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ChooseFI | Financial Independence Podcast
542 | Mastering Tax Strategies: How to Optimize Your Path to Financial Independence
00:52:11
In this episode of ChooseFI, hosts Brad and Sean Mulaney dive deep into tax strategies crucial for financial independence, focusing on tax basketing, asset location, and effective use of retirement accounts. The conversation includes recent changes...
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- [00:00]
Brad
Hello and welcome to Choose a fi. Today in the show we have our good friend Sean Mulaney back for another mailbag episode and we really touch on a lot here. So very quickly we talk about tax basketing and tax allocation 529s into Roth IRAs. Is it too late to start FI at 35? The actual nuts and bolts of selling funds contributing to Roth versus traditional 401k and should I do a backdoor Roth depending on my very precise situation? I think you're really going to like this episode with that. Welcome to Choose Sean. Welcome back to the podcast. I really appreciate it as always, Brad.
- [00:40]
Sean Mulaney
Thanks so much for having me.
- [00:41]
Brad
Yeah, this should be fun. So we always have a good time every time you're on the podcast, and this one is no exception. We have a nice little mailbag episode. I know you've identified at least a handful of questions here, so we're just going to kind of get after it and just bomb through them. So I'm going to read the first question and it came in from Jay. Jay said most FI discussions always seem to presume having more funds in retirement accounts than brokerage or savings accounts. So what we would call taxable accounts. But since the FI community focuses on a high savings rate, isn't the opposite common? The problem is that continually adding to your savings brokerage accounts could generate meaningful interest and dividend income and end tax drag, taking many popular FI strategies off the table like ACA subsidies, Roth conversions, capital gains harvesting, et cetera. Would love for this topic to get some attention. If it hasn't before, I genuinely don't know what strategies are recommended for growing non retirement funds. Sean, this is a really good one.
- [01:36]
Sean Mulaney
This is an excellent question.
- [01:37]
Brad
Yeah, it's fantastic. Beautifully laid out too.
- [01:40]
Sean Mulaney
This touches on a concept I just love. It's called tax basketing, sometimes referred to as asset location. So the correspondent is concerned about tax drag. And it turns out for most early retirees in the FI community, tax drag created by taxable accounts is not a thing. Wait a minute, how can that be? Well, let's just play it out in our mind's eye for one second. Think about in our community, folks. Love these domestic equity index funds, all right? Vtsax is one of them. I'm not giving anyone investment advice, but let's just look at that particular fund. Look up its dividend yield. As we record in the end of February 2025, its dividend yield is 1.22%. So let's play this out. In early retirement, say you get to early retirement and you're holding $1 million in a domestic equity index fund like VTSAX in your taxable brokerage account, how much taxable income is that going to create by itself because of the dividends, the so called tax drag, it will create approximately $12,200 worth of income, 90 plus percent of which is so called qualified dividend income. Think about that for a second, Brad. It took $1 million for me to be able to wring out not even a Toyota Corolla worth of taxable income. That's crazy.
- [03:05]
Brad
That's a minuscule amount. Minuscule.
- [03:07]
Sean Mulaney
So essentially in today's environment, look, if this was the 1980s, this is 1982, it's a very different analysis. But in today's world of low domestic equity index fund yields, tax drag isn't really much of a thing at all. And in fact, this is what makes things like the correspondent mentioned, Roth conversions, premium tax credit. This is what's making all that stuff possible. So let's think about our three primary tax baskets or asset locations, Roth traditional and taxable. And we get to early retirement, we're before 65, we want to be on an ACA medical insurance plan. Let's just run three extreme scenarios. Scenarios to see just how good or bad our taxable assets, particularly in domestic equity index funds are. Right? So let's start with our Roth basket. Think about Goldilocks, right? She has the three things of porridge. If we do Roth, it's too cold. Because if the only thing we live off of is Roth accounts, we're probably not generating any income. And now we don't qualify for a premium tax credit. That's a really bad outcome. That one's too cold. Okay, let's say it's all Traditional Retirement Accounts, 401ks IRAs. Well, if we take all our living expenses from them in early retirement now, it's too hot, right? Because it's all taxable income. Not necessarily a disaster, but we might get very little premium tax credit because too much of our income was taxed. And now we have a low or non existent premium tax credit. Not a good outcome there. Well, let's go to our taxable brokerage accounts to fund our living expenses. And recall, when we sell a mutual fund, our tax on that is not the amount of the sale, it's the amount of the sale less the basis. So if we're living on $80,000 worth of expenses and we sell 80,000 of save ETS X to fund that, well, okay, what's our taxable income, it's 80,000 less our basis. That basis could be 30,000, 40,000, $50,000. We just found a way to create some, but not too much income in many cases. Now, that doesn't mean we only live on taxable assets first, but boy, isn't that an interesting indicator that we should be living on these taxable assets first and these taxable assets are a solution, not a problem in early retirement. And then lastly, just think about the three primary financial asset classes. A lot of early retirees in the FI community, like domestic equity index funds, international equity index funds, and domestic bond funds. If we look at the dividend yields on those, like I said, domestic is going to be 1.2, 1.3%. In today's environment, these numbers are subject to change. International is over 3% today. U.S. bonds, 3 to 4% today. So can't we use this tax basketing to essentially avoid a lot of the quote, unquote, tax drag? Tax basketing solves for tax drag in many cases. So we put our bonds in our traditional retirement accounts, international in retirement accounts, and then domestic, we could pepper all over the place. But, you know, for the taxable, it really sits well in the taxable account. We keep our income low and now we're cooking with gas, getting premium tax credits and happy and early retirement.
