Did you receive a Form 1099-DIV which lists an amount in Box 5 “Section 199A dividends”? If so, you might be asking, what the heck are Section 199A dividends?
You probably never came across the term “Section 199A dividends” in high school algebra. That’s okay. Below I discuss what a Section 199A dividend is and how to report it on your tax return.
Who Pays Section 199A Dividends?
Real estate investment trusts (“REITs”) pay Section 199A dividends. REITs are a special type of business entity. A REIT owns almost entirely real estate. Many office buildings, hotels, hospitals, malls, and apartment buildings are owned by REITs. Investors can own the stock of a single REIT, or they can own mutual funds or ETFs that are partly or entirely composed of REIT stock. For example, there are some REITs in the Vanguard Total Stock Market Index Fund (VTSAX).
REITs are advantageous from a tax perspective. In exchange for paying 90 plus percent of its income out to investors as dividends, the REIT itself does not pay federal corporate income taxes. This results in REITs often paying higher dividends than companies in other industries. The dividends paid by the REIT are Section 199A dividends.
What is the Tax Benefit of a Section 199A Dividend?
Here is an example of how the tax deduction works for Section 199A dividends.
Catherine owns shares of ABC REIT Mutual Fund. The mutual fund pays her $1,000.00 of dividends, all of which are Section 199A dividends reported to her in both Box 1a and Box 5 of Form 1099-DIV. She gets a $200 qualified business income deduction on her federal tax return (20 percent of $1,000.00) because of the $1,000.00 of Section 199A dividend.
There are several things to keep in mind when considering Section 199A dividends:
First, Section 199A dividends are a slice of the pie of dividends. The full pie of dividends, “total ordinary dividends,” is reported in Box 1a of Form 1099-DIV. Since Box 1a reports all of the dividends, Box 5 must be equal to or less than Box 1a.
Second, there is no income limit (taxable income, MAGI, or otherwise) on the ability to claim the Section 199A qualified business income deduction for Section 199A dividends. The QBI deduction for self-employment income is generally subject to taxable income limitations on the ability to claim the deduction. Not so with the Section 199A dividends.
Third, taxpayers get the Section 199A QBI deduction regardless of whether they claim the standard deduction or itemized deductions.
Fourth, there is no requirement to be engaged in a qualified trade or business to claim the QBI deduction for Section 199A dividends.
Sixth, Section 199A dividends are not qualified dividends (which are reported in Box 1b of Form 1099-DIV). They are taxed as ordinary income subject to the taxpayer’s ordinary income tax rates. They do not qualify for the preferred federal income tax rates for qualified dividends.
Seventh is a 2025 revision to this article: Some taxpayers cannot get the QBI deduction because their long-term capital gains exceed their ordinary income. This is usually a good outcome. See “An Exception: Too Little Ordinary Income to Claim a Section 199A Deduction” below.
Where Do I Report a Section 199A Dividend on My Tax Return?
Section 199A dividends create tax return reporting in three prominent places on a federal income tax return.
First, Form 1099-DIV Box 1a total ordinary dividends are reported on Form 1040 Line 3b. As Section 199A dividends are a component of Box 1a total ordinary dividends, they are thus reported on the Form 1040 on Line 3b. Section 199A dividends are not reported on Line 3a of Form 1040 because Section 199A dividends are not qualified dividends.
Second, Section 199A dividends are reported on either Line 6 of Form 8995 or Line 28 of Form 8995-A. In most cases, taxpayers will file the simpler Form 8995 to report qualified business income and Section 199A dividends. By reporting Section 199A dividends on one of those lines most tax return preparation software should flow the dividends through the rest of the form as appropriate (but it never hurts to double check).
Third, the QBI deduction, computed on either Form 8995 or Form 8995-A, is claimed on Line 13 of Form 1040.
Tax return software varies. Hopefully, by entering the Form 1099-DIV in full in the software’s Form 1099-DIV input form, all of the above will be generated. Ultimately, it is up to the taxpayer to review the return to ensure that the information has been properly input and properly reported on the tax return.
An Exception: Too Little Ordinary Income to Claim a Section 199A Deduction
In this 2025 article revision, I want to consider cases where a taxpayer might not be able to claim a QBI deduction for Section 199A dividends.
At first glance, you might think that this is a bad thing. But it’s usually indicative that someone has structured their tax basketing very effectively.
There is a limit on the Section 199A deduction. If your ordinary income is low vis-a-vis your long-term capital gain income, you lose the Section 199A for dividends and all other qualified business income. See Section 199A(a)(2) for the rule providing this result.
This sounds bad but it usually is good! Here’s an example:
Justin, an early retiree 56 years old in 2025. He has $90,000 of annual living expenses, which he funds by selling $90,000 of ABC Domestic Equity index fund in his taxable account. Those sales generate $50,000 of long-term capital gains. Further, he reports $13,000 of qualified dividend income, $1,000 of nonqualified dividends, and $1,000 of Section 199A dividends from his ABC Domestic Equity Index Fund. He also reports $2,000 of interest income.
Justin’s net taxable income is $52,000 ($67,000 of adjusted gross income less a $15,000 standard deduction), which is less than his long-term capital gain income of $63,000 ($50,000 long-term capital gains plus $13,000 qualified dividend income).
When long-term capital gain income exceeds net taxable income, the taxpayer cannot claim the QBI deduction, even for Section 199A dividends. This happens in situations where ordinary income is less than capital gain income. Justin is thus precluded from taking a QBI deduction, even for his Section 199A dividends.
Never fear, however. Justin’s total federal income tax for 2025 is just $746 on his AGI of $67,000. I put together a spreadsheet illustrating how his income is taxed, which I think you will find illuminating.
Does Justin need a $200 QBI deduction when his federal income tax effective rate is just 1.11%?
As I discussed in my Tax Basketing article, early retirees benefit from having as little ordinary income as possible. Any small QBI deduction on Section 199A dividends that sacrifices is well worth it, as Justin’s example illustrates.
Conclusion
Section 199A dividends create a taxpayer favorable federal income tax deduction. They are reported in Box 5 of Form 1099-DIV and should be reported on a taxpayer’s federal income tax return.
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, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
I’ve talked about what I refer to as a “72(t) IRA” both here on the blog and on my YouTube channel.
What I haven’t talked much about, until now, is a 72(t) payment plan coming out of a 401(k). Is it possible? Does it make sense?
Inspired by a comment on a recent video, I’m breaking down taking 72(t) payments from a 401(k) in this post. As you will see, when compared with the 72(t) IRA, the 72(t) 401(k) has significant disadvantages.
401(k) Plan Rules
Can you do a 72(t) out of your 401(k)? The answer is “maybe.” Qualified plans, including 401(k)s, have all sorts of unique rules. They vary plan to plan.
There’s no guarantee that you can access partial withdrawals from a 401(k) in accordance with a 72(t) payment plan after a separation from service.
By contrast, IRAs allow for easily accessible partial withdrawals regardless of age.
Must Separate From Service
There’s a tax rule to consider: one can only do a 72(t) payment plan from a 401(k) or other qualified plan after a separation from service from the employer.
From a planning perspective, this is not much of an issue. Few would want to do a 72(t) payment plan while still working, as taxable withdrawals from a 401(k) are not ideal if one still has significant W-2 income hitting their tax return.
72(t) Account Size
According to Notice 2022-6, the 72(t) account balance for the fixed amortization calculation must be determined in a reasonable manner. See Section 3.02(d). The Notice goes on to state that using a balance of the account from December 31st of the prior year through the date of the first 72(t) distribution is reasonable. One should document, usually with an account statement, the balance they are using to have in case the IRS ever examines the 72(t) payment.
Account size is one area where a 72(t) IRA is generally preferable to a 72(t) 401(k). As Natalie Choate observes in her classic Life and Death Planning for Retirement Benefits (8th Ed. 2019), an IRA can be sliced and diced into two or more IRAs, allowing one to take a 72(t) payment from a smaller IRA and remain flexible, in part through having a non-72(t) IRA as well. This flexibility is generally not possible with a 401(k) or other qualified plan. See Choate, page 595. That means without a transfer to an IRA first, the 401(k) account holder is generally stuck with an account size for the fixed amortization calculation, other than the bit of wiggle room given by Notice 2022-6 Section 3.02(d). Further, the entire account is subject to the locked 72(t) cage.
72(t) Locked Cage
A 72(t) 401(k) is entirely subject to the many restrictions on 72(t) retirement accounts. When one uses a 72(t) IRA, they often can have a 72(t) IRA and a non-72(t) IRA. This means less of their retirement account portfolio is subject to the 72(t) rules “locking the cage.” For example, the non-72(t) IRA can be used to accept other IRA roll-ins.
