Tag Archives: 401(k)

The SECURE Act’s Impact on the FI Community

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

The Big Picture

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

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

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

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

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

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

Opportunities

Traditional IRA Contributions for those 70 ½ and Older

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

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

RMDs Begin at 72

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

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

Annuities in 401(k)s

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

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

Leaving Retirement Accounts to Heirs

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

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

Spouses

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

Minor Children

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

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

Other Eligible Beneficiaries

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

Planning

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

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

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

Conclusion

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

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

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

Follow me on Twitter: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters. 

Roth Conversions for the Self-Employed

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

Takeaways

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

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

QBI Deduction and Initial Limitation

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

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

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

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

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

Income Limited

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

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

His Income Limit is computed as follows:

Schedule C Income: $100,000

Interest Income: $1,000

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

Standard Deduction: ($12,550)

Taxable Income: $81,385

20% Limit: $16,277

Seth’s QBI Limit is computed as follows:

Schedule C Income: $100,000

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

QBI: $92,935

20% Limit: $18,587

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

Roth Conversion Planning

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

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

Without Roth Conversion

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

With Roth Conversion

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

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

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

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

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

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

Strategy

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

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

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

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

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

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

Conclusion

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

Further Reading

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

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

Follow me on Twitter at @SeanMoneyandTax

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

Defending HDHPs

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

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

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

HDHP Critiques

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

Financial Independence Mentality

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

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

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

Health Insurance and Behavior

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

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

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

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

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

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

The Role of Insurance

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

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

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

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

Risk/Reward Trade-off

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

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

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

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

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

Conclusion 

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

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

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.

Understanding Your 401(k)

As an employee, your employer’s 401(k) plan can be your most important wealth building tool. Understanding how it functions will help you build your wealth in a tax efficient manner.

The Plan

A 401(k) plan is established by an employer. The employer provides the account, the account administration, and the investment choices. Usually, the investment options include a menu of stock and bond mutual funds and/or similar investments. In some plans, employer stock is one of the investment choices.

While the employer administers the plan, most of the assets in the plan (see Vesting below) belong the employees in individual accounts. Therefore, the employees, not the employer, enjoy the benefits and burdens of the economic appreciation and/or depreciation of the investments.

Creditor Protection

401(k) plans are subject to a host of rules, most of which (from a practical perspective) are the concern of the employer, not the employee. One important benefit of the rules for employees is that under ERISA, assets in a 401(k) plan are generally protected from creditors. During your lifetime only two creditors can access assets in your 401(k): the IRS and an ex-spouse.

Vesting

Contributions to a 401(k) made by the employee (referred to as “employee deferrals” and “after-tax contributions” — see numbers 1 and 3 below) are always immediately “100% vested.” This means that regardless of whether the employee leaves the employment of the employer tomorrow, he or she owns the money he or she contributed to the 401(k) and any related growth.

However, contributions to a 401(k) account made by the employer may be subject to a vesting schedule. Simply put, vesting means amounts become the property of the employee after the employee has been employed by the employer for a certain period of time.

Some plans use a gradual vesting schedule. The least generous of these is as follows:

Years of ServiceVesting Percentage
220%
340%
460%
580%
6100%

More generous (i.e., quicker) vesting is permissible.

Some plans use a “cliff” vesting schedule. This means that employer contributions go from 0% vested to 100% vested when the employee has been employed for a certain period. The longest permissible period is 3 years.

The growth associated with employer contributions is also subject to vesting.

Vesting incentivizes staying with the same employer for a sufficient period of time to capture all of the employer contributions to a 401(k) plan. It can also incentivize returning to a former employer if you have worked a number of vested years of service for them.

Some plans provide for 100% immediate vesting for employer contributions as well as employee contributions.

Contributions

There are five types of contributions to 401(k) plans, listed below in order of their prevalence (employee deferrals being the most prevalent).

1. Employee Deferrals

Employees can contribute, through payroll withholding, a portion of their salary to a 401(k) plan. All 401(k) plans offer “traditional” contributions, meaning employees can contribute amounts to the 401(k) plan and exclude those amounts from their taxable income for the year. Some plans, but certainly not all plans, also offer “Roth” contributions, which are not excludible from taxable income, but, if properly withdrawn, can be tax free in the future when withdrawn.

Employee deferrals are the only type of contribution to a 401(k) plan that can be done as a “Roth” contribution. All other contributions are “traditional” contributions.

Read here for more on the desirability of Roth contributions compared to traditional contributions.

Neither traditional nor Roth contributions reduce the amount of income subject to payroll (i.e., Social Security and Medicare) taxes.

2. Matching Contributions

Matching contributions are one of the most powerful ways employees can build wealth. Previously, I have written that if you participate in a 401(k) plan with an employer match, you must make it your top wealth building priority to contribute at least enough to your 401(k) to secure all of the employer match.

How does it work? Different employers have varying matching programs. There are two components: 1) the percentage of salary that is matched, and 2) the percentage of the match.

Here is an illustrative example:

Example 1: Elaine Benes works for Pendant Publishing. She is under 50 years old and earns $100,000 in annual W-2 wages. Pendant Publishing matches 100 percent of employee contributions up to 3 percent of salary, and matches 50 percent of employee contributions for the next 2 percent of salary. Based on this matching program, Elaine would be a fool not contribute at least 5 percent of her salary to Pendant Publishing’s 401(k) plan. Doing so will earn her $4,000 of matching contributions from Pendant Publishing on her $5,000 of employee contributions.

