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.
Listen to me discuss year-end tax planning with Brad and Jonathan on the ChooseFI podcast. The episode is available on all major podcast players, YouTube, and on the ChooseFI website (https://www.choosefi.com/year-end-tax-planning-2021-ep-351/).
During the conversation we referenced this blog post.
As always, the discussion is general and educational in nature and does not constitute tax, investment, legal, or financial advice with respect to any particular individual or taxpayer. Please consult your own advisors regarding your own unique situation. Sean Mullaney and ChooseFI Publishing are currently under contract to publish a book authored by Sean Mullaney.
FI Tax Guy can be your financial advisor! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters.Please also refer to the Disclaimer & Warning section found here.
It’s time to think about year-end tax planning. Year-end is a great time to get tax planning ducks in a row and take advantage of opportunities. This is particularly true for those in the financial independence community. FI principles often increase one’s tax planning opportunities.
Remember, this post is for educational purposes only. None of it is advice directed towards any particular taxpayer.
Backdoor Roth IRA Deadline 2021
As of now (December 7, 2021), the legal deadlines around Backdoor Roth IRAs have not changed: the nondeductible 2021 traditional IRA contribution must happen by April 18, 2022 and there is no legal deadline for the second step, the Roth conversion. However, from a planning perspective, the practical deadline to have both steps of a 2021 Backdoor Roth IRA completed is December 31, 2021.
This is because of proposed legislation that eliminates the ability to convert nondeductible amounts in a traditional IRA effective January 1, 2022. As of December 7th, the proposed legislation has passed the House of Representatives but faces a very certain future in the Senate. Considering the risk that the Backdoor Roth elimination proposal is enacted, taxpayers planning on completing a 2021 Backdoor Roth IRA should act to ensure that the second step of the Backdoor Roth IRA (the Roth conversion) is completed before December 31st.
Taxpayers on the Roth IRA MAGI Limit Borderline
In years prior to 2021, taxpayers unsure of whether their income would allow them to make a regular Roth IRA contribution could simply wait until tax return season to make the determination. At that point, they could either make the regular Roth IRA contribution for the prior year (if they qualified) or execute what I call a Split-Year Backdoor Roth IRA.
With the proposed legislation looming, waiting is not a good option. The good news is that taxpayers executing a Backdoor Roth IRA during a year they actually qualify for a regular annual Roth IRA contribution suffer no material adverse tax consequences. Of course, in order for this to be true there must be zero balance, or at most a very small balance, in all traditional IRAs, SEP IRAs, and SIMPLE IRAs as of December 31, 2021.
December 31st and Backdoor Roth IRAs
December 31st is a crucial date for those doing the Roth conversion step of a Backdoor Roth IRA during the year. It is the deadline to move any balances in traditional IRAs, SEP IRAs, and SIMPLE IRAs to workplace plans in order to ensure that the Roth conversion step of any Backdoor Roth IRA executed during the year is tax-efficient.
This December 31st deadline applies regardless of the proposed legislation discussed above.
The self-employed should consider this one. Deadlines vary, but as a general rule, those eligible for a Solo 401(k) usually benefit from establishing one prior to year-end. The big takeaway should be this: if you are self-employed, your deadline to seriously consider a Solo 401(k) for 2021 is ASAP! Usually, such considerations benefit from professional assistance.
Something to look forward to in 2022: my upcoming Solo 401(k) book!
Charitable Contributions
For those itemizing deductions in 2021 and either not itemizing in 2022 or in a lower marginal tax rate in 2022 than in 2021, it can be advantageous to accelerate charitable contributions late in the year. It can be as simple as a direct donation to a qualifying charity by December 31st. Or it could involve contributing to a donor advised fund by December 31st.
A great donor advised fund planning technique is transferring appreciated securities (stocks, bonds, mutual funds, or ETFs) to a donor advised fund. Many donor advised fund providers accept securities. The tax benefits of making such a transfer usually include (a) eliminating the built-in capital gain from federal income taxation and (b) if you itemize, getting to take a current year deduction for the fair market value of the appreciated securities transferred to the donor advised fund.
The elimination of the lurking capital gain makes appreciated securities a better asset to give to a donor advised fund than cash (from a tax perspective). Transfers of appreciated securities to 501(c)(3) charities can also have the same benefits.
The 2021 deadline for this sort of planning is December 31, 2021, though taxpayers may need to act much sooner to ensure the transfer occurs on time. This is particularly true if the securities are transferred from one financial institution to a donor advised fund at another financial institution. In these cases, the transfer may have to occur no later than mid-November, though deadlines will vary.
Early Retirement Tax Planning
For those in early retirement, the fourth quarter of the year is the time to do tax planning. Failing to do so can leave a great opportunity on the table.
Prior to taking Social Security, many early retirees have artificially low taxable income. Their only taxable income usually consists of interest, dividends, and capital gains. In today’s low-yield environment, without additional planning, early retirees’ taxable income can be very low (perhaps even below the standard deduction).
Artificially low income gives early retirees runway to fill up lower tax brackets (think the 10 percent and 12 percent federal income tax brackets) with taxable income. Why pay more tax? The reason is simple: choose to pay tax when it is taxed at a low rate rather than defer it to a future when it might be taxable at a higher rate.
The two main levers in this regard are Roth conversions and tax gain harvesting. Roth conversions move amounts in traditional retirement accounts to Roth accounts via a taxable conversion. The idea is to pay tax at a very low tax rate while taxable income is artificially low, rather than leaving the money in deferred accounts to be taxed later in retirement at a higher rate under the required minimum distribution (“RMD”) rules.
Tax gain harvesting is selling appreciated assets when one is in the 10 percent or 12 percent marginal tax bracket so as to incur a zero percent long term capital gains federal tax rate on the capital gain.
Early retirees can do some of both. In terms of a tiebreaker, if everything else is equal, I prefer Roth conversions to tax gain harvesting, for two primary reasons. First, traditional retirement accounts are subject to ordinary income tax rates in the future, which are likely to be higher than preferred capital gains tax rates. Second, large taxable capital gains in taxable accounts can be washed away through the step-up in basis at death. The step-up in basis at death doesn’t exist for traditional retirement accounts.
One time to favor tax gain harvesting over Roth conversions is when the traditional retirement accounts have the early retiree’s desired investment assets but the taxable brokerage account has positions that the early retiree does not like anymore (for example, a concentrated position in a single stock). Why not take advantage of tax gain harvesting to reallocate into preferred investments in a tax-efficient way?
Long story short: during the fourth quarter, early retirees should consider their taxable income for the year and consider year-end Roth conversions and/or tax gain harvesting. Planning in this regard should be executed no later than December 31st, and likely earlier to ensure proper execution.
Roth Conversions, Tax Gain Harvesting, and Tax Loss Harvesting
Early retired or not, the deadline for 2021 Roth conversions, tax gain harvesting, and tax loss harvesting is December 31, 2021. Taxpayers should always consider timely implementation: these are not tactics best implemented on December 30th!
For some who find their income dipped significantly in 2021 (perhaps due to a job loss), 2021 might be the year to convert some amounts in traditional retirement accounts to Roth retirement accounts. Some who are self-employed might want to consider end-of-year Roth conversions to maximize their qualified business income deduction.
Stimulus and Child Tax Credit Planning
Taxpayers who did not receive their full 2021 stimulus may want to look into ways to reduce their 2021 adjusted gross income so as to qualify for additional stimulus funds. I wrote in detail about one such opportunity in an earlier blog post. Lowering adjusted gross income can also qualify taxpayers for additional child tax credits.
There are many factors you and your advisor should consider in tax planning. This opportunity may be one of them. For example, taxpayers considering a Roth conversion at the end of the 2021 might want to hold off in order to qualify for additional stimulus and/or child tax credits.
Accelerate Payments
The self-employed and other small business owners may want to review business expenses and pay off expenses before January 1st, especially if they anticipate their marginal tax rate will decrease in 2022. Depending on structure and accounting method, doing so may not only reduce income taxes, it could also reduce self-employment taxes.
