Sean Mullaney and Cody Garrett answer audience questions about taxes in early retirement.
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[00:00:00] Jon: Bogleheads® Live is our ongoing Twitter Space series where the do-it-yourself investor community asks their questions to financial experts live on Twitter. You can ask your questions by joining us for the next Twitter Space.
[00:00:13] Get the dates and times of the next Bogleheads® Live by following the John C. Bogle Center for Financial Literacy on Twitter. That's @Bogleheads. For those that can't make the live events, episodes are recorded and turned into a podcast. This is that podcast.
[00:00:28] Thank you for joining us for the 11th Bogleheads® Live. My name is Jon Luskin, and I'm the host for today. In a first ever, I have not one, but two co-hosts for today, Sean Mullaney and Cody Garrett. Today, we'll be discussing tax planning for early retirees. I’ll rotate between asking Sean and Cody questions that I got beforehand from the Bogleheads® Forum at bogleheads.org and Bogleheads® Reddit and taking live audience questions from the folks here today.
[00:01:04] Let's start by talking about the Bogleheads®, a community of investors who believe in keeping it simple, following a small number of tried-and-true investing principles. You can learn more at the John C. Bogle Center for Financial Literacy at boglecenter.net.
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[00:01:43] Mark your calendars for future episodes of Bogleheads® Live. June 1st, we'll have Robin Wigglesworth discussing his book, “Trillions: How a Band of Wall Street Renegades Invented the Index Fund and Changed Finance Forever.” The following week we'll have Dan Egan, VP of Behavioral Finance and Investing at Betterment. And then the following week, we'll have David Blanchett, Managing Director and Head of Retirement Research for PGIM DC solutions. Future guests include Barry Ritholtz, J.L. Collins, and Jim Dahle of The White Coat Investor.
[00:02:15] Before we get started on today's show, a disclaimer. This is for informational and entertainment purposes only, and should not be relied upon as a basis for investment, tax, or other financial planning decisions.
[00:02:26] Let's get started on today's show on tax planning for early retirees with Sean and Cody. Sean Mullaney is a financial planner offering fiduciary fee-only and advice-only financial planning. Sean is a Certified Public Accountant licensed in California and Virginia. He blogs on tax and financial planning at fitaxguy.com. You can follow him on Twitter @SeanMoneyandTax.
[00:02:46] Cody is an advice-only financial planner passionate about helping families refine their path to financial independence as do-it-yourself investors. As a Certified Financial Planner™ professional, Cody specializes in comprehensive financial plan development, topic research, and personalized financial education. You can follow him on Twitter @MeasureTwiceMNY.
[00:03:06] I received a lot of great questions about tax planning in early retirement today. Thank you to everyone who submitted questions. We might not have enough time to answer all those questions.
[00:03:16] Sean and Cody, thank you for joining us today on Bogleheads® Live. Let's start with our first question on Affordable Care Act (ACA) credits. normchad from the forums writes, “In early retirement there is a desire to do Roth IRA conversions, and that can be at odds with a desire to minimize Modified Adjusted Gross Income (MAGI) for the purposes of maximizing ACA premium tax credits. What are some smart planning steps to keep those two things in mind?”
[00:03:44] Sean: What the correspondent is getting at is a lot of early retirees are on Affordable Care Act medical insurance, and that has the premium tax credit to offset the premiums that you pay for that insurance. It's measured by Modified Adjusted Gross Income (MAGI).
[00:04:03] For the most part, other than the years 2021 and 2022, what happens is that credit falls off a cliff, the moment your Modified Adjusted Gross Income is over 400% of the federal poverty level. You can Google what the 400% of federal poverty level is in any one year. And it increases per person in the household.
[00:04:27] What happens is folks get to, say, 55 years old, and they've got their medical insurance through an Affordable Care Act plan. Other than some interest, dividends, some occasional capital gains, their tax return makes them look artificially low in terms of income.
[00:04:44] The first instinct for planners is, "Oh, great! Let's do some Roth conversions while you're in an artificially low tax rate." Okay, that's great. But we have some guardrails, and the biggest guardrail is that 400% of federal poverty level. This is definitely a roadblock to, hey, let's deduct, deduct, deduct while we're working, deduct, deduct, deduct, like crazy, traditional 401(k), whatever we’ve got to do. Then let's get to early retirement, tax rate arbitrage before Social Security, just convert, convert, convert.
[00:05:17] Jon: Hey folks, Jon Luskin, your Bogleheads® Live host, jumping in for a podcast edit. Here Sean mentions a particular tax planning strategy. Let's break that down for those who aren't tax planning nerds.
[00:05:30] When you're working, you're hopefully a relatively higher lifetime tax bracket.
[00:05:35] Therefore it makes sense to contribute to tax-deferred accounts, such as a traditional 401(k), decreasing your tax bill for the year. But there's a catch. Any taxes deducted for making contributions to accounts such as a traditional 401(k) eventually must be paid. Taxes are due when money is taken out of these accounts with the IRS even requiring you every year, starting at age 72. In short, the IRS lets you postpone taxes, but not avoid them.
