Tag Archives: 403(b)

Retire on 72(t) Payments

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

This post is for you!

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

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

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

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

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

72(t) Substantially Equal Periodic Payments

Methods

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

The required minimum distribution method allows taxpayers to take a 72(t) payment just like an RMD. Take the prior year end-of-year balance and divide it by the factor off the IRS table. The biggest problems with this method are it tends to produce a smaller payment the younger you are and the payment changes every year and can decrease if the IRA portfolio declines in value. The fixed annuitization method is complex and generally yields a payment less than that of the fixed amortization method from the same sized retirement account. 

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

Resource: The MyFRS 72(t) calculator can be helpful to early retirees and those planning an early retirement. While I have not validated the calculator’s coding, I have never seen it produce results that I know to be incorrect. 

Computing Fixed Amortization 72(t) Payments

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

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

Interest Rate: Notice 2022-6 allows taxpayers to always use an interest rate anywhere from just above 0% to 5%, or, if greater, up to 120% of mid-term federal rate for either of the two months preceding the first 72(t) payment distribution. The IRS publishes that rate on a monthly basis.  

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

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

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

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

Validating a Google Sheets 72(t) IRA Calculation: One technique I recommend to validate a 72(t) IRA calculation in Google Sheets is to use the same formula in Google Sheets on the numbers provided by the IRS FAQ 7. I did that on YouTube here. Note that as applied to the IRS numbers, the final 72(t) size is $6.97 off – an immaterial difference caused by the IRS not using cents. 

Another technique to consider is, after doing one’s own calculations to redo the same calculations using the MyFlorida Retirement 72(t) Calculator. 

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

Annual Equal 72(t) Fixed Amortization Payments

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

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

72(t) Payments Case Study

Let’s return to the example discussed above: it is early January 2026 and you (let’s call you Pat) are 53 years old (your birthday was January 5th) and you want to retire, spending $80K a year from your $2.5M 401(k). Let’s solve for the size of the 72(t) IRA:

Interest Rate: 5.00% (the highest 120% of federal mid-term rate of the previous two months per the IRS is less than 5.00%)

Life Expectancy: 33.4

Payment: $80,000

The size of the 72(t) IRA is $1,286,384.59. See IRS FAQ Q&A 7.

Pat would first transfer (preferably through a direct trustee-to-trustee transfer) the 401(k) to a traditional IRA worth $2.5M. Once in the traditional IRA, Pat would call their financial institution and ask them to divide the traditional IRA into two IRAs: one with exactly $1,286,384.59 (the “72(t) IRA”) and one with the reminder of the traditional IRA (the “non-72(t) IRA”). I recommend initially investing the 72(t) IRA in a money market fund so that it can be clearly established that the beginning account balance was exactly the $1,286,384.59 computed to yield the correct payment. Pat takes the first payment of $80,000 on January 29th from the 72(t) IRA in this hypothetical scenario.

Let’s keep going. Assume that in 2030, when Pat turns age 57 and interest rates are well below 5%, Pat wants to increase their annual withdrawal from $80K to $90K. As discussed below, Pat can’t simply increase the withdrawal from the 72(t) IRA. But since Pat kept a non-72(t) IRA, Pat can slice that one up to create a second 72(t) IRA. That second 72(t) IRA can give Pat the extra $10,000 Pat wants to spend.

Here’s what that looks like.  

Interest Rate: 5.00% 

Life Expectancy: 30.6

Payment: $10,000

The size of the second 72(t) IRA is $153,270.74.

Pat would call their financial institution and ask them to divide the non-72(t) IRA into two IRAs: one with exactly $153,270.74 (the “Second 72(t) IRA”) and one with the remainder of the traditional IRA (the surviving non-72(t) IRA). Pat takes the additional payment of $10,000 also on January 28th from the Second 72(t) in this hypothetical scenario.

Here is what Pat’s withdrawals would look like:

YearBirthday AgeRequired First 72(t) January 29 WithdrawalRequired Second 72(t) January 28 WithdrawalTotal Annual Withdrawal
202653$80,000$0$80,000
202754$80,000$0$80,000
202855$80,000$0$80,000
202956$80,000$0$80,000
203057$80,000$10,000$90,000
203158$80,000$10,000$90,000
203259$80,000$10,000$90,000
203360$0$10,000$10,000
203461$0$10,000$10,000

Remember that the First 72(t) IRA and the Second 72(t) are locked up for a period of time. See Locking the Cage below. The First 72(t) IRA is locked up until and through July 4, 2032, the day before Pat’s 59 ½ birthday. The Second 72(t) IRA is locked up until and through January 27, 2035, the day before the fifth anniversary of the first $10,000 payment from the Second 72(t) IRA. See IRS FAQ 13 on this point. Generally speaking, no amount other than the annual payment should go into, or out of, a 72(t) IRA until the end of the lock-up period.

Maintain Flexibility

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

First, the non-72(t) can be, in a flexible manner, sliced and diced to create a second 72(t) IRA if wanted or needed. Second, for a variety of reasons Roth conversions are generally to be avoided out of a 72(t) IRA. While those on a 72(t) payment plan often have little need to do Roth conversions, if they are so inclined they are better done out of a non-72(t) IRA.  

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

72(t) Payment Plan Disqualification

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

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

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

72(t) Payment Reduction

Imagine that instead of wanting an additional 72(t) payment amount, Pat wanted to reduce the 72(t) payment. This is not uncommon. Perhaps Pat has a significant inheritance in 2030 and thus no longer needs to take an $80,000 annual payment and pay tax on it.

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

But, the rules allow a one-time switch to the RMD method. Making the switch is likely to significantly reduce the annual 72(t) payment. For example, if Pat wants a smaller payment starting in 2030, Pat could take the 72(t) IRA balance on December 31, 2029 (imagine it is exactly $1M) and divide it by the age 57 factor off the Single Life Table (29.8) and get a 2030 72(t) payment of $33,557.05. Alternatively, Pat could use the age 57 factor off the Notice 2022-6 Uniform Life Table (41.6) and get a 2030 72(t) payment of $24,038.46.

If Pat makes this one-time switch, Pat will annually compute the 72(t) payment for the remainder of the 72(t) term using the table used in 2030 (see Notice 2022-6 page 6) and the prior-year end-of-year 72(t) IRA balance.

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

72(t) Locking The Cage

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

Just how rigid is the IRS? In one case, the IRS disqualified a 72(t) SEPP because a taxpayer transferred a workplace retirement plan into the 72(t) IRA during the 72(t) payment period. See page 4 of this newsletter (page 4 is behind a paywall). Right, wrong, or other, Notice 2022-6 Section 3.02(e) has not been updated for SECURE 2.0’s adding Section 72(t)(4)(C), which clearly allows for some roll outs from 72(t) IRAs. Thus, this is an area where early retirees should proceed with caution. 

Assuming one is using the fixed amortization method for their 72(t) payments, not a dollar more than the 72(t) SEPP should come out each year. It appears the IRS expects the amount to be equal each tax year, see page 5 of this PLR. 

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

Practice Point: As of this writing, it is not a good idea to add money to a 72(t) IRA during the lockup period due to Notice 2022-6 Section 3.02(e). This includes never making an annual contribution to a 72(t) IRA and never rolling an IRA, 401(k), or other qualified plan into a 72(t) IRA. Incredibly enough, current IRS guidance prohibits breaking into jail in this regard. 

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

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

A Note on the 72(t) Risk Profile

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

Why?

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

Consider Pat’s example. If Pat blows up the First 72(t) payment plan in early 2031, Pat owes the 10% early withdrawal penalty and interest on five previously taken 72(t) payments from the First 72(t) IRA (2026 through 2030). If Pat blows up the Second 72(t) payment plan in early 2035, Pat only owes the early withdrawal penalty and interest on the three 72(t) payments received before Pat turned age 59 ½. 

In February 2026 I self-published a 38-page article on the risks presented by 72(t) payment plans. You can access the article here.

72(t) Payment Tax Return Reporting

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

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

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

Other Penalty Free Sources of Early Retirement Funding

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

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

Taxable Accounts: This video discusses why I’m so fond of spending down taxable accounts first in early retirement.

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

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

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

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

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

72(t) Landscape Change

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

Resources

Cody Garrett, CFP(R), and I wrote Tax Planning To and Through Early Retirement. The book goes into detail on early retirement withdrawal strategies. 