Employers vary in terms of when they match contributions. Some employers match employee contributions only once a year (usually at or after year-end). Other employers match employee contributions each pay period. If you work for an employer that does so, you need to be careful not to max-out your 401(k) early in the year, as each pay period requires an employee 401(k) contribution in order to obtain the match. Here is an example:

Example 2: The facts are the same as Example 1. In addition, Pendant Publishing’s matches 401(k) contributions every pay period, and has 24 pay periods per year. Elaine believes it is a good idea to accelerate her 401(k) contributions, and thus contributes $3,750.00 of her salary for each of the first 6 pay periods of the year ($22,500 total) and makes no contributions the rest of the year. For those 6 pay periods she receives an employee match of $166.67 each pay period ($100,000 divided by 24 times 4 percent) for a total annual match of $1,000. By doing this, Elaine misses out on $3,000 of her potential employer 401(k) match, because for the next 18 pay periods, she contributes nothing to her 401(k).

Some 401(k) plans adjust for this and would fully match Elaine’s contribution (in her case, by adding $3,000 to her 401(k) plan), but many do not. In Elaine’s case, she should have stretched out her contribution such that she contributed at least 5 percent of each pay period’s paycheck to her 401(k).

Note that employers are not required to provide a matching program. There are some employer 401(k) plans that provide no match at all.

Tax Treatment: Employer match contributions are traditional contributions. They are not subject to income tax when added to your 401(k), but they will be in the future when withdrawn (as will the growth on matching contributions). Matching contributions are not subject to payroll taxes.

3. After-Tax Contributions

Some 401(k) plans allow for employees to make so-called after-tax contributions to their 401(k) through payroll withholding. These contributions are not excluded from the employee’s taxable income, but do create basis in the 401(k) account. After-tax contributions are what make Mega Backdoor Roth IRA planning possible. Unless one is engaging in Mega Backdoor Roth IRA planning, in most cases after-tax contributions are not advisable.

Tax Treatment: After-tax contributions do not reduce the employee’s taxable income (for both income tax and payroll tax purposes). In the future after-tax contributions are taxable to the employee as withdrawn, but the employee can use the created basis to reduce the income inclusion. Depending on how the 401(k) account is disbursed, that basis recovery may be subject to the Pro-Rata Rule.

4. Profit-Sharing Contributions

Some 401(k) programs have a profit-sharing program, whereby the employer contributes additional amounts to each employee’s 401(k) account based on a formula.

Tax Treatment: Profit-sharing contributions are traditional contributions and are treated in the same manner as matching contributions, including being exempt from payroll tax.

5. Forfeitures

Because of vesting, employees forfeit unvested amounts in their 401(k)s when they leave the employer’s employment prior to fully vesting in the 401(k). When that happens, the unvested amounts must be accounted for. In some plans, the unvested amounts are used to offset plan administrative costs. In other plans, forfeited amounts are added to the remaining participants’ accounts.

Tax Treatment: Forfeitures are traditional contributions and are treated in the same manner as matching contributions, including being exempt from payroll tax.

Contribution Limits

Contribution limits get a bit complicated because there are two distinct 401(k) plan contribution limits, not one. Numerical limits are updated annually by the IRS to account for inflation. The numbers provided below are the numbers for 2023.

Employee Deferrals

There is an annual employee deferral limitation. For 2023, that limit is the lesser of $22,500 or total compensation (if under age 50) and the lesser of $30,000 or total compensation (if 50 or older). The limit applies to Roth employee contributions, traditional employee contributions, or any combination thereof.

This limit is per person, not per employer. Thus, those with side hustlers must coordinate employee deferrals to their large employer 401(k) plan with employee deferrals to their Solo 401(k). I discuss this topic in detail in my book, Solo 401(k): The Solopreneur’s Retirement Account.

All Additions

There is a second, less understood limitation on 401(k) contribution. The annual limit for all additions to 401(k) and other employer retirement accounts is the lesser of $66,000 or total compensation (if under age 50) and the lesser of $73,500 or total compensation (if 50 or older).

The all additions limit applies to the sum of numbers 1 through 5 above (employee deferrals through forfeitures) plus a sixth amount. The sixth amount is the amount which is contributed by your employer to another qualified retirement plan account on your behalf.

Some employers offer additional qualified retirement plans. These plans often provide for a contribution to an account by the employer based on a stated percentage of compensation. Employers use various names for these plans. Contributions may be subject to vesting and are traditional contributions that are not subject to payroll tax.

The all additions limit applies per employer, not per employee as the employee deferrals limit does.

Watch me discuss the all additions limit on YouTube.

Auto Enrollment

Many employers now auto-enroll new employees in a 401(k) plan. This has two components: contribution level and investment choice. In most cases, new employees should not simply settle for auto-enrollment. When you start a job, you should review your new 401(k) plan and make informed decisions regarding contribution level and investment choice.

Contribution Level

Auto-enrollment will set a contribution level. Not all employers set the contribution level at a level that maximizes employer matching. Even if the automatic contribution level is set at a level that maximizes the employer match, that level might not be the appropriate level for any particular person.