State Tax Planning
For my fellow Californians, the big one here is property taxes. It may be advantageous to pay billed (but not yet due) property taxes in late 2021. This allows taxpayers to deduct the amount on their 2021 California income tax return. In California, the standard deduction ($4,601 for single taxpayers, $9,202 for married filing joint taxpayers) is much lower than the federal standard deduction, so consideration should be given to accelerating itemized deductions in California, regardless of whether the taxpayer itemizes for federal income tax purposes.
Required Minimum Distributions (“RMDs”)
They’re back!!! RMDs are back for 2021. The deadline to withdraw a required minimum distribution for 2021 is December 31, 2021. Failure to do so can result in a 50 percent penalty.
Required minimum distributions apply to most retirement accounts (Roth IRAs are an exception). They apply once the taxpayer turns 72. Also, many inherited retirement accounts (including Roth IRAs) are subject to RMDs, regardless of the beneficiary’s age.
Planning for Traditional Retirement Accounts Inherited in 2020 and 2021
Those inheriting traditional retirement accounts in 2020 or later often need to do some tax planning. The end of the year is a good time to do that planning. Many traditional retirement account beneficiaries will need to empty the retirement account in 10 years (instead of being on an RMD schedule), and thus will need to plan out distributions over the 10 year time frame to manage taxes rate on the distributions.
2021 Federal Estimated Taxes
For those with small business income, side hustle income, significant investment income, and other income that is not subject to tax withholding, the deadline for 2021 4th quarter estimated tax payments to the IRS is January 18, 2022. Such individuals should also consider making timely estimated tax payments to cover any state income taxes.
Review & Update Beneficiary Designation Forms
Beneficiary designation forms control the disposition of financial assets (such as retirement accounts and brokerage accounts) upon death. Year-end is a great time to make sure the relevant institutions have up-to-date forms on file. While beneficiary designations should be updated anytime there is a significant life event (such as a marriage or a death of a loved one), year-end is a great time to ensure that has happened.
2022 and Beyond Tax Planning
The best tax planning is long term planning that considers the entire financial picture. There’s always the temptation to maximize deductions on the current year tax return. But the best planning considers your current financial situation and your future plans and strives to reduce total lifetime taxes. 2022 is as good a time as any to do long-term planning.
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.
New Year’s Eve is an important day if you do a Backdoor Roth IRA. Read below to find out why.
The Backdoor Roth IRA
I’ve written before about the Backdoor Roth IRA. It is a two step process whereby those not qualifying for a regular Roth IRA contribution can qualify to get money into a Roth IRA. Done over several years, it can help taxpayers grow significant amounts of tax free wealth.
One of the best aspects of the Backdoor Roth IRA is that it does not forego a tax deduction. Most taxpayers ineligible to make a regular Roth IRA contribution are also ineligible to make a deductible traditional IRA contribution. In the vast majority of cases, the choice is between investing money in a taxable account versus investing in a Roth account. For most, a Roth is preferable, since Roths do not attract income taxes on the interest, dividends, and capital gains investments generate.
The Basic Backdoor Roth IRA and the Form 8606
Let’s start with a fairly basic example.
Example 1
Betsy, age 40, earns $300,000 from her W-2 job in 2021, is covered by a workplace 401(k) plan, and has some investment income. Betsy has no balance in a traditional IRA, SEP IRA, or SIMPLE IRA.
At this level of income, Betsy does not qualify for a regular Roth IRA contribution, and she does not qualify to deduct a traditional IRA contribution.
Betsy contributes $6,000 to a traditional IRA on May 20, 2021. The contribution is nondeductible. Because the contribution is nondeductible, Betsy gets a $6,000 basis in her traditional IRA. Betsy must file a Form 8606 with her 2021 tax return to report the nondeductible contribution.
On June 5, 2021, Betsy converts the entire balance in the traditional IRA, $6,003, to a Roth IRA. As of December 31, 2021, Betsy has no balance in a traditional IRA, SEP IRA, or SIMPLE IRA.
Betsy has successfully executed a Backdoor Roth IRA. Here is what page 1 of the Form 8606 Betsy should file with her 2021 income tax return should look like.
Notice here that I am using the 2020 version of the Form 8606 for this and all examples. The 2021 Form 8606 is not yet available as of this writing.
The most important line of page 1 of the Form 8606 is line 6. Line 6 reports the fair market value of all traditional IRAs, SEP IRAs, and SIMPLE IRAs Betsy owns as of year-end. Because Betsy had no traditional IRAs, SEP IRAs, and SIMPLE IRAs as of December 31, 2021, her Backdoor Roth IRA works and is tax efficient. This important number ($0) on line 6 of the Form 8606 is what ensures Betsy’s Backdoor Roth IRA is tax efficient.
Note that Betsy’s Backdoor Roth IRA creates an innocuous $3 of taxable income, which is reported on the top of part 2 of the Form 8606.
The Pro-Rata Rule and December 31st
But what if Betsy did have a balance inside a traditional IRA, SEP IRA, or SIMPLE IRA on December 31, 2021? Would her Backdoor Roth IRA still be tax efficient? Probably not, due to the Pro-Rata Rule.
The Pro-Rata Rule tells us just how much of the basis in her traditional IRA Betsy can recover when she does the Roth conversion step of the Backdoor Roth IRA. Betsy’s $6,000 nondeductible traditional IRA creates $6,000 of basis. As we saw above, Betsy was able to recover 100 percent of her $6,000 of basis against her Roth conversion.
But the Pro-Rata Rule says “not so fast” if Betsy has another traditional IRA, SEP IRA, or SIMPLE IRA on December 31st of the year of any Roth conversion. The Pro-Rata Rule allocates IRA Basis between converted amounts (in Betsy’s case, $6,003) and amounts in traditional IRAs, SEP IRAs, and SIMPLE IRAs on December 31st. Here’s an example.
Example 2
Betsy, age 40, earns $300,000 from her W-2 job in 2021, is covered by a workplace 401(k) plan, and has some investment income. Betsy has no balance in a traditional IRA, SEP IRA, or SIMPLE IRA.
Betsy contributes $6,000 to a traditional IRA on May 20, 2021. The contribution is nondeductible. Because the contribution is nondeductible, Betsy gets a $6,000 basis in her traditional IRA. Betsy must file a Form 8606 with her 2021 tax return to report the nondeductible contribution.
On June 5, 2021, Betsy converts the entire balance in the traditional IRA, $6,003, to a Roth IRA.
On September 1, 2021, Betsy transfers an old 401(k) from a previous employer 401(k) plan to a traditional IRA. On December 31st, that traditional IRA is worth $100,000. The old 401(k) had no after-tax contributions.
This one 401(k)-to-IRA rollover transaction dramatically changes both the taxation of Betsy’s Backdoor Roth IRA and her 2021 Form 8606. Here’s page 1 of the Form 8606.
Line 6 of the Form 8606 now has $100,000 on it instead of $0. That $100,000 causes Betsy to recover only 5.67 percent of the $6,000 of basis she created by making a nondeductible contribution to the traditional IRA. As a result, $5,663 of the $6,003 transferred to the Roth IRA in the Roth conversion step is taxable to Betsy as ordinary income. At a 35% tax rate, the 401(k) to IRA rollover (a nontaxable transaction) cost Betsy $1,982 in federal income tax on her Backdoor Roth IRA. Ouch!
Quick Lesson: The lesson here is that prior to rolling over a 401(k) or other workplace plan to an IRA, taxpayers should consider the impact on any Backdoor Roth IRA planning already done and/or planned for the future. One possible planning alternative is to transfer old employer 401(k) accounts to current employer 401(k) plans.
