As always, the discussion is general and educational in nature and does not constitute tax, investment, legal, or financial advice with respect to any particular individual or taxpayer. Please consult your own advisors regarding your own unique situation.
FI Tax Guy can be your financial advisor! Find out more by visiting mullaneyfinancial.com
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.
Last month the blog discussed the beginning of the self-employment journey. Specifically, it discussed how one pays taxes when they become self-employed. This post goes further. It explores a potentially powerful tax planning for self-employed solopreneurs, the S corporation.
None of the below is tax advice for any particular taxpayer. Note that if you are considering an S corporation, you are generally well advised to work with a tax professional before and during the process of implementing an S corporation.
The S Corporation Concept
Generally speaking, a corporation is subject to federal income tax at a 21 percent rate. For example, if Acme Incorporated has $100,000 of taxable income for the year, it owes the IRS $21,000 of federal income tax. Further, the shareholders are subject to taxes on the receipt of dividends from the corporation. If Acme Incorporated pays its after tax profit of $79,000 to its shareholders, generally its shareholders must include the receipt of the dividend in taxable income (though the dividend may qualify for the favorable qualified dividend income rates).
Based on both the corporation and the shareholders having to pay tax on the same income, it is said that many corporations (so-called “C corporations”) are subject to double tax.
For smaller businesses, this can be very problematic. The tax rules recognize this, and thus, for certain small business entities, allow an “S corporation” election (meaning that the corporation is taxed under the rules of Subchapter S of the Internal Revenue Code).
S corporations are generally subject to only one level of tax, as all of the tax items of the S corporation (taxable income, gain, loss, credits, etc.) are reported and taxed on the shareholder(s) individual tax returns. The S corporation itself usually does not pay federal income tax.
Most states replicate this treatment to a large extent. For example, in my home state of California, S corporation income is reported on the shareholders’ tax returns, but the S corporation itself is subject to a 1.5% income tax (with a minimum annual tax due of $800 regardless of income).
The Self-Employment Tax Savings and Reasonable Compensation
There is another wrinkle to S corporations which can make them advantageous to solopreneurs. The S corporation must pay owner-employees reasonable compensation as W-2 salary. However, the rules generally allow the owner-employee to take some of the earnings of the S corporation as a dividend. This has the rather interesting effect of, in many cases, reducing the overall payroll tax liability of the solopreneur.
Here’s a quick example of how that could work:
Aurora works as a private detective. After business expenses, she has a net income of $110,000. The payroll taxes she pays will depend on whether the business is organized as a sole proprietorship or an S corporation.
If she is operating as a sole proprietorship, she will pay $15,543 in self-employment taxes, as computed on Schedule SE (roughly, 14.13% of her profits are due in self-employment taxes).
Things are different if the business is organized as an S corporation. Assume, just for the sake of this example, that the S corporation pays Aurora $55,000 in W-2 compensation and this is reasonable. The FICA tax she and the S corporation together pay is 15.3% of that amount, $8,415.
In this example, Aurora saves over $7,000 in payroll taxes by electing to operate out of an S corporation.
Of course, compensation must be reasonable. S corporation owner-employees who pay themselves very small W-2 salaries can have dividend payments recharacterized as W-2 salary, prompting disputes with the IRS and state taxing agencies and the collection of back payroll taxes.
Solopreneur Requirements for an S Corporation
Below I discuss, very broadly, the general requirements to establish and maintain an S corporation for a solopreneur who does not employ other people. Those items with a single asterisk can (but does not have to) apply to a Schedule C sole proprietorship (for example, for solopreneurs a limited liability company can be either a Schedule C sole proprietorship or an S corporation). The item with a double asterisk also applies to a sole proprietorship, but perhaps to a somewhat lesser extent.
Entity Formation*
To have an S corporation, one must operate out of a legal entity. Generally, the legal entity can be a corporation or a limited liability company (an “LLC”). Corporations and LLCs are creatures of state law. Each state has its own formation and regulation procedures, requirements, and fees. Often it is wise to consult with legal counsel when forming a legal entity.
Under the federal income tax rules, an S corporation generally must have 100 or fewer shareholders and only a single class of stock outstanding.
Tax Election
Electing S corporation status requires the filing of a Form 2553 with the IRS with the signatures of all the shareholders. In community property states, usually one’s spouse is considered a shareholder. Taxpayers omitting a spouse’s signature where the S corporation stock is community property can fix the omission under the procedure available under Revenue Procedure 2004-35.
Entity Maintenance*
Legal entities have requirements for maintenance. These vary by state, and can include annual fees, annual shareholders’ meetings, and meetings of a Board of Directors. Consultations with legal counsel can be helpful in this regard.
Separate Books, Records, and Bank Accounts**
A legal entity should have its own bank account to collect revenue and pay expenses. Most solopreneurs operating out of either a sole proprietorship or an S corporation are well advised to hire a (very likely virtual) bookkeeper to track revenues and expenses.
Separate Federal Income Tax Return
S corporations must file an annual income tax return with the federal government, the Form 1120-S. Included in this Form is a Form K-1. Form K-1 reports to both the shareholders and the IRS the ordinary income and other tax results of the S corporation for the year that must be reported on the income tax returns of the shareholders.
Generally speaking, the Form 1120-S is due March 15th, but can be extended to September 15th.
Separate State Income Tax Return
In most states, S corporations have to file income tax returns. There can be entity level taxes on S corporations (such as California’s 1.5% income tax, $800 minimum tax) and in most states the shareholders will need to report the S corporation’s income on their own state income tax return.
