Many investors love the Federally tax-free income they receive from municipal bonds. Municipal bonds are debt securities issued by state and local governments to fund operations or special projects. Because the income an investor receives is not taxed, the after-tax return of municipal debt is often higher than the after-tax income provided by corporate bonds and bank CDs.
For example, the yield on the iShares Core US Aggregate Bond ETF (AGG) currently stands at about 2.3%. For a taxpayer subject to a 22% marginal income tax rate, the after-tax return drops to just 1.8% and is even lower as you climb into higher marginal tax brackets. Compare this to the Vanguard Tax-Exempt Bond Index Fund ETF (VTEB) which yields 2.1% federally income tax free.
An often-underappreciated item in the US income tax code deals with qualified dividends. A qualified dividend is a dividend from a common stock or a preferred stock that the filer owns for a specified minimum time period. The beauty of qualified dividends is that they are taxed at the filer's long-term capital gains rate rather than as ordinary income. The following table compares ordinary income rates and long-term capital gains rates for married filing jointly returns for the tax year 2021
*Includes 3.8% net investment income surcharge.
Which brings us to the value of qualified dividend income (QDI). QDI extends to income received from preferred securities. Preferred stocks are debt-like securities issued by corporations that rank below the bond holders-- but above the stockholders-- in the event of a liquidation. The term preferred is used because the dividends on these shares must be paid in preference to dividends paid to common stock shareholders. To learn more about preferred stocks you can view the Wikipedia entry here.
The importance of this is the after-tax returns of many preferred securities held long enough to receive QDI tax treatment, are higher than rates generally available in the municipal bond market. Take the Bank of America preferred series A (BAC-PA) for example. This security has a current dividend yield of 5.8%, even at the highest capital gain rate of 20% and add in the 3.8% net investment income surcharge the after-tax net on this income is 4.4% or more than double the tax-free rate of 2.1% from VTEB.
There are some details to keep in mind; to qualify for QDI status, the security must be held for 91 days out of the 181-day period, beginning 90 days before the ex-dividend date. Because most preferred securities pay quarterly dividends, you would generally need to make your purchase the day of the preferred trade’s ex-dividend to ensure you receive favorable tax treatment.
Also, preferred issues are highly concentrated in the financial and utility sectors of the market which could lead to poor diversification. You could use exchange traded funds (ETFs) like the iShares Preferred and Income Securities ETF (PFF) or an open-end mutual fund like the Nuveen Preferred Securities and Income Fund; but be aware that not all the distributions from funds like these are considered Qualified Dividend Income. Only 62% of the distributions from PFF were eligible for QDI treatment in 2018 and usually about 60% of the Nuveen funds distributions were QDI eligible.
Still, for investors concerned with building a tax-efficient portfolio, preferred securities are certainly worth consideration.
A health savings account is a tax-deductible savings plan for individuals covered by a qualified High-Deductible Health Plan (HDHP). This program allows for tax deductible contributions to a special account that allows you to pay for expenses your insurance plan does not cover with pretax and tax-free dollars.
A high deductible plan for 2021 requires a minimum deductible of $1,400 for individuals and/or $2,800 for a family. These plans must have a maximum out-of-pocket expense of at least $7,000 for an individual and $14,000 for a family.
If you’re covered by a spouse’s workplace policy, Tricare, the Veterans Administration, or Medicare you are not eligible. If you are a dependent on someone else’s tax return or covered by a Flexible spending account or Health reimbursement account, you are not eligible.
How an HSA Works
The beauty of an HSA is you make contributions that are deducted from your taxable income, yet when you spend the money for qualified expenses, the distribution is tax-free as well. Any growth within the HSA account is also tax-free. So, the contributions are deductible like a Traditional IRA, but earnings and distributions are tax-free, like a Roth IRA – you get the best of both worlds!
Contributions to an HSA are deductible from your taxable income in the years you contribute, and like a Traditional IRA, you can make contributions until April the 15th or your normal tax filing deadline of the following year. For 2021, the maximum HSA contribution is $3,600 for and individual and $7,200 for a family, with an additional $1,000 per year “catch-up” contribution for those over age 55. It is important to know that for married couples the $1,000 catch-up provision applies to each spouse. If you and your spouse are each over 55 your HSA contribution limit for 2021 would be $9,200.
