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The Tax-Inclusive Gift Strategy Calculator

Stephen Nelson CPA — Mon, 02 Mar 2026 19:03:24 +0000

If you’re a Washingtonian who worries about estate taxes? You should know paying gift tax can reduce estate tax. And maybe more than you might guess.

But let me explain how this simple technique works. And then illustrate why it’s so powerful using our tax-inclusive gift tax calculator (which appears below).

A $10,000,000 Gift Shows Mechanics

To set this up, assume your estate will be subject to the 40% federal estate or gift tax as well as the top state estate tax (currently 35%.)

Note: For the record, few families need to worry about federal estate taxes. But Washington state estate taxes kick in when an estate exceeds roughly $3,000,000. (More information: here.)

If you gift $10,000,000 in this situation, you pay a 40% gift tax or $4,000,000. That sounds terrible. But in effect, in a best-case scenario, you may be moving $14,000,000 out of your estate. Thus, one way to look at this is you’re paying $4,000,000 to move $14,000,000 out of your estate. And that amounts to a 29%-ish federal “estate and gift tax.” (Okay, maybe that still sounds like a lot. But 29% is less than 40%.)

Further, in the best case scenario, that $14,000,000 transfer zeros out Washington state estate taxes on $14,000,000 of your estate. That would save $4,900,000 in state estate taxes.

The Gift Tax Addback

But there’s a wrinkle here. If you die within three years of gifting, the gift tax you paid? It gets added back to the estate on which you pay federal and state estate taxes. In other words, that $4,000,000 in the earlier example? Your estate pays federal and state estate taxes on that money if you die within three years of the gift.

You still save taxes in this scenario. But the math gets tricky. Thus, the calculator below.

Using Tax-Inclusive Gift Strategy Calculator

The initial inputs show a $10,000,000 gift and set the federal estate or gift tax percent to 40% and the state estate tax to 35%. You can enter some other gift amount. Or change the estate and gift tax percentages. The calculator recalculates as you make changes.

Note: On July 1, 2025, the Washington state estate tax jumped from 20% to 35%. As I’m writing this, however, the state legislature is in process of enacting a bill that may return the top estate tax rate to 20% as of April 1, 2026.

Tax-Inclusive Gift Strategy Calculator

Gift amount

Enter dollars (commas OK), e.g. 10,000,000

Federal estate/gift tax rate

Enter percent (e.g. 40) or decimal (e.g. 0.40)

State estate tax rate

Enter percent (e.g. 35) or decimal (e.g. 0.35)

Gift tax paid at time of gift

—

Gifted early but tax addback

—

No action full estate taxes

—

Estimated savings range

—

Understanding the Tax-Inclusive Gift Strategy

A quick overview of the two potential savings that flow from a tax-inclusive gift:

First, if you gift, pay the gift tax, but then your estate avoids the gift tax addback? That means you only paid federal taxes on only a portion of the money you’re effectively moving out of your estate. (With the default inputs, this is the best case “all you pay is $4,000,000 of gift tax” scenario.)

Second, if you gift but your estate later does the addback? Then you lose some of the savings. Roughly half in fact with the default inputs. What’s happening here is, your estate pays state and federal estate taxes on the gift tax you paid to the IRS.

Third, if you do nothing? That’s the worst-case scenario modeled here. That worst case “pay state and then federal estate taxes” scenario means you first pay the Washington state estate tax on your $14,000,000 (or whatever). And then, after that, you pay the federal estate tax on the leftover.

In the area under the input boxes, the calculator shows the range of estimated tax savings a tax-inclusive gift generates for a specified gift amount.

Some Caveats

You need to think carefully about the tax-inclusive gifts. And probably you want the help of your tax and legal advisors. But some things to ponder:

You obviously are moving assets out of your estate. So that impacts your income and lifestyle potentially.

Related to this point, for good or bad, you also move income out of your estate and into your heirs. If you did move $10,000,000 from your investment account to your daughters and you paid a $4,000,000 gift tax, every year you would have held that money is a year you don’t earn income on the $14,000,000. But, of course, every year your daughters do earn income on $10,000,000. That’s something to consider.

If you gift appreciated assets you lose the Section 1014 adjustment (aka “step-up basis” adjustment). Probably, then, you would not want to gift appreciated assets.

Finally, whether this tactic makes sense and optimizes depends on your alternatives. Your estate planning attorneys have lots of other options which will potentially work well in scenarios where you’re not paying gift taxes.

Some Other Resources

Another high impact option for avoiding Washington state estate taxes (or income taxes) is changing domicile. We talked about that in a recent blog posts here: Washington State Millionaires Tax Residency Rules and here: Changing Your Washington State Residency.

If you’re interested in reading the actual law that creates the gift tax addback, that appears here: Section 2035.

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Exporting Assets Avoids Washington State’s 35% Estate Tax

Stephen Nelson CPA — Tue, 03 Feb 2026 16:12:39 +0000

The clean, nuclear way to avoid Washington state’s new 35% estate tax is change domicile. (Something we’ve discussed here: Changing Your Washington State Residency. )

But if you can’t move to another state—and most people can’t—another option possibly exits: You can move some assets to another state.

To begin this discussion, let me start with a quick example of how the state’s estate tax formula works. (I’m going to use the estate tax formula for 2025 because that makes for rounder numbers.) And then I’ll get into the exporting assets thing.

Quick Review of How Washington State’s Estate Tax Formula Works

In 2025, a decedent dying in the last half of the year pays zero estate taxes on the first $3,000,000 of their net worth. (The amount inflates in subsequent years. For 2026, for example, that nice round $3,000,000 ratchets up to $3,076,000.)

On the next $9,000,000, they pay an estate tax rate that starts at 10% but quickly escalates to 35%. In total, though, on that $9,000,000 “band”, they pay $1,930,000 of estate tax.

On the rest of their net worth, they pay a flat 35% estate tax.

Thus, for example, the estate (or really the heirs) of someone who dies with $22,000,000 in late 2025 pays $5,430,000 in estate taxes.

How Out of State Assets Affect the Taxes

But here’s something else to note: Washington state doesn’t “estate tax” residents on out of state tangible property.

For example, while a Washington state resident who died in late 2025 with a $22,000,000 of net worth pays $5,430,000 if the assets are all located in Washington state? If a taxpayer stored or situated half of their assets, or $11,000,000 of their $22,000,000, out of state? That allocation halves the estate tax bill.

Thus this idea to export assets…

How Would Someone Export Assets?

To make this illustration easy, I want to use some big round numbers. So, let’s say two Washington state residents, Tom and Pete, each have $22,000,000. Both own a $10,000,000 retirement account, a $10,000,000 rental income property, a $1,000,000 rare coins collection, and a $1,000,000 condominium where they reside.

I also need to tell you something else here. Washington state sources intangible assets to the state of domicile. Thus, that giant retirement account holding $10,000,000? That’s an intangible asset. No matter what, for both Tom and Pete, Washington state treats it as located in Washington state. (This bit becomes important in a minute.)