- [06:22]
Brad
Yeah, I love that, Sean. So, right. It's essentially that last point is thinking about your net worth holistically. Right. So I think some people like to say, oh, I'm going to have a 6040 portfolio. So that means every single account. I'm saying this hypothetically. Again, like you said, we're not giving advice here, obviously, but I'm going to put 60% equities and 40% bonds in every single account I have. And come hell or high water, Right. Doesn't matter if it's a taxable account, if it's Roth, Ira, traditional 401k, whatever. That's not what you're advocating at all. And that's, I think, the intelligent way to look at this is say, okay, let's look at our net worth holistically. Let's see, we make our allocation as a general number and then we apply it where it makes the most sense. Right? So something that's kicking off a lot of income, like you said, a bond fund, for instance, or maybe that, that international fund, Even at a 3% dividend, we don't want that in taxable brokerage account necessarily, if we have, if we have options. Right. And I think that's the nice thing is you can look at this holistically and you can make decisions that best fit your portfolio allocation. So I think that's critical. I also love how you talked about the Goldilocks, right? So I think just to kind of take a step back on that, again, it's about flexibility, right? So having all three of these options especially. So I like the premise of Jay's question. I really genuinely do, because I think ultimately asking, hey, we talk a lot about retirement accounts, but aren't we going to have a lot in taxable brokerage? And so I think that's just like the general 30,000 foot question. And the answer is, yeah, we are. But to your point, John, that's not a bad thing at all, right? Because especially with capital gains harvesting, again, with some, with some flexibility, you might be able to sell that. And like you said, sales price minus basis, and again, like just another caveat basis, in very broad terms is what did I buy this for now, plus or minus. But we're going to say in the vast majority of cases it is as simple as that. It's what did I buy this for? So just always think of basis as that was my cost basis. That's actually the term. This is what I bought the thing for. It went up. And the difference in that is my unrealized capital gain until you realize it and actually sell the security. So just again, conceptually for us to understand the vocabulary here. But yeah, I mean, Sean, it's really neat to just look at a portfolio holistically in terms of all of those wonderful things that Jay pointed out, the subsidies for the aca, Roth conversions, capital gains. Like, you might be able to do a lot of these things. And to your point, you're in again, Goldilocks, right? Like your income can't be too low or you won't get ACA subsidies. So therefore 100% Roth doesn't make sense. So it just speaks to. All right, let's be a little diverse here. So I think Jay nailed it. But yeah, I think your answer is perfect.
- [09:10]
Sean Mulaney
Yeah. And you made a great point about the investment allocation decision comes first. So if you're thinking about this, you're looking for content on choose a five, for example, you know, whether it's J.L. collins, Frank Vasquez, Big earn, whoever you want to pick or pick all of them and more, right? So that's the first decision. That decision has nothing to do with Roth IRA or traditional 401k. Once you've made that decision, then tax basketing steps in and says, well, okay, I've made my investment allocation decision, whatever that is. Now I'm going to come in and say, how do I hold that? And in today's environment with low dividend yields and think about most in the FI community, I'm just going to make a generalization. Most get to FI in the early retirement phase and they say, half or more of my wealth is in traditional retirement accounts. Okay. Some people say, oh, that's a problem. I say, well, that gives you a great opportunity. Most people, and I'm not giving investment advice, are going to say, I want my bonds to be less than 50% of my portfolio. Well, if 50% plus 1 of my portfolio or more is in traditional 401ks and IRAs, and 50% minus 1 is supposed to be in domestic bonds, we've just solved for where do the bonds go very well. And all right, there could be some more equities in the traditional retirement account. That's fine, but we've just solved for, okay, we hold our bonds in these traditional retirement accounts. They sit very efficiently and the interest income they're creating doesn't hit our tax return. And, you know, depending, we might do some Roth conversions. You know, there might be a time when it does, but now we get to control it much more than just every year. We're throwing all this interest income onto our tax return. So, yeah, tax basketing step two, essentially. Step one, investment allocation step two, tax basketing, when we put them all together, can be very powerful. Agreed.
- [10:56]
Brad
Okay, I think we nailed that one. So let's move on to Doug's question. So Doug said, with the Secure Act 2.0 and the resulting ability to move some 529 money to, to your kids, Roth IRAs in certain situations. Can you have someone, can you have someone on that walks us through the process? So, Sean, you have elected yourself as the person to walk us through. So I guess first for everyone, let's just talk high level. What's going on here? What's new?
- [11:22]
Sean Mulaney
So this is a secure 2.0 change. And what it says is subject to rules and limitations. A 529 can be emptied into a beneficiary's Roth IRA, up to 35,000 doll thousand dollars for the beneficiary. And it's subject to the annual contribution limits today as we record that $7,000 a person. And what it was intended for is its best use, which is a limited bailout of an overfunded 529. Now, I tend to favor finding another beneficiary. So if junior has a kid's sister or you know, someone else you can change the beneficiary to on the 529. I tend to favor that. But let's say Junior doesn't have a kid sister we can eas beneficiary to and fund their college. You have an overfunded 529. What you could do every year, assuming you meet the terms and conditions, is say, okay, here's the 529. I'm going to move up to the annual contribution limit for Roth IRAs into Junior's Roth IRA. Now, this requires some coordination because this contribution substitutes for Junior making his own contribution to, to the Roth ira. So before you do this, you have to call your kid and say, hey, you didn't contribute to a Roth IRA this year yet, have you? If the answer is yes, then probably this is off the table for this year. But you could do it in the future years potentially anyway. And the way you do this is really just some coordination with financial institutions. I was looking at Fidelity's website, and they have a 529 withdrawal form, and one of the options is 529 to Roth IRA withdrawal. And so literally, you're going to have to do some coordination with both institutions. Now, it could be that maybe your kids got the Roth IRA at Fidelity, you got the 529 of Fidelity, you make it all work. But Maybe the Roth IRA is at Schwab and the 529 is a Fidelity. You got to call both institutions and say, I'm doing the 529 to Roth IRA rollover at Fidelity. The form, you could just, you know, point the representative to the form. And you just got to coordinate. It's not that complicated because literally just up to $7,000 goes from one account to the other account. You can only do that up to 35,000 lifetime total for the beneficiary. And then the last thing to at least consider before you do this, check your state's tax treatment. So I know out here in California, at least as of my last checking, California doesn't respect this. Now, that's not that big a deal, but it's a bit of a deal. So my understanding what that means is the 529 is old contributions and earnings. The earnings piece in California attracts California income tax, and I believe a 2.5% withdrawal penalty, the tax out here for working parents could be like 9.3%. You had that penalty. You're now over 10 cents on the dollar. Now, you still might say, hey, I'M going to do that. But on your state income tax return it might be less than optimal. And I know California is not the only state that has that treatment, so you're going to have to make a judgment call. But if you're in Texas or Florida, Nevada, Washington state, this is just not going to be a thing because they don't even have an income tax. And many states do have the same treatment, by the way. But to answer the correspondent's question, it's really going to be coordination and paperwork between two different financial institutions, the 529 Institution and the Roth IRA Institution of your kid. So that's where it gets a little more complicated.