[00:06:07] Despite that, there is a tax planning or arbitrage opportunity. In retirement, you're no longer working. So, you'll likely be in a relatively lower tax bracket compared to your working years. That allows you to pay taxes at a lower rate when distributing from these traditional tax-deferred accounts.
[00:06:26] In short, we're deducting taxes at a higher rate during our working years to pay taxes at a lower rate in retirement, generating a lifetime tax savings. And sometimes it can make sense to pay taxes by taking money out of these accounts to make a Roth conversion. Although we’ll be paying taxes, we'll be doing so at a relatively lower lifetime rate, and money in a Roth IRA can grow tax free for our entire life and then some.
[00:06:52] And now back to the show.
[00:06:55] Sean: A few practical considerations on this. One, it's an argument for using COBRA for the first 18 months of an early retirement. You're going to pay 102% of the employer costs for your health insurance. But if you like it, it could be an argument for using COBRA, at least for the first year and a half. That's all you can generally use it for.
[00:07:16] But a few other things. One is it emphasizes that need to be precise in terms of measurement. When you get to the fourth quarter and you're thinking about Roth conversions, you've got to be precise because you get a penny over that 400% of federal poverty level, you lose all these premium tax credits. A huge tax on that last dollar. Not a good outcome.
[00:07:39] Fourth quarter is the time to do Roth conversion planning. Every now and then you'll see folks who say, "oh, well, if you do your Roth conversions in the first quarter, time value of money, you get that over sooner in the year, over many years, that makes your Roth conversion so much more valuable because they're in the Roth for that much longer."
[00:07:56] My view is the planning advantage of not locking into Roth conversions in most cases is going to make sense to wait to that fourth quarter to do your Roth conversions.
[00:08:07] The other thing to remember is, used to be you could recharacterize Roth conversions. Can't do that anymore. You’ve got to be very careful with these Roth conversions. Once you do it, they're done. I would wait till the fourth quarter.
[00:08:18] Two last points. One that Cody makes very effectively. So, I'll steal his thunder is taxable investments are actually a really good thing when you are in early retirement. It's great to put money in the 401(k), sock away. I'm a big fan of the backdoor Roth IRA for many in the financial independence community. I think that has a lot of value, but having some taxable accounts so you have to draw less on other resources to fund an early retirement, keep that taxable income low, is very helpful.
[00:08:48] The last thing to keep in mind is this is all I think going to change. Just give you one recent example. This issue changed for the year 2021 and this year, 2022. That 400% cliff does not exist this year and last year. But in 2023, it comes back. This year, it's just a gradual decline. So going over 400% is not particularly deleterious this year. We want to keep it in mind.
[00:09:13] It's a very important issue. The correspondent is right on to be thinking about this if you're early retired. But keep in mind, this thing is going to change. I can't tell you how it's going to change, but it's going to change.
[00:09:25] Jon: Cody, is there anything you'd like to share on that subject?
[00:09:28] Cody: You always hear from financial planners, “it depends.” But really this is an opportunity cost discussion about should I convert to Roth or should I get the maximum subsidies for healthcare insurance? You're looking at the opportunity cost of these savings. It might be short-term. It might be intermediate-term depending on how old you are.
[00:09:46] In Sean's example, somebody's 55. That means they have 10 years until Medicare begins. They can potentially be maximizing their ACA tax credits for 10 years, depending on what happens with the future legislation. The opportunity cost you're looking at is, how much will I receive in short-term savings in terms of the tax credit, dollar-for-dollar reduction of taxes owed, versus the reduction of lifetime taxes and inherited taxes by doing the Roth conversion.
[00:10:11] An important variable to consider is looking at your balance between asset tax locations. What does it look like in terms sources of income in retirement? Whether from pre-tax accounts, taxable accounts, tax-free Roth or HSA accounts. You have to estimate and assume your future income needs and your future income sources along with which accounts are you going to pull from in which order.
[00:10:34] If we were talking about somebody with a third, a third, a third and they had no other sources of income, if they're 60 that's very different from if they're 45 because if you put off doing any of the conversions until you're 65 when Medicare starts, you have a very short runway to do Roth conversions as effectively.
[00:10:52] Let's say that you wait until 65 to do conversions because you really wanted to get the maximum tax credits. Then you only have from 65 until you claim Social Security. You've got five years. The bigger thing is you should determine what will your tax burden of required minimum distributions be.
[00:11:08] If you can estimate - whether you use an Excel spreadsheet or planning software like New Retirement which would be helpful for consumers -you can estimate, "Hey, when I turn 72, my required minimum distributions exceed my need for income in retirement." If your RMDs are going to exceed how much you need to sustain your desired lifestyle, then you can back up and say, "well, how can I do Roth conversions effectively to reduce my future RMDs, try to smooth out my tax ride by paying more taxes on purpose in the beginning."
[00:11:37] It's a balancing act between the two. Health insurance, like the premium tax credit, because it's a credit, it's probably the most important consideration for early retirement. Much more important than the capital gains tax rates like tax gain harvesting we talk about within the 0% capital gains bracket. It's also a lot more important than the consideration of IRMAA, the Medicare premium increases.
[00:12:00] It depends on your situation. Primarily focus on cash flow flexibility and having options for which types of accounts in terms of tax characteristic you can take from in early retirement.
