Monthly Archives: October 2024

Thoughts on Trump and Taxes

It happened. The frontrunner for the Presidency said “Sure, . . . why not?” when asked if he would eliminate the income tax on the Joe Rogan podcast. Whoa!!!

Okay, let’s calm down. Let’s not plan on never filing a tax return again just yet.

Tax planning is all about probabilities. Over the 2024 presidential campaign, probabilities have shifted. Below I’ll discuss the changing landscape, what it means for how Americans should approach their own planning (at year-end in 2024 and beyond), and a few thoughts on the future of American taxation.

Trump Tax Promises and Trend

Trump has been quite explicit with three individual income tax cut promises during the campaign:

No tax on tips
No tax on Social Security
No tax on overtime

Trump and his campaign have frequently mentioned these. It’s more than fair for the electorate to hold Trump to these promises.

Separately, Trump has been speaking quite fondly of tariffs. He did so during an interview with Dave Ramsey, which caught my attention.

I saw then what has become even clearer thanks to Donald Trump’s answer Joe Rogan’s question: the Trump Era would, to at least some degree, shift America away from income taxes and towards tariffs.

I do not view Trump’s answer to Rogan as a promise. It was one line during a 3 hour interview. It should be taken seriously, not literally. Trump briefly stated it in response to Rogan’s question. Importantly, Trump then went into detail not on eliminating income taxes but rather on his fondness of tariffs.

The above caveats aside, trend here is obvious. Much like with polling, trends matter much more than the top line. I have previously stated that tariffs might become very popular with politicians after Trump’s retirement. Voters don’t file tariff tax returns! That alone indicates future politicians might be more than happy to adopt pro-tariff positions, which could mean less in the way of income taxes.

What this Means for Americans

Does a Joe Rogan episode radically change financial planning for most Americans? No. But considering the odds, I think it, combined with Trump’s other promises, gives us two insights to consider.

2024 Year-End Roth Conversions

First, there is little reason to rush year-end 2024 Roth conversions, particularly before Election Day. The conventional wisdom had been “better do those Roth conversions before taxes go up in 2026!” That conventional wisdom is now out the window.

I generally recommend Roth conversions when they make sense for the individual based on the individual’s circumstances. I don’t recommend Roth conversions based on “conventional wisdom” about tax changes in 2026.

Question Paying Tax to Get Into Roth

I have been fond of traditional retirement account contributions. I didn’t think I would get evidence supporting that view from a Joe Rogan episode, but that’s where we are.

If future income taxes are trending down, why not take the deduction while it is valuable? That’s where we are going into the 2024 Election.

Does this mean we should never go Roth? No! But now we must start to question paying tax to get into Roth.

Please don’t read this to say “oh wow, FI Tax Guy is against Roth.” Far from it! But I must question paying federal income tax in 2024 to get into Roth.

There are times we pay tax to get into a Roth. Contributing to a Roth 401(k) instead of to a traditional 401(k) is paying tax to get into Roth, because we have foregone the tax deduction that we could have received for a traditional 401(k) contribution. Taxable Roth conversions are another time we pay tax to get into a Roth.

There are times we don’t pay tax to get into a Roth. For most people, an annual Roth IRA contribution involves no additional tax, since most Americans do not qualify to deduct contributions to traditional IRAs. Backdoor Roth IRA contributions are the same – there’s no forgone tax deduction. “Taxable” Roth conversions against the standard deduction are another example where there’s no additional federal income tax incurred to get money into a Roth.

To my mind, these “tax free” ways are the best way to get money into Roth accounts, and in this environment should be favored.

My Proposal

Many questions and challenges remain regardless of the outcome of the Election. It remains to be seen how much revenue can be raised by tariffs. The 47th President must prioritize significant cuts to federal spending, particularly foreign military spending. Oh, and the federal government has over $35 trillion of accumulated debt.

We are a long way away from axing the individual income tax. But, perhaps a relatively modest measure could get many Americans there. I propose doubling the standard deduction. The IRS just announced the 2025 standard deduction will be $15,000 for singles and $30,000 for married filing joint couples. Why not double it to $30K for singles and $60K for marrieds?

My proposal achieves some great outcomes. Combined with no taxes on Social Security, a doubled standard deduction would eliminate income taxes for most retired Americans. Trump could say he eliminated millions of tax returns with this one change.

