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Retire on 72(t) Payments

Want to retire before age 59 ½? Have most of your wealth in traditional tax-deferred retirement accounts? Worried about the 10 percent early withdrawal penalty?

This post is for you!

Picture it: You’re age 53, have $50,000 in a savings account, a paid-off home, and $2.5M in a 401(k). Including income taxes, you spend about $80,000 a year. You want to retire, but you’re worried about paying the early withdrawal penalty, which would be about $8,000 a year (not factoring in the penalty on the penalty!).

What to do, what to do? The tax law allows someone in this situation to take a “series of substantially equal periodic payments” to avoid the 10 percent penalty. The payments must occur annually for the longer of 5 years or until the taxpayer turns 59 ½.

72(t) payments can make retirement possible prior to age 59 ½ when one has most of their assets in traditional deferred retirement accounts. Done properly, these payments avoid the 10 percent early withdrawal penalty.

Below I explore some of the rules of 72(t) payments (sometimes referred to as a “72(t) SEPP” or “SEPP”) and lay out what I hope will be an informative case study.

** As always, none of this is personalized advice for you, but rather educational information for your consideration. Consult with your own advisors regarding your own situation.

72(t) Substantially Equal Periodic Payments

Methods

The IRS and Treasury provide three methods for computing a 72(t) payment. As a practical matter, the third one I discuss, the fixed amortization method, tends to be the most commonly used and most user friendly in my opinion.

The required minimum distribution method allows taxpayers to take a 72(t) payment just like an RMD. Take the prior year end-of-year balance and divide it by the factor off the IRS table. The biggest problems with this method are it tends to produce a smaller payment the younger you are and the payment changes every year and can decrease if the IRA portfolio declines in value. The fixed annuitization method usually requires actuarial assistance, making it more complicated and less desirable. See Choate, referenced below, at page 587.

We will focus the rest of the post on the fixed amortization method of computing 72(t) payments (other than a brief foray into the RMD method to account for changing circumstances)).

Computing Fixed Amortization 72(t) Payments

To compute a 72(t) payment and the size of the 72(t) IRA using the fixed amortization method, we will need to run through some math. Four numbers are required: the interest rate, the life expectancy, the annual payment, and the size of the 72(t) IRA.

Usually the IRS gives us the interest rate and the life expectancy and we need to solve for the 72(t) IRA size.

Interest Rate: In a very positive development, the IRS and Treasury issued Notice 2022-6 early in 2022. This notice allows taxpayers to always use an interest rate anywhere from just above 0% to 5%. There is a second, older rule: the taxpayer can use any interest rate that is not more than 120% of the mid-term federal rate for either of the previous two months. The IRS publishes that rate on a monthly basis.

As a general rule, taxpayers will usually want to use the greatest interest rate permitted to as to decrease the size of the 72(t) IRA. Decreasing the size of the 72(t) IRA will usually be advantageous, for the reasons discussed below.

Life Expectancy: The life expectancy comes to us from an IRS table. While we have three possible choices to use, generally speaking taxpayers will want to use the Single Life Table found at Treas. Reg. Section 1.401(a)(9)-9(b). See Choate, referenced below, at page 587. The taxpayer takes their age on their birthday of the year of the first 72(t) payment and uses the factor from the Single Life Table as the life expectancy.

Payment: Finally, we, not the IRS, get to determine a number! The payment is simply the annual payment we want to receive as a 72(t) payment every year. While this amount is rather inflexible, as discussed below it will be possible to establish additional 72(t) IRAs and payments to increase the amount received if desired.

Size of the 72(t) IRA: This is what we’re solving for to establish a “right-sized” IRA to produce the desired 72(t) payment. In Google Sheets, we do a present value calculation to solve for the size of the 72(t) IRA that generates the desired payment amount. The formula is rather simple: =-PV(Interest Rate Cell, Life Expectancy Cell, Annual Payment Cell). I put a negative sign in front of the PV to have the size of the 72(t) IRA appear as a positive number. It’s important that the formula be entered in that order and that the formatting be correct in each cell.

Note on 72(t) Payments with non-IRA Accounts: Setting up a 72(t) from a non-IRA is possible but not frequent in practice. It is not possible to divide up a 401(k) account in a manner conducive to establishing a “right-sized” 72(t) payment account. See Choate, referenced below, at page 595.

Annual Equal 72(t) Fixed Amortization Payments

The computed payments must be made annually and equally. This means that no more and no less than the computed payment comes out every year. I believe that taking an annual flat payment on or around the first payment anniversary date is a best practice. However, this best practice is not required. See also Choate, referenced below, at page 600. For example, monthly payments of the computed amount are allowable. See Choate, referenced below, at page 600.

Annual payments must be made for the longer of five years or until the taxpayer reaches age 59 ½.

72(t) Payments Case Study

Let’s return to the example discussed above: it is early November 2023 and you (let’s call you Pat) are 53 years old (your birthday was June 8th) and you want to retire, spending $80K a year from your $2.5M 401(k). Let’s solve for the size of the 72(t) IRA:

Interest Rate: 5.33% (the highest 120% of federal mid-term rate of the previous two months per the IRS)

Life Expectancy: 33.4

Payment: $80,000

The size of the 72(t) IRA is $1,236,012.95. See IRS FAQ Q&A 7.

Pat would first transfer (preferably through a direct trustee-to-trustee transfer) the 401(k) to a traditional IRA worth $2.5M. Once in the traditional IRA, Pat would call their financial institution and ask them to divide the traditional IRA into two IRAs: one with exactly $1,236,012.95 (the “72(t) IRA”) and one with the reminder of the traditional IRA (the “non-72(t) IRA”). I recommend initially investing the 72(t) IRA in a money market fund so that it can be clearly established that the beginning account balance was exactly the $1,236,012.95 computed to yield the correct payment. Pat takes the first payment of $80,000 on November 29th from the 72(t) IRA in this hypothetical scenario.

Let’s keep going. Assume that in 2027, when Pat turns age 57 and interest rates are well below 5%, Pat wants to increase their November withdrawal from $80K to $90K. As discussed below, Pat can’t simply increase the withdrawal from the 72(t) IRA. But since Pat kept a non-72(t) IRA, Pat can slice that one up to create a second 72(t) IRA. That second 72(t) IRA can give Pat the extra $10,000 Pat wants to spend.

Here’s what that looks like.

Interest Rate: 5.00%

Life Expectancy: 30.6

Payment: $10,000

The size of the second 72(t) IRA is $155,059.55.

Pat would call their financial institution and ask them to divide the non-72(t) IRA into two IRAs: one with exactly $155,059.55 (the “Second 72(t) IRA”) and one with the remainder of the traditional IRA (the surviving non-72(t) IRA). Pat takes the additional payment of $10,000 also on November 29th from the Second 72(t) in this hypothetical scenario.

Here is what Pat’s withdrawals would look like:

Year	Birthday Age	Required First 72(t) November 29 Withdrawal	Required Second 72(t) November 29 Withdrawal	Total Annual Withdrawal
2023	53	$80,000	$0	$80,000
2024	54	$80,000	$0	$80,000
2025	55	$80,000	$0	$80,000
2026	56	$80,000	$0	$80,000
2027	57	$80,000	$10,000	$90,000
2028	58	$80,000	$10,000	$90,000
2029	59	$80,000	$10,000	$90,000
2030	60	$0	$10,000	$10,000
2031	61	$0	$10,000	$10,000

Remember that the First 72(t) IRA and the Second 72(t) are locked up for a period of time. See Locking the Cage below. The First 72(t) IRA is locked up until and through December 7, 2029, the day before Pat’s 59 ½ birthday. The Second 72(t) IRA is locked up until and through November 28, 2032, the day before the fifth anniversary of the first $10,000 payment from the Second 72(t) IRA. See IRS FAQ 13 on this point. Generally speaking, no amount other than the annual payment should go into, or out of, a 72(t) IRA until the end of the lock-up period.

Maintain Flexibility

I strongly recommend maintaining as much flexibility as possible. One way to do that is to have the 72(t) IRA be as small as possible, leaving as much as possible in a non-72(t) IRA or IRAs. Why?

First, the non-72(t) can be, in a flexible manner, sliced and diced to create a second 72(t) IRA if wanted or needed. Second, it is not abundantly clear what happens when a 72(t) IRA is used for partial Roth conversions. See Choate, referenced below, at page 384. As Ms. Choate discusses, the only clarity we have is that if the entire 72(t) IRA is Roth converted, the taxpayer must continue to take withdrawals from the Roth IRA for the remainder of the 72(t) term. Doing so limits the benefit of doing Roth conversions in the first place, since we usually want Roth converted amounts to stay in a Roth IRA to facilitate many years of tax-free growth.

Imagine if Pat did not divide the $2.5M traditional IRA into two IRAs. Pat could have simply used a smaller interest rate on the entire $2.5M traditional IRA to get the $80,000 annual payment out. However, then Pat would not have had the flexibility to create a second 72(t) payment stream. This is an important reason that it is usually best to use the highest possible interest rate to lower the 72(t) IRA size and maintain the most flexibility.

