Harry Sit's Blog, page 21

Long Box Spread Trade vs Buying Treasury Note or CD

We looked at the short box spread as an alternative to securities-based lending in the previous post. This time we look at its mirror image: the long box spread. Once again, this post is more on the “advanced” side of things. It’s totally optional. Please feel free to skip it if you prefer to stick with safety in the mainstream.

Table of ContentsLong Box SpreadHow Does It Help?What Are the Downsides?How To Do It at FidelityLong Box Spread

A long box spread is also a specifically constructed set of four option holdings, which are typically implemented on a market index. When you buy (“long”) a box spread, you —

(a) pay a sum of cash upfront; and
(b) are guaranteed to receive a known larger sum on a specific date in the future.

When you pay upfront for a guaranteed larger sum on a future date, you’re effectively lending at a fixed rate for a fixed term. The difference between the amount you pay and the amount you will receive in the future is your effective interest income for giving the cash upfront.

How Does It Help?

If you want a guaranteed return for a fixed term, you can already buy a Treasury note or a CD. A long box spread gives you a slightly higher yield than buying a Treasury note or a CD.

Slightly Higher Yield

As we learned from the previous post on the short box spread, the implied interest rate in a box spread trade is about 0.3% – 0.5% above the Treasury yield of a comparable term. Brokers also sell brokered CDs. The best yields on a one-year or two-year brokered CD sold through Fidelity and Vanguard at this time are worse than the Treasury yields.

You’re getting paid a small premium over the Treasury yield when you hold a long box spread. The going rate is about 1.0% per year for one year and 1.6% per year for two years at this time.

Low Credit Risk

Even though your money initially goes to the market participant that sold the box spread to you, you’re not relying on their goodwill to be paid back. You’re paid back by the options exchange through your broker when the options expire. The options exchange debits the other party’s broker. If the other party can’t come up with the money, their broker will go after them by selling their investments. It’s not your worry.

No New Accounts

According to depositaccounts.com, the best yield on a two-year CD at this moment is 1.19%, which is offered by a credit union in Wyoming. When you buy a long box spread, you’re getting a higher effective yield than that CD special using money in your brokerage account. You don’t have to open new accounts with banks and credit unions all over the place.

Favorable Tax Treatment

Your effective interest income in a long box spread is an investment gain in Section 1256 contracts, which is treated as 60% long-term gain and 40% short-term gain, whereas your interest from a CD is 100% ordinary income.

A higher yield, the convenience of staying in your brokerage account, plus a favorable tax treatment make it attractive to buy a long box spread.

What Are the Downsides?

The biggest downside in a long box spread trade is the same as in a short box spread trade: the risk of screwing up when you enter your order. If you accidentally make a mistake, you may turn a small guaranteed gain into a big loss.

Rule #1 if you’re going to venture into box spreads: Don’t screw up. 

Another downside is liquidity. If you want your money back sooner, you’d have to sell your long box spread, which isn’t nearly as liquid as a Treasury note.

How To Do It at Fidelity

If you fully understand what you’re doing and you’re super careful, here’s an example of how to do a long box spread at Fidelity. It may be similar at other brokers.

Four Legs

As in doing a short box spread trade, you need to be approved for options trading Level 3.

Choose “Options” in the Trade popup.

Enter “.SPX” in the symbol field. This is for the S&P 500 index. Again, we use the S&P 500 index (SPX) as opposed to the S&P 500 ETF (SPY) because SPX options can’t be exercised early whereas SPY options can be. Your box will be knocked out of balance if one of your legs is exercised early.

Click on “Spread” as the options strategy. You automatically get two legs. Click on “Add Leg” twice to add two more legs.

Click on the “Call” toggle for the first two legs and the “Put” toggle for the next two legs.

Select Action in this sequence for a long box spread, which is the opposite of a short box spread:

Buy To OpenSell To OpenSell to OpenBuy to Open

Remember for a long box spread: Buy – Sell – Sell – Buy.

Set the expiration to the same date for all four legs. This is the date you will get paid back.

Choose strike prices around the current index value (4,400 to 4,600 in the screenshot when the index was around 4,500). The gap between the strike prices times 100 is the amount you’ll be paid back. If you have $20,000 to invest, make the gap 200 wide. The strike prices go from low to high in your two calls and two puts. Match the two spreads exactly between your two calls and two puts. Finally, enter the same quantity for all four legs.

When you need to invest $40,000, you can choose a spread of 400 (for example 4,300 to 4,700) with a quantity of 1 or you can choose a spread of 200 (for example 4,400 to 4,600) with a quantity of 2. All else being equal, a smaller quantity with a larger spread saves a small amount of money on commissions and fees but a larger quantity with a smaller spread may be easier to execute. The commissions and fees at Fidelity are $2.68 for each set of four legs at a quantity of 1 ($0.67 per leg).

Limit Price

Now you need to enter a limit price for your four legs. Look up recent trades on boxtrades.com. Boxtrades.com gives you a target price when you enter the desired yield.

This screenshot shows when you’re willing to accept a yield of 1.5% per year for a spread of 200 until December 15, 2023, you should enter a limit price of 194.55.

Make sure the order type is Net Debit. You’re offering to pay someone in the market $19,455 now for you to receive $20,000 on December 15, 2023. You’ll pay $19,455 + $2.68 = $19,457.68 after commissions and fees.

Execution

After you place the order, you wait to see if someone accepts your offer. Your four-leg option trade is offered as a full package. It’s not possible for someone to pick it apart and accept some legs of your trade but not the others.

It may take some time for your trade to execute. If no one is interested after an hour, you may need to raise the offering price (pay more and receive a lower effective yield). Or you can try it on another day if you aren’t in a hurry. Again, you can calculate the effective yield for your new higher price at boxtrades.com.

After Execution

If your order is filled, you’ll pay a sum of cash in your account. You’ll also have four option positions in your holdings. These option positions added together have a net positive value. They will turn into the predictable positive cash credit when you hold them to the expiration date. You’re effectively paid back at that point.

Ignore Values in the Evening

The values of the option positions will fluctuate with the market even though they will converge to the predictable value on the expiration date. The prices used to calculate their values are especially wild when the market is closed. You’ll have to learn to ignore the account balance you see in the off-hours.

Don’t be alarmed when you see your balance drop by a huge sum in the evening. They’ll return to more reasonable values when the market is open.

Mark-to-Market Gain/Loss for Taxes

The year-end 1099 form you receive from the broker will include entries for your Section 1256 gain or loss. Enter the 1099 form as-is into your tax software. The tax software will handle it with the proper tax treatment.

***

A long box spread can be a good alternative to buying a Treasury note or a CD when you execute it correctly. You must be super careful not to screw up in placing your order. Don’t do it if there’s any slight chance you’ll make a mistake. The loss from your mistake can be many times your potential gain from a slightly higher yield. It’s perfectly valid to avoid the possible disaster and only stick with safety in the mainstream.

Learn the Nuts and Bolts I put everything I use to manage my money in a book. My Financial Toolbox guides you to a clear course of action.Read Reviews

The post Long Box Spread Trade vs Buying Treasury Note or CD appeared first on The Finance Buff.

2021 Self-Employed ACA Health Insurance Deduction In TurboTax

Updated on February 6, 2022, with new screenshots from TurboTax Deluxe downloaded software for the 2021 tax year. If you use other tax software, see:

2021 Self-Employed ACA Health Insurance In H&R Block Software

Many self-employed business owners buy health insurance through the ACA healthcare marketplace (healthcare.gov or a state-specific exchange). If your estimated income qualifies for a subsidy, the marketplace will pay part of the premium directly to the insurance company.

However, the advance subsidy is only an estimate based on the income estimate you provided when you signed up. As self-employed people know full well, the actual income from self-employment can vary greatly from year to year. After the year is over, you have to square up and calculate the actual subsidy you really qualify for. If your business didn’t do as well as you anticipated, you may qualify for a higher subsidy. If you had a great year, you may have to pay back some of it.