Running W-2 Payroll/Reasonable Compensation
S corporations must pay their employees, including solopreneur owners, reasonable compensation. This requires running W-2 payroll, including federal and state payroll tax withholding and remittance. There are payroll processors that specialize in providing payroll services for small S corporations.
As discussed above, W-2 compensation must be reasonable.
Forms W-2, W-3, 940, and 941
There are both quarterly and annual payroll tax returns that must be filed to report salaries paid and payroll taxes withheld and remitted. The Form 941 is filed for each quarter and is generally due one month after the end of the quarter.
Forms W-2, W-3, and 940 are filed on an annual basis and generally due January 31st.
Tracking Distributions and S Corporation Stock Basis
Shareholders must track their “basis” in their S corporation stock. Generally speaking, dividends from an S corporation are not taxable to the shareholder. However, they reduce the shareholder’s basis in their S corporation stock. If the shareholder receives a distribution at a time he or she does not have basis in their S corporation stock, it triggers a taxable gain to the shareholder.
Basis should generally be tracked as part of the tax return preparation process. However, basis should also be tracked during the year prior to the shareholder taking significant dividends from the S corporation.
Increased Professional Fees
Operating out of an S corporation generally increases the professional fees a solopreneur pays. This absolutely can be worth it, but in many cases there needs to be professional assistance regarding reasonable compensation, tax filings, legal maintenance, and payroll processing.
Tax Planning
In a world without two of my favorite tax topics, the qualified business income deduction and the Solo 401(k), the analysis was usually somewhat straightforward. Estimate business income and run it through the filters of income and self-employment tax if reported on a Schedule C versus income and payroll tax if reported through an S corporation. This yielded an estimate of the overall tax savings obtained using an S corporation structure.
To make the “S corporation or Schedule C” decision, the taxpayer would then, for the most part, compare the estimated annual tax savings versus the additional administrative burden and costs associated with the S corporation.
Today, we live in a world with the qualified business income deduction and the Solo 401(k). These planning opportunities make the “S corporation or Schedule C” question more nuanced. At a minimum, solopreneurs should work with their tax advisors to model out what the income tax, self-employment tax, qualified business income deduction, and retirement plan results look like at their anticipated business income level and desired retirement plan contribution level to determine whether the S corporation or the Schedule C route is better.
Operating through an LLC
One option available to solopreneurs is operating out of an LLC as the sole owner. LLCs provide a legal entity out of which to conduct business. Properly operated, an LLC can provide a solopreneur with liability protection and reputational advantages. One great feature of LLCs is their tax flexibility. They default to disregarded status, meaning that for a solopreneur, the default option is that the taxable income of the LLC is simply reported on their Schedule C. However, using the Form 2553, a solopreneur can elect to have the LLC treated as an S corporation.
Those looking to work through an LLC should consider hiring legal counsel regarding the establishment and maintenance of their legal entity.
Conclusion
Operating out of an S corporation is a significant additional operational commitment. There are instances where it can make a great deal of sense for a solopreneur. Those considering using an S corporation should understand the administrative commitment involved and should work with advisors as appropriate to ensure they make an informed decision.
FI Tax Guy can be your financial advisor! Find out more by visiting mullaneyfinancial.com
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.
I was honored to discuss using tax returns as a springboard to tax planning on a recent episode of the ChooseFI podcast. Click here for the episode website.
During the conversation we referenced this blog post.
As always, the discussion is general and educational in nature and does not constitute tax, investment, legal, or financial advice with respect to any particular individual or taxpayer. Please consult your own advisors regarding your own unique situation. Sean Mullaney and ChooseFI Publishing are currently under contract to publish a book authored by Sean Mullaney.
FI Tax Guy can be your financial advisor! Find out more by visiting mullaneyfinancial.com
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.
Thinking of shifting to self-employment? If you’re thinking about starting a business and being your own boss, one of the things you need to do is figure out how to pay taxes. The transition from W-2 work to self-employment significantly alters the tax landscape.
Below I discuss the taxes self-employed solopreneurs are subject to and how to pay them. As always, the below is for educational purposes only and is not tax advice for any particular taxpayer.
Taxes Paid by the Self-Employed
Federal Income Tax
The first tax is the exact same tax you paid as a W-2 worker: federal income tax. The determination of how much of your income is subject to this tax is a bit different. As a W-2 employee, you received a Form W-2, and, generally speaking, Box 1 of Form W-2 told you how much of your income was subject to federal income taxes.
As a self-employed individual, you now need to track the income and expenses of your business. Solopreneurs should strongly consider practices such as having a separate bank account for the business and hiring a bookkeeper, possibly a virtual one.
Income and expenses of the solopreneur’s business are reported annually on a Schedule C filed with Form 1040 every year. The amount of income computed on Schedule C is taxable on Form 1040.
Federal Self-Employment Tax
Congratulations on the transition to self-employment! You just signed up for a new tax: the federal self-employment tax. It’s actually (roughly speaking) the same FICA tax you paid as a W-2 employee, but now you pay it yourself (instead of through employer W-2 withholding), and you pay both halves of it.
Here is an example of federal self-employment tax:
Leslie reports self-employment income of $80,000 on her Schedule C. Leslie has no W-2 income. Her self-employment tax is $11,304, computed as 14.13 percent of $80,000.
One’s self-employment tax will not always be approximately 14.13 percent of self-employment income. That said, in many cases 14.13 percent will be the approximate percentage. Self-employment tax is computed and reported annually on Schedule SE. Schedule SE is filed with the annual Form 1040.
