Monthly Archives: April 2025

The Middle Class Trap

I have said the tax laws want you to retire early.

Counter to that point, the BiggerPockets Money podcast has warned that the tax laws are an effective bar to many retiring prior to age 59 ½.

So who is right? The FI Tax Guy or Scott Trench and Mindy Jensen of the BiggerPockets Money podcast?

This isn’t just a discussion in my mind or a late night debate at the Waffle House. It’s become a debate in the financial independence space. Just last week, the Middle Class Trap was the topic of the ChooseFI podcast.

We will return to that episode of ChooseFI later. For now, I want to start by defining the Middle Class Trap and providing the two reasons I don’t believe the Middle Class Trap is a trap. Then I will move onto several numerical examples, including four Mindy Jensen provided on ChooseFI.

The Middle Class Trap Defined

Scott Trench and Mindy Jensen walk through their definition of the Middle Class Trap from in this YouTube video. I encourage you to watch it.

Boiled down, the argument is that primary residence wealth is trapped and traditional retirement accounts are trapped until age 59 ½. Thus, many in the middle class have trapped wealth and cannot retire prior to age 59 ½ despite good numbers on paper.

There are two problems with their argument. First, primary residence wealth isn’t the owner’s wealth as we ordinarily conceive and define it. Second, traditional retirement accounts are not trapped prior to age 59 ½.

The Primary Residence Question

Too often we think of primary residences as investments. They are not, as Douglas Boneparth observes. They are a form of consumption.

People say “I have a million dollars in home equity so I am a millionaire.”

No, you are not.

I can prove it.

Peter has a $500 checking account, a car, clothes, and a $1 million home with no mortgage. He sells the home for $1 million. He immediately must get a hotel room to sleep in tonight.

John has a $500 checking account, a car, clothes, rents an apartment, and has $1 million in VTSAX in a taxable account. He sells $10,000 of VTSAX for cash. He now has a pile of cash and need not make any adjustments to have a bed for the night.

Is Peter’s home equity really his wealth when accessing causes significant life adjustments? John’s VTSAX is his wealth. His accessing it requires no life adjustments.

So what then is market driven appreciation in home equity? It’s growth in asset value that primarily benefits three classes of people:

The next generation
Owners willing to change geographies or willing to significantly downsize
Owners needing long-term care at the end of life

Market driven increases in home equity are not a trap. Rather, they are wealth that, in many cases, someone else gets to enjoy.

Imagine I’m writing a blog post and the doorbell rings. I answer and the delivery man says, “Mr. Mullaney, congratulations! You won a contest. The prize is $1,000 of Blippi toys!”

Those Blippi toys are my wealth that my toddler Goddaughter gets to enjoy.

It’s no different with market driven increases in home equity. It’s wealth that shows up on your doorstep that most likely will be enjoyed by the next generation.

In no way do those Blippi toys trap me. Same with market driven increases in home equity.

The 10% Early Withdrawal Penalty is No Bar to Early Retirement

I’ve written about the myriad ways to fund retirement prior to 59 ½ without incurring the 10 percent early withdrawal penalty. I’ve spoken about it on two episodes of the ChooseFI podcast (475 and 491).

But until now, I have never explicitly said the following:

Those 50 and older with sufficient assets are in no way barred from early retirement due to the 10 percent early withdrawal penalty even if all of their financial asset wealth is in traditional retirement accounts.

While 72(t) payment plans are not the ideal retirement plan, they are more than adequate enough to use to retire in the year one turns age 50 or later. Those 50 or older, with a simple spreadsheet and some diligence, are in no way barred from early retirement due to the 10 percent early withdrawal penalty.

What about those under age 50?

Few under age 50 will be able to retire on traditional retirement accounts alone because of sufficiency concerns. Tax concerns are not the problem when thinking about retiring prior to age 50 – it’s all about sufficiency!

Fortunately, the profile tends to resolve itself. To have enough financial wealth to retire in one’s 40s, the prospective early retiree most likely contributed to some combination of Roth accounts or taxable accounts prior to retirement. While not insignificant, traditional retirement account contribution limits are such that for many, it will be difficult to rely on them exclusively to build up sufficient assets for retirement prior to January 1st of the year of one’s 50th birthday. The 40-something early retiree can start their early retirement distributions from Roth accounts, taxable accounts, or a combination of both, obviously without penalty.