72(t) 401(k) Example
An example can illustrate the problems involved in using a 72(t) 401(k) instead of a 72(t) IRA.
Bob wants to retire early in 2024 at age 53. He has some rental real estate that will generate $40,000 of positive cash flow annually and needs $50,000 more annually from his retirement account to support his lifestyle. He has a $2,000,000 401(k) at his current employer. He sets up a 72(t) 401(k) instead of rolling out to a traditional IRA and establishing a non-72(t) IRA and a 72(t) IRA.
Solving for interest rate, we get an interest rate of -1.015124%.
Notice that in order to generate a $50K annual payment out of a $2M 401(k), Bob must use a negative interest rate. Bob can’t simply ask his 401(k) administrator to establish two separate 401(k) accounts for him and then use a positive interest rate for the 72(t) payment plan.
72(t) Negative Interest Rate
This raises an issue: can a taxpayer use a negative interest rate for a 72(t) payment plan under the fixed amortization method?I believe the answer is Yes. Notice 2022-6 Section 3.02(c) allows an interest rate “that is not more than the greater of (i) 5% or (ii) 120% of the federal mid-term rate (determined in accordance with section 1274(d) for either of the two months immediately preceding the month in which the distribution begins)” (emphasis added).
In my opinion, that wording in no way precludes using a negative interest rate for a 72(t) payment plan. Further, I see no compelling reason for the IRS to be concerned about using a negative interest rate. That said, there is at least some uncertainty around the issue.
The issue is entirely avoided if Bob rolled out to a traditional IRA and then split that traditional IRA into two IRAs. He could have a 72(t) IRA of about $804K generating an annual $50K payment (using a 5% interest rate) and a non-72(t) IRA of about $1.196M. From a planning perspective, it’s certainly my preference to avoid the issue by using the 72(t) IRA.
72(t) Structuring Alternative
As a structuring alternative that might be available to Bob (depending on the plan’s rules), Bob could roll the $804K out to a traditional IRA and use that as a 72(t) IRA. He could keep the balance inside his 401(k) and effectively use his 401(k) as what I refer to as the “non-72(t) IRA.” This sort of structuring was discussed on the Forget About Money podcast (timestamped here).
Unfortunately, using a 72(t) 401(k) boxed Bob into a bad corner. Say Bob is age 57 and the 72(t) 401(k) is still worth exactly $2M. He could use the age 57 factor from the Notice 2022-6 Uniform Life Table (41.6) and reduce his annual payment to $48,077. Not much of a reduction from his $50,000 required annual payment.
Had he used a 72(t) IRA/non-72(t) IRA structure instead, and the 72(t) IRA was worth $804K, he could reduce his $50,000 annual payment all the way down to $19,327.
For those looking for protection against significant tax in the event of an inheritance or other income producing event, the 72(t) IRA is preferable to the 72(t) 401(k).
What if Bob has a 72(t) 401(k)? I believe that establishing a second 72(t) payment from his 72(t) 401(k) would blow up his existing 72(t) payment plan. The second 72(t) payment would be an impermissible modification of the original 72(t) payment plan, triggering the 10 percent early withdrawal penalty and interest charges with respect to all prior distributions.
I am uncomfortable with any modification to a 72(t) retirement account unless it is specifically allowed by IRS guidance such as Notice 2022-6, and I see no evidence that a second 72(t) payment plan out of the same retirement account is permissible. Natalie Choate is also of the opinion that taking a second 72(t) payment from an existing 72(t) account is an impermissible modification of the first 72(t) payment plan. See Choate, page 594. See also IRS Q&A 9 (nonbinding), allowing a new 72(t) payment plan from the retirement account only after the taxpayer has blown up their original 72(t) payment plan.
That said, there is a single 2009 Tax Court case, Benz v. Commissioner, that gives the slightest glimmer of hope. In that case an additional distribution from a 72(t) IRA excepted from the 10% early withdrawal penalty as being for higher education expenses did not blow up an existing 72(t) payment plan, because the additional distribution itself qualified for a 10 percent early withdrawal penalty exception under Section 72(t)(2)(E).
It’s likely a stretch to apply Benz to a second 72(t) payment plan from the same retirement account. That said, I don’t believe it is an impossible outcome. But note that Benz is a single 15 year old court case binding neither on any federal district court nor on any federal appellate court. Further, the IRS never acquiesced to the decision in Benz, meaning they may still disagree with it. Even if the IRS now agrees with Benz they (and more importantly, a court) may not believe the logic of Benz goes so far as to allow a second 72(t) payment plan from the same retirement account.
Asset Protection
Depending on the circumstances and on the state, it can be true that IRAs offer materially less creditor protection than 401(k)s and other qualified plans. That could be a reason to use a 72(t) 401(k) instead of a 72(t) IRA.
I believe that, as a practical matter, sufficient personal liability umbrella insurance, which tends to be affordable, can adequately fill-in gaps between IRA and 401(k) creditor protection. Of course, everyone needs to do their own analysis, possibly in consultation with their lawyers and/or insurance professionals, as to the adequacy of their creditor protection arrangements.
72(t) Payment Plan Resources
72(t) payment plans are complex. Here are some resources from me and other content creators for your consideration:
The 72(t) 401(k) is a possibility if one’s 401(k) plan allows it. I usually strongly disfavor doing a 72(t) payment plan out of a 401(k) considering how rigid it is compared to the 72(t) IRA alternative. Further, as discussed above, 72(t) 401(k)s can create situations where the tax law has not, to my knowledge, definitely stated the governing rules. For these reasons, I generally favor using 72(t) IRAs in conjunction with non-72(t) IRAs instead of the more inflexible 72(t) 401(k).
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.
One thing I like about the Financial Independence community is that members are not beholden to Conventional Wisdom.
Many in the Establishment believe retirement is for 65 year olds (and some basically think it’s not for anyone).
My response: Oh, heck no!
Sure, some people have jobs they very much enjoy. If that’s the case, then perhaps retirement isn’t your thing in your 50s. But many in the FI movement have accumulated assets such that they no longer have a financial need to work. Perhaps their job is not all that enjoyable – it happens. Or perhaps their job won’t exist in a year or two – that happens too.
The tax rules require some planning if one retires prior to turning age 59 ½. Age 59 ½ is the age at which the pesky 10 percent early withdrawal penalty no longer applies to tax-advantaged retirement account distributions.
Thus, there’s a need to consider what to live off of once one is age 59 ½. Below I list the possibilities in a general order of preference and availability. Several of these options (perhaps many of them) will simply not apply to many 50-something retirees. Further, some retirees may use a combination of the below discussed options.
Listen to Sean discuss accessing money in retirement prior to age 59 ½ on a recent ChooseFI episode! Part Two on the ChooseFI podcast is coming soon.
Taxable Accounts
The best retirement account to access if you retire before age 59 ½ isn’t even a “retirement” account: it’s a taxable account. I’m so fond of using taxable accounts first in retirement I wrote a post about the concept in 2022.
The idea is to use some combination of cash in taxable accounts (not at all taxable – it’s just going to the ATM!) and sales of brokerage assets (subject to low long term capital gains federal income tax rates) to fund your pre-59 ½ retirement. This keeps taxable income low and sets up potential additional tax planning.
Pros: Because of tax basis, living off $100,000 of taxable brokerage accounts doesn’t cause $100,000 of taxable income. Further, long term capital gains receive very favorable federal income tax treatment. Some may even qualify for the 0% long term capital gains tax rate!
But that’s not all. There are significant creditor protection benefits to living off taxable assets first. As we spend down taxable assets, we are reducing those assets that are most vulnerable to potential creditors. By not spending down tax-advantaged retirement accounts, we are generally letting them grow, thus growing the part of our balance sheet that tends to enjoy significant creditor protection. Note that personal liability umbrella insurance is usually a good thing to consider in the creditor protection context regardless of tax strategy.
Spending taxable assets first tends to limit taxable income, which can open the door to (1) a significant Premium Tax Credit in retirement (if covered by an Affordable Care Act medical insurance plan) and (2) very tax advantageous Roth conversions in early retirement.
There’s also a big benefit for those years after we turn 59 ½. By spending down taxable assets, we reduce future “uncontrolled income.” Taxable accounts are great. But they kick off interest, dividends, and capital gains income, even if we don’t spend them. By reducing taxable account balances, we reduce the future income that would otherwise show up on our tax return in an uncontrolled fashion.
Cons: To my mind, there are few cons to this strategy in retirement.
