Tag Archives: Early Retirement

Accessing Retirement Accounts Prior to Age 59 ½

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

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

My response: Oh, heck no!

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

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

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

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

Taxable Accounts

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

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

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

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

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

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

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

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

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

Inherited Retirement Accounts

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

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

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

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

Rule of 55 Distributions

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

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

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

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

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

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

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

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

Governmental 457(b) Plans

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

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

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

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

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

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

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

Roth Basis

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

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

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

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

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

Creates income for purposes of the FAFSA.

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

72(t) Payments

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

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

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

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

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

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

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

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

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

HSA PUQME

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

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

Does not create income for purposes of the FAFSA.

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

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

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

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

Ideal For: Those with significant HSAs and significant PUQME.

Net Unrealized Appreciation

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

This opportunity usually requires professional assistance, in my opinion.

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

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

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

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

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

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

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

Pay the Penalty

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

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

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

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

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

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

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

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

Conclusion

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

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

Follow me on Twitter: @SeanMoneyandTax

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

Tax Basketing for a 72(t) Payment Plan

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:

Maximum allowable interest rate, 5.79%,
The Single Life Table factor for age 53 (33.4), and
The annual payment he’s selected, $80,000.

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?

Monty has an option available: a one-time change of the 72(t) payment to the RMD method. If Monty switches to the RMD method, he’s likely to dramatically reduce the annual amount of the required 72(t) payment. The RMD method keys off the account balance at the end of the prior year. The lower the balance, the lower the required annual payment under the RMD method.

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

Follow me on Twitter: @SeanMoneyandTax

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

Retire on 72(t) Payments

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

This post is for you!

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

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

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

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

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

72(t) Substantially Equal Periodic Payments

Methods

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

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

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

Computing Fixed Amortization 72(t) Payments

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

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

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

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

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

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

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

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

Annual Equal 72(t) Fixed Amortization Payments

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

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

72(t) Payments Case Study

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

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

Life Expectancy: 33.4

Payment: $80,000

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

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

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

Here’s what that looks like.

Interest Rate: 5.00%

Life Expectancy: 30.6

Payment: $10,000

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

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

Here is what Pat’s withdrawals would look like:

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.

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

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

72(t) Landscape Change

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

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

72(t) and Employer Stock

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

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

Resource

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

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

Follow me on Twitter: @SeanMoneyandTax

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

Time to Stop 401(k) Contributions?

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 the widow’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

Follow me on Twitter at @SeanMoneyandTax

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

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

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

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

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	408A(d)(2)(B)	1.408A-6 Q&A 2
Second Five-Year Rule	10% early withdrawal penalty on withdrawal of taxable converted amounts from Roth IRA only	Only bites if owner is under age 59 ½	408A(d)(3)(F)	1.408A-6 Q&A 5(b)

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

If Anyone on Capitol Hill is Reading This . . .

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

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

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

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

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

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

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

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

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

When Might the Second Roth IRA Five-Year Rule Apply

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

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

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

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

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

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

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

Year	Age	Roth IRA Contribution	Backdoor Roth IRA	Taxable Amount
2004	30	$3,000
2005	31	$4,000
2006	32	$4,000
2007	33	$4,000
2008	34	$5,000
2009	35	$5,000
2010	36	$5,000
2011	37	$5,000
2012	38	$5,000
2013	39	$5,500
2014	40		$5,502	$2
2015	41		$5,503	$3
2016	42		$5,501	$1
2017	43		$5,502	$2
2018	44		$5,501	$1
2019	45		$6,001	$1
2020	46		$6,002	$2
2021	47		$6,002	$2
2022	48		$6,001	$1
2023	49		$6,004	$4

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

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

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

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

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

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

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

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

Conclusion

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

Medicare Resources

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.

Sarasota Tim on Medicare Basics and Enrolling: https://www.youtube.com/watch?v=FNCk7x26i_M

Clark Howard Shares His Concerns with Medicare Advantage (Medicare Part C): https://youtu.be/QUSdn7nGXvQ?t=192

Danielle Kunkle Roberts on Medigap Part G: https://www.youtube.com/watch?v=XtqfO22-Tss

Danielle Kunkle Roberts on Medigap High Deductible Part G: https://www.youtube.com/watch?v=s2aRGN7pR1Q

MedicareSchool on Medigap Part G Versus Medigap Part N: https://www.youtube.com/watch?v=tYXvKvMPbpI

MedicareSchool on Medicare Part D (Prescription Drugs): https://www.youtube.com/watch?v=rSLx-lFr-DM

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

Follow me on Twitter at @SeanMoneyandTax

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

Saving Social Security and Medicare

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.

