Category Archives: Tax

Articles that are mostly tax focused

From Tax Returns to Tax Planning

Many colloquially refer to the Winter and early Spring as “tax season.” To my mind, that is short sighted. Yes, for most the time from late January to mid-April are when their tax return is prepared and filed. But the most impactful tax work is not tax return preparation — it’s tax planning!

Below I discuss ways to use your current tax return as a springboard to tax planning. 

Before we get started, two notes. First, there is some tax planning that can be “do it yourself” and some tax planning that is best considered and implemented with the help of a tax planning professional. When in doubt, the concept is probably the latter. Second, it is helpful to keep in mind the correct use of this blog or any other blog–as a tool to raise awareness. Blogs are not a substitute for professional advice, and are not advice for any particular person. Rather, this post and others should be viewed as a way to increase knowledge and help faciliate more informed conversations with professionals. 

Your 2020 Tax Return

Your 2020 tax return is a great springboard for tax planning. Look at the following items on your tax return to jump start your tax planning.

Schedule D Line 13 Capital Gain Distributions

Everyone should review their own tax returns for the past few years and look at this line. If there is a substantial number on this line, it should raise a red flag.

I previously discussed capital gain distributions here. Generally, they come from mutual funds and ETFs in taxable accounts. These financial securities pass gains out to the shareholders, creating capital gains income on the shareholders’ tax returns. Actively managed funds tend to have much greater capital gain distributions than passively managed index funds.

The planning opportunity is to review the accounts that are generating significant capital gain distributions. If the realized gain in such accounts is low (or if there is a realized loss in those accounts), it might be advisable to sell the holding and replace it with a fund likely to have lower capital gain distributions. Taxpayers considering this strategy should be sure to fully understand the gain or loss in the securities before selling. Financial institutions do not have to report to investors (and the IRS) basis in mutual funds purchased prior to 2012, so sometimes it can be difficult to determine the taxable built-in gain or loss on older holdings.

Form 8889 Line 14c Distributions

Form 8889 is the tax return form for a FI favorite: the health savings account. Amounts other than $0 on Line 14c of Form 8889 should appear, in my opinion, only if the taxpayer is elderly or found themselves in a dire situation during the tax year. It is generally not optimal, from a tax perspective, to take distributions from an HSA to fund medical expenses when one is neither elder nor in a dire situation. 

Amounts other than $0 on Line 14c can be a learning and planning opportunity. Future routine medical expenses are usually best paid from one’s checking account (a regular taxable account), and taxpayers should save the receipt. In the future, taxpayers can reimburse themselves tax free from their HSA for that expense. In the meantime, the money has grown in the HSA and enjoyed many years of tax free compounding. 

Form 1040 Line 4b IRA Distributions Taxable Amount

Taxpayers who did a Backdoor Roth IRA and have a large amount on Line 4b of Form 1040 should review their transactions to make sure everything was correctly reported. Part of the idea behind a Backdoor Roth IRA is that, if properly executed, it should result in a very small amount of taxable income (as indicated on Line 4b). 

It may be the case that the tax return improperly reported the Backdoor Roth IRA (and thus, the taxpayer should amend their return to obtain a refund). Or, it may be the case that the taxpayer did the steps of the Backdoor Roth IRA at a time they probably should not have (because they had a significant balance in a traditional IRA, SEP IRA, or SIMPLE IRA). 

Discovering the problem can help effectively plan in the future, and if necessary take corrective action. 

For those executing Roth Conversion Ladders, a large amount on Line 4b is the equivalent of Homer Simpson’s Everything OK Alarm. Roth Conversion Ladders are intended to create a significant amount of taxable income, and Line 4b is where that income is reported on Form 1040. Note further that all Roth IRA conversions require the completion of Part II of the Form 8606. 

Schedule A Line 17 Total Deductions

Those who claimed itemized deductions in 2020 should review Line 17 of Schedule A. Is the number reported for the total itemized deductions close to the standard deduction amount (for 2021, single taxpayers have a standard deduction of $12,550 and married filing joint taxpayers have a standard deduction of $25,100)?

If so, there a tax planning opportunity. Why is that number what it is? Is it because of charitable contributions? If so, the donor advised fund might be a good opportunity. Here’s how it might work:

Example: Joe and Lisa file married filing joint. In 2020, they itemized based on $10K of state taxes, $9K of mortgage interest, and $6K of charitable contributions ($500 a month to their church). Thus, at $25,000 of itemized deductions, they were barely over the threshold to itemize. In 2021, they move a sizable amount into a donor advised fund ($25,000). They use the donor advised fund to fund their 2021, 2022, 2023, and 2024 monthly church donations. 

From a tax perspective, Joe and Lisa itemize in 2021 (claiming total deductions of $44K – the state taxes, mortgage interest, and a $25K upfront deduction for contribution to the donor advised fund). In 2022, 2023, and 2024, they would claim the standard deduction, which is (roughly speaking) almost equivalent to their 2020 itemized deductions. 

By using the donor advised fund, Joe and Lisa get essentially the same deduction in 2022 through 2024 that they would have received without the donor advised fund, and they get a tremendous one year increase in tax deductions in 2021. 

Form 8995 or Form 8995-A Line 2

Those with any amount on Line 2 of the Form 8995 or the Form 8995-A should likely consider some tax planning. This line indicates that the taxpayer has qualified trade or business income that may qualify for the new Section 199A qualified business income deduction. Taxpayers in this situation might want to consider consulting with a professional, as there are several planning opportunities available to potentially increase any otherwise limited Section 199A qualified business income deduction.

2021 Adjusted Gross Income Planning to Maximize Stimulus Payments

Taxpayers should review line 11 (adjusted gross income or “AGI”) on their Form 1040 in concert with reviewing their stimulus checks. For those taxpayers who did not receive their maximum potential stimulus payments in 2021, there can be opportunities to lower AGI so as to qualify for additional stimulus payments and/or increased child tax credits. I blogged about one planning opportunity in that regard here.

The Shift to Tax Planning

Tax planning can take many shapes and sizes. But it needs to be driven by goals, not by tactics. Bad tax planning begins something like this: “I need a Solo 401(k), how do I set it up?” N.B. Opening a Solo 401(k) when you do not qualify for one is a great way to create a tax problem for yourself. 

Good tax planning begins more like this: “I want to achieve financial independence. How do I best save for retirement in a tax advantaged way? I’ve heard a Solo 401(k) is a great option. As part of this process, we should consider it as a possible way to help me achieve my goal.”

Another point: I find there is far too much focus on “I had to pay [insert perceived sizable amount here] this year in taxes” and far too little focus on lifetime taxes. To my mind, the goal should not be to pay less tax in any one year. Rather, the goal should be to legitimately reduce lifetime tax burden. Sure, there can be tax planning that does both, but the best tax planning (whether DIY or with the help of a professional) places reducing lifetime tax burden as its primary goal.

Below are just some areas where taxpayers can begin their tax planning considerations.

Retirement Planning

This is a big one. Taxpayers should understand whether they contribute to a traditional IRA and/or Roth IRA, and why or why not. This post helps explain whether taxpayers qualify to make an annual contribution to a traditional IRA and/or a Roth IRA. 

Taxpayers should consider their workplace retirement plans, which can provide several planning opportunities. 

Small Business/Self-Employment Income

For those with a small business and/or significant self-employment income, tax planning is very important. I have written several posts about just some of the tax planning available to those with small businesses. People with small businesses often benefit from professional, holistic tax and financial planning. 

Stock Options

Stock options and employer stock grants provide some good tax planning opportunities. I’ve previously written about ISOs, but all kinds of stock option programs can be an opportunity to do some tax planning, which often should be with a professional advisor. 

