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At last year’s open enrollment for ACA health insurance, we switched from a PPO plan to an HMO plan, because the premium for the HMO plan was lower by $470/month. Both plans have a $6,000/person annual deductible. We decided to continue seeing our doctors, now out of network, and just use the $470/month savings to pay cash for the services we actually use. See previous post When ACA Insurance Does Not Include Your Doctor.

I had an opportunity to test this new setup last month.

After I had a haircut shorter than I usually get, my wife noticed some dark spots on my scalp. Those spots could’ve been there all along because they were hidden under the hair, or they could be new. Skin cancer jumped into mind. She said I should see a doctor and have them checked.

When I had skin problems a few years ago I went to a dermatologist. She prescribed a cream and the condition was treated successfully. I decided to see her again. When I made the appointment I told the front desk that I would self-pay because my HMO insurance doesn’t cover her. At the time of the visit, I was asked to pay $150 as a deposit. No problem.

The dermatologist examined the spots and she told me not to worry. They weren’t skin cancer. No treatment was necessary. Great.

A few days later I received a bill. The total for the visit was $230. After the $150 deposit, I had a balance of $80. The health system advertises a 30% discount for self-paying patients if bills are paid in 20 days. I called the billing office and asked for the discount. The rep there said she had to send a request to another team and it would take a few days. No problem. A few days later I received a revised bill with the 30% discount. The total came down to $161. I paid my $11 balance. Done.

When I saw the same dermatologist back in 2015, I also had a high deductible plan with HSA. My HSA records showed that I paid $360 with insurance after the in-network discount, because I hadn’t met the deductible.

There, 4 years later, paying cash to see the doctor out of network cost less than half of seeing the same doctor in-network with insurance.

Why?

1. The health system billed more to insurance than it billed me. This is not unique to healthcare. Insurance is seen as having a deeper pocket — better ability to pay. When I wanted to have a broken windshield replaced for my car, every glass shop quoted me two prices: going through insurance or not going through insurance. The price for going through insurance was about 50% higher than paying cash.

2. The health system offered a larger discount to a self-paying patient than to insurance. This health system is a major player in our local market. Insurance companies have to include them in their network in order to sell their plans to employers. They can’t get much bargain from the health system. On the other hand the health system understands that self-paying patients by definition have choices, and prices are an important factor when they consider where they go.

The combination of these two angles made paying cash less expensive than paying the in-network price toward the deductible.

I learned from this episode that having a very high deductible is a blessing, not a curse. When you have little chance to meet the deductible anyway, it gives you the freedom to choose any provider. When you pay cash, every provider is in your network because they all accept cash. When you pay cash, you get the rate by your perceived ability to pay, not the rate reserved for the insurance company. When you pay cash, you save money on insurance because you don’t have to choose the more expensive insurance plan that covers your doctors in-network.

It’s not just me, not just for ACA plans, and it’s not new. I found this blog post by Jeanne Pinder on Clear Health Costs from 2014: Is it cheaper to pay cash than to use your insurance? Maybe. It has more stories along the same lines. It also links to several newspaper articles and other blog posts that reported the same phenomenon.

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If an advisor is charging you a percentage of your assets, you are paying 5-10x too much. Learn how to find an independent advisor, pay for advice, and only the advice: Find Advice-Only.

See A Doctor Out of Network And Pay Less Than The In-Network Rate is copyrighted material from The Finance Buff. All rights reserved.

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You know what they say about death and taxes. If you work for an employer, the IRS requires the employer to withhold taxes. If you don’t have an employer, you will have to pay taxes on your own, and you can’t just wait to pay when you file your tax return. The IRS describes it this way in Topic No. 306 – Penalty for Underpayment of Estimated Tax:

“The United States income tax system is a pay-as-you-go tax system, which means that you must pay income tax as you earn or receive your income during the year. You can do this either through withholding or by making estimated tax payments. If you didn’t pay enough tax throughout the year, either through withholding or by making estimated tax payments, you may have to pay a penalty for underpayment of estimated tax.”

I had worked as both a W-2 employee and self-employed for a long time. In the past I just had my employer withhold extra to cover the taxes owed on my self-employment income. This is easier because taxes paid through withholding are assumed to be paid evenly throughout the year even if the actual withholding is more skewed toward the end of the year. By October I had a good idea how much I would earn from my self-employment in that year. I then requested my employer to withhold extra from my paychecks.

Base On Prior Year Or Current Year

After I left my full-time job last year, I’m now completely on my own. In order to avoid an underpayment penalty, the IRS says you must pay this much, whichever is lower:

  1. 100% of the total tax last year (110% if your last year’s AGI is more than $150k); or
  2. 90% of your total tax this year

Between the two methods, it’s easier to use the total tax last year because it’s not a moving target. After you file your tax return, you already know what that number is from line 15 of your 1040 form. Then you just take 100% or 110% of that amount as your target this year. It also works well when your income is going up. Even if you pay 110% of your last year’s tax, it won’t be too far off from your tax on a higher income.

However, when you expect a large drop in income, such as the case for me this year, paying based on previous year’s tax will be way off. So I’m left to guess what my income will be this year, and then calculate what my tax will be from there. Fortunately they do allow a 10% buffer. If I guess wrong, as long as I pay more than 90% I will be OK.

If you use downloaded/installed tax software instead of the online service, it’s very easy to estimate your tax based on your estimated income. Just make a copy of last year’s tax file, open it, and change the income numbers to your estimates. If you don’t have installed tax software, the Case Study Spreadsheet (aka Personal Finance Toolbox) can help, but you will have to learn how to use it. See Tax Calculator With ACA/Obamacare Health Insurance Subsidy.