The one con in the accumulation phase is that when we choose to invest in taxable accounts instead ofin traditional deductible retirement accounts we forego a significant tax arbitrage opportunity. That said, these are not mutually exclusive. Members of the FI community can max out deductible retirement account contributions and also build up taxable accounts.
Ideal For: Someone who is able to save beyond tax-advantaged retirement accounts during their working years. This is the “ideal” for financial independence in my opinion, though it may be challenging for some.
Inherited Retirement Accounts
Withdrawals from inherited retirement accounts (other than those the spouse treats as their own) are never subject to the 10% early withdrawal penalty. Often they are subject to a 10-year drawdown rule, so usually they should be accessed prior to using many other draw down techniques.
Pros: If it’s a traditional retirement account inherited from a parent or anyone else more than 10 years older than you are, you generally have to take the money out within 10 years. Why not just live on that money? Simply living on that money, instead of letting the traditional inherited retirement grow for ten years, avoids a “Year 10 Time Bomb.” The time bomb possibility is that the inherited traditional retirement account grows to a huge balance that needs to come out in the tenth full year following death. Such a large distribution could subject the recipient subject to an abnormally high marginal federal income tax rate.
Cons: Not very many other than if the account is a Roth IRA, using the money for living expenses instead of letting it grow for 10 years sacrifices several years of tax free growth.
Ideal For: Someone who has inherited a retirement account prior to turning age 59 ½.
This is a great way to avoid the early withdrawal penalty. But remember, the money must stay in the workplace retirement account (and not be rolled over to a traditional IRA) to get the benefit.
Pros: Funds retirement prior to age 59 ½ without having to incur the 10 percent early withdrawal penalty.
Whittles down traditional retirement accounts in a manner that can help reduce future required minimum distributions (“RMDs”).
Cons: You’re handcuffed to the particular employer’s 401(k) (investments, fees, etc.) prior to age 59 ½. Review the plan’s Summary Plan Description prior to relying on this path to ensure flexible, periodic distributions are easily done after separation from service and prior to turning age 59 ½.
Limited availability as one must separate from service no sooner than the year they turn age 55.
Creates taxable income (assuming a traditional account is used), which is less than optimal from a Premium Tax Credit and Roth conversion perspective.
Ideal For: Those with (1) large balances in their current employer 401(k) (or other plan), (2) a quality current 401(k) or other plan in terms of investment selection and fees, (3) a plan with easily implemented Rule of 55 distributions, and (4) plans to retire in their mid-to-late 50s.
Governmental 457(b) Plans
Withdrawals from governmental 457(b) plans are generally not subject to the 10% early withdrawal penalty. This is the Rule of 55 exception but they deleted the “55” 😉
Like the Rule of 55, this is only available so long as the governmental 457(b) is not rolled to a traditional IRA.
Pros: Funds retirement prior to age 59 ½ without having to incur the 10 percent early withdrawal penalty. If you have a governmental 457(b), it’s better than the Rule of 55 because you don’t have to worry about your separation from service date.
Whittles down traditional retirement accounts in a manner that can help reduce future RMDs.
Cons: You’re handcuffed to the particular employer’s 457 (investments, fees, etc.) prior to age 59 ½. Review the plan’s Summary Plan Description prior to relying on this path to ensure flexible, periodic distributions are easily done after separation from service and prior to turning age 59 ½.
Creates taxable income (assuming a traditional account is used), which is less than optimal from a Premium Tax Credit and Roth conversion perspective.
Ideal For: Those (1) with large balances in their current employer governmental 457(b) and (2) a quality current governmental 457(b) in terms of investment selection and fees.
Roth Basis
Old annual contributions and conversions that are at least 5 years old can be withdrawn from Roth IRAs tax and penalty free at any time for any reason. This can be part of the so-called Roth Conversion Ladder strategy, though it does not have to be, since many will have Roth Basis going into retirement.
Pros: Roth Basis creates a tax free pool of money to access prior to turning age 59 ½.
Cons: We like to let Roth accounts bake for years, if not decades, of tax free growth. Using Roth Basis in one’s 50s significantly reduces that opportunity.
Some may need taxable income in early retirement to qualify for Premium Tax Credits. Relying solely on Roth Basis can be much less than optimal if Premium Tax Credits are a significant part of one’s early retirement plan.
Roth 401(k) contributions, for many workers, are disadvantageous in my opinion. Many Americans will forego a significant tax rate arbitrage opportunity if they prioritize Roth 401(k) contributions over traditional 401(k) contributions.
Ideal For: Those with significant previous contributions and conversions to Roth accounts.
72(t) Payments
I did a lengthy post on this concept. The idea is to create an annual taxable distribution from a traditional IRA and avoid the 10 percent early withdrawal penalty.
Pros: Avoids the early withdrawal prior to turning age 59 ½.
Whittles down traditional retirement accounts in a manner that can help reduce future RMDs.
Inside a traditional IRA, the investor controls the selection of financial institutions and investments and has great control on investment expenses.
Cons: This opportunity may require professional assistance to a degree that many of the other concepts discussed do not.
There is a risk that if not done properly, previous years’ distributions may become subject to the 10 percent early withdrawal penalty and related interest charges.
Creates taxable income, which is less than optimal from a Premium Tax Credit and Roth conversion perspective.
Ideal For: Those with most of their financial wealth in traditional deferred retirement accounts prior to age 59 ½ and without easy access to other alternatives (such as the Rule of 55 and/or governmental 457(b) plans.
HSA PUQME
Withdrawals of Previously Unreimbursed Qualified Medical Expenses (“PUQME”) from a health savings account are tax and penalty free at any time for any reason. Thanks to ChooseFI listener and correspondent Kristin Smith for suggesting the idea to use PUQME to help fund retirement in one’s 50s.
Pros: Withdrawals of PUQME creates a tax free pool of money to access prior to turning age 59 ½.
Reduces HSA balances in a way that can help to avoid the hidden HSA death tax in the future.
Cons: This is generally a limited opportunity. The amount of PUQME that can be used prior to age 59 ½ is limited to the smaller of one’s (1) PUQME and (2) HSA size. Because HSAs have relatively modest contribution limits, in many cases HSA PUQME withdrawals would need to be combined with one or more of the other planning concepts to fund retirement prior to age 59 ½.
We like to let HSAs bake for years, if not decades, of tax free growth. Using HSA PUQME in one’s 50s significantly reduces that opportunity.
Some may need taxable income in early retirement to qualify for Premium Tax Credits. Relying on PUQME can be less than optimal if Premium Tax Credits are a significant part of one’s early retirement plan.
Ideal For: Those with significant HSAs and significant PUQME.
Net Unrealized Appreciation
Applies only to those with significantly appreciated employer stock in a 401(k), ESOP, or other workplace retirement plan. I’ve written about this opportunity before. That employer stock with the large capital gains can serve as a “Capital Gains IRA” in retirement. Retirees can possibly live off sales of employer stock subject to the 0% long term capital gains rate.
This opportunity usually requires professional assistance, in my opinion.
The move of the employer stock out of the retirement plan into a taxable brokerage account (which sets up what I colloquially refer to as the “Capital Gains IRA” may need to be paired with the Rule of 55 (or another penalty exception) to avoid the 10 percent early withdrawal penalty on the “basis” of the employer stock.
Pros: Moves income from “ordinary” income to “long term capital gains” income, which can be very advantageous, particularly if one can keep their income entirely or mostly in the 0% long term capital gains marginal bracket.
Cons: Remember Enron? NUA is essentially Enron if it goes fabulously well instead of failing spectacularly.
Employer stock is problematic during the accumulation phase since your finances are heavily dependent on your employer without a single share of employer stock. People make their finances more risky by having both their income statement and their balance sheet highly dependent on a single corporation.
It keeps the retiree heavily invested in the stock of their former employer, which is much less than optimal from an investment diversification perspective.
Another con is that this usually requires professional assistance (and fees) to a much greater degree than several of the other withdrawal options discussed on this post.
Ideal For: Those with large balances of significantly appreciated employer stock in a workplace 401(k), ESOP, or other retirement plan.
Pay the Penalty
The federal early withdrawal penalty is 10 percent. For those in California, add a 2.5 percent state penalty. For some, perhaps the best idea is to simply bite-the-bullet and pay the early withdrawal penalty. That said, anyone accessing a tax-advantaged retirement account in a way not covered above should always consult the IRS list to see if perhaps they qualify for one of the myriad penalty exceptions.
Pros: Why let a 10 percent penalty prevent you from retiring at age 58 if you have sufficient assets to do so and you might be looking at a year or two of the penalty, tops?
Whittles down traditional retirement accounts in a manner that can help reduce future RMDs.
