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Ali Mogharabi: CEO and co-founder of Facebook Mark Zuckerberg testified in front of Congress yesterday and answered questions about the latest data breach issue that involved Cambridge Analytica.
While this recent development may have brought forth further doubts regarding Facebook and its user growth and engagement, along with more demand for a GDPR-type of regulation in the U.S., we're still confident that the firm is more likely to endure the short-term impact of the data breach issue and at this point don't expect a significant long-term negative effect on Facebook's platform and operations. We are sticking with our wide-moat rating and $198 fair value estimate for Facebook.
Zuckerberg clearly admitted to mistakes and took responsibility. He also said that the firm will be increasing resources to investigate apps and take appropriate actions. Facebook will be using AI technology to identify questionable activities and content posted. The firm also plans to assign around 20,000 people to work on security and content.
Zuckerberg also appeared willing to work with lawmakers on possible regulations, which we think may actually create a barrier to entry in the social network space and help Facebook maintain its market leadership.
Overall, the testimony didn't really change our view and valuation on the company. We're still rating Facebook as a wide-moat and valuing it at $198 per share.
Vishnu Lekraj: Today, we are highlighting McKesson. It's one of the most powerful players on the global pharmaceutical supply chain. The company specializes in bringing in brain drugs from overseas and domestically to the end consumer retail pharmacies. It can do this at a more efficient pace and a more cost-effective level than many of its clients can on their own.
The company has a wide economic moat and has come under pressure here recently because of the drug pricing issues and headlines that have put the onus on middlemen who distribute drugs in the U.S. However, we believe many of these concerns and many of these issues are overblown, and McKesson's stellar position as one of the most powerful players within the pharmaceutical market today positions it well for long term. Combining this with its undervalued stock makes it one of the best ideas here at Morningstar.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. With the new tax laws there's lots of confusion about the deductibility of home mortgage and home equity loan interest. Joining me to discuss this topic and clear up the confusion is Michael Kitces. He is a financial planning expert.
Michael, thank you so much for being here.
Michael Kitces: Absolutely. Thanks for having me.
Benz: I want to discuss home mortgage interest and the deductibility of mortgage interest and home equity loan deductibility. Let's start with what's changing with the tax laws that are going into effect with the 2018 tax year.
Kitces: The Tax Cuts and Jobs Act that passed last December made some fairly sudden changes about tax deductibility of mortgage interest, kicked in immediately for this year. We are a few months into the year, the rules are already in effect. At a high level, there were two changes.
The first is, we've had for many, many years a limit that said you can deduct the mortgage interest from the $1 million worth of debt principal. We're pulling that number down, from $1 million down to $750,000. If you have an existing mortgage that was over the $750,000 limit, you can still go up to $1 million. If you refinanced an old mortgage that was over the $750,000 limit, you still get to keep it at $1 million. But any new mortgages going forward, actually all the way back to mid-December since the law was passed, we have a debt limit now that's $750,000 instead of $1 million.
The second change that we made is for the deductibility of interest for home equity debt. The rules changes there were a little bit more harsh. It simply says, all that interest on home equity indebtedness--no longer deductible. No grandfathering, no if I have the existing home equity loan, can I still deduct the interest on the payments. Just flat out effective 2018 no more deductibility for home equity indebtedness. That's gone.
Benz: There's this concept of home acquisition indebtedness versus home equity indebtedness. Let's talk about the difference and why it's important. It depends on what you are using the money for.
Kitces: There has been a lot of confusion around this. This difference between money we use to buy our house and home equity loans isn't actually new to Tax Cuts and Jobs Act. We already had a couple of rules around this. The old rule said, you could normally deduct the mortgage interest up to $1 million; you could deduct home equity loans for $100,000 of debt; there were some special AMT adjustments that applied to the home equity debt but not the rest of the mortgages. We've actually had this separation for a while.