But the tangible stuff? So, the $10,000,000 rental property and the $1,000,000 rare coins collection and the $1,000,000 condo? State law sources those to the state where the property is.

If Tom’s rental property, coin collection and condo are all in Washinton state? All $22,000,000 of his stuff sits in Washington state. And he pays the estate tax on the full $22,000,000. So, $5,430,000.

If Pete’s condo is in Washington state but the rental property and coin collection are in Nevada? Yeah, in that case, $11,000,000 of his $22,000,000 estate is tangible property outside of Washington. And therefore, his estate only pays Washington state estate taxes on half of his estate, so $2,715,000.

The obvious maneuver then: If Tom moves his coin collection to another state and exchanges his Washington rental property for one in some other state, voila. He halves the estate taxes his heirs effectively pay.

Three Wrinkles Related to Exporting Assets

You want to know three other things as you think about this strategy of exporting assets. The first one? You want to export assets to a state with no estate tax. (That should be pretty easy. Most states don’t levy estate taxes. And none levies an estate tax as high as Washington’s 35% rate.)

The second thing to know: If you invest in tangible property through a limited liability company, Washington state sees that as intangible property. Not tangible property. Intangible property, as noted earlier, gets sourced to the state of domicile. Thus, you need to directly own the property. Tom then, in the example above, needs to exchange his $10,000,000 rental property in Washington state for a $10,000,000 rental property in Nevada. Not for a Nevada LLC that owns a $10,000,000 rental property in Nevada. (The Washington Department of Revenue explains and confirms this treatment here.)

A third thing to know and this is common sensed: A person needs to move tangible assets out of the state before they die. This “exporting assets” tactic isn’t something an executor or personal representative does while administering the estate.

Other Resource

Our Washington State Estate Tax Calculator

How Washington State “Estate Taxes” Income in Respect of a Decedent

Powerball Estate Tax Planning

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Trump Savings Accounts – Free Money from the Government

Christian Block CPA — Wed, 01 Oct 2025 17:59:58 +0000

Child focused tax benefits have taken on many forms over the years. We’ve had child tax credits, dependent care credits, education credits, 529 accounts, UTMA & UGMA accounts, and more. But, the recently passed One Big Beautiful Bill (OBBB) introduced something completely new: a federally seeded, tax deferred savings product for children known as Trump Savings Accounts.

This is a big deal that parents, grand parents, legal guardians, and even employers should pay attention to. The federal government is giving $1,000 to eligible new born babies. This isn’t a tax credit, a tax deduction, or anything else. It is actual cash the government deposits into a bank account. And that is just the beginning.

We’ll unpack what these new Trump Savings Accounts are, who qualifies, how to maximize contributions, and what they can be used for. We’ll also compare these to other accounts designed for children and see how they differ from what is already available.

What is a Trump Savings Account?

A Trump Savings Accounts is a tax-deferred custodial account that is structured like a Roth IRA. Qualifying children will receive a seed deposit of $1,000 from the federal government, beginning 1/1/2026.

To be absolutely clear, this is FREE money from the government! To qualify, a child only needs to:

Be a United States Citizen
Be born between 1/1/2025 and 12/31/2028
Have a Social Security number

No income limits for the parents or guardians exist. Every single qualifying child receives the seed deposit. However, parents and guardians can make additional deposits into the account as well. Lets dig into the details.

Contribution Rules and Limits

In addition to the government seed money, parents, relatives, friends, and even employers can make contributions into the savings account until the child reaches age 18.

The annual contribution limit is $5,000/child, indexed for inflation in future years. Employer’s can also contribute up to $2,500 per child, which counts towards the $5,000 contribution cap. Ignoring the inflation adjustments, it’s possible for a child to have $90,000 deposited into their account by the time they reach 18! That is serious money.

Contributions aren’t tax-deductible for the donor and aren’t treated as income to the child. The money grows tax deferred, however, until the child starts withdrawing the funds.

The IRS determines the tax rate on a distribution based on how the recipient uses the funds. The tax rate is the same as long term capital gains tax rates on qualified withdrawals. A qualified withdrawal includes the following:

Education, including tuition, supplies, & room and board.
Expanded definition of education to include certified trade and vocational programs
First time home purchase
Starting a business

If the recipient uses the money for anything else before turning 59½, they must pay ordinary income taxes and a 10% penalty on the amount withdrawn. These are the same consequences as taking a nonqualified distribution from a retirement account.

Account Investment Vehicles

The money must be invested within specific eligible investments as detailed in the OBBB. Eligible investment means any mutual fund or exchange traded fund which:

Tracks the returns of a qualified index
Does not use leverage
Does not have annual fees and expenses of more than 0.1% of the balance of the investment fund

The term “qualified index” means:

The S&P 500 market index, or
Any other index which is
- comprised of equity investments in primarily United States companies, and
- for which regulated futures contracts are traded on a qualified board or exchange

So how do you open an account?

Opening a Trump Savings Account

First, as previously discussed, you must have a qualifying child born between 1/1/2025 – 12/31/2028 to open an account. If qualified, there are two ways to establish an account:

Eligible custodians can manually open accounts after 12/31/2025 with an authorized financial institution.
If no eligible custodian establishes an account on behalf of a qualified child within 12 months of the child’s date of birth, the Secretary of Treasury shall cause an account to be opened in the name of such child and held by a designated institutional custodian.

The treasury hasn’t issued guidance or an approved list of authorized financial institutions at the time of this writing. But most likely, a majority of the major financial institutions (Fidelity, Vanguard, Ascensus, JP Morgan Chase etc.) will support the accounts.

Trump Savings Account Alternatives

Now let’s see how Trump Savings Accounts stack up against more familiar options like 529 plans and custodial accounts, and explore which might be the best fit for your financial goals.

As compared to Trump Savings accounts, Section 529 plans

Are designed to help families save for education-related expenses
Contributions are not federally deductible but are deductible in some states
No contribution limits and considered as gifts to minor
Can change beneficiary
Funds grow inside of the account tax free
Qualified withdrawals are not taxed, if used to pay for
- College tuition and fees
- K-12 tuition
- Room and board
- Books, supplies, and required technology
Non-qualified distributions are taxed at ordinary rates and subject to a 10% penalty

A Section 529 plan has the advantage over a Trump Savings Account IF the funds are used for college expenses. If flexibility is a priority, the advantage goes to the Trump Savings Account.

As compared to Trump Savings accounts, custodial Accounts (UTMA, UGMA)

Are designed to allow an adult custodian to manage assets of a minor child
Contributions are not federally or state deductible
No contribution limits and considered as gifts to minor
Cannot change beneficiary
Funds can be used for anything that benefits the child
No tax shelter treatment, income is subject to kiddie tax annually

A custodial account has the advantage over a Trump Savings Account when spending flexibility is the priority. However, there is little to no tax advantage like a Trump Savings Account provides. Verdict? Max out Trump Savings Account contributions first, fund a custodian account second.

Are Trump Savings Accounts a Good Deal?

For eligible families (those with children born between 2025 and 2028) they present a rare opportunity: a $1,000 head start, tax-deferred investment growth, and potential employer contributions.