Conclusion

Filing timely, accurate tax returns is important. But the best way to optimize one’s tax situation is to do quality, intentional tax planning. Tax planning should prioritize goals over tactics. There is some tax planning that can be done by yourself, but many areas of tax planning strongly benefit from professional assistance.

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

Follow me on Twitter: @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. 

Understanding Your Form 1099-DIV

If you’re reading this in the Winter of 2024, you may have already received a bill from your financial institution. It’s called a Form 1099-DIV. Oddly, the financial institution isn’t demanding a penny of payment. Rather, your 1099-DIV prompts the IRS and your state tax agency (in most states) to expect the payment of income tax with respect to your financial assets.

A Form 1099-DIV is a great window into your taxable investments. By learning how to read the major boxes of your 1099-DIV, you can gain valuable insights about your investments and their tax efficiency.

VTSAX Form 1099-DIV 2024 Update

The Basics

Form 1099-DIV exists so that taxpayers and the IRS know the income generated by financial assets in dividend paying accounts. These include stocks, mutual funds, and exchange traded funds (“ETFs”). The financial institution prepares the Form 1099-DIV and submits a copy to the IRS and a copy to the taxpayer. 

Let’s be clear about what we are talking about. We are not talking about assets in retirement accounts (401(k)s, IRAs, Roth accounts, HSAs, etc.). You do not receive a Form 1099-DIV from a retirement regardless of how much money the account earned during the year. This is one of the advantages of saving through a retirement account. Dividends and other income generated by assets in a retirement account are not taxable to the account holder when generated (so long as the funds stay in the retirement account).

Dividends

Corporations pay dividends to their shareholders as a return to the shareholders of their portion of some or all of the earnings of the corporation. The corporation’s Board of Directors vote from time to time to pay dividends to the shareholders. Boards determine dividends based on a variety of factors, including the company’s profitability, industry, stage in the corporate life cycle, and business cash needs.

All shareholders of a corporation receive dividends. Some of those shareholders are themselves mutual funds or ETFs. Mutual funds and ETFs distribute out dividends and certain other income they receive (such as interest) to their shareholders as dividends.

Box 1a and Box 1b

Box 1a lists the so-called “total ordinary dividends” received from the account. That is all of the dividends paid by the stocks, mutual funds, and ETFs in the account. 

Box 1a should be understood as the entire pie. It represents all of the dividends received in the taxable account. The amounts in Box 1a are reported on line 3b of the Form 1040 (and on Schedule B if required).

Box 1b qualified dividends should be understood as a slice of the pie. It represents the portion of the total ordinary dividends that qualify for the long-term capital gains rates. Dividends create “ordinary income” for U.S. federal income tax purposes. However, certain “qualified dividends” (referred to as “QDI”) are taxed at preferential long term capital gains rates. As I have previously written, “[g]enerally, two requirements apply for the dividend to qualify for favorable QDI tax treatment. Very generally stated, they are:

  • The shareholder must own the stock for 60 of the 121 days around the “ex-dividend” date (the first date on which the stock sells without the right to receive the upcoming dividend); and,
  • The paying corporation must be incorporated either in the United States or in a foreign country with which the United States has a comprehensive income tax treaty.

Shareholders can obtain QDI treatment for stock owned through mutual funds and ETFs.

It may be that your qualified dividend slice is the entire pie. In most cases, there are usually some dividends that do not qualify for QDI treatment. 

Amounts reported in Box 1b are reported on line 3a of the Form 1040.

Box 2a Capital Gain Distributions

Box 2a is the danger zone of the Form 1099-DIV. In a way, it is unavoidable to recognize dividends (even if such dividends are QDI) if one wants to invest in a broad based portfolio of equities in a taxable account. Eventually corporations pay out dividends. While younger companies tend not to pay dividends, as companies mature they tend to start paying dividends.

What are much more avoidable (at least to a degree) are capital gain distributions. Capital gain distributions come from mutual funds and ETFs (they do not come from individual stocks).

Capital gain distributions occur when fund managers sell individual holdings at a gain. The fund is required to (usually toward year end) pay out those gains to the shareholders. The paid out gains are reported in Box 2a.

Three things tend to increase capital gain distributions: 1) active management; 2) a bull market; and 3) fund redemptions.

Active Management

Usually, this is the most significant factor in capital gain distributions. In order to actively manage a mutual fund or ETF, fund managers generally need to buy and sell different holdings. The selling of holdings is what creates capital gain distributions.

Frequent trading can make certain actively managed mutual funds and ETFs very tax inefficient, because they trigger capital gain distributions that are currently taxed to the owner at capital gains rates. 

From this, we can deduce the secret tax advantage of index funds. Index mutual funds and ETFs seek to simply replicate a widely known index. Other than occasional mergers and acquisitions of companies in the index, index fund managers rarely need to sell a holding to meet an investment objective. Thus, in many cases holding index funds in taxable accounts is tax efficient and will be better from a tax perspective than holding an actively managed fund.

Bull Market

Mutual funds and ETFs pass out capital gain distributions, not capital loss distributions. But in order for the shareholders to have a capital gain distribution, the mutual fund or ETF must (a) sell a holding and (b) must realize a gain on that sale.

In bear markets, it is often the case that the second requirement is not satisfied. The fund often realizes a loss on the sale of holding, meaning that the portfolio turnover does not generate a capital gain distribution reported in Box 2a. However, bear markets don’t always mean there will be no capital gain distributions, as active management and fund redemptions can still trigger capital gain distributions.

Fund Redemptions

There is an important distinction between mutual funds and ETFs in this regard. ETFs trade like public company stock — other than IPOs and secondary offerings, generally you buy and sell the stock of a public company and an ETF with an unrelated party that is not the issuer itself. 

Mutual funds, on the other hand, are bought and sold from the issuer. If I own 100 shares of the XYZ mutual fund issued by Acme Financial, when I redeem my 100 shares, Acme Financial buys out my 100 shares.

In order to buy out mutual fund shares, the mutual fund must have cash on hand. If it runs out of cash from incoming investments into the fund, it will have to sell some of its underlying holdings to generate the cash to fund shareholder redemptions. This creates capital gain distributions for the remaining shareholders. 

Interestingly, Vanguard has created a method to reduce the tax impact of mutual fund redemptions. Further, in recent times, fund redemptions have not caused significant capital gain distributions in many cases because in this current bull market mutual fund inflows often exceed outflows. 

Box 3 Nondividend Distributions

There are occasions where corporations make distributions to shareholders during a time where the corporation does not have retained earnings (i.e., it either has not made net income or it has previously distributed out is net income). Such distributions are not taxable as dividends. Rather, such dividends first reduce the shareholder’s basis in their stock holding. Once the basis has been exhausted, the distribution causes a capital gain.

Box 5 Section 199A Dividends

Section 199A dividends are dividends from domestic real estate investment trusts (“REITs”) and mutual funds that own domestic REITs. These dividends are reported on Form 8995 or Form 8995-A and qualify for the Section 199A QBI deduction. The good news is that the taxpayer (generally) gets a federal income tax deduction equal to 20 percent of the amount in Box 5. This deduction does not reduce adjusted gross income but does reduce taxable income.

Section 199A dividends are another slice of the pie of Box 1a ordinary dividends.

Watch me explain Section 199A dividends

Box 7 Foreign Tax Paid

An amount in Box 7 is generally good news from a federal income tax perspective. Many countries impose a tax on the shareholder when the corporation pays a dividend is a non-resident shareholder. The corporation withholds a percentage of the dividend and then remits the net amount of the dividend to the shareholder. 

