It’s that time of year again. The air is cool and the Election is in the rear-view mirror. That can only mean one thing when it comes to personal finance: time to start thinking about year-end tax planning.
I’ll provide some commentary about year-end tax planning to consider, with headings corresponding to the timeframe required to execute.
As always, none of this is advice for your particular situation but rather it is educational information.
Urgent
By urgent, I mean those items that (i) need to happen before year-end and (ii) may not happen if taxpayers delay and try to accomplish them late in the year.
Donor Advised Fund Contributions
The donor advised fund is a great way to contribute to charity and accelerate a tax deduction. My favorite way to use the donor advised fund is to contribute appreciated stock directly to the donor advised fund. This gets the donor three tax benefits: 1) a potential upfront itemized tax deduction, 2) removing the unrealized capital gain from future income tax, and 3) removing the income produced by the assets inside the donor advised fund from the donor’s tax return.
In order to get the first benefit in 2024, the appreciated stock must be received by the donor advised fund prior to January 1, 2025. This deadline is no different than the normal charitable contribution deadline.
However, due to much year end interest in donor advised fund contributions and processing time, different financial institutions will have different deadlines on when transfers must be initiated in order to count for 2024. Donor advised fund planning should be attended to sooner rather than later.
Taxable Roth Conversions
For a Roth conversion to count as being for 2024, it must be done before January 1, 2025. That means New Year’s Eve is the deadline. However, taxable Roth conversions should be done well before New Year’s Eve because
It requires analysis to determine if a taxable Roth conversion is advantageous,
If advantageous, the proper amount to convert must be estimated, and
The financial institution needs time to execute the Roth conversion so it counts as having occurred in 2024.
Before the Election, many commentators said “you’ve gotta get your Roth conversions done before tax rates go up in 2026!” If this were X (the artist formerly known as Twitter), the assertion would likely be accompanied by a hair-on-fire GIF. 😉
I have disagreed with the assertion. As I have stated before, there’s nothing more permanent than a temporary tax cut! Now with a second Trump presidency and a Republican Congress, it is likely that the higher standard deduction and rate cuts of the Tax Cuts and Jobs Act will be extended.
Regardless of the particulars of 2025 tax changes, I recommend that you make your own personal taxable Roth conversion decisions based on your own personal situation and analysis of the landscape and not a fear of future tax hikes.
Adjust Withholding
This varies, but it is a good idea to look at how much tax you owed last year. If you are on pace to get 100% (110% if 2023 AGI is $150K or greater) or slightly more of that amount paid into Uncle Sam by the end of the year (take a look at your most recent pay stub), there’s likely no need for action. But what if you are likely to have much more or much less than 100%/110%? It may be that you want to reduce or increase your workplace withholdings for the rest of 2024. If you do, don’t forget to reassess your workplace withholdings for 2024 early in the year.
One great way to make up for underwithholding is through an IRA withdrawal mostly directed to the IRS and/or a state taxing agency. Just note that for those under age 59 ½, this tactic may require special planning.
These items can wait till close to year-end, though you don’t want to find yourself doing them on New Year’s Eve.
Tax Gain Harvesting
For those finding themselves in the 12% or lower federal marginal income tax bracket and with an asset in a taxable account with a built-in gain, tax gain harvesting prior to December 31, 2024 may be a good tax tactic to increase basis without incurring additional federal income tax. Remember, though, the gain itself increases one’s taxable income, making it harder to stay within the 12% or lower marginal income tax bracket.
I’m also quite fond of tax gain harvesting that reallocates one’s portfolio in a tax efficient manner.
Tax Loss Harvesting
The deadline for tax loss harvesting for 2024 is December 31, 2024. Just remember to navigate the wash sale rule.
RMDs from Your Own Retirement Account
The deadline to take any required minimum distributions from one’s own retirement account is December 31, 2024. Remember, the rules can get a bit confusing. Generally, IRAs can be aggregated for RMD purposes, but 401(k)s cannot.
RMDs from Inherited Accounts
The deadline to take any RMDs from inherited retirement accounts is December 31st. For some beneficiaries of retirement accounts inherited during 2020, 2021, 2022, and 2023, the IRS has waived 2024 RMDs. That said, all beneficiaries of inherited retirement accounts may want to consider affirmatively taking distributions (in addition to RMDs, if any) before the end of 2024 to put the income into a lower tax year, if 2024 happens to be a lower taxable income year vis-a-vis future tax years.
Can Wait Till Next Year
Traditional IRA and Roth IRA Contribution Deadline
The deadline for funding either or both a traditional IRA and a Roth IRA for 2024 is April 15, 2025.
Backdoor Roth IRA Deadline
There’s no law saying “the deadline for the Backdoor Roth IRA is DATE X.” However, the deadline to make a nondeductible traditional IRA contribution for the 2024 tax year is April 15, 2025. Those doing the Backdoor Roth IRA for 2024 and doing the Roth conversion step in 2025 may want to consider the unique tax filing when that happens (what I refer to as a “Split-Year Backdoor Roth IRA”).
HSA Funding Deadline
The deadline to fund an HSA for 2024 is April 15, 2025. Those who have not maximized their HSA through payroll deductions during the year may want to look into establishing payroll withholding for their HSA so as to take advantage of the payroll tax break available when HSAs are funded through payroll.
The deadline for those age 55 and older to fund a Baby HSA for 2024 is April 15, 2025.
2025 Tax Planning at the End of 2024
HDHP and HSA Open Enrollment
It’s open enrollment season. Now is a great time to assess whether a high deductible health plan (a HDHP) is a good medical insurance plan for you. One of the benefits of the HDHP is the health savings account (an HSA).
For those who already have a HDHP, now is a good time to review payroll withholding into the HSA. Many HSA owners will want to max this out through payroll deductions so as to qualify to reduce both income taxes and payroll taxes.
Self-Employment Tax Planning
Year-end is a great time for solopreneurs, particularly newer solopreneurs, to assess their business structure and retirement plans. Perhaps 2024 is the year to open a Solo 401(k). Often this type of analysis benefits from professional consultations.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, 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.
It happened. The frontrunner for the Presidency said “Sure, . . . why not?” when asked if he would eliminate the income tax on the Joe Rogan podcast. Whoa!!!
Okay, let’s calm down. Let’s not plan on never filing a tax return again just yet.
Tax planning is all about probabilities. Over the 2024 presidential campaign, probabilities have shifted. Below I’ll discuss the changing landscape, what it means for how Americans should approach their own planning (at year-end in 2024 and beyond), and a few thoughts on the future of American taxation.
Trump Tax Promises and Trend
Trump has been quite explicit with three individual income tax cut promises during the campaign:
No tax on tips
No tax on Social Security
No tax on overtime
Trump and his campaign have frequently mentioned these. It’s more than fair for the electorate to hold Trump to these promises.
I saw then what has become even clearer thanks to Donald Trump’s answer Joe Rogan’s question: the Trump Era would, to at least some degree, shift America away from income taxes and towards tariffs.
I do not view Trump’s answer to Rogan as a promise. It was one line during a 3 hour interview. It should be taken seriously, not literally. Trump briefly stated it in response to Rogan’s question. Importantly, Trump then went into detail not on eliminating income taxes but rather on his fondness of tariffs.
The above caveats aside, trend here is obvious. Much like with polling, trends matter much more than the top line. I have previously stated that tariffs might become very popular with politicians after Trump’s retirement. Voters don’t file tariff tax returns! That alone indicates future politicians might be more than happy to adopt pro-tariff positions, which could mean less in the way of income taxes.
What this Means for Americans
Does a Joe Rogan episode radically change financial planning for most Americans? No. But considering the odds, I think it, combined with Trump’s other promises, gives us two insights to consider.
2024 Year-End Roth Conversions
First, there is little reason to rush year-end 2024 Roth conversions, particularly before Election Day. The conventional wisdom had been “better do those Roth conversions before taxes go up in 2026!” That conventional wisdom is now out the window.
I generally recommend Roth conversions when they make sense for the individual based on the individual’s circumstances. I don’t recommend Roth conversions based on “conventional wisdom” about tax changes in 2026.
If future income taxes are trending down, why not take the deduction while it is valuable? That’s where we are going into the 2024 Election.
Does this mean we should never go Roth? No! But now we must start to question paying tax to get into Roth.
Please don’t read this to say “oh wow, FI Tax Guy is against Roth.” Far from it! But I must question paying federal income tax in 2024 to get into Roth.
There are times we pay tax to get into a Roth. Contributing to a Roth 401(k) instead of to a traditional 401(k) is paying tax to get into Roth, because we have foregone the tax deduction that we could have received for a traditional 401(k) contribution. Taxable Roth conversions are another time we pay tax to get into a Roth.
There are times we don’t pay tax to get into a Roth. For most people, an annual Roth IRA contribution involves no additional tax, since most Americans do not qualify to deduct contributions to traditional IRAs. Backdoor Roth IRA contributions are the same – there’s no forgone tax deduction. “Taxable” Roth conversions against the standard deduction are another example where there’s no additional federal income tax incurred to get money into a Roth.
To my mind, these “tax free” ways are the best way to get money into Roth accounts, and in this environment should be favored.
