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Wash Sale Rules and IRAs

Mar 21st, 2022
by jblankenship.
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Photo credit: jb

You may already be familiar with the Wash Sale Rule for buying and selling securities. Briefly, when you sell a security at a loss, if you’ve purchased it within 30 days (either before or after the sale), then the loss is disallowed for tax purposes, and the basis of the newly-purchased stock is then increased by the amount of the disallowed loss.

The general rule disallowing the loss is relatively clear, but what’s not clear to many folks is that this applies to all accounts that you and your spouse own – including IRAs. How can capital losses be considered within IRAs, you may ask?

Here’s an example: Say you purchased 100 shares of ABC stock in your taxable account at $50 per share several years ago. After holding the shares for quite a while and watching them languish and continue to lose value, you decide to sell the shares at $40 so that you can at least take the tax loss for some minimal benefit from the situation.

Then, a week after you sell the shares, you learn that ABC is ready to introduce a brand-new, absolutely revolutionary, widget. This new widget is expected to blow the industry away – and you want to get in on the action. So, realizing that you just sold 100 shares for a loss, you have your spouse buy 100 shares in his IRA for $43, 8 days after you sold the original 100 shares.

Bingo. You just triggered the wash sale rule, disallowing the original loss for tax purposes. This is because in considering the wash sale, all accounts, IRA and otherwise, for you and your spouse, are included. Unfortunately in this case your tax loss is gone forever since your IRA purchase has no tax basis.

Had the accounts been different – that is, if the original purchase had been made in your taxable account and the subsequent purchase made in another (or the same) taxable account, you’d at least have your basis of $43, plus the disallowed loss of $10 (new basis = $53) against which future capital gains or losses would be calculated. Additionally, if you had only waited 30 days from the original sale of the shares of ABC, you could have made the purchase in either account with no wash sale impact.

So be careful as you make tax loss moves – consider all of the ramifications of the wash sale rules.

Posted on Mar 21st, 2022
by author: jblankenship.

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Wash Sale Rules

Mar 14th, 2022
by jblankenship.
4 comments
wash sale

Photo credit: jb

If you’ve been investing for any period of time, you may have run across the term Wash Sale. Do you know what it means? And what are the IRS rules regarding Wash Sales?

In a nutshell, a wash sale occurs when you sell a security (stock, bond, or mutual fund, for example) at a loss, either followed by or preceded by a purchase of substantially the same security within 30 days of the sale. The IRS disallows the recognition of the loss for tax purposes in such cases. Without the purchase portion of the set of transactions, you would be allowed to utilize the capital loss to offset other capital losses and possibly offset ordinary income, depending upon the circumstances.

The Details

When you sell, at a loss, a security of any sort that would be treated as a capital item, the loss will be disallowed for tax purposes if you purchased substantially the same security within 30 days before or after the sale:

  • In a taxable account or a deferred account (all accounts under your household are counted together, that is, yours, your spouse’s, and any corporation you control) or
  • As options or futures contracts

Of course, the initial sale of the security must be within a taxable account – that is, not within an IRA or other deferred-tax account. This is because we’re referring to capital gains treatment of gains and losses, which do not apply to IRAs and deferred-tax accounts. Prior to Revenue Ruling 2008-5, one could effectively purchase a new, substantially same position in your IRA or Roth IRA within the 30 day period after the loss sale in your taxable account, and it would not engage the wash rule. This has been disallowed now.

So what makes up a substantially identical security?

In the IRS’ own words:

In determining whether stock or securities are substantially identical, you must consider all the facts and circumstances in your particular case. Ordinarily, stocks or securities of one corporation are not considered substantially identical to stocks or securities of another corporation. However, they may be substantially identical in some cases. For example, in a reorganization, the stocks and securities of the predecessor and successor corporations may be substantially identical.

Similarly, bonds or preferred stock of a corporation are not ordinarily considered substantially identical to the common stock of the same corporation. However, where the bonds or preferred stock are convertible into common stock of the same corporation, the relative values, price changes, and other circumstances may make these bonds or preferred stock and the common stock substantially identical. For example, preferred stock is substantially identical to the common stock if the preferred stock:

  • Is convertible into common stock,
  • Has the same voting rights as the common stock,
  • Is subject to the same dividend restrictions,
  • Trades at prices that do not vary significantly from the conversion ratio, and
  • Is unrestricted as to convertibility.
The above is quoted directly from IRS Publication 550

The question comes up all the time – I always say as a rule of thumb that if you have to question whether your choice of a replacement is substantially identical or not, then it’s not worth it to have to argue the point with the IRS when you’re audited. It’s only 30 days, after all.

Examples of Wash Sale Avoidance

Below are a few examples to help understand the idea of substantially identical, and how to avoid it in practice.

Example 1:  You sell, at a loss, shares of a mutual fund that is invested in the S&P 500 index. On the same day you purchase a mutual fund that is invested in a total stock market index. The two investments are not substantially identical, so you avoid wash sale treatment. If you instead purchased another mutual fund (perhaps with another fund family) that invests in the S&P 500 index, you will be subject to the wash sale rules because the new fund is substantially identical to the original fund.

Example 2: You sell, at a loss, shares of a mutual fund that owns a portfolio of Treasury Inflation-Protected Securities (TIPS). Within 30 days you use the proceeds from the sale to purchase another mutual fund that invests in GNMA bonds (Government National Mortgage Association, or Ginny Mae). This set of transactions avoids the wash sale, because GNMA bonds are not identical to TIPS.

Example 3: You sell your S&P 500 index investment mentioned in example 1. You wait 30 days, and on the 31st day you purchase the exact same (or another fund family’s) S&P 500 index investment. This set of transactions avoids wash sale treatment because enough time has passed (30 days) since the sale for a loss.

Examples for Handling Wash Sale Disallowed Losses

So, instead of allowing the loss, the IRS gives you the ability to increase the basis of the security that you purchased, by the amount of loss that you were disallowed.

Example 1: You own 100 shares of stock that you purchased last year for $1,000. You sell those shares for $750, and within 30 days, you purchase another 100 shares for $800. You have a disallowed loss of $250, which will be added to the basis of your current holding, making the basis now $1,050 ($800 plus $250).

Example 2: You purchase 100 shares of stock for $1,000, and then sell them for $750 within 30 days. Your loss is disallowed. In this case, since you don’t own the stock any more, the loss is just gone, unless you repurchase the position within 30 days, within a taxable account. Purchasing the shares in an IRA won’t provide the benefit of the disallowed loss added to basis, since your stock in the IRA has no basis. All sales within an IRA result in zero tax impact.

Example 3: You own 100 shares of stock that you purchased last year for $1,000. You sell all 100 of those shares for $500, and within 30 days you purchase 50 shares again for $200. These 50 shares will have a basis of $450 due to the disallowed loss of $250 (since you only have wash impact on half of your sale). You would still have an allowed loss of $250 for the activity (the other half) unless you repurchased additional shares within 30 days.

It can get really complicated if you have multiple purchases and sales and overlapping 30 day periods, so if you have a particular situation that you’d like to review, please let me know. Other complicating factors include the use of short sales, options, and futures contracts.

Posted on Mar 14th, 2022
by author: jblankenship.

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Posted in: financial planning, investing, IRA, tax, wash sale.
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Principles of Pollex: Debt Reduction

Mar 7th, 2022
by jblankenship.
1 comment
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Photo credit: jb

(In case you’re confused by the headline: a principle is a rule, and pollex is an obscure term for thumb. Therefore, this series is all about Financial Rules of Thumb.)

Try as we might, there are times when debts just overtake us. Quite often it is one of several things that causes this to happen – either we’ve had unexpected expenses hit us “alla sudden-like”, or perhaps a layoff or lean time with little or no income. Or maybe we just didn’t pay attention and debt grew out of control.

How’d I Get Here?

The reason we’re in this position is important, because we can’t let the debts continue to increase – so the first order of business in reducing your debts is to stop the bleeding. Figure out what the cause of the debt was, and work out a way to stop increasing the debt (if possible). If it’s just regular spending, shopping and the like, you need to get a handle on your outflows, or come up  with a way to increase your income so that you’re not adding to the debt load. Whatever the cause of the debt in the first place, you need to stop it from increasing.

I recognize that folks with high medical expenses (for example) are not in a position to reduce the outflows. In a situation like that, godspeed to you, hope your situation improves.

