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.
Recently, the FIRE movement has come in for some criticism. Here is one prominent example. While I don’t want to speak for the critics, some of the arguments boil down to a version of the following: FI or FIRE (I prefer FI, but let’s not argue over terminology) overemphasizes personal responsibility and individualism, as most financial outcomes are the result of luck and the work of others. For example, if you invest $250,000 in real estate and local property values skyrocket such that your investment is now worth $600,000, most of the value of your investment is not attributable to anything you did.
While I appreciate the perspective provided by these commentators, I respectfully disagree with the criticisms.
My Journey with FI
Before I address the criticisms, I thought it would be helpful to share a bit of my perspective on FI. My journey with personal finance mostly starts in college, when I began to become interested in some of the tactics of personal finance. Things like the Roth IRA and passive investing.
For me, the tactics were like the quartz countertops, cabinets, and ceiling beams on a home construction site: shiny objects drawing attention, but by themselves not all that impactful. As applied to personal finance, when you add in the FI framework, you transform shiny objects into a house. Having the FI framework and goals ultimately drives better choices and better luck.
Getting introduced to FI in 2017 flipped a switch for me. It gave meaning to the personal finance tactics. More important, it encouraged me to make better choices. For me, it’s not about a FI number or a retirement deadline.* And it has never been about anyone who retired at a particularly early age. Rather, to me FI is all about making better choices that give me and my family more options and better financial luck.
This is why I don’t believe “financial literacy” is an adequate substitute for FIRE. You can teach people about 401(k)s and HSAs until you’re blue in the face. Without something akin to the FI framework, financial knowledge by itself does not often materially improve choices and outcomes. Financial literacy without a framework and goals is sort of like teaching algebra in high school. There’s nothing wrong with it, but how much did algebra affect your adult life?
Having shared a bit of my own FI journey, here are my thoughts on the recent criticisms of the FIRE movement.
* Note: For some, FI is about hitting a FI number and/or retiring by a certain date. That’s great–to each their own.
The Role of Luck
Michael Jordan won six NBA Championships. Wouldn’t we all say that he was a great basketball player?
But wait a minute. Wasn’t almost all of his success attributable to luck? First, Dr. James Naismith invented the sport of basketball. Then players, promoters, and team owners spread the sport throughout the United States such that professional leagues could become a way to earn an income. Then the founders, players, coaches, owners, television executives, and fans of the National Basketball Association had to build it and sustain it through some very challenging times. Without the work and support of countless people, Michael Jordan would not have been able to make a living playing basketball, much less win six championships playing basketball.
And what about Jordan’s height, good health, parents, coaches, and teammates? Talk about lucky . . .
Most of us, when confronted with all the luck Michael Jordan had in his basketball career, would simply acknowledge that luck played a role, but that in no way diminishes all the hard work he put into his craft and the fact that he was a great basketball player.
In all situations, luck plays an important role. There is little anyone can do to avoid being subject to a significant degree of luck. All you can do is make choices based on judgment and what experience and history teach. Often, you will enjoy more good luck as you make better choices.
Luck and choices are not entirely unrelated. The better financial choices you make, the more likely it is you will have good financial outcomes and enjoy better luck along the way. For example, you can’t get lucky with an investmentif you don’t make the investment!
Investment growth could** be thought of as luck. But without an individual financial choice (the decision to invest), you get absolutely none of that luck! The FIRE movement simply says “we have hundreds of years of economic data: we know diversified baskets of productive investments generally tend to grow over long periods of time, so start investing!”
FI provides a framework for capturing financial luck. Why shouldn’t there be a “movement” (if you want to call it that) of people who are intentional about making better choices that increase the odds that they and others will experience financial luck and success?
** Note: I do not believe investment growth is luck. I simply acknowledge that some might think of investment growth as luck.
Credit versus Choices
The FIRE movement is not about claiming credit for financial outcomes. It’s about encouraging good financial choices.
To my mind, arguing that the FIRE movement is lacking because most of the credit belongs to others misses the point. The point of the Financial Independence movement is not to “deserve” financial success. Rather, the point is to make choices that increase the odds of financial success and having more financial options.
If I wear a seatbelt, I’m making a choice that increases my odds of staying safe.
I (hopefully) don’t demand credit for being safe. Rather, I simply make an informed choice that makes my life incrementally better.
That is what the FIRE movement is all about: make good choices in your financial life, and, generally speaking, your financial life tends to have good outcomes. If someone wants to give you credit for the resulting outcomes, that’s fine, but that credit is not what the FIRE movement is all about.
None of this makes financial independence easy, and financial independence as an end goal will be more difficult for some than for others.
But practically everyone has financial choices to make. Thus, the FIRE movement can speak to everyone. The FIRE movement offers a framework and encouragement to make good choices. Regardless of the luck you have had up to now, it is better to be intentional about your financial choices and seek to improve your future financial choices.
Room for Improvement
Is everything perfect in the FIRE movement? Surely not. For example, extreme examples of FIRE tend to get overemphasized in the media and within the movement (in my opinion).
Overemphasizing certain stories causes a distorted view of financial independence. But podcasts, YouTube, blogs, and other forums help all sorts of FI stories to get out there. The FIRE movement is constantly developing and different FIRE voices appeal to different listeners (and hopefully to a growing number of listeners).
My hope is that the movement and the media reduce the emphasis on some of the more extreme FIRE examples (while still acknowledging their validity) and choose to promote a diverse array of FIRE perspectives. No one has all the answers, but everyone can make a contribution.
FI/FIRE will survive out of economic necessity. What else are people to do? Tie their entire economic future to one job that can be gone in an instant? The economic downturn occurring due to Coronavirus demonstrates that you need multiple sources of economic support. Part of FI (or FIRE) is that you ultimately build up so many sources of support (essentially, a well-diversified portfolio) that your job becomes an unnecessary source of support.
I stand by that. Some argue that FIRE is unrealistic. I’d argue that tying your financial future to a single job (or, more broadly, to your ability to always earn an income from your labor) is unrealistic.
The FIRE movement provides a framework for improving your financial condition through better choices. That is a movement worth staying in.
FI Tax Guy can be your financial advisor! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
Really enjoyed this year-end tax planning conversation with Doc G on the Earn & Invest podcast. Stay tuned to the end for some candid behind the scenes podcast recording.
This post (and this podcast episode) is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
How do you pass your family’s house to your children? It’s a pressing question and involves significant tax, legal, and emotional considerations. Unfortunately, it is a topic about which there is much confusion.
This blog post discusses some of the important considerations. But as a blog post, it can only scratch the surface. Anyone looking to efficiently pass on their home is well advised to consult with their own lawyer, tax professional, and in some cases, their banker as well.
Minor Children
To my mind, the primary planning objective of married couples with minor children vis-a-vis their home is to account for what happens if both spouses die. Such couples would want their children taken care of in the most flexible manner possible.
Generally speaking, in such situations, it is often best to work with a lawyer to transfer the primary residence to a revocable living trust (explained below). In the event of both spouses’ deaths, the house would be held by the trust and managed by the trustee of the trust. It could be sold or rented for the benefit of the children, or kept so the children and their guardian(s) could live in the house.
This resolution is generally preferable to leaving a house directly to minor children.
Revocable Living Trusts
What is a revocable living trust? It is generally a written trust (drafted by a lawyer) that owns property the grantor(s) or settlor(s) transfers to the trust. For this sort of planning, usually spouses (the grantors) transfer their home to the trust and designate themselves as the primary beneficiaries of the trust. The trust provides that the grantors’ minor children are the successor beneficiaries. Upon both spouses’ deaths, the trust becomes irrevocable, and a trustee holds the assets and manages them on behalf of the beneficiaries (the minor children).
The best thing about a revocable living trust: as long as the grantor(s) is/are alive, the trust is fully revocable! So mistakes can be easily fixed (working with a lawyer).
Revocable living trusts also generally avoid probate.