Doubling the standard deduction would be a significant tax cut for millions of working Americans. Further, it would greatly reduce the number of Americans claiming itemized deductions, making the tax code easier to administer for the Internal Revenue Service.

Lastly, a government with $35 trillion plus of debt probably shouldn’t stop taxing the Elon Musks of the world. My proposal keeps taxing him and is no tax cut for him at all (assuming he makes more than $30,000 annually in charitable contributions).

Assuming Congress passes significantly increased tariffs in 2025, I recommend a five year doubling of the standard deduction. That would give the government five years to test out the new system to see if increased tariffs and decreased income taxes, hopefully in concert with significant spending cuts, is successful.

Conclusion

I will cry no tears if the income tax goes away. However, I don’t think we can plan for its demise.

While the income tax is likely here to stay, the trend is becoming obvious. Tariffs are likely on the way up and income taxes are likely on the way down. That informs retirement and tax planning. There’s little reason to rush Roth conversions, and traditional retirement account contributions are more attractive.

Of course, stay tuned. The Election is not over. There are no guarantees as I write this on October 26, 2024. I promise I’ll have plenty of commentary about year-end planning and more after the Election.

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.

Using IRAs to Pay Income Taxes In Retirement

It’s the fourth quarter. Now is a great time to check and see if you are on pace to have enough federal and state income tax paid in for 2024.

It happens: people get to the end of the year and see they are severely underwithheld. What do you do in such a situation?

This post explores using IRAs to pay income taxes and explores a novel approach: using a 72(t) payment plan to pay income taxes.

Income Tax Withholding Requirements

Before we discuss curative tactics, let’s briefly review the requirements. In order to avoid an underpayment penalty for 2024, on must pay in, either through withholding (could be W-2 or 1099-R, we’ll come back to that) or quarterly estimated tax payments, either (or both) 90% of the current year’s tax liability or 100% of the prior year’s tax liability. These are the two so-called “safe harbors.” For those with an adjusted gross income of more than $150,000 in the prior year, that 100% safe harbor increases to 110%.

The 100%/110% safe harbor protects the late-in year lottery winner (among others). As long as he or she has withholding or estimated tax payments that meet 100% or 110% (as applicable) safe harbor, he or she can have millions or billions of dollars in income, meet the safe harbor requirements, avoid the underpayment penalty and pay most of the 2024 tax by April 15, 2025.

Estimated tax payments are great, but they require early in the year action not possible in the fourth quarter. To meet the safe harbor, generally one quarter of the total amount due under the safe harbor must be paid by April 15th, June 15th, September 15th, and the following January 15th. That’s great, but for those who didn’t make the first three payments going into the fourth quarter, estimated tax payments may not be all that helpful at this point.

Most states with an income tax have rules that mirror the federal income tax withholding rules, but some states have differences.

The Retiree’s Secret Weapon for Estimated Tax Payments

Retirees have a secret weapon for making income tax payments, particularly late in the year. IRAs!

People miss paying taxes during the year. It happens for a variety of reasons. If I were a retiree and I found myself underpaid for either (or both) federal and state income taxes purposes in the fourth quarter, the first place I would look to make an estimated tax payment would be a traditional IRA.

Why?

Because income tax withheld from a traditional IRA is deemed paid equally to the IRS throughout the year regardless of when the withholding occurs.

IRA owners can initiate a distribution from their traditional IRA and direct that most of it be directed to the IRS and/or the state taxing authority. That withholding is treated as if it is paid equally throughout the year regardless of whether it occurs on January 5th or December 21st.

That’s pretty good! A late in the year IRA distribution withheld to the IRS can meet either (or both) the 90% safe harbor and/or the 100%/110% safe harbor.

The downside is that it creates taxable income. In many cases, it turns out retirees are rather lightly taxed. As long as the retiree had a relatively low income tax burden either last year or this year, the taxable withdrawal won’t be a large number, because the applicable required safe harbor withholding will be modest. Thus, the tax hit on the mostly withheld distribution should be rather modest.

Another advantage of using a traditional IRA to pay income taxes is RMD mitigation. While I believe the concerns around RMDs are wildly overstated, RMD mitigation is a perfectly valid financial planning objective and a good outcome.