[00:12:11] Sean: I think some folks in the audience will have this question. It's a related point, and it's around tax gain harvesting versus Roth conversions. And this part of life, some folks might be "Tax gain harvesting? Who's got gains these days?" Don't worry, they're going to come back.
[00:12:27] Tax gain harvesting is this idea of selling appreciated, usually individual equities, but it could be a mutual fund, could be any sort of financial asset that has a built-in gain while you're in that 12% marginal federal tax bracket or less because of the 0% qualified capital gains rate. The idea is let's sell today. We can buy back tomorrow. There's no wash sale rule on this tactic.
[00:12:51] Folks sometimes wonder, should I do Roth conversion? Should I do tax gain harvesting? Remember tax gain harvesting creates income for this 400% threshold. So, even if you don't pay tax on it, it’s still creating income.
[00:13:03] I tend to favor Roth conversions at this stage of life not tax gain harvesting, but there are some exceptions. So why do I prefer Roth conversions rather than tax gain harvesting? One because the Roth conversions have a permanent ordinary income benefit. You're getting that money out of tax-deferred accounts where it's subject to ordinary income, either in your lifetime, your spouse's lifetime, or most likely 10 years after your or your spouse's death. I love that idea of just getting those traditional accounts over to Roth while we can with good arbitrage.
[00:13:36] The second thing is someone in human history is paying that tax on your traditional deferred accounts. It may be the case that no one is going to pay the tax on the capital gain that is in your taxable brokerage account. There's a rule called the step-up in basis. Oftentimes the solution to, “oh boy, I bought Apple stock in the 1980s, it has this huge built-in gain” is just let it sit. Your passing, your spouse’s passing, one or both of those things could be more than sufficient to wipe away the capital gain on that.
[00:14:08] Not so with traditional retirement accounts. Somebody in human history is going to pay the tax on those traditional retirement accounts unless you can manage for a 0% rate. Not impossible, but not likely for most.
[00:14:20] The big exception is when I prefer tax gain harvesting over Roth conversions is when I want to do some portfolio reallocation. Think of an investor, he or she has great accounts in their traditional IRAs, traditional 401(k)s. They love those investments. But then they have in their taxable brokerage account, they have some old cats and dogs. That Apple stock that for whatever reason now they don't like so much.
[00:14:46] That person I would probably recommend, no, you should do tax gain harvesting. The idea being sell while you're in that 0% rate and then get an investment benefit by reallocating into those stocks, bonds, mutual funds, ETFs, whatever it is you prefer. You've now done that in a tax efficient way. Yes, you still have this traditional IRA you’ve got to manage, but we've gotten you a better investment outcome with a 0% tax rate.
[00:15:13] Cody: I like to tell people that we view traditional 401(k)s and traditional IRAs as assets on the balance sheet. But the IRS use them as income that hasn't been taxed yet. For example, on a balance sheet if you see a $1 million Roth IRA and a $1 million traditional IRA, they look the same on the balance sheet. But you have to realize that's just future income that hasn't been taxed.
[00:15:33] I love what Sean talked about in terms of prioritizing your decision making. Diversification and the ability to maintain your desired income needs in retirement should be prioritized over any tax strategies such as tax harvesting, Roth conversions. When tax gain harvesting or just harvesting any realized gains makes sense is when that appreciated security is preventing you to have the diversification required to maintain your desired lifestyle.
[00:16:00] If you have appreciated stock that's not diversified, you're taking a lot of risk in that individual security going into retirement. The priority is diversification, realizing those gains, before you start playing around with some more advanced tax strategies.
[00:16:15] Jon: Absolutely.
[00:16:16] I like to tell folks investments first, taxes second. If we can make the same investment in a more tax-efficient manner, let's do it. Hey, if I've got six grand to invest, it's better in an IRA than it is a plain vanilla taxable account. But I don't necessarily want to be sitting on an inappropriate investment just to defer capital gains because I can lose a lot more money if that investment goes south, which it probably will do if it's either high-fee or really concentrated compared to whatever I would save in taxes.
[00:16:45] Investments first, taxes second.
[00:16:47] David you should be live to ask your question.
[00:16:51] David: Do you have any sense of when paying into the Social Security system becomes a pure tax rather than a benefit? Second question is, these 55 and older communities or assisted living facilities, I was told that a portion of the entrance fees and a portion of the recurring fees for some of these communities are considered tax-deductible because they're deemed a prepaid medical expense.
[00:17:19] If that is the case and these types of communities may be something that's appealing to an individual or something they may consider in the future, does it make sense to not “Rothify” completely? So, you could essentially turn a RMD taxable cash flow into essentially a tax free cashflow, given the tax-deductibility of some of these fees.
[00:17:43] Sean: I did a blog post on early retirement and Social Security. It walks through how I would think about one last year in the workforce. And how much is that going to add to my Social Security earnings? It's hard to say, to give absolutes in terms of when would Social Security have no return so that it would be a pure tax. It would if you get hit by a bus tomorrow and pass away. What about survivor benefits?