Investment Selection

Plans typically have a default investment plan for new 401(k) participants. It is best to review your investment options when you start a new job and select an appropriate investment allocation for your circumstances.

Withdrawals from Traditional 401(k)s

When a taxpayer is 59 ½ years old or older, they can withdraw amounts in a traditional 401(k) penalty free. Withdrawals are included in taxable income as ordinary income. Beginning at age 72, taxpayers must take out a required minimum distribution (“RMD”) for each year. The RMD is computed based on IRS tables.

If a taxpayer withdraws money from a 401(k) prior to age 59 ½, the withdrawal is not only taxable, it is subject to a 10 percent early withdrawal penalty, unless a penalty exception applies.

Taxpayers may transfer amounts in a 401(k) to another 401(k) to an IRA. Amounts in traditional 401(k)s and IRAs can be converted to Roth accounts. Such conversions create taxable income, but are not subject to the early withdrawal penalty.

Conclusion

Your workplace 401(k) plan is a vitally important wealth building tool. It is important to be an informed user of your 401(k) in order to build tax advantaged wealth.

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. 

What to Do if You Don’t Qualify for a Backdoor Roth IRA

In my last post, I discussed the basics of the Backdoor Roth IRA, which can be a great planning tool for some higher income Americans. But not everyone qualifies for a tax-efficient Backdoor Roth IRA. Recall Jennifer’s case:

Jennifer makes too much to qualify to make a Roth IRA contribution in 2022. She contributed $6,000 to a nondeductible traditional IRA on April 19, 2022. She also had a separate traditional IRA with no basis. As of December 31, 2022, that separate traditional IRA was worth $93,998.53.

If, in 2022, Jennifer were to convert the $6,000 that she put into the nondeductible traditional IRA to a Roth IRA she would increase her taxable income by over $5,600. Ouch!

Options

Jennifer has two possible options to qualify for a much more tax efficient Backdoor Roth IRA. The first option is to use her workplace 401(k), 403(b), or 457 plan. Some 401(k) plans and other workplace plans allow participants to “roll in” amounts in traditional IRAs. Workplace plans are not required to offer participants this option. If a workplace plan does, it can be worthwhile to consider this option in order to facilitate Backdoor Roth IRA planning.

Of course, there are considerations that go beyond income tax planning, including the quality of the investment choices available in a traditional IRA versus a workplace 401(k) or other retirement plan, and the expenses associated with each option.

A second option is rolling the traditional IRA into a Solo 401(k) plan. Jennifer must have a Solo 401(k) plan from self-employment and the plan must accept IRA roll ins in order for her to do this. As with workplace retirement plans, Solo 401(k) plans are not required to accept traditional IRA roll ins, and any decision must appropriately consider the relevant non-tax issues (as discussed above). Further, a Solo 401(k) plan has several requirements (including the conduct of a trade or business) that should be carefully considered before opening a Solo 401(k).

Considerations

Trustee-to-Trustee Rollover

If Jennifer wants to roll her traditional IRA into a workplace retirement plan or Solo 401(k), she should structure the transfer as a “trustee-to-trustee” direct rollover of the money between the financial institution holding the traditional IRA and the workplace retirement plan or Solo 401(k). If instead of a trustee-to-trustee direct rollover, Jennifer receives a check from her IRA financial institution payable to her, she has 60 days to roll over that check (i.e., to get it to her workplace retirement plan or Solo 401(k)). If she does not move the money within the 60 days, the distribution from the IRA is taxable, subject to early withdrawal penalties if Jennifer is under age 59 ½, and cannot be transferred into a retirement plan.

Timing

Roll ins should be completed by December 31st of the year of the Roth IRA conversion. Otherwise the pro-rata rule will bite, because there will be a balance in the taxpayer’s traditional IRAs at year-end. That balance will attract a sizable portion of the $6,000 of IRA basis established by the nondeductible traditional IRA contribution. This causes the Roth IRA conversion to grab little basis and thus be tax inefficient.

For simplicity’s sake, it is usually best to clean out traditional IRAs, SEP IRAs, and SIMPLE IRAs and then make the nondeductible traditional IRA contribution.

Basis

Prior to implementing a traditional IRA to 401(k) “roll-in” strategy, Jennifer should review all of her traditional IRAs to ensure that she has no basis in any existing traditional IRA. IRA basis amounts cannot be rolled into the 401(k) and must be left behind under the rule of Section 408(d)(3)(A)(ii) and this technical write up.

SIMPLE IRAs and SEP IRAs

Those with amounts in SIMPLE IRAs, need to be careful. During the first two years of the SIMPLE IRA account, it cannot be rolled into a plan other than another SIMPLE IRA plan. Doing so would create a taxable event, subject to both early withdrawal and excess contribution penalties (on the transfer to the non-SIMPLE IRA).

Thus, if Jennifer’s traditional IRA balance is in a SIMPLE IRA and she first deposited into the SIMPLE IRA less than two years ago, she must wait until the two year window has expired to roll her SIMPLE IRA into a workplace retirement plan or a Solo 401(k).