There is an antidote to the Pro-Rata Rule when one has amounts in traditional IRAs, SEP IRAs, and SIMPLE IRAs. It is transferring the traditional IRA, SEP IRA, or SIMPLE IRA to a qualified plan (such as a 401(k) plan) before December 31st. Here is what that might look like in Betsy’s example.
Example 3
Betsy, age 40, earns $300,000 from her W-2 job in 2021, is covered by a workplace 401(k) plan, and has some investment income. Betsy has no balance in a traditional IRA, SEP IRA, or SIMPLE IRA.
Betsy contributes $6,000 to a traditional IRA on May 20, 2021. The contribution is nondeductible. Because the contribution is nondeductible, Betsy gets a $6,000 basis in her traditional IRA. Betsy must file a Form 8606 with her 2021 tax return to report the nondeductible contribution.
On June 5, 2021, Betsy converts the entire balance in the traditional IRA, $6,003, to a Roth IRA.
On September 1, 2021, Betsy transfers an old 401(k) from a previous employer to a traditional IRA. The old 401(k) had no after-tax contributions.
On November 16, 2021, Betsy transfers the entire balance in this new traditional IRA to her current employer’s 401(k) plan in a direct trustee-to-trustee transfer.
Here is Betsy’s 2021 Form 8606 (page 1) after all of these events:
Betsy got clean by December 31st, so her Backdoor Roth IRA now reverts to the optimized result (just $3 of taxable income) she obtained in Example 1.
Pro-Rata Rule Clean Up
Implementation
From a planning perspective, it is best to clean up old traditional IRAs/SEP IRAs/SIMPLE IRAs prior to, not after, executing the Roth conversion step of a Backdoor Roth IRA. I say that because things happen in life. There is absolutely no guarantee that those intending to roll amounts from IRAs to workplace qualified plans will get that accomplished by December 31st.
Further, transfers from one retirement account to another are usually best done through a direct “trustee-to-trustee” transfer to minimize the risk that the money in the retirement account accidentally is distributed to the individual, causing potential tax and penalties.
Before cleaning up old traditional IRAs, SEP IRAs, and SIMPLE IRAs, one should consider the investment choices and fees inside their employer retirement plan (such as a 401(k)). If the investment options are not good, and/or the fees are high, perhaps cleaning up an IRA to move money into less desirable investments is not worth it. This is a subjective judgment that must weigh the potential tax and investment benefits and drawbacks.
Tax Issues
Amazingly enough, the Pro-Rata Rule is concerned with only one day: December 31st. A taxpayer can have a balance in a traditional IRA, SEP IRA, or SIMPLE IRA on any day other than December 31st, and it does not count for purposes of the Pro-Rata Rule. Perhaps December 31st should be called Pro-Rata Rule Day instead of New Year’s Eve. 😉
Extra care should be taken when cleaning up (a) large amounts in any type of IRA and (b) any SIMPLE IRA. While it is fairly obvious that significant sums should be moved only after considering all the relevant investment, tax, and execution issues, the SIMPLE IRA provides its own nuances. Any SIMPLE IRA cannot be rolled to an account other than a SIMPLE IRA within the SIMPLE IRA’s first two years of existence. Thus, SIMPLE IRAs must be appropriately aged before doing any sort of Backdoor Roth IRA clean up planning.
Spouses are entirely separate for Pro-Rata Rule purposes, even in community property states. Cleaning up one spouse, or failing to clean up one spouse, has absolutely no impact on the taxation of the other spouse’s Backdoor Roth IRA.
Lastly, non spousal inherited IRAs do not factor into a taxpayer’s application of the Pro-Rata Rule. Each non spousal inherited IRA has its own separate, hermetically sealed Pro-Rata Rule calculation. The inheriting beneficiary does a Pro-Rata Rule calculation on all IRAs he/she owns as the original owner, separate from any inherited IRAs. In addition, non spousal inherited IRAs cannot be rolled into a 401(k).
Mega Backdoor Roth
Good news: the concerns addressed in this blog post generally do not apply with respect to the Mega Backdoor Roth (sometimes referred to as a Mega Backdoor Roth IRA, though a Roth IRA does not necessarily have to be involved). Qualified plans such as 401(k)s are not subject to the Pro-Rata Rule.
While 401(k)s are not subject to the Pro-Rata Rule, amounts within a particular 401(k) plan’s after-tax 401(k) are subject to the “cream-in-the-coffee” rule I previously wrote about here. Thus, if there is growth on Mega Backdoor Roth contributions before they are moved out of the after-tax 401(k), generally speaking either the taxpayer must pay income tax on the growth (if moved to a Roth account) or the taxpayer can separately roll the growth to a traditional IRA (which could then create a rather small Pro-Rata Rule issue with future Backdoor Roth IRAs). Fortunately, the cream-in-the-coffee rule has a much narrower reach than the Pro-Rata Rule.
Backdoor Roth IRA Tax Return Reporting
Watch me discuss Backdoor Roth IRA tax return reporting.
Conclusion
Get your IRAs in order so you can enjoy New Year’s Eve!
December 31st is an important date when it comes to Backdoor Roth IRA planning. It is important to plan to have no (or at a minimum, very small) balances in traditional IRAs, SEP IRAs, and SIMPLE IRAs on December 31st when planning Backdoor Roth IRAs.
None of what is discussed in this blog post is advice for any particular taxpayer. Those working through Backdoor Roth IRA planning issues are often well advised to reach out to professional advisors regarding their own tax situation.
Further Reading
I did a blog post about Backdoor Roth IRA tax return reporting here.
I did a deep dive on the taxation of Roth IRA withdrawals here.
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
Is the backdoor closing? If a recently released proposal from the House Ways & Means Committee is enacted, then yes it is.
My analysis and commentary below is just my initial take on the proposed new laws: it is subject to revision.
UPDATE December 18, 2021
The update as of December 18, 2021 can be read here. Turns out that as of now (December 18th) my predictive analysis offered in November appears rather spot on. But remember, things can change.
Here’s what I wrote in November: On November 19, 2021, the House of Representatives passed the proposals discussed below. To my mind, the passage of this legislation is a 26.2 mile marathon: Passage in the House is the first mile, and passage in the Senate is the next 25.2 miles. There are absolutely no guarantees as to whether the proposals ultimately become law. My view is that passage in the Senate is going to be much more difficult than passage in the House.
Backdoor Roths
The Backdoor Roth IRA has been a popular transaction for over a decade. It allows those unable to make a direct Roth IRA contribution to get an annual contribution into a Roth IRA through a two-step process. There is a 401(k) version popularly referred to as the Mega Backdoor Roth IRA, which allows taxpayers to move significant amounts into Roth accounts using after-tax 401(k) contributions.
House Ways & Means Proposal
On September 13, 2021, the House Ways and Means committee released legislative text and an explanation of proposed new rules that would change the Roth landscape.
Elimination of Backdoor Roth IRAs and Mega Backdoor Roth IRAs
Effective in 2022, after-tax amounts in IRAs could not be converted to Roth IRAs. This rule would apply to all taxpayers regardless of their level of adjusted gross income. This rule would eliminate the Backdoor Roth IRA, as amounts contributed to a nondeductible traditional IRA (the first step of a Backdoor Roth IRA) could not be converted to a Roth IRA.
The bill would also eliminate after-tax contributions to qualified plans. As a result, workplace plans such as 401(k)s could no longer offer the Mega Backdoor Roth.
Effect on 2021 Backdoor Roth IRAs
In a twist, the new rule would effectively impose a deadline on all 2021 Backdoor Roth IRA planning: December 31, 2021. If the new law is passed, both the nondeductible traditional IRA contribution step and the Roth conversion step for a Backdoor Roth IRA would need to be completed by 2021 in order to do a 2021 Backdoor Roth IRA.
Usually, the deadline to worry about from a Backdoor Roth IRA perspective is the deadline to make the nondeductible traditional IRA contribution, usually April 15th of the following year. There is no particular deadline to complete the Roth conversion step. By prohibiting Roth conversions of after-tax money in traditional IRAs beginning January 1, 2022, Congress effectively makes December 31, 2021 the deadline to execute the Roth conversion step of a 2021 Backdoor Roth IRA.
