You stick around as long as I have (yes, I am officially 103 years old), you start to see smart people have the same confusion and misunderstandings about personal finances from smart people.Some of these misunderstandings are kinda benign. Some can really damage your finances.
Trust me when I say that you are far from alone if you have misunderstood these things yourself. They’re important to understand (which is why I’m writing about them here), but I also recognize that it is f*cked up that we all have to know these things in order to properly protect and care for ourselves.
I mean, seriously, I don’t want a nanny state, but I do want a state where teachers, bike-shop owners, UX designers, firefighters, baristas, data analysts, and content marketers don’t need to understand Roth IRA contribution limits and what really is an index fund and how exactly are bonuses taxed?
At first I just listed all the misunderstandings in a long list. Then I decided to categorize them. It was perhaps not surprising—but still telling—to see that the bigger category was “Taxes.”
Have I mentioned lately that you should hire a CPA?
Alright, let’s play “Have I messed this up in my own financial life?” BINGO…
- The Type of Account is the Investment Itself.
- Index Funds Are Safe.
- You’re Diversified Because You Have Multiple Funds/Accounts at Multiple Custodians.
- You Can Always Contribute to a Roth IRA.
- You Should Totally Attempt a Backdoor Roth IRA by Yourself.
- Bonuses Are Taxed at Lower (or Higher!) Rates.
- You Can Extend Your Tax Return and Your Tax Payment.
- You Don’t Need a CPA. You Can Do Your Taxes Yourself and Save Money.
Misunderstandings About Investing
This section left, unfortunately, intentionally blank.
The Type of Account makes it safe or unsafe. (aka “Roth IRAs Are Neither Safe Nor Risky.”)
There are many types of accounts. In my world, the most common are: 401(k), Roth 401(k), IRA, Roth IRA, and a taxable investment account. People in government and non-profit jobs have a variety of other types.
The type of account dictates the rules by which you put money in and take money out. Mostly tax-related.
For example, a Roth IRA has rules around:
- how much you can contribute per year: $6500 in 2023 for people under 50 years old
- what tax benefits you get when contributing: None
- what tax benefits you get year after year: There are no taxes while the money stays and grows in the account.
- what tax benefits you get when you withdraw the money: You can take money out tax free; there are more rules than this, but for our purposes today, this is good enough.
The account type of “Roth IRA” has basically nothing to do with how your money is invested. You can invest in the same things in an IRA as you can in a taxable account, for the most part.
So, it doesn’t make much sense to say “Roth IRAs are risky” or “Roth IRAs are safe.” Just as it makes no sense to say “401(k)s are risky/safe” or “taxable investment accounts are risky/safe.”
The type of account isn’t safe or not safe or really anything else other than a set of rules by which you put money in or take money out.
It’s how you invest the money inside the account that dictates what happens to the money.
Is the account safe? Well, if you leave it as cash, it certainly won’t lose value. But nor will it grow. If you put it in a triple leveraged fund tied to the S&P 500, then yeah…that’s gonna be volatile. But that’s because of the investment, not the type of account.
The big dangers here are:
- You might stop as soon as you put money in the account. But if you’re trying to manage your money to provide for long-term financial independence, and you don’t invest it, it won’t have a chance to grow.
Have you ever discovered a 401(k) from yeeears ago…only to discover it’s been sitting in cash this whole time, not growing at all? Yeah, well, that goes to show you that just putting money in a certain account type don’t mean diddly. You gotta invest it.
- You’ll have the wrong idea about how much risk you’re taking (or not) in your own investments. You need risk for long-term investing success. You need to avoid or manage risk in other circumstances.
Index Funds Are Safe.
This is going to sound a lot like the section above. Just a warning…
An “index” fund is simply a group of investments that mimics or “tracks” a chosen index. The safety (or lack thereof) of the fund depends entirely on the index it tracks and how well it tracks it.
Does the index fund track the short-term US Treasuries? Well, then, it’s likely not going to go up or down very much in value.