After you’ve stopped your debt from increasing, it’s time to come up with a plan to start reducing the debt load. In order to do this, we go back to the time-honored method of Organization, Efficiency, and Discipline to work through your debt reduction.

Organization

To start off with, you need to Organize. List all of your debts, including the balance, interest rate and minimum payment for each. You can do this on a sheet of tablet paper, or on a spreadsheet like Excel or Google docs. Once you’ve listed all of your debts, you can tally up your total amount that you owe, as well as how much your monthly cost is at a minimum.

For many folks this is the first time they’ve put it all together in one place, and it can be a bit scary. What’s important is that now you know where you are… and of course, where you’re going is to take that balance down to zero. It becomes a matter of filling in the space in between.

One way to do this is to just make the minimum payments every month, and eventually you’d pay it all off. But there are better ways to go about this, more efficient ways, especially if you have a little extra to pay each month above the minimum. If you don’t have any extra, consider eliminating some other monthly expense, or selling an item (or items) that you no longer use.

Efficiency

Let’s use a very simple example – say you have three debts, totaling $200 each, at rates of 10%, 15%, and 20% respectively. These three debts each have a monthly minimum payment of $10 each. If you paid the minimum on each debt every month, you’d pay off the 10% debt in 24 months, the 15% debt in 26 months, and the 20% debt in 27 months. But let’s say you have a total of $40 to apply toward debt each month…

If you split the $40 evenly between the debts, now your 10% and 15% debts would be paid off in 19 months and the 20% debt in 20 months. Pretty good deal, right? You’ve shaved 8 months off the time to pay it all off. But there’s a better way to do this.

What if you took the extra $10 and paid it toward the highest rate first? Now the 20% loan would be paid off in 14 months. Then, if you took the $20 that you’d been paying toward the 20% debt and added that to the $10 minimum that you’d been paying on the 15% debt (so that the total payment now is $30), that debt would be eliminated by the 17th month. Adding that $30 to your 10% debt payment, you’d be finished paying off that debt by the 18th month.

Not only have you shortened the timeline by a month, but by paying the highest rate debt first, you’d reduce the overall cost of the debt earlier. This method is known as a “debt snowball”.

Discipline

The debt snowball will only work if you stick to it… and the whole idea of debt reduction requires discipline in order to make it work. If you start off on the project and free up some of your credit line, only to build up the debt again, you’ll be back to square one again before you know it. This is why I mentioned at the start that you need to understand how you got into this debt position in the first place. If you’re simply spending far more money than you can bring in with your income, you have to figure out a way to fix that situation. There is no way to resolve this problem without either bringing in more money or reducing your expenditures.

Posted on Mar 7th, 2022
by author: jblankenship.

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Posted in: financial planning, principles of pollex, rules of thumb.
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Are You Really Diversified?

Feb 21st, 2022
by jblankenship.
1 comment
eggs-basket

Photo credit: steelo

Sometimes we fool ourselves. Sometimes we think we’re doing the right thing, when in fact the result is that we’re not at all doing what we think we are.

I’m talking about your investment diversification. Within your 401(k) you have certain options available for you to choose from: a large cap stock fund, a mid cap stock fund, an international stock fund, and a bond fund. Recalling an article you read somewhere… you know you need to split up your investments among many allocation options. So, wanting to do this diversification thing right, you split up your 401(k) contributions with 25% in each of the funds available. You’re well-diversified, right?

Wrong city, bucko.

Correlation

Welcome to correlation. Investopedia defines correlation as:

a statistical measure of how two securities move in relation to each other.

It’s pretty complicated, but the gist is this – if two securities are perfectly correlated, when one moves up or down, the other moves up or down in perfect relation to the other. Such securities are said to have a correlation coefficient of +1.

On the other hand, if one security moves up and the other moves down (and vice versa, by the same proportions), they are said to be negatively correlated, with a correlation coefficient of -1.

Lastly, if one security’s movement has no relationship whatsoever to the other security – that is, any particular movement by one of the securities may or may not result in a movement in the same direction, the opposite direction or no movement at all. These two securities have a correlation coefficient of 0 (zero).

Most pairs of common securities fit somewhere along the spectrum between +1 and 0, since very few are perfectly correlated. Negative correlation is typically found in hedge funds – which are a costly, complex sort of asset to hold, being designed to work opposite of the general market movements. Since long-term stock market movement is in a positive direction, many hedge funds are “hedging” that the opposite will occur.

With the above explanation, hopefully it becomes clearer to you why we want securities in our portfolio that are not correlated closely to one another… having such pairs of securities spreads out our risk of any single market event having adverse impact on everything in our portfolio.

Examples of Correlation

Back to our example portfolio, here are the hypothetical correlation coefficients* for your four choices, shown in a matrix:

1 2 3 4
1. Large-Cap Stock 1.00 0.96 0.93 0.28
2. Mid-Cap Stock 0.96 1.00 0.91 0.27
3. International Stock 0.93 0.91 1.00 0.44
4. Bond Fund 0.28 0.27 0.44 1.00

*Note: These hypothetical correlation coefficients are for illustration only, but were accurate at one time, but they are subject to change over time. In addition, the specific makeup of each fund will produce a different correlation coefficient versus the other funds in the real world. Use one of the many tools available on the internet to get a handle on the coefficients for your chosen funds.

As you can see, the large cap, mid cap, and international stock choices are very closely related to one another. That’s why, even though you thought you were well-diversified during the market slump a couple of years ago, everything you had took a dive.

Note how the Bond Fund is far less correlated to the to the stock funds. Each of the correlation coefficients is less than 0.5. The large- and mid-cap are nearing 0.25, coming very close to the 0 of perfect non-correlation.

This is why the first, most important allocation choice you can make is between stocks and bonds (we’ll get to some other allocation options later). These two, of the choices you have, are the least correlated, so it’s very important to include these non-correlated assets together in your allocation scheme. And then within your chosen split into stocks, you can choose some of the other asset options – large cap, mid cap, small cap, international – since those assets aren’t perfectly correlated, it can be beneficial to include diversification among these options as well.

The same goes for bonds – other types of bonds, such as Treasury Inflation-Protected bonds, are not perfectly correlated with the total bond market, so it might make sense to include some of these as allocation options as well.

What about other types of assets?

We’ve talked about some very basic allocations – but what about other types of assets? There’s real estate (both domestic and international), emerging markets stocks, commodities, and others. How does the correlation of these assets look?

The table below details the hypothetical correlation matrix for these additional assets in relation to domestic stocks, international stocks, and bonds.

1 2 3 4 5 6 7
1. Domestic Stock 1.00 0.93 0.27 0.84 0.93 0.89 0.60
2. Int’l Stock 0.93 1.00 0.44 0.79 0.96 0.93 0.65
3. Domestic Bond 0.27 0.44 1.00 0.33 0.39 0.32 0.25
4. Domestic RE 0.84 0.79 0.33 1.00 0.83 0.68 0.44
5. Int’l RE 0.93 0.96 0.39 0.83 1.00 0.88 0.65
6. Emerging Stock 0.89 0.93 0.32 0.68 0.88 1.00 0.71
7. Commodities 0.60 0.65 0.25 0.44 0.65 0.71 1.00

As you can see in the matrix, adding these additional asset classes gives you even more diversification (per the correlation). Commodities show up as the next most non-correlated to stocks (after bonds), which explains why this is a popular asset class to consider. Not only are commodities not well correlated with stocks, they are even less correlated to bonds.

Real estate, both domestic and international, gives you additional diversification, but not nearly as much as bonds and commodities – turns out that real estate, while not a perfect match for stocks, does follow the movement of stocks somewhat closely.

How?

You might be saying “but I don’t have those kinds of options available in my 401(k)” – what can you do? This is part of why it can be useful to have other savings plans in your scheme, such as a Roth IRA or a taxable account. With these other accounts, you can have the flexibility to invest in whatever asset classes you like.

Investing in multiple asset classes has the effect of lowering the overall risk in your portfolio, while (potentially) enhancing the return, more than just averaging the returns together. Since your well-diversified assets do not move in direct relation to one another, when the domestic (US) stock market has a downturn, your other assets don’t necessarily reflect that same downturn, buoying your overall return.

Posted on Feb 21st, 2022
by author: jblankenship.

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Posted in: financial planning, investing, IRA, retirement plan.
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Social Security vs. Saving

Feb 14th, 2022
by jblankenship.
4 comments
triple-decker

Photo credit: jb

I received a question from a reader that sort of dovetails with the earlier post about payback from Social Security, so I thought I’d run through the numbers on his question here. I never met a spreadsheet I didn’t like!