After this year I will go back to using prior year’s tax as the target, which doesn’t require guessing the income or running software.

Timing

The IRS expects estimated tax payments in four equal installments by April 15, June 15, September 15, and January 15 (of the following year). The due dates are extended to the following business day if they fall on a weekend or holiday.

Even if you earn 100% of your income in January, you can still pay in four equal installments. If you earn 100% of your income in December, they don’t expect you to have the foresight for what your annual income will be at the earlier due dates. You can pay less early in the year and more later in the year when your income also skews more toward later in the year. So just do the best you can in estimating your annual income and your tax at each due date. If you have a larger income later in the year, just pay more to catch up.

State Income Tax

The state wants their taxes too. I live in California, which has the same due dates as the IRS, but they have an accelerated collection requirement. Instead of 1/4 each at each due date, California requires 30% of the annual tax due on April 15, another 40% on June 15,  and a final 30% on January 15 of the following year. This way California gets paid more sooner. By June 15, California will have already received 70% of the annual estimated tax.

Paying Online

The tax authorities make it relatively easy for you to pay your taxes. The IRS offers Direct Pay for one-time payments. No login or password is required. You just pay with a bank account. For scheduled payments, the IRS offers EFTPS, which requires registration and waiting for a PIN coming by mail. If you’d like to earn some reward points you can also pay with a debit card or a credit card through some third-party processors. The third-party processor will charge a fee but the fee may be lower than value of the rewards you earn.

California’s Franchise Tax Board offers Web Pay, which you can use either with a registered account or without. Without a registered account you can just pay on the fly. With a registered account you can link a bank account and schedule payments ahead of time.

Because I will be paying on my own in the foreseeable future, I registered for both IRS EFTPS and California’s Web Pay. The scheduled payments for April 15 went through smoothly.

I noticed that if you schedule a payment, the date specified is the date the debit will hit your account. They send out the debit the day before to make the debit hit your account on the scheduled date. So make sure you have the money in the account on the scheduled date and don’t think you have another day after the scheduled date. If you don’t have enough money in your account when the debit hits, the IRS can charge you a dishonored payment penalty at 2% of the payment amount with no cap. California also charges a similar dishonored payment penalty. Bouncing those two debits can cost a small fortune!

Say No To Management Fees

If an advisor is charging you a percentage of your assets, you are paying 5-10x too much. Learn how to find an independent advisor, pay for advice, and only the advice: Find Advice-Only.

Paying Taxes On Your Own: Amount, Timing, and Mechanics is copyrighted material from The Finance Buff. All rights reserved.

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I read a great comment on the blog Frugal Professor that I’d like to share. The business school professor there needed a new mattress. One model that came into consideration costs $3,500. Someone commented that considering that you spend around 1/3 of your life on the mattress, it’s worth spending $3,500 on a good mattress. The professor replied:

These thoughts have gone through my mind as well. But I also spend around 95% of my life wearing socks and can’t justify paying $3500 on them. The tradeoff I’m making with this purchase, as with all purchases, is to maximize value by maximizing marginal benefit divided by the marginal cost. In the case of the mattress, I’m trying to figure out what the marginal benefit is of a $3500 mattress relative to a $500 mattress (does the marginal benefit exceed the marginal cost of $3k). But, overall, I’m sympathetic to the idea of not cheaping out on a mattress given that it will affect the quality of my life in a non-trivial way for at least 10 years.

This highlighted the difference between what I call the absolute value and the relative value.

The absolute value is the value of having something over having nothing. If I must sleep on concrete for 10 years, I would spend $3,500 on a mattress. If I must walk 10 miles to work every day, I would pay $35,000 for a car.

The relative value is the value of something over its next acceptable alternative. When a $1,000 mattress does the job, a $3,500 mattress offers poor relative value. When a $5,000 car gets me to work just fine, a $35,000 car offers poor relative value.

Sellers like to use the absolute value to make the sale and justify to themselves they are providing value. Here are some examples:

“Before I sold you this whole life policy, you had no life insurance. You would’ve blown your money on unnecessary spending. You should be happy your family is protected now and the policy is worth something.”

“When you walked into the bank, your money was all in CDs. These mutual funds with 2% expense ratios still made more money for you than those CDs.”

“I talked you out of selling at the bottom when the market crashed. That’s worth a lot more than the 1% I’m charging you.”

“If I didn’t treat you after that bus accident, you would’ve bled to death. So pay me $27,000 for giving you stitches.”

In each case the sellers provided absolute value. However, buyers still received poor relative value. A whole life policy isn’t the only option to protect one’s family. You don’t have to blow away your money if you don’t buy a whole life policy. When you can buy a target date fund with expense ratios under 0.2%, paying 2% is crazy. Even if you need someone to talk you out of self-inflicted harm, 1% of assets under management is still 5-10 times too high.

A fair price is determined by the next acceptable alternative. When you must have something and nothing else will do, you will pay a very high price. You will get better relative value when you are open to more alternatives. If you hear a seller making the argument based on the absolute value, alarm bells should go off right away, because doing nothing is almost never the true alternative. They make the argument based on the absolute value when the relative value is poor.

Say No To Management Fees

If an advisor is charging you a percentage of your assets, you are paying 5-10x too much. Learn how to find an independent advisor, pay for advice, and only the advice: Find Advice-Only.

Absolute Value vs Relative Value: Doing Nothing Is Not The True Alternative is copyrighted material from The Finance Buff. All rights reserved.