In addition, those with a SIMPLE IRA (beyond the two year window) or a SEP IRA from their current employer may not be allowed in-service distributions. Thus, they would not be able to roll over those accounts into a 401(k)/Solo 401(k)/403(b)/457. Additionally, amounts may be added to these accounts prior to December 31st. These considerations make it difficult to successfully execute Backdoor Roth IRA planning for those currently covered by an employer’s SIMPLE IRA or SEP IRA.

December 31st

Any Backdoor Roth IRA planning should involve an additional diligence step: ensuring that as of December 31st of the year of the Roth conversion step, the taxpayer has a zero balance in all traditional IRAs, SEP IRAs, and SIMPLE IRAs. This helps ensure the Backdoor Roth IRA is a tax-efficient tactic.

Illustrative Example

Jennifer expects to earn $300,000 from her W-2 job in 2022, is covered by a workplace 401(k) plan, and expects to have some investment income. On March 1, 2022, Jennifer has a $90,000 balance in a traditional IRA but otherwise has no balance in a traditional IRA, SEP IRA, or SIMPLE IRA.

On March 2, 2022, Jennifer directs her workplace 401(k) plan and her IRA custodian to roll her traditional IRA to her workplace 401(k) plan. Her traditional IRA is rolled into her workplace 401(k) through a trustee-to-trustee direct rollover.

Jennifer contributes $6,000 to a traditional IRA on April 20, 2022. The contribution is nondeductible. Because the contribution is nondeductible, Jennifer gets a $6,000 basis in her traditional IRA. Jennifer must file a Form 8606 with her 2022 tax return to report the nondeductible contribution.

On May 2, 2022, Jennifer converts all the money in her traditional IRA to a Roth IRA (a Roth IRA conversion). At that time, Jennifer’s traditional IRA had a value of $6,001.47. Jennifer also ensures that as of December 31, 2022, she has a $0 balance in all traditional IRAs, SEP IRAs, and SIMPLE IRAs.

If Jennifer executes the above steps as described above, she will get the desired result. Done in this manner, the Roth IRA conversion step results in an increase in Jennifer’s taxable income of just $1.47 ($6,001.47 fair market value less $6,000 of traditional IRA basis).

Tactics vs. Goals

What if Jennifer’s workplace retirement plan does not accept roll ins? What if Jennifer doesn’t have access to a Solo 401(k)? What if Jennifer’s workplace retirement plan accepts roll ins but does not have quality investment options and/or charges high fees?

Remember, Jennifer’s ultimate goal is not to do a Backdoor Roth IRA. Her goal is financial independence! She should not let what I call the “tyranny of tactics” distract her from her ultimate goal.

The Backdoor Roth IRA is a great tactic to employ toward achieving that goal. But it’s okay if you can’t use this particular tactic. Plenty of people have and will achieve financial independence without executing a Backdoor Roth IRA.

If you can’t use the Backdoor Roth IRA for whatever reason, simply use other appropriate tactics, including but not limited to a high savings rate, to achieve your financial goals.

Further Reading

I discuss how to properly report a Backdoor Roth IRA on a tax return and what to do if has been incorrectly reported here.

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.

Tax Efficient Estate Planning

THIS POST HAS NOT BEEN UPDATED FOR THE SECURE ACT, WHICH WAS ENACTED IN LATE 2019.

If you have significant assets, you need an estate plan. A good estate plan makes handling the financial aspects of your death much easier for your loved ones and creates the opportunity for multiple generation wealth creation.

For most, the need for good estate plan is not about the estate tax. Very few Americans, particularly very few actively seeking financial independence, will be subject to the federal estate tax, as there is now (as of 2019) a $11.4 million estate tax exemption. Thus, only the very largest of estates will pay the federal estate tax. For purposes of this post, assume that all estates are below this threshold.

If you are aren’t subject to the estate tax, why do you need to make a tax efficient estate plan? The answer is the income tax considerations of your heirs and beneficiaries. Some assets cause your heirs and beneficiaries to have very little or no additional income tax. Other assets can cause a significant increase in the income tax burdens of your heirs and beneficiaries. Below I analyze each of the tax baskets and discuss the estate planning considerations for each one.

Being that the FI community generally aims to build up significant assets to achieve financial independence, good estate planning is particularly important if you are on the road to (or have achieved) financial independence.

A quick caveat at the beginning – tax is only one consideration in estate planning. There are many others, including the needs of spouses, children, and other potential heirs, and the desires of the donor. Below I offer thoughts on tax optimal estate planning — of course the tax considerations need to be balanced with other estate planning objectives.

Spouses

A quick note on leaving assets to spouses. Generally speaking, the tax laws favor leaving assets to spouses. A spouse is a tax-preferred heir in most situations (the main exception being leaving retirement accounts to younger beneficiaries with low RMDs). As the focus of this post is passing wealth to the second generation efficiently, most of the discussion, other than a few asides, will not address the tax consequences when leaving an asset to a spouse.