If you contribute to an HSA plan through your employer, your annual contributions are reduced dollar-for-dollar by any contributions your employer makes on your behalf. For example, if you and your spouse are under age 55 and your employer makes a $1,200 annual contribution on your behalf, you would only be allowed to contribute and deduct from your taxable income $6,000 for 2021 ($7,200 contribution limit minus $1,200 employer contribution).
If you drop out of a high deductible plan before the end of any calendar year, say you become eligible for Medicare, or you change employers and the new coverage does not qualify as a high deductible plan, your contributions for that year are simply pro-rated. Meaning if you participate for three months then changed to a plan that is not eligible for HSA contributions, you would be eligible for a 3/12ths deduction in that calendar year.
On the other hand, if you become eligible for HSA contributions during a calendar year, you can make contributions as if you were covered by a high-deductible plan for the full year. So, if you moved from an employer plan that was not HSA compliant to another employer plan that was HSA eligible in October you would be allowed to contribute as if you were eligible for the entire year. This is known as the last month rule.
The contribution rules for HSA accounts also allow others to contribute to the account on your behalf. For example, if you have a working child who is covered by an HSA compliant insurance policy, you can contribute directly to the account for them. The contribution is considered a gift so you will not receive an income tax deduction, but it may be an important step to helping your child become financially stable.
Qualified HSA Funding Distribution
An important funding technique is the ability to make a trustee to trustee transfer from an IRA into your HSA account. Each taxpayer may only do one qualified transfer in their lifetime and the amount of your HSA contribution will be reduced dollar-for-dollar in the year you make a conversion. This is an outstanding opportunity to convert dollars that are potentially taxable in the future to dollars that can be tax-free. If you are young and make a conversion, the potential for tax free growth can’t be beat. Even if you’re just shy of Medicare eligibility, the income tax savings of this strategy make it worthy of consideration.
An important note for couples is that only one person can own an HSA account. To maximize the Qualified HSA funding distribution benefit, one spouse will open a family HSA for a calendar year and use their qualified funding distribution. In the following year the other spouse will open a separate HSA account and use their own once in a lifetime qualified funding distribution to fund that account. This would allow a couple to convert up to $18,000 from IRAs where distributions are likely to be taxable--into HSA accounts that compound tax-free and provide tax-free future benefits.
You are allowed to rollover funds, via a trustee-to-trustee transfer, from one HSA account to another without triggering a taxable event. This means if you leave an employer’s plan and wish to establish an HSA account through a different provider, you can consolidate your account with the new provider and simplify your finances. Or if you wish you can change HSA account custodians anytime.
If you name your spouse as the beneficiary of your HSA account, the account will be treated as the spouse’s HSA upon your death. For other beneficiaries, the fair market value becomes a taxable distribution to the beneficiary.
Funds from your HSA account can be used for qualified medical expenses for you and your family. The IRS is a bit liberal in their definition of family. Anyone who qualifies as a dependent on your income tax return can have medical expenses paid from your HSA account. You, your spouse, your children under age 19 or under age 24 if a full-time student, grandchildren, parents, and foster children are all included.
Medically necessary expenses not covered by insurance can be paid from your HSA account without taxation. Even things like drug and alcohol rehab, home modifications for disabilities, acupuncture, dental and vision care, and over the counter drugs prescribed by your doctor, are all allowed expenses.
Although your current insurance premiums cannot be paid from you HSA account, you can use those funds to pay for Long-Term Care insurance and Medicare Part B and Part D premiums.
For a complete listing of eligible expenses see IRS publication 502.
Look Back Provision
If you have an HSA account open during any tax year and do not have enough money contributed to cover all the allowed reimbursements, you can use future years contributions to pay yourself back. For example; In 2020 you had an HSA balance of $4,000 but in December you had a large unexpected $5,000 medical expense. You would be able to make 2021 contributions and then reimburse yourself for the extra $1,000 expense you incurred in 2020.
