Tag Archives: 457

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

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.

Retire on 72(t) Payments

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

This post is for you!

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

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

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

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

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

72(t) Substantially Equal Periodic Payments

Methods

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

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

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

Computing Fixed Amortization 72(t) Payments

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

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

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

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

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

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

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

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

Annual Equal 72(t) Fixed Amortization Payments

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

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

72(t) Payments Case Study

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

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

Life Expectancy: 33.4

Payment: $80,000

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

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

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

Here’s what that looks like.  

Interest Rate: 5.00% 

Life Expectancy: 30.6

Payment: $10,000

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

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

Here is what Pat’s withdrawals would look like:

YearBirthday AgeRequired First 72(t) November 29 WithdrawalRequired Second 72(t) November 29 WithdrawalTotal Annual Withdrawal
202353$80,000$0$80,000
202454$80,000$0$80,000
202555$80,000$0$80,000
202656$80,000$0$80,000
202757$80,000$10,000$90,000
202858$80,000$10,000$90,000
202959$80,000$10,000$90,000
203060$0$10,000$10,000
203161$0$10,000$10,000

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

Maintain Flexibility

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

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

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

72(t) Payment Plan Disqualification

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

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

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

72(t) Payment Reduction

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

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

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

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

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

72(t) Locking The Cage

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

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

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

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

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

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

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

A Note on the 72(t) Risk Profile

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

Why?

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

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

72(t) Payment Tax Return Reporting

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

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

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

Other Penalty Free Sources of Early Retirement Funding

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

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

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

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

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

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

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

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

72(t) Landscape Change

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

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

72(t) and Employer Stock

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

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

Resource

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

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

Follow me on Twitter: @SeanMoneyandTax

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

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.

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/

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 Resources

Here is the bill text for SECURE 2.0.

SECURE 2.0 Big Picture

SECURE 2.0 tinkers, almost in an unprecedented fashion. Instead of repealing obviously bad retirement tax rules, it adds to them! I suspect that for many Americans, SECURE 2.0 will have only a marginal impact on their retirement savings and financial planning. This version of SECURE 2.0 has some aspects of what the House passed much earlier in 2022, but there are many significant additions and changes.

I discuss what I believe to be the two biggest problems with SECURE 2.0

Some Highlights (or Lowlights)

  • Increased catch-up contributions for those aged 60-63, effective starting in 2025
  • Denial of catch-up contribution deduction for those with prior-year income over $145,000, effective starting in 2024
  • Delay RMDs to age 73 for a decade, then delayed to age 75. This change is effective starting in 2023.
  • Increased auto-enrollment for workplace retirement plans
  • Roth options for (i) SIMPLE IRAs, (ii) SEP IRAs, (iii) employer contributions to employer plans such as 401(k)s
  • Minor emergency withdrawals from retirement accounts. Limited to one distribution per year of no more than $1,000, effective starting in 2024
  • $2,500 of contributions to emergency side accounts for workplace retirement plans, effective starting in 2024
  • Elimination of RMDs from Roth 401(k)s during the owner’s lifetime
  • Allowing Schedule C self-employed individuals to adopt a Solo 401(k) after year-end and make employee contributions (first year only), effective starting with the 2023 plan year
  • Indexing for inflation of the $1,000 annual catch-up contribution to traditional IRAs and Roth IRAs
  • Reform to penalties for missed RMDs
  • No change to the Backdoor Roth IRA rules and no change to the Mega Backdoor Roth IRA rules
  • Expansion of the exceptions to the 10% early withdrawal penalty

Resources

Bill text

Jeffrey Levine’s excellent Twitter thread on the particulars of SECURE 2.0: https://twitter.com/CPAPlanner/status/1605609788183924738

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

My breakdown of SECURE 2.0 and the FI Community: https://fitaxguy.com/secure-2-0-and-the-fi-community/

My mini Twitter thread on minor emergency withdrawals: https://twitter.com/SeanMoneyandTax/status/1605117417721434113

My mini Twitter thread on new employer plan emergency accounts: https://twitter.com/SeanMoneyandTax/status/1605119482803863552

My Plan

I have a retirement tax reform plan that I believe is better and simpler than SECURE 2.0.

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.

2023 Retirement Tax Reform

An Open Letter to the Members of the 118th Congress

Dear Senators and Congressmen,

Congratulations on your victories in the Senate and House elections. I write with respect to one aspect of your legislative endeavors in the 118th Congress: reforming our tax-advantaged retirement savings system. As you will see, much of it is antiquated and in need of reform.

Before I discuss the problems, allow me to briefly recite my qualifications to write you this letter. My primary qualifications are that I am an American citizen and taxpayer. My secondary qualifications include:

  • I am a financial planner and advise clients on retirement planning and saving.
  • I am the author of a book on one of the tax-advantaged retirement savings accounts, Solo 401(k): The Solopreneur’s Retirement Account.
  • I am a CPA (licensed in California and Virginia) and I have a Juris Doctor degree and a LLM in Taxation degree. My background is on my LinkedIn page.
  • I write a four year-old blog (fitaxguy.com) focused on tax planning for individuals, particularly the use of retirement accounts. 

The views expressed in this open letter are mine only. I have not been compensated for writing this letter and my views are not necessarily the views of any of the clients of my financial planning firm. 

Problems with the Current Retirement Savings System

Limits Are Unequal and Unfair

There’s a myth that Congress and IRS inflation adjustments determine the retirement plan contribution limits every year. If one looks at the Internal Revenue Code and the IRS website, they’d walk away with that belief.

But is that really true? It turns out that one’s employer often defines just how much an employee can get into tax-advantaged retirement accounts every year. In practice, the current system disproportionately benefits a privileged few.