Tax Effect
One nice thing about a revocable living trust is that it doesn’t change the grantor’s tax situation. All the income of the trust assets remain the taxable income of the grantor. Generally speaking, the grantor’s tax return does not change at all. Further, favorable tax rules, such as the $250K per person exclusion for capital gains on qualified primary residences, apply unchanged.
Parents placing their primary residence in their own revocable living trust does not necessitate the filing of a federal gift tax return (Form 709).
Upon inheriting a house as the beneficiary of a revocable living trust, the child takes a fair market value tax basis in the house (the so-called “step-up in basis”). This makes using a revocable living trust a tax-efficient way of passing a house to the next generation.
Adult Children
Okay, but what about adult children? It’s readily apparent that five-year olds should not own real estate outright. But what about grown children? If a primary goal is simply avoiding probate, why not use a joint tenancy with rights of survivorship instead of a revocable living trust?
Putting an adult child’s name on the title of the parent(s) primary residence (and thus, creating a joint tenancy with rights of survivorship) can lead to a host of issues, but perhaps not the issues that initially come to mind.
Capital Gains Tax
What about the adult child’s capital gain upon the sale of the house after the parent’s death? Is that a reason to use a revocable living trust to house the house (pun intended)?
Well, it turns out the answer is generally No. Assuming the adult child did not contribute to the acquisition of the house, the adult child can take a full fair market value basis in a house acquired from a joint tenancy. Here is an example very loosely based on the example on page 10 of IRS Publication 551:
Example: Joan and Jane owned, as joint tenants with rights of survivorship, Joan’s home. Joan paid $300K for it, Jane paid nothing for it. Upon Joan’s death, the home has a fair market value of $600K. Jane inherits (as the surviving joint tenant) the house from Joan with a $600K basis (a fully stepped-up basis).
If interested, I’ve prepared a technical analysis as to why the surviving non-contributing non-spouse joint tenant receives a full step-up in basis here.
Note that the above full stepped-up basis does not obtain if the gift of a portion of the house was through a tenancy-in-common (instead of through a joint tenancy with rights of survivorship). However, there is little reason to use a tenancy-in-common to transfer a house, because the original owner’s remaining share simply remains in his/her name, and absent other arrangements, passes through probate.
Other Problems with Joint Tenancies
If the capital gains tax upon the original owner’s death isn’t an issue, why not use a joint tenancy to transfer your house to your adult children? Here are some of the considerations.
Capital Gains Tax
Wait, what? I thought you said capital gains taxes were not an issue. They generally aren’t an issue after the original owner’s death. But they can be an issue before his or her death.
What if, during the owner’s lifetime, the house is sold? What if there’s a pressing need to sell the house, perhaps to help pay for long-term care?
The owner/occupant is at least somewhat protected by the $250K per person primary residence gain exclusion. But the adult child is not protected by that exclusion if the home is not their primary residence. The adult child could have to pay capital gains tax (based on their share of the proceeds less their share of the owner’s historic tax basis) on the transaction if the house is sold prior to the owner/occupant’s death.
Loss of Control
Simply put, transferring an interest in your home to another person relinquishes some of your control over the property. You never know if you will need that control in the future. Proceed with significant caution, and consult a trusted lawyer, prior to putting anyone else on the title of your home.
Gift Tax
While not a horrible problem, adding an adult child to the title of a house as a gift requires the filing of a Form 709 gift tax return. Due to the high estate and gift tax exemptions, in most cases it is highly unlikely the transfer would trigger actual gift tax.
Disputes Among Adult Children
Adding multiple adult children to the title as joint tenants with rights of survivorship can create issues after the parent’s death. If siblings cannot agree amongst themselves how to handle and/or dispose of the house, the disagreement can be difficult to resolve. Using a revocable living trust (which becomes irrevocable upon the parent’s death) gives the parent the opportunity to work with their lawyer to put in place a trustee and ground rules for how the house is to be managed and/or disposed of after death.
Children’s Issues
Adult children are people. And people have problems. Divorces, liabilities, bankruptcies, etc. Putting an adult child on the title of a home could subject the home to the adult child’s creditors in a problematic manner.
Summary
The above are just some of the considerations to weigh before adding adult children to the title of a home as a joint tenant with rights of survivorship.
Revocable living trusts keep control with the original owner. Further, they facilitate transferring real estate to the next generation in a tax-efficient manner. Based on these advantages and the issues that exist with joint tenancies, I generally prefer revocable living trusts over joint tenancies for primary residences. Using a will can also be effective from a tax perspective, but should be discussed with a lawyer considering state and local real estate laws. Some states have transfer-on-death type real estate deeds, which also should be considered with a lawyer (if that sort of deed is available).
Outright Gift
You might be saying, well, I have only one child I want to give my house to. Further, I don’t need to own my house. Why not simply give the house outright to that child during my life and avoid any legal events/issues occurring at my death?
Besides some of the issues discussed above and the full loss of control (which are troublesome enough), an outright gift creates a significant capital gains tax issue for the adult child. This capital gains tax issue exists both before and after the original owner’s death.
William lives in a house he purchased in 1970 for $50,000. In 2019 the house is worth $950,000. If William gifts the house to his son Alan in 2019, Alan’s basis in the house is $50,000. However, if William leaves the house to Alan at William’s death, Alan’s basis in the house will be the fair market value of the house at William’s death.
Giving William’s house to Alan during William’s lifetime could increase the capital gains taxable to Alan by $900K! Ouch!
So, whatever you do (a) consult with your lawyer before determining how to pass your house to your children and (b) be very, very hesitant to outright give your house to your child.
Conclusion
There are various ways in which you can transfer your home to your children. In many cases, I believe revocable living trusts are a great way to leave a house to children. You are always well advised to consult with your lawyer before making any decisions on how you want to title your house and how you want to transfer your house. If you do inherit a house from your parents, you should consult with a lawyer regarding titling issues and with your tax professional regarding the tax implications of selling the inherited home.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
Roth 401(k)s are gaining prominence as a tax-advantaged workplace retirement account. This post provides introductory information regarding Roth 401(k)s and their potential benefits as a retirement savings account.
Two important introductory notes. First, not all 401(k) plans offer a Roth option, so for some employees, a Roth 401(k) contribution is not an option. Second, this post is for educational purposes only and is not advice for any particular taxpayer.
Traditional 401(k) versus Roth 401(k)
In an ideal world, contributions by an employee to a traditional 401(k) result in a tax deduction when contributed, and taxable income when withdrawn.
Example 1: Tony makes $100,000 from his employer in W-2 wages in 2021. Tony contributes $15,000 during the course of 2021 to his employer’s traditional 401(k). Tony will receive a W-2 from his employer reporting $85,000 of taxable W-2 wages for 2021.
In an ideal world, contributions by an employee to a Roth 401(k) result in no tax deduction when contributed, and no taxable income when withdrawn.
Example 2: Rudy makes $100,000 from his employer in W-2 wages in 2021. Rudy contributes $15,000 during the course of 2021 to his employer’s Roth 401(k). Rudy will receive a W-2 from his employer reporting $100,000 of taxable W-2 wages for 2021.
Roth 401(k) Contributions
Employees can contribute the lesser of their earned income or $19,500 (2021 limit) to a Roth 401(k) in “employee deferrals.” For those 50 years old or older, the 2021 limit is the lesser of earned income or $26,000.
The employee deferral limit factors in both traditional 401(k) employee contributions and Roth 401(k) employee contributions. Here’s an illustrative example.
Example 3: Sarah, age 35, earns $100,000 in W-2 income in 2021 at Acme Industries, Inc. Sarah contributes the maximum to her 401(k) plan. Assuming Acme offers both a traditional 401(k) and a Roth 401(k), that maximum $19,500 contribution can be split up however Sarah chooses ($13,000 to the traditional 401(k) and $6,500 to the Roth 401(k), $5,000 to the traditional 401(k) and $14,500 to the Roth 401(k), etc.).