Tax Baskets

Below are the four main tax baskets (tax categories in which individuals can hold assets):

  1. Traditional (a/k/a Deductible) Retirement Accounts: These include workplace plans such as the 401(k), the 403(b), the 457, and the TSP, and IRAs. Under ideal conditions, the contributions, when earned, are not taxed but the contributions and earnings are taxed when later withdrawn.
  2. Roth Retirement Accounts: These include workplace plans such as the Roth 401(k), the Roth 403(b), and the Roth TSP, and Roth IRAs. Under ideal conditions, the contributions, when earned, are taxed but the contributions and earnings are tax-free when later withdrawn.
  3. Health Savings Accounts: HSAs are tax-advantaged accounts only available to you if you have a high deductible health plan (a “HDHP”) as your health insurance. Under ideal conditions, the contributions, when earned, are not taxed and the contributions and earnings are tax-free when later withdrawn.
  4. Taxable Accounts: Holding financial assets in your own name or otherwise not in a tax-advantaged account (tax baskets 1 through 3). The basic concept is taxable in, taxable on “realized” earnings (rental income, business income, dividends, interest, etc.) while in the account, and partially taxable (value less “tax basis”) on the way out.

Baskets 1 through 3 require “ideal conditions” (i.e., compliance with the related tax rules) to operate as outlined above. Let’s assume for purposes of this post that no errors are made with respect to the account in question.

Traditional Accounts

Of the four tax baskets, traditional accounts are often (from a tax perspective) the worst kind to leave to a spouse and the third worst to leave to non-spouse heirs. Why? Because traditional accounts, through required minimum distributions (“RMDs”), are eventually going to be entirely taxable to your beneficiaries and/or their beneficiaries. Non-spouse beneficiaries generally must take RMDs in the year following the donor’s death.

When passing traditional accounts to the next generation(s), a general rule of thumb is younger beneficiaries are better for such accounts, because the younger the beneficiary, the smaller their earlier RMDs, and thus the lower the tax hit of the RMD and the longer the tax-deferred growth.  

Spousal beneficiaries, unlike non-spouse beneficiaries, have the option to delay RMDs until the year they turn 70 ½. However, once they turn 70 ½ they will be required to take taxable RMDs, increasing their taxable income.

For charitably inclined, traditional accounts (or portions thereof) are a great asset to leave to charity. As you will see, your individual beneficiaries would prefer to inherit Roth accounts (and in most cases will prefer to inherit taxable accounts), but the charity is generally indifferent to the tax basket of an asset, because charities pay no income tax. So all other things being equal, if you have money in traditional accounts, Roth accounts, and taxable accounts, the first money you should leave to a charity should be from your traditional accounts.

Lastly, whatever your plans, you are well advised to ensure that all your traditional, Roth, and HSA accounts have valid beneficiary designation forms on file with the employer plan or financial institution.

Roth Accounts

Roth accounts are fantastic accounts to inherit for both spouses and non-spouses. While non-spouses must take RMDs from the inherited Roth account in the year following death, the RMD is non-taxable to them. All beneficiaries benefit from tax-free growth of assets while they are in an inherited Roth account. This makes spouses (able to defer RMDs until age 70 ½) and younger beneficiaries ideal (from a tax perspective) to inherit Roth accounts.

Roth conversions are a potential strategy to save your heirs income tax. If you believe your heirs will have a higher marginal income tax rate than you do, and you do not need the tax on the Roth conversion, you can convert amounts in traditional accounts to Roth accounts, pay the tax, and lower the overall tax burden incurred by you and your family.

Health Savings Accounts

There are two, and only two, ideal people to leave an HSA to – your spouse or a charity. Spouses and charities are the only ones who do not pay tax immediately on an HSA in the year of death.

Unfortunately for non-spouse, non-charity beneficiaries, the entire account becomes taxable income to the beneficiary in the year of death and loses its status as an HSA. This can cause a significant one-time spike in marginal tax rates and cause the beneficiary to lose (to federal and state income taxes) a significant amount of the HSA. This makes the HSA the worst tax basket to leave to non-spouse, non-charitable beneficiaries.

Spouses are allowed to continue the HSA as their own HSA, and thus can use it to grow tax-free wealth that can cover (or reimburse) qualified medical expenses.

If you are charitably inclined and unmarried, the HSA should be the first account you consider leaving some or all of to charity.

Taxable Accounts

Taxable accounts, including real estate and securities, are generally good assets to leave to beneficiaries because of the so-called “step-up” in basis. As a general matter, when a person dies, their heirs inherit assets in taxable accounts with a “stepped-up” basis. This gives the heirs a basis of the fair market value of the property on the date of death.

As a result, a beneficiary can generally sell inherited assets shortly after receiving them and incur relatively little, if any, capital gains tax.

A couple of additional notes. First, leaving appreciated taxable assets at death to heirs is much better than gifting such assets to heirs during your life. A quick example: 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.

Second, the step-up in basis at death benefits spouses in both “common law” states and community property states. In all states, separately held property receives a full step up in basis when inherited by a spouse. For residents of common law states, jointly held property receives a half step-up – the deceased spouse’s portion is receives a step-up in basis while the surviving spouse’s half does not. For residents in community property states, the entirety of community property receives a full basis step-up at the death of one spouse.

Conclusion

Generally speaking, in most cases spouses will prefer to inherit assets in the following order:

  1. Roth
  2. HSA
  3. Taxable
  4. Traditional

In most cases, non-spouses will prefer to inherit assets in the following order:

  1. Roth
  2. Taxable
  3. Traditional
  4. HSA

The best two tax baskets to leave to charities are HSAs and traditional accounts.

You can obtain significant tax benefits for your heirs by being intentional regarding which tax baskets you leave to which beneficiaries. Some relatively simple estate planning can save your heirs a significant amount of federal and state income tax.