I wrote about how the legislative proposal impacts the approach to 2021 Backdoor Roth IRA planning and deadlines here.
I have previously written about late or “split-year” Backdoor Roth IRAs under current law here.
Update on Legislative Proposals (As of November 4, 2021)
On October 28th, a new tax proposal came out which did not have the Backdoor elimination proposals. However, a second new tax proposal issued on November 3rd did contain the Backdoor Roth elimination proposals. Based on the current political landscape, there is significant doubt as to whether any tax proposal is enacted during this Congress. However, there is at least some chance the Backdoor Roth proposals are enacted.
Elimination of Roth Conversions for High Income Taxpayers Beginning in 2032
The legislative proposal also eliminates Roth conversions in any year a taxpayer’s adjusted taxable income is $400K (single filers) or $450K (married filing joint) starting in the year 2032.
A couple of observations about this rule. First, this rule would have no practical effect on the FI community. Usually, those in the FI community avoid taxable Roth conversions during high income years. Taxable Roth conversions (such as the so-called Roth Conversion Ladder strategy) are usually executed during early retirement before collecting Social Security. Those years often have artificially low taxable income, so a high income cap on the ability to do a Roth conversion is a rule without consequence for the FI community.
Second, you might be wondering: why the heck are they changing the tax law 10 years in the future? Why not now? The answer lies in how Congress “scores” tax bills. Taxable Roth conversions, particularly in the near term, increase tax revenue. An immediate repeal of Roth conversions would “cost” the government money in the new few years. But by delaying implementation for 10 years, Congress is able to predict that taxpayers, facing a future with no Roth conversions, will increase Roth conversions in 2030 and 2031, increasing tax revenues in those years.
Outlook
Congress is closely divided. There is absolutely no guarantee this bill will pass both houses of Congress and be signed by the President. That said, these proposed rules are now “out there” and being “out there” is the first step towards a tax rule becoming law.
I will Tweet and blog about any future developments in this regard.
FI Tax Guy can be your financial advisor! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters.Please also refer to the Disclaimer & Warning section found here.
Really enjoyed this year-end tax planning conversation with Doc G on the Earn & Invest podcast. Stay tuned to the end for some candid behind the scenes podcast recording.
This post (and this podcast episode) is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
The Roth IRA is 25 years old as of 2023 (its birthday was January 1st). Yet there is still confusion about the rules applicable whenever someone withdraws money from a Roth IRA prior to turning 59 ½. This blog post attempts to correct some misconceptions on the taxation of nonqualified Roth IRA withdrawals.
Watch me discuss Roth IRA withdrawals.
Roth IRAs: The Basics
A Roth IRA is a tax-advantaged account that generally offers tax-free growth for invested amounts. Taxpayers receive no upfront tax deduction for putting money into a Roth IRA. If properly executed, taxpayers can withdraw money from a Roth IRA entirely tax and penalty free, and can enjoy years of tax-free growth on the amounts invested in a Roth IRA.
I have previously blogged about why I believe the Roth IRA is a great tax-advantaged account in my An Ode to the Roth IRA.
Roth IRA Funding
How does one move money into a Roth IRA? There are three ways.
Annual Contributions
Generally speaking, if your income is below certain limits, you can contribute up to the lesser of $6,500 or your earned income (2023 limits) to a Roth IRA. If you are aged 50 or older, the limits are the lesser of $7,500 or earned income (2023 limits).
I discussed Roth IRA annual contributions, including the income limits on the ability to make Roth IRA contributions, in this post.
Conversions
Amounts can be converted from traditional retirement accounts into a Roth IRA. Any taxpayer can convert amounts from a traditional retirement account to a Roth IRA. There are no restrictions based on level of income and/or having had earned income.
Conversions are taxable in the year of the conversion.
There are several reasons you might want to do a Roth IRA conversion. One might be the anticipation of paying tax at a higher rate in the future. The planning concept is to “lock in” the lower tax rate in the year of the conversion rather than tomorrow’s (anticipated) higher tax rate, and to get all of the earnings on the contribution out of income taxation.
Unlimited Roth IRA conversions form the backbone of the Backdoor Roth IRA planning concept.
Note that inherited traditional IRAs cannot be converted to Roth IRAs.
Transfers from Workplace Retirement Accounts
A third way to get money into a Roth IRA is by using workplace retirement accounts. Amounts in Roth 401(k)s and other workplace Roth accounts can be transferred into a Roth IRA. Generally, it is best to use direct “trustee-to-trustee” transfers to accomplish this.
Further, after-tax contributions in workplace retirement plans can be directly transferred to Roth IRAs, as discussed in Notice 2014-54. The ability to transfer after-tax contributions into a Roth IRA has facilitated the use of the Mega Backdoor Roth IRA planning technique.
Roth IRA Withdrawals: The Confusion
You may have heard that you cannot take money out of a Roth IRA if the account is not 5 years old without paying tax and a penalty. Not true!
There are not one, but two, five (5) year rules applicable to Roth IRAs. But neither one of them prohibit you from taking money out of a Roth IRA you have previously contributed through annual contributions. First, I will illustrate the default Roth IRA withdrawal rules, and then I will discuss the two 5 year rules.
Quick Thought: Most of this blog post addresses situations where the taxpayer does not qualify for a qualified distribution. Generally, a taxpayer fails to qualify for a qualified distribution if he or she has not attained the age of 59 ½, and/or if he or she has not owned a Roth IRA for 5 years. The advantage of a qualified distribution is that it is automatically tax and penalty free.
Roth IRA Withdrawals: The Layers
Here is the default order of distributions that come out of a Roth IRA. These are the rules that apply in cases where the taxpayer does not qualify for a qualified distribution. All Roth IRAs (other than inherited Roth IRAs) the taxpayer owns are aggregated for purposes of determining his or her Roth IRA layers.
First Layer: Tax-free return of Roth IRA contributions
Second Layer: Roth IRA conversions (first-in, first-out)
Third Layer: Roth IRA earnings
Each layer must come out entirely before the subsequent layer is accessed.
Here’s a brief example:
Example 1: Samantha opened her only Roth IRA in 2018. Samantha has made three prior $5,000 contributions to her Roth IRA (one for each of 2018, 2019, and 2020). She also made a $5,000 conversion from a traditional IRA to a Roth IRA in 2018. In 2021, at a time when her Roth IRA is worth $30,000 and Samantha is 50 years old, she takes a $10,000 withdrawal from her Roth IRA. All $10,000 will be a recovery of her previous contributions (leaving her with $5,000 remaining of previous contributions). Thus, the entire $10,000 distribution from the Roth IRA will be tax and penalty free.
The Roth IRA contributions come out tax and penalty free at any time for any reason! The 5 year rules have nothing to do with whether a taxpayer can recover their previous Roth IRA contributions tax and penalty free!
For those wanting to dig deeper into the tax law, please refer to this technical slide deck discussing why the Roth IRA contributions are distributed tax and penalty free regardless of the 5 year rules.
Note that aggregation rules always apply. In making an analysis like the one provided in Example 1, one must account for all their Roth IRAs and treat all of their Roth IRAs as a single Roth IRA to determine their own Roth IRA layers. Roth 401(k)s and inherited Roth IRAs are not included in the analysis.
5 Year Rule for Roth IRA Earnings
The first five-year rule for Roth IRAs applies only to a withdrawal of earnings from a Roth IRA. If the account owner has not owned a Roth IRA for at least 5 years, the earnings withdrawn from the account are subject to ordinary income tax (and possibly a penalty).