The amount in Box 7 usually creates a foreign tax credit that reduces federal income tax dollar for dollar. If you have $300 or less in foreign tax credits ($600 or less if married filing joint) you can simply claim the foreign tax credit on your Form 1040 without any additional work. If your foreign tax credits exceed these amounts, you will also need to file a Form 1116 to claim the foreign tax credit.

The ability to claim foreign tax credits is a reason to hold international equities in taxable accounts.

Watch me discuss how VTIAX might generate a foreign tax credit on a US income tax return.

Boxes 11 and 12 Exempt-Interest Dividends and Private Activity Bond Interest

Box 11 represents all of the tax-exempt dividends received in the taxable account. Typically this is generated by state and municipal bond interest received by the mutual fund or ETF and passed out to the shareholders. This income is tax-exempt for federal income tax purposes.

This income may not be tax-exempt for state tax purposes. For example, in my home state of California, this income is taxable unless it is established that 50 percent or more of the funds assets are invested in California state and municipal bonds. In that case, the exempt-interest dividend attributable to California state and municipal bonds is tax-exempt for California purposes. The financial institution must separately provide the percentage of income attributable to California bonds to the shareholder in order to compute the amount of exempt-interest dividend exempt from California income tax. 

Box 12 is a subset of Box 11 (Box 11 is the whole pie, Box 12 is a slice). Box 12 dividends are those attributable to private activity bonds. The significance is for alternative minimum tax (“AMT”) purposes. While this income is tax-exempt for regular federal income tax purposes, it is not tax-exempt for AMT purposes (and thus is subject to the AMT). After the December 2017 tax reform bill this issue still exists, though it affects far fewer taxpayers.

Conclusion

The Form 1099-DIV conveys important information, all of which must be properly assessed in order to correctly prepare your tax return. It can also provide valuable insights into the tax-efficiency of your investments. 

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

Follow me on Twitter: @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. 

The SECURE Act’s Impact on the FI Community

In late December 2019 the President and Congress enacted the SECURE Act. The SECURE Act makes some significant revisions to the laws governing IRAs, 401(k)s, and other retirement accounts. This post discusses the impacts of these changes on those pursuing financial independence.

The Big Picture

The SECURE Act is a big win for the FI community, in my opinion. 

The FI community significantly benefits from IRAs, 401(k)s, and other tax-advantaged retirement accounts. However, the federal government is facing increasing debts and annual deficits. That puts tax-advantaged accounts in the crosshairs. What Congress gives in tax benefits Congress can take away.

So what does the SECURE Act do? First, it actually gives us a couple more tax advantages during our lifetimes (see “Opportunities” below). Second, it significantly reduces the tax advantages of inherited retirement accounts for our heirs.

For those either with large retirement account balances or planning to have large retirement account balances, any change in tax laws is a potential problem. We should be glad that this round of tax law changes has occurred without our own retirement accounts being negatively impacted. Congress has passed the bill to our heirs, which, right or wrong, is a victory for us. 

When you see people in the financial press squawking about how awful the SECURE Act is, remember, it could be a whole lot worse–your retirement account could have been more heavily taxed during your lifetime! 

For those pursuing FI, the ability to use tax-advantaged retirement accounts remains the same, and in a couple small ways, has been enhanced. The next generation still has all those retirement account opportunities, even if they won’t be able to benefit from inheriting retirement accounts as much as they do under current law. 

Opportunities

Traditional IRA Contributions for those 70 ½ and Older

Starting in 2020, those aged 70 ½ and older will be able to contribute to a traditional IRA. This will open up Backdoor Roth IRA planning for those 70 ½ and older and still working. For those still working (or doing side hustles) at age 70 ½ or older, this is a nice change.

Remember, regardless of age, in order to contribute to an IRA, you or your spouse must have earned income. 

RMDs Begin at 72

For those attaining age 70 ½ after December 31, 2019, the age at which they will need to take RMDs will be 72, not 70 ½. This gives retirement accounts a bit more time to bake tax-deferred. It also slightly expands the window to do Roth conversions before RMDs begin. However, this last benefit is tempered by the fact that you must take Social Security no later than age 70. Roth conversion planning to reduce taxable RMDs should be mostly completed well before age 70 ½, regardless of this change in the law. 

Note that taxpayers can still make qualified charitable distributions (“QCD”) starting when they turn age 70 ½. While pre-age 72 QCDs won’t satisfy RMD requirements, they will (a) help optimize charitable giving from a tax perspective (by keeping adjusted gross income lower and avoiding the requirement to itemize to deduct the contribution) and (b) reduce future RMDs.

Annuities in 401(k)s

The new law provides rules facilitating annuities in 401(k) plans. This one requires proceeding with extreme caution. If your 401(k) plan decides to offer annuity products, you need to carefully assess whether an annuity is the right investment for you and you need to fully understand the fees charged. 

Remember, just because the law changed doesn’t mean your asset allocation should change!

Leaving Retirement Accounts to Heirs

This is the where the SECURE Act raises taxes. The SECURE Act removes the so-called “stretch” for many retirement plan beneficiaries. For retirement accounts inherited after December 31, 2019, only certain beneficiaries will be able to stretch out distributions over their remaining life (or based on the age of the decedent if over 70 ½ at death). For nonqualified beneficiaries, the rule will simply be that the beneficiary must take the account within 10 years of the owner’s death (the “10-year rule”).

My overall opinion on the SECURE Act stated above, planning for the next generation is important. Particularly if you are already financially independent and want to help your children become financially independent, the SECURE Act has significant ramifications.

Spouses

If your current estate plan features your spouse as your retirement account primary beneficiary, the SECURE Act should in no way change that aspect of your plan. Fortunately, the many advantages applicable to spouses inheriting retirement accounts will not change. Spouses remain an excellent candidate to inherit a retirement account. 

Minor Children

If you leave your retirement account to your minor children, they are exempt from the 10-year rule (and can generally take distributions based on IRS RMD tables that are generous to younger beneficiaries) while they are still minors. Once your children reach the age of majority, they will have ten years to empty the retirement account. 

The exception to the 10-year rule applies only to your minor children. It does not apply to your grandchildren, your adult children, and the children of others (including nieces and nephews). 

Other Eligible Beneficiaries

The exceptions to the 10-year rule apply to your spouse, your minor children, the disabled, the chronically ill, and persons not more than 10 years younger than you at your death. All others will need to empty retirement accounts within 10 years of inheritance. This will require some significant planning in cases where the beneficiary has inherited a traditional retirement account to strategically empty the account over the 10 year window to manage adjusted gross income, taxable income, and total tax. 

Planning

For those of you with estate plans involving adult children, the passage of the SECURE Act may well require revisions to your plans. First off, as a practical matter, your revocable living trust may need modifications. Many have designated a trust as a retirement account beneficiary. To do so properly requires conforming with specific income tax rules. Those with trusts as the beneficiary of their retirement account would be well advised to, at a minimum, consult with their lawyer to determine if the language of the trust needs updating.

Second, understanding that inheriting a traditional retirement account will now mean accelerated, and possibly significantly increased, taxation for their heirs, many will want to consider Roth conversion planning. Roth accounts will be subject to the 10-year rule, but the good news is that the beneficiary can keep the assets in the Roth account for 10 years, let it grow tax free, and then take out the money in 10 years tax free. Not too bad.

Roth conversion planning to optimize your heirs’ income tax picture is now even more important. However, it should not be done if it will impose a financial hardship on the account owner during their lifetime. The first priority should be securing the account owner’s retirement. Only if the account owner is financially secure should they consider Roth conversion planning to reduce their heirs’ tax liability.

