Monthly Archives: July 2022

Baby HSA

Are you married? Age 55 or older? You might have an opportunity to open up a small health savings account and get a $1,000 annual tax deduction!

HSA Contribution Limits

Health Savings Accounts (“HSAs”) have annual contribution limits. The limits depend on two things: medical insurance coverage through a high deductible health plan (a “HDHP”) and age. Here are the 2024 HSA contribution limits (hat tip to Kay Bell).

AgeHDHP Self CoverageHDHP Family Coverage
Under Age 55$4,150$8,300
Age 55 or Older$5,150$9,300

Family HDHP Coverage

Family HDHP coverage is coverage of an insured plus either or both a spouse or a dependent(s). Coverage must be the only medical insurance coverage the person has. 

HSA Catch-Up Contributions

Those age 55 or older can contribute an extra $1,000 per person to an HSA every year. While the “normal” contribution limits ($4,150 self / $8,300 family) are indexed for inflation, the $1,000 annual catch-up contribution limit is not indexed for inflation.

Two additional notes: First, as a practical matter, at age 65 a taxpayer will no longer qualify for an HSA (and thus, the catch-up contribution). This is because at age 65 most Americans switch from a HDHP to Medicare for their medical insurance. 

Second, for IRAs and qualified plans (such as 401(k)s), the age to be eligible to make “catch-up” contributions is 50. For HSAs, the age is 55, not age 50. 

HSA Contribution Limits for Married Couples

The normal contribution limits are coordinated. Thus, the family contribution maximum for a married couple is normally $8,300, not $8,300 times two. Here’s an example of how that works: 

Example 1: Steven and Holly are married, both age 45, and covered by a family high deductible health plan for all of 2024. Thus, each has an HSA contribution limit of $8,300. However, when looking at Steven’s limit, we must look at what Holly has contributed to her HSA for 2024. If Holly contributes $8,300 to her HSA for 2024, then Steven’s HSA contribution limit is reduced by Holly’s contribution to $0. 

Interestingly enough, catch-up contributions are not coordinated. Let’s change the example to have Steven and Holly be both age 55.

Example 2: Steven and Holly are married, both age 55, and covered by a family high deductible health plan (provided by Holly’s employer) for all of 2024. Thus, each has an HSA contribution limit of $9,300. Holly maxes out her 2024 HSA ($9,300) through payroll withholding (to get the payroll tax exclusion as well as the income tax exclusion). When looking at Steven’s normal contribution limit, we must look at what Holly has contributed to her HSA for 2024. Since Holly maxed out her HSA, Steven’s normal contribution limit is $0. However, Steven’s catch-up contribution limit is still $1,000, since it is not reduced for contributions Holly made to her HSA.

Steven is eligible for what I refer to as a Baby HSA. He will need to find a financial institution which offers HSAs. He can contribute up to $1,000 to his Baby HSA for 2024. Even better, Steven and Holly will get a $1,000 tax deduction on their 2024 tax return which lowers their adjusted gross income. 

Note that Steven’s Baby HSA cannot just be simply added to Holly’s HSA. Each of them have their own limits, and an HSA is an account in the name of a single owner (the same as an IRA). Thus, Steven will need to reach out to a financial institution to establish his own HSA. 

Benefits of the Baby HSA

Yes, a $1,000 tax deduction is nice, but it is not life changing. Let’s not pooh-pooh it too quickly, however. Steven might qualify for 10 years of that $1,000 Baby HSA, which is $10,000 of tax deductions. Second, Steven and Holly get this deduction against adjusted gross income, which means that they won’t have to claim itemized deductions to obtain it. 

Third, most tax deductions require giving up money to get a tax benefit. Often we think about business deductions, charitable contributions, and home mortgage interest. It’s great to take tax deductions for those, but you are giving up the money. The deduction for a Baby HSA contribution is simply moving money from a taxable account to an HSA: it’s still your money!

Last, an HSA deduction/exclusion is better than a deduction/exclusion for a traditional 401(k) contribution. In exchange for the upfront tax benefit, the traditional 401(k) will be fully taxable when withdrawn later on. Not so with the HSA. As long as the HSA is used to pay qualified medical expenses and/or to reimburse PUQME, the money comes out tax-free. No wonder I’m so fond of HSAs!