Does it track a triple-leveraged small-cap US stock index? Well, then, it’s going to be super volatile.
It could also track an index for New York State municipal bonds, or large international companies in developed countries, or the price of beans, for goodness sake.
The fact that it’s an index fund doesn’t make it safe, or not safe. Just like the investment being in a Roth IRA (or taxable account or 401(k) or traditional IRA) doesn’t make it safe, or not safe. The specific investments inside the index fund are what matters.
You’re Diversified Because You Have Multiple Funds/Accounts at Multiple Custodians
Portfolio diversification is described as “the only free lunch” in investing. By owning a little bit of stock in lots of companies, or by owning parts of bonds in lots of companies and government entities, you improve your “risk-adjusted return” (OMG, I just realized that a colleague of mine reviewed this Investopedia entry…so cool.) (Also, womp womp…technical jargon).
Diversification prevents too much of your money from being in any single investment that might go way up, oooooorrrr might go way down. Mutual funds, and more recently ETFs, have made getting a diversified portfolio like falling off a very inexpensive log.
To put it succinctly: Diversification is good.
But I’ve noticed that people get confused about what makes an investment portfolio actually diversified. So, they think they’re diversified (yay!) when in fact they’re not (boo).
What is diversification not?
Owning Multiple Funds
I mean, this could be diversification. But it all depends on what each fund (mutual fund, index fund, ETF) holds.
If you own three funds, but they’re all large-cap US stock funds, then you haven’t really increased your diversification.
To diversify, you’d want to hold a large-cap US stock fund, and a mid-cap and a small-cap, and also maybe an international stock fund, and some bonds, too.
One of the most common ways I see this is when people are invested in a target-date fund in their 401(k)…and then also a bunch of other funds.
In fact, you don’t need anything beyond the target-date fund! One of the reasons for the existence of these funds is that they provide you diversification across the entire spectrum of stocks and bonds…all in one fund.
Owning Accounts at Multiple Custodians
All those old 401(k)s that are still sitting where your old employer’s plan lived?
If you left them there out of ”ugh” (aka, inertia) or ignorance, cool, I get that. But that’s not providing diversification.
It’s the investments inside those accounts that do (or don’t) provide diversification.
So, if you can handle it, you probably want to consolidate all those accounts into your current 401(k) or into an IRA, to vastly simplify your life. And, then, of course, look at what your money is actually invested in.
The same logic applies if you have multiple IRAs or taxable investment accounts sprinkled everywhere.
Misunderstandings About Taxes
This section also left, unfortunately, intentionally blank.
You Can Always Contribute to a Roth IRA.
So much financial advice online focuses on “max out your Roth IRA every year!”
But not everyone is allowed to contribute directly to a Roth IRA. (If you can’t contribute directly, you might be able to make a “backdoor” Roth IRA contribution.) You may do so only if you make less than a certain dollar amount: in 2023, that’s $153k (single person) or $228k (filing taxes jointly).
Yes, there are plenty of people in tech who make under that income threshold: you’re early in your career, you took partial-year unpaid leave, you’re in a role that simply isn’t compensated that highly, etc.
But there are plenty of people who make more.
We see this confusion arise frequently when people start with a low-income income (and are therefore allowed to contribute directly).…and then their income increases.
In general, whoo! Mo’ money! (I hear it comes problem-free.) But people don’t realize that they are no longer eligible to contribute directly to their Roth IRAs, and so continue to do so.
The financial institution (“custodian”) where your Roth IRA lives (Betterment, Schwab, Fidelity, etc.) will not help you in this regard. They don’t know anything about your income and so won’t tell you “Oh, hey, you can’t contribute that!” You’re on your own, sucker.
We have helped more than one client un-do direct contributions to Roth IRAs from past year because they made too much money to be eligible. It’s a pain.
‘Tis better to not make the mistake in the first place.
