Client Guidance

Betterment answers your tax season questions—from 401(k)s to HSAs A timely Q&A about tax management on the Betterment platform. It’s tax time! Read on as Eric Bronnenkant, Betterment’s Head of Tax, and Nick Holeman, Betterment’s Head of Financial Planning, discuss common tax queries. Which combination of retirement accounts will likely provide this particular client the most beneficial tax savings over their lifetime? Nick: The words of this sentence were chosen very carefully because it's likely going to be that one retirement account alone is not enough to fully optimize things. It's going to be a combination, and it's going to depend on this particular client’s situation. We're not focused solely on minimizing taxes today. We want to try to minimize and control taxes over the client's lifetime to try and save them the most cumulative amount of taxes. And as we'll get into, that might not be the type of account that's going to give them the largest tax break today. So, we're going to dive in, but this is the underlying theme or question. The reason why this is so complicated is because there are so many factors and inputs to this decision—kind of this patchwork of special retirement accounts that Congress and the IRS have created over decades. This is why the question is so complicated for us advisors. It's also why it's so confusing for clients. And it's why there's so much bad advice out there. A lot of the clients that I work with have their own CPAs, and I can't tell you how many times I've had to correct them. A lot of CPAs are experts in tax, but they're not experts in looking 20-30 years down the road when it comes to retirement planning. So today, we want to focus on some of the more common scenarios and questions. Traditional IRA vs. Roth IRA? Eric: While this can also potentially be looked at in the Traditional 401(k) versus the Roth 401(k), there are some nuanced differences there, too. For today, we're going to look at the Traditional IRA versus Roth IRA because this is something that typically the client has the most amount of control over in making their own decisions about what account type to choose. And there's a lot of uncertainty; as Nick pointed out, there's also a lot of information. Some of it's good, and some of it could use improvement. So, thinking about someone who's 25, single, earning $50K: Should they be in the Traditional IRA or the Roth IRA? What’s better for them? Eric: Nobody really knows the answer to that question today. You really only know the answer to that question after a whole lifetime. What are your initial thoughts, Nick? What jumps out at you when you look at this type of scenario? Nick: Yeah, I like that we're starting with the basics and we're going to build onto the more complex topics. This is one instance where I tend to agree with the standard advice I hear from other CFP® professionals: When you're younger, you're likely able to expect your income to grow. So paying taxes now is going to be better than paying taxes later. In general, without knowing too much about this client situation, I would probably recommend Roth if I had to give an answer. For someone who's age 40, married, and has earnings of $250K: What type of IRA do you think they might want to consider? Nick: This is where we start to get borderline on some of those tax rules. I don't know all of their adjustments or other things that might lower their modified AGI, but here we're probably going to be phased out of a Roth, so we might not have a choice. We would go with a Traditional IRA. Maybe that's when we start getting into the more advanced topics, like a backdoor Roth IRA. But yeah, probably Traditional. Eric: Right. Regardless of how much money you make, you can always contribute to a Traditional IRA. You just may not get a tax deduction for it if you're covered by a retirement plan at work and you make too much money. So the Roth income limit, you get phased out at about $208,000 for last year; $214,000 this year. It would be tough, even for married couples maxing out their 401(k),to potentially help them get below those thresholds. Tough to meet those MAGI limits. But you definitely brought up a great point as far as the backdoor Roth. So for people who make too much money to contribute to the Roth directly, they can contribute to the Traditional and then do the conversion over to Roth. Fun fact: the Roth conversion income limitation was eliminated permanently in 2010, and as of right now, there is nothing on the horizon that is going to change that. Obviously laws can always change, but it is not scheduled to return at this point. Nick: Backdoor Roths are super powerful potential strategies for high income earners. We talk about them a lot with our clients at Betterment. They're a little more complex, so they're not usually part of the baseline retirement plan that we're building up, but if they have a tax professional involved who’s keeping track