To account for the fact that the self-employed pay both halves of the payroll tax (the employee side and the employer side), they receive an income tax deduction (from adjusted gross income) on Schedule 1, line 14 for the “employer” half of the payroll tax.
State Income Tax
Most states have an income tax, and the self-employed must pay it too, no different than when one is a W-2 employee.
Local Taxes
Localities have various taxes solopreneurs may be subject to. First, there may be a general business tax which is often either a flat annual fee or a small percentage of revenue. Especially with the latter, there may be an exemption amount (usually, a revenue threshold) below which the solopreneur does not owe the tax. It is usually important to register with your locality to be able to claim any exemption from these taxes.
Second, localities sometimes impose a separate sales tax on particular industries or goods.
It is best to look into these taxes upfront. Localities know that sometimes small businesses miss these taxes and are usually willing to work with those who apply for relief for any missed filings or payments.
Paying Taxes
Now that we’ve discussed the broad categories of taxes the self-employed are subject to, the next step is to determine how and when to pay those taxes.
Federal Income Tax and Self-Employment Tax
This is one stop shopping. The federal tax rules require the self-employed to pay estimated taxes in quarterly payments (referred to as estimated tax payments). The dates they are due for each quarter of the year are as follows (assume the estimated tax payments account for Year 1):
Quarter
Date Estimated Tax Payment is Due
First Quarter
April 15, Year 1
Second Quarter
June 15, Year 1
Third Quarter
September 15, Year 1
Fourth Quarter
January 15, Year 2
Note that if a payment due date occurs on a weekend or federal holiday, generally the due date is moved to the next day that is not a weekend and/or a federal holiday.
Generally speaking, the estimated tax payment must include both the estimated income tax due and the estimated self-employment tax due. Further, it must account for all taxable income (interest, dividends, capital gains, etc.), not just self-employment income.
Failure to pay in sufficient amounts on time can lead to an underpayment penalty computed on Form 2210. Usually, the amount required to avoid an underpayment penalty is the lesser of (i) 90 percent of the current year tax due (paid in timely, equal payments) or (ii) 110 percent of the previous year tax due (paid in timely, equal payments). These two standards are often referred to as safe harbors.
Note that if previous year adjusted gross income was less than $150,000, the 110 percent safe harbor drops to 100 percent.
For those with growing incomes, the 110 percent safe harbor often works best. Those who have filed your Year 1 tax return by April 15, Year 2 (or at least have it just about ready to go) can take the total tax due number from the Form 1040, multiply it by 1.1, and divide it by 4 to get the amount of the required quarterly estimated tax payment to be good to go. Here is an example:
Josh is self-employed and filed his Year 1 tax return on April 1, Year 2. His business is growing. His total federal tax for Year 1 (including income tax and self-employment tax) was $45,000. Josh believes that his self-employment income could significantly increase in Year 2, so he has decided to rely upon the 110 percent safe harbor to pay his estimated tax. He multiplies $45,000 by 1.1 and then divides that product ($49,500) by 4 to get his quarterly estimated tax payment of $12,375). He makes four $12,375 payments to the IRS no later than April 15, Year 2, June 15, Year 2, September 15, Year 2, and January 15, Year 3.
The nice thing about this strategy is that Josh is now protected against the underpayment penalty even if he wins the lottery during Year 2. He simply makes those estimated payments and then, with his Year 2 Form 1040, he pays the IRS the balance due, which could be quite large. But regardless of the balance due, Josh’s underpayment penalty is $0.
Taxpayers who might be subject to the underpayment penalty can request relief from it on the Form 2210 and/or “annualize” their income on Form 2210 to prove that the majority of their income came from later in the year (and thus estimated taxes paid later in year are sufficient for the current year’s estimated tax). Using the 110 percent safe harbor generally eliminates the need to look to mitigation tactics.
Paying the IRS
Solopreneurs can mail estimated taxes to the IRS with a Form 1040-ES. Alternatively, solopreneurs can use the IRS DirectPay system and pay electronically at this IRS website.
State Income Taxes
States with income taxes also generally require periodic or quarterly estimated tax payments. Many follow some or all of the IRS rules. My home state of California has its own timing rules for estimated tax payments. It generally requires taxpayers to pay 30 percent of their estimated income tax liability during the first quarter (April 15th due date), the next 40 percent of their estimated income tax liability during the second quarter (June 15th) and the remaining 30 percent after the end of the fourth quarter (the following January 15th).
States, like the IRS, generally have website portals where solopreneurs can make estimated tax payments.
The Transition Year
Transitions from W-2 work to solopreneurship presents many challenges and opportunities. One potential opportunity is the need to pay less or possibly no estimated taxes for the year of the transition. This can be true for several reasons.
It may be that based on the W-2 withholding collected prior to leaving full time employment, the new solopreneur had enough withheld to cover the tax on their annual income. W-2 withholding generally assumes a full year of employment, but if one leaves full time employment and experiences start-up expenses and lower self-employment income as they build a business, it may be the case that they need to make little or no estimated tax payments in that first year.
Another source of tax payments is spousal W-2 withholding. If filing jointly with a spouse, the spouse’s W-2 withholding combined with the new solopreneur’s partial year W-2 withholding might be enough to cover the estimated taxes for the transition year.
EINs and Forms 1099
In most cases, it makes sense for sole proprietors to obtain an employer identification number (“EIN”) from the IRS for their sole proprietorship. This EIN is used on the business’s Schedule C. Further, this number is used (instead of a Social Security number) to file any required Forms 1099s paid with respect to the business. Forms 1099 (such as the Form 1099-NEC) are required for cash payments of $600 or more during the year to individuals in the course of business.
