How Do Capital Gains Taxes Work, Exactly?

Table of Contents

1. How Capital Gains Work: Long-Term vs. Short-Term
   1. Current Long-Term Capital Gains Tax Rates
2. Tax Advantages to Holding Investments for Longer Periods
3. Using Capital Gains Rates to Your Advantage
   1. How Much Can You Save with Long-Term Capital Gains Tax Rates?
4. What About Investment Losses?
5. Tracking Capital Gains (and Losses)
   1. Specifying Which Shares to Sell
6. Special Exclusions to Capital Gains Taxes
7. Capital Gains FAQs
   1. Do I Need to Pay Estimated Taxes on Capital Gains?
   2. Will the Capital Gains Rate Remain the Same?
8. Planning Around Capital Gains Taxes is Only Part of the Picture

When you sell an investment for more than you bought it for, the government wants a cut of the gains. You are required to pay capital gains taxes on your increased earnings when you realize them. However, the amount of taxes you have to pay on the gains depends on two major factors: how long you have owned the investment, and your income.

Now for the good news. You only pay capital gains taxes on the increased value when you sell. So, if you bought an asset for $500, and it appreciates over time to $1,500, you don’t pay taxes on the $1,500 when you sell the asset. Instead, you only pay taxes on the gains — in this case $1,000.

How Capital Gains Work: Long-Term vs. Short-Term

Careful planning can give you excellent tax advantages

The rate at which you pay capital gains taxes is determined by how long you have held the asset, and your income.

If you hold the asset for a year or less, it is considered a short-term investment. You are taxed at your marginal tax rate, meaning that the gain is treated as regular income.

If, however, you hold the asset for at least one year and one day, it is considered a long-term investment. When you sell, your gains are taxed at a rate that might differ from your marginal tax rate. Sometimes this works in your favor.

Right now, taxpayers in the lowest two tax brackets don’t pay any federal capital gains taxes when they sell long-term assets.

Those who are in higher tax brackets will have to pay either 15% or 20% on their capital gains. (Capital gains taxes were previously capped at 15%).

Current Long-Term Capital Gains Tax Rates

2022 Long-Term Capital Gains Tax Rate	0%	15%	20%
Single Filers	$0 - $41,675	$41,675 - $459,750	Over $459,750
Married Filing Jointly	$0 - $83,350	$83,351 - $517,200	Over $517,200
Head of Household	$0 - $55,800	$55,801 - $488,500	Over $488,500
Married Filing Separately	$0 - $41,675	$40,401-$258,600	Over $258,600
Trusts & Estates	$0 - $2,800	$2,801 - $13,700	Over $13,700

Tax Advantages to Holding Investments for Longer Periods

As you can see, there are tax advantages to holding investments for longer periods of time. If you expect your income to increase in the future, holding long-term assets can allow you to take advantage of the lower tax rate on your gains.

Indeed, one of the reasons that many of the wealthiest pay at a lower tax rate is due to the fact that a large chunk of their incomes come from selling long-term investments. You might be in the 32% tax bracket, but if the bulk of your income comes as you sell long-held assets, you are only paying 15% on that income.

Using Capital Gains Rates to Your Advantage

Many people wait long enough for their investments to be taxed at long-term capital gains rates before selling. This allows them to realize gains, access funds, and avoid paying short term tax rates, which are the same as their marginal income tax bracket.

If you’re trying to minimize the taxes, long-term investments are the best choice.

That said, not all buy/sell decisions should be based on the tax impact. That should only be one factor to consider, not the only factor.

Short-term investments and trades can be an excellent option depending on your involvement in your portfolio and your risk preferences. Sometimes you should lock in gains when you have them, rather than risk losing them. It’s better to pay higher taxes on gains than to watch those gains melt away and sell at a loss.

Just be aware that locking in gains on a short-term trade may result in higher taxes.

If you are confused about how your investments are going to be taxed, I would suggest meeting with a financial advisor. They can walk you through the whole process and help you determine which type of investments are going to be best for you.

How Much Can You Save with Long-Term Capital Gains Tax Rates?

Let’s look at a simple example based on current tax rates. Let’s assume you are Married Filing Jointly, and your taxable income is $250,000. This is right in the middle of the 24% tax bracket.

Now let’s assume you sell some mutual funds for a gain of $10,000.

If this was a short-term capital gain, you would have to pay $2,400 in capital gains taxes.

If this was a long-term capital gain, you would have to pay only $1,500 in capital gains taxes, a savings of $900.

What About Investment Losses?

One way you can offset Capital Gains Taxes is when you lost on another investment. These are Capital Losses, if you will. Let’s see how this works in practice.

Let’s say you have $1,000 worth of stocks in two different companies, Company A and Company B.

Company A’s stock price increases by 20%, but Company B’s stock price decreases by 10%. You decide to sell both at these prices.

So your holdings are now:

Company A:

• Bought – $1,000
• Sold – $1,200
• Realized Gain – $200

Company B:

• Bought – $1,000
• Sold – $900
• Realized Loss – $100

The terms, “Realized Gain” and “Realized Loss” indicates that these are no longer paper gains or losses. Once you execute the trade, you have “Realized” the final value. As far as the IRS is concerned, this is what matters.

When it comes time to file your taxes, you subtract any Realized Losses from your Realized Gains.

Just keep in mind that all short-term transactions are lumped together and all long-term transactions are lumped together. You will pay the short-term or long-term capital gains taxes on the gains.

If you lose money, you can write-off, or deduct, up to $3,000 in losses each year against your income.

Nobody wants to lose money on an investment. But you can at least use your capital losses to offset some of the gains that would otherwise be taxed.

Note: Be sure to understand the wash-sale rule, which states you can’t deduct losses if you sell an investment at a loss, then repurchase it within 30 days. This is an important tax rule for planning purposes.

Tracking Capital Gains (and Losses)

Not too long ago, it was up to investors to report taxable events to the IRS. However, investment firms and brokerages are now required to track your cost basis (the amount of money you paid for the investment), the duration of time you held the investment, and the final sale price.

All of this is automated on the back end of their software systems. They report the final tally for your account at the end of the calendar year. The IRS logs it on their end, and the brokerage firm sends you an IRS Form 1099 to report your investment gains and losses, and whether those gains are short-term or long term (there is no distinction between short-term and long-term losses).

Most brokerages will also allow you to download a file that you can import into your tax software to help make tax filing easier. Once you upload the data, the tax software will process your short-term and long-term gains and offset any losses. Then they determine the appropriate amount of taxes you should pay based on your total tax return (all your income, deductions, credits, and other factors).

The biggest decision you have to make is when to sell to best optimize your gains and losses, and ultimately, your taxes. The rest can be handled automatically.

Specifying Which Shares to Sell

As an investor, you need to pay attention to your overall holdings. More importantly, you need to pay attention to how the cost basis is tracked for your shares.

Brokerage and investment firms will normally track your investments in one of three ways:

• FIFO – First In, First Out
• Average Cost
• Specific ID (spec ID).

FIFO – With the First In, First Out, accounting method, investment firms will always sell the first shares you acquired, regardless of the cost basis. This can be an easy way to track your accounting, but it gives you less overall flexibility in the long run.

Average Cost – The Average Cost of Shares is another simple way to track investments. In some ways, it can be good because it smooths your returns over time. However, like the FIFO method, you lose flexibility in how you handle your sales.