My Proposal
Many questions and challenges remain regardless of the outcome of the Election. It remains to be seen how much revenue can be raised by tariffs. The 47th President must prioritize significant cuts to federal spending, particularly foreign military spending. Oh, and the federal government has over $35 trillion of accumulated debt.
We are a long way away from axing the individual income tax. But, perhaps a relatively modest measure could get many Americans there. I propose doubling the standard deduction. The IRS just announced the 2025 standard deduction will be $15,000 for singles and $30,000 for married filing joint couples. Why not double it to $30K for singles and $60K for marrieds?
My proposal achieves some great outcomes. Combined with no taxes on Social Security, a doubled standard deduction would eliminate income taxes for most retired Americans. Trump could say he eliminated millions of tax returns with this one change.
Doubling the standard deduction would be a significant tax cut for millions of working Americans. Further, it would greatly reduce the number of Americans claiming itemized deductions, making the tax code easier to administer for the Internal Revenue Service.
Lastly, a government with $35 trillion plus of debt probably shouldn’t stop taxing the Elon Musks of the world. My proposal keeps taxing him and is no tax cut for him at all (assuming he makes more than $30,000 annually in charitable contributions).
Assuming Congress passes significantly increased tariffs in 2025, I recommend a five year doubling of the standard deduction. That would give the government five years to test out the new system to see if increased tariffs and decreased income taxes, hopefully in concert with significant spending cuts, is successful.
Conclusion
I will cry no tears if the income tax goes away. However, I don’t think we can plan for its demise.
While the income tax is likely here to stay, the trend is becoming obvious. Tariffs are likely on the way up and income taxes are likely on the way down. That informs retirement and tax planning. There’s little reason to rush Roth conversions, and traditional retirement account contributions are more attractive.
Of course, stay tuned. The Election is not over. There are no guarantees as I write this on October 26, 2024. I promise I’ll have plenty of commentary about year-end planning and more after the Election.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
Is earned income required to contribute to an individual retirement account (an “IRA”)? If you’re married, it may not be, thanks to the Spousal IRA.
The Spousal IRA is a great opportunity for families to build financial stability, and perhaps get a juicy tax deduction, even if only one of the spouses work outside of the home. It can help families save for the future and prioritize other important goals such as raising children.
IRA Basics
There are two types of IRAs that most working Americans can consider. I did a primer about them here.
A Roth IRA offers no tax deduction on the way in, but features tax-free growth and tax-free withdrawals in retirement.
Both can be a great way to build up tax-advantaged wealth for retirement.
IRA Contribution Limits
The limit on IRA contributions for 2023 is the lesser of $6,500 or earned income ($7,500 or earned income if you are age 50 or older in 2023). The limit on IRA contributions for 2024 is the lesser of $7,000 or earned income ($8,000 or earned income if you are age 50 or older in 2024). Remember that traditional IRAs and Roth IRAs share that contribution limit, so a dollar contributed to a traditional IRA is a dollar that cannot be contributed to a Roth IRA and vice-versa.
IRA Contribution Deadlines
Generally speaking, the deadline to contribute to either a traditional IRA or a Roth IRA is April 15th of the following year. The deadline cannot be extended even if the taxpayer files for an extension to file their own tax return. On rare occasions the IRS may provide a very limited exception to the April 15th IRA contribution deadline.
The Spousal IRA
For purposes of having earned income allowing one to make an IRA contribution (tradition and/or Roth), a non-working spouse can use their spouse’s earned income for purposes of making either (or both) a traditional IRA or a Roth IRA contribution.
Here is an example:
Joe and Mary are married. Joe has a W-2 job and Mary does not. Mary can make an IRA contribution (a Spousal IRA) based on Joe’s W-2 earned income.
The Spousal IRA can be used to increase tax-advantaged retirement savings. It can also be used to strategically optimize tax deductions. Many W-2 workers are covered by a workplace 401(k) plan. Thus, based on low income limits, it is difficult for them to deduct a traditional IRA contribution.
However, when one is not covered by a workplace retirement plan, it is much easier to qualify to deduct a traditional IRA contribution. It is often the case that a Spousal IRA will offer a potential tax deduction when the working spouse is not able to deduct a traditional IRA contribution.
Split-Year Spousal IRA Contribution Example
As I write this, the 2024 tax return season (for 2023 tax returns) is about to get started. Now’s the time to be thinking about 2023 IRA contributions if you have not yet made one!
There’s still plenty of time to contribute to an IRA (traditional or Roth) for the year 2023. Some of that planning might involve strategically employing a Spousal IRA. Here’s an example:
It is early April 2024 and Mark and Theresa are about to file their tax returns. They see they have $8,500 in cash available to use to make 2023 IRA contributions. What they might want to do is contribute $6,500 to a 2023 deductible traditional IRA for Theresa (a Spousal IRA) and the remaining $2,000 to a 2023 Roth IRA for Mark, since he cannot deduct a traditional IRA contribution. By prioritizing a tax deduction, Mark and Theresa save $2,034.50 on their 2023 income taxes.
The Spousal IRA as a Backdoor Roth IRA
The Spousal IRA can be executed as a Backdoor Roth IRA. Here is an example:
Jack and Betty, both age 42, are married. Jack works a W-2 job and Betty does not have earned income. Jack is covered by a 401(k) at work. Their MAGI for 2024 is $260,000 and thus neither of them qualify to make a regular annual contribution to a Roth IRA.
Assuming Betty has no balances in traditional IRAs, SEP IRAs, and SIMPLE IRAs (and thus does not have a Pro-Rata Rule problem), Betty can contribute $7,000 to a nondeductible traditional IRA and then convert that amount (plus any growth) to a Roth IRA. Doing so uses a Spousal IRA to implement a Backdoor Roth IRA.
Spousal IRA Tax Return Reporting
To report a deductible traditional Spousal IRA contribution, the amount of the contribution must be reported on Schedule 1, line 20, filed with the couple’s annual federal income tax return.
To report a nondeductible traditional Spousal IRA contribution, the amount of the contribution must be reported on Part I of the Form 8606.
There is no required federal income tax return reporting for a Roth Spousal IRA contribution. However, such contributions should be entered into the tax return software to help determine the potential eligibility for a retirement savers’ credit.
Conclusion
The Spousal IRA creates a great opportunity for married couples to save for retirement and possibly gain access to valuable tax deductions. It can help married couples focus on important priorities such as child rearing and still make significant contributions to retirement accounts.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
If you have basis in an IRA, you will want to read this post. Basis in an IRA creates all sorts of confusion, but it also presents a great planning opportunity for many of those still working. I refer to this opportunity as the Basis Isolation Backdoor Roth IRA.
Where Does IRA Basis Come From?
Basis in a traditional IRA generally emerges from two sources. The first source is old nondeductible traditional IRA contributions that have not been Roth converted or withdrawn. Nondeductible traditional IRA contributions should be reported on a Form 8606 filed with one’s annual federal income tax return.
Many times this basis is simply exhausted annually by Backdoor Roth IRAs. Here’s a quick example:
Example 1: Becky contributed $6,500 to a traditional, nondeductible IRA on January 2, 2023. On February 1, 2023, when the traditional IRA was worth $6,504, she converted the entire traditional IRA balance to a Roth IRA. On December 31, 2023, she had $0 in all traditional IRAs, SEP IRAs, and SIMPLE IRAs. She successfully completed the Backdoor Roth IRA, which created $6,500 of IRA basis on January 2nd and exhausted all $6,500 of that basis on February 1st.
However, there are plenty of Americans who have existing and remaining IRA basis because they can’t do the Backdoor Roth IRA efficiently, or they never did the Backdoor Roth IRA.
To sum up, those doing annual tax-efficient Backdoor Roth IRAs tend not to have any IRA basis at year-end. But some Americans do have existing and remaining IRA basis.
There are Americans with existing IRA basis through transfers from a 401(k) (or other qualified plan) to a traditional IRA. However, going forward this should generally not occur. The IRS and Treasury issued Notice 2014-54, which provides that after-tax 401(k) contribution amounts can be rolled directly to a Roth IRA. From a planning perspective, after-tax 401(k) contributions (and other qualified plan after-tax contributions) should generally be directed into Roth IRAs if the plan participant prefers to exit the plan for IRAs (at retirement or a job change, for example).
Example 2: Chris is age 53. He leaves employment at Consolidated Industries, Inc. on November 1, 2023. At that time, he had a traditional 401(k) at Consolidated worth $500,000. During his time at Consolidated, Chris made $75,000 of after-tax contributions to the traditional 401(k) which remain in the traditional 401(k). Chris prefers to manage the money himself in an IRA or IRAs. Thus, he has two options:
Option One: Transfer the money (preferably through a direct trustee-to-trustee transfer) to a single traditional IRA. Chris now has $75,000 of traditional IRA basis.
Option Two: Transfer (preferably through direct trustee-to-trustee transfers) the after-tax money $75,000 to a Roth IRA and $425,000 to a traditional IRA. The $75,000 goes into the Roth IRA as a nontaxable conversion contribution (see also Notice 2014-54 Example 4). Chris receives no basis in his traditional IRA.