Cons: Who wants to pay ordinary income tax and the early withdrawal penalty? Even for those close to the 59 ½ finish line, a 72(t) payment plan for five years might be a better option and would avoid the penalty if properly done.
Ideal For: Those very close to age 59 ½ who don’t have a more readily available drawdown tactic to use. That said, even these retirees should consider a 72(t) payment plan, in my opinion.
Combining Methods to Access Funds Prior to Age 59 1/2
For some, perhaps many, no single one of the above methods will be the optimal path. It may be that the optimal path will involve combining two or more of the above methods.
Here’s an example: Rob retires at age 56. He uses the Rule of 55 to fund most of his living expenses prior to turning age 59 ½. Late in the year, he finds that a distribution from his traditional 401(k) would push him up into the 22% federal income tax bracket for the year. Thus, for this last distribution he instead elects to take a recovery of Roth Basis from his Roth IRA. This allows him to stay in the 12% marginal federal income tax bracket for the year.
Conclusion
Don’t let anyone tell you you can’t retire in your 50s. If you have reached financial independence, why not? Of course, you will need to be very intentional about drawing down your assets and funding your living expenses. This is particularly important prior to your 59 1/2th birthday.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
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.
Some retiring in their 50s will need to use a 72(t) payment plan. This often involves establishing a “72(t) IRA” and a “non-72(t) IRA.”
People wonder “how do you allocate your portfolio when you have a 72(t) payment plan?”
Below we tackle 72(t) IRAs from a tax basketing perspective. Most investors in the financial independence community want some allocation to bonds and some to equities.* Thus, questions emerge for those employing a 72(t) payment plan: what should be in my 72(t) IRA? What should be in my non-72(t) IRA?
* This post simply takes that as an assumption and is not investment advice for you or anyone else.
Watch me discuss portfolio allocation for 72(t) payments plans on YouTube.
72(t) Example
Monty, age 53, has a $2M traditional 401(k), $10,000 in a savings account, and a paid off house. He wants to retire and take his first annual $80,000 72(t) payment in February 2023. Monty also wants to have a 75/25 equity/bond allocation.
First, Monty would need to transfer his 401(k) to a traditional IRA (preferably through a direct trustee-to-trustee transfer).
Once the 401(k) is in the traditional IRA, Monty needs to split his traditional IRA into two traditional IRAs, one being the 72(t) IRA (out of which he takes the annual 72(t) payment) and one being the non-72(t) IRA.
To determine the size of the 72(t) IRA, Monty uses the commonly used fixed amortization method and decides to pick the following numbers:
With those three numbers, Monty can do a calculation (see IRS Q&A 7 and my YouTube video on the calculation) and determine that the 72(t) IRA should be $1,170,848.59. Thus, the non-72(t) IRA should be $829,151.41.
72(t) Portfolio Allocation
How does Monty allocate the 72(t) IRA and the non-72(t) IRA such that (1) his overall financial asset portfolio ties out to the desired 75/25 allocation and (2) he is as tax optimized as possible.
I believe that Monty should aim to keep his 72(t) IRA as small as possible. Why? Because it is possible that Monty will not need his 72(t) payment at some point prior to turning age 59 ½.
Perhaps Monty inherits $300,000 when he is age 57. At that point, he can use that money to fund his lifestyle until age 59 ½. Why does he want to keep paying taxes on the $80,000 annual 72(t) payment?
Since Monty has decided to invest in equities and bonds, I believe that Monty should house his bonds inside his 72(t) IRA. While there are absolutely no guarantees when it comes to investment returns, equities tend to grow more than bonds. Since bonds tend to be lower growth, they are a great candidate for the 72(t) IRA.
It would stink if Monty wanted to reduce his annual 72(t) payment only to find that a 72(t) IRA composed entirely of equities had skyrocketed in value, increasing the amount of his revised annual payment under the RMD method.
Thus, I believe that Monty should put his entire bond allocation, $500,000, inside his 72(t) IRA. That makes the rest of the tax basketing easy: have the entire non 72(t) IRA be invested in equities, and have the remainder of his 72(t) IRA, $670,849, be invested in equities.
72(t), Sequence of Returns Risk, and Safe Withdrawal Rate
One must remember that 72(t) is entirely a tax concept. At least in theory, it has nothing to do with sequence of returns risk and safe withdrawal rate.
Some might look at the 72(t) IRA, $1,170,848.59, and say “Wait a minute: an $80K withdrawal is way more than 4% or 5% of that 72(t) IRA! Isn’t this a dangerous withdrawal rate? Doesn’t this amplify the sequence of returns risk?”
Remember, Monty’s withdrawal rate is $80,000 divided by the entire $2M portfolio (4%), not $80,000 divided by the $1,170,848.59 72(t) IRA. Further, Monty’s sequence of returns risk on this withdrawal rate exists regardless of the 72(t) plan. The greater the overall withdrawal rate, the greater the sequence of returns risk.
Lastly, the 5.79% interest rate Monty chooses has nothing to do with the withdrawal rate. It has everything to do with keeping the size of the 72(t) IRA as small as possible. The chosen interest rate doesn’t change the amount of the annual withdrawal ($80,000) but rather changes the size of the 72(t) IRA.
Conclusion
Tax basketing should be considered when crafting a 72(t) payment plan. I generally believe that investments that are less likely to have substantial gains sit better inside an investor’s 72(t) IRA rather than their non-72(t) 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.
Want to retire before age 59 ½? Have most of your wealth in traditional tax-deferred retirement accounts? Worried about the 10 percent early withdrawal penalty?
This post is for you!
Picture it: You’re age 53, have $50,000 in a savings account, a paid-off home, and $2.5M in a 401(k). Including income taxes, you spend about $80,000 a year. You want to retire, but you’re worried about paying the early withdrawal penalty, which would be about $8,000 a year (not factoring in the penalty on the penalty!).
72(t) payments can make retirement possible prior to age 59 ½ when one has most of their assets in traditional deferred retirement accounts. Done properly, these payments avoid the 10 percent early withdrawal penalty.
Below I explore some of the rules of 72(t) payments (sometimes referred to as a “72(t) SEPP” or “SEPP”) and lay out what I hope will be an informative case study.
** As always, none of this is personalized advice for you, but rather educational information for your consideration. Consult with your own advisors regarding your own situation.
72(t) Substantially Equal Periodic Payments
Methods
The IRS and Treasury provide three methods for computing a 72(t) payment. As a practical matter, the third one I discuss, the fixed amortization method, tends to be the most commonly used and most user friendly in my opinion.
The required minimum distribution method allows taxpayers to take a 72(t) payment just like an RMD. Take the prior year end-of-year balance and divide it by the factor off the IRS table. The biggest problems with this method are it tends to produce a smaller payment the younger you are and the payment changes every year and can decrease if the IRA portfolio declines in value. The fixed annuitization method usually requires actuarial assistance, making it more complicated and less desirable. See Choate, referenced below, at page 587.
We will focus the rest of the post on the fixed amortization method of computing 72(t) payments (other than a brief foray into the RMD method to account for changing circumstances)).
Computing Fixed Amortization 72(t) Payments
To compute a 72(t) payment and the size of the 72(t) IRA using the fixed amortization method, we will need to run through some math. Four numbers are required: the interest rate, the life expectancy, the annual payment, and the size of the 72(t) IRA.
Usually the IRS gives us the interest rate and the life expectancy and we need to solve for the 72(t) IRA size.
As a general rule, taxpayers will usually want to use the greatest interest rate permitted to as to decrease the size of the 72(t) IRA. Decreasing the size of the 72(t) IRA will usually be advantageous, for the reasons discussed below.
Life Expectancy: The life expectancy comes to us from an IRS table. While we have three possible choices to use, generally speaking taxpayers will want to use the Single Life Table found at Treas. Reg. Section 1.401(a)(9)-9(b). See Choate, referenced below, at page 587. The taxpayer takes their age on their birthday of the year of the first 72(t) payment and uses the factor from the Single Life Table as the life expectancy.
Payment: Finally, we, not the IRS, get to determine a number! The payment is simply the annual payment we want to receive as a 72(t) payment every year. While this amount is rather inflexible, as discussed below it will be possible to establish additional 72(t) IRAs and payments to increase the amount received if desired.
Size of the 72(t) IRA: This is what we’re solving for to establish a “right-sized” IRA to produce the desired 72(t) payment. In Google Sheets, we do a present value calculation to solve for the size of the 72(t) IRA that generates the desired payment amount. The formula is rather simple: =-PV(Interest Rate Cell, Life Expectancy Cell, Annual Payment Cell). I put a negative sign in front of the PV to have the size of the 72(t) IRA appear as a positive number. It’s important that the formula be entered in that order and that the formatting be correct in each cell.