Summed up, when assessing the Middle Class Trap, for those under 50, their profile itself usually resolves the issue. For those 50 and older, the 72(t) payment plan rules are so advantageous (due to a major change in 2022) that a spreadsheet requiring one amortization calculation, some coordination with a financial institution, and a bit of ongoing additional diligence resolves the issue.

For both age cohorts, there is no tax trap.

Does this mean the 10 percent early withdrawal penalty has been, in effect, repealed? Hardly! If someone like me, in their late 40s, wants to take $20,000 from a traditional 401(k) to fly round-trip in a suite, I will pay a hefty 10 percent early withdrawal penalty. The penalty is still effective to discourage impulsive onetime withdrawals before retirement. But the penalty is not effective to prevent early retirements with a systematic, sustainable withdrawal plan. That’s the obvious intention behind the series of substantially equal periodic payments exception.

Examples from Mindy Jensen on ChooseFI Episode 543

Last week’s episode of the ChooseFI podcast, featuring host Brad Barrett, Mindy Jensen, and Can I Retire Yet blog author Chris Mamula was a great contribution to the FI space.

During the ChooseFI episode, Mindy offered some numerical examples to argue for her case. That is a very legitimate tactic, and I personally love examples. Unfortunately, using numerical examples ran up against a limitation of the audio podcast format, since it can be difficult for participants and listeners to fully process multiple numbers while listening to an episode.

Mindy started sharing numerical examples around 25:00 in the podcast. I went back to the YouTube video and put Mindy’s numbers in the below table. I then added a row totaling financial assets and two rows laying out theoretically possible annual withdrawal rates.

Amount	Person A	Person B	Person C	Person D
Primary Residence Value or Equity	Not given	Not given	$3,000,000	$800,000
Traditional Retirement Accounts	$268,000	$36,000	$1,200,000	$234,000
Roth Retirement Accounts	$18,000	$143,000	$0	$0
Taxable Brokerage Accounts	$187,000	$306,000	$0	$60,000
Cash	$106,000	$119,000	$225,000	$69,000
HSA	$0	$0	$35,000	$0
Total Financial Assets	$579,000	$604,000	$1,460,000	$363,000
Morningstar Annual SWR (3.7%)	$21,423	$22,348	$54,020	$13,431
Six Percent Annual Withdrawal Rate	$34,740	$36,240	$87,600	$21,780

Let’s use a range of withdrawal rates just for illustrative purposes. On the low end, we’ll use Morningstar at 3.7 percent, which can be fairly considered to be conservative. On the high end, let’s roll the dice a bit and use 6 percent.

Notice that the problem in the examples is not that the person has everything locked up in traditional accounts. The problem is sufficiency! Aside from Person C, it does not matter if all of the financial wealth is in Roth accounts, taxable accounts, or split between the two of them.

Persons A, B, and D are not in the Middle Class Trap. Rather, they are in a situation where they need to work longer unless their annual spending is incredibly modest, even by financial independence standards.

I believe that Person C could consider living on cash and later starting a 72(t) payment plan, but we really can’t tell without knowing much more information, including their age and their annual spending level in retirement.

Middle Class Trap 72(t) Payment Plan Examples

In one podcast episode, Mindy and Scott put the parameters of the Middle Class Trap at $1M to $1.5M of trapped wealth (see 3:19 of this video). How bad is the federal income tax result if we assume practically all of that wealth is in traditional deferred retirement accounts?

Using the old Four Percent Rule of Thumb for our 72(t) annual payment at both ends of the spectrum, and assuming a $40,000 taxable savings account and 5 percent interest on it and on the annual 72(t) payment taken at the beginning of the year and spent evenly during the year, here’s the 2025 federal income tax result by my estimation.