Which option is better for Chris? Clearly it is Option Two, which gives Chris tax-free growth on his $75,000. Further, Chris can withdraw the $75,000 from the Roth IRA tax and penalty free at any time while Chris would be subject to the hard bite of the Pro-Rata Rule if he used Option 1 and later withdrew $75,000 from the traditional IRA. Thus, while Chris is allowed to roll his $75K 401(k) basis into a traditional IRA, he would be much better served to roll the basis tax-free into a Roth IRA.
A Current Employer Qualified Plan That Accepts Rollovers
In order to have an IRA basis isolation opportunity, one must be currently employed by an employer with a qualified plan (often a 401(k)) that accepts IRA roll-ins. Many qualified plans accept IRA roll-ins but not all do.
One should generally employ the Basis Isolation Backdoor Roth IRA if they have a 401(k) or other qualified plan at work they are satisfied with from both an investment choice standpoint and a fee standpoint. If one isn’t satisfied with their workplace retirement plan the Basis Isolation Backdoor Roth IRA may not be a good tactic to employ.
Comprehensive Basis Isolation Backdoor Roth IRA Case Study
Having addressed the two prerequisites to do a Basis Isolation Backdoor Roth IRA, let’s dive in with a comprehensive case study.
Imagine Ray has two (and only two) traditional IRAs. IRA 1 is a $100K traditional IRA rollover from an old 401(k). No basis came along in the rollover into IRA 1. IRA 2 is a traditional IRA worth $25K. It was established with three $6K nondeductible traditional IRA contributions for 2020 through 2022. He filed Forms 8606 reporting those contributions.
Ray’s current employer (Acme) has a great 401(k) that accepts roll-ins of traditional IRAs. What could Ray do to take advantage of his traditional IRA basis? He will need to isolate that basis, and that’s where the Basis Isolation Backdoor Roth IRA comes in.
Step 1
Ray transfers IRA 1 to the Acme 401(k), preferably through a direct trustee-to-trustee transfer.
Step 2
Ray invests about $18,010 of IRA 2 in a money market account and invests the remainder of IRA 2 in any investment of his choice (Mutual Fund A).*
By putting that $18,000 and a bit of change in a money market, Ray makes sure he “leaves behind” the IRA basis in the IRA! We will come back to why this “leave behind” asset is so critically important in the Step 3 discussion and analysis.
* As a practical matter, it may be easier to split IRA 2 into IRA 2 and IRA 3, with the $18,010 in IRA 2 and Mutual Fund A in IRA 3. Either path can work, but splitting into IRA 2 and IRA 3 may be the easier path. That split should be done internally at the IRA 2 institution without any check coming out of IRA 2 to the owner.
Step 3
Ray transfers the entire value of Mutual Fund A to the Acme 401(k), preferably through a direct trustee-to-trustee transfer.
If the $18,010 was invested in an equity mutual fund (call it Mutual Fund B), there’s a risk that when Ray does Step 3 he will leave behind only Mutual Fund B, which could be less than his $18K basis if Mutual Fund B declines in value.
Example 3: Imagine Ray does Step 3 when Mutual Fund A is worth $10K and Mutual Fund B, originally worth $18K is now only worth $14K based on market declines. In such a case, $4K of basis would (theoretically) move into the Acme 401(k) with the $10K going from IRA 2 to the Acme 401(k). That would be a prohibited transfer of basis.
IRA Aggregation: Remember that for tax purposes, the IRS looks at all of Ray’s traditional IRAs (whether he has one or ten) as a single traditional IRA. We can’t say that basis attaches to IRA 2 only, so it is important that Ray leave at least $18K behind in an IRA so that after the transfers from his IRAs to qualified plans he can demonstrate that his basis was left behind in one or more of his traditional IRAs.
Step 4
Step 4: Ray converts the entire remaining balance in IRA 2 (likely to be $18,010 plus a bit of additional interest) to a Roth IRA. The only taxable amount is the small amount over $18,000.
Step 4 is reported on a Form 8606 (Parts 1 and 2).
The Benefits of the Basis Isolation Backdoor Roth IRA
Ray has moved approximately $107K from traditional IRAs to the Acme 401(k). That is entirely tax free and does not change the future tax treatment of that money. Perfectly fine, but by itself this doesn’t improve Ray’s tax position.
Before this planning, Ray had $18K of IRA basis that was of limited value due to the Pro-Rata Rule. Future taxable distributions or conversions from his traditional IRAs would have picked up only a small portion of that $18K, meaning that it would only protect small portions of future distributions and conversions from current taxation.
Example 4 The Pro-Rata Rule Bites Ray: If Ray had $18K of basis and $125K of total traditional IRAs and decided to do a $10K Roth conversion (without first doing the Basis Isolation Backdoor Roth IRA), approximately $1,440 of that Roth conversion would have been tax free and approximately $8,560 would have been taxable. See the mock Form 8606 Part I here and Form 8606 Part II here (though note that tax return software programs may use a separate statement instead of actually completing the form).
But with the Basis Isolation Backdoor Roth IRA Ray puts $18K plus into a Roth IRA and paid almost no tax to do so! Ray successfully isolated all $18,000 of basis to get it all into a Roth IRA without being adversely affected by the Pro-Rata Rule. Further, that $18,000 can now grow tax free for the rest of Ray’s life. Previously, inside a traditional IRA that $18,000 was growing tax-deferred, not tax free.
The Basis Isolation Backdoor Roth IRA improved Ray’s position by getting around the Pro-Rata Rule to get $18K plus into a Roth IRA for hardly any income tax. The only tax Ray pays is on the small amount the conversion amount in Step 4 exceeds $18,000.
The Basis Isolation Backdoor Roth IRA also opens another future tax planning opportunity. Going forward, Ray can do annual Backdoor Roth IRAs in a tax-efficient manner because he cleaned out his traditional IRAs into his workplace 401(k).
Practical Considerations
The Basis Isolation Backdoor Roth IRA is not a tactic to be affirmatively planned into. Rather, it is a clean up tactic. It makes the best of a situation where one has both basis and pretax amounts in traditional IRAs. The Backdoor Roth IRA is an affirmative planning technique, though it may require similar clean-up steps prior to implementation.
This planning is sophisticated and benefits from professional assistance. I recommend that most work with a professional if they are considering this sort of planning. Further, this planning does not occur every day. My experience suggests that most professionals are unfamiliar with this type of planning. Professionals will need to review resources such as this blog post and other sources and measure two or three times to dot I’s and cross T’s on this type of planning.
Of course, this blog post is not advice for the reader or any particular individual.
Additional IRA Basis and IRA Basis Isolation Resource
I went into detail on this planning in a June 2023 Measure Twice Planners presentation. While the presentation is mostly geared towards advisors, I hope I presented it in such a way that layman can also understand much of it and get value from it. The presentation and its slides, like this particular post, are for educational purposes only and are not intended as advice for any particular individual.
Conclusion
Existing basis in IRAs is a planning opportunity if the investor has a good workplace 401(k) or other qualified plan that accepts IRA roll-ins. That planning requires intention and diligence, and measuring two or three times, even if working with a professional.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
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.
There are only three types of annual contributions to individual retirement accounts (“IRAs”). They are:
Traditional, nondeductible contributions
Traditional, deductible contributions
Roth contributions
This post discusses when a taxpayer can make one or more of these types of annual contributions.
Let’s dispense with what we are not talking about. This post has nothing to do with annual contributions to employer retirement plans (401(k)s and the like) and self-employed retirement plans. We’re only talking about IRAs. The Individual in “IRA” is the key – anyone can set up their own IRA. IRAs are not pegged to any particular job or self-employment.
The above list is the exhaustive list of the possible types of annual contributions you can make to an IRA. But there is plenty of confusion about when you are eligible to make each of the three types of annual contributions.
Why Contribute to an IRA?
Before we dive into annual contributions to IRAs, let’s discuss why you would consider contributing to an IRA. The main reason is to build up tax-deferred wealth (traditional IRAs) and/or tax-free wealth (Roth IRAs) for your future, however you define it: financial independence, retirement, etc. A second potential benefit is the ability to deduct some annual contributions to traditional IRAs. A third benefit is some degree of creditor protection. States offer varying levels of creditor protection to traditional IRAs and Roth IRAs, while the federal government provides significant bankruptcy protection for traditional IRAs and Roth IRAs.
IRA Annual Contribution Requirement: Earned Income
In order to make any of the three types of IRA annual contributions for any particular year, you or your spouse must have earned income during that year. Earned income is generally that income that is reported to you on your Form W-2, or is reported by you on your tax return on Schedule C (self-employment income). It also includes self-employment income reported to you on a Form K-1 (because you are a self-employed partner in a partnership). It does not include income reported to you on a Form K-1 from an S corporation.
While wages, nontaxable combat income, and self-employment income qualify as earned income for this purpose, several types of income do not. Social security, pensions, rentals, royalties, interest, and dividends are not earned income. Income excluded from taxable income under the foreign earned income exclusion also does not constitute “earned income” for IRA purposes.
Traditional Nondeductible IRA Annual Contributions
There’s are only one requirement to contribute to a traditional, nondeductible IRA for a taxable year:
You and/or your spouse have earned income during that taxable year.
That’s it! As long as you satisfy that requirement, you can contribute to a traditional nondeductible IRA, no further questions asked.