While they don’t replace the role of Section 529s for education savings or offer the flexibility of UGMA/UTMA custodial accounts, they fill a new niche by helping families build long-term wealth for their children with minimal upfront cost. Like any financial tool, the value depends on your goals, but for many, opening one is a low-risk, high-upside way to diversify a child’s financial future.

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The Washington Estate Tax Income in Respect of Decedent Problem

Stephen Nelson CPA — Mon, 11 Aug 2025 15:20:51 +0000

Washington state’s estate tax hits only a small percentage of the state’s decedents. (The threshold for paying tax is $3,000,000, and though the data is scarce, it looks like less than one percent of estates trip over this amount.)

But when taxpayer estates do the pay the tax? Ouch. Rates start at 20%. And rise ultimately to 35%.

Further, as bad as that may sound if your estate or the estate of someone in your family pays this tax? The situation may be far worse because of the way “income in respect of a decedent” is taxed.

The problem in a nutshell: State estate taxes may fully tax the “pre-tax” income in respect of a decedent.

What is Income in Respect of a Decedent?!

Good and important question. And one we can best answer with a simple example. The most common form of income in respect of a decedent are the wages someone earned but hadn’t yet been paid when they died. That income hasn’t yet been subjected to income taxes. Thus, federal tax laws tax it.

Example: Someone dies with $10,000 of accrued wages. Those wages paid after death represent income in respect of a decedent. The estate or heirs pay the income taxes the decedent would have paid on the $10,000. Maybe $3,000 to $4,000 in most cases. Thus the estate or heirs may only receive $6,000 or $7,000. But Washington state may tax the full $10,000.

Now a single payroll? Probably not that big a deal. A family that’s just lost a breadwinner has far bigger issues and concerns. And most estates don’t pay the Washington state estate tax.

But if an estate does pay Washington state estate taxes, the IRD issue grows in significance. And here’s why.

IRD includes a bunch of stuff. It includes most retirement account balances like traditional deductible IRA, 401(k), 403(b) and 457(b) and cash balance retirement plans. IRD includes some of the common equity compensation income provided to technology company employees including nonqualified stock options, restricted stock units, restricted stock awards and then other deferred compensation or stock deferral plans. IRD can also include large windfall amounts—lottery winnings, composer and author royalties, and SEC and IRS whistleblower awards—which won’t be collected until years or decades after the estate taxes are due. (More on this in few paragraphs.)

How Washington State Handles IRD

The problem here? The Washington estate tax is imposed on the full value of income in respect of a decedent (IRD) without regard to the income taxes that will later be owed.

Example: A Washington decedent’s estate includes $10,000,000 of IRD and is subject to the top 35% Washington estate tax rate. The resulting state estate tax equals $3,500,000.

When the IRD is later received, the estate or beneficiaries receive an income-tax deduction under IRC §691(c) equal to the estate tax attributable to the IRD. As a result, only $6,500,000 of the IRD is subject to federal income tax. At a combined 37% federal rate plus 3.8% net investment income tax, that produces an additional $2,652,000 of federal income tax.

In total, the combined Washington estate tax and federal income tax equal $6,152,000 — an effective tax rate of roughly 62%

How Federal Estate Taxes Handle IRD and State Estate Taxes

The tax situation becomes even worse when federal estate tax applies because the decedent’s estate exceeds the basic exclusion amount. In that case, income in respect of a decedent (IRD) can be subjected to Washington estate tax, federal estate tax, and federal income tax.

Example: A Washington decedent’s estate includes $10,000,000 of IRD. Washington estate tax at 35% produces a $3,500,000 tax. Because Washington estate tax is deductible for federal estate tax purposes, the federal taxable estate attributable to the IRD equals $6,500,000, resulting in $2,600,000 of federal estate tax at a 40% rate.

The total estate tax attributable to the IRD is therefore $6,100,000. Under IRC §691(c), that amount becomes an income-tax deduction when the IRD is later received. As a result, only $3,900,000 of the IRD is subject to federal income tax. At a combined 37% federal rate plus 3.8% net investment income tax, this produces an additional $1,591,200 of income tax.

In total, combined Washington estate tax, federal estate tax, and federal income tax equal $7,691,200 — an effective tax rate of nearly 77% on the $10,000,000 of IRD.

And believe it or not, the situation can in a handful of situations get even worse. There is a nightmare scenario.

The Liquidity Nightmare: Estate Taxes Due Before IRD Pid

Here’s the true nightmare scenario: a decedent’s estate includes substantial income in respect of a decedent (IRD), but the estate will not actually receive the income for many years.

This can occur, for example, when IRD consists of a long-term payout stream such as a lottery annuity, structured settlement, or deferred compensation arrangement. In these cases, the estate tax is due shortly after death—even though the cash needed to pay that tax may not arrive for decades.

Example: Suppose a Washington decedent dies owning the right to receive $1,000,000 per year from a lottery annuity, with 15 annual payments remaining. For estate-tax purposes, the annuity is valued at $10,000,000. Washington estate tax at the top 35% rate produces a $3,500,000 estate tax liability attributable to the IRD.

The problem is timing. The Washington estate tax is generally due within nine months of death, but the estate does not receive its next $1,000,000 lottery payment until a year later. As a result, the estate must either borrow to pay the tax or request extensions while interest accrues.

When the first $1,000,000 annuity payment is eventually received, a substantial portion is immediately consumed by federal income taxes. Even after accounting for the §691(c) deduction, roughly $250,000 to $300,000 of the payment may go to federal income tax and net investment income tax. The remaining cash is then applied toward interest and principal on the estate tax obligation, leaving only a fraction of each annual payment to reduce the underlying estate tax balance.

Because the annuity payments are relatively small compared to the upfront estate tax liability, it can take many years for the estate to fully retire the tax debt. During that period, interest continues to accrue, and heirs may receive little or no net benefit from the IRD for a long time.

In extreme cases, the estate may be forced to borrow repeatedly or even liquidate non-IRD assets simply to service the estate tax obligation created by the IRD itself.

Some Quick Final Comments

What do you do about this? You’ve already taken the first step (maybe) which is recognizing the potential size of the problem if your estate includes substantial IRD.

As far as remedies or palliative measures? Your first step is probably to confer with a good estate planner. All the usual federal estate planning techniques and methods probably get turbocharged if you’re talking about IRD potentially subject to Washington state’s estate tax. (Here’s a primer of basic techniques: Washington state estate tax planning techniques. But if you’re potentially taxed on a lot of IRD? You’re going to want to look at the more sophisticated techniques available too.)

Thus, three closing remarks and ideas to discuss with your attorney or accountant.

First, an interesting feature of Washington’s estate tax regime is, the state doesn’t tax gifts. Thus, while a large gift to heirs might trigger federal gift taxes or use up the federal basic exclusion amount, those gifts typically don’t result in additional Washington state estate taxes.

Note: Starting in 2026, you can gift up to $15,000,000 without triggering gift taxes. Married? The amount doubles: You and your spouse can together gift up to $30,000,000.