Any combination (including all in the traditional or all in the Roth) is permissible as long as the total does not exceed $19,500 (using 2021’s limits).
Roth 401(k) Contributions: Income Limits
There’s good news here. Unlike their Roth IRA cousins, Roth 401(k) contributions have no income limits. In theory, one could make $1 billion annually in W-2 income and still contribute $19,500 to a Roth 401(k).
Matching Contributions
Employer matching contributions are one of the best benefits of 401(k) plans.
Example 4: Elaine, age 35, works at Perry Publishing. She earns a salary of $50,000. Perry matches 50% of the first 6% of salary that Elaine contributes to her 401(k). Elaine decides to contribute $3,000 (6 percent) of her salary to the 401(k) as a Roth contribution. Perry contributes $1,500 as a matching contribution. The $1,500 employer match goes into the 401(k) as a traditional contribution. The $3,000 and its growth are treated as a Roth 401(k), and the $1,500 and its growth are treated as a traditional 401(k).
Matching contributions may be subject to vesting requirements, as described in this post. Employee contributions to a 401(k) (whether traditional or Roth) are always 100% vested.
Roth 401(k) Withdrawals
The greatest benefits of a Roth 401(k) are tax-free growth and tax-free withdrawals. Tax-free withdrawals are generally the goal, but they are not automatic. Recently, I wrote a post on Roth 401(k) withdrawals.
One important consideration regarding Roth 401(k) withdrawals: Roth 401(k)s are subject to the required minimum distribution rules starting at age 72. Thus, you must start withdrawing money from a Roth 401(k) at age 72. As a result, you will have less wealth growing tax-free. For this reason, many consider rolling Roth 401(k)s to Roth IRAs prior to age 72.
Conclusion
Roth 401(k)s provide a great opportunity to save and invest for retirement. Taxpayers should consider their own circumstances, and often consult with tax professionals, in deciding their own investment program.
Further Reading
For more information about 401(k) plans, please read this post.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters.Please also refer to the Disclaimer & Warning section found here.
We live in a Roth IRA world (or, at least I wish we did). We also live in a world where increasing numbers of people invest through a Roth 401(k).
The Roth 401(k) is still a relatively new account. Taxpayers and practitioners alike are still learning its contours. Things get even more complicated when you roll money from a workplace Roth 401(k) to a Roth IRA.
To get our feet wet, first I will illustrate the ordering rules for withdrawals from a Roth IRA. Then we will explore withdrawals from a Roth 401(k).
Note that much of this post discusses withdrawals before age 59 ½. In most cases, it is not wise to take a withdrawal from a retirement account before age 59 ½ unless (a) there is an emergency or (b) it is part of a well crafted financial plan.
Watch me discuss Roth 401(k) withdrawals.
Default Rule for Roth IRA Withdrawals: The Layers
Unless the distribution qualifies as a “qualified distribution” (see below), amounts come out of Roth IRAs in layers. Only after one layer has been exhausted can the next layer come out.
Here is the order of distributions that come out of a Roth IRA:
Second Layer: Roth IRA conversions (first-in, first-out)
Third Layer: Roth IRA earnings
Here’s a brief example:
Example 1: Steve has made five $5,000 contributions to his Roth IRA in previous years. He also made a $10,000 conversion from a traditional IRA to a Roth IRA in 2014. In 2021, at a time when his Roth IRA is worth $60,000 and Steve is 45 years old, he takes a $10,000 withdrawal from his Roth IRA. All $10,000 will be a recovery of his previous contributions (leaving him with $15,000 remaining of previous contributions). Thus, the entire distribution from the Roth IRA will be tax and penalty free.
The Roth IRA contributions come out tax and penalty free at any time for any reason!
A qualified distribution from a Roth IRA is usually one where the account holder both (i) has owned a Roth IRA for at least 5 years and (ii) is at least 59 ½ years old. If either condition is not satisfied, the default layering rules described above apply. Qualified distributions from a Roth IRA are tax and penalty free regardless of the layers inside the Roth IRA.
See page 31 of IRS Publication 590-B for more information about qualified distributions from Roth IRAs.
Roth 401(k) Withdrawals
First, a practical note: employers may restrict in-service Roth 401(k) withdrawals before age 59 1/2. Consider that before thinking about how the tax rules apply to withdrawals.
Default Rule: Cream-in-the-Coffee
Generally speaking, Roth 401(k)s have (1) investment in the contract (“IITC”), which is generally previous contributions and conversions and (2) earnings.
Unlike the sequenced layering of Roth IRA withdrawals, Roth 401(k) withdrawals generally default to what Ed Slott refers to as the “cream-in-the-coffee” rule (see Choate — discussed below, page 140).
As a result, withdrawals default to carrying out both some IITC and some earnings. Here’s an example:
Example 2: Lilly has made five $6,000 contributions to her Roth 401(k) in previous years. She also made a $10,000 conversion from a traditional 401(k) to her Roth 401(k) in 2014. In 2021, at a time when her Roth 401(k) is worth $60,000 and Lilly is 45 years old, she takes a $10,000 withdrawal from her Roth 401(k). Two-thirds ($6,667, computed as the fraction $40,000 divided by $60,000 times the withdrawal) of the $10,000 will be a recovery of her IITC (entirely tax and penalty free), and one-third ($3,333, computed as the fraction $20,000 divided by $60,000 times the withdrawal) of the $10,000 will be earnings, which are subject to both ordinary income taxation and a 10 percent penalty.
Quick Thought: Had Lilly’s Roth conversion occurred in 2017 or later, the portion attributable to the conversion ($1,667) would be subject to the 10 percent early withdrawal penalty (but not to ordinary income taxation).See Section 402A(c)(4)(D) and Section 408A(d)(3)(F). Note an earlier version had “2018 or earlier” where the bolded words are in error. I regret the error.
Quick Thought: The cream-in-the-coffee rule does not factor in amounts in traditional 401(k) accounts, even if they are within the same 401(k) plan.
Solving the Cream-in-the-Coffee Issue
We see that the cream-in-the-coffee rule has bad effects. It does not allow exclusive access to tax-favored amounts when there are non-tax favored amounts in an account. So what to do? There are three primary exceptions to the cream-in-the-coffee rule.
Exception 1: Wait for a Qualified Distribution
The cream-in-the-coffee rule can be waited out.
A qualified distribution from a Roth 401(k) is a withdrawal that occurs when the owner is age 59 ½ (see Treas. Reg. Sec. 1.402A-1 Q&A 2(b)(2)) and has had that particular Roth 401(k) account for five years (see Treas. Reg. Sec. 1.402A-1 Q&A 2(b)(1) and Q&A 4). Other qualified distributions can occur upon death or disability (if the 5 year test is satisfied), but for our purposes, we will assume for the rest of the article that any qualified distributions are qualified distributions occurring at or after age 59 ½ and after five years of ownership.
The owner of a Roth 401(k) who qualifies for a qualified distribution does not need to roll the Roth 401(k) to a Roth IRA to take a tax free withdrawal. Once the owner qualifies for a qualified distribution he or she can simply withdraw amounts from the Roth 401(k) tax-free.
However, as a practical matter, it is often the case that Roth 401(k)s are rolled into Roth IRAs (for several reasons). If the rollover from the Roth 401(k) to the Roth IRA would qualify as a qualified distribution if taken directly, then the entire amount in the Roth 401(k) (IITC and earnings) goes into the Roth IRA as a contribution. Ian Berger discussed this issue in an August 11, 2022 response to a question. His answer applies the rule in Treas. Reg. Sec. 1.408A-10 Q&A 3 (the sentence beginning with “Thus,”).
Up to the amount rolled into the Roth IRA can be distributed tax and penalty free. So long as the taxpayer has met the 5 year rule with respect to any Roth IRA, any future earnings beyond the amount rolled in can be withdrawn tax free at any time.