The IRS has an internet portal here for taxpayers to apply online for EINs.
Tax Planning
The transition from W-2 employment to self-employment can provide several tax planning challenges and opportunities. Here is a brief overview of several challenges and opportunities.
Qualified Business Income Deduction
The Section 199A qualified business income deduction is a relatively new deduction for small businesses, including solopreneurs. I have previously blogged about this deduction here and here.
Roth Conversions for the Self-Employed
The transition to self-employment may present Roth conversion opportunities, for two reasons. First, as a business starts up, the soloprenuer’s taxable income might be very low, and thus a start up year might be a great time to execute a Roth conversion (i.e., moving amounts from traditional IRAs/401(k)s etc. to Roth accounts) and enjoy a low marginal federal income tax rate on the converted amount.
Second, there are instances where Roth conversions by the self-employed can benefit from the Section 199A qualified business income deduction. I blogged about that opportunity here.
S Corporations
Many solopreneurs will have the opportunity to operate out of what is referred to as an “S corporation” for U.S. federal tax purposes. There are several advantages to operating out of an S corporation, but there are also some disadvantages.
Next month’s blog post discusses S corporations and some of the planning considerations involved.
Solo 401(k)s
Solopreneurs are responsible for their own workplace retirement account. The Solo 401(k) is a great opportunity for many solopreneurs to stash significant amounts into tax-advantaged retirement accounts.
As I announced in March, I’m currently working on a book about Solo 401(k)s, which is tentatively set to be published in early 2022.
Hiring Professionals
To my mind, the shift from W-2 employment to self-employment often signals the need to hire a tax return preparer, and possibly a (virtual) bookkeeper as well. Self-employment significantly increases the complexity of one’s tax return and thus it is often wise for the self-employed to hire a tax return preparer and a bookkeeper.
Conclusion
The shift to self-employment is both exciting and challenging. Yes, the self-employed have a more complicated tax picture. But with some intentional planning, managing and ultimately optimizing the tax picture is very much possible.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
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.
Qualified charitable distributions (“QCDs”) are an exciting tax planning opportunity, particularly for the FI community. Below I describe what a qualified charitable distribution is and how members of the FI community should think about them when tax planning.
Of course, this post is educational in nature. Nothing in this blog post is tax advice for any particular taxpayer. Please consult your own tax advisor regarding your unique circumstances.
Qualified Charitable Distributions
QCDs are transfers from a traditional IRA directly to a charity. Up to $100K annually, they are (a) not included in the taxpayer’s taxable income, (b) not deductible as charitable contributions, and (c) qualify as “required minimum distributions” (“RMDs”) (to the lesser of the taxpayer’s required minimum distribution or the actual distribution to the charity). Here is an example:
Example 1: Jack and Jill are 75 years old and file their tax return married filing joint. Jack has a RMD from his traditional IRA of $40,000 in 2021. Jack directs his traditional IRA institution to transfer $40,000 during 2021 to a section 501(c)(3) charity. Jack and Jill recognize no taxable income on the transfer, and Jack does not have to take his 2021 RMD (the $40K QCD having covered it). Further, Jack and Jill receive no charitable contribution deduction for the transfer.
Considering that Jack & Jill (both age 75) enjoy a standard deduction of $27,800 in 2021, they get both the standard deduction and a $40K deduction for the charitable contribution from the traditional IRA (since they do not have to include the $40K in their taxable income). This is the best of both worlds. Further, excluding the $40K from “adjusted gross income” (“AGI”) is actually better than taking the $40K as an itemized deduction, since many tests for tax benefits are keyed off of AGI instead of taxable income.
Important QCD Considerations
Take QCDs Early
Generally speaking, it is best that QCDs come out of the traditional IRA early in the year. Why? Because under the tax rules, RMDs come out of a traditional IRA first. So it is usually optimal to take the QCD early in the year so it can fulfill all or part of the required minimum distribution for the year. Then you can do Roth conversion planning (if desired), so long as the full RMD has already been withdrawn (either or both through a QCD and a regular distribution) from the traditional IRA first.
No Trinkets
I don’t care how much you love your PBS tote bag: do not accept any gift or token of appreciation from the charity. The receipt of anything (other than satisfaction) from the charity blows the QCD treatment. So be sure not to accept anything from the charity in exchange for your QCD.
QCDs Available Only from Traditional IRAs
In order to take advantage of QCD treatment, the account must be a traditional IRA. 401(k)s and other workplace plans do not qualify for QCDs. Further, SIMPLE IRAs and SEP IRAs do not qualify for QCD treatment.
As a practical matter, this is not much of an issue. If you want to do a QCD out of a 401(k) or other tax advantaged account, generally all you need to do is rollover the account to a traditional IRA.
QCD Age Requirement
In order to take advantage of the QCD opportunity, the traditional IRA owner must be aged 70 ½ or older.
Inherited IRAs
QCDs are available to the beneficiary of an inherited IRA so long as the beneficiary is age 70 ½ or older.
QCDs For Those Age 70 ½ and Older
If you are aged 70 ½ or older and charitably inclined, the QCD often is the go-to technique for charitable giving. In most cases, it makes sense to make your charitable contributions directly from your traditional IRA, up to $100,000 per year. QCDs help shield RMDs from taxation and help keep AGI low.
QCDs and the Pro-Rata Rule
If you have made previous non-deductible contributions to your traditional IRA, distributions are generally subject to the pro-rata rule (i.e., the old contributions are recovered ratably as distributions come out of the traditional IRA).