- [14:50]
Brad
Okay, so yeah, that makes sense. And yeah, just like always, I think a, as the years go by, many of these institutions, this will be old hat. Right. Like this will be something they've done hundreds of thousands of times. Sure. Like I'm thinking, okay, I have Virginia 5 29. Like this just came into existence in the last year or two. I might actually have to call up and speak with somebody. It might not just be something I can click on the website, though I suspect there probably is something. But nevertheless, a handful of years from now, I suspect this will be something that's readily, readily available at essentially every institution. But I think, Sean, the biggest point that's brand new to me is you can only so it's as currently constituted, it's 35,000 is the lifetime limit for this. Right.
- [15:32]
Sean Mulaney
35,000 is the lifetime limit. There are questions on the margins about, well, what if I do this for one beneficiary and then change the beneficiary on the 529 account? There are questions about what if I'm in Iowa's 529 and I accrue the 15 years there and then I roll it to Utah's 529. Have I just reset the 15 year clock that this thing is subject to? So there are these minor, these questions on the margins. So this is one where you might need to seek some professional advice. Secure 2.0 has its own set of issues that I don't want to even get into today. But let's just assume it's valid law for the time being. So there's definitely some issues here. But look for an overfunded 529, it could be a viable way of reducing that overfunding. I will say my view is you don't want to intentionally overfund a529. And I get that that's easier said than done. Because college costs and scholarship, scholarships, it's all variable, but it's. Some people got over their skis on this one. This came out. And some people said, this is the greatest thing since sliced bread. It's like, no, it's actually not. Because the thing is, as you know, Brad, is your kids, your daughters become in their 20s, all you need to fund their Roth IRA every year is a checking account. You don't need a 529 with too much money in it. That's the thing people missed. And so not saying don't do this. I'm saying don't affirmatively plan into an overfunding situation.
- [16:55]
Brad
Agreed. Totally agreed. And yeah, like you said, the annual limit for the Roth IRA, which is currently $7,000 a year, that was the number you quoted. That's the maximum you can do per year for this. So if that limit just hypothetically stayed the same, which, you know, it almost always goes up at some point, you would be able to do this over five years. So that's just the pace you can do it. You can't do all 35k at once. So that, to me is the big takeaway for sure. And otherwise, just call your financial institution. They'll be able to help with this. I think it's. It's going to be a lot easier than we fear or suspect. Thanks for listening to Choose a Phy and for all your support of our mission here. The absolute best way to support Choose a Phy is when you sign up for your next rewards credit card to use our cards page at choose a buy.com cards. I keep this page constantly updated, so it should always be the top resource for you. Thanks for being part of our community and for your support. All right, John, the next question came in from someone anonymous here and said, I'm currently 35 and now just discovering Fi and I feel far behind, overwhelmed and unsure where to start. My financial literacy is very low, even though I'm an engineer, so I'm pretty good at concepts and system thinking. But I guess, how much available money do I need to start? I've dabbled with stocks years ago by buying into specific companies, but again, get overwhelmed and haven't touched those stocks since. What should I do with them? Understanding that every single person is different. But how long does it usually take on average for people to reach five again? I'm 35. Is it too late? So, Sean, this is a, this is a really poignant question and I think the obvious answer is that I want to scream before I let you go. No, you're not even close to too late. You know, this is amazing. If you're finding it at 35, you're. You're crushing it. So do not worry at all. That's my. Again my quick little rah rah speech. But Sean, why don't you take a stab at this?
- [18:48]
Sean Mulaney
Well, it literally takes zero dollars to start. Okay. And in fact, this correspondent doesn't have $0. By his own admission, he dabbled in some stocks. Now who knows, maybe they went far down. By the way, if they have a built in loss, great, you sell them, you trip the loss on the tax return. Fantastic. And now we put that into a more appropriate, more diversified investment. I would point this correspondent to choose FI episode 100. Okay, it's not about. In three months, this gentleman is going to master personal finance. I'm guessing it's a gentleman, maybe it's a woman. Whoever this person is, it's not about, we're going to just master this all overnight. It's about marginal incremental gains and stacking those on top of each other. And choose a 5 episode 100. Just a great, great place to start. You're not going to get overwhelmed and you just learn some of the basic concepts and then you'll learn, oh, there's a choose a fi episode on this, there's a catching up to fi episode on that, there's a how to money on this, there's a blog post on that. You eventually just build and build and build and you get there. The other thing he could think about is he might have a handful of these equities where he bought, you know, 100 shares of X and 20 shares of Y. And maybe there's a built in gain on them. Maybe it's not the worst thing in the world to trigger that gain and redeploy those into good investments. And you know, he said he dabbled, so I'm guessing it's not a million dollars, right? And oh, by the way, if it's a million dollars, you got other problems and you're not really all that far behind at age 35. So he may want to think about selling these things and redeploying them. That's just one little tactical consideration. But in no way is it too late and the entry price is zero and just start being better with the first dollar you earn tomorrow.