But the confusion that crops up is, it's not actually based on what the bank calls the loan; although traditional mortgages are fully deductible but HELOCs--home equity lines of credit or home equity loans--are not.
As far as the tax code is concerned, the deductibility of the mortgage is based on how you use the money. What do you do with the proceeds of the mortgage? If you use the money to acquire, build, or substantially improve a primary residence that's secured by that mortgage--you borrow money against it and you use it to buy, acquire it, build it, or improve it--it's deductible with that--used to be $1 million--now $750,000 limit.
Any money you borrow against the residence and use for essentially any reason except acquire, build, substantially improve, is treated as home equity indebtedness and now is no longer deductible. The reason why that distinction matters around use is, it means if I take out a HELOC and I use it to build a new room and an addition on my house, that's actually still fully deductible mortgage interest today …
Benz: That's a substantial improvement.
Kitces: It's a substantial improvement. It falls under the $750,000 category. I've still got an aggregate debt limit. I've got a $500,000 mortgage already. I do a $50,000 home equity line of credit, and I do it to do a substantial renovation on my home. I've now got a $550,000 mortgage balance--all of that is deductible, even though part of it is a traditional mortgage and part of it is a HELOC, because I used all the money for--the category is called acquisition indebtedness, but it's acquire or build or substantially improve.
On the flip side, if I take out that HELOC and I use it to send my kids to college, buy a car, or refinance some other debt, I don't use it for anything in the acquisition category, now, it's not deductible debt. My HELOC may or may not be deductible depending on how I use the money, and even my traditional mortgage may or may not be deductible. Classically, when I take out a mortgage, I borrow the money to buy the house, so that's still fine. We do live in a world where thankfully real estate is appreciating again, at least in most areas, people are building equity. It's not uncommon for people to go and do a cash out refinance. I've got a 30-year mortgage with $500,000, I do a cash out refinance for $550,000 and then I take the $50,000, and I send my kids to college and do a little bit of credit card refinancing. That $50,000 excess is now home equity indebtedness. It's a traditional 30-year mortgage, but if I didn't use the money for the acquire, build, or substantially improve category, it's now treated as home equity indebtedness and I literally have like a split loan. The balance is $550,000. I make my monthly payments. But $500,000 of it is acquisition indebtedness, the last $50,000 is nondeductible indebtedness.
Benz: Let's discuss how this should affect how people approach these issues from a practical standpoint. Say someone has home equity debt on their books that they may be used to pay for college or to pay off credit cards or whatever. Does that mean that they should accelerate the payment of that debt because they are not getting a tax break for that any longer?
Kitces: We are not necessarily telling people, now that your home equity loan isn't deductible, you just got to pay that off and get rid of it. Mortgage debt is still a pretty compelling low rate these days, certainly compared to where we've been in the past. It does mean, like, we don't look at it and say, I'm borrowing at 4%, but my tax rate is about 25%, so I get the deductions, so the net cost is really 3%. No, if you borrow at 4%, your rate is 4%. It's not 4% minus the tax break. It's 4%. 4% is not a horrible rate, even plus a little as rates start creeping up. I think, we will still see a lot of people that are comfortable keeping the debt.
We still have clients that we work with where we are going through discussions and saying, this debt isn't deductible anymore, but it's still a compelling rate. We've got cash we are using for other purposes. I'm not going to do a big liquidation of a portfolio just to pay off a loan that's still at 4% because that might be a pretty good rate for them. But it is bringing a fresh look to the conversation when we say, this debt may not be deductible anymore, either a portion of it or all of it depending on what you've been doing with your borrowing into the house over time. We can't just throw it all in one bucket and say, all that mortgage stuff we get all these tax breaks with it. It's a much more nuanced question now about whether or how much tax benefit you are actually getting from a mortgage.
Benz: Another question is, I could see a profile, I think, it's common among some of our readers and users, would be the person who is approaching retirement maybe has some liquidity on hand because they are getting ready to retire. They plan to stay in their home, and say they have like $100,000 left on the mortgage. Does this sort of embellish the case for potentially prepaying the mortgage that they are not necessarily gaining that much from holding on to that debt, and that could improve their overall household balance sheet?
