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Inherited Roth IRAs

Inherit a Roth IRA in 2023 or later? Thinking about leaving a Roth IRA to heirs at your death? Then this article is for you. Note that it is an educational resource. It is not advice for any individual’s particular situation. Further, this article does not address situations where a person inherited a Roth IRA prior to the year 2023.

Inheriting a Roth IRA is great, since distributions are always penalty free and tax-free 99.99% of the time. The only time a distribution from a non-spousal inherited Roth IRA could be subject to income tax is if the distribution is a distribution earnings from the Roth IRA prior to the passage of 5 years from January 1st of the year the original owner first contributed to a Roth IRA. See Treas. Reg. Section 1.408A-6 Q&A 1(b). As a practical matter, few distributions from inherited Roth IRAs will be both (i) earnings of the inherited Roth IRA and (ii) made prior to the end of the five year clock.

Said differently, both the original owner and the beneficiary would have to be incredibly unlucky in order for a beneficiary to pay federal income tax on an inherited Roth IRA distribution.

In theory, a spouse inheriting a Roth IRA could pay tax and/or a penalty on distributions from an inherited Roth IRA the spouse treated as their own, but even that occurrence is likely to be rare, as discussed in more detail below.

Terminology and Titling

One inheriting a Roth IRA is a beneficiary. Yes, that inherited Roth IRA is now your property, but you are not the “owner” from a tax perspective. The original owner is the owner. You, the inheritor, are the beneficiary. If you die, the person inheriting the Roth IRA you inherited is a successor beneficiary.

Upon the owner’s death, the beneficiary should work with the Roth IRA’s financial institution to retitle the Roth IRA. The titling should indicate that the beneficiary is a beneficiary and should reference the owner.

The above two paragraphs are not the case as applied to spouses who choose to treat an inherited Roth IRA as their own. In that case, the inheriting spouse becomes the owner, not the beneficiary.

Types of Beneficiaries

To my mind, there are generally seven types of Roth IRA beneficiaries. Below, I use my own colloquialisms for each. You will not find the term “10-year beneficiary” in the Internal Revenue Code or the IRS website, for example. Rather, it is simply a term I colloquially use to refer to a particular type of inherited Roth IRA beneficiary.

To understand what happens when one inherits a Roth IRA, one must first understand what type of beneficiary they are among the below seven categories.

Watch me discuss Inherited Roth IRAs on YouTube.

Spouses

Spouses are generally favored inherited Roth IRA beneficiaries from a tax planning perspective. Married individuals should think long and hard prior to naming someone other than their spouse as their Roth IRA primary beneficiary for many reasons, including tax planning.

There are three options a spouse has when inheriting a Roth IRA. Two of those options entail the inherited IRA being treated as the inheriting spouse’s own Roth IRA. This is usually advantageous for several reasons, including the fact that an owner is never subject to required minimum distributions (“RMDs”) with respect to their own Roth IRA. Practically speaking, this is how most inherited Roth IRAs are handled by spouses.

SECURE 2.0 added a new fourth option for spouses to be treated as the deceased spouse when inheriting a retirement account. This change appears to matter as applied to RMDs, which the Roth IRA never has for an owner. Thus, I do not believe this change impacts spouses inheriting Roth IRAs to any significant degree.

The inheriting spouse could treat the inherited Roth IRA as an inherited account (i.e., become a beneficiary instead of being the owner). Practically speaking, an inheriting spouse would only consider this if they are under 59 ½ years old and they believe it is likely they would need to access earnings in their Roth IRAs (including the inherited accounts) prior to age 59 ½.

Considering a spouse treating an inherited Roth IRA as their own can recover their own and their decedent spouse’s Roth IRA contributions and 5 year-old conversions tax and penalty free at any time and recovers these amounts before Roth earnings are ever accessed, most inheriting spouses will not need to elect inherited Roth IRA (i.e., beneficiary) treatment. This may be true even in situations where the inheriting spouse is under 59 ½ years old and needs access to some of the inherited Roth IRA funds prior to age 59 ½. Further, treating the inherited Roth IRA as one’s own Roth IRA instead of keeping it as an inherited IRA will generally be advantageous from a creditor protection standpoint.

One potential planning option for the spouse is to roll the decedent spouse’s Roth IRA to an inherited Roth IRA and later (presumably at age 59 ½) roll it into their own Roth IRA. See Choate, referenced below, page 225. This offers the inheriting spouse protection as it allows him or her to access Roth earnings tax-free prior to the spouse turning age 59 ½ and then later avoids RMDs to the spouse (see discussion of that possibility below).