Quick Thought: I would be remiss if I didn’t insert the standard tax planner advice that rollovers from Roth 401(k)s to Roth IRAs are best accomplished through a direct trustee-to-trustee transfer.
There is one five year rule nuance to consider. If the taxpayer has never had a Roth IRA, he or she must wait 5 years (regardless of their age) to access later earnings generated by rollover contribution tax free. Here’s a quick example:
Example 3: John is 60 years old. He has never had a Roth IRA. He has had a Roth 401(k) with his employer for over five years. He has made $100,000 of contributions to the Roth 401(k) which has grown to $200,000. He does not need to roll his Roth 401(k) into a Roth IRA to take out money entirely tax and penalty free.
If John chooses to roll all $200,000 in his Roth 401(k) into a Roth IRA, all $200,000 goes into the Roth IRA as a contribution. If John withdraws more than $200,000 from the new Roth IRA before the Roth IRA turns 5 years old, those withdrawals of new earnings would be subject to income tax (though, of course, penalty free since John is over 59 ½ years old).
As a practical matter, as long as the taxpayer does not plan on withdrawing more than the rolled over amount in the first five years, this nuance is not likely to be a gating issue in determining whether the Roth 401(k) should be rolled over to a Roth IRA.
Exception 2: Roth 401(k) Rollover then Withdraw
The second strategy to overcome the cream-in-the-coffee rule is to rollover the Roth 401(k) to a Roth IRA without waiting.
If either the taxpayer is less than 59 ½ years old and/or has not held that particular Roth 401(k) for at least five years, the nonqualified distribution rules apply to the rollover. The Roth 401(k) goes into the Roth IRA as “contributions” to the extent of the IITC in the Roth 401(k), and as “earnings” to the extent of growth in the Roth 401(k).
Recall the example of Lilly above. Here is how it changes if she rolls the Roth 401(k) into a Roth IRA and then takes the withdrawal.
Example 4: Lilly has made five $6,000 contributions to her Roth 401(k) in previous years. She also made a $10,000 conversion from a traditional 401(k) to her Roth 401(k) in 2014. In 2021, at a time when her Roth 401(k) is worth $60,000 and Lilly is 45 years old, she rolls her Roth 401(k) over to a Roth IRA (her first ever). A month later, Lilly takes a $10,000 withdrawal from her Roth IRA. All $10,000 will be a recovery of her previous contributions (leaving her with $30,000 remaining of previous contributions). Thus, the entire withdrawal will be tax and penalty free.
While rollovers of nonqualified distributions do not eliminate Roth 401(k) earnings, they do eliminate the cream-in-the-coffee rule. As a result, Roth 401(k) to Roth IRA rollovers often make sense.
The Five Year Roth Earnings Rule
Where such rollovers can be disadvantageous is the five year rule as applied to earnings. Recall that being age 59 ½ is a necessary, but not sufficient, condition to withdrawing Roth earnings tax free. You also need to meet a 5 year rule.
If you have a Roth 401(k) that is 5 years old but have never had any Roth IRA, and you are less than 5 years away from attaining age 59 ½, rolling into a Roth IRA could subject withdrawals of earnings (after age 59 ½) in excess of IITC to ordinary income taxation. That said, often withdrawals do not exhaust contributions in the first five years after a rollover. Thus, often this will not be a gating issue.
Exception 3: Roth 401(k) Withdrawal then Rollover
There is a third way to overcome the cream-in-the-coffee rule. It is to take a withdrawal from the Roth 401(k) and then rollover the earnings component to a Roth IRA. Let’s see how that would affect Lilly:
Example 5: Lilly needs $10,000 and has decided to access it from her Roth 401(k). Lilly has made five $6,000 contributions to her Roth 401(k) in previous years. She also made a $10,000 conversion from a traditional 401(k) to her Roth 401(k) in 2014. In 2021, at a time when her Roth 401(k) is worth $60,000 and Lilly is 45 years old, Lilly takes a $15,000 withdrawal from her Roth 401(k). Based on her Roth 401(k) consisting of two-thirds IITC and one-third earnings, $5,000 of the withdrawal is taxable and subject to an early withdrawal penalty. However, Lilly can, within 60 days, rollover the $5,000 of earnings into a Roth IRA. The earnings will go into the Roth IRA as earnings, and Lilly avoids the tax and penalty on the withdrawal.
Note that if Lilly does this partial rollover, the rollover piece is not subject to the cream-in-the-coffee rule. The partial rollover attracts earnings before attracting any IITC (see Treasury Regulation Section 1.402A-1 Q&A 5).
Note further that if Lilly has no other Roth IRAs, she now has a Roth IRA that consists only of earnings. She will not (generally speaking) be able to touch this Roth IRA without ordinary income tax and a penalty until age 59 ½.
As a practical matter, the “withdraw then rollover” strategy may not be available to Lilly. The 401(k) plan may not allow partial distributions pre-age 59 1/2 after separation from service.
Coordination with the Rule of 55
Many like the Rule of 55, which is a rule that allows taxpayers to take amounts from workplace retirement plans such as 401(k)s without the early withdrawal penalty. It applies when a taxpayer separates from service at age 55 or older (up to age 59 ½, when withdrawals become penalty free), and the plan allows partial withdrawals.
So the question becomes, if you are in the 4.5 year Rule of 55 window (ages 55 to 59 ½) and you separate from service, should you leave a Roth 401(k) in the plan or roll it into a Roth IRA if you need to withdraw from it? Let’s consider an example.
Example 6: James is 56 years old and leaves his employment. He has contributed $100,000 over more than five years to his Roth 401(k), and it is currently worth $200,000. If he keeps the amounts in the Roth 401(k), every dollar he takes out will be half recovery of IITC (tax-free) and half a withdrawal of earnings (taxable, but qualifies for a penalty exception). If, instead, James follows the “rollover then withdraw” strategy and rolls his Roth 401(k) to a Roth IRA, the first $100,000 he withdraws before age 59 ½ will be a return of contributions, and only if he exceeds $100,000 in withdrawals will he have ordinary income and a penalty. A second option for James would be to do the “withdraw then rollover” strategy whereby James would direct half of each distribution (the earnings half) to a Roth IRA in order to avoid ordinary income taxation on the earnings portion.
This illustrates that numbers matter in this regard. It also shows that as long as the pre-age 59 ½ withdrawals will be less than the previous Roth 401(k) contributions, it is generally better to take the withdrawals from a rollover Roth IRA than from a Roth 401(k) penalty protected by the Rule of 55.
However, if one employs the “withdraw then rollover” strategy, keeping money in the Roth 401(k) can work as effectively as rolling over to a Roth IRA.
A Note on Rollovers
Any designated Roth account (401(k), 403(b), and/or 457) can be rolled into a Roth IRA. Designated Roth accounts can be rolled into other designated Roth accounts, though note there can some be some complexity in this regard.
Roth IRAs cannot be rolled into a designated Roth account, including a Roth 401(k).
The IRS has a handy rollover chart accessible here.
SECURE 2.0 Update
SECURE 2.0 makes three changes relating to Roth 401(k)s. First, it eliminates required minimum distributions (“RMDs”) from Roth 401(k)s during the owner’s lifetime. This change has little practical effect, as many Roth 401(k)s will ultimately be rolled to Roth IRAs anyway in order for the owner to obtain more investment choice and control of the account.
Second, SECURE 2.0 mandates that beginning in 2024, employee catch-up contributions to 401(k) accounts must be Roth contributions if the employee made more than $145,000 in wages the prior year.
Third, SECURE 2.0 allows employer contributions to Roth 401(k)s.
I suspect that based on the second and third changes, more employers may offer Roth 401(k)s in addition to traditional 401(k)s.
Further Reading
For those interested in seeing more information on distributions out of Roth IRAs after rollovers of Roth 401(k)s, please see Treasury Regulation Sec. 1.408A-10. For more information on rollovers of distributions from Roth 401(k)s into Roth IRAs, please see Treasury Regulation Sec. 1.402A-1.