Using an IRA to Pay Income Taxes Under Age 59 ½

You may now be thinking “Sean, that’s a great idea for those over age 59 ½. But what if I’m under age 59 ½? Won’t I be subject to the 10% early withdrawal penalty on the amount I fork over to the IRS?”

That’s an excellent thought! Fortunately, the answer to your questions is “maybe.”

The IRS maintains a list of exceptions to the 10% early withdrawal penalty. Many will not be applicable to most retirees. But there are some options–let’s explore two of them: Inherited IRAs and 72(t) payment plans.

Inherited IRAs

Beneficiaries of inherited IRAs never pay the 10% early withdrawal penalty with respect to distributions from their “inherited IRAs.” Thus, the inherited IRA is a great place to look to pay taxes from late in the year.

The only downside is the distribution to the IRS or the state taxing authority is itself taxable to the beneficiary. However, the money in the inherited IRA has to come out eventually (usually under the 10 year rule at a minimum), so why not whittle the traditional IRA down by using it to pay income taxes and avoid an underpayment penalty?

72(t) Payment Plan to Pay Income Taxes

Could someone start a 72(t) payment plan to pay required income taxes? Absolutely, in my opinion. It might even be a good idea!

72(t) Payment to Pay Income Taxes Example

Homer and Marge both turned age 56 in the year 2024. They retired early in 2023 and thus had some W-2 income and some investment income in 2023. They had approximately $120K of adjusted gross income in 2023 and thus paid approximately $8,800 of federal income taxes in 2023 (see Form 1040 line 24 less most tax credits — see the comment below) and $2,000 of California income taxes in 2023.

In 2024 they have ordinary income below the standard deduction and taxable income below the top of the 12% federal income tax bracket. Thus, they owe no federal income tax and a very small amount of California income tax for 2024. They’ve made no estimated tax payments.

In August 2024 they decided to sell their Bay Area home worth $2M to move to a more rural part of California. The sale closed in October 2024 and they had a $500,000 basis in the home. Qualifying for the $500K exclusion, this triggers a $1M taxable long term capital gain to Homer and Marge in 2024. D’oh!

Very, very roughly, the capital gain creates approximately $175K of federal income tax, $30K of federal net investment income tax, and $100K of California income tax. Note also that the proceeds from the home sale are likely to cause some taxable income in December 2024, but let’s just use the above three tax numbers for illustrative purposes only.

One of their other assets is a $2M traditional IRA. They have no inherited retirement accounts but they do have some taxable brokerage accounts. To my mind, there are four main ways Homer and Marge can avoid an underpayment penalty.

Option 1: Q4 Estimated Tax Payments

Homer and Marge could make substantial fourth quarter estimated tax payments out of their taxable brokerage accounts by January 15, 2025. They would owe 90% their entire 2024 tax liability at that time and would need to use annualization on the Form 2210 to avoid an underpayment penalty.

Compared to the other three methods described below, this costs them 3 months of interest on about $275K. In today’s interest rate environment, that is about $2,700 of interest in an online FDIC insured savings account.

Option 2: IRA Regular Distribution

Homer and Marge could, no later than December 31st, trigger a distribution from one of their traditional IRAs, say for $11,100. They could direct the institution to send $8,880 (80%) to the IRS, $2,109 (19%) to the California Franchise Tax Board, and $111 (1%) to themselves (the intuition will likely require they take at least 1% of the distribution). This creates $11,100 more taxable income (taxed at a low federal rate due to income stacking).

The advantage is this qualifies for the safe harbor, meaning Homer and Marge don’t have to pay most of their 2024 income tax until April 15, 2024. The downside to this is it triggers a 10% early withdrawal penalty ($1,110) payable to the IRS and a 2.5% early withdrawal penalty ($278) payable to California.

Option 3: IRA Regular Distribution and Rollover

This option is the IRA Regular Distribution option plus refunding the $11,100 traditional IRA distribution to the traditional IRA from their taxable accounts within 60 days. This has all the same advantages as the IRA Regular Distribution option plus it reduces 2024 taxable income by $11,100 and avoids the early withdrawal penalties.