If you’re self-employed, you also qualify for a tax deduction for the health insurance premium. If you qualify for both a subsidy and a deduction, they form a circular relationship. The IRS prescribed a method to calculate the split between the subsidy and the deduction. It’s difficult to calculate by hand but tax software will take care of it for most people.

Use TurboTax Download

The screenshots below are from TurboTax Deluxe downloaded software. The downloaded software is way better than online software. If you haven’t paid for your TurboTax Online filing yet, you can buy TurboTax download from Amazon, Costco, Walmart, and many other places and switch from TurboTax Online to TurboTax download.

We will use this scenario as an example:

You are single, self-employed, with no dependent. You had health insurance through the ACA healthcare marketplace for all 12 months in the year. The full unsubsidized preimium for the second lowest cost Silver plan was $600/month. The full unsubsidized premium for the plan you chose was $500/month. Based on your estimated income, you got a $150/month advance credit. You paid net $350/month. After deducting your business expenses, your income from self-employment was $45,000 for the year. You don’t have any other income or deductions.

Enter 1095-A

Go to Federal Taxes -> Deductions & Credits. Scroll down and find Affordable Care Act (Form 1095-A) under Medical.

This is a special deal only for 2020 and 2021. If you received unemployment benefits for one week, you get free (or nearly free) health insurance for the full year. We didn’t receive unemployment in our example.

You should have a Form 1095-A from the healthcare marketplace. If you didn’t get it in the mail, log in to your online account and look for a document download.

Enter the month-by-month numbers from your Form 1095-A. It’s tedious to repeat for all 12 months but you have to do it. The first column is the full unsubsidized monthly premium for your plan. The middle column is the full unsubsidized premium of the second lowest cost Silver plan, which is used to calculate your subsidy. The last column is the advance subsidy the ACA exchange already paid on your behalf to the insurance company.

This is important but easy to miss. Even though TurboTax knows you’re self-employed and you have the 1095-A form from the ACA healthcare marketplace, you still must check this box.

Associate the health insurance with your self-employment and say during which months it applied.

If you have more than one Form 1095-A, repeat and add them all. We only have one in our example.

TurboTax crunches the numbers in a split second. It says we’re eligible for more tax credit than the ACA healthcare marketplace already paid directly to the insurance company. We’ll get the difference in our tax refund. If you qualify for less subsidy than the advance already paid, you’ll pay back the difference, subject to a cap (see Cap On Paying Back ACA Health Insurance Subsidy Premium Tax Credit).

Self-Employed Health Insurance Deduction

We’re also eligible for a tax deduction for the portion not covered by the premium tax credit.

To see your self-employed health insurance deduction, click on Forms on the top right. Find Schedule 1 in the left navigation pane. Look at Line 17. It shows we’re getting a $1,388 tax deduction for self-employed health insurance.

Premium Tax Credit

To see the subsidy you qualify for based on your actual income, find Form 8962 in the forms list navigation pane. Scroll down and look at Line 24. When you’re done looking for the form, click on Step-by-Step on the top right to get back to the interview.

$1,388 in self-employed health insurance tax deduction plus $4,612 in premium tax credit equals $6,000 ($500/month), which is the full unsubsidized premium for our health plan (plus any dental and vision insurance premium, which we didn’t have in our example). The numbers add up! TurboTax figured out the split between the tax deduction and the tax credit. It also matched the result from H&R Block software for the same example.

Edge Cases

TurboTax works for most cases but it doesn’t work for everyone. You know you’re running into one of the edge cases for which the software doesn’t work when the numbers from the software fail this equation (except for a small difference due to rounding):

Self-Employed Health Insurance Deduction + Premium Tax Credit = Unsubsidized Health Insurance Premium (including any dental and vision premiums)

When this happens, you need a better calculator. See When TurboTax and H&R Block Give Self-Employed Wrong ACA Subsidy.

Learn the Nuts and Bolts I put everything I use to manage my money in a book. My Financial Toolbox guides you to a clear course of action.Read Reviews

The post 2021 Self-Employed ACA Health Insurance Deduction In TurboTax appeared first on The Finance Buff.

How to Report 2021 Backdoor Roth in H&R Block Tax Software

Updated on February 4, 2022, with updated screenshots from H&R Block software for tax year 2021. If you use other tax software, see:

How To Report Backdoor Roth In TurboTaxHow to Report Backdoor Roth In FreeTaxUSA

If you did a Backdoor Roth, which involves making a non-deductible contribution to a Traditional IRA and then converting from the Traditional IRA to a Roth IRA, you need to report both the contribution and the conversion in the tax software. For more information on Backdoor Roth, please read Backdoor Roth: A Complete How-To and Make Backdoor Roth Easy On Your Tax Return.

Table of ContentsWhat To ReportUse H&R Block Download SoftwareConvert Traditional IRA to RothNon-Deductible Contribution to Traditional IRATaxable Income from Backdoor RothTroubleshootingWhat To Report

You report on the tax return your contribution to a traditional IRA *for* that year and your conversion to Roth *during* that year.

For example, when you are doing your tax return for year X, you report the contribution you made *for* year X, whether you actually did it in year X or between January 1 and April 15 of the following year. You also report your converting to Roth *during* year X, whether the money was contributed for year X, the year before, or any previous years.

Therefore a contribution made during the following year for year X goes on the tax return for year X. A conversion done during year Y after you made a contribution for year X goes on the tax return for year Y.

You do yourself a big favor and avoid a lot of confusion by doing your contribution for the current year and finishing your conversion during the same year. I called this a “planned” Backdoor Roth — you’re doing it deliberately. 

Don’t wait until the following year to contribute for the previous year.  Contribute for year X in year X and convert it during year X. Contribute for year Y in year Y and convert it during year Y. This way everything is clean and neat. 

If you are already off by one year, catch up. Contribute for both the previous year and the current year, then convert the sum during the same year.  See Make Backdoor Roth Easy On Your Tax Return.

Use H&R Block Download Software

The screenshots below are taken from H&R Block Deluxe downloaded software. The downloaded software is way better than online software. If you haven’t paid for your H&R Block Online filing yet, consider buying H&R Block download software from Amazon, Walmart, Newegg, and many other places. If you’re already too far in entering your data into H&R Block Online, make this your last year of using H&R Block Online. Switch over to H&R Block download software next year.

Here’s the scenario we’ll use as an example:

You contributed $6,000 to a traditional IRA in 2021 for 2021. Your income is too high to claim a deduction for the contribution. By the time you converted it to Roth IRA, also in 2021, the value grew to $6,200. You have no other traditional, SEP, or SIMPLE IRA after you converted your traditional IRA to Roth. You did not roll over any pre-tax money from a retirement plan to a traditional IRA after you completed the conversion.

If your scenario is different, you’ll have to make some adjustments to the screens shown here.

Before we start, suppose this is what H&R Block software shows:

We will compare the results after we enter the Backdoor Roth.

Convert Traditional IRA to Roth

Income comes before deductions on the tax form. Tax software also organizes this way. Even though you contributed before you converted, the software makes you enter the income first.

Enter 1099-R

When you convert the Traditional IRA to Roth, you receive a 1099-R for that year. Complete this section only if you converted *during* the year for which you are doing the tax return. If you only contributed for the year in question but didn’t convert until the following year, skip all the way to the next section heading “Non-Deductible Contribution to Traditional IRA.”

In this example, we assume by the time you converted, the money in the Traditional IRA had grown from $6,000 to $6,200.

Click on Federal -> Income. Scroll down and find IRA and Pension Income (Form 1099-R). Click on “Go To.”

Click on Import 1099-R if you’d like. I show manual entries with “Enter Manually” here.

Just a regular 1099-R.