Like IRA accounts, there are certain transactions that are prohibited inside your HSA account. You cannot have any self-dealing transactions such as sale leasing or exchange of property between yourself and your HSA account, you cannot charge your HSA account for services you provide, and you cannot use your HSA account as collateral for any loans. A violation of these rules will trigger a deemed distribution from your HSA account and subject all the funds to taxation in the year the violation occurs. For more information on prohibited transactions see section 4975 of the tax code.
For the full IRS guidance on Health Savings Accounts see Publication 969.
The recent income tax revamp has made income tax planning early in the year a must for many self-employed professionals. The ability to take a 20% deduction of business income, available for single filers with income below $164,900 for 2021 and married filers with income below $329,800, is too good to pass up. Filers with taxable income at these levels will be in the 24% marginal tax bracket, so being able to qualify for the business income deduction is worth thousands, particularly when proper tax planning can prevent many from reaching the next 32% bracket. There are a number of ways to game your reported income, allowing many filers with reportable income well above these limits to qualify for the 20% exclusion.
First, the exclusion counts toward reducing your income below the phaseout thresholds. A married couple with employment income of $175,000 and a like amount received as business income would see their total income of $350,000 reduced by 20% of the business income or $35,000 allowing them to remain within the proscribed income limits.
Contributions made to an Health Savings Accounts will also reduce your taxable income. For 2021 single filers can deduct up to $3,450 and couples up to $6,900.
A real biggie for high earners looking to qualify for the 20% exclusion is retirement plan contributions. Money contributed to your qualified retirement plans can make a huge difference. For 2021 those under age 50 can contribute $19,500 to a 401k and those 50 and above can contribute up to $26,000. Presumably as a business owner you can also be sure to offer a generous match. Matching contributions are a deductible business expense that benefits you the owner directly yet reduces your reported profits and thus your total income for purposes of qualifying for the 20% deduction. And for very high earners, adding a defined benefit plan to your existing defined contribution plan might be a smart move, depending on the demographics and size of your workforce.
Don’t overlook simple things like using tax free municipal bonds for your savings versus taxable bonds and CDs.
Going beyond the basics, some business owners could benefit from reimagining their business ownership. Suppose you are a professional who owns your place of business. Setting up a separate company to own the real estate could be a smart move. You lease the building back from the owner at a fair market rate creating business income that is not subject to the target income limits.
Busy professionals have little time to devote to income tax planning and their CPAs are busy during tax season, but the difference between qualifying for the deduction and not qualifying could hinge on how soon you begin a given strategy.
Roth IRA accounts have been available since 1997. Unlike a Traditional IRA, Roth IRA contributions are taxed in the year of the contribution but never taxed again if certain requirements are met.
If you are a single filer with gross income of up to $52,525 or joint filers with gross income of up to $105,050 for the 2020 tax year, all of your income is taxed at 12% or less, and we strongly encourage you to make Roth IRA contributions rather than Traditional IRA contributions.
The magic of compounding means, the earlier you start, the greater the tax-free growth within the account. If you are 20 when you start making contributions, you could be looking at four doubles of your original contribution by the time you retire at age 60. That means a $6,000 contribution this year could grow to $96,000, creating $90,000 of tax-free income for your retirement years.
With today’s historically low income-tax rates, it would be prudent to put as much money as one can into a Roth IRA. Always consult your CPA before making this decision, but one could argue the tax-free growth and withdrawals outweigh the hurt of paying today’s top tax rates.
Contribution and Income Limits
For 2021 eligible individuals can contribute up to $6,000 if they are under age 50 and $7,000 over the age of 50. You can contribute 100% of any eligible income up to these limits.
For single filers with Adjusted Gross Income of less than $125,000 ($124,000 for 2020) can make a full Roth IRA contribution. If the adjusted gross income is between $125,000 and $140,000 ($124,000 to $139,000 for 2020) they can make a partial Roth IRA contribution. For joint filers the threshold is below $198,000 AGI ($196,000 for 2020)and the phaseout is between AGI of $198,000 to $208,000 for 2021 ($196,000 to $206,000 for 2020). For adjusted gross incomes above these amounts, a back-door Roth IRA strategy will be needed.