Conclusion

Tax rules are always changing. This round of changes is a victory for those pursuing financial independence. Any tax law change that does not negatively impact your path to financial independence is a win. 

For those considering the financial health of their heirs, particularly their adult children, the SECURE Act should prompt some reconsideration of estate plans. Often it is wise to consult with professional advisors in this regard. 

FI Tax Guy can be your financial advisor! FI Tax Guy can prepare your tax return! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @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. 

Roth Conversions for the Self-Employed

Are you self-employed? Is your self-employment income your primary source of income? If so, you might want to consider doing a Roth conversion before the end of the year.

Takeaways

  • If most of your taxable income is self-employment income (either reported on Schedule C or from a partnership), you might want to consider year-end Roth conversions to maximize your QBI deduction and pay a lower-than-expected federal income tax rate on the conversion.
  • To optimize this strategy, convert traditional IRAs to Roth IRAs (or do in-plan traditional 401(k) to Roth 401(k) conversions) to increase your QBI deduction. 

Why? Because of the still relatively new qualified business income (“QBI”) deduction (also known as the Section 199A deduction). 

QBI Deduction and Initial Limitation

Starting in 2018, there is a deduction for “qualified business income.” This is generally income from a qualified trade or business received from a sole proprietorship (and reported on Schedule C), from a partnership, or from a S Corporation (in these cases, generally reported to the taxpayer on a Form K-1 and reported on the Schedule E with the tax return). 

Important for this purpose is the initial limit on the QBI deduction. It is the lesser of following two amounts:

  1. 20 percent of taxable income less “net capital gain” which is generally capital gains plus qualified dividend income (“QDI”) (the “Income Limit”) or
  2. 20 percent of QBI (the “QBI Limit”).

As a practical matter, in most cases the limit will be determined by the second limitation (such taxpayers are what I call “QBI Limited”). Many taxpayers will have much more taxable income than they have QBI. Consider spouses where one has self-employment income and the other has W-2 income. Unless the W-2 income is very small, their combined taxable income is likely to be in excess of their combined QBI, and thus they will be QBI Limited.

Alternatively, consider a situation where a single person has QBI from an S corporation (say $50,000) and the S corporation also pays him or her a W-2 salary (say $60,000). In such a case the QBI is $50,000 (20% of which is $10,000) and the taxable income might be $97,450 ($110,000 total from the S corporation less a $12,550 standard deduction), 20% of which is $19,490. This taxpayer would also be QBI Limited. 

Income Limited

But what if you are not QBI Limited, but rather, limited by the Income Limit listed above (what I call “Income Limited”)? Here is an illustrative example.

Example 1: Seth is single and self-employed. He claims the standard deduction in 2021. He reports a business profit of $100,000 on his Schedule C. He also has $1,000 of interest income.

His Income Limit is computed as follows:

Schedule C Income: $100,000

Interest Income: $1,000

Deduction for ½ Self-Employment Taxes: ($7,065)

Standard Deduction: ($12,550)

Taxable Income: $81,385

20% Limit: $16,277

Seth’s QBI Limit is computed as follows:

Schedule C Income: $100,000

Deduction for ½ Self-Employment Taxes: ($7,065)

QBI: $92,935

20% Limit: $18,587

In this case, Seth’s QBI deduction is only $16,277 (he is Income Limited), the lesser of these two calculated limits. 

Roth Conversion Planning

Is there anything Seth can do to increase his limitation and optimize his QBI deduction?

Imagine Seth has $20,000 in a traditional IRA (with zero basis). He could convert some of that traditional IRA to a Roth IRA by December 31, 2021. This would create taxable income, which would increase Seth’s Income Limit. Here is how that could play out:

Without Roth Conversion

Schedule C Income$ 100,000
Interest Income$ 1,000
Deduction for ½ Self-Employment Taxes$ (7,065)
Adjusted Gross Income$ 93,935
Standard Deduction$ (12,550)
Qualified Business Income Deduction (see above)$ (16,277)
Taxable Income$ 65,108
Federal Income Tax$ 10,072

With Roth Conversion

Schedule C Income$ 100,000
Interest Income$ 1,000
Deduction for ½ Self-Employment Taxes$ (7,065)
Roth IRA Conversion$ 11,550
Adjusted Gross Income$ 105,485
Standard Deduction$ (12,550)
Qualified Business Income Deduction$ (18,587)
Taxable Income$ 74,348
Federal Income Tax$ 12,105

What has the $11,550 Roth IRA conversion done? First, it has made the Income Limit ($18,587) the exact same as the QBI Limit ($18,587). Thus, Seth’s QBI deduction increases from $16,227 to $18,587. 

Second, notice that Seth’s taxable income has increased, but not by $11,550! Usually one would expect that a Roth IRA conversion with no basis recovery would simply increase taxable income by the amount converted. But not here! The interaction with the QBI deduction caused Seth’s taxable income to increase only $9,240 ($74,348 minus $65,108). 

This example illustrates that, under the right circumstances, a Roth IRA conversion can receive the benefit of the QBI deduction!

As a result, at Seth’s 22 percent marginal federal income tax bracket, his total federal income tax increased only $2,033. In effect, Seth pays only a 17.6 percent rate on his Roth IRA conversion ($2,033 of federal income tax on a $11,550 Roth IRA conversion). This is true even though Seth is in the 22 percent marginal tax bracket. His Roth IRA conversion is only 80 percent taxable. This is the flip-side of the 80% deduction phenomenon I previously blogged about here. 

Is it advantageous for Seth to convert his traditional IRA? Well, it depends on Seth’s expected future tax rates. If Seth’s future marginal tax bracket is anticipated to be 22 percent, then absolutely. Why not convert at a 17.6 percent instead of face a 22 percent rate on future traditional IRA withdrawals?

Strategy

Seth’s Roth IRA conversion is optimized. The takeaway is that the Roth IRA conversion gets the benefit of the QBI deduction, but only for amounts that increase the Income Limit up to the QBI Limit.

A *very general* rule of thumb for solving for the optimal Roth conversion amount is to multiply the difference between the QBI Limit and the Income Limit (without a Roth conversion) by 5. In Seth’s case, that was $18,587 minus $16,277 (which equals $2,310) times 5.

In this case, converting exactly $11,550 made Seth’s Income Limit exactly equal his QBI Limit. As long as the Roth conversion increases the Income Limit toward the QBI Limit, the conversion benefits from the QBI deduction.

But the first dollar of the Roth conversion that pushes the Income Limit above the QBI Limit does not receive the benefit. If Seth converted $11,551 from his traditional IRA to his Roth IRA, that last dollar above $11,550 would be taxed at Seth’s full 22 percent federal marginal tax bracket. 

Note that instead of / in addition to a Roth IRA conversion, Seth could do an in-plan traditional 401(k) to Roth 401(k) conversion, if he had sufficient funds in a traditional 401(k), and the 401(k) plan permits Roth 401(k) conversions.

Also note that the strategic considerations with QBI deductions become much more complicated once taxpayers exceed the initial QBI taxable income limitations (in 2021, those are $164,900 for single taxpayers and $329,800 for married filing joint taxpayers). 

Conclusion

Taxpayers whose taxable income consists mostly or exclusively of self-employment income should consider Roth conversions toward year-end. This is often an area that benefits from consulting with a professional tax advisor before taking action.

Further Reading

I have blogged about the QBI deduction and retirement plans here. After the IRS and Treasury provided some QBI deduction regulations in January 2019, I provided some QBI deduction examples and lessons 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. 

Top 5 HSA Tips

For those with a health savings account, December is a great time to review how it has been used and to see if there are ways to better optimize the account.

One: Let it Grow!!!