of the Form 8606 so they're not getting double-taxed, then a backdoor Roth can be a super powerful strategy. Do contributions to a Traditional 401(k) help me qualify for a Traditional IRA deduction or a Roth IRA contribution? Eric: So let's say you have a married couple where one spouse is earning $214,000, and one spouse put in the $20,500 into their 401(k), now that $20,500 would put them below the Roth income limit. Then they'd go from a situation where they weren't able to make any Roth contribution directly to being able to make the full $6,000 or $7,000 Roth contribution directly. So a contribution to a Traditional 401(k) may help you qualify for other benefits, like a deduction on a Traditional or making direct contributions to a Roth or even other things, like child tax credits and any other AGI sensitive items. Do tax-free withdrawals from a Roth IRA impact social security benefits and Medicare premiums in retirement? Nick: Roth IRAs don't impact social security benefits. They don't impact Medicare premiums. Those are two big potential ways to optimize retirement down the road. It's not just looking at tax brackets, either. I know oftentimes when Eric and I will chat, we’re like, ‘Oh, it's current bracket versus future bracket, and you can kind of decide which one is best.’ And that's true, but that's a little bit too simplified. We know tax brackets fluctuate, and there are other things aside from taxation, as well: social security, Medicare premiums, things like that. So big shout out to Roths if they make sense for each client, but just a reminder not to only focus on tax brackets. Can I withdraw contributions from a Roth IRA without tax/penalties? Eric: The power of the Roth is that you're able to withdraw your regular contributions at any time — tax and penalty free — regardless of your age. Some people use it as an emergency fund; that is a possibility. If you can afford to have a Roth and an emergency fund, that's even better. Let's say you need to use your Roth as an emergency fund: it is potentially a tax-efficient way to withdraw those regular contributions tax and penalty free regardless of your age. I do want to point out that if you wanted to withdraw the earnings, which would come out second, those are subject to tax and penalty if you're under age 59-and-a-half. 401(k) vs. IRA? Eric: The first thing you should think about in this type of scenario is: Can I contribute to both my IRA and my 401(k)? I'm not sure where this rumor got started, but it's definitely been flying around the internet for a long time that if you contribute to a 401(k), you can't contribute to an IRA, which is not true. You can contribute to both. Now, what could potentially be impacted is that if you contribute to a 401(k), you may not get a deduction for your Traditional IRA contribution. So is there an interrelationship of the two? Yes. But it's not that you won't be able to make the Traditional IRA contribution, you just may not get a deduction for it. What are some other reasons why you might want to prioritize a 401(k) versus an IRA? Nick: I'll go with one of the less common ones to make this interesting. Behavioral benefits, right? A 401(k) contribution is going to come directly out of your paycheck before it even hits your account. At Betterment, we're big fans of automation. Out of sight out of mind. If it's so easy to spend your money, we want to try to make it just as easy to save your money. So 401(k)s or auto-deposits into an IRA, vice versa. Those are some great benefits that you can do with their 401(k). Can I access 401(k) funds 10% penalty-free at age 55? Eric: Not everyone wants to work until age 59-and-a-half. Retiring early is on a lot of people's minds, and most people are pretty familiar with the fact that if you want to access 401(k) funds before 59-and-a-half, you have to pay a 10% penalty. IRA 10% penalty exceptions versus 401(k), 10% penalty exceptions are not symmetric. Some are the same, but some are not the same. Nick: 401(k)s are great for age 55 early withdrawals. That's a big win, right? We're talking to more and more clients who are, I don’t know if 55 necessarily counts as FIRE (Financial Independence Retire Early), but we're talking to more and more clients who are getting really into that. Can I borrow against an IRA? Nick: We don't love seeing that, but there's a little more flexibility with borrowing against the 401(k). Eric: Actually, a fun fact about the 55-or-later rule is that you don't even have to be 55, as long as you separate from service in the year you turn 55 or later. So you could potentially turn 55 on Christmas day and leave your job on January 1st of that year, and you still qualify for that 10% penalty exception. One thing you shouldn't do if you want to keep that exception is roll those funds over to an IRA, because you'll lose that 10% penalty exception, even though you're allowed to rollover. Nick: You want to make sure you've got enough