72(t) Payment Plan Disqualification

A “modification” to the 72(t) payment plan blows up the plan with unfavorable consequences. In the year of the modification the taxpayer owes the 10 percent early withdrawal penalty plus interest on the penalty on all the previously taken 72(t) payments. See Choate, referenced below, at page 596.

A blow up after age 59 ½, for those on the five year rule, is bad but tends to be less deleterious than a blow up occurring with respect to a SEPP ending at age 59 1/2. The early withdrawal penalty and related interest are not assessed on 72(t) payments taken after one’s 59 ½ birthday. See Choate, referenced below, at page 596.

There are a few modifications to a 72(t) payment plan that do not blow it up (i.e., they are permissible and don’t trigger the penalty and interest). See Choate, referenced below, at pages 597-601. Those looking to change the payment amount are often well advised to set up a second 72(t) payment plan (as Pat did) rather than seeking a modification to the existing 72(t) payment plan.

72(t) Payment Reduction

Imagine that instead of wanting an additional 72(t) payment amount, Pat wanted to reduce the 72(t) payment. This is not uncommon. Perhaps Pat has a significant inheritance in 2027 and thus no longer needs to take an $80,000 annual payment and pay tax on it.

Unfortunately, Pat is not allowed to simply discontinue or reduce the 72(t) payment without triggering the early withdrawal penalty (and interest charges) on the previously taken 72(t) payments.

But, the rules allow a one-time switch to the RMD method. Making the switch is likely to significantly reduce the annual 72(t) payment. For example, if Pat wants a smaller payment starting in 2027, Pat could take the 72(t) IRA balance on December 31, 2026 (imagine it is exactly $1M) and divide it by the age 57 factor off the Single Life Table (29.8) and get a 2027 72(t) payment of $33,557.05. Alternatively, Pat could use the age 57 factor off the Notice 2022-6 Uniform Life Table (41.6) and get a 2027 72(t) payment of $24,038.46.

If Pat makes this one-time switch, Pat will annually compute the 72(t) payment for the remainder of the 72(t) term using the table used in 2027 (see Notice 2022-6 page 6) and the prior-year end-of-year 72(t) IRA balance.

The one-time switch to the RMD method is helpful if the taxpayer wants to significantly reduce their 72(t) annual payment, perhaps because of an inheritance, marriage, YouTube channel blowing up, or returning to work. The availability of this method to reduce required 72(t) payments (if desired) is another reason to keep 72(t) IRAs as small as possible.

72(t) Locking The Cage

The 72(t) IRA should be thought of as a locked cage. No one goes in, and only the 72(t) payment comes out annually. The rigidity with which the IRS treats the 72(t) IRA gives early retirees incentive to use as high an interest rate as possible to get the highest annual payment out of the smallest 72(t) IRA possible.

Just how rigid is the IRS? In one case, the IRS disqualified a 72(t) SEPP because a taxpayer transferred a workplace retirement plan into the 72(t) IRA during the 72(t) payment period. See page 4 of this newsletter (page 4 is behind a paywall). Imagine paying penalties and interest on old 72(t) payments for what is seemingly an unrelated rollover!

Remember, the “series of substantially equal periodic payments” requires not just an annual payment. It requires that the 72(t) IRA be locked up. Assuming one is using the fixed amortization method for their 72(t) payments, not a dollar more than the 72(t) SEPP should come out each year. It appears the IRS expects the amount to be equal each tax year, see page 5 of this PLR.

Further, the 72(t) lockup does not end with the taking of the last payment. Rather, as described in IRS FAQ 13, it ends at the end of the lock up period. So if Sean, age 57 in 2023, takes his first 72(t) SEPP of $10,000 from IRA 1 on July 15, 2023, his taking of payment number 5 ($10,000) on July 15, 2027 does not end the lock up. Sean can’t take any additional money out of IRA 1 until July 1, 2028 (the fifth anniversary of his first $10,000 72(t) payment).

Practice Point: Never add money to a 72(t) IRA during the lockup period. This includes never making an annual contribution to a 72(t) IRA and never rolling an IRA, 401(k), or other qualified plan into a 72(t) IRA.

IRS FAQ 13 is instructive in terms of when the lock up ends. The IRS is clear that the lock up ends on the date of the 59 ½ birthday, not on January 1st of that year. Say Rob, born January 14, 1971, takes his first SEPP of $40,000 on August 16, 2023. His 72(t) IRA is free on his 59 ½ birthday, which is July 14, 2030. Presumably, Rob takes his last $40,000 SEPP on or around August 16, 2029. Nevertheless, he can’t add to or withdraw from his 72(t) IRA prior to July 14, 2030 without blowing up his 72(t) payment plan and incurring significant penalties and interest.

As discussed above, the one-time switch to the RMD method is a permissible modification to the 72(t) payment terms that does not trigger the early withdrawal penalty and related interest on previously taken 72(t) payments.

A Note on the 72(t) Risk Profile

The earlier in life the 72(t) payment plan starts, the greater the risk profile on the 72(t) payment plan. The opposite is also true: the later in life a 72(t) payment plan starts, the lower the risk profile.

Why?

Because the sooner the 72(t) payment plan starts, the more years (and more interest) that can be blown up by a future modification requiring the payment of the 10 percent early withdrawal penalty and interest.

Consider Pat’s example. If Pat blows up the First 72(t) payment plan in early 2028, Pat owes the 10% early withdrawal penalty and interest on five previously taken 72(t) payments from the First 72(t) IRA (2023 through 2027). If Pat blows up the Second 72(t) payment plan in 2032, Pat only owes the early withdrawal penalty and interest on the three 72(t) payments received before Pat turned age 59 ½.

72(t) Payment Tax Return Reporting

Taxpayers should keep the computations they and/or their advisors have done to document the 72(t) payment plan. Distributions should be reported as taxable income and on Form 5329. Code 02 should be entered on Line 2 of Form 5329.

72(t) Is An Exception to More Than One Rule

72(t) payment plans are an exception to the 10 percent early withdrawal penalty. They are also an exception to the general rule that the IRS views all of your IRAs as a single IRA. The 72(t) IRA is the 72(t) IRA. If you have a separate IRA and take ten dollars out of it prior to age 59 ½, you trigger ordinary income tax and a $1 penalty. If you take an additional ten dollars out of the 72(t) IRA prior to the end of the 72(t) lock up, you blow up the 72(t) payment plan and owe the 10 percent early withdrawal penalty and interest on all the pre-59 ½ 72(t) payments.

Other Penalty Free Sources of Early Retirement Funding

Let’s remember that 72(t) payments are a tool. In many cases they are not a “go-to” strategy. I’ve written this post not because 72(t) payments are a go-to strategy but rather because I know there are many in their 50s thinking about retirement but daunted by the prospect of accessing traditional retirement accounts prior to age 59 ½.

Generally speaking, I encourage using resources other than 72(t) payments if you are able to. They include:

Taxable Accounts: I’m so fond of using taxable accounts first in retirement I wrote a post about the concept in 2022.

Inherited Retirement Accounts: Withdrawals from inherited retirement accounts (other than those the spouse treats as their own) are never subject to the 10% early withdrawal penalty. Often they are subject to a 10-year draw down rule, so usually they should be accessed prior to implementing a 72(t) payment plan from one’s own accounts.

Rule of 55 Distributions: Only available from a qualified retirement plan such as a 401(k) from an employer the employee separates from service no sooner than the beginning of the year they turn age 55. This is a great workaround from the early withdrawal penalty, and much more flexible than a 72(t) payment plan. But remember, the money must stay in the workplace retirement account (and not be rolled over to a traditional IRA) to get the benefit.

Governmental 457(b) Plans: Withdrawals from governmental 457(b) plans are generally not subject to the 10% early withdrawal penalty.

Roth Basis: Old annual contributions and conversions that are at least 5 years old can be withdrawn from Roth IRAs tax and penalty free at any time for any reason.

I previously discussed using a 72(t) payment plan to bail out Roth IRA earnings penalty-free prior to age 59 ½. This is a tactic that I would not recommend unless absolutely necessary (which I believe is a very rare situation).

72(t) Landscape Change

It should be noted that the issuance of Notice 2022-6 in early 2022 changed the landscape when it comes to 72(t) payments. Before the 5 percent safe harbor, it was possible that taxpayers could be subject to sub-0.5 percent interest rates, meaning that it would take almost $1M in a retirement account to generate just $30,000 in an annual payment in one’s mid-50s. Now with the availability of the 5 percent interest rate much more modest account balances can be used to generate significant 72(t) payments in one’s mid-50s.

I Tweeted some additional thoughts on what the changing landscape means for how we should approach 72(t) payments.

72(t) and Employer Stock

What if Pat’s 401(k) contained significant amounts of employer stock? What if that employer stock had significantly appreciated in value since the time Pat and/or Pat’s employer contributed that stock? If so, a 72(t) payment plan may not be ideal. Rather, Pat may want to work with Pat’s advisor(s) to look into a separate and distinct tax planning opportunity, net unrealized appreciation (“NUA”).

I collaborated with Andrea MacDonald to discuss the tax return reporting requirements for NUA here.

Resource

Natalie B. Choate’s treatise Life and Death Benefits for Retirement Planning (8th Ed. 2019), frequently referenced above, is an absolutely invaluable resource regarding retirement account withdrawals.