One additional benefit for retirees is the $1,000 deducted for a Baby HSA is $1,000 more of Roth conversions that can be slotted in at a low tax rate. The HSA deduction also lowers both adjusted gross income and “modified adjusted gross income” for Premium Tax Credit purposes, making it valuable for early retiree tax planning.

One Spouse Under Age 55

What happens if one of the spouses is under age 55? Here’s an example:

Example 3: Steven (age 56) and Holly (age 52) are married and covered by a family high deductible health plan provided by Holly’s employer for all of 2024. Thus, Holly has an HSA contribution limit of $8,300. Steven has an HSA contribution limit of $9,300, computed as a $8,300 normal contribution limit plus a $1,000 catch-up contribution limit. Holly maxes out her 2024 HSA ($8,300) through payroll withholding. When looking at Steven’s normal contribution limit, we must look at what Holly has contributed to her HSA for 2024. Since Holly maxed out her HSA, Steven’s normal contribution limit is $0. However, Steven’s catch-up contribution limit is still $1,000, since it is not reduced for contributions Holly made to her HSA.

Because Steven was 55 or older during the year, he still gets to contribute $1,000 to his Baby HSA. Holly’s age and contributions are irrelevant because the catch-up contributions of one spouse are not limited by the age and contributions of the other spouse. 

Watch me discuss the Baby HSA on YouTube. Stay to the end to see me butcher some 80’s movie trivia.

Conclusion

The Baby HSA is a nice tax planning tactic for married individuals with a HDHP as their only medical insurance between turning age 55 and going on Medicare. While limited in scale, the Baby HSA can provide real tax benefits and later tax-free growth. Of note, some ACA plans qualify as HDHPs. This means that the Baby HSA opportunity will exist for some using ACA plans in early retirement, as well as those covered by a HDHP through an employer. 

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter at @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

TikTok Tax Advice

There’s tax advice available on TikTok. Is it worth following? Does it miss the big picture?

Retirement Saving Through Various Forms of Life Insurance

TikTok tax advice often boils down to something like the following: don’t save in traditional retirement accounts where you will get crushed by taxes in retirement. Rather, save for retirement through permanent life insurance products (such as indexed universal life insurance policies) to get tax free growth and tax free withdrawals during retirement. 

Watch me discuss two problems with TikTok tax advice on YouTube.

This advice is not just offered on TikTok, though, anecdotally, it appears TikTok is at least something of a hub for promoting indexed universal life (“IUL”) and other forms of permanent life insurance. 

One recent example of this sort of advice posits a retired couple making $160,000 a year in IRA/401(k) distributions and $40K in Social Security/pension income and worries that the couple will have a terrible tax problem. 

But is that really the case? Let’s play it out with a detailed example.

Sally and Joe both turn age 75 in 2022. They are California residents. During their working years, they were prodigious savers in their workplace 401(k) plans, and their employers offered generous matching contributions. As a result, in 2022 they have required minimum distributions (“RMDs”) of $160,000. They also will have $40,000 of Social Security income, $4,000 of qualified dividend income, and $1,000 of interest income. Further, being tax savvy, they contribute $500 a month to their church through qualified charitable distributions (“QCDs”) from their traditional IRAs. They claim the standard deduction as their home is paid off and thus have no mortgage interest deductions. 

