In this episode of Motley Fool Answers, with the help of Motley Fool Wealth Management financial planner and tax expert Megan Brinsfield, we’re answering your questions about finding or becoming a professional financial planner, using your stimulus check to jump-start your child’s retirement savings, and lots of tax stuff.
To catch full episodes of all The Motley Fool’s free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.
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JPMorgan Chase is an advertising partner of The Ascent, a Motley Fool company. Alison Southwick has no position in any of the stocks mentioned. Megan Brinsfield has no position in any of the stocks mentioned. Megan Brinsfield is an employee of Motley Fool Wealth Management, a separate, sister company of The Motley Fool, LLC. The views of Megan Brinsfield and Motley Fool Wealth Management are not the views of The Motley Fool, LLC and should not be taken as such. Robert Brokamp, CFP has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
This video was recorded on March 30, 2021.
Alison Southwick: This is Motley Fool Answers. I’m Alison Southwick, and I’m joined as always by Robert free-frappa-lula Brokamp, personal finance expert at The Motley Fool.
Robert Brokamp: Where the helicopter did that come from?
Southwick: Hey, in this week’s episode, it’s the March Mailbag and we’ll be answering your questions on using home equity to buy stock, reducing required minimum distributions, and botching the backdoor Roth. All that and more on this week’s episode of Motley Fool Answers.
Hey, Megan Brinsfield is back. She heads up the team of financial planners over at Motley Fool Wealth Management.
Brokamp: A sister company of The Motley Fool.
Southwick: [laughs] Beautiful. We’re so excited to have you back answering your questions. What’s fun is Bro didn’t realize that that was coming, and he was going for a sip of water right at the exact moment, so good job, Bro.
Southwick: Megan, thanks for coming back on the show. Where are you coming to us from?
Megan Brinsfield: I’m traveling throughout the United States right now, and at the moment, I’m in Jackson, Wyoming.
Southwick: Very cool. You’ve been all over, you’ve just been seeing America.
Southwick: Do you anticipate that you’ll keep doing this even in the future like and beyond, you’re going to always going to be a nomad?
Brinsfield: It’s my dream. It’s a passion I’m chasing, but I’ve got to wait for The Fool to allow us to do that and for the tax laws to accommodate people like me. [laughs]
Southwick: All right. [laughs] Well, we appreciate you coming back on the show no matter where you are in this fine country. So I guess we can just get into it, shall we?
Brokamp: Let’s do it.
Southwick: All right, here we go. Our first question comes from Paul. “I recently learned that when my parents were younger and had significant equity in their house but little to no retirement savings, they used their equity to fund their retirement accounts. They believe this was a big reason why they feel comfortable now as they approach retirement. Should I consider this? I do not have huge equity built up, but I do have a HELOC. I have a 401(k) at work, but we have not been able to contribute much out of cash flow for the most recent few years, and my wife is not employed. I make $100,000 per year and have two preschool-aged children. According to the retirement calculators I look at, I am behind on my retirement savings. I’m almost 40 and have about $100,000 total in retirement accounts, so I’m looking for ways to catch up.”
Brokamp: Well, I’m going to say using home equity to buy stocks can be tricky. Because when you increase the amount you borrow, you also increase your payments. You’ve got to pay that HELOC back, right? Since Paul says he can’t contribute to a 401(k) out of cash flow, I’m worried that he also wouldn’t be able to afford the higher debt payments. If he can’t, I mean technically he could lose his home.
I have known people to use home equity to buy stocks, but it was more often done after a stock market crash, which is also often accompanied by a drop in mortgage rates. So what these people did was a cash-out refinancing, which not only allowed them to have more money to invest, but it also resulted in lower monthly mortgage payments so they didn’t have to worry about more debt increasing the burden on their budgets.
Nowadays, it’s a little different. Stocks have recovered since the pandemic panic and mortgage rates have ticked up, so I’m less excited about the strategy. But if refinancing would increase Paul’s cash flow, then it might make sense to do at least that if he plans to be in the house long enough to recoup the up-front cost of refinancing.
Paul thinks that he is behind in his savings and using just some of the guidelines provided by some of the financial services firms I’ve quoted in previous shows, he’s probably right. He’s 40, has an income of $100,000, savings of $100,000. According to Fidelity savings guidelines, he should have 3 times that by age 40, so $300,000. T. Rowe Price is two times $200,000. JPMorgan is a little bit in the middle, 2.3, so he should have somewhere between $200,000 and $300,000.