Here are two examples (using 2023 limits) that prove my point in a stark fashion. Josh is a 50 year-old employee of a large Fortune 500 company with a $300,000 salary. Josh maxes out contributions to his traditional 401(k) at work and maxes out his Backdoor Roth IRA and Mega Backdoor Roth (available through his employer’s 401(k)). Further, Josh receives a 3% match in his employer 401(k). Here are what his annual retirement savings contributions look like:

401(k) Employee Deferral: $30,000

401(k) Employer Match: $9,000

401(k) Mega Backdoor Roth: $34,500

Backdoor Roth IRA: $7,500

Total traditional deductible contributions: $39,000. Total Roth contributions: $42,000. Total contributions: $81,000.

Sarah, single, is a 50 year-old non-profit executive director with a $150,000 annual salary and no workplace retirement plan. Under today’s rules, Sarah can only contribute a maximum of $7,500 to a deductible traditional IRA. That’s it! She may be able to make a partial Roth IRA contribution or a Backdoor Roth IRA contribution, but if she does, it reduces her maximum allowed deductible traditional IRA contribution. Thus, her total contributions are, at a maximum, just $7,500 for the year.

Sadly, there are many more workers in the latter situation than in the former situation. 

Because of their choice in employers, Josh gets to put more than 10 times the amount Sarah can into tax-advantaged retirement accounts.

Yes, that is today’s reality. It makes absolutely no sense. Long term, a system that disproportionately rewards workers at some employers and barely covers workers at other employers is not sustainable. 

Where you work should not increase your tax-advantaged retirement account contributions by more than 10 times!

Many retirement provisions benefit a very select few. Most of the time, those select few are among the people who need the least amount of help in achieving a successful retirement. Retirement tax advantages should have broad applicability and should not disproportionately reward any particular subgroup, particularly very small subgroups. 

Other Retirement Account Problems

  • Complexity and confusion (Ever fill out a Form 8606?)
  • Penalties and penalty exceptions that are outdated and not entirely rational
  • Remedies for problems with retirement accounts are neither taxpayer nor IRS friendly

Goals for Retirement Account Reform

Here are the goals I believe the 118th Congress should have in enacting retirement account reform.

  • Reduce complexity and confusion. Simplify the mechanisms of retirement savings. “Backdoors” should be eliminated because retirement savings should occur through direct, simple transactions. 
  • Increase retirement savings, particularly among Americans who have struggled economically over the past three years.
  • Effective yet modest changes. While it is tempting to throw out all the rules, a complete rewrite of the rules would create tremendous confusion and likely reduce, rather than increase, tax-advantaged retirement savings. 
  • Democratize retirement account contributions while acknowledging the role employers can play in offering retirement savings for employees. That said, there should be at least some shift of dollars away from contributions to employer plans towards contributions to individual retirement accounts.
  • Reform cannot simply be a massive tax cut. The federal budget cannot afford a massive tax cut. 
  • Special advantages available to very limited groups should be reduced and eliminated.
  • Remove punitive rules and traps for the unwary. 
  • There are too many penalties in the retirement account system that are too high, too punitive, and too confusing. My proposal attempts to reduce the number of penalties, give the IRS and taxpayers more common sense tools to mitigate them, and make the rules simpler and fairer. 
  • Reduce the competition between funding expenses attendant to having a child and funding retirement savings. 
  • Avoid slogans. Our tax rules are now far too complicated to say “everyone gets a tax cut” or “no one below X income will have a tax increase.” Besides, slogans belong to the politics of the 80s and 90s. 

While my primary audience is the members of the 118th Congress, please allow me to direct a quick word to my fellow American taxpayers who might lose out on an opportunity described below and thus might oppose these proposals. I ask potential opponents of this proposal this question: how sustainable is a retirement system that gives a select few Americans 10 times the tax-advantaged savings capacity as other Americans? 

Why fight to preserve your special tax break when the myriad special tax breaks make the entire system less and less sustainable? Does my proposal make everything entirely fair? Surely not, but, as you will see below, it makes the system much fairer and simpler. I believe that will make the system more sustainable over the long run, which is good for everyone. 

Lastly, retirement savings are far from the only component of the U.S. tax system needing legislative change. But, as you can see from my secondary qualifications above, retirement savings are of particular interest to me, so I’ll mostly limit my commentary here to tax law changes on retirement savings. 

Retirement Tax Reform Proposals

Expanded Universal Roth IRAs and Closing Backdoors

1. Eliminate the MAGI Limitation on annual Roth IRA contributions. Why is there an income limit on contributing to a Roth IRA, which does not produce a tax deduction? Further, removing the income limitation will align the United States Roth account rules with Canadian tax-free savings account rules. Canada does not have an income limit on the ability to contribute. Why should the United States? This proposal also ends the Backdoor Roth IRA. 

2. Increase annual IRA contribution limit (traditional and Roth) to $10,000, then index annually. It is time to shift retirement savings towards individuals. This will help expand individual and spousal contributions to retirement accounts, particularly Roth IRAs, and give individuals more control over their own retirement savings. This proposal makes individuals less reliant on their employer to offer a good retirement savings plan. 

In the 10 year budget window, proposals 1 and 2 will cost some money, but I suspect not a whole lot. In fact, this expansion of Roth IRAs might make Roths more attractive and cause some taxpayers to direct what would have been traditional, deductible 401(k) contributions to their Roth IRA, increasing tax revenue in the early years. 