Here’s the question from the reader, verbatim (yes, I get emails this brief and to the point sometimes):

started work at age 20 retire at age 70.

Over 50 years of work I average $50,000 a year.

If I put 10% of my income away every month from age 20 to age 70 how would I come out versus depending on the government social security checks I would receive after retirement.

Initial Reaction

My initial reaction to this question was that you’d be much better off with the savings option, since you’re saving at a much greater rate (10%) than the withholding, and for fifteen more years than the Social Security system takes into account. However, that’s not altogether correct, since the Social Security system includes both your withholding and your employer’s withholding, for a rate in 2022 of 12.4%. So let’s go ahead and run the numbers.

Assumptions

There are a few assumptions that we have to make in order to complete this exercise:

  • In order to come up with an average wage, I first looked at the maximum Social Security withholding.  By calculating the average from 1962 to 2022, we come up with an average of $60,422. This is more than the average that the reader suggested, but it will work for our purposes and keep the calculations a bit simpler.
  • Putting aside 10% each year requires that we come up with a rate of return for this investment account.  I used a simple 5% return, which is reasonable over a long period of time.
  • I assumed that the side account is an IRA or a 401(k), so taxes have not been factored into the acquisition phase equations.

Calculations

As we saw in the earlier post, earning the Social Security maximum over the final 35 years of your working career will give you a monthly benefit of $3,878 in 2022 if you file at age 70.

Saving 10% of your earnings (using the maximum Social Security wage base) over 50 years at 5% will bring you to a total in your IRA or 401(k) of $1,055,178. Running a few simple quotes from single premium annuity websites indicates that an immediate joint and survivor annuity with a single deposit of $1,055,178 will result in approximately a $4,873 monthly payment.  And that’s a fixed payment, not a COLA-adjusted payment like your Social Security benefit is.

As well, the $4,873 is fully taxed, whereas the Social Security benefit is, at most, 85% taxed. It could be much less, even zero, depending on your other income in retirement. If we take the reader’s word as literal, that this is all he has available to him (either the IRA or the Social Security), we see that the annuity will be taxed at 12% assuming married filing jointly (2022 rates), while the Social Security would be tax free. The end result is that the savings is a better option, with a net $4,609 per month after taxes, versus $3,878 in Social Security (no tax).

With a modest 1.5% COLA, the Social Security benefit catches up with the net annuity by his age 82.

However, upon the death of both you and your spouse, there is nothing left over in either situation – so the question becomes one of longevity. If you both live long, full lives, the Social Security option works out much better. If you and your spouse die earlier, any time before about age 85, there may be something left over for your heirs in the savings option.

Conclusion

In the end result, it seems that the Social Security benefit option is a pretty good deal, especially since we all hope to live a long, full life. The savings option works better if you die earlier than age 85, by possibly providing a residual amount to your heirs. This is a little different from what I’d originally thought, but when you consider that the average life expectancy of a male age 70 is roughly 84 (86 for females), there’s about even probability between outliving and not outliving your savings.

The fact that the Social Security benefit is tax preferred (85% at most, as little as zero taxed), subject to COLA adjustments, and is guaranteed (ok, don’t beat me up on that one, because any adjustments to the guarantee are bound to be pushed out way beyond the lifespan of this individual), it’s a triple-decker. Social Security is the hands down winner, assuming you live long enough. Plus, instead of 10% being put into savings, only 6.2% of your own income is going toward the Social Security taxation. The other 3.8% could be diverted to savings, making the SS side even better.

And finally, since you don’t really have a choice in the matter, the entire question is really moot – but an interesting exercise, nonetheless.

Posted on Feb 14th, 2022
by author: jblankenship.

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Posted in: financial planning, investing, IRA, reader questions, retirement plan, Social Security.
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Running Afoul of the One-Rollover-Per-Year Rule (and How to Fix It)

Feb 7th, 2022
by jblankenship.
3 comments
no-no

Photo credit: jb

In case you’re not aware of it, there is a strict rule that the IRS applies with regard to IRA rollovers: you are allowed to roll funds over from an IRA using the 60-day rule only once during each 12-month period. FYI: Trustee-to-trustee transfers are not considered rollovers for this rule.

Here’s an example of what could happen: Early in the year, you withdraw some money from your IRA to help you catch up on some bills. Then, you receive a bonus within the 60-day period after your withdrawal, so you deposit those funds back into the same (or any other) IRA.

Later in the year, you want to take another short-term distribution from your IRA, and once again circumstances present the opportunity to put the funds back into the first IRA… but now you’re stuck. You can’t roll the distribution back into the original IRA (or any IRA), since you’re still within the 12-month period, and the 12-months won’t be up until after your 60 days is past. And you can’t roll it into another IRA either, since the rule applies to all IRAs.

You’ll be liable for the tax on this distribution, which might be troublesome in itself. Plus, you’ll be derailing a portion of your retirement funding, taking this money out of the deferred-tax bucket. Also, unless you meet one of the exceptions (see #3 below) you may be subjected to an additional 10% penalty for the withdrawal.

Here’s what you can do

You have a few choices in a situation such as this:

  1. Rollover the IRA money into a qualified plan, such as a 401(k) or 403(b). Not all of these plans allow “roll-ins” but many allow roll-ins nowadays. The 12-month rule doesn’t apply to rollovers from an IRA to other types of plans. This will keep the money in a deferred-tax account, costing you no additional tax or penalties at this time.
  2. Convert the funds to a Roth IRA. Even though you’ll have to pay tax on the conversion, this can be a valid move as well. The 12-month rule also doesn’t apply to conversions. You’ll have to pay tax on the withdrawal anyway since it can’t be rolled back into a traditional IRA, so you might as well make lemonade from your lemony situation.
  3. Review the list of exceptions to the early withdrawal rules in 19 Ways to Withdraw IRA Funds Without Penalty – you might be able to at least avoid the early withdrawal penalty of 10% by applying one of these options.

That’s all I can come up with to help you deal with a situation where you’re affected by the one-rollover-per-year rule. See the article The One-Rollover-Per-Year Rule: Revised for more information about how this limitation rule works.

Posted on Feb 7th, 2022
by author: jblankenship.

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Your Payback from Social Security

Jan 31st, 2022
by jblankenship.
5 comments
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Photo credit: hbd

One of the big questions that many folks face with regard to Social Security benefits is – I’ve paid in so much, will I ever see it come back?

I thought I’d show what a payback break-even might look like, in terms of the money you put into the system and what you’ll get back out of it.  I made an assumption in the calculations:

Future COLAs were not calculated into the example, keeping things in terms of today’s dollars. COLAs would only confuse the calculations.

Full Retirement Age

In this first series I assumed the normal, Full Retirement Age scenario, with two options: 1) you earned exactly half of the wage base that SSA requires withholding for each year of your 35-year working life, and you’re now age 66 and 2 months, Full Retirement Age; and 2) you earned exactly (or more than) the maximum amount of money that the SSA requires withholding during that period. Here’s the outcome:

Earnings Withholding Benefit Payback Period
Half $1,608,000 $99,696 $2,113/month 3 years, 11 months
Full $3,216,000 $199,392 $2,889/month 5 years, 9 months

Did you find that surprising? I bet you might have. So, in terms of dollars in, dollars out, you get your money back out of the system in less than six years, less than four if you earned half of the max.

I’ve included the half wage base example to point out the fact that people who earn more take a longer time to receive all of their money back out of the system. This is because of the way your benefit is calculated – notice that the benefit for the half wage base earner is actually 73.1% of the benefit of the full wage base earner, even though the half wage base earner only earned (and paid in) half of what the full wage base earner did.

But wait a second… if I didn’t have that money withheld by SSA, I’d be doing something with it, right? Okay, let’s look at the situation if you had put that money into a savings account for later use (even though there’s a strong likelihood you’d have just bought something with it, right?).

Saving The Withholding Yourself

So we’ll assume that you put this money aside in a savings account which earns 3% per year. Here’s the outcome:

Earnings Withholding
(plus interest)		 Benefit Payback Period
Half $1,608,000 $160,884 $2,113/month 6 years, 4 months
Full $3,216,000 $321,770 $2,889/month 9 years, 3 months

Still, in my opinion, a pretty surprisingly low number. This means that, in the maximum withholding example, you’ll get back everything that you put into the system in less than nine and a half years, by your age 75 and a few months. In the half wage base earner example, your money is returned to you in less than six and a half years, by age 72 and a few months.

