribe to Pure Financial Advisors on YouTube to watch weekly webinars with Joe and Pure’s Director of Research, Brian Perry CFP®, CFA, providing updates and commentary on the latest in the financial markets. Click the link in the description of today’s episode in your podcast app to go to the podcast show notes to read the full transcript of today’s episode and to access our updates and webinars. Click the Ask Joe and Al On Air banner and the fellas will answer your questions as soon as they’re able.

I’m Fully Funding Roth. Should I Convert the Employer Match From Traditional to Roth?

Joe: Shea writes in from New York. “Hey, guys. Just recently found your show and I’m a big fan.” Awesome.

Al: Yes.

Joe: “Enjoy the insight. Coupled with the random detours and humor along the way.”

Al: Do we do random detours?

Joe: Never. You’ve got the wrong show, Shea.

Al: Do we ever laugh? I think so many people complain about it.

Joe: Yeah. Because you giggle like a little child.

Al: Apparently.

Joe: You’re Dr. Roth.

Al: That’s right. I need some respect. Come on.

Joe: “I was looking for some advice on retirement accounts. I’m 30 years old and live in New York. I make $225,000 a year. Currently, I fully fund a Roth 401(k) and Roth IRA and my employer matches 5%. I also have money saved in a brokerage account and high yielding savings account outside of retirement. I’ve been debating converting my employer’s match from traditional to Roth and paying the taxes. But I’m also- but I am not sure I should. I kind of like the idea of hedging my tax situation down the road. Curious on you guys’ thoughts given my age, tax bracket. Current traditional balance is $45,000. Thanks and I look forward to hearing what you guys think.” All right. Shea. 30 years old, making $225,000 a year. That’s pretty impressive.

Al: Yeah. That’s about 10 times better than I did at age 30.

Joe: I would say it’s probably a lot more than that. Shea. Just curious, are you single? Or married? Just for tax purposes.

Andi: Ah, okay. I was starting to wonder, Joe.

Joe: “Currently I fully fund the Roth 401(k), the employer matches 5%.” So but Shea’s fully funding the Roth IRA.

Al: Roth and a 401(k).

Joe: I don’t think you can fund a Roth IRA. Shea, you make $225,000.

Al: I would agree with you. Unless it’s a Backdoor Roth.

Joe: Just be careful with that contribution because your income might be too high for you to do a direct Roth IRA contribution. Unless it’s like Al said if you put it into an IRA and then automatically convert it. So the employer’s matching 5%. So the question she has is should she convert the match?

Al: My answer is I don’t think so.

Joe: I don’t think so either.

Al: Because you actually want tax diversification. And so it’s okay to have some regular 401(k) money and have Roth 401(k) money and then in retirement you can pick from either.

Joe: Because there’s- I guess historically there’s always going to be rates that are lower, 10%, 12%. There are standard deductions. So you do want to take tax deductions especially if you’re in that high of a bracket. If you’re single, $225,000, it’s a pretty high bracket. So I get the fact that you want to go Roth IRA and you’re getting the match and you’re like, you know what? Let me just convert the match too and have everything Roth and I’m hedging my tax liability so everything’s gonna be tax-free when I retire. I love that but don’t necessarily be so glued on that because it’s a 5% match. So now let’s say in retirement you have a few hundred thousand dollars that is going to come out taxable. I mean who cares? You slowly leaked that out. You use up the lower brackets. The bulk of the money is gonna be in Roth anyway.

Al: I mean if you talk about when to convert it, assuming that all these tax laws hold for the next 50 years. You would convert it when you’re when your tax bracket’s lower like let’s say between jobs or maybe upon retirement. That would be the better time. But yeah I wouldn’t worry too much about that. I think you’re doing the right thing by getting as much money into the Roth as possible and go for some tax diversification. It’s all right.

Joe: Yeah. So. Okay. Very cool. Thanks, Shea. Hopefully, that helps you out.

Why Contribute to Roth in States that Don’t Tax Withdrawals?