Most can agree with a simple proposition: over the long term, there are fiscal holes in Social Security and Medicare.

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.

Some propose to increase the eligibility age for Medicare and/or Social Security full retirement age.

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.

I’m not the only commentator to oppose increasing Social Security eligibility ages.

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.

Any delay of the eligibility age will likely be at least somewhat delayed. No politician is going to vote to raise a 66 year old’s Social Security full retirement age overnight from age 67 to age 70. There’s zero chance of that. That’s demonstrated by this proposal, which proposes to increase Social Security eligibility ages by 3 years and admits that the proposal would not save money for at least 10 years!

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.

A group of Republican Congressmen argue Social Security eligibility ages should be increased in the future to account for increased life expectancy (see the bottom of page 88 of this file). I believe their argument is mistaken for two reasons. First, some increases in life expectancy are attributable to diminished infant mortality instead of increased lifespan in old age. Second, in 2020 and 2021, American life expectancy decreased.

PROPOSAL TWO: No Increase to the FICA Tax Rates (Employee and Employer)

Historically, there have been many payroll tax increases to fund Social Security and Medicare. I believe, in today’s economy, a simple payroll tax rate increase would be unfair and would hurt many Americans who have not benefited from the surge in financial markets the way the affluent have. In a world where working class workers have not experienced real significant salary increases in decades, while the stock market has soared over several decades, we can’t simply increase payroll taxes on everyone and call it fair.

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.

PROPOSAL FOUR: Increase the Medicare surtax on net investment income from 3.8% to 5.0%. Use the increase (1.2%) to 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.

This new tax would replace the tiny 1.4% excise tax on some college endowments enacted as part of the Tax Cuts and Jobs Act (TCJA) in 2018.

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.

Incredibly enough, the United States has nearly three times as many foreign military bases as it has embassies. It’s time to ditch the bases and bring the troops home for many reasons. Having so many military and other government personnel overseas is contrary to the great history of our republic. As John Quincy Adams said, “America does not go abroad in search of monsters to destroy.” Today’s historically out-of-whack military and foreign spending is destabilizing the government’s finances. It’s time to cut military and foreign spending significantly and redeploy that money to reduce the deficit and secure the financial stability of the federal government.

A financially stable government is much more likely to be able to successfully meet its Social Security and Medicare obligations.

Some might argue that neither our current level of military spending nor Social Security and Medicare are consistent with the founding and history of our country, so shouldn’t both be cut? Jeffrey Sachs has observed that there is some popular support for cutting America’s foreign military involvement. On the other hand, there is very little appetite among the electorate for reductions to Social Security and Medicare. There’s no reason to consider wildly unpopular options when there are much more popular options on the table.

Self-Help

PROPOSAL SEVEN: Change Your Health

Not every change to improve the Social Security and Medicare system needs to come from Congress.

Over the years I have become more and more convinced that almost everything we learned about health and nutrition is wrong. It is time for each of us to radically take charge of our own healthcare. We need to do this regardless of the fiscal state of Social Security and Medicare. But my hope is this shift will reduce spending on Medicare.

I have seen my health improve by focusing on eating high quality animal fats and proteins, avoiding seed oils (which are very new in human history), and dramatically reducing sugar consumption. One reason I continue with that focus is that, as discussed by Doctors Ken Berry and Lisa Wiedeman, sugar feeds cancer! See also Dr. Ken Berry discussing this further. Avoiding certain foods can dramatically improve health outcomes and reduce medical spending (including Medicare spending).

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.

Follow me on Twitter at @SeanMoneyandTax

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.

Sean on the Catching Up to FI Podcast

Listen as I talk tax with Becky Heptig and Bill Yount on the Catching Up to FI podcast.

You can access the podcast on Apple Podcasts.

We discuss tax planning for financial independence, particularly planning for those catching up later in their careers.

The show notes include references to the following FI Tax Guy blog posts.

The Advantages of Living on Taxable Assets First in Early Retirement

TikTok Tax Advice

Early Retirement and Social Security

HSAs and Las Vegas

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.