What happens though, if you take your benefit early, at age 62?

Starting at age 62

Since at age 62 you’d be taking the benefit at a 75% rate, this will take a bit longer to pay back, but you’re starting earlier so you’ll perhaps have more life ahead of you to achieve the payback. Here’s the result from these calculations (with the interest factor built in):

Earnings Withholding
(plus interest)		 Benefit Payback Period
Half $1,409,400 $139,938 $1,585/month 7 years, 4 months
Full $2,818,800 $279,875 $2,167/month 10 years, 9 months

In the half wage base example, your payback period is increased to more than 7 years, but you’re only age 69 and 4 months at this stage. With the full wage base, a year and a half is added to the payback period, but instead of age 75, you hit the break-even point just before age 73.

Just for grins, let’s figure this out for filing at age 70.

Starting at age 70

By delaying to age 70, you achieve an 8% increase in your benefit each year. Here’s the tale of the tape (again, with interest added in):

Earnings Withholding
(plus interest)		 Benefit Payback Period
Half $1,923,900 $205,265 $2,845/month 6 years, 0 months
Full $3,847,800 $410,529 $3,878/month 8 years, 9 months

In the full wage base example, your personal money paid into the system, with interest added, is paid back in just a bit less than nine years (right at six years in the half wage base example), when you’re just less than age 79. In the half wage base option you’ve been paid back in full just at your age 76.

A note about the calculations: Don’t get too hung up on the specifics of the calculations – they’re meant to be a representative example that the payback of what you had withheld occurs relatively quickly. The assumptions that I made throughout may not match your own circumstances, so the result will differ somewhat, but the principle is the same.

Conclusion

If you happen to have the mindset that you should try to get your money back out of the system as soon as possible (which I believe is a short-sighted approach), then you should start taking your benefit as early as possible at age 62. You’ll get your payback before age 72 if you’ve maxed out your withholding, or before age 69½ in the half wage base example.

Unfortunately, you’ll be short-changing yourself (and your spouse, if you’re the primary breadwinner) of future increased benefits at the cost of saving only four years in the payback cycle (or five years in the half wage base example). Of course, this assumes that you do live at least to the ages we calculated. See the article Ah, Sweet Procrastination! for more details on the benefit of delaying taking your Social Security benefit.

Posted on Jan 31st, 2022
by author: jblankenship.

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Posted in: financial planning, Social Security.
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RMDs in 2022 and beyond

Jan 17th, 2022
by jblankenship.
4 comments
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In case you didn’t realize it, the IRS made some changes to the RMD process, which applies to Required Minimum Distributions in 2022 and years thereafter. For most folks this is a minor adjustment which actually reduces your RMD a bit. But for folks with inherited IRAs that aren’t subject to the 10-year payout or the 5-year payout, you’ll want to pay attention to the section below about RMDs for Inherited IRAs.

So what changed? The actuaries at the IRS (under an executive order from the President) reviewed the then-current tables in 2018 and determined that the changes in longevity made the old tables inaccurate. So new tables were generated, and they are applicable beginning with tax year 2022.

These tables – specifically Table I (the Single Life Expectancy table – used for inherited IRAs), Table II (Joint and Survivor table – for use when there is more than 10 years between the ages of a couple), and Table III (Uniform Life Expectancy table – for regular IRAs when there is less than 10 years between the ages of a couple, or the individual is single) – were updated for 2022 to reflect longer lifespans for Americans that are subject to these required distributions.

Generally the Uniform Life Table (Table III) is the most commonly used table. If you’re using this table for RMDs from your IRA (or other qualified plan), you will just refer to the new table (use the link above) when you calculate the RMD for 2022. It’s really that simple, and you may notice that using the new table results in a slightly smaller percentage of your account as an RMD. This is because the table was lengthened, making the earlier payments a bit smaller.

The same is true if you have a regular IRA and you’re using Table II, for a situation where your spouse is more than 10 years younger. Again, just apply the new table factor and you’re good to go, with a slightly decreased RMD percentage for 2022 and beyond.

RMDs for Inherited IRAs

Beginning with 2022, if you inherited an IRA prior to the rule changes which took effect in 2020, you were likely using Table I, the Single Life Expectancy table. If you inherited an IRA in 2020 or later, unless you’re a Eligible Designated Beneficiary (EDB), you’ll be subject to the 10-year payout period. This means that you don’t have to take annual distributions from the inherited IRA, you just need to completely distribute the IRA by the end of year of the 11th anniversary of the death of the original owner (it’s called the 10-year payout period because you have a full 10 years to withdraw). In some cases you might be subjected to a 5-year payout period, but that’s a topic for another time.

If you just inherited this account in 2021, the RMD for 2022 (your first year of RMDs) is straightforward. Look up your current age on Table I, the Single Life Expectancy table, and divide your 2021 year-end balance by the factor given. Then in each subsequent year, subtract 1 from the factor you got for the prior year, and divide your previous year-end balance by the new figure to produce your RMD.

However, if you inherited the IRA sometime prior to 2021 and had begun taking RMDs in 2021 or earlier based on the old tables, you have to make an adjustment to your process. Essentially you need to go back to when you first calculated an RMD for yourself on this account, and replace that figure with the new figure from the updated Single Life Expectancy table. Now, you’ll subtract 1 from the new factor for each year that has passed since you started. This will bring you to the new RMD factor for 2022. For each subsequent year, you’ll just subtract 1 from last year’s factor and divide.

Let’s walk through an example which may help your understanding:

Michelle inherited an IRA from her father, who died in 2018. Michelle was required to begin taking RMDs from the account in 2019 when she was 52 years old. The account’s year-end balance for 2018 was $90,000. From the old Single Life table, Michelle’s age 52 gave her a factor of 32.3. Dividing the year-end balance by 32.3 results in $2,786.38, which is Michelle’s Required Minimum Distribution for 2019.

For 2020, no RMDs were required (waived by the CARES Act), so Michelle skipped this distribution. If the “skip” wasn’t in place, Michelle would have taken the 2019 year-end balance in the IRA ($92,446) and divided it by her updated factor of 31.3 (subtracting 1 from her original factor). This would have resulted in an RMD of $2,953.55 for 2020.

For 2021, RMDs were once again required. Michelle took the year-end balance from the IRA ($97,992) and divided it by the updated factor of 30.3 (again, subtracting 1 from last year’s factor). The resulting RMD is $3,234.06.

The 2021 year-end balance of the IRA has grown to $103,286. If the old table was still in effect, all Michelle would have to do is subtract 1 from last year’s factor, resulting in 29.3, and divide the balance by that number. The result would have been an RMD of $3,525.12. 

However. There’s a new table in town.

The implementation of the new table requires Michelle to go back and do some adjusting. She needs to go to the new Single Life Expectancy table and get her new factor from when she started RMDs – her age 52. This new factor is 34.3. Since 2022 is the third year since she started RMDs, she’ll subtract 3 from her factor, to come up with the new factor of 31.3. Dividing the 2021 year-end balance of $103,286 by 31.3 results in an RMD of $3,299.87 – a few hundred less than the original table’s result.

Then for next year, Michelle will subtract 1 from her 2022 factor, which results in 30.3. She’ll divide the 2022 year-end balance in the IRA by that factor to calculate her 2023 RMD. 

In all cases that I can think of, these new tables will result in a lower RMD for everyone. The good news is that if you don’t make the adjustment, the only thing that will happen is you will take a slightly higher RMD than you had to. This will result in a slightly shorter payout period for your IRA – not the end of the world, but if you’re hoping to stretch that IRA out as long as possible, you’ll want to use the new tables.

A sample spreadsheet to calculate RMDs

Here’s a way you can use a simple spreadsheet to calculate the figures:

In a blank spreadsheet (Excel or GSheets or whatever spreadsheet tool you use), list the year in the first column. Second column will have your year-end balance from the prior year. The third column will hold your Table I factor. And in the fourth column, you can calculate the resulting RMD. I use the simple formula of “=B2/C2” (don’t include the quotation marks) in the fourth column (column D).

It looks like this when finished:

Then for the next year you can put the formula “=C2-1” (don’t include the quotation marks) in your third column (cell C3), which will subtract 1 from the prior year’s factor. In my sample I just made up a number for the 2022 year-end balance (which is in cell B3) to make the calculation in D3 work.