What can Paul do? First of all, he should contribute any future raises to his 401(k). Instead of using raises to increase his lifestyle, it should just go in his 401(k), and maybe he should talk to his manager or supervisor to see what it would take to earn even bigger raises.
When his kids go to school, his wife could start working, and they could just bank everything that she makes. Again, instead of increasing their lifestyle, just save her salary to catch up.
A more extreme solution might be to downsize or move to a lower-cost part of the country. If he doesn’t want to do that now, maybe when the kids are out of the house. I’ve known many people in their late 50s to 60s, they did that, they had that three- or four-bedroom house because there is a family. They scaled down to a two-bedroom house, maybe a lower part of the country, or even just a lower cost part of the city where you’re not paying up to be in a good school district. They’re able to do that and realize $100,000, $200,000, $300,000 in extra savings that they could invest.
Those are some ideas. But generally speaking, not a big fan of taking money out of your home equity to invest in the stock market.
Brinsfield: A fun tip from a tax perspective is that if you do one of those cash-out refinances, if you are using that refinance for anything other than your main home, paying for the original debt on your home or improvements on the home, that’s not deductible as mortgage interest expense. You hear about a lot of these strategies where people want to refinance, take cash out, get some of that equity, and put it toward other things, be it paying down a car loan or a student loan or what have you.
One of the “good things,” I say that in air quotes, “good things” about if you did use your HELOC to pay for investing is that that interest expense is then deductible as investment interest expense and can offset your investment income, which is pretty cool and can be valuable. But in essence, this question is basically, should I take a loan to buy stocks? I know that The Fool has a long history of basically saying no to that.
Southwick: All right. Our next question comes from Eric. “Do the changes to the tax filing deadline affect other tax and retirement-related deadlines? For example, will the deadline to contribute to a 2020 IRA also be extended beyond the usual April 15 deadline?”
Brinsfield: Yes. This is a pretty exciting component of the deadline extension, is that if you haven’t heard yet, the new federal deadline for filing your taxes is May 17 for individuals, and that is not just an extension of the deadline to file but the deadline to pay any taxes due for 2020 as well, which is pretty cool.
What doesn’t change, though, is that folks that have to pay estimated payments, your Q1 estimated payment is still due April 15. But the tax return that you’re basing that quarterly payment on isn’t due until May 17, so you’ve got a little bit of a squeeze there in terms of timing.
But in terms of Eric’s question, yes, if you are looking to still fund your IRA for last year, which would be 2020 at this point, and where in 2021 you have until May 17 to get that done, which is great.
Brokamp: A couple of things I’ll highlight is that your state may or may not have extended the deadline. I think at this point, most states have, but just check with your state. Previously in the year, the IRS gave the residents of Texas, Oklahoma, and Louisiana till June 15 to file their federal tax returns due to the storms that happened in February. This doesn’t change that those folks still have until June 15.
Southwick: Next question comes from Mohan. “In March after the pandemic market slump, I was fortunate to have some extra cash to buy more of my winners. But I also bought a few pandemic stocks that I believed were significantly undervalued. These are companies I have no interest in owning for the long term but believed would rise to their previous highs at least. These companies have mostly beat the market and gone up from 20% to 113% in value, and I was planning on waiting one year to sell for tax purposes. What do you think about that strategy? I know it goes against The Fool’s guidance to buy and hold for three to five years at least. But I would use the cash to buy other companies I am more interested in holding for the long term.”
Brokamp: Well, Mohan, a common phrase you hear in these situations is “Don’t let the tax tail wag the dog.” But if you no longer believe in investment, and you need the money to buy something you’re more excited about, then I am inclined to say you should just sell. But that really does depend on how close you are to that one-year mark. I mean, based on what you said, it could be just a matter of days, since we just passed the one-year anniversary of the lowest point the market reached after the pandemic panic. I can’t tell you what to do, but if it really is just a matter of days, maybe a couple of weeks, maybe hold on, or maybe sell just some so you’re covered in both scenarios.
But since you may be counting the actual days, you may have a question about exactly when the clock starts and ends. Just to make sure everyone knows when it comes to long-term capital gains, it is more than a year, so a year or less is short term. When do you start counting that? Well, according to the IRS website, you generally count from the day after you acquired the asset up to and including the day you disposed of the asset. Then another question people ask was is it the trade date that matters or is it the settlement date? Trades often set on the day or two after you do the trade, and in most cases, it is the trade date that matters.