Kitces: It is a conversation now that we've been having more over the first few months of the year. At the end of the day, frankly, we have never been in the camp of saying, you should have a mortgage for a tax deduction and doing it for that reason alone. At the end of the day, by definition, the tax deduction is a portion of your interest. You are still paying interest. They give you a little bit of tax benefit against the interest. 4% minus 1% is a net cost of 3%. But you are still paying 3%. If you don't want the debt and you don't want the payments and you are not invested in a way that's beating 3%, you should still pay off the debt.
The fact that the rate 3% is not 3% now; it's 4%, because we lose the tax benefit, it's still kind of the same calculus. What else should we be doing with the money; do we have alternatives that are compelling at a higher prospective rate of return than just getting essentially a guaranteed return of 4% by paying off the debt at 4%.
For a lot of clients, we are not seeing, it was a slam dunk to keep my mortgage at 3%, but at 4%, now it's off. The numbers haven't moved that much just for the change in tax treatment. We are seeing more conversations of, we were doing it, maybe tax deduction was at least in the mix as a part of the reason why we were doing it, and now the tax deduction isn't on the table or it's less or the last 100,000 is still there and it's technically deductible, but maybe we'll just pay it off and then we'll borrow it back later if we need to, is entering in the equation a little more.
If I just have a good old traditional amortizing mortgage, I've been paying on it all along, your $100,000 balance is still deductible. Nothing has actually changed. But people who have borrowed against the house and built up debt over time and added to it, now have all these split loans, and that's really where we are seeing the biggest discussion of, do I want to hold on to it. A tax rate savings on a low interest-rate mortgage, usually the tax deduction alone doesn't solely drive the outcome. But it is, I think, making people a little bit more cognizant of, well, if we just take the tax benefit off the table, now, do you really want to actually this mortgage in retirement or not, and taking a fresh look at that.
Benz: Another issue is this idea of carrying some home equity line of credit as a source of emergency funding. In the past, I know that that was kind of a standard prescription for homeowners as a way to protect themselves against emergency cash needs. Would you say that's still the case?
Kitces: We're still a fan of keeping home equity lines of credit in place just as something that's available. Again, it's not like we ever went to someone to said, hey, you need to borrow some money, you should take it all against your house because you get a little tax deduction. You take it out because you need to borrow the money for something, and if we need to borrow the money and we don't have a lot of other sources of liquidity, really thankful we've got that home equity line of credit in place. That to me is as relevant as ever. We needed some emergency funds, it's helpful to have another source of liquidity. Borrowing against equity and a home is a good way to do it.
I suspect we may actually use it a little bit less often because the rates are a little bit higher when we don't get the tax benefits associated with it. But the idea of having an available, an open and frankly, praying we will never actually need to use it, I think it's still as relevant today as it was in the past. When we get to the moment, maybe you'll decide since the interest isn't deductible you want to go somewhere else. But when our HELOCs are a couple of percent and our credit cards are in the teens, tax deduction or not, often still a compelling option to borrow money if we need to borrow money for some purpose.
Benz: Lots to talk about here, but it sounds like this is a classic case of not letting the tax tail wag the dog. Put the other considerations first before you consider …
Kitces: Correct. And we would have argued for doing that in the first place, but there's nothing like losing some of the tax breaks to have a little bit of a reminder of, let's just recognize that a mortgage first and foremost is a debt with some interest payments. They are relatively low interest payments, there are some nice terms about it, it's not the worst place to borrow if you need to. But it's a debt with interest, first and foremost. Does it make sense for that purpose? And then let's see if we get a little bit of tax breaks that go along with it.
Benz: Makes sense to me. Michael, thank you so much for being here.
Kitces: Absolutely. Thank you.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.