Example: Teve Torbes is the publisher of a successful magazine. He is paid a salary of $1,000,000 in 2024 and is covered by the magazine’s 401(k) plan. Teve can make up to a $7,000 nondeductible contribution to a traditional IRA, and Teve’s wife can also make up to a $7,000 nondeductible contribution to a traditional IRA.
There is no tax deduction for contributing to a traditional nondeductible IRA. The amount of your nondeductible contribution creates “basis” in the traditional IRA. When you withdraw money from the traditional IRA in retirement, a ratable portion of the withdrawal is treated as a return of basis and thus not taxable (the “Pro-Rata Rule”).
Example: Ted makes a $6,000 nondeductible traditional IRA contribution for each of 10 years ($60,000 total). When he retires, the traditional IRA is worth $100,000, and he takes a $5,000 distribution from the traditional IRA. Ted is over 59 ½ when he makes the withdrawal. Of the $5,000 withdrawal, Ted will include $2,000 in his taxable income, because 60 percent ($3,000 — $60,000 basis divided by $100,000 fair market value times the $5,000 withdrawn) will be treated as a withdrawal of basis and thus tax free.
Traditional nondeductible IRA contributions generally give taxpayers a rather limited tax benefit. However, since 2010 traditional nondeductible IRA contributions have become an important tax planning tool because of the availability of the Backdoor Roth IRA.
Making a nondeductible IRA contribution requires the filing of a Form 8606 with your federal income tax return.
Traditional Deductible IRA Annual Contributions
In order to make a deductible contribution to a traditional IRA, three sets of qualification rules apply.
ONE: No Workplace Retirement Plan
Here are the qualification rules if neither you nor your spouse is covered by an employer retirement plan (401(k)s and the like and self-employment retirement plans):
You and/or your spouse have earned income during that taxable year.
That’s it! As long as you satisfy that requirement and you and your spouse are not covered by an employer retirement plan, you can make a deductible contribution to a traditional IRA, no further questions asked.
Example: Teve Torbes is the publisher of a successful magazine. He and his wife are 45 years old. He is paid a salary of $1,000,000 in 2024. Neither he nor his wife is covered by an employer retirement plan. Teve can make up to a $7,000 deductible contribution to a traditional IRA, and Teve’s wife can also make up to a $7,000 deductible contribution to a traditional IRA.
TWO: You Are Covered by a Workplace Retirement Plan
Here are the deductible traditional IRA qualification rules if you are covered by an employer retirement plan:
You and/or your spouse have earned income during that taxable year.
Your modified adjusted gross income (“MAGI”) for 2024 is less than $87,000 (if single), $143,000 (if married filing joint, “MFJ”), or $10,000 (if married filing separate, “MFS”).
Note that in between $77,000 and $87,000 (single), $123,000 and $143,000 (MFJ) and $0 and $10,000 (MFS), your ability to make a deductible contribution to a traditional IRA phases out ratably. Here is an illustrative example.
Example: Mike is 30 years old, single, and is covered by a 401(k) plan at work. Mike has a MAGI of $82,000 in 2024, most of which is W-2 income. Based on a MAGI in the middle of the phaseout range, Mike is limited to a maximum $3,500 deductible contribution to a traditional IRA.
Assuming he makes a $3,500 deductible IRA contribution, Mike has $3,500 worth of IRA contributions left. He can either, or a combination of both (up to $3,500) (a) make a contribution to a nondeductible traditional IRA, since he meets the qualification requirement to contribute to a nondeductible traditional IRA or (b) make a contribution to a Roth IRA, since he meets the qualification requirements (discussed below) to contribute to a Roth IRA. In such a case, Mike would be likely to favor a Roth IRA contribution over a nondeductible traditional IRA contribution.
THREE: Only Your Spouse is Covered by a Workplace Retirement Plan
Here are the deductible traditional IRA qualification rules if you are not covered by an employer retirement plan but your spouse is covered by an employer retirement plan:
You and/or your spouse have earned income during that taxable year.
Your MAGI for 2024 is less than $240,000 (MFJ) or $10,000 (MFS).
Note that in between $230,000 and $240,000 (MFJ) and $0 and $10,000 (MFS), your ability to make a deductible contribution to a traditional IRA phases out ratably.
Roth IRA Annual Contributions
Here are the Roth IRA annual contribution qualification rules.
You and/or your spouse have earned income during that taxable year.
Your MAGI for 2024 is less than $161,000 (single), $240,000 (MFJ), or $10,000 (MFS).
Note that in between $146,000 and $161,000 (single), $230,000 and $240,000 (MFJ), and $0 and $10,000 (MFS), your ability to make a Roth IRA contribution phases out ratably.
Notice that whether you and/or your spouse are covered by an employer retirement plan (including a self-employment retirement plan) is irrelevant. You and your spouse can be covered by an employer retirement plan and you can still contribute to a Roth IRA (so long as you meet the other qualification requirements).
Here is an example illustrating your options in the Roth IRA MAGI phaseout range.
Example: Mike is 30 years old, single, and covered by a workplace retirement plan. Mike has a MAGI of $155,000 for 2024, most of which is W-2 income. Based on a MAGI 60 percent through the phaseout range, Mike is limited to a maximum $2,800 contribution to a Roth IRA.
Assuming he makes a $2,800 annual Roth IRA contribution, Mike has $4,200 worth of IRA contributions left. He can make up to $4,200 in annual contributions to a nondeductible traditional IRA, since he meets the qualification requirement to contribute to a nondeductible traditional IRA.
IRA Annual Contribution Limits
For taxpayers younger than 50 years old during the entire year, the maximum (for 2024) that can be contributed to the combination of all three types of IRAs is the lesser of:
The taxpayer’s and their spouse’s combined earned income, or
$7,000.
Thus, if both spouses are younger than 50 years old, the maximum IRA contributions for a married couple is $14,000.
For taxpayers 50 years old or older during any part of the taxable year the maximum (for 2024) that can be contributed to the combination of all three types of IRAs is the lesser of:
The taxpayer’s and their spouse’s combined earned income, or
$8,000.
Thus, if both spouses are 50 or older, the maximum IRA contributions for a married couple is $16,000.
Deadlines
The deadline to make an IRA contribution for a particular year is April 15th of the year following the taxable year (thus, the deadline to make a 2024 IRA contribution is April 15, 2025). The deadline to make earned income for a taxable year is December 31st of that year.
Rollover Contributions
There’s a separate category of contributions to IRAs: rollover contributions. These can be from other accounts of the same type (traditional IRA to traditional IRA, Roth IRA to Roth IRA) or from a workplace retirement plan (for example, traditional 401(k) to traditional IRA, Roth 401(k) to Roth IRA).
Rollover contributions do not require having earned income and have no income limits and should be generally tax-free. For a myriad of reasons, it is usually best to effectuate rollovers as direct trustee-to-trustee transfers.
As a practical matter, it is often the case that IRAs serve at the retirement home for workplace retirement plans such as 401(k)s.
Correction
A previous version of this blog post, titled “IRA Contributions for Beginners” erroneously stated that one must be a citizen or resident of the United States to make an IRA contribution. I regret the error.
Further Reading
Deductible traditional IRA or Roth IRA? If you qualify for both, it can be difficult to determine which is better. I’ve written here about some of the factors to consider in determining whether a deductible traditional contribution or a Roth contribution is better for you.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
It’s that time of year again. The air is crisp and my favorite football team is surging. That can only mean one thing when it comes to personal finance: time to start thinking about year-end tax planning.
I’ll break it down with three categories: Urgent, Year-End Deadline, and Can Wait Till Next Year. I will also provide some thoughts on 2024 tax planning that can/should be done before year-end in 2023.
As always, none of this is advice for your particular situation but rather it is educational information.
Urgent
By urgent, I mean those items that (i) need to happen before year-end and (ii) may not happen if taxpayers delay and try to accomplish them late in the year.
A tax deduction for the fair market value of the contributed appreciated stock,
Elimination of the built-in capital gain on the contributed appreciated stock, and
Tax-free treatment of the income earned inside the donor advised fund.
In order to get the first benefit in 2023, the appreciated stock must be received by the donor advised fund prior to January 1, 2024. This deadline is no different than the normal charitable contribution deadline.
However, due to much year end interest in donor advised fund contributions and processing time, different financial institutions will have different deadlines on when transfers must be initiated in order to count for 2023. Donor advised fund planning should be attended to sooner rather than later.
Taxable Roth Conversions
For a Roth conversion to count as being for 2023, it must be done before January 1, 2024. That means New Year’s Eve is the deadline. However, taxable Roth conversions should be done well before New Year’s Eve because
It requires analysis to determine if a taxable Roth conversion is advantageous,
If advantageous, the proper amount to convert must be estimated, and
The financial institution needs time to execute the Roth conversion so it counts as having occurred in 2023.
Roth Conversion Example: See slides 8 through 10 of this slide deck for an example of a Roth conversion in retirement. You might be surprised by just how little federal income tax is owed on a $23,000 Roth conversion.
Example Where I Disfavor Roth Conversions: I present an example of a 73-year old married couple with $400K in deferred retirement accounts and $87K in 2023 gross income. I would not recommend they do end-of-year Roth conversions. This spreadsheet computes the taxable Social Security with and without a $10K Roth conversion.