If you imported your 1099-R, double-check to make sure the import exactly matches the copy you received. If you enter your 1099-R manually, be sure to enter everything on the form exactly. Box 1 shows the amount converted to Roth IRA. It’s normal to have the same amount as the taxable amount in Box 2a when Box 2b is checked saying “taxable amount not determined.” Pay attention to the distribution code in Box 7. My 1099-R has the code 2.

My 1099-R had the IRA/SEP/SIMPLE box checked.

Did not inherit.

Converted to Roth

This is a very important question. Read carefully. Answer No, because you converted, not rolled over.

Now answer Yes, you converted.

We converted all of it in our example.

Answer Yes because you made a nondeductible contribution to a traditional IRA.

The refund in progress drops a lot at this point. We went from a $2,434 refund to $946. Don’t panic. It’s normal and only temporary. It will come back up after we complete the section for IRA contributions.

You are done with one 1099-R. Repeat the above if you have another 1099-R. If you’re married and both of you did a Backdoor Roth, pay attention to whose 1099-R it is when you enter the second one. You’ll have problems if you assign both 1099-R’s to the same person when they belong to each spouse. Click on Finished when you are done with all the 1099-Rs.

Additional Questions

A few more questions.

Answer Yes because you contributed to a Traditional IRA for the year.

Will wait.

Non-Deductible Contribution to Traditional IRA

Now we enter the non-deductible contribution to the Traditional IRA *for* the year in question. Complete this part whether you contributed in the same year or you did it or are planning to do it in the following year between January 1 and April 15.

If your contribution during the year in question was for the previous year, make sure you entered it on your previous tax return. If not, fix your previous return first.

Click on Federal -> Adjustments. Find IRA Contributions. Click on “Go To.”

Wrong tense but answer “Yes” because you contributed to an IRA for the year in question.

Check the box for Traditional IRA if you contributed directly to a Traditional IRA. If you originally contributed to a Roth IRA and then you recharacterized the contributions as traditional contributions, check the Roth IRA boxes here and then answer yes when it asks you whether you recharacterized.

You know you don’t get a deduction due to income. Enter anyway.

Enter your contribution amount. We contributed $6,000 in our example.

This is important. Answer No if you contributed to a Traditional IRA and converted to Roth. Answer Yes if you originally contributed to a Roth IRA, recharactered it to Traditional, and then converted.

If you did a clean “planned” backdoor Roth and you started fresh each year, enter zero. If you contributed non-deductible for previous years (regardless of when), enter the number on line 14 of your Form 8606 from last year.

This is another important question. Read carefully. If you are doing it the easy way, as in our example, answer “Yes” — you converted all. If you are doing it the hard way in offset years — contributing for year X in the following year and converting during the following year — answer “No” and you will see some more questions.

If you already did it the hard way, please, please, please do yourself a big favor and do it the easy way next year. See Make Backdoor Roth Easy On Your Tax Return.

A summary of your contributions. 0 in Traditional IRA deduction means it’s nondeductible. Click on Next. Repeat for your spouse if both of you did a Backdoor Roth.

We are done entering the nondeductible contribution to the Traditional IRA. Now the refund in progress should go back up. It was a refund of $2,434 when we first started. Now it’s a refund of $2,396. The difference of $38 is due to the tax on the extra $200 earned before the Roth conversion.

If you only contributed *for* last year but you didn’t convert until the following year, remember to come back next year to finish the conversion part.

Taxable Income from Backdoor Roth

After going through all these, let’s confirm how you’re taxed on the Backdoor Roth.

Click on Forms on the top and open Form 1040 and Schedules 1-3. Click on Hide Mini WS. Scroll down to lines 4a and 4b.

It shows $6,200 in IRA distributions, $198 of which is taxable. The taxable income came out to $198, not $200, due to some rounding in the calculation. If you are married filing jointly and both of you did a backdoor Roth, the numbers here will show double.

Tah-Dah! You got money into a Roth IRA through the backdoor when you aren’t eligible to contribute to it directly. You will pay tax on a small amount in earnings if you waited between contributions and conversion. That’s negligible relative to the benefit of having tax-free growth on your contributions for many years.

Troubleshooting

If you followed the steps and you are not getting the expected results, here are a few things to check.

Fresh Start

It’s best to follow the steps fresh in one pass. If you already went back and forth with different answers before you found this guide, some of your previous answers may be stuck somewhere you no longer see. You can delete them and start over.

Click on Forms and delete IRA Contributions Worksheet, 1099-R Worksheet and Form 8606. Then start over by following the steps here.

W-2 Box 13

Make sure the “Retirement plan” box in Box 13 of the W-2 you entered into the software matches your actual W-2. If you are married and both of you have a W-2, make sure your entries for both W-2’s match the actual forms you received.

When you are not covered by a retirement plan at work, such as a 401k or 403b plan, your Traditional IRA contribution may be deductible, which also makes your Roth conversion taxable.

Self vs Spouse

If you are married, make sure you don’t have the 1099-R and the IRA contribution mixed up between yourself and your spouse. If you inadvertently assigned two 1099-Rs to one person instead of one for you and one for your spouse, the second 1099-R will not match up with a Traditional IRA contribution made by a spouse. If you entered a 1099-R for both yourself and your spouse but you only entered one Traditional IRA contribution, you will be taxed on one 1099-R.

Learn the Nuts and Bolts I put everything I use to manage my money in a book. My Financial Toolbox guides you to a clear course of action.Read Reviews

The post How to Report 2021 Backdoor Roth in H&R Block Tax Software appeared first on The Finance Buff.

How To Report 2021 Backdoor Roth In TurboTax (Updated)

Updated on February 4, 2022, with new screenshots from TurboTax Deluxe downloaded software. If you use other tax software, see:

How To Report Backdoor Roth In H&R Block SoftwareHow to Report Backdoor Roth In FreeTaxUSA

If you did a Backdoor Roth, which involves making a non-deductible contribution to a Traditional IRA and then converting from the Traditional IRA to a Roth IRA, you need to report both the contribution and the conversion in the tax software. For more information on Backdoor Roth, see Backdoor Roth: A Complete How-To.

Table of ContentsWhat To ReportUse TurboTax DownloadConvert Traditional IRA to RothNon-Deductible Contribution to Traditional IRATaxable Income from Backdoor RothTroubleshootingWhat To Report

You report on the tax return your contribution to a Traditional IRA *for* that year and your conversion to Roth *during* that year.

For example, when you are doing your tax return for year X, you report the contribution you made *for* year X, whether you actually did it during year X or between January 1 and April 15 of the following year. You also report your conversion to Roth *during* year X, whether the contribution was made for year X, the year before, or any previous years.

Therefore a contribution made during the following year for year X goes on the tax return for year X. A conversion done during year Y after you made a contribution for year X goes on the tax return for year Y.

You do yourself a big favor and avoid a lot of confusion by doing your contribution for the current year and finish your conversion in the same year. I called this a “planned” Backdoor Roth — you’re doing it deliberately. Don’t wait until the following year to contribute for the previous year.  Contribute for year X in year X and convert it during year X. Contribute for year Y in year Y and convert it during year Y. This way everything is clean and neat.

If you are already off by one year, catch up. Contribute for both the previous year and the current year, then convert the sum during the same year. See Make Backdoor Roth Easy On Your Tax Return.

Use TurboTax Download

The screenshots below are from TurboTax Deluxe downloaded software. The downloaded software is way better than online software. If you haven’t paid for your TurboTax Online filing yet, you can buy TurboTax download from Amazon, Costco, Walmart, and many other places and switch from TurboTax Online to TurboTax download.

Here’s the planned Backdoor Roth scenario we will use as an example:

You contributed $6,000 to a traditional IRA in 2021 for 2021. Your income is too high to claim a deduction for the contribution. By the time you converted it to Roth IRA, also in 2021, the value grew to $6,200. You have no other traditional, SEP, or SIMPLE IRA after you converted your traditional IRA to Roth. You did not roll over any pre-tax money from a retirement plan to a traditional IRA after you completed the conversion.