Gold, right? My view: I tend to disfavor this tactic. Why? Americans are limited to one 60 day rollover from an IRA to an IRA every 12 months. My personal opinion is that pre-age 59 ½ retirees are usually better served to keep that option on the table. You never know when a significant sum will pop out of a traditional IRA. It will be good to have the option to put that money back into the traditional IRA. If Homer and Marge do the $11,100 IRA Regular Distribution and Rollover, they are locked out from the ability to do a 60 day IRA to IRA rollover for the next 12 months.

Option 4: 72(t) Payment Plan

This option is simply the IRA Regular Distribution option as part of a 72(t) payment plan. The advantage of adding the 72(t) payment plan is avoiding the 10% early withdrawal penalty (federal) and the 2.5% early withdrawal penalty (California).

Here’s how it works. Before making the $11,100 IRA withdrawal, Homer and Marge do a 72(t) distribution calculation and have their financial institution set up a $172,116.10 72(t) IRA. Here is the 72(t) fixed amortization calculation:

Item	Amount	Source
Interest Rate	5.00%	Notice 2022-6
Single Life Expectancy Years at Age 56	30.6	IRS Single Life Table
Account Balance	$172,116.10
Annual Payment	$11,100.00

Homer and Marge then take the distribution from the 72(t) IRA prior to the end of 2024, directing 80% to the IRS and 19% to the Franchise Tax Board.

You say, but wait a minute, now they have $11,100 they have to take annually for each of the following four years. I say, well, okay, they have $2M in tax deferred accounts, why not take some of that without a penalty (perhaps as a form of the “Hidden Roth IRA”) and whittle down future RMDs a bit?

That said, Homer and Marge can drastically reduce the annual 72(t) payment if they want with a one-time change to the RMD method. Assuming the 72(t) balance on December 31, 2024 is $164,000, here’s what the 2025 taxable RMD from the 72(t) could look like:

Item	Amount	Source
Account Balance	$164,000
Single Life Expectancy Years at Age 57	41.6	Notice 2022-6 Uniform Life Table
2025 Payment	$3,942.31

One would hardly expect that $4,000 of taxable income would derail Homer and Marge’s tax planning in retirement. Further, they can direct most of that $4,000 to the IRS and Franchise Tax Board to help take care of 2025 tax liabilities, if any.

Conclusion

For those under age 59 ½, a 72(t) payment plan might be the answer to an underpayment of estimated taxes problem. It is a bit of an “out of the box” solution, but it has several advantages. It allows some taxpayers to delay paying significant amounts of tax until April 15th of the following year by qualifying the taxpayer for the 100% of prior year tax safe harbor. Second, it avoids the 10% early withdrawal penalty. Third, it avoids the once-every-twelve-months 60 day rollover rule. Lastly, a 72(t) payment plan is rather flexible and the required taxable distribution in future years can be significantly reduced by a one-time switch to the RMD method.

The above said, the first IRA I would look to if I was under age 59 ½ and looking to pay estimated taxes is an inherited IRA. Those are never subject to the early withdrawal penalty and can always be accessed in a flexible manner.

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

Follow me on X: @SeanMoneyandTax

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

Inherited Retirement Account Rules Need Radical Reform

My hope is that 2025 ushers in an era of simplification when it comes to all federal laws. Justice Neil Gorsuch co-wrote a book arguing we have far too many laws, and I agree with him. The more numerous the laws, the more corrupt the state.

One area that is insanely and needlessly complicated is the inherited retirement account rules. What happens when someone inherits a traditional IRA, Roth IRA, and/or qualified workplace retirement account? It depends on far too many factors and there are far too many potential outcomes! As just one example, financial planner Jeffrey Levine came up with a flow chart of possible outcomes when a successor beneficiary inherits a retirement account.

That Mr. Levine could come up with such a flow chart is an absolute disgrace (to the government, not to Mr. Levine).

Complexity in our tax and retirement account laws shifts power away from ordinary Americans towards lawyers, accountants, advisors (such as me), and the IRS. Let’s shift some power back to ordinary Americans!

It’s time to radically simplify and reform the inherited retirement account rules.

Current Inherited Retirement Account Rules

Upon the death of the owner of an IRA or qualified plan, the following are potential outcomes in terms of potential inherited retirement account distribution rules:

Spousal Rollover
Required Minimum Distributions (“RMDs”)
10 Year Rule
10 Year Rule with RMDs
5 Year Rule

Woah! That there are so many possible outcomes, which require significant analysis to determine, is absolutely ridiculous and an unnecessary burden on American taxpayers.