Jeremy Glaser: Target-date funds could be a great all-in-one, hands-off option for investors saving for retirement. But not all target-date series are created equally. From fees to the mix of asset classes it owns to how that mix changes over time, there could be a lot to consider. We asked our analysts to share three of their favorite series.
Jeff Holt: The BlackRock LifePath Index target date funds are a solid choice for investors looking for an all-in-one solution for their retirement savings. While the funds have only been around since 2011, BlackRock's history with target-date funds goes back to the 1990s. And while these funds might be considered passive because they invest in index funds and ETFs, BlackRock has consistently applied a research-driven, proactive approach in designing the glide path and in selecting these underlying asset classes for the funds.
For instance, BlackRock has well-documented rationale on the reasoning behind not shifting the portfolios once they hit their target date as well as behind the decisions to exclude certain asset classes from the underlying mix such as foreign bonds and high-yield bonds. Plus, the funds come at a low cost which is appealing to foreign investors and all of this makes it a good target-date series. All these attributes make the BlackRock LifePath Index funds a solid choice for investors.
Leo Acheson: JPMorgan SmartRetirement target-date series is a top-rated option in our view. In fact, it's the only Gold-rated plan that invests exclusively in actively managed underlying funds. We think that the series hits the mark on a number of fronts. First of all, the management team is very tenured, with Anne Lester and Dan Oldroyd serving at the helm since its 2006 inception. They are also supported by a very broad group of more than 80 investment professionals in the multi-asset group.
Additionally, their process is strong on a number of fronts. For instance, their strategic asset allocation remains robust and has been consistent over time. Their manager selection process is very thoughtful. In fact, they won't hesitate to fire one of their own managers when they deem it's appropriate. Additionally, their tactical allocation process has been in place for over 15 years and they have proven an ability to add value in the majority of those years. Overall, the fund has actually improved during the last year as it has lowered fees and some of the underlying funds were upgraded by Morningstar analysts. Performance has been stellar, and overall, we think that the fund will continue to be a great option for investors.
Heather Larsen: The Gold-rated Vanguard Target Retirement Series is an excellent choice for investors as it provides a well-diversified asset class mix that will help investors reach their long-term retirement goals. While the series' glide path hews close to the industry norm, it's subasset class exposure represents one of the most globally diverse in the industry. International equities account for about 40% of the series' underlying equity exposure, while 30% of the bond portfolio is stashed abroad. A lean set of passively managed index strategies makes up the serious underlying components.
Strong oversight for this series is provided Vanguard Strategic Asset Allocation Committee which includes senior level executives at the firm like Vanguard's chief economist. The Committee is responsible for all decisions relating to this series' glide path construction, asset allocation, and underlying fund selection.
Finally, low costs here provide an enduring head start against the competition. This series investor share class costs 13 to 15 basis points which ranks among the cheapest in the industry.
David Kathman: Real estate mutual funds have had a rough time lately. They lost almost 7% on average in the first quarter of 2018, which was one of the worst returns of any Morningstar category. Anticipation of higher interest rates is one big reason for that, since REITs tend to be rate-sensitive, and also retail REITs have been hammered by the threat of online retail.
This kind of short-term bump in the road isn't a good reason for investors to jump ship, though, because these funds can play an important role in diversifying a portfolio, given that real estate tends not to be very highly correlated with the broader stock or bond markets. They can also be a decent source of income, since REITs have to pay out at least 90% of their profits as dividends.
REIT funds as a group have had a lot of ups and downs over the past decade, but the top funds in the category have been pretty consistent and solid. They include T. Rowe Price Real Estate, the one fund in the category with a Morningstar Analyst Rating of Gold; and Silver-rated Vanguard Real Estate Index, which is the top passive option.
Christine Benz: Hi, I'm Christine Benz from Morningstar.com. Vanguard's equity exchange traded funds have managed to be very tax-efficient so far, but will they always be? Joining me to discuss some research on this topic is Ben Johnson, he's director of global ETF research for Morningstar.