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 Basis Isolation Backdoor Roth IRA

If you have basis in an IRA, you will want to read this post. Basis in an IRA creates all sorts of confusion, but it also presents a great planning opportunity for many of those still working. I refer to this opportunity as the Basis Isolation Backdoor Roth IRA.

Where Does IRA Basis Come From?

Basis in a traditional IRA generally emerges from two sources. The first source is old nondeductible traditional IRA contributions that have not been Roth converted or withdrawn. Nondeductible traditional IRA contributions should be reported on a Form 8606 filed with one’s annual federal income tax return.

Many times this basis is simply exhausted annually by Backdoor Roth IRAs. Here’s a quick example:

Example 1: Becky contributed $6,500 to a traditional, nondeductible IRA on January 2, 2023. On February 1, 2023, when the traditional IRA was worth $6,504, she converted the entire traditional IRA balance to a Roth IRA. On December 31, 2023, she had $0 in all traditional IRAs, SEP IRAs, and SIMPLE IRAs. She successfully completed the Backdoor Roth IRA, which created $6,500 of IRA basis on January 2nd and exhausted all $6,500 of that basis on February 1st.

However, there are plenty of Americans who have existing and remaining IRA basis because they can’t do the Backdoor Roth IRA efficiently, or they never did the Backdoor Roth IRA.

To sum up, those doing annual tax-efficient Backdoor Roth IRAs tend not to have any IRA basis at year-end. But some Americans do have existing and remaining IRA basis.

The second source of IRA basis is from after-tax 401(k) contributions that have been transferred to a traditional IRA (see Natalie B. Choate’s treatise Life and Death Benefits for Retirement Planning (8th Ed. 2019), page 150).

There are Americans with existing IRA basis through transfers from a 401(k) (or other qualified plan) to a traditional IRA. However, going forward this should generally not occur. The IRS and Treasury issued Notice 2014-54, which provides that after-tax 401(k) contribution amounts can be rolled directly to a Roth IRA. From a planning perspective, after-tax 401(k) contributions (and other qualified plan after-tax contributions) should generally be directed into Roth IRAs if the plan participant prefers to exit the plan for IRAs (at retirement or a job change, for example).

Example 2: Chris is age 53. He leaves employment at Consolidated Industries, Inc. on November 1, 2023. At that time, he had a traditional 401(k) at Consolidated worth $500,000. During his time at Consolidated, Chris made $75,000 of after-tax contributions to the traditional 401(k) which remain in the traditional 401(k). Chris prefers to manage the money himself in an IRA or IRAs. Thus, he has two options:

Option One: Transfer the money (preferably through a direct trustee-to-trustee transfer) to a single traditional IRA. Chris now has $75,000 of traditional IRA basis.

Option Two: Transfer (preferably through direct trustee-to-trustee transfers) the after-tax money $75,000 to a Roth IRA and $425,000 to a traditional IRA. The $75,000 goes into the Roth IRA as a nontaxable conversion contribution (see also Notice 2014-54 Example 4). Chris receives no basis in his traditional IRA.

Which option is better for Chris? Clearly it is Option Two, which gives Chris tax-free growth on his $75,000. Further, Chris can withdraw the $75,000 from the Roth IRA tax and penalty free at any time while Chris would be subject to the hard bite of the Pro-Rata Rule if he used Option 1 and later withdrew $75,000 from the traditional IRA. Thus, while Chris is allowed to roll his $75K 401(k) basis into a traditional IRA, he would be much better served to roll the basis tax-free into a Roth IRA.

A Current Employer Qualified Plan That Accepts Rollovers

In order to have an IRA basis isolation opportunity, one must be currently employed by an employer with a qualified plan (often a 401(k)) that accepts IRA roll-ins. Many qualified plans accept IRA roll-ins but not all do.

Former employees generally are not able to contribute to 401(k)s and other qualified plans, so having a 401(k) plan at a former employer is generally not sufficient for this planning opportunity.

One should generally employ the Basis Isolation Backdoor Roth IRA if they have a 401(k) or other qualified plan at work they are satisfied with from both an investment choice standpoint and a fee standpoint. If one isn’t satisfied with their workplace retirement plan the Basis Isolation Backdoor Roth IRA may not be a good tactic to employ.

Comprehensive Basis Isolation Backdoor Roth IRA Case Study

Having addressed the two prerequisites to do a Basis Isolation Backdoor Roth IRA, let’s dive in with a comprehensive case study.

Imagine Ray has two (and only two) traditional IRAs. IRA 1 is a $100K traditional IRA rollover from an old 401(k). No basis came along in the rollover into IRA 1. IRA 2 is a traditional IRA worth $25K. It was established with three $6K nondeductible traditional IRA contributions for 2020 through 2022. He filed Forms 8606 reporting those contributions.

Ray’s current employer (Acme) has a great 401(k) that accepts roll-ins of traditional IRAs. What could Ray do to take advantage of his traditional IRA basis? He will need to isolate that basis, and that’s where the Basis Isolation Backdoor Roth IRA comes in.

Step 1

Ray transfers IRA 1 to the Acme 401(k), preferably through a direct trustee-to-trustee transfer.

Step 2

Ray invests about $18,010 of IRA 2 in a money market account and invests the remainder of IRA 2 in any investment of his choice (Mutual Fund A).*

By putting that $18,000 and a bit of change in a money market, Ray makes sure he “leaves behind” the IRA basis in the IRA! We will come back to why this “leave behind” asset is so critically important in the Step 3 discussion and analysis.

* As a practical matter, it may be easier to split IRA 2 into IRA 2 and IRA 3, with the $18,010 in IRA 2 and Mutual Fund A in IRA 3. Either path can work, but splitting into IRA 2 and IRA 3 may be the easier path. That split should be done internally at the IRA 2 institution without any check coming out of IRA 2 to the owner.

Step 3

Ray transfers the entire value of Mutual Fund A to the Acme 401(k), preferably through a direct trustee-to-trustee transfer.

The money market account is crucial. The Internal Revenue Code provides that IRA basis cannot be transferred to a 401(k) (see also Natalie B. Choate’s treatise Life and Death Benefits for Retirement Planning (8th Ed. 2019), page 158). By establishing that IRA 2 will have at least $18K that will not be moved into the 401(k), Ray ensures that he “leaves behind” at least his basis inside the IRA.

If the $18,010 was invested in an equity mutual fund (call it Mutual Fund B), there’s a risk that when Ray does Step 3 he will leave behind only Mutual Fund B, which could be less than his $18K basis if Mutual Fund B declines in value.

Example 3: Imagine Ray does Step 3 when Mutual Fund A is worth $10K and Mutual Fund B, originally worth $18K is now only worth $14K based on market declines. In such a case, $4K of basis would (theoretically) move into the Acme 401(k) with the $10K going from IRA 2 to the Acme 401(k). That would be a prohibited transfer of basis.

IRA Aggregation: Remember that for tax purposes, the IRS looks at all of Ray’s traditional IRAs (whether he has one or ten) as a single traditional IRA. We can’t say that basis attaches to IRA 2 only, so it is important that Ray leave at least $18K behind in an IRA so that after the transfers from his IRAs to qualified plans he can demonstrate that his basis was left behind in one or more of his traditional IRAs.

Step 4

Step 4: Ray converts the entire remaining balance in IRA 2 (likely to be $18,010 plus a bit of additional interest) to a Roth IRA. The only taxable amount is the small amount over $18,000.

Step 4 is reported on a Form 8606 (Parts 1 and 2).

Step 5

Ray ensures that as of December 31st of the year Step 4 occurs, Ray has $0 balances in all traditional IRAs, SEP IRAs, and SIMPLE IRAs.

The Benefits of the Basis Isolation Backdoor Roth IRA

Ray has moved approximately $107K from traditional IRAs to the Acme 401(k). That is entirely tax free and does not change the future tax treatment of that money. Perfectly fine, but by itself this doesn’t improve Ray’s tax position.

Before this planning, Ray had $18K of IRA basis that was of limited value due to the Pro-Rata Rule. Future taxable distributions or conversions from his traditional IRAs would have picked up only a small portion of that $18K, meaning that it would only protect small portions of future distributions and conversions from current taxation.

Example 4 The Pro-Rata Rule Bites Ray: If Ray had $18K of basis and $125K of total traditional IRAs and decided to do a $10K Roth conversion (without first doing the Basis Isolation Backdoor Roth IRA), approximately $1,440 of that Roth conversion would have been tax free and approximately $8,560 would have been taxable. See the mock Form 8606 Part I here and Form 8606 Part II here (though note that tax return software programs may use a separate statement instead of actually completing the form).

But with the Basis Isolation Backdoor Roth IRA Ray puts $18K plus into a Roth IRA and paid almost no tax to do so! Ray successfully isolated all $18,000 of basis to get it all into a Roth IRA without being adversely affected by the Pro-Rata Rule. Further, that $18,000 can now grow tax free for the rest of Ray’s life. Previously, inside a traditional IRA that $18,000 was growing tax-deferred, not tax free.

The Basis Isolation Backdoor Roth IRA improved Ray’s position by getting around the Pro-Rata Rule to get $18K plus into a Roth IRA for hardly any income tax. The only tax Ray pays is on the small amount the conversion amount in Step 4 exceeds $18,000.