Proposed Inherited Retirement Account Reform

I propose that the current voluminous, complicated inherited retirement account rules be scrapped. They should be replaced by the following simple rules, all effective January 1, 2025 unless otherwise noted.

At the decedent spouse’s death, any retirement account left to a spouse becomes the surviving spouse’s retirement account in the surviving spouse’s own name automatically and immediately upon death.

All other beneficiaries inherit an inherited retirement account which must be emptied within 10 full years following the owner’s death with no RMDs in years 1 through 9.

The death of a spouse entitles the surviving spouse to a permanent exception to the Section 72(t) 10 percent early withdrawal penalty with respect to distributions from any retirement account.
- This applies even if the widow/widower remarries.
- For fairness and simplicity, this applies even if the spouse died prior to 2025.

Any inherited retirement account a widow or widower treats as an inherited retirement account instead of a spousal rollover account as of the end of 2024 automatically becomes the surviving spouse’s own retirement account in their own name as of January 1, 2025.

The death of the beneficiary of an inherited retirement account does not change the clock. Successor beneficiaries must empty the inherited retirement account by the end of the 10th full calendar year following the original owner’s death.

Existing inherited retirement accounts (as of the end of 2024) are no longer subject to both the 10 year rule and RMDs. For 2025 and beyond, such accounts are subject to only the 10 year rule.

For fairness and simplicity, any retirement account inherited prior to 2025 subject to a 5 year rule will switch to the 10 year rule (measured as of the owner’s date of death).

Reset Day for Inherited Retirement Accounts Subject to an RMD in 2025: If the original owner died in 2024 or earlier and the inherited retirement account is subject to only an RMD in the year 2025 (under any of the old rules), the inherited account will become subject to the 10 year rule, and no longer be subject to RMDs (both as of 2026), as if the original owner died on December 31, 2025.
- The 2025 New Year’s Eve Reset Day applies to both beneficiaries and successor beneficiaries, including those who become successor beneficiaries during 2025.

Simplification

After my proposed reform, there will be two and only two potential treatments for an inherited retirement account: spousal rollovers for spouses and the 10 year rule for everyone else. Note: It takes 8 rules to get to a 2 rule system because in order to get to a 2 rule system there needs to be rules to account for the transition from a very complex system to an understandable system.

Replacing the existing rules with the above 2 rule system would significantly reduce the amount of federal regulations and reduce complexity. Congress stumbled into a great inherited retirement account rule in the SECURE Act: the 10 year rule. It’s time to make that the rule for all inherited retirement accounts except spousal rollovers.

Rules 4, 7, and 8 are simplification and consistency measures. They logically transition the inherited retirement accounts rules to a single, uniform system with only two outcomes: a spousal rollover or the 10 year rule.

Rapid Transition

I propose a rapid, though not overnight, transition to a uniform system. Assuming a bill is passed in early to mid-2025, 2025 can be a transition year and then by New Year’s Day 2026 all inherited retirement accounts would be on the new system, meaning all inherited retirement accounts, regardless of when inherited, would be subject to only one of two rules as of New Year’s Day 2026.

Protecting Young Widows and Widowers

Rule 3 is needed to avoid reform harming pre-age 59 ½ widows and widowers. Under today’s rules, surviving spouses can elect to treat a spouse’s retirement account as an “inherited” account instead of doing a spousal rollover. That inherited treatment avoids the 10 percent early withdrawal penalty on pre-age 59 ½ distributions.

If pre-age 59 ½ widows/widowers must do a spousal rollover (as I propose), they would be subject to the 10 percent early withdrawal penalty if they took taxable distributions prior to their 59 1/2th birthday. To avoid that outcome, why not make becoming a widow/widower an automatic, permanent exception to the 10 percent early withdrawal penalty?

Transition Entirely to a New Uniform System

Reform should clean the slate of complexity. Without rules 4, 7, and 8, there would be separate systems of rules for retirement accounts inherited prior to 2025 and those inherited in 2025 or later. There’s no need for two separate systems of rules. These three rules make the rules simple for all inherited retirement accounts going forward.