Gotta Happen Before 2026!!!
You will hear many commentators say “do more Roth conversions before tax rates go up in 2026!” If this were X (the artist formerly known as Twitter), the assertion would likely be accompanied by a hair-on-fire GIF. 😉
I disagree with the assertion. As I have stated before, there’s nothing more permanent than a temporary tax cut. You do your own risk assessment, but mine is this: members of Congress like to win reelection, and they are not going to want to face voters without having acted to ensure popular tax cuts, such as the reduction of the 15% tax rate down to 12% and the increased standard deduction, are extended.
I recommend that you make your own personal taxable Roth conversion decisions based on your own personal situation and analysis of the landscape and not a fear of future tax hikes.
This varies, but it is a good idea to look at how much tax you owed last year (line 24 on the Form 1040). If you are on pace to get 100% (110% if 2022 AGI is $150K or greater) or slightly more of that amount paid into Uncle Sam by the end of the year (take a look at your most recent pay stub), there’s likely no need for action. But what if you are likely to have much more or much less than 100%/110%? It may be that you want to reduce or increase your workplace withholdings for the rest of 2023. If you do, don’t forget to reassess your workplace withholdings for 2024 early in the year.
There’s plenty of planning that needs to be done for solopreneurs in terms of retirement account contributions. Even though Schedule C solopreneurs can now establish a Solo 401(k) after year-end (up to April 15th), it is absolutely the case that it is better to do the planning upfront. For those Schedule C solopreneurs with a Solo 401(k) established, December 31st is the deadline to make 2023 employee deferral contributions or make a 2023 deferral election as an alternative to making the payments in 2023. December 31st is also the 2023 employee deferral contribution for solopreneurs operating out of S corporations.
The Solo 401(k) can get complicated. That’s why I wrote a book about them and post an annual update on Solo 401(k)s here on the blog.
Year-End Deadline
These items can wait till close to year-end, though you don’t want to find yourself doing them on New Year’s Eve.
Tax Gain Harvesting
For those finding themselves in the 12% or lower federal marginal income tax bracket and with an asset in a taxable account with a built-in gain, tax gain harvesting prior to December 31, 2023 may be a good tax tactic to increase basis without incurring additional federal income tax. Remember, though, the gain itself increases one’s taxable income, making it harder to stay within the 12% or lower marginal income tax bracket.
I’m also quite fond of tax gain harvesting that reallocates one’s portfolio in a tax efficient manner.
Tax Gain Harvesting Example:See slide 15 of this slide deck for an example of tax gain harvesting in retirement.
Tax Loss Harvesting
The deadline for tax loss harvesting for 2023 is December 31, 2023. Just remember to navigate the wash sale rule.
RMDs from Your Own Retirement Account
The deadline to take any required minimum distributions from one’s own retirement account is December 31, 2023. Remember, the rules can get a bit confusing. Generally, IRAs can be aggregated for RMD purposes, but 401(k)s cannot.
RMDs from Inherited Accounts
The deadline to take any RMDs from inherited retirement accounts is December 31st. For some beneficiaries of retirement accounts inherited during 2020, 2021, and 2022, the IRS has waived 2023 RMDs. That said, all beneficiaries of inherited retirement accounts may want to consider affirmatively taking distributions (in addition to RMDs, if any) before the end of 2023 to put the income into a lower tax year, if 2023 happens to be a lower taxable income year vis-a-vis future tax years.
Can Wait Till Next Year
Traditional IRA and Roth IRA Contribution Deadline
The deadline for funding either or both a traditional IRA and a Roth IRA for 2023 is April 15, 2024.
Backdoor Roth IRA Deadline
There’s no law saying “the deadline for the Backdoor Roth IRA is DATE X.” However, the deadline to make a nondeductible traditional IRA contribution for the 2023 tax year is April 15, 2024. Those doing the Backdoor Roth IRA for 2023 and doing the Roth conversion step in 2024 may want to consider the unique tax filing when that happens (what I refer to as a “Split-Year Backdoor Roth IRA”).
HSA Funding Deadline
The deadline to fund an HSA for 2023 is April 15, 2024. Those who have not maximized their HSA through payroll deductions during the year may want to look into establishing payroll withholding for their HSA so as to take advantage of the payroll tax break available when HSAs are funded through payroll.
The deadline for those age 55 and older to fund a Baby HSA for 2023 is April 15, 2024.
2024 Tax Planning at the End of 2023
HDHP and HSA Open Enrollment
It’s open enrollment season. Now is a great time to assess whether a high deductible health plan (a HDHP) is a good medical insurance plan for you. One of the benefits of the HDHP is the health savings account (an HSA).
For those who already have a HDHP, now is a good time to review payroll withholding into the HSA. Many HSA owners will want to max this out through payroll deductions so as to qualify to reduce both income taxes and payroll taxes.
Self-Employment Tax Planning
Year-end is a great time for solopreneurs, particularly newer solopreneurs, to assess their business structure and retirement plans. Perhaps 2024 is the year to open a Solo 401(k). Perhaps their business is growing such that an S corporation election makes sense. The best time to be thinking about these sorts of things for 2024 is late in 2023. Often this analysis benefits from professional consultations.
Additional Resource
Please see my November 11, 2023 ChooseFI Orange County year-end tax planning presentation slide deck.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
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.
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
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.
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.
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 deductibletraditional 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.
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
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.
HUGE UPDATE: On October 16, 2023, the IRS issued this, extending the October 16, 2023 deadline for 2022 tax acts and filings to November 2023.The IRS announcement allows (most) Californians to make Roth IRA, traditional IRA, and HSA contributions for 2022 up to November 16, 2023 and delays the deadline for many 2022 federal income tax returns and income tax payments to November 16, 2023. Hat tip to Justin Miller on X for the news.
Please enjoy below the rest of my post, as originally authored in August 2023, understanding that now you can replace “October 16” with “November 16” for most Californians.
I’m glad that title intrigued you enough to stop on by. It’s not too late for most Californians to make a 2022 IRA contribution, a 2022 Roth IRA contribution, a 2022 HSA contribution, and/or do a 2022 Backdoor Roth IRA contribution.
You’re probably thinking “What the heck are you talking about? It’s the late summer 2023. Time to be thinking about football, not funding 2022 IRAs and HSAs.”
Your thoughts are correct as applied to most Americans. However, most Californians are the beneficiaries of a special situation. The IRS announced that because of early 2023 flooding in many areas of California, most Californians have an extended deadline, October 16, 2023, to perform most 2022 tax acts that otherwise would have been due early in 2023.
This extension opens the door for millions of Californians to consider 2022 contributions to tax-advantaged accounts. Of course, nothing increases the amount Californians can contribute. Thus, those who have already maxed out for 2022 do not benefit from this deadline extension.
2022 Traditional IRA Contributions
Most working Californians can still make 2022 contributions to a traditional IRA. If the taxpayer has not yet filed their 2022 Form 1040, the deduction or the Form 8606 (for a nondeductible contribution) can simply be included with the to-be filed Form 1040.
But what if the taxpayer has already filed their Form 1040 for 2022? Then the question becomes: are they deducting their 2022 traditional IRA contribution? If no, then the taxpayer can simply file a Form 8606 as a standalone tax return to report the 2022 nondeductible contribution.
However, if the contribution is tax deductible, then the taxpayer would need to file amended Forms 1040 and 540 (for California) to report the deductible IRA contribution and claim refunds from both the IRS and the Franchise Tax Board for the tax reduced because of the deductible traditional IRA deduction.
2022 Roth IRA Contributions
Many working Californians can still make 2022 contributions to a Roth IRA. Since Roth IRA contributions are not deductible, and do not require a separate form to report them, the contribution likely would not require any amending of already-filed 2022 tax returns. One exception would be the case of a taxpayer with a low income in 2022. He or she could make a 2022 Roth IRA contribution and possibly qualify for the Saver’s Credit. In order to claim the credit, they would need to amend their Form 1040 if they already filed it for 2022.
2022 Backdoor Roth IRAs
It’s not too late for a 2022 Backdoor Roth IRA for some Californians! This would be a Split-Year Backdoor Roth IRA. The pressing deadline as of late August 2023 is that the 2022 nondeductible traditional IRA contribution needs to be made by October 16, 2023.
Anyone pursuing a Split-Year Backdoor Roth IRA for 2022 in 2023 should ensure they have no balances in traditional IRAs, SEP IRAs, and/or SIMPLE IRAs as of December 31, 2023.
2022 HSA Contributions
Some Californians can still make 2022 contributions to a health savings account. If the taxpayer has not yet filed their 2022 Form 1040, the tax deduction can simply be added to the to-be filed Form 1040.
But what if the taxpayer has already filed their Form 1040 for 2022? Then the taxpayer would need to file amended Form 1040 to claim the tax deduction and the resulting tax refund from the IRS. Since California does not recognize HSAs, there’s no California tax deduction and no need to amend the California Form 540.
Of course, the taxpayer must meet the eligibility requirements (generally, having had a high deductible health plan as their only medical insurance) in 2022 in order to contribute to a HSA for 2022.