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Contributing enough to the 401k plan in order to get the full employer match is among the most basic rule in saving and investing. When it comes to matching your 401k contributions, employers can do it in several different ways.

Every Payroll

Suppose your employer matches dollar for dollar on the first 4% of pay and your pay is $120,000 per year. With 24 pay periods in a year, your gross pay is $5,000 per pay period. If you contribute $200 per pay, which is 4% of $5,000, your employer matches another $200. Over the course of a year, your employer will match $4,800. Now, if you contribute $1,000 in the first pay period of the year, should your employer match $1,000 because it’s still below 4% of your pay for the year?

No, because even though your annual pay is $120,000, your employer doesn’t know whether you will work the entire year. If you quit right afterwards, you will have earned only $5,000, and the employer should only match $200. So the employer only wants to match $200 in the first pay period of the year, not $1,000. In the next pay period, same thing, you earn $5,000 and contribute $1,000, and the employer matches $200.

Some employers make it simple for themselves and they just operate on a per-payroll basis. Whatever you earn and contribute in a pay period, the employer just calculates the match based on those. This method is easiest for the payroll software but it creates a problem for employees who max out the 401k contributions.

To continue the previous example, you contribute $1,000 per pay period and the employer matches $200. This goes on until you max out your $19,000 annual contribution in the 19th pay period. In pay period 20, your contribution stops and the employer match also stops. Over the course of the year, you only received $20 * 19 = $3,800 in employer match, not the $4,800 you expected. When the employer operates on a per-payroll basis, you have to make sure you contribute at least 4% of pay through the last pay period. If you max out too soon, you miss out on the match. It can be tricky if your pay varies from pay period to pay period or if you get a surprise bonus in the middle of the year.

Annual True-Up

To make life easier for the employees, some employers will do an extra calculation after the end of the year. In our previous example, when the employee maxed out too early and only received $3,800 in 401k match, the employer will contribute additional $1,000 in the following year to make up the difference. This is called a true-up contribution. This way the employees won’t have to worry about adjusting their contribution percentages to make sure they don’t max out too early. You can front-load their 401k contributions and still receive the full match.

However, besides making you wait until the following year to receive the true-up match, some employers impose another requirement for the true-up match. You only get the true-up match if you work through the end of the year. If you max out your contribution in May and you quit in September, you will get less match than if you make your contributions last through September. This saves the employer a little money on the employees who maxed out before they quit.

Not all employers have this silly requirement. If your employer gives a true-up match and it isn’t limited to employees who work through the end of the year, after you quit, you should wait for the true-up match before you roll over your 401k money.

True-Up Every Payroll

Employers who are more current with the best practice give a true-up match every payroll. In our previous example, when your contribution stops in pay period 20, the employer sees you made $100,000 and you contributed $19,000 year-to-date. The employer should match $4,000. Therefore the employer matches another $200 in pay period 20 even though your contribution is zero. This continues through the end of the year. If you quit, the employer match also stops. You always get the promised match.

In terms of employee-friendliness, the employer match practices go in this order, from least friendly to most friendly:

  1. Every payroll with no true-up: Employees must watch and adjust the contributions throughout the year.
  2. Annual true-up with end-of-year requirement: Employees who maxed out early and quit are deprived of the full match.
  3. Annual true-up without end-of-year requirement: Employees who maxed out early must wait for the true-up in the following year.
  4. True-up every payroll: Employees always get the full match in real time.
Say No To Management Fees

If an advisor is charging you a percentage of your assets, you are paying 5-10x too much. Learn how to find an independent advisor, pay for advice, and only the advice: Find Advice-Only.

401k Match Policies: Every Payroll and True-Up is copyrighted material from The Finance Buff. All rights reserved.

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In the previous post Tax Software: Buy Download Or CD, Not Online Service, we focused on the 40% of tax filers who prepare their own returns. More people actually don’t do it themselves. They use the service of a tax preparer to file their taxes. Granted some people have complex tax situations with self-employment, rental properties, complex investments and what not, and some people are wealthy enough that they just don’t want the chore of doing their own taxes, but it’s hard to believe that those make up over 50% of all tax filers.

According to a Bloomberg article two years ago, brick-and-mortar tax preparation services charged on average $176 for a tax return with just the standard deduction. I see tax filing offices inside Walmart stores. I don’t suppose people with complex tax situations are going there.

One theory given for the surprisingly high number of people who use a tax preparation service is the Earned Income Tax Credit (EITC).  EITC is a refundable tax credit available to eligible workers earning relatively low wages. To those who qualify, EITC represents a substantial amount of money they will receive from the government. The 2018 maximum EITC for a tax filer with one child is $3,461; for two children, $5,716; and for three or more children, $6,431. When you are receiving that much from filing the tax return, paying $200 can be seen as a necessary and acceptable cost.

However, receiving EITC and paying for tax preparation don’t have to be linked. The EITC comes from the government. You get it whether you use someone or you do it yourself. If you do the tax return on your own, you will still receive EITC. You just save the $200 tax preparation fee.

In this article I will show you how to do the tax return on your own and still receive EITC. 28 million tax filers receive EITC. If only 0.01% are able to save $200 by following this guide, this guide will save people $560,000 a year!

I will use this example:

Jen is a single parent with one 5-year-old child. She files taxes as Head of Household. Jen makes $30,000 from her job. She has no other income or complexities.

I will use TurboTax Free Edition for this example, only because TurboTax is a popular online service. I will create the same guide for using other services in the future.