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

Sean Mullaney, What are the Risks of a 72(t) Payment Plan?, an article that goes into detail on the risks presented by a 72(t) payment plan and ways to mitigate those risks.

Correction

The previous version of this post published in November 2023 incorrectly used 30.6 as the age 57 factor in one of the calculations. The correct factor is 29.8. I regret the error. 

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

Follow me on LinkedIn: @SeanWMullaney

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.

2026 401(k) Catch-Up Contributions and the Quorum Clause

Starting in 2026, those with significant prior year W-2 incomes must make catch-up contributions to 401(k)s and other workplace retirement plans as Roth contributions. 

Mandatory Roth catch-up contributions deny many workers 50 and older a valuable tax deduction. 

The new rule originates with SECURE 2.0, a component of the Omnibus bill passed in December 2022.

The validity of the Omnibus bill has been questioned. In 2023, the Attorney General of the State of Texas sued the Department of Justice claiming that the House of Representatives did not have a sufficient quorum under the Quorum Clause to enact legislation when the Omnibus was passed. I share the Attorney General’s concern and have written to the government expressing that concern. 

Were the Omnibus were to be invalidated on Quorum Clause grounds, the rule requiring mandatory Roth catch-up contributions could not be sustained.

Judicial Results to Date

In the federal courts in Texas, four federal judges have weighed in. Two have opined that the Omnibus was passed in a Constitutionally qualified manner consistent with the Quorum Clause. Two have opined that the Omnibus was not passed in a Constitutionally qualified manner since the House did not have a sufficient quorum at the time of the Omnibus’s purported passage.

First, in February 2024 a federal district court judge determined that the Omnibus was not passed in a Constitutionally qualified manner. In August 2025, that opinion was overturned 2 to 1 by a three judge panel of the Fifth Circuit. 

SECURE 2.0 Lay of the Land in September 2025

Here is how I assess where we are in September 2025. 

First, it is likely that SECURE 2.0 will never be overturned. While I cannot say that definitively, I feel rather confident that it will survive, and I would plan around that outcome.

Let’s play out the future. As of this writing, I do not know if Ken Paxton, the Attorney General of the State of Texas, will appeal the August decision to an en banc panel of the Fifth Circuit and/or to the Supreme Court. But assuming it goes to the Supreme Court, just for analytical purposes, I suspect at least two of the institutionalist bloc of Justices Roberts, Kavanaugh, and Barrett would side with both the Biden and Trump Departments of Justice against overturning the Omnibus on Quorum Clause grounds.

From a planning perspective, it’s time for higher income W-2 workers to understand that they must make any 401(k) or other workplace retirement plan catch-up contributions as Roth contributions in 2026. The IRS confirmed this in recent guidance. 

The threshold to be considered high income for this purpose is likely to be slightly more than $145,000 of W-2 wages from that employer in 2025. I suspect that in October the IRS will come out with the exact threshold 2025 W-2 wage threshold amount applicable in 2026 (this is adjusted based on inflation). 

In late 2025, those subject to this potential restriction may want to prioritize W-2 income reduction planning opportunities such as making remaining 2025 401(k) contributions as traditional contributions to potentially fit under the 2026 threshold. 

Silver Lining: Required Minimum Distributions

There’s a silver lining to SECURE 2.0 likely surviving Quorum Clause concerns: delayed RMDs. For those born in 1960 or later, SECURE 2.0 delays the onset of required minimum distributions (“RMDs”) from age 72 to age 75. 

This delay requires all of us to step back from the inchoate fears about taxes in retirement and reassess RMDs and their impact.

Conclusion

While the final path of the Omnibus Quorum Clause litigation is not certain, it’s tilting heavily towards the Omnibus, and thus SECURE 2.0, surviving concerns about the House of Representatives’ use of proxies to establish a quorum in December 2022.

From a financial planning perspective, it is time to plan for higher income workers being required to make 401(k) catch-up contributions as Roth contributions. Further, it’s quite reasonable for those born in 1960 and later to plan on RMDs beginning at age 75.

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

Follow me on LinkedIn: @SeanWMullaney

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

The Odd 403(b) Rule for Side Hustlers

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

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

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

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

History of Section 415(k)(4)

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

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

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

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

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

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

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

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

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

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

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

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

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

Effect of Section 415(k)(4) Biting

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

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

Repeal List

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

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

Conclusion

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

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

Follow me on X: @SeanMoneyandTax

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.

Protecting the Constitution and Workers Saving for Retirement

Retirement planning rarely intersects with the Constitution.

SECURE 2.0, the component of the late December 2022 Omnibus bill with dozens of retirement account rule changes, does.

As discussed by Judge James W. Hendrix in his excellent opinion in Texas v. Garland, the House of Representatives used proxies to establish a quorum to pass the Omnibus, in violation of the Constitution’s Quorum Clause. 

The Constitutional issue with SECURE 2.0 is now ripe for the new Trump Administration. On its way out the door, the Biden Administration issued proposed regulations under Section 603 of SECURE 2.0 (mandatory Rothification of certain catch-up contributions) on January 13th. 

Typically, the government gets comments on proposed regulations and considers changes around the edges before finalizing the regulations. But SECURE 2.0 presents a unique case. 

I wrote a comment letter in response to the proposed regulations asking the government to withdraw the proposed regulations since the underlying statute was not passed in a Constitutionally qualified manner. You can read the comment letter here and here. 

Let me know what you think about the Constitutionality of SECURE 2.0 in the comments.

This post and the linked-to comment letter do 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. 

SECURE 2.0 and Section 72(t) Comment Letter

Recently, the IRS and Treasury issued Notice 2024-55. This notice provided initial rules for SECURE 2.0 emergency personal expense distributions (“EPEDs”), domestic abuse victim distributions, and repayments into retirement accounts. The Notice also asked for comments on the above and on Section 72(t) in general.

I wrote a comment letter (which you can read here) to the IRS and Treasury obliging that request. The letter addresses EPEDs, repayments into retirement accounts, and the impact of Texas v. Garland on SECURE 2.0. Further, the comment letter requests clarification that Solo 401(k)s of retired solopreneurs qualify for the Rule of 55 exception to the Section 72(t) ten percent early withdrawal penalty.

Follow me on X: @SeanMoneyandTax

This post (and the linked-to comment letter) is for entertainment and educational purposes only. They do not constitute accounting, financial, investment, legal, or tax advice for you or any other individual. 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.

Accessing Retirement Accounts Prior to Age 59 ½

One thing I like about the Financial Independence community is that members are not beholden to Conventional Wisdom.

Many in the Establishment believe retirement is for 65 year olds (and some basically think it’s not for anyone). 

My response: Oh, heck no! 

Sure, some people have jobs they very much enjoy. If that’s the case, then perhaps retirement isn’t your thing in your 50s. But many in the FI movement have accumulated assets such that they no longer have a financial need to work. Perhaps their job is not all that enjoyable – it happens. Or perhaps their job won’t exist in a year or two – that happens too.

The tax rules require some planning if one retires prior to turning age 59 ½. Age 59 ½ is the age at which the pesky 10 percent early withdrawal penalty no longer applies to tax-advantaged retirement account distributions.

Thus, there’s a need to consider what to live off of once one is age 59 ½. Below I list the possibilities in a general order of preference and availability. Several of these options (perhaps many of them) will simply not apply to many 50-something retirees. Further, some retirees may use a combination of the below discussed options. 

Listen to Sean discuss accessing money in retirement prior to age 59 ½ on a recent ChooseFI episode! Part Two on the ChooseFI podcast is coming soon. 

Taxable Accounts

The best retirement account to access if you retire before age 59 ½ isn’t even a “retirement” account: it’s a taxable account. I’m so fond of using taxable accounts first in retirement I wrote a post about the concept in 2022.

The idea is to use some combination of cash in taxable accounts (not at all taxable – it’s just going to the ATM!) and sales of brokerage assets (subject to low long term capital gains federal income tax rates) to fund your pre-59 ½ retirement. This keeps taxable income low and sets up potential additional tax planning. 

Pros: Because of tax basis, living off $100,000 of taxable brokerage accounts doesn’t cause $100,000 of taxable income. Further, long term capital gains receive very favorable federal income tax treatment. Some may even qualify for the 0% long term capital gains tax rate!