Joe: David, Chicago writes in. “In podcast 257 you responded to Kenny from Granite City regarding Illinois state taxes and whether or not to use a regular 401(k) or Roth 401(k) due to the lack of state tax on withdrawals.” Granite City. We talked about some beer and booze, I believe. I don’t remember 257 to be exact there, David. “So for states that provide a deduction for regular 401(k) but not a tax on withdrawals or conversions, I would contend no one should ever, irrespective of their tax bracket, make a Roth 401(k) contribution. If you desire to do so, you should first make your regular 401(k) contribution to obtain the deduction and then convert. This locks in a 5% effective gain with the same result of having the funds in Roth. For my question, when does it make sense to engage in such a strategy even when you are in the top tax bracket? I already have a significant balances my 401(k), $1,000,000 plus, and these amounts should continue to build due to the company profit sharing and contributions. I plan to work 15 more years. Thank you. Truly enjoy the show.” Very good point David. So David saying hey if there’s no tax on IRA or retirement withdrawals from the state of Illinois, why on earth would you do a Roth 401(k)? Makes no sense.

Al: Because you could otherwise get the deduction upfront.

Joe: And then you convert and you don’t pay the 5% tax for the state of Illinois. Very well said there, David. So a couple of things is that you’ve got to be careful with that strategy too depending. Because I like tax- compounding tax-free growth is something that is kind of forgotten here in the equation. If I convert let’s say $30,000 and still pay the 5% and now that $30,000 is in a Roth and compounding for me over the next 15 years, that $30,000 is going to be something a lot larger, 15 years 100% tax-free. You’re stating don’t do it. Put everything into the regular 401(k) and then convert at a later date and save that 5%. But for me to get the same amount of money into a Roth IRA 15 years from now, that conversion is going to be a lot larger. And the amount of taxes that I’m potentially going to pay to match that is going to be that much larger. Does that make sense?

Al: I think so. I’m still trying to wrap my head around this question.

Joe: Because he’s not paying 5% tax on the withdrawals from retirement accounts.

Al: OK. So but how about a situation where you go ahead and set up the Roth 401(k) now because you’re anticipating moving to another state in retirement? So there wouldn’t be any benefit then.

Joe: No. So what he’s saying is that if I take the deduction- because a Roth 401(k) is after-tax. So you pay 5% state tax, let’s call it 22% federal tax, you pay that. Money goes into the Roth. Make sense?

Al: Gotcha.

Joe: Or let’s say it’s $10,000. I’m going to put $10,000 in my Roth 401(k) plan. I’m going to pay $10,000 federal tax, $5000 state tax, just to make the math really simple.

Al: Got it.

Joe: So that would be $1500 in tax to get the $10,000 into the Roth. Make sense? He’s saying don’t do that, do $10,000 pre-tax. Save that money and then convert the $10,000 into a Roth. Because the $10,000 conversion, you’re not going to pay the 5% state tax on it. So it’s only going to cost me $1,000 in tax to convert that $10,000 because I got the deduction.

Al: So that assumes you can do it as you go.

Joe: Exactly. That was my point.

Al: So it means you have to either have an in-service withdrawal ability or you have to have a Roth option that allows you to do conversions in-plan.

Joe: Right. And if that’s the case then yes, I agree with David wholeheartedly. So you’re making the contribution one year and then you’re just automatically converting it each year, each year, you’re just converting out.

Al: Otherwise you keep it in this account and all the growth is taxable.

Joe: You got it.

Al: At least on a federal level.

Joe: On the federal level and I don’t really care for that. So I might forego that even though I don’t pay tax on the state of whatever state that allows tax-free distributions from retirement accounts. If I can’t do that in-service conversion I think I would still take advantage of the Roth. Regardless- or he said a very kind of a big word- in respective of your-

Andi/Al: -irrespective-

Joe: irrespective- I knew I would screw that up. So what, he’s looking at- he’s planning to work 15 years. When should he start doing conversions? Well, you’ve got to take a look at your tax bracket. You’ve already got $1,000,000 plus in a retirement account. Let’s say 15 years if you’re going to still put in a full 401(k) contribution plus a big profit sharing. I don’t know, that could be $3,000,000. Now you got $3,000,000. 100% of it’s going to be taxed at the federal level which is a lot higher tax rate than the state level. So then you’re like should I- now do I convert? Yeah, but you’re not going to nearly get enough money into the Roth to have a true diversified strategy. I could run the numbers for you until I’m blue in the face and show you that doing the Roth is going to be better for you now given the fact that David has this much money.

Al: And then I’ll go back to my first point. If David moves to another state and he pulls the money out or converts it-

Joe: Oh, I see what you’re saying.

Al: He still pays state tax anyway.

Joe: But who would want to leave ChiTown?