Note on 72(t) Payments with non-IRA Accounts: Setting up a 72(t) from a non-IRA is possible but not frequent in practice. It is not possible to divide up a 401(k) account in a manner conducive to establishing a “right-sized” 72(t) payment account. See Choate, referenced below, at page 595.
Annual Equal 72(t) Fixed Amortization Payments
The computed payments must be made annually and equally. This means that no more and no less than the computed payment comes out every year. I believe that taking an annual flat payment on or around the first payment anniversary date is a best practice. However, this best practice is not required. See also Choate, referenced below, at page 600. For example, monthly payments of the computed amount are allowable. See Choate, referenced below, at page 600.
Annual payments must be made for the longer of five years or until the taxpayer reaches age 59 ½.
72(t) Payments Case Study
Let’s return to the example discussed above: it is early November 2023 and you (let’s call you Pat) are 53 years old (your birthday was June 8th) and you want to retire, spending $80K a year from your $2.5M 401(k). Let’s solve for the size of the 72(t) IRA:
The size of the 72(t) IRA is $1,236,012.95. See IRS FAQ Q&A 7.
Pat would first transfer (preferably through a direct trustee-to-trustee transfer) the 401(k) to a traditional IRA worth $2.5M. Once in the traditional IRA, Pat would call their financial institution and ask them to divide the traditional IRA into two IRAs: one with exactly $1,236,012.95 (the “72(t) IRA”) and one with the reminder of the traditional IRA (the “non-72(t) IRA”). I recommend initially investing the 72(t) IRA in a money market fund so that it can be clearly established that the beginning account balance was exactly the $1,236,012.95 computed to yield the correct payment. Pat takes the first payment of $80,000 on November 29th from the 72(t) IRA in this hypothetical scenario.
Let’s keep going. Assume that in 2027, when Pat turns age 57 and interest rates are well below 5%, Pat wants to increase their November withdrawal from $80K to $90K. As discussed below, Pat can’t simply increase the withdrawal from the 72(t) IRA. But since Pat kept a non-72(t) IRA, Pat can slice that one up to create a second 72(t) IRA. That second 72(t) IRA can give Pat the extra $10,000 Pat wants to spend.
Here’s what that looks like.
Interest Rate: 5.00%
Life Expectancy: 30.6
Payment: $10,000
The size of the second 72(t) IRA is $155,059.55.
Pat would call their financial institution and ask them to divide the non-72(t) IRA into two IRAs: one with exactly $155,059.55 (the “Second 72(t) IRA”) and one with the remainder of the traditional IRA (the surviving non-72(t) IRA). Pat takes the additional payment of $10,000 also on November 29th from the Second 72(t) in this hypothetical scenario.
Here is what Pat’s withdrawals would look like:
Year
Birthday Age
Required First 72(t) November 29 Withdrawal
Required Second 72(t) November 29 Withdrawal
Total Annual Withdrawal
2023
53
$80,000
$0
$80,000
2024
54
$80,000
$0
$80,000
2025
55
$80,000
$0
$80,000
2026
56
$80,000
$0
$80,000
2027
57
$80,000
$10,000
$90,000
2028
58
$80,000
$10,000
$90,000
2029
59
$80,000
$10,000
$90,000
2030
60
$0
$10,000
$10,000
2031
61
$0
$10,000
$10,000
Remember that the First 72(t) IRA and the Second 72(t) are locked up for a period of time. See Locking the Cage below. The First 72(t) IRA is locked up until and through December 7, 2029, the day before Pat’s 59 ½ birthday. The Second 72(t) IRA is locked up until and through November 28, 2032, the day before the fifth anniversary of the first $10,000 payment from the Second 72(t) IRA. See IRS FAQ 13 on this point. Generally speaking, no amount other than the annual payment should go into, or out of, a 72(t) IRA until the end of the lock-up period.
Maintain Flexibility
I strongly recommend maintaining as much flexibility as possible. One way to do that is to have the 72(t) IRA be as small as possible, leaving as much as possible in a non-72(t) IRA or IRAs. Why?
First, the non-72(t) can be, in a flexible manner, sliced and diced to create a second 72(t) IRA if wanted or needed. Second, it is not abundantly clear what happens when a 72(t) IRA is used for partial Roth conversions. See Choate, referenced below, at page 384. As Ms. Choate discusses, the only clarity we have is that if the entire 72(t) IRA is Roth converted, the taxpayer must continue to take withdrawals from the Roth IRA for the remainder of the 72(t) term. Doing so limits the benefit of doing Roth conversions in the first place, since we usually want Roth converted amounts to stay in a Roth IRA to facilitate many years of tax-free growth.
Imagine if Pat did not divide the $2.5M traditional IRA into two IRAs. Pat could have simply used a smaller interest rate on the entire $2.5M traditional IRA to get the $80,000 annual payment out. However, then Pat would not have had the flexibility to create a second 72(t) payment stream. This is an important reason that it is usually best to use the highest possible interest rate to lower the 72(t) IRA size and maintain the most flexibility.
72(t) Payment Plan Disqualification
A “modification” to the 72(t) payment plan blows up the plan with unfavorable consequences. In the year of the modification the taxpayer owes the 10 percent early withdrawal penalty plus interest on the penalty on all the previously taken 72(t) payments. See Choate, referenced below, at page 596.
A blow up after age 59 ½, for those on the five year rule, is bad but tends to be less deleterious than a blow up occurring with respect to a SEPP ending at age 59 1/2. The early withdrawal penalty and related interest are not assessed on 72(t) payments taken after one’s 59 ½ birthday. See Choate, referenced below, at page 596.
There are a few modifications to a 72(t) payment plan that do not blow it up (i.e., they are permissible and don’t trigger the penalty and interest). See Choate, referenced below, at pages 597-601. Those looking to change the payment amount are often well advised to set up a second 72(t) payment plan (as Pat did) rather than seeking a modification to the existing 72(t) payment plan.
72(t) Payment Reduction
Imagine that instead of wanting an additional 72(t) payment amount, Pat wanted to reduce the 72(t) payment. This is not uncommon. Perhaps Pat has a significant inheritance in 2027 and thus no longer needs to take an $80,000 annual payment and pay tax on it.
Unfortunately, Pat is not allowed to simply discontinue or reduce the 72(t) payment without triggering the early withdrawal penalty (and interest charges) on the previously taken 72(t) payments.
But, the rules allow a one-time switch to the RMD method. Making the switch is likely to significantly reduce the annual 72(t) payment. For example, if Pat wants a smaller payment starting in 2027, Pat could take the 72(t) IRA balance on December 31, 2026 (imagine it is exactly $1M) and divide it by the age 57 factor off the Single Life Table (29.8) and get a 2027 72(t) payment of $33,557.05. Alternatively, Pat could use the age 57 factor off the Notice 2022-6 Uniform Life Table (41.6) and get a 2027 72(t) payment of $24,038.46.
If Pat makes this one-time switch, Pat will annually compute the 72(t) payment for the remainder of the 72(t) term using the table used in 2027 (see Notice 2022-6 page 6) and the prior-year end-of-year 72(t) IRA balance.
The one-time switch to the RMD method is helpful if the taxpayer wants to significantly reduce their 72(t) annual payment, perhaps because of an inheritance, marriage, YouTube channel blowing up, or returning to work. The availability of this method to reduce required 72(t) payments (if desired) is another reason to keep 72(t) IRAs as small as possible.
72(t) Locking The Cage
The 72(t) IRA should be thought of as a locked cage. No one goes in, and only the 72(t) payment comes out annually. The rigidity with which the IRS treats the 72(t) IRA gives early retirees incentive to use as high an interest rate as possible to get the highest annual payment out of the smallest 72(t) IRA possible.
Just how rigid is the IRS? In one case, the IRS disqualified a 72(t) SEPP because a taxpayer transferred a workplace retirement plan into the 72(t) IRA during the 72(t) payment period. See page 4 of this newsletter (page 4 is behind a paywall). Imagine paying penalties and interest on old 72(t) payments for what is seemingly an unrelated rollover!
Remember, the “series of substantially equal periodic payments” requires not just an annual payment. It requires that the 72(t) IRA be locked up. Assuming one is using the fixed amortization method for their 72(t) payments, not a dollar more than the 72(t) SEPP should come out each year. It appears the IRS expects the amount to be equal each tax year, see page 5 of this PLR.