3. Eliminate nondeductible contributions to IRAs and qualified plans, effective January 1, 2024. This ends Mega Backdoor Roth IRAs as of January 1, 2024. The Mega Backdoor Roth benefits only those few whose employers offer it and can afford to make after-tax contributions. The Mega Backdoor Roth, which only came to prominence starting in 2014, turbocharges the unfair advantages the retirement account system currently confers on a select few Americans (such as Josh in the example above).

As a result of eliminating the Mega Backdoor Roth, most of these contributions will be diverted to taxable accounts, which is not a horrible outcome for those currently taking advantage of the Mega Backdoor Roth. Further, those losing the Mega Backdoor Roth under this proposal gain expanded access to Roth IRAs under proposals 1, 2, and 4. 

4. Increase age 50 or older IRA (traditional and Roth) annual catch-up contribution from $1,000 to $2,000, index for inflation annually. The current $1,000 annual catch-up contribution limit is not enough move the needle in terms of likelihood of financial success in retirement. 

Eliminate Traditional Retirement Account Basis

5. Eliminate IRA Basis / after-tax 401(k) basis, effective January 1, 2027. The Pro-Rata Rule is an unnecessarily complicated rule for retirement account withdrawals. It has even created litigation. Basis record keeping is challenging and creates confusion. Enough already! 

This proposal eliminates retirement account basis recovery as of January 1, 2027. To be fair to those with retirement account basis, this proposal allows elective withdrawal of basis amounts from traditional retirement accounts (including inherited traditional retirement accounts) to taxable accounts during the 2024, 2025, and 2026 tax years. Any elective withdrawals of basis for the year would not count towards RMDs and could not be converted to Roth accounts. Regular withdrawals, RMDs, and Roth conversions in the year of an elective withdrawal of basis could not access existing basis. 

Eliminating basis eliminates page 1 of the Form 8606. This simplifies traditional retirement account withdrawals, inheriting traditional retirement accounts, and Roth conversions. In turn, this makes the retirement account provisions easier for the IRS to administer and easier for taxpayers to understand. 

Simplify and Rationalize Retirement Account Rules

6. Unify Roth account nonqualified withdrawal treatment such that the current Roth IRA nonqualified distribution rules apply to nonqualified Roth 401(k) distributions. The rules for Roth 401(k) nonqualified distributions are confusing, and can be avoided by rolling into a Roth IRA. Why not make them consistent?

7. Change the age for HSA catch-up contributions to age 50. Catch-up contributions to all accounts should kick-in at one, and only one, age. Make it age 50 for all accounts by changing the HSA catch-up contribution kick-in age from 55 to 50. Unifying the HSA/IRA/401(k) catch-up contribution age at age 50 makes the rules simpler. 

8. Unify rules for taking RMDs from traditional retirement accounts. Under this proposal, so long as the total required is taken during the year, it doesn’t matter which account (401(k), 403(b), IRA) or accounts the distributions come from. 

9. Eliminate NUA tax treatment. Net Unrealized Appreciation allows for employer stock in a 401(k) to get preferential tax treatment. As workers are already heavily economically tied to their employer (because of their salary and benefits), NUA treatment encourages something that probably should be discouraged (investing significantly in the stock of one’s own employer). Further, the NUA rules are complex. Removing them simplifies the tax code. 

10. Simplify treatment when spouses inherit a retirement account. Currently, there are three options and planning choices to be made when a spouse inherits a retirement account. The death of a spouse is challenging enough without having to make a complicated tax planning decision. New rule to simplify this: all retirement accounts inherited by spouses are deemed to be the inheriting spouse’s own retirement account as of the first spouse’s death. To prevent any early withdrawal penalties to surviving spouses under age 59 ½ due to this change, add a new 10% early withdrawal penalty exception: being widowed prior to age 59 ½. This new penalty exception applies to all widows and widowers for all pre-age 59 ½ retirement account distributions regardless of whether the widow/widower inherited a retirement account.  

11. Clarify the SECURE Act to provide that if the 10 year rule applies to an inherited account, RMDs do not apply to the account, other than in the final year of the 10 year window. The IRS came out with overly complicated proposed regulations requiring RMDs for many inherited accounts even though the 10 year rule applies to them. This clarification repeals the needlessly complicated proposed regulations, and the government’s interests are already adequately protected by the 10 year rule. 

12. Adopt a supercharged version of SECURE 2.0 Section 321. Allow the self-employed (generally those reporting self-employment income on Schedule C or through partnerships) to both establish a Solo 401(k) after year-end and make employee contributions to their Solo 401(k) before the tax return deadline for the taxable year. This eliminates the election required under Treas. Reg. Sec. 1.401(k)-1(a)(6)(iii). There’s no reason for a self-employed individual to have to make an election with themselves to make a retirement account contribution. This change would make the contribution deadline rules for self-employed employee contributions the exact same as the contribution deadline rules for self-employed employer contributions for every year (not just for the first year as Section 321 proposed to do). 

Combat Mega Retirement Accounts and Limit Benefits for the Very Rich

13. Eliminate (as of enactment) new tax-advantaged retirement account investments in private equity, venture capital, and companies 10% or more owned (by vote or value) by the account owner. These investments have allowed a very select few to accumulate hundreds of millions of dollars in IRAs. IRAs and qualified plans are best when they provide growth and capital preservation from diversified assets to fund retirement. They were never intended to create 9 figure-plus hoards of wealth sheltered from taxation. 

14. Required Accumulation Distribution (RAD) of 20 percent of the amount over $5M anytime all traditional accounts (IRAs and qualified plans) exceed $5M (indexed for inflation) at year-end for the following year prior to age 72. RAD of 20 percent of the amount over $5M anytime all Roth accounts (IRAs and qualified plans) exceed $5M (indexed for inflation) at year-end for the following year. Under this proposal, there would be no penalty on any RAD. RADs from Roths are treated as qualified distributions. This is much simpler than the Build Back Better proposals on mega retirement accounts. RADs from traditional accounts cannot be converted to Roth accounts. 