SECURE 2.0 and the FI Community

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

SECURE 2.0 Big Picture

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

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

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

Traditional Retirement Account Contributions Are Even More Attractive

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

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

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

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

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

Rothification Trap

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

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

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

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

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

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

Rothification Trap Antidote

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

No Changes to Backdoor Roths

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

Rolling 529 Plans to Roth IRAs

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

SECURE 2.0 and the FIRE Movement on YouTube

Resources

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

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

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

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

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

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

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

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

Follow me on Twitter: @SeanMoneyandTax

2022 Year-End Tax Planning

Below are the main tax planning items for the year 2022 as I see them. Of course, this is educational information for the reader, and not tax advice directed toward any particular individual.

The first two tax loss harvesting items are particularly unique to 2022 vis-a-vis recent years.

Tax Loss Harvesting

2022 has given us plenty of lemons. For some Americans, it’s time to make some lemonade through tax loss harvesting. The deadline to do this and obtain a benefit on one’s 2022 tax return is December 31, 2022.

Tax Loss Harvesting and Bonds

There is a tax loss harvesting opportunity in 2022 that has not existed in recent years to the scope and scale it exists today: tax loss harvesting with bonds and bond funds. In a recent post I went into that opportunity in detail and how it might create both a great tax loss harvesting opportunity and a great tax basketing opportunity.

Tax Loss Harvesting Crypto

Many cryptocurrencies have declined in value. This can create a tax loss harvesting opportunity, regardless of whether the taxpayer wants to remain invested in crypto. To harvest the loss if one wants to get out of crypto, it’s easy: just sell the asset. For those wanting to stay in crypto, it’s not that much harder: sell the crypto (by December 31, 2022 if wanting the loss on their 2022 tax return) and they rebuy the crypto shortly thereafter. Crypto is not a “security” for wash sale purposes, and thus, repurchases of crypto are not subject to the wash sale rule, regardless of when they occur.

Solo 401(k) Establishment

Quick Update 12/23/2022: My initial reading of SECURE 2.0 is that it does not change any 2022 Solo 401(k) deadlines. The one deadline it appears to change is effective starting for plan years beginning in 2023.

For Schedule C solopreneurs looking to make a 2022 employee contribution to a Solo 401(k), the Solo 401(k) must be established by December 31, 2022. This is NOT the sort of thing you want to try to do on December 30th. Almost certainly those trying to establish a Solo 401(k) will want to act well before the end of December, as it takes time to get the Solo 401(k) established prior to year-end.

The deadline to establish a Solo 401(k) for an employer contribution is the tax return filing deadline. For individuals, this is April 18, 2023, but can be extended to October 15, 2023. For S corporations, this is March 15, 2023, but can be extended to September 15, 2023.

Solo 401(k) Funding for Schedule C Solopreneurs

Employee elective deferral contributions (traditional and/or Roth) must meet one of two standards. Either (i) they must be made by December 31st or (ii) they are elected by December 31st and made by the tax return filing deadline, including any filed extensions.

Employer contributions must be made by the tax return filing deadline, including any filed extensions.

Roth Conversions

Taxpayers with lower income (relative to the rest of their lives) may want to consider taxable conversions of traditional retirement accounts to Roth accounts. The deadline to get the Roth conversion on one’s 2022 tax return is December 31st, though it is not wise to wait until the last minute.

For the self-employed, there may be a unique opportunity to use Roth conversions to optimize the qualified business income deduction.

Tax Gain Harvesting

For those finding themselves in the 12% or lower federal marginal income tax bracket and with an asset in a taxable account with a built-in gain, tax gain harvesting prior to December 31, 2022 may be a good tax tactic to increase basis without incurring additional federal income tax. Remember, though, the gain itself increases one’s taxable income, making it harder to stay within the 12% or lower marginal income tax bracket.

HSA Funding Deadline

The deadline to fund an HSA for 2022 is April 18, 2023. Those who have not maximized their HSA through payroll deductions during the year may want to look into establishing payroll withholding for their HSA so as to take advantage of the payroll tax break available when HSAs are funded through payroll.

The deadline for those age 55 and older to fund a Baby HSA for 2022 is April 18, 2023.

Roth IRA Contribution Deadline

The deadline for funding a Roth IRA for 2022 is April 18, 2023.