funds to be able to bridge the gap between 55 and 59-and-a-half. So you might do a partial rollover, for example. Eric, I don't know what your thoughts are on that, but make sure you're not leaving them hanging out to dry in that little window there. Eric: Yeah. I mean, is the 401(k) penalty-free provision useful? Absolutely. Is it the best thing? Not necessarily. If, let's say, you don't like your 401(k) investment options, you could roll it over to your IRA and then do substantially equal periodic payments for five years, which is longer than 59-and-a-half, so that's more restrictive. If you were willing to give up some control on your payment timing, you still might find the IRA option more attractive. I want to use a retirement plan to partially fund a new home purchase. Should I use my IRA or 401(k) first? Eric: There are a few different ways to fund that. Obviously if people have enough extra money in their non-retirement accounts, that's typically the first place they're looking to fund that first-time home purchase, but not everyone has a 20% down payment available in cash. People are always looking at other alternatives for funds, and that would include a 401(k) and an IRA. What are your thoughts on the 401(k) versus IRA in this scenario, Nick? Nick: My real thoughts would be neither. Typically if a client's asking me this question, it means that they either didn't plan or they're kind of feeling pressured out of a situation or going beyond their budget. So I know that's being a little judgmental, but typically I discourage both. Your IRA has that $10,000 first time-home exemption, 401(k), you may be able to take out a loan and the provisions are a little bit more flexible if that loan is for home purchase. Depending on the situation, I would probably go to my IRA because it has that smaller limit; it would prohibit them from dipping too much into their 401(k). But there are definitely pros and cons to each. Eric: Right. So you can do the Roth IRA. And now, obviously this is if you need the money, because Roth IRAs are such a powerful retirement savings tool, and the longer you hold the money in there, the better. But let's say you need the money: You could withdraw all of your regular contributions, first tax and penalty free. And then if you've had the account open for at least five years, you can withdraw up to $10,000 of earnings tax and penalty free, too. That can count as a qualified distribution. So an IRA may be useful, but some people have most of their money set aside in their 401(k). And that's where a loan with generous repayment terms, where you're able to push that out over a long period of time, may be attractive. Nick: True. Maybe this is me, but the whole benefit of Roth IRAs is tax-free growth. So if you're not getting a lot of tax-free growth, you're missing out on some of the benefits. It only makes sense to be invested aggressively if you're looking at a long-term time horizon. If you're planning on using a Roth IRA to buy a house next year, you shouldn't have had that money invested super aggressively anyways, which means you're probably looking at cash or more conservative investments, which means you're missing out on the single biggest benefit of Roth IRAs in general, which is tax-free growth. So again, I just don't understand why I see so many people talking about using your Roth IRA for this home purchase exemption or for your emergency fund. I don't understand it, unless it's an absolute emergency; not something I typically recommend. Eric: That's fair. When you're thinking about whether you should be buying a home in the first place, you do want to think about: ‘How is this going to impact my retirement, especially if I'm going to use some or all of my retirement funds?’ to fund that home purchase. HSA vs. 401(k)? Eric: I love HSAs, and I know Nick loves HSAs. You can put money in pre-tax, and it's pre-federal tax, pre-social security, pre-Medicare, pre-most state taxes, except for mine in New Jersey — and California. In general, it's pre-tax across the board and it grows tax deferred, and then the withdrawals come out tax-free in retirement or for qualified medical expenses. There are lower limits for the HSA than for the 401(k) and different rules about what you use the funds for along the way. You actually might be able to save more money in taxes on an HSA contribution than a Traditional 401(k), because the Traditional 401(k) doesn't save you on any social security or Medicare taxes. Those you're always contributing to after those taxes have been applied. I want to maximize retirement savings. Can I use the HSA as a retirement savings vehicle and a medical savings vehicle? Nick: I've seen a lot of advisors get into some sticky situations when recommending using HSAs for retirement. They're not right for everyone. The two biggest rookie mistakes that I see are getting too excited and recommending an HSA without remembering that you need to pair