If your scenario is different, you will have to make some adjustments to the screens shown here.

Before we start, suppose this is what TurboTax shows:

We will compare the results after we enter the Backdoor Roth.

Convert Traditional IRA to Roth

The tax software works on income items first. Even though the conversion happened after the contribution, we enter the conversion first.

When you convert from Traditional IRA to Roth, you will receive a 1099-R form. Complete this section only if you converted *during* the year for which you are doing the tax return. If you only converted during the following year, you won’t have a 1099-R until next January. Skip this section and wait until the next year.

In our example, we assume by the time you converted, the money in the Traditional IRA had grown from $6,000 to $6,200.

Enter 1099-R

Go to Federal Taxes -> Wages & Income -> IRA, 401(k), Pension Plan Withdrawals (1099-R).

As you work through the interview, you will eventually come to the point to enter the 1099-R. Select Yes, you have this type of income. Import the 1099-R if you’d like. I’m choosing to type it myself.

Just the regular 1099-R.

Box 1 shows the amount converted to Roth IRA. It’s normal to have the same amount as the taxable amount in Box 2a when Box 2b is checked saying “taxable amount not determined.” Pay attention to the code in Box 7 and the IRA/SEP/SIMPLE box. Make sure your entry matches your 1099-R exactly.

You get this Good News, but …

Your refund in progress drops a lot. We went from $2,384 down to $858. Don’t panic. It’s normal and temporary.

Converted to Roth

Didn’t inherit it.

First click on “I moved …” then click on “I did a combination …” Enter the amount converted in the box. Don’t choose the “I rolled over …” option. A Roth conversion is not a rollover.

No, you didn’t put the money in an HSA.

Not due to a disaster.

You get a summary of your 1099-R’s. Repeat the previous steps to add another if you have more than one. If you’re married and both of you did a Backdoor Roth, enter the 1099-R for both of you, but pay attention to select whose 1099-R it is. Don’t accidentally assign two 1099-R’s to the same person.

Basis and End-of-Year Values

Didn’t take any disaster distribution.

Here it’s asking about the prior year carryover. When you’re doing a clean “planned” Backdoor Roth as in our example — contribute for year X in year X and convert before the end of year X — you can answer No here. If you contributed for the previous year between January 1 and April 15 during year X, answer Yes here.

If you answered Yes to the previous question and you did your previous year’s return correctly also in TurboTax, your basis from the previous year will show up here. If you did your previous year’s tax return wrong, fix your previous return first.

Enter the values at the end of the year. We don’t have anything in traditional, SEP, or SIMPLE IRAs after we converted it all.

That’s it so far on the income side. Continue with other income items. The refund in progress is still temporarily depressed. Don’t worry. It will change.

Non-Deductible Contribution to Traditional IRA

Now we enter the non-deductible contribution to a Traditional IRA *for* the year we are doing the tax return.

Complete this part whether you contributed before December 31 or you did it or are planning to do it in the following year between January 1 and April 15. If your contribution during the year in question was for the year before, make sure you entered it on the previous tax return. If not, fix your previous return first.

Go to Federal Taxes -> Deductions & Credits -> Traditional and Roth IRA Contributions.

Because we did a clean “planned” Backdoor Roth, we check the box for Traditional IRA. If you did a detour when you first contributed to a Roth IRA before you realized your income is too high and you recharacterized the contribution as to a Traditional IRA, check the box for Roth IRA and answer the questions accordingly.

TurboTax offers an upgrade but we choose to stay in TurboTax Deluxe.

We already checked the box for Traditional but TurboTax just wants to make sure.

It was NOT a repayment of a retirement distribution.

Enter the contribution amount. Because we contributed for year X in year X, we put zero in the second box. If you contributed for the previous year between January 1 and April, enter the contribution in both boxes.

Right away our federal refund in progress goes back up! We started with $2,384. It went down to $858. Now it comes back to $2,335. The $49 difference is because we have to pay tax on the $200 in earnings when we contributed $6,000 and converted $6,200. If you had less in earnings, your refund numbers would be closer still.

This is a critical question. Answer “No.” You converted the money, not switched or recharacterized.

You may not get this question if you already entered your W-2 and it has Box 13 for the retirement coverage checked. Answer yes if you’re covered by a retirement plan but the box on your W-2 wasn’t checked.

No excess contribution.

Same question we saw before. For a clean “planned” Backdoor Roth, we can answer No. If you made non-deductible contribution for previous years, answer Yes.

Total basis through the previous year. If you did your taxes correctly on TurboTax last year, TurboTax transfers the number here. If you made non-deductible contributions for previous years (regardless of when), enter the number on line 14 of your Form 8606 from last year.

Because we did a clean “planned” Backdoor Roth, we don’t have anything left after we converted everything before the end of the same year.

Income too high, we know. That’s why we did the Backdoor Roth.

The IRA deduction summary shows $0 deduction, which is expected.

Taxable Income from Backdoor Roth

After going through all these, would you like to see how you are taxed on the Backdoor Roth?

Click on Forms on the top right.

Find Form 1040 in the left navigation panel. Scroll up or down on the right to find lines 4a and 4b. They show a $6,200 distribution from the IRA and only $200 of the $6,200 is taxable. That’s the earning between the time you contributed to your Traditional IRA and the time you converted it to Roth.

When you’re done examining the form, click on Step-by-Step on the top right to go back to the interview.

Tah-Dah! You got money into a Roth IRA through the backdoor when you aren’t eligible for contributing to it directly. That’s why it’s called a Backdoor Roth. You will pay tax on a small amount in earnings if you waited between contributions and conversion. That’s negligible relative to the benefit of having tax-free growth on your contributions for many years.

Troubleshooting

If you followed the steps and you are not getting the expected results, here are a few things to check.

Fresh Start

It’s best to follow the steps fresh in one pass. If you already went back and forth with different answers before you found this guide, some of your previous answers may be stuck somewhere you no longer see. You can delete them and start over.

Click on Forms on the top right.

Find “IRA Contrib Wks” and “IRA Info Wks” in the left navigation pane and click on “Delete Form” to delete them. Then you can start over following the steps above.

W-2 Box 13

Make sure the Retirement Plan box in Box 13 of the W-2 you entered into the software matches your actual W-2. If you are married and both of you have a W-2, make sure your entries for both W-2’s match the actual forms you received.

When you are not covered by a retirement plan at work, such as a 401k or 403b plan, your Traditional IRA contribution may be deductible, which also makes your Roth conversion taxable.

Self vs Spouse

If you are married, make sure you don’t have the 1099-R and IRA contribution mixed up between yourself and your spouse. If you inadvertently entered two 1099-Rs issued to you instead of one for you and one for your spouse, the second 1099-R to you will not match up with a Traditional IRA contribution made by your spouse. If you entered a 1099-R for both yourself and your spouse but you only entered one Traditional IRA contribution, you will be taxed on one 1099-R.

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Short Box Spread Trade vs Margin Loan: How It Works at Fidelity

Today’s post is more on the “advanced” side. It’s completely optional in managing one’s finance and investments. Please feel free to skip it if you prefer to stick with safety in the mainstream.

The beginning of a new year creates a large demand for cash. I needed cash to contribute to our IRAs and HSA and to buy I Bonds in multiple accounts. I could sell from our brokerage account to generate cash but both stocks and bonds weren’t doing too well in January. I thought of tapping security-based lending for cash before I read this blog post from Karsten on Early Retirement Now: Low-Cost Leverage: The “Box Spread” Trade. I decided to look into it and see how it works.

Table of ContentsWhat Is a Box SpreadShort Box SpreadHow Does It Help?What Are the Downsides?How Much Can You Borrow?How to Do It at FidelityWhat Is a Box Spread

A box spread is a specifically constructed option trade with a guaranteed outcome on a preset date no matter how the underlying market moves. The trade is typically implemented as options on a stock index such as the S&P 500 index (SPX) because options on the S&P 500 index can’t be exercised early (“cash-settled European options”). This guarantees a predictable result on the option expiration date.