The Basis Isolation Backdoor Roth IRA also opens another future tax planning opportunity. Going forward, Ray can do annual Backdoor Roth IRAs in a tax-efficient manner because he cleaned out his traditional IRAs into his workplace 401(k).

Practical Considerations

The Basis Isolation Backdoor Roth IRA is not a tactic to be affirmatively planned into. Rather, it is a clean up tactic. It makes the best of a situation where one has both basis and pretax amounts in traditional IRAs. The Backdoor Roth IRA is an affirmative planning technique, though it may require similar clean-up steps prior to implementation.

This planning is sophisticated and benefits from professional assistance. I recommend that most work with a professional if they are considering this sort of planning. Further, this planning does not occur every day. My experience suggests that most professionals are unfamiliar with this type of planning. Professionals will need to review resources such as this blog post and other sources and measure two or three times to dot I’s and cross T’s on this type of planning.

Of course, this blog post is not advice for the reader or any particular individual.

Additional IRA Basis and IRA Basis Isolation Resource

I went into detail on this planning in a June 2023 Measure Twice Planners presentation. While the presentation is mostly geared towards advisors, I hope I presented it in such a way that layman can also understand much of it and get value from it. The presentation and its slides, like this particular post, are for educational purposes only and are not intended as advice for any particular individual.

Conclusion

Existing basis in IRAs is a planning opportunity if the investor has a good workplace 401(k) or other qualified plan that accepts IRA roll-ins. That planning requires intention and diligence, and measuring two or three times, even if working with a professional.

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

Follow me on X at @SeanMoneyandTax

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

2024 Solo 401(k) Update

There are some new developments in the world of the Solo 401(k). Here are the highlights:

New Solo 401(k) Employee Contributions Limit for 2024

The IRS announced that for 2024, the employee deferral limit for all 401(k)s, including Solo 401(k)s, will be $23,000.

Solo 401(k) Catch-Up Contributions Limit for 2024

The IRS also announced that for 2024, the employee deferrals catch-up contribution limit remains $7,500. As a result, those aged 50 or older can contribute, in employee contributions, a maximum of the lesser of $30,500 ($23,000 plus $7,500) or earned income.

New Solo 401(k) All Additions Limit for 2024

The new all-additions limit for Solo 401(k)s is $69,000 (or earned income, whichever is less). For those aged 50 or older during 2024, the $66,000 number is $76,500 ($69,000 plus $7,500).

Wither Roth Employer Contributions?

One of the changes SECURE 2.0 ushered in was allowing Roth employer contributions to 401(k) plans, including Solo 401(k)s. Interestingly enough, three of the largest institutions offering Solo 401(k)s, Fidelity, Schwab, and Vanguard, have not added that feature to their Solo 401(k)s. Vanguard’s website goes so far as to affirmatively state it will not add the Roth employer contribution feature to their Solo 401(k) at this time.

I mention this development to inform the reader, not to criticize Solo 401(k) providers. If you’ve read some of my other work, you may know I don’t think a lack of Roth employer contributions in Solo 401(k)s is a problem.

UPDATE March 2, 2024: Today I learned that Schwab now offers Roth employee contributions (a change) and Roth employer contributions (also a change). Based on this January 21, 2024 post, I suspect this change occurred prior to the federal district court’s publishing of its decision in Texas v. Garland on February 27, 2024.

Ambiguity on New Schedule C Solo 401(k) Funding Deadline

UPDATE December 14, 2023: I Tweeted a thread about the provision that allows Schedule C solopreneurs to establish and fund a new Solo 401(k) with an employee deferral contribution after year-end. There is at least some concern that if one is diligent enough to establish a new Solo 401(k) prior to year-end they might not get the benefit of Section 401(b)(2)‘s funding deadline extension. If that is true (and to my mind this is an ambiguous issue), then the solopreneur establishing the new Solo 401(k) prior to year-end would need to either fund the employee contribution prior to year-end or elect to make an employee deferral contribution prior to year-end.

UPDATE March 2, 2024: There’s new uncertainty when it comes to the new Solo 401(k) establishment deadline for Schedule C solopreneurs looking to make a first-time employee contribution. A federal district court in Texas held on February 27, 2024, in Texas v. Garland, that the House of Representatives did not have a sufficient Quorum when it passed the Omnibus, which includes SECURE 2.0 and the Solo 401(k) deadline extension in SECURE 2.0 Section 317. Here’s my X/Twitter thread on the case and here’s my YouTube video on the case. Stay tuned to my YouTube channel for future updates!

2024 Update to Solo 401(k): The Solopreneur’s Retirement Account

Solo 401(k): The Solopreneur’s Retirement Account explores the nooks and crannies of Solo 401(k)s. On page 16 of the paperback edition, I provide an example of the Solo 401(k) limits for 2022 if a solopreneur makes $100,000 of Schedule C income. Here is a revised version (in italics) of the example (with the footnote omitted) applying the new 2024 employee contribution limit:

Lionel, age 35, is self-employed. His self-employment income (as reported on the Schedule C he files with his tax return) is $100,000. Lionel works with a financial institution to establish his own Solo 401(k) plan and choose investments for the plan. Lionel can contribute $23,000 to his Solo 401(k) as an employee deferral (2024 limit) and can choose to contribute, as an employer contribution, anywhere from 0-20% of his self-employment income.

Lionel’s maximum potential tax-advantaged Solo 401(k) contribution for 2024 is $41,587! That is a $23,000 employee contribution and a $18,587 employer contribution. Note there’s no change in the computation of the employer contribution for 2024 in this example.

On page 18 I provide an example of the Solo 401(k) contribution limits factoring in catch-up contributions. Here’s the example revised for 2024:

If Lionel turned 50 during the year, his limits are as follows:

Employee contribution: lesser of self-employment income ($92,935) or $30,500: $30,500
Employer contribution: 20% of net self-employment income (20% X $92,935): $18,587
Overall contribution limit: lesser of net self-employment income ($92,935) or $76,500: $76,500

Amazon Reviews

If you have read Solo 401(k): The Solopreneur’s Retirement Account, you can help more solopreneurs find the book! How? By writing an honest, objective review of the book on Amazon.com. Reviews help other readers find the book!

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2024 IRA Contributions for Beginners

There are only three types of annual contributions to individual retirement accounts (“IRAs”). They are:

Traditional, nondeductible contributions
Traditional, deductible contributions
Roth contributions

This post discusses when a taxpayer can make one or more of these types of annual contributions.

Let’s dispense with what we are not talking about. This post has nothing to do with annual contributions to employer retirement plans (401(k)s and the like) and self-employed retirement plans. We’re only talking about IRAs. The Individual in “IRA” is the key – anyone can set up their own IRA. IRAs are not pegged to any particular job or self-employment.

The above list is the exhaustive list of the possible types of annual contributions you can make to an IRA. But there is plenty of confusion about when you are eligible to make each of the three types of annual contributions.

Why Contribute to an IRA?

Before we dive into annual contributions to IRAs, let’s discuss why you would consider contributing to an IRA. The main reason is to build up tax-deferred wealth (traditional IRAs) and/or tax-free wealth (Roth IRAs) for your future, however you define it: financial independence, retirement, etc. A second potential benefit is the ability to deduct some annual contributions to traditional IRAs. A third benefit is some degree of creditor protection. States offer varying levels of creditor protection to traditional IRAs and Roth IRAs, while the federal government provides significant bankruptcy protection for traditional IRAs and Roth IRAs.

IRA Annual Contribution Requirement: Earned Income

In order to make any of the three types of IRA annual contributions for any particular year, you or your spouse must have earned income during that year. Earned income is generally that income that is reported to you on your Form W-2, or is reported by you on your tax return on Schedule C (self-employment income). It also includes self-employment income reported to you on a Form K-1 (because you are a self-employed partner in a partnership). It does not include income reported to you on a Form K-1 from an S corporation.

While wages, nontaxable combat income, and self-employment income qualify as earned income for this purpose, several types of income do not. Social security, pensions, rentals, royalties, interest, and dividends are not earned income. Income excluded from taxable income under the foreign earned income exclusion also does not constitute “earned income” for IRA purposes.

Traditional Nondeductible IRA Annual Contributions

There’s are only one requirement to contribute to a traditional, nondeductible IRA for a taxable year:

You and/or your spouse have earned income during that taxable year.

That’s it! As long as you satisfy that requirement, you can contribute to a traditional nondeductible IRA, no further questions asked.

Example: Teve Torbes is the publisher of a successful magazine. He is paid a salary of $1,000,000 in 2024 and is covered by the magazine’s 401(k) plan. Teve can make up to a $7,000 nondeductible contribution to a traditional IRA, and Teve’s wife can also make up to a $7,000 nondeductible contribution to a traditional IRA.

There is no tax deduction for contributing to a traditional nondeductible IRA. The amount of your nondeductible contribution creates “basis” in the traditional IRA. When you withdraw money from the traditional IRA in retirement, a ratable portion of the withdrawal is treated as a return of basis and thus not taxable (the “Pro-Rata Rule”).