The hope is that after a while, there will be few, if any RADs. In a world without private equity and venture capital type investments in retirement accounts it will be quite difficult to accumulate in excess of $5M (adjusted for inflation) in either type of retirement account. The RAD rules do not need to apply to traditional retirement accounts at 72 and beyond, since the owner is already subject to the RMD rules. Inherited retirement accounts would be exempt from the RAD rules.  

Examples: Joe, age 65 in 2024, has $4.9 million in all traditional retirement accounts (401(k)s, IRAs, etc.) on December 31, 2023. He also has $4.9 million in all Roth retirement accounts (401(k)s, IRAs, etc.) on December 31, 2023. His 2024 RAD from traditional retirement accounts is $0, and his 2024 RAD from Roth retirement accounts is $0.

Sally, age 65 in 2024, has $7 million in all traditional retirement accounts (401(k)s, IRAs, etc.) on December 31, 2023. She also has $4 million in all Roth retirement accounts (401(k)s, IRAs, etc.) on December 31, 2023. Her 2024 RAD from traditional retirement accounts is $400,000 ($7M minus $5M times 20%), and her 2024 RAD from Roth retirement accounts is $0.

John, age 75 in 2024, has $7 million in all traditional retirement accounts (401(k)s, IRAs, etc.) on December 31, 2023. He also has $7 million in all Roth retirement accounts (401(k)s, IRAs, etc.) on December 31, 2023. His 2024 RAD from traditional retirement accounts is $0 (since he is 72 or older), and his 2024 RAD from Roth retirement accounts is $400,000. Under the existing rules (unchanged by this proposal), John is subject to RMDs in 2024 totalling $284,553 ($7M divided by 24.6) from his traditional retirement accounts (though see proposal 8 giving John more flexibility in terms of which account(s) he can take the RMDs from).

15. Cap at $25,000 the maximum annual amount that can be deferred by those with salaries (W-2, self-employment income) of $400K or more per year (indexed for inflation) under a Section 409A nonqualified deferred compensation plan. This rule change is logical considering (i) the tax law’s benefits for retirement saving have been too skewed towards helping a very affluent few who need the least amount of saving help, (ii) most of the beneficiaries of nonqualified deferred compensation plans are the ones doing best economically, and (iii) the need to provide more benefits of tax-advantaged retirement savings to a larger swath of Americans. Further, those losing a tax benefit because of this rule gain a significant benefit in the removal of income limits on Roth IRA contributions and the increased contribution limits. 

For administrative convenience, the new rule would not apply to any amount deferred at any time during one year and paid out at any time during the immediately following tax year.

Proposals 13, 14, and 15 raise revenue to expand the amounts that every worker can save in Roth IRAs, and some Americans will get increased deductible traditional IRA contributions because of proposals 2 and 4. 

Penalty Reform

16. New 20% penalty on all missed RADs and reduce the missed RMD penalty to 20%. The current 50% penalty on missed RMDs is unnecessarily punitive. 

17. Unify the exceptions to the 10 percent early withdrawal penalty so there is no difference between qualified plans and IRAs. It makes no sense that under current law there are some penalty exceptions only applicable to IRAs and some penalty exceptions applicable only to qualified plans. After this change, the only “plan only” exception would be the exception applicable to nonqualified 457(b) plans.

18. Change the Rule of 55 “separation from service” qualified plan penalty exception to be a broader, fairer age 55 need-based exception. Currently a 56 year-old CEO can leave their job and qualify for the penalty exception from their 401(k) but a 57 year-old teacher cannot qualify for the exception from an IRA. How does that make sense? 

New exception: Starting in the year one turns age 55, if AGI other than the taxpayer’s and/or their spouse’s potential Rule of 55 distribution(s) is less than $70K single, $110K MFJ (indexed for inflation), then the distribution (a “Rule of 55 distribution”) from the qualified plan or IRA is penalty free. Each person would have a $70K annual maximum (indexed for inflation) that could be accessed penalty free under this new, more rational Rule of 55 exception. In between $70K and $90K ($110K to $145K MFJ) of AGI (other than the potential Rule of 55 distributions), the $70K limitation per person is ratably reduced. 

The new Rule of 55 exception would be a Rule of 50 exception for public safety employees subject to the AGI limits described immediately above.

Eliminate Loopholes Benefitting Very Few

19. Age 15 requirement for IRA (traditional and Roth) contributions. Today a very few advantaged families can fund a retirement account for young children. Sometimes this takes the form of paying an infant a salary, which is at best questionable. Even with the elimination of this loophole, the family’s total annual Roth IRA contributions may be greater under this proposal. Instead of $6,500 per person ($19,500 total for family of 3), each parent can contribute $10,000 into a Roth IRA ($20,000 total). Of note, Canada requires being at least age 18 to make contributions to a tax-free savings account.

20. Eliminate the “super HSA” by deeming all persons covered by a HDHP other than the policyholder and their spouse to be a dependent of the policyholder for purposes of determining HSA contribution limits. The super HSA allows young adults covered by their parents’ high deductible health plans to put more into an HSA than most single HSA owners can. That’s not fair and illogical, and the super HSA is a loophole created not by Congressional intent but rather by the drafting technicalities used to create HSAs in IRC Section 223. 