You can either sell (“short”) a box spread or buy (“long”) a box spread. We only look at the short box spread in this post. We’ll look at the long box spread in the next post.

Short Box Spread

When you sell (“short”) a box spread, you —

(a) receive a sum of cash upfront; and
(b) are guaranteed to lose a known larger sum on a specified future date.

When you receive cash up front and you must lose a larger sum on a future date, you’re effectively taking out a loan with a balloon payment at the end. The difference between the amount you receive and the amount you must pay back in the future is your effective interest payment for having the cash upfront.

How Does It Help?

Getting your effective loan from selling a box spread helps because the implied interest rate is quite low. It’s also independent of the broker you use.

Low Fixed Rate

The effective interest rate from a short box spread is about 0.3% – 0.5% above the Treasury yield of a comparable term. According to a helpful website boxtrades.com, the current effective interest rates as I’m writing this are about 1.0% per year for one year and 1.5% per year for two years.

The implied interest rate is also fixed for the term whereas the interest rates in securities-based lending programs are typically variable rates. As the Fed raises the short-term interest rate, those variable rates will likely go up in tandem. If you do a short box spread that expires in two years, you’ll have the 1.5% rate guaranteed for two years.

Use Any Broker

You’re getting the money from the market participants when you sell a box spread. Your broker doesn’t control your effective interest rate. The broker only receives a small commission for facilitating the trade.

You don’t have to transfer your account to Interactive Brokers only to access their low margin rates. You don’t have to have a large balance with your broker and beg for an unpublished rate in their securities-based lending program. You can still do it even if you use Vanguard, which doesn’t offer special low margin rates or a separate securities-based lending program.

Favorable Tax Treatment

Another advantage of a short box spread is that the effective interest payment is an investment loss in Section 1256 contracts, which is treated as 60% long-term loss and 40% short-term loss. The investment loss can offset your capital gains. You don’t have to itemize deductions to use your investment loss.

If you borrow from a securities-based lending program, the interest is often effectively not tax-deductible when you don’t itemize deductions.

What Are the Downsides?

The biggest downside is that you may make a mistake in entering the trade and screw it up. If you accidentally choose the wrong direction (buy versus sell), the wrong strike price, or the wrong expiration date for one part of your four option legs, your trade as a whole won’t guarantee that you’ll only lose a set amount on a set date. The sky is the limit if you screw up.

If you already have a low interest rate from your broker and you don’t mind that the rate is variable, getting a loan from your broker is much simpler and less error-prone.

Rule #1 if you’re going to venture into box spreads: Don’t screw up. I don’t blame you if you decide not to do the box spread simply to avoid possible screwups.

Another downside that comes with the fixed rate is the fixed term. The date you must pay it back is fixed after you execute the trade. If you’d like to pay it back sooner, you’ll have to buy back your box spread, which will be subject to the market condition at that time. If you’d like to pay it back later, you’ll have to sell another box spread with a later expiration date.

If you borrow and pay back frequently for the short term, it’s more convenient to use a securities-based lending program. The variable rate doesn’t matter much in the short term. If you borrow a large sum for a long period of time, a short box spread can get you a low fixed rate for a fixed term.

How Much Can You Borrow?

The amount you can borrow doesn’t change between securities-based lending and selling a box spread.

Although your broker isn’t coming up with the money for your effective loan, they aren’t going to let you get into a position such that your other investments can’t cover the required balloon payment when the options expire. You’re still subject to the same margin requirements. If the values of your other investments drop in a crash, your broker can still sell them at the bottom to meet margin requirements.

Treat selling box spreads the same as borrowing from securities-based lending. Don’t go overboard. Limit your borrowing to no more than a small percentage of your account value. Borrow for the shortest term you need. Repay as soon as you can.

How to Do It at Fidelity

If you decide to sell a box spread, here’s an example of how to do it at Fidelity. It may be similar at other brokers.

First, you need to apply for options trading in your taxable account. Fidelity categorizes options trading into five levels by the risks. You need to apply for Level 3 or above. Applying for Level 3 options trading also automatically applies for margin. Your investment objective in the application must be Growth or above.

Four Legs

You’ll be able to enter option trades on an index after your account is approved for options trading Level 3.

Choose “Options” in the Trade popup.

Enter “.SPX” in the symbol field. This is for the S&P 500 index. We use the S&P 500 index (SPX) as opposed to the S&P 500 ETF (SPY) because SPX options can’t be exercised early, whereas SPY options can be. Your box will be knocked out of balance if one of your legs is exercised early.

Click on “Spread” as the options strategy. You automatically get two legs. Click on “Add Leg” twice to add two more legs.

Click on the “Call” button for the first two legs and the “Put” button for the next two legs.

Select Action in this sequence for your four legs:

Sell To OpenBuy To OpenBuy to OpenSell to Open

Remember: Sell – Buy – Buy – Sell.

Set the expiration to the same date for all four legs. This is the date you will effectively pay back the loan.

Choose a spread around the current index value for the strike price (4,400 to 4,600 in the screenshot when the index was around 4,500). The size of the spread times 100 is the amount of your effective loan. If you need to borrow $20,000, make the spread 200 wide. The spread goes from low to high in your two calls and two puts. Match the two spreads exactly between your two calls and two puts. Finally, enter the same quantity for all four legs.

When you need to borrow $40,000, you can choose a spread of 400 (for example 4,300 to 4,700) with a quantity of 1 or you can choose a spread of 200 with a quantity of 2. All else being equal, a smaller quantity with a larger spread saves a small amount of money on commissions but a larger quantity with a smaller spread may be easier to execute. The commission at Fidelity is $2.68 for each set of four legs at a quantity of 1.

Limit Price

Now you need to enter a limit price for your order. Look up recent trades on boxtrades.com. Boxtrades.com gives you a target price when you enter a desired APR.

This screenshot shows when you’re willing to pay 1.5% APR for a spread of 200 until December 15, 2023, you should enter a limit price of 194.55.

Make sure the order type is Net Credit. You’re asking someone in the market to pay you $19,455 now for you to pay back $20,000 on December 15, 2023.

Execution

After you place the order, you wait to see if someone takes your offer. Your four-leg option trade is offered as a full package. It’s not possible for someone to pick it apart and accept some legs of your trade but not the others.

It may take some time for your trade to execute. If no one is interested after an hour, you may need to lower the offering price (receive less, a higher effective APR). Or you can try another day if you aren’t in a hurry. Again, you can calculate the effective APR for your new lower price at boxtrades.com.

After Execution

If your order is filled, you’ll receive a sum of cash in your account. You can do whatever you want with this cash including withdrawing from your account for your cash needs.

You’ll also have four option positions in your holdings. These option positions added together have a net negative value. They will turn into the predictable negative cash debit when you hold them to the expiration date. When you put cash back into your account before the expiration date, your cash will be used to offset the debit. You effectively pay off your loan at that point.

Ignore Values in the Evening

The values of the option positions will fluctuate with the market even though they will converge to the predictable value on the expiration date. The prices used to calculate their values are especially wild when the market is closed. You’ll have to learn to ignore the account balance you see in the off-hours.

Don’t be alarmed when you see your balance drop by a huge sum in the evening. They’ll be back to more reasonable values when the market is open.

Mark-to-Market Gain/Loss for Taxes

The year-end 1099 form you receive from the broker will include entries for your Section 1256 gain or loss. Enter the 1099 form as-is into your tax software. The tax software will handle it with the proper tax treatment.

***

A short box spread can be a good alternative to securities-based lending when you execute it correctly. This is especially helpful when you can’t get a good rate from your broker. You must be super careful not to screw up in placing your order. Don’t do it if there’s any slight chance you’ll make a mistake. The loss from your mistake can be many times your potential gain from having a low-interest loan.