an HSA with a high deductible healthcare plan. If the high deductible plan doesn't make sense for the client in the first place, then the HSA probably doesn't make sense. And the second is if you're going to be using your HSA for retirement, you're probably looking at investing it in more aggressive investments, which means they're going to be a lot more volatile. Whenever I recommend a client use an HSA for retirement, I pretty much tell them we're not going to do this until we have a fully funded emergency fund as well, separate from the HSA, because Murphy's law, worst-case scenario. If we're going to have your HSA be aggressive, I want to make sure that the client also has a separate, lower risk emergency fund just in case something happens. Eric: All great points. I do want to clarify: In New Jersey HSAs are not pre-tax; in Pennsylvania, 401(k)s are not pre-tax, but you do get the HSA deduction in Pennsylvania and you do get the 401(k) contribution in New Jersey. So you always want to look at state laws. They may not drive your decision, but they may be a factor in your ultimate decision. Nick: That's why I always caveat: Make sure to bring in your CPA if you have a client, and make sure that you're all working together. They might know something that you don't, that’s state-specific to your rules or something like that. I want to live a tax-free lifestyle in retirement. Is the trifecta to use an HSA with a Roth IRA and Roth 401(k)? Eric: I love talking about the tax-free lifestyle. How can you get to that point? Well, there are ways. Let's say you max out your Roth 401(k), $20,500, you're not getting any break upfront, but then all the earnings come out tax-free in retirement. Roth IRA for another 6,000 there, no tax break upfront, all the earnings are tax-free in retirement. And then the HSA, you're getting a tax break upfront and even if you're not using it for medical expenses, once you're over 65, then you'll pay taxes. You can also use what's called the shoe box rule, where if you keep track of all of your unreimbursed medical expenses since you opened your HSA, you can use that as an account to withdraw from based on all of those previous expenses. If you accumulated $50,000 worth of expenses since your HSA was opened, you'd still be able to withdraw $50,000 in retirement even though in that year, you may have had no medical expenses at all, because you're able to use that kind of look-back process. Nick: That's personally what I do. I'm looking forward to that. I don't have an actual shoe box, but I've got a spreadsheet — and it's a beautiful spreadsheet. So I'm excited for that. Eric: There are also a number of apps out there where you can save your receipts, whether it comes by email, you can just put that in the app, or you can take a picture if you're at the doctor's office. There are plenty of ways to track these receipts and expenses over time in an efficient way. SEP vs. Solo 401(k)? Eric: There are a lot of self-employed people out there, and they’re always asking, ‘Should I do the SEP or the Solo 401(k)?’ The answer, as with most tax questions, is it depends. It depends on if your goal is to maximize your savings, if your goal is to minimize regulatory filings, there are a variety of factors to consider. Your SEP contribution, you can do 20% of your net earnings from self-employment, up to $61,000. But that's still only 20%. There's no employee contribution — it's all employer contributions. Whereas the Solo 401(k) allows for employee contributions as well as employer contributions and generally still has the same overall limit as the SEP, except for people who are age 50 or older. Let's say we had someone who's a self-employed, 50-year-old who has a business profit of $100,000. SEP or Solo 401(k)? Eric: That person can do just $20,000 into the SEP, but if they did the Solo 401(k), they'd be able to do the $20,000 employer contribution plus the $27,000 employee contribution because that's the $20,500 standard contribution, plus the $6,500 for being 50 or older. Obviously that would take up a significant portion of their $100,000, but at the end of the day, if they have extra money in savings elsewhere that they could use to help maximize their retirement savings, that's something they may want to consider. I prefer to minimize the possibility of regulatory filings. Should I make contributions to a SEP or Solo 401(k)? Nick: Oftentimes when I'm speaking with a small business owner, they might not be able to save that much. Last year, a lot of the entrepreneurs I was talking to had a little bit of a rough year, to say the least. And if you're looking at starting a retirement plan for your self-employed business, SEPs, you might not be able to contribute quite as much. Sometimes, for a lot of people starting out their business, that's not an issue. They wish contribution limits were something they had to worry about, but they're trying to get their business up and