The rules around Roth 401(k)s are complex, and different than those applicable to Roth IRAs. This blog post only presents an educational introduction to those rules. Taxpayers should exercise extra caution, and often consult with tax professionals, before moving money out of a Roth 401(k).
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters.Please also refer to the Disclaimer & Warning section found here.
It won’t surprise many to find out that a tax-focused financial planner is fond of the Roth IRA. Below is a brief review of the advantages of a Roth IRA.
Tax Free Growth
Amounts in Roth IRAs grow tax free. Considering many Americans may now live into their 80s, 90s, and beyond, this is a tremendous benefit.
The only caveat is that in order for all distributions from Roth IRAs to be tax and penalty free, they generally have to be either (a) a return of contributions or of sufficiently aged conversions (see below), or (b) a distribution of earnings made in the Roth IRA (or other amounts in the Roth IRA) at a time when the owner of the account is 59 ½ or older and has owned a Roth IRA for at least five years.
The rules for ordering distributions out of a Roth IRA generally provide that contributions come out first, and then the oldest conversions come out next. This means that in many cases Roth IRA distributions, even those occurring before age 59 ½, are tax and penalty free.
N.B. Generally speaking, you want to only take a distribution from a Roth IRA before age 59 ½ if it is either (i) a serious emergency or (ii) part of a well crafted, very intentional financial plan.
Ease of Administration and Withdrawal
There are many financial institutions that provide Roth IRAs. Investment expenses in low-cost index funds at financial institutions that provide Roth IRAs are approaching zero. Vanguard, Fidelity, and Schwab are among the very good providers of low-cost Roth IRAs (and there are others).
It is also relatively easy to access money inside a Roth IRA. This makes the Roth IRA a great account to have in an emergency. Of course, it is generally best to leave money inside a Roth IRA to let it grow tax free, but it is good to know that you can access money in a Roth IRA relatively easily if an emergency arises.
Tax Free Withdrawals of Contributions
This is a great benefit of the Roth IRA. Contributions to a Roth IRA can be withdrawn at any time for any reason tax and penalty free. Further, the first money deemed distributed from a Roth IRA is a contribution. Here is a quick example:
Mark is 35 years old in 2025. He made $6,000 contributions to his Roth IRA in each of 2020, 2021, 2022, 2023, and 2024 (for $30,000 total). In 2025, when his Roth IRA is worth $41,000, Mark withdraws $10,000 from his Roth IRA in 2025. All $10,000 will be deemed to be a return of contributions, and thus entirely tax free and penalty free.
The only exception is a taxpayer favorable exception: a timely withdrawal of an excess contribution (and related earnings) occurs before regular contributions are considered withdrawn.
N.B. Roth 401(k)s, 403(b)s, and 457s have different distribution rules — most pre-age 59 ½ distributions will take out some taxable earnings.
Tax Free Withdrawals of Sufficiently Aged Converted Amounts
If you convert an amount into a Roth IRA, you start a five year clock as of January 1st of the year of the conversion. Quick example:
Mike is 35 years old in 2025. Mike converts $10,000 from a traditional IRA to a Roth IRA on July 2, 2025. His five year conversion clock starts January 1, 2025. On January 1, 2030, Mike can withdraw the entire $10,000 he converted in 2025 tax and penalty free.
This feature of the Roth IRA, the tax free withdrawal of sufficiently aged conversions, is the basis for the Roth Conversion Ladder strategy. Sufficiently aged converted amounts are deemed to come out after contributions are exhausted and before more recent conversions and earnings come out.
No Required Minimum Distributions
During an account holder’s lifetime, there are no required minimum distributions from a Roth IRA. You can live to 150 and never be required to take money from a Roth IRA.
Creditor Protection
In federal bankruptcy proceedings, Roth IRAs are (as of 2024), protected up to $1,512,350.
Where there can be differences in liability protection are state general creditor claims (i.e., creditor protection in non-bankruptcy situations). In some states, Roth IRAs receive a level of creditor protection similar to that of ERISA plans. Generally, such protection is absolute against all creditors except for an ex-spouse or the IRS.
In other states, Roth IRAs receive no or limited creditor protection. In my home state of California, Roth IRAs are only creditor protected up to the amount necessary to provide for you and your dependents in your retirement (as determined by the court). Such protection is valuable but hardly airtight.
A Sneaky Way to Contribute More to Your Retirement
Yes, in theory everyone should save for retirement based on exacting calculations (i.e., I estimate I need $X in retirement, so based on projections I save $A in traditional accounts and $B in Roth accounts this year). That’s the theory.
In practice, it’s “I maxed out this account and that account” or “I put $C into this account and $D into that account.” There isn’t that much wrong with how we practically save for retirement, as long as we are saving sufficient amounts for retirement.
But not all “maxing out” is created equal. We know this because if Jane has $100,000 in a traditional IRA and Mary has $100,000 in a Roth IRA, who has more wealth? Mary! Unless Jane can always be in a zero percent income tax bracket, Mary has more than Jane, even though they both nominally have $100,000.
A Great Account to Leave to Heirs
While non-spouse heirs will have to take taxable required distributions from inherited IRAs (in many cases beginning in 2020 they will need to drain the account within 10 years of death), heirs are never taxed on distributions from Roth IRAs. This makes a Roth IRA a great account to leave to your heirs.
Compare with Other Retirement Accounts
No other retirement account combines ease of administration and withdrawal, low costs, significant tax benefits, creditor protection, and great emergency access the way the Roth IRA does. Most workplace retirement plans have some restrictions on withdrawals. Traditional account withdrawals do not have the tax advantages of a Roth IRA. Distributions from a traditional IRA, even one at a low-cost, easy to use discount brokerage, will trigger ordinary income taxes, and possible penalties, if withdrawn for emergency use.
Financial Planning Objectives
Personal finance is indeed personal. But I submit the following: pretty much every individual has some desire (and/or need) to not work at some point in his/her lifetime and every individual needs to be prepared for emergencies. Further, these are two very important financial planning objectives for most, if not all, individuals.
If the above is true, then we must ask “which account type best supports the combination of these two pressing financial planning objectives?” It appears to me that the answer is clearly the Roth IRA.
None of this is to say that a Roth IRA is the only way to plan for retirement and plan for emergencies, but rather, it is to say that, generally speaking, a Roth IRA ought to be a material element in such planning. Other tools, such as other retirement accounts, insurances, investments in taxable accounts, and sufficiently funded emergency funds are likely needed in addition to a Roth IRA.
Retirement Accounts and Emergencies
Let’s examine how a Roth IRA might help someone facing a very serious emergency.
Picture Jack, who is 52 years old, and has a full time job. He has $1M in a traditional 401(k) and $10,000 in cash in a taxable account. That’s it. Then picture Chuck, also 52 with a full time job. Chuck has $700,000 in a traditional 401(k), $250,000 in a Roth IRA, and $10,000 in cash.
Who is better situated to deal with an emergency? Far and away the answer is Chuck. 401(k)s are difficult to access in an emergency. First of all, the 401(k) plan might not allow in-service distributions, and it might not allow taking out a loan.
Even if the 401(k) allows in-service distributions, distributions from 401(k)s are immediately taxable, and often subject to penalties (10% federal, 2.5% in California, for example) if you are under age 59 ½. Loans, while not immediately taxable, can become taxable if not paid back.
Long story short, a 401(k) may be a tough nut to crack in an emergency.
What about a Roth IRA? In Chuck’s case, he can access his prior Roth IRA contributions and sufficiently aged contributions tax and penalty free at any time for any reason! And his Roth IRA is easy to access, particularly if it is at a low-cost discount brokerage.
When you combine tax-free growth, no requirement to take required minimum distributions during the account holder’s lifetime, and the best emergency access of any tax-advantaged retirement account, it is difficult to see why working adults should not have at least some money in a Roth IRA.