However, QCDs are not subject to the pro-rata rule! This has a positive effect on future taxable distributions from the traditional IRA. Here is an example of how this works:
Example 2: Mike is age 75. On January 1, 2021, he had a traditional IRA worth $500,000 to which he previously made $50,000 of nondeductible contributions. If Mike makes a $10,000 QCD to his favorite charity, his traditional IRA goes down in value to $490,000. However, his QCD does not take out any of his $50,000 of basis from nondeductible contributions. This has the nice effect of reducing the tax on future taxable distributions to Mike from the traditional IRA, since the QCD reduces denominator (by $10K) for determining how much basis is recovered, while the numerator ($50K) is unaffected.
QCDs for Those Under Age 70 ½
Those in the FI community considering early retirement need to strongly consider Roth conversions. The general idea is that if you can retire early with sufficient wealth to support your lifestyle, you can have several years before age 70 during which your taxable income is artificially low. During those years, you can convert old traditional retirement accounts Roth accounts while you are taxed at very low federal income tax brackets.
For the charitably inclined, the planning should account for the QCD opportunity. There is no reason to convert almost every dime to Roth accounts if you plan on giving significant sums to charity during your retirement. Why pay any federal or state income tax on amounts that you ultimately will give to charity?
If you are under the age of 70 ½ and are charitably inclined, QCDs should be part of your long term financial independence gameplan. You should leave enough in your traditional retirement accounts to support your charitable giving at age 70 ½ and beyond (up to $100K annually). These amounts can come out as tax-free QCDs at that point, so why pay any tax on these amounts in your 50s or 60s? Generally speaking, a Roth conversion strategy should account for QCDs for the charitably inclined.
Conclusion
For the charitably inclined, QCDs can be a great way to manage taxable income and qualify for tax benefits in retirement. QCDs also reduce the pressure on Roth conversion planning prior to age 72, since it provides a way to keep money in traditional accounts without having to pay tax on that money.
FI Tax Guy can be your financial advisor! Find out more by visiting mullaneyfinancial.com
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.
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.
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.
Really enjoyed this year-end tax planning conversation with Doc G on the Earn & Invest podcast. Stay tuned to the end for some candid behind the scenes podcast recording.
This post (and this podcast episode) 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 Roth IRA is 25 years old as of 2023 (its birthday was January 1st). Yet there is still confusion about the rules applicable whenever someone withdraws money from a Roth IRA prior to turning 59 ½. This blog post attempts to correct some misconceptions on the taxation of nonqualified Roth IRA withdrawals.
Watch me discuss Roth IRA withdrawals.
Roth IRAs: The Basics
A Roth IRA is a tax-advantaged account that generally offers tax-free growth for invested amounts. Taxpayers receive no upfront tax deduction for putting money into a Roth IRA. If properly executed, taxpayers can withdraw money from a Roth IRA entirely tax and penalty free, and can enjoy years of tax-free growth on the amounts invested in a Roth IRA.
I have previously blogged about why I believe the Roth IRA is a great tax-advantaged account in my An Ode to the Roth IRA.
Roth IRA Funding
How does one move money into a Roth IRA? There are three ways.
Annual Contributions
Generally speaking, if your income is below certain limits, you can contribute up to the lesser of $6,500 or your earned income (2023 limits) to a Roth IRA. If you are aged 50 or older, the limits are the lesser of $7,500 or earned income (2023 limits).
I discussed Roth IRA annual contributions, including the income limits on the ability to make Roth IRA contributions, in this post.
Conversions
Amounts can be converted from traditional retirement accounts into a Roth IRA. Any taxpayer can convert amounts from a traditional retirement account to a Roth IRA. There are no restrictions based on level of income and/or having had earned income.
Conversions are taxable in the year of the conversion.
There are several reasons you might want to do a Roth IRA conversion. One might be the anticipation of paying tax at a higher rate in the future. The planning concept is to “lock in” the lower tax rate in the year of the conversion rather than tomorrow’s (anticipated) higher tax rate, and to get all of the earnings on the contribution out of income taxation.
Unlimited Roth IRA conversions form the backbone of the Backdoor Roth IRA planning concept.
Note that inherited traditional IRAs cannot be converted to Roth IRAs.
Transfers from Workplace Retirement Accounts
A third way to get money into a Roth IRA is by using workplace retirement accounts. Amounts in Roth 401(k)s and other workplace Roth accounts can be transferred into a Roth IRA. Generally, it is best to use direct “trustee-to-trustee” transfers to accomplish this.
Further, after-tax contributions in workplace retirement plans can be directly transferred to Roth IRAs, as discussed in Notice 2014-54. The ability to transfer after-tax contributions into a Roth IRA has facilitated the use of the Mega Backdoor Roth IRA planning technique.
Roth IRA Withdrawals: The Confusion
You may have heard that you cannot take money out of a Roth IRA if the account is not 5 years old without paying tax and a penalty. Not true!
There are not one, but two, five (5) year rules applicable to Roth IRAs. But neither one of them prohibit you from taking money out of a Roth IRA you have previously contributed through annual contributions. First, I will illustrate the default Roth IRA withdrawal rules, and then I will discuss the two 5 year rules.
Quick Thought: Most of this blog post addresses situations where the taxpayer does not qualify for a qualified distribution. Generally, a taxpayer fails to qualify for a qualified distribution if he or she has not attained the age of 59 ½, and/or if he or she has not owned a Roth IRA for 5 years. The advantage of a qualified distribution is that it is automatically tax and penalty free.