Example: Ted makes a $6,000 nondeductible traditional IRA contribution for each of 10 years ($60,000 total). When he retires, the traditional IRA is worth $100,000, and he takes a $5,000 distribution from the traditional IRA. Ted is over 59 ½ when he makes the withdrawal. Of the $5,000 withdrawal, Ted will include $2,000 in his taxable income, because 60 percent ($3,000 — $60,000 basis divided by $100,000 fair market value times the $5,000 withdrawn) will be treated as a withdrawal of basis and thus tax free.

Traditional nondeductible IRA contributions generally give taxpayers a rather limited tax benefit. However, since 2010 traditional nondeductible IRA contributions have become an important tax planning tool because of the availability of the Backdoor Roth IRA.

Making a nondeductible IRA contribution requires the filing of a Form 8606 with your federal income tax return.

Traditional Deductible IRA Annual Contributions

In order to make a deductible contribution to a traditional IRA, three sets of qualification rules apply.

ONE: No Workplace Retirement Plan

Here are the qualification rules if neither you nor your spouse is covered by an employer retirement plan (401(k)s and the like and self-employment retirement plans):

You and/or your spouse have earned income during that taxable year.

That’s it! As long as you satisfy that requirement and you and your spouse are not covered by an employer retirement plan, you can make a deductible contribution to a traditional IRA, no further questions asked.

Coverage by an employer retirement plan means either you or your employer contributed any amount to an employer retirement plan (on your behalf) during the taxable year. Coverage by an employer retirement plan includes coverage under a self-employment retirement plan.

Example: Teve Torbes is the publisher of a successful magazine. He and his wife are 45 years old. He is paid a salary of $1,000,000 in 2024. Neither he nor his wife is covered by an employer retirement plan. Teve can make up to a $7,000 deductible contribution to a traditional IRA, and Teve’s wife can also make up to a $7,000 deductible contribution to a traditional IRA.

TWO: You Are Covered by a Workplace Retirement Plan

Here are the deductible traditional IRA qualification rules if you are covered by an employer retirement plan:

You and/or your spouse have earned income during that taxable year.
Your modified adjusted gross income (“MAGI”) for 2024 is less than $87,000 (if single), $143,000 (if married filing joint, “MFJ”), or $10,000 (if married filing separate, “MFS”).

Note that in between $77,000 and $87,000 (single), $123,000 and $143,000 (MFJ) and $0 and $10,000 (MFS), your ability to make a deductible contribution to a traditional IRA phases out ratably. Here is an illustrative example.

Example: Mike is 30 years old, single, and is covered by a 401(k) plan at work. Mike has a MAGI of $82,000 in 2024, most of which is W-2 income. Based on a MAGI in the middle of the phaseout range, Mike is limited to a maximum $3,500 deductible contribution to a traditional IRA.

Assuming he makes a $3,500 deductible IRA contribution, Mike has $3,500 worth of IRA contributions left. He can either, or a combination of both (up to $3,500) (a) make a contribution to a nondeductible traditional IRA, since he meets the qualification requirement to contribute to a nondeductible traditional IRA or (b) make a contribution to a Roth IRA, since he meets the qualification requirements (discussed below) to contribute to a Roth IRA. In such a case, Mike would be likely to favor a Roth IRA contribution over a nondeductible traditional IRA contribution.

THREE: Only Your Spouse is Covered by a Workplace Retirement Plan

Here are the deductible traditional IRA qualification rules if you are not covered by an employer retirement plan but your spouse is covered by an employer retirement plan:

You and/or your spouse have earned income during that taxable year.
Your MAGI for 2024 is less than $240,000 (MFJ) or $10,000 (MFS).

Note that in between $230,000 and $240,000 (MFJ) and $0 and $10,000 (MFS), your ability to make a deductible contribution to a traditional IRA phases out ratably.

Roth IRA Annual Contributions

Here are the Roth IRA annual contribution qualification rules.

You and/or your spouse have earned income during that taxable year.
Your MAGI for 2024 is less than $161,000 (single), $240,000 (MFJ), or $10,000 (MFS).

Note that in between $146,000 and $161,000 (single), $230,000 and $240,000 (MFJ), and $0 and $10,000 (MFS), your ability to make a Roth IRA contribution phases out ratably.

Notice that whether you and/or your spouse are covered by an employer retirement plan (including a self-employment retirement plan) is irrelevant. You and your spouse can be covered by an employer retirement plan and you can still contribute to a Roth IRA (so long as you meet the other qualification requirements).

Here is an example illustrating your options in the Roth IRA MAGI phaseout range.

Example: Mike is 30 years old, single, and covered by a workplace retirement plan. Mike has a MAGI of $155,000 for 2024, most of which is W-2 income. Based on a MAGI 60 percent through the phaseout range, Mike is limited to a maximum $2,800 contribution to a Roth IRA.

Assuming he makes a $2,800 annual Roth IRA contribution, Mike has $4,200 worth of IRA contributions left. He can make up to $4,200 in annual contributions to a nondeductible traditional IRA, since he meets the qualification requirement to contribute to a nondeductible traditional IRA.

IRA Annual Contribution Limits

For taxpayers younger than 50 years old during the entire year, the maximum (for 2024) that can be contributed to the combination of all three types of IRAs is the lesser of:

The taxpayer’s and their spouse’s combined earned income, or
$7,000.

Thus, if both spouses are younger than 50 years old, the maximum IRA contributions for a married couple is $14,000.

For taxpayers 50 years old or older during any part of the taxable year the maximum (for 2024) that can be contributed to the combination of all three types of IRAs is the lesser of:

The taxpayer’s and their spouse’s combined earned income, or
$8,000.

Thus, if both spouses are 50 or older, the maximum IRA contributions for a married couple is $16,000.

Deadlines

The deadline to make an IRA contribution for a particular year is April 15th of the year following the taxable year (thus, the deadline to make a 2024 IRA contribution is April 15, 2025). The deadline to make earned income for a taxable year is December 31st of that year.

Rollover Contributions

There’s a separate category of contributions to IRAs: rollover contributions. These can be from other accounts of the same type (traditional IRA to traditional IRA, Roth IRA to Roth IRA) or from a workplace retirement plan (for example, traditional 401(k) to traditional IRA, Roth 401(k) to Roth IRA).

Rollover contributions do not require having earned income and have no income limits and should be generally tax-free. For a myriad of reasons, it is usually best to effectuate rollovers as direct trustee-to-trustee transfers.

As a practical matter, it is often the case that IRAs serve at the retirement home for workplace retirement plans such as 401(k)s.

Correction

A previous version of this blog post, titled “IRA Contributions for Beginners” erroneously stated that one must be a citizen or resident of the United States to make an IRA contribution. I regret the error.

2023 Year-End Tax Planning

It’s that time of year again. The air is crisp and my favorite football team is surging. That can only mean one thing when it comes to personal finance: time to start thinking about year-end tax planning.

I’ll break it down with three categories: Urgent, Year-End Deadline, and Can Wait Till Next Year. I will also provide some thoughts on 2024 tax planning that can/should be done before year-end in 2023.

As always, none of this is advice for your particular situation but rather it is educational information.

Urgent

By urgent, I mean those items that (i) need to happen before year-end and (ii) may not happen if taxpayers delay and try to accomplish them late in the year.

Donor Advised Fund Contributions

The donor advised fund is a great way to contribute to charity and accelerate a tax deduction. My favorite way to use the donor advised fund is to contribute appreciated stock directly to the donor advised fund. This gets the donor three tax benefits:

A tax deduction for the fair market value of the contributed appreciated stock,
Elimination of the built-in capital gain on the contributed appreciated stock, and
Tax-free treatment of the income earned inside the donor advised fund.

In order to get the first benefit in 2023, the appreciated stock must be received by the donor advised fund prior to January 1, 2024. This deadline is no different than the normal charitable contribution deadline.

However, due to much year end interest in donor advised fund contributions and processing time, different financial institutions will have different deadlines on when transfers must be initiated in order to count for 2023. Donor advised fund planning should be attended to sooner rather than later.

Taxable Roth Conversions

For a Roth conversion to count as being for 2023, it must be done before January 1, 2024. That means New Year’s Eve is the deadline. However, taxable Roth conversions should be done well before New Year’s Eve because

It requires analysis to determine if a taxable Roth conversion is advantageous,
If advantageous, the proper amount to convert must be estimated, and
The financial institution needs time to execute the Roth conversion so it counts as having occurred in 2023.

Remember, generally speaking it is not good to have federal and/or state income taxes withheld when doing Roth conversions!

Roth Conversion Example: See slides 8 through 10 of this slide deck for an example of a Roth conversion in retirement. You might be surprised by just how little federal income tax is owed on a $23,000 Roth conversion.

Example Where I Disfavor Roth Conversions: I present an example of a 73-year old married couple with $400K in deferred retirement accounts and $87K in 2023 gross income. I would not recommend they do end-of-year Roth conversions. This spreadsheet computes the taxable Social Security with and without a $10K Roth conversion.

Gotta Happen Before 2026!!!

You will hear many commentators say “do more Roth conversions before tax rates go up in 2026!” If this were X (the artist formerly known as Twitter), the assertion would likely be accompanied by a hair-on-fire GIF. 😉

I disagree with the assertion. As I have stated before, there’s nothing more permanent than a temporary tax cut. You do your own risk assessment, but mine is this: members of Congress like to win reelection, and they are not going to want to face voters without having acted to ensure popular tax cuts, such as the reduction of the 15% tax rate down to 12% and the increased standard deduction, are extended.