Back-Door Roth IRA Contributions
Without income limitations for converting assets in a Traditional IRA to a Roth IRA, many who are disqualified for income resort to the back-door method for funding a Roth IRA. This works because anyone may open and contribute to a non-deductible Traditional IRA, even if you are covered by a qualified retirement plan.
Once the funds are deposited into the non-deductible Traditional IRA, they can then be converted to a Roth IRA. This has the same net income-tax effect as contributing directly to a Roth IRA. The IRS recently loosened the back-door conversion rules and allow for immediate conversions, where in the past investors were recommended to wait a few months before converting to satisfy the IRS.
The 5 Year Rule
Another reason to open a Roth IRA is the flexibility it can provide to fund emergencies that may arise over your life.
You can always withdraw any Roth IRA contributions you have made without taxes, after all, you paid income tax on the money prior to making the contribution. However, if you haven’t had the Roth IRA open for at least five years, your distribution could still be subject to a 10% tax penalty, similar to the early withdrawal penalty for Traditional IRAs.
The five years for withdrawals begins on January the 1st of the year you open the account, not when you make subsequent contributions. There is also a five-year rule for Roth IRA conversions that start in January of the year you make a conversion; this prevents someone from using a Roth IRA conversion to avoid early distribution penalties from early Traditional IRA withdrawals.
The Younger, The Better
Tax-free growth and tax-free distributions are very enticing, especially for young investors. The more time your account grows tax-free, the better. Another point to make is that the more of your nest egg you have in a Roth IRA, the less your Required Minimum Distributions (RMDs) will be during retirement. Which inherently leads to you and your financial advisor having more ability to control/minimize income taxes during retirement years.
If you're age 72 or older you probably know you must begin taking distributions from your IRA -whether you want to or not. The IRS life expectancy tables determine your required minimum distribution (RMD) based on the previous years ending balance for your IRA and your attained age for the tax year.
The qualified charitable distribution rules provide those subject to RMDs an option that can help them reduce their income tax liability by having certain charitable contributions made directly to a qualified charity. Given the changes to itemized deductions and the standard deduction in the 2017 tax law update, the qualified charitable distribution rules for your IRA account becomes even more important.
If you make charitable contributions throughout the year, it would be wise to consider making those contributions directly from your IRA. Up to $100,000 of charitable distributions from each IRA owner's accounts can be excluded from your taxable income each year.
Say you plan to give $10,000 to your church or another qualified charity and you are receiving taxable distributions from your IRA. If you make the contribution to the charity directly from your IRA, your $10,000 gift will not be reported as income on your income tax return.
If you instead receive these funds as income from your IRA distribution and then send the same $10,000 to the charity it is included in your taxable income and could result in higher Medicare premiums and a higher percentage of your social security income being taxable. If you do not have itemized deductions that exceed the new $24,000 per couple or $12,000 per individual standard deduction, you could lose all the tax benefits of your generosity.
By having the distributions sent directly to the qualified charity from your IRA, you will exclude the amount from your taxable income, potentially lowering your Medicare premiums, the taxable portion of your social security benefits, and your overall income tax rate at both the federal and state level.
If you follow this strategy, be sure to let your income tax preparer know. There may be no indicator on the 1099R you receive at the end of the year that shows that part of your distribution is non-taxable, so there is a chance many people using this strategy are over-paying their income taxes each year.
Get Your Financials in Order, Gain Financial Freedom, and Get the Most Out of Retirement
Budgeting for retirement is based on a projected retirement date. But when most people start their retirement income planning, they may not be sure exactly when they will want to step away from their job—and as they age, their planning for retirement may change. If you are thinking about accelerating your retirement plans, you are not alone.