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

Follow me on Twitter at @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters.

Section 199A Examples and Lessons

Introduction

As this is being re-published (January 2021), we are in the third filing season of the new Section 199A qualified business income deduction. It is an area of the tax law that practitioners are still digesting.

I have previously written on the basics of the Section 199A deduction. This post builds on that introductory post. It provides analysis on rules from the IRS and Treasury and gives examples of how the deduction works in specific situations.

Takeaways

  • Deductions such as the deduction for one-half of self-employment taxes paid and the deduction for self-employed retirement plan contributions reduce the qualified business income (“QBI”) qualifying for the Section 199A deduction.
  • In many cases, Section 199A reduces the tax savings on traditional retirement plan contributions. Taxpayers may want to consider Roth employee contributions instead of traditional employee contributions to retirement plans because of this change.
  • Some taxpayers may want to prioritize contributions to traditional IRAs and HSAs instead of contributions to self-employed and small business retirement plans to maximize their Section 199A deduction.
  • Potentially powerful tax planning opportunities exist whereby taxpayers can reduce their taxable incomes such that they can go from no Section 199A deduction to a significant deduction. See Managing Taxable Income below for one example.
  • Many small businesses (including many sole proprietorships and S corporations) should not make charitable contributions, since these reduce qualified business income deduction. Rather, the owners of these small businesses should make charitable contributions in their own names.
  • The IRS and Treasury have provided a safe harbor under which rental real estate activities can qualify for the Section 199A deduction.
  • Dividends received from mutual funds and ETFs investing in domestic REITs can qualify for the Section 199A deduction.

Below are examples and commentary addressing Section 199A.

Side Hustler

Mike works a full-time job. His W-2 for 2018 reports $90,000 of wages. Mike also receives $1,000 of qualified dividend income (“QDI”) in his taxable account. Mike has a side hustle where he nets $10,000 in Schedule C profit. Mike pays $1,413 in self-employment tax on that profit. Mike claims the standard deduction.

Recall that the Section 199A deduction is the lesser of:

  1. 20 percent of your taxable income less your “net capital gain” which is generally your capital gains plus your QDI; or,
  2. 20 percent of your qualified business income (“QBI”).

The deduction for one-half of self-employment taxes is factored into the determination of QBI. Thus, in Mike’s case, his Section 199A deduction is the lesser of:

  • 20% of Taxable Income: 20% times ($90,000 plus $10,000 plus $1,000 less $707 less $1,000 less $12,000 = $87,293) = $17,459; or,
  • 20% of QBI: 20% times ($10,000 less $707 = $9,293) = $1,859

In this case, Mike’s Section 199A deduction is $1,859.

Mike’s taxable income is determined by deducting, for adjusted gross income, one-half of the self-employment taxes ($707) he pays with respect to his side hustle income. However, that deduction for half of his self-employment tax must also be subtracted in determining his QBI.

Note further that the Section 199A deduction does not reduce self-employment taxes. The Section 199A deduction is only an income tax deduction. It does not reduce the amount subject to self-employment taxes (in Mike’s case, $10,000).

Sole Proprietor with a Solo 401(k)

Lisa owns a sole-proprietorship that generates $100,000 of business income in 2020 as reported on Schedule C. Lisa pays $14,130 in self-employment taxes. Lisa contributed $19,500 to her traditional Solo 401(k), and makes an employer contribution to her traditional Solo 401(k) of $18,587. Lisa is married to Joe who makes $75,000 in W-2 wages. Lisa and Joe claim the standard deduction.

The deduction for retirement plan contributions is factored into the determination of QBI. Thus, in Lisa’s case, her Section 199A deduction is the lesser of:

  • 20% of Taxable Income: 20% times ($100,000 plus $75,000 less $7,065 less $19,500 less $18,587 less $24,800 = $105,048) = $21,010; or,
  • 20% of QBI: 20% times ($100,000 less $7,065 less $19,500 less $18,587 = $54,848) = $10,970

In this case, Lisa’s Section 199A deduction is $10,970.

QBI has the effect of making certain income “80% income.” What I mean by that term is that only 80% of the income is subject to income tax. This has a flip side – some deductions become only “80% deductions,” meaning that only 80% of the deduction generates a tax break.

Notice that the Solo 401(k) contributions reduce the QBI deduction. Thus, Solo 401(k) contributions are now “80% deductions” due to the QBI regime. For example, if your marginal tax rate is 22 percent, the marginal tax rate savings on your traditional 401(k) employee contribution is only 17.6 percent. But years later, when you withdraw the money from the Solo 401(k) the money will be “100% income.” You will not get a QBI deduction for those withdrawals.

I blogged more about the 80% deduction phenomenon here.

This will cause many sole proprietors to consider Roth Solo 401(k) employee contributions instead of traditional Solo 401(k) employee contributions, since the the tax savings on traditional self-employed employee contributions is reduced as a result of the QBI deduction.

Note further that for the Solo 401(k) employer contribution there is no choice to be made because there is no option to make a Roth employer contribution. All employer contributions must be traditional contributions.

Another observation: If Lisa and Joe had a low enough adjusted gross income (under $105,000) and Lisa made a deductible $6,000 contribution to a traditional IRA, that contribution would not have counted against her QBI. A contribution to a health savings account would also not have lowered her QBI.