Ben, thank you so much for being here.
Ben Johnson: Thanks for having me Christine.
Benz: Ben, before we get into Vanguard specifically and its lineup of ETFs. I'd like to talk about equity exchange traded funds, why the broad market index trackers tend to be pretty tax-efficient investment vehicles.
Johnson: Generally speaking ETFs have two sources that drive their tax advantages. The first is not unique to the ETF structure, and it has to do with the fact that most ETFs track broad-based market-capitalization-weighted indexes. These indexes will have, say for example in the case of a U.S. Total Stock Market Index, a run rate of turnover around 3% to 5% per year. This low rate of turnover within the portfolio is really the bedrock of their tax efficiency, relative to actively managed mutual funds that might turnover 50%, 60%, 70% a year.
The other source of their tax advantage has to do with the ETF structure. The fact that as ETF shares are created, as ETF shares are redeemed, they take securities from a special breed of market-maker called an authorized participant and take into the portfolio say the stocks that make up the S&P 500 on an in-kind basis. When those shares are no longer needed in the market place and are ultimately destroyed, those shares are sent back out to that same authorized participant and then sold on the marketplace.
So, by virtue of purging the portfolio of those shares on an in-kind basis--which I should stress is a feature that's not unique to ETFs it's just far more commonplace relative to the same practice in traditional mutual funds--you are not unlocking any embedded capital gains that might be present in those securities. Strategy as represented by broad-based market-cap-weighted passive exposure to the market or a slice thereof, and the structural advantage of that in-kind creation to redemption underpin ETFs' tax efficiency.
Benz: That structural setup that you just referenced that stands in contrast to how it works if I have a traditional mutual fund and I want to sell some shares, maybe I am a big investor in that fund. The fund has to send me my cash and they may have to sell stuff in order to raise the cash to pay me back, right?
Johnson: That’s absolutely right. So more often than not when a mutual fund faces redemptions they'll follow exactly those steps by liquidating a portion of the portfolio to meet redemptions. And as has been the case, as we've seen over the course of recent years, is there have been large outflows from many funds. There have been mass liquidations and the unlocking and what has been, generally speaking, an upward trending market of sizable capital gains that have been distributed to those fund shareholders.
Benz: And we should say before we go any further. If I'm in an IRA or a 401(k) this discussion doesn't matter to me.
Johnson: It means nothing to you. This means something and is very meaningful to investors in a taxable setting.
Benz: Let's talk about Vanguard's setup for its exchange traded funds, they are share classes of its index funds. Let's talk about that structure and also the implications for tax management of those funds.
Johnson: Vanguard's ETF structure is unique and that, as you alluded to, it's a separate share class of their mutual funds. This has certain benefits to the extent that when the ETFs that are indeed structured in that manner were first launched, they had the benefit of the scale of the existing mutual fund, which was expressed chiefly in a very competitive price tag. They benefit from lower trading cost, given that the overall heft of the portfolio creates greater efficiencies with respect to trading in the securities and just the day-to-day portfolio management function.
Now that said, because they are just a separate sleeve, a separate share class of the fund, they will, in the event of any taxable capital gains, take their fair share of those taxable capital gains distributions, which is a risk that is unique to this particular structure that isn't present in the case of standalone ETFs.
Benz: Let's walk through that, say it's a big index fund, a big Vanguard index fund, and for whatever reason investors begin to redeem heavily the traditional index fund. You are saying because of that setup even though if I am situated over here in the ETF share class that could still affect me.
Johnson: That could negatively affect ETF shareholders, the bad behavior, say a mass exodus from the admiral or the investor share class of a Vanguard mutual fund that also has an ETF share class--any gains that are unlocked by that behavior, that selling on behalf of shareholders of the mutual fund share classes will be shared pro rata with investors in the ETF share class.
Benz: You did an article on this topic for ETFInvestor. Let's talk about how realistic such a scenario is. Should this be something that Vanguard ETF investor should be worried about?