CERTIFIED FINANCIAL PLANNER™ practitioners work hard to make sure their clients are ready for retirement. When people change their minds about when they want to retire, their retirement income planning does, too. Sudden changes in fortune or lifestyle can prompt people to wonder if they can reach financial freedom sooner than they expected, like coming into a big inheritance, a generous severance package near the end of a career or a big offer to sell your company, or even a health scare or a spouse’s retirement.
If you feel you may be reaching financial freedom sooner than you thought, we are always ready to explore your options for an early retirement.
So, when should YOU retire? Not before you can answer “yes” to the four questions below!
1. If I retire now, is my healthcare—and that of my spouse—covered?
When you think about your road to financial freedom, do you think about your personal health? You should. If you are like most working people, you have a health insurance plan that is covered or partially compensated by your work. Retiring tips don’t often talk about health care because they assume you have reached the age of 65 and are eligible for Medicare plans.
If you retire today, how will you get healthcare for yourself and for your family? Depending on your retirement plans, you may need to pay for your health insurance plan out of pocket for years—and potentially for your spouse and for any children under age 26 currently on your healthcare plan as well. A high-quality healthcare plan that goes beyond catastrophic coverage can be costly, depending on your age or any pre-existing conditions. (Don’t fall for low-cost, Medishare-style junk plans that do not provide adequate coverage!)
Healthcare challenges can strike at any time and turn your financial freedom into a financial disaster. At Oak Street Advisors, our fee-only financial advisors recommend strategies to protect your finances from catastrophic healthcare expenses while concurrently also minimizing taxes and potentially realizing tax-free investment growth if you choose to retire before you are eligible for Medicare.
If I retire now, can I get by without my social security benefits?
Most retirement strategies rely on social security benefits on some level. During your retirement income planning, your financial advisor helps you decide the optimal time to begin drawing your social security income. Most try to find ways for you to postpone taking social security until you reach at least full retirement age—as late as 67 years old, depending upon your birthdate, if not age 70.
If your retirement income planning relied on receiving social security (or receiving the maximum amount of social security) and you are not yet eligible to draw payments, can you replace that income or get by without it until you reach the appropriate age?
If I retire now, am I truly debt-free?
Financial planning after retirement usually assumes you have paid off all of your credit cards, any outstanding medical or educational debts, and—hopefully—your home. Most CERTIFIED FINANCIAL PLANNER™ practitioners encourage all of our clients to make a debt-free retirement a high priority. You cannot retire with confidence if you are still making credit card, car, boat, student loan, or mortgage payments.
Why? Peace of mind. When your home is paid off, your retirement income planning needs to cover taxes, insurance, and general home maintenance, not costly mortgage payments.
If I retire now, do I have a personal or professional goal?
Financial freedom tips fail to ask what, exactly, you plan to do with that newfound financial freedom. When you begin planning for your retirement, you should think about what your hopes and dreams for this incredible phase of your life might be.
Getting away from the daily grind can sound wonderful when we are in the working world. But if you do not have ideas or plans for how to spend that new free time, you may find it weighs more heavily on you than you had imagined. Your retirement plans should include more than retirement income planning. Retirement planning should include new challenges, opportunities for learning and personal growth, restorative rest and relaxation, community involvement, family connections, travel … whatever is meaningful and motivating for you. Your road to financial freedom needs a destination.
Not sure how to choose a financial advisor? It’s a big decision! Our guide on how to find a good CERTIFIED FINANCIAL PLANNER™ practitioner can help you ask the right questions and select someone able to help you reach your personal financial goals and find financial freedom.
Do You Need a Financial Advisor?
Depending upon where you are in your life, you may not have spent much time thinking about your financial future. NOW is always the best time to start! Finding a financial planner can help you focus on personal financial goals, like buying a new home, saving for a child’s college education, or retiring at a certain age. And if you have recently received a significant pay raise, come into an inheritance or trust, or need help with tax planning, a financial advisor can help you leverage and maximize those assets.
Do You Need a New Financial Advisor?
Have you started to wonder if your current financial advisor is right for you?