Al: Well that’s a good point. I’m just thinking he might want to come to California.

Joe: But I guess David let’s just take that 5% out right now. Look at what tax bracket that you’re in and that I would run a projection to say 15 years putting X amount of dollars in the 401(k) plan. I have no idea what the profit-sharing component is. I don’t know how much that you are putting in. I don’t know if you’re married or single or how much money that your spouse has and everything else. But right now with 15 years still to go to retirement and you have $1,000,000 plus in a tax-deferred account, that’s only going to create more tax problems in the future. And I bet you let’s say if you’re in the 22% tax bracket, federally that’s going to go to the 25% tax bracket or 28% tax bracket. So you’re doing all this stuff to save 5% where you could be losing 20% in the future. So you can’t just look at everything in a bubble, irrespective of your tax bracket. How’d that sound?

Al: That was clever.

Andi: Sounded like you knew what you’re talking about.

Joe: Yeah. Alan just writes me a script.

Al: And then I can tune out.

Joe: And I just read it.

If you missed the episode Dave was talking about regarding states that don’t tax withdrawals, you’ll find it in the show notes, along with our Roth IRA Basics Guide. And on the subject of taxes, I want to quickly mention that since we recorded the answers to all of these questions, the IRS has extended the tax filing and tax payment deadline for 2019 from April 15th to July 15th for all taxpayers. You’ll find the IRS’ written guidance on these extensions in the podcast show notes. The California Franchise Tax Board has also delayed until July 15, but you’ll want to check with your local tax authorities in other states. So when you hear Big Al say April 15th in a little bit, remember that it’s actually July 15th this year. Now, Tennessee Dave has a question about the purpose of Roth conversions.

What’s the Purpose of Roth Conversions If I’m Just Leaving the Money to My Kids?

Joe: You call him Tennessee Dave? Or does he go by Tennessee Dave?

Andi: That’s what he called himself.

Joe: Was that somewhere later in the e-mail or is that how he started off?

Andi: He signed it “Thanks, Tennessee Dave.” So I just moved to ‘Tennessee Dave’ to the top.

Joe: Got it. Tennessee Dave. “Hi Andi, Joe and Big Al. Love your show. Been listening for about a year now and have a question about Roth IRA conversions.” First time question on conversions Big Al.

Al: Oh yeah. Right?

Joe: “My wife and I are both 61. I retired from full time work this year and will still work part-time for the next 2 to 3 years. My wife retired this year and is no longer working. I’ve been self-employed for the last 25 years while my wife has been a W2 employee. Our 3 children are grown, married, out of the house and on their own. We’ve been blessed with being able to earn a very good income and have been careful with our spending so we’ve amassed decent savings.” Way to go, Tennessee Dave. “Currently our investments are split between regular taxable investment accounts, my SEP IRA, a regular IRAs and my wife’s 403(b). The total in the IRAs is just shy of $2,000,000. We have not done any Roth conversions yet because our income in the past has been in the 35% or higher tax bracket. But now that our income is lower I’m considering it. Will be in the 24% tax bracket this year. I can convert $50,000 or $60,000 for the next 10 years and still stay in that 24% tax bracket and pay the tax due from our regular savings and have enough income left to meet our lifestyle needs. In our situation we will not spend all that we have by the time we die.” OK. Tennessee Dave’s had little thought.

Al: Great situation.

Joe: I’m just kind of painting the picture just thinking about Tennessee Dave, his lovely wife, his children and how blessed he was to make a bunch of money.

Al: It’s a great life.

Joe: “Most of the simulations we have run would leave somewhere between $1,000,000 and $1,500,000 left even if we live into our early 90s, most of which we would leave to our children. If we did Roth conversions, I’m assuming the money we leave them would mainly be the unspent Roth IRA funds.” All right so he’s thinking he’s going to give the kids the Roths. “Which they can let ride for 10 years and take a lump sum distribution and owe no taxes. That is good for them. But what did doing the conversions get me?” Now Tennessee Dave is a little selfish.

Al: Well there’s gotta be something in it for Dave.

Joe: “I love my children.” Kind of.

Andi: He didn’t say that.