But that’s not all. There are significant creditor protection benefits to living off taxable assets first. As we spend down taxable assets, we are reducing those assets that are most vulnerable to potential creditors. By not spending down tax-advantaged retirement accounts, we are generally letting them grow, thus growing the part of our balance sheet that tends to enjoy significant creditor protection. Note that personal liability umbrella insurance is usually a good thing to consider in the creditor protection context regardless of tax strategy. 

Spending taxable assets first tends to limit taxable income, which can open the door to (1)  a significant Premium Tax Credit in retirement (if covered by an Affordable Care Act medical insurance plan) and (2) very tax advantageous Roth conversions in early retirement. 

There’s also a big benefit for those years after we turn 59 ½. By spending down taxable assets, we reduce future “uncontrolled income.” Taxable accounts are great. But they kick off interest, dividends, and capital gains income, even if we don’t spend them. By reducing taxable account balances, we reduce the future income that would otherwise show up on our tax return in an uncontrolled fashion. 

Cons: To my mind, there are few cons to this strategy in retirement. 

The one con in the accumulation phase is that when we choose to invest in taxable accounts instead of in traditional deductible retirement accounts we forego a significant tax arbitrage opportunity. That said, these are not mutually exclusive. Members of the FI community can max out deductible retirement account contributions and also build up taxable accounts.

Ideal For: Someone who is able to save beyond tax-advantaged retirement accounts during their working years. This is the “ideal” for financial independence in my opinion, though it may be challenging for some. 

Inherited Retirement Accounts

Withdrawals from inherited retirement accounts (other than those the spouse treats as their own) are never subject to the 10% early withdrawal penalty. Often they are subject to a 10-year drawdown rule, so usually they should be accessed prior to using many other draw down techniques.

Pros: If it’s a traditional retirement account inherited from a parent or anyone else more than 10 years older than you are, you generally have to take the money out within 10 years. Why not just live on that money? Simply living on that money, instead of letting the traditional inherited retirement grow for ten years, avoids a “Year 10 Time Bomb.” The time bomb possibility is that the inherited traditional retirement account grows to a huge balance that needs to come out in the tenth full year following death. Such a large distribution could subject the recipient subject to an abnormally high marginal federal income tax rate. 

Cons: Not very many other than if the account is a Roth IRA, using the money for living expenses instead of letting it grow for 10 years sacrifices several years of tax free growth. 

Ideal For: Someone who has inherited a retirement account prior to turning age 59 ½.

Rule of 55 Distributions

Rule of 55 distributions are only available from a qualified retirement plan such as a 401(k) from an employer the employee separates from service no sooner than the beginning of the year they turn age 55. 

This is a great way to avoid the early withdrawal penalty. But remember, the money must stay in the workplace retirement account (and not be rolled over to a traditional IRA) to get the benefit. 

Pros: Funds retirement prior to age 59 ½ without having to incur the 10 percent early withdrawal penalty. 

Whittles down traditional retirement accounts in a manner that can help reduce future required minimum distributions (“RMDs”).

Cons: You’re handcuffed to the particular employer’s 401(k) (investments, fees, etc.) prior to age 59 ½. Review the plan’s Summary Plan Description prior to relying on this path to ensure flexible, periodic distributions are easily done after separation from service and prior to turning age 59 ½. 

Limited availability as one must separate from service no sooner than the year they turn age 55. 

Creates taxable income (assuming a traditional account is used), which is less than optimal from a Premium Tax Credit and Roth conversion perspective.

Ideal For: Those with (1) large balances in their current employer 401(k) (or other plan), (2) a quality current 401(k) or other plan in terms of investment selection and fees, (3) a plan with easily implemented Rule of 55 distributions, and (4) plans to retire in their mid-to-late 50s.

Governmental 457(b) Plans

Withdrawals from governmental 457(b) plans are generally not subject to the 10% early withdrawal penalty. This is the Rule of 55 exception but they deleted the “55” 😉

Like the Rule of 55, this is only available so long as the governmental 457(b) is not rolled to a traditional IRA.

Pros: Funds retirement prior to age 59 ½ without having to incur the 10 percent early withdrawal penalty. If you have a governmental 457(b), it’s better than the Rule of 55 because you don’t have to worry about your separation from service date. 

Whittles down traditional retirement accounts in a manner that can help reduce future RMDs.

Cons: You’re handcuffed to the particular employer’s 457 (investments, fees, etc.) prior to age 59 ½. Review the plan’s Summary Plan Description prior to relying on this path to ensure flexible, periodic distributions are easily done after separation from service and prior to turning age 59 ½. 

Creates taxable income (assuming a traditional account is used), which is less than optimal from a Premium Tax Credit and Roth conversion perspective.

Ideal For: Those (1) with large balances in their current employer governmental 457(b) and (2) a quality current governmental 457(b) in terms of investment selection and fees.

Roth Basis

Old annual contributions and conversions that are at least 5 years old can be withdrawn from Roth IRAs tax and penalty free at any time for any reason. This can be part of the so-called Roth Conversion Ladder strategy, though it does not have to be, since many will have Roth Basis going into retirement. 

Pros: Roth Basis creates a tax free pool of money to access prior to turning age 59 ½. 

Cons: We like to let Roth accounts bake for years, if not decades, of tax free growth. Using Roth Basis in one’s 50s significantly reduces that opportunity. 

Some may need taxable income in early retirement to qualify for Premium Tax Credits. Relying solely on Roth Basis can be much less than optimal if Premium Tax Credits are a significant part of one’s early retirement plan. 

Roth 401(k) contributions, for many workers, are disadvantageous in my opinion. Many Americans will forego a significant tax rate arbitrage opportunity if they prioritize Roth 401(k) contributions over traditional 401(k) contributions. 

Creates income for purposes of the FAFSA. 

Ideal For: Those with significant previous contributions and conversions to Roth accounts. 

72(t) Payments

I did a lengthy post on this concept. The idea is to create an annual taxable distribution from a traditional IRA and avoid the 10 percent early withdrawal penalty.

Pros: Avoids the early withdrawal prior to turning age 59 ½. 

Whittles down traditional retirement accounts in a manner that can help reduce future RMDs.

Inside a traditional IRA, the investor controls the selection of financial institutions and investments and has great control on investment expenses. 

Cons: This opportunity may require professional assistance to a degree that many of the other concepts discussed do not.

There is a risk that if not done properly, previous years’ distributions may become subject to the 10 percent early withdrawal penalty and related interest charges. 

They are somewhat inflexible. That said, if properly done they can be either increased (by creating a second 72(t) payment plan) or decreased (via a one-time switch in method). 

Creates taxable income, which is less than optimal from a Premium Tax Credit and Roth conversion perspective.

Ideal For: Those with most of their financial wealth in traditional deferred retirement accounts prior to age 59 ½ and without easy access to other alternatives (such as the Rule of 55 and/or governmental 457(b) plans. 

HSA PUQME

Withdrawals of Previously Unreimbursed Qualified Medical Expenses (“PUQME”) from a health savings account are tax and penalty free at any time for any reason. Thanks to ChooseFI listener and correspondent Kristin Smith for suggesting the idea to use PUQME to help fund retirement in one’s 50s. 

Pros: Withdrawals of PUQME creates a tax free pool of money to access prior to turning age 59 ½. 

Does not create income for purposes of the FAFSA.

Reduces HSA balances in a way that can help to avoid the hidden HSA death tax in the future.

Cons: This is generally a limited opportunity. The amount of PUQME that can be used prior to age 59 ½ is limited to the smaller of one’s (1) PUQME and (2) HSA size. Because HSAs have relatively modest contribution limits, in many cases HSA PUQME withdrawals would need to be combined with one or more of the other planning concepts to fund retirement prior to age 59 ½.

We like to let HSAs bake for years, if not decades, of tax free growth. Using HSA PUQME in one’s 50s significantly reduces that opportunity. 

Some may need taxable income in early retirement to qualify for Premium Tax Credits. Relying on PUQME can be less than optimal if Premium Tax Credits are a significant part of one’s early retirement plan. 

Ideal For: Those with significant HSAs and significant PUQME. 

Net Unrealized Appreciation

Applies only to those with significantly appreciated employer stock in a 401(k), ESOP, or other workplace retirement plan. I’ve written about this opportunity before. That employer stock with the large capital gains can serve as a “Capital Gains IRA” in retirement. Retirees can possibly live off sales of employer stock subject to the 0% long term capital gains rate. 

This opportunity usually requires professional assistance, in my opinion. 