Personal Information

After you sign up with TurboTax and you enter the software, you will be asked for your name, address, Social Security Number, and your marriage status. Those are very straight forward.

Dependent Information

97% of people who receive EITC have children. Here Jen answers Yes because she has a child.

Jen supports her child.

Jen gives the name, date of birth, citizenship, and the relationship about her child.

Jen’s son lived with her in the U.S. the whole year.

Jen’s son wasn’t disabled and didn’t pass away.

Jen’s son din’t support himself.

Jen has agreement with her son’s father about who would claim her son as a dependent on the tax return.

The agreement was that her son’s father would not claim her son as a dependent.

No other relative lived in Jen’s home and helped raise her son.

Having a child as the dependent on her tax return will increase her chance of receiving EITC.

Jen needs to provide her son’s Social Security Number.

Because Jen only has one child, this is the end of entering dependents. If you have more than one child, repeat and enter the information about your other children.

Filing Status

Jen paid more than half of the cost to keep up her home.

That qualified her to file as the Head of Household, which gives her a larger standard deduction.

Income

Jen enters the numbers on her W-2 into each corresponding box.

Right away TurboTax tells Jen she would get $2,442 in tax refund.

Because Jen only has one W-2, she continues to the Deductions & Credits section. Earned Income Credit and Child and Other Dependent Tax Credit are listed and marked as “Needs review.” She clicks on the Review button to go into each one.

Earned Income Credit

She still needs to confirm a few things before she gets the EITC.

She lived in the U.S. for more than six months.

She didn’t have any of the uncommon situations.

She’s now qualified to receive the EITC.

Child Tax Credit

Jen also needs to confirm a few things before she gets the Child Tax Credit.

She did not earn income as an inmate.

She’s eligible for the Child Tax Credit.

She didn’t received a letter from the IRS telling her she must file Form 8862 in order to claim Child Tax Credit.

Jen will receive $1,645 in EITC and $2,000 in Child Tax Credit. After subtracting $1,203 in income tax, she will receive net $2,442 from the IRS.

That’s it. Without paying $200 to a tax preparation service, Jen is able to do the tax return on her own and still receive her EITC and Child Tax Credit.

Say No To Management Fees

If an advisor is charging you a percentage of your assets, you are paying 5-10x too much. Learn how to find an independent advisor, pay for advice, and only the advice: Find Advice-Only.

How To File EITC and Child Tax Credit For Free: TurboTax Edition is copyrighted material from The Finance Buff. All rights reserved.

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My beloved dentist Dr. M retired after 45 years (see Staying In Your Job After Financial Independence). A new dentist who only graduated dental school 3 years ago took over (bought?) his practice. I met this new dentist in a routine cleaning-and-exam appointment last month.

The new dentist was very friendly. After a thorough exam, he recommended that I get a night guard to prevent damages from night time grinding or clenching. Because I have some gum recession, he also recommended gum line fillings for 5 teeth. These issues never came up before with Dr. M. The gum recessions had been there for many years. Dr. M told me if the teeth were sensitive he could desensitize them but otherwise I didn’t have to do anything.

I understand different medical professionals have different treatment approaches. I’m not saying the new dentist must be wrong but this interaction also revealed how health insurance affects our healthcare consumption and how our healthcare decisions affect health insurance.

Among different branches of healthcare, dental services are very transparent in prices. You get a treatment plan with itemized prices up front. If you have insurance, the amount covered by insurance will be estimated quite accurately. You don’t get into a situation where the doctor recommends something but nobody can tell you how much it will cost until you actually do it. You know up front what your out-of-pocket cost will be. You then decide whether to proceed. If all healthcare works like dental services we will have much less headache.

As usual, the dental office gave me an itemized treatment plan with my expected out-of-pocket cost. I was reminded that my dental insurance covers 80% for the treatments. If I don’t have dental insurance, I probably wouldn’t go for those treatments because they look like marginal value to me. But at 80% off? Yes?

And that’s a problem.

Before I buy insurance, I wouldn’t pay for treatments that offer only marginal value. After I buy insurance, I have a strong incentive to go for those treatments because I already paid for insurance and the incremental costs to me are substantially lower (80% off!). If I don’t get the treatments I still pay the same insurance premium.

When insurance pays for those treatments of marginal value, the costs are just included in the premiums. Health insurance gets expensive because health insurance covers expensive treatments. Treatments are expensive because once you have health insurance you don’t care how expensive the treatments are. After you satisfy the annual deductible, additional services cost substantially less. After you blow past your out-of-pocket maximum, everything is free!

Dental insurance actually has the least problem because it usually has a low annual cap. My dental insurance pays maximum $2,000/year. This problem is much more pronounced in medical insurance. I have seen many ads for devices that prominently mention they are covered by Medicare. As in the popular saying, “Why rob a bank? Because the money is there!” billing insurance through price-insensitive consumers is a game simply because the money is there.

After my dental appointment I discovered I could download audiobooks from my public library with the Libby app. I listened to the audiobook Catastrophic Care: Why Everything We Think We Know about Health Care Is Wrong by David Goldhill. It made me re-think a lot about healthcare and health insurance. The author gave a very good analysis of what’s going on from a microeconomics angle. It challenged many assertions I used to assume to be true.

Some highlights from the book:

1. We give healthcare a pass and treat it as if it’s on its own island where the economic laws for everything else don’t apply.

We talk about healthcare cost not healthcare prices, accepting the cost for what it is. We talk about healthcare benefits, thinking someone else is paying for us, when we collectively must pay everything for everyone.

