Non-Deductible IRA Contribution & Roth IRA Conversion Rules

Mrs. MMB and I both contributed $5,000 each to a non-deductible Traditional IRA again for the 2012 tax year this week, with the intention of converting it into a Roth IRA in the future. Are you eligible to do this as well? Of course, we had to wade through a ton of IRS fine print to try and achieve a bit of tax savings.

First, can we just contribute directly to a Roth IRA? Per this IRS flowchart, because we are married filing jointly and will most likely have a modified adjusted gross income (MAGI) over $183,000, we are unable to contribute to a Roth IRA. How many people know what their MAGI is? It’s not impossible to figure out, but if I was closer I’d rather wait and have TurboTax figure it out for me when I filed my 2012 taxes.

Can I contribute to a Traditional IRA, even if I have a work retirement plan? Yes, it doesn’t matter if you have a 401k or 403b or whatever. The question is whether it is tax-deductible. Remember, when money is withdrawn from a Traditional IRA, it is taxed again at ordinary income rates.

Well, is the contribution tax-deductible? From this other IRS flowchart, because we are married filing jointly, covered by a retirement plan at work, and have an MAGI of over $112,000 or more, I see out that our contribution is not tax-deductible. Finally, you should remember to note the non-deductible (post-tax) contributions on IRS Form 8606 at tax time.

Can I convert my non-deductible IRA to a Roth IRA? In 2010, the previous $100,000 income limit for Roth IRA conversions was removed. It was initially thought to be a temporary thing, but it has not been addressed since. There is some speculation that the government is quietly (and happily) collecting taxes right now on all the rollover money, as opposed to later. Thus for 2012, there is again no income limit on the conversion from a Traditional IRA to Roth IRA. Even so, there are still some catches if you have both deductible and non-deductible (pre-tax vs. post-tax) IRA balances available to be converted. We have already converted all our pre-tax IRAs a while back, so it will be a simple “same trustee transfer” at Vanguard for us.

Okay, so we successfully navigated all these IRS rules and legally minimized our tax liability. But how many people won’t? Even for tax benefits for low to moderate-income earners like the Earned Income Tax Credit, the Government Accountability Office (GAO) found that between 15% and 25% of households who are entitled to the EITC do not claim their credit, or between 3.5 million and 7 million households. I mean, just look at how long the Wiki page that supposedly summarizes the credit is. It shouldn’t be this complicated.

What Cities Are People Moving To For Financial Reasons?

This post has been revised with new info and added to my Expense Reduction Guide: Housing.

Although it takes considerable effort, nearly 40 million Americans move every year. Now, the reasons for all these moves are not all financial, but you can improve your financial situation drastically by moving. You might increase your income, decrease your housing costs, or decrease your tax bill.

Where are people moving to? This Forbes article analyzed address data from IRS tax filings, and found that a trend that households are moving to warmer climates with lower taxes and property values. The majority of the top ten counties are in Texas and Florida, where there is no state income tax.

After accounting for property taxes, Shrum’s analysis shows that Texas has the fourth-lowest personal tax burden in the country, and Florida has the eighth lowest.

They also compiled an interactive map which shows relative inflows and outflows for each county. (Previous year’s version here). It’s pretty fun to click around to where you live, and where you might consider moving to.

Below is the map for Travis County, TX, where Austin is the major population center. A blue line between two counties mean that more people migrated to Austin than left, and a red line means that more people left Austin for that county than came in.

Where are people leaving? Places with high tax rates.

Shrum also points to eight states that have targeted wealthy households with extra-high tax brackets: California, New Jersey, New York, Maryland, Hawaii, Oregon, Connecticut and Wisconsin. Six of the top 10 counties the rich are fleeing are located in those states.

Personal case study. My sister used to live in San Francisco, California. She recently moved to Austin, Texas where her income increased and her housing costs decreased at the same time. Texas has no state income tax but relatively high property taxes. But since she rents in both places, the lack of state income tax becomes yet another boost to her bottom line. I should note that we both lived there for a while as children, so there is some familiarity, but she left in elementary school. From the looks of it, she wasn’t alone!

Poll: Which Tax Software Did You Use In 2011?

January 31st was the deadline for companies to mail out W-2 forms and 1099 forms involving other income and interest. Coming up is February 15th, the deadline for brokerages to send out 1099-B forms listing stock sale proceeds.

That means you early-birds out there (not me) are probably chomping at the bit to file your taxes! So here’s a question to you readers about last year:

What Did You Use To File Your Tax Return in 2011?

Total Voters: 2,027

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A better question would be why you chose that software – price, convenience, trust, quality of product, or what? Would you have switched if a competitor was $25 cheaper?