For subsequent years, fill in column A with the applicable year, column B with the new year-end balance, and then copy down the formulas in columns C and D. You can do this quickly by highlighting the current year’s C column, then while holding down the shift key hit the right arrow and the down arrow once each – this expands your highlight to current cells C and D and the corresponding C & D below. Release the shift key, and then hit Ctrl+D on your keyboard. Sorry Mac users, I don’t have your shortcut but I’m sure it’s just as simple.

Posted on Jan 17th, 2022
by author: jblankenship.

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Posted in: IRA, required minimum distribution, rmd.

Rolling Over Your Roth 401(k)

Jan 3rd, 2022
by jblankenship.
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Roth 401(k) plans have been around for a while now, but here’s something you want to keep in mind about these accounts. When you leave your employer, generally speaking, you should always rollover your Roth 401(k) to a Roth IRA. There may be a few exceptions, but that’s the general advice.

This is primarily due to the Required Minimum Distribution (RMD) requirement that is placed on Roth 401(k) accounts… unlike a Roth IRA, the owner of a Roth 401(k) is required to take minimum distributions (RMDs) beginning at age 72, just like traditional 401(k) and IRA plans. Therefore, at some point before age 72 (often upon separation from service) the owner of the Roth 401(k) should rollover the account to a Roth IRA. But see the caution below!!

Roth IRAs do require the beneficiary to take RMDs after the death of the primary owner, but the distributions are tax free, as would be expected. But otherwise, during the life of the primary owner of the account, there is no RMD required.

A Word of Caution

The Roth 401(k) (and Roth IRA) both require you to have held the account for five years, and a triggering event must have occurred (such as reaching age 59½), before the distribution is qualified and therefore tax-free. The tricky part is that the time in the Roth 401(k) doesn’t count toward time held in a Roth IRA.

So, if you roll over the Roth 401(k) account before you’ve met the five year requirement, all the time that you’ve held that account is wiped out, and the time you’ve held the Roth IRA is the new holding period. If you put the funds into a new Roth IRA, you will have to wait another five years before you can take the money out in a qualified fashion.

If you’d held the Roth 401(k) for five years or longer and a triggering event has occurred, rolling the funds over to a Roth IRA (of any age) allows you to withdraw the funds at any time, for any purpose, without tax.

Posted on Jan 3rd, 2022
by author: jblankenship.

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Posted in: retirement plan, Roth 401(k), Roth IRA.
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Book Review: Stacked – Your Super Serious Guide to Modern Money Management

Dec 27th, 2021
by jblankenship.
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Stacked

Stacked

If you’ve looked for a good book to help you manage your money better, I’m sure you’ve been overwhelmed by all of the possible options out there. The problem with most of these books is that they take a very serious approach to teaching you about money – after all, money is a serious matter, right? And being serious is not a very enjoyable place to be, so unfortunately working through many of the books available can be a real slog.

What if I told you that there’s another option out there, a book that will entertain you, even make you snicker, along with teaching you some very serious things about money?

Today I have the privilege of reviewing a new book by my friend Emily Guy Birken and her co-author, Joe Saul-Sehy. The book is entitled Stacked – Your Super Serious Guide to Modern Money Management. These two folks have taken on the monumental task of keeping you engaged, entertained, and learning all the way through their guide to a quite serious subject – and they’ve done an amazing job! 

You might recognize the names – Emily has been writing in the personal finance space for many years now, and Joe has a very successful personal finance podcast, Stacking Benjamins. If you’ve spent any time at all searching through the internet for personal financial guidance, you’re sure to have come across one or the other (or both!) many times. As I understand it, this is the first time they’ve worked together, and they have done a wonderful job, in my opinion.

Throughout the book, you’ll find many new and interesting angles to consider each financial concept – and you’ll find a peppering of interesting factors as well. Who knew you could learn about money management alongside such diverse references as: Oregon Trail, Gordita Supremes, Thomas Jefferson (“stone-cold red headed Tommy Jeff”), Tetris, platform shoes with goldfish in the heels, Veruca Salt, MFs, a Snoopy Sno-Cone maker, beanie babies, a notorious tatoo, fine Michigan wine, as well as David Lee Roth and Brian Wilson (in the same paragraph, no less!). 

You’ll also find out the answers to some burning questions that you didn’t even realize you needed to know, such as why you might need to call Sallie Mae “Ms. Mae”, why debt-payoff strategies are so snowy, and what makes a sleeping financial professional exclaim “Past performance is no guarantee of future results” without actually waking up. 

Clearly this isn’t your typical money management book. But the lessons within are fantastic, and all of the wonderful sidebars and somewhat silly examples kept me entertained throughout. 

Joe and Emily don’t do all of this alone, either. Sprinkled throughout the book are timely advice from Joe’s Mom, who is a surprisingly astute observer of all things financial. In addition, each chapter contains a transcript from the popular Stacking Benjamins podcast, from financial industry and personal finance luminaries such as Jean Chatzky, Paula Pant, David McKnight, Jill Schlesinger, and Farnoosh Torabi, to name a few. With these additions, you not only get Joe & Emily’s view of matters, but some of the finest minds in the personal finance space to boot.

All in, I thoroughly enjoyed reading this book. At 300+ pages, it was a surprisingly quick read, primarily due to the fun and irreverent ways the authors present these serious topics. I highly recommend this book for anyone who has been left cold by the current offerings of money management guides, as well as for anyone who could use another perspective to help them along the way to managing your money. I’ve been in this industry for, well let’s just say a long time, and I picked up a few gems myself!

Kudos, Emily and Joe!

Posted on Dec 27th, 2021
by author: jblankenship.

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Posted in: Book review, financial planning, personal finance.

3 Ways of Dealing Without Recharacterization

Dec 20th, 2021
by jblankenship.
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As of the passage of the Tax Cuts and Jobs Act of 2017, recharacterization of a Roth IRA conversion is no longer an option. What can you do to now, to simulate the benefit had by recharacterization of a conversion?

It should be noted that regular contributions to a traditional or Roth IRA can still be recharacterized – it’s only a traditional IRA-to-Roth IRA conversion that is disallowed.

If you recall, the primary reason that you would want to recharacterize is if you converted funds and then, by the time you pay the tax, the holdings that you converted have dropped in value. So, instead of paying tax on something that is much less in value than previously, for a Roth IRA conversion you can recharacterize the conversion up to October 15 of the following year (see Help Mr. Wizard – I didn’t wanna do a Roth Conversion for more details on recharacterization).

While you can no longer just recharacterize and “reset” things when you face a situation like that with a Roth conversion, there are ways to reduce the risk associated with your Deemed Roth Account Conversion (since you are not eligible to recharacterize the conversion).

For one thing, you could use dollar-cost averaging to spread the risk of market fluctuations over several points in time through the year. Simply split your intended conversion amount into four amounts (or 12 amounts, if you want to do it monthly), and convert one of those amounts each quarter, for example. This way if the market drops through the year, you’re converting funds at the lower values.

Another option would be to spread the date-specific risk over several years, by converting smaller amounts each year. This would also reduce the risk of adverse market results, and spread out the tax over several years (if possible).

Timing the conversion for late in the tax year will give you the opportunity to fully (to a degree) understand the tax impact of the conversion. With little time remaining in the tax year, presumably there will be little in the way of fluctuation. This is the opposite of the recommendations that used to apply, which was to do your conversion early in the year to potentially take advantage of a recharacterization event, or (more hopefully) realize significant gains on a your converted sum.

Yet another choice could be to convert only those assets that have very low volatility, such as bonds. The probability of a major drop in value is much lower for these assets, so your need for a recharacterization would be far less likely. Sell your bond holdings in the IRA, convert the funds over to Roth, and then re-purchase the bond holding again in the Roth IRA.

There are many other, more complicated ways to reduce your risk against such a situation, but these are a few that are easily implemented. Hopefully this will help you in your process of converting retirement plan assets to Roth.

Posted on Dec 20th, 2021
by author: jblankenship.

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Posted in: investing, IRA, retirement plan, Roth conversion, tax.
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Talking to the Social Security Office

Dec 13th, 2021
by jblankenship.
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I often recommend talking to the Social Security Administration (SSA), either at your local office or on their hotline, to review your particular situation.  But this advice comes with a caveat… you need to know as much as you can about your options, and what you are entitled to do, so that you are well-armed when you speak with the SSA.

This is because the SSA representatives’ default advice is often to recommend the option that provides you the largest benefit today. The reason for this may be because it is in the SSA’s best interest for you to make your move now, because you’re on the phone with them, so you must be interested in getting benefits right away.