When a Roth IRA Doesn’t Make Sense
The short answer is: not often! I struggle to come up with profiles of individuals that would not benefit from having some amount in a Roth IRA.
I can think of two profiles. The first, a rare case, is someone with very large legal liabilities such that all of their wealth would benefit from the creditor protections offered by an ERISA retirement plan (such as a 401(k)) and who needs almost all of their wealth shielded from creditors.
First, if you have built up 6 figures or more in wealth, having creditors able to claim your entire wealth is relatively rare. Second, in most cases, good insurance coverage, including adequate medical insurance, professional liability insurance (as applicable), home and automobile insurance, and personal umbrella liability insurance, should protect the vast majority of people such that they could withstand any liability exposure caused by having money in a Roth IRA instead of an ERISA protected plan.
The second profile is someone with incredibly high income currently and very little anticipated income in the future (such that their future tax rate is much lower than today’s rate). This too is a bit of a unicorn – people with high income today tend to have decent income tomorrow (even in the FI community).
Health Savings Accounts
It will also come as no surprise that I am fond of health savings accounts. Health savings accounts share some of the attributes that make the Roth IRA such a winner for both retirement savings and emergency planning.
But, there are some drawbacks. First, the distribution ordering rules are not as taxpayer friendly. While it may be the case that you have sufficient old medical expenses that you can reimburse yourself for (and thus not pay tax and a penalty on the HSA distribution), that is not always going to be the case, and even if it is, does add a layer of complexity.
Second, the HSA is not for everyone. If a high deductible health plan is not good medical insurance for you, an HSA is generally off the table.
So, that leaves the HSA as a fantastic option for those who qualify for and use a high deductible health plan (and usually an option that should be part of a comprehensive financial plan if you use a HDHP). But it also means that the HSA is not quite as good as a tool for the combination of retirement saving and emergency planning.
Conclusion
Assuming that an individual (a) has retirement planning and emergency preparedness as financial planning objectives and (b) is not in a position where legal liabilities would cripple them without ERISA creditor protection, it is hard to argue against having at least some material amount in a Roth IRA.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters.Please also refer to the Disclaimer & Warning section found here.
In late December 2019 the President and Congress enacted the SECURE Act. The SECURE Act makes some significant revisions to the laws governing IRAs, 401(k)s, and other retirement accounts. This post discusses the impacts of these changes on those pursuing financial independence.
The Big Picture
The SECURE Act is a big win for the FI community, in my opinion.
The FI community significantly benefits from IRAs, 401(k)s, and other tax-advantaged retirement accounts. However, the federal government is facing increasing debts and annual deficits. That puts tax-advantaged accounts in the crosshairs. What Congress gives in tax benefits Congress can take away.
So what does the SECURE Act do? First, it actually gives us a couple more tax advantages during our lifetimes (see “Opportunities” below). Second, it significantly reduces the tax advantages of inherited retirement accounts for our heirs.
For those either with large retirement account balances or planning to have large retirement account balances, any change in tax laws is a potential problem. We should be glad that this round of tax law changes has occurred without our own retirement accounts being negatively impacted. Congress has passed the bill to our heirs, which, right or wrong, is a victory for us.
When you see people in the financial press squawking about how awful the SECURE Act is, remember, it could be a whole lot worse–your retirement account could have been more heavily taxed during your lifetime!
For those pursuing FI, the ability to use tax-advantaged retirement accounts remains the same, and in a couple small ways, has been enhanced. The next generation still has all those retirement account opportunities, even if they won’t be able to benefit from inheriting retirement accounts as much as they do under current law.
Opportunities
Traditional IRA Contributions for those 70 ½ and Older
Starting in 2020, those aged 70 ½ and older will be able to contribute to a traditional IRA. This will open up Backdoor Roth IRA planning for those 70 ½ and older and still working. For those still working (or doing side hustles) at age 70 ½ or older, this is a nice change.
Remember, regardless of age, in order to contribute to an IRA, you or your spouse must have earned income.
RMDs Begin at 72
For those attaining age 70 ½ after December 31, 2019, the age at which they will need to take RMDs will be 72, not 70 ½. This gives retirement accounts a bit more time to bake tax-deferred. It also slightly expands the window to do Roth conversions before RMDs begin. However, this last benefit is tempered by the fact that you must take Social Security no later than age 70. Roth conversion planning to reduce taxable RMDs should be mostly completed well before age 70 ½, regardless of this change in the law.
Note that taxpayers can still make qualified charitable distributions (“QCD”) starting when they turn age 70 ½. While pre-age 72 QCDs won’t satisfy RMD requirements, they will (a) help optimize charitable giving from a tax perspective (by keeping adjusted gross income lower and avoiding the requirement to itemize to deduct the contribution) and (b) reduce future RMDs.
Annuities in 401(k)s
The new law provides rules facilitating annuities in 401(k) plans. This one requires proceeding with extreme caution. If your 401(k) plan decides to offer annuity products, you need to carefully assess whether an annuity is the right investment for you and you need to fully understand the fees charged.
Remember, just because the law changed doesn’t mean your asset allocation should change!
Leaving Retirement Accounts to Heirs
This is the where the SECURE Act raises taxes. The SECURE Act removes the so-called “stretch” for many retirement plan beneficiaries. For retirement accounts inherited after December 31, 2019, only certain beneficiaries will be able to stretch out distributions over their remaining life (or based on the age of the decedent if over 70 ½ at death). For nonqualified beneficiaries, the rule will simply be that the beneficiary must take the account within 10 years of the owner’s death (the “10-year rule”).
My overall opinion on the SECURE Act stated above, planning for the next generation is important. Particularly if you are already financially independent and want to help your children become financially independent, the SECURE Act has significant ramifications.
Spouses
If your current estate plan features your spouse as your retirement account primary beneficiary, the SECURE Act should in no way change that aspect of your plan. Fortunately, the many advantages applicable to spouses inheriting retirement accounts will not change. Spouses remain an excellent candidate to inherit a retirement account.
Minor Children
If you leave your retirement account to your minor children, they are exempt from the 10-year rule (and can generally take distributions based on IRS RMD tables that are generous to younger beneficiaries) while they are still minors. Once your children reach the age of majority, they will have ten years to empty the retirement account.
The exception to the 10-year rule applies only to your minor children. It does not apply to your grandchildren, your adult children, and the children of others (including nieces and nephews).
Other Eligible Beneficiaries
The exceptions to the 10-year rule apply to your spouse, your minor children, the disabled, the chronically ill, and persons not more than 10 years younger than you at your death. All others will need to empty retirement accounts within 10 years of inheritance. This will require some significant planning in cases where the beneficiary has inherited a traditional retirement account to strategically empty the account over the 10 year window to manage adjusted gross income, taxable income, and total tax.
Planning
For those of you with estate plans involving adult children, the passage of the SECURE Act may well require revisions to your plans. First off, as a practical matter, your revocable living trust may need modifications. Many have designated a trust as a retirement account beneficiary. To do so properly requires conforming with specific income tax rules. Those with trusts as the beneficiary of their retirement account would be well advised to, at a minimum, consult with their lawyer to determine if the language of the trust needs updating.
Second, understanding that inheriting a traditional retirement account will now mean accelerated, and possibly significantly increased, taxation for their heirs, many will want to consider Roth conversion planning. Roth accounts will be subject to the 10-year rule, but the good news is that the beneficiary can keep the assets in the Roth account for 10 years, let it grow tax free, and then take out the money in 10 years tax free. Not too bad.
Roth conversion planning to optimize your heirs’ income tax picture is now even more important. However, it should not be done if it will impose a financial hardship on the account owner during their lifetime. The first priority should be securing the account owner’s retirement. Only if the account owner is financially secure should they consider Roth conversion planning to reduce their heirs’ tax liability.
Conclusion
Tax rules are always changing. This round of changes is a victory for those pursuing financial independence. Any tax law change that does not negatively impact your path to financial independence is a win.