The move of the employer stock out of the retirement plan into a taxable brokerage account (which sets up what I colloquially refer to as the “Capital Gains IRA” may need to be paired with the Rule of 55 (or another penalty exception) to avoid the 10 percent early withdrawal penalty on the “basis” of the employer stock. 

Pros: Moves income from “ordinary” income to “long term capital gains” income, which can be very advantageous, particularly if one can keep their income entirely or mostly in the 0% long term capital gains marginal bracket. 

Cons: Remember Enron? NUA is essentially Enron if it goes fabulously well instead of failing spectacularly. 

Employer stock is problematic during the accumulation phase since your finances are heavily dependent on your employer without a single share of employer stock. People make their finances more risky by having both their income statement and their balance sheet highly dependent on a single corporation.

It keeps the retiree heavily invested in the stock of their former employer, which is much less than optimal from an investment diversification perspective.  

Another con is that this usually requires professional assistance (and fees) to a much greater degree than several of the other withdrawal options discussed on this post. 

Ideal For: Those with large balances of significantly appreciated employer stock in a workplace 401(k), ESOP, or other retirement plan. 

Pay the Penalty

The federal early withdrawal penalty is 10 percent. For those in California, add a 2.5 percent state penalty. For some, perhaps the best idea is to simply bite-the-bullet and pay the early withdrawal penalty. That said, anyone accessing a tax-advantaged retirement account in a way not covered above should always consult the IRS list to see if perhaps they qualify for one of the myriad penalty exceptions.  

Pros: Why let a 10 percent penalty prevent you from retiring at age 58 if you have sufficient assets to do so and you might be looking at a year or two of the penalty, tops? 

Whittles down traditional retirement accounts in a manner that can help reduce future RMDs.

Cons: Who wants to pay ordinary income tax and the early withdrawal penalty? Even for those close to the 59 ½ finish line, a 72(t) payment plan for five years might be a better option and would avoid the penalty if properly done. 

Ideal For: Those very close to age 59 ½ who don’t have a more readily available drawdown tactic to use. That said, even these retirees should consider a 72(t) payment plan, in my opinion. 

Combining Methods to Access Funds Prior to Age 59 1/2

For some, perhaps many, no single one of the above methods will be the optimal path. It may be that the optimal path will involve combining two or more of the above methods.

Here’s an example: Rob retires at age 56. He uses the Rule of 55 to fund most of his living expenses prior to turning age 59 ½. Late in the year, he finds that a distribution from his traditional 401(k) would push him up into the 22% federal income tax bracket for the year. Thus, for this last distribution he instead elects to take a recovery of Roth Basis from his Roth IRA. This allows him to stay in the 12% marginal federal income tax bracket for the year. 

Conclusion

Don’t let anyone tell you you can’t retire in your 50s. If you have reached financial independence, why not? Of course, you will need to be very intentional about drawing down your assets and funding your living expenses. This is particularly important prior to your 59 1/2th birthday.

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

Follow me on Twitter: @SeanMoneyandTax

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

Traditional Versus Roth 2023

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

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

Traditional and Roth Retirement Basics

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

Traditional

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

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

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

Roth

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

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

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

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

The Risk of Traditional Retirement Accounts is Vastly Overstated

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

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

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

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

The Needle Keeps Moving Towards Traditional

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

Then a few things happened.

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

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

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

Taxable Roth Conversions Going Away?

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

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

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

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

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

Special Years Favor Roths

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

Optimize for Known Trade-Offs

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

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

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

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

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

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

Roth Contributions End the Planning

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

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

Rothification Risks

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

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

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

Sufficiency

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

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

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

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

Conclusion

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

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

Follow me on Twitter at @SeanMoneyandTax

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

How I Learned to Stop Worrying About the Roth IRA 5 Year Rules

You know what gets too much attention in the personal finance space? The two five-year Roth IRA rules. 

Why do I say that? Because the odds are extremely low that either rule will ever impact most Roth IRA owners. While the rules theoretically have wide effect, in practice, discussed further below, they rarely impact the taxation of Roth IRA distributions.

Before I get started, below is a summary table of the two five-year rules (or five-year clocks, use whichever terminology you prefer). The table is not comprehensive, but rather intended to cover the vast majority of situations. I hope you find this table to be a useful reference regarding the two five-year rules. 

RuleTax BiteAgeCode SectionRegulation
First Five-Year RuleOrdinary income tax on withdrawal of earnings from Roth IRA onlyGenerally bites only if owner is over 59 ½ years old408A(d)(2)(B)1.408A-6 Q&A 2
Second Five-Year Rule10% early withdrawal penalty on withdrawal of taxable converted amounts from Roth IRA onlyOnly bites if owner is under age 59 ½ 408A(d)(3)(F)1.408A-6 Q&A 5(b)

First Five-Year Rule: Earnings Cannot Be Withdrawn Income Tax Free From a Roth IRA Unless the Account Holder has Owned a Roth IRA for Five Full Tax Years

At first, this rule seems daunting. As written, it applies to anyone owning a Roth IRA. But in practice, it rarely has any bite. First, the rule only serves to disqualify a distribution from being a “qualified distribution.” 

Here’s the thing: outside of rare circumstances (see “Two Uncommon Situations” below), anyone under age 59 ½ cannot receive a “qualified distribution” from their own Roth IRA regardless of the first five-year rule.

Thus, as a general matter, the first five-year rule is a rule that only applies to those age 59 ½ and older. 

For those doubting me, I’ll prove it with two examples:

Example 1: Ernestine turns age 25 in the year 2023. In March, she made a $6,500 annual contribution to a Roth IRA for the year 2023. This is her only ever Roth IRA contribution. In 2026, when the Roth IRA is worth $8,000 and Ernestine turns age 28, Ernestine withdraws all $8,000 from the Roth IRA. The first $6,500 is a nontaxable return of the $6,500 contribution, and the remaining $1,500 is a taxable distribution of earnings subject to both ordinary income tax and the 10 percent early withdrawal penalty. 

Example 2: Hortense turns age 25 in the year 2023. In March, she made a $6,500 annual contribution to a Roth IRA for the year 2023. This is her only ever Roth IRA contribution. In 2030, when the Roth IRA is worth $8,000 and Hortense turns age 32, Hortense withdraws all $8,000 from the Roth IRA. The first $6,500 is a nontaxable return of the $6,500 contribution, and the remaining $1,500 is a taxable distribution of earnings subject to both ordinary income tax and the 10 percent early withdrawal penalty. 

Ernestine did not satisfy the first five-year rule, Hortense did. Notice that it did not matter! Both must pay ordinary income tax and the 10% early withdrawal penalty on the $1,500 of earnings they each received from their Roth IRA. The first five-year rule had absolutely no impact on the taxation of the withdrawal because both Roth IRA owners are under age 59 ½. This proves that outside unusual circumstances, the first five-year rule has no impact on those under age 59 ½.

I’ve said it before and I’ll say it again: Previous annual contributions to a Roth IRA can be withdrawn from a Roth IRA tax and penalty free at any time for any reason! The first five-year rule has nothing to do with withdrawals of previously made contributions. See Treas. Reg. Sec. 1.408A-6 Q&A 1(b) (previous contributions are withdrawn tax free) and Q&A 5(a) (tax free withdrawals of previous regular annual contributions are not subject to the 10% early withdrawal penalty).

So when the heck does the first five-year rule matter? Here are two examples to help us figure it out.

Example 3: Ernie turns age 58 in the year 2023. In March, he made a $7,500 annual contribution to a Roth IRA for the year 2023. This is his only ever Roth IRA contribution. In 2026, when the Roth IRA is worth $10,000 and Ernie turns age 61, Ernie withdraws all $10,000 from the Roth IRA. The first $7,500 is a nontaxable return of the $7,500 contribution, and the remaining $2,500 is a taxable distribution of earnings subject to ordinary income tax. Ernie does not pay the 10 percent early withdrawal penalty because he is over age 59 ½ when he receives the earnings. 

Example 4: Harry turns age 58 in the year 2023. In March, he made a $7,500 annual contribution to a Roth IRA for the year 2023. This is his only ever Roth IRA contribution. In 2030, when the Roth IRA is worth $10,000 and Harry turns age 65, Harry withdraws all $10,000 from the Roth IRA. As Harry satisfies both the first five-year rule and is over age 59 ½, the entire $10,000 distribution is a qualified distribution and thus entirely tax and penalty free.