Backdoor Roth IRA

There’s no law saying “the deadline for the Backdoor Roth IRA is DATE X.” However, the deadline to make a nondeductible traditional IRA contribution for the 2022 tax year is April 18, 2023. Those doing the Backdoor Roth IRA for 2022 and doing the Roth conversion step in 2023 may want to consider the unique tax filing when that happens (what I refer to as a “Split-Year Backdoor Roth IRA”).

Anyone who has already completed a Backdoor Roth IRA for 2022 should consider New Year’s Eve. December 31st is the deadline to be “clean” for 2022. Anyone who has done the Roth conversion step of a Backdoor Roth IRA during 2022 will want to consider (to the extent possible and desirable) “cleaning up” all traditional IRAs, SEP IRAs, and SIMPLE IRAs as of December 31, 2022.

Charitable Contributions

The deadline to make charitable contributions that can potentially be deducted on one’s 2022 tax return is December 31, 2022. Planning in this regard could include contributions to donor advised funds. If one is considering establishing a donor advised fund to get a deduction in 2022, I recommend moving well before December 31st, since it takes time for financial institutions to process donations and establish donor advised funds.

RMDs from Your Own Retirement Account

The deadline to take any required minimum distributions from one’s own retirement account is December 31, 2022. Remember, the rules can get a bit confusing. Generally, IRAs can be aggregated for RMD purposes, but 401(k)s cannot.

RMDs from Inherited Accounts

The deadline to take any RMDs from inherited retirement accounts is December 31st. For some beneficiaries of retirement accounts inherited during 2020 and 2021, the IRS has waived 2022 RMDs. That said, all beneficiaries of inherited retirement accounts may want to consider affirmatively taking distributions (in addition to RMDs, if any) before the end of 2022 to put the income into a lower tax year, if 2022 happens to be a lower taxable income year vis-a-vis future tax years.

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Taxable Accounts

Inherited Retirement Accounts

Rule of 55 Distributions

Governmental 457(b) Plans

Roth Basis

72(t) Payments

HSA PUQME

Net Unrealized Appreciation

Pay the Penalty

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

Conclusion

72(t) Example

72(t) Portfolio Allocation

72(t), Sequence of Returns Risk, and Safe Withdrawal Rate

Conclusion

72(t) Substantially Equal Periodic Payments

Methods

Computing Fixed Amortization 72(t) Payments

Annual Equal 72(t) Fixed Amortization Payments

72(t) Payments Case Study

Maintain Flexibility

72(t) Payment Plan Disqualification

72(t) Payment Reduction

72(t) Locking The Cage

A Note on the 72(t) Risk Profile

72(t) Payment Tax Return Reporting

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

Other Penalty Free Sources of Early Retirement Funding

72(t) Landscape Change

72(t) and Employer Stock

Resource

Why the Traditional 401(k) Is Good for the FI Community

How Bad is the Retiree Tax Problem?

Future Retirees’ Tax Risk

The Risks of Not Having Money in Traditional Retirement Accounts

Qualification for Premium Tax Credits

Charitable Contributions

Unused Standard Deductions

Deduct at Work, Roth at Home

Conclusion

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

If Anyone on Capitol Hill is Reading This . . .

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

When Might the Second Roth IRA Five-Year Rule Apply

Conclusion

Further Reading

Who Pays to Save Social Security and Medicare?

PROPOSAL ONE: No changes to the Social Security and Medicare eligibility ages.

PROPOSAL TWO: No Increase to the FICA Tax Rates (Employee and Employer)

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.

PROPOSAL FOUR: Increase the Medicare surtax on net investment income from 3.8% to 5.0%. Use the increase (1.2%) to fund Social Security.

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.

Stabilizing The Federal Government’s Finances

PROPOSAL SIX: Significant reductions in military and foreign spending

Self-Help

PROPOSAL SEVEN: Change Your Health

Conclusion

SECURE 2.0 Big Picture

Traditional Retirement Account Contributions Are Even More Attractive

Rothification Trap

Rothification Trap Antidote

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

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

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

No Changes to Backdoor Roths

Rolling 529 Plans to Roth IRAs

SECURE 2.0 and the FIRE Movement on YouTube

Resources

Tax Loss Harvesting

Tax Loss Harvesting and Bonds

Tax Loss Harvesting Crypto

Solo 401(k) Establishment

Solo 401(k) Funding for Schedule C Solopreneurs

Roth Conversions

Tax Gain Harvesting

HSA Funding Deadline

Roth IRA Contribution Deadline

Backdoor Roth IRA

Charitable Contributions