2. We think health insurance is the only way to cover healthcare.

We have true catastrophic risks in healthcare (getting cancer, serious injury, …) and we have expected expenses (child birth, non-catastrophic illness, …), but we use a single tool — health insurance — to handle both. Outside healthcare we use insurance for unpredictable catastrophic risks and we use saving and borrowing for expected expenses.

3. We think healthcare is the best way to achieve good health.

Education, income, diet, exercise, etc. all affect health but the government earmarks huge spending only on healthcare. Through Medicare, Medicaid, and tax subsidies for health insurance, citizens become the conduit to funnel money to the healthcare industry. Spending on healthcare crowds out spending on other things that improve people’s lives.

4. Let consumers drive their healthcare spending.

Collectively we already spend a lot of money on health insurance, including Medicare and Medicaid. Expanding health insurance only makes healthcare more expensive. If we just give the money to people and let people drive their healthcare spending, we might achieve better results at a much lower cost.

Before you read the book or listen to the audiobook, you can also watch this interview of the author by Malcolm Gladwell.

David Goldhill on health care - The New Yorker Festival - The New Yorker - YouTube

David Goldhill’s suggested policy solutions may be politically infeasible at the moment but I like his economic analysis of why healthcare and health insurance are so expensive. Before public policies change, consider getting the least expensive insurance and saving the difference for out of pocket expenses. As I discovered recently, it’s less expensive to pay my doctor out of pocket than paying the extra insurance premium to have her in-network.

Say No To Management Fees

If an advisor is charging you a percentage of your assets, you are paying 5-10x too much. Learn how to find an independent advisor, pay for advice, and only the advice: Find Advice-Only.

When Health Insurance Makes Healthcare More Expensive is copyrighted material from The Finance Buff. All rights reserved.

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Updated on Feb. 3, 2019 with updated screenshots from the 2018 software. If you use other tax software, see:

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

What To Report

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

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

You do yourself a big favor and avoid a lot of confusion by doing your contribution for the current year and finish your conversion during the same year. Don’t wait until the following year to contribute for the previous year.  Contribute for year X in year X and convert it during year X. Contribute for year Y in year Y and convert it during year Y. This way everything is clean and neat. If you are already off by one year, catch up. Contribute for both the previous year and the current year, then convert the sum during the same year.  See Make Backdoor Roth Easy On Your Tax Return.

H&R Block Software

The screenshots below are taken from H&R Block Deluxe desktop software. If you use H&R Block Online, the screens may be similar. In general you are better off with buying software installed on your computer, not the online service. See Tax Software: Buy Download Or CD, Not Online Service.

Here’s the scenario used in the example:

You contributed $5,500 to a traditional IRA in 2018 for 2018. Your income is too high to claim a deduction for the contribution. By the time you converted it to Roth IRA, also in 2018, the value grew to $5,530. You have no other traditional, SEP, or SIMPLE IRA after you converted your traditional IRA to Roth.

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

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

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

Convert Traditional IRA to Roth

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

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

In this example, we assume by the time you converted, the money in the Traditional IRA had grown from $5,500 to $5,530.

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

Click on Import 1099-R if you’d like. I show manual entries with Add 1099-R here.

Just a regular 1099-R.

Enter the 1099-R exactly as you received. Pay attention to the code in Box 7 and the checkboxes. My 1099-R had Box 2b checked, code 2 in Box 7.

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

Did not inherit.

This is a very important question. Read carefully. You converted, not rolled over.

Yes, you converted.

Converted all.

Answer yes.

You are done with one 1099-R. Repeat the above if you have another 1099-R. Click on Finished when you are done with all the 1099-Rs.

A few more questions.

Answer yes if you contributed for the year.

Will wait.

Don’t Panic

After entering the Roth conversion, if you see your taxes go up a lot, don’t panic. In our test case we turned a refund of $941 into owing $995. This is normal. You haven’t entered your non-deductible contribution yet. It will come back down when you do.

Non-Deductible Contribution to Traditional IRA

Now we enter the non-deductible contribution to the Traditional IRA *for* the year in question. Complete this part whether you contributed in the same year or you did it or are planning to do it in the following year before April 15. If your contribution during the year in question was for the previous year, make sure you entered it on your previous tax return. If not, fix your previous return first.

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

Answer ‘Yes’ if you contributed to an IRA for the year in question.

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

No deduction due to income. Contribute anyway.

Enter your contribution amount.

This is important. Answer ‘no’ to recharacterization. You converted, not recharacterized. See the difference in Traditional and Roth IRA: Recharacterize vs Convert.

If you started fresh, enter zero. If you contributed non-deductible for previous years (regardless when), enter the number on line 14 of your Form 8606 from last year.

Some follow-up questions.

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

Please, please, please do yourself a big favor and do it the easy way. See Make Backdoor Roth Easy On Your Tax Return.

Just a note about Form 8606. Nothing to do here.

A summary of your contributions. 0 in Traditional IRA deduction means it’s non-deductible. Repeat for your spouse if both of you did backdoor Roth.

We are done for entering the non-deductible contribution to the Traditional IRA. Now the running meter for your taxes should go back down. It was a refund of $941 when we first started. Now it’s a refund of $930 due to the tax on the extra $30 earned before the Roth conversion.

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

Taxable Income from Backdoor Roth

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

Click on Forms on the top and open Form 1040 and Schedules 1-6. Click on Hide Mini WS. Scroll down to line 4a.

It shows $5,530 in Roth conversion, $28 of which is taxable. The taxable income came out to $28 not $30 due to some rounding in the calculation. If you are married filing jointly and both of you did backdoor  Roth, the amounts here will show double.