We’ve found where the first five-year rule matters! Generally speaking, the first-five year rule only bites when applied to a distribution of earnings if the recipient is over the age of 59 ½. Further, it only applies to subject the earnings to ordinary income tax, not the 10% early withdrawal penalty (as being age 59 ½ or older is always a valid exception to the early withdrawal penalty). 

Remember, though, in most cases it is difficult to access Roth IRA earnings. Why? Because earnings come out of a Roth IRA last. Ernie’s fact pattern is rare. Many Roth IRA owners will have years of contributions and/or conversions inside their Roth IRA. As I have previously discussed, nonqualified distributions from Roth IRAs first access Roth IRA contributions and then access Roth IRA conversions before they can access a penny of earnings. See also Treas. Reg. Sec. 1.408A-6 Q&A 8 and Natalie B. Choate’s Life and Death Benefits for Retirement Planning (8th Ed. 2019), page 328. 

Further, in today’s world, most (though not all) 59 ½ year old Roth IRA owners will satisfy the five-year rule. All Roth IRAs are aggregated for this purpose, so the funding (through a contribution or conversion) of any Roth IRA starts the five-year clock as of January 1st of the year for which the contribution was made. See Treas. Reg. Sec. 1.408A-6 Q&A 2. 

Two Uncommon Situations: There are two uncommon situations in which a Roth IRA owner under age 59 ½ receiving a Roth IRA distribution could save the ordinary income tax by satisfying the first five-year rule. The first is the taking of an up-to $10,000 first-time home buyer distribution. See Choate, previously referenced, at page 612. The second is if the owner is disabled as defined by Section 72(m)(7). Both are rare situations. Further, in both such cases, satisfying the first five-year rule would be irrelevant if the distribution would have been a return of contributions, nontaxable conversions, and/or taxable conversions at least 5 years old. 

Inherited Roth IRA Twist: The first five-year rule can affect distributions from an inherited Roth IRA. I’ve heard this referred to as the third Roth IRA five-year rule, but I view it as simply a continuation of the first five-year rule. A withdrawal of earnings by a beneficiary from an inherited Roth IRA made less than five tax years after the owner originally funded the Roth IRA is subject to ordinary income tax. See Treas. Reg. Sec. 1.408A-6 Q&A 7.  These situations are quite rare. 

If Anyone on Capitol Hill is Reading This . . .

The first five-year rule serves no compelling purpose, and is superfluous as applied to most taxpayers under the age of 59 ½.

Perhaps in 1997 Congress worried about quick withdrawals from Roth IRAs. Now that we fully understand that contributions and conversions come out of Roth IRAs first, and that being under age 59 ½ prevents a tax-free distribution of earnings in most cases, there’s no reason for the first five-year rule. Being age 59 ½ or older (or death, disability, or first-time home buyer) should be sufficient to receive a qualified distribution. 

I recommend that Congress repeal the first five-year rule by removing Section 408A(d)(2)(B) from the Internal Revenue Code as part of retirement tax simplification.

Second Five-Year Rule: Taxable Conversions Are Subject to the Ten Percent Early Withdrawal Penalty if Withdrawn from the Roth IRA Within Five Taxable Years

This rule is much more logical than the first five-year rule. The reason has nothing to do with Roth IRAs. Rather, the reason is to protect the 10% early withdrawal penalty as applied to traditional IRAs and traditional workplace plans such as 401(k)s and 403(b)s. Without the second five-year rule, taxpayers would never pay the 10% early withdrawal penalty. 

Rather, taxpayers under age 59 1/2 would simply convert any money they want to withdraw from a traditional retirement account to a Roth IRA, and then shortly thereafter withdraw the amount from the Roth IRA tax-free as a return of old contributions or of the conversion itself. 

The second five-year rule prevents the total evisceration of the 10% early withdrawal penalty. 

The second five-year rule applies separately to each taxable Roth conversion. Each Roth conversion that occurs during a year is deemed to occur January 1st of that year for purposes of the second five-year rule. See Treas. Reg. Sec. 1.408A-6 Q&A 5(c).

Note further that the second five-year rule has nothing to do with income tax: its bite only triggers the distribution being subject to the 10% early withdrawal penalty. 

When Might the Second Roth IRA Five-Year Rule Apply

I am not too worried about the application of the second five-year rule. Here’s why.

First, the second five-year rule is not likely to apply while one is working. During the accumulation phase, many are looking to contribute to, not withdraw from, Roth IRAs.

Second, for those retiring after age 59 ½, the second five-year rule will have practically no impact, as (i) they are not likely to take pre-retirement distributions from their Roth IRA, and (ii) distributions taken from the Roth IRA by the owner after turning age 59 ½ are never subject to the 10% early withdrawal penalty. 

Third, many early retirees will choose to live off taxable assets first in early retirement. As a result, many will not access Roth accounts until age 59 ½ or later, and thus the second five-year rule will not be relevant. 

However, some will choose to employ a Roth Conversion Ladder strategy with respect to an early retirement. Here the second five-year rule might bite. Let’s consider a quick example:

Example 5: Josh is considering retiring in 2024 when he turns age 50. In his 30s, he qualified to make an annual Roth IRA contribution and maxed out his Roth IRA each year. In his 40s, he made income in excess of the annual MAGI limits on Roth IRA contributions, so he maxed out the Backdoor Roth IRA for each year. He plans on living on taxable assets for the first five years of retirement and then living off Roth conversion ladders from age 55 through age 59 ½. Josh has never previously taken a distribution from a Roth IRA.

Here is Josh’s Roth IRA history in table form. Thanks to Investopedia for the historic annual contribution maximums. 

YearAgeRoth IRA ContributionBackdoor Roth IRATaxable Amount
200430$3,000
200531$4,000
200632$4,000
200733$4,000
200834$5,000
200935$5,000
201036$5,000
201137$5,000
201238$5,000
201339$5,500
201440$5,502$2
201541$5,503$3
201642$5,501$1
201743$5,502$2
201844$5,501$1
201945$6,001$1
202046$6,002$2
202147$6,002$2
202248$6,001$1
202349$6,004$4

If Josh started withdrawing from his Roth IRA in 2024, he would first withdraw all $45,500 of previous annual contributions (all tax and penalty free) and then withdraw all $33,510 of his 2014 through 2019 Backdoor Roth IRAs (all tax and penalty free) before he could take a distribution with respect to which the second five-year rule could bite. 

Note that for withdrawals of up to $79,010, it is irrelevant that Josh does not satisfy the second five-year rule with respect to the 2020 through 2023 Backdoor Roth IRAs. Josh can withdraw up to $79,010 entirely tax and penalty free in 2024. Perhaps the second five-year rule’s bark is worse than its bite . . .

If, in 2024, Josh withdraws both of the above listed amounts from his Roth IRA, then yes, the next $2 of withdrawals in 2024 would be from the $2 taxable amount of his 2020 Backdoor Roth IRA, which would be subject to the 10% early withdrawal penalty ($0.20) under the second five-year rule. 

In Josh’s extreme example, the second five-year rule bites, but, as you can see, it barely bites!

As an aside, assuming Josh continues to withdraw money from his Roth IRA in 2024, the next $6,000 is a tax and penalty free return of the non-taxable portion of his 2020 Backdoor Roth IRA! See Treas. Reg. Sec. 1.408A-6 Q&A 8. The generosity of the Roth IRA nonqualified distribution rules is, by itself, a reason not to sweat the two Roth IRA five-year clocks too much. 

Assuming Josh follows through with his plan and waits until age 55 (the year 2029) to start withdrawing from his Roth IRA, he can access all of his 30s Roth IRA annual contributions ($45,500), all of his 40s Backdoor Roth IRAs ($57,519), and whatever amount he converted to his Roth IRA in 2024 tax and penalty free in 2029! After that, however, the second five-year rule will bite ten cents on the dollar for amounts additionally distributed in 2029, since amounts converted in 2025 or later would still be subject to the second five-year rule if distributed in 2029. 

In Josh’s early retirement example, assuming Josh takes no distributions from his Roth IRA until age 55, the second five-year rule can only possibly bite from age 55 to 59 ½, and even then, the combination of years of built up Roth basis and affirmative planning make that possibility at least somewhat remote. 

Don’t over think it: If the owner of a Roth IRA is 59 1/2 years old or older, and has owned a Roth IRA for at least 5 years, all distributions they receive from a Roth IRA are qualified distributions and thus fully tax and penalty free. In such circumstances, the 5-year clocks are entirely irrelevant.