Specific ID – This accounting method gives you the most flexibility and allows you to “specify” which shares you want to sell. This allows you to sell some shares at long-term capital gains rates, or specify specific shares to sell at a loss if you want to offset some other gains.

Special Exclusions to Capital Gains Taxes

Realize that there are special cases when it comes to capital gains taxes. Two items to consider include:

• Home sale exclusion: If you sell your qualifying primary residence, you are exempt from paying on up to $250,000 in gains ($500,000 in gains if you’re married). This means that if your main home appreciates in value, and you have primarily lived in the property for at least two years out of the last five, you are eligible for an exemption in the need to pay taxes on the gains. Check with IRS to find out how to calculate qualifying and non-qualifying use on the home sale exclusion.
• Collectibles: Collectibles, such as coins or art, are taxed with a maximum capital gains tax rate of 28% unless you have held them for less than a year. If you have held the investments for less than a year, then you will pay your ordinary income tax rate (your marginal income tax rate). Understand that physical gold is taxed as a collectible.
• Lower income tax bracket. If you’re in the 10% or 12% tax rate bracket (which is the standard rate), then your capital gains rate is zero. If your taxable income, after deductions, is lower than $39,475 if you’re single or $78,750 if you’re filing jointly, then you’re in this tax bracket.

Capital Gains FAQs

Capital Gains taxes aren’t super-complicated. But it is a good idea to understand the ins and outs to minimize your tax obligations.

Do I Need to Pay Estimated Taxes on Capital Gains?

If you have a large taxable capital gain, you may be required to make estimated tax payments. This will depend on the amount of your capital gains, your current income, and other factors.

For additional information, consult with a tax professional, or refer to IRS Publication 505, Tax Withholding and Estimated Tax, Estimated Taxes and Am I Required to Make Estimated Tax Payments?.

Will the Capital Gains Rate Remain the Same?

The capital gains tax rate, like all tax rates, is subject to change.

Previously, capital gains tax rates were either 0% or 15%. However, recent tax law changes created three brackets – 0%, 15%, and 20%.

The ultimate long-term tax rate depends on your income.

Even the recent increase still represents tax planning opportunities based on how much of your income is derived from long-term investments. Keep this in mind when planning taxable events, such as selling stocks or other investments subject to capital gains taxes.

Planning Around Capital Gains Taxes is Only Part of the Picture

Investing is the only way to get ahead financially. That said, it doesn’t have to be overly complicated. If you’re new to investing, you might be worried about the taxes you’re going to pay. It’s simpler than you might think. In fact, most tax software programs handle capital gains taxes automatically. Don’t let the capital taxes gains scare you away from making some short-term and long-term investments.

Instead, focus on the underlying fundamentals and use the capital gains tax rates as a way to plan your purchases and sales so you can maximize your gains and minimize your tax impact.

If you need any additional advice regarding taxes, check out our full Tax Guide.

The post How Do Capital Gains Taxes Work, Exactly? appeared first on Cash Money Life | Personal Finance, Investing, & Career.

source https://cashmoneylife.com/how-capital-gains-taxes-work/

2022 Federal Tax Brackets – How to Use Marginal Tax Rates to Your Advantage

Table of Contents

1. Understanding Marginal Tax Rates
   1. What Are Tax Brackets?
   2. What Does the Marginal Tax Rate Mean?
   3. How Do I Find My Marginal Tax Rate?
2. 2022 Federal Tax Rates, Standard Deductions, & Capital Gains
   1. 2022 Federal Income Tax Brackets
   2. 2022 Standard Deductions
   3. 2022 Long-Term Capital Gains Tax Rates
3. Applying Federal Tax Rates to Your Situation
4. How to Your Calculate Effective Tax Rate
5. Using Marginal Tax Rates for Tax Planning
   1. Marginal Tax Rate Case Study
   2. Understanding Marginal Tax Brackets is Essential for Tax Planning
6. Conclusion

Marginal tax brackets are a frequently misunderstood topic. It’s not uncommon for someone to say they don’t want to get a raise because it will put them in a higher tax bracket and force them to pay more taxes on all the money they earn. They believe they would be better off not receiving the raise in the first place. This is a common misconception, but thankfully, that is not how marginal tax rates work.

For example, let’s say you receive a salary increase that takes your final salary from the 12% tax bracket to the 22% tax bracket. Your raise doesn’t place all of your income to the 22% tax bracket. You only pay the higher taxes on the amount that falls within the 22% tax bracket.

We’ll show you the income levels for each tax bracket and show some examples of income tax brackets and how marginal taxes actually work. You can use these to calculate your effective tax bracket or the amount of taxes you are actually paying on all of your income.

Understanding Marginal Tax Rates

Tax planning is one of the most fundamental aspects of financial planning. In fact, many people would argue that financial planning without respect to taxes is not really financial planning. Yet, in order to fully understand how tax planning works, it’s important to understand what your marginal tax rate is.

This “gradual” tax schedule is called a marginal tax rate system. In effect, the amount of taxes you pay increases as your income increases. The IRS places the marginal tax rates into brackets, making the marginal tax formula easier to understand and compute by hand.

Let’s look at the 2022 Federal Tax Brackets to see this in action.

What Are Tax Brackets?

Before we can discuss marginal tax rates, it’s important to understand how income tax brackets work. For federal tax purposes (and most states that do not have a flat income tax), income tax brackets state the amount of tax that is paid for income earned within that bracket.

For example, in 2022, a married couple (filing jointly) making under $20,550 is taxed at 10% of their income. Thus, they’re in the 10% tax bracket.

Once they make over $20,500, they are taxed at 12% of the income above $20,550. Now, they’re in the 12% tax bracket and will be until they earn over $83,550. Then, they’ll move up to the 22% tax bracket, where they’ll pay 22% on the income above $83,550, and so on.

Once you determine what income tax bracket you’re in, then your marginal tax rate is simply the applicable tax on your next dollar of earned income. For example, if you’re in the 22% tax bracket, then your marginal tax rate is 22%. For every additional dollar you earn, you’ll pay an additional 22 cents in tax. Conversely, for each dollar of decreased taxable income, you’ll save 22 cents in tax. It’s this understanding that helps define a sound tax planning approach.

What Does the Marginal Tax Rate Mean?

Now that we know what the marginal tax rate is, we can think about how it applies in tax planning. Simply put, every decision that has a tax impact can now be evaluated to determine the tax savings, and the after-tax financial impact. Decisions that might be very tax-wise in one tax bracket (such as accelerating or postponing taxable income) might not be prudent in another.

For example, let’s assume that you just bought a stock six months ago. Since then, a series of developments and bad earnings reports have convinced you to sell.

Now, you’re trying to decide whether to sell the stock at the end of the year or at the beginning of next year. If you’re in the 12% tax bracket, but expect to be in a higher tax bracket next year, you might want to sell now. If you’re in the 32% tax bracket, but expect to be in a lower bracket next year, you might want to wait.

This is a basic example of how marginal tax brackets affect tax planning. We’ll look at another example in more depth. First, let’s discuss how you can find your marginal tax rate.

How Do I Find My Marginal Tax Rate?