	Single $1M	Single $1.5M	Married $1M	Married $1.5M
Interest Income	$3,000	$3,500	$3,000	$3,500
72(t) Payment	$40,000	$60,000	$40,000	$60,000
AGI	$43,000	$63,500	$43,000	$63,500
Standard Deduction	$15,000	$15,000	$30,000	$30,000
Taxable Income	$28,000	$48,500	$13,000	$33,500
Federal Income Tax	$3,122	$5,584	$1,300	$3,543
72(t) Payment Funding for Expenses Other Than Federal Income Tax	$36,878	$54,416	$38,700	$56,457
Effective Federal Income Tax Rate	7.26%	8.79%	3.02%	5.58%
AGI as a Percent of 2025 Federal Poverty Level	274.76%	405.75%	203.31%	300.24%

I believe this table strongly supports my contention that the tax laws want you to retire early. Look how light the taxation is on 72(t) payments!

You may ask “I thought federal tax rates started at 10 percent – how do these people pay effective rates less than that?” The answer is the standard deduction, which loves early retirees. Because of the standard deduction, all four taxpayers enjoy what I refer to as the Hidden Roth IRA. They take some amounts from their traditional IRAs and pay 0 percent federal income tax on them.

Is the 72(t) payment plan outcome perfect? No. Those on a 72(t) payment plan have to abide by the restrictions of the 72(t) payment plan rules. But those rules are not that bad, and allow for techniques to potentially increase or decrease the annual payment.

I will note two things. First, I am not arguing anyone should simply plan on getting to an early retirement age and have every last penny in traditional retirement accounts. I am arguing that it is hardly a trap if someone gets to age 50, has every penny in traditional retirement accounts, and wants to retire using a reasonable withdrawal rate.

Second, managing for Premium Tax Credit can be a concern. At the high end of Mindy and Scott’s Middle Class Trap range, a single taxpayer would be shut out of a Premium Tax Credit (having gone a bit over the 400 percent of FPL cliff) if they were on an ACA medical insurance plan in 2026, unless later tax law changes in 2025 amend Section 36B. This person could turn on Premium Tax Credits by electing a slightly lower initial 72(t) annual payment.

Sufficiency Is The Real Problem

We should spend more time on the real problem: retirement sufficiency. According to UBS, median adult wealth in the United States in 2023 was just $112,157. Even considering that older Americans are likely to have greater wealth than younger adults, the median wealth statistic means many Americans of all ages are significantly behind in retirement savings. The best way to catch up is by making traditional retirement account contributions.

Update May 1, 2025

Thank you to Mindy Jensen who wrote a thoughtful response to this blog post. You can read it over at BiggerPockets.

Stay Tuned

This won’t be the last time you hear from me on this topic. Cody Garrett and I are currently writing Tax Planning To and Through Early Retirement, a book we hope to publish later this year. We will address all sorts of issues when it comes to accessing wealth and tax planning for those retiring prior to turning 59 ½.

What questions do you have about retiring prior to 59 ½? Let us know in the comments below and we might just answer your questions in Tax Planning To and Through Early Retirement!

Sign up for updates about Tax Planning To and Through Early Retirement here: https://www.measuretwicemoney.com/book

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

Follow my YouTube Channel at @SeanMullaneyVideos

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.

The Odd 403(b) Rule for Side Hustlers

403(b) plans are offered by certain non-profit organizations such as universities and 501(c)(3) charities.There’s an odd rule that side hustlers covered by a 403(b) plan should be aware of.

Section 415(k)(4) provides that the all additions limit (sometimes referred to as the 415(c) limit) is applied by aggregating 403(b) contributions with any contributions a side hustler makes to their own self-employment retirement plan such as a SEP IRA or Solo 401(k). Recall that the 2025 all additions limit is the lesser of 100% of compensation or $70,000 for those under age 50.

Section 415(k)(4) is an exception to the general rule that unrelated employers are not aggregated for the all additions limit. Since side hustlers are not usually aggregated with their employers for all additions limit purposes, they can have the ability to make very substantial contributions to a Solo 401(k) without worrying about the overall contributions made into their workplace retirement plans.

Note, of course, the annual deferral limit (the Section 402(g) limit, which is $23,500 for those under age 50 in 2025) is always coordinated with all of one’s employers since it is a per person limit, not a per employer limit.