Johnson: It's something where I will say that, in the grand scheme of things, the probability of this risk manifesting is probably quite low. And the magnitude of any negative tax consequences, at least based on many Vanguard funds' historical track record, I would say is quite small. What would result in such a scenario is really the most important question. The circumstances that would have to sort of transpire would be large scale selling in a favorable market environment, such as we are in today. Why are we even talking about this, because there are some index funds that we've seen over the course of recent years that have seen their asset bases cut in half by such a mass exodus, by huge outflows in the midst of a bull market. The portfolio managers can try to do everything in their power to try to shield shareholders, ongoing shareholders from realizing taxable capital gains, but when your asset base is cut in half there is only so much you can do.
What is the probability of something similar happening in Vanguard funds? I would say it's really quite low, to be honest. Generally speaking what we've seen is that Vanguard investors tend to be somewhat better behaved than investors in other fund families. You also have to consider the channels via which their funds are distributed and take into account that in many cases these are funds that are a component of a target date portfolio, where we have documented very good behavior on behalf of investors largely because these portfolios--be they target date portfolios or the individual a la carte index mutual funds--are made available to investors through a defined contribution platform, where, generally speaking, we see better behavior than investors in other settings and other channels. The odds of a mass exodus among mutual fund shareholders I would argue are probably very low. Thus, I would say that potential for nasty tax surprises for ETF shareholders of those same funds is equally low.
Benz: Ben, you mentioned the in-kind redemption process that's available for ETFs. Does that help mitigate this problem potentially for Vanguard funds, for the ETF share class as well as potentially the traditional index funds?
Johnson: It absolutely does. Absolutely in the case of the ETF share class, but also as I mentioned before, important to keep in mind, that mutual funds can redeem in-kind as well. Vanguard retains the right and has executed the right historically in the case of potentially disruptive redemptions from the mutual fund share classes to meet those redemption requests on an in-kind basis, thus forgoing liquidation which would potentially unlock capital gains, and thus protecting ongoing shareholders from the negative tax consequences of any such liquidation. If you take, for example, the case of the Vanguard 500 Index ETF and go all the way back to 1999, which is the last time that that particular fund distributed a taxable capital gain, Vanguard exercised that right, did not completely shield shareholders from taxable capital gains but certainly mitigated the magnitude of that particular distribution which amounted to less than 1% of the fund's net asset value.
Benz: To take a step back say I am a taxable investor, and I am really concerned with limiting tax efficiency in my portfolio. How do I make smart choices here in terms of trying to find the investment that's going to do the best job of limiting these taxable capital gains distributions to me?
Johnson: A lot of it has to do with focusing on the traits that we discussed earlier: looking at turnover and looking at structure. The ETF structure is really quite powerful, and I think it's power to shield investors from negative tax events is actually best demonstrated by the fact that there are a number of ETFs that have had median turnover in excess of 100% now for five years running, that have yet to distribute a taxable capital gain to investors. That is the structural advantage of that format on display. Now if you want to mitigate the risk that’s present and unique to the Vanguard structure or at least just reduce the likelihood of such tax consequences. You can consider an ETF that's a standalone ETF that isn't structured--and all non-Vanguard ETFs are structured--as standalone ETFs that sit on their own, that haven't been bolted on to an existing fund. But again, I would stress that both the probability and the magnitude of negative tax consequences for investors in Vanguard ETFs is really quite low.
Benz: A related issue is that if someone is watching this and maybe inclined to say, I am a little spooked by my Vanguard ETFs, you probably have an embedded gain in that holding anyway. Before you switch into something else, be careful there.
Johnson: That’s absolutely right. I would stress too, and we’ve had conversations about this in the past, is that as this field becomes increasingly competitive, these fears are more often than not being fanned by Vanguard's competitors that are trying to poke holes in their product because their products are so substantially similar in so many different ways, that they are splitting hairs that have already been split two or three times.