Second, I’m usually not a big Roth account fan. (See here for a list of all blog posts that discuss the reasons here.) But paying the taxes now to convert a big $10,000,000 tax-deferred IRA (and IRD) to a smaller but equivalent after-tax $5,900,200 Roth account (which is not IRD)? That often makes good sense if it saves Washington state estate taxes. If a $10,000,000 traditional IRA gets converted and you’re avoiding the top estate tax rate, for example, the tax savings roughly equal $1.6 million.

And then, third, the other obvious option to at least consider: Someone with a lot of IRD in their estate may want to consider changing their domicile.

Additional Resources

Need more background information on the state’s new estate tax? Check out this blog post: Planning for the New 35% Washington State Estate Tax.

Want to estimate what state taxes an estate might pay? This calculator makes a good estimate for estates created after July 1, 2025: Washington State Estate Tax Calculator.

The post The Washington Estate Tax Income in Respect of Decedent Problem appeared first on Evergreen Small Business.

Washington State Estate Tax Calculator (2025 Version)

Stephen Nelson CPA — Tue, 22 Apr 2025 11:02:35 +0000

In mid-2025, Washington adjusted its state estate tax for estates created on or after July 1, 2025. The new version uses a larger, inflation adjusted deduction of $3,000,000 and higher tax rates that start at 10% and fairly quickly rise to 35%. (For context, the previous state estate tax, applicable for the estates of decedents who passed away before July 1, 2025, uses a $2,193,000 deduction and tax rates that ran from 10% to 20%.)

To estimate the Washington state estate tax someone might owe under the new 2025 law’s rules, use the Washington State estate tax calculator shown below. Instructions and additional information appear below the calculator input and outputs.

Washington State Assets:

Non-Washington State Assets:

Total Liabilities:

Spousal Transfers:

Estate Costs:

Charitable Contributions:

Exclusion Amount:

Taxable Estate: 0.00

Washington Estate Tax: 0.00

Instructions for Washington State Estate Tax Calculator

You need to describe an estate using the roughly half a dozen inputs. And the three things to know are as follows:

First, Washington state subtracts the following items from your taxable estate: Liabilities, spousal transfers, estate administration costs, charitable contributions and then a new “standard” exclusion equal to $3,000,000 starting July 1, 2025 and then some higher, inflation-adjusted amount in later years.

Note: A special qualified family owned business interest deduction also exists and that can amount to another $3,000,000 roughly. But that deduction is very difficult to use and rather problematic.

Second, if you have out of state real estate, the formulas adjust for this. Washington state doesn’t tax its residents on real property held out of state. (Those other states, by the way, might.) But as an example, if someone holds real estate outside Washington state that amounts to 25 percent of the person’s estate? Washington state only taxes the remaining 75 percent.

Third, the actual tax calculation uses a sliding scale which starts at 10 percent and rises to 35 percent.

Some Other Stuff to Know

Some other things helpful to know:

A wrinkle for people who hold real property inside or outside of Washington state: The values you enter for that property in the “Washington state assets” and “Non-Washington state assets” boxes need to be net of any nonrecourse debt like mortgages the decedent isn’t personally liable for. Use the liabilities box to show only the total recourse liabilities.

You ought to consider the calculation results an estimate. They do give you a good sense of the taxes an estate pays.

Finally, these generalizations maybe help. Fewer estates will need to file estate tax returns under the new law due to the higher, inflation-indexed threshold going forward. And the new law’s higher tax brackets don’t really “kick in” until someone’s estate hits $10,000,000 if single or $15,000,000 if married. But at estate sizes larger than these amounts, the new estate tax becomes strikingly large. Affected taxpayers will want to update their estate and business plans. And probably many will want to consider relocating outside of Washington state. (The tipping point is probably about $30 million of net worth.)

Other Resources

More information about and the text of Washington SB 5813 appears here.

To compare the new bill’s tax to the prior one, you can use this earlier version of the calculator.

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Short-term-rental Tax Tips and Tricks

Stephen Nelson CPA — Mon, 03 Feb 2025 16:08:33 +0000

Short-term rentals provide some of the easiest and most powerful tax savings opportunities available to investors. You can literally save six figures of federal and state income taxes in many cases.

But you need to know the rules. And plan ahead. The paragraphs below give the low-down. And maybe the good news here? None of these tips are hard to use. Or too complicated.

Tip #1: Invest in Short-term-rental Properties for Profit

Let me start with a subtle but probably the most important point. Your short-term-rental investment? You need to be doing this to make money. As a way to build wealth. Maybe to prepare for retirement.

Vey frankly? The right way to plan this all out is that you will ultimately invest in multiple properties. Gain some economies of scale. Build expertise.

The reason this “pursuit of profits” angle is so important? The best and really the only big tax savings come when you invest in short-term-rentals for profits. And to grow your wealth.

Note: Section 183, commonly known as the hobby loss rule, and Section 162 set this requirement.

Tip #2: Average Rental Intervals of Seven Days or Less

The next tip: You want to average rental intervals of seven days or less. And for a simple reason: If your average rental interval is more than seven days? You probably won’t be able to use the big tax deductions your property or properties generate.

With intervals of seven days or less, you can probably get big tax savings if you (and your spouse if married) spend more than 100 hours a year. You may even be able to get big savings if you spend just a few hours a year.

With intervals of more than seven days? Tax law considers your short-term-rental a real estate trade or business. And in that case, Section 469(c)(7) of the Internal Revenue Code says you or your spouse will need to qualify as a real estate professional by spending more than 750 hours and more than half your work hours on real estate businesses if you want to deduct losses. That qualification? Obviously much harder for new and very part-time investors to achieve.

Tip #3: Track Your Time

A third really important tip. You need to track the hours you spend on your short-term-rental business starting with the minute you begin your search for your first property. Here’s why: Even if your average rental interval averages seven days or less, you also need to materially participate in the short-term-rental business.

The lowest-hour route to achieving material participation: Be the only person who spends time on the rental. For example, you’re single. You buy a property late in the year. Say mid- to late-November. You rent the property once for a week in December. And the only person who works on the rental—the only person—is you. (For example, if the property is a cabin in the woods? You do any maintenance. And you do the housekeeping before and after your guests stay.)

The most practical route to achieving material participation however? Spend more than 100 hours working on the rental and more time than anyone spends. You can combine the hours that spouses work. But some hours don’t count. (More details on that here: Grouping activities to achieve material participation.) And then this predictable tip: You want to document your hours—and the hours others spend.

Tip #4: Expense as Supplies Everything You Can

Assuming you’ve followed the first three tips, you’re ready to begin loading up your tax return with deductions.

And here’s the tip for doing that: Expense any individual thing that costs $2500 less as “supplies.” So, the $400 chair, the $800 sofa, the $1800 TV, and so on. Appliances, you should be able to expense too.

One caution: You can’t expense individual components of some bigger thing. For example, if master suite bed includes an $800 mattress, a $600 box spring, and a $1200 antique frame thing? You look at the total $2600 of cost to provide someone a place to sleep.

If just writing off as supplies seems funny? You should know that Treasury regulation 1.263(a)) says you can do this by making an election in your tax return.