History of Section 415(k)(4)

The odd rule of Section 415(k)(4) dates back to Section 632(b) of the Economic Growth and Tax Relief Reconciliation Act of 2001. It’s clear that back then Congress was tinkering with the contribution limits on all defined contribution retirement accounts. The 403(b) rules back then were complicated and EGTRRA revised them. In my review of the legislative history, I have not found a particular reason for the self-employment/403(b) all additions limit aggregation rule. Nevertheless, it is the law of the land.

Another part of Section 632, Section 632(a)(1), is what opened the door to Solo 401(k)s having significantly greater contribution limits than SEP IRAs. Section 632(a)(1) increased the Section 415(c) annual limit from 25% to 100% of compensation, which meant that Solo 401(k)s could, for the first time, offer both significant employee contributions and employer contributions.

Section 415(k)(4) Often Has No Effect

As a practical matter, Section 415(k)(4) will often have no effect, even on highly compensated professionals. Even with very generous employer contributions to the 403(b) for highly compensated professionals with a side hustle, the numbers won’t add up to the top of the Section 415(c) limit. Here’s an illustrative example:

Dr. Funke works at a university hospital making $260,000 in annual salary and has $120,000 of Schedule C side hustle income in 2025. Dr. Funke maxes out his 403(b) at $23,500 (employee contributions) and the hospital contributes 5% of salary ($13,000). Dr. Funke also maxes out a SEP IRA or Solo 401(k) employer contribution at $23,678 for his Schedule C side hustle. Those rather healthy numbers only get the total contributions to $60,178, well under the 2025 all additions limit of $70,000.

You can see that without any “after-tax” contributions, it will be quite rare that Section 415(k)(4) bites, especially considering that few employers offer a full 5 percent match.

Section 415(k)(4) and Notice 2014-54

To the extent Section 415(k)(4) creates a problem, it’s largely a problem of the IRS’s own benevolent creation with Notice 2014-54. Notice 2014-54 is what opened the flood gates by clearly allowing after-tax traditional contributions to retirement accounts to be immediately converted to Roth accounts without additional tax (the so-called Mega Backdoor Roth).

I’m not aware that many 403(b) plans offer after-tax contributions. Where the issue is more likely to come up is after-tax contributions to a Solo 401(k) as part of a Mega Backdoor Roth. Going back to Dr. Funke’s example, if he made after-tax contributions to a Solo 401(k) based on his $120,000 of Schedule C income, those combined with the other 403(b) and Solo 401(k) contributions could trip him over the combined $70,000 all additions limit.

I generally disfavor the Mega Backdoor Roth with the Solo 401(k) for two primary reasons.

First, most pre-approved Solo 401(k) plans do not offer after-tax contributions. I believe pre-approved plans tend to be the most desirable Solo 401(k) plans for most solopreneurs. Pre-approved plans tend to be the lowest cost plans (think Fidelity, Schwab, and Ascensus). They tend to offer low-cost, diversified index investments. Pre-approved plans also tend to have the lowest compliance risk. It’s difficult to have a prohibited transaction when the investment in the Solo 401(k) is one or more index funds. For most solopreneurs, avoiding pre-approved plans, the sacrifice required to do a Mega Backdoor Roth, is not worth it, in my opinion.

Second, the numbers often don’t work out when it comes to combining the Solo 401(k) with the Mega Backdoor Roth. This can be because the solopreneur doesn’t have enough cash flow to make the Mega Backdoor Roth a practical option. Or it could be because a solopreneur benefits from the high Solo 401(k) employee deferral and employer contribution limits to such an extent that the Mega Backdoor Roth does not add much value. That said, I do acknowledge that in Dr. Funke’s example, if his employer offered a 401(k) instead of a 403(b), the numbers work out to make the Mega Backdoor Roth in his a Solo 401(k) attractive from a tax standpoint.

Those with a 403(b) looking to “optimize” a Mega Backdoor Roth in a Solo 401(k) for a side hustle need to think twice and consider the impact of Section 415(k)(4).