Most financial advisors receive a significant portion of their pay in commissions. When they recommend that you purchase shares of stock or mutual funds from a broker, they receive a portion of the proceeds of that sale in return. They can also make money through mark-ups of bonds, CDs, or new stock issues through a broker. And because advisors paid in by commission make the most money when you purchase financial products, they may be tempted to recommend buying things you do not really need. And their interest in your financial wellbeing may not extend beyond that sale. Many financial advisors do not assist with 529 savings plans, employer benefits packages, healthcare options, or estate planning, all critical components of a good financial plan.
If you have started to wonder if your current financial advisor is truly looking out for your best interests, it is time to look for a fee-only financial advisor.
What is Fee-Only Financial Advising?
Fee-only is a better way to get smart financial advice you can trust. Fee-only financial advisors never make money from commissions or mark-ups. We are only paid by you to give advice that we believe will work best for you. You will never need to second-guess our motives, suggestions, or strategies. You will always know that your financial future is our highest priority.
Fee-only financial advisors must meet a very strict professional fiduciary standard. Fee-only financial advisors must become Registered Investment Advisors and meet the highest fiduciary standard, while other financial advisors are held to a lower suitability standard.
To be sure you are working with the best and that your financial advisor has only your best interests at heart, choose a fee-only Certified Financial Planner™ Practitioner (CFP®).
Research a Financial Advisor
Word of mouth can be a great way to find a financial advisor. Asking your friends, relatives, and coworkers if they have a financial advisor they trust and would recommend can be a great place to start. Online research can also help you find and look into your options.
Whenever you are given or find a name, take a moment to look them up on the broker check tools maintained by the Security and Exchange Commission or FINRA. And don’t stop with the broker name! Make sure you also plug in their firm’s name. If the firm has multiple infractions that may be an indication of poor corporate culture.
What to Know Before Meeting with a Financial Advisor
Questions to Ask Your Financial Advisor
Selecting a Financial Advisor
Finding a financial planner lets you start the exciting and rewarding process of creating a financial plan calibrated just for you and your personal financial goals. Abstract ideas become an action plan. You have specific instructions and ways to mark your progress. You know how to ask for help and when to ask for changes or adjustments. And you can finally see the big picture—not only where you are today, but where you want to go.
WHAT’S A DONOR ADVISED FUND?
A donor advised fund (DAF) is a relatively new tool that helps both taxpayers and charities reduce taxes now while providing planned donation strategies to continue in the future. Much like a deductible IRA, assets contributed to these donor accounts produce tax savings based on specific IRS guidelines.
Every dollar donated to a donor advised fund reduces the donor’s taxable income dollar-for-dollar in the year of the gift. For high earners this is one of the few strategies to reduce taxable income outside employer retirement plans and benefit packages. Once in the account, the gifted assets grow tax-free until the donor decides to distribute the funds to the qualified charities they desire.
There’s great advantage in the flexibility a donor advised fund offers. Donors make contributions now to reduce taxes now, those donations then grow via investments tax-free and those appreciated assets are then are distributed at some time in the future to a qualified charity. This is a good deal for everyone involved, except Uncle Sam. Even better-- for 2020, the CARES Act allows taxpayers to contribute up to 100% of their Adjusted Gross Income to a donor advised fund.
For those in the highest tax bracket, every $1,000 donated to your donor advised fund results in a Federal and SC state tax savings of ~$440. Donating $100,000 would save that same taxpayer $44,000 in Federal & state income taxes; you can also use a DAF to avoid taxation on appreciated assets with low cost basis altogether.
GIFTING APPRECIATED STOCK TO YOUR DONOR ADVISED FUND
To really compound the tax savings inherent with a DAF, we recommend donating appreciated stock positions from your taxable accounts. You avoid capital gains taxes, get full value of the gifted equities in the form of the tax deduction and the assets grow tax-free until distributed to a qualified charity.
BUNDLING CHARITABLE DONATIONS TO OFFSET INCOME WINDFALLS
Some taxpayers may consider bundling annual contributions to their Donor Advised Fund into a single year to avoid wasted donation dollars that the newer and higher standard deductions produce.