Southwick: Our next question comes from Ken. “I filed a paper return last year [2019 taxes]. It’s still not processed, COVID yadda, yadda. Everyone said, ‘Oh, you should do e-file, It’s not glacially slow like paper,’ so I did for this year [2020 taxes]. I got a letter 5071c.” Bro, is that one of your favorite tax letters?
Brokamp: Among the top five, for sure.
Southwick: At least, right? “It requires me to verify my identity [laughs] before they will do anything. However, I cannot register with the IRS in order to verify my identity. My theory is that the verification of the stuff I entered just to get an account is based upon the previous year’s return, which has not been processed, trapping me in an Orwellian nightmare. Calling them via the phone number provided on the letter is a cruel [laughs] and unending string of, ‘Sorry, no help for you, click’ phone calls. Each of which makes you listen to a litany of how you should be using the online method. What in the world can I do? I’m out last year’s refund and it looks like this year’s going to be in limbo too. If I just ignore the 5071c letter, will something eventually happen that lets me talk to an actual person? I already have a job and don’t need another continually calling them up.”
Brinsfield: All right. Ken is in one of these situations that I think many people are finding themselves in. I actually did a search on Twitter for 5071c just to see how popular that little —
Southwick: Is it trending?
Brinsfield: It is not trending, it’s quite a ways down, a distant 300th or something in terms of the trends. But just to remind folks as to why there’s this backup: Paper returns take a long time to process. The IRS basically shut down and sent everyone home this time last year, in the heat of tax season for filing 2019 returns. When all of their employees came back, they had a ton of backlog. I imagine it’s just huge piles of envelopes sitting in a warehouse somewhere. But I don’t think that’s too far off from the truth. Now, you’ve got people trying to catch up on last year’s returns and that processing at the same time that taxpayers are filing this year’s returns, and it’s just creating a big mess.
I’m sorry, Ken, that you found yourself in this situation. There are a few steps, one is very passive which is to just wait very patiently for your 2019 return to be processed so that you can use the online or phone methods for verifying your identity for your 2020 tax return.
The other option, aside from just screaming “representative” into the automated call response system, is to actually go in person. The IRS has taxpayer [laughs] assistance centers throughout the country. You can call and make an appointment for one of these centers.
I hope you don’t mind, I pretended to be this morning, Ken, and I called my IRS taxpayer assistance center and was able to talk to someone within 20 minutes to book an appointment. So you have to wait probably, 20 to 30 minutes on the phone with the IRS and make an appointment to go in person, bring all of your documents, prove your identity, and good standing as a citizen in person. I’ll share that phone number here for anyone who finds themselves in the situation: It’s 844-545-5640. The representative I talked to is actually quite pleasant.
I hope you don’t think of it as a second job, but hopefully just assisting and getting that done. I will say the worst thing to do in this situation is send more paper correspondence to the IRS. It’s just adding to the backlog, and is going to confuse things if your response to this 5071c letter gets processed before your tax return does or something like that. It could just create more of a nightmare for you.
Brokamp: Not only is there this paperwork backlog, but the IRS has been tasked with sending out all the stimulus payments. They’re just getting crushed, and I’ll just say, the few people I know personally who work at the IRS are perfectly pleasant, wonderful people. They don’t deserve the reputation they sometimes get. Be nice to your local IRS person, because, man, they’re working hard.
Southwick: I once had a delightful time with the DMV, personally. I mean, you just never know.
All right. Next question comes from Austin. “I have both a Roth IRA and brokerage account. I tend to put more of my income into the latter because I’m not sure I can wait until I’m 59 years old to use the money in the IRA. However, I recently learned you can take money out of an IRA for a down payment on a house. If buying a house is my five-year goal, should I put the money into my Roth IRA or my standard brokerage account?”
Brokamp: Well, Alison, the good thing about putting money into a Roth IRA is you can take the contributions out anytime, tax and penalty free, for any reason. However, it’s the earnings that would be penalized if taken out before age 59.5.
That said, there are some situations where you can take the money out of a traditional or Roth IRA before 59.5, and you can avoid that 10% early-withdrawal penalty, and one of those is for what the IRS calls a first-time home purchase. The funny thing about this is the home doesn’t actually have to be your first home ever. If you haven’t owned a home within the last two years, you are still considered a first-time homebuyer as far as the IRS is concerned with this rule. It’s not a big benefit; it’s limited to just $10,000, and that’s a lifetime limit, not annual. So if you’ve ever used it before, you can’t use it again, and in terms of Roth, it’s on top of your contribution.