Roth IRA Withdrawals: The Layers
Here is the default order of distributions that come out of a Roth IRA. These are the rules that apply in cases where the taxpayer does not qualify for a qualified distribution. All Roth IRAs (other than inherited Roth IRAs) the taxpayer owns are aggregated for purposes of determining his or her Roth IRA layers.
First Layer: Tax-free return of Roth IRA contributions
Second Layer: Roth IRA conversions (first-in, first-out)
Third Layer: Roth IRA earnings
Each layer must come out entirely before the subsequent layer is accessed.
Here’s a brief example:
Example 1: Samantha opened her only Roth IRA in 2018. Samantha has made three prior $5,000 contributions to her Roth IRA (one for each of 2018, 2019, and 2020). She also made a $5,000 conversion from a traditional IRA to a Roth IRA in 2018. In 2021, at a time when her Roth IRA is worth $30,000 and Samantha is 50 years old, she takes a $10,000 withdrawal from her Roth IRA. All $10,000 will be a recovery of her previous contributions (leaving her with $5,000 remaining of previous contributions). Thus, the entire $10,000 distribution from the Roth IRA will be tax and penalty free.
The Roth IRA contributions come out tax and penalty free at any time for any reason! The 5 year rules have nothing to do with whether a taxpayer can recover their previous Roth IRA contributions tax and penalty free!
For those wanting to dig deeper into the tax law, please refer to this technical slide deck discussing why the Roth IRA contributions are distributed tax and penalty free regardless of the 5 year rules.
Note that aggregation rules always apply. In making an analysis like the one provided in Example 1, one must account for all their Roth IRAs and treat all of their Roth IRAs as a single Roth IRA to determine their own Roth IRA layers. Roth 401(k)s and inherited Roth IRAs are not included in the analysis.
5 Year Rule for Roth IRA Earnings
The first five-year rule for Roth IRAs applies only to a withdrawal of earnings from a Roth IRA. If the account owner has not owned a Roth IRA for at least 5 years, the earnings withdrawn from the account are subject to ordinary income tax (and possibly a penalty).
Example 2: Joe is 62 years old in 2024. He has owned a Roth IRA since 2021. In 2024, after having made $14,000 in prior annual contributions to his Roth IRA, he withdrew $17,000 from the Roth IRA. Because Joe has not owned a Roth IRA for 5 years, the withdrawal is not a qualified distribution. Joe recovers his first $14,000 tax free as a return of contributions. The next $3,000 of earnings is taxable to Joe as ordinary income (because of the first five-year rule). Because Joe is over age 59 ½, he does not owe the ten percent penalty on the distribution. If Joe had not attained the age of 59 ½, he would owe the 10 percent penalty on the $3,000 of earnings he received.
5 Year Rule for Roth IRA Conversions
There is a five-year rule applicable to taxable money converted from a traditional retirement account to a Roth IRA (what I will colloquially refer to as the “second five-year rule”). The idea behind the second five-year rule is to protect the 10% early withdrawal penalty applicable when someone has a traditional retirement account. Here is an illustrative example.
Example 3: Milton has $100,000 in a traditional IRA, no basis in any IRA, and is age 50. If he were to withdraw $1,000 from his traditional IRA (assuming no penalty exception applies), he would owe (in addition to ordinary income tax) a $100 penalty (ten percent) on the withdrawal.
Okay, but what if Milton first converts that money from a traditional IRA to a Roth IRA (assume Milton has no other balance in a Roth IRA)? Would that get him out of the 10 percent penalty? No, it won’t, because of the second five-year rule.
Example 4: Milton has $100,000 in a traditional IRA, no basis in any IRA, has no Roth IRAs, and is age 50. In September 2024, he converts $1,000 to a Roth IRA. In October 2024, he withdraws $1,000 from that Roth IRA. Because of the five-year rule applicable to Roth IRA conversions, Milton will still owe the $100 penalty on the withdrawal from the Roth IRA.
Had Milton waited until 2029 or later, he would not have owed the penalty on the withdrawal of that $1,000.
The 5 Year Rule for Roth IRA Conversions and the Backdoor Roth IRA
The Backdoor Roth IRA is subject to the second five-year rule, but the penalty effect turns out to be very minor (or non-existent) if the Backdoor Roth IRA has been properly executed.
Conversions, the second layer of the Roth IRA stack, come out first-in, first out. Further, the taxable amount (potentially subject to the 10 percent penalty upon withdrawal) of any one particular Roth IRA conversion comes out first within the conversion amount. Thus, the second layer (the conversion layer) can be composed of several mini-layers.
Here is a quick example:
Example 5: Denzel made $6,000 nondeductible traditional IRA contributions on January 1, 2019 and January 1, 2020. On February 2, 2019 and February 2, 2020, Denzel converted the entire balance of the traditional IRA ($6,010 each time) to a Roth IRA. As of December 31, 2019 and December 31, 2020, Denzel had $0 balances in all traditional IRAs, SEP IRAs, and SIMPLE IRAs.
In 2021, at a time when Denzel is 35 years old and has made no other contributions or conversions to a Roth IRA, he withdraws $3,000 from his Roth IRA. The first $10 of the withdrawal will be from the taxable amount of his 2019 Roth conversion, and thus, will be subject to the 10 percent penalty as it violates the second five-year rule (Denzel will owe $1 in penalties). The next $2,990 is attributable to the non-taxable portion of his 2019 Roth conversion, and as such, will not be subject to the 10 percent penalty. None of the $3,000 will be subject to ordinary income tax.