- [20:35]
Brad
Yeah, Sean, I, I think so. Obviously I kind of flippantly said, no, it's not too late, of course, and, and that is certainly true. But let's and actually address the Emotion behind this, which is some people do feel like it's too late. They feel like maybe they're beating themselves up for making mistakes in the past. Maybe they haven't saved as much. Maybe they wake up and they're 40 or 45 and they have a zero net worth or a negative net worth. Let's be clear, it is never too late to start on the path to fi. I think very clearly, if the goal was only Sean, maybe circa 2013, it's either you're FI or you're not FI, and everything else in between is immaterial, or we don't consider that progress, right? Like that was the old, old style thinking. Today's five thinking is every action you take on your own behalf to make your life better in any way, certainly financially, is going to put you in a better position. So for this person, I don't know what their net worth is, but let's even assume it's zero, right? Let's assume they have virtually nothing other than a couple of these stocks that maybe went down to zero, right? The first time. They have $5,000 saved up because they made some changes that actually brought some money in. They were in the black every month and they could save like their life is dramatically better. It's dramatically less stressful when you have a little bit of money, when you have a little bit of margin. So let's be clear. Nobody is too late to make changes to make their life better. Nobody ever. So you could beat yourself up. I hope you don't. But you can't change the past. The past, quite literally is the past. There's nothing we can do about it. So we can only make changes to make our life better today and every tomorrow thereafter. And I think that is the message of choose a buy. I think that, frankly, is why we've been so popular over these last eight years, because it's an empowering message. It's, hey, you can make changes, you can make dozens of them, you can make hundreds of them. And that's just that you really can. You can do this. There are literally millions of people have listened to this podcast and so many of them have taken action to make their life better. So please don't think you're ever behind. And ultimately the money part of this is actually fairly straightforward. I mean, for a lot of people. Again, like we've said three times now, we don't give advice here, Sean, as you well know, but like the advice that I give for my daughters, which that's advice I'm allowed to Give is just try to save as much as you can while still having a wonderful life. If you can make that so not at 35, but at 22 when they get out of college, like save 30, 40, 50% of income. And for me, my advice to them again and solely them, is invest in something like vti, which is Vanguard's total stock market etf. And you can buy that pretty much anywhere. Buy to Fidelity, buy to Schwab, buy to Vanguard itself. You can get fractional shares at most places. At most places. But even if you can't, as of the day we're recording this one share is $290. So to the the question, okay, worst case scenario, if you can't buy fractional shares, it's $290 to start. So we're not talking a big hurdle here. Right?
- [23:27]
Sean Mulaney
Well, and Brad, you mentioned something around the tactics and it's great to focus on, hey, how can we best tax basket or how do we do the steps of a backdoor Roth IRA? But the generalities are worth 80% plus. And I'll give you an example in the Choose A5 Facebook group, someone wrote a comment in the Choose A5 Facebook group not too long ago saying something to the effect of, I know I need to do a backdoor Roth. And I actually made a comment in there and I said, you know, I'm going to exception from my general rule. I am going to give this individual person individual advice I want them to rely on. And it's this. You do not need a backdoor Roth ira. No one needs a backdoor Roth ira. Right? You need nutrition, you need oxygen, you need some shelter. And you know, really hot day in the summer, you might need some air conditioning, really cold day in the winter, you might need some heating. You know, that sort of thing. Many people have become very, very rich without ever having done a backdoor Roth ira. Look, I like the backdoor Roth ira. You know, it's fine. But no one needs a backdoor Roth ira. It's a good tactic to potentially deploy to get to financial independence. But you know, I think sometimes we overemphasize some of these tactics.
- [24:41]
Brad
Totally agreed. And let's be clear, I've never done a backdoor Roth ira. I don't ever plan to. And that's just the deal. Just not something I'm interested in. And that might be silly, it might be stick your head in the sand. But I'm focusing on simplicity. Sean, I think that's another. We talked about asset allocation before being like, let's make the first step for me, my operating principle is simplicity. And I think that's perfectly fine. I sleep really well at night knowing that and just makes life easier. So I think we all need to figure out what that operating principle is for us. But there are people who love to optimize, and that's great. Do your thing. Nobody's going to have any issue with that. But please, please, everybody out there don't think you have to at all.
- [25:20]
Sean Mulaney
Yeah, I mean, so just one great piece of wisdom J.L. collins had was to title his book the Simple Path to Wealth. And people say, well, wait a minute, that's just a simple path. And I come back with, well, the simple path and the best path are not necessarily mutually exclusive.
- [25:38]
Brad
Yeah, yeah, that is the path for me. That's for sure. So, all right, Sean, next question came in from Frank. So Frank said, so here's my capital gains question. One, I sell 200 shares of my Schwab S&P 500 mutual fund. Two, I will only be taxed on the gain from that sale. Three, who determines the gain, the actual dollar amount gained from the sale? And he said, I assume Schwab does this with their year end reporting. So, okay, very general question on the nuts and bolts of capital gains.