When it comes to HSAs, often the best advice is Let it Grow, Let it Grow!!! Sing it to the tune of the popular Disney movie song if it helps you to remember.

Adding an “r” and a “w” would make Elsa a tremendous HSA advisor.

Spend HSA money only if one of the following two adjectives apply: DIRE or ELDERLY. Those neither in a dire situation nor elderly should think twice before spending HSA money! Instead, Let it Grow!

The tax benefits of an HSA are so powerful that funds should stay in the HSA (to keep growing tax free) and only be removed in dire (medical or financial) circumstances or by the elderly. Unless you leave your HSA to your spouse or a charity, HSAs are not great assets of leave to heirs. Thus, HSAs are great to spend down in your later years (after years of tax-free growth). 

Two: Max Out Payroll Contributions by December 31st

While you can contribute via non-payroll contribution by April 15, 2020 for 2019, contributing to your HSA through payroll deductions is generally optimal since it secures both an income tax deduction and a payroll tax deduction for the money contributed.

If you didn’t max out your HSA through payroll deductions in 2019 and your employer allows HSA payroll deductions, write the check to your HSA in early 2020 (for 2019) and set up your 2020 payroll elections so as to max out your HSA through payroll deductions in 2020.

Three: Review HSA Investment Allocation

Those with low-cost diversified investment choices in their HSA are generally well advised to invest in higher growth assets inside their HSAs. The HSA is a great tax-protected vehicle. That tax protection is best used for high growth assets. 

Those who have invested their HSA funds solely or mostly in cash should consider reassessing their HSA investment strategy.

Four: Track Medical Expenses 

Medical expenses incurred after coverage begins under a high deductible health plan (a “HDHP”) can be reimbursed to you from an HSA many years in the future. There is no time limit on the reimbursement. Unless you are elderly, long-delayed reimbursement (instead of directly paying medical expenses with a HSA) is usually the tax-optimal strategy. Keep a digital record of your medical expenses and receipts to facilitate reimbursements out of the HSA many years in the future. 

Five: Properly Report HSA Income (CA, NJ, NH, TN)

HSAs are tax-protected vehicles for federal income tax purposes and in most states. On your federal tax return, you need to report your HSA contributions and distributions (see Form 8889). However, you are not taxed on the interest, dividends, and capital gains earned in the HSA, and you do not need to report these amounts. 

It is very different if you live in California and New Jersey. Neither California nor New Jersey recognize HSAs as having any sort of state income tax protection. They are simply treated as taxable accounts in those states. In preparing your California or New Jersey state tax return, you must (1) increase your federal wages for any excluded HSA contributions, (2) remove any deduction you took for HSA contributions (non-payroll contributions to your HSA), and (3) report (and pay state income tax on) your HSA interest, dividends, capital gains, and capital losses.

This last step will generally require accessing your HSA account online and pulling all of the income generating activity, including asset sales, in order to properly report it on your California or New Jersey tax return. 

Tennessee and New Hampshire do not impose a conventional income tax, but do tax residents on interest and dividends above certain levels. HSA interest and dividends are included in the interest and dividends subject to those taxes.

FI Tax Guy can be your financial advisor! 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, 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. 

Fixing Backdoor Roth IRAs

Watch me discuss Backdoor Roth IRA tax return reporting on YouTube.

The word is out. The Backdoor Roth IRA is a powerful tax planning tool. You may believe that by previously executing Backdoor Roth IRAs, you have planned well and received a great tax benefit while building retirement savings.

Is it possible you are mistaken? It is possible you did not complete the Backdoor Roth IRA correctly? 

It may be true that you have successfully completed the two independent steps of a Backdoor Roth IRA: a traditional, non-deductible IRA contribution followed by a later Roth IRA conversion. It may also be true that you had no balances in a traditional IRA, SEP IRA, and/or SIMPLE IRA as of December 31st of the year you did the Backdoor Roth IRA. 

Year-end tip: The deadline to clean out traditional/SEP/SIMPLE IRAs (by rolling them into employer retirement plans such as 401(k)s) so as to optimize a Backdoor Roth IRA is December 31st of the year of the Roth IRA conversion step. As a practical matter, you should not complete the Roth IRA conversion step until you have cleaned out the traditional/SEP/SIMPLE IRAs. Life happens; there is simply no guarantee you complete the clean out before December 31st. Failing to do so will significantly increase the tax on your Backdoor Roth IRA. 

But you may not have correctly reported the Backdoor Roth IRA on your tax return. This last step is too-often overlooked. Below I discuss how to properly report a Backdoor Roth IRA, a potential tax return mistake that could have cost you thousands in erroneous taxes, and ways to fix the mistake. 

Backdoor Roth IRA Example

Charlie is single and 35 years old. He is covered by a retirement plan at work. In 2018 his W-2 salary was $200,000, and thus he did not qualify to make a Roth IRA contribution for 2018. He has no balance in a traditional IRA, SEP IRA, or SIMPLE IRA. He decides to do a Backdoor Roth IRA. 

On September 2, 2018, Charlie contributed $5,500 to a traditional, non-deductible IRA. On October 10, 2018, he converted the entire balance in the traditional IRA, then $5,510, to a Roth IRA. 

So far, so good with the Backdoor Roth IRA! But Charlie’s not done yet. Let’s look at how the Charlie should file his tax return and the pitfalls he should avoid.

Backdoor Roth IRA Tax Return Reporting

Early in the year, Charlie should receive a Form 1099-R that looks like the following from his financial institution.

Charlie’s Backdoor Roth IRA Form 1099-R should look something like this. Note that the “taxable amount” is the full conversion amount ($5,510) and the box indicating that the taxable amount has not been determined is checked.

This requires precise tax return reporting to ensure Charlie increases his taxable income by the correct amount to account for the Backdoor Roth IRA. An error in the tax return reporting could erroneously overstate his adjusted gross income and thus cause him to pay significantly more to the IRS and state tax agency than he owes.

There are two places Charlie needs to report the Backdoor Roth IRA: Pages 1 and 2 of Form 8606 and lines 4a and 4b of the Form 1040.

Let’s start with the Form 8606. Below is the correct way for Charlie to file Page 1 of his Form 8606.

Lines 1, 6, and 11 of the Form 8606 are crucial to properly reporting a Backdoor Roth IRA and computing the nontaxable portion of the Roth IRA conversion.

Notice a few things about this form. First, on line 1 Charlie reports his traditional, non-deductible IRA contribution of $5,500. Second, on line 6, Charlie reports the total combined value of his traditional IRAs, SEP IRAs, and SIMPLE IRAs as of December 31, 2018. He can find this number on the Forms 5498 that his financial institutions send him and the IRS regarding his IRA accounts. To have a very efficient Backdoor Roth IRA, ideally Charlie should no balance in these accounts on December 31, 2018, and thus Charlie can, and does, report zero on line 6. If Charlie has any such balances the total must be reported here and it will cause his Backdoor Roth IRA to be partially (maybe mostly) taxable. 

Next, Charlie reports his Roth IRA conversion amount on line 8. This is the total taxable amount he converted, reported to him in Box 2 of the Form 1099-R, $5,510. The mechanics of the Form 8606 then lead to lines 11 and 13, the nontaxable portion of Charlie’s Roth IRA conversion. In Charlie’s case, this is $5,500. This is because he is entitled to recover all $5,500 of basis he has in his traditional IRA (as computed in this part of the Form 8606). This $5,500 number is required to correctly prepare Page 2 of the Form 8606 and line 4b of the Form 1040.

Form 8606 Line 18 should be reported on Line 4b of Form 1040 for a 2018 Backdoor Roth IRA.