Joe: Well it sure sounds like it. “But from my viewpoint it seems to me that all I’m accomplishing by doing a Roth conversion is paying taxes money that I’m likely never going to need and will end up leaving to my children. If I left it all that money in the regular IRAs and did no conversions we just took out the RMDs over the years between 72 and let’s say age 90, assuming a conservative 5% or 6% growth rate over the years, how much would we be left in the regular IRA for them to inherit? And how much would they be left with after that? Or would the account that he used to pay the taxes? How would this compare to inheriting a Roth if I did those conversions?” So he’s looking if I convert or not to convert what the hell’s the difference for the kids? It seems like he’s getting screwed, the kids are going to make out like bandits. He’s like well this sucks. How would-? Right? Is that what you heard?

Al: Yeah that’s what I heard.

Joe: Something like that?

Al: Yep.

Joe: “If the benefit is significant I’m willing to bite the bullet and do the conversions to pay the taxes owed. However the benefit is not that much which is what I contend. Although I love my kids very much I would just as soon not go through the trouble and just let them pay the taxes on the IRA money that they inherit. What am I missing?” Tennessee Dave.

Al: Well here’s what you’re missing, Tennessee Dave. The reason- one of the main reasons that you do the Roth conversions when your income is lower, before Social Security, before required minimum distributions, is that at that point you can actually pull those dollars out, do the Roth conversions while in lower brackets. And that avoids you paying higher taxes when you hit 72 and your RMDs kick in on $2,000,000 of IRAs which could be $3,000,000 or $4,000,000, if you’re 61 now at the time where you start withdrawing the RMDs start. So if I did my math right your required minimum distribution could be $160,000. I don’t know what other kind of income you have. Then there’s Social Security on top of that. Then we’re going back to the old tax rates. You’ll probably be in the 25% to 28% bracket. If you can do some conversions now while you’re working part-time and then maybe that’s for 2 or 3 years then you’re in a lower bracket. You can get a bunch of money out while for sure in lower tax brackets it’ll save you from paying higher taxes later on.

Joe: Tennessee Dave. Here’s the information that we would need or here’s the calculation that you have to take a look at. So your wife has 403(b). She’s not working. I’m assuming she has a pension. I bet they have very high fixed income because if they’re in the 35% tax bracket now they’re still in the 24% tax bracket. Well the 24% tax bracket was the 28% tax bracket that goes to like $300,000 and some dollars as a married couple. So if you’re working part time- so now you’ve got to start taking a look at some different type of tax planning here. If you’re in the 24% tax bracket as a married couple and your wife is no longer working and you’re working part-time and you’re still in that higher bracket, double check to make sure that you’re in the 24% tax bracket, Tennessee Dave. If you are, then where’s the new income sources coming from? Do you have a pension? And how big of part-time income do you have from your self-employment? Because you might be able to shelter some of that and do even larger conversions. So I mean there’s all sorts of different tools that you could use depending on what the overall situation looks like. But saying you got $2,000,000 in retirement accounts, you’re probably not going to spend it all. And then you’re looking hey I’m still going to have a $2,000,000 left over. I’m just going to draw some money of this out have a conservative growth rate on it and then the kids are going to get the money. If I do all these conversions and pay all this tax it seems net net I lose and the kids win. I think that the math is off. Because you have to look at your taxable income on your tax return which is line 10. And then compare that to what brackets are from the IRS code to see how much room do you truly have. Because he says 10 years will the tax code is going to change at 5.

Al: And so the key is and you said if you live into your early 90s, your required minimum distributions start at 72. So you get to have roughly 20 years with much higher income still, over and above what you have right now. So consider that tax rate.

Joe: And the RMDs continue to go up. They want you to deplete that account before you die. So it’s not that RMDs stay steady at 4%. It continues to increase the older you get more and more money has to come out of the retirement account and then that’s going to potentially push you up into higher tax brackets. Losing that money, less to kids. Well you don’t care about your kids anyway. I’m kidding, Tennessee Dave. I know you love your kids very much. But you can leverage it even better. You could pay less tax for you. And you could spend more money today. And you could give more to your kids if you do the right planning.

The Different Paths to Roth Conversion

Joe: We got Chris from Austin, Texas. “Greetings to you, Joe, Al and Andi. Even though I’m very tech and social savvy, he’s a late comer to the world of finance though that was out here, so at 63-” I’m not sure what he’s writing-.

Andi: “I’m a late comer to the world of financial info that was out here, so at 63-“

Joe: “- that was out here.” Out here in Austin, Texas?

Andi: No, out in the world, like podcasts.

Joe: Oh. Out here in the world- so he is listening to a podcast-

Al: We’re a podcast. Yeah. All right.