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

If you find this article helpful and you would like to contribute something to the tip jar, I thank you for your generosity.

Say No To Management Fees

If an advisor is charging you a percentage of your assets, you are paying 5-10x too much. Learn how to find an independent advisor, pay for advice, and only the advice: Find Advice-Only.

How To Report Backdoor Roth In H&R Block Software is copyrighted material from The Finance Buff. All rights reserved.

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My wife and I came back from our trip to Kenya. We achieved our primary goal of climbing Mount Kenya. My wife was able to get on Nelion and Batian, the highest two peaks in Mount Kenya. According to Wikipedia, only 200 people get on Nelion each year and only 50 people get on Batian each year.

I attribute the success to polepole (pronounced “PO-lay-PO-lay”), which is Swahili for slowly. The mountain isn’t necessary hard. The major cause of failed attempts is altitude sickness. In a mild form of altitude sickness, you get headaches and vomiting. In more severe forms you get fluid build-up in your lungs or in your brain, which can be life threatening. Altitude sickness is caused by ascending to high altitude too fast. It often affects the young and the very fit more, because the young and the very fit are able to ascend fast to begin with.

The standard itinerary for climbing Mount Kenya goes from the bottom of the mountain to the top in four days. We paid extra to our tour operator and made our itinerary six days. When we met other tourists on our way up, we would naturally chit chat about each others’ plans for the next few days. Others were going twice the distance and twice the elevation per day. It naturally made us wonder whether we were too conservative and we were missing out. Our guide kept telling us polepole.

Polepole won in the end. When we finally reached the highest hut, we were very well acclimatized. We were able to perform to our ability and achieve our goal successfully. We weren’t trying to set a speed record. Making sure we get there and come down safely was more important to us than the number of days it took.

On our way up we met a young couple from Estonia who were very close to their next camp but had to come down because they had severe headaches from altitude sickness.

We didn’t just sit in camps when we were going polepole. Our guide took us to caves, waterfalls, and up and down nearby hills for more exercise. We camped at a beautiful lake that other people only look at from a distance. Polepole not only increased our chances of success but it was also more enjoyable.

Polepole applies to preparing for retirement as well. We live in today’s world that incites FOMO (Fear Of Missing Out). The age at which one retires is used as a primary measure of success. Retiring in one’s 50s is no longer early. You’d have to do it in your 30s. Before you know, a 12-year-old will have retired already.

Don’t fall for FOMO. Safety and soundness are more important than the age at which one claims the “retired” badge.

Training and Preparation

In addition to practicing polepole, we also prepared ourselves before we went on the trip. We had vaccine for yellow fever and we took prescription pills for preventing malaria, even though we saw very few mosquitoes when were there. We would’ve probably been fine if we didn’t have the shots or take the prescription. Wasted money? Yes, but we are happy to waste it.

Translation for personal finance: Buy insurance if the consequence of an unlikely event is poor.

We also trained for several months. Our longest training hike was 9 hours and over 20 miles with 6,000 feet of elevation gain. When we were in Kenya our longest day up was only 4 hours. We don’t regret our seemingly over-training at all because the training hikes were still very enjoyable even though they may not have been strictly necessary.

Translation for preparing for retirement: If you make your preparation enjoyable, working more years than strictly necessary isn’t a waste.

Help From a Guide

We hired a guide. We learned the Swahili word polepole from our guide. The guide helped us navigate.

We met two guys from Colorado at the top hut. They didn’t have a guide. They got on the second highest peak the day before but they weren’t able to go to the highest peak even though it was only 400 yards away in distance and 10 yards higher in elevation. They failed because they ran out of time after getting lost in finding the start of the route and getting lost again on the way up. Getting a little lost and finding your way can be a small adventure, but getting seriously lost at high elevation can have very bad consequences.

Our guide isn’t necessarily a more capable climber but he knows the way. That made all the difference.

Translation for personal finance: There’s no shame in getting help when you need it. Machismo has its limits.

Say No To Management Fees

If an advisor is charging you a percentage of your assets, you are paying 5-10x too much. Learn how to find an independent advisor, pay for advice, and only the advice: Find Advice-Only.

Polepole: Anti-FOMO In Preparing for Retirement is copyrighted material from The Finance Buff. All rights reserved.

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When you have a joint account, each person on the account can transact with the account. As part of our estate planning package, my wife and I created a trust, with both of us as co-trustees (see Will and Trust Through Employer Legal Plan). We stated in the trust that each trustee can act alone. However, our IRAs and HSAs can only be in our individual names. It’s not possible to have a joint IRA or a joint HSA. We can name beneficiaries, but the beneficiaries only become relevant after the owner dies. When you are alive, a spouse does not have any authority over your IRA or your HSA unless you grant some permissions.

We also executed a Durable Power of Attorney in our estate planning package. We granted the authority to act on behalf of each other in case we are not able to act ourselves. However, we also learned that financial institutions often don’t recognize these broad Powers of Attorney. They want the signatures and the language on their own forms. It’ll be a bummer when you really need to use the Durable Power of Attorney, you are only told by the financial institution they don’t accept it. If you’d like to be prepared, it’s better to sign the forms required by your financial institutions before you need a family member to act on your behalf.

Vanguard

We have IRAs with Vanguard. Vanguard has a process for authorizing another person to act on your behalf over your accounts. They call it agent authorization.

On Vanguard.com, click on Forms, and then look for Account Access.