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TurboTax 2021 CARES Act 2.0 $600 Charity Donation Deduction

From the previous posts, we know that in 2021, even if you take the standard deduction you can still deduct up to $600 in cash donations to charities (up to $300 for single or married filing separately). See 2021 $300 Charity Deduction For Non-Itemizers $600 Married. However, finding the place to get this deduction in TurboTax requires some patience.

TurboTax

TurboTax has a place to enter charity donations as you would expect. It’s under Federal Taxes -> Deductions & Credits -> Charitable Donations. So far so good.

It’s also straightforward to enter the donations. You arrive at this summary after you enter all the details. In our example, the taxpayer donated $700 cash to a favorite charity.

However, your refund number doesn’t change after you click on “Done with Charitable Donations.” It’s as if you’re not getting the deduction for your donations. In our example, the refund was $3,836 before we started, and it was still $3,836 when we were done with charitable donations.

TurboTax continues to ask you about other deductions. After you’re done with all the deductions, TurboTax will do an analysis at that point.

TurboTax double-checks some items until it concludes that you should take the standard deduction.

And now the refund number will change. It was $3,836. Now it’s $3,908. We’re getting $72 for the donations.

So if you don’t see your refund change after you enter your donations, be patient. Keep going, going, and going. Eventually, you will reach the place where TurboTax recognizes that you’re taking the standard deduction and you’re entitled to the $300 or $600 deduction for your donations to charity.

H&R Block Software

It’s much more straightforward to do this in the H&R Block software. The H&R Block software assumes you’ll take the standard deduction until it sees enough deductions worth itemizing. It’s a good assumption to make because close to 90% of all taxpayers take the standard deduction. As soon as you enter the charity donations in H&R Block software, the refund number will change.

TurboTax doesn’t assume. It tries to demonstrate it’s thorough and it’s doing the heavy lifting of giving you the maximum deductions. After a song and dance, you end up with the standard deduction anyway. I think the approach in the H&R Block software works better, but TurboTax’s convoluted way creates good materials for blog posts.

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How To Use a Password Manager with TreasuryDirect for I Bonds

When you buy I Bonds in multiple accounts for yourself, spouse, , trust, and business, logging in to the TreasuryDirect website can be a pain.

You have to log in separately using each assigned account number. It’s difficult to remember the account numbers. You’d have to save them somewhere, ideally in a password manager such as KeePass, Bitwarden, or LastPass. You copy the account number from the password manager and paste it on the login page. You’ll receive a one-time passcode by email. You paste it on the next page. So far so good.

Virtual Keyboard

Now comes the password part. You can’t paste directly into the password field. The TreasuryDirect website uses this virtual keyboard:

You click on the buttons with your mouse or finger to enter your password. If you follow the recommended practice and use a long password with a mix of letters, numbers, and symbols, it’s painful to click in your long password.

Some password managers can fill in the password automatically. If your password manager doesn’t, you may be tempted to reset your password to a simpler one just to avoid this pain. Don’t. There’s a workaround.

Remove HTML Attribute

The reason you can’t paste into the password field is that the TreasuryDirect web page instructs your browser to set that field to read-only. If you right-click on the password field and choose “Inspect” in the context menu (it works at least in Chrome and Firefox), you will see this:

readonly="readonly" name="password" size="20" maxlength="16" class="pwordinput" value="" data-cip-id="blah blah">

When you double-click in that area and simply remove the part in red, the password field won’t be read-only anymore. Now you can paste your password!

Whether the password field is read-only or not only affects the behavior of your browser. Whether you click on the virtual keyboard or paste your password, the password will be transmitted to TreasuryDirect in the same way.

Browser Bookmark

If you’d like to eliminate the extra steps to right-click and remove the HTML attribute every time you log in, you can use a browser bookmark to automate the task. Create a bookmark in your browser and use this as the URL:

javascript:(function(){document.querySelector(".pwordinput").removeAttribute("readonly")})();

Next time when you’re on the password page in TreasuryDirect, click on that bookmark. Nothing visible happens but it removes the read-only attribute from the password field. You can paste your password from the password manager now.

It works the same way as manually removing the HTML attribute. It just happens in one click instead of multiple steps.

Browser Extension

If you’re more technical and you already use a browser extension (add-on) such as Greasemonkey for Firefox or Tampermonkey for Chrome, you can put a script in the browser extension and eliminate that one click of a bookmark.

This is beyond the scope of this post. Here’s a solution I found on the Internet:

TreasuryFix on GitHub

I haven’t tested either script. It may not be the only solution or the best one. Inspect and use it at your own risk. Because I don’t log in frequently, clicking on a bookmark once per session is easy enough for me.

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How To Report 2021 ESPP Sale In TurboTax: Don’t Pay Tax Twice!

[Updated in 2022 with new screenshots from TurboTax.]

If your employer offers an Employee Stock Purchase Program (ESPP), you should max it out. You come out ahead even if you sell the shares as soon as you can. See Employee Stock Purchase Plan (ESPP) Is A Fantastic Deal.

After you sell the shares from the ESPP, part of the income will be included on your W-2. However, the 1099-B form you receive from the broker still reflects your discounted purchase price. This post shows you how to make the necessary adjustment on your tax return using TurboTax.

Don’t pay tax twice!

If you use other tax software, please read:

How to Report ESPP Sale in H&R Block Software

If you’re looking for a guide on doing taxes on RSU sales, please read Restricted Stock Units (RSU) and TurboTax: Net Issuance.

Table of ContentsWhen to Report1099-B From BrokerUse TurboTax DownloadEnter 1099-BCorrect Cost BasisVerify on Schedule DWhen to Report

Before you begin, be sure to understand when you need to report. You report when you sell the shares you bought under your ESPP. If you only bought shares but you didn’t sell during the tax year, there’s nothing to report yet.

Wait until you sell, but write down the full per-share price (before the discount) when you bought. If you purchased multiple times, write down for each purchase:

The purchase dateThe closing price on the grant dateThe closing price on the purchase dateThe number of shares you bought

This information is very important when you sell.

Let’s use this example:

You bought 1,000 shares under your ESPP on 9/30/20xx. The closing price on the purchase date was $12 per share. The closing price on the grant date six month before was $10 per share. You bought at $8.50 per share with the discount.

You would write down:

Grant Date4/1/20xxMarket Price on the Grant Date$10 per sharePurchase Date9/30/20xxMarket Price on the Purchase Date$12 per shareShares Purchased1,000Discounted Price$8.50 per share

Keep this information until you sell.

1099-B From Broker

When you sell, you will receive a 1099-B form from the broker in the following year. You will report your gain or loss using this 1099-B form and the information you accumulated for each purchase.

Let’s continue our example:

You sold 1,000 shares from your purchase above on 10/5/20xx at $11.95 per share. After commission and fees, you netted $11,925. You received a 1099-B form from your broker showing a sales proceed of $11,925 in the following year. The 1099-B form shows the cost basis as $8,500, which reflects your discounted purchase price.

Because you didn’t hold it for two years after the grant date and one year after the purchase date, your sale was a “disqualifying disposition.” The discount is added as income to your W-2. This raises your cost basis. If you just accept the 1099-B as-is, you will be double-taxed!

Now let’s account for it in TurboTax.

Use TurboTax Download

The screenshots below are from TurboTax Deluxe downloaded software. The downloaded software is way better than online software. If you haven’t paid for your TurboTax Online filing yet, you can buy TurboTax download from Amazon, Costco, Walmart, and many other places and switch from TurboTax Online to TurboTax download.

Enter 1099-B

Go to “Federal Taxes” -> “Wages & Income” -> “Investment Income” and find “Stocks, Mutual Funds, Bonds, Other.”

Answer “Yes” because you did sell stocks.

TurboTax offers an upgrade but we don’t need it. TurboTax Deluxe handles ESPP sale just fine.

We did receive a 1099-B form.

Import your 1099-B if you’d like. I’ll type it myself here.

Select or enter the financial institution. Suppose it’s E*Trade.