- [26:10]
Sean Mulaney
Great question, Frank. And the answer is, you determine it. And Schwab's 1099B form determines it. So what do I mean by that? There are rules that are far too complicated to get into specific detail on the Choose a Five podcast. But essentially, before you sell 100 shares, 200 shares of XYZ Mutual Fund, ETF, whatever it is, you can choose a cost recovery method. And what I think a lot of folks in the audience are going to want to do is they're going to want to go on Google, okay? And Google their specific institution. So in Frank's case, it would be Schwab. And then after that, after the term Schwab, Google Specific lots or specific identification. And I know Schwab actually has a little resource, it's called how to Sell Specific Lots. And so what happens is it pulls up all the historic purchases. And you gotta remember, with dividend reinvestment, that could be dozens of them, even if you've only owned this for a handful of years, because all the dividends are paid out by the mutual fund or ETF or the stock and then reinvested, if you have reinvestment set, which a lot of folks do. But what you could do is you can go in there and then you see the particular gain that's inherent in these 10 shares and then these separate 20 shares you bought on another day and these 30 shares you bought on another day and this 4 shares that were dividend reinvestment. So you could do specific identification or sell specific lots or even parts of specific lots. So you want to sell 16 shares, you find a lot with 20 shares that has a high basis. Maybe the stock was, or the mutual fund or the ETF was really high. So when you do the specific identification before you sell, you're picking the specific lots or the specific shares you're selling. And that can reduce the capital gain that you ultimately report on your tax return. And then Frank is absolutely right. What happens is at the end of the year, and it's actually going to be in January, February, March, depending on the particular security and institution they're going to send you. It's called a form 1099 dash B. I think that stands for brokerage and that reports your short and long term capital gains during the previous year. So that you could put it on the tax return. Oh, by the way, the IRS gets a copy of that, so you better put it on your tax return. So there you go. It's basically a combination of any step you take with respect to the specific identification. You can elect other things out. You can, you can elect first in, first out, last in, first out. But the specific identification really lets you jigger it and get to a good place there. And like I'm saying, what you probably want to do is just Google, you know, Vanguard, E Trade, Schwab, Fidelity, whatever your institution is, and then put specific identification or specific lots after that in Google and it should come up with some sort of resource about how you do it in their platform.
- [29:02]
Brad
Agreed. And I know I've done this at Vanguard many times and it's, yeah, it's really nice to have that granular detail just to be able to pick. Because sometimes, frankly there might be instances where you want more capital gains. There might be some instances where you want to minimize that. So having the ability to just not be that, okay, average cost is one option. Or like you said, LIFO or fifo, which is accountants speak, right? Like, oh, the first ones I bought, the last ones I bought, right? It's like, okay, I would always rather personally and everybody can make their own decision, but I'd always rather just be able to very specifically pick the lot. And it's really straightforward. I know with Vanguard it just gives you a nice little list. You just click a button, you say exactly how many shares out of that lot you want to sell, and that's that. So, yeah, I mean, ultimately, the Frank's question is, or the answer is, yeah, you ultimately are making that decision. But Fidelity or Schwab or Vanguard or whoever your institution is, they will corroborate it with that form 1099 B at the end of the year. So it's not like they're making it up. It's just literally, hey, I bought these shares, this lot, for X number of dollars each, and I sold them for Y number of dollars each. So there's no magic here. That's the nice part. It's especially when you do the spec id. All right, Sean, moving on. We got a question from Raj, who said, hello. I started saving for my retirement pretty late in my career. By normal standards, at 43, I'll be 54 this year and hope to retire at 65. I have roughly $750,000 saved up and conservatively should end up with around $1,500,000 by 65, hopefully. My question is, is there a good number after which you say, maybe Roth 401k contributions are a better option? I have most of my contributions going into the traditional 401 and some into the Roth. Thanks.
- [30:50]
Sean Mulaney
Okay, Raj, this is just a fantastic question, and I'll give you a very generic answer, and then I'll break down how I look at it. So the generic answer is there's no number. There's no magic number out there that says, okay, you have a million in your 401k. Now you got to do a Roth 401k. Right? That number, to my mind, does not exist. So what do I do? And, in fact, our friend Cody Garrett and I am currently working on a tax planning book. We're focused on retirement planning. 20, 25 changes, those sorts of things. And so this whole Roth versus Traditional thing comes up. And part of the way you have to do this is, I think, in examples a lot of times. So I came up with an example in the course of writing this book that says, okay, husband and wife both working. They combine $300,000 W2 salary. Okay? So that's where they are today. And they're trying to be financially independent. So they save a third of their gross income, and that looks like 47,023. Five each in a 401 traditional. They do a backdoor Roth IRA, each $14,000, and to get to the third of savings, they put $39,000 in taxable brokerage accounts. Okay. The traditional 401 benefit for them is 24 cents on the dollar. That's the rate we have to test in the future to see. Does that traditional 401 make sense? If you just look at the tax tables, $300,000 couple, they're easily in 24%. Okay, well, what's it going to look like in retirement? And there's essentially, I would say, three phases to consider. First phase, say it's an early retirement. And like I'm saying, they're building up taxable brokerage accounts. So they're probably going to first save on the taxable brokerage accounts. They're going to be in like Flynn for that piece of their retirement. Very low tax. Great. But now let's worst case scenario, the tax accounts are gone. They're going to have to start spending. Let's just worst case scenario, the traditional retirement accounts. Well, what does that look like? Well, here's an easy way to test it. If they're earning 300 today and they're investing 100, what is their consumption? Just use $200,000. That's their tax. And their groceries and heating and cooling and mortgage payment. Now, by the way, we're almost certainly overestimating their retirement spending in 2025 numbers, but we just use 2025 numbers for all of it. So we just say $200,000 is their retirement spending in 2025 numbers. And so then we can use the 2025 tax brackets. Well, let's start taking that whole 200,000 from their traditional retirement accounts. Well, what does the tax look like on that? All right, well, the first 33,200 if they're 65 or older, zero standard deduction, then we get, I think it's 23, 24,000 in 10%, 73,012%. We ultimately get the last dollar to get to the 200,000 is taxed against 22%. So that means that they took a deduction at work at 24%. And then when they took that money out of the retirement account, it came out against the 0, 10, 12 and 22% they won on every last dollar in the traditional retirement account. And then you say, well, wait a minute. Well, eventually they're going to have to take Social Security. Well, okay, that's fine. That'll be 85 cents taxable on the dollar, although there's a proposal to even get rid of that. But let's assume it's 85 cents on the dollar, taxable. That's that much less they have to take from the traditional retirement accounts. Their taxes actually go just a little down in that scenario. So in a relatively worst case scenario, taking out $200,000, you're seeing that traditional retirement accounts often win even at that level of spend $200,000 in 20, $25. That doesn't mean we never do Roths. Right? Roth IRAs at home. I believe the correspondent said Roth IRA at home. I love that. Maybe this correspondent in retirement could do more Roths or it could take some money from Roths if it helps up a premium tax credit or avoid 22%. But you know, there's a lot of fear out there about these traditional retirement accounts. Well then, okay, just play it out. And it turns out for many working Americans, it's hard in retirement to get back up to the rate at which you deduct. Is that a 100% universally true statement? No. Maybe Raj has some huge pension. Although that's a big maybe. That's not a very wide fact pattern. Not a non existent fact pattern. So you have to think about things like that on the margins. But boy, these traditional retirement accounts tend to look really good even at a high balance because of this progressive taxation in retirement.