To find your previous year’s marginal tax rate, you only need your tax return (Form 1040 for most people). Depending on the type of return, you’ll use the line that correlates to taxable income:

• Form 1040: Line 43
• Form 1040A: Line 27
• Form 1040EZ: Line 6

Once you determine your taxable income, you can refer to the IRS tax tables to figure your marginal tax bracket. Keep in mind your filing status (single, married filing jointly, married filing separately, or head of household), particularly if your status has changed. Since the IRS tax tables are updated as part of a revenue procedure that contains a lot of other annual updates, they can be cumbersome. You may find a plethora of websites, such as taxfoundation.org that make this information easier to digest.

2022 Federal Tax Rates, Standard Deductions, & Capital Gains

Here are the current tax rates. You can use this information to help plan your tax bill this year, as well as for long-term tax planning, such as doing a Roth IRA conversion, selling stocks for short-term or long-term capital gains, making charitable donations, and other moves that will impact your tax return.

2022 Federal Income Tax Brackets

2022 Marginal Tax Rate	Single Individuals Taxable Income Above	Married Filing Jointly or Qualified Widow(er) Taxable Income Above	Head of Household Taxable Income Above	Married Filing Separately
10%	$0	$0	$0	$0
12%	10,275	$20,550	$14,650	10,275
22%	$41,775	$83,550	$55,900	$41,775
24%	$89,075	$178,150	$89,050	$89,075
32%	$170,050	$340,100	$170,050	$170,050
35%	$215,950	$431,900	$215,950	$215,950
37%	$539,900	$647,850	$539,900	$323,925

2022 Standard Deductions

The Standard Deduction is an amount taxpayers can deduct from their income before paying income tax. You can choose to apply the Standard Deduction or itemize deductions, whichever results in the best tax return for your situation.

The Tax Cuts and Jobs Act substantially increased the Standard Deduction, removed personal exemptions, and decreased the amount taxpayers could deduct for SALT taxes (State and Local taxes, including state and property taxes). These tax changes make it less viable for many people to claim deductions.

Here are the current Standard Deductions:

Filing Status	Standard Deduction Tax Year - 2021	Standard Deduction Tax Year - 2022
Single	$12,550	$12,950
Married Filing Separately	$12,550	$12,950
Married Filing Jointly	$25,100	$25,900
Head of Household	$18,800	$19,400

It only makes sense to itemize tax deductions if they will be larger than the Standard Deduction.

2022 Long-Term Capital Gains Tax Rates

Capital gains taxes are assessed when you sell certain property or investments for a profit. Short-term gains are for investments you held for less than a year. These are assessed as regular income and are taxed at your marginal income tax bracket.

Long-term capital gains are for investments that were held for longer than a year. They are taxed at the following schedule:

2022 Long-Term Capital Gains Tax Rate	0%	15%	20%
Single Filers	$0 - $41,675	$41,675 - $459,750	Over $459,750
Married Filing Jointly	$0 - $83,350	$83,351 - $517,200	Over $517,200
Head of Household	$0 - $55,800	$55,801 - $488,500	Over $488,500
Married Filing Separately	$0 - $41,675	$40,401-$258,600	Over $258,600
Trusts & Estates	$0 - $2,800	$2,801 - $13,700	Over $13,700

Some investments, such as gold or collectibles, are not taxed by the capital gains guidelines.

Applying Federal Tax Rates to Your Situation

As you can see from the above federal tax bracket table, there are tax brackets for income ranges. For example, a married couple will pay the following taxes:

• 10% federal income tax on the first $20,550 of income;
• 12% federal income tax on income from $20,551 – $83,550;
• 22% federal income tax on income from $83,551 – $178,150;
• and so on.

As mentioned above, this is a gradual tax system. This does not mean that you will pay the corresponding income tax rate if you break the threshold by $1.

For example, receiving a raise from $83,550 to $83,551 will not subject all of your income to the 22% tax bracket – it will only apply to income earned within that specific tax bracket. These gradual tax rates add up to your effective tax rate.

How to Your Calculate Effective Tax Rate

Let’s use an example of a married couple filing jointly with $100,000 of taxable income (after deductions, exemptions, etc.). They are in the 22% tax bracket but don’t actually pay $22,000 in federal taxes. They would pay:

• 10% on first $20,550 of income ($2,055.00)
• 12% on income from $20,551 – $83,550 ($7,560.00)
• 22% on income from $83,551 – $178,150 ($3,619.00)
• for a total of $13,234.00

In this example, the weighted, or effective tax bracket, is 13.234%.

Note: this is a very simplified example, and does not include any deductions. This example also only takes federal taxes into account and does not include state or local taxes. You should be able to find a state tax calculator to assist your calculations.

Note: this is a very simplified example, and does not include any deductions. This example also only takes federal taxes into account and does not include state or local taxes. You should be able to find a state tax calculator to assist your calculations.

This is easy to figure out when you file your taxes, and most tax software programs, including TurboTax and H&R Block (H&R Block Online Review), can give you these calculations when you use their program.

Using Marginal Tax Rates for Tax Planning

Using your knowledge of the marginal tax rate system, you can use them to help reduce your taxes if you are near one of the tax bracket limits. All you need to do is bring your final number below the tax bracket.

For example, if you are married filing jointly and earn $85,550, you can contribute $2,000 to your 401k and avoid paying the higher tax rate on $2,000.

The marginal tax bracket on the amount over $83,550 would be 22%. By dropping back down to the 12% tax bracket, you can save 10% on the taxes paid for that $2,000. So your 401k contributions in this situation would save you $200 in taxes.

Again, this is a simplified example.

However, you can see that the tax savings can easily add up to a couple of hundred dollars to several thousand, depending on how much you can shave from your marginal tax rate.

Marginal Tax Rate Case Study

Let’s consider a young couple that is looking into converting their traditional IRA to a Roth IRA. To summarize, a Roth conversion is simply transferring funds from a traditional or non-deductible account to a Roth account. The benefit is that you do not pay taxes on earnings in a Roth account.

However, you have to pay taxes on any traditional IRA funds that you convert. It makes sense to do this if you expect to be in a higher tax bracket in your retirement years when you are drawing from your IRA.

Joe & Jane have a traditional IRA account valued at $50,000. They’ve been saving diligently since they got married 5 years ago. They feel like they’re doing pretty well, especially since they’re only 30. At some point, they heard that a Roth IRA would be better suited for their financial goals, especially if they can convert at a relatively low tax rate. In order to do so, they have to pay ordinary taxes on the converted amount.

Let’s calculate their tax bracket. Since Joe is an O-3 in the Air Force, and has been in for 8 years, their monthly income is $6,241.57. Assuming they have no other taxable income, this puts their 2022 annual taxable income at $74,899.00 (rounded up to the nearest dollar). Exemptions and deductions notwithstanding, this puts them squarely in the 12% tax bracket. This is their marginal tax rate.

Let’s assume that Joe & Jane want to convert as much as they can, but stay within their current tax bracket. A quick look at the tax tables shows that they’ll remain in the 12% bracket until their income reaches $83,550. In other words, they could convert $8,651 this year at 12%. After that, they would pay 22% for the amount above $8,651.