In Proposal 10 of my retirement tax reform proposal, I offer suggestions to simplify the treatment when spouses inherit retirement accounts.

RMD Beneficiaries

The SECURE Act set up a new standard to be an RMD beneficiary (what the SECURE Act termed an “eligible designated beneficiary”). Some practitioners use the term “EDB” for these beneficiaries, but I prefer the term “RMD beneficiary” because these are the beneficiaries that are allowed to (i) avoid the new 10-year rule discussed below and (ii) withdraw from the inherited Roth IRA RMDs based on their own remaining life expectancy.

Who qualifies as an RMD beneficiary? These include:

A spouse electing to treat the inherited Roth IRA as an inherited Roth IRA
Any individual not more than 10 years younger than the owner (think parents and adult siblings, but it can be others)
Anyone chronically ill or disabled

An RMD beneficiary must start taking RMDs from the inherited IRA in the year after the owner died. He or she goes to the IRS Single Life Table and finds the factor for their age in the year following the owner’s death. The RMD for that first year is the prior-year end-of-year account balance divided by that factor. The following year’s RMD is the prior-year end-of-year account balance divided by the first year’s factor minus one. See Choate, referenced below, at pages 67-68 and 73-74. Here’s an example of how it works.

Jack died on December 1, 2023. He was 65 at his passing. He leaves his Roth IRA to his brother Jim. In 2024, Jim turns 62. Jim is an RMD beneficiary and should* take an RMD based on his IRS Single Life Table factor at age 62, 25.4. If the inherited Roth IRA balance on December 31, 2023 is $500,000, Jim’s 2024 inherited Roth IRA RMD is $19,685.04 ($500,000 divided by 25.4). If the balance in the inherited Roth IRA is $510,000 on December 31, 2024, Jim’s 2025 RMD is $20,901.65 ($510,000 divided by 24.4). Jim takes annual RMDs in a similar fashion in subsequent years.

As Natalie Choate notes in her treatise referenced below (see page 74), Jim only looks at the IRS Single Life Table once: for the first RMD year. After that, he simply subtracts 1 from the factor every year. Thus, those using the Single Life Table only look at it a single time.

*Note that an RMD beneficiary can, instead of taking RMDs, elect the 10-year rule discussed below. See Choate supplement, page 12, Andy Ives at IRAHelp.com, and Ian Berger at IRAHelp.com. In many cases, I suspect taking relatively modest tax-free RMDs will facilitate more tax-free growth than avoiding RMDs and emptying the inherited Roth IRA within 10 years. This is because taking RMDs allows a large portion of the inherited Roth IRA to survive well beyond 10 years in cases where the beneficiary is not themselves rather elderly. That said, the older the beneficiary is, the more likely electing into the 10-year rule is to be advantageous. It is not clear how the beneficiary makes the election (see Choate supplement, page 50), though presumably failing to take RMDs would do it.

Spouses electing beneficiary treatment (which is RMD beneficiary treatment in their case) are generally not required to take the annual RMD until the later of (i) the year after the decedent spouse’s death or (ii) the year the decedent spouse would have reached age 72. See Choate, referenced below, page 97, Prop. Reg. Section 1.401(a)(9)-3(d) on page 109 of this PDF file (also see Prop. Reg. Section 1.408-8(b)(2)(ii) on page 253 of the PDF file).

Successor Beneficiaries

Successor beneficiaries of RMD beneficiaries must, in most cases, empty the inherited Roth IRA by the end of the 10th calendar year following the RMD beneficiary’s death. See Natalie Choate supplement page 43 and Prop. Reg. Section 1.401(a)(9)-5(e)(3) on page 142 of this PDF file. Update August 4, 2023: In addition to being subject to the 10-year rule, the successor beneficiary must continue to take the annual RMDs the RMD beneficiary would have been required to take had they lived. See Natalie Choate supplement page 51.

Update July 10, 2023: Sarah Brenner of IRAHelp.com raises an interesting possibility. What if the RMD beneficiary elects the 10-year rule? If that happens, the successor beneficiary must empty the inherited Roth IRA by the end of the 10th year after the original owner’s death!

Minor Children of the Owner

If a minor child of the owner inherits a Roth IRA, he or she gets to take RMDs for all the years through the year he or she turns 21. Then the inherited Roth IRA must be emptied by the end of the 10th calendar year following the beneficiary turning age 21. See Prop. Reg. Section 1.401(a)(9)-5(e)(4) on pages 142-43 of this PDF file. Update September 11, 2023: the minor child starting the RMDs prior to turning age 21 triggers RMDs during the later 10-year period.