A Small Net Tax Increase

Rule 8 is a modest tax increase, mostly falling on the wealthiest Americans. Considering the hope that 2025 will bring some popular tax cuts, such as eliminating taxes on tips and Social Security, it is good to have at least some logical tax increases in 2025 that would not significantly impact ordinary Americans. Note also that rules 2 and 5 are also likely to be small tax increases while rules 3 and 7 are likely to be small tax cuts.

Regardless of the likely very modest net tax effect, the simplicity brought by this new system would greatly benefit the administration of the tax rules and ordinary Americans.

Rule 8 Transition Examples

Rule 8, eliminating inherited retirement account RMDs and switching to a 10 year rule as of 2026, is key to transitioning old inherited retirement accounts to the new, uniform system for taxing inherited retirement accounts. Here are three examples of how it would work.

Example 1: In 2017 Jock died and left his $1M traditional IRA to his son JR. JR, 23 years younger than Jock, turned 40 in 2017. JR started taking traditional IRA RMDs based on the IRS Single Life Table in 2018. In 2022 he redetermined the RMD factor such that by 2025 the factor was 37.8 (start with 44.8 for 2018 theoretically, subtract one annually to get down to 37.8 for 2025). For 2025, JR must take his RMD under the old rules (which still apply) by dividing the inherited traditional IRA 12/31/2024 balance by 37.8 and taking that amount by December 31, 2025. In 2026 JR becomes subject to the 10 year rule by Jock’s deemed death on December 31, 2025. Thus, JR has until the end of 2035 to empty the inherited traditional IRA. He has no RMDs other than in 2035 (the entire remaining balance).

Example 2: In 2022 Huey died and left his $1M traditional IRA to his brother Earl. Earl, two years younger than Huey, turned 66 in 2022. Earl, an “eligible designated beneficiary” under the SECURE Act, started taking inherited traditional IRA RMDs based on the IRS Single Life Table in 2023. For 2025, Earl must take his RMD under the old rules (which still apply) by dividing the inherited traditional IRA 12/31/2024 balance by 19.2 and taking that amount by December 31, 2025. In 2026 Earl becomes subject to the 10 year rule by Huey’s deemed death on December 31, 2025. Thus, Earl has until the end of 2035 to empty the inherited traditional IRA. He has no RMDs other than in 2035 (the entire remaining balance).

Example 3: In 2017 Al died and left his $1M traditional IRA to his son Barry. Barry has taken RMDs annually. During 2025 Barry dies and Carl becomes the successor beneficiary. In 2026 Carl becomes subject to the 10 year rule (as Al is deemed to have died December 31, 2025) and Carl has until the end of 2035 to empty the inherited traditional IRA. He has no RMDs other than in 2035 (the entire remaining balance).

Conclusion

The inherited retirement account rules are mindlessly and needlessly complicated. The complexity creates confusion shortly after the death of a loved one. Enough is enough!

It’s time for greatly simplified inherited retirement account rules. That simplifying these rules might help fund popular tax cuts such as eliminating taxes on tips and Social Security is the cherry on top of a great tax reform proposal.

Follow me on X at @SeanMoneyandTax

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

Note that a version of this proposal will be posted to the crowd sourced policy website PoliciesforPeople.com. The views reflected in this post are only those of the author, Sean Mullaney, and are not the views of anyone else.

72(t) Payment Plan With a 401(k)

I’ve talked about what I refer to as a “72(t) IRA” both here on the blog and on my YouTube channel.

What I haven’t talked much about, until now, is a 72(t) payment plan coming out of a 401(k). Is it possible? Does it make sense?

Inspired by a comment on a recent video, I’m breaking down taking 72(t) payments from a 401(k) in this post. As you will see, when compared with the 72(t) IRA, the 72(t) 401(k) has significant disadvantages.

401(k) Plan Rules

Can you do a 72(t) out of your 401(k)? The answer is “maybe.” Qualified plans, including 401(k)s, have all sorts of unique rules. They vary plan to plan.

There’s no guarantee that you can access partial withdrawals from a 401(k) in accordance with a 72(t) payment plan after a separation from service.

By contrast, IRAs allow for easily accessible partial withdrawals regardless of age.

Must Separate From Service

There’s a tax rule to consider: one can only do a 72(t) payment plan from a 401(k) or other qualified plan after a separation from service from the employer.

From a planning perspective, this is not much of an issue. Few would want to do a 72(t) payment plan while still working, as taxable withdrawals from a 401(k) are not ideal if one still has significant W-2 income hitting their tax return.