Alright, let’s see what Sally and Joe’s 2022 tax picture (all numbers are estimates) looks like:

First, their rough 2022 federal income tax return:

Federal Income Tax Return
RMDs$ 160,000
Social Security$ 40,000
15% Social Security Exclusion$ (6,000)
Interest$ 1,000
Qualified Dividends$ 4,000
QCD RMD Exclusion$ (6,000)
Adjusted Gross Income (“AGI”)$ 193,000
Standard Deduction$ (25,900)
Additional SD Age 65+$ (2,800)
Federal Taxable Income$ 164,300

Let’s turn to what their $164,300 federal taxable income means in terms of federal and California income taxes paid and their 2022 cash flow:

2022 Income Taxes and Cash Flow (Estimated)
Federal Income Tax$ 27,100
Effective Tax Rate on AGI14.04%
Marginal Federal Income Tax Rate22%
California Taxable Income (Approximate):$ 149,000
California Income Tax (Approx.)$ 7,862
Effective CA Income Tax Rate on Fed AGI4.07%
Marginal CA Income Tax Rate9.30%
Total Fed & CA Effective Income Tax Rate18.11%
Cash Flow After Fed & CA Income Tax & QCDs$ 164,038

By my math, after paying both income taxes and charitable contributions, this retired couple has $164,000 in cash flow for living expenses. Considering that, like many retirees, they live in a paid-off home, do we really believe there is a significant risk they will not be able to pay their bills? This couple ought to be able to enjoy a very pleasant, comfortable lifestyle, including recreational activities and travel.

Are Sally and Joe really getting crushed by income taxes? As residents of a high tax state, they do pay about $35K in combined federal and state income taxes. Sure, if $35K was on the table in front of you, you’d grab it pretty quick. But considering the $200K plus in cash flow they generated during the year, paying $35K in income taxes to the IRS and California is hardly financially debilitating. 

Most retired couples, even financially successful couples, will not have federal adjusted gross income of $193,000. If Sally and Joe are not crushed by income taxes (paying just an 18.11% estimated effective rate even living in a high-tax state), it is likely most retirees will be able to withstand the tax hits at retirement from having significant savings in traditional deferred retirement accounts. 

The Trade-Off Unstated on TikTok

TikTok tax advice often presents the boogeyman of taxes in retirement. It says “don’t invest in your 401(k) because it will get crushed in retirement.” Even if that were true, it usually neglects an important consideration: the upfront benefit of investing in a 401(k). 

During their working careers, it is likely that Joe and Sally were subject to marginal income tax rates of 24% or more federal and 9.3% California. Had they used permanent life insurance to save instead of using their 401(k)s, they would have lost 33 cents (or more) on every dollar in immediate tax savings, as there is no tax deduction for amounts contributed to life insurance policies.

The existence of the tax deduction for amounts contributed to a traditional 401(k) does not automatically mean that using permanent life insurance products for retirement is a bad idea. However, in weighing the tax benefits of the traditional 401(k) approach compared to the permanent life insurance approach, one must consider the immediate, and potentially substantial, tax benefits of traditional 401(k) contributions. 

One consideration in weighing the pros and cons of each: traditional 401(k) contributions generally get a tax benefit at the taxpayer’s marginal tax rate, while withdrawals from traditional 401(k)s and IRAs are more generally taxed at a taxpayer’s lower effective rate. On the way out, withdrawals are taxed through the relatively progressive tax brackets existing today, getting the benefits of the 10%, 12%, and 22% federal income tax brackets. 

Uncertainty

But, Sean, what about future tax rate increases! The federal government is running a huge deficit and it’s not getting any better.

This is a valid point. But let’s consider a few things. First, in my example, Sally and Joe were subject to a 33.3% marginal tax rate during their working years, and barely over an 18% effective tax rate during their retirement. For the math to work out to make permanent life insurance more attractive (tax-wise) than traditional 401(k)s for them, tax rates would need to be increased substantially, by over 80%. Thus, even if tax rates on retirees such as Joe and Sally were to increase 85% from current levels, the tax math might only marginally favor using permanent life insurance instead of a traditional 401(k). 

Second, if there are going to be income tax rate increases, they are more likely to be to the upper tax brackets. There are fewer taxpayers (read: voters) subject to the higher tax brackets, so those are the ones the politicians are more likely to increase. Increasing the 10%, the 12%, and/or the 22% tax brackets will impact more voters and lead to more election risk for the politicians.