[00:18:09] What you want to think about is Social Security works off your 35 high years of earnings. In theory, if you had 35 years of maxed out Social Security earnings - the current cap I think is $147,000 - if you had that earnings record, then you basically cannot do anything to improve that.
[00:18:30] But what that also means is that if you already have 35 years in, even if some of those years are smaller years, working year 36 is only going to replace the lowest earning year you ever had. And maybe that's a very low year, but regardless, any one particular year on your Social Security record tends not to have that much of an impact.
[00:18:49] In terms of making deductions for moving into Del Boca Vista and those sorts of things, I can't say I've ever looked at that. One thing you’ve got to keep in mind in terms of medical expenses and even retirees in general, most retirees are not going to itemize their deductions. I think it's over 90% of Americans today - it's something like that - with the new high standard deductions are not itemizing anyway.
[00:19:12] And generally speaking that's going to be the truth even in retirement because you've lost your home mortgage interest deduction in most cases, you're probably not paying as much in state taxes because you're not working, and at age 65 you get a higher standard deduction anyway. Most retirees these days are just going to be taking the standard deduction and the medical deduction is not going to be worth much to them.
[00:19:34] That said, think about things like qualified charitable distributions. David, you make a great point around, you're probably not going to want to convert every last dollar from traditional to Roth as much as it hurts me to say that because I love Roth so much. But all joking aside, converting every last dollar from a traditional to Roth before age 72 probably does not make sense for most Americans for a variety of reasons.
[00:19:58] One of them is the potential for future bailouts and the already existing bailout. There's one big one. The qualified charitable distribution, you can take up to $100,000 a year as a qualified charitable distribution (QCD). You give it to charity. For those who are already giving the charity, it's a great tactic to get money out of your traditional IRA tax-free.
[00:20:19] There's something called a qualified health funding distribution, where you move one year of contributions from an IRA to an HSA. Very limited opportunity. But my point being, is one, the QCD is already a great bailout strategy and two, it would not stun me in the next 10, 15 years if Congress puts in one or two more of these bailout strategies that folks might be able to take advantage of.
[00:20:44] Cody: Most early retirees that I work with, they're going to retire before they have those 35 years. If you create a Social Security “My Account” they have a calculator where you can change the assumption for your future earnings. If you look at your Social Security statement, it's basing your age 62, 67, and age 70 retirement benefits with the assumption that you make what you made last year all the way until the year you claim benefits. Which isn't usually going to be the case for somebody within the FIRE movement.
[00:21:11] Definitely check out the calculators. Conservatively assume no future income, to see the lowest ballpark in terms of retirement benefits in today's dollars.
[00:21:19] In terms of the second question, the tax deductibility of those medical expenses are only tax deductible if you're itemizing. Most likely, only going to happen if you give substantially to charity using Donor-Advised Funds or just giving straight up to charity in the year.
[00:21:35] Also usually that's going to be if you have a mortgage, which again, a lot of the people in their sixties and older try to eliminate debt for the most part. If they don't have the mortgage, maybe they have property tax, but that's capped currently at $10,000 a year. If that were to go away, I think that would be a game-changer for the itemization of medical benefits. And medical expenses that are itemized also have a floor. A percentage of AGI. Most people aren't going to get the tax deductibility for the medical expenses with those facilities.
[00:22:02] Also like Sean said at age 70 1/2, the qualified charitable distributions. If you give to charity, you should not convert all of your traditional money if you plan to give to charity in traditional retirement.
[00:22:12] The last thing I wrote here, it sounds really funny, you want sources of taxable income in retirement. The biggest reason is of course you want to be able to fill up what I call effectively the 0% tax rate which is the standard or itemized deduction. That standard deduction for a married couple is $25,900 plus $1,400 per spouse 65 or older. I would definitely want some sources of taxable income. Don't convert everything to Roth is typically going to be the case.
[00:22:39] Jon: Taking advantage of that 0% tax bracket, that standard deduction, whether that means at least taking that amount out from those traditional tax-deferred accounts, tax-free for that amount or just making Roth conversions, certainly don't want to give up that planning opportunity.
[00:22:55] Sean, I'm curious with respect to, "Hey, I already have several years of earnings in my Social Security earning record, so is one year going to make a difference?" What if you're that high earner earning that maximum Social Security amount that's going to give you the highest credit and then the year that falls off is going to be when you are working a summer job at the ice cream shop. So how much does that make a difference?
[00:23:20] Sean: It absolutely can make a difference, but one year even at the highest rate - Cody made a great point - most people in the FIRE movement don't have the 35 years.
[00:23:29] I actually posited an example on my blog where somebody had 32 years of earnings and they were thinking about working one more year. At something like $125,000 or $130,000. And I think at full retirement age that came out to something like $557 a year in expected annual Social Security benefits.
[00:23:51] You’ve got to remember two things. One is it's replacing 35 years of average annual income. So, you have to take your new income for this year capped by that $147,000 divided by 35. That's the beginning of the additional annual benefit of full retirement age. And then you’ve got to multiply it by whatever bend point you're in.