This treatment is quite favorable considering the relatively low RMDs during one’s youth, as the RMD is based on their relatively long life expectancy.

The only children qualifying for this treatment are the children of the owner. Grandchildren, nieces, nephews, etc. will not qualify, and in most cases will be 10-year beneficiaries. These children could qualify for RMD beneficiary treatment if they are chronically ill or disabled.

Note that technically minor children of the owner qualify as “eligible designated beneficiaries” but since the treatment they receive is, to my mind, quite different from the treatment RMD beneficiaries receive, I mentally carve them out as their own distinct category.

Successor Beneficiaries

Natalie Choate observes on page 43 of her supplement that in the case of a minor-child RMD beneficiary, the successor beneficiary must empty the account by the earlier of (i) the end of the 10th full year following the minor-child’s death or (ii) the end of the 10th full year following the former minor child turning age 21. Update August 4, 2023: If the minor-child beneficiary dies while collecting RMDs, it appears the successor beneficiary would also be subject to annual RMDs using the decedent minor-child’s life expectancy during the 10-year time frame.

10-year Beneficiaries

10-year beneficiaries are those individuals who are not spouses, minor children of the owner, and RMD beneficiaries. They are everyone else. From a practical perspective, most 10-year beneficiaries are the adult children of the owner.

10-year beneficiaries are not subject to RMDs. However, they must empty the inherited Roth IRA by the end of the 10th year following death. From a purely tax planning perspective, the beneficiary will want to leave the money inside the inherited Roth IRA and withdraw the money in December of the 10th full year following the owner’s death to get as much tax-free growth out of the inherited Roth IRA as possible. Of course, distributions prior to the end of the 10th year are permitted, and, as discussed above, should be tax-free in practically all cases.

Successor Beneficiaries

Successor beneficiaries of 10-year beneficiaries must empty the inherited Roth IRA by the end of the 10th calendar year following the owner’s death. See Prop. Reg. Section 1.401(a)(9)-5(e)(2) on page 142 of this PDF file. Thus, the death of a 10-year beneficiary does not extend the time to empty an inherited Roth IRA.

Estates

A pulse is worth at least 5 years of tax-free growth!

Roth IRAs can be left to one’s own estate, but generally speaking, they should not be. In order to qualify for the 10-year rule or better treatment (see the first four categories of beneficiaries), the beneficiary designation form must leave the Roth IRA to a human being. Estates can become the Roth IRA beneficiary if no beneficiary designation form is filed, or if the filed beneficiary designation form names the estate as the beneficiary. When an estate inherits a Roth IRA, the inherited Roth IRA is subject to a 5-year payout rule. See Choate, referenced below, pages 77 and 104.

If left to one’s estate, the Roth IRA must be paid out by the end of the fifth full calendar year following death. See Choate supplement page 100. This is true even if the estate will ultimately pay the money out to actual humans who could have, on their own, qualified as 10-year beneficiaries, RMD beneficiaries, and/or spousal beneficiaries.

Trusts

If you want to see some tax complexity, look at inherited retirement accounts and trusts. Trusts themselves often have human beneficiaries, but the trust mechanism is used to protect the beneficiary and/or the assets inside the trust. There are valid reasons to name a trust as a retirement account beneficiary (usually surrounding the nature of the potential beneficiaries), but naming a trust should not be done lightly.

The tax risk is that the inherited Roth IRA will be subject to the 5-year rule. Properly structured (including the provisions required by Treas. Reg. Sec. 1.401(a)(9)-4 Q&A 5(b)), the human beneficiaries of the trust can qualify for the applicable treatment offered by one of the first four categories of beneficiary. However, if the trust is not properly structured, the trust and the human beneficiaries of the trust will be subject to the 5-year rule and lose out on 5 or more years of tax-free growth.

Charities

A charity must take an inherited Roth IRA in 5 years, but it does not care, as it is not generally subject to income tax. From a planning perspective, Roth IRAs are the assets that are least advantageous to leave to charity. Your human heirs like to inherit Roth accounts and generally would prefer to inherit a Roth over an account such as a traditional IRA or a HSA. Here’s an example of how that could play out.