- [35:25]
Brad
Yeah, that's a really compelling case. There's no question. And obviously, like you said, this is not in 100% of cases. You clearly, you have to have a sense of, all right, what's my income now? What's the actual value of this deduction? To me now that's critical. We can never know the future in terms of tax rates and any kind of prognosticating is difficult. But as Sean just laid out, yeah, this is probably going to make a lot of sense in almost all cases for traditional IRA and 401k. So that's a really cool way of looking at it. And I think, Sean, this is one where I'll quote Charlie Munger and say, I have nothing further to add. You absolutely nailed it. So, all right, let's move on to the next question. This is another anonymous Facebook question. My mother is 66 years of age and has been on Social Security after reaching age 65. She has roughly 110,000 in a traditional IRA invested in a total US cap weighted index fund and partial total US bond fund and no other retirement nor regular brokerage accounts. Am I correct in that she can convert some money to Roth and still stay within 10% bracket while also not incurring any taxes on her Social Security amount nor future IRMAA surcharge. She receives $21,000 per year from Social Security and no other income less the standard deduction of 15,000 equals about a $6,000 AGI. The top single filer 10% bracket is 11,925. So can she convert $5,925 to Roth and only pay the 10% tax on that converted amount? Seems wise to do this every year. Now to reduce the RMD is starting at age 73, which might possibly create more taxes. So. Okay, Sean, this is a lot of detail and I'd love for you to start off like, fundamentally is this looking at this properly.
- [37:12]
Sean Mulaney
So, Brad, I know the term anger and the Choose A five podcast don't typically go together, but they do not. Hearing this makes me angry, not at the correspondent. And the correspondent is bringing to light a great situation. I'm angry that someone in the general public could walk away, say, looking at his mother.
- [37:30]
Brad
Right.
- [37:30]
Sean Mulaney
We got to step back. Mom is, I think, 65, $21,000 a year in Social Security, $110,000 traditional IRA and that's it.
- [37:40]
Brad
Yeah.
- [37:41]
Sean Mulaney
All right, so this is somebody who is not doing very well economically. And what is our correspondent worried about? He's worried about RMDs and IRMAA. I mean, that makes me angry, Brad. And here's the thing. Our correspondent wasn't born worrying about Irma. Personal finance content creators created this fear in this gentleman. That is nonsense. This is absolute nonsense. I'm getting worked up as I'm talking about this. Next time you see somebody out there, Irma, Irma, Irma, it's going to ruin your retirement. This is what comes out of stuff like that. That's nonsense. Cody Garrett was recently on the choose a five podcast with you, Brad. He mentioned the most. Apparently IRMAA can even go up to is 3% of your income. But this is a situation where this woman is basically impoverished and should be thinking about benefits that might be available to her. IRMAA is never going to bite. This woman isn't going to come anywhere near it. Right. RMDs will never be a problem at $110,000 balance. Even if it doubles, RMDs will never be a thing. Now, the correspondent is right to identify a potential opportunity the Roth conversions. And in fact, he's overestimating how much tax. There'd be no tax, almost certainly if he did a $6,000 Roth conversion. But the Roth conversion should be done only if it costs nothing in federal income tax, which it almost certainly will. Right. Just the way Social Security is taxed today. Almost certainly. It's a zero on federal income tax. It costs nothing in state income tax, which it could you got to look at the state situation and it in no way reduces any benefits like property tax reductions or there are things that seniors who are, you know, low income, low wealth could qualify for. So you'd want to run any Roth conversion through those three filters. Correspondent's absolutely right that yeah, this is a great opportunity theoretically on the federal side, but you'd want to look through the state and the benefits side of it. But Brad, I mean, this is a real tribute to you. You're out there as a personal finance content creator creating real knowledge and education in the world and you're not putting, you know, you're not scaring people about boogeymen like Irma. And that's a credit to you because this, this correspondent did not get this, this bad message from someone like you. Irma's out there. It's a nuisance tax that generally, you know, hits the wealthy and it's like, okay, nobody wants to pay it, but it's no big deal. Has very little to do with anybody's lived experience. But people want attention, so they create boogeymen. And that this is out there definitely got my dander up.