running. They’re also just trying to find time in the day to do everything. So for the SEP, if you're not even bumping up against the contribution limits and it requires less regulatory filing, and it's just a little bit easier, it's something to consider. You might be able to contribute more with a Solo 401(k), but on the SEP side, there are some other advantages as well. Eric: Why do people love the SEP? The SEP has no filings with the Department of Labor. As a Solo 401(k), there is a Form 5500 filing once the assets get over $250,000, whereas regardless of how much money is in the SEP, there are no Form 5500 filings. And while I don't think the Form 5500 is particularly burdensome, most people I know would prefer to file fewer forms with the government. I definitely appreciate the avoidance of filing any additional paperwork, even if it's not that burdensome. I want to make Roth type contributions. Should I make contributions to a SEP or a Solo 401K? Nick: I don't think so. Eric: No, there is no Roth SEP. Now what you could do is convert your SEP contribution into a Roth, because there aren't income limits on doing conversions. But if you want to make a regular Roth-type contribution, then it would have to be an employee contribution to a Solo 401(k) subject to the $20,500 or $27,000 annual limits. There are pros and cons on both sides here, and it's very client-specific on whether they prefer the SEP or the Solo 401(k). Which retirement plan should I make contributions to in order to make tax/penalty-free withdrawals before retirement? Nick: There's a few options. The easiest is just a plain old taxable brokerage account. There's no contribution limits, there's no age requirements, there's no early withdrawal penalties. They're a little bit easier to plan for; again, you might be missing out on some of the tax benefits, but that's one. HSAs are one as well; it doesn't have an age limit, as long as you've got qualified medical expenses. Roth IRAs, you can withdraw your contributions penalty free and tax free at any time. So there's lots of choices. Eric: Getting back to what we were discussing before, the 55-or-later exception is a powerful tool to access funds pre-59-and-a half without a 10% penalty and avoiding the substantially equal periodic payment option. Being able to withdraw those raw Roth contributions at any time is good too, but the closer that you get to 59-and-a-half, you also want to be particularly cautious. Let's say if you have a Roth IRA and you withdraw earnings before you're 59-and-a-half, those are typically subject to a regular income tax and a 10% penalty. So, whereas if you had made the five years plus 59-and-a-half, you would have gotten that tax free. The difference could potentially be if you're the day before 59-and-a-half. Then it's possible though that you would have to pay taxes and penalty on earnings, whereas once you make it to 59-and-a-half, and you've had the account open for five years, then you get it tax free. It's a very binary type of thing, and you always want to be cautious about where you are relative to that line in the sand. Can Roth conversions be part of an early retirement strategy? Eric: Early retirement is not for everyone. Some people are able to afford it. Some people try to fit their life into an early retirement strategy, and for some people, that works better than others. One thing you already mentioned was some of the five-year rules. If you do a Roth conversion of pre-tax money before you're 59-and-a-half and you want to withdraw those funds in the future before you're 59-and-a-half, there is a five-year holding period for each conversion to avoid the 10% penalty. This rule is designed to prevent people from converting and withdrawing immediately to avoid the 10% penalty. You can still do a conversion at age 45, age 46, age 47, age 48, let's say a rolling conversion strategy, which then you'll be able to access those converted amounts five years later, tax and penalty free. Again, those earnings would have to stay in the Roth until 59-and-a-half to avoid any tax or penalty. Nick: Good points. One thing I found practical to keep in my toolkit so to speak is to get familiar with the IRS website. That sounds like that's a terrifying task, but Google is your friend. “IRS gov Roth IRA,” for example, the first hit is likely going to be the contribution limits for that particular year. So if you forget, it's just something that’s good to be familiar with. Not everyone has an Eric that they can just Slack on demand. I'd say bookmark them, familiarize yourself with them. The IRS has some pretty good pages on Roth IRA, contribution limits, Traditional IRA deductibility limits. So if you can't remember them or keep track with them every year, just get used to Googling. Betterment is not a tax advisor, and all information is solely intended to be educational in nature. Please consult a qualified tax professional. 