Reform, Expand, and Simplify Qualified Birth Distributions

21. Reform, expand, and simplify SECURE Act Qualified Birth Distributions. Repeal as written in the SECURE Act. Capped at only $5,000 and confusing in their details, the current qualified birth distribution rules are not effective for parents. The new qualified birth distribution and recontributions rules would be as follows: 

For those under age 59 ½, up to $30,000 of distributions from qualified plans, SEP IRAs, SIMPLE IRAs, traditional IRAs, and Roth IRAs per parent distributed within 18 months (9 months before and 9 months after) surrounding a birth and/or an adoption are presumed to be a qualified birth distribution (QBD) and as such (i) are not treated as distributions in the year of the distribution (and not subject to tax withholding) and (ii) can be rolled back into the account by the end of the third year following the distribution. Amounts not repaid to the account are treated as distributions from the account at the end of that third year (including for estimated tax purposes), and are excused from the 10% early withdrawal penalty (if the penalty would otherwise apply to the deemed distribution). No mandatory reporting requirements for the parents (other than for any deemed distribution at the end of the third year), but the IRS is authorized to provide a voluntary reporting form reporting qualified birth distributions and qualified birth recontributions. The new law would authorize financial institutions and plan providers to rely on taxpayer representations for both distributions and recontributions in issuing Forms 1099-R and 5498 and accepting recontributions. 

This is a good idea for several reasons. It means saving for retirement is not a hindrance to financial security when adults are considering whether to have children. Our country is facing a decline in births. This proposal helps parents use retirement accounts to help during pregnancy and after childbirth while not handicapping their retirement. People can invest in Roth IRAs, for example, knowing that the money can be available for both the initial expenses of childbirth and their future retirement. 

Unfortunately, saving for birth and saving for retirement can compete. New, more robust and parent-friendly qualified birth distributions can reduce this competition and allow retirement savings to help during pregnancy and the first nine months after birth. 

Here is an example of how it could work: Robert, age 30, is the father of Mark, born February 2, 2024. On December 1, 2023, Robert withdrew $30,000 from his Roth IRA. At the time of the distribution, Robert had previously made $23,000 of annual contributions to his Roth IRA. Robert’s recontribution deadline is December 31, 2026. On April 2, 2026, Robert recontributes $20,000 to the Roth IRA, and makes no other qualified birth recontributions. On December 31, 2026, the $10,000 Robert did not recontribute to the Roth IRA is deemed to be a distribution from the Roth IRA to Robert. Robert took no other distributions from his Roth IRA prior to December 31, 2026. Since Robert had $23,000 of previous Roth IRA contributions to his Roth IRA as of the end of 2023 and may have made further annual contributions to his Roth IRA after 2023, the deemed distribution of $10,000 is deemed to be return of old annual contributions (under the nonqualified distribution rules) on December 31, 2026 and thus not taxable to Robert. The deemed distribution reduces Robert’s previous annual Roth IRA contributions by $10,000 for purposes of the nonqualified distribution rules as applied to any future nonqualified distributions. 

As a practical matter, the combination of this proposal and proposals 1 and 2 are likely to result in most QBDs coming from Roth IRAs. Thus, most QBDs not recontributed to the Roth IRA will simply be nontaxable deemed distributions of previous Roth IRA annual contributions. 

The new QBD rules would include rules providing that retirement account direct trustee-to-trustee transfers, rollovers, and Roth conversions occurring during the QBD 18 month window are not considered QBDs so as to preserve each parent’s $30K limitation. For simplicity’s sake, each birth and adoption will be treated as a distinct event for QBD purposes. Under this simplicity convention, parents of twins can each take up to $60K of QBDs. In addition, the QBD rules will have no adverse effect on the adoption tax credit. Funds sourced from a QBD for qualified adoption expenses will remain fully eligible for adoption tax credits based on the existing adoption tax credit rules. Lastly, a birth for QBD purposes will include the birth of a baby the parents give up for adoption. 

Expand and Rationalize Remedial Measures for Retirement Accounts

22. Adopt a supercharged version of SECURE 2.0 Section 308. Enact section 308 (expanding the IRS Employee Plans Compliance Resolution System) and add a self-correction safe-harbor (available both before an IRS exam and during IRS examination activity) whereby all individual traditional IRAs and Roth IRAs, and SEP IRAs, SIMPLE IRAs, 401(k)s, and qualified plans involving 10 or fewer individuals/employees (including Solo 401(k)s) automatically qualify for self-correction and forgiveness of all penalties so long as (i) the account owner/plan sponsor implements reasonable corrections (such as refunding excess contributions and attributable earnings penalty free, subject to ordinary taxable income inclusion — in the year of the corrective distribution — for earnings and any returned contributions actually deducted on a tax return or previously excluded from taxable income), and (ii) the total amount in the plan or IRA has never exceeded $500,000 as of any year-end. For this purpose, accounts would only be aggregated for a person or plan sponsor at the same financial institution. The new rules would provide that financial institutions can rely on taxpayer representations in issuing Forms 1099-R to report corrective distributions. Financial institutions will continue to compute attributable earnings as they do under current regulations.

This proposal reduces penalties (such as excess contribution penalties) and helps ensure plans and IRAs remain qualified. Self-correction is much better for taxpayers and the IRS, particularly when accounts are relatively modest in size. Currently, the IRS offers the Voluntary Compliance Program for qualified plans. Since VCP covers very large employer plans, it is a very odd fit for Solo 401(k)s and would be an odd fit for traditional IRAs and Roth IRAs. It is much better to encourage the use of self-correction. This encourages compliance, makes correcting mistakes easier, reduces penalties, and makes the IRS’s oversight of modest sized retirement accounts easier and more effective. 