Example 2: Joe is 62 years old in 2024. He has owned a Roth IRA since 2021. In 2024, after having made $14,000 in prior annual contributions to his Roth IRA, he withdrew $17,000 from the Roth IRA. Because Joe has not owned a Roth IRA for 5 years, the withdrawal is not a qualified distribution. Joe recovers his first $14,000 tax free as a return of contributions. The next $3,000 of earnings is taxable to Joe as ordinary income (because of the first five-year rule). Because Joe is over age 59 ½, he does not owe the ten percent penalty on the distribution. If Joe had not attained the age of 59 ½, he would owe the 10 percent penalty on the $3,000 of earnings he received.
5 Year Rule for Roth IRA Conversions
There is a five-year rule applicable to taxable money converted from a traditional retirement account to a Roth IRA (what I will colloquially refer to as the “second five-year rule”). The idea behind the second five-year rule is to protect the 10% early withdrawal penalty applicable when someone has a traditional retirement account. Here is an illustrative example.
Example 3: Milton has $100,000 in a traditional IRA, no basis in any IRA, and is age 50. If he were to withdraw $1,000 from his traditional IRA (assuming no penalty exception applies), he would owe (in addition to ordinary income tax) a $100 penalty (ten percent) on the withdrawal.
Okay, but what if Milton first converts that money from a traditional IRA to a Roth IRA (assume Milton has no other balance in a Roth IRA)? Would that get him out of the 10 percent penalty? No, it won’t, because of the second five-year rule.
Example 4: Milton has $100,000 in a traditional IRA, no basis in any IRA, has no Roth IRAs, and is age 50. In September 2024, he converts $1,000 to a Roth IRA. In October 2024, he withdraws $1,000 from that Roth IRA. Because of the five-year rule applicable to Roth IRA conversions, Milton will still owe the $100 penalty on the withdrawal from the Roth IRA.
Had Milton waited until 2029 or later, he would not have owed the penalty on the withdrawal of that $1,000.
The 5 Year Rule for Roth IRA Conversions and the Backdoor Roth IRA
The Backdoor Roth IRA is subject to the second five-year rule, but the penalty effect turns out to be very minor (or non-existent) if the Backdoor Roth IRA has been properly executed.
Conversions, the second layer of the Roth IRA stack, come out first-in, first out. Further, the taxable amount (potentially subject to the 10 percent penalty upon withdrawal) of any one particular Roth IRA conversion comes out first within the conversion amount. Thus, the second layer (the conversion layer) can be composed of several mini-layers.
Here is a quick example:
Example 5: Denzel made $6,000 nondeductible traditional IRA contributions on January 1, 2019 and January 1, 2020. On February 2, 2019 and February 2, 2020, Denzel converted the entire balance of the traditional IRA ($6,010 each time) to a Roth IRA. As of December 31, 2019 and December 31, 2020, Denzel had $0 balances in all traditional IRAs, SEP IRAs, and SIMPLE IRAs.
In 2021, at a time when Denzel is 35 years old and has made no other contributions or conversions to a Roth IRA, he withdraws $3,000 from his Roth IRA. The first $10 of the withdrawal will be from the taxable amount of his 2019 Roth conversion, and thus, will be subject to the 10 percent penalty as it violates the second five-year rule (Denzel will owe $1 in penalties). The next $2,990 is attributable to the non-taxable portion of his 2019 Roth conversion, and as such, will not be subject to the 10 percent penalty. None of the $3,000 will be subject to ordinary income tax.
Penalty Exceptions
From time to time you will hear things such as “you can withdraw only $10,000 from a Roth IRA for a first-time home purchase.” Does that mean everything else discussed above does not apply?
Fortunately, the answer is no!
So what is the $10,000 rule getting at? It is getting at amounts withdrawn from a Roth IRA that would otherwise be subject to the penalty (and possibly income taxes — see The Super Exceptions below).
There are several penalty exceptions applicable to taxable converted amounts and earnings that are withdrawn from a Roth IRA in a nonqualified distribution. But the penalty exception rules generally apply on top of the usual layering rules, not instead of the usual Roth IRA layering rules.
In a discussion on social media, I used a version of the following example.
Example 6: Jane Taxpayer, age 30, has had a Roth IRA since 2017. In 2020, she withdraws $30,000 from her Roth IRA to acquire her first home, and has never used traditional IRA and/or Roth IRA money for such a purchase. She has previously made $20,000 in annual contributions to the Roth IRA. The first $20,000 of the withdrawal is a tax-free return of those contributions (see the layers above). The next $10,000 is out of earnings (see the layers above). This $10,000 is taxable to her as ordinary income. But, because of the $10,000 “qualified first-time homebuyer distribution” exception, she does not owe the 10 percent penalty on the withdrawal of those earnings.
In this case, withdrawals used to fund certain home purchases can qualify for a penalty exception (the first-time homebuyer exception is subject to a $10,000 cap). Please visit this website for a list of the possible penalty exceptions applicable to withdrawals from a traditional IRA and a Roth IRA.
The Super Exceptions
If the taxpayer is relying on the disability, age 59 ½, death, or qualified first-time home purchase penalty exceptions, the earnings also come out income tax free so long as the taxpayer has owned a Roth IRA for five years. See slide 5 of the above referenced technical slide deck.
As applied to Jane Taxpayer in Example 6 above, if she had owned a Roth IRA since any time in 2015 or earlier, the distribution of $10,000 of earnings would not only have been penalty free, it would have also been income tax free.
60 Day Rollovers
A taxpayer might take money out of a Roth IRA and then reconsider. Perhaps he or she wants the money to grow tax-free. Or perhaps the taxpayer dipped into earnings and the distribution is not a qualified distribution, meaning that it will likely be subject to both ordinary income and a ten percent penalty.
He or she might be able to roll the money back into the Roth IRA. However, the tax rules allow only one 60 day rollover every 12 months. The IRS has a website here discussing some of the issues.
Because of the one-rollover-per-year rule, I generally advise against doing 60 day rollovers unless you need to. Generally, it is best to avoid them, and then have the option available as a life raft if money somehow comes out of a Roth IRA (or other IRA) when it should not have.
Required Minimum Distributions
There are no required minimum distributions from a Roth IRA! Every other non-HSA tax-advantaged retirement account, including the Roth 401(k), has required minimum distributions.
Note that required minimum distributions are generally required once the Roth IRA becomes an inherited Roth IRA (in the hands of anyone but certain surviving spouses).
Tax Planning
Okay, so taxpayers always have tax and penalty free access to old Roth IRA annual contributions. So what of it? As a practical matter, maybe nothing.
In most cases, it makes sense to simply keep the money in the Roth IRA and let it grow tax free!
That said, there can be instances where, as part of a well crafted financial plan, it can make sense to withdraw previous Roth IRA contributions prior to age 59 ½. Further, it is good to know that, in an emergency situation, those old Roth IRA contributions are accessible.
Of course, prior to taking an early withdrawal from a Roth IRA, it is usually best to consult with your own financial advisor and/or tax advisor.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
It won’t surprise many to find out that a tax-focused financial planner is fond of the Roth IRA. Below is a brief review of the advantages of a Roth IRA.
Tax Free Growth
Amounts in Roth IRAs grow tax free. Considering many Americans may now live into their 80s, 90s, and beyond, this is a tremendous benefit.
The only caveat is that in order for all distributions from Roth IRAs to be tax and penalty free, they generally have to be either (a) a return of contributions or of sufficiently aged conversions (see below), or (b) a distribution of earnings made in the Roth IRA (or other amounts in the Roth IRA) at a time when the owner of the account is 59 ½ or older and has owned a Roth IRA for at least five years.
The rules for ordering distributions out of a Roth IRA generally provide that contributions come out first, and then the oldest conversions come out next. This means that in many cases Roth IRA distributions, even those occurring before age 59 ½, are tax and penalty free.
N.B. Generally speaking, you want to only take a distribution from a Roth IRA before age 59 ½ if it is either (i) a serious emergency or (ii) part of a well crafted, very intentional financial plan.