Active Mutual Funds, Passive ETFs, & Tax Efficiency

When looking at your investment returns, it’s important to calculate your return after the impact of taxes and expenses (management fees, commissions, bid/ask spreads). That number is what you really end up with, but it’s never shown on any year-end statements. ETF provider iShares put out a Managing Tax Challenges brochure that shows the average annualized tax cost for actively-managed mutual funds over the last 10 years. Via Abnormal Returns and Mebane Faber.

(Click to enlarge)

Many actively managed mutual fund managers have had difficulty delivering benchmark-beating, after-tax returns. Figure 1 shows the 10-year average tax cost for active funds and top quartile active funds. What’s striking is that in every case except for mid cap blend and small cap value, top quartile funds’ tax costs (as indicated with a white dot) were equal to or greater than those of the category average (black dot). Even worse, after taking taxes and fees into consideration, the average active fund underperformed its benchmark.

The takeaway is that expenses and tax-efficiency both matter greatly to the bottom line, and passively-managed ETFs are much more tax-efficient than actively-managed mutual funds, possibly enough to counter the performance benefit of active management. For one, being passively-managed on its own means lower turnover (less buying and selling) and thus less taxable events. Second, the ETF structure itself has inherent advantages over open-ended mutual funds. Neither of these traits are specific to iShares, by the way, although they do have some of the most popular index ETFs out there.

I should note that many Vanguard ETFs are simply different share classes of open-ended mutual funds (Example: VTI and VTSMX). Theoretically, this extends the tax-advantages of ETFs to the mutual fund shareholders, as described in Vanguard’s ETF brochure:

Tax advantage. Like other ETF providers, Vanguard can push low-cost-basis shares out of the portfolio through the in-kind redemption process. Our patented share-class system provides an additional benefit. To meet cash redemption requests from non-ETF shareholders, Vanguard can sell high-cost-basis securities to generate a capital loss. These losses offset any current taxable gains and, if not exhausted, can be carried forward to offset future capital gains—a recycling that is not likely within stand-alone ETFs. Theoretically, cash redemptions could trigger a gain instead of a loss; however, Vanguard’s deep tax-lot structure has allowed us to select high-costbasis shares in both good markets and bad, resulting in a high degree of tax efficiency.

As a result, in many cases if I can own Admiral shares of Vanguard index funds that have the same low expenses as the ETF version, I’d rather just own the mutual fund version for the sake of simplicity. For instance, I like making dollar-based transactions at net-asset value (NAV) instead of having to place a market order (potential loss due to bid/ask spread) and also worrying about NAV discount/premiums. It also keeps me from doing silly things like trying to time the market intraday.

IRA Monte Carlo Revisited: Undo Traditional IRA to Roth IRA Conversions

My post yesterday about the varying performance of different asset classes reminded me about a Businessweek article called the IRA Monte Carlo. This is a tax-saving trick for those who wish to convert their Traditional IRAs or old 401ks to Roth IRAs. Here’s a snippet:

1. Let’s say an investor has one traditional IRA with a value of $4 million.

2. The traditional IRA is split up into four traditional IRAs, each worth $1 million.

3. The investor converts all four to Roth IRAs at the beginning of the year.

4. The IRS effectively allows taxpayers to undo the conversion for up to 21 months. So in 21 months the investor looks at the performance of the IRAs. Say two of them go up from $1 million to $2 million and two drop from $1 million to zero. Because the IRAs were split into four, the investor can change her mind on the two that went down and revert those back to traditional IRAs. Thus, she owes taxes on only the two contributions that went up in value, and nothing on the two that went down, cutting her tax bill in half. This lops 21 months of risk off the bet that paying taxes now will be paid off with tax-free appreciation later.

Did that make sense? It was a little confusing for me, so here’s my take on it. Right now, there is no income limit converting Traditional IRAs to Roth IRAs (and paying the taxes owed). Everyone can do it. Basically, in the conversion you pay taxes now on gains at your current tax rate, but then as a Roth IRA your future gains are tax-free. This works out to be a good idea if your future tax rates upon withdrawal end up higher than your tax rates right now.

It boils down to: Pay your taxes now? or pay taxes in the future?

Let’s say you agree your future tax rate will be higher, whether for personal reasons (you think future income will be higher or at least the same) or external reasons (you think Uncle Sam will raise tax rates). The loophole here is that you are allowed an “undo” by the IRS, which you can take advantage of by splitting your big traditional IRA into multiple, smaller, separate traditional IRAs. Then convert the smaller IRAs, and wait up to 21 months:

  • If the value of the converted IRA goes down, then you can undo the conversion and then redo it later, saving you on taxes. For example, if you converted $100,000 in Emerging Markets stocks in the beginning of the year and it went down to $80,000 – would you rather pay taxes on $100k or $80k?
  • If the value of the converted IRA went up – say from $100k to $115k if you invested in Treasury bonds throughout 2011 – then you’re happy because that $15k gain is all tax-free. You just sit back, sip your cocktail, and leave it alone.