For taxpayers whose Section 199A deduction is limited by 20% of QBI, contributions to traditional IRAs and HSAs should be favored over self-employment retirement plan contributions, since the IRA and HSA deductions are 100% deductions while the self-employment retirement plan contributions are 80% deductions. Hat tip to Jeff Levine who made the retirement plan contribution prioritization point on Twitter.

For taxpayers whose Section 199A deduction is limited by 20% of taxable income, contributions to traditional IRAs, HSAs, and self-employment retirement plans are all 80% deductions, and thus Section 199A normally does not factor into determining how to prioritize these contributions. However, all of these are tools taxpayers may be able to use to lower taxable income to qualify for a Section 199A deduction, as discussed in the Managing Taxable Income section below.

S Corporation

Assume the facts are the same as the previous example, except for the following differences. Lisa operates her business as a wholly-owned S corporation instead of as sole proprietorship. Before any sort of compensation, the S corporation makes $100,000. Assume that in this case, the S corporation pays Lisa $50,000 of W-2 wages, which is further assumed to be reasonable. Lisa makes employee contributions of $19,500 to her traditional Solo 401(k) from those wages. The S corporation makes the maximum employer contribution of $12,500 (computed as $30,500 of Box 1 W-2 wages plus $19,500 of elective deferrals times 25 percent). Thus, Lisa will have flow-through income from the S corporation (reported to her on a Schedule K-1) of $33,675 ($50,000 less $12,500 less $3,825 — the employer portion of the payroll tax).

Thus, in Lisa’s case, her Section 199A deduction is the lesser of:

  • 20% of Taxable Income: 20% times ($50,000 plus $33,675 plus $75,000 less $19,500 less $24,800 = $114,375) = $22,875; or,
  • 20% of QBI: 20% times ($33,675 — the QBI) = $6,735

In this case, Lisa’s Section 199A deduction is $6,735 because in the S corporation structure, the business income is split between a salary the S corporation pays her (which is not QBI) and the flow through profit of the S corporation, which is QBI (assuming it is domestic trade or business income).

The S corporation has various pros and cons from a tax perspective. Lower employment (payroll) taxes are a significant benefit, while lower maximum employer retirement plan contributions and lower Section 199A deductions are drawbacks.

Managing Taxable Income

Jackie is a lawyer operating as a sole proprietor. Law is one of several specified service trade or businesses (“SSTBs”) where the benefits of Section 199A are completely phased out if your taxable income exceeds $213,300 ($426,600 for married filing joint taxpayers using 2020 numbers). In 2020 Jackie has $240,000 of Schedule C income from the business. His self-employment taxes are $17,075 in Social Security taxes and $6,428 in Medicare taxes, for a total of $23,503 reported on Schedule SE. Jackie takes the standard deduction.

Jackie’s taxable income is thus $215,848 ($240,000 less $11,752 less $12,400). Because Jackie’s QBI is from an SSTB and his taxable income is above $213,300, he cannot claim any Section 199A deduction.

Now let’s add some tax planning to the scenario. Imagine that early in 2020 Jackie realizes he won’t qualify for the Section 199A deduction based on his numbers. He decides to open a Solo 401(k), which he can make an $19,500 employee traditional contribution to, and he can make an employer contribution of $37,500 for total contributions of $57,000 (the maximum allowed). This radically changes his Section 199A math, since (as will be demonstrated) his taxable income is now below $163,300. Once your income is below $163,300, you qualify for the Section 199A deduction only subject to the computational limits. Thus, in Jackie’s case, his Section 199A deduction is the lesser of:

  • 20% of Taxable Income: 20% times ($240,000 less $11,752 less $12,400 less $57,000 = $158,848) = $31,770; or,
  • 20% of QBI: 20% times ($240,000 less $11,752 less $57,000 = $171,248) = $34,250

Thus, Jackie’s Section 199A deduction is now $31,770! By managing his taxable income (by maximizing retirement savings), Jackie turned a $57,000 deduction into a more than $88,000 of deductions. Sure, the $57,000 deduction for retirement plan contributions is an “80% deduction,” but it creates the additional $31,770 of a Section 199A deduction (which is itself a “100 percent” deduction).

Jackie also lowered his marginal federal income tax rate from 35 percent to 24 percent and reduced his taxable income from $215,848 to $127,078!

Note that contributions to a health savings account would be another tool to deploy to lower your taxable income if you are concerned about Section 199A’s taxable income limitations.

Taxpayers bumping up against Section 199A taxable income limitations will likely need to prioritize traditional employee contributions to Solo 401(k) plans over Roth employee contributions. In addition, self-employed taxpayers bumping up against the taxable income limits in 2021 may want to establish 2021 Solo 401(k)s (if they are eligible to do so) to lower taxable income in order to qualify for the Section 199A deduction.

It will be wise for taxpayers to consult with tax advisors to run the numbers on Section 199A and other tax planning considering the complexity of the rules and the potential benefits of successful planning.

Charitable Contributions

The IRS gave us a bit of a head-scratcher in the instructions to the new Form 8995. The Form 8995 is used (starting with 2019 tax returns) to compute the QBI deduction. In the instructions, it states that charitable contributions reduce QBI.