Further, the 72(t) lockup does not end with the taking of the last payment. Rather, as described in IRS FAQ 13, it ends at the end of the lock up period. So if Sean, age 57 in 2023, takes his first 72(t) SEPP of $10,000 from IRA 1 on July 15, 2023, his taking of payment number 5 ($10,000) on July 15, 2027 does not end the lock up. Sean can’t take any additional money out of IRA 1 until July 1, 2028 (the fifth anniversary of his first $10,000 72(t) payment).
Practice Point: Never add money to a 72(t) IRA during the lockup period. This includes never making an annual contribution to a 72(t) IRA and never rolling an IRA, 401(k), or other qualified plan into a 72(t) IRA.
IRS FAQ 13 is instructive in terms of when the lock up ends. The IRS is clear that the lock up ends on the date of the 59 ½ birthday, not on January 1st of that year. Say Rob, born January 14, 1971, takes his first SEPP of $40,000 on August 16, 2023. His 72(t) IRA is free on his 59 ½ birthday, which is July 14, 2030. Presumably, Rob takes his last $40,000 SEPP on or around August 16, 2029. Nevertheless, he can’t add to or withdraw from his 72(t) IRA prior to July 14, 2030 without blowing up his 72(t) payment plan and incurring significant penalties and interest.
As discussed above, the one-time switch to the RMD method is a permissible modification to the 72(t) payment terms that does not trigger the early withdrawal penalty and related interest on previously taken 72(t) payments.
A Note on the 72(t) Risk Profile
The earlier in life the 72(t) payment plan starts, the greater the risk profile on the 72(t) payment plan. The opposite is also true: the later in life a 72(t) payment plan starts, the lower the risk profile.
Why?
Because the sooner the 72(t) payment plan starts, the more years (and more interest) that can be blown up by a future modification requiring the payment of the 10 percent early withdrawal penalty and interest.
Consider Pat’s example. If Pat blows up the First 72(t) payment plan in early 2028, Pat owes the 10% early withdrawal penalty and interest on five previously taken 72(t) payments from the First 72(t) IRA (2023 through 2027). If Pat blows up the Second 72(t) payment plan in 2032, Pat only owes the early withdrawal penalty and interest on the three 72(t) payments received before Pat turned age 59 ½.
72(t) Payment Tax Return Reporting
Taxpayers should keep the computations they and/or their advisors have done to document the 72(t) payment plan. Distributions should be reported as taxable income and on Form 5329. Code 02 should be entered on Line 2 of Form 5329.
72(t) Is An Exception to More Than One Rule
72(t) payment plans are an exception to the 10 percent early withdrawal penalty. They are also an exception to the general rule that the IRS views all of your IRAs as a single IRA. The 72(t) IRA is the 72(t) IRA. If you have a separate IRA and take ten dollars out of it prior to age 59 ½, you trigger ordinary income tax and a $1 penalty. If you take an additional ten dollars out of the 72(t) IRA prior to the end of the 72(t) lock up, you blow up the 72(t) payment plan and owe the 10 percent early withdrawal penalty and interest on all the pre-59 ½ 72(t) payments.
Other Penalty Free Sources of Early Retirement Funding
Let’s remember that 72(t) payments are a tool. In many cases they are not a “go-to” strategy. I’ve written this post not because 72(t) payments are a go-to strategy but rather because I know there are many in their 50s thinking about retirement but daunted by the prospect of accessing traditional retirement accounts prior to age 59 ½.
Generally speaking, I encourage using resources other than 72(t) payments if you are able to. They include:
Taxable Accounts: I’m so fond of using taxable accounts first in retirement I wrote a post about the concept in 2022.
Inherited Retirement Accounts: Withdrawals from inherited retirement accounts (other than those the spouse treats as their own) are never subject to the 10% early withdrawal penalty. Often they are subject to a 10-year draw down rule, so usually they should be accessed prior to implementing a 72(t) payment plan from one’s own accounts.
Rule of 55 Distributions: Only available from a qualified retirement plan such as a 401(k) from an employer the employee separates from service no sooner than the beginning of the year they turn age 55. This is a great workaround from the early withdrawal penalty, and much more flexible than a 72(t) payment plan. But remember, the money must stay in the workplace retirement account (and not be rolled over to a traditional IRA) to get the benefit.
Governmental 457(b) Plans: Withdrawals from governmental 457(b) plans are generally not subject to the 10% early withdrawal penalty.
I previously discussed using a 72(t) payment plan to bail out Roth IRA earnings penalty-free prior to age 59 ½. This is a tactic that I would not recommend unless absolutely necessary (which I believe is a very rare situation).
72(t) Landscape Change
It should be noted that the issuance of Notice 2022-6 in early 2022 changed the landscape when it comes to 72(t) payments. Before the 5 percent safe harbor, it was possible that taxpayers could be subject to sub-0.5 percent interest rates, meaning that it would take almost $1M in a retirement account to generate just $30,000 in an annual payment in one’s mid-50s. Now with the availability of the 5 percent interest rate much more modest account balances can be used to generate significant 72(t) payments in one’s mid-50s.
What if Pat’s 401(k) contained significant amounts of employer stock? What if that employer stock had significantly appreciated in value since the time Pat and/or Pat’s employer contributed that stock? If so, a 72(t) payment plan may not be ideal. Rather, Pat may want to work with Pat’s advisor(s) to look into a separate and distinct tax planning opportunity, net unrealized appreciation (“NUA”).
I collaborated with Andrea MacDonald to discuss the tax return reporting requirements for NUA here.
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.
You know what gets too much attention in the personal finance space? The two five-year Roth IRA rules.
Why do I say that? Because the odds are extremely low that either rule will ever impact most Roth IRA owners. While the rules theoretically have wide effect, in practice, discussed further below, they rarely impact the taxation of Roth IRA distributions.
Before I get started, below is a summary table of the two five-year rules (or five-year clocks, use whichever terminology you prefer). The table is not comprehensive, but rather intended to cover the vast majority of situations. I hope you find this table to be a useful reference regarding the two five-year rules.
Rule
Tax Bite
Age
Code Section
Regulation
First Five-Year Rule
Ordinary income tax on withdrawal of earnings from Roth IRA only
Generally bites only if owner is over 59 ½ years old
First Five-Year Rule: Earnings Cannot Be Withdrawn Income Tax Free From a Roth IRA Unless the Account Holder has Owned a Roth IRA for Five Full Tax Years
At first, this rule seems daunting. As written, it applies to anyone owning a Roth IRA. But in practice, it rarely has any bite. First, the rule only serves to disqualify a distribution from being a “qualified distribution.”
Here’s the thing: outside of rare circumstances (see “Two Uncommon Situations” below), anyone under age 59 ½ cannot receive a “qualified distribution” from their own Roth IRA regardless of the first five-year rule.
Thus, as a general matter, the first five-year rule is a rule that only applies to those age 59 ½ and older.
For those doubting me, I’ll prove it with two examples:
Example 1: Ernestine turns age 25 in the year 2023. In March, she made a $6,500 annual contribution to a Roth IRA for the year 2023. This is her only ever Roth IRA contribution. In 2026, when the Roth IRA is worth $8,000 and Ernestine turns age 28, Ernestine withdraws all $8,000 from the Roth IRA. The first $6,500 is a nontaxable return of the $6,500 contribution, and the remaining $1,500 is a taxable distribution of earnings subject to both ordinary income tax and the 10 percent early withdrawal penalty.
Example 2: Hortense turns age 25 in the year 2023. In March, she made a $6,500 annual contribution to a Roth IRA for the year 2023. This is her only ever Roth IRA contribution. In 2030, when the Roth IRA is worth $8,000 and Hortense turns age 32, Hortense withdraws all $8,000 from the Roth IRA. The first $6,500 is a nontaxable return of the $6,500 contribution, and the remaining $1,500 is a taxable distribution of earnings subject to both ordinary income tax and the 10 percent early withdrawal penalty.
Ernestine did not satisfy the first five-year rule, Hortense did. Notice that it did not matter! Both must pay ordinary income tax and the 10% early withdrawal penalty on the $1,500 of earnings they each received from their Roth IRA. The first five-year rule had absolutely no impact on the taxation of the withdrawal because both Roth IRA owners are under age 59 ½. This proves that outside unusual circumstances, the first five-year rule has no impact on those under age 59 ½.
I’ve said it before and I’ll say it again: Previous annual contributions to a Roth IRA can be withdrawn from a Roth IRAtax and penalty free at any time for any reason! The first five-year rule has nothing to do with withdrawals of previously made contributions. See Treas. Reg. Sec. 1.408A-6 Q&A 1(b) (previous contributions are withdrawn tax free) and Q&A 5(a) (tax free withdrawals of previous regular annual contributions are not subject to the 10% early withdrawal penalty).