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5 Tips to Give to Inexperienced Investors During A Market Dip If your clients are first-time investors, helping them make that initial deposit and setting up their portfolios can be difficult. During a market dip? Even more so. Here are 5 talking points to help you communicate with inexperienced investors in times of volatility. Investing money for the first time may make your clients feel like they're diving into the deep end of the pool. It can be even more nerve-wracking when market conditions are choppy. If they ultimately decide they're ready, here are 5 tips for helping new investors get started during a market downturn. 1. "Have an emergency fund." Talking about emergency planning can be a great way to get new investors comfortable with the idea of investing. Help your client set about 3 to 6 months worth of expenses and recurring payments aside to build an emergency fund held in a cash account or a low-risk investment portfolio. Having this safety net will give your client the confidence to invest the rest of their money more aggressively—and with less worry. 2. "Invest at your own pace." Lump sum investing allows clients to optimize their money immediately in an appropriate portfolio strategy based on their specific goals and time horizon. Although this approach may generate a better investment outcome over the long term, inexperienced investors can be hesitant. Your more risk averse clients may prefer to dollar-cost average, spreading out risk during volatile market periods. Another approach that may make clients feel more comfortable is to invest a little bit at a time. One of the best ways to do this is by helping your clients set up an auto-deposit schedule where they choose the investment amount (i.e., $300) and frequency (i.e., monthly). By setting their own pace, your client can feel more secure moving forward. 3. "Focus on your time horizon." Remind your clients that not all of their investments need to have the same risk level. Your clients are likely investing for multiple financial goals at the same time, such as a home down payment, future college expenses, or retirement. Each of these financial goals likely has a different time horizon and should be invested accordingly. Breaking your clients’ investments into goals allows you to better control their risk and build a personalized investing plan. It can also make less experienced investors feel more comfortable with the level of risk they are taking on in proportion to how soon they’ll need to access a particular bucket of money. Betterment for Advisors' powerful portfolio-building tools enable you to serve your clients' needs and investing preferences. Our tooling automates rebalancing, tax-loss harvesting, deposits, and more, so you can more efficiently manage your clients' plans. 4. "Pay attention to historical context." As a new investor, your client may not have much context or know what to expect in terms of performance. It can be helpful to let clients know that many others before them have felt nervous about markets. From 1942 to 2022, the U.S. has been through 15 bear markets. On average, bear markets last for about 11.3 months, which tend to be significantly shorter than bull markets which last 4.4 years on average. Remind them that, after each of the past downturns, the stock market often recovers. You should make sure clients understand that there have been many market dips in the past, and they will likely see many more in the future. They are an inescapable part of investing and all investors, new and old, should learn to cope with volatility. Though your clients may be tempted to make major withdrawals or even halt their auto-deposits when the market dives, remind them that now is the time to stay the course. History shows us that the market, and their portfolio, can recover. 5. "Focus on what you can control." Your clients can't control the stock market. They also can't control the news, inflation, GDP growth, or unemployment rates. However, they can control how much they save, how much risk they take, how diversified they are, and how they react when markets get scary. In the long run, push your clients to focus on what they can control, and encourage them to do their best to ignore what they can't. New investors should not be discouraged by market dips. At Betterment, our passive investing model is derived from the idea that taking action solely based on market movement can be detrimental—contrary to what your clients might think. Ultimately, being thoughtful about your clients' finances and overall risk in their portfolios during market uncertainty can help them weather the storm, no matter how long the downturn lasts. When volatility hits, rest assured that we are working for your clients. Our automatic allocation adjustments, portfolio rebalancing, and tax-loss harvesting can help your clients ride out a choppy market.

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