You can give another person Information-Only access or you can make another person a Limited Agent or a Full Agent. Someone with Information-Only access can’t make any changes. A Limited Agent can:

  • view your account balances and transaction history
  • make transactions within your account
  • withdraw from your account to your own linked bank account or have a check issued in your own name

A Full Agent can do everything a limited agent does, plus:

  • change your address or bank account
  • change your beneficiary
  • withdraw from your account to any bank account or have a check issued in any name
  • open new account in your name or close your account
  • convert assets from traditional IRA to Roth IRA

When you follow the process, you tell Vanguard the name, address, Social Security number, email address, etc. of the agent, whether you want the person to be a limited agent or a full agent, and for a limited agent, which account(s) the agent is authorized for. The agent will receive an email from Vanguard to confirm that he or she will accept the authorization. Once the agent confirms, the authorization becomes effective. If the agent has a user name on Vanguard.com, the agent will see additional accounts listed when he or she logs in.

If two of you would like to make each other an agent, you will have to go through the process separately from each direction. Person A makes Person B an agent and Person B makes Person A an agent.

Fidelity

We also have IRAs and HSAs at Fidelity. Fidelity also has a similar process. They have four levels of access (follow the link to start the process to give access to your accounts).

Inquiry Access is view-only. The person with Inquiry Access can see your account balance and history but can’t transact or make any changes.

A person with Limited Authority can trade but can’t withdraw from your account, make IRA contributions, or convert assets from a Traditional IRA to a Roth IRA.

A person with Full Authority can trade, withdraw from your account, and initiate IRA contributions, recharacterizations, and Roth conversions.

A person with Power of Attorney can do everything plus account maintenance tasks on your behalf. Granting Power of Attorney requires notarized signatures.

Similar to Vanguard, Fidelity will also send an email to the person receiving the access permissions. The access becomes effective only after the person accepts the access. Once accepted, the person who received access will see additional accounts listed when he or she logs in to Fidelity.com. The additional accounts will be under a separate account group. You can customize the display name of each account to something that makes more sense to you.

If two of you would like to give access to each other, you will have to go through the process separately from each direction. Person A gives access to Person B and Person B gives access to Person A.

Limited or Full?

You have the choice to give only limited access or full access. Because we already signed broad Durable Power of Attorney we are comfortable with letting each other do everything. We chose Full Agent/Full Authority.

Revoking Access

The person who gave access can revoke the permissions at any time. If you change your mind you just follow the same process to revoke access to your accounts.

No Sharing User Name and Password

Going through the official process of giving permissions is the right way to do it. Sharing your user name and password with another person can weaken your protection from the financial institution. It can also put the other person in a position that he or she can be accused of identity theft or hacking. After you grant access, each person should log in with their own user name and password.

Trusted Contacts

In light of elder financial abuse or scams, new regulations require financial institutions to offer the ability to designate trusted contacts. When they suspect a customer is being scammed or the customer has displayed diminished mental capacity, they will contact the trusted contact(s) to make sure the transactions are legit or alert the trusted contacts potential issues.

Adding a trusted contact by itself does not give the trusted contact any permission to access the account but it can be used in conjunction with account access permissions. For instance if an elderly parent adds an adult child as the trusted contact in addition to giving the adult child permission to view the accounts, the adult child can monitor the parent’s accounts and receive alerts from the financial institution for suspicious activities. Of course the parent has to add trusted contacts before getting scammed or experiencing reduced mental capacity.

To add trusted contacts:

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If an advisor is charging you a percentage of your assets, you are paying 5-10x too much. Learn how to find an independent advisor, pay for advice, and only the advice: Find Advice-Only.

Authorize A Family Member To Access Your Accounts is copyrighted material from The Finance Buff. All rights reserved.

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Most financial articles are written for people with higher incomes, because people with more discretionary income naturally want to know what to do with their discretionary money. However, people with modest incomes actually have more need for advice. People with higher incomes will do fine either way, while even a slight improvement will make a big difference to people with modest incomes. Unfortunately, the right moves for people with higher incomes are often exactly the wrong moves for people with modest incomes. When you read an article, you really have to know whom it’s for.

For instance, when it comes to saving for retirement, a typical rule of thumb is that when you are in a low tax bracket, you should use Roth accounts. The thinking is when you don’t pay much tax anyway, you might as well pay the tax now and make your retirement withdrawals tax free. Except it doesn’t apply to people with modest incomes, especially those with kids.

Why? Because being in a low tax bracket doesn’t mean you have a low marginal tax rate when you receive tax credits linked to your income. When you lose tax credits as your income goes up, you face a much higher marginal tax rate than just the tax bracket indicates.

I will give three examples. All calculations are done with H&R Block 2018 tax software.

Single, No Child

Tim is single, with no child. He makes $21,000 from his job. He decides to save 10% of his income for retirement. His employer matches contributions to the 401k plan. If he saves $2,000 in the company’s 401k, should he go with Traditional 401k or Roth 401k?

Assuming Tim has no other income or deductions, if he goes with Roth 401k, after the standard deduction of $12,000, Tim’s taxable income is only $9,000. He’s in the 10% tax bracket. His federal income tax will be $903 (not exactly 10% of $9,000 due to tax table lookup). He also qualifies for $200 Saver’s Credit. The net total will be $703.

If Tim contributes $2,000 to Traditional 401k, his W-2 income becomes $19,000. After the same standard deduction of $12,000, his taxable income is $7,000. His federal income tax will be $703. But, because his AGI is now $19,000 as opposed to $21,000, it goes into the 50% tier for the Saver’s Credit. He will qualify for $1,000 in Saver’s Credit but because the credit is non-refundable, it’s reduced to $703, which makes him pay net $0.