[00:24:09] Most people listening to this thinking about an early retirement are likely to be either in the 32% bend point or the 15% bend point. So, take your new salary for that one year capped at $147,000, divide it by 35, multiply it by the bend point, which is 0.32 or 0.15 and you're going to find out the average annual Social Security increase - and that's a full retirement age, but still - is just not going to be that impactful for most folks even if it's replacing a zero on your Social Security record.
[00:24:43] Cody: To show an example here, I pulled up a Social Security statement for somebody who's in the early thirties with only about 10 or so years of earnings. And then also a retiree who has 32 years out the 35. The one who has worked for 32 years out of the 35, by not working anymore it's less than hundred bucks a year of difference. Again, it depends on their whole history. If you don't have that 35th year it's negligible for the most part.
[00:25:06] On the flip side, looking at a Social Security estimation for somebody who's 30, their statement says at 67, they should expect $38,000 a year. But I said, "what happens if we turn off your earnings next year?" and it went from $38,000 down to $16,000.
[00:25:20] If you're planning for early retirement, be careful about making the assumptions based on what your statement says and use one of those Social Security calculators on the SSA website instead.
[00:25:31] Jon: This one is from ginrummy from the forums who asks, "to take the Roth conversion conversation one step further, I found that where you actually decide to live and spend those tax-free dollars can have a "yes" or "no" impact on whether a Roth conversion is worth it. With some early retirees it's hard to tell where they'll end up after age 60."
[00:25:51] Sean and Cody, what are your thoughts on the value of doing a Roth conversion with respect to “I'm going to retire in this state versus I'm not sure what state I'm going to retire in versus I know I'm going to move to another state.”
[00:26:06] Cody: State income tax is certainly something to consider. It's one of those variables on should I contribute to Roth or traditional or when should I convert? A lot of retirees specifically want to move to a state like Texas, Florida, Tennessee, New Hampshire, places that have no state income tax.
[00:26:20] But on the flip side, you might be going to a place that has very high state income tax. And maybe even, people who live in New York City, they've got a local tax as well. First of all, you should consider the actual state. There are three states that don't tax retirement account distributions even though they do have state income tax: Illinois, Mississippi, Pennsylvania.
[00:26:37] Focus on Roth conversion strategies from a federal income tax standpoint, at least first. It's one of those things where I wouldn't let the state income tax wag the dog at the federal level. Because most state income tax levels are pretty low in the single digits.
[00:26:52] Consider it if you're using any type of planning software, maybe pull that lever, say, “Hey, I live in California and now I live in Texas, what's the difference in terms of the tax benefit or the lack thereof when switching?”
[00:27:02] I probably wouldn't make the decision solely on where you live in retirement, just because the federal tax benefit reduction usually makes the case for the decision to begin with.
[00:27:12] Jon: One thing I think about when it comes to the state income tax question is, "Hey, there's no state income tax in Texas. There's no state income tax in Florida." Have you looked at the property taxes in Texas? Which is to say they are a lot. So, while you might not be spending money on income taxes, you're going to be spending it on taxes still.
[00:27:32] I think that the no state income tax on Texas is actually just a little bit of marketing. You are going to spend that money either way. You're just going to spend it differently. I'm not really sure it makes sense to form your retirement plan around. "Hey, I'm going to move to a low or no income tax state." Well, it takes money to run a government. So, unless you're going to live somewhere where there's not going to be any basic services, you're probably going to pay taxes one way or another.
[00:27:59] Cody: A really great case you make there too is that where you don't pay taxes, you pay somewhere else. A big place you pay it is in those marketplace exchanges.
[00:28:07] I've looked at couples spending about $15,000 a year on their insurance plan without the ACA premium tax credits. But if they move to a different place, that price moves from $15,000 to $30,000. Specifically, I see that really going up in price, people moving down to Southern Florida. Your ACA premiums are based on where you live.
[00:28:25] You might move to a place with no state income tax, but you are going to be paying maybe even double for your healthcare.
[00:28:31] Jon: I'm going to jump to Tyler's question next.
[00:28:34] Tyler: Because tax planning is so complex, it's one of the places that I find most people are less inclined to do-it-yourself (DIY). I think the majority of us here are inclined to support that. Sean, it sounds like your blog is a pretty deep dive into tax planning, but besides that, are there any other resources that you would direct consumers to so that they could do it themselves? Where can they look to educate themselves?
[00:28:59] Sean: My blog is sort of the intersection of tax and financial independence and it has tax planning aspects to it. Cody, he's done blog work that's really good. There's Jeffrey Levine and folks like him who do great content. He does it on Kitces’ blog.
[00:29:13] I'm not so sure that those are usually best at the consumer level. Those are more for the advisor, but there are plenty of very smart consumers out there.
[00:29:21] And we see this with folks having frustrations around tax return preparers, not understanding that tax return preparation is a separate and distinct exercise from tax planning. But you're right. It's a little bit of a jungle out there.
[00:29:33] Cody: It's one of those issues that we're seeing and why we're creating a lot of educational content.
[00:29:37] I wrote an article on measuretwicemoney.com that walks through that formula. You could actually walk down a tax return understanding what each of these means. Most of us don't learn the basic formula on like, hey, there's income. We reduce that by deductions. What's hard about taxes, they're so complex to truly do tax planning as a DIY investor, you need to know a lot of complex topics.