Let’s say you’ve contributed $15,000 to a Roth IRA over the years. You take that $15,000 out, tax and penalty free, and then take out this $10,000 homebuyer exception. Now, the question is whether that $10,000 will be taxed. If it came from a deductible traditional IRA, the answer is yes. If it came from a Roth that has been open for less than five years, the answer is yes. But if it’s been open for five or more years, then the withdrawal will also be tax free. If you decide to do this, dig into the details because there’s some other rules, like you have to use the money to buy or build a home within 120 days of withdrawal.
Finally, of course, I have to point out that retirement accounts are for retirement. Ideally, you’d be able to save enough for your down payment without having to touch a Roth. But I understand that we don’t live in a world of unlimited resources, so you’ll have to make your choices. But it is certainly an option if buying that home in five years is worth it to you.
Southwick: Our next question comes from Larry. “We need to reduce our adjusted gross income for 2020 so that we pay less out-of-pocket for the health insurance premium through the marketplace. We originally contributed $4,755 to a Roth IRA in early 2020. We don’t have the cash right now, nor in the foreseeable three months, to add more to our traditional IRAs for 2020 and, therefore, reduce our AGI. Is it possible to withdraw the amount we already contributed to the Roth IRA for 2020 and then turn around and contribute that money to our traditional IRA and get the income deduction for the contribution? The Roth IRA has been open for 10-plus years.”
Brinsfield: Larry asked a pretty straightforward question, but I do want to talk about why someone would do this little dance with their IRA contributions, or in general, try to manipulate how much they’re reporting as adjusted gross income for a year, because there are a number of secondary and tertiary effects to that reporting number.
To answer Larry directly, yes, he could, from an administrative standpoint, recharacterize his contribution from a Roth IRA to a traditional IRA. That’s basically what the brokerages call it. You want to change the form of the contribution that you made, and you have until May 17 now, thanks to that tax extension we talked about earlier, to do this process. There’s usually just a form that you have at your brokerage that you fill out and complete.
The kicker there is that you do have to remove any growth that has come along with that contribution that you made, and that growth is taxable to you. So there may be a small tax element in terms of making this administrative shuffle.
Why would Larry or people like him want to reduce their AGI? Well, he mentioned one reason, which is healthcare costs. Now, he’s buying healthcare through the marketplace and gets what sounds like an Affordable Care Act subsidy for that, assuming his income is below a certain threshold. A lot of people aren’t aware that if you are a retiree or of retirement age, 65 and older and on Medicare, your Medicare premium is actually determined by your AGI from two calendar years ago. That would be one reason you might want to reduce your AGI.
Another would be just the ability to make IRA or Roth IRA contributions. There are some income thresholds there associated with either being able to deduct a traditional IRA contribution or to make a direct Roth IRA contribution. You might also have medical expenses that become more deductible if your AGI is lower, because deducting those medical expenses requires you to get over 10% of your AGI in spending before being able to deduct anything. The lower your AGI is, the lower that threshold needs to be for deducting those costs.
This year very importantly, your AGI impacts whether or not you get a stimulus check or how much of a stimulus check you would get. That’s another great reason to reduce your AGI. Then for younger folks that might still have student loan repayments, if you’re on an income-based repayment plan, having a lower AGI can actually affect how much you have to repay on that loan throughout the year.
Finally, one downside of potentially reducing your AGI is that if you are going to apply for a new loan, say a mortgage on a house or something like that, showing less AGI can actually be detrimental to how much you can qualify for on that loan.
I thought of six different ways that your AGI can affect the rest of your life, [laughs] so you want to be careful with it.
Brokamp: That’s a good point, because we often talk about whether you should contribute to a Roth or a traditional just in terms of what it means for your income taxes. But it’s not just your income taxes, because your AGI really does affect all these other things, and if you’re making a big decision about contributing to a Roth or making a big conversion, you might want to talk to your financial planner or your CPA to get a good idea of all the impacts of making those decisions.
Southwick: Our next question comes from Sean. “I’m in the process of finding a financial planner, and pretty much everyone I talked to has a suggestion. Some planners have pursued me pretty hard as well. Is there a centralized place for comparing or reviewing financial planners?
“Also, what should I expect the cost of a financial planner to be? Many charge 1% of the account value of the assets they manage. But to me, that seems a lot when I can buy into many index funds for an expense ratio of 0.15%.
“I’m 30 years old, and over the past year, I’ve had all my assets in my IRA, 401(k), and individual brokerage account invested in stocks. I’ve started to cash out some of these equities and want to lessen my exposure, especially retirement accounts, and increase my investments in index funds.”