Effect of Section 415(k)(4) Biting

The IRS and Treasury issued Treasury Regulation Section 1.415(g)-1(b)(3)(iv)(C)(2), which has an example illustrating how Section 415(k)(4) applies in an overcontribution situation. If the combined annual 403(b) contributions and SEP IRA/Solo 401(k) contributions exceed the aggregated all additions limit, the excess is deemed to have been made to the 403(b) plan, not to the SEP IRA or Solo 401(k).

The IRS places the onus on the 403(b) plan sponsor to enforce Section 415(k)(4). Employers should have communications in place with plan participants to make them aware of the effect contributions to self-employment retirement plans such as SEP IRAs and Solo 401(k)s can have on their 403(b).

Repeal List

If anyone in Congress is reading this, Section 415(k)(4) should be repealed. It’s a trap for the unwary that accomplishes next to nothing in furtherance of sound tax policy and revenue collection. If someone has a 401(k) their workplace 415(c) limit is not aggregated with their self-employment 415(c) limit. Why should people with 403(b)s instead of 401(k)s get worse treatment?

Let’s add Section 415(k)(4) repeal to Section 408A(d)(2)(B) repeal as easy wins for Congress to start simplifying the tax code at no significant cost to the fisc.

Conclusion

For those side hustlers covered by a 403(b) plan, it’s a good idea to ensure their total retirement plan contributions do not exceed the all additions limit. Unlike most side hustlers, those covered by a 403(b) plan only have one all additions limit shared between the 403(b) plan and their self-employment plan. The Mega Backdoor Roth is not very attractive for the Solo 401(k)s of side hustlers covered by a 403(b) because of the restrictions imposed by Section 415(k)(4).

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

Follow me on X: @SeanMoneyandTax

What are Section 199A Dividends?

Did you receive a Form 1099-DIV which lists an amount in Box 5 “Section 199A dividends”? If so, you might be asking, what the heck are Section 199A dividends?

You probably never came across the term “Section 199A dividends” in high school algebra. That’s okay. Below I discuss what a Section 199A dividend is and how to report it on your tax return.

Who Pays Section 199A Dividends?

Real estate investment trusts (“REITs”) pay Section 199A dividends. REITs are a special type of business entity. A REIT owns almost entirely real estate. Many office buildings, hotels, hospitals, malls, and apartment buildings are owned by REITs. Investors can own the stock of a single REIT, or they can own mutual funds or ETFs that are partly or entirely composed of REIT stock. For example, there are some REITs in the Vanguard Total Stock Market Index Fund (VTSAX).

REITs are advantageous from a tax perspective. In exchange for paying 90 plus percent of its income out to investors as dividends, the REIT itself does not pay federal corporate income taxes. This results in REITs often paying higher dividends than companies in other industries. The dividends paid by the REIT are Section 199A dividends.

What is the Tax Benefit of a Section 199A Dividend?

A Section 199A dividend qualifies for the Section 199A qualified business income deduction. This is also referred to as the QBI deduction. The qualified business income deduction is a 20 percent federal income tax deduction.

Here is an example of how the tax deduction works for Section 199A dividends.

Catherine owns shares of ABC REIT Mutual Fund. The mutual fund pays her $1,000.00 of dividends, all of which are Section 199A dividends reported to her in both Box 1a and Box 5 of Form 1099-DIV. She gets a $200 qualified business income deduction on her federal tax return (20 percent of $1,000.00) because of the $1,000.00 of Section 199A dividend.

There are several things to keep in mind when considering Section 199A dividends:

First, Section 199A dividends are a slice of the pie of dividends. The full pie of dividends, “total ordinary dividends,” is reported in Box 1a of Form 1099-DIV. Since Box 1a reports all of the dividends, Box 5 must be equal to or less than Box 1a.

Second, there is no income limit (taxable income, MAGI, or otherwise) on the ability to claim the Section 199A qualified business income deduction for Section 199A dividends. The QBI deduction for self-employment income is generally subject to taxable income limitations on the ability to claim the deduction. Not so with the Section 199A dividends.

Third, taxpayers get the Section 199A QBI deduction regardless of whether they claim the standard deduction or itemized deductions.

Fourth, there is no requirement to be engaged in a qualified trade or business to claim the QBI deduction for Section 199A dividends.