Tip #5: Pay for a Cost Segregation Study (Maybe)

Another tip related to ginning up deductions. You maybe want to pay for a cost segregation study. That study, conducted by a civil engineer or consultant (so not your tax accountant probably), breaks apart the price of the building into real property and personal property.

Without a cost segregation study, you’ll depreciate the building part of the short-term-rental over 27.5 or 39 years. For example, if you buy a $1,000,000 property, you might call $200,000 of that land and $800,000 of that building. And you depreciate the $800,000 of building over basically three or four decades.

With a cost segregation study, probably, you might instead (in effect) look at the $1,000,000 of purchase price representing $200,000 of land, $600,000 of building, and $200,000 of personal property. That $200,000 personal property chunk you will write off in the first few years of ownership. That frontloads the depreciation into the first few years.

Note: We have a short-term rental depreciation calculator you can use to estimate what a cost segregestion study does to your depreciation deductions.

Tip #6: Consider Bonus Depreciation

By the way, if you do a cost segregation study? Consider using bonus depreciation to immediately deduct some large percentage of the personal property. The bonus depreciation percentage is slowly deflating: 60% in 2024, 40% in 2025, 20% in 2026 and 0 in 2027.

But if you can use bonus depreciation to create a big deduction? And then use that big deduction to save highly taxed income? That’s a no brainer.

Tip #7: Consider Section 179 Depreciation

Bonus depreciation, if it’s available, works best for frontloading depreciation. But some short-term-rental investors may be able to use a similar depreciation trick: the Section 179 election. A Section 179 election allows a short-term-rental business to deduct 100% of most of the personal property shown in the cost segregation study.

To use Section 179 for a short-term-rental, however, your short-term-rental operation needs to rise to the level of a “Section 162 trade or business.” That’s technical tax law concept that looks at your profit motive and then at whether you show continuous, considerable and regular involvement in the business.

Note: The Section 179 method of loading up deductions creates a depreciation recapture risk. Thus, confer with your tax advisor if you want to even think about using this tip.

Tip #8: No Personal Use

A quick caution: You should not use your short-term-rental for personal use. That use triggers Section 280A, a chunk of tax law that explicitly exists to limit or eliminate deductions stemming from a home or vacation home.

The one exception to personal use? If you stay at a property and you (or your spouse if you’re married) works full-time during maintenance.

By the way, if you go spend a week at the Hawaiian condo? And you work full-time during the regular work days but then “take the weekend off?” Now you have two personal days. And Section 280A will basically dial down your tax deductions because some of your use during the year was “personal.”

Tip #9: No Family or Friends

A related point: If you rent to a family member? That counts as a personal day, triggers the Section 280A formulas and probably limits your short-term-rental deductions.

And if you rent to someone at discounted rate? A good friend you don’t want to charge the regular full price? That then counts as a personal day, triggers the Section 280A formulas, and again probably limits your deductions.

A consolation related to tips #8 and #9. A few years down the road? Once you’ve burned off a bunch of the depreciation? You’ll be able to use the property for personal days, family or friends with less disastrous consequences. But not early on. (And also, just to say this, not if you use the Section 179 election described in tip #7.)

Tip #10: Invest Out of State (Maybe)

A final big, move-the-needle tip. If you reside currently in a high-income tax state and you plan to someday move to lower tax state? Consider investing in short-term rentals in that other state.

The out of state property’s depreciation creates deductions and tax savings on your, say, California state income return while you’re a California resident. But later on, when you reside in some no-income-tax state, say, Florida, you can sell the property without having to pay any state income taxes. Including to your original home state.

Closing Comments and Caveats

Part-time real estate investors often struggle to harvest tax savings from their real estate properties. But for investors willing to plan ahead and think outside the box? The Short-term-rentals tax tips and tricks described above can allow most taxpayers to shelter very large chunks of income.

The post Short-term-rental Tax Tips and Tricks appeared first on Evergreen Small Business.

Super Safe Withdrawal Rate Calculator

Stephen Nelson CPA — Fri, 13 Dec 2024 18:15:48 +0000

The ‘super safe withdrawal rate” calculator below estimates certainty-equivalent returns and the Merton share.

You can use these certainty-equivalent returns as ultraconservative safe withdrawal rates. And the Merton share as the optimal allocation to stocks in your portfolio.

Click Calculate to see example calculations using historical averages. Or follow the instructions below the calculator to make your own personalized calculations.

Note: The initial default inputs use U.S. historical real average returns and volatility with one simplification: While the historical volatility of intermediate US treasury bonds equals 5 percent. I set this input to 0 (zero) to match the typical textbook treatment.

Equity Geometric Return (%):

Risk-free Geometric Return (%):

Equity Standard Deviation (%):

Risk-free Return Standard Deviation (%):

Equity Arithmetic Mean (%):

Riskfree Arithmetic Mean (%):

Equity Premium (%):

How Calculator Works

The super safe withdrawal rate calculator steps through three calculations.

First, it takes the average geometric returns expected from equities and risk-free assets and adjusts these percentages so they approximate arithmetic mean returns. (Mechanically, the formulas add one-half the squared volatility.)

Second, the calculator estimates the equity premium. (If equities return 7 percent and risk-free bonds return 2 percent, the equity premium equals 5 percent.)

Third, finally, the super safe withdrawal rate calculator estimates the certainty-equivalent returns (CERs) as well as the resulting Merton “equity allocation” shares suggested for the standard set of risk tolerances.

Personalized Super Safe Withdrawal Rate

To calculate a personal super safe withdrawal rate, replace the default annual average “geometric mean” returns for equities and risk-free bonds with your forecasted returns. And then also estimate the volatilty, or standard deviation, for both asset classes.

You may aleady have estimates for these inputs. But if you don’t? No problem. The large investment services also provide this information regularly. (See here, for example, for the December 2024 Market Outlook from Vanguard.)

Certainty-equivalent Returns and Merton Shares in a Picture

A simple line chart accurately shows how Merton shares and certainty-equivalent returns work (see below).

The blue line shows the average expected arithmetic returns for portfolios using a variety of stock allocations: 0%, 10%, 20%, 30% and so on. If the portfolio holds only risk-free assets, for example, the expected return equals the risk-free return. If the portfolio holds only equities, the expected return equals the equity return. In between those equity percentages, the expected return reflects a weighted average.

The line chart hints at the portfolio risks using those two dashed grey lines. They show the 25th and the 75th percentile returns. (All of these calculations reflect the historical real returns of US stocks and risk-free assets and their volatility. Also, in this chart to make it make sense, I did set the standard deviation of the risk-free assets to 5%.)

That green line shows the certainty-equivalent returns, or CERs, and graphically shows the utility the investor enjoys at various stock allocations. The green line flattens as the investor increases the allocation to stocks. That visually signals the diminished marginal utility. In effect, the formulas assume there’s a risk penalty diminishing the expected value.