Benz: Great insight, Ben. Thank you so much for being here.
Johnson: Thanks for having me.
Benz: Thanks for watching. I'm Christine Benz from Morningstar.com.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Investors have until April 17 to make an IRA contribution for the 2017 tax year. Joining me via Skype to discuss some IRA contribution mistakes to avoid is the IRA expert himself, Ed Slott.
Ed, thank you so much for being here.
Ed Slott: Great to be here.
Benz: We are hurtling toward this April 17 deadline for IRA contributions for the 2017 tax year. I want to tackle with you, Ed, some contribution mistakes to avoid as the deadline draws close. Let's start with the one that's at the top of the list. This April 17 deadline, it's coming up upon us. What do extensions have to do with this deadline, if anything?
Slott: That's the big mistake. Absolutely nothing. It's one of the few areas in the tax code that an extension won't help you. If you have an extension for your regular tax return, there is no extension on the April 17 this year, a due date for making an IRA or Roth IRA contribution for the prior year, being 2017. This April 17, whether you are on extension or not, is the drop-dead due date for making an IRA or Roth contribution for 2017.
Benz: Time's a wasting on that one. Another thing you say that people sometimes get confused about is needing to have earned income in order to make an IRA contribution. Let's talk about that one.
Slott: People think you can just put anything in a Roth IRA or an IRA. There are qualifying factors. One of them is you need earned income. Now, earned income can be wages or self-employment. Some people don't know this, but it could also alimony. Believe it or not, taxable alimony counts as earned income, and the old joke is, who said I didn't earn it.
Benz: Let's talk about the fork in the road that a lot of investors hit where they can make either a traditional IRA contribution or a Roth IRA contribution. Making the wrong contribution type can also be a stumbling block for some investors looking to fund an IRA. Can you offer any tips there, talk about how people can go wrong when they are making contributions to an IRA?
Slott: Each one, it's odd, because the two different IRAs have almost totally opposite rules. For example, for a traditional IRA, there's an age limit. After you are 70 1/2 you can no longer contribute, even if you have the earned income, you can no longer contribute to a traditional IRA for the year you turned age 70 1/2 and future years. For Roth, there is no age limit. You can contribute to a Roth as long as you have the income forever, if you are 90 years old.
Now, there's earned income and then there's income test. An IRA, a traditional IRA, has no income tests. You could make $1 billion and still contribute to a traditional IRA. With a Roth, there are income limits. Now, they are pretty high. Most people, most workers aren't able to do it, but that's another difference. You have differences in qualifications and differences in what's best for you.
By the way, back on that other one, I know some people will pick up, I said there is no income limits for making a contribution to a traditional IRA, they they might say, but yes there are. Only if you want to deduct it and you are active in a company plan, then there are income limits. But to do a nondeductible traditional IRA, there are no income limits.
Then there's the decision, should I do a traditional or a Roth. And generally, I am a big Roth IRA fan, because I don't think the deduction is worth all that much unless you are in a very high tax bracket. But even so, you might get a deduction at a high tax bracket this year even using the 2017 higher rates. Then all the earnings will be taxable forever. At one point when you pull it out, as opposed to a Roth, you forgo, you give up the tax deduction, but all the earnings accrue tax-free forever. That's a choice. I kind of like having tax-free income in retirement. I like the Roth IRA. But some people can't do a Roth IRA because they are over those high income limits that I talked about. That leads us to probably the next point.
Benz: Well, yeah, and in any case, investors need to mind those income limits and spend a little bit of time thinking about what is the right IRA type for them. Ed, for people who are shut out of deductible, traditional IRA contributions or Roth IRA contributions, one strategy that has become really popular is this backdoor Roth IRA. Let's talk about that and talk about how investors can stub their toe a little bit, especially if they have other IRA assets that might be sitting around. How can they inadvertently get themselves into a little bit of a tax pickle?