Brokamp: Well, Sean, I don’t know of a centralized ratings provider of planners, and if one exists, I’m not sure I trust it, because so much of what a financial planner does is just between the planner and the client, and I don’t know how anyone would rate that.
What I suggest you do is start by determining what you want from a planner. If it’s asset management, 1% or so is the standard fee these days. If, after that fee, they’re managing your assets better than you would on your own, then it’s perfectly worth it. Especially if they’re providing some financial planning services on top of that. Like determining how much you need to save for retirement, whether you should choose the Roth or traditional, how much you need life insurance, and that type of stuff. Many of the big-name financial-services firms also provide asset management, plus there are the robo-advisors.
If your goal is to move more money into index funds, I’d see what’s being offered from the likes of your Vanguard, Schwab, Fidelity, as well as some of the robo-advisors; they charge much less than 1%. The Motley Fool has a website called The Ascent, and on that site they rank robo-advisors, including the ones that are better known, like Wealthfront and Betterment, as well as robo-advisor services from folks like Vanguard, Schwab, Fidelity. Just Google “Motley Fool Ascent robo-advisors.” You’ll find that page and you’ll see what they’re charging.
If you’re looking mostly for financial planning services and you’re comfortable managing your assets on your own, maybe you wouldn’t mind a second opinion on your portfolio, I would look for a planner that charges by the hour. A couple of places we’ve mentioned before, the Garrett Planning Network, National Association of Personal Financial Advisors or NAPFA, and you’ll find that they just charge between $100 and $300 an hour or so.
Brinsfield: If you are into the latest cutting-edge news in financial advisory reviews, [laughs] which who isn’t these days? One of the things that has been very restricted in the past for financial advisors and registered investment advisors in particular is that the SEC does not allow testimonials, which is broadly defined as any statement of experience. You can’t really go onto a website for a financial planner and say, “Well, let me see your testimonials from your other clients,” because that’s not allowed. Or at least it hasn’t been until very recently, the SEC just put out new marketing guidelines that allows, under very limited circumstances, for testimonials to exist for financial advisors. This is actually something that might be changing. We might be on the new frontier here of reviews for financial planners.
Brokamp: I should add another network, by the way, that might even be more geared toward this young fellow. That is the XY Planning Network, which really started out as a service for millennials and folks starting out in their careers, although they’ve expanded their purview since then. You might want to check them out as well.
Southwick: Our next question comes from Lee. “I just retired and have a defined benefit pension, a supplemental pension account, a traditional IRA, and an inherited IRA. Unfortunately, I will have a similar income or perhaps a touch higher than I had when I was working. I’m turning 70 this month, and in 2.5 years, I will have RMDs to deal with, resulting in taxes on my IRA and supplemental pension account. If I convert my IRA to Roth, I will pay a substantial tax. I’m already taking RMDs on the inherited IRA, but it is a stretched IRA. Is there anything I can do to avoid more taxes now, or is it too late?”
Brinsfield: All right, so Lee, well, just one quick reminder, is that the latest SECURE Act did change the RMD age from 70.5 to 72. At age 72, Lee will have to pick up those required minimum distributions. That’s where the IRS and Congress basically says you’ve deferred taxes long enough; it’s time you paid the piper. We make sure you do that by taking a minimum distribution and paying taxes on that every year after you turn 72 now.
This is a common question, and I see this from folks who are really good savers. You’re taking advantage of every tax opportunity you have while you’re working, socking away those 401(k) contributions, those IRA deductions. Then you get into retirement and realize you’re in a situation where you have basically forced income on you that you wouldn’t otherwise elect or need. This gets to be a pretty tight squeeze for folks who are getting these multiple income sources and end up in an excess position.
One great way that you can consider to avoid your required minimum distribution or avoid paying tax on it is what’s called a qualified charitable distribution. This is where instead of you taking the required minimum distribution and just adding to your other accounts or spending it, you would give that money directly to a charity.
That does two things. One, it means that you’ve satisfied your required minimum distribution from the IRS’s perspective, but you don’t have to include it as income because it’s gone directly to this charity. If you do have charitable intent, using this qualified charitable distribution is a cool way to make some contributions to charities that you care about and want to support. You can do that for up to $100,000 worth of your required minimum distribution every year, and if you’re married, your spouse can do the same. That’s pretty cool stuff. You cannot give that to a private foundation or a donor-advised fund, but there are plenty of organizations that will happily accept your qualified charitable distribution dollars.