By the way, the green line reflects a good guess as to the utility. The Python script that draws the line chart uses the standard utility function, or formula, economists think does a pretty good job. But the main takeaway here for non-economists? Sure, you and I get larger returns by allocating ever larger percentages to stocks (see the blue line). But risks explode as we do this (see the two grey dashed lines.) The utility we enjoy (see the green line) essentially tops out at the Merton share.

Historical Context Helps

Using the historical default numbers, which is what the line chart does, the Merton share formula suggests a 62.5% allocation to stocks based on a constant relative risk aversion equal to 2. (More on this constant in a minute.) So very close to the orthodox 60-percent stocks and 40-percent bonds asset allocation. Furthermore, the certainty-equivalent return per the formula equals about 3.56%. Which is interestingly close to the cannonical four percent safe withdrawal rate.

Personalizing Your Relative Risk Aversion

For practical purposes, the super safe withdrawal calculator above assumes your personal relative risk aversion equals 1, 2, 3, 4 or 5. The way the Merton share and CER formulas work, those values are sort of the standard “shoe sizes.”

Most people, according to the research, feel a constant relative risk aversion equal to 2 or 3.

A constant relative risk aversion equal to 1 might signal someone comfortable with a leveraged portfolio in many economic scenarios. (In late December 2024, a constant relative risk aversion equal to 1 would mean an investor focusing on only US stocks might invest between 60 and 65 percent of their portfolio in US equities.)

A constant relative risk aversion equal to 4 or 5 would suggest in the current market an allocation to US equities of maybe 10 percent to 15 percent.

Use CER as a Super Safe Withdrawal Rate?

The $64 question: Can you or I really use certainty-equivalent returns as a “safer” safe withdrawal rate? Good question. And one worth chewing over a bit.

Certainty-equivalent returns can provide a good safe withdrawal rate number. As noted, if you make the calculations using historical averages? The resulting Merton shares and CERs mesh with the almost canonical 4 percent rule and popular 60-percent stocks and 40-percent bonds asset allocation. But you need to be careful here.

True, using CERs as a super safe withdrawal rate delivers some unique benefits. The approach considers the risks of a particular portfolio. It explicitly addresses periods where expected returns going forward will probably be lower. (If you don’t like the idea of forecasting lower expected equity returns, you can surely see it makes sense to forecast lower expected bond returns if interest rates have dropped.) Further for investors with long retirements and who want to preserve their wealth? The ultraconservative nature of CERs mean they’re almost guaranteed not to fail. (If this sounds implausible, consider the CER percentages start lower. And then if portfolios shrink in value, that CER percentage probably increases but it also gets multiplied by the new year’s lower portfolio value.)

However, using the CER as a super safe withdrawal rate may not make sense in many situations. Currently, the formula returns a very low withdrawal rate for investors who limit their equity investments to US stocks. (The certainty-equivalent return in late 2024 might suggest a super safe withdrawal rate of less than 2 percent for an all US stocks investor.) The CER formula would also often result in investors simply not spending much of their retirement nest egg. (That doesn’t really make sure.) And the formula would tend to restrict a retiree’s spending. (That doesn’t sound great.)

Two Final Thoughts

A couple of other thoughts before I end.

First, if you’ve been using the four percent safe withdrawal rate, one way to maybe benefit from the super safe withdrawal rate calculator is to make the calculations for your portfolio. And then think about an average of the CER percentage and that four percent figure. That hybrid approach hedges your bets a bit.

A second idea: Calculating CERs and Merton shares may help you think about diversifying away from US stocks. (Adding more international stocks will make the numbers work better.) And doing the arithmetic may also help you more unemotionally calibrate your portfolio risks. (The CERs and Merton share math help you quantatively adjust your portfolio risk.) Those effects? Arguably pretty good.

Related Resources

This companion calculator and discussion may be interesting as you’re learning about this stuff: Merton Share Estimator.

This related discusion of the variability of portfolio returns may provide nice context: Retirement Plan B: Why You Need One.

I like the insights the Merton share and certainty-equivalent returns provide when thinking about retirement. But personally? I think it makes more sense to do Monte Carlo simulations to think about the risks. That topic is discussed in more detail here: Monte Carlo Safe Withdrawal Rates for Low Expected Returns.

Finally, if you’re struggling with the math and logic of certainty-equivalent returns and how lower-returning bonds can possibly help? Check this blog post: Monte Carlo Simulations Show How Bonds Dampen Retirement Risk. It provides a visual approach to exploring how risk-free assets can mostly dial down your risks during retirement.

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Merton Share Estimator

Stephen Nelson CPA — Fri, 13 Dec 2024 18:00:04 +0000

You can use rules of thumb to determine what percentage to allocate to stocks versus bonds. Like “60 percent to stocks and 40 percent to bonds.”

But Nobel Laureate Robert Merton developed a formula you can use to calculate a “Merton share” or optimal allocation to equities. The Merton share estimator below makes this calculation for you.

Note: Instructions and additional information appear beneath the calculator.

Merton Share Estimator

Geometric Equity Return:

Equity Standard Deviation:

Geometric Risk-free Return:

Risk-free Standard Deviation:

Constant Relative Risk Aversion:

Merton Share:

Merton Share Estimator Instructions

The Merton Share Estimator requires five inputs in order to calculate how much you or I should allocate to equities: equity return, equity standard deviation, risk-free return, risk-free standard deviation, and the constant relative risk aversion.

You should be able to get needed estimates of rates of return from the financial services company that holds your 401(k) or Individual Retirement Account. These firms also usually provide a volatility measure, too, which is the standard deviation.

Three tips here. First, if you’ve invested in several different equity classes with different expected returns? For example, if your equities allocation invests 50 percent in U.S. stocks expected to earn three percent and 50% in Non-US stocks expected to earn five percent? You calculate a weighted average return equal to four percent for the blended equities. For example:

50% * 3% + 50% * 5% = 4% weighted average return

A second tip: Adjust for inflation and work with real returns. That approach lets you use Treasury Inflation Protected Securities (TIPS) rates as the risk-free return. To adjust nominal equity returns for inflation, just subtract the inflation rate. For example, a six percent nominal equity return equates to a four percent real return if inflation equals two percent. For example:

6% nominal return – 2% inflation = 4% real return

A third tip: You can probably use historical standard deviations for your calculations. At least to start. Sometimes people say the standard deviation equals 15% roughly. Sometimes 20%. But an online tool like Portfolio Visualizer lets you calculate the actual standard deviation of blended portfolios of equities. Also, the CBOE VIX index shows the expected standard deviation on US stocks expected over the next month. (You can Google to get the most recent VIX value.)

Understanding Merton Share Estimator Calculations

A single formula calculates the Merton share. And that formula basically divides the equity premium by the squared standard deviation, or variance, of equities. So like this:

Equity Premium / Standard Deviation^2 = Equity allocation

For example, in a simple case where equities return two percent more than riskless investments and the standard deviation equals twenty percent? The formula might make this calculation and return .5, or 50%, thus signaling a 50 percent allocation to equities. Here’s the formula:

2% equity premium / (20% standard deviation ^2) = 50% equity allocation

But in practice, it’s a little more complicated. So let me drop down the rabbit hole for just a few sentences.