Page 1 computed how much of Charlie’s basis he can recover and the nontaxable portion of his Roth IRA conversion. Page 2 answers the second question: How much of Charlie’s Roth IRA conversion is taxable? Line 16 is simply line 8, and line 17 is simply line 11. Subtracting the nontaxable portion of the Roth IRA conversion from the total converted amount yields the amount of the Roth IRA conversion that is taxable. In Charlie’s case, it is only $10. This amount goes to Charlie’s Form 1040, line 4b. 

This is how a Backdoor Roth IRA should look on your Form 1040. Notice the very small number on Line 4b.

The Wrong Way

The following is what Charlie’s Form 1040 might look like if his Backdoor Roth IRA is misreported. 

Heed the warning of my chicken scratch: a four figure number on Line 4b after a Backdoor Roth IRA is likely an indication that either the tax planning or the tax reporting is off.

How might this happen? It could be that a Form 8606 simply was not prepared, or it was incorrectly prepared. Sometimes the Form 1099-R is misunderstood. People see that $5,510 is the “taxable amount” in line 2 of the Form 1099-R and believe that must be the taxable amount reported on line 4b. But remember, the Form 1099-R has a box checked indicating that the taxable amount is not determined. The Form 8606 is what determines the taxable amount created by the Backdoor Roth IRA (in Charlie’s case, $10). 

As a check, you should ensure that the Lines 18 of your previously filed Forms 8606 agree to the appropriate line on the Form 1040 (line 4b in 2018). If there are discrepancies (and/or a Form 8606 was not filed for a Backdoor Roth IRA), that is an indication there is likely an error on the tax return. If Line 18 on the Form 8606 is a four-figure or greater number after a Backdoor Roth IRA, it is very likely that either the tax planning or the tax return reporting went wrong somewhere.

We can see how deleterious this error is for Charlie. If he filed his tax return the wrong way, his federal taxable income is overstated by $5,500. In his case, this caused him to erroneously owe $1,760 more in federal income tax ($43,613 minus $41,853 — hat tip to ProConnect Tax Online for the tax calculations). If Charlie lives in a state with a state income tax, he will also overpay his state income taxes because of this error. 

Filing an Amended Tax Return

Imagine that Charlie filed his tax return as pictured in the Wrong!!! picture above. What can Charlie do?

Charlie’s remedy is to file an amended return. This entails refiling the Form 1040 and all of its related forms and schedules (including the Form 8606) with the correct amounts. It also entails filing a Form 1040X. This form presents amounts as originally filed and as corrected, with the difference illustrated. It also requires a narrative submission explaining the changes made on the amended tax return.

There are several things to keep in mind when filing an amended tax return. First, a taxpayer filing an amended return is under an obligation to correctly report amounts. If, as part of the exercise of fixing a Backdoor Roth IRA through an amended tax return, the taxpayer learns that other amounts on the originally filed tax return were incorrect, he or she must correct those amounts if they choose to file an amended return. 

Second, there is a deadline for amending a federal income tax return (the so-called statute of limitations). Generally, the deadline is three years from the later of the tax return due date (if originally filed on or prior to the initial tax return due date) or the filing date (if filed after the initial tax return due date). This later deadline applies anytime the taxpayer files after the initial due date (including, for example, a timely post-April 15th tax return filing made after filing for an extension). 

If the amended return claiming the refund (because of the corrected Backdoor Roth IRA tax return reporting) is filed after this three year deadline, the IRS cannot and will not issue a refund to the taxpayer due to the statute of limitations. There are limited exceptions to this rule (such as when the IRS and the taxpayer have mutually agreed to extend the statute of limitations). 

States have their own statutes of limitations, which may or may not be the same as the federal statute of limitations. In my home state of California, it is a four-year statute of limitations instead of a three-year statute of limitations. 

The statute of limitations means the clock is ticking to correct Backdoor Roth IRAs not correctly reported on previously filed tax returns. In many cases, taxpayers learning they have incorrectly filed a tax return (for whatever reason, including an erroneously reported Backdoor Roth IRA) are well advised to seek professional assistance in amending their tax returns. 

Further Reading

I have previously blogged about Backdoor Roth IRAs for beginners here and about tactics to employ if you want to do a Backdoor Roth IRA but currently have a balance in a traditional IRA, SEP IRA, and/or SIMPLE IRA.

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

Follow me on Twitter: @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.

IRS Identity Protection PIN

UPDATE (January 13, 2021): The IRS has expanded the PIN program to all Americans. See https://www.irs.gov/newsroom/all-taxpayers-now-eligible-for-identity-protection-pins Hat Tip to Ed Zollars for the update: https://www.currentfederaltaxdevelopments.com/blog/2021/1/13/ip-pin-program-available-to-all-taxpayers

The post below has NOT been updated for the January 13, 2021 update. Please use the below for general background purposes only and refer to the IRS website and Mr. Zollars’ article.

Identity theft continues to be a significant 21st century concern. It can happen in many ways. One particularly nefarious way is that your identity might be stolen to file a tax return with the IRS. Below I discuss a relatively new program that the IRS has made available to many Americans to help prevent identity theft with the IRS. If you are eligible, you should give strong consideration to opting into the program.

Identity Theft and Tax Returns

Obviously identity theft is bad. But why would someone use your identity with the IRS?

The answer is a tax refund. The scam often works like this: a scammer steals your identity and files a tax return with your name and Social Security number early in the year, before you have a chance to file your tax return for the prior year. The scammer will report taxable income and tax payments such that the tax return claims you have a significant income tax refund due from the IRS. The phony tax return will direct the refund such that the scammer gets the tax refund.

This becomes a nightmare for the victim. Once the IRS accepts the tax return and issues the scammer a refund, the victim will not be able to file a tax return. The IRS will reject the valid return and will not issue any tax refunds owed to the victim. The victim now faces what is likely months of remedial action to correct the situation.

Identity Protection PINs

The IRS is aware of this problem. They have an optional program that allows certain people to obtain an Identity Protection Personal Identification Number (PIN). The PIN functions to protect a taxpayer. 

If a taxpayer has an Identity Protection PIN issued with the IRS, the IRS will only accept that taxpayer’s electronic tax return if the tax return provides the Identity Protection PIN. That stops the sort of scams described above. For paper returns, a missing or incorrect PIN will delay the IRS accepting the tax return while the IRS takes additional steps to verify that the tax return came from the taxpayer whose name and Social Security number appear on the tax return. Either way, obtaining a PIN provides a level of protection against tax return identity theft.

Spouses each separately apply for their own PIN and the IRS will issue each spouse a unique PIN. If the spouses file jointly, both PINs are included on the tax return. If you have an Identity Protection PIN and use a paid tax preparer, it is important that your paid tax preparer include the PIN on your tax return. 

Eligibility

You are eligible to apply for an Identity Protection PIN from the IRS if:

Arizona, California, Colorado, Connecticut, Delaware, District of Columbia, Florida, Georgia, Illinois, Maryland, Michigan, Nevada, New Jersey, New Mexico, New York, North Carolina, Pennsylvania, Rhode Island, Texas, and Washington.

The yellow states below are the ones in which all taxpayers may apply for an IRS Identity Protection PIN (hat tip to 270toWin.com).

PLEASE SEE UPDATE FROM JANUARY 13, 2021 ABOVE: NOW ALL AMERICANS CAN POTENTIALLY QUALIFY.

Application

To obtain an IRS Identity Protection PIN, you can start at this website.

You will need to establish an IRS electronic account. The IRS website will guide you through the process and will use some credit history information to verify your identity. Once you have your IRS electronic account, you can easily obtain an IRS Identity Protection PIN. 