Fifth, the QBI deduction does not reduce adjusted gross income. Thus, it does not help a taxpayer qualify for many tax benefits, such as the ability to make an annual contribution to a Roth IRA.

Sixth, Section 199A dividends are not qualified dividends (which are reported in Box 1b of Form 1099-DIV). They are taxed as ordinary income subject to the taxpayer’s ordinary income tax rates. They do not qualify for the preferred federal income tax rates for qualified dividends.

Seventh is a 2025 revision to this article: Some taxpayers cannot get the QBI deduction because their long-term capital gains exceed their ordinary income. This is usually a good outcome. See “An Exception: Too Little Ordinary Income to Claim a Section 199A Deduction” below.

Where Do I Report a Section 199A Dividend on My Tax Return?

Section 199A dividends create tax return reporting in three prominent places on a federal income tax return.

First, Form 1099-DIV Box 1a total ordinary dividends are reported on Form 1040 Line 3b. As Section 199A dividends are a component of Box 1a total ordinary dividends, they are thus reported on the Form 1040 on Line 3b. Section 199A dividends are not reported on Line 3a of Form 1040 because Section 199A dividends are not qualified dividends.

Second, Section 199A dividends are reported on either Line 6 of Form 8995 or Line 28 of Form 8995-A. In most cases, taxpayers will file the simpler Form 8995 to report qualified business income and Section 199A dividends. By reporting Section 199A dividends on one of those lines most tax return preparation software should flow the dividends through the rest of the form as appropriate (but it never hurts to double check).

Third, the QBI deduction, computed on either Form 8995 or Form 8995-A, is claimed on Line 13 of Form 1040.

Tax return software varies. Hopefully, by entering the Form 1099-DIV in full in the software’s Form 1099-DIV input form, all of the above will be generated. Ultimately, it is up to the taxpayer to review the return to ensure that the information has been properly input and properly reported on the tax return.

An Exception: Too Little Ordinary Income to Claim a Section 199A Deduction

In this 2025 article revision, I want to consider cases where a taxpayer might not be able to claim a QBI deduction for Section 199A dividends.

At first glance, you might think that this is a bad thing. But it’s usually indicative that someone has structured their tax basketing very effectively.

There is a limit on the Section 199A deduction. If your ordinary income is low vis-a-vis your long-term capital gain income, you lose the Section 199A for dividends and all other qualified business income. See Section 199A(a)(2) for the rule providing this result.

This sounds bad but it usually is good! Here’s an example:

Justin, an early retiree 56 years old in 2025. He has $90,000 of annual living expenses, which he funds by selling $90,000 of ABC Domestic Equity index fund in his taxable account. Those sales generate $50,000 of long-term capital gains. Further, he reports $13,000 of qualified dividend income, $1,000 of nonqualified dividends, and $1,000 of Section 199A dividends from his ABC Domestic Equity Index Fund. He also reports $2,000 of interest income.

Justin’s net taxable income is $52,000 ($67,000 of adjusted gross income less a $15,000 standard deduction), which is less than his long-term capital gain income of $63,000 ($50,000 long-term capital gains plus $13,000 qualified dividend income).

When long-term capital gain income exceeds net taxable income, the taxpayer cannot claim the QBI deduction, even for Section 199A dividends. This happens in situations where ordinary income is less than capital gain income. Justin is thus precluded from taking a QBI deduction, even for his Section 199A dividends.

Never fear, however. Justin’s total federal income tax for 2025 is just $746 on his AGI of $67,000. I put together a spreadsheet illustrating how his income is taxed, which I think you will find illuminating.

Does Justin need a $200 QBI deduction when his federal income tax effective rate is just 1.11%?

As I discussed in my Tax Basketing article, early retirees benefit from having as little ordinary income as possible. Any small QBI deduction on Section 199A dividends that sacrifices is well worth it, as Justin’s example illustrates.

Conclusion

Section 199A dividends create a taxpayer favorable federal income tax deduction. They are reported in Box 5 of Form 1099-DIV and should be reported on a taxpayer’s federal income tax return.

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

Follow my YouTube Channel at @SeanMullaneyVideos

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, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.