Nitty Gritty Details of Merton Share Estimator

To calculate the equity premium, the calculator assumes you’ve entered the expected, real, geometric mean return of equities and the expected, real, geometric mean return of risk-free bonds (like Treasury Inflation Protected Securities) along with the expected standard deviations of these two investment choices. (When a financial services company like Vanguard, Blackrock or Fidelity estimates the return you or I might earn from stocks or bonds over a decade? That’s a geometric mean, or average. It may also be nominal so including inflation. Or real, so adjusted for inflation.)

The calculator then estimates the real, arithmetic, mean return on equities and on risk-free bonds, and the difference between the two–which is the equity premium. (To make this estimate, the calculator uses a common but imprecise tweak: It adds half the variance, or the standard deviation squared divided by two, to the geometric return.)

To determine the appropriate allocation to equities, the calculator then does that simple division operation. But with another tweak, this one from Professor Merton. The formula actually divides by equity premium by the standard deviation squared, or the variance, times the constant relative risk aversion input. Thus the actual formula looks like this:

Equity Premium / (Standard Deviation^2*Constant Relative Risk Aversion)

The “constant” lets people assume different risk aversions. Research suggests many people have constant relative risk aversion equal to 2, a level which suggests some risk aversion. And the common range of constants runs from 1 (low risk aversion) to 5 (high risk aversion). For what it’s worth? I think my personal constant relative risk aversion equals 1 or 2. Most people’s relative risk aversion constant equals 2 or 3.

Note: Someone who is risk neutral or nearly so? Their relative risk aversion constant maybe equals 0. And in this case, they ignore risk and focus solely on the expected return.

Observations about Making Merton Share Estimator Calculations

Some quick observations about making Merton share calculations. And about using the calculation results to make better decisions.

First, the calculations suggest that we ought to often bear more risk than we do. Not always, no. And maybe not at the time I’m writing this in December of 2024, but usually individuals should bear more risk to earn higher expected returns.

A second point: The Merton Share Estimator’s calculations suggest that currently (late 2024) a smart way to dial down US investors’ risk is to invest more broadly than just in US stocks. If I model investing half in US stocks and half in international stocks, for example, the calculator suggests maybe a 70 percent allocation to equities for an average-ish risk aversion investor. If I model just investing in US stocks? It suggests less than a 40 allocation to equities for a low risk aversion investor and a 20 allocation to equities for an average-ish risk aversion investor.

Third, and this is personal and anecdotal… but I suspect the more you or I experiment with Merton share calculations? And the more you or I root around to get updated expected returns and standard deviations for stocks and bonds? Yeah. Okay. I think that may jack your or my constant relative risk aversion input. Thus, be careful.

Other Resources

The Super Safe Withdrawal Rate blog post provides a companion discussion and another calculator: Super Safe Withdrawal Rate Calculator.

Professor Merton’s research paper appears here: Lifetime Portfolio Selection under Uncertainty: The Continuous-Time Case

The authors of the book, “The Missing Billionaries,” use Merton’s share in their wealth advisory business. Lots of interesting insights appear at their website, including this one: Man Doth Not Invest by Earnings Alone. BTW, “The Missing Billionaires” is dense but a very interesting read.

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Roth Calculator

Stephen Nelson CPA — Wed, 25 Sep 2024 16:15:54 +0000

The Roth Calculator below helps you determine whether you end up with more retirement income using a Roth IRA or 401(k). Or using a traditional IRA or 401(k).

By the way? Most people probably end up with a better outcome using a traditional IRA or 401(k). But you want to “run the numbers”

Click the Calculate button to see example calculations using the default inputs. To get actionable insights for your own “Roth or not” decision, replace the default inputs with your own. Detailed instructions and additional information appear below the calculator.

Collect the Roth Calculator Inputs

Contribution:
Years of Saving:
Years of Spending:
Rate of Return:
Inflation Rate:
Saving Years Tax Rate:
Spending Years Tax Rate:
Qual Dividends Tax Rate:
Qual Dividends Yield:

Simple Strategy Withdrawals

Simple Strategy	Traditional	Roth
Accumulation
Withdrawal
Less: Taxes
Net Amount

Hybrid Strategy Withdrawals

Hybrid Strategy	Traditional	Roth
IRA Balance		0
Taxable Acct		0
Accumulation
Withdrawal
Less: Taxes		0
Net Amount

Collecting the Inputs

You need to collect a handful of inputs. Most make intuitive sense. You enter the annual contribution you will make, the years you’ll save and the years you’ll spend, and then the nominal return and inflation rate you expect.

You need to enter at least two tax rates: your saving years “marginal” tax rate and the spending years tax rate on the withdrawals. The saving years marginal tax rate allows the calculator to estimate the taxes you save by making a deductible contribution to a tax-deferred IRA or 401(k). The spending years tax rate allows the calculator to estimate that taxes you’ll pay on the withdrawals from your tax-deferred IRA or 401(k).

Note: Your saving years tax rate usually is higher than your spending years tax rate. Your saving years tax rate equals your top marginal tax rate. The spending years tax rate, in comparison, blends low tax rates and higher tax rates. Also many people, and probably most people, report higher incomes during their working years than during their retirement years.

Understanding the Simple Strategy Results

The Roth Calculator lets you look at simple Roth strategies where you start with a set amount of pre-tax income. (Like $7,000.) And then either you use all of that pre-tax income to contribute to a traditional IRA or 401(k). Or you can first pay the taxes on that income and then contribute the leftover, after-tax amount (like maybe $5,320) to a Roth IRA or Roth 401(k).

Obviously, when you contribute smaller amounts to a Roth account with the simple strategy, you end up with a smaller future value. But that smaller future value represents after-tax savings. Thus, as you draw from the Roth account, you avoid paying income taxes again.

The calculator then assumes you annuitize the IRA balances over the specified years of spending. And that you pay income taxes only on the withdrawals from the traditional IRA or 401(k) at the spending years tax rate.

Obviously, you want to replace the default entries with your own personalized inputs. But the 22% tax rate is what a single filer reporting taxable income between roughly $47,000 and $100,000 might pay in 2024. Or what a married couple reporting taxable income between roughly $94,000 and $200,000 might pay in 2024. The 11% tax rate is what somone might pay by drawing from a roughly $500,000 IRA account and receiving typical Social Security benefits.

Understanding the Hybrid Strategy Results

The Roth Calculator also lets you look at a hybrid strategy where you contribute the same amount to both accounts. (Probably the maximum contribution allowed? So a number like $7,000.) But then you also save the extra tax savings you get from the traditional IRA contribution. In other words, if you save $1700 in income taxes by contributing to a traditional IRA or 401(k), the calculator looks at what happens if you save that money in a tax efficient stock index fund. The calculator assumes you pay qualified dividend tax rates on the dividends during your saving years. Thus, to model the hybrid strategy, you may want to replace the qualified dividends tax rate and the qualified dividends yield with your own numbers.