The easiest way to avoid making this mistake is to wait until after the calendar year has ended, when you’re doing your taxes, because then you’ll know what your total income is. Then you’ll know for sure whether you can make a direct Roth IRA contribution. You have up until tax-return filing deadline (April 15ish) to make the contribution for the previous year.
You Should Totally Attempt a Backdoor Roth IRA by Yourself.
Backdoor Roth IRAs are this weirdly popular and attractive personal finance maneuver. Let me reassure you, however: Your savings rate is soooooo much more important than executing technically finicky maneuvers like this.
People screw up backdoor Roth IRA contributions all. the. time.
And unfortunately “people” includes financial professionals, too.
What’s the biggest thing people screw up? Not understanding IRA pro rata and aggregation rules. (Finance-nerd alert for that article, folks.)
If you don’t want to read that article, here’s what you should keep in mind:
You should have no money in your traditional IRA before you make the $6000 contribution.
After you make a $6000 contribution, if you have any other, pre-tax money in your traditional IRA, and you convert $6000 from the traditional IRA to the Roth IRA, you are going to pay taxes on some portion of the converted $6000. If the traditional IRA started empty, then you will pay no taxes on the converted $6000.
For example, let’s say you have $18,000 of pre-tax money in your traditional IRA. You contribute $6000 as part of a backdoor Roth IRA. You now have $24,000 total. You now convert $6000. The IRS does this calculation: of the $24k, $18k is pre-tax, meaning 75% is pre-tax. Meaning 75% of that converted $6000 is pre-tax. Meaning you will have to pay income tax on $6000 x 75% = $4500.
If you mess this up, you are going to be surprised come tax time, when you find you owe taxes on some portion of the converted money.
Which means you paid taxes on the $6000 you contributed to your traditional IRA…and then you pay taxes again on some part of the $6000 you moved from the traditional IRA to Roth IRA. Which kinda defeats the purpose.
Now, paying taxes intentionally to convert money in a traditional IRA to a Roth IRA is a legitimate tax-minimization tactic. But it’s a separate tactic from backdoor Roth IRA contributions, and the two shouldn’t be unwittingly combined.
Bonuses Are Taxed at Lower (or Higher!) Rates.
You owe just as much in taxes for $1 in bonus income as you do for $1 in salary.
Taxes on your salary are easy to understand for most people. You get a salary from your job. You fill out a W-4 with your personal tax-withholding information. Your company withholds roughly enough taxes from each paycheck. No big surprises come April 15.
What you owe taxes is roughly what is withheld. You don’t really have to think much about it.
But bonuses don’t work the same way. (For reference, RSU income and NSO-exercise income are treated the same as bonus income. They’re all considered “supplemental income.”)
Taxes for bonus income are withheld automatically by your employer at the same rate—the “supplemental tax rate”—for everyone: 22%.
That’s great if your personal top/”marginal” tax rate is 22% or close to it.
But lots of people have different marginal tax rates. Many folks in tech have a marginal tax bracket of 35% or even 37% (the top tax bracket).
So, let’s say your top/marginal tax bracket is 37%. You get bonus income. Taxes are withheld at 22%. You still owe another 15% in taxes on that bonus income.
If your bonus is $100k, $22k will be withheld. But you owe $37k. So you still owe an extra $15k on top of what your company withholds.
The main point is that, for supplemental income like bonuses, the tax withholding rate is not necessarily right for you.
Taxes that are withheld <> Taxes that you owe
The danger here is that, if you don’t realize this, you could get socked with an unexpected tax bill come April 15, for the remaining taxes you owe on your bonus income.
Note: Supplemental tax withhold is usually only an issue at the federal level. States tend to treat all income the same, and so companies withhold enough state taxes on bonuses.
You Can Extend Your Tax Return and Your Tax Payment.
Extending your tax return filing doesn’t extend your ability to pay.
You can choose to file your personal tax return by October 15 instead of April 15. You just need to file an extension. No penalty.