Ease of Administration and Withdrawal
There are many financial institutions that provide Roth IRAs. Investment expenses in low-cost index funds at financial institutions that provide Roth IRAs are approaching zero. Vanguard, Fidelity, and Schwab are among the very good providers of low-cost Roth IRAs (and there are others).
It is also relatively easy to access money inside a Roth IRA. This makes the Roth IRA a great account to have in an emergency. Of course, it is generally best to leave money inside a Roth IRA to let it grow tax free, but it is good to know that you can access money in a Roth IRA relatively easily if an emergency arises.
Tax Free Withdrawals of Contributions
This is a great benefit of the Roth IRA. Contributions to a Roth IRA can be withdrawn at any time for any reason tax and penalty free. Further, the first money deemed distributed from a Roth IRA is a contribution. Here is a quick example:
Mark is 35 years old in 2025. He made $6,000 contributions to his Roth IRA in each of 2020, 2021, 2022, 2023, and 2024 (for $30,000 total). In 2025, when his Roth IRA is worth $41,000, Mark withdraws $10,000 from his Roth IRA in 2025. All $10,000 will be deemed to be a return of contributions, and thus entirely tax free and penalty free.
The only exception is a taxpayer favorable exception: a timely withdrawal of an excess contribution (and related earnings) occurs before regular contributions are considered withdrawn.
N.B. Roth 401(k)s, 403(b)s, and 457s have different distribution rules — most pre-age 59 ½ distributions will take out some taxable earnings.
Tax Free Withdrawals of Sufficiently Aged Converted Amounts
If you convert an amount into a Roth IRA, you start a five year clock as of January 1st of the year of the conversion. Quick example:
Mike is 35 years old in 2025. Mike converts $10,000 from a traditional IRA to a Roth IRA on July 2, 2025. His five year conversion clock starts January 1, 2025. On January 1, 2030, Mike can withdraw the entire $10,000 he converted in 2025 tax and penalty free.
This feature of the Roth IRA, the tax free withdrawal of sufficiently aged conversions, is the basis for the Roth Conversion Ladder strategy. Sufficiently aged converted amounts are deemed to come out after contributions are exhausted and before more recent conversions and earnings come out.
No Required Minimum Distributions
During an account holder’s lifetime, there are no required minimum distributions from a Roth IRA. You can live to 150 and never be required to take money from a Roth IRA.
Creditor Protection
In federal bankruptcy proceedings, Roth IRAs are (as of 2024), protected up to $1,512,350.
Where there can be differences in liability protection are state general creditor claims (i.e., creditor protection in non-bankruptcy situations). In some states, Roth IRAs receive a level of creditor protection similar to that of ERISA plans. Generally, such protection is absolute against all creditors except for an ex-spouse or the IRS.
In other states, Roth IRAs receive no or limited creditor protection. In my home state of California, Roth IRAs are only creditor protected up to the amount necessary to provide for you and your dependents in your retirement (as determined by the court). Such protection is valuable but hardly airtight.
A Sneaky Way to Contribute More to Your Retirement
Yes, in theory everyone should save for retirement based on exacting calculations (i.e., I estimate I need $X in retirement, so based on projections I save $A in traditional accounts and $B in Roth accounts this year). That’s the theory.
In practice, it’s “I maxed out this account and that account” or “I put $C into this account and $D into that account.” There isn’t that much wrong with how we practically save for retirement, as long as we are saving sufficient amounts for retirement.
But not all “maxing out” is created equal. We know this because if Jane has $100,000 in a traditional IRA and Mary has $100,000 in a Roth IRA, who has more wealth? Mary! Unless Jane can always be in a zero percent income tax bracket, Mary has more than Jane, even though they both nominally have $100,000.
A Great Account to Leave to Heirs
While non-spouse heirs will have to take taxable required distributions from inherited IRAs (in many cases beginning in 2020 they will need to drain the account within 10 years of death), heirs are never taxed on distributions from Roth IRAs. This makes a Roth IRA a great account to leave to your heirs.
Compare with Other Retirement Accounts
No other retirement account combines ease of administration and withdrawal, low costs, significant tax benefits, creditor protection, and great emergency access the way the Roth IRA does. Most workplace retirement plans have some restrictions on withdrawals. Traditional account withdrawals do not have the tax advantages of a Roth IRA. Distributions from a traditional IRA, even one at a low-cost, easy to use discount brokerage, will trigger ordinary income taxes, and possible penalties, if withdrawn for emergency use.
Financial Planning Objectives
Personal finance is indeed personal. But I submit the following: pretty much every individual has some desire (and/or need) to not work at some point in his/her lifetime and every individual needs to be prepared for emergencies. Further, these are two very important financial planning objectives for most, if not all, individuals.
If the above is true, then we must ask “which account type best supports the combination of these two pressing financial planning objectives?” It appears to me that the answer is clearly the Roth IRA.
None of this is to say that a Roth IRA is the only way to plan for retirement and plan for emergencies, but rather, it is to say that, generally speaking, a Roth IRA ought to be a material element in such planning. Other tools, such as other retirement accounts, insurances, investments in taxable accounts, and sufficiently funded emergency funds are likely needed in addition to a Roth IRA.
Retirement Accounts and Emergencies
Let’s examine how a Roth IRA might help someone facing a very serious emergency.
Picture Jack, who is 52 years old, and has a full time job. He has $1M in a traditional 401(k) and $10,000 in cash in a taxable account. That’s it. Then picture Chuck, also 52 with a full time job. Chuck has $700,000 in a traditional 401(k), $250,000 in a Roth IRA, and $10,000 in cash.
Who is better situated to deal with an emergency? Far and away the answer is Chuck. 401(k)s are difficult to access in an emergency. First of all, the 401(k) plan might not allow in-service distributions, and it might not allow taking out a loan.
Even if the 401(k) allows in-service distributions, distributions from 401(k)s are immediately taxable, and often subject to penalties (10% federal, 2.5% in California, for example) if you are under age 59 ½. Loans, while not immediately taxable, can become taxable if not paid back.
Long story short, a 401(k) may be a tough nut to crack in an emergency.
What about a Roth IRA? In Chuck’s case, he can access his prior Roth IRA contributions and sufficiently aged contributions tax and penalty free at any time for any reason! And his Roth IRA is easy to access, particularly if it is at a low-cost discount brokerage.
When you combine tax-free growth, no requirement to take required minimum distributions during the account holder’s lifetime, and the best emergency access of any tax-advantaged retirement account, it is difficult to see why working adults should not have at least some money in a Roth IRA.
When a Roth IRA Doesn’t Make Sense
The short answer is: not often! I struggle to come up with profiles of individuals that would not benefit from having some amount in a Roth IRA.
I can think of two profiles. The first, a rare case, is someone with very large legal liabilities such that all of their wealth would benefit from the creditor protections offered by an ERISA retirement plan (such as a 401(k)) and who needs almost all of their wealth shielded from creditors.
First, if you have built up 6 figures or more in wealth, having creditors able to claim your entire wealth is relatively rare. Second, in most cases, good insurance coverage, including adequate medical insurance, professional liability insurance (as applicable), home and automobile insurance, and personal umbrella liability insurance, should protect the vast majority of people such that they could withstand any liability exposure caused by having money in a Roth IRA instead of an ERISA protected plan.
The second profile is someone with incredibly high income currently and very little anticipated income in the future (such that their future tax rate is much lower than today’s rate). This too is a bit of a unicorn – people with high income today tend to have decent income tomorrow (even in the FI community).
Health Savings Accounts
It will also come as no surprise that I am fond of health savings accounts. Health savings accounts share some of the attributes that make the Roth IRA such a winner for both retirement savings and emergency planning.
But, there are some drawbacks. First, the distribution ordering rules are not as taxpayer friendly. While it may be the case that you have sufficient old medical expenses that you can reimburse yourself for (and thus not pay tax and a penalty on the HSA distribution), that is not always going to be the case, and even if it is, does add a layer of complexity.
Second, the HSA is not for everyone. If a high deductible health plan is not good medical insurance for you, an HSA is generally off the table.