One other note: The hybrid strategy formulas assume you pay the qualified dividend rate on half of the money withdrawn from the taxable account. That’s probably conservative. Many retirees might pay less tax. (If paying taxes on only half of the money sounds wrong, remember that you’ve already been taxed on the contributions over the years. And on the dividends.)

Additional Resources

If your modeling suggests a Roth IRA or Roth 401(k) doesn’t make sense and that’s a surprise? You might find this old blog post useful: Are Roth-IRAs and Roth-401(k)s Really a Good Deal?

To get up-to-date IRA and Roth-IRA contribution limits refer to the IRS’s “Retirement Topics – IRA Contributions Limits” web page.

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Backdoor Roth IRAs Really a Smart Idea?

Stephen Nelson CPA — Tue, 02 Apr 2024 15:12:19 +0000

Maybe the last ten individual tax returns I’ve signed? They all included a backdoor Roth IRA.

That got me thinking: How much tax do you really save with a backdoor Roth? And the answer: Probably not as much as you hope.

But let’s start with an overview of how Roth IRAs work. And then I’ll show you how a tax accountant calculates the tax benefits of a Roth IRA conversion, aka a “backdoor Roth.”

First a Quick Explanation

A Roth IRA lets you contribute money to a special version of an IRA, or individual retirement account. You don’t get a tax deduction in the year you make a contribution to a Roth IRA. But as long as you follow the rules, you don’t ever pay income taxes on your Roth IRA’s earnings. Or when you draw money from the account.

You do not, for example, pay income taxes when/if your Roth IRA earns dividends and capital gains that first year, the second year, and so on.

Even better? In retirement, so maybe two or three decades from now, you do not pay income taxes as you draw the money you contributed. Or draw the profits your investment earned over the years.

That all sounds good. But not every taxpayer gets to make regular contributions to a Roth IRA. For 2023, a single taxpayer can’t earn more than $138,000 and a married couple can’t earn more than $218,000 and make a full Roth IRA contribution. (In 2024, those limits rise to $146,000 and $230,000.) Also as you cross those income limits, the amount you can contribute to a Roth IRA phases out. (More details here.)

Which is where the backdoor Roth IRA comes in…

How Backdoor Roth IRA Works

If high income taxpayers can’t contribute directly to a Roth IRA, they usually can contribute money to a nondeductible IRA. Even if they have a regular retirement plan at their job.

They then can convert that non-deductible, non-Roth-IRA account to a Roth-IRA account. And that two-step dance allows a higher-income taxpayer to get money into a Roth IRA. Thereby dodging the income limits I mentioned earlier.

A final important point: As long as the person doesn’t hold other traditional non-Roth-IRA IRA balances? She or he moves the money into a Roth-IRA account without paying any income taxes.

Calculating the Front-end Annual Tax Savings

But the idea doesn’t work as well as you might hope. Most people don’t save much tax during the years they work using a Roth IRA. Or using a backdoor Roth IRA.

Let’s look at the numbers for 2023 for a typical taxpayer aged 49 or younger who can “backdoor” $6,500 into a Roth IRA and then avoid income taxes on the earnings.

While the $6,500 might earn, say, five percent or $325 the first year? An investor investing outside of a Roth IRA wouldn’t have gotten taxed on the full $325. Rather, she or he gets taxed on just the dividends and realized capital gains. And probably that fraction of the return? Only lightly taxed.

Note: I use five percent as the rate of return because after rounding the Vanguard Group expects that return over the next decade.

The taxed dividend yield on a US stock market index fund like Vanguard’s Total Stock Market, probably runs roughly 1.8%. On a $6,500 Roth IRA, that means taxable income of maybe $117 the first year.

Most taxpayers won’t even pay taxes on that income. But at a 15% qualified dividend tax rate—so for example married people making more than $123,500 adjusted gross income in 2024—the first year savings equal about $18.

That annual savings amount grows over time if someone keeps on “backdooring”: $36 in year two, $55 in year three, $75 in year four, and so on.

After two decades of steady backdoor Roth IRA contributions, the annual tax savings might be $500 to $600 annually. Which is pretty good. But maybe not great.

You would not want to pay an accountant $200, $300 or $400 an hour or pay a financial planner 1/2% or 1% fee to help you harvest these sorts of modest savings.

Calculating Back-end Roth IRA Tax Savings in Retirement

Fortunately, the back-end tax savings of a Roth IRA look better. Use a Roth IRA and in retirement, you won’t pay income taxes when drawing down the money.

An example illustrates this: Say someone saving $6,500 annually faces two choices: Invest money using a backdoor Roth IRA or invest money using a regular old taxable account. To keep this all apples-to-apples, assume something like the Vanguard Group’s Total Stock Market Fund.

If the investor earns five percent return annually and pays a 15% tax rate, they end up with almost identical balances after two decades. The Roth-IRA balance equals $226,000 and the taxable account balance equals $219,000. (The $7000 difference reflects that annual income tax bill. And, yes, I’m rounding.)

But here’s the thing: The Roth-IRA investor can draw the entire $227,000 balance without paying income taxes.

In comparison, if the “taxable account” investor draws the $219,000? She or he may trigger long-term capital gains taxes on the unrealized gains, or appreciation, in the account. Those unrealized gains which may get taxed equal roughly $53,000 using the assumptions provided earlier.

How much tax would someone pay on $53,000 of long-term capital gains in retirement? You have to do the accounting carefully.

A middle-class taxpayer and even some upper-class taxpayers might pay zero taxes, as noted earlier. And so most people, especially in retirement, could draw down a large taxable account without paying income taxes. Especially if they drain the account over multiple years.

A high-income taxpayer, in contrast, might potentially pay a 15% or even 20% capital gains tax. She or he probably also will pay the 3.8% Obamacare tax. That would mean an $8,000-ish to $13,000-ish total tax bill.

But often even these folks have good ways to dodge this tax bill. Spreading realization of the gain over a few years. Using some of these funds for charitable contributions. Leaving the money for their heirs which would let them entirely avoid paying taxes on the gain.

Closing Comments and Caveats

Given the above? I don’t find backdoor Roth IRAs particularly compelling. Sorry. But, three final thoughts:

First, if you expect higher returns? Or if inflation runs hot? (The inflation rate embedded in that five percent return from Vanguard runs between two and three percent, by the way.) In those scenarios, the tax savings from a Roth IRA get better.

Second, I think you don’t do this for only a year or two. Rather, you do something like this over decades. That’s the way to snowball the benefits. You’re working the compound interest engine when you do this.

Third, finally, this awkward acknowledgement. Most people don’t earn enough or accumulate enough to pay the sorts of taxes a Roth-IRA account saves. Especially in retirement. Therefore, backdoor Roth IRAs really only make sense for high-income taxpayers who can confidently look forward to high-income lifestyles in the final chapters of their lives.

Note: We’ve got several blog posts that describe the economics of what one might label, ‘”Frontdoor” Roth IRAs and Roth 401(k)s: Are Roth IRAs and 401(k)s Really a Good Deal?, Worst-case Scenarios for Roth-style Accounts, and The Only Times You Want to Use a Roth-style Account. If you found this blog post interesting, you might also find those interesting too.

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