Walter, age 80, is a widow and has one adult son, Paul, age 50. Walter has the following assets:

*Asset Location*	*Amount*
Roth IRA	$100,000
Taxable Brokerage	$100,000
Traditional IRA	$50,000
HSA	$50,000
*Total*	*$300,000*

Walter intends on leaving two-thirds of his assets to Paul and one-third of his assets to his Catholic parish, a 501(c)(3) charitable organization. From Paul’s perspective, he’d prefer to inherit the $100,000 Roth IRA (10 more years of tax-free growth, no income tax and full step up in basis when the assets are distributed to him) and $100,000 taxable brokerage (no income tax and full step up in basis). Paul would prefer that the $100,000 left to the parish be the $50,000 traditional IRA (which would be taxable to Paul through RMDs and the 10-year rule) and the $50,000 HSA (which is immediately fully taxable to Paul in the year of Walter’s death if Paul inherits).

Why waste the Roth’s step-up in basis, tax-free treatment, and 10 years of additional tax-free growth on a charity when you can give the charity assets that are otherwise less favorable to the human beneficiary (the traditional IRA and the HSA)?

Planning

For Owners

Retirement account owners may want to think about inter-generational planning, for two reasons. First, if the owner is in a relatively low marginal tax bracket, and their beneficiaries (perhaps successful adult children) are in relatively high marginal tax brackets, they may want to think about Roth conversions during their lifetimes to move money from traditional retirement accounts to Roth IRAs. This can reduce the income tax paid with respect to the traditional retirement accounts. Second, it eliminates the chance that adult children could be subject to both the 10-year rule and to RMDs (see this article for more details).

Any planning in this regard should consider that tax planning for one’s adult children is a second order planning priority. The first planning priority should be the financial success of the retirement account owner. His or her financial success should be prioritized ahead of tax planning geared toward a better result for one’s adult children.

For Beneficiaries

Generally speaking, beneficiaries and successor beneficiaries will want to leave funds inside an inherited Roth IRA for as long as possible. For many in a SECURE Act world, that will be 10 years following the end of the year of death. Here’s a quick example of how that works: Joe dies on August 1, 2023. His 10-year beneficiary has until the end of the 10th year following his death, December 31, 2033, to empty the Roth IRA he inherits from Joe.

Of course, tax is just one consideration. If the money is needed sooner than that, at least the beneficiary knows that the distribution is tax-free in all but the rarest of situations.

As discussed above, beneficiaries should understand how long the owner had any Roth IRA. Once the beneficiary is sure 5 years have passed since January 1st of the year of the original owner’s first contribution, he or she can take Roth earnings out of the inherited Roth IRA and know that it is tax free. Even if the Roth IRA is less than 5 years old, the beneficiary can take old contributions and conversions tax free. Such amounts come out first under the ordering rules prior to the removal of any earnings.

SECURE 2.0 529-to-Roth IRA Rollovers

Below I’ll discuss the ins and outs of the new SECURE 2.0 529-to-Roth IRA rollover provision. While an understanding of the details is great, the more important issue is this: does this new rule fundamentally change financial decision making and planning?

UPDATE 1 March 1, 2024: There are now significant doubts as to the validity of SECURE 2.0, including the 529-to-Roth IRA rollover provision. See my YouTube video on a very important court decision that puts SECURE 2.0 on very shaky ground (though it is still the law of the land as of March 1, 2024).

UPDATE 2 March 1, 2024: As of now, the IRS and Treasury have not issued significant guidance on the 529-to-Roth IRA Rollover. Thus, many questions remain on how it works.

529-to-Roth IRA Rollover Introduction

SECURE 2.0 has a special rule (see Section 126 on page 2161), first effective in 2024, allowing a tax-free transfer of money inside a 529 to a Roth IRA. This provision has been met with some unbridled enthusiasm that, to my mind, should be scaled back.

Before we get started, it’s important to note that (i) this is a very new rule and (ii) at any time the IRS and Treasury could issue guidance concerning this new rule. For both those reasons, everything discussed in this post is subject to change.

The above said, let’s discuss the parameters of this new rule, adding in the context of the already existing Section 529 rules.

First, consider the statutory definition of a 529. From Section 529(b)(1)(A)(ii): an account which is established for the purpose of meeting the qualified higher education expenses of the designated beneficiary of the account.

Second, we must consider Section 529(b)(6):

(6)Prohibition on excess contributions

A program shall not be treated as a qualified tuition program unless it provides adequate safeguards to prevent contributions on behalf of a designated beneficiary in excess of those necessary to provide for the qualified higher education expenses of the beneficiary.