Slott: We are only talking about Roth IRAs because that's the IRA that has the income limits, those high income limits. We are talking only about, when we say Roth, you've got to be clear, we are talking about contributions, not conversions. Conversions, there are no income limits. We are talking about the $5,500 a year, or if you are 50 or over, the $6,500 and that's another point--some people forget about the catch-up contribution, that extra $1,000.
Let's say, you are over the income limit. You are around $200,000 of income and you are over the income limit, so you can't qualify for the $5,500 or $6,500 Roth IRA contribution. There's something that's been so-called the backdoor Roth IRA. What that is, as I told you earlier, there are no income limits like that on a traditional IRA. You could make a nondeductible traditional IRA as long as, again, you have the earnings, and convert it to a Roth IRA. On in prior years, people questioned, was that a legal strategy. Nobody really knew the answer, but now, we do know the answer because in the conference committee report or the new tax law, the Tax Cuts and Jobs Act, Congress actually said in four places that that is an allowable strategy. There's no problem there.
What you have to do, you still have four different cautions. The idea is, you make a nondeductible contribution to a traditional IRA. That's where it starts and then you convert to a Roth IRA. There's four cautions, I call them. First, the age. Remember I said traditional IRA contributions have an age test. If you are over 70 1/2, this strategy won't work with you because the whole strategy starts with making a contribution to a traditional IRA. If you are 75, you can't do that. So, that won't work.
You have to have the income. Even though you are making a traditional IRA nondeductible contribution, you still have to qualify as having earned income to be able to do that. But there is a loophole. Even if you don't have earned income, if you file a joint return with a spouse who does have earned income, you can qualify on his or her as a spousal IRA. So, you are OK there, but you have to have earned income.
The rule you are talking about is if you have other IRA--so people tell you sometimes you make this contribution to a nondeductible IRA and then you convert it tax-free to a Roth IRA. Well, if you have other IRAs, traditional IRAs, pre-tax money, you have to figure that into the mix. It's a so-called pro rata rule, a proportionate rule. It means if you have a lot of other IRAs, chances are maybe 90% of the conversion to the Roth could be taxable. It may not be tax-free if you have other IRAs. Just be aware of that. I don't think it's a bit deal because you are only talking about the tax on maybe part of the $5,500 or $6,500.
The last caution is, it goes in as a conversion, not a Roth contribution. We call it a backdoor Roth contribution. But really, the way the money gets to the Roth is through a conversion, not a contribution. Now, that makes no difference if you've had a Roth for five years and you are over 59 1/2, then whatever you pull out is tax-free. But if you ever need to get to your Roth money early, the fact that it goes in as a conversion, you have to hold that money for five years and 59 1/2, as opposed to a contribution--if it was a straight Roth contribution--Roth contributions can be withdrawn at any time, for any reason, tax- and penalty-free. But this is not going in as a contribution. It's going in as a conversion. The best advice, if you are doing a Roth, you are doing it for the long term. You shouldn't be looking at taking it out early. The power of the Roth is the decades of tax-free compounding. That's where you really make your money. The point is to hold it for the five years and you are 59 1/2. That's why you will do better and then that's not an issue.
Benz: Some important things to know if people are considering embarking upon this backdoor Roth IRA maneuver. One other point you make is, and a place where people can sometimes drop the ball, is that they do need to file an additional piece of paperwork if they are doing this backdoor Roth IRA contribution and conversion. This is a Form 8606. Tell us what we need to know about that one.
Slott: It's a separate form that's attached to your tax return. You have to file it anytime you do a Roth conversion. That's a Roth conversion. That has to be filed, and that's the form that figures and you don't have to figure it. It does that pro rata calculation automatically, through the computer, as most people do it. So, it will tell you how much of that $5,500 or $6,500 will be taxable. The form goes through that calculation. That will help you there to make sure you are showing the right amount as taxable.
Benz: Ed, as IRA contribution season winds down, thank you so much for being with us to share these tips.
Slott: Great to be with you again, Christine. Thank you very much.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.