For example, if you plan to give $50,000 a year for the next 10 years, and you know you have a big real estate sale, sales or performance based bonus, or generally know your taxable income will be irregularly elevated in a single tax year, you may want to bundle those annual amounts into a single, large donation that year. In this scenario, you’d donate $500,000 immediately but only distribute $50,000 each year out of the DAF while the remaining principle donations continue to grow tax-free via your investments; This strategy allows a taxpayer to continue their plan of gifting $50,000 annually while realizing a tax savings of ~$220,000 in the year of the windfall.
Why you might not want to rollover that old 401k
*The rollover strategies discussed also apply to 403b, 457b, 401a and other employer sponsored qualified retirement plans
For many high wage earners, making contributions up to annual Roth IRA limits (6k/$7k over 50; 2020) via the backdoor Roth IRA strategy is an appealing way to generate income tax free growth and income for future years. The backdoor Roth strategy entails making a non-deductible IRA contribution and immediately converting that contribution to a Roth IRA account. If you have no other rollover tax deferred IRA accounts when you execute this strategy, then you have simply moved money from a taxable account into a tax-free account.
What If I have existing Rollover IRA and/or Traditional IRA Assets?
When executing the backdoor Roth strategy, if you have any tax-deferred Rollover or Traditional IRA Assets, i.e. you haven’t paid income taxes on them yet, the Roth conversion will result in at least some of those funds being taxed in the year of the conversion.
For example, let’s say you have a Traditional IRA or Rollover IRA worth $60,000 and make a non-deductible contribution of $6,000 to this IRA in accordance with your backdoor Roth IRA strategy. When you convert the same $6,000 from your Traditional or Rollover IRA to Roth IRA assets, you’ll actually be taxed on ~91% of the conversion, which creates extra taxable income of $5,460 for the tax year.
This overlooked tax trap results from IRS rules which mandate, for tax calculations, your tax-deferred contributions and gains and non-deductible contributions from all IRA accounts (Rollover, Traditional & Roth) are combined into a theoretical IRA pot. From this theoretical pot, the IRS requires you to calculate the ratio of tax-deferred dollars to non-deductible dollars; the percentage of tax-deferred dollars in your theoretical account is the percentage of your Roth IRA conversion that will be taxed.
In this example your non-deductible $6,000 contribution to your Traditional IRA or Rollover IRA is divided by the total account value of $66,000—just roughly 9% is not subject to income taxes at the time of conversion.
The aggregation rules are one of the few reasons you should carefully think about not rolling over an old 401k or other employer plan. If the funds remain in a 401k, 401a, 403b, 457b etc. they are not subject to the aggregation rules.
While there’s no avoiding taxation of previously deducted personal Traditional IRA contribution assets during a backdoor Roth IRA strategy execution or other Roth conversion, there are sometimes opportunities to clean up existing Rollover IRA accounts to avoid this unpleasant tax consequence.
The Difference Between a Rollover IRA and a Traditional IRA
Though they’re nearly identical, there is a subtle, but significant, difference. You can roll over a 401k to a Traditional IRA or Rollover IRA. If you choose to roll funds into a Rollover IRA, rather than a Traditional IRA, you maintain the ability to roll those funds into another current or future 401k plan, if the plan documents allow.
Why Does That Matter?
There are 401k plans that allow IRA roll-in contributions, but they must come from a Rollover IRA, not a Traditional IRA. If your company has such a plan, you can roll your existing Rollover IRA account into your 401k plan which eliminates the tax-deferred IRA portion of your aggregate portfolio, allowing a high earner to execute the backdoor strategy completely tax-free. Without this keen planning taxes would be paid at high income brackets on the conversion, which is counterproductive to high earner’s overall tax strategy.
Don’t Commingle Rollover IRA and Traditional IRA Assets
If you commingle “regular” Traditional IRA funds and Rollover IRA funds you lose the ability to roll-in former Rollover IRA assets. It’s important to keep the Rollover IRA and Traditional IRA accounts separate. Consider opening a stand-alone Traditional IRA for annual personal IRA contributions and a separate Rollover IRA for rollover assets.
As always, things are rarely as simple as they seem. You should work with a competent Financial Planner to determine the best advice on your personal tax planning strategy.