23. Repeal and reform section 403 of the SECURE Act as applied to Form 5500-EZ filings. The SECURE Act increased penalties for late filed Form 5500 Series filings by tenfold. While this may make sense for large employer plans, the increase in penalties drastically overshot the mark when it comes to small businesses filing the Form 5500-EZ. Under the new law, a self-employed Solo 401(k) owner could (theoretically) be liable for a $150,000 penalty for failing to file a two page informational tax return (the Form 5500-EZ). Such a penalty is excessive and obscene. While relief procedures are available, it is ridiculous that the penalty could be, at least in theory, so onerous. Replace the current $250 per day penalty with a flat $500 per late Form 5500-EZ penalty (capped at $2,000 per plan sponsor) that can be excused for either reasonable cause or a first time abatement distinct to the Form 5500-EZ return. Cap the IRS period to assess the penalty at four years from the original filing deadline. Further, make the new rules effective to all missed Form 5500-EZ filings regardless of when they occurred. In addition, increase the asset threshold whereby a Form 5500-EZ is required from $250,000 to $500,000 to account for the passage of time and inflation. The Form 5500-EZ would still be required at the closing of the plan under this proposal, regardless of account size. 

Repeal Traps for the Unwary

24. Eliminate the once-a-year IRA to IRA 60-day rollover limit. It’s a trap for the unwary and by eliminating it, the rules would be synchronized for all rollovers. The once-a-year limit makes no sense (as the 60-day time limit is sufficient to police money coming out of retirement accounts) and is punitive and unnecessary. 

25. Repeal the SIMPLE IRA 25% penalty for early distributions within the first two years of establishing the SIMPLE IRA. Under this rule, the 25% penalty even applies to rollovers to traditional IRAs within the first two years. It’s a trap for the unwary and should be fully repealed. 

Miscellaneous

26. Do not pass (or repeal if passed) the rest of SECURE 2.0, the EARN Act, and other related proposals, other than as discussed above. My opinion is that SECURE 2.0/EARN Act introduced changes that were at best marginally beneficial for Americans saving for retirement. Unfortunately, SECURE 2.0 has counterproductive provisions (such as eliminating the tax deduction for 401(k) catch-up contributions) and increases the complexity of the retirement account system. 

Revenue Raisers (If Needed)

My hope is that my proposals would reduce federal revenue over the 10 year budget window by only a fairly modest amount, as there are provisions that would cost the government money and proposals that would increase revenue. If this nets out to costing too much money in Congress’s judgment, I recommend the following tax increase: an increase (starting in 2024) of the top capital gain/qualified dividend income rate (currently 20%) by the amount needed to close the gap. Considering that the highest earners have done the best in recent years, and do receive benefits under the overall proposal (see proposals 1, 2, and 4), this tax increase is fair and helps many Americans save for retirement by funding expansion of Roth IRAs and reduction of penalties.

If any other tax increases are deemed necessary, I recommend that Congress consider an increase to the rate of the corporate book minimum tax and/or a tax on investment income of college endowments comprised of $1 billion or more of assets. These two proposals shift the tax burden to those who have benefited the most from the American economy in recent years. 

Landscape After Retirement Account Reform

Let’s return to Josh and Sarah. What might their tax-advantaged retirement account contributions look like after my proposed reform. Here’s Josh’s contributions:

401(k) Employee Deferral: $30,000

401(k) Employer Match: $9,000

Roth IRA: $12,000

Total traditional deductible contributions: $39,000, total Roth contributions: $12,000, total contributions: $51,000. Yes, Josh lost his Mega Backdoor Roth IRA. But, now instead of a gimmicky $7,500 Backdoor Roth IRA, he gets to simply make a $12,000 annual contribution to a Roth IRA. Further, Josh did not lose any tax deductions under my proposal. Josh can invest the difference between $81,000 (his old tax-advantaged contribution total) and $51,000 (his new tax-advantaged contribution total), $30,000, in a taxable account.

Sarah has significantly increased the amount of her contributions. She goes from a $7,500 annual contribution to a traditional deductible IRA or Roth IRA to a $12,000 traditional deductible or Roth IRA contribution. 

Perfect? No. But instead of a 10.8 to 1 ratio we have moved the needle significantly such that the ratio is now 4.25 to 1. Further, many of the retirement account rules are simpler and fairer. If Josh, Sarah, or other Americans run into problems with their retirement accounts, their remedial paths are likely to be easier to navigate and they are more likely to avoid onerous and unfair penalties. 

I believe that our retirement system would be significantly better if Congress passes and the President signs the 26 proposals I outlined above in 2023. If any of you have questions about the above, I would be happy to communicate with you and/or your staff about these proposals.

To my fellow Americans reading this letter, I’d be honored to read your comments in the comments section below. I’m sure there are other ideas that could simplify and improve retirement accounts. 

Sincerely,

Sean Mullaney

This post 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.

The Advantages of Living On Taxable Assets First in Early Retirement

The FIRE community loves the accumulation phase. Build up assets towards the goal of financial independence.

Questions increasingly creep in when it comes to the distribution phase. Members of the FIRE community wonder: what do I live on when I get to retirement? This is particularly true when one reaches early retirement prior to age 59 ½. 

Below I discuss the options and the reasons I believe that for many, the best assets to live off of first in early retirement are taxable assets. This analysis assumes the early retiree has access to some material amount of assets in each of the three tax baskets discussed below.

Early Retirement Drawdown Options

For most Americans reaching retirement prior to age 59 ½, there are three main tax baskets of assets that can be lived off prior to age 59 ½.

Taxable Assets: This can include cash in bank accounts, brokerage accounts (stocks, bonds, mutual funds, and ETFs), and for some, income from rental properties. For purposes of this blog post, I will assume the early retiree does not own any rental real estate. 