72(t) Account Size

According to Notice 2022-6, the 72(t) account balance for the fixed amortization calculation must be determined in a reasonable manner. See Section 3.02(d). The Notice goes on to state that using a balance of the account from December 31st of the prior year through the date of the first 72(t) distribution is reasonable. One should document, usually with an account statement, the balance they are using to have in case the IRS ever examines the 72(t) payment.

Account size is one area where a 72(t) IRA is generally preferable to a 72(t) 401(k). As Natalie Choate observes in her classic Life and Death Planning for Retirement Benefits (8th Ed. 2019), an IRA can be sliced and diced into two or more IRAs, allowing one to take a 72(t) payment from a smaller IRA and remain flexible, in part through having a non-72(t) IRA as well. This flexibility is generally not possible with a 401(k) or other qualified plan. See Choate, page 595. That means without a transfer to an IRA first, the 401(k) account holder is generally stuck with an account size for the fixed amortization calculation, other than the bit of wiggle room given by Notice 2022-6 Section 3.02(d). Further, the entire account is subject to the locked 72(t) cage.

72(t) Locked Cage

A 72(t) 401(k) is entirely subject to the many restrictions on 72(t) retirement accounts. When one uses a 72(t) IRA, they often can have a 72(t) IRA and a non-72(t) IRA. This means less of their retirement account portfolio is subject to the 72(t) rules “locking the cage.” For example, the non-72(t) IRA can be used to accept other IRA roll-ins.

72(t) 401(k) Example

An example can illustrate the problems involved in using a 72(t) 401(k) instead of a 72(t) IRA.

Bob wants to retire early in 2024 at age 53. He has some rental real estate that will generate $40,000 of positive cash flow annually and needs $50,000 more annually from his retirement account to support his lifestyle. He has a $2,000,000 401(k) at his current employer. He sets up a 72(t) 401(k) instead of rolling out to a traditional IRA and establishing a non-72(t) IRA and a 72(t) IRA.

Size: $2,000,000

Life Expectancy: 33.4 (see the IRS Single Life Table)

Payment: $50,000

Solving for interest rate, we get an interest rate of -1.015124%.

Notice that in order to generate a $50K annual payment out of a $2M 401(k), Bob must use a negative interest rate. Bob can’t simply ask his 401(k) administrator to establish two separate 401(k) accounts for him and then use a positive interest rate for the 72(t) payment plan.

72(t) Negative Interest Rate

This raises an issue: can a taxpayer use a negative interest rate for a 72(t) payment plan under the fixed amortization method? I believe the answer is Yes. Notice 2022-6 Section 3.02(c) allows an interest rate “that is not more than the greater of (i) 5% or (ii) 120% of the federal mid-term rate (determined in accordance with section 1274(d) for either of the two months immediately preceding the month in which the distribution begins)” (emphasis added).

In my opinion, that wording in no way precludes using a negative interest rate for a 72(t) payment plan. Further, I see no compelling reason for the IRS to be concerned about using a negative interest rate. That said, there is at least some uncertainty around the issue.

The issue is entirely avoided if Bob rolled out to a traditional IRA and then split that traditional IRA into two IRAs. He could have a 72(t) IRA of about $804K generating an annual $50K payment (using a 5% interest rate) and a non-72(t) IRA of about $1.196M. From a planning perspective, it’s certainly my preference to avoid the issue by using the 72(t) IRA.

72(t) Structuring Alternative

As a structuring alternative that might be available to Bob (depending on the plan’s rules), Bob could roll the $804K out to a traditional IRA and use that as a 72(t) IRA. He could keep the balance inside his 401(k) and effectively use his 401(k) as what I refer to as the “non-72(t) IRA.” This sort of structuring was discussed on the Forget About Money podcast (timestamped here).

Decreasing the 72(t) Payment

What if Bob wants to reduce his 72(t) 401(k) annual payment (perhaps because he inherits a significant traditional IRA)? Bob can do a one-time change to the RMD method, which is the primary method of reducing the annual taxable 72(t) payment.

Unfortunately, using a 72(t) 401(k) boxed Bob into a bad corner. Say Bob is age 57 and the 72(t) 401(k) is still worth exactly $2M. He could use the age 57 factor from the Notice 2022-6 Uniform Life Table (41.6) and reduce his annual payment to $48,077. Not much of a reduction from his $50,000 required annual payment.