I recommend that you make your own personal taxable Roth conversion decisions based on your own personal situation and analysis of the landscape and not a fear of future tax hikes.

Learn all about the Pro-Rata Rule here.

Adjust Withholding

This varies, but it is a good idea to look at how much tax you owed last year (line 24 on the Form 1040). If you are on pace to get 100% (110% if 2022 AGI is $150K or greater) or slightly more of that amount paid into Uncle Sam by the end of the year (take a look at your most recent pay stub), there’s likely no need for action. But what if you are likely to have much more or much less than 100%/110%? It may be that you want to reduce or increase your workplace withholdings for the rest of 2023. If you do, don’t forget to reassess your workplace withholdings for 2024 early in the year.

Backdoor Roth IRA Diligence

The deadline for the Backdoor Roth IRA for 2023 is not December 31st, as I will discuss below. But if you have already completed a Backdoor Roth IRA for 2023, the deadline to get to a zero balance in all traditional IRAs, SEP IRAs, and SIMPLE IRAs is December 31, 2023.

Solo 401(k) Planning

There’s plenty of planning that needs to be done for solopreneurs in terms of retirement account contributions. Even though Schedule C solopreneurs can now establish a Solo 401(k) after year-end (up to April 15th), it is absolutely the case that it is better to do the planning upfront. For those Schedule C solopreneurs with a Solo 401(k) established, December 31st is the deadline to make 2023 employee deferral contributions or make a 2023 deferral election as an alternative to making the payments in 2023. December 31st is also the 2023 employee deferral contribution for solopreneurs operating out of S corporations.

The Solo 401(k) can get complicated. That’s why I wrote a book about them and post an annual update on Solo 401(k)s here on the blog.

Year-End Deadline

These items can wait till close to year-end, though you don’t want to find yourself doing them on New Year’s Eve.

Tax Gain Harvesting

For those finding themselves in the 12% or lower federal marginal income tax bracket and with an asset in a taxable account with a built-in gain, tax gain harvesting prior to December 31, 2023 may be a good tax tactic to increase basis without incurring additional federal income tax. Remember, though, the gain itself increases one’s taxable income, making it harder to stay within the 12% or lower marginal income tax bracket.

I’m also quite fond of tax gain harvesting that reallocates one’s portfolio in a tax efficient manner.

Tax Gain Harvesting Example: See slide 15 of this slide deck for an example of tax gain harvesting in retirement.

Tax Loss Harvesting

The deadline for tax loss harvesting for 2023 is December 31, 2023. Just remember to navigate the wash sale rule.

RMDs from Your Own Retirement Account

The deadline to take any required minimum distributions from one’s own retirement account is December 31, 2023. Remember, the rules can get a bit confusing. Generally, IRAs can be aggregated for RMD purposes, but 401(k)s cannot.

RMDs from Inherited Accounts

The deadline to take any RMDs from inherited retirement accounts is December 31st. For some beneficiaries of retirement accounts inherited during 2020, 2021, and 2022, the IRS has waived 2023 RMDs. That said, all beneficiaries of inherited retirement accounts may want to consider affirmatively taking distributions (in addition to RMDs, if any) before the end of 2023 to put the income into a lower tax year, if 2023 happens to be a lower taxable income year vis-a-vis future tax years.

Can Wait Till Next Year

Traditional IRA and Roth IRA Contribution Deadline

The deadline for funding either or both a traditional IRA and a Roth IRA for 2023 is April 15, 2024.

Backdoor Roth IRA Deadline

There’s no law saying “the deadline for the Backdoor Roth IRA is DATE X.” However, the deadline to make a nondeductible traditional IRA contribution for the 2023 tax year is April 15, 2024. Those doing the Backdoor Roth IRA for 2023 and doing the Roth conversion step in 2024 may want to consider the unique tax filing when that happens (what I refer to as a “Split-Year Backdoor Roth IRA”).

HSA Funding Deadline

The deadline to fund an HSA for 2023 is April 15, 2024. Those who have not maximized their HSA through payroll deductions during the year may want to look into establishing payroll withholding for their HSA so as to take advantage of the payroll tax break available when HSAs are funded through payroll.

The deadline for those age 55 and older to fund a Baby HSA for 2023 is April 15, 2024.

2024 Tax Planning at the End of 2023

HDHP and HSA Open Enrollment

It’s open enrollment season. Now is a great time to assess whether a high deductible health plan (a HDHP) is a good medical insurance plan for you. One of the benefits of the HDHP is the health savings account (an HSA).

For those who already have a HDHP, now is a good time to review payroll withholding into the HSA. Many HSA owners will want to max this out through payroll deductions so as to qualify to reduce both income taxes and payroll taxes.

Self-Employment Tax Planning

Year-end is a great time for solopreneurs, particularly newer solopreneurs, to assess their business structure and retirement plans. Perhaps 2024 is the year to open a Solo 401(k). Perhaps their business is growing such that an S corporation election makes sense. The best time to be thinking about these sorts of things for 2024 is late in 2023. Often this analysis benefits from professional consultations.

Additional Resource

Please see my November 11, 2023 ChooseFI Orange County year-end tax planning presentation slide deck.

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

Follow me on Twitter at @SeanMoneyandTax

CampFI 2023 Presentation

Here are my presentation slides for my presentation delivered October 7, 2023 at CampFI Southwest.

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.

Traditional Versus Roth 2023

The debate continues: what’s preferable, traditional retirement accounts or Roth retirement accounts?

Fortunately, there are plenty of shades of gray in this debate. There’s no “right” answer, but I do believe that there are good insights that can help individuals make the right planning decisions for themselves.

Traditional and Roth Retirement Basics

Before we dive into the traditional versus Roth debate, we should quickly survey the basics of these types of retirement accounts.

Traditional

Traditional retirement accounts feature a tax deduction on the way in (i.e., for contributions) and ordinary income tax on the way out (i.e., for withdrawals). At work these are known as traditional 401(k)s, 403(b), 457s, and occasionally have other names. At home these are known as traditional IRAs.

Additional twist: many working Americans do not qualify to deduct a traditional IRA contribution due to relatively low income limits on claiming a deduction.

Part of the appeal of traditional retirement accounts includes: (i) the notion that many will have lower taxable income (and thus lower income tax) in retirement than they did during their working years and (ii) the tax saved by contributing to traditional accounts can be invested, potentially creating more wealth for retirement.

Roth

Roth retirement accounts feature no tax deduction on the way in (i.e., for contributions) and tax free treatment on the way out (i.e., for withdrawals). At work these are known as Roth 401(k)s, 403(b), 457s, and (after SECURE 2.0 implementation) will occasionally have other names. At home these are known as Roth IRAs.

Additional twist: some working Americans do not qualify to make an annual Roth IRA contribution based on income limits, but many can get around this rule by implementing a Backdoor Roth IRA.

Part of the appeal of contributions to Roth retirement accounts is the notion that it is better for our younger, healthier selves to pay the tax associated with retirement savings when cash flow is good and the investor knows they can bear the cost.

The basics out of the way, we can get into 2023 insights on the debate between the two types of retirement accounts.

The Risk of Traditional Retirement Accounts is Vastly Overstated

We hear it time and again: be worried about all the tax lurking inside traditional retirement accounts such as 401(k)s and IRAs!

Here’s the thing: rarely do commentators offer any sort of mathematical analysis backing up that contention. I ran the math, and I repeatedly find that many retirees with traditional retirement accounts are likely to pay Uncle Sam a very manageable amount of income taxes in retirement.

You be the judge and jury. I believe a fair assessment of my posts and videos and the numbers behind them shows that most Americans do not face a high risk of crippling federal income taxes in retirement, even if the vast majority of their portfolio is in traditional 401(k)s and IRAs.

While I cannot give readers of this blog individualized advice, I can say that if one considers themselves to be an “Average Joe” it is difficult to see how having significant amounts in traditional retirement accounts is a problem.

The Needle Keeps Moving Towards Traditional

Picture it: United States, September 2017, six short years ago. You’re bright-eyed, bushy-tailed, and fear only one thing: incredibly high taxes on your traditional 401(k) and IRA in retirement.

Then a few things happened.

December 2017: TCJA increased the standard deduction and lowered the 15% bracket to 12%
December 2019: The SECURE Act (SECURE 1.0) delayed RMDs from age 70 ½ to 72
March 2020: CARES Act cancels 2020 RMDs and allows taken RMDs to be rolled back in
November 2020: IRS and Treasury issue a new Uniform Life Table, decreasing the amount of annual RMDs beginning in 2022
December 2022: SECURE 2.0 delays RMDs from age 72 to 73, and all the way to age 75 for those born in 1960 and later

Tax cut after tax cut for traditional retirement accounts and retirees! In the traditional versus Roth debate, DC keeps putting a thumb on the scale for traditional.

Watch me assess recent tax law change history as it applies to retirees.

Taxable Roth Conversions Going Away?

One reason I like traditional 401(k) contributions is that they do not close the door on Roths. Rather, traditional retirement account contributions at work are a springboard for years of Roth conversions in retirement for many in the FI community!