Without going into detail about what Joe & Jane SHOULD do, let’s talk about what they COULD do:

• They could convert the entire amount this year. They would pay a total of $10,134.90. This includes $1,038.12 for converting $8,651 at the 12% rate plus $9,096.78 for converting the remaining amount at the 22% rate.
• They could convert up to the 12% limit without going over. In doing so, they would pay $1,038.12 this year. They could always revisit this in future years to take advantage of their 12% tax bracket. Assuming they could fully convert at the 12% bracket, they would pay a total of $6,000. This would save them over $4,130 compared to converting their entire IRA at one time…with no substantial impact to their portfolio! Remember, we’re not talking about changing investments, we’re only talking about changing asset location from a tax-deferred to a Roth account.
• They could choose not to convert at this time. They could make this decision based upon any number of reasons. Perhaps they find a better opportunity. Maybe the tax rules change. Perhaps there’s an upcoming deployment that allows them to convert some of their money at the 10% bracket.

Assumptions:

Again, we’re looking at rough assumptions to show how tax brackets work, and factors to consider for tax planning purposes. In the above case study, we are assuming there are no additional deductions that reduce taxable income. Contributing to a Traditional IRA, the Thrift Savings Plan (similar to a government 401k), or itemizing deductions can reduce the taxable, which means the individual may be able to convert more money within the 12% tax bracket.

Understanding Marginal Tax Brackets is Essential for Tax Planning

That’s an example of how understanding your marginal tax bracket influences your tax planning. It’s important to highlight that tax should be a consideration, but not the only consideration. Bad investments do not become sound ones because they’re tax-efficient. Bad purchases (such as buying more of a house than you need or can afford) do not become good ones just because there’s a tax benefit.

However, tax efficiency can make a good investment even more compelling, or it could make an otherwise ho-hum investment a better one. More importantly, it can help you think in more than one dimension. Instead of focusing on ‘either-or,’ tax-planning also should include ‘when?’

In Joe & Jane’s example, you can understand their approach if they decide to stretch out their Roth conversions over a 10-15 year period. Since they’re only 30, there is zero impact on their ability to use the money in retirement. However, that extra $4,400 could grow into much more over time. Of course, this could not happen if Joe & Jane didn’t take the time to understand their marginal tax rate or what tax bracket they’re in. Without understanding your marginal tax bracket, tax planning cannot take place.

Conclusion

There can be many opportunities to incorporate tax planning into your financial planning. Understanding your marginal tax bracket is the first step in being able to determine what tax planning decisions are best for your situation. While this article is not a substitute for tax advice, I hope it helps set an educational foundation for future planning efforts. Check out our tax guide if you anymore questions or need help.

The post 2022 Federal Tax Brackets – How to Use Marginal Tax Rates to Your Advantage appeared first on Cash Money Life | Personal Finance, Investing, & Career.

source https://cashmoneylife.com/marginal-tax-rates/

2022 401k Plan Contribution Limits – Maximum You Can Contribute

Table of Contents

1. How Much Can I Contribute to my 401k in 2022?
2. Maximum 401k Contribution Limits – 2007 – 2022
3. These Contribution Limits Apply to 401k, 403b, 457, 401a Plans, and Thrift Savings Plan
4. Maximize Your 401(k) Contributions if You Are Able
   1. Maximize Your 401k Through Fixed Contributions
   2. Maximize Your 401k with Percentage Based Contributions
   3. What About Contributing Too Much to Your 401k?
5. IRA or 401k? – Which is Better for Retirement Planning?
   1. Where Should You Invest First – IRA or 401(k)?
   2. Why Contribute to an IRA?
6. Managing Your 401k with Your Other Investments
   1. Tools to Help Manage Your 401k Plan

Update: The IRS just announced the 2020 401(k) contribution limits: The employee elective deferral limit increased to $20,500, and the catchup contributions remain $6,500 for those ages 50 and up.

Investing in your 401k plan or other retirement account is one of the easiest and best ways to prepare for retirement. These accounts offer an incredibly valuable tax advantage for investors. But there are limitations to these plans. Each year the IRS evaluates and releases updated 401k Plan Contribution Limits. This limit is the maximum you can contribute based on your age.

While the IRS won’t increase contribution limits every year, they also won’t decrease the contribution limits either. At worst, contribution limits will remain stagnant.

How Much Can I Contribute to my 401k in 2022?

The maximum employee deferral for 2022 is $20,500 per person. The employee deferral is the amount the employee can contribute to their 401k plan from their paycheck.

There is also a maximum Catch-up Contribution of $6,500, which is only available to participants age 50 and over. This is the same amount as it has been since 2020, when it was increased $500 over the previous limit of $6,000, which had been in place since 2015.

2022 saw a $1,000 increase for the maximum employee deferral over the 2021 tax year. (See the chart below for historical 401k contribution limits).

There was also a $3,000 increase to the Total Contribution Limit for 2022, which now comes to $61,000. The max deferred compensation includes employee contributions, matching contributions, bonuses, and other deferred compensation. (If you are over age 50, you can also add your catch-up contributions to this number, bringing the max total deferred contribution limit to $67,500 for 2022).

Let’s take a look at all of these numbers in more detail and discuss what they mean for investors.

Maximum 401k Contribution Limits – 2007 – 2022

How to read this chart: The following chart lists the maximum 401k plan contribution limits, along with the contribution limits from previous years.

The number under the heading “Employee Contributions” applies to persons under age 50. “Catch-up Contributions” apply to people aged 50 and over.

The column labeled “Total Contribution Limit” is the maximum you can apply to your 401k plan in any given year if you are under age 50. This includes all possible contributions, including employee contributions, employer contributions, profit-sharing, or any other allowable contributions.

The final column is the total contribution limit from all sources for those who are age 50 or older.

Year	Employee Contributions	Catch-Up Contributions (Age 50+)	Total Contribution Limit	Total Contribution Limit w/ Catch-Up
2022	$20,500	$6,500	$61,000	$67,600
2021	$19,500	$6,500	$58,000	$64,500
2020	$19,500	$6,500	$57,000	$63,500
2019	$19,000	$6,000	$56,000	$62,000
2018	$18,500	$6,000	$55,000	$61,000
2017	$18,000	$6,000	$54,000	$60,000
2015-2016	$18,000	$6,000	$53,000	$59,000
2014	$17,500	$5,500	$52,000	$57,500
2013	$17,500	$5,500	$51,000	$56,500
2012	$17,000	$5,500	$50,000	$55,500
2009-2011	$16,500	$5,500	$49,000	$54,500
2007-2008	$15,500	$5,000	$46,000	$51,000

These Contribution Limits Apply to 401k, 403b, 457, 401a Plans, and Thrift Savings Plan

These contribution limits apply to more than just the 401(k) plan – they actually apply to several different retirement plans that are written into the tax code. These limits also apply to Individual 401k Plans (also called the Solo 401k; this is a small business retirement plan).

It is worth looking into your specific plan as there may be slight differences you should be aware of, particularly when it comes to employer contribution rules, profit sharing, or other plan specific topics.

TheMilitaryWallet.com covers Thrift Savings Plan contribution limits to discuss some of these examples as they apply to the Thrift Savings Plan, which is similar to a 401(k) plan but is only available to military members and certain government employees.

These contribution limits also apply to the Roth and Traditional versions of the 401(k) plan and similar employer-sponsored retirement plans.