Had he used a 72(t) IRA/non-72(t) IRA structure instead, and the 72(t) IRA was worth $804K, he could reduce his $50,000 annual payment all the way down to $19,327.

For those looking for protection against significant tax in the event of an inheritance or other income producing event, the 72(t) IRA is preferable to the 72(t) 401(k).

Increasing the 72(t) Payment

But maybe Bob wants to increase his 72(t) annual payment from $50,000 to $60,000 at age 57. For those with a non-72(t) IRA, this is easy: simply slice and dice that non-72(t) IRA into two IRAs, one of which is a small new 72(t) IRA supporting the additional $10,000 annual 72(t) payment.

What if Bob has a 72(t) 401(k)? I believe that establishing a second 72(t) payment from his 72(t) 401(k) would blow up his existing 72(t) payment plan. The second 72(t) payment would be an impermissible modification of the original 72(t) payment plan, triggering the 10 percent early withdrawal penalty and interest charges with respect to all prior distributions.

I am uncomfortable with any modification to a 72(t) retirement account unless it is specifically allowed by IRS guidance such as Notice 2022-6, and I see no evidence that a second 72(t) payment plan out of the same retirement account is permissible. Natalie Choate is also of the opinion that taking a second 72(t) payment from an existing 72(t) account is an impermissible modification of the first 72(t) payment plan. See Choate, page 594. See also IRS Q&A 9 (nonbinding), allowing a new 72(t) payment plan from the retirement account only after the taxpayer has blown up their original 72(t) payment plan.

That said, there is a single 2009 Tax Court case, Benz v. Commissioner, that gives the slightest glimmer of hope. In that case an additional distribution from a 72(t) IRA excepted from the 10% early withdrawal penalty as being for higher education expenses did not blow up an existing 72(t) payment plan, because the additional distribution itself qualified for a 10 percent early withdrawal penalty exception under Section 72(t)(2)(E).

It’s likely a stretch to apply Benz to a second 72(t) payment plan from the same retirement account. That said, I don’t believe it is an impossible outcome. But note that Benz is a single 15 year old court case binding neither on any federal district court nor on any federal appellate court. Further, the IRS never acquiesced to the decision in Benz, meaning they may still disagree with it. Even if the IRS now agrees with Benz they (and more importantly, a court) may not believe the logic of Benz goes so far as to allow a second 72(t) payment plan from the same retirement account.

Asset Protection

Depending on the circumstances and on the state, it can be true that IRAs offer materially less creditor protection than 401(k)s and other qualified plans. That could be a reason to use a 72(t) 401(k) instead of a 72(t) IRA.

I believe that, as a practical matter, sufficient personal liability umbrella insurance, which tends to be affordable, can adequately fill-in gaps between IRA and 401(k) creditor protection. Of course, everyone needs to do their own analysis, possibly in consultation with their lawyers and/or insurance professionals, as to the adequacy of their creditor protection arrangements.

72(t) Payment Plan Resources

72(t) payment plans are complex. Here are some resources from me and other content creators for your consideration:

Retire on 72(t) Payments

Tax Basketing for 72(t) Payment Plan

IRS 72(t) Questions and Answers

Jeffrey Levine Strategies For Maximizing (Or Minimizing!) Rule 72(t) Early Distribution Payments Using IRS Notice 2022-6

Denise Appleby Watch this before starting a Substantially Equal Periodic Payment – SEPP 72t program

Natalie B. Choate Life and Death Planning for Retirement Benefits (8th Ed. 2019), particularly pages 582 to 605.

Florida Retirement System 72(t) Calculator (not validated by me).

The 72(t) is far from the only option available for those looking to retire prior to age 59 ½.

Conclusion

The 72(t) 401(k) is a possibility if one’s 401(k) plan allows it. I usually strongly disfavor doing a 72(t) payment plan out of a 401(k) considering how rigid it is compared to the 72(t) IRA alternative. Further, as discussed above, 72(t) 401(k)s can create situations where the tax law has not, to my knowledge, definitely stated the governing rules. For these reasons, I generally favor using 72(t) IRAs in conjunction with non-72(t) IRAs instead of the more inflexible 72(t) 401(k).

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