There’s not many times in life you get to hit the “undo” button. As in the examples given, I would recommend putting different asset classes in your separate IRAs so that you can take advantage of any non-correlated performance. Don’t completely change your investment holdings just for this tax trick, though. Just putting stocks in one and bonds in the other can offer a potential benefit.

How To Find Amount and Date of Past Roth IRA Contributions?

Here’s a reader question about tracking Roth IRA contributions is previous years (slightly paraphrased for clarity) that I answered to the best of my ability, but perhaps there is a better solution out there.

I am looking to make a withdraw of my Roth IRA contribution that I made
prior to 5 years to avoid taxes and penalties. My question is:

How do I find out how much and when I made contributions?

This will tell me how much I can withdraw without taxes or penalties. I am also only age 50. Thank you!

My initial answer was to look at past income tax returns, as that should provide a good record of your Roth IRA contribution history. However, since Roth IRA contributions do not affect your tax liability, they likely aren’t listed directly on the tax return. Going through my own old returns, I found my contributions noted in a supporting document called a Roth IRA Carryover Worksheet. In addition, your IRA broker (trustee) should send an IRS Form 5498 (PDF) showing the amount of your contribution each year. If you’re really lucky, perhaps your broker has records for previous years.

If you don’t have access to old returns or the proper supporting documents, you can ask the IRS for a copy. There are two options:

  • Request a tax return transcript. A transcript is not a direct copy of your actual return, but includes most of the line items of a 1040 Form going back up to 10 years. It is free and can be done online, via mail, or over the phone. However, as noted above the return itself may not include Roth IRA contribution information. Update: Form 4506-T does allow you to request Form 5498 transcripts, which should include IRA contribution data.
  • Request an exact copy of your tax return and all attachments. This option gives you an exact copy of a previously filed and processed tax return and all attachments. You must complete Form 4506 (PDF) and include a check for $57 for each year requested. Copies are generally available for returns filed in the current and past six years. Would Form 5498 be an included attachment? I’m not sure.

Any better suggestions?

Compare Sales, Income, and Property Taxes By State – US Map 2011

(Update 2011: I ran a search for this topic and found my own site. Ha! The maps were from 2009, so I updated this post with the updated 2011 information. They appear to have actually taken some of the feedback from earlier comment and improved the general applicability of each chart.)

I ran across some nice visual maps from today. Each one compares a different type of tax across all 50 states. How does your home state choose to extract revenue from its residents? (Yes, extract. They have to pay for things, but I doubt asking gently with a packet of free address labels would work very well for them.)

State Sales Taxes – State and Local (Combined) General Sales Tax Rates, 2011 (Greener is higher)


State Income Taxes – Top Marginal State Income Tax Rates By State, 2011


State Property Taxes – Median Property Taxes Paid by County, 2005-2009 (Darker is higher)

Click on the images for a bigger source version.

How To Check If You’re Getting the 2% Payroll Tax Cut

As you may know, there is a temporary 2% payroll tax cut in 2011. Instead of the normal 6.2% Social Security tax on gross wages up $106,800 for employees, it is only 4.2%. This is supposed to be reflected automatically in your paycheck, so most people’s paychecks this year should have been a little bit bigger. I say most because at the same time, the Making Work Pay Tax Credit was expired for 2011. Here’s a chart from the Tax Policy Center showing the net savings from last year for your given income:

A single person earning $50,000 would be paying $600 less in taxes in 2011 vs. 2010. This is the net result of gaining the $1,000 payroll tax cut, and losing $400 from the Making Work Pay Tax Credit of 2009/2010.

The law was passed right around the start of the new year, so according to Consumer Reports so there could have been a mix of under-withholding and over-withholding for the first few pay cycles. Employers had until March 31st to get all the withholding sorted out. It’s pretty late in the year already, but still I just did a quick check to make sure that I am still getting that 2% savings. It just takes a minute – find your paycheck stub, and divide the Social Security line by your Gross Pay line. It should equal to 0.042, or 4.2%.

(Update: It could end up a bit less than 4.2% if you have items that are not subject to Social Security tax, like health insurance premiums or Flexible Spending Accounts. But it shouldn’t be more than 4.2%.)

You’ve been putting that extra money to good use, right?