Another, less common way that you might consider avoiding those required minimum distributions is that there is an exception to required minimum distributions for people who are still actively working. Lee, congratulations on your retirement. You probably don’t want to go back. That’s a one-way door for you, potentially. But there are a number of folks that we’ve seen that really are continuing to work on maybe a part-time basis or even a full-time basis after age 70. Our law says that if you are an employer-sponsored retirement plan and you are still working and an active participant in that plan, you do not have to take required minimum distributions from that plan.
We’ve actually seen people go back to work, start participating in the 401(k), and taking their rollover IRA and rolling it into that employer-sponsored plan in order to defer requirements among distributions. This isn’t a total escape plan, but it is more of a deferral down the road.
I will say that the tax environment that we’re in right now is relatively attractive in terms of overall rates. We’ve got Trump tax rates expiring in 2025. They’re lower than they have been in the past, and so if you are considering a Roth conversion, doing so in the next couple of years might be a good thing to consider anyway, just from the perspective of those tax rates going up in the relatively near future.
Brokamp: The good thing about doing that is once it’s in the Roth, you don’t have to worry about RMDs, because Roth IRAs do not have RMDs. If you’re already taking RMD, some people are like, instead of taking the RMDs, can I do the conversion, or does the conversion count as the RMD. My answer is no. You have to take the RMD first and then do the conversion.
Southwick: Next question comes from Christy. “My husband and I are both about 50 years old and have always planned to retire at about age 65. But a few years ago, we realized that if we saved a lot and invested it wisely, we might be able to retire earlier. We’re about two-thirds of the way to our retirement savings goal. The plan is to keep saving like mad for five years and then at least partly retire.
“About four years ago, I took 10% of our money and used it as my sandbox in a taxable brokerage account to invest in individual stocks Fool style, mostly tech stocks. That 10% has grown to about 20% of our overall portfolio. The question is, how do we allocate our money going forward? The recent declines in tech stocks have demonstrated that we might need to bring down the volatility of our portfolio. Volatility has never bothered me in the past, but now that I’m getting more into capital preservation mode and have more to lose, I find that volatility bothers me more than it used to.
“Should we start increasing our cash allocation, and if so, how much? Right now, we have about a year’s worth of living expenses in cash. Bonds seemed just terrible right now. While 10% of our portfolio is currently in bonds, I don’t love the idea of increasing our bond allocation.”
Brokamp: As every long-term listener knows, for me, the foundation of a retirement portfolio is having a three- to five-year cushion of cash. Maybe short-term bonds that you live off of and you annually replenish unless the stock market is down when you try to wait until the market recovers before you restuff your cushion. You will earn virtually nothing on this money. But it’s not about return, it’s about protection.
You already have some of that setup, I would definitely suggest that you start building that up over the next few years. You can do that by not reinvesting dividends; just let it stay in cash or maybe for your future contributions to your retirement accounts, just put them in cash.
For your sandbox money. First of all, congrats on doing so well, that’s outstanding. I understand though that how can be a bit unsettling, especially if you invested in a bunch of tech stocks. You’re within five years of wanting to retire, and then you see a lot of these stocks sell off, as we have recently.
You certainly could pare some of those back, especially if you want to ramp up the creation of your income cushion. You imply your question that you’re a member of a Motley Fool service. If so, use the guidance of the service. Maybe they have discussion boards and just get some input on which stocks you might consider cutting back on.
But I will say that you can’t play it too safe. Retiring in your mid-50s means you could be retired for 40 years, and having too much money in cash or bonds won’t provide the long-term goals that you are probably going to need. The good news about your situation is that it sounds like you want to partially retire, but then you partially want to work, and then you can adjust your hours from year to year based on how your portfolio performs.
Southwick: Our next question comes from Nick. “We just received our stimulus check. Can I use our three-year-old daughter’s portion to start an IRA for her?”
Brinsfield: This is a pretty easy one for Nick. The answer is no. The economic stimulus payment is not considered earned income, and earned income is required for an individual to be able to contribute to an IRA. If you’re thinking, “Well, it’s income. I got it in the mail. It’s a check and it has my name on it.” That is true, but it’s actually considered a prepayment on a tax credit. It’s how it’s administratively kept at that IRS in terms of their bookkeeping. It’s not actually income to you; it’s just refunding your tax payment that you might not have, anyway, in the future.
Southwick: All right. Next question comes from Wilson. “What paths should one take in order to have a career researching stocks or even to become a certified financial planner? Are there any specific college degrees people or this field usually complete? Other than college, what entry-level jobs would put me on the right path? After eight years in the culinary industry, I’m in the middle of a career change and have always been interested in this space and learning about finance and investing on my own. Currently starting college again, but I’m curious if you have any suggestions.”