So when the heck does the first five-year rule matter? Here are two examples to help us figure it out.
Example 3: Ernie turns age 58 in the year 2023. In March, he made a $7,500 annual contribution to a Roth IRA for the year 2023. This is his only ever Roth IRA contribution. In 2026, when the Roth IRA is worth $10,000 and Ernie turns age 61, Ernie withdraws all $10,000 from the Roth IRA. The first $7,500 is a nontaxable return of the $7,500 contribution, and the remaining $2,500 is a taxable distribution of earnings subject to ordinary income tax. Ernie does not pay the 10 percent early withdrawal penalty because he is over age 59 ½ when he receives the earnings.
Example 4: Harry turns age 58 in the year 2023. In March, he made a $7,500 annual contribution to a Roth IRA for the year 2023. This is his only ever Roth IRA contribution. In 2030, when the Roth IRA is worth $10,000 and Harry turns age 65, Harry withdraws all $10,000 from the Roth IRA. As Harry satisfies both the first five-year rule and is over age 59 ½, the entire $10,000 distribution is a qualified distribution and thus entirely tax and penalty free.
We’ve found where the first five-year rule matters! Generally speaking, the first-five year rule only bites when applied to a distribution of earnings if the recipient is over the age of 59 ½. Further, it only applies to subject the earnings to ordinary income tax, not the 10% early withdrawal penalty (as being age 59 ½ or older is always a valid exception to the early withdrawal penalty).
Remember, though, in most cases it is difficult to access Roth IRA earnings. Why? Because earnings come out of a Roth IRA last. Ernie’s fact pattern is rare. Many Roth IRA owners will have years of contributions and/or conversions inside their Roth IRA. As I have previously discussed, nonqualified distributions from Roth IRAs first access Roth IRA contributions and then access Roth IRA conversions before they can access a penny of earnings. See also Treas. Reg. Sec. 1.408A-6 Q&A 8 and Natalie B. Choate’s Life and Death Benefits for Retirement Planning (8th Ed. 2019), page 328.
Further, in today’s world, most (though not all) 59 ½ year old Roth IRA owners will satisfy the five-year rule. All Roth IRAs are aggregated for this purpose, so the funding (through a contribution or conversion) of any Roth IRA starts the five-year clock as of January 1st of the year for which the contribution was made. See Treas. Reg. Sec. 1.408A-6 Q&A 2.
Two Uncommon Situations: There are two uncommon situations in which a Roth IRA owner under age 59 ½ receiving a Roth IRA distribution could save the ordinary income tax by satisfying the first five-year rule. The first is the taking of an up-to $10,000 first-time home buyer distribution. See Choate, previously referenced, at page 612. The second is if the owner is disabled as defined by Section 72(m)(7). Both are rare situations. Further, in both such cases, satisfying the first five-year rule would be irrelevant if the distribution would have been a return of contributions, nontaxable conversions, and/or taxable conversions at least 5 years old.
Inherited Roth IRA Twist: The first five-year rule can affect distributions from an inherited Roth IRA. I’ve heard this referred to as the third Roth IRA five-year rule, but I view it as simply a continuation of the first five-year rule. A withdrawal of earnings by a beneficiary from an inherited Roth IRA made less than five tax years after the owner originally funded the Roth IRA is subject to ordinary income tax. See Treas. Reg. Sec. 1.408A-6 Q&A 7. These situations are quite rare.
If Anyone on Capitol Hill is Reading This . . .
The first five-year rule serves no compelling purpose, and is superfluous as applied to most taxpayers under the age of 59 ½.
Perhaps in 1997 Congress worried about quick withdrawals from Roth IRAs. Now that we fully understand that contributions and conversions come out of Roth IRAs first, and that being under age 59 ½ prevents a tax-free distribution of earnings in most cases, there’s no reason for the first five-year rule. Being age 59 ½ or older (or death, disability, or first-time home buyer) should be sufficient to receive a qualified distribution.
Second Five-Year Rule: Taxable Conversions Are Subject to the Ten Percent Early Withdrawal Penalty if Withdrawn from the Roth IRA Within Five Taxable Years
This rule is much more logical than the first five-year rule. The reason has nothing to do with Roth IRAs. Rather, the reason is to protect the 10% early withdrawal penalty as applied to traditional IRAs and traditional workplace plans such as 401(k)s and 403(b)s. Without the second five-year rule, taxpayers would never pay the 10% early withdrawal penalty.
Rather, taxpayers under age 59 1/2 would simply convert any money they want to withdraw from a traditional retirement account to a Roth IRA, and then shortly thereafter withdraw the amount from the Roth IRA tax-free as a return of old contributions or of the conversion itself.
The second five-year rule prevents the total evisceration of the 10% early withdrawal penalty.
The second five-year rule applies separately to each taxable Roth conversion. Each Roth conversion that occurs during a year is deemed to occur January 1st of that year for purposes of the second five-year rule. See Treas. Reg. Sec. 1.408A-6 Q&A 5(c).
Note further that the second five-year rule has nothing to do with income tax: its bite only triggers the distribution being subject to the 10% early withdrawal penalty.
When Might the Second Roth IRA Five-Year Rule Apply
I am not too worried about the application of the second five-year rule. Here’s why.
First, the second five-year rule is not likely to apply while one is working. During the accumulation phase, many are looking to contribute to, not withdraw from, Roth IRAs.
Second, for those retiring after age 59 ½, the second five-year rule will have practically no impact, as (i) they are not likely to take pre-retirement distributions from their Roth IRA, and (ii) distributions taken from the Roth IRA by the owner after turning age 59 ½ are never subject to the 10% early withdrawal penalty.
Third, many early retirees will choose to live off taxable assets first in early retirement. As a result, many will not access Roth accounts until age 59 ½ or later, and thus the second five-year rule will not be relevant.
However, some will choose to employ a Roth Conversion Ladder strategy with respect to an early retirement. Here the second five-year rule might bite. Let’s consider a quick example:
Example 5: Josh is considering retiring in 2024 when he turns age 50. In his 30s, he qualified to make an annual Roth IRA contribution and maxed out his Roth IRA each year. In his 40s, he made income in excess of the annual MAGI limits on Roth IRA contributions, so he maxed out the Backdoor Roth IRA for each year. He plans on living on taxable assets for the first five years of retirement and then living off Roth conversion ladders from age 55 through age 59 ½. Josh has never previously taken a distribution from a Roth IRA.
If Josh started withdrawing from his Roth IRA in 2024, he would first withdraw all $45,500 of previous annual contributions (all tax and penalty free) and then withdraw all $33,510 of his 2014 through 2019 Backdoor Roth IRAs (all tax and penalty free) before he could take a distribution with respect to which the second five-year rule could bite.
Note that for withdrawals of up to $79,010, it is irrelevant that Josh does not satisfy the second five-year rule with respect to the 2020 through 2023 Backdoor Roth IRAs. Josh can withdraw up to $79,010 entirely tax and penalty free in 2024. Perhaps the second five-year rule’s bark is worse than its bite . . .
If, in 2024, Josh withdraws both of the above listed amounts from his Roth IRA, then yes, the next $2 of withdrawals in 2024 would be from the $2 taxable amount of his 2020 Backdoor Roth IRA, which would be subject to the 10% early withdrawal penalty ($0.20) under the second five-year rule.
In Josh’s extreme example, the second five-year rule bites, but, as you can see, it barely bites!
As an aside, assuming Josh continues to withdraw money from his Roth IRA in 2024, the next $6,000 is a tax and penalty free return of the non-taxable portion of his 2020 Backdoor Roth IRA! See Treas. Reg. Sec. 1.408A-6 Q&A 8. The generosity of the Roth IRA nonqualified distribution rules is, by itself, a reason not to sweat the two Roth IRA five-year clocks too much.
Assuming Josh follows through with his plan and waits until age 55 (the year 2029) to start withdrawing from his Roth IRA, he can access all of his 30s Roth IRA annual contributions ($45,500), all of his 40s Backdoor Roth IRAs ($57,519), and whatever amount he converted to his Roth IRA in 2024 tax and penalty free in 2029! After that, however, the second five-year rule will bite ten cents on the dollar for amounts additionally distributed in 2029, since amounts converted in 2025 or later would still be subject to the second five-year rule if distributed in 2029.
In Josh’s early retirement example, assuming Josh takes no distributions from his Roth IRA until age 55, the second five-year rule can only possibly bite from age 55 to 59 ½, and even then, the combination of years of built up Roth basis and affirmative planning make that possibility at least somewhat remote.