[00:29:59] The IRS probably does a pretty good job of having as plain as you can get in terms of tax language. But each tax topic has a specific publication. For example, like, IRS contributions have publication 590-A. You can go to IRS and type in pretty much any tax topic like HSAs or IRAs, Roth IRAs. Each of them is going to have a publication that's written in as plain language as they could possibly make it.
[00:30:24] Tyler you've really hit on one of the issues. There's not a great resource for tax education because so many content creators either don't know much about tax or they're trying to avoid that compliance issue of, “oh, we don't give tax advice.”
[00:30:37] Tyler: If they do decide to hire somebody, is there anything besides just confirming that they're either an enrolled agent or a CPA that you'd recommend corroborating that they're competent?
[00:30:48] Sean: When you say hire someone, what do you mean? Because is it hiring someone for a tax return? Is it hiring somebody for tax planning? Financial planning that includes tax planning? It's a jungle out there. I really don't think there's any silver bullet in terms of, oh, this qualification, this credential.
[00:31:06] The one piece of advice I have is for those looking for tax returns to be prepared, I would go and find a preparer that's willing to do it on extension. I think clients should be affirmatively pushing this on tax return preparers. And I say that because I think you want your tax return preparer to be working on your matters for the most part in May, June, July so that you're working with somebody who isn't sleep deprived and under an April 15th time crunch.
[00:31:34] Cody: You can just simply ask them, “Hey, what does your business look like for tax season?” If they tell you that, oh, that's their time that they take some time off, like, that's great.
[00:31:43] If they're truly running a tax planning business, they're probably going to be working year-round, not just during those big crunch times. You want to work with somebody who, quote unquote, do your taxes in November, which means try to find a tax preparer, tax planner, who can work with you in November when you can still implement certain things.
[00:32:00] Most people are looking at reducing their tax bill, certainly, but are there things I can do before the end of the year? And are they willing to work with you at that timeline?
[00:32:07] Jon: Also working with someone recently, helping them with looking at everything in their financial life, tax planning included, and we were going over some tax planning strategies. IRA to 401(k) transfer. So, they could do backdoor Roth IRAs tax efficiently. And sharing that strategy with them, their response was “why didn't my tax preparer tell me this? I've got to find a new tax preparer.” And at that point I have to tell them, no, your tax preparer is doing their job. They're preparing your taxes. Pleases don't fire a tax preparer if they're not doing tax planning. That wasn't part of the deal when you signed up with them in the first place. If you want tax planning, you want to look for tax planning.
[00:32:44] Folks, this one is from sailaway from the Bogleheads® forms. sailaway writes, “I feel pretty confident about the long-range stuff, but am stressing about the transitional periods. Make the most of the mega backdoor Roth even if you have to withdraw from the taxable? Use after-tax dollars to top up the HSA after income ends?”
[00:33:06] Cody and Sean, what do you gentlemen think about that lateral move?
[00:33:10] Cody: One thing I see here is, is a question about, should I use after-tax dollars to top up the HSA after my income ends? It sounds like they're saying after their money they earned this year is soaked up, do I take money out of my taxable savings to top off my HSA? I do want to say here that for the most part, yes, typically the HSA contributions you contribute through your employer, you also exclude those employment taxes - Social Security and Medicare - on that portion. You can still contribute to your HSA outside of your employer up until the tax deadline, typically April 15th.
[00:33:43] Those are adjustments to income. That's a reduction in your taxable income for the year. Usually, an HSA contribution is going to be closer to the top of what we call the accumulation order of operations - which accounts are you contributing to and what order. If somebody came to me and they hadn't maximized their HSA contributions and they spent their current money for the year, I'd probably still recommend just generally that they fill up the HSA to take advantage of that long-term tax-free growth for healthcare, whether for reimbursement or otherwise for medical expenses.
[00:34:15] I would say that HSA contributions are generally beneficial for people in any marginal tax rate. It's not something where I say, oh, you're in the 12% instead of the 22%, stop doing that. Even if I had very little income, I'd probably still contribute to an HSA. A personal decision, but I wouldn't make an HSA contribution decision solely based on your level of income.
[00:34:35] Jon: That HSA, that is a magical unicorn of a tax-advantaged investment account. It's hard to make a case for not contributing to that thing. Quadruple tax-advantaged if you do it through your employer. Triple tax-advantaged outside of it. That can be pretty hard to beat.
[00:34:50] Sean: One thing I would add is it may be that the strategy or the tactics you've been using during your high earning years may be the wrong tactics for that last stub year.
[00:35:01] What does that last year look like? Is it just 12 months of W2 income? Okay, fine. Don't need to make an adjustment. But maybe the last year is three months. Maybe that year you do a Roth 401(k) instead of a traditional 401(k).
[00:35:12] Jon: To give this question a little more context, this is certainly something I've come across before. They've got a lot of space. They have access to tax-advantaged investing. They can do that mega back door Roth, that's going to be an additional $40,500 they can put in a tax-advantaged account.