Brokamp: Well, Wilson, I wish I had a definitive answer for you and I really don’t, but I’m just going to offer some thoughts. First of all, I think you’ll have to eventually decide which one you like more, picking stocks or creating financial plans, because they’re different paths. If it might be stocks, you might start by just creating your own portfolio of investment ideas and maybe keep an ongoing journal of why you picked those investments and just see how you do. You can track it on sites like Yahoo! Finance or Morningstar. I use Morningstar personally. You can also try the Fool’s CAPS service, which is free and it’s like a stock-picking game thing. You’ll find it at caps.fool.com.
But just as you do that, you’ll first of all find out whether you enjoy it, and you also find out whether you’re any good at it. If it turns out that you really like that and you’re good at it, the designation there that is probably the gold standard in the industry is called the CFA. It’s really tough. It’s three tests. If you want to be a stock picker at The Motley Fool, it’s not necessary, but if you want to go to a more traditional financial services firm, it’s required. That might be also something that you just take a look at and see if that looks like that would interest you.
Then I would also look into financial planning, and you can do that in a couple of ways. First of all, just find a book on financial planning. You say you’re going to school. Many schools now have programs and degrees in financial planning; maybe take a class or even just sit in on a class if they’ll let you, see if that interests you. This whole thing, retirement planning, taxes, state planning, that type of stuff may interest you, or you may find out that after a couple of classes, you’re really bored by it.
I’ll just tell you how I got in the industry and I know other people have as well. Basically, I joined an existing firm, and they were looking for someone to be an administrative assistant that would want to be on the path to becoming a financial planner. That’s what I did. That’s important, because to become a Certified Financial Planner, you have to have three years of experience or two years if you’re under the supervision of another Certified Financial Planner.
You might look into something like contact a network like Garrett or NAPFA or XY planning and say, “Is there an opportunity for me to put my name out there to your network and say I would like to help out some financial planning service in exchange for getting on the path to being a financial planner?” There is now a profession called a paraplanner, in which you are an assistant to financial planners, but many of them are also on the path to becoming a financial planner. Those are just some suggestions.
Southwick: Megan, what would you say is the top skills that you need to have and be good at if you want to be a financial planner?
Brinsfield: We always joke — and it’s not really a joke — that you’re part analyst and financial planner and part therapist, and I think Robert would have some commentary on this, since he did his financial therapy degree. But it is true that a lot of times, you are working with people’s finances, and their finances are very tied in to their emotions and beliefs. So you do have to have that empathetic ear as well, and remember that it’s not all about just maximizing dollars per se. Financial planning is combining the maximizing-the-wealth aspect with maximizing people’s individual goals, and so there is an art to that.
Southwick: Our next question comes from Sanjay. “I’m a U.S. citizen living and working in Switzerland. Also, I have a rental property in California. My plan is to live in the property for two years before I sell it to reduce my capital gains tax, but I want to live in it for the shortest amount of time possible. What qualifies for two years? Could I live in the unit from July 1 to December 31 in year one, 184 days. Then from January to July 2, 183 days in year two? So I’d live in the unit for 367 days over two years, but in each calendar year, I live in the unit for over half the year. Would this meet the two-year requirement?”
I have no idea what I just read, but I trust that you do, whoever is answering this question. I think I got the gist of it. I could see where Sanjay was going.
Brinsfield: Totally, and this is a very accountant question. You lean in over the table and you go, “But what is two years, really?” [laughs] and start having some arguments about it.
So just to give some background for why Sanjay would be asking this question: There’s a provision of the tax code that’s really beneficial for homeowners that says, if you have lived in your home for two out of the last five years and you sell that home, you can exclude a portion or all of the appreciation from tax. That exclusion is $250,000 if you’re single or $500,000 if you’re married filing jointly.
You can see that there’s a pretty meaningful reduction in tax at stake here for meeting this criteria. At its face value, two out of five years sounds like a pretty straightforward thing. But then you get into these questions about what is time? Where am I on [laughs] the time-space continuum, and where do I have to be to get the tax benefit?
The IRS is pretty clear here that two years is 730 days. That’s a lot more than Sanjay was planning for. But the good thing is, it doesn’t have to be consecutive. You can look at that entire five-year period, and if you can crank out 730 days that you’ve been using that property as your primary residence, it qualifies.