- [40:10]
Brad
Yeah, understandably so. Right. I mean, we, we focus on the little minutiae sometimes or people do or like you're saying these, the boogeymen come out and, and scare people for no particular reason, but. Right. Unfortunately, this person's mother gets about $1,750 a month to live on through their entire lifetime. Has saved about $110,000. And you know, like you said, that's a precarious financial position. Obviously we don't know exactly. Is she living with a family member? Yada yada. We couldn't possibly know that. But nevertheless, I think it's, you have to focus on the big things most of the time. And this is why there's always, there's always additional detail in the fi world. But at its essence, this really is simple. I think this is the larger message again to our earlier correspondent, starting too late at 35. And it's just most of this stuff is actually, it's pretty simple once you get into it. It's just you take these changes, you take action to make your life better, to save a little bit of extra money, to try to be able to save every single month, to be able to invest. And it starts compounding at a miraculous rate, frankly, is what I've seen in my own personal life with the way our net worth has grown. And I've seen in countless number of people who have written into me, who have just done this. This is. No, there's no get rich quick scheme like you're saying. Like, Sean, obviously, I'm not trying to sell anything to anybody. I'm just trying to give good advice, just like you. And first off, you and Cody Garrett putting a book together is like a dream team. So that's. I'm super excited about that. And, you know, it's. You find the people who are doing it the right way and you listen to them. And I think for everybody out there, just don't get bogged down in the detail. You can get into the detail when it's important. And there's so many strategies. There's an incredible number of strategies. Like Sean said, you can find it on our podcast. We have 700 plus episodes. There are other amazing podcasters and blog writers and such. You can find all that. But just please don't get bogged down in the minutia over nothing. Over a couple percent. In this case on a hundred thousand dollars. I mean, we're talking pennies. And like Sean said, this person's not going to pay this, so let's be clear. But even if they did, it's nothing.
- [42:17]
Sean Mulaney
And you know, every now and then. Look, I'm a financial planning nerd. I like going down rabbit holes. What I don't like is fear, right? If you want to spend your Saturday afternoon going down some rabbit hole on the Mega Backdoor Roth, fine, have at it. But when you're doing stuff and you're worried about stuff because of fear, that's when I get angry, right? Where it's not just a hobby now. We're worried about something because someone wants some attention. I just don't like that. I don't like this whole, hey, here's something to fear. So now read my article or click my video that I don't like.
- [42:50]
Brad
Yep, wholeheartedly. Agreed. And unfortunately, there's a lot of the snake oil salesmen and such out there that are really either people selling things or like you said, just being sensational and really tricking people into thinking something is. Is important when it applies to very few people. It's. It's similar to. And we don't want to get into this, but like the estate tax, for instance, right? Like gets branded as the death tax and this and that. And it's like this affects. You can round to almost zero the number of people it affects, especially with the current exclusions. And does that mean that at one point that wasn't the case when the, the Exclusion was dramatically lower. No, but like, right now, almost zero people have to worry about the estate tax. Really? We could round to almost zero. So again, don't want to get into that, Sean, but it's just like I hear that kind of scaremongering all the time. It's like, nobody's paying that. You're not even close. You could save money for the rest of your life and you won't even be close. Like, let's worry about the things that actually matter. So, all right, now my anger's up a little bit, Sean, so you got me too. But okay, we got one more question that you've highlighted here. And this is another choose it by Facebook group anonymous question. So I'm going to do a little bit of summarizing here, especially with account balances, but I think we got this one. So the question comes in. I'm just starting to learn about backdoor Roth conversions and I'm trying to see if it might make sense for us. My husband is 67 and I'm 54. So the age difference is throwing me a little first off for some context. And yeah, to summarize here, they have about a $1.1 million net worth and approximately 900,000 of that is in traditional IRAs or traditional retirement accounts. It looks like the remainder is mostly in Roth accounts. They don't really speak to any taxable brokerage accounts, at least here. But yeah, roughly 1.1 million net worth, roughly 900,000 in traditional accounts. So the plan is for my husband to work until 70 and me until 57. So this is Sean, this is three years off. Our combined income has been too high for us to contribute to our Roth IRAs for the last five years. Thus I'm looking into the backdoor conversions. It feels to me like the age difference would make our approach to backdoor conversions different than for a couple who are more similar in age. But I just can't wrap my brain on why that would be. And asking for can you confirm or deny or refute my suspicion and explain. So, Sean, brothers to you.
- [45:12]
Sean Mulaney
Yeah, this is a great little hypothetical and there's definitely little layers you can unpack here. So 67 and 54, 13 year age gap, and they're going to each work for three more years. And most of the financial wealth is in traditional IRAs. That's an important little distinction here. It's not in there's a little bit in a traditional 401 at a current employer, a little bit in a Roth 401 at a current employer, but most of it's in traditional IRAs. And so the correspondent is correct that the backdoor Roth is not really that good of a tactic for them. But it has nothing to do with their age gap. It has everything to do with their expected remaining career length, which is just three years. Right? They're only going to work for three years. And so you say, well, if they did the backdoor Roth IRA, that's 8,000 a pop, right? Per year, 16,000 a year. Add some inflation adjustments, maybe 50,000 for the rest of their careers, they're worth 1.1 million. Yeah, it'd be nice to have 50,000 more in a Roth IRA, but it's not that big of a thing that just take that 50,000 invested in taxable accounts at home, you're fine. If this correspondent was in their 30s and the spouse is in their early 40s and you're going to work for 20 more years, then yes, maybe the backdoor Roth makes some more sense. The other issue in their case is almost all their wealth is in traditional IRAs. One is 700,000 and change, the other is 200,000 and change. So in order to do $50,000 worth of backdoor Roths for three years, they would have to move their existing, almost their entire financial wealth into a workplace retirement plan. That sort of planning can make sense when it's 50,000. A hundred thousand, sure. Why even take the execution risk on Somehow they foul up that transaction. There's very little reason for just three years of backdoor Roths to be moving almost a million dollars into workplace plans. So for them, I think it makes very little sense to do independent transactions that would be required to do a good backdoor Roth because of the whole pro rata rule. That's a separate rabbit hole. But they have some other interesting things in their situation. When we are married to a spouse who is more than 10 years older than us, we get to take reduced RMDs. So they have a nice little opportunity here where you say, okay, RMDs, which I've said have been sort of overhyped as a quote unquote problem in the world. Well, their RMDs are going to be a smidge less. There's an IRS table, it's a joint life table, where you take the husband's age on one axis and then the wife's age on a second axis and you get the factor. And in their case, their RMDs or his RMDs because he's the older one will go down because he happens to have a spouse that's younger than he is. So RMDs will be even less of a concern for this particular couple. And then the third point is for the last three years, you know, a lot of people are going to say, well just max out both their traditional 401ks. And that's decent enough advice. Maybe they don't have enough Runway to max out both. So who do you max out? I would argue you max out the wife's because you're putting deferred money in there that won't become subject to RMDs until she, who's now in her family, 54. She's now 54 until she gets to her 70s. So it's another way of delaying RMD. So if they're going to max out the 401ks, fine. But if the cash flow isn't sufficient to max out, then maybe just focus on, you know, get the employer match on both. Of course, doesn't matter their ages on that. That's very good planning. And then if you only have a limited amount, you know, just put the additional limited amount in her traditional 401k so it becomes subject to RMDs later rather than sooner. So those are three little points there. Great question. And yeah, when we have age gaps, it could definitely open up some interesting planning concepts.