This also could be the case because a very high percentage of the eligible benefit recipients do not wish to delay receiving their benefit. So the folks you talk to at the SSA office are playing the averages by assuming that that’s what you want to do.

It is for these reasons that it makes very good sense to know as much as possible about your situation and the options that you have available (and what you are entitled to) before you talk to the SSA. Explain to the representative what you’re planning to do, and have them run the numbers to tell you what your benefits will be in the scenario(s) you’re suggesting.

Use the internet’s resources to find out what strategy works best for your particular situation. If you’re married, for example, there may be coordination strategies to think about. The same is true if you are divorced after at least ten years of marriage and not remarried. If you’re a widow(er) or your ex-spouse has died, even more coordination is available. Learn about your possible strategies and choose the right one for you. Then talk to SSA about it.

It pays to be informed – this is especially important when it’s something as confusing and complicated (with so much potential gain and loss) as your Social Security benefits.

Posted on Dec 13th, 2021
by author: jblankenship.

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What to do with a Year-End Bonus

Dec 6th, 2021
by jblankenship.
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This article originated from a reader question…

Suppose I get a $5000 bonus before the end of the year, would I be better off giving it away or putting it in 401k to avoid tax consequences, putting some in Roth IRA (if I still qualify), paying the tax bill on a conversion of some rollover IRA $$ to a Roth, paying my child’s tuition bill (too late for 529 now) to avoid debt, or replacing the 10-year old heating and A/C system to lower ongoing utility costs?

The specifics of this question are unique to the individual who asked the question, but the reasoning behind the response can be tailored to fit many other circumstances. What follows is an example of the process that I typically go through to assist folks in the process of understanding the impacts of various choices…

Assumptions

To start off, we need to make some assumptions about the situation that will guide us through the process. The reader who posted the question leaves us with a few clues that help us understand his tax situation – he’s made reference to income level with the “if I still qualify” parenthetical comment, so we should assume that the tax bracket for the bonus money is relatively high, close to the limit for Roth IRA contributions, which for 2021 puts him in the 24% bracket. In addition to the marginal tax rate, we’ll assume that the asker is married, filing taxes jointly. We’ll also assume that the asker’s spouse is already contributing to a retirement plan (so a Spousal IRA contribution is not in play). So in all cases the net after-tax bonus is assumed to be $3,800 (24% or $1,200 is used for taxes).

We also assume that in retirement, the tax bracket will be lower than it is currently, making tax deferral today more beneficial – meaning that we want to pay as little tax as we can today if we can pay tax on that income tomorrow.

Other assumptions include: the asker of the question has not maximized his contributions for the year to a 401(k), or a Roth IRA; the child (student) has not exhausted his student loan options, and funds can be borrowed at an unsubsidized rate of 6.8%; the cost of purchasing a new heating and A/C system for the home in question is $7,000; and lastly, there are funds available from other sources to pay for the needed heating and A/C unit or the tuition bill (if a loan is not used).

Analysis (*2021 tax provisions in use)

Donating – This would give you a tax deduction, so it would reduce your overall tax by $912, if he otherwise is eligible for itemization (his total itemized deductions are above $25,100). Otherwise, he can deduct up to $600 without itemizing.

Contribute to 401(k) – In this case, given the relatively high tax bracket, there would be a tax reduction (from all other options) of $1,200, allowing the reader to put the entire $5,000 to work in the retirement account. The assumption here includes the fact that you expect your tax bracket to be lower in retirement than it is presently – since when you take the money out of the 401(k), it’ll be taxed as ordinary income, thereby reducing the benefit of this tax reduction today.

Roth IRA contribution – If the asker of the question has not made his Roth IRA maximum contribution for the year and all other tax reduction and deferral options have been exhausted, this might make a great deal of sense. However, since there are other alternatives to look at, the Roth IRA contribution might not be the best option to use in these circumstances – since the tax cost of the money is relatively high.

Paying the tax on a Roth IRA conversion – Again, given the tax bracket involved here, a Roth IRA conversion is probably not a good idea. This amount of $3,800 could pay the tax for up to $15,833 of Roth Conversion, but as we have discussed in other articles, at the 24% bracket this is a somewhat costly conversion. It is assumed that in retirement his tax bracket could be less than the 24% current bracket – so only a very long period of deferral in the Roth account would prove beneficial.

Paying your child’s tuition – Paying the tuition bill could be a good use of these funds, because you would likely be eligible to use the American Opportunity Tax Credit on the tuition payment, giving you a credit of up to $2,500 directly against your overall tax, although the amount attributable to the net (after-tax) $3,800 would be $2,400 at most. This would eliminate the tax on the bonus altogether and give you an additional $1,200 in tax credit.

Replacing the aging heating and A/C – A 30% tax credit is available on the purchase price of eligible Qualified Residential Energy Property, up to $1,500. The cost of the installation is not allowable for the credit, this would be added to the basis of the property. For the net $3,800 from the bonus, the credit would be $1,140. In addition, assuming that the current system in place is far less efficient than a new system, this might equate to as much as an annual reduction of $200 or more in your annual heating and cooling costs.

Putting it all together…

Now that we’ve looked at the tax benefits of the options available, let’s compare them all side-by-side:

Donation – $912 tax reduction

401(k) – $1,200 tax deferred

Roth Contribution or Conversion – no current tax benefit

Tuition – $2,400 tax credit

Heating & A/C – $1,140 tax credit, plus ongoing $200 reduction in heating/cooling costs

So – the best route to go with this bonus, purely from a tax benefit standpoint, is paying the tuition bill. This would give you all of the withheld tax back, plus an additional $1,200 in tax credits. However, if you already have other funds set aside to use to pay the tuition, you might use those instead, and then use the bonus for one of the other options. (It should also be noted here that, if you haven’t taken advantage of your employer matching contributions in your 401(k), that might be the best possible place to use the bonus money.)

In the case of the heating and A/C system – this is a matter of priority… if the system truly needs replacing (beginning to show signs of failing), then you might put it higher in the priority order above the tuition or the 401(k) plan. For example, the student or the parent could get unsubsidized loans to pay for the tuition bill, since the interest on these loans can be deducted from taxes in the future, and then use the bonus (and the tax credit) to pay for the heating and A/C system.

Other options that you might consider for these funds would be: pay down high interest debt (credit cards, auto loans, or student loans), spend it on your own education (a master’s degree could make a significant difference in your future income), improve your “emergency” fund, or consider starting your own small side business. You could also use a portion of your funds to treat yourself and your family to a vacation, or perhaps some other leisure pursuit that will improve your life or provide other intangible benefits.

Of course, all of these options require you to put your own priority system to work. We’ve covered the tax implications – now it’s up to you to decide what makes the most sense for you. If it is of a high priority for you to make donations to a charity of importance to you, this might be the best option for you.

Posted on Dec 6th, 2021
by author: jblankenship.

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Posted in: financial planning, reader questions, tax.
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GPO and WEP – When Do These Apply?

Nov 22nd, 2021
by jblankenship.
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In earlier articles we talked about the Government Pension Offset (GPO) and the Windfall Elimination Provision (WEP). These two rules within the Social Security Administration’s procedures reflect reductions to Social Security benefits for receiving pension benefits from a job where your salary is not subject to Social Security withholding. Usually these are federal, state, or local government jobs, including teaching jobs at public institutions. The WEP applies to your own Social Security benefit and pension, while the GPO applies to your spousal or survivor’s Social Security benefit and your own pension.

The WEP may impact you if you are receiving a pension from a non-covered job and you also are qualified to receive Social Security benefits based upon your own record. The same holds true for Spousal benefits based on your record – if you are receiving a non-covered pension and your spouse is eligible for Spousal benefits, these can be reduced by the WEP as well. Survivor’s benefits and spousal benefits (where you’re receiving the non-covered pension and the Social Security spousal or survivor benefit is based on your spouse’s record) are NOT subject to the WEP. For 2022 the maximum WEP reduction is $512, but it can be much less (even eliminated) depending on how long you worked in the Social Security-covered job and how much money you made there.

The GPO may impact you if you are receiving a pension from a government job and are qualified to receive Survivor’s or Spousal benefits based upon your spouse’s or ex-spouse’s record. Your Survivor benefit may be reduced by an amount equal to two-thirds of the amount of your pension.

Posted on Nov 22nd, 2021
by author: jblankenship.