You might ask questions like, well, what if I take a prolonged vacation, or what if I am in the hospital for a long time in a coma, is that still my primary residence? The answer for the most part is yes, that those temporary absences don’t count against you. But the IRS would look at things like where are you registered to vote? Where is your car licensed? Where are your friends and banking relationships and where do you work and things like that to prove that this is actually where you are located as your primary residence.
One fun thing here is, this exclusion in 2009, there was a loophole that was closed. What Sanjay is doing is, I don’t know what happened before he moved to Switzerland. But let’s say he used this as his primary residence, moved to Switzerland to be a professional yodeler, and then returned home to California and lived in this residence for two more years. Does he just easy peasy he gets that exclusion?
Well, not necessarily because in 2009, there was reform to this rule that said, if you are using your home as a rental and then you come back and move in and use it as your primary residence, you can’t just take that two out of five easy-peasy; you have to actually prorate your gain between the period you used it as a residence and the period that you used it as a rental and split the gain and apportion it and see if you can deduct the whole thing. Just know that if you’re using it as a rental first and then you move in, there’s a few more hurdles that you have to overcome.
This isn’t true for the opposite situation. If you lived in that home for two out of five years and then you moved away for three years, at the end of that three years, you can still sell it and get that full exclusion available to you. It’s weird that it doesn’t go both ways, but it is an interesting rule that is more complex than it sounds at face value.
The one final thing I’ll mention to Sanjay is that if you’re using your home as a rental, you are getting the benefit of depreciation on your taxes, and anytime you sell a rental property, you are going to be subject to recapturing that depreciation. That’s a flat rate of 25% at the federal level. So you want to incorporate that into your planning as well.
Southwick: Our next question comes from Clifford. “I’m 69 and worked only in January of 2021. My total pre-tax earnings will be between $7,000 and $8,000. If I contribute all of my earnings to my Roth 401(k), it will still show up on my W-2 at the end of the year as taxable income. Does that mean I can also contribute the maximum $7,000 to a Roth IRA?”
Brokamp: Unfortunately, though, Clifford, the total amount that you can contribute to all your accounts, or even your spouse’s account if you’re spouse is going to have a spousal IRA, cannot exceed the amount you actually earned in the year. So if you earn between $7,000 and $8,000, it all went to your Roth 401(k), then you cannot then contribute to an IRA on top of it.
Southwick: Our last question comes from Isa. “I attempted a backdoor Roth IRA conversion this year since I’m over the income limits for contributing directly. I used after-tax dollars to fund a traditional IRA that I created for this purpose and then converted it to a Roth a day or two after the funds vested. Since starting my taxes, I’m a bit concerned I’m paying taxes twice. I pay taxes on the income I use to fund the traditional IRA and now I’m paying taxes again on the conversion. Is this what’s expected, or have I gone wrong somewhere?”
Brokamp: Well, Isa, I think you did go wrong somewhere, and it’s probably one of two places. When you do the backdoor Roth, you contribute to a nondeductible traditional IRA. It’s possible that when you contributed to it, maybe you had to check a box or something that instead you indicated you were contributing to a deductible IRA. That could’ve been one of the issues.
The other issue is when you convert that nondeductible traditional IRA, you should not owe taxes on that converted amount. The other possibility is that you just didn’t indicate that this was a nondeductible traditional IRA you were converting from when you did your taxes using the tax software.
It’s also, I guess, possible too, that you ran afoul of the ratable rule, which is very complicated, but basically, the backdoor Roth, when you convert it, you have to include all your traditional IRAs as part of it. If you had a whole bunch of other traditional IRAs that were deductible and they had a lot of growth, that also can lead to tax problems, which is why, generally speaking, the backdoor Roth does not make much sense if you already have a lot of money in traditional IRAs.
My suggestion for you is to just start, first of all, with your broker to make sure that you did contribute to a nondeductible traditional IRA. Then check with either your accountant or the tax software you’re using to make sure that all that has been filled out and completed correctly.
Southwick: We did it. That was all the questions. Megan, thank you so much for coming on this month.
Brinsfield: Thank you for having me, it was exciting.
Southwick: We appreciate you so much making the time to do this and I know we’ll have you back again if you’ll have us.
Brinsfield: Of course.
Southwick: Well, that’s the show, it’s edited peak bloomly by Rick Engdahl. Yes, it’s peak bloom here in DC. Megan, you got to hustle back so you can see those cherry blossoms. Our email is [email protected] For Robert Brokamp, I’m Alison Southwick. Stay Foolish, everybody!