$2,000 to Roth 401k $2,000 to Traditional 401k
Gross $21,000 $21,000
W-2 $21,000 $19,000
Taxable income $9,000 $7,000
Tax before credits $903 $703
Saver’s Credit $200 $703
Net after credits $703 $0
Traditional Advantage $703

Saving $2,000 in Traditional 401k as opposed to Roth 401k gives Tim $703 in tax savings. That’s 35%, far higher than the 10% tax bracket. The extra 25% comes from qualifying for additional Saver’s Credit.

Single Parent, One Child

Jen is a single parent with one child. She files taxes as Head of Household. Jen makes $32,000 from her job. Her employer matches 401k contributions up to 6% of pay. Jen knows she should contribute to get the full match. When she contributes $2,000, should she go with Traditional 401k or Roth 401k?

The standard deduction for Head of Household is higher than that for Single. If Jen contributes to Roth 401k, assuming she has no other income or deductions, her taxable income is $14,000, which is barely in the 12% tax bracket. She receives $200 in Saver’s Credit. With one child, she gets $2,000 in Child Tax Credit (CTC) and Additional Child Tax Credit (ACTC). She also qualifies for $1,325 in Earned Income Tax Credit (EITC). All told, she will receive $2,114 in net tax refund.

However, if she contributes $2,000 to Traditional 401k, her W-2 income becomes $30,000. Her taxable income is $12,000 after the $18,000 standard deduction, which puts her in the 10% tax bracket. Her Saver’s Credit goes up to $400. She still receives $2,000 in Child Tax Credit (CTC) and Additional Child Tax Credit (ACTC). Her Earned Income Tax Credit (EITC) goes up to $1,645. Altogether, she will receive $2,842 in net tax refund.

$2,000 to Roth 401k $2,000 to Traditional 401k
Gross $32,000 $32,000
W-2 $32,000 $30,000
Taxable income $14,000 $12,000
Tax before credits $1,411 $1,203
Saver’s Credit $200 $400
Child Tax Credit and Additional Child Tax Credit $2,000 $2,000
Earned Income Tax Credit $1,325 $1,645
Net after credits -$2,114 -$2,842
Traditional Advantage $728

Saving $2,000 in Traditional 401k as opposed to Roth 401k gives Jen extra $728. That’s a gain of 36%, also far higher than the 10% or 12% tax bracket. That 36% is broken down into 10% in regular tax, 10% in Saver’s Credit, and 16% in Earned Income Tax Credit.

Married Filing Jointly, Two Kids

Mike and Lori are a a married couple with two kids, ages 5 and 2. Mike makes $42,000 from his job. Lori stays at home and takes care of the kids. Mike’s employer matches 401k contributions. When Mike contributes $2,000 to the 401k, should he go with Traditional 401k or Roth 401k?

If Mike contributes to Roth 401k, assuming they have no other income or deductions, after the $24,000 standard deduction, their taxable income is $18,000. That’s in the 10% tax bracket. With their $42,000 AGI,  they will receive $200 in Saver’s Credit. With two kids, they get $4,000 in Child Tax Credit (CTC) and Additional Child Tax Credit (ACTC). They also qualify for $1,994 in Earned Income Tax Credit (EITC). Altogether, Mike and Lori will receive $4,391 in net tax refund.

However, if Mike contributes $2,000 to Traditional 401k, his W-2 income becomes $40,000. Their taxable income is $16,000 after the standard deduction. Their Saver’s Credit goes up to $400. They still receive $4,000 in Child Tax Credit (CTC) and Additional Child Tax Credit (ACTC). Their Earned Income Tax Credit (EITC) goes up to $2,415. Altogether, they will receive $5,212 in net tax refund.

$2,000 to Roth 401k $2,000 to Traditional 401k
Gross $42,000 $42,000
W-2 $42,000 $40,000
Taxable income $18,000 $16,000
Tax before credits $1,803 $1,603
Saver’s Credit $200 $400
Child Tax Credit and Additional Child Tax Credit $4,000 $4,000
Earned Income Tax Credit $1,994 $2,415
Net after credits -$4,391 -$5,212
Traditional Advantage $821

Saving $2,000 in Traditional 401k as opposed to Roth 401k gives Mike and Lori extra $821. That’s a gain of 41%, also far higher than their 10% tax bracket. The 41% is broken down into 10% in regular tax, 10% in Saver’s Credit, and 21% in Earned Income Tax Credit.

Conclusion

The three examples here showed that the tax bracket is far from the full story when someone also receives tax credits. I only included the effect of the Saver’s Credit and the Earned Income Tax Credit (EITC). If they also get health insurance from the Affordable Care Act marketplace, their Premium Tax Credit (aka the Obamacare subsidy) also changes with their income. If they contribute to a Traditional 401k, they will increase their Premium Tax Credit by another 15% or so of the contribution. The total increase in tax credits can be well over 50% of the contribution.

Gaining extra tax credits from lowering income that’s already modest gives a big advantage to saving in a Traditional 401k. With one child, EITC alone increases at 16% for each dollar removed from the W-2. With two or more kids, EITC increases at 21%. If you receive EITC or the ACA subsidy, you should contribute to Traditional 401k, not to Roth 401k.

Say No To Management Fees

If an advisor is charging you a percentage of your assets, you are paying 5-10x too much. Learn how to find an independent advisor, pay for advice, and only the advice: Find Advice-Only.

Receive EITC, Contribute to Traditional 401k Not Roth 401k is copyrighted material from The Finance Buff. All rights reserved.

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