Maximize Your 401(k) Contributions if You Are Able

If you are able to maximize your 401(k) contributions, you should be well on your way to setting yourself up for a solid retirement fund. There are two easy ways to determine how much to contribute to maximize your 401(k) account this year.

Maximize Your 401k Through Fixed Contributions

If your company allows contributions of a flat dollar amount per month or per check, then simply contribute that amount from your paycheck. If you are under age 50, then you would be able to contribute up to $1,708.33 per month, or $854.16 each check if you are paid twice each month.

If you are age 50 or over, you can contribute up to $2,250 per month, or $1,125 per check if you are paid twice per month.

Remember, those are the numbers to max out your contributions. You can contribute less than that amount if that is what works with your budget.

Maximize Your 401k with Percentage Based Contributions

If your company doesn’t allow you to make a flat-rate contribution, then you will need to do a little math. To do this, divide the maximum you can contribute (either $19,500 or $26,000) by your total salary. The percentage you see is how much you should contribute every paycheck.

For example, if you earn $100,000 per year and you can contribute up to $20,500 to your 401k, you need to contribute 20.5% of your salary ($20,500 / $100,000 = 20.5%).

If you cannot afford to contribute up to the maximum, then try to at least contribute up to your employer match if your employer makes matching contributions.

The employer match is part of your compensation package and is essentially free money. Not contributing up to this amount is like leaving free money on the table!

You should be able to change your 401k contribution amount, your tax withholding, and other similar actions through your Human Resources Department.

What About Contributing Too Much to Your 401k?

There are annual contribution limits, so you will want to avoid contributing too much. The IRS will likely penalize you if you aren’t able to correct the problem by the end of the calendar year. Thankfully, many HR offices and 401k plans have systems in place that will either prevent over-contributions or will automatically refund the overage.

However, those systems, by default, can only work if you remain employed by the same company for the entire year. You will want to pay special attention to the annual 401k contribution limitations if you change jobs during the year.

If you do happen to contribute too much, I strongly recommend working with your HR department or 401k plan administrator as soon as you notice the issue. You may also want to consult with a tax professional to help you understand if there will be any long-term ramifications or if you will owe any additional taxes or penalties.

IRA or 401k? – Which is Better for Retirement Planning?

Most employees who have access to a 401k plan may also have the opportunity to contribute to another type of retirement plan, the Individual Retirement Arrangement, or IRA.

Where Should You Invest First – IRA or 401(k)?

Another consideration when contributing to your 401(k) plan is whether or not you should contribute to it at the expense of contributing to a Roth or Traditional IRA. I covered this topic in a previous article – where should you invest first – IRA or 401(k)?

In general, it is best to contribute enough to maximize any employer contributions you may be eligible for, then try to max out a Roth IRA if you are eligible to contribute to one.

This ensures you are taking advantage of the free money through your employer’s matching contributions. It also gives you the best of both worlds when it comes to current and future taxes. Tax flexibility is an important retirement planning tool.

If your company doesn’t offer 401k matching contributions, then you may consider contributing to a Roth IRA first, then contributing to your 401k if you are able to do so.

Why Contribute to an IRA?

Why Contribute to an IRA?: For the most part, IRAs have similar tax rules as 401k plans, but with different contribution limits.

While IRAs have similar tax benefits to 401k plans, they do have a few important benefits – namely, they are more flexible, as you control how and where your investments are made. This allows you more freedom and control over investment types, and more importantly, investment costs (this article covers what to do if your 401k plan has poor investment options).

Roth IRAs also don’t have Required Minimum Distributions (RMDs), which exist in all 401k plans, including the Roth 401k.

If you can afford to maximize both investments, then go for it! If you can maximize both an IRA and a 401k, then you should read this article to help decide how to invest after maxing out your retirement accounts. You may still have options, such as investing through an HSA, a taxable investment account, peer to peer loans, real estate, and more.

Managing Your 401k with Your Other Investments

Many people chose to manage their own investments. This could include managing the investments within their 401k plan, as well as any outside investments, such as an IRA, taxable investment account, etc.

If this describes you, and you are confident in your ability to manage your investments, then go for it! This is what I do, and I’m comfortable managing my investments.

Tools to Help Manage Your 401k Plan

There are tools out there that help employees get the most out of their defined-contribution plans (e.g. 401(k), 401(a), 403(b), 457, and the Thrift Savings Plan).

I do manage my own investments, but I do so using a free online tool from Personal Capital. This free tool gives me a better understanding of how all of my investments work together. You can learn more in our Personal Capital Review, or you can visit their site for more information.

Another online tool to help manage your 401k plan is Blooom. Blooom helps investors by overseeing the account and analyzing investing opportunities that investors may not be aware of.

Blooom can help investors analyze their investment fees, improve their diversification, and find the right mix of stocks, bonds, and other investments.

If this interests you, head over to Blooom’s secure website to learn more.

Whichever retirement plan you choose, you are doing the right thing by saving and investing for your retirement.

Visit the IRS website for more details regarding 401k plans and other retirement plans.

The post 2022 401k Plan Contribution Limits – Maximum You Can Contribute appeared first on Cash Money Life | Personal Finance, Investing, & Career.

source https://cashmoneylife.com/401k-plan-contribution-limits/

Why I Have Life Insurance – 10 Reasons to Buy a Life Insurance Policy

Table of Contents

1. Why I Have Life Insurance
2. Reasons to Buy Life Insurance
   1. Common Reasons to Buy Life Insurance:
   2. Additional Reasons to Buy Life Insurance (Case by Case):
3. Who Doesn’t Need Life Insurance
4. Which Type of Life Insurance Should You Buy?
   1. Term Life Insurance
   2. Whole Life Insurance
   3. Other Types of Life Insurance
5. How Much Life Insurance Should You Buy?
6. In Summary – You Probably Need Life Insurance
7. Next Steps – Take Action

Life insurance is one of those topics few people even want to think about, much less take the time to research the different types of life insurance policies, get quotes, and go through the process of buying a policy.

Buying life insurance can be a hassle and it is something many people put off for too long (sometimes forever).

But I don’t think about life insurance that way. To me, life insurance gives me peace of mind, knowing that my family will be taken care of if something happens to me.

And even though I am the primary breadwinner in our family, we maintain a life insurance policy on my spouse as well.

We have a policy on my wife to help cover any final expenses policies that might arise, as well as to help offset the cost of her contributions to our household.

Should something happen to me or my wife, our respective life insurance policies would provide enough money to help us to maintain our current standard of living.

That gives us a lot of comforts and freedom to pursue our life on our terms. In my opinion, life insurance is an essential part of a comprehensive financial plan.

Why I Have Life Insurance

They say a picture is worth a thousand words. This photo speaks volumes to me. This is my family and me on vacation in Hawaii a couple of years ago.

I want my family to know that I will always be there for them. And I will. Even if the worst happens to me, they will always have the memories we made together.

And their financial needs will also be taken care of. I can rest easy knowing they will be provided for, even if I pass away at a young age – my life insurance policy and our current investments will see to that.

We have a life insurance policy for my wife for the same reasons. The money would never be able to replace her contributions to our family and our household.

But having that policy in place would make certain things easier, such as paying for childcare or paying for additional help around the house.

Reasons to Buy Life Insurance

Everyone has different needs when it comes to life insurance. My primary goal is to provide for my family if I pass away.