Roth Basis/HSAs: Early retirees can live off of what I colloquially refer to as “Roth Basis.” Generally, Roth Basis is the sum of previous annual contributions to Roth accounts and Roth conversions that are at least five years old. Further, early retirees can harvest amounts in HSAs tax and penalty free to the extent that they have allowable previously unreimbursed qualified medical expenses (what I refer to as PUQME). HSAs can also be used for qualified medical expenses incurred in early retirement. 

Traditional Retirement Assets: Assets such as traditional 401(k)s and traditional IRAs. Generally “inaccessible” prior to turning age 59 ½ due to being subject to both ordinary income tax and the 10% early withdrawal penalty. However, there are exceptions to the early withdrawal penalty. They include:

  • Rule of 55: Separation from service from an employer after turning age 55 (exception available for withdrawals from that workplace retirement plan only).
  • 72(t) Payments: Establishing a series of substantially equal periodic payments.
  • Governmental 457(b) Plans

Drawbacks of Using Roth Basis/HSAs

Some might argue for using tax-free withdrawals of Roth Basis and HSAs to fund early retirement. This allows the early retiree to pay no taxes on funds used for living expenses. 

To my mind, the main drawback of doing so is opportunity cost. Removing assets from Roths and HSAs cuts off the opportunity for future tax free growth. 

As a general planning objective, many will want to let their Roths and HSAs grow as long as possible to maximize tax-free growth. 

Using Roths and HSAs can also have a significant drawback from a creditor protection perspective, as I will discuss below. 

Drawbacks of Using Traditional Retirement Assets

The below analysis assumes that the early retiree qualifies for an exception from the 10% early withdrawal penalty.

The biggest drawback to using traditional retirement accounts to live off of in early retirement is all living expenses become subject to federal and state income taxes. It puts the most important consideration (funding living expenses) in opposition to the secondary (but still important) consideration: tax planning.

Living off traditional retirement accounts in early retirement reduces tax planning flexibility. It reduces the ability to do tax-optimized Roth conversions in early retirement. In addition, living off traditional retirement accounts during early retirement can reduce Premium Tax Credits for those on Affordable Care Act (“ACA”) medical insurance plans.

Premium Tax Credit Planning: Many early retirees will use an Affordable Care Act medical insurance plan. The premiums are subsidized through a tax code mechanism: the Premium Tax Credit (the “PTC”). PTCs are reduced as the taxpayer’s modified adjusted gross income (“MAGI”) increases. Very roughly speaking, for planning purposes, an additional dollar of MAGI often reduces the PTC by 10 to 15 cents, meaning early retirees using traditional retirement accounts to fund living expenses may be subject to a surtax of 10 to 15 percent on retirement account withdrawals due to PTC reduction. Resources for the PTC include this article and this spreadsheet. 

There’s an argument that it is good to live off traditional retirement accounts early because withdrawals used to fund living expenses reduce future required minimum distributions (“RMDs”). But one must consider that there are two types of withdrawals an early retiree can make from a traditional retirement account: an actual withdrawal or a Roth conversion. Both reduce future RMDs, but a Roth conversion is the most tax efficient withdrawal for the early retiree. Why? Because it sets up future tax-free growth! Actual withdrawals used for living expenses do not enhance future tax-free growth. 

Another drawback of using traditional retirement accounts to fund early retirement includes being constrained by the parameters of the applicable penalty exception. For example, needing to keep money inside a former employer’s retirement plan in order to qualify for the Rule of 55, or needing to withdraw precise amounts annually if using a 72(t) payment plan. Further, using traditional retirement accounts in early retirement has creditor protection drawbacks, discussed below. 

Advantages of Using Taxable Assets

Living off drawdowns of taxable assets can be a great way to fund the first expenses of early retirement. Here are some of the advantages. 

Zero Percent Long Term Capital Gains Rate

Early retirees worry: I need $60,000 of income to live my life. Won’t that create $60,000 of taxable income? 

If drawing from a taxable account, almost certainly it will not. Consider Judy, an early retiree needing $60,000 to pay her living expenses. If she sells $60,000 worth of the XYZ Mutual Fund (all of which she has owned for over a year), in which she has $40,000 of basis, her resulting taxable income is only $20,000. Not $60,000!

But it gets even better for Judy. The capital gain can qualify for the 0% federal long term capital gains tax rate. Outstanding! By using taxable assets, Judy may pay $0 federal income tax, and likely only a very small state income tax, on the money she uses to fund her living expenses. Pretty good. 

Even if Judy’s income puts her above the 0% federal capital gains tax bracket, (i) some of her capital gains will likely qualify for the 0% rate, and (ii) the next bracket is only a 15% tax rate.

Basis Recovery While Basis is Valuable

During 2022, we learned an important financial lesson: inflation is a thing. Retirement draw down planning should consider inflation. 

One way to fight inflation is to use tax basis before its value is inflated away. Tax basis is never adjusted for inflation. Thus, failing to harvest tax basis exposes the early retiree to the risk that future capital gains in taxable accounts will be subject to taxation on inflation gains. Early retirees should consider harvesting basis (like Judy in the above example) when the tax basis is its most valuable. 

Using taxable assets as the first assets to fund early retirement takes maximum advantage of tax basis, unless the U.S. dollar begins to deflate (a possible but not very likely long term outcome, in my opinion). 

Opens the Door for Roth Conversions

Now we get to the fun part. Roth conversions! Using taxable assets first for living expenses in early retirement facilitates conversions of amounts in traditional retirement accounts to Roth accounts. The idea is to have artificially low taxable income such that the taxpayer can do Roth conversions taxed at 0% federal (offset by the standard deduction) and then in the 10% or 12% tax bracket. Occasionally, it will be logical for the taxpayer to incur an even greater tax rate on such Roth conversions. 