Choose to enter one sale at a time. Fill in the boxes from your 1099-B form. Look carefully which category the sale belongs to on your 1099-B form. It was Box A on my form. It could be a different one on your form.

The cost basis on your 1099-B was reported to the IRS but it was too low. Don’t change it here directly.

We don’t have any of these fields on our 1099-B form.

Correct Cost Basis

Check the box for “The cost basis on my statement is incorrect.” Enter your purchase cost plus the amount added to your W-2. When you did a “disqualifying disposition” your cost basis was the full value of the shares on the date of the purchase. The market price was $12 per share when you purchased those 1,000 shares at $8.50 per share. Your employer added the $3,500 discount as income to your W-2. Therefore your true basis is $8,500 + $3,500 = $12,000.

If you didn’t sell all the shares purchased in that batch, multiply the number of shares you sold by the discount price on the date of purchase and add the discount included on your W-2. For example, if you sold only 500 shares and your employer added $1,750 to your W-2, your corrected cost basis is:

$8.50 * 500 + $1,750 = $6,000

Repeat if you have more sales to enter. We only had one sale in our example.

You get a summary of the sales you entered.

You get a summary of your net gain and loss. We have a net loss because we received less money after selling the shares and paying the commission and fees than our discounted purchase plus the income added to our W-2.

Verify on Schedule D

We can verify that the adjustment makes it all the way to the tax form. Click on “Forms” on the top right.

Find “Schedule D” in the left navigation pane.

Scroll up or down to find lind 1b, 2, 3, 8b, 9, or 10 depending on the sale category on your 1099-B form.

You see the negative adjustment in column (g). If you didn’t make the adjustment and you just accepted the 1099-B as-is, you will pay capital gains tax again on the $3,500 discount you are already paying taxes through your W-2. Remember to make the adjustment!

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The Forgotten Deductible Traditional IRA

This article was inspired by a post made by Kevin M on the Bogleheads forum. You may have heard of this rule of thumb about retirement savings priorities:

Contribute to 401k (or 403b) to get the full employer matchMaximize Roth IRAMaximize 401k (or 403b)Invest in taxable account

Kevin asked why a Roth IRA as opposed to a deductible Traditional IRA is used in Step 2. It’s a very good question. In the financial media and blogs, everybody talks about the Roth IRA. The deductible Traditional IRA is hardly mentioned.

There are reasons Roth IRAs have better publicity. Some are good reasons; some aren’t. Today’s article is about the forgotten deductible Traditional IRA and how it shouldn’t be neglected.

Available to Most People

One reason a Roth IRA is recommended more often than a deductible Traditional IRA is probably that some people can’t contribute to a deductible Traditional IRA but they can contribute to a Roth IRA. For people covered by a retirement plan at work, the AGI cutoff for contributing to a deductible Traditional IRA in 2022 is $78k single, $129k married filing jointly whereas the cutoff for contributing to a Roth IRA is $144k single, $214k married filing jointly.

Therefore for people with an AGI between $78k and $144k (single) or between $129k and $214k (married filing jointly), if they are covered by a retirement plan at work, the Roth IRA is an option but the deductible Traditional IRA isn’t.

But that’s only a narrow band. The vast majority of people have an AGI below $78k single, $129k married. The deductible Traditional IRA is also an available option to these vast majority of people but they probably don’t hear about it as often as they do about the Roth IRA.

Also remember the AGI is after all pre-tax deductions from the paycheck such as 401k contributions and health insurance. The actual cutoff for gross income is probably another $10,000 higher.

It could be because people who consume financial media tend to have a higher income. Therefore the financial media write for the higher-income people. If your AGI is below $78k single/$129k married but you are reading articles written for people with income above that, you are not getting the full picture if the articles don’t state that assumption.

Higher Income Limit Without a Workplace Retirement Plan

Moreover, according to data from EBRI, only 60% of all workers have a retirement plan at work to begin with. For the other 40% of the population who don’t have a retirement plan at work, there’s either no income limit at all for contributing to a deductible Traditional IRA or the income limit is the same as that for contributing to a Roth IRA.

I would say most people are eligible for a deductible Traditional IRA but they don’t know it.

Traditional Wins

When both options are available, should you automatically choose a Roth IRA over a deductible Traditional IRA, as the coverage in the financial media would suggest? Of course not.

I wrote The Case Against Roth 401k. It’s still true today. Everything I mentioned in that article against a Roth 401k applies to Roth IRA as well if you have the option to use a deductible Traditional IRA. To summarize, a deductible Traditional IRA helps:

Fill in lower tax brackets in retirementAvoid high state income taxLeave the option open for future Roth conversionsAvoid triggering phaseouts

You still have to evaluate today’s tax bracket versus the possible tax brackets when you retire. If today’s tax bracket is 22% plus state income tax rate, it’s far from a forgone conclusion that tax rates will be higher when you retire than when you are working.

Don’t Worry About the RMD

Roth proponents often cite the lack of Required Minimum Distributions (RMD) as an advantage of Roth accounts. It’s true but I’m afraid that’s another artifact of today’s retirees having pensions.

When you have a pension and you live comfortably on the pension and Social Security, RMD from your 401k and IRAs starting at age 72 adds to your taxable income, which is taxed at the marginal income tax rate and probably triggers some other taxes and phaseouts.

However, most of today’s workers don’t have a pension. They will need to withdraw from their 401k and IRAs anyway for retirement income. RMD won’t be a big problem if you don’t have a pension or you don’t have a large account balance. For the vast majority, the problem will be not having enough balance in the 401k and IRAs. Their problem won’t be being forced to withdraw more than they need.

Irrational Reasoning

So why are Roth IRAs and Roth 401k’s so popular that the deductible Traditional IRAs are almost forgotten? I can think of two reasons.

First, many people think they have a zero marginal income tax rate because they have low income. It’s been reported nearly 50% of taxpayers don’t actually pay federal income tax after all deductions and credits. However, their marginal tax rate isn’t necessarily zero. If they take a deduction they will receive more refundable tax credit.

The second reason is certainty. Paying a known rate today versus an unknown rate in the future is appealing, but I don’t think it’s rational, at least not for everyone. If the rate is low enough (10%?), paying it to remove uncertainty can be worth it. If it’s 22% plus the state income tax rate, it’s not clear at all. Going for certainty can cost you in retirement income.

Don’t forget the deductible Traditional IRA.

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The Case Against Roth 401(k): Still True After All These Years

[Originally written in 2008. Updated in 2022. The case is still valid after all these years.]

To Roth or not to Roth, that is the question.

Many employers offer both a Traditional and a Roth contribution option in their 401(k) plan. If you choose the Traditional option, your contributions go in pre-tax but you pay tax when you withdraw after you retire. If you choose the Roth option, you pay tax first before you contribute but your withdrawals are tax-free after you retire. You can mix and match between Traditional and Roth but your total contributions between the two can’t exceed the annual limit.

TraditionalRothContributionspre-taxpost-taxEarningstax-deferredtax-freeWithdrawalstaxabletax-free

This question of whether one is better off with contributing to the Traditional 401k or contributing to the Roth 401k has been the subject of a lot of debate. Although there is no one-size-fits-all answer, I think for most people the majority, if not 100%, of the contribution should go to a Traditional 401(k). I will state my case against the Roth 401(k) in this article.

Table of ContentsFill In Lower Tax Brackets In RetirementAvoid High State Income TaxLeave the Option Open for Future Roth ConversionsAvoid Triggering Phase-outsEasier to Get the Full Employer MatchWho Should Use a Roth 401(k)?Tax Diversification?Higher Effective ContributionsWhat About Roth IRA?

The basic premise of a Roth 401(k), and to some extent a Roth IRA, is that of prepayment. You are prepaying taxes now so you don’t have to pay tax later. This prepayment concept is not uncommon. For example, buying a season ticket is prepaying for the individual events. Buying a timeshare is prepaying for vacation accommodation.