Conclusion

It’s perfectly cromulent to proceed with financial planning without too much worry about the two Roth IRA five-year rules. For personal finance nerds (myself included), the two Roth IRA five-year clocks can be fun to dive into. But from a practical standpoint, they rarely impact the taxation of distributions from Roth IRAs. The two five-year clocks are best understood as sporadically applicable exceptions to the general rule that most nonqualified distributions from Roth IRAs are tax and penalty free.

Further Reading

For even more on Roth IRA distributions, please read this post, which goes through the details of Roth IRA distributions, including citations to the relevant regulations and links to three example Forms 8606 Part III.

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

Follow me on Twitter at @SeanMoneyandTax

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

Emergency Access to Retirement Accounts

The newly passed SECURE Act 2.0 has put a renewed focus on the use of retirement funds to cover pre-retirement emergencies. This post discusses the options available with respect to using tax-advantaged retirement accounts to fund emergency expenses.

To my mind, there are five primary ways to use retirement funds to pay for emergencies. Considering the complexities of our tax system, I don’t claim this covers every possible situation, but it does highlight the most readily available ways of using retirement funds for pre-retirement emergencies. For purposes of this post, a “pre-retirement emergency” is an emergency that occurs prior to turning age 59 ½. 

ONE: Direct Distribution from a Non-Roth IRA Retirement Account

In theory, one can pay for emergencies from their non-Roth IRA retirement accounts. To my mind, this tends to be the worst way to use a retirement account to pay for a pre-retirement emergency. At least initially, the withdrawal will be subject to both the income tax and the 10 percent early withdrawal penalty. California residents can add an additional 2.5 percent early withdrawal penalty. 

There are exceptions to the penalty, and the IRS maintains a website detailing them. 

One practical consideration: 401(k)s and other qualified workplace retirement plans tend to limit or restrict in-service withdrawals, so the money may not be readily available if needed in an emergency. Traditional IRAs tend to be rather readily available, so long as the money is invested in relatively liquid assets and/or easily sold financial assets. 

From traditional retirement accounts, the withdrawal is taxable and then the question becomes does one of the penalty exceptions apply. However, there is a way to avoid taxation and the penalty: putting the money back into a retirement account within 60 days. First off, one facing an emergency may not have the liquidity to return the money in 60 days even if they want to. Second, 60 day rollovers between IRA accounts are limited to once every 12 months. As a general rule, I recommend avoiding 60 day rollovers to keep that option open if money ever came out of an IRA for whatever reason. 

If liquidity is not an issue within the 60 day rollover period, one way to avoid the once-per-year rule on a distribution from a traditional IRA is to rollover to a Roth IRA (essentially, a Roth conversion). This might make sense when one takes an emergency withdrawal from a traditional IRA within 12 months of a previous 60 day IRA-to-IRA rollover. In such a case, if the person cannot roll the money into a workplace retirement plan, the only options are (i) keep the money and pay income tax and likely the 10 percent penalty or (ii) convert over to a Roth IRA, get tax free growth in the future, and only pay the income tax. Roth conversions always avoid the 10 percent early withdrawal penalty. 

3 Year Pay Back

SECURE 2.0 has changed the landscape in terms of refunding pre-retirement emergency withdrawals. In some limited situations, there may be a 3 year pay back window, not a 60 day pay back window.

There are now, by my count, six provisions allowing taxpayers to pay back money distributed out of a retirement account within 3 years of the withdrawal. Please note that I and others are still digesting SECURE 2.0, so the below is intended only as an initial, introductory primer. 

Qualification for the 3 year pay back is good because it generally means (i) no 10 percent penalty on the initial withdrawal and (ii) the money can be refunded to the retirement account within 3 years, resulting in (a) a refund of the income tax paid on the distribution and (ii) keeping the money growing tax-deferred (or tax-free for Roths) for retirement. 

Please note that each of these is quite narrow. Despite the limited availability, in cases where a taxpayer has taken out a significant amount of money from a retirement account in an emergency, these rules should be reviewed to see if the taxpayer could qualify to avoid the 10 percent penalty and later get the money back into the retirement account and obtain a significant tax refund. 

Jamie Hopkins detailed some of the new SECURE 2.0 provisions in a recent Forbes article. I’ve prepared the below chart to lay out the basics (as I understand them now) of the new 3 year pay back rules. 

ProvisionEffective DateSourceLimitsQualification
Minor Emergency Withdrawals2024SECURE 2.0 Sec. 115$1,000 per year, 1 distribution per yearExpenses incurred for an emergency
Domestic Abuse Victims2024SECURE 2.0 Sec. 314Lesser of $10K or 50% of account balance per yearMust be a victim of domestic abuse within the year preceding the distribution
Federally Declared Disaster AreaJanuary 26, 2021SECURE 2.0 Sec. 331$22,000 limit per disasterMust live in a federally declared disaster area and suffered an economic loss due to the disaster
Terminally Ill IndividualEnactment of SECURE 2.0SECURE 2.0 Sec. 326UnlimitedMust be terminally ill (generally, medicially expected to die within 7 years).
Qualified Birth or Adoption Distribution2020SECURE Sec. 113$5,000 per parent per birthDistribution must be within 1 year after birth or adoption of child
Coronavirus Related Distributions can no longer be made, but previously made CRDs can be paid back within 3 years of the distribution.

As all of the 3 year pay back provisions are new (several less than a month old as of this writing!), practitioners (myself included) are still learning about them. That learning will change when the IRS and Treasury issue regulations and/or other guidance on these new rules. 

Future 3 Year Pay Back Regulations

I hope the regulations contain a waiver of excess contribution penalties when taxpayers pay back money into a retirement account and the IRS subsequently determines that the taxpayer did not qualify for 3 year pay back treatment. These provisions are complex and subjective, and it is not fair to assess an excess contribution penalty when a taxpayer’s interpretation of a complex and/or subjective provision is not the same as the IRS’s interpretation. 

Further, any regulations should clarify that individual taxpayers over age 59 ½ qualify for the 3 year pay back provisions, even though they are exempt from the 72(t) penalty regardless of the application of a 3 year pay back provision.

Prior to the issuance of regulations or other guidance from the IRS and Treasury, taxpayers should proceed with caution and consult their tax advisors when applying the 3 year pay back provisions. 

TWO: Plan Loans

Not available from IRAs and Roth IRAs, some employer plans allow for loans from the plan. If you read my book, you know I am generally not fond of 401(k) loans.

That said, in an emergency, if the plan allows it, a loan can be a tax-free way to access retirement account funds and later replenish them. Loans are generally limited to the lesser of half the account balance or $50,000 and require the payment of interest to the 401(k). One advantage of plan loans is that they can be spent on anything without restrictions. 

I do not like relying on plan loans for several reasons. First, 401(k)s plans do not have to offer loans. Second, if the employee leaves the employer, the loan becomes due, and failure to repay it results in the entire outstanding balance becoming taxable income and is likely subject to the 10 percent early withdrawal penalty. Ouch! Third, the interest paid to the 401(k) is double taxed, as there’s generally no tax deduction for the payment of interest to the 401(k), and later in life the interest will be taxed to the 401(k) account owner when withdrawn or Roth converted. 

THREE: SECURE 2.0 Minor Emergency Withdrawals

As mentioned in the chart above, Section 115 of SECURE 2.0 allows, beginning in 2024, one annual up-to $1,000 penalty free distribution from retirement accounts for an emergency. I refer to these as minor emergency withdrawals.

The distribution will be taxable if from a traditional retirement account. Further, the $1,000 withdrawn can be refunded into the retirement account up to 3 years from the original distribution. Refunding the distribution will allow the taxpayer to amend any tax return reporting the distribution as taxable income and obtain a refund. 

As a practical matter, I suspect that most minor emergency withdrawals will come from traditional IRAs and Roth IRAs, as accessing money from them tends to be far easier than accessing money from workplace retirement accounts such as 401(k)s while someone is still working at the employer.

I previously Tweeted about this provision. Obviously, this provision is very limited as it is capped at one distribution per year and $1,000 per distribution. Here’s hoping everyone only faces emergencies costing $1,000 or less!

In theory, there’s a risk when taking a minor emergency withdrawal. What if the IRS disagrees with your view that you had an emergency? The IRS could (i) assess the 10 percent penalty on the distribution, (ii) deny any claimed tax refunds for repayments of the minor emergency withdrawal, and/or (iii) assess a 6 percent (per year) excess contribution penalty for repayments of the withdrawal back into the retirement account. 