[00:35:29] But they might not necessarily have the cash flow because of limited income, but maybe they're sitting on a big taxable account. So, the question is I can move money from my taxable account to my mega backdoor Roth because I'm still working, I'm still generating that earned income. Should I do that? And perhaps I think the variable missing there is, well, what's your unrealized gain on the taxable account? Do you have low basis or high basis? I'm not sure if that gives any more context.
[00:35:54] Cody: That does help and saying like, I have so many opportunities to save for retirement including a mega backdoor. I don't make enough money to provide my current income needs plus max this thing out.
[00:36:04] Money is fungible. If you have the savings in your taxable accounts that can help you maintain your current living expenses while being able to put more money into the mega backdoor Roth, it's certainly something you should consider. Again, you can only contribute to that mega backdoor Roth as you're working, and that opportunity is going away in retirement. Usually if you can find an opportunity for that much money going into Roth as a contribution, I mean, effectively with the conversion, doing that as a contribution.
[00:36:30] Sean mentioned earlier, I'm a huge fan of just normal taxable brokerage accounts. I think they're the most underappreciated retirement savings vehicle. Yes, there's no deduction on the way in. They provide so much what I call cash flow flexibility and income tax control in retirement because it's up to you how you invest and distribute that income.
[00:36:50] There's no penalty for withdrawals from a taxable brokerage account before 59 1/2, but those other accounts there is. The mega backdoor, yes you can take out your original contributions to that anytime, any age. Once you have access to it, when you leave your employer, but all those earnings are still subject to those early retirement distribution rules.
[00:37:10] Jon: Let's jump to Nina.
[00:37:11] Nina: Back to the comments from tax preparation versus tax planning. Do you guys have any thoughts about whether they should be the same person or different people?
[00:37:20] Sean: I think you're going to struggle to find folks who are really good at both tax prep and tax planning. I'm not saying that doesn't exist, but I think folks struggle to find it.
[00:37:30] Cody: I would just say that if they are different people, I want them talking to each other. For example, I'll tell somebody to implement a Roth conversion strategy in early retirement and their tax preparer is like, “Why are you doing that? That makes no sense. You're paying more taxes than you needed to this year." Because they're focused typically on short-term reduction in taxes versus thinking long-term.
[00:37:48] It's best if the person plans and prepares, I would probably use one person, but if there are multiple people, just make sure that there're communicating with each other, maybe on three-way calls as long as they're open to it.
[00:38:00] If I were using somebody for tax prep, I would want them to speak up and say, "Hey, just to let you know, I was prepping your return I noticed that, you know, you're both over 55 contributing to a family HSA and you didn't contribute the catch up for the other spouse." If I were working with a tax prep preparer, I would want them to at least discover those opportunities and share them with me as a client.
[00:38:21] Jon: This question from the Bogleheads® forums asks, "Does it make sense to use money in my Health Savings Account to pay for COBRA premiums? And does that answer change being either a California or New Jersey resident?"
[00:38:35] Sean: I think sort of the flip makes sense. Generally, what I would recommend is use taxable accounts - checking account, savings account - to pay the COBRA premiums, keep the receipt and years down the road you might have 18 months of COBRA premiums you can bail out of that HSA tax- and penalty-free at any time for any reason.
[00:38:56] Now, generally speaking, you are going to want to do that later in life to let more tax-free growth compound. So, from a strategic perspective, I tend to think most folks who are on COBRA are pre-age 65, so they probably don't want to spend down their HSA. They want to let it grow tax-free and then just keep the receipts and you've got a bailout valve post-65 to get that money tax- and penalty-free.
[00:39:21] Cody: I was going to say the same thing. I said, doesn't make sense to use an HSA for COBRA. But it makes sense to reimburse yourself for COBRA, not to reimburse yourself in the same year that you pay the premiums.
[00:39:32] COBRA premiums are considered qualified medical expenses for the HSA distribution. But if you're an early retiree on ACA and you're not a business owner, in that case it's not an HSA deductible expense.
[00:39:44] Specifically for COBRA. Yes, I would use your HSA to pay for COBRA, but through reimbursement possibly decades later when you have all that additional growth on that money.
[00:39:56] Sean: California and New Jersey do not recognize the HSA. So, for state income tax purposes it's a taxable brokerage account. You have different treatments. You have one treatment on the state return, you have a different treatment on the federal return. And so that means no deduction or exclusion when the money goes in. It also means the interest, dividends, capital gains are an add-back in terms of determining taxable income.
[00:40:21] It makes the HSA less attractive. But certainly still very attractive because you're getting all those federal tax benefits. Even with those drawbacks in California and New Jersey, it's still so attractive.
[00:40:33] Jon: Let's jump to Tecmo. He has requested to be a speaker.
[00:40:39] Tecmo/Tommy: You mentioned the COBRA premiums being eligible for HSA payments. I'm not super familiar with COBRA. I've had government insurance for a while. Do regular, like, Blue Cross Blue Shield premiums, do they qualify as well?
[00:40:52] Cody: They don't. If you get outside coverage, it's those premiums that are continued through your group health benefits, not through a private insurer or through the healthcare marketplace, they're not qualified in that sense.
[00:41:03] Tecmo/Tommy: In your day-to-day normal working years, I was like, oh wait, should I be tracking my monthly or my biweekly premiums on my paycheck, but I guess not.