To my mind, the combination of these two rules* and how the IRS views them in a new environment where money can go tax-free from a 529 to a Roth IRA tamps down on any affirmative planning to stuff 529s with a primary purpose of getting money into Roth IRAs. I would not be surprised to see the IRS and Treasury come out with regulations more explicitly prohibiting stuffing 529s in this way.

*See also page 5 of the preamble of the never-finalized proposed 529 regulations stating that a 529 is “an account established exclusively for the purpose of meeting qualified higher education expenses of the designated beneficiary.”

What I believe is very much allowed is parents rounding up when funding a child’s 529. The above-cited Section 529 language should not be read to require parents to be conservative when funding 529s. Future higher education expenses are quite speculative. What will future college tuition be? Will the child go to grad school? Will the child graduate undergrad 3 years, 4 years, or 5 years? Will the child get scholarships?

529-to-Roth IRA Rollover Details

First, the rule provides that, in any year, the beneficiary of the 529 can be given up to the annual maximum allowed Roth IRA contribution as a Roth IRA contribution from the 529. If done, the contribution from the 529 becomes the beneficiary’s annual Roth IRA contribution for the year. Thus, this new rule does not create additional Roth IRA limits for the beneficiary.

One advantage is that the contribution is not subject to the Roth IRA MAGI limits. This advantage is not all that great, considering most young adult beneficiaries will not earn income exceeding the Roth IRA MAGI limits. Even if the beneficiary is very high income, he or she may be able to use the Backdoor Roth IRA to get around the MAGI limits.

Second, in order to execute this maneuver, the 529 must be at least 15 years old, and the amount contributed is limited to the amount of contributions (and earnings attributable to those contributions) occurring at least 5 years prior to the transfer to the Roth IRA. The 5 year rule defeats the idea of “oh, my daughter’s a senior in college, let me contribute $30K to her near-empty-529 and now have runway to make 5 annual Roth IRA contributions for her for her first 5 years after college graduation.”

Third, the total that can be transferred to the beneficiary’s Roth IRA is $35,000. The $35,000 is not adjusted for inflation, significantly limiting the benefit of this new rule.

As a planning tool, this technique is quite limited because the technique does not create any new Roth IRA contribution limitation. The new rule does not, generally speaking, increase Roth IRA contribution limits. Further, parents thinking of supporting young adult children can simply gift their adult children their annual Roth IRA contribution out of Mom and Dad’s bank account.

529 Rollovers as Roth Contributions and Roth Earnings

The new 529-to-Roth IRA maneuver preserves earnings in the 529 as “earnings” inside the Roth IRA. I refer to this as the “earnings-to-earnings rule.” This impacts how any future nonqualified withdrawals are made from the Roth IRA. From the now adult child’s perspective, a regular annual Roth IRA contribution is better than a 529-to-Roth rollover, because the 529-to-Roth rollover limits how much of the contribution is easily withdrawn as a return of prior contributions.

Here are two examples to illustrate the concept:

Example 1: Mark graduated college and started his first full time job in 2024. He contributes $6,500 to a Roth IRA for 2024. If Mark ever has an emergency, he can withdraw the $6,500 from the Roth IRA at any time for any reason tax and penalty free.

Example 2: Julile graduated from college and started her first full time job in 2024. Her father named her the beneficiary of a 529. Assuming the 15 year rule and the 5 year rule are satisfied, her father can direct $6,500* from the 529 to Julie’s Roth IRA for 2024. At the time of the transfer, the 529 consisted of $30,000, $15,000 of previous contributions and $15,000 of earnings. The $6,500 goes into the Roth IRA as $3,250 of contributions and $3,250 of earnings. Assuming Julie has made no other Roth IRA contributions, the most she can withdraw from the Roth IRA tax and penalty free for any reason prior to age 59 1/2 is $3,250.

*Note the 2024 Roth IRA contribution limits have not been published as of this writing. This uses the 2023 contribution limit as the 2024 contribution limit for illustrative purposes only.

The earnings-to-earnings rule makes sense to (somewhat) protect the 529 earnings rule. If 529 rollovers went into Roth IRAs entirely as contributions, the 529-to-Roth maneuver could be used to bail out 529 earnings by rolling to a Roth IRA and then immediately withdrawing, taking advantage of the Roth IRA nonqualified withdrawal rules to get the 529 earnings out tax free.

The above said, the hope for most receiving the benefit of the 529-to-Roth IRA rollover is that they do not make withdrawals from their Roth IRA for many years, making the new earnings-to-earnings rule mostly academic.