Joe: All right. “At 63, I began my bringing back in these-“

Andi: “binging-“

Joe: Oh, binging-

Al: Binging.

Joe: I thought it said bringing- I got to get glasses. I got to get a new license-

Al: Here, let me pull out my glasses for ya.

Joe: I am 40 years old. My eyes are gone.

Al: Plus, plus, plus, plus, plus-

Andi: Right?

Joe: Wow.”I began my binging back in December and quickly got fixated on your podcast. Your podcasts have top billing now.” Huh. “Thanks for what you offer and the focus you put on Roth IRAs. Even though I binge to catch up with what you’ve covered, I can’t find from you or anyone about the ways you can stumble into a Roth conversion. What I mean is, I did a Roth conversion last year by converting $100,000 from a rollover traditional IRA I had into a Roth. All of my reading and prepping had told me that all I had to do was be prepared to pay the taxes on that money for my tax bracket. Then I started running into podcasts and reading, talking about putting money into a non-qualified IRA for the purpose of converting to a Roth IRA and the taxes involved in doing so. I’m not sure what I did now and if it’s going to cost me additional costs at tax time. Can you explain the different paths to converting to Roth IRAs? And if what I did is going to cost me some penalty? Thanks and I hope one day I actually get on your schedule and catch a live show. Hopefully if you answered this one- hopefully if you answer this one by the way, ‘infested with tax’ has stuck with me and a term you should coin.”

Al: It’s a good term.

Joe: Yeah, infested.

Al: That’s what a IRA is. Infested with taxes.

Joe: It’s infested with taxes.

Al: You could say infected too.

Joe: “If so, fits-“

Andi: “It so fits what I’ve learned during my FI indoctrination.” Thank you Andi. “Thank you so much guys. Happy trails.” So Chris is very socially savvy. And he’s doing some Roths and how many ways can he do a Roth conversion? Is that what he’s asking?

Al: I’m a little confused. Let’s go back. “What I mean is I did a Roth conversion last year by converting-

Joe: Do you think he like talked it versus typed it? He used one of those dictating-

Al: Maybe. He did $100,000 conversion from a traditional IRA. “All of my reading and prepping it told me that all I had to do was be prepared to pay taxes on the money for my tax bracket.” OK. So far. So good.

Joe: So then there’s also confusion here with sometimes people will convert, let’s say $100,000. They’re in the 12% tax bracket. And they think they only have to pay 12% tax on the $100,000. But that $100,000 conversion put them in the 22% tax bracket. So now they have to pay 22% tax on the $100,000 when they said well I’m in the 12% tax bracket. Why do I have to pay 22% on this $100,000 conversion? What the hell happened?

Al: Yeah, it’s not fair.

Joe: It’s because the brackets stair step. So you have you pay a little bit of tax at 12%, a little bit tax at 22%, and so on. So depending on how much income that that conversion is going to do you’re going to pay taxes in different brackets depending on the amount of the conversion. So that could be a source of some problems.

Al: It could be. And just to clarify, as you go into the next bracket it’s only those few extra dollars in the next bracket that get taxed at the higher amount. It’s not the entire income. So let’s be aware of that. But if we sort of go on- I guess he heard about putting money into a non-qualified IRA. What do you think that is?

Joe: I don’t know.

Al: I don’t know either.

Joe: Maybe a non-deductible IRA.

Al: That’s the best I can do too. You probably heard about a Backdoor Roth. And putting money in, not getting a deduction and then doing a Roth conversion, not paying tax on that. Which you can do but not if you have other IRA money because of the aggregation rule and the pro-rata rules. So that doesn’t necessarily work. I think Chris, you didn’t do anything wrong. You do a Roth conversion. You’ll pay tax. That’s what you were expecting. That’s what’s going to happen. You’ll pay tax on April 15th. I will say in certain cases, you may have been required to make estimated payments after your Roth conversion. And if you don’t make those estimate of penalties you could be potentially penalized on April 15th. It’s usually not a huge penalty. But just be aware of that. For some people they don’t want to pay an extra dollar to the IRS which is a lot of people. Just be aware that in some cases you may have to pay the tax before April 15th.