Third, recent history suggests that the politicians are not likely to target retirees. It’s true that Social Security went from being tax free to being largely subject to taxation, up to 85% taxable. Interestingly enough, the second Social Security tax increase, which subjected Social Security to possibly being 85% taxable, passed through a Democratic Congress in 1993. The following year the Democrats suffered historic losses in the House and Senate elections. Many factors came into play, but it is interesting that since 1994 tax policy has generally benefited retirees (no more tax increases on Social Security, increasingly progressive tax brackets, and the increased standard deduction). 

Perhaps the politicians in both parties have learned a lesson when it comes to retiree taxation.

Is there zero risk that retirees could be subject to higher taxes in the future? Absolutely not. But, is that risk great enough to eschew traditional 401(k) contributions in favor of permanent life insurance? Not in my opinion.

Further, there are simpler, less costly planning techniques other than permanent life insurance that those using 401(k)s for retirement planning can avail themselves of, including Roth accounts and health savings accounts. 

Roth Accounts

Savers worried about future tax rate hikes have a simple, easy to implement tool to hedge against future tax rate increases: the Roth IRA. The Roth IRA solves the same tax problem that permanent life insurance solves for. In today’s environment, Roth IRAs are available at a vast array of financial institutions with very low fees. 

As I have previously discussed, many savers will benefit from the combination of a maxed out traditional 401(k) and a maxed out annual Roth IRA. 

Many will point out the possibility of much greater contributions to an indexed universal life insurance policy than to a Roth IRA. While true, many of those concerned with getting large amounts into tax-free accounts while working can turn to the Roth 401(k), which has significantly greater annual contribution limits than the Roth IRA. 

Roth Conversions

Many in the FIRE community have access to Roth conversions during what are likely to lower taxable income years. The tax idea behind retiring early is to load up on traditional 401(k) contributions during working years, and then convert amounts inside traditional retirement accounts to Roth accounts during early retirement years prior to collecting Social Security. 

In early retirement years, many in the FIRE movement appear, at least initially, to be poor on their tax return. No longer working, and not yet collecting Social Security, one’s tax return only includes interest income, dividend income, and some capital gains income. If that income is relatively low (which it is likely to be for many early retirees), it likely leaves room for Roth conversions at the 10% or 12% tax brackets during early retirement. 

This is tax rate arbitrage. First, deduct 401(k) contributions in the 24% or greater federal income tax brackets during one’s working years. Then, during early retirement, convert amounts in the traditional retirement accounts at a 10%, 12%, or perhaps 22% marginal federal income tax rate. 

Two observations: A) using permanent life insurance instead of traditional 401(k) contributions followed by early retirement Roth conversions denies members of the FIRE community a significant tax rate arbitrage opportunity. While there is no taxable income inclusion when withdrawing from a permanent life insurance policy, there is also no tax deduction for contributions to IULs, whole life insurance, and other permanent life insurance policies. 

B) By doing Roth conversions during early retirement, FIRE members reduce the uncertainty risk described above. FIRE members face a shorter time frame during which significant savings are in traditional retirement accounts, as the goal is (generally speaking) to get the money (mostly) converted to Roths prior to age 70.

The Roth conversion tool reduces the risk that future tax increases will crush savers who mostly use traditional 401(k)s during their working years. While this is true for all savers, it is most especially true for members of the FIRE community. 

A note on tax optimization: Imagine Joe and Sally were retired at age 55, today’s tax laws existed, and they had many years with artificially low taxable income. Say they did not do Roth conversions during this time. Is that a mistake? From a tax optimization perspective, absolutely. They would have likely been able to do Roth conversions at a 10% or 12% federal income tax rate, which is lower than both their retirement 22% marginal federal income tax rate and 18.11% combined effective income tax rate. While they are not tax optimized, they are something more important in my example: financially successful. Yes, tax optimization is important, but it is not the be-all and end-all. My guess is that financially successful individuals do not regret the failure to tax optimize on their deathbeds, though I look forward to reading Jordan “Doc G” Grumet’s new book to be sure. 

Conclusion

I’m not here to tell you exactly how to save for retirement. But I am concerned that TikTok tax advice has two deficiencies. First, it overstates the problem of taxation in retirement. Is there a potential problem? Yes. Is it as severe as some make it out to be? Not under today’s laws. Further, there are tactics such as annual Roth IRA contributions and Roth conversions during early retirement that can address the problem. Second, TikTok tax advice understates the current benefit of deductible traditional 401(k) contributions during one’s working years. 