The idea is to take deductions at high marginal tax rates at work into a 401(k) and build up wealth for an early retirement. Then, in retirement, one’s tax rate is artificially low as they no longer have W-2 income to report. This opens up room for potentially very efficient Roth conversions (affirmatively moving money in traditional accounts to Roth accounts) taxed at the 10% or 12% federal income tax rate.

That’s a great plan, in theory. But couldn’t Congress take it away? Sure, they could, but I seriously doubt they will in an effective way. First, let’s look at recent history. In 2021 the Democratic Congress proposed, but did not pass, a provision to eliminate (starting a decade in the future) taxable Roth conversions for those north of $400K of annual income. Such a rule would have had no effect on most retirees, who will never have anything approaching $400K of income in retirement.

Second, why would Congress eliminate most taxable Roth conversions? They “budget” tax bills in a 10 year window. Taxable Roth conversions create tax revenue inside that budget window, making it that much less likely a Congress would eliminate most of them.

While there is not zero risk taxable Roth conversions will go away, I believe that the risk is negligible. The greater one believes Roth conversion repeal risk is, the more attractive Roth contributions during one’s working years look.

Special Years Favor Roths

I’ve written before about how workers in the early years of their careers may want to consider Roth 401(k) contributions prior to their income significantly increasing. Those in transition years, such as those starting a job after graduating college and those about to take a mini retirement may want to prioritize Roth 401(k) contributions over traditional 401(k) contributions.

Optimize for Known Trade-Offs

People want to know: what’s the optimal income for switching from traditional to Roth? What’s the optimal percentage to have each of traditional, Roth, and taxable accounts?

Here’s the thing: there are simply too many unknown future variables to come up with any precision in this regard. That said, I don’t believe we have to.

Why? Because in retirement planning, we can optimize for known trade-offs. Let me explain. At work, Americans under age 50 can contribute up to $22,500 (2023 number) to a 401(k). At most employers, that can be any combination of traditional or Roth contributions. Every dollar contributed to a Roth 401(k) is a dollar that cannot be contributed to a traditional deductible 401(k). That’s a known trade-off.

What about at home? For most working Americans covered by a 401(k), a dollar contributed to a Roth IRA is not a dollar that could have been contributed to a deductible traditional IRA. So a Roth IRA contribution is not subject to the trade-off downside that a Roth 401(k) contribution is.

Why not optimize for known trade-offs? Contribute to a traditional 401(k) at work and a Roth IRA (or Backdoor Roth IRA) at home. This approach optimizes for the known trade-offs and sets one up with both traditional and Roth assets heading into retirement.

Further, Roth IRA contributions and Backdoor Roth IRAs can serve as emergency funds, while traditional IRAs, traditional 401(k)s, and Roth 401(k)s do not serve well as emergency funds. Roth IRA contributions do not suffer from an adverse trade-off when it comes to emergency withdrawals, unlike Roth 401(k) contributions.

Roth Contributions End the Planning

Traditional retirement account contributions set up great optionality. A retiree may have years or decades of opportunity to strategically convert traditional accounts to Roth accounts. Or, a retiree might say, “thanks, but no thanks, on those Roth conversions, I’ll simply wait to withdraw for RMDs or living expenses later in retirement at a low tax rate.” Traditional retirement account contributions open the doors to several planning options.

Roth contributions end the planning. That’s it, the money is inside a Roth account. Considering the potential to have low tax years after the end of one’s working years, is that always a good thing?

Rothification Risks

Having all one’s retirement eggs in the Roth basket can create significant problems. This is an issue I do not believe receives sufficient attention. Previously I posited an example where an early retiree had almost all his wealth in Roth accounts (what I refer to as the Rothification Trap).

Risks of having all of one’s eggs inside the Roth basket going into retirement include:

Missing out on standard deductions
Inability to qualify for ACA premium tax credits
Missing out on benefits of qualified charitable distributions (QCDs)
Missing out on tax efficient Roth conversions in retirement

Sufficiency

Much of the traditional versus Roth debate misses the forest for the trees. Rarely do commentators state that long before one worries about taxation in retirement they have to worry about sufficiency in retirement!

Recent reports indicate that many if not most Americans struggle to afford a comfortable retirement. A quick review of average retirement account balances indicates that many Americans are not set up for what I’d call a comfortable retirement. Further, according to a recent report, the median American adult has a wealth around $108,000. That means the median adult has a significant sufficiency concern when it comes to retirement planning.

Most Americans will be lucky to have a tax problem in retirement! Most Americans need to build up retirement savings. The quickest, easiest way to do that is by making deductible traditional 401(k) contributions. That deduction makes the upfront sacrifice involved in retirement saving easier to stomach. Further, if one is not likely to have substantial retirement savings, they are not likely to be in a high marginal tax bracket in retirement.

If all the above is true, what is the problem with having taxable retirement accounts? The tax savings in retirement from having Roth accounts is not likely to be very high for many Americans.

Conclusion

Both traditional retirement accounts and Roth retirement accounts have significant benefits. When viewed over the spectrum of most Americans’ lifetimes, I believe that workplace retirement plan contributions should be biased toward traditional retirement accounts. For many Americans, either or both of the following will be true. First, there will be low tax years in retirement during which retirees can take advantage of low tax Roth conversions. Second, many Americans will be in a low tax bracket when taking retirement account withdrawals for living expenses and/or RMDs.

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

Follow me on Twitter at @SeanMoneyandTax

It’s Not Too Late, California!

HUGE UPDATE: On October 16, 2023, the IRS issued this, extending the October 16, 2023 deadline for 2022 tax acts and filings to November 2023. The IRS announcement allows (most) Californians to make Roth IRA, traditional IRA, and HSA contributions for 2022 up to November 16, 2023 and delays the deadline for many 2022 federal income tax returns and income tax payments to November 16, 2023. Hat tip to Justin Miller on X for the news.

ADDITIONAL UPDATE 10/16/2023 7:06PM: California has also extended the 2022 filing and payment deadline to November 16, 2023. Hat tip to Kelly Phillips Erb.

Please enjoy below the rest of my post, as originally authored in August 2023, understanding that now you can replace “October 16” with “November 16” for most Californians.

I’m glad that title intrigued you enough to stop on by. It’s not too late for most Californians to make a 2022 IRA contribution, a 2022 Roth IRA contribution, a 2022 HSA contribution, and/or do a 2022 Backdoor Roth IRA contribution.

You’re probably thinking “What the heck are you talking about? It’s the late summer 2023. Time to be thinking about football, not funding 2022 IRAs and HSAs.”

Your thoughts are correct as applied to most Americans. However, most Californians are the beneficiaries of a special situation. The IRS announced that because of early 2023 flooding in many areas of California, most Californians have an extended deadline, October 16, 2023, to perform most 2022 tax acts that otherwise would have been due early in 2023.

This extension opens the door for millions of Californians to consider 2022 contributions to tax-advantaged accounts. Of course, nothing increases the amount Californians can contribute. Thus, those who have already maxed out for 2022 do not benefit from this deadline extension.

2022 Traditional IRA Contributions

Most working Californians can still make 2022 contributions to a traditional IRA. If the taxpayer has not yet filed their 2022 Form 1040, the deduction or the Form 8606 (for a nondeductible contribution) can simply be included with the to-be filed Form 1040.

But what if the taxpayer has already filed their Form 1040 for 2022? Then the question becomes: are they deducting their 2022 traditional IRA contribution? If no, then the taxpayer can simply file a Form 8606 as a standalone tax return to report the 2022 nondeductible contribution.

However, if the contribution is tax deductible, then the taxpayer would need to file amended Forms 1040 and 540 (for California) to report the deductible IRA contribution and claim refunds from both the IRS and the Franchise Tax Board for the tax reduced because of the deductible traditional IRA deduction.

2022 Roth IRA Contributions

Many working Californians can still make 2022 contributions to a Roth IRA. Since Roth IRA contributions are not deductible, and do not require a separate form to report them, the contribution likely would not require any amending of already-filed 2022 tax returns. One exception would be the case of a taxpayer with a low income in 2022. He or she could make a 2022 Roth IRA contribution and possibly qualify for the Saver’s Credit. In order to claim the credit, they would need to amend their Form 1040 if they already filed it for 2022.

2022 Backdoor Roth IRAs

It’s not too late for a 2022 Backdoor Roth IRA for some Californians! This would be a Split-Year Backdoor Roth IRA. The pressing deadline as of late August 2023 is that the 2022 nondeductible traditional IRA contribution needs to be made by October 16, 2023.

Anyone pursuing a Split-Year Backdoor Roth IRA for 2022 in 2023 should ensure they have no balances in traditional IRAs, SEP IRAs, and/or SIMPLE IRAs as of December 31, 2023.

2022 HSA Contributions

Some Californians can still make 2022 contributions to a health savings account. If the taxpayer has not yet filed their 2022 Form 1040, the tax deduction can simply be added to the to-be filed Form 1040.

But what if the taxpayer has already filed their Form 1040 for 2022? Then the taxpayer would need to file amended Form 1040 to claim the tax deduction and the resulting tax refund from the IRS. Since California does not recognize HSAs, there’s no California tax deduction and no need to amend the California Form 540.