Joe: So yes there are basically 3 ways to do a Roth conversion. One way is an IRA directly into a Roth IRA and you pay the tax on the amount of money that you converted depending on what bracket you’re in. Second, is that you can do a 401(k) into a Roth 401(k) or IRA. So there are inner-plan conversions. I have a Roth component in my 401(k) plan. I could put money from a pre-tax into the Roth component of the 401(k). That’s a conversion. But it stays in the 401(k) plan. Or I could directly convert from a 401(k) to a Roth IRA. The other is that I make a non-deductible IRA contribution and then convert that. In most cases, if you do it correctly, you don’t have to pay tax on the conversion. And the reason why people don’t pay tax on that conversion because it’s an after-tax contribution and they have no other IRAs in their name. And I don’t think of any other conversion you could do.

Al: Well you could do- if you can get after-tax money in a 401(k) and then you can convert that and pay no tax.

Joe: That’s the Mega Backdoor.

Al: Mega Backdoor is what people like to call it. But we have other names-

Joe: – the garage door-

Al: You have other names- you have other thoughts when you say that. Which we won’t repeat here.

Can My Spouse Contribute to her Existing Roth IRA?

Joe: Margaret writes in from Richmond, Virginia. “Hi Joe, Big Al and Andi. Love, love, really love the show. My wife recently retired from her job and I still work and contribute the max to my Roth IRA. Can my wife contribute the max to her existing Roth IRA? Or does she have to contribute to a separate spousal Roth IRA? Thanks guys. Keep up the good work.” Good question. So let’s talk about a spousal IRA. So you’re married, one spouse is not working, but one spouse is working. Both spouses can still contribute to a retirement account.

Al: As long as there’s enough earned income for the one that is working.

Joe: Correct. So $7000 is the max for a Roth IRA contribution.

Al: 50 and older.

Joe: So one spouse needs to at least be making $14,000 a year for both spouses to make that $14,000- or $7000 each contribution. The answer to your question is no. It doesn’t have to be- I mean- that’s a it logically- it’s good thinking. It’s like one spouse is retired. Do they have to open up like a separate account? Does that have to say spousal IRA or spousal Roth IRA?

Al: Because it wasn’t from her income.

Joe: Correct. So the answer is No. You could continue to contribute into the same retirement account. That’s just a term that they use.

Al: And by the way, and we get this question, we have got this question, is it needs to go into her account not yours. Sometimes people get confused about that. It’s based upon your income. But it goes into her account.

Joe: Correct. So one spouse makes the income. Both spouses can make the IRA contributions. Into their own individual retirement accounts. There’s no such thing as a joint account or a spousal IRA account. It’s not going to say spousal IRA. Just their own IRA or Roth IRA. OK. Do we got time for one more or no?

Andi: No. Wrap it up.

Joe: Geez.

Al: Yeah.

Joe: Crabby Pants.

Andi: (laughs) You asked a question, I answered. Come on now.

Whether you call it the Garage Door, the big-ass Barn Door, or the Mega Backdoor, this type of Roth Conversion might be right for your situation. Click the link in the description of today’s episode in your podcast app to go to the show notes and check out Joe and Big Al’s previous discussions of the Mega Backdoor Roth strategy. Now I may have been Crabby Pants and said that we’re out of time, and generally we like to finish up our episodes in about 45 minutes, but Sunil has been waiting for an answer to his question for a long time so we are gonna squeak that in now. Thanks to all of you for your patience as we make it through the email inbox – click Ask Joe and Al On Air in the podcast show notes to send in yours.

529 Plan Overseas Withdrawal Strategy: Would I Owe Tax and Penalty?

Joe: Sunil. He wrote in Alan. Doesn’t give a location. So this must be a first time listener.

Al: Could be.

Joe: Could be. We like to know where you’re at, Sunil.

Al: And we’d like to know what color your car- what type of car you have.

Andi: What kind of dog you’re walking.

Joe: Oh yeah it’s fun. We kinda chat about it. So he writes in. “Hello YMYW team.” So Sunil, if you’re going YMYW, we know you’re a listener. So where are you calling from? Oh and he just writes in “a longtime listener of your podcast. Really enjoy the content and the hilarious answers that make me ROLF.”

Andi: Roll on the floor laughing.

Joe: Oh is that what that is?

Andi: ROFL.

Al: ROFL.

Joe: RO- ROFL.

Al: I would have had no idea what that meant.

