Retirement Answers

Jacob: 00:00

Well, hey there, everybody, and welcome back to another episode of the Retirement Answers podcast. My name is Jacob Duke. I'm so excited that you're here. And today, I've got a a really good, episode and show for you. We're talking about kinda all things taxes, primarily around four zero one k's, Roth conversions, and capital losses, like, in an investment account.

Jacob: 00:19

So we're kinda focusing on taxes today, but I've got three questions that have come across my desk recently that I think would be helpful just to share some ideas and knowledge around. So I'm just gonna go ahead and get started. The first question I got is I have a large four zero one k that I started over forty years ago back when I started working. When I start taking money from that account, that will be taxed as capital gains. Right?

Jacob: 00:39

And so that's the question I received. This is a very common misunderstanding. The first thing you need to know is that all distributions from a tax deferred retirement account, whether that's an IRA or a four zero one k, if it's tax deferred, all of that income, whatever you take from it, is counted as normal income and will be taxed as such. Those account types, 401ks, 403bs, TSPs, any retirement account, IRAs, they do not receive capital gains treatment. Things like investment accounts, trust accounts, and then also real estate are eligible for capital gains treatment.

Jacob: 01:12

But if you think about it, you know, if you took a income tax deduction whenever you added money to that account back as you grew through your career, so you added money to your four zero one k, therefore, it was not counted as income in the year in which you earned that income. You simply just deferred that income into the future. So you're gonna have to pay that income tax at some point. It's just a matter of when. And so the way that works is is if you took the tax deduction whenever you put money into that four zero one k or IRA, whenever you take money from that in the future, you're gonna pay income tax on it at that point.

Jacob: 01:43

Now if tax rates are higher, that's worse for you. But if tax rates are lower, that's good for you. Now one thing to be clear here is the the tax brackets could be all over the board. They could be higher or they could be lower than they are right now today, but your effective tax rate could be higher or lower regardless of whatever the tax brackets are. Right?

Jacob: 02:02

Because if your income is low enough in retirement and you're pulling money from your four zero one k and the tax bracket you're in is at 10 or 15%, that could still be lower than what you would have paid on that contribution had you not contributed to your four zero one k while you were working. Right? Because you could have been in a 20 or 25% tax bracket at that point. So it still might be advantageous in the future, even if tax bracket rates are higher. Just because the rates are, might be higher in the future does not mean that your tax rate will be higher.

Jacob: 02:29

So it's something to pay attention to there, but everything that you pull from a traditional or tax deferred account, like a four zero one ks, four zero three b, an IRA will be taxed as normal income. Therefore, you do not receive capital gains treatment. And this is one of the things that I think is a super, super big downfall or negative of those tax deferred accounts is number one, you know, anytime you take money from them, that's gonna be taxed as normal income. So it just falls on your income tax return as normal income. Therefore, it's taxed at whatever rate.

Jacob: 02:58

And, also, you will have to begin taking money from those because of RMDs in the future. So it's kind of like this ticking time bomb, if you will. And so kinda planning for that, different episode for a different day, but kinda planning for your taxes around your tax deferred accounts is a huge deal and making sure that you do that correctly. Alright. So let's go ahead and jump to the second question.

Jacob: 03:18

It's, around Roth conversions, and they asked, how should I pay taxes on my Roth conversions? So this is a really good question because there's, I believe one distinct answer that is far and away better. Now, this does not mean that everybody can do this. So in a perfect world, you would want to pay the taxes on your Roth conversions from cash. So that's cash sitting in the bank or cash sitting in an investment account, basically money that you can access without paying much or any taxes.

Jacob: 03:46

Right? So cash is one of those assets. You're not gonna pay tax on that just to take it from your bank account and then move it into pay taxes with it. Another option instead of paying Roth conversion taxes from cash is to pay those taxes out of your IRA at the same time as your conversion. Right?