So, that leaves the HSA as a fantastic option for those who qualify for and use a high deductible health plan (and usually an option that should be part of a comprehensive financial plan if you use a HDHP). But it also means that the HSA is not quite as good as a tool for the combination of retirement saving and emergency planning.
Conclusion
Assuming that an individual (a) has retirement planning and emergency preparedness as financial planning objectives and (b) is not in a position where legal liabilities would cripple them without ERISA creditor protection, it is hard to argue against having at least some material amount in a Roth IRA.
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.
Perhaps you find yourself preparing your 2020 tax return in early April 2021.You have not contributed anything to a traditional IRA or a Roth IRA yet for 2020. Do you have time to perhaps do a Roth IRA or a Backdoor Roth IRA? The answer is, “Absolutely!” if you have the right facts in place. Let’s discuss a comprehensive example:
Example 1: Jack is single, 35 years old, participates in a 401(k) at work, and has self-prepared his 2020 tax return but not yet filed it. It is April 9, 2021, and his tax-return software indicates that he does not qualify for a Roth IRA, as his modified adjusted gross income for 2020 is $150,000. Jack has no traditional IRAs, SEP IRAs, or SIMPLE IRAs. Jack just learned about the existence of the Backdoor Roth IRA.
What can Jack do? Can he do a Backdoor Roth IRA for 2020? The answer is, Yes!
First, Jack should, by April 15, 2021, make a traditional, non-deductible IRA contribution of $6,000. When he does this, he should designate the contribution as being for 2020. With his soon-to-be-filed 2020 federal income tax return, he should file a Form 8606 which will report the $6,000 traditional, non-deductible IRA contribution. Easy enough.
Assuming Jack contributed to his 2020 traditional, non-deductible IRA in April 2021, in May of 2021 Jack should convert the entire balance in his traditional IRA to a Roth IRA. Third, he should ensure he has no balance in traditional IRAs/SEP IRAs/SIMPLE IRAs as of December 31, 2021.
Jack can also do a Backdoor Roth IRA for 2021, which may be advisable if (a) his modified adjusted gross income exceeds the Roth IRA contribution thresholds and (b) he will have no balance in traditional IRAs/SEP IRAs/SIMPLE IRAs as of December 31, 2021.
Assume Jack makes a traditional, non-deductible contribution to an IRA for 2021 on June 1, 2021, and on July 2, 2021, he converts the amounts in the traditional IRA to a Roth IRA. Further assume (a) the amounts converted in May and July were $6,001 and $6,002, respectively, and (b) Jack has no balance in traditional IRAs/SEP IRAs/SIMPLE IRAs as of December 31, 2021.
When Jack files his 2021 tax return, Page 1 of his Form 8606 should look like this:
Page 1 of the Form 8606 reflects the total basis in traditional IRAs (without considering the Roth conversions). Note that I had to use the 2019 version of the Form 8606, as the 2021 version has not yet been released. Please adjust all dates in your mind’s eye accordingly.
Page 2 (reporting the 2021 Roth IRA conversions) of the Form 8606 should look like this:
The gross amount of the Roth IRA conversions are taxable, but Jack gets to recover his $12,000 of traditional IRA basis.
Post Tax Return Filing Split-Year Backdoor Roth IRA
Example 2: Jim is single, 35 years old, participates in a 401(k) at work, and has self-prepared his 2020 tax return and filed it on March 15, 2021. Jim’s modified adjusted gross income for 2020 is $150,000. Jim has no traditional IRAs, SEP IRAs, or SIMPLE IRAs. It is April 9, 2021 and Jim just learned about the existence of the Backdoor Roth IRA.
Can Jim still do a Backdoor Roth IRA for 2020? Absolutely!
First, Jim should, by April 15, 2021, make a traditional, non-deductible IRA contribution of $6,000. When he does this, he should designate the contribution as being for 2020. So far, everything is the same as Example 1.
But here is where things change. Jim should also, by April 15, 2021, file a standalone Form 8606 with the IRS and be sure to sign the form on page 2. The Form 8606 will report the contribution to the traditional, non-deductible IRA. Jim will have to paper file the Form 8606 and mail it to the IRS Service Center that he would mail his Form 1040 to (if he were to paper file his Form 1040).
Jim could then convert the traditional IRA to a Roth IRA to successfully complete the Backdoor Roth IRA. He should also ensure he had no balance in a traditional IRA, SEP IRA, or SIMPLE IRA on December 31, 2021.
Advanced Split-Year Backdoor Roth IRA
Example 3: Jill is married to Joe, 35 years old, participates in a 401(k) at work, and has self-prepared their 2020 tax return but not yet filed it. Jill and Joe’s modified adjusted gross income for 2020 is $250,000. Jill has a traditional IRA with a balance of $100,000 (and no previous non-deductible contributions). It is April 9, 2021 and Jill just learned about the existence of the Backdoor Roth IRA.
Jill’s example is a bit more challenging than Jack and Jim’s previous example. Yes, it is possible that Jill could successfully complete a Backdoor Roth IRA for 2020. But it involves much more execution risk – the risk that the proper steps will not be completed in time. While taxpayers engaging in any sort of tax planning should consider engaging professional assistance, Jill is in a position where that is even more so the case.
Here is how Jill could successfully execute a Backdoor Roth IRA for 2020. Jill should go to her workplace benefits website and download and review the “Summary Plan Description” for the 401(k) plan (sometimes initialized “SPD”).
It may be the case that Jill’s workplace 401(k) plan will accept a roll-in of her traditional IRA. Many 401(k)s do, but many do not. Some plans will only accept roll-ins of other qualified plans (401(k)s, 403(b)s, etc.), and some plans will only accept roll-ins of qualified plans and so-called “conduit IRAs” i.e., IRAs that consist only of money that was formerly in a qualified plan. However, there are some plans that will accept roll-ins of both old qualified plans and any type of traditional IRA (though note that in all events 401(k) plans cannot accept roll-ins of amounts representing non-deductible IRA contributions).
If Jill’s workplace 401(k) plan will accept a roll-in of the $100,000 traditional IRA, then Jill could transfer (in a direct trustee-to-trustee transfer) her traditional IRA (other than the amount of any nondeductible contributions, including a $6,000 2020 contribution) to the 401(k). If she fails to do that by December 31, 2021, then any Backdoor Roth IRA would be very tax inefficient (and unavisable) – you can read more here in the “Jennifer” example.
This is one reason I say that there is “execution risk” – perhaps Jill does the “Backdoor Roth IRA” steps but neglects the transfer of the old traditional IRA to the 401(k) until after December 31, 2021. If that happens, Jill’s Backdoor Roth IRA will now be very tax inefficient.
Some might say “couldn’t Jill start a side hustle, open a Solo 401(k) for it, and then roll the traditional IRA into the Solo 401(k)?” To my mind, that is a dangerous path. Jill’s side hustle might not rise to the level of a trade or business for tax purposes. If it does not, then it is not eligible to have a Solo 401(k). Any transfer of a traditional IRA to a plan that does not qualify as either an IRA, 401(k), 403(b), or similar plan is simply a taxable distribution subject to full income tax and a 10 percent early withdrawal penalty. Ouch!!!
Jill should not over think it. If she can easily roll her old traditional IRA into her workplace 401(k), then she should consider doing so and doing a Backdoor Roth IRA. But if she cannot, then fine, there are plenty of other ways to become financially independent and/or achieve retirement planning goals. Not having the Backdoor Roth IRA tool available is no killer to her future plans and goals.
Note further that if Jill’s balance was in a SIMPLE IRA that was less than 2 years old, she could not roll the SIMPLE IRA into anything other than a SIMPLE IRA for the first two years of her SIMPLE IRA’s existence without incurring a 25% penalty.
FI Tax Guy can be your financial advisor! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters.Please also refer to the Disclaimer & Warning section found here.