Joe: “I have a unique situation. I’m an Indian citizen on a work visa in the USA and am unsure on when I would get permanent residency or citizenship. Hopefully I can stick around for another 5 to 10 years. I have two sons, age 7 and 5, both U.S. citizens by birth. I want to start a 529 college savings plan for both just in case I’m lucky enough to stick around for long and they go to college here. But if I have to go back and if kids decide to do their college in India I might withdraw the 529 plan money. At that point Indian colleges are not 529 qualified international colleges.” Did you know that Al?

Al: I had a good suspicion.

Joe: “I know I will have to pay a 10% penalty on the growth but at that point since I won’t have U.S. income, will I have to pay income taxes on it?” Huh interesting.

Al: Very interesting.

Joe: So he is now in India, Alan. He blows out of the 529 plan.

Al: He’s saying if he has to go back to India and he blows out of the 529 plan, now what?

Joe: Yeah. He doesn’t have any U.S. income. So he’s like well if I don’t have any U.S. income I don’t have to pay any tax. I’ll pay the 10% penalty but I’m not going to pay any tax because I don’t have U.S. income.

Al: Well it depends. It depends- how much income he’s got out of this. Because he has to pay tax on the income as well as penalty. He’s got to do both. So let’s say he puts in $40,000 and it grows to $60,000, let’s just say. And when he when he pulls it out he’ll have to pay tax on $20,000 growth, plus he’ll have to pay 10% penalty on that $20,000.

Joe: So he has zero income in USA.

Al: Except for that.

Joe: So he’s got $20,000 of income.

Al: And if he’s single and the standard deduction is $30,000 let’s just say, he’d have $7000 of income in the 10% bracket. He could owe $700 income tax as well as 10% penalty on $20,000, in my example. So then he’d have another $2000- he’d have $2700 in that example. On the other hand, if he takes a little bit out this year, a little bit out next year to where he stays to negative taxable income. There is no tax but he does have to pay the penalty.

Joe: So how about if he makes $1,000,000 in India and he’s got this 529 plan with $20,000 of growth. So how does that all work? He’s not a U.S. citizen. So he just has to file a U.S. tax return for the $20,000 of growth and take the standard deduction and do it that way?

Al: Yes.

Joe: But now he’s making money in India?

Al: Yes. Because he’s got U.S. source income. So I don’t know much about tax law in India.

Joe: You’re not an expert?

Al: I’ll admit that. But I do know if it were the other way. Let’s just say-

Joe: Well how about if he works for a U.S. company in India?

Al: Well that depends.

Joe: He’s not a U.S. citizen.

Al: Yeah. So he’s not a U.S. citizen. So it wouldn’t matter. So but the basic rule if it’s the other way like let’s just say he’s in the U.S. and he has all this income from India, then he would have to pick that up on his tax return in the U.S.. Because U.S. taxes on worldwide income and then he gets a tax credit for taxes he paid in India. That’s the basic premise of U.S. taxes and foreign income. And that’s true whether you’re a U.S. citizen or you’re just a resident in the U.S.

Joe: So U.S. taxes on worldwide income. But India probably does not tax on worldwide-.

Al: Well, that I don’t know. That’s why I’m saying I’m not an expert on that,

Joe: So he might have to file that income on his India tax return.

Andi: As a dual citizen of the United States and Australia, I know that every country has different rules regarding whether or not they will tax their income, your income depending on where you are.

Al: As a matter of fact, if you’re ever curious about this, every single country has tax treaties with every other country.

Andi: Yep.

Al: So that’s why you won’t find too many accountants that can just spit out the rules. You have to go actually to a specialist-

Joe: You’re not just an average account Al.

Al: No, but I’m-

Andi: He’s Big Al.

Al: I’m average plus, but I’m not an international expert.

Joe: Got it. Hopefully that helps, Sunil.

Al: But I think that does bring up a good point and we’ve mentioned this before but I’ll repeat it again. And that is if you take money out of a 529 plan that wasn’t used for education, for qualifying education, then you do have to pay taxes and penalties. But only on the growth, not on the entire amount.

Joe: I guess for those of you that don’t know what a 529 plan is, it’s a college savings plan that you can invest in that will grow 100% tax free, if used for qualified educational expenses. The SECURE Act kind of opened up a little bit more opportunity there but not as much as I think people hoped.

Al: Agreed.
_______

We do have a couple Derails at the very end of the episode so stick around if you like the non-financial nonsense, and as always, thanks for listening – we appreciate our YMYW community, you guys really make this show what it is with your great emails, voice messages and fun.

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