Practical Considerations
First, contributions to IRAs, Roth IRAs, and HSAs made in 2023 that are to count for 2022 must be specifically designated as being for 2022.
Second, I believe that in many cases, in order for qualifying Californians to do this, it will be necessary to use the phone, not internet portals. I suspect most financial institutions’ internet portals will not accommodate a 2022 IRA/Roth IRA/HSA contribution this late. Remember, financial institutions would not want to encourage the vast majority of Americans who do not currently qualify to make 2022 contributions to make 2022 contributions.
Thus, I believe as a practical matter using the phone is a best practice in terms of making any 2022 contributions at this late date.
Who Benefits?
Residents of all California counties except threequalify for the extended deadline. The vast majority of the population of the state qualifies for the extended deadline, but residents of Lassen, Modoc, and Shasta do not appear to qualify (don’t blame me, I don’t make the rules!).
Note that some taxpayers in parts of Alabama and Georgia qualify for this opportunity, but I personally have not explored this in any detail.
Conclusion
Many California residents should consider whether there is some extended last minute 2022 tax planning they can implement by October 16, 2023.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
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.
Ed Slott believes most Americans should not contribute to traditional 401(k)s. His recent essay on the subject is a great opportunity for the FI community to reassess its love for the traditional 401(k).
My conclusion is that for many in the FI community, traditional deductible 401(k) contributions are still the most logical path when it comes to workplace retirement saving. Below I explain my thinking.
It is important to note it is impossible to make a blanket statement as applied to the entire FI community.
Why the Traditional 401(k) Is Good for the FI Community
Many in the FI community have the very reasonable hope that in retirement they will have years, possibly decades, where their effective tax rate will be lower than their marginal tax rate in their working years.
The above is true of many Americans, but it is particularly true if one retires early by conventional standards. The idea is deduct, deduct, deduct into the 401(k) during one’s working years (particularly the high earning years) and then retire early by conventional standards. Prior to collecting Social Security and/or required minimum distributions (“RMDs”), most retirees look artificially poor on their tax return. This opens up the door to affirmatively convert money from traditional retirement accounts to Roth accounts and pay tax at the lowest federal income tax brackets (currently 10% and 12%). For those who deducted contributions into the 401(k) at a 24% or greater marginal federal tax rate, this is great tax rate arbitrage planning.
Minor litigation risks aside, this strategy just got even easier for those born in 1960 and later, who don’t have to take RMDs under SECURE 2.0 until age 75. With the new delayed RMD beginning date, even those retiring as late as age 65 will have a full decade prior to being required to take RMDs to do tax-efficient Roth conversions at low marginal tax rates. For some in the FI community, this opportunity window might not be a decade long but rather a quarter-century long (if they retire at age 50).
How Bad is the Retiree Tax Problem?
As wonderful as FI tax rate arbitrate planning might be, Ed Slott’s concern that retiree taxes will increase is not entirely unwarranted. It is obvious that the government is not fiscally responsible, and it is obvious that tax increases could be coming in the future.
Let’s assess the situation by looking at just how bad the problem of taxes is in retirement.
We begin with a baseline case. David and Hannah are in their 70s. They never did Roth conversions in early retirement and have the bulk of their financial assets in traditional IRAs and traditional 401(k)s. During most of their working years, David and Hannah maxed out 401(k)s and got deductions in the 24% bracket or greater. For 2023, they have taxable RMDs of $160,000, Social Security of $40,000, $4,000 of qualified dividends and $1,000 of interest income. How bad is their federal income tax situation?
Federal Income Tax Return
RMDs
$ 160,000
Social Security
$ 40,000
15% Social Security Exclusion
$ (6,000)
Interest
$ 1,000
Qualified Dividends
$ 4,000
Adjusted Gross Income (“AGI”)
$ 199,000
Standard Deduction
$ (27,700)
Additional SD Age 65+
$ (3,000)
Federal Taxable Income
$ 168,300
Federal Income Tax (Estimated)
$ 27,361
Effective Tax Rate on AGI
13.75%
Marginal Federal Income Tax Rate
22%
Under today’s rules, David and Hannah, who did no tax planning other than “deduct, deduct, deduct” are doing great. Their federal effective tax rate, even with $200K of RMDs and Social Security, is just 13.75%. They incur such a low effective tax rate because their RMDs go against the 10% tax bracket, the 12% bracket, and the 22% bracket.
While I do think David and Hannah would be in a better position had they done some tax efficient Roth conversion planning earlier in retirement, their unbridled enthusiasm for traditional retirement accounts served them well.
Note: David and Hannah are borderline IRMAA candidates: a $199K 2023 AGI might cost them approximately $2,000 in IRMAA surcharges in 2025 (but it is possible that inflation adjustments for 2025 will prevent that from happening). This is another reason to consider pre-RMD Roth conversions at lower marginal tax rates.
Update 8/19/2023: But what about thewidow’s tax trap? If David or Hannah die, won’t the survivor get crushed by tax increases? Check out this estimate. Assuming the survivor loses the lower-earning spouse’s Social Security benefits of at least $10,000, the survivor’s marginal federal income tax rate would climb from 22% all the way up to . . . 24%!
But what about future tax increases? Okay, let’s add four tax increases to the picture and see just how bad it looks:
Eliminate the TCJA increase to the standard deduction (the law reverts to pre-2018 lower standard deduction and personal exemptions). This would reduce David and Hannah’s deductions by roughly $2,740, costing them approximately $602.80 in additional federal income tax (at today’s 22% marginal tax rate).
Eliminate the TCJA decrease in the 15% tax bracket to 12%. This would cost David and Hannah $2,023.50 in additional federal income tax. I’m highly skeptical that either of these two tax increases will actually occur, but as written in today’s laws they are scheduled to happen in 2026.
Increase the 15% long term capital gains and qualified dividend income rate to 25%. While I believe that the real risk is an increase in the 20% long term capital gains and qualified dividend income rate, let’s stress test things and consider a large increase in the 15% rate. In David and Hannah’s case, this costs them $400 in additional federal income tax.
Increase the 22% tax rate to 33%. Ed Slott is worried about large tax rate increases, so let’s consider one that I believe is politically infeasible, a 50% increase in the 22% tax bracket. This type of tax rate increase would hit millions of voters in a major way. But it’s helpful to consider what could be a worst case scenario. In this case, this tax rate increase costs David and Hannah an additional $8,233.50 in federal income tax.
There’s one more tax hike to consider: the combination of tax increases numbers 1 and 4. If both occurred together, combined they would cost David and Hannah an additional $301.40 in federal income tax.
Here’s what David and Hannah’s federal tax picture looks like if all of the above tax increases occur:
Federal Income Tax Return
RMDs
$ 160,000
Social Security
$ 40,000
15% Social Security Exclusion
$ (6,000)
Interest
$ 1,000
Qualified Dividends
$ 4,000
Adjusted Gross Income (“AGI”)
$ 199,000
Standard Deduction
$ (15,240)
Additional SD Age 65+
$ (3,000)
Personal Exemptions
$ (9,720)
Federal Taxable Income
$ 171,040
Federal Income Tax (Estimated)
$ 38,922
Effective Tax Rate on AGI
19.56%
Marginal Federal Income Tax Rate
33%
Significant tax increases hurt David and Hannah, but how much? By my math, very significant tax increases, including a 50% increase in the 22% bracket, cost them about 6% of their income. Not nothing, but wow, they’re still doing very well.
Yes, on the margin, the last dollars David and Hannah contributed to the traditional 401(k) were not ideal since they faced a 33% marginal federal tax rate in retirement. But let’s remember (i) their overall effective rate is still more than 4 percentage points lower than their working years’ marginal rate (at which they deducted their 401(k) contributions), (ii) they have income significantly above what most Americans will have in their 70s, and (iii) in my scenario they face four separate tax hikes and still pay a federal effective tax rate less than 20 percent.
Future Retirees’ Tax Risk
Do future tax hikes pose no threat to future retirees? Absolutely not! But my stress test shows that many Americans with substantial RMDs will not get walloped even if Congress enacts unpopular tax increases. Considering many in the FI community will have modest RMDs due to pre-RMD Roth conversions, the threat of future tax hikes is even less perilous for the FI community.
Further, many Americans, particularly those in the FI community, have a great tool that can mitigate this risk: Roth conversions during retirement! With RMDs now delayed to age 75 for those born in 1960 and later, many Americans will have years if not decades where money can be moved in a tax-efficient manner from old traditional accounts to Roth accounts.
Further, many Americans can claim deductions at work and then at home contribute to a regular Roth IRA or a Backdoor Roth IRA. This too mitigates the risk of having all of one’s retirement eggs in the traditional basket.
Last, do we really believe that Congress is just itching to raise taxes on future retirees? Sure, it’s possible. But to my mind taxes are more likely to be raised on (i) those in higher ordinary income tax brackets and/or (ii) long term capital gains and/or qualified dividends (particularly the current 20% bracket). If anything, the most Congress is likely to do to retirees is slightly increase their taxes so as to mitigate the political risk involved in raising taxes on retirees who tend to vote.
The Risks of Not Having Money in Traditional Retirement Accounts
Risk isn’t a one-way street. There are some risks to not having money in traditional retirement accounts. I identify three below.