Further Reading

Forbes has recently published two articles on the sorts of insurance policies frequently promoted on TikTok. They are available here and here. 

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter at @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

The Mystery of the Disappearing Tax Basis

Tax loss harvesting is all the rage in a down stock market. Did you know that it can create a mystery worthy of the Hardy Boys? Read on to find out how tax basis can disappear because of tax loss harvesting and the wash sale rule. 

Tax Loss Harvesting

I’ve previously written about tax loss harvesting. The idea is to sell a stock, bond, mutual fund, ETF, or other asset at a loss and report that loss on a tax return. That loss can offset other capital gains, and after having done that, it can offset ordinary income (W-2 income, interest income, etc.) up to $3,000 per year. Unused capital losses can be carried forward to subsequent tax returns indefinitely.

Tax loss harvesting is a nice tactic and in the right circumstances can be beneficial. That said, tax loss harvesting should not be a primary driver of one’s investment portfolio allocation. 

The Wash Sale Rule

The opportunity presented by tax loss harvesting has a major hurdle: the wash sale rule. Any acquisition of the same asset or a “substantially identical” asset 30 days before or 30 days after the sale at a loss denies the loss on the tax return. This is a very logical rule, considering the potential for abuse. Here’s an example:

Example 1: Sal owns 30 shares of Acme Corporation stock. He purchased it for $200 per share, and it is now worth $140 per share. Without the wash sale rule, Sal could sell all 30 shares for $140 on December 1st (triggering a $1,800 loss on his tax return) and then purchase 30 shares of Acme Corporation on December 2nd for its current value and have very little change in his economic position. 

Seen through the lens of Sal’s example, the wash sale rule makes sense. Why should Sal get to claim a loss on 30 shares of Acme stock he owns at year-end?

However, the wash sale rule can be implicated in less clear cut situations. Here’s one example:

Example 2: Cate owns 500 shares of IBM stock* in her taxable brokerage account. She purchased each share for $150 per share. On July 6, 2022, she sold 300 shares for $140 per share, realizing a $3,000 capital loss (300 times $10 loss per share). On July 29, 2022, IBM paid a dividend of $3 per share ($600 total on Cate’s remaining 200 shares), which Cate automatically reinvested in IBM stock, now valued again at $150 per share. 

In Cate’s case, the dividend reinvestment purchased 4 shares of IBM stock within the 61-day wash sale window. The taxable loss on 4 shares of the 300 sold ($40 total) is disallowed by the wash sale rule, and Cate will only be able to claim a taxable loss of $2,960 on the July 6th sale. 

* All values used in this blog post are hypothetical for purposes of the example. I did not look up IBM’s actual stock prices on these dates. The IBM dividend is also made up for the sake of the example.

One interesting tidbit about the wash sale rule in today’s environment: as the rule only applies to “securities” it does not apply to cryptocurrencies. Thus, an investor can sell a cryptocurrency at a loss on one day and repurchase it a day later and claim the entire loss on his or her tax return. There are proposals to do away with this treatment and subject cryptocurrencies to the wash sale rule. 

Retirement Accounts and the Wash Sale Rule

Let’s change Cate’s example just a bit, by having the repurchase occurring inside a Roth IRA.

Example 3: Cate owns 300 shares of IBM stock in her taxable brokerage account. She purchased each share for $150 per share. On July 6, 2022, she sold all 300 shares for $140 per share, realizing a $3,000 capital loss (300 times $10 loss per share). Separately, Cate owns 200 shares of IBM in her Roth IRA. On July 29, 2022, IBM paid a dividend of $3 per share ($600 total on Cate’s remaining 200 shares), which Cate’s Roth IRA automatically reinvested in IBM stock, now valued again at $150 per share. 

What result? The IRS has issued a Revenue Ruling, Rev. Rul. 2008-5, ruling that if the repurchase occurs inside the taxpayer’s Roth IRA or traditional IRA, the wash sale rule applies. Cate would suffer the exact same $40 wash sale rule loss disallowance. 