I bought my first life insurance policy when I learned my wife was pregnant. I bought a 30-year term life policy, and continue to make payments on it today.

I bought a large policy and have periodically reviewed my coverage to ensure it still meets our needs (it does).

If you are on the fence about buying a life insurance policy, I encourage you to think about what it would mean to your survivors if you were to pass away without a life insurance policy in place.

• Would they be OK from a financial standpoint?
• Could they continue living their lives with the same standard of living?
• Would they have to downsize their home, sell their possessions, skip out on college or take out substantial student loan debt?
• Would they be saddled with final expenses, such as medical bills or funeral expenses?
• Would they have to change their life plans? (go back to work, take a second job, work longer before retiring).

When I ask myself these questions, it becomes evident that I absolutely need a life insurance policy. Having one gives me peace of mind and helps me sleep better at night.

And my family knows that they will be covered in the event the worst happens.

Common Reasons to Buy Life Insurance:

In addition to providing for your survivors, there are many other reasons to buy a life insurance policy. Here are just a few of many:

1) To Cover Final Expenses (Medical & Burial Expenses): Medical bills and funeral expenses can easily run into the thousands of dollars. Hopefully, you will have medical insurance. But it may not cover everything. The average funeral now costs over $10,000. Some people choose to buy a burial insurance policy or final expense insurance. While a final expense policy may be helpful, it may not be adequate for your family’s other financial needs.

2) To Replace a Primary Income: I am the primary income earner in our family. And my family would not be able to cover our regular bills without my monthly income. But our life insurance policy would cover the outstanding balance on our mortgage and leave enough to help pay for living expenses for the next 20 years or so – until my wife would be able to start making penalty-free withdrawals from our retirement accounts.

3) To Cover the Cost of a Spouse’s Contributions: It’s a good idea to have life insurance coverage on a stay at home spouse, even if they don’t earn much (or any) income. Stay at home spouses often contribute in a wide variety of ways, including child care, running the household, cooking, cleaning, etc. You might be able to do it on your own, but having the financial means to hire help when needed can make a huge difference. This is especially important if you have children that haven’t yet begun attending school. Childcare is very expensive.

4) To Pay for Children’s Expenses: This includes childcare, as well as other school age needs, such as activities, sports, music, tutoring, or anything else that may crop up during a childhood. And of course, don’t forget about college expenses. College may be a ways off for your children, or it might be right around the corner. Either way, it’s very expensive. Having a life insurance policy may mean the difference between your child being able to attend college without worrying about the cost, or skipping college or taking out large student loans.

5) To Pay Off Any Outstanding Debts. Thankfully, my wife and I don’t have any consumer debt. Our only outstanding obligation is our mortgage. As I mentioned above, my policy is enough to pay off the balance, and still have some left over for bridging the gap between now and retirement. But each situation is different, so I recommend you look at any outstanding debts you may have and consider those when determining how much life insurance you need. Being able to pay off all debts would give your family a fresh start should the worst happen.

Another way to look at buying a life insurance policy – the last thing I would want to do is to pass away and leave my family holding the bag for debts that I owed.

Additional Reasons to Buy Life Insurance (Case by Case):

The above reasons apply to many common situations. But some people have additional reasons to consider a life insurance policy. Some of these include:

6) To Pay for Long-term Care for Special Needs Children. You may want to consider a large life insurance policy if your income is needed to support dependents long after your working life. This could include a child or someone else with special needs who will not able to support themselves. This is one of the few times when a whole life insurance policy is recommended over a term life policy, since the coverage may be needed to support a future generation.

7) To Buy Out a Business Partner’s Interest. Many business partners take out a life insurance policy on their partner to help ensure a more stable transition in the event one of the partners passes away while the business is still operating. This is often coupled with a buy-sell agreement that is triggered in the event of one partner’s death. This can help the business continue without trying to find a buyer for either the entire business or for the deceased partner’s shares. This also prevents the heirs from dealing with a business in which they may not have any interest or knowledge. This can be a complicated topic and is worth exploring with the assistance of a legal consultant that specializes in small businesses.

8) To Cover Estate Taxes. Estate taxes are expensive and can eat away a large percentage of the heir(s)’ inheritance. Many high net worth individuals use life insurance as an estate planning tool and a way to mitigate the cost of their estate taxes. Again, this is a more advanced topic and one that is worth consulting with an estate lawyer. This is also one of the few times that whole life insurance is recommended over term-life, since the policy will be in place through the policyholder’s life, and not just for a fixed term.

9) Viatical Settlements: A viatical settlement (or life settlement) is just the sale of a life insurance policy to a third party. Usually, such actions include policies of high-value whole life insurance policies such as an amount of $250,000 or more.

10) Life Insurance is Affordable: This is perhaps the best reason. Life insurance is generally very affordable, unless you have a serious pre-existing medical condition, or have been previously found ineligible for a life insurance policy. Even then, there may be ways you can get some life insurance coverage, through a no-exam policy, a mortgage life insurance policy, or some other types of policies.

Barring those reasons, most people can afford a reasonable life insurance policy that can provide protection should the worst happen. I recommend getting quotes from at least two or three life insurance providers to find the best policy for your needs.

Who Doesn’t Need Life Insurance

There are some people who don’t need life insurance. I didn’t have a life insurance policy on myself until I was married and had a family.

Prior to that, there was no one who was relying upon my income for support. My family and friends would have mourned my passing.

But no one would have been in the poorhouse from a lack of my income.

That changed when I got married and when my wife and I had our first child. I am currently about 10 years into a 30-year term life insurance policy.

I hope to carry that policy until its term, then hopefully be in a position where I can let it lapse. By then, I hope to be financially independent and no longer need a life insurance policy.

By that time, I hope my children are grown, through college, and have families of their own.

My mortgage should be more or less paid off by that time, and I hope to have sufficient investments to support myself and my wife for the rest of our lives.

If we reach that point, we will no longer need life insurance.

Those two situations sum up the most common situations when you don’t need life insurance – when no one is relying upon your income for support, or you have already won the financial game and your assets or estate can provide for your heirs long after you pass away.

Which Type of Life Insurance Should You Buy?

The argument typically comes down to whole life or term life.

The difference is whole life lasts for the person’s entire life, while a term life insurance policy only lasts for the “term” of the policy (often issued in 10, 20, or 30 year periods).

Term Life Insurance

Term life insurance is often recommended for most common life insurance needs. Term life insurance premiums are less expensive for the same value policy as whole life insurance.

And most people don’t need a life insurance policy for their entire lives.

If things work out well, your need for insurance will often decrease as you age, because fewer people are relying upon your income to support them.

Many people find they can go without life insurance after they reach a certain stage in life, often at or near retirement.

Prior to that, their financial needs are often greater – paying for their mortgage, supporting a family, school and college expenses, saving for retirement, etc.

But financial needs are often less once children have left the home, the mortgage is paid off, and you are no longer saving for retirement.

A Term life policy is a good solution for life insurance needs that follow this path.

Whole Life Insurance

Whole life insurance, on the other hand, lasts for your entire life, provided you current on your premiums. There are a couple downsides to whole life insurance, and it often gets a bad rap.

But there are also times when it is the best form of life insurance for a specific person or situation.

First, the downsides – whole life insurance premiums are significantly more expensive than term life insurance premiums for the same amount of coverage.