These Roth conversions move assets to Roth accounts where they enjoy tax free growth. In addition, early retirement Roth conversions reduce future RMDs. 

There is a taxpayer-friendly rule that assists early retirement Roth conversion planning: long-term capital gains income is stacked on top of ordinary income in the tax computation. Thus, Roth conversions can benefit from being sheltered by the standard deduction (or itemized deductions if the taxpayer itemizes). This makes Roth conversion planning in early retirement that much better, as some Roth conversions can benefit from a 0% federal income tax rate. 

Further, this tells us it is generally better from a tax basketing perspective not to have bonds and other assets that generate ordinary income, since that income eats up part of the standard deduction, diminishing the opportunity to 0% taxed Roth conversions. One way to avoid having such ordinary income is to sell bonds, bond mutual funds, and other assets that generate ordinary income and use the proceeds to fund early retirement living expenses. 

Another advantage of early retirement Roth conversions is the reduction of the risk that future tax increases will drive up taxes on future traditional retirement account withdrawals.

Roth Conversions, ACA PTC Eligibility, and Medicaid

Lastly, there can be an ancillary benefit to Roth conversions. Taxpayers lose all ACA subsidies (thus, PTCs) if their MAGI is below certain thresholds. For example, a family of four in California with MAGI less than $41,400 (2023 number) would meet the income threshold for Medi-Cal (Medicaid in California) and thus would get no ACA PTC. 

Roth conversions can keep early retirees’ MAGI sufficiently high such that they do not meet the income threshold for Medicaid. By keeping MAGI above the Medicare threshold, early retirees can qualify for significant PTCs.

Creditor Protection

Financial assets can receive protection from creditors to varying degrees. Taxable brokerage accounts tend to have little, if any, creditor protection. 401(k) and other ERISA government workplace retirement accounts benefit from ERISA’s anti-alienation provisions. Generally speaking, only the IRS and an ex-spouse can get assets out of a 401(k). Traditional IRAs and Roth IRAs enjoy significant protection in bankruptcy. Traditional IRAs have varying degrees of non bankruptcy creditor protection, but in many states are fully protected. Roth IRAs are non bankruptcy protected in most states, but more states protect traditional IRAs than Roth IRAs.

HSAs do not enjoy federal bankruptcy protection, but do enjoy creditor protection in some states (to varying degrees).

By spending down taxable assets in early retirement, the early retiree optimizes for creditor protection in two ways. First, diminishing taxable assets by using them for living expenses reduces creditor vulnerable assets. Second, when an early retiree lives off taxable assets, they leave their more protected assets (traditional and Roth retirement accounts) to grow. Diminishing vulnerable assets while growing protected assets improves the early retiree’s balance sheet from a creditor protection perspective.

Lastly, early retirees should always consider personal umbrella liability insurance and other relevant property and casualty insurance for creditor protection. 

Premium Tax Credit Planning

Living off taxable assets in early retirement limits taxable income. This has a good side effect. It increases the potential PTC available for early retirees using an ACA medical insurance plan. 

Reducing Future Uncontrollable Taxable Income

Roths and HSAs are great because their taxable income is entirely controllable, and generally speaking should be $0. Even traditional retirement accounts have very controllable taxable income. There are no RMDs until age 72, and even then the amount of taxable income is quite modest for the first few years. 

Taxable assets, on the other hand, expose the early retiree to uncontrollable taxable income, in the form of interest, dividends, and capital gain distributions. You never know when a mutual fund or other investment will spit out a taxable dividend or capital gain distribution. Such income reduces the runway for tax planning and can reduce PTCs.

Further, in recent years, we have become accustomed to living in a low-yield world. In the past decade plus a taxable portfolio has kicked off (in many cases) income yields of 3%, 2%, or less. Thus, the tax hit from taxable assets has not been too bad for many. That said, low yields are not guaranteed in the future. It could be that yields will rise, and thus taxable assets will generate increasing amounts of taxable income. 

By living off taxable assets first, early retirees reduce and ultimately eliminate taxable interest, dividends, and capital gain distributions generated by holding assets in taxable accounts. This reduces the tax cost of the overall portfolio, and makes planning MAGI, taxable income, and tax paid annually an easier and potentially more beneficial exercise. 

I discuss the early retirement Roth Conversion Ladder strategy in this video.

Conclusion

In many cases, I believe that the tax optimal path for the early retiree is to live off taxable assets first in early retirement prior to accessing Roth Basis, HSAs, and traditional retirement accounts. Of course, this is not individualized advice for you or any other particular individual. Those considering early retirement are well advised to consider their future drawdown strategy as they are building their assets. Those already retired should consider their own particular circumstances and ways to optimize their drawdown strategy. 

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.

Tax Efficient Estate Planning

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

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

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

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

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

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

Spouses

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

Tax Baskets

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

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

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

Traditional Accounts

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

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

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

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

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

Roth Accounts

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

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

Health Savings Accounts

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

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

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

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

Taxable Accounts

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

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

A couple of additional notes. First, leaving appreciated taxable assets at death to heirs is much better than gifting such assets to heirs during your life. A quick example: William lives in a house he purchased in 1970 for $50,000. In 2019 the house is worth $950,000. If William gifts the house to his son Alan in 2019, Alan’s basis in the house is $50,000. However, if William leaves the house to Alan at William’s death, Alan’s basis in the house will be the fair market value of the house at William’s death.

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

Conclusion

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

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

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

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

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

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

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

Follow me on Twitter at @SeanMoneyandTax

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