Penalty Exceptions
From time to time you will hear things such as “you can withdraw only $10,000 from a Roth IRA for a first-time home purchase.” Does that mean everything else discussed above does not apply?
Fortunately, the answer is no!
So what is the $10,000 rule getting at? It is getting at amounts withdrawn from a Roth IRA that would otherwise be subject to the penalty (and possibly income taxes — see The Super Exceptions below).
There are several penalty exceptions applicable to taxable converted amounts and earnings that are withdrawn from a Roth IRA in a nonqualified distribution. But the penalty exception rules generally apply on top of the usual layering rules, not instead of the usual Roth IRA layering rules.
In a discussion on social media, I used a version of the following example.
Example 6: Jane Taxpayer, age 30, has had a Roth IRA since 2017. In 2020, she withdraws $30,000 from her Roth IRA to acquire her first home, and has never used traditional IRA and/or Roth IRA money for such a purchase. She has previously made $20,000 in annual contributions to the Roth IRA. The first $20,000 of the withdrawal is a tax-free return of those contributions (see the layers above). The next $10,000 is out of earnings (see the layers above). This $10,000 is taxable to her as ordinary income. But, because of the $10,000 “qualified first-time homebuyer distribution” exception, she does not owe the 10 percent penalty on the withdrawal of those earnings.
In this case, withdrawals used to fund certain home purchases can qualify for a penalty exception (the first-time homebuyer exception is subject to a $10,000 cap). Please visit this website for a list of the possible penalty exceptions applicable to withdrawals from a traditional IRA and a Roth IRA.
The Super Exceptions
If the taxpayer is relying on the disability, age 59 ½, death, or qualified first-time home purchase penalty exceptions, the earnings also come out income tax free so long as the taxpayer has owned a Roth IRA for five years. See slide 5 of the above referenced technical slide deck.
As applied to Jane Taxpayer in Example 6 above, if she had owned a Roth IRA since any time in 2015 or earlier, the distribution of $10,000 of earnings would not only have been penalty free, it would have also been income tax free.
60 Day Rollovers
A taxpayer might take money out of a Roth IRA and then reconsider. Perhaps he or she wants the money to grow tax-free. Or perhaps the taxpayer dipped into earnings and the distribution is not a qualified distribution, meaning that it will likely be subject to both ordinary income and a ten percent penalty.
He or she might be able to roll the money back into the Roth IRA. However, the tax rules allow only one 60 day rollover every 12 months. The IRS has a website here discussing some of the issues.
Because of the one-rollover-per-year rule, I generally advise against doing 60 day rollovers unless you need to. Generally, it is best to avoid them, and then have the option available as a life raft if money somehow comes out of a Roth IRA (or other IRA) when it should not have.
Required Minimum Distributions
There are no required minimum distributions from a Roth IRA! Every other non-HSA tax-advantaged retirement account, including the Roth 401(k), has required minimum distributions.
Note that required minimum distributions are generally required once the Roth IRA becomes an inherited Roth IRA (in the hands of anyone but certain surviving spouses).
Tax Planning
Okay, so taxpayers always have tax and penalty free access to old Roth IRA annual contributions. So what of it? As a practical matter, maybe nothing.
In most cases, it makes sense to simply keep the money in the Roth IRA and let it grow tax free!
That said, there can be instances where, as part of a well crafted financial plan, it can make sense to withdraw previous Roth IRA contributions prior to age 59 ½. Further, it is good to know that, in an emergency situation, those old Roth IRA contributions are accessible.
Of course, prior to taking an early withdrawal from a Roth IRA, it is usually best to consult with your own financial advisor and/or tax advisor.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
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.
How do you pass your family’s house to your children? It’s a pressing question and involves significant tax, legal, and emotional considerations. Unfortunately, it is a topic about which there is much confusion.
This blog post discusses some of the important considerations. But as a blog post, it can only scratch the surface. Anyone looking to efficiently pass on their home is well advised to consult with their own lawyer, tax professional, and in some cases, their banker as well.
Minor Children
To my mind, the primary planning objective of married couples with minor children vis-a-vis their home is to account for what happens if both spouses die. Such couples would want their children taken care of in the most flexible manner possible.
Generally speaking, in such situations, it is often best to work with a lawyer to transfer the primary residence to a revocable living trust (explained below). In the event of both spouses’ deaths, the house would be held by the trust and managed by the trustee of the trust. It could be sold or rented for the benefit of the children, or kept so the children and their guardian(s) could live in the house.
This resolution is generally preferable to leaving a house directly to minor children.
Revocable Living Trusts
What is a revocable living trust? It is generally a written trust (drafted by a lawyer) that owns property the grantor(s) or settlor(s) transfers to the trust. For this sort of planning, usually spouses (the grantors) transfer their home to the trust and designate themselves as the primary beneficiaries of the trust. The trust provides that the grantors’ minor children are the successor beneficiaries. Upon both spouses’ deaths, the trust becomes irrevocable, and a trustee holds the assets and manages them on behalf of the beneficiaries (the minor children).
The best thing about a revocable living trust: as long as the grantor(s) is/are alive, the trust is fully revocable! So mistakes can be easily fixed (working with a lawyer).
Revocable living trusts also generally avoid probate.
Tax Effect
One nice thing about a revocable living trust is that it doesn’t change the grantor’s tax situation. All the income of the trust assets remain the taxable income of the grantor. Generally speaking, the grantor’s tax return does not change at all. Further, favorable tax rules, such as the $250K per person exclusion for capital gains on qualified primary residences, apply unchanged.
Parents placing their primary residence in their own revocable living trust does not necessitate the filing of a federal gift tax return (Form 709).