Many colloquially refer to the Winter and early Spring as “tax season.” To my mind, that is short sighted. Yes, for most the time from late January to mid-April are when their tax return is prepared and filed. But the most impactful tax work is not tax return preparation — it’s tax planning!
Below I discuss ways to use your current tax return as a springboard to tax planning.
Before we get started, two notes. First, there is some tax planning that can be “do it yourself” and some tax planning that is best considered and implemented with the help of a tax planning professional. When in doubt, the concept is probably the latter. Second, it is helpful to keep in mind the correct use of this blog or any other blog–as a tool to raise awareness. Blogs are not a substitute for professional advice, and are not advice for any particular person. Rather, this post and others should be viewed as a way to increase knowledge and help faciliate more informed conversations with professionals.
Your 2020 Tax Return
Your 2020 tax return is a great springboard for tax planning. Look at the following items on your tax return to jump start your tax planning.
Schedule D Line 13 Capital Gain Distributions
Everyone should review their own tax returns for the past few years and look at this line. If there is a substantial number on this line, it should raise a red flag.
I previously discussed capital gain distributions here. Generally, they come from mutual funds and ETFs in taxable accounts. These financial securities pass gains out to the shareholders, creating capital gains income on the shareholders’ tax returns. Actively managed funds tend to have much greater capital gain distributions than passively managed index funds.
The planning opportunity is to review the accounts that are generating significant capital gain distributions. If the realized gain in such accounts is low (or if there is a realized loss in those accounts), it might be advisable to sell the holding and replace it with a fund likely to have lower capital gain distributions. Taxpayers considering this strategy should be sure to fully understand the gain or loss in the securities before selling. Financial institutions do not have to report to investors (and the IRS) basis in mutual funds purchased prior to 2012, so sometimes it can be difficult to determine the taxable built-in gain or loss on older holdings.
Form 8889 Line 14c Distributions
Form 8889 is the tax return form for a FI favorite: the health savings account. Amounts other than $0 on Line 14c of Form 8889 should appear, in my opinion, only if the taxpayer is elderly or found themselves in a dire situation during the tax year. It is generally not optimal, from a tax perspective, to take distributions from an HSA to fund medical expenses when one is neither elder nor in a dire situation.
Amounts other than $0 on Line 14c can be a learning and planning opportunity. Future routine medical expenses are usually best paid from one’s checking account (a regular taxable account), and taxpayers should save the receipt. In the future, taxpayers can reimburse themselves tax free from their HSA for that expense. In the meantime, the money has grown in the HSA and enjoyed many years of tax free compounding.
Form 1040 Line 4b IRA Distributions Taxable Amount
Taxpayers who did a Backdoor Roth IRA and have a large amount on Line 4b of Form 1040 should review their transactions to make sure everything was correctly reported. Part of the idea behind a Backdoor Roth IRA is that, if properly executed, it should result in a very small amount of taxable income (as indicated on Line 4b).
It may be the case that the tax return improperly reported the Backdoor Roth IRA (and thus, the taxpayer should amend their return to obtain a refund). Or, it may be the case that the taxpayer did the steps of the Backdoor Roth IRA at a time they probably should not have (because they had a significant balance in a traditional IRA, SEP IRA, or SIMPLE IRA).
Discovering the problem can help effectively plan in the future, and if necessary take corrective action.
For those executing Roth Conversion Ladders, a large amount on Line 4b is the equivalent of Homer Simpson’s Everything OK Alarm. Roth Conversion Ladders are intended to create a significant amount of taxable income, and Line 4b is where that income is reported on Form 1040. Note further that all Roth IRA conversions require the completion of Part II of the Form 8606.
Schedule A Line 17 Total Deductions
Those who claimed itemized deductions in 2020 should review Line 17 of Schedule A. Is the number reported for the total itemized deductions close to the standard deduction amount (for 2021, single taxpayers have a standard deduction of $12,550 and married filing joint taxpayers have a standard deduction of $25,100)?
If so, there a tax planning opportunity. Why is that number what it is? Is it because of charitable contributions? If so, the donor advised fund might be a good opportunity. Here’s how it might work:
Example: Joe and Lisa file married filing joint. In 2020, they itemized based on $10K of state taxes, $9K of mortgage interest, and $6K of charitable contributions ($500 a month to their church). Thus, at $25,000 of itemized deductions, they were barely over the threshold to itemize. In 2021, they move a sizable amount into a donor advised fund ($25,000). They use the donor advised fund to fund their 2021, 2022, 2023, and 2024 monthly church donations.
From a tax perspective, Joe and Lisa itemize in 2021 (claiming total deductions of $44K – the state taxes, mortgage interest, and a $25K upfront deduction for contribution to the donor advised fund). In 2022, 2023, and 2024, they would claim the standard deduction, which is (roughly speaking) almost equivalent to their 2020 itemized deductions.
By using the donor advised fund, Joe and Lisa get essentially the same deduction in 2022 through 2024 that they would have received without the donor advised fund, and they get a tremendous one year increase in tax deductions in 2021.
Form 8995 or Form 8995-A Line 2
Those with any amount on Line 2 of the Form 8995 or the Form 8995-A should likely consider some tax planning. This line indicates that the taxpayer has qualified trade or business income that may qualify for the new Section 199A qualified business income deduction. Taxpayers in this situation might want to consider consulting with a professional, as there are several planning opportunities available to potentially increase any otherwise limited Section 199A qualified business income deduction.
2021 Adjusted Gross Income Planning to Maximize Stimulus Payments
Taxpayers should review line 11 (adjusted gross income or “AGI”) on their Form 1040 in concert with reviewing their stimulus checks. For those taxpayers who did not receive their maximum potential stimulus payments in 2021, there can be opportunities to lower AGI so as to qualify for additional stimulus payments and/or increased child tax credits. I blogged about one planning opportunity in that regard here.
The Shift to Tax Planning
Tax planning can take many shapes and sizes. But it needs to be driven by goals, not by tactics. Bad tax planning begins something like this: “I need a Solo 401(k), how do I set it up?” N.B. Opening a Solo 401(k) when you do not qualify for one is a great way to create a tax problem for yourself.
Good tax planning begins more like this: “I want to achieve financial independence. How do I best save for retirement in a tax advantaged way? I’ve heard a Solo 401(k) is a great option. As part of this process, we should consider it as a possible way to help me achieve my goal.”
Another point: I find there is far too much focus on “I had to pay [insert perceived sizable amount here] this year in taxes” and far too little focus on lifetime taxes. To my mind, the goal should not be to pay less tax in any one year. Rather, the goal should be to legitimately reduce lifetime tax burden. Sure, there can be tax planning that does both, but the best tax planning (whether DIY or with the help of a professional) places reducing lifetime tax burden as its primary goal.
Below are just some areas where taxpayers can begin their tax planning considerations.
Retirement Planning
This is a big one. Taxpayers should understand whether they contribute to a traditional IRA and/or Roth IRA, and why or why not. This post helps explain whether taxpayers qualify to make an annual contribution to a traditional IRA and/or a Roth IRA.
Taxpayers should consider their workplace retirement plans, which can provide several planning opportunities.
Small Business/Self-Employment Income
For those with a small business and/or significant self-employment income, tax planning is very important. I have written several posts about just some of the tax planning available to those with small businesses. People with small businesses often benefit from professional, holistic tax and financial planning.
Stock Options
Stock options and employer stock grants provide some good tax planning opportunities. I’ve previously written about ISOs, but all kinds of stock option programs can be an opportunity to do some tax planning, which often should be with a professional advisor.
Conclusion
Filing timely, accurate tax returns is important. But the best way to optimize one’s tax situation is to do quality, intentional tax planning. Tax planning should prioritize goals over tactics. There is some tax planning that can be done by yourself, but many areas of tax planning strongly benefit from professional assistance.
FI Tax Guy can be your financial advisor! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters.Please also refer to the Disclaimer & Warning section found here.