Note that a Revenue Ruling is not binding on taxpayers and the courts. Of course, a judge or appellate court may agree with the conclusion the IRS reaches in a Revenue Ruling, but they are not obligated to do so based solely on the IRS having issued the ruling. Rev. Rul. 2008-5 cites two 1930s court cases as authority for the conclusion reached in the ruling. Those cases involve a taxpayer using a controlled corporation to attempt to get around the wash sale rule, and the courts ruled that the wash sale rule applied regardless. 

In my research, I have not found any published court cases which have weighed in on Rev. Rul. 2008-5. The wash sale rule, as found in Section 1091, does not explicitly deem a retirement account and its owner to be the same person. Thus, there is at least some (perhaps quite small) risk to the IRS that a court would deem the primary result in Rev. Rul. 2008-5 to be too much of a stretch. That said, I certainly would not recommend taking a position counter to the ruling. I would struggle to advise that the wash sale rule does not apply if the security is repurchased in a retirement account. 

Disappearing Basis?

The wash sale rule disallows a loss, but it does not disallow basis. Section 1091(d) of the Internal Revenue Code and Treasury Regulation Section 1.1091-2 provide for a tax basis adjustment so that taxpayers are ultimately made whole after the application of the wash sale rule. Broadly speaking, the tax rules allow the disallowed loss to be added to the basis of the repurchased asset. In my Example 2 above, the basis of the 4 shares Cate repurchased is their historic cost ($150 per share) increased by the $10 per share disallowed loss. Thus, if Cate later sells those 4 shares, she will have a basis of $160 in those shares for purposes of determining gain or loss. 

In theory, the wash sale rule is simply a timing rule. It is inappropriate to allow a taxpayer to currently claim a loss when they wind up holding the exact same stock or securities. But, over time the tax basis rules should work out such that ultimately the correct amount is taxed to the taxpayer. 

What about basis adjustments when the wash sale occurs because of a repurchase made inside a retirement account? Rev. Rul. 2008-5 states that there is no basis adjustment with respect to a retirement account. There is an argument that Section 1091(d) should create Pro-Rata Rule basis in a traditional IRA. However, considering how highly technical and structured IRAs are, that is not a very likely outcome were the issue ever to be litigated. Further, that outcome would (quite oddly) give the taxpayer a different basis result based on whether they repurchased in a Roth retirement account or a traditional retirement account.

So what becomes of the basis? Does it just disappear? If the basis vanishes, the taxpayer obtains a worse wash sale result by repurchasing inside a retirement account. It seems odd that a taxpayer would receive a worse outcome for doing a repurchase through a retirement account instead of through a taxable brokerage account. 

Solving the Disappearing Basis Mystery

I have a theory that might solve the mystery. 

To get us started, consider that neither the Revenue Ruling nor Example 3 above discuss the “replacement property” in the taxable brokerage account. Here are two examples to ponder.

Example 4: Tim owns 1,000 shares of Domestic Equity Mutual Fund A (worth $50,000) he purchased for $60,000. It is held in a taxable brokerage account. On December 1, 2022, he sold Domestic Equity Mutual Fund A for $50,000 cash. He used the cash received to fund living expenses (food, clothing, heating bills, travel expenses, insurance, gasoline, etc.). On December 2, 2022, Tim purchased 1,000 shares of Domestic Equity Mutual Fund A in his Roth IRA. 

Example 5: Tim owns 1,000 shares of Domestic Equity Mutual Fund A (worth $50,000) he purchased for $60,000. It is held in a taxable brokerage account. On December 1, 2022, he exchanged all of his Domestic Equity Mutual Fund A for $50,000 worth of International Equity Mutual Fund B. On December 2, 2022, Tim purchased 1,000 shares of Domestic Equity Mutual Fund A in his Roth IRA. 

The wash sale rule disallows the $10,000 capital loss in both Example 4 and Example 5. But does Tim lose $10,000 of basis permanently? If he does, it’s an odd result considering that had he repurchased Domestic Equity Mutual Fund A in a taxable brokerage account (instead of in a retirement account), he would not lose that basis. 