- [49:10]
Brad
Yeah, that's cool. So, right, for anybody out there, RMD is required minimum distribution and basically it's the amount that you are pretty much forced to take out each year. Again, there's certain rules, we can't go into that right now, but depending on the account and the age and etc. But nevertheless, what RMDs do is reduce your flexibility because anytime that you are forced to take distributions from an account, it just reduces flexibility for all of the cool fi things and hacks that we can do. Right. So you want to be in a position where you can mitigate that as much as possible. So Sean's idea here for it going in, in this case the wife, the younger person's account, okay, that pushes off RMDs for quite some time. So that's pretty cool. Sean, the, the one thing you said, that again, way too complicated for this, but the pro rata rule, it's these back to Roth conversions get really complex when it comes to like you having money in traditional IRAs. And that's why you said like you'd have to move all this money to a workplace 401k. And it's like it for me. It's like Is the juice worth the squeeze?
- [50:11]
Sean Mulaney
That's exactly right.
- [50:12]
Brad
Right. Like, frankly, when I said before, I've never done this, that's largely why, because I never wanted it. Just like the juice wasn't worth the squeeze for me, I just didn't want to be bothered with that. And that might be my own limitation, frankly, but that was how I judge this.
- [50:25]
Sean Mulaney
Well, I think the juice is worth the squeeze. Like, I'll just give you an example. They have a $20,000 traditional IRA and they're going to work 20 more years, all of which are going to be above the Roth IRA income limits. Okay, great. Move the $20,000 IRA to a 401k, do 20 years or the backdoor Roth and be happy with that. But when we're only going to do three years worth of backdoor Roths, and we're now taking. I call this execution risk. What if you try to do a transaction, you screw it up and $700,000 comes out of a traditional IRA and doesn't get into the 401k within 60 days? The odds of that happening, very, very, very low. But it's $700,000. It's most of their financial wealth. What are we doing here? Right?
- [51:08]
Brad
Let's.
- [51:09]
Sean Mulaney
Let's step back and say, okay, they can take that, you know, the 7 or the 8,000, they would have put in the backdoor Roth, put in a taxable account or more into the 401k or whatever they want to do, and they're going to be fine.
- [51:21]
Brad
Sean, this was great. We really bombed through a lot of questions here. We really did a great job. Thank you for preparing all this. It was absolutely wonderful. And as always, we'll have some links in the show, notes, everything we talked about. But where can people find you? Where do you want them to reach out?
- [51:35]
Sean Mulaney
Thanks so much, Brad. Really enjoy the conversation. You can reach me on my blog, FI, tax guy.com, my financial planning firm, which is Mulaney financial.com and on X. Sean, Money and Tax.
- [51:49]
Brad
Beautiful. Sounds good. Sean, as always, thank you for being here. I really appreciate it. And to everybody out there, this is incredible information. And it's. It can be as specific or as general as you need it at this point. And that's the beautiful thing about FI and our entire community is all the info is there. Don't feel like you need to obsess about these little details now, but file it away and say, okay, look, these strategies exist, and when it comes time for it, you know, they're out there. And I think that just, just having a comprehension of what is available to you, I think that's what is most critical. But don't lose the forest for the trees here. Just really focus on what's important at your stage of the journey to FI and you're going to succeed wildly. So as always, thank you for being here and thanks for listening to Choose a Phi.
- [52:33]
Cody Garrett
Thank you for listening to today's show and for being part of the choose of community. If you haven't already, the best ways to get involved are first subscribe to the podcast. So you're listening to this on a podcast player. Just hit subscribe and then subscribe to my weekly newsletter. I actually sit down every Monday and write this by hand and I send it out Tuesday morning. So just head over to choosefi.com subscribe and it's really, really easy to get on the the newsletter list right there and I would greatly appreciate it. It's the best way to get in touch with me. You can actually just hit reply to any of those emails and it comes directly to my inbox. So that's the way that I keep a pulse of the community and how we keep this the ultimate crowdsourced personal finance show. And finally, if you're looking to join an in real life community, we have choose a vi local groups in 300 plus cities all around the world. So head to choose a vi.com local and you'll find a list of all of Those cities in 20 plus countries all across the world. And if you're just getting started with FI or you have a family member or friend who you think would be interested, two easy ways choose a Fi episode 100 is kind of our welcome to the Fi community. And even though it's a couple years old at this point, it still stands up and it's a really great just starting point to get an understanding of what is financial independence. What are we doing here? Why are we looking to live a more intentional life where we save money and use it as a springboard to live a better life? And then choose if I created a Financial Independence 101 course that's entirely free. Just head to choosefi.comfi101 and again, thanks for listening.