Of course, the taxpayer must meet the eligibility requirements (generally, having had a high deductible health plan as their only medical insurance) in 2022 in order to contribute to a HSA for 2022.

Practical Considerations

First, contributions to IRAs, Roth IRAs, and HSAs made in 2023 that are to count for 2022 must be specifically designated as being for 2022.

Second, I believe that in many cases, in order for qualifying Californians to do this, it will be necessary to use the phone, not internet portals. I suspect most financial institutions’ internet portals will not accommodate a 2022 IRA/Roth IRA/HSA contribution this late. Remember, financial institutions would not want to encourage the vast majority of Americans who do not currently qualify to make 2022 contributions to make 2022 contributions.

Thus, I believe as a practical matter using the phone is a best practice in terms of making any 2022 contributions at this late date.

Who Benefits?

Residents of all California counties except three qualify for the extended deadline. The vast majority of the population of the state qualifies for the extended deadline, but residents of Lassen, Modoc, and Shasta do not appear to qualify (don’t blame me, I don’t make the rules!).

Note that some taxpayers in parts of Alabama and Georgia qualify for this opportunity, but I personally have not explored this in any detail.

Conclusion

Many California residents should consider whether there is some extended last minute 2022 tax planning they can implement by October 16, 2023.

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.

FI Tax Guy Nominated for a Plutus Award

I’m pleased to announce that FI Tax Guy has been nominated for the Best Tax-Focused Content Plutus Award at the upcoming 14th Annual Plutus Awards.

The Plutus Awards honor personal finance independent media content creators.

The award winners will be announced on September 22nd.

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

Traditional 401(k) Contributions Are Fine for Most Americans (Really!)

Yesterday I posted Time to Stop 401(k) Contributions?, arguing that as applied to many in the FI community, traditional deductible 401(k) contributions are fine.

Today two very interesting pieces of content hit my radar. First, one of my favorite personal finance content creators, Clark Howard, is advocating for Roth contributions instead of traditional contributions for most Americans.

Second, UBS and Credit Suisse issued their Global Wealth Report for 2023. Allow me to call your attention to page 16. The median American adult has personal wealth just a bit under $108,000. This means almost half of American adults have less than $100K of wealth, and the majority of American adults do not have $200K of wealth. For most Americans, deferred taxation is not the problem! Sufficiency is the problem!

For me this report cracks the case. If the median American adult does not have close to sufficient wealth to comfortably retire, why are they worried about taxes in retirement?

Assuming this report is anywhere near close to a correct measure of adult American wealth, I believe I am correct and personal finance legends Ed Slott and Clark Howard are wrong when it comes to the traditional 401(k) versus Roth 401(k) debate.

The best way for working Americans to address sufficiency problems is by contributing to traditional, deductible retirement accounts. As demonstrated below, one employing this sort of deduct, deduct, deduct strategy would need to be successful well beyond what most Americans accomplish in order to create a tax problem.

When one has insufficient resources for retirement, the traditional, deductible 401(k) makes the most sense. He or she needs to build up assets, not worry about future taxes! With relatively little in the way of resources, future taxes are not likely to be a problem (especially in retirement when compared to one’s working years). Further, by contributing to a traditional, deductible 401(k) instead of a Roth 401(k), one behind in retirement saving takes home more money to invest in additional saving mechanisms such as Roth IRAs and taxable brokerage accounts.

Let’s Break Down Some Retirement Numbers

I believe we need some numbers to figure out who’s right.

Example 1: I start with Single Sally, who is 75 years old. Since she is somewhat like the median American, but older, let’s assume she has $250,000 of wealth and receives $30,000 a year in Social Security. Assume further that all $250K is in a traditional IRA and Sally, age 75, wants to live for today: she isn’t constrained by the 4% rule but rather decides to withdraw 10 percent per year ($25,000). On that $55,000 annual gross income, Single Sally pays just over $2,000 in federal income taxes (an effective rate less than 4%).

Why would Sally pass on a 10%, 12%, or 22% deduction from a traditional 401(k) contribution during her working years? Why would Single Sally put the money in a Roth 401(k) so as to avoid a less than 4% federal income tax in retirement? And how different is Sally’s situation from that of many Americans?

Update 8/17/2023: Single Sally is in the Tax Torpedo, an interesting tax phenomenon with a modest impact on her total tax liability. I added a spreadsheet to look at this in more detail.

Example 2: But Sean, I’m reading your blog. I’m not shooting for just $250K in retirement wealth! Okay, let’s start testing it by considering wealth significantly above the mean and median adult Americans. Single Sarah is 75 years old. She receives $30,000 a year in Social Security. But now she also has a $1M traditional IRA and takes an RMD ($40,650) based on her age. Single Sarah also has some taxable accounts and thus has $4,000 of qualified dividend income and $1,000 of interest income. On that approximate $76,000 annual gross income, Single Sarah pays just over $7,200 in federal income taxes (an effective rate of a bit more than 9.5%).

In order to grow a $1M traditional IRA (likely rolled over from workplace 401(k)s), she almost certainly was in the 22% or greater federal marginal tax bracket while working. Why would Single Sarah switch from taking a 22% tax deduction (the traditional 401(k) contribution) to a Roth 401(k) contribution to avoid a 9.5% effective federal tax rate in retirement?

Example 3: Example 3 is Single Sarah at age 80. Her investments are doing so well her traditional IRA is still worth $1M, causing her to be required to take a $49,505 RMD. This causes her federal income tax to increase to $9,175, for an effective federal income tax rate of almost 11%.

How many Americans will get to age 80 with $1M or more in tax deferred accounts? Even if they do, how bad is the tax problem? If Single Sarah’s effective tax rate is 11%, a 50% tax hike gets her to about 16.5%. Will she enjoy paying that tax? No. Is it crippling? Hardly!

Still worried about contributing to a traditional 401(k)? I’ve got a video for you!

Conclusion

The next time you hear “30 or 40% of your 401(k) belongs to the government” you should consider my examples. For many Americans, “10%” will be much closer to the mark than 30% or 40%.

It’s time to step back and ask whether prioritizing Roth 401(k) contributions during one’s working career is the best advice for the majority of Americans. As demonstrated above, a tax increase of 50 percent (highly unlikely) would result in most Americans having an effective tax rate below 20% in retirement.

I believe for many Americans, the optimal retirement savings path combines deductible workplace 401(k) contributions with Roth IRA contributions at home.

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, investment, 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.

72(t) Substantially Equal Periodic Payments

Methods

Computing Fixed Amortization 72(t) Payments

Annual Equal 72(t) Fixed Amortization Payments

72(t) Payments Case Study

Maintain Flexibility

72(t) Payment Plan Disqualification

72(t) Payment Reduction

72(t) Locking The Cage

A Note on the 72(t) Risk Profile

72(t) Payment Tax Return Reporting

72(t) Is An Exception to More Than One Rule

Other Penalty Free Sources of Early Retirement Funding

72(t) Landscape Change

72(t) and Employer Stock

Resource

Where Does IRA Basis Come From?

A Current Employer Qualified Plan That Accepts Rollovers

Comprehensive Basis Isolation Backdoor Roth IRA Case Study

Step 1

Step 2

Step 3

Step 4

Step 5

The Benefits of the Basis Isolation Backdoor Roth IRA

Practical Considerations

Additional IRA Basis and IRA Basis Isolation Resource

Conclusion

New Solo 401(k) Employee Contributions Limit for 2024

Solo 401(k) Catch-Up Contributions Limit for 2024

New Solo 401(k) All Additions Limit for 2024

Wither Roth Employer Contributions?

Ambiguity on New Schedule C Solo 401(k) Funding Deadline

2024 Update to Solo 401(k): The Solopreneur’s Retirement Account

Amazon Reviews

Why Contribute to an IRA?

IRA Annual Contribution Requirement: Earned Income

Traditional Nondeductible IRA Annual Contributions

Traditional Deductible IRA Annual Contributions

ONE: No Workplace Retirement Plan

TWO: You Are Covered by a Workplace Retirement Plan

THREE: Only Your Spouse is Covered by a Workplace Retirement Plan

Roth IRA Annual Contributions

IRA Annual Contribution Limits

Deadlines

Rollover Contributions

Correction

Further Reading

Urgent

Donor Advised Fund Contributions

Taxable Roth Conversions

Gotta Happen Before 2026!!!

Adjust Withholding

Backdoor Roth IRA Diligence

Solo 401(k) Planning

Year-End Deadline

Tax Gain Harvesting

Tax Loss Harvesting

RMDs from Your Own Retirement Account

RMDs from Inherited Accounts

Can Wait Till Next Year

Traditional IRA and Roth IRA Contribution Deadline

Backdoor Roth IRA Deadline

HSA Funding Deadline

2024 Tax Planning at the End of 2023

HDHP and HSA Open Enrollment

Self-Employment Tax Planning

Additional Resource

Traditional and Roth Retirement Basics

Traditional

Roth

The Risk of Traditional Retirement Accounts is Vastly Overstated

The Needle Keeps Moving Towards Traditional

Taxable Roth Conversions Going Away?

Special Years Favor Roths

Optimize for Known Trade-Offs

Roth Contributions End the Planning

Rothification Risks

Sufficiency

Conclusion