What you cannot do is choose to pay your tax liability after April 15 (or whatever the tax deadline is for the year, which can be a few days later).
Regardless of when you file your taxes, if you don’t pay your tax liability by April 15, the IRS will impose a late-payment penalty and also charge interest on the money you should have paid.
This has become a bigger issue in the last few years as more and more tax returns are being extended. Why are more being extended?
- The tax system has gotten much more complicated (all sorts of new tax laws coming into effect over the last few years especially).
- IRS customer service has been in the dumpster
- The tax profession has seen professionals fleeing it and not being replaced by new talent.
A common question is: How can I know how much to pay by April 15 if I don’t do my taxes until later?
The CPAs we work with always encourage clients to do a tax projection with the information available. That projection usually provides a good estimate of the money owed, without requiring all the hours necessary to prepare the actual tax return.
You Don’t Need a CPA. You Can Do Your Taxes Yourself and Save Money.
Maybe for some people.
But we don’t work with “some people.” Our clients work in one state but live in another. They exercise stock options. Their employers go public. They have worked overseas. They have RSUs. They sell ESPPs. They receive short-term disability income when out on parental leave. Which is to say, their tax sh*t is complicated.
Some of our clients have engaged a CPA only after their faces have been shoved forcefully and painfully into an obviously complicated tax situation (like having to deal with UK taxes as well as US taxes…why is this so common with our clients?).
But I’m telling you, your taxes are probably more complicated than you think they are. Just because you don’t recognize the complexity doesn’t mean it’s not there. You likely haven’t been keeping up to speed on all the many changes to the tax code in the last several years. But tax professionals have been (to their great irritation).
Much as people tend to continue (erroneously) contributing to a Roth IRA because they don’t recognize that their income has increased beyond the income threshold for eligibility, many clients don’t recognize that their tax situation has gotten more complex over the years.
Maybe TurboTax was fine when you were single, rented your home, had only a salary, and your only investments were your 401(k).
But the older you get, the wealthier you get, the more complicated your finances and life get…the more complicated your taxes get, even if you don’t realize it.
Having seen so many errors on self-prepared taxes over the years (errors caught either by us or the CPAs we work with), I just don’t think working with a CPA is optional anymore. You are disrespecting yourself, honestly, if you’re still pushing yourself through TurboTax. I mean, my CPA catches sh*t for me all the time.
CPAs have helped our clients (an incomplete list):
- Undo an erroneous Roth IRA contribution
- Get back > $10k of overpaid taxes on RSUs
- Figure out which state they actually owe taxes in (remote work has made this really common…and complicated!)
- Avoid paying state taxes on $100ks of RSU income because they had moved to a no-income-tax state
- Identify how big of a Roth conversion to do
- Avoid penalties for paying taxes late on RSU and bonus income
- Exercise ISOs without triggering AMT
Now, I get it. Tax professionals cost good money. And you’ve probably run into some tax professionals who didn’t leave a good taste in your mouth.
It still boils down to:
You need a good CPA. A good CPA could be hard to find and pricey to engage. And totally worth it. So suck it up. You’ll thank me.
I mean, we here at Flow literally pay a CPA firm just so our clients can get access to them. (I’m not complaining. They’re great.) That’s how important—and difficult it is—to find a good CPA.
Whew! Well, that was…exhausting.
Modern personal finance is really complicated. Unfairly so. I’m not at all surprised that these misunderstandings exist. But it’s a problem that they do.
Make the investment in yourself that you deserve: Continue to learn more about personal finance, and engage the financial professionals you need to do all this stuff right.
Do you want to work with a financial planner who can help you shortcut your way to understanding personal finance and doing it right? Reach out and schedule a free consultation or send us an email.
Sign up for Flow’s weekly-ish blog email to stay on top of our blog posts and videos.
Disclaimer: This article is provided for educational, general information, and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. We encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Flow Financial Planning, LLC, and all rights are reserved. Read the full Disclaimer.