Second, many life insurance salesmen peddle whole life insurance as an investment. It’s actually not a good investment. Life insurance and investing should never be mixed.

Life insurance should only be used as life insurance.

On the plus side, whole life insurance is good for situations when you will need the life insurance premium for your heirs, regardless of your age when you pass away.

Two common situations were mentioned above – caring for a special needs dependent, and for estate planning.

These are situations when the higher life insurance premiums are worth paying for the permanent policy that never expires.

Other Types of Life Insurance

There are other types of life insurance, but many of them are overly complicated.

And in the financial industry, more complication often means added expense, regardless of whether or not it provides added value.

Unfortunately, added expense also equals increased commissions, so some life insurance salesmen try to push these complicated insurance policies because they will make a bigger commission check.

Find your needs, and then work from there. Don’t let a salesman sweet talk you into buying something you don’t need.

How Much Life Insurance Should You Buy?

This is a big topic and one that doesn’t have a one-size-fits-all answer. There are several rules of thumb, such as 10 times annual income.

But those types of rules of thumb can be overkill, or woefully inadequate, depending on your situation.

The better way to approach this is to consider what your expenses will be to care for your survivors after you pass away.

Your goal is to help your survivors maintain their quality of life after you are gone.

So consider factors such as your current debt (mortgage, cars, student loans, and other loans), expected costs for dependents (daycare age through high school age, activities, college tuition and living expenses, etc.), how much of your income would have been used to support the family, etc.

This should be enough to get you started with the brainstorming process and also let you think about which riders you might want to add to your policy.

We have a full-length article that can help you decide how much life insurance to buy.

Take the time to think this through. Any life insurance is helpful. But it would be better to have adequate life insurance compared to too little.

You can also stack life insurance policies. For example, you can start with a 30-year term life insurance policy.

As your needs grow, you can add another 20-year policy, then a 10-year policy. Or any combination, really.

This concept is becoming more popular and is similar to what Ladder offers. With Ladder, policyholders can ladder down with a few clicks, or ladder up by applying for more coverage as needed.

This makes planning easier for many situations. You can learn more at the Ladder website.

In Summary – You Probably Need Life Insurance

We covered the two common situations when you don’t need a life insurance policy – when you have no one that needs your income for support, and when your assets are large enough to provide for your survivors long after you are gone.

Outside of those two situations, you probably need a life insurance policy. How much life insurance you need will completely depend on your situation.

So I encourage you to run the numbers and do some deep thinking to come up with a number that makes sense for your situation.

You should also be aware of what will happen to your coverage if for some reason your provider goes out of business.

As for the type of life insurance, term life is the best fit for most common life insurance needs.

The monthly premiums are less expensive than whole life insurance premiums and hopefully, the policy will last until you no longer need life insurance as part of your overall financial plan.

If you anticipate needing life insurance for longer-term needs, then consider a whole life insurance policy. Just be sure not to confuse it with an investment policy.

It’s not. It’s simply a life insurance policy with no expiration date.

You’ll pay more for that privilege, but it may be worth it to help maintain your family’s lifestyle or support your estate after you pass away.

Next Steps – Take Action

I hope this gets you thinking. I want you to do two things if you think you need life insurance:

1. Think about how much life insurance you need.
2. Get a life insurance quote or two. You will be surprised at how affordable life insurance can be.

You can get started with a company such as HavenLife, Ladder, USAA, or others.

Here’s hoping you never need it.

Ladder Insurance Services, LLC (CA license # OK22568; AR license # 3000140372) distributes term life insurance products issued by multiple insurers – for further details see ladderlife.com. All insurance products are governed by the terms set forth in the applicable insurance policy. Each insurer has financial responsibility for its own products.

The post Why I Have Life Insurance – 10 Reasons to Buy a Life Insurance Policy appeared first on Cash Money Life | Personal Finance, Investing, & Career.

source https://cashmoneylife.com/reasons-to-buy-life-insurance/

How to Convert a Roth IRA at Vanguard – An Illustrated Tutorial

Table of Contents

1. What is a Roth IRA Conversion?
2. Converting a Traditional IRA to a Roth IRA – Assumptions in this Guide
3. How to Convert a Traditional IRA to a Roth IRA at Vanguard
   1. Step 1. Visit the Balances and Holdings Page in Your Vanguard Account
   2. Step 2. Find your Traditional IRA Account and Click the Covert to IRA Link
   3. Step 3. Visit the Roth IRA Conversion Page
   4. Step 4. Choose Which Account to Convert
   5. Step 5. Choose Which Account to Convert to
   6. Step 6. Choose Your Tax Withholding
   7. How should you handle the tax withholding section? 
   8. Step 7. Confirm the Conversion
4. What Next?

Note: Roth IRA Conversions may soon become a thing of the past, as the current administration is condsidering legislation that would prohibit some or all future Roth IRA conversions, potentially starting in 2022. We will update this article if Roth IRA conversions are prohibited in the future.

You have a lot of choices when it comes to retirement planning. From employer-sponsored accounts, such as a 401k or 403b, to the Individual Retirement Account, or IRA. These accounts come in different flavors too. You get to decide when you want to pay your taxes – either now (Traditional 401k or IRA), or in the future (Roth 401k or IRA). These decisions can have a profound impact on your overall retirement planning.

Of course, these accounts come with certain conditions, such as income eligibility, annual contribution limits, and other conditions. So you need to do your research to optimize your retirement accounts and minimize your taxes, either today or in the future.

And that is exactly what we will look at today: how to convert a Traditional IRA to a Roth IRA at Vanguard.

What is a Roth IRA Conversion?

A Quick primer:

Simply put, a Roth IRA conversion is when you convert, or transfer, your investments from a Traditional IRA to a Roth IRA. This changes how your retirement account will be taxed when you make withdrawals. Contributions to Traditional IRAs are made pre-tax, and withdrawals are taxed when made in retirement. Contributions to a Roth IRA are made after taxes have been withheld, and withdrawals are tax-free in retirement. Learn more about the differences between Roth and Traditional IRAs.

Why convert? Taxes, taxes, taxes. And flexibility.

Converting a Traditional IRA to a Roth IRA – Assumptions in this Guide

This website isn’t about tax planning, so you will need to do your research before proceeding with this tutorial. We are going to go on the assumption that you are aware of the tax implications of converting to a Roth IRA and you have already decided this is the course of action you wish to take.

If you are still deciding, then I recommend reading this primer on Roth IRA conversions so you can understand what they are, how they work, and the impact it may have on your taxes. Of course, it’s never a bad idea to consult with a financial planner or tax professional for further guidance if needed.

This guide is also specific to Vanguard, though the process may be similar at other financial institutions. I simply chose to cover Vanguard because I already have an IRA there. If you don’t already have a Roth IRA, then I recommend looking into some of our recommended options for opening a Roth IRA (Vanguard is listed, as are several other major mutual fund firms and discount brokerages).

How to Convert a Traditional IRA to a Roth IRA at Vanguard

Here is how to do it at Vanguard:

Step 1. Visit the Balances and Holdings Page in Your Vanguard Account

You can navigate to your Balances &Holdings page by clicking the link at the top of your navigation bar. See the screenshot for an image of the drop down. Click the link and you will see a list of all your accounts, including each account balance and its holdings.