For those considering the financial health of their heirs, particularly their adult children, the SECURE Act should prompt some reconsideration of estate plans. Often it is wise to consult with professional advisors in this regard.
FI Tax Guy can be your financial advisor! FI Tax Guy can prepare your tax return! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters.
Are you self-employed? Is your self-employment income your primary source of income? If so, you might want to consider doing a Roth conversion before the end of the year.
Takeaways
If most of your taxable income is self-employment income (either reported on Schedule C or from a partnership), you might want to consider year-end Roth conversions to maximize your QBI deduction and pay a lower-than-expected federal income tax rate on the conversion.
To optimize this strategy, convert traditional IRAs to Roth IRAs (or do in-plan traditional 401(k) to Roth 401(k) conversions) to increase your QBI deduction.
Starting in 2018, there is a deduction for “qualified business income.” This is generally income from a qualified trade or business received from a sole proprietorship (and reported on Schedule C), from a partnership, or from a S Corporation (in these cases, generally reported to the taxpayer on a Form K-1 and reported on the Schedule E with the tax return).
Important for this purpose is the initial limit on the QBI deduction. It is the lesser of following two amounts:
20 percent of taxable income less “net capital gain” which is generally capital gains plus qualified dividend income (“QDI”) (the “Income Limit”) or
20 percent of QBI (the “QBI Limit”).
As a practical matter, in most cases the limit will be determined by the second limitation (such taxpayers are what I call “QBI Limited”). Many taxpayers will have much more taxable income than they have QBI. Consider spouses where one has self-employment income and the other has W-2 income. Unless the W-2 income is very small, their combined taxable income is likely to be in excess of their combined QBI, and thus they will be QBI Limited.
Alternatively, consider a situation where a single person has QBI from an S corporation (say $50,000) and the S corporation also pays him or her a W-2 salary (say $60,000). In such a case the QBI is $50,000 (20% of which is $10,000) and the taxable income might be $97,450 ($110,000 total from the S corporation less a $12,550 standard deduction), 20% of which is $19,490. This taxpayer would also be QBI Limited.
Income Limited
But what if you are not QBI Limited, but rather, limited by the Income Limit listed above (what I call “Income Limited”)? Here is an illustrative example.
Example 1: Seth is single and self-employed. He claims the standard deduction in 2021. He reports a business profit of $100,000 on his Schedule C. He also has $1,000 of interest income.
His Income Limit is computed as follows:
Schedule C Income: $100,000
Interest Income: $1,000
Deduction for ½ Self-Employment Taxes: ($7,065)
Standard Deduction: ($12,550)
Taxable Income: $81,385
20% Limit: $16,277
Seth’s QBI Limit is computed as follows:
Schedule C Income: $100,000
Deduction for ½ Self-Employment Taxes: ($7,065)
QBI: $92,935
20% Limit: $18,587
In this case, Seth’s QBI deduction is only $16,277 (he is Income Limited), the lesser of these two calculated limits.
Roth Conversion Planning
Is there anything Seth can do to increase his limitation and optimize his QBI deduction?
Imagine Seth has $20,000 in a traditional IRA (with zero basis). He could convert some of that traditional IRA to a Roth IRA by December 31, 2021. This would create taxable income, which would increase Seth’s Income Limit. Here is how that could play out:
Without Roth Conversion
Schedule C Income
$ 100,000
Interest Income
$ 1,000
Deduction for ½ Self-Employment Taxes
$ (7,065)
Adjusted Gross Income
$ 93,935
Standard Deduction
$ (12,550)
Qualified Business Income Deduction (see above)
$ (16,277)
Taxable Income
$ 65,108
Federal Income Tax
$ 10,072
With Roth Conversion
Schedule C Income
$ 100,000
Interest Income
$ 1,000
Deduction for ½ Self-Employment Taxes
$ (7,065)
Roth IRA Conversion
$ 11,550
Adjusted Gross Income
$ 105,485
Standard Deduction
$ (12,550)
Qualified Business Income Deduction
$ (18,587)
Taxable Income
$ 74,348
Federal Income Tax
$ 12,105
What has the $11,550 Roth IRA conversion done? First, it has made the Income Limit ($18,587) the exact same as the QBI Limit ($18,587). Thus, Seth’s QBI deduction increases from $16,227 to $18,587.
Second, notice that Seth’s taxable income has increased, but not by $11,550! Usually one would expect that a Roth IRA conversion with no basis recovery would simply increase taxable income by the amount converted. But not here! The interaction with the QBI deduction caused Seth’s taxable income to increase only $9,240 ($74,348 minus $65,108).
This example illustrates that, under the right circumstances, a Roth IRA conversion can receive the benefit of the QBI deduction!
As a result, at Seth’s 22 percent marginal federal income tax bracket, his total federal income tax increased only $2,033. In effect, Seth pays only a 17.6 percent rate on his Roth IRA conversion ($2,033 of federal income tax on a $11,550 Roth IRA conversion). This is true even though Seth is in the 22 percent marginal tax bracket. His Roth IRA conversion is only 80 percent taxable. This is the flip-side of the 80% deduction phenomenon I previously blogged about here.
Is it advantageous for Seth to convert his traditional IRA? Well, it depends on Seth’s expected future tax rates. If Seth’s future marginal tax bracket is anticipated to be 22 percent, then absolutely. Why not convert at a 17.6 percent instead of face a 22 percent rate on future traditional IRA withdrawals?
Strategy
Seth’s Roth IRA conversion is optimized. The takeaway is that the Roth IRA conversion gets the benefit of the QBI deduction, but only for amounts that increase the Income Limit up to the QBI Limit.
A *very general* rule of thumb for solving for the optimal Roth conversion amount is to multiply the difference between the QBI Limit and the Income Limit (without a Roth conversion) by 5. In Seth’s case, that was $18,587 minus $16,277 (which equals $2,310) times 5.
In this case, converting exactly $11,550 made Seth’s Income Limit exactly equal his QBI Limit. As long as the Roth conversion increases the Income Limit toward the QBI Limit, the conversion benefits from the QBI deduction.
But the first dollar of the Roth conversion that pushes the Income Limit above the QBI Limit does not receive the benefit. If Seth converted $11,551 from his traditional IRA to his Roth IRA, that last dollar above $11,550 would be taxed at Seth’s full 22 percent federal marginal tax bracket.
Note that instead of / in addition to a Roth IRA conversion, Seth could do an in-plan traditional 401(k) to Roth 401(k) conversion, if he had sufficient funds in a traditional 401(k), and the 401(k) plan permits Roth 401(k) conversions.
Also note that the strategic considerations with QBI deductions become much more complicated once taxpayers exceed the initial QBI taxable income limitations (in 2021, those are $164,900 for single taxpayers and $329,800 for married filing joint taxpayers).
Conclusion
Taxpayers whose taxable income consists mostly or exclusively of self-employment income should consider Roth conversions toward year-end. This is often an area that benefits from consulting with a professional tax advisor before taking action.
Further Reading
I have blogged about the QBI deduction and retirement plans here. After the IRS and Treasury provided some QBI deduction regulations in January 2019, I provided some QBI deduction examples and lessons here.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters.Please also refer to the Disclaimer & Warning section found here.
Watch me discuss Backdoor Roth IRA tax return reporting on YouTube.
The word is out. The Backdoor Roth IRA is a powerful tax planning tool. You may believe that by previously executing Backdoor Roth IRAs, you have planned well and received a great tax benefit while building retirement savings.
Is it possible you are mistaken? It is possible you did not complete the Backdoor Roth IRA correctly?
It may be true that you have successfully completed the two independent steps of a Backdoor Roth IRA: a traditional, non-deductible IRA contribution followed by a later Roth IRA conversion. It may also be true that you had no balances in a traditional IRA, SEP IRA, and/or SIMPLE IRA as of December 31st of the year you did the Backdoor Roth IRA.