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Posted in: Social Security.
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Windfall Elimination Provision (WEP) for Social Security

Nov 15th, 2021
by jblankenship.
68 comments

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If you have worked in a job where your pay was subject to Social Security tax withholding, and also have worked in another job where Social Security tax is not  withheld, such as for a government agency or an employer in another country, the pension you receive from the non-Social Security taxed job may cause a reduction in your Social Security benefits. This reduction is known as the Windfall Elimination Provision (WEP). It’s named such since it was enacted to eliminate the “windfall” that would otherwise be received by a worker who fit into this description. Without the WEP, the worker would effectively be double-dipping by receiving full benefits from both the pension and Social Security.

This provision primarily affects Social Security benefits when you have earned a pension in any job where you did not pay Social Security tax and you also worked in other jobs long enough to qualify for Social Security benefits. However, federal service where Social Security taxes are withheld (Federal Employees’ Retirement System) will not reduce your Social Security benefits, since Social Security tax is applied to earnings. The WEP may apply if:

  • you reached age 62 after 1984; or
  • you became disabled after 1985; and
  • you first became eligible for a monthly pension based on work where you did not pay Social Security taxes after 1985, even if you are still working.

Here’s How WEP Works

True to form, the Social Security Administration doesn’t make it easy to figure all this out…

You must start out by understanding your Primary Insurance Amount, which begins with your Average Indexed Monthly Earnings (AIME), and then take the Bend Points for the current year into account. For 2022 the first Bend Point is $1,024 and the second Bend Point is $6,172. As we discussed in the article on Primary Insurance Amount (PIA), the amount of your AIME that makes up the first Bend Point is multiplied by 90%; the amount between the first Bend Point and the second Bend Point is multiplied by 32%; and finally any amount above the second Bend Point is multiplied by 15%. These three figures are added up to create your PIA.

However – if WEP applies to your situation and you reached age 62 after 1989, the 90% factor (applied to the first Bend Point) can be reduced to as little as 40%. Effectively, this reduces the PIA by as much as $512 per month (for 2022). The reduction factor was phased in if you reached age 62 between 1986 and 1989.

Exceptions

Again true to form, the SSA has exceptions to the rule. If it turns out that your service in the Social Security taxed job was for 30 years or more and you earned “substantial” wages (substantial is defined as $27,300 for 2022 and has been indexed over the years), then your 90% factor is not reduced at all. If you had substantial earnings for at least 21 years but less than 30 years, the 90% factor is reduced by 5% each year between 21 and 30 years that you had “substantial” earnings in the Social Security-taxed job, starting at 45% for 21 years of substantial earnings.

Additionally, the WEP doesn’t apply to Survivor’s benefits or Spousal benefits (but the Government Pension Offset does). Other exceptions include the following:

  • You are a federal worker first hired after December 31, 1983;
  • You were employed on December 31, 1983 by a nonprofit organization that did not withhold Social Security taxes from your pay at first, but then began withholding Social Security taxes from your pay;
  • Your only pension is based on railroad employment; or
  • The only work you did where you did not pay social Security taxes was before 1957.

Parting Shots

There is a limit to the amount that your Social Security benefit can be reduced: no matter what your factor has been reduced to (from the original 90%), the resulting reduction cannot be more than 50% of your pension based on earnings after 1956 on which you did not pay Social Security taxes. Likewise, if your AIME is less than the first bend point and all of your PIA is within that 90% bracket, the minimum Social Security benefit is 50% of your original PIA.

And lastly, the WEP also applies to Disability benefits from Social Security, using the same factors.

Posted on Nov 15th, 2021
by author: jblankenship.

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Posted in: federal employees retirement system, primary insurance amount, Social Security, social security administration, social security benefits, social security tax, wep, windfall elimination provision.
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Government Pension Offset for Social Security

Nov 8th, 2021
by jblankenship.
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There’s a somewhat confusing situation that occurs when a spouse is receiving either a Spousal benefit or a Survivor’s benefit from Social Security while at the same time is receiving a pension from a federal, state, or local government. This is specifically so if the pension being received is from a job where Social Security taxes (OASDI) were not withheld. This situation triggers the Government Pension Offset, or GPO.

What happens is that the Social Security Administration will reduce the Spousal or Survivor’s benefit by a factor equal to two-thirds of the government pension that he or she is receiving. This is called the Government Pension Offset, or GPO (yay, another acronym from the Social Security Administration SSA!) The GPO is often confused with the Windfall Elimination Provision (WEP), but they are different provisions.

Why?

Eligibility for Spousal or Survivor’s benefits are based upon your spouse’s record with the Social Security administration. If your own benefit is greater than the Survivor’s or Spousal benefit, of course you would not be receiving the Survivor’s or Spousal benefit. You can only receive either your own benefit or the Survivor’s or Spousal benefit, whichever is greater.

If you are receiving a pension from a government job that did not require you to have Social Security tax withheld, your own Social Security record doesn’t reflect the income earned from that job. The government pension is designed to take the place of Social Security benefits – at least to some degree. This particular quandary was first addressed in 1977 with the amendments in that year – but it really went too far at that stage.

1977 Amendment

Government pensions from jobs not subject to Social Security tax withholding are designed to be equal to partially pension, and partially compensation intended to replace Social Security benefits for the retiree. In 1977 an amendment was made to the Social Security Act to address the fact that, otherwise, a Spousal benefit or Survivor’s benefit would be compensating the Spouse more than the system originally intended. The 1977 Amendment offset (reduced) the Social Security Spousal or Survivor’s benefit by one dollar for each dollar of pension received from government work that was not subject to Social Security tax. This only applied if the pension was from a job that the Spouse or Survivor worked.

1983 Amendment

In the 1983 Amendment (which is the current set of rules), the Government Pension Offset (or GPO) was improved for Spousal and Survivor’s benefits. Instead of the original dollar-for-dollar offset, now the Social Security Spousal or Survivor’s benefit is only reduced by two-thirds of the government pension amount. This more accurately reflects the fact that the government pension is part pension and part compensation to replace the Social Security benefit.

When Does the GPO NOT Apply?

It’s possible that your particular situation may provide for your Spousal or Survivor’s benefit to not be impacted by the Government Pension Offset. Listed below are several situations that will permit the GPO to not apply:

  • If you are receiving a government pension that is not based on earnings;
  • If you are a state or local employee whose government pension is based on a job where you were paying Social Security taxes
    • on the last day of your employment and your last day was prior to July 1, 2004; or
    • during the last five years of employment and your last day of employment was July 1, 2004 or later. Depending upon the circumstances, fewer than five years could be required for folks whose last day of employment fell between July 1, 2004 and March 1, 2009 inclusive.
  • If you are a federal employee, including Civil Service Offset employee, who pays Social Security taxes on your earnings. (A Civil Service Offset employee is a federal employee who was rehired after December 31, 1983, following a break in service of more than 365 days and had five years of prior civil service retirement system coverage);
  • If you are a federal employee who elected to switch from the Civil Service Retirement System (CSRS) to the Federal Employees’ Retirement System (FERS) on or before June 30, 1988. If you switched after that date, including during the open season from July 1, 1998 through December 31, 1998, you need five years under FERS to be exempt from the GPO;
  • If you received or were eligible to receive a government pension before December 1982 and meet all the requirements for Social Security Spousal benefits or Survivor’s benefits in effect in January 1977; or
  • If you received or were eligible to receive a federal, state or local government pension before July 1, 1983, and were receiving one-half support from your spouse.

Unlike WEP, there is no way to work your way out of the impact, other than the aforementioned final five years covered option.

Posted on Nov 8th, 2021
by author: jblankenship.

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Posted in: government pension offset, GPO, Social Security.
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Combining IRAs with Other Retirement Plans

Nov 1st, 2021
by jblankenship.
2 comments

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Photo credit: jb

Quite often, we are faced with multiple options for retirement savings. With these decisions, it is important to understand what options are actually available to you – such as, can you contribute to both a 401(k) or 403(b) plan and an IRA in the same year?

Combinations

If you have a retirement plan available to you at your employer (401(k), 403(b) or traditional pension), depending upon your income you may be able to contribute to an IRA (a traditional, deductible IRA) in the same year. See Facts & Figures for the income limits.

Depending on your own circumstances, these income limits may be relatively low, so the likelihood of having the deductible IRA available to you is limited. On the other hand, the income limits for Roth IRA contributions are much higher, so for most this is a viable option.