Here is an example of how that rule would play out:

Cosmo is the sole shareholder of Acme Industries, an S corporation. In 2019, Acme reports QBI operating income of $100,000 to Cosmo on his Form K-1. It also reports $1,000 of charitable contributions made by Acme during 2019. The total QBI Cosmo can claim from Acme Industries is only $99,000, as the charitable contribution reduces QBI, according to the IRS. This is true even if Cosmo claims the standard deduction and thus has no use for the charitable contribution on his 2019 tax return.

Personally, I believe the IRS is on questionable ground in claiming charitable contributions reduce qualified business income. However, with some rather simple tax planning (which I generally believe to be prudent), you can avoid this issue altogether. If you want to make a charitable contribution, simply do so in your own name. Do not have your business — whether an S corporation, a small partnership, or a sole proprietorship, make the charitable contribution.

Rental Real Estate

The IRS and Treasury issued Notice 2019-7 and Revenue Procedure 2019-38 providing a safe harbor under which rental real estate activity can qualify for the Section 199A deduction. A safe harbor is a set of requirements, which, if satisfied, automatically qualify a taxpayer for a particular benefit. Stated differently, a safe harbor is a sufficient, but not necessary condition, to receive a benefit.

While rental activities that constitute a trade or business can still qualify for the deduction if they do not meet the requirements of the safe harbor, as a practical matter it will be much easier to sustain the deduction if you can qualify for the safe harbor.

Requirements

The requirements to satisfy the safe harbor with respect to any “rental real estate enterprise”  (a “RREE”) are as follows:

  • Separate books and records documenting the income and expenses of the RREE must be maintained.
  • At least 250 hours per year of qualifying activity must be done with respect to the RREE.
  • Starting in 2020, detailed records documenting the time spent on the RREE must be maintained (see Revenue Procedure 2019-38).
  • A statement electing the application of the safe harbor must be attached to the tax return.

Multiple Rental Properties

Rental property can be combined for purposes of determining if you have an RREE. However, residential and commercial real estate cannot be aggregated and must be kept separate. Thus, at a minimum if you own both commercial and residential property, you have two RREEs, and you must apply the tests to each separately to determine if each RREE qualifies for the safe harbor.

Qualifying Activities

In a bit of good news, the 250 hours can be done by the owner, agents, employees, and/or independent contractors. However, many activities do not count toward the 250 hours, including building and long-term redevelopment, finding properties to rent, and arranging financing. Qualifying activities include collecting rent, daily operation of property, negotiating leases, screening tenants, and maintenance and repairs.

Triple Net Leases

Triple net leases do not qualify for the safe harbor. For purposes of the rule, these include “a lease agreement that requires the tenant or lessee to pay taxes, fees, and insurance, and to be responsible for maintenance activities for a property in addition to rent and utilities.”

House Hacking

For those using house hacking to pursue financial independence, there are several considerations. If you house hack by renting spare bedrooms in your primary residence (tenants, Airbnb, etc.), then you do not qualify for the safe harbor with respect to the rent generated by your primary residence. However, if your house hack consists of renting out separate units in a single building, the rental income could qualify for the safe harbor if (i) those other units are separate residences and not your own residence for any part of the year and (ii) you otherwise satisfy the requirements of the safe harbor.

REIT Mutual Fund Dividends

Dividends from REITs and REIT mutual funds can qualify for the QBI deduction. Generally, box 5 of Form 1099-DIV will indicate those REIT dividends which qualify as Section 199A dividends.

Example

In 2018 Luke makes $50,000 from his W-2 job. He operates a sole proprietorship that generates a $4,000 taxable loss (which would have been QBI had it been net income). Luke also receives $3,000 of dividends from the Acme Real Estate Mutual Fund, which he holds in a taxable account. Acme’s Form 1099-DIV provided to Luke indicates in box 5 that $2,400 of the dividends are Section 199A dividends. Luke claims the standard deduction. In Luke’s case, his Section 199A deduction is the lesser of:

  • 20% of Taxable Income: 20% times ($50,000 less $4,000 plus $3,000 less $12,000 = $37,000) = $7,400; or,
  • 20% of REIT Dividends: 20% times $2,400 = $480

Thus, Luke’s Section 199A deduction is $480. He gets this deduction even though the dividend was paid by a mutual fund and even though he had a QBI loss. His QBI loss will carryover to 2019, and will reduce his 2019 QBI that potentially qualifies for the Section 199A deduction.

Lastly, note that if Luke held the Acme mutual fund shares in a retirement account (traditional and/or Roth IRA/401(k), etc.) or a health savings account, the REIT dividend would not have qualified for the Section 199A deduction.

Conclusion

Even as of January 2021, taxpayers and practitioners are learning new wrinkles in the Section 199A QBI deduction. For taxpayers with side hustles and small businesses, it can represent a significant income tax break. Some taxpayers will need professional help to determine how best to maximize the deduction.

Further Reading

I have written several blog posts addressing the Section 199A QBI deduction. Here are the links below:

Introductory Post

Section 199A and Retirement Plans

Read why the Section 199A QBI deduction may mean a Solo 401(k) is better than a SEP IRA

For the self-employed, the Section 199A QBI deduction may present an opportunity to do more efficient Roth IRA conversions.

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