Year-end tip: The deadline to clean out traditional/SEP/SIMPLE IRAs (by rolling them into employer retirement plans such as 401(k)s) so as to optimize a Backdoor Roth IRA is December 31st of the year of the Roth IRA conversion step. As a practical matter, you should not complete the Roth IRA conversion step until you have cleaned out the traditional/SEP/SIMPLE IRAs. Life happens; there is simply no guarantee you complete the clean out before December 31st. Failing to do so will significantly increase the tax on your Backdoor Roth IRA.
But you may not have correctly reported the Backdoor Roth IRA on your tax return. This last step is too-often overlooked. Below I discuss how to properly report a Backdoor Roth IRA, a potential tax return mistake that could have cost you thousands in erroneous taxes, and ways to fix the mistake.
Backdoor Roth IRA Example
Charlie is single and 35 years old. He is covered by a retirement plan at work. In 2018 his W-2 salary was $200,000, and thus he did not qualify to make a Roth IRA contribution for 2018. He has no balance in a traditional IRA, SEP IRA, or SIMPLE IRA. He decides to do a Backdoor Roth IRA.
On September 2, 2018, Charlie contributed $5,500 to a traditional, non-deductible IRA. On October 10, 2018, he converted the entire balance in the traditional IRA, then $5,510, to a Roth IRA.
So far, so good with the Backdoor Roth IRA! But Charlie’s not done yet. Let’s look at how the Charlie should file his tax return and the pitfalls he should avoid.
Backdoor Roth IRA Tax Return Reporting
Early in the year, Charlie should receive a Form 1099-R that looks like the following from his financial institution.
Charlie’s Backdoor Roth IRA Form 1099-R should look something like this. Note that the “taxable amount” is the full conversion amount ($5,510) and the box indicating that the taxable amount has not been determined is checked.
This requires precise tax return reporting to ensure Charlie increases his taxable income by the correct amount to account for the Backdoor Roth IRA. An error in the tax return reporting could erroneously overstate his adjusted gross income and thus cause him to pay significantly more to the IRS and state tax agency than he owes.
There are two places Charlie needs to report the Backdoor Roth IRA: Pages 1 and 2 of Form 8606 and lines 4a and 4b of the Form 1040.
Let’s start with the Form 8606. Below is the correct way for Charlie to file Page 1 of his Form 8606.
Lines 1, 6, and 11 of the Form 8606 are crucial to properly reporting a Backdoor Roth IRA and computing the nontaxable portion of the Roth IRA conversion.
Notice a few things about this form. First, on line 1 Charlie reports his traditional, non-deductible IRA contribution of $5,500. Second, on line 6, Charlie reports the total combined value of his traditional IRAs, SEP IRAs, and SIMPLE IRAs as of December 31, 2018. He can find this number on the Forms 5498 that his financial institutions send him and the IRS regarding his IRA accounts. To have a very efficient Backdoor Roth IRA, ideally Charlie should no balance in these accounts on December 31, 2018, and thus Charlie can, and does, report zero on line 6. If Charlie has any such balances the total must be reported here and it will cause his Backdoor Roth IRA to be partially (maybe mostly) taxable.
Next, Charlie reports his Roth IRA conversion amount on line 8. This is the total taxable amount he converted, reported to him in Box 2 of the Form 1099-R, $5,510. The mechanics of the Form 8606 then lead to lines 11 and 13, the nontaxable portion of Charlie’s Roth IRA conversion. In Charlie’s case, this is $5,500. This is because he is entitled to recover all $5,500 of basis he has in his traditional IRA (as computed in this part of the Form 8606). This $5,500 number is required to correctly prepare Page 2 of the Form 8606 and line 4b of the Form 1040.
Form 8606 Line 18 should be reported on Line 4b of Form 1040 for a 2018 Backdoor Roth IRA.
Page 1 computed how much of Charlie’s basis he can recover and the nontaxable portion of his Roth IRA conversion. Page 2 answers the second question: How much of Charlie’s Roth IRA conversion is taxable? Line 16 is simply line 8, and line 17 is simply line 11. Subtracting the nontaxable portion of the Roth IRA conversion from the total converted amount yields the amount of the Roth IRA conversion that is taxable. In Charlie’s case, it is only $10. This amount goes to Charlie’s Form 1040, line 4b.
This is how a Backdoor Roth IRA should look on your Form 1040. Notice the very small number on Line 4b.
The Wrong Way
The following is what Charlie’s Form 1040 might look like if his Backdoor Roth IRA is misreported.
Heed the warning of my chicken scratch: a four figure number on Line 4b after a Backdoor Roth IRA is likely an indication that either the tax planning or the tax reporting is off.
How might this happen? It could be that a Form 8606 simply was not prepared, or it was incorrectly prepared. Sometimes the Form 1099-R is misunderstood. People see that $5,510 is the “taxable amount” in line 2 of the Form 1099-R and believe that must be the taxable amount reported on line 4b. But remember, the Form 1099-R has a box checked indicating that the taxable amount is not determined. The Form 8606 is what determines the taxable amount created by the Backdoor Roth IRA (in Charlie’s case, $10).
As a check, you should ensure that the Lines 18 of your previously filed Forms 8606 agree to the appropriate line on the Form 1040 (line 4b in 2018). If there are discrepancies (and/or a Form 8606 was not filed for a Backdoor Roth IRA), that is an indication there is likely an error on the tax return. If Line 18 on the Form 8606 is a four-figure or greater number after a Backdoor Roth IRA, it is very likely that either the tax planning or the tax return reporting went wrong somewhere.
We can see how deleterious this error is for Charlie. If he filed his tax return the wrong way, his federal taxable income is overstated by $5,500. In his case, this caused him to erroneously owe $1,760 more in federal income tax ($43,613 minus $41,853 — hat tip to ProConnect Tax Online for the tax calculations). If Charlie lives in a state with a state income tax, he will also overpay his state income taxes because of this error.
Filing an Amended Tax Return
Imagine that Charlie filed his tax return as pictured in the Wrong!!! picture above. What can Charlie do?
Charlie’s remedy is to file an amended return. This entails refiling the Form 1040 and all of its related forms and schedules (including the Form 8606) with the correct amounts. It also entails filing a Form 1040X. This form presents amounts as originally filed and as corrected, with the difference illustrated. It also requires a narrative submission explaining the changes made on the amended tax return.
There are several things to keep in mind when filing an amended tax return. First, a taxpayer filing an amended return is under an obligation to correctly report amounts. If, as part of the exercise of fixing a Backdoor Roth IRA through an amended tax return, the taxpayer learns that other amounts on the originally filed tax return were incorrect, he or she must correct those amounts if they choose to file an amended return.
Second, there is a deadline for amending a federal income tax return (the so-called statute of limitations). Generally, the deadline is three years from the later of the tax return due date (if originally filed on or prior to the initial tax return due date) or the filing date (if filed after the initial tax return due date). This later deadline applies anytime the taxpayer files after the initial due date (including, for example, a timely post-April 15th tax return filing made after filing for an extension).
If the amended return claiming the refund (because of the corrected Backdoor Roth IRA tax return reporting) is filed after this three year deadline, the IRS cannot and will not issue a refund to the taxpayer due to the statute of limitations. There are limited exceptions to this rule (such as when the IRS and the taxpayer have mutually agreed to extend the statute of limitations).
States have their own statutes of limitations, which may or may not be the same as the federal statute of limitations. In my home state of California, it is a four-year statute of limitations instead of a three-year statute of limitations.
The statute of limitations means the clock is ticking to correct Backdoor Roth IRAs not correctly reported on previously filed tax returns. In many cases, taxpayers learning they have incorrectly filed a tax return (for whatever reason, including an erroneously reported Backdoor Roth IRA) are well advised to seek professional assistance in amending their tax returns.
Further Reading
I have previously blogged about Backdoor Roth IRAs for beginners here and about tactics to employ if you want to do a Backdoor Roth IRA but currently have a balance in a traditional IRA, SEP IRA, and/or SIMPLE IRA.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