U.S. Government Debt, Income, and Expenses as Percentage of GDP

There was plenty of discussion on simplifying the US budget to household-sized numbers, and I have nothing to add, because I have zero interest in being an economist. 🙂 Here’s one more attempt at sharing some digestible information. An interesting site called Department of Numbers has collated numbers from government sources like the Treasury and put them together nicely into a series of charts. Here are two I wanted to point out and also save as a historical snapshot of “what things in 2011 looked like”.

US Government Debt as Percentage of GDP

US Government Income and Expenses as Percentage of GDP

From the top chart, you can see that we are close to a 100% debt-to-GDP ratio. The last time it was this high was World War II. Even in recent “good times” – or at least better times than now – the percentage hasn’t really gone down much. That’s what I mean by “kicking the can down the road”. In the bottom chart, you can see the large gap between government revenue generated (taxes) and expenditures.

I’ll go back to saving 50%+ of my income now, hopefully investing it wisely, and not reading scary bedtime stories like Boomerang!

US Budget Numbers Simplified To The Household Level

Someone sent this to me via e-mail, and I don’t know the original source. From the $38.5 trillion number, that seems to refer to the budget cut deal that averted a US government shutdown in April 2011. In any case, it does make the numbers much more easy to grasp.

Some stats about the US government:

  • U.S. Tax revenue: $2,170,000,000,000
  • Fed budget: $3,820,000,000,000
  • New debt: $ 1,650,000,000,000
  • National debt: $14,271,000,000,000
  • Recent budget cuts: $ 38,500,000,000

Now, remove 8 zeroes and pretend it’s a household budget:

  • Annual family income: $21,700
  • Money the family spent: $38,200
  • New debt on the credit card: $16,500
  • Outstanding balance on the credit card: $142,710
  • Total budget cuts: $385

I know that this is macroeconomics vs. microeconomics. But the orders of magnitude are correct, and it can’t look good to anybody. I’ve never really liked the macroeconomics theory that it’s okay for governments to carry huge amounts of debt as long as it’s “only” a certain percentage of GDP. The idea is that you’ll grow your way out of it. Europe has shown us that entire developed countries can default.

Now, I’m more of a microeconomics guy. I try to figure out the rules of the game and play it the best that I can. I avoid getting emotionally involved in things that I view are out of my control. But to me, it just seems like all the politicians ever do is kick the can down the road. You can’t do that forever.

My Unclaimed Money From State of California Actually Came

Amazingly, less than two months from mailing in my claim submission, the State of California actually sent me a check for my $74.93 in unclaimed money. Thanks guys, sorry you can’t use it to plug your gaping budget hole, but I’m sure you’ll get me back somehow. 😉 Here’s an expanded listing of useful websites to see if you’ve got any money waiting for you:

  • – Listing of US government-related items, including bank FDIC insurance failures, mortgage insurance refunds, and more.
  • – State-by-state unclaimed property listings
  • California Unclaimed Property page
  • – Unclaimed pension plan benefits

California vs. in Sales Tax Battle

California, along with many other states, is broke. As part of an attempt to create more revenue, California passed a more aggressive law to force online merchants to collect sales tax. A 1992 Supreme Court decision stated that retailers that don’t have a physical presence in a state don’t have to collect sales taxes for sales to that state. But some states have passed new laws that redefine “physical presence” to include online affiliates and any subsidiaries. affiliates are the thousands of websites like this one, where if you click on a link to a book or other product and buy something within a certain time frame, I get a commission of a few percent of your purchase. It’s a safe bet that the majority of blogs you read participate, even if the actual revenue is relatively small. But, by California’s new definition, if just one person is both an affiliate and lives in California, then has to start collecting sales tax from everyone in the state. What’s Amazon’s solution? Easy, cut off all CA affiliates immediately. That’s what they’ve done everywhere else. From CNN:

Other states that have passed the so-called “Amazon tax” in recent years include Connecticut, Illinois, New York, North Carolina, Arkansas and Rhode Island. The retailer has dropped the associates program in all these states, except New York, where it has a brought a lawsuit against the state.

Many other merchants that operate online like have been doing the same thing. They’d much rather lose the incremental revenue from affiliates than have to effectively increase prices for all customers from an entire state. For many website owners, Amazon is their primary source of income, and this move will force many of them to pick up and move.

At the same time, not paying sales tax is one of the expected benefits of buying from Amazon. (Even though in many states you’re technically still supposed to calculate and send it in manually, people rarely do.) This understandably annoys the national brick-and-mortar merchants like Walmart or Target.

As both a consumer and an Amazon affiliate, I am a concerned onlooker. These are two behemoths playing a high-stakes game, but I feel empathy towards those small businesses that just lost a huge chunk of their revenue overnight through no fault of their own. They seem to be collateral damage in this battle.

More reading: NYT, IBT