Qualification for Premium Tax Credits
Picture it: Joe, age 55, retires with the following assets: (i) a paid off car, (ii) a paid off house, (iii) a $40,000 emergency fund in an on-line savings account, and (iv), $2 million in Roth 401(k)s and Roth IRAs. He heard that Roth is the best, so he only ever contributed to Roth IRAs and Roth 401(k)s, including having all employer contributions directed to a Roth 401(k). Having fallen into the Rothification Trap, in retirement Joe must work in order to generate sufficient taxable income to qualify for any ACA Premium Tax Credit.
For at least some early retirees, the ability to create modified adjusted gross income by doing Roth conversions will be the way they guarantee qualifying for significant Premium Tax Credits to offset ACA medical insurance premiums.
Charitable Contributions
Many Americans are at least somewhat charitably inclined. Starting at age 70 ½, Americans can transfer money directly from a traditional IRA to a charity, exclude the distribution from taxable income, and still claim the standard deduction. Essentially, if you’re charitably inclined, at a minimum you would want to go into age 70 ½ with enough in your traditional IRAs (likely through contributions to traditional 401(k)s that are later transferred to an IRA) to fund your charitable contributions from 70 ½ until death.
Why ever pay tax on that money (i.e., by making contributions to a Roth 401(k) that are later withdrawn to be donated) if the money is ultimately going to charity anyway?
Unused Standard Deductions
Currently, the government tells married couples, hey, you get to make $27,700 a year income tax free! Why not take advantage of that exclusion every year, especially prior to collecting Social Security (which, in many cases will eat up most, if not all, of the standard deduction).
Why be retired at age 55 with only Roth accounts? By having at least some money in traditional retirement accounts going into retirement, you ensure you can turn traditional money into Roth money tax-free simply by converting (at any time) or even distributing (usually after age 59 1/2) the traditional retirement account against the standard deduction.
Deduct at Work, Roth at Home
I think for many it makes sense to max out traditional 401(k)s at work and contribute to Roth IRAs or Backdoor Roth IRAs at home. Why? As discussed above, traditional 401(k)s can set up tax rate arbitrage in retirement, help early retirees qualify for Premium Tax Credits, and make charitable giving after age 70 ½ very tax efficient. At home, many working Americans do not qualify to deduct IRA contributions, so why not contribute to a Roth IRA or Backdoor Roth IRA, since (i) you aren’t giving up a tax deduction in order to do so and (ii) you establish assets growing tax free for the future.
In this post I discuss why deduct at work, Roth at home can often make sense and I provide examples where Roth 401(k) contributions are likely to be better than traditional 401(k) contributions.
Conclusion
I believe that for many in the FI community, a retirement savings plan that combines (i) traditional deductible 401(k) contributions during one’s working years and (ii) Roth conversions prior to collecting RMDs is likely to be a better path than simply making all workplace retirement contributions Roth contributions.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
Roth IRAs allow tax-free distributions to fund retirement. However, to help secure retirement savings and avoid premature raiding of Roth IRAs, Congress did not give them blanket exemption from taxes and penalties. Thus, there are times where distributions from Roth IRAs are subject to either or both ordinary income tax and/or the 10% early withdrawal penalty. The IRS and Treasury have issued regulations governing the rules of the road for Roth IRAs, which interpret the rules Congress wrote in IRC Section 408A.
A Few Introductory Notes Before We Get Started
The below post is different from many posts on FITaxGuy.com in two respects. First, my posts tend to be planning focused, though they often dive into tax rules, as a good understanding of the rules helps with planning. This post is almost entirely rules focused rather than planning focused.
Second, the primary audience for this post is tax and financial advisors (though I welcome both laymen and professionals reading and questioning the post). I have recently observed that professionals seem to be confused about the Roth IRA distribution rules. It’s time to lay out the rules with citations to the relevant governing regulations!
Below I lay out my breakdown of the rules with extensive citation to the regulations so you can see where I’m getting my assertions from. You get to be the judge and jury as to whether I have properly presented the relevant rule.
Now, back to the show. Per Treas. Reg. Section 1.408A-6 Q&A 1(a) “[t]he taxability of a distribution from a Roth IRA generally depends on whether or not the distribution is a qualified distribution.”
Roth IRA Qualified Distributions
A qualified distribution is not included in the Roth IRA’s owner’s gross income (Treas. Reg. Section 1.408A-6 Q&A 1(b)) and is thus tax free and penalty free (see Treas. Reg. Section 1.408A-6 Q&A 5(a)).
The way most distributions from a Roth IRA qualify as a “qualified distribution” is by satisfying the requirements that the owner (1) is age 59 ½ or older (see Treas. Reg. Section 1.408A-6 Q&A 1(b)(2)) and (2) has owned a Roth IRA for at least 5 years (see Treas. Reg. Section 1.408A-6 Q&A 1(b)(1)).
Once one qualifies for a qualified distribution by satisfying both the age 59 ½ requirement and the 5 year requirement, he or she no longer has any need to consider either of the two Roth IRA 5-year rules (the so-called 5-Year Conversion Clockand the so-called 5-Year Earnings Clock).
Roth IRA Nonqualified Distributions
Now we turn to the taxation of distributions that do not qualify as qualified distributions (what I colloquially refer to as “nonqualified distributions”). As a very general matter, the taxation of these distributions is mostly governed by Treas. Reg. Section 1.408A-6 Q&As 1, 4, 5, 8, and 9.
Ordering Rule
Treas. Reg. Section 1.408A-6 Q&A 8 provides an ordering rule for distributions from a Roth IRA. This creates three layers. Each layer must be fully withdrawn prior to a subsequent layer being accessed. See Treas. Reg. Section 1.408A-6 Q&A 8(a).
First, all annual contributions are withdrawn. Second, all previous Roth conversions are withdrawn (first in, first out). Third, earnings (growth) in the Roth IRA are withdrawn.
Tax Free Withdrawal of Owner Contributions (Both Annual Contributions and Roth Conversions)
Annual contributions and Roth conversions are “contributions” that are always withdrawn income tax free. See Treas. Reg. Section 1.408A-6 Q&A 1(b) (contributions always are withdrawn tax free), Q&A 8(a) (annual contributions and Roth conversions are both “contributions”).
However, the withdrawal of taxable Roth conversions can be subject to the 10% early withdrawal penalty. See Treas. Reg. Section 1.408A-6 Q&A 5(b) (see also IRC Section 408A(d)(3)(F)). This is only true if the Roth conversion is withdrawn within 5 years. See Treas. Reg. Section 1.408A-6 Q&A 5(b) (the 5-Year Conversion Clock).
Per Treas. Reg. Section 1.408A-6 Q&A 5(b), the exceptions to the 10% early withdrawal penalty also apply. The most prominent such exception is having attained the age of 59 ½. Thus, a distribution from a Roth IRA received by an owner at least 59 ½ years old will never be subject to the 10% early withdrawal penalty.
Roth Earnings
Nonqualified distributions of earnings are subject to ordinary income tax (see Treas. Reg. Section 1.408A-6 Q&A 4) and potentially the 10% early withdrawal penalty (see Treas. Reg. Section 1.408A-6 Q&A 5(a)). Generally speaking, if one is either under age 59 ½ years old (see Treas. Reg. Section 1.408A-6 Q&A 1(b)(2)) or if the owner has not owned a Roth IRA for at least 5 years (see Treas. Reg. Section 1.408A-6 Q&A 1(b)(1), the 5-Year Earnings Clock), any withdrawal of earnings will be subject to ordinary income tax. Further, if one receives a distribution of earnings prior to age 59 ½, they are generally subject to the 10% early withdrawal penalty, unless they qualify for another exception.
Note that as a practical matter, distributions of earnings received prior to turning age 59 ½ are rare since all previous annual contributions and Roth conversions must be withdrawn prior to a distribution being considered a distribution of earnings.
A Quick Note on Roth IRA Aggregation
For purposes of assessing the taxation of a distribution from a Roth IRA, one aggregates all of their Roth IRAs and treats them together as a single Roth IRA. See IRC Section 408A(d)(4), Treas. Reg. Section 1.408A-6 Q&A 9(a) and (b), and my YouTube video on the subject.
UPDATE October 30, 2023: I appreciate Andy Ives’s post on IRAHelp.com. He lays out very simply the Roth IRA Distribution rules at the end of this short post. His analysis agrees with mine.
Application to Fact Patterns
Having now covered the universe of the taxation of Roth IRA distributions (both qualified distributions and nonqualified distributions), let’s apply the rules to four examples.
Example 1: Jorge celebrates his 65th birthday in the year 2023. After his birthday party, he converted $40,000 of his traditional 401(k) to a Roth IRA. The conversion is fully taxable. This is the first time Jorge has owned any Roth IRA. On January 1, 2024, Jorge withdrew $25,000 from his Roth IRA. On January 1, 2025, Jorge withdrew $25,000 from his Roth IRA.
What results in 2024 and 2025?
Jorge, as of both 2024 and 2025, does not meet the criteria for taking a qualified distribution because he has not owned a Roth IRA for at least 5 years. Thus, he has a nonqualified distribution in both years.