Jacob: 04:02

So that's one way of doing it is you could do it that way. That's typically not gonna be the best way because if you think about it, if you've got $100,000 in your IRA and you do a $100,000 conversion to move that to your Roth and you need to pay taxes out of that 100,000, let's say it's a 20% tax rate, now you went from having 100,000 invested, now you have 80,000 invested over in your Roth. So it's gonna take you that much longer to recoup some of those tax payments, and you would be hurting yourself in some sense because you would not be growing as much in that Roth account, which is tax free. So that's the main thing to know is if you can pay your taxes from cash, and this goes back to one of the biggest things that I think people can do as they get close to retirement is build up the amount of cash you have. It gives you so much flexibility, especially from a Roth conversion or tax paying standpoint, is you if you can build up cash as you in the last five to ten years as you near retirement, what you can do then is you can have an ample resource to pull from to pay taxes on your Roth conversions rather than having to pay your conversions out of your IRA account, which means you're gonna have less going into your Roth, then you're also gonna have to have a larger distribution from your IRA just to cover the taxes.

Jacob: 05:14

So it's kind of like a, it's kinda like a snowball effect whenever you have to pay taxes from your IRA. Doesn't mean it's not beneficial. It just means that the benefit of it is reduced by a pretty large margin. So if you can pay taxes from cash, that is the best way to go. Now something I want to be clear here and kinda remind you of so that you're careful is that if you are under age 59.5, you can pay taxes out of your IRA account for the Roth conversion.

Jacob: 05:41

I would probably recommend not doing that because if you're under age 59.5, the tax withholding is counted as an early distribution. Okay? The Roth conversion itself is not, but the tax withholding is. So if you're under age 59.5 and you're gonna do a Roth conversion, it almost makes sense to only do that Roth conversion if you have the cash to pay the taxes with. You don't wanna have to do the conversion and then also have to withhold taxes if you're under age 59.5 because what you'll do is you'll have to pay tax on that withholding from your IRA, but then also you'll have to pay an additional 10% penalty because you have an early distribution.

Jacob: 06:15

So if you're under age 59.5, something to be aware of there, but if you're over 59.5, you are good to go. You can withhold those taxes from your IRA without having that additional 10% penalty. Alright. And so the final question I had for you today that I wanted to answer since we are kinda in the middle of tax season right now and everybody's kinda thinking about that is, can I use capital losses to offset dividends that I earned last year? And this is a question around a taxable investment account or perhaps a trust account, anything that's not a retirement account where the taxes flow into your $10.40 every single year.

Jacob: 06:46

If you have capital losses, those cannot offset dividends technically. You can't say, hey. If I earn 10,000 of dividends and then I also have 10,000 of potential capital losses, should I realize those losses and then therefore they're awash, therefore I'm gonna pay no taxes? It doesn't work that way. You can't offset a capital loss from selling an asset with the dividends that those assets generated.

Jacob: 07:10

They're they're viewed differently in the IRS's perspective. Now, one caveat to that is no matter what, in any given year, you can use capital losses up to $3,000 to offset any normal income. K? So in that example I just gave, if you had $10,000 of dividends and then you had $10,000 of capital losses, technically, you can only use 3,000 of the capital losses to offset 10,000 of the dividends. So that leaves you with a a net of $7,000 of dividends total.

Jacob: 07:40

And then you would be able to take your capital losses and use those over the subsequent and following years. You can do that 3,000 year after year. Those capital losses do not go away. You can continue to use those in perpetuities until they run out. So that's something to be aware of.

Jacob: 07:56

A lot of people think you can do some tax, planning, if you will, or some tax loss harvesting to offset dividends. You can't do it per se. There is a rule that allows you to do up to $3,000 of capital losses to offset any type of income. And so that's how you would be able to do that. You can't do it a one for one across the board at any amount.

Jacob: 08:15

So, just something to be aware of there as you kinda go through tax season and begin to navigate some of that stuff. But I hope that these are kinda some helpful ideas and tips around some of these questions that I've recently gotten, hopefully, to help you. If you have questions, feel free to send them to me. Happy to answer them on the show here and help everybody out by answering those. Once again, I appreciate you being here so much.

Jacob: 08:34

My name is Jacob Duke, and, this has been another episode of Retirement Answers. I will see you next week.