Whenever we deal with a prepayment scheme, we have to assess whether prepaying is “worth it.” The same paradigm also applies to Traditional versus Roth 401(k). There are several factors that make prepaying the taxes now not worth it.

Fill In Lower Tax Brackets In Retirement

I showed in a previous post Commutative Law of Multiplication that if the marginal tax rate at retirement is the same as it is now, the Traditional and Roth 401(k)’s are equivalent. If the marginal tax rate is higher now than in retirement, one is better off contributing to a Traditional 401k. If the current marginal tax rate is lower, one is better off contributing to a Roth 401k.

But that applies only to the marginal dollar, which is the last dollar you can shift between Traditional and Roth 401(k). It is not necessarily the case for the entire contribution or the average dollar.

The tax system in the United States is progressive and it will probably stay that way. It means that income is taxed at increasing rates as it goes higher. Even if you think the marginal tax rate in the future will be higher, there will still be lower brackets and these lower brackets should be filled with money from a Traditional 401(k).

The chart below illustrates how the tax brackets work:

Picture a bucket with markings on the side. As you pour water into the bucket, the water goes up and crosses the marked lines. This represents how your income is taxed. The first chunk of your income absorbed by your tax deduction isn’t taxable. The next chunk of your income is taxed at 10%. The next chunks after that are taxed at 12%, 22%, etc.

When you contribute to a Traditional 401(k), you are scooping up income from the top of this bucket. The dollars you contribute come from the highest tax bracket for your income.

After you retire, you’re staring at an empty or shallow bucket before you pour in money from your 401(k). The money first goes through the lower brackets before it reaches the top.

Even if you assume your marginal tax bracket in retirement will be higher due to tax increases, a large portion of the 401(k) withdrawal may still be taxed at a lower rate than what it was when you contributed the money.

Until you know you can generate from your Traditional 401(k) enough income to fill the lower brackets, it doesn’t make sense to contribute to a Roth 401(k). For people without a pension, it means the majority of the retirement savings should go to a Traditional 401(k), not Roth.

If you have a pension and/or you expect to have a huge balance in Traditional 401(k)/IRA, large enough to fill the lower brackets every year, then contributing some money to Roth makes sense.

Avoid High State Income Tax

Many people work in high-tax states like California and New York today. They work there because there are a lot of good-paying jobs in those states. They won’t necessarily retire there because taxes and the cost of living are high in those states.

States popular with retirees like Florida and Texas have no state income tax. If you’re working in a high-tax state today but there’s a good chance you will retire in a no-tax or low-tax state, contributing to a Traditional 401(k) lets you avoid paying the high state income tax on the contributions. Prepaying the high state income tax now is a dead loss.

Leave the Option Open for Future Roth Conversions

When you leave your employer, you can roll over the Traditional 401(k) to a Traditional IRA, which then can be converted to a Roth IRA at a later time when it is advantageous to you. A Roth 401k or IRA on the other hand can never be converted back to Traditional.

With a Traditional 401k, you hold the option, which has value. If you contribute to a Roth, you give up that valuable option. You can decide to convert and pay the tax whenever you are in a lower tax bracket than where you are now. Good times for conversion include:

Going back to school for a career change.Becoming unemployed due to layoffs or burn-out.Starting a business (not as much income in the first few years).A two-income couple having one parent stay at home or work part-time for a few years after they have kids.A high-income single person marrying a lower-income spouse.Taking early retirement.Moving from a high-tax state to a no-tax or low-tax state.

Unless you’re sure that your marginal tax bracket will never be lower throughout your lifetime, you should leave the option open by putting money in a Traditional 401(k) and waiting to convert to Roth when an opportunity comes.

Avoid Triggering Phase-outs

Because contributing to a Roth 401k does not reduce your gross income, you appear to have a higher income than if you contributed to a Traditional 401k.

There are all kinds of income-based eligibility cutoffs and phase-outs in the tax code. When you exceed the income threshold, your tax benefits from those programs are either reduced or eliminated. Some of these tax breaks include:

Child Tax CreditChild and Dependent Care CreditAmerican Opportunity tax creditLifetime Learning creditEligibility to contribute to a Roth IRAStudent loan interest tax deduction

Think of the stimulus payments during the COVID pandemic. If a single person earned $80,000 but contributed $10,000 to a Roth 401k, he/she wasn’t eligible for the payment. If he/she contributed $12,000 to a Traditional 401(k) instead, he/she was eligible.

Easier to Get the Full Employer Match

Some people think if you contribute to Roth 401k, the employer’s match will also go there, which will effectively increase your employer match. That’s not true. The employer match always goes to the pre-tax account whether you contribute to the Traditional 401k or the Roth 401k.

When money is tight, it’s easier to qualify for the full employer match when you contribute to the Traditional 401k with pre-tax dollars.

Who Should Use a Roth 401(k)?

With so many disadvantages, then, for whom does a Roth 401(k) make sense?

A Roth 401(k) is good for people in low-paying jobs now but expect to have high-paying jobs later. Doctors in resident programs fit that description very well. They are paid very little while they are in residency but their income is expected to rise substantially higher when they finish the program. Their income will stay high in their career and they will receive a high income after they retire. Prepaying tax now makes sense because they are prepaying at a low rate and they will avoid paying a higher rate later.

College students working part-time jobs or recent graduates working in entry-level jobs are also good examples for taking advantage of a Roth 401(k) while their income (and their tax rate) is low.

A Roth 401(k) is also good for people who are already in the top tax bracket and expect to be there forever. If they don’t see any chance of being in a lower tax bracket, prepaying tax now will lock in the tax rate so they won’t have to worry about future tax increases. On the other hand, people who are in the top tax bracket are in a good position to retire early, with many years of lower tax brackets to fill. So don’t be too sure of staying in the top tax bracket forever.

Tax Diversification?

What about the idea of tax diversification? Some advocate both a Roth 401k and a Traditional 401k because the tax rates in the future are uncertain.

Diversification is good in general but it doesn’t mean automatic 50:50. Just like investing in emerging markets provides diversification, it doesn’t mean you should invest 50% of your money in emerging markets. You still have to decide how much you should allocate your retirement savings between Traditional and Roth just like you allocate a portfolio between developed markets and emerging markets.

Tax diversification also doesn’t mean you have to do it right now if you are in your peak earning years. There might be better times coming up in the future.

As for me, I had contributed 100% to a Traditional 401(k) every year when I worked full-time. Prepaying taxes just wasn’t worth it.

Higher Effective Contributions

Some say the Roth 401(k) is better because you can fool yourself into contributing more when you’re using after-tax money. Contributing 10% of your salary post-tax effectively puts more money into your 401k than contributing 10% of your salary pre-tax. It’s true but you should adjust your contribution to 12% or 15% to equalize the net paycheck when you contribute to a Traditional 401k.

A Roth 401k has a higher effective contribution limit because the annual contribution limit is the same when you max out your 401k. There is some truth to it. See follow-up post, Roth 401(k) for People Who Contribute the Max, which includes an online spreadsheet that calculates the value of having a higher effective contribution limit in a Roth 401k.

What About Roth IRA?

All arguments for and against the Roth 401k also apply to the Roth IRA when you are not yet contributing the maximum to your Traditional 401k. Instead of contributing to the Roth IRA, you can just increase the contribution to your Traditional 401k.

An additional argument in favor of the Roth IRA is that some 401k plans have higher fees. Even then the Traditional 401k can still be better when you don’t expect to work there for many years. You can roll over to your own IRA for lower fees when you change jobs. See Alternatives to a High Cost 401k Or 403b Plan.

If you are already contributing the maximum to your Traditional 401k, you may still be able to take a deduction for contributing to a Traditional IRA. See The Forgotten Deductible Traditional IRA. A Roth IRA is better when you already contribute the maximum to your Traditional 401k and you don’t get a deduction for contributing to a Traditional IRA anyway.

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