Future Years

Your PIN changes every year. At the beginning of the year, the IRS will put your new PIN (for use in filing the prior year’s tax return) in your IRS electronic account and they will mail your PIN to your last address of record. This makes it crucial to file a Form 8822 with the IRS to officially change your address with the IRS anytime you move, so that any PIN related correspondence (including retrievals in the event you lose your PIN) are directed to your correct address. 

The IRS will change your PIN every year, so it is important to ensure you use the correct PIN when filing your tax return. A PIN received in October 2019 will be for 2018 and you will need to use the PIN issued early in 2020 to file your 2019 tax return. 

Conclusion

Taxpayers eligible for the IRS Identity Protection PIN program should strongly consider applying for a PIN. It can help protect you from the serious headache of having your identity stolen and used to file a false tax return in your name. 

Further Reading

Kay Bell wrote a great post about the IRS Identity Protection PIN program here. 

FI Tax Guy can be your financial advisor! 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 Tax Challenges of ISOs

Incentive stock options (“ISOs”) are a great employee benefit. ISOs are very powerful because they provide the possibility of compensating employees at preferential long term capital gains rates instead of at ordinary income tax rates, and they avoid Social Security and Medicare taxes. ISOs can also help build wealth by allowing employees to purchase employer stock at a discount. However, ISOs can create several tax challenges, and reporting them on your tax return can be confusing.

Incentive Stock Options

Employers grant employees incentive stock options as an incentive to stay with the company. The company grants the employee an option to purchase the stock of the company at a certain price (the “exercise price” or the “strike price”). That price is no less than the company’s current stock price (i.e., the stock price on the grant date, defined below). 

There is a $100,000 annual limit on the fair market value of stock subject to ISO treatment per employee. If an employee leaves the employer’s employment, he or she must exercise or forfeit their ISOs within three months.

Three dates matter when considering ISOs. 

Grant Date: The date the employee is granted the option (i.e., the first date the employee has the option to purchase the stock at the strike price).

Exercise Date: The date the employee exercises the ISO (i.e., the date the employee purchases the stock of the company under the terms of the ISO at the strike price). 

Disposition Date: The date the employee sells the stock acquired by the previous exercise of the ISO.

Tax Treatment

Grant: There is no tax consequence to the employee upon the grant of the ISO.

Exercise: Upon exercise, there is no income tax consequence to the employee. However, the difference between the fair market value of the ISO and its strike price is an adjustment that creates income for alternative minimum tax purposes (the dreaded AMT). Fortunately, the late-2017 tax reform bill increased AMT exemptions (i.e., the amount of income below which the AMT does not apply), thus reducing, but not eliminating, the potential negative impact AMT can have on ISO exercises. 

Further, the AMT issue is removed if the exercise and later stock disposition occur in the same year. As a practical matter, it is often the case that the later stock disposition occurs almost instantaneously after exercise, which takes the AMT issue off the table. 

Dispositions: ISOs have very favorable tax treatment upon disposition if the disposition of the shares satisfies both of the following rules.

  1. The disposition is at least two years from the grant date; and,
  2. The disposition is at least one year from the exercise date.

If both rules are satisfied, the employee has long term capital gain or loss upon the disposition of the shares. Long term capital gains are taxed at preferential rates for federal income tax purposes.

Example: Gary works for Acme Explosives, Inc. Acme grants Gary 10,000 ISOs at an exercise price of $10 per share on January 1, 2018. Gary exercises the ISOs on June 1, 2018 at a time when the fair market value of the stock is $15 per share. On February 1, 2020, Gary sells each share acquired through the ISO exercise at a price of $20 per share. Assume that Gary was not subject to AMT in 2018. 

Because Gary sold the Acme shares at least one year after exercise and at least two years after the ISO grant, Gary’s sale qualifies entirely for long term capital gain treatment (creating a $100,000 capital gain — $200,000 sales proceeds less $100,000 basis) and creates no taxable ordinary income.

Early Dispositions

Often employees will dispose the ISO stock before the time required to get favorable income tax treatment. As a practical matter, employees often exercise the ISO and immediately sell the stock. 

Employees are exposed to the economic performance of their employer through their job and possibly other equity holdings. Thus, they often want to reduce the risk associated with their employer’s performance and dispose of their ISO stock as soon as possible. Most view the tax cost as well worth it considering that (i) the employee immediately pockets (net of tax) the difference between the fair market value of the stock and the strike price, and (ii) the diversification benefits of investing the ISO proceeds into other investments.

If the employee disposes of the ISO stock early (referred to as a “disqualifying disposition”), what result? The difference between the strike price and the fair market value of the stock at exercise becomes ordinary income to the employee reported to the employee as compensation income included in Box 1 of the employee’s Form W-2. The remaining amounts create long or short term capital gain or loss.

Example: Angela works for Acme Anvils, Inc. Acme grants Angela 10,000 ISOs at an exercise price of $10 per share on January 1, 2019. Angela exercises the ISOs on June 1, 2019 at a time when the fair market value of the stock is $15 per share. On December 1, 2019, Angela sells each share acquired through the ISO exercise at a price of $20 per share. 

Because Angela’s December 2019 sale violates both timing tests, Angela’s sale does not qualify for long term capital gain treatment. Thus, Angela has $50,000 of compensation income ($15 fair market value less $10 strike price times 10,000 shares) of ordinary compensation income. The remaining $50,000 of gain is short term capital gain. 

Fortunately, the compensation income is not included in compensation income for purposes of Social Security and Medicare payroll taxes (and, thus, is not included in Boxes 3 and 5 on the Form W-2). Because Angela sold the ISO shares in the same year she exercised the ISOs, there will not be a separate AMT consequence of the ISOs. 

Tax Reporting

Staying with Angela’s example, the $50,000 of ordinary income will be reported as compensation income in Angela’s Form W-2 Box 1, but not in Boxes 3 and 5. Box 14 should indicate “ISO DISQ” and $50,000 as the amount.

Angela should also receive two other tax reporting documents. First, Angela should receive a Form 1099-B. The form should indicate $200,000 of sales proceeds ($20 per share times 10,000 shares) and should indicate a basis of $100,000 (Angela’s historic cost basis, as she paid $10 per share for 10,000 shares). Angela should also receive a Form 3921. This form should indicate the exercise price per share ($10) and the fair market value per share on the date of the exercise ($15).

The IRS will expect to see at least two numbers on Angela’s tax return. First, the compensation income must be reported on Angela’s Form 1040 box 1. Second, the $200,000 stock sale should be reported on Schedule D and on Form 8949. 

This is where it gets interesting. If Angela simply reports $200,000 as gross proceeds and $100,000 as basis on her Schedule D and her Form 8949, she is going to have a very bad tax result. Why? Angela’s W-2 includes $50,000 of the overall $100,000 of income she recognized on the ISO exercise and disposition. If she simply reports a $100,000 gain on her Schedule D/Form 8949, her total reported income will be $150,000, creating $50,000 in over-reported taxable income. 

Thus, Angela must increase the basis she reports on Schedule D and Form 8949 by the $50,000 of ordinary compensation income reported on her Form W-2. Her Schedule D and Form 8949 should report both the $200,000 of gross proceeds and $150,000 of basis in the disposed of Acme shares. 

Estimated Taxes

Even though the gain on a disqualifying disposition of an ISO is taxable as ordinary income in Box 1 of the Form W-2, there is no requirement that the employer withhold any income tax with respect to the gain. Thus, the onus falls to the employee to ensure he or she pays the proper amount of federal and state estimated income tax to avoid penalties. The good news is that there is a safe harbor under which employees can avoid underpayment penalties. 