[00:41:13] Cody: Right yeah, you're correct. Those are not qualified for the HSA.
[00:41:16] Jon: One more question I sourced from the Bogleheads® ahead of time: “Any special considerations for Roth versus traditional in the last year if you expect income to straddle your anticipated future tax bracket?”
[00:41:28] Sean: Take a look at what you expect your taxable income to be, and it may be that if you're only working two or three months, you might want to do the Roth. It could be a year where you turn on qualification for a Roth IRA and maybe even a spousal Roth IRA. It could be, hey, I'm only working two months I made $20,000 and in the past we were always Modified AGI’d out of a Roth IRA, but this year maybe one spouse works and the other is already retired. Now you could do two Roth IRAs for that year.
[00:41:57] So it's thinking about your income in that last year. Some people retire on December 31st. Not much of an opportunity there, but if that last year just happens to be very short, there could be some planning opportunities.
[00:42:10] Cody: Two examples here, if you wait until the year after you retire, you're typically able to convert within each of the lower tax brackets. That effective 0% tax rate with the standard deduction as we talked about - the 10%, the 12%, et cetera, however high in terms of marginal tax brackets you’d like to convert.
[00:42:27] On the flip side, if you begin converting in a year that you retire, you may be converting all or some of those retirement accounts in only your highest marginal tax brackets. Let's say that, I have a game plan that when I retire, I want to convert my traditional IRA to my Roth IRA, up to the top of the 22% bracket. If I worked for half the year, puts me into the 22% bracket anyway. All those remaining conversions will be at the 22% tax rate. It's all stuck in that marginal rate. Whereas if I, for one or two months out of the year, that might have just pushed me only through the beginning of the 12% bracket. When I do conversions, I'm getting a big portion of that 12% and the 22%.
[00:43:06] Really depends on how much you worked and a lot of other things. When I'm working with financial planning clients, we usually start conversions the year after they retire.
[00:43:14] Jon: Certainly you want to be looking at your tax planning annually. And to Cody's point, if your income is low enough you can actually just start those Roth conversions a little bit early, right? That's what you're effectively doing, if you're making a Roth contribution as opposed to traditional in that final year when that income is low.
[00:43:30] Brad, you can ask your question.
[00:43:31] Brad: Before I learned about index funds, I got slammed with taxes on actively managed mutual funds. The solution I found was a variable annuity, probably the worst thing that I could have done. I have a sizeable variable annuity balance that I never intended to annuitize. And then I also have an IRA that I'm converting to a Roth.
[00:43:55] I've been retired for about eight years now, and I've been doing conversions out of the IRA to a Roth. Now I'm to the point where I'm wondering, I have such a low basis in my annuities, I thought I should start taking money out of those before they become so big that I'm never going to get to my basis.
[00:44:19] And then at the same time rather than convert out of my traditional IRA to my Roth and use the annuity for my living expenses to try and draw that down, to get to the basis. I'm just wondering what anyone's thoughts are on that strategy. If you had a variable annuity and a traditional IRA that you wanted to convert.
[00:44:43] Cody: I'm assuming this is a non-qualified annuity. It's with, after tax money you put in?
[00:44:47] Brad: Correct.
[00:44:48] Cody: There's a lot of “it depends” in this answer. The first thing I would consider is what's the role of an annuity? When used appropriately, the role of the annuity is to provide a guaranteed income source in retirement. Again, once you annuitize or take withdrawals. I know it's variable, so you're still subject to investment volatility and depending on your caps and all those things like that and floors. Typically, annuities are going to be your income base providing your income needs.
[00:45:11] It's too hard to know right now whether it's worth doing any type of surrendering of that and investing it differently.
[00:45:18] Sean: I think that's the sort of thing where it's easy for me as an advisor to say, hey, seek professional advice. I do think that might be one of those cases where it's a little harder. You have to really have a lot of the pieces on the table to give it even a good academic analysis.
[00:45:33] Cody: There are some advice-only financial planners, meaning financial planners who don't manage any client investments don't sell any investment products or insurance products such as annuities so you don't have to feel like they're going to try to sell you or churn you into some other product. There are some advice-only financial planners who do have a background in annuities and insurance. I can send you their name through DM if you'd like.
[00:45:55] Jon: Fantastic. Thank you, gentlemen, for sharing that.
[00:45:58] Brad, in hearing your question, the first thing I think about is you're asking a tax question, but as we touched on earlier in this call, we want to do investments first, taxes second. So, the first thing to figure out is, does it make sense to keep this annuity or not? And if so, what's the best way to get out of it. And then once you've made that decision, then you want to consider the tax impacts.
[00:46:20] That's going to be all the time that we have for today.
[00:46:24] Thank you to Sean Mullaney and Cody Garrett for joining us today. And thank you for everyone who joined us for today's Bogleheads® Live.
[00:46:30] Our next Bogleheads® Live, we'll have Robin Wigglesworth discussing his book “Trillions: How a Band of Wall Street Renegades Invented the Index Fund and Changed Finance Forever.” The week after that, we're going to have Dan Egan, Vice President of Behavioral Finance and Investing at Betterment.
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