If your income is higher than the limits for a Roth IRA contribution, you still have another option available to you: non-deductible traditional IRA contribution. In this contribution there is no income limit at all. The primary value you receive from this sort of contribution is in the tax deferral that any growth in your account receives – as your investments accrue growth (hopefully) you will not have to pay tax on that growth until you withdraw the funds.

In addition, there are often cases where you may have more than one employer plan available to you. The limitation here is that you can contribute fully to either a 401(k) plan or a 403(b) plan up to the limit, but only one limit applies to all of these plans you may have available to you. Depending upon your employer, you may also have a 457 (generally only available to governmental units) with a separate annual limit available to you.

Regarding mixing Roth IRA and traditional IRA (either deductible or nondeductible), you also have only one annual contribution limit available to you for all IRA contributions. The combination of all IRA contributions cannot be greater than that limit.

All of these limitations also apply to the catch-up provisions for folks age 50 or better. Use the following table to help you better understand the combinations of accounts that are available to you. To use the table, you first determine which type of account you presently have available to you in the left column – and then move across that row in the table to see which other additional accounts are available to you and with what limitations (the numbers refer to the footnotes below the table). If the answer in the box is “Yes”, you can, without income limitation, contribute to the other plan.

401k 403b 457 IRA Roth Nondeductible
401k 1 1 Yes 2 3 Yes
403b 1 1 Yes 2 3 Yes
457 Yes Yes Yes Yes Yes Yes
IRA 2 2 Yes 4 4 4
Roth 3 3 Yes 4 4 4
Nondeductible Yes Yes Yes 4 4 4
Footnotes:
1: a single contribution limit applies for the year, no matter how many 401(k) plans you are eligible to participate in
2: within income limits, if you are eligible for a 401(k) or 403(b) plan, you may also be eligible to contribute to a deductible IRA
3: within income limits, participation in a 401(k) or 403(b) plan has no impact on Roth IRA contributions
4: for all IRA contributions (Roth, traditional deductible or nondeductible) contributions are limited by the annual limit.

Spousal IRAs

If your spouse is not employed by an employer that sponsors a retirement plan (including a traditional pension), you may be able to make either a traditional deductible IRA contribution or a Roth IRA contribution – up to the limit for the year for all IRA contributions for this individual. This assumes that you have the earned income to support that IRA contribution (and any of your own, if this is applicable).

Posted on Nov 1st, 2021
by author: jblankenship.

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Posted in: 401 k 403 b, combinations, contribution limit, employer plan, IRA, retirement plan, retirement plans, retirement savings, roth ira contribution, roth ira contributions, traditional deductible ira, traditional ira contribution.
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How to Bypass Mandatory Withholding on a 401(k) Distribution

Oct 18th, 2021
by jblankenship.
3 comments

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Just ferinstance, let’s say you need to take a withdrawal from your 401(k) plan – and you’re eligible, either by way of your plan allowing in-plan distributions or the fact that you’re already retired (but you still have the money in your former employer’s 401(k) plan). But here’s the rub: when you take a distribution from a 401(k) plan, the IRS requires that the plan administrator withhold 20% from the distribution. If it’s a significant amount being withheld, it can be a long time before next April when you file your tax return to get the withholding refunded (as long as you’ve covered the tax in some fashion).

Is there are way around this withholding? Of course there is – I wouldn’t tease you like that!

Getting Around the Mandatory Withholding

Cutting to the chase: if you had your money in an IRA and took a distribution, the IRS would not require withholding. But how do you get it to the IRA? Didn’t I just say that the IRS require withholding when you take money out of the 401(k) plan?

Well – not in all cases. If you do a trustee-to-trustee transfer (also knowns as a direct rollover) to an IRA, no withholding is required. So, as long as you do this correctly, you can effectively take the distribution and you don’t have to have any withholding at all. Of course, since you’ll eventually be taxed on the distribution, you probably should have something withheld, but depending on your circumstances, the rate of the withholding may be something far less than 20%. You might even make up the difference (again, depending on the circumstances) by increasing your W4 withholding, or making an estimated tax payment from other sources.

Once you’ve completed the direct rollover to the IRA, you’re free to take a distribution at any time.

Since IRAs are not subject to the mandatory 20% withholding by the IRS, and further since a direct, trustee-to-trustee rollover from a 401(k) plan is also not subject to the mandatory withholding, you can bypass the withholding requirement in the described manner. Just make sure you have a plan to cover the tax on the distribution somehow.

Posted on Oct 18th, 2021
by author: jblankenship.

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Posted in: IRA, retirement plan, tax.
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The Primary Insurance Amount (PIA)

Oct 11th, 2021
by jblankenship.
12 comments

rule

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Just because there can be some confusion over the PIA, I am writing this particular article to (hopefully) help reduce the confusion. In an earlier article – Social Security’s PIA – What is this? – we worked through how PIA is calculated, I’m just giving it another treatment here, to help clarify.

Primary Insurance Amount

As you know from the other article, the PIA is based upon your Average Indexed Monthly Earnings (AIME), which is the average of your highest 35 years of earnings, indexed for inflation, and expressed as a monthly figure. The AIME then has bend points applied in the year that you reach age 62, in order to calculate the Primary Insurance Amount (PIA).

This PIA is equal to the projected benefit amount that you would receive if you started benefits upon reaching your Full Retirement Age (FRA). The actual amount that you receive if you take your benefit at FRA would likely be different due to Cost of Living Adjustments (COLAs) that would be applied between age 62 and FRA – but the PIA is not changed.

The only way that the PIA is adjusted from the original calculation is if the projection has changed. The projection made at your age 62 assumes that you continue working, earning the same amount as your last reported year, and as such your AIME is not changed during that period. If you happen to have already worked your 35 years by that point and do not work after age 62, your PIA will be pretty close. But your PIA will be adjusted if you work from age 62 to FRA and your earnings are either 1) greater than one of the other 35 years used in your AIME at age 62; or 2) being added to the AIME calculation because you didn’t have a full 35 years of earnings when the PIA was calculated at age 62.

Likewise, if you do not work from age 62 to FRA or you work for lower wages than your AIME projection assumed (and you had fewer than 35 years of earnings as of age 62), your PIA at FRA could actually be a bit lower than the original projection. This might happen because your original PIA calculation depended on your future earnings being equal to your most recently-reported earnings, replacing lower or zero earnings years in your current history.

Calculating Benefits

When your actual benefits are calculated, your PIA is the starting point. Then all COLAs are applied, if you’re older than age 62. After this, your age when you initiated benefits is taken into account – if it was before FRA, there will be a reduction; if after FRA, an increase. This increase or decrease is applied against the COLA-adjusted-PIA, resulting in your monthly benefit amount. That’s all there is to it.

Posted on Oct 11th, 2021
by author: jblankenship.

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Posted in: PIA, primary insurance amount, Social Security.
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How to Check Your Social Security Benefits

Oct 4th, 2021
by jblankenship.
1 comment

Photo credit: jb

A reader of this blog recently suggested that it might be helpful to include an article on how to check up on your Social Security benefits. Long ago, we used to receive a paper statement of Social Security benefits in the mail each year, but that has changed. Now, you might receive a mailed paper statement right around your 60th birthday, but it’s very simple to check your benefits at any time via Social Security’s website.

It’s quite simple to check out your up-to-date information in the Social Security system – at least the retirement estimates. Simply go to the Social Security website, and select “Create Your Own my Social Security Account Today” – if you haven’t already created your own account. If you have already created an account, just skip down to Checking Your Benefit.

You’ll then be asked to fill in your information, including your Social Security number, birth date, and other pertinent information. Following the instructions, you’ll soon have your my Social Security account created.

Checking Your Benefit

Now you can log in to the account. This will be a two-step verification process, where they’ll send you a code on your email that you’ll have to submit in order to complete the login process. Then you’re in!

Once you’ve logged in, you can look at your Social Security statement, in order to estimate your retirement benefits and other possible benefits, as well as to review your earnings history to make sure all of the information is correct. The information on earnings in the statement is condensed, but you can view the complete earnings history via the online system (not a .pdf as the statement is).

You can do lots of other things once you’ve set up your account, including filing for benefits when you’re ready to do so. You can order a replacement card, estimate your retirement benefits in various scenarios, and much more.

So that’s all there is to it! Reviewing your Social Security benefits regularly is a good idea, so you can get a good idea of what benefits you can expect, as well as note how recent earnings has an impact on the future benefits estimates.

Posted on Oct 4th, 2021
by author: jblankenship.

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Posted in: Social Security.
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