Step 2. Find your Traditional IRA Account and Click the Covert to IRA Link

You should see the account name and description, along with several links for actions you can take, such as Buy and Sell, Order Status, Transaction History, etc. Click the link, Convert to Roth IRA.

This will take you to the Roth IRA Conversion page.

Here is the screenshot of the link to click:

Step 3. Visit the Roth IRA Conversion Page

This is where you need to confirm you do in fact want to convert your Traditional IRA to a Roth IRA, and you are aware of the potential tax consequences. The latter is a huge factor, and you don’t want to wait until the last minute to decide if a Roth IRA conversion is right for you.

The Roth IRA Conversion Page will have a large notice at the top of the page, informing you a Roth IRA conversion is a taxable event, and cannot be changed. Prior to 2018, it was possible to recharacterize or unwind a Roth IRA conversion. This could be used to strategically unwind the Roth IRA and recharacterize it as a Traditional IRA if it lost value. The taxpayer could then later convert it back to a Roth IRA if they wanted to, but at a lower tax basis. As you can imagine, the paperwork trail could be onerous!

However, recharacterizing the conversion is no longer allowed. In other words, this is a final decision with no take-backs!

Text:

A conversion is a taxable event and can’t be changed.

If you choose to convert to a Roth IRA, your conversion will be final and can’t be reversed. You can’t unwind—or recharacterize—conversions made in 2018 or later.

Generally, you’ll owe taxes on the amount you convert from any eligible retirement account into a Roth IRA for that calendar year.

Moving money out of a retirement account is a distribution, and all or a portion of your distribution may be subject to federal and state tax. You’re liable for any taxes due. Penalties may apply if your estimated tax payments or withholding is insufficient under federal or state rules.

You’re not required to have federal income tax withheld from this distribution. However, if you elect to have us withhold federal income tax, you must withhold at least 10% of the total distribution amount.

You may maximize the benefit of the conversion if you pay taxes from a separate nonretirement account instead of withholding during the transaction. If you choose not to have taxes withheld you’ll remain liable for any applicable taxes.

If you’ve ever made a nondeductible contribution or after-tax rollover to an IRA, you may owe tax on only a portion of this conversion. See IRS form 8606 for more information.

We encourage you to consult a tax advisor about your individual situation.

Step 4. Choose Which Account to Convert

This decision is made for you if you only have one Traditional IRA. But many Vanguard customers have an IRA in a Vanguard Mutual Fund account, and some have them in a Vanguard Brokerage account. The difference? You can trade any security inside the Brokerage account. You can only trade Vanguard securities inside the mutual fund account. It’s also possible to have multiple IRAs with Vanguard if you did an IRA rollover from a 401k or another retirement account, or if you inherited an IRA.

You may have to make more than one conversion if you have more than one Traditional IRA with Vanguard. The process is the same, you would simply repeat the steps for the other account(s).

Keep in mind you will receive a Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. from Vanguard for each account you convert to a Roth IRA. These forms will be sent out at the beginning of the following calendar year and will also be sent to the IRS.

So you will need to take the appropriate action when you file your taxes the following year. If your Traditional IRA was a tax-deductible IRA, then you will have to pay taxes on the amount you convert. If your Traditional IRA was of the non-deductible variety, then you will only pay taxes on the gains, not the contributions.

Choose Which Shares to Convert: After selecting which account to convert, you must also decide which shares to convert. In the above screenshot, I chose to “Convert all of the account.” However, you can elect to choose some, or all, of the account. If you choose to do a partial conversion, you will see something like this:

As you can see from the screenshots above, the balance from this conversion was $11,003.10, which represents a non-deductible Traditional IRA contribution for two tax years, plus a partial month’s interest. The $11,000.00 will not be taxed on the conversion, but the $3.10 will be considered a taxable distribution. So I will need to pay taxes on the $3.10.

Step 5. Choose Which Account to Convert to

This is very similar to the step above. You may only have one Roth IRA with Vanguard. If so, it will already be selected as the default account when you convert to a Roth IRA. However, you will have to choose which Roth IRA to convert your Traditional to if you have more than one account.

Vanguard also will not allow you to access this page without already having a Roth IRA. You will be prompted to create a Roth IRA account if you don’t already have one when you click the “Convert to Roth IRA” link from Step 2.

Choose your destination Roth IRA, then move to the next step.

Step 6. Choose Your Tax Withholding

Converting a Roth IRA is considered a distribution of your Traditional IRA. The good news is you’re not required to have state or federal income tax withheld from your distribution (Roth IRA conversion). However, if you elect to have us withhold federal income tax, you must withhold at least 10% of the total distribution amount.

Let that last bit sink in. If you choose to have your taxes withheld, Vanguard will withhold at least 10% of your distribution.

The better way to maximize your Roth IRA conversion is to pay any taxes from a non-retirement account. This keeps more of your money in your Roth IRA where it can compound over time and will grow tax-free. Of course, it will also provide you with more tax-free withdrawals in retirement.

You will still owe taxes on the distribution, but you can decide how you want to pay them. That is a very powerful tool.

A Note About Back Door Roth IRA Conversions: As noted above, this particular Roth IRA conversion was from a non-deductible Traditional IRA. It’s important to file IRS Form 8606 with your taxes each year you make any non-deductible contributions so there is no confusion on the cost-basis of your distribution. In my case, I had two years worth of Traditional IRA contributions, plus a small amount of interest. In my case, only the gains will be considered a taxable distribution.

How should you handle the tax withholding section? 

The Vanguard representative suggested clicking the radio button for electing not to have federal and state income taxes withheld from the conversion. Again, that simply passes the tax obligation to a different bucket. In most cases, you will want to pay the taxes out of a non-retirement account if you have the means to do so.

Additionally, I elected not to have Vanguard send me a Tax Withholding Notice. I’m aware of the conversion I am making, and having them send me a form in the mail doesn’t do me any good. It’s a waste of time, money, and resources. And Vanguard works hard to keep their investment management fees low and passing on savings to their members. So it’s in the best interest of all Vanguard members to choose electronic notices when possible.

Step 7. Confirm the Conversion

You will need to click the Continue button at the bottom of the Roth Conversion page (as seen in the screenshot above). The next screen will be the confirmation page. Simply review the information then submit. The conversion will be official, though it may take some time for the conversion to actually happen, especially if you have securities in your Traditional IRA that need to be closed out.

It’s also best to make sure there are no pending transfers, trades, or other actions within the account you are converting to a Roth IRA.

What Next?

You should be good to go and begin investing in mutual funds! You will likely see a pending transaction in both your Traditional IRA and Roth IRA accounts. It may take a day or three for the accounts to settle. That’s normal. Just verify everything goes through properly.

Also be sure to keep good notes of your actions. You will want to have records when you file your taxes the following year. My tax situation is fairly complex, due to running a small business, paying quarterly estimated taxes, participating in a small business retirement plan, doing back-door Roth IRAs, and similar fun things. So I keep a spreadsheet tracking all of my financial accounts, the dates I make contributions and the contribution amount, and anything other major financial transactions, such as this Roth IRA conversion.

This spreadsheet is part of a larger spreadsheet I keep to track my net worth, charitable contributions, and other financial activities.

Here is how to do a 401k rollover at Vanguard.

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