In 2024, the $25,000 withdrawal of Roth conversions is income tax free (see Treas. Reg. Section 1.408A-6 Q&A 1(b)) and is penalty free because Jorge is older than age 59 ½. This demonstrates that the 5-Year Conversion Clock is irrelevant once one turns age 59 ½. Check out Jorge’s 2024 Form 8606 Part III here (pardon the use of the 2022 version, it’s the latest one available as of this writing).
In 2025, the first $15,000 of Jorge’s withdrawal is a return of Roth conversions and thus not subject to ordinary income tax. Further, this withdrawal is not subject to the 10% early withdrawal penalty. The second $10,000 Jorge withdrew is a nonqualified distribution of earnings. Jorge must pay ordinary income tax on those $10,000 (see Treas. Reg. Section 1.408A-6 Q&A 4). This withdrawal of earnings violates the 5-Year Earnings Clock and is thus subject to ordinary income tax. However, this withdrawal of earnings is not subject to the 10% early withdrawal penalty as Jorge is older than age 59 ½. Check out Jorge’s 2025 Form 8606 Part III here.
Example 2: Samantha celebrates her 45th birthday in the year 2023. After her birthday party, she converted $60,000 of her old traditional 401(k) to a Roth IRA. The conversion is fully taxable. This is the first time Samantha has owned any Roth IRA. On January 1, 2024, Samantha withdrew $25,000 from her Roth IRA. On January 1, 2025, Samantha withdrew $40,000 from her Roth IRA.
What results in 2024 and 2025?
Samantha, as of both 2024 and 2025, does not meet the criteria for taking a qualified distribution because she has not owned a Roth IRA for at least 5 years. Thus, she has a nonqualified distribution in both years.
In 2024, Samantha’s withdrawal is a return of Roth conversions and thus not subject to ordinary income tax. However, because the withdrawal is from Roth conversions younger than 5 years old, and Samantha is under age 59 ½, Samantha must pay the 10% early withdrawal penalty ($2,500) on the distribution (she violates the 5-Year Conversion Clock), unless an exception applies.
In 2025, the first $35,000 of Samantha’s withdrawal is a return of Roth conversions and thus not subject to ordinary income tax. However, because the withdrawal is from Roth conversions younger than 5 years old, Samantha must pay the 10% early withdrawal penalty ($3,500) on the distribution (she violates the 5-Year Conversion Clock), unless an exception applies.
The second $5,000 Samantha withdrew in 2025 is a nonqualified distribution of earnings. Samantha must pay ordinary income tax on those $5,000 (see Treas. Reg. Section 1.408A-6 Q&A 4) and generally must pay the 10% early withdrawal penalty ($500) on that $5,000 distribution of earnings, unless an exception applies.
Example 3: Ed celebrates his 65th birthday in the year 2023. After his birthday party, he converted $40,000 of his old traditional 401(k) to a Roth IRA. The conversion is fully taxable. Ed has owned a Roth IRA since 1998. On January 1, 2024, Ed withdrew $25,000 from his Roth IRA. On January 1, 2025, Ed withdrew $25,000 from his Roth IRA.
What results in 2024 and 2025?
Unlike Examples 1 & 2, we finally have a qualified distribution! Why? Ed has (i) owned a Roth IRA since 1998 (more than 5 years) and (ii) is over age 59 ½. Thus, the only type of distribution Ed can take from his Roth IRA is a qualified distribution. Per Treas. Reg. Section 1.408A-6 Q&A 1(b), a qualified distribution is tax free. Further, Ed cannot pay the early withdrawal penalty on a distribution from his Roth IRA as he is in his 60s (see also Treas. Reg. Section 1.408A-6 Q&A 5(a)). Thus, there is no tax and no penalty on either the 2024 distribution or the 2025 distribution.
Example 4: This example is based on my conversation with Brad Barrett on a recent episode of the ChooseFI podcast. Jonathan turns age 57 on July 1, 2023. He’s never had a Roth IRA. On July 1, 2023, he converted $50,000 from a traditional IRA to a Roth IRA. The conversion is fully taxable.
What withdrawal constraints does Jonathan have on his Roth IRA?
If Jonathan withdraws up to $50,000 from his Roth IRA prior to turning age 59 ½ on January 1, 2026, Jonathan will have to pay the 10% early withdrawal penalty as he violates the 5-Year Conversion Clock (unless an exception applies).
If Jonathan cumulatively withdraws amounts in excess of $50,000 from his Roth IRA prior to turning age 59 ½, he will pay ordinary income tax on the withdrawal of those earnings (as he violates the 5-Year Earnings Clock) and he will pay the 10% early withdrawal penalty (unless an exception applies).
From January 1, 2026 through December 31, 2027, if Jonathan cumulatively withdraws amounts in excess of $50,000 from his Roth IRA, he will pay ordinary income tax on the withdrawal of those earnings (as he violates the 5-Year Earnings Clock). However, Jonathan will not pay the 10% early withdrawal penalty. Starting on January 1, 2028, Jonathan satisfies the 5-Year Earnings Clock (see Treas. Reg. Section 1.408A-6 Q&A 2) and is now permanently able to take a qualified distribution from his Roth IRA going forward.
On January 16, 2024, Denzel withdrew $3,000 from his Roth IRA and made no contributions to his Roth IRA during 2024.
What results in 2024?
Denzel, as of 2024, does not meet the criteria for taking a qualified distribution because he has not owned a Roth IRA for at least 5 years. Thus, he has a nonqualified distribution in 2024.
Pursuant to Treas. Reg. Section 1.408A-6 Q&A 8(b), the taxable portion of the Roth conversion ($2 out of $6,502) comes out first. That $2 is subject to the 10% early withdrawal penalty (a $0.20 penalty which roundsdown to $0) since he violates the 5-Year Conversion Clock, unless an exception applies. This $2 constitutes what I colloquially refer to as a micro layer inside the Roth IRA: for 5 years it is subject to the 10% early withdrawal penalty if withdrawn (unless an exception applies).
However, the $2 recovery of the taxable Roth conversion is not subject to ordinary income tax. See Treas. Reg. Section 1.408A-6 Q&A 1(b).
Second, the $2,998 nontaxable portion of the Roth conversion is distributed out. This nonqualified distribution is subject to neither ordinary income tax nor the 10% early withdrawal penalty. See Treas. Reg. Section 1.408A-6 Q&A 1(b), 5(a), and 5(b). Check out Denzel’s 2024 Form 8606 Part III here.
There is some confusion on this latter result. Treas. Reg. Section 1.408A-6 Q&A 4 provides that only once all of the owner’s previous “contributions” have been withdrawn are nonqualified Roth IRA distributions subject to ordinary income tax. For this purpose, it is clear from reading Treas. Reg. Section 1.408A-6 Q&A 8(a) that “contributions” include both “annual contributions” and “Roth conversions.” See also Treas. Reg. Section 1.408A-6 Q&A 5(b) providing that the 10% early withdrawal penalty does not hit withdrawals of nontaxable converted amounts (“For purposes of applying the tax, only the amount of the conversion contribution includible in gross income as a result of the conversion is taken into account.”). Thus, the nontaxable portion of a Backdoor Roth IRA can be recovered tax and penalty free at any time for any reason.
Other than the minor potential Backdoor Roth IRA micro layer issue, a Backdoor Roth IRA could, in theory, serve as an emergency fund (though generally we want to plan for long term Roth IRA tax-free growth).
Roth IRA Distributions Summary Chart
Type of Distribution
Ordinary Income Tax
10% Early Withdrawal Penalty
Notes
Qualified Distribution
Never
Never
Main way to qualify: attain age 59 ½ and own Roth IRA for 5 years.
NQ Return of Annual Contributions
Never
Never
Comes out prior to returns of conversions and earnings.
NQ Return of Roth Conversions
Never
Can apply. Applies if the taxable conversion is less than 5 years old and the owner is under age 59 ½ (though exceptions can apply).
Come out only if all prior annual contributions and conversions have been withdrawn.
NQ stands for nonqualified
Exceptions to the 59 ½ Year Age Requirement
It is possible to qualify for a qualified distribution if one is younger than 59 ½ years of age. It happens if (1) the 5-Year Earnings Clock is satisfied and (2) the Roth IRA owner (i) is using the money for a first-time home purchase (limit of $10,000), or (ii) is disabled, or (iii) has died. See Treas. Reg. Section 1.408A-6 Q&A 1(b)(2). Outside of the owner’s death, these situations are rare.
Resources
Notice this post cites the to regulation and occasionally the Internal Revenue Code. That’s because they are the law of land! The Code is the primary law of the land, but it tends to be written in a manner inaccessible to most laymen and difficult for many professionals to understand. The regulations interpret the Code. While not an elementary school level read, Treas. Reg. Section 1.408A-6 is much more comprehensible than the Code. The regulation’s question and answer format makes it much easier to digest.
IRS Publication 590-B, Distributions from Individual Retirement Arrangements (IRAs), is an IRS publication. As such it is (i) informative and (ii) not binding authority on either the IRS or on taxpayers. Please understand both when using an IRS publication. I will note that Publication 590-B has an excellent flowchart (Figure 2-1) which can be used to help determine if a distribution from a Roth IRA is a qualified distribution.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