Upon inheriting a house as the beneficiary of a revocable living trust, the child takes a fair market value tax basis in the house (the so-called “step-up in basis”). This makes using a revocable living trust a tax-efficient way of passing a house to the next generation.
Adult Children
Okay, but what about adult children? It’s readily apparent that five-year olds should not own real estate outright. But what about grown children? If a primary goal is simply avoiding probate, why not use a joint tenancy with rights of survivorship instead of a revocable living trust?
Putting an adult child’s name on the title of the parent(s) primary residence (and thus, creating a joint tenancy with rights of survivorship) can lead to a host of issues, but perhaps not the issues that initially come to mind.
Capital Gains Tax
What about the adult child’s capital gain upon the sale of the house after the parent’s death? Is that a reason to use a revocable living trust to house the house (pun intended)?
Well, it turns out the answer is generally No. Assuming the adult child did not contribute to the acquisition of the house, the adult child can take a full fair market value basis in a house acquired from a joint tenancy. Here is an example very loosely based on the example on page 10 of IRS Publication 551:
Example: Joan and Jane owned, as joint tenants with rights of survivorship, Joan’s home. Joan paid $300K for it, Jane paid nothing for it. Upon Joan’s death, the home has a fair market value of $600K. Jane inherits (as the surviving joint tenant) the house from Joan with a $600K basis (a fully stepped-up basis).
If interested, I’ve prepared a technical analysis as to why the surviving non-contributing non-spouse joint tenant receives a full step-up in basis here.
Note that the above full stepped-up basis does not obtain if the gift of a portion of the house was through a tenancy-in-common (instead of through a joint tenancy with rights of survivorship). However, there is little reason to use a tenancy-in-common to transfer a house, because the original owner’s remaining share simply remains in his/her name, and absent other arrangements, passes through probate.
Other Problems with Joint Tenancies
If the capital gains tax upon the original owner’s death isn’t an issue, why not use a joint tenancy to transfer your house to your adult children? Here are some of the considerations.
Capital Gains Tax
Wait, what? I thought you said capital gains taxes were not an issue. They generally aren’t an issue after the original owner’s death. But they can be an issue before his or her death.
What if, during the owner’s lifetime, the house is sold? What if there’s a pressing need to sell the house, perhaps to help pay for long-term care?
The owner/occupant is at least somewhat protected by the $250K per person primary residence gain exclusion. But the adult child is not protected by that exclusion if the home is not their primary residence. The adult child could have to pay capital gains tax (based on their share of the proceeds less their share of the owner’s historic tax basis) on the transaction if the house is sold prior to the owner/occupant’s death.
Loss of Control
Simply put, transferring an interest in your home to another person relinquishes some of your control over the property. You never know if you will need that control in the future. Proceed with significant caution, and consult a trusted lawyer, prior to putting anyone else on the title of your home.
Gift Tax
While not a horrible problem, adding an adult child to the title of a house as a gift requires the filing of a Form 709 gift tax return. Due to the high estate and gift tax exemptions, in most cases it is highly unlikely the transfer would trigger actual gift tax.
Disputes Among Adult Children
Adding multiple adult children to the title as joint tenants with rights of survivorship can create issues after the parent’s death. If siblings cannot agree amongst themselves how to handle and/or dispose of the house, the disagreement can be difficult to resolve. Using a revocable living trust (which becomes irrevocable upon the parent’s death) gives the parent the opportunity to work with their lawyer to put in place a trustee and ground rules for how the house is to be managed and/or disposed of after death.
Children’s Issues
Adult children are people. And people have problems. Divorces, liabilities, bankruptcies, etc. Putting an adult child on the title of a home could subject the home to the adult child’s creditors in a problematic manner.
Summary
The above are just some of the considerations to weigh before adding adult children to the title of a home as a joint tenant with rights of survivorship.
Revocable living trusts keep control with the original owner. Further, they facilitate transferring real estate to the next generation in a tax-efficient manner. Based on these advantages and the issues that exist with joint tenancies, I generally prefer revocable living trusts over joint tenancies for primary residences. Using a will can also be effective from a tax perspective, but should be discussed with a lawyer considering state and local real estate laws. Some states have transfer-on-death type real estate deeds, which also should be considered with a lawyer (if that sort of deed is available).
Outright Gift
You might be saying, well, I have only one child I want to give my house to. Further, I don’t need to own my house. Why not simply give the house outright to that child during my life and avoid any legal events/issues occurring at my death?
Besides some of the issues discussed above and the full loss of control (which are troublesome enough), an outright gift creates a significant capital gains tax issue for the adult child. This capital gains tax issue exists both before and after the original owner’s death.
William lives in a house he purchased in 1970 for $50,000. In 2019 the house is worth $950,000. If William gifts the house to his son Alan in 2019, Alan’s basis in the house is $50,000. However, if William leaves the house to Alan at William’s death, Alan’s basis in the house will be the fair market value of the house at William’s death.
Giving William’s house to Alan during William’s lifetime could increase the capital gains taxable to Alan by $900K! Ouch!
So, whatever you do (a) consult with your lawyer before determining how to pass your house to your children and (b) be very, very hesitant to outright give your house to your child.
Conclusion
There are various ways in which you can transfer your home to your children. In many cases, I believe revocable living trusts are a great way to leave a house to children. You are always well advised to consult with your lawyer before making any decisions on how you want to title your house and how you want to transfer your house. If you do inherit a house from your parents, you should consult with a lawyer regarding titling issues and with your tax professional regarding the tax implications of selling the inherited home.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
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.