The IRS and Treasury will have to issue regulations defining emergency for this purpose. My hope is that they will define emergency quite broadly, which it appears Congress intended based on the wording of Section 115. Hopefully, the IRS and Treasury decide they want to limit fights with taxpayers over $1,000 distributions. The regulations should take the approach that anything that could plausibly be viewed as an emergency will count as an emergency for this purpose. Further, it would be very useful if the regulations contained safe-harbors and waive excess contribution penalties in cases where taxpayers wrongly believed they qualified as having an emergency. 

FOUR: SECURE 2.0 401(k) Emergency Savings Accounts

Section 127 of SECURE 2.0 establishes a relatively limited emergency savings account as part of a 401(k) or other workplace retirement plan. It is the employer’s option to add this to their retirement plan, and this cannot be added until 2024 (see page 2199 of the Omnibus Bill text). These are not available from traditional IRAs and Roth IRAs. 

For the reasons discussed below, I suspect very few plans will add this feature, and very few employees will want to use this account.

The account must be a Roth 401(k) (or other Roth employer account) and generally can only invest in cash and cash-type assets in order to preserve purchasing power. Employees’ unwithdrawn contributions cannot exceed $2,500, and highly compensated employees (those employees who made more than $150,000 in wages in the previous year) cannot contribute to the account. 

From the employee’s perspective, these accounts are generally undesirable. The tax shelter is minimal: Roth treatment on cash accounts of no more than $2,500 of contributions. Sure, withdrawals are fully tax-free, but all that’s been saved is the tax on the interest income. In theory, one would want to contribute to one of these accounts to have more contributions that can get employer matches into their 401(k), but many participants have both the smarts and the liquidity to capture the entire employer match without contributing to this account. 

More importantly, in an emergency situation, (i) $2,500 only goes so far and (ii) you probably do not want the hassle of dealing with your workplace 401(k) plan administrator. “In-service withdrawals” from 401(k)s are notoriously cumbersome. From a user-experience perspective, I strongly suspect emergency access to cash in a checking account or online savings account the owner controls will usually be much better than using money inside an employer’s 401(k) plan. 

One advantage of these accounts is that there is no “emergency” requirement for withdrawals. The employee can withdraw the money for any reason. Another advantage is that, in theory, this creates head room for getting $2,500 more (plus interest) into Roth accounts. If not used, the balance can be rolled into the regular Roth 401(k) when the employee leaves employment. See page 2130 of the Omnibus bill text.  

As undesirable as these accounts are for employees, they are much more so from the employer perspective. Why would a retirement plan administrator want to sign up to field calls from employees for emergency distributions? If I’m a plan administrator and I want my employees to have flexibility and resources in an emergency, I don’t amend my plan document and encourage them to come to my plan when easier to use alternatives already exist (checking accounts and savings accounts). Employers adopting these accounts are signing up to become emergency distributors, which fundamentally is not what a retirement plan is. Further, the amounts involved (maximum contributions of just $2,500) and the fact that many employees, including decision makers, generally can’t be covered because of the prohibition on offering emergency accounts to highly compensated employees discourage employer plans from incurring the hassle and administrative costs to add these accounts. 

Note that the emergency account feature is not available for Solo 401(k)s, because anyone owning more than 5% of a business is, by definition, a highly compensated employee, regardless of their earnings. 

FIVE: Roth IRA Basis

If one wants to access retirement accounts in an emergency, my favored technique of the five discussed in this post is to use Roth IRA basis. Generally speaking, Roth IRA basis is the sum of previous annual contributions plus all previous Roth conversions, less any previous Roth IRA withdrawals. 

Recall that previous annual contributions to Roth IRAs and Roth conversions that are at least 5 years old can be accessed at any time for any reason tax and penalty free. Further, withdrawals from Roth IRAs occurring prior to turning age 59 ½ access prior contributions first (until exhausted), then old conversions (first in, first out, and until exhausted), and last access Roth earnings.

As a result of this pecking order, most non qualified Roth IRA withdrawals will simply be nontaxable returns of old contributions. This makes the Roth IRA the best retirement account to use in the event of an emergency. Taking advantage of Roth basis results in no tax and no penalty, and simply requires the filing of a Part III of the Form 8606 when filing one’s tax return. 

The downside of accessing Roth IRA basis is that outside of a 60 day rollover, a $1,000 refund of a minor emergency withdrawal, and/or a possible 3 year pay back, tapping Roth basis reduces the amount inside the Roth IRA growing tax free for the taxpayer’s retirement. Further, do not forget the once-every-12 months limit on IRA to IRA 60 day rollovers (including Roth IRAs) and the fact that Roth IRAs cannot be transferred to workplace retirement Roth accounts. 

Roth IRA Basis and the Minor Emergency Withdrawal Rule

Starting in 2024, perhaps the best approach for those taxpayers experiencing emergencies is to combine using Roth IRA basis with the minor emergency withdrawal rule.  Taxpayers making emergency withdrawals from a Roth IRA should consider refunding up to $1,000 to the Roth IRA within 3 years. From a risk perspective, this tactic is relatively low risk. Withdrawals of Roth IRA basis are tax and penalty free. The only tax risk is the 6% excess contribution penalty on putting the money back into the Roth IRA. For a non-qualifying $1,000 refund back into the Roth IRA, that penalty is only $60 annually. One would hope the IRS will not be overly strict in assessing taxpayers’ contentions that the withdrawals were in fact for an emergency. 

Roth IRA Basis and Other 3 Year Pay Back Rules

In limited circumstances, one or more of the 3 year pay back rules may be available to get the money back into the Roth IRA. This keeps the money available for retirement in a tax-free account. One advantage of combining a withdrawal of Roth IRA basis with a 3 year pay back is that the IRS should not require the filing of an amended return, since no items of income, deduction, or tax should change. In theory, the IRS could require the filing of an amended Form 8606, since that form can be filed as a standalone tax return. In regulations or other guidance, the IRS and Treasury should make clear their position on what amended tax return filings are needed, if any. 

Taxable Accounts

Here’s the thing. One should not look to use retirement accounts for emergency expenses. I understand that sometimes it is necessary to do so. But generally speaking, if one has adequate financial resources, they should set up a savings account to have funds available to handle emergencies. One tax benefit of doing so is that in today’s low-yield environment, a savings account can protect against emergencies without generating much in the way of taxable income. 

Conclusion

The hope is tax-advantaged savings never need to be accessed in an emergency. Of course, life does not always go to hope or to plan, so there are times when retirement accounts are accessed in an emergency. Taxpayers and practitioners should research options when taking pre-retirement emergency withdrawals from tax-advantaged retirement accounts. The IRS and Treasury will (hopefully soon) issue regulations and/or other guidance on the many new SECURE 2.0 emergency withdrawal rules and pay back rules. 

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.

SECURE 2.0 and the FI Community

Congress just passed a very long retirement tax bill, colloquially referred to as SECURE 2.0 or the SECURE Act 2.0. The FI community is interested in anything affecting tax-advantaged retirement accounts. This post dives in on the impact of SECURE 2.0 on the FI community. 

SECURE 2.0 Big Picture

SECURE 2.0 tinkers. It contains dozens of new rules. It’s easy to get lost in the weeds of the new rules, but I don’t recommend it. Many new rules have very little impact on financial planning for those in the FI community.

Here’s one example: SECURE 2.0 eliminates (effective 2024) required minimum distributions (“RMDs”) from Roth 401(k)s during the owner’s lifetime. Since Roth IRAs never had RMDs during the owner’s lifetime, and Roth 401(k)s are easily transferable to Roth IRAs at or after retirement, this is a rule change without much practical impact for most from a planning perspective.

However, there are two main takeaways those in the FI community should focus on when it comes to SECURE 2.0. First, SECURE 2.0 makes traditional, deductible retirement account contributions even more attractive. Second, SECURE 2.0 sets what I refer to as the Rothification Trap. Don’t fall into the Rothification Trap!

Traditional Retirement Account Contributions Are Even More Attractive

In the classic traditional versus Roth debate, SECURE 2.0 moves the needle towards traditional deductible retirement account contributions. Why?