Questions about tax minimization strategies regarding your 401k rollover or rollover IRA? Click here to setup a no cost discussion with us today!
As financial planners, we meet with many parents concerned about how they will pay for their child’s college education. These parents often ask about the Future Scholar program, the 529 college savings plan for residents of South Carolina. We created our educational savings guide below to explain how a 529 program works, the benefits of a 529 plan and the disadvantages of a 529 plan, and help you determine whether or not the SC Future Scholar Program is right for your family.
What is the South Carolina Future Scholar program?
Paying for college can feel like a monumental task for any family, no matter how financially comfortable they may be. Although tuition inflation in higher education has slowed in recent years, the price of a four-year college degree is still very high.
State governments have developed a special type of savings plan designed to help families save for this significant financial expense: the 529 college savings plan. In South Carolina, the plan is called the Future Scholar program, and it includes tax benefits designed to ease the burden of college tuition and encourage regular contributions.
How does a 529 Plan work
Any U.S. citizen can open a 529 savings account for a child regardless of their income level or their relationship to that child. There can even be multiple accounts for the same child as long as all combined contributions across these accounts do not exceed $520,000 in South Carolina. The maximum aggregate contribution limits vary by state.
Most 529 plans allow participants to deduct part or all of their contributions on their income taxes and contributions to the SC Future Scholar Program are tax-deductible on the state level.
And like any savings account, the money in a 529 account grows over time through additional contributions and interest earned. Unlike other savings accounts, however, the interest earned and the withdrawals you make are also tax-free.
Money can be withdrawn from a 529 college savings plan for tuition and fees, room and board, books, computers and other supplies required to attend any eligible institution offering post-high school education: two and four-year colleges, graduate and professional programs, and even certain vocation/technical schools.
Benefits of a 529 Plan
Disadvantages of a 529 Plan
How Do I Open an SC Future Scholar Program 529 Plan?
The SC Future Scholar Program is managed by a group called Columbia/Threadneedle, created by the merger of Columbia Management Investment Distributors of the US and Threadneedle Investments of the UK. Columbia Management is owned by Ameriprise, a national broker/dealer and financial service firm.
There are two ways to invest in the Future Scholar program. If you are a South Carolina resident, you can open and fund your accounts online directly with Columbia/Threadneedle or you can invest through the broker or your choice. See the sections on fees and expenses to understand the differences between these two approaches.
What is the Current Ranking for the SC Future Scholar Program 529 Plan?
Each year, Morningstar publishes a ranking of all 529 college savings plans across the country, awarding them gold, silver, or bronze status—or below. The SC Future Scholar plan landed solidly in the middle of the pack this year with a Neutral rank for the direct option.
If I Want a Gold 529 Plan, What are My Options?
The younger your beneficiary, the greater the value of lower fees and better fund selections. South Carolina residents can get the biggest bang for their buck by opening and contributing to the SC Future Scholar Program to capture state income tax savings. As their child approaches college age, they can execute a custodian-to-custodian transfer to a better 529 plan, such as the gold rated Utah Educational Savings Plan. Because a custodian-to-custodian transfer is not taxable, you can have your cake and eat it, too.
How Do I Get the Most Out of My SC Future Scholar Program Plan?
How Do I Calibrate My Investment in a SC Future Scholar Program Plan to Maximize My Investment or Manage My Risk?
Because you can only change the investments in a 529 plan twice each calendar year, many investors choose to select an age-based or a risk-based portfolio that is rebalanced by the plan administrator. The SC Future Scholars Program plan offers the following asset allocation portfolios:
The age-based portfolios are divided into Aggressive, Moderate, and Conservative tracks. Different asset allocation portfolios can be used at different ages to create a glide path toward your child’s college entrance date.
If you purchase share through a broker, there are some small differences in the allocation portfolios because they offer some actively managed fund choices not available to direct buyers.
Ready to take advantage of significant state income tax savings while creating future educational opportunities for a child? Talk to Oak Street Financial Advisors about the best way to set up and calibrate your SC Future Scholars Program 529 Plan today.