Don’t over think it: If the owner of a Roth IRA is 59 1/2 years old or older, and has owned a Roth IRA for at least 5 years, all distributions they receive from a Roth IRA are qualified distributions and thus fully tax and penalty free. In such circumstances, the 5-year clocks are entirely irrelevant.
Conclusion
It’s perfectly cromulent to proceed with financial planning without too much worry about the two Roth IRA five-year rules. For personal finance nerds (myself included), the two Roth IRA five-year clocks can be fun to dive into. But from a practical standpoint, they rarely impact the taxation of distributions from Roth IRAs. The two five-year clocks are best understood as sporadically applicable exceptions to the general rule that most nonqualified distributions from Roth IRAs are tax and penalty free.
Further Reading
For even more on Roth IRA distributions, please read this post, which goes through the details of Roth IRA distributions, including citations to the relevant regulations and links to three example Forms 8606 Part III.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
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.
You know what doesn’t get enough coverage in the personal finance space: Medicare! It’s complicated, and frankly, I have neither the time nor the mental bandwidth to become a Medicare expert.
However, recently I have seen some excellent YouTube Videos on the topic. I believe all the links provided below are worthy of consideration. That consideration should, of course, include critical analysis: these videos are great, but they didn’t come down the mountain with Moses (neither did any of my blog posts or YouTube videos).
Further, none of the videos should be relied upon as advice for any particular person. They are all educational resources.
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.
America has a retirement savings problem. To varying degrees, Social Security and Medicare support retirees. Other than for the very wealthy, a significant diminution in either program would materially hurt retirees.
I have seven proposals to address the problem. These proposals won’t solve funding problems for all time, but will move the needle significantly towards securing Social Security and Medicare. All the tax related proposals tax those who have benefited the most from the American economy and a very favorable investment tax climate.
Before I get started, I would like to encourage the reader to endeavor to reduce his or her dependence on these programs by building up their own retirement assets and/or income streams. That said, as a practical matter both Social Security and Medicare are very important to the retirements of the vast majority of Americans.
Who Pays to Save Social Security and Medicare?
PROPOSAL ONE: No changes to the Social Security and Medicare eligibility ages.
I believe that to be a horrible idea, for a myriad of reasons. Over the long term, there are fiscal holes in Social Security and Medicare. By definition, someone in the world must pay for those holes. If we eliminate more outlandish possibilities such as billing invading extraterrestrials and foreign plunder, most of the cost must be made up by some cohort or cohorts of Americans. Raising the eligibility ages to fix the holes simply decides that Americans in their mid-to-late 60s of all income and wealth levels are the cohort of Americans who must pay for those holes.
But why? Are 60-somethings particularly well off compared to other cohorts? I don’t believe they are, and many in their mid-to-late 60s are far worse off than the average American citizen.
My three tax proposals below are hardly perfect. But at least they put the onus on filling the holes on those who (i) have benefited most from the recent American economy and (ii) have most benefited from America’s very favorable investment and endowment tax environment. Why shouldn’t the people who have benefited the most, and would be harmed by tax increases the least, fix the Social Security and Medicare holes?
Further, my three tax proposals have a significant advantage over delaying eligibility ages. Delaying eligibility ages is a delayed fix! If enacted in 2023, my three proposals go to work (in full!) on January 1, 2024.
Would you be happy if you called a plumber to fix a leak in your sink and he responded, “Sure, happy to help, I’ll swing on by in 10 years.” No!
Further, I am not going to advocate for a politically untenable solution, and I wouldn’t recommend any politician do so either. There are plenty of solutions that can be implemented short of solutions that are guaranteed to be wildly unpopular with the electorate.
One piece of evidence demonstrates just how unpopular cutting Social Security and Medicare are. A recent Axios-Ipsos poll (see the bottom of page 9) found that Americans generally oppose Social Security and Medicare cuts by a 7 to 2 margin. Any highly unpopular solution will ultimately be counterproductive.
Further, it might be tempting to only increase the payroll tax rates paid by employers. But this runs into two big problems. First, it’s a tax on job creation. I, for one, want employers of all sizes creating more jobs in the United States. Increasing the tax rates employers pay for Social Security and Medicare increases incentives to offshore jobs and shifts towards automation. Count me against that.
Second, increasing employer tax rates is a tax hike on the self-employed. The self-employed face many challenges. They are not a cohort that should shoulder the burden of closing the fiscal holes in Social Security and Medicare.
Tax Increases to Save Social Security and Medicare
PROPOSAL THREE: Increase the additional Medicare tax on earned income from 0.9% to 2.0% Use half the tax (1.0%) fund Medicare and half the tax (1.0%) fund Social Security.
These two proposals have several advantages. They incrementally increase taxes on the most successful in America in order to close the shortfalls in Social Security and Medicare. They are not taxes on employers hiring more employees, so they do not discourage hiring. Further, these two tax proposals leverage off existing taxes such that implementation of the proposals should be relatively easy.
PROPOSAL FIVE: Impose a new 25% excise tax on net investment income of college endowments with $1 billion or more in assets as of year end.
Congress can allocate tax collections between Social Security and Medicare as they best see fit.
Once subject to the tax, a college endowment would be subject to it going forward until the endowment can demonstrate its year-end assets have been under $750 million for three consecutive years.
Net investment income for this purpose would be the endowment’s Section 1411(c)(1)(A) income, less the following limited expenses: salaries and benefits for employees primarily working for the endowment (limited to $20,000 per month per employee), endowment tax return preparation fees, endowment legal fees, office supplies and equipment (printers, copiers, scanners, etc.) for the endowment, and computer software for the endowment (limited to $1 million per year). Capital gains and capital losses would be netted and no net capital loss could be taken, though any net capital loss would carry forward without limit to subsequent years.
As the excise tax taxes endowments of financial assets, dorms, classrooms, and other buildings used by the university in their educational mission would not be endowment assets for purposes of the new excise tax.
Estimated payments would be due the same dates as individual estimates are due (and the same underpayment penalties would apply), and the net investment income of any controlled endowment entity (domestic or foreign) would also be included in the endowment’s net investment income.
These tax-free hoards have enjoyed incredibly favored treatment long enough.Some of these endowments now exceed $1 million per student, more than enough to fund many students without collecting a dollar of tuition.
Most colleges do not pay income tax on tuition and donations received. I don’t propose to change that, but it’s time these colleges, which mostly serve a select privileged few, pay a significant tax on their investment income. Considering these endowments are worth vast sums of money, that tax should be equal to the rate paid by highest income individuals on long term capital gains, 25% (20% long term capital gain rate plus 5% net investment income tax under my proposal).
You might think this is unfair to colleges. But let’s imagine we were tasked with creating the entire U.S. federal tax system from scratch. If I proposed to subject waiters and factory workers to both income taxes and payroll taxes on their entire salary, while exempting colleges from taxation on tuition collected and donations received, and then added a 25% net investment income tax on large endowments, you’d probably say “Wow, you’re being unfair to waiters and factory workers and too generous to colleges.”
I don’t propose a revolution in tax policy, but rather a fair, equitable, and incremental tax change that increases the tax burden on those most able to bear it in order to combat funding shortfalls in Social Security and Medicare.
Stabilizing The Federal Government’s Finances
PROPOSAL SIX: Significant reductions in military and foreign spending
Practically all Americans reading this are owed Social Security and/or Medicare benefits! That makes you a creditor of the U.S. government.
Your creditor’s financial health matters to you. It’s time your creditor got its house in order. Your creditor’s house is not in order for many reasons, including spending that is consistent with neither the founding nor the history of our great republic.
My hope is that more and more Americans will become aware of the role of diet in health, and that will, over time, reduce long term medical expenses, including the expenses paid for by Medicare. Eventually, this renewed health will hopefully lead to longer life spans and increase future Social Security payments. If this happens, it hurts Social Security many years in the future. That much delayed good problem to have will hopefully be more than compensated for by earlier (and hopefully permanent) reductions in Medicare costs.
Conclusion
As the federal government racks up more and more debt, and the clock ticks towards financial peril for both Social Security and Medicare, it’s time to take action to preserve and protect these programs.
This post is for entertainment and educational purposes only. It does not constitute medical, accounting, financial, legal, investment, or tax advice. Please consult with your advisor(s) regarding your personal medical, accounting, financial, legal, investment, and tax matters. Please also refer to the Disclaimer & Warning section found here.
The above does not represent the opinion of anyone other than the author, Sean W. Mullaney. The author was not compensated by any individual or entity for writing this blog post, and this blog post does not necessarily reflect the views of any current or former employer of Sean W. Mullaney.
This post, and the above mentioned podcast episode, are for entertainment and educational purposes only. They do not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