I believe that there is a reasonable possibility that a court would rule that the $10,000 of basis shifts to the replacement property received in the wash sale. In Example 4, that conclusion leads Tim to no better position: he uses the cash for personal expenses, and there is no tax deduction for personal expenses. Further, I can’t imagine a court would give a step up in basis in Tim’s functional currency, the U.S. dollar. 

As applied to Example 5, where there has been a reinvestment in a taxable brokerage account, the equities of the situation might encourage some judges to find that Tim’s International Equity Mutual Fund B basis at a later sale is $60,000, not $50,000. 

Tim originally had $60,000 of basis in the system. While it is appropriate for a current loss to be disallowed, it is not appropriate for Tim’s basis in the system to be diminished in a situation where his overall taxable investment has not changed.

It’s one thing for the wash sale rule to operate to deny Tim a current loss deduction. It’s entirely another thing to interpret the wash sale rule to both deny current loss recognition and to permanently deny Tim $10,000 of basis. In its enactments of the wash sale rule and of the basis rules, Congress never manifested an intention for this one-two punch to bite Tim twice. If Tim sells the International Equity Mutual Fund B shares and recovers only $50,000 of basis he is inappropriately overtaxed. 

I believe some judges might determine that the IRS cannot have its cake (wash sale loss disallowance) and eat it too (permanent basis reduction). Basis exists to appropriately tax property transactions. Allowing Tim only $50,000 of future basis recovery over-taxes a later sale of his International Equity Mutual Fund B shares. While the IRS has a good argument that the wash sale rule disallowance should be spread to retirement account repurchases, it does not have a good argument that the overall result should be worsened if the repurchase occurs inside a retirement account.

Further, there is at least some risk to the IRS that a court would consider them to have reached just a bit by applying the wash sale rule to a repurchase inside a retirement account. The court might determine that what is good for the goose is good for the gander: if the IRS can reach a bit to apply the wash sale rule, the taxpayer can reach a bit to adjust the basis of the newly acquired securities in the taxable account.

The policies behind the rules point in the direction of allowing a taxpayer to add the disallowed loss to the basis of any replacement capital asset obtained through a direct exchange or a close-in-time use of the sales proceeds.

My proposed resolution has basis behave as it does in more familiar contexts. Say you received $50 from your grandmother when you were 12 years old. If you spent it on movie tickets and going bowling, the basis vanished for tax purposes. What if, instead, you purchased one share of stock of a publicly traded company for that $50? You’d get $50 of basis in that share of stock. Same with your first job: if you spend your first $1,000 W-2 paycheck on rent and groceries, tax basis disappears. But if you take that $1,000 and buy shares of ABC Mutual Fund in a taxable brokerage account, the basis stays attached to the mutual fund shares. Basis surviving when assets are reinvested in capital assets is a logical outcome.

Conclusion

Does anyone know for sure what happens to basis when the wash sale rule is tripped due to a repurchase in a retirement account? I believe it is still an unsolved mystery. 

Does basis vanish into the night? Or can it be preserved if the taxpayer reinvests in a capital asset in a brokerage account, as I have suggested?

Remember, the text of the Revenue Ruling does not affirmatively state that the basis simply disappears. Rather, all it says is that the basis does not get added to the taxpayer’s basis in the retirement account. To my mind, that’s a clue. It is not a definitive answer to the mystery. 

Now that we are 14 years removed from the issuance of Rev. Rul. 2008-5, it might be time for the IRS and Treasury Department to revisit the basis issue. The government could issue a regulation or another Revenue Ruling addressing the basis result in a situation similar to my Example 5. 

Of course, for taxpayers, this mystery is best avoided if possible. Repurchases should either (i) occur outside of the 61-day wash sale window or (ii) be of securities that are not the same or substantially identical to the sold securities.

I’ve also posted a video on YouTube with thoughts on this topic.

Lastly, the above is simply my technical analysis. It is not legal advice applicable to any one particular taxpayer or real life situation. 

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter at @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.