For federal income tax purposes, there will not be an underpayment of estimated tax penalty if the employee has paid in at least 90 percent of their current year total tax liability and/or 100 percent of their prior year total tax liability. If current year income is $150,000 or more, 100 percent becomes 110 percent. 

Regardless of whether there is a qualifying disposition triggering long term capital gain or a disqualifying disposition triggering ordinary income, the employee should endeavor through a combination of estimated tax payments, additional workplace withholding, and/or additional spousal workplace withholding to ensure that he or she has withheld enough during the year to avoid federal and state underpayment penalties. 

Conclusion

ISOs can be a great wealth building tool. But because of the tax rules and at times confusing tax reporting, they present a challenge. Anyone with ISOs (or with clients that own ISOs) should step back and fully understand the tax ramifications of selling them. It is often advisable to work with a professional advisor as you sell ISOs and manage the tax ramifications of the sale. 

Further Reading

The IRS provides some tax resources on ISOs starting on page 12 of Publication 525.

FI Tax Guy can be your financial advisor! FI Tax Guy can prepare your tax return! 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.

Defending HDHPs

In the financial independence community and beyond, high deductible health plans (“HDHPs”) have received significant criticism. Few downplay the significant tax benefits of their tag-team partner, the health savings account. But some have written that the HSA sweetener is not sufficient to make high deductible health plans desirable. 

Below I offer a different perspective. I write regarding the approach of anyone seeking financial independence, but I believe much of what is discussed below applies regardless of whether you are seeking financial independence. 

One quick caveat: the below assumes that you are relatively healthy when you select your medical insurance, and that you expect that you will most likely remain so. For those with significant, chronic medical conditions, an HDHP is not likely to be a good medical insurance choice.

HDHP Critiques

High deductible health plans have been criticized by both the national media and by financial independence writers. Several studies have found that those covered by HDHPs tend to delay or forego needed medical assistance when compared with the population at large. This study found that those with HDHP insurance tend not to take advantage of free preventive services. Based on these study findings, there is a concern that the use of HDHPs can cause long term harm and worsen medical and health outcomes. 

Financial Independence Mentality

Those actively seeking financial independence (“FIers”) embrace two beliefs. First, they believe they are not constrained by others’ failures. While FIers understand that others’ failures can be indicative of difficulties they themselves might face, FIers believe that with intentional action they can overcome those difficulties.

FI exists because people see what the “average” or “typical” person does (for example, a very low savings rate) and say, “wait a minute, I’m going to do something very different.” FIers acknowledge a societal trend and then pursue a different path with intention. 

Second, FIers prioritize valuable purchases over immediate bottom-line results. Being financially independent (or seeking FI) frees you from the tyranny of any particular financial number when considering necessary expenses.

Health Insurance and Behavior

Your medical insurance should not determine whether you seek medical care. Only your current condition should determine whether you seek medical care. Assuming, only for the sake of argument, that the studies’ findings are correct, should those findings deter someone pursuing FI from using an HDHP as their medical insurance? I argue that they should not, for several reasons.

First, the studies probably did not include you. Why would you have a limiting belief about your own future behavior based on studies of other people? Even if you were in one of the studies and delayed or forwent necessary medical treatment, is it not possible that you could change your behavior?

Second, why not simply accept that cost will deter some people from obtaining needed medical assistance, but resolve that you will not act in such a shortsighted fashion. Many FIers seek to obtain financial assets of $1 million, $1.5 million, $2 million or more to fund the rest of their lives. Neither an unanticipated $300 medical expense nor an unanticipated $5,000 medical expense will derail your plans to achieve financial independence. 

If you commit to FI, you are committing to acting very differently than most people when it comes to spending and saving. Why then would you believe you will act like the average study subject when it comes to obtaining medical treatment for a medical need? 

Third, there is nothing preventing those with HDHPs from taking advantage of free preventive services. Many workers do not take advantage of the employer match to their 401(k). That outcome does not make a 401(k) a bad retirement plan. Rather, it illustrates that in many areas of life, people should be more intentional about taking advantage of what is offered to them. Suboptimal human behavior does not make 401(k)s and HDHPs bad, and others’ mistakes should not limit your insurance choices.

Finally, financial independence exists in part to make personal finances revolve around what needs to happen, and not to have what needs to happen revolve around personal finances. FIers ought to make medical care decisions based on their health, and not based on avoiding a medical bill that is ultimately minor in the grand scheme of things.

The Role of Insurance

What the studies appear to illustrate is a widespread misunderstanding of medical insurance. Insurance does not exist to determine whether you obtain medical assistance. Insurance exists to prevent financial ruin. 

Might an unexpected medical situation be expensive if you have an HDHP? Yes, absolutely. But should it be ruinous? It should not be. Your annual out-of-pocket maximum for medical expenses will be high: imagine in your mind’s eye that it is $10,000. In the event of a medical calamity, you will pay $10,000 in expenses annually. Then your finances are protected. 

Does an unexpected $10,000 expense hurt? Absolutely. But if your FI plan was to build $1.5 million in assets to fund the rest of your life, is not possible that you instead build $1.51 million in assets? Why would you put off necessary medical care to avoid a very slight increase in the assets you will need to build up to become financially independent? Are you much worse off in this situation than someone with zero-deductible medical insurance? Their “FI number” is $1.5 million; yours is $1.51 million. 

You might argue “but might my insurance company deny my claim?” That is a valid concern with insurance. But it is a concern whether you have a gold-plated, zero-deductible insurance plan, an HDHP, or any other type of medical insurance. Thus, the possibility that you might have to fight with your insurance company to get an expense covered is not a reason to avoid HDHPs. 

Risk/Reward Trade-off

When you use an HDHP, you assume additional risk. Put simply, you risk paying annual medical expenses up to the higher deductible. Two things should be noted about that risk. First, it is capped, as described above. A capped risk is the sort of risk that those building up assets should usually be willing to take on, as long as there is sufficient benefit to doing so.

Second, you are compensated for taking that risk. While your future annual medical expenses are uncertain, the benefits of using an HDHP are largely certain and immediate. Namely, they are:

  1. Lower insurance premiums
  2. Income and payroll tax savings (if the HSA is properly funded)
  3. Employer contributions to the HSA on your behalf
  4. Tax-deferred or (if withdrawn correctly) tax-free growth of the investments in the HSA

For taking on the risk of medical expenses up to the annual out-of-pocket maximum, there are two or three measurable, guaranteed benefits every pay period for using the HSA/HDHP combination. And while the fourth benefit can vary greatly (depending on the length of tax-free growth, future tax rates, etc.), it too is a significant benefit.

When evaluating an insurance plan, the risk/reward trade-offs and the costs are what should be evaluated. When comparing an HDHP with a lower deductible insurance plan, you must weigh the assumption of a speculative, capped risk in exchange for the benefits listed above. Based on the protection against very high annual medical expenses and the four benefits listed above, an HDHP appears to be, in many cases, a good risk/reward trade-off for those without expensive, chronic medical conditions. 

Conclusion 

The studies have not found that an HDHP is suboptimal from a risk trade-off perspective. Rather, they have found suboptimal consumer behavior. That’s where FI comes back in. FI is all about turning around suboptimal saving, investing, and consumer behavior and re-ordering financial priorities. Why shouldn’t obtaining necessary medical care be among the highest financial priorities? Why can’t you examine your own healthcare purchasing behavior and improve it? 

There can be good reasons not to select an HDHP based upon your particular circumstances. Perhaps you have a chronic condition, you do not like the HDHP’s particular insurance carrier, and/or you do not believe the risk trade-off benefits are sufficient. But don’t eschew an HDHP because of a limiting belief about something under your own control: your behavior as a patient and medical consumer. 

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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.