SECURE 2.0 delays the required beginning date for RMDs! Starting in 2023, RMDs must begin at age 73, buying those born from 1951 through 1959 one more year to do tax-efficient Roth conversions prior to being required to take RMDs. But for most of the readers of this blog, the news is much better. Those born in 1960 or later now must take RMDs starting at age 75.

This is a big win for the FI community! Why? Many in the FI community will have artificially low taxable income in retirement prior to having to take RMDs at age 75. That increases the window for Roth conversions while a retiree otherwise has low taxable income. 

Delaying RMDs makes traditional FI tax planning even more attractive, particularly for those born after 1959. Retirees will have through the year of their 74th birthday to make Roth conversions to (i) get tax rate arbitrage on traditional retirement accounts and (ii) lower RMDs when they are ultimately required.

The planning runway to do Roth conversions prior to taking RMDs just got three years longer. This gives both early retirees and conventional retirees that much more of an opportunity to do Roth conversions at low income tax rates prior to being required to take RMDs. There are three additional years of progressive tax brackets to absorb efficient Roth conversions and reduce future RMDs. 

Rothification Trap

Be aware of the Rothification Trap!

SECURE 2.0 promotes even more in the way of Roth contributions. It allows employees to elect to have their employer 401(k) and other workplace plan contributions be Roth contributions, effective immediately. See Section 604 of SECURE 2.0. Plans will have to affirmatively add this feature (if they so choose), so it won’t be immediately effective in most cases. I predict that at least some plans will offer this option. I suspect some plans will not offer this option, since Roth employer contributions must be immediately vested. Some employers will be hesitant to eliminate vesting requirements for employer contributions, though it must be remembered that some employers immediately vest all employer contributions.

In addition, effective starting in 2023, SEP IRAs and SIMPLE IRAs can be Roth SEP IRAs and Roth SIMPLE IRAs. See Section 601 of SECURE 2.0. 

Here’s the thing: for those planning an early retirement, Rothification is a trap! The name of the game for those thinking about early retirement is to max out deductions while working and later do Roth conversions in early retirement. This maximizes deductions while one is subject to their highest marginal tax rate (their working years) and moves income to one’s lower taxable income years (the early retirement years). The combination of these opportunities creates tax rate arbitrage. 

I’m worried some in the FI community will say “I really love Roth, so I’ll make all my contributions–IRA, employee 401(k), and employer 401(k))–Roth now!” I believe that path is likely to be a mistake for many in the FI community, for two reasons. First, this foregoes the great tax planning opportunity presented by deducting retirement contributions at one’s highest lifetime marginal tax rates while working and then converting to Roths at low early retirement tax rates. 

Second, it sets one up to have difficulty qualifying for Affordable Care Act Premium Tax Credits. In order to qualify for Premium Tax Credits, which could be worth thousands of dollars in early retirement, one must have income above their state’s applicable Medicaid threshold. For example, in 2023 a family of four in California with a modified adjusted gross income (“MAGI”) of less than $39,750 would qualify for MediCal (California’s Medicaid) and thus get $0 Premium Tax Credits if they choose to use an Affordable Care Act insurance plan. Most early retirees will want to be on an ACA plan instead of their state’s Medicaid insurance for a variety of reasons. 

In a low-yield world, an early retiree with only taxable accounts and Roth accounts may find it difficult to generate sufficient MAGI, even with tax gain harvesting, to avoid Medicaid and qualify for a Premium Tax Credit. The earlier the retirement, the more likely having only taxable accounts and Roth accounts will eventually lead to an inability to generate sufficient MAGI to qualify for Premium Tax Credits. 

Rothification Trap Antidote

How might one qualify for the Premium Tax Credit in early retirement? By doing Roth conversions of traditional retirement accounts! If there’s no money in traditional retirement accounts, there’s nothing to Roth convert. 

I discussed the issue of early retirees not having enough income to qualify for Premium Tax Credits, and the Roth conversion fix, with Brad Barrett on a recent episode of the ChooseFI podcast (recorded before SECURE 2.0 passed). 

Previously, I’ve stated that for many in the FI movement, the “dynamic duo” of tax-advantaged retirement account savings is to max out a traditional deductible 401(k) at work and max out a Roth IRA contribution (regular or Backdoor) at home. Now that SECURE 2.0 has passed, I believe this is still very much the case. 

At the very least, those shooting for an early retirement should strongly consider leaving employer contributions to 401(k)s and other workplace retirement plans as traditional, deductible contributions. This would give them at least some runway to increase MAGI in early retirement sufficient to create enough taxable income to qualify for a Premium Tax Credit. 

401(k), 403(b), and 457 Max Contributions Age 50 and Older

The two most significant takeaways from SECURE 2.0 out of the way, we now get to several other changes members of the FI community should consider. 

First, for those age 50 and older, determining one’s maximum workplace retirement account contributions is about to get complicated. By 2025, there will be up to three questions to ask to determine what one’s maximum retirement contribution, and how it can be allocated (traditional and/or Roth), will look like:

  1. What’s my age?
  2. What was my prior-year wage income from this employer?
  3. Does my employer offer a Roth version of the retirement plan?

Specifically, the changes to 401(k) and other workplace employee contributions are as follows:

Increased Catch-Up Contributions Ages 60, 61, 62, and 63

SECURE 2.0 Section 109 (see page 2087) increases workplace retirement plan catch-up contributions for those aged 60 through 63 to 150% of the regular catch-up contribution limit, starting in 2025.

Catch-Up Contributions Must be Roth if Prior-Year Income Too High

Starting in 2024, 401(k) and other workplace retirement plan catch-up contributions (starting at age 50) must be Roth contributions if the worker made more than $145,000 (indexed for inflation) in wages from the employer during the prior year. Interestingly enough, if the employer plan does not offer a Roth component, then the worker is not able to make a catch-up contribution regardless of whether they made more than $145,000 from the employer during the previous year. Hat tip to Josh Scandlen and Jeffrey Levine for making this latter point, which the flow-chart I featured in the originally published version of this post missed. Sorry for the error as we are all learning about the many intricate contours of SECURE 2.0, myself included!

I do anticipate that many 401(k) plans that do not currently offer a Roth component will start to offer one to allow age 50 and older workers to qualify for catch-up contributions (even if they now must be Roth contributions for those at higher incomes).

From a planning perspective, I still believe that catch-up contributions will make sense for many required to make them as Roth contributions. In such a case, the option is either (i) make the Roth catch-up contribution or (ii) invest the money in a taxable brokerage account. Generally speaking, I believe that it is advantageous to put the money in a Roth account. However, one can easily imagine a situation where someone is thinking about an early retirement and does not have much in taxable accounts such that it might be better to simply invest the money in a taxable account.

Note that the prior-year wage restriction on deducting catch-up contributions does not appear to apply to the Solo 401(k) of a Schedule C solopreneur, but it does appear to apply to the Solo 401(k) of a solopreneur operating out of an S corporation.

No Changes to Backdoor Roths

In another win for the FI community, the Backdoor Roth IRA and the Mega Backdoor Roth are not changed or curtailed by SECURE 2.0.

Rolling 529 Plans to Roth IRAs

SECURE 2.0 has a notable provision allowing up to $35,000 of a 529 plan to be rolled over to the Roth IRA of the beneficiary. I agree with Sarah Brenner that this rule is not one to get too excited about. Why I feel that way is another story for another day. That day is February 15, 2023, when my post on the 529-to-Roth IRA rollover drops on the blog. 

SECURE 2.0 and the FIRE Movement on YouTube

Resources

Sarah Brenner’s helpful summary: https://www.irahelp.com/slottreport/happy-holidays-congress-gifts-secure-20

The Groom Law Group goes through SECURE 2.0 section by section: https://www.jdsupra.com/legalnews/secure-2-0-hitches-a-ride-just-in-the-9280743/

Final Omnibus (which contained SECURE 2.0) text: https://www.appropriations.senate.gov/imo/media/doc/JRQ121922.PDF

Jeffrey Levine’s detailed blog post on SECURE 2.0: https://www.kitces.com/blog/secure-act-2-omnibus-2022-hr-2954-rmd-75-529-roth-rollover-increase-qcd-student-loan-match/

Jeffrey Levine’s detailed Twitter thread on SECURE 2.0: https://twitter.com/CPAPlanner/status/1605609788183924738

My video about the two biggest problems with SECURE 2.0: https://www.youtube.com/watch?v=Zsy1SQXogAg

My December 2022 SECURE 2.0 Resources post: https://fitaxguy.com/secure-2-0-resources/

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