Sean’s Take

So how do I view the 529-to-Roth IRA rollover? I view this as a helpful, though quite limited, bailout technique for overfunded 529s. As a bailout technique, it’s a nice tool to have in the toolbox. The people who should be happy about it are those parents/grandparents with either a student in college today and/or a recent graduate and an overfunded 529.

The above said, the 529-to-Roth IRA is not a technique that provides much, if any, value from a planning perspective. I do not believe that this new maneuver significantly impacts financial planning for most parents, as I don’t believe it makes the 529 all that much more attractive.

Compare (i) 529s and this provision with (ii) simply investing money in taxable mutual funds and then using that money to fund a child’s college education and giving them $35K to be invested in Roth IRAs as a young adult. Yes, the 529 plus the 529-to-Roth is better than using taxable accounts, but not by enough for me to get very excited. Remember, in the FI community, the primary goal is not to optimize your child’s tax situation. Rather, for most parents, the primary goals are to secure Mom & Dad’s financial independence and be sure that Junior never has to worry about Mom & Dad’s financial security during Junior’s adulthood.

The availability of the 529-to-Roth rollover reduces concerns about overfunding a 529, but only modestly so. Even with this new rule, I believe two things are true. First, most young parents should focus on building up their own financial assets instead of funding 529s. The availability of this new rollover does not significantly change planning for young parents, in my opinion.

Second, those parents with extra money in 529s after a child graduates college should still consider changing beneficiaries to younger children or grandchildren primarily, and use the new 529-to-Roth IRA bailout technique as an alternative if no other beneficiary needing tuition assistance is readily available. To my mind, if there’s a successor beneficiary readily available, changing the beneficiary will usually be the preferable option, as it can be done instantaneously without worrying about limits and holding periods, and there’s no need to coordinate with the Roth IRA’s financial institution.

529 Seasoning

Some are discussing new parents opening a 529 at birth just to season the account so the account qualifies for the 529-to-Roth IRA maneuver sooner rather than later (before the child’s 16th birthday). As I believe young parents should be focused (financially) on securing their own financial future, I do not believe it should be a priority to do this. My (financial) hope for most young parents is that they first secure their own financial future during their child’s childhood.

If the parents’ financial future is secured by the time the child is in high school, the parents can start 529 funding to grab some state tax deductions or credits (if applicable). In such cases, when the funding occurs closer in time to college, it should be much easier for the parents to “right size” the 529 such that it is not overfunded for college. In those cases, any small remaining 529 balance can be bailed out by changing the beneficiary or using the 529-to-Roth IRA maneuver, even if it does take a few more years to satisfy the 15 year rule.

In addition, what’s the rush? So what if you have to wait 10 years until after Junior graduates college to execute the 529-to-Roth IRA rollover? In those 10 years you get tax free growth, and even if Junior has become the CEO you can still execute the maneuver, since the annual contribution MAGI limit has been eliminated for those doing the 529-to-Roth IRA rollover.

The downside of foregoing several years of pre-graduation seasoning is that additional time could cause growth such that the total in the 529 exceeds $35K by the time the 15 year clock is satisfied. I’d argue a 529 established much closer to the beginning of college is less likely to be significantly overfunded, mitigating this downside concern.

Multiple Beneficiaries

I think multiple beneficiary planning for the 529-to-Roth IRA maneuver is going to be very challenging. Consider the following situation:

Example 3: Dad owns a 529 and Son, age 21 is the beneficiary. Dad has paid for Son’s first three years of college through the 529. Daughter, age 25, is already a college graduate and in the workforce. If Dad’s 529 is now worth $100,000, in theory Dad could do a partial rollout of $30,000 to a 529 naming the Daughter as beneficiary with an eye towards the 529-to-Roth IRA rollover for Daughter’s benefit. However, remember the 15 year rule. The new 529 could not seed Daughter’s Roth IRA until Daughter is age 40. Further, if Daughter never uses any of the money for qualified educational expenses, the account is likely to run into issues being a valid 529.

529 plans cannot have multiple beneficiaries. This alone makes split-up planning for the 529-to-Roth IRA maneuver quite difficult. That said, if Daughter attended a year of graduate school at age 27 largely funded by this new 529, then Dad’s maneuver works, though remember that Daughter can only get the money into her own Roth IRA starting at age 40.

Starting with Owner as Beneficiary

Some might consider a parent opening a 529 before the child is born naming the parent as both owner and beneficiary. After 15 years, the parent can make annual 529 to Roth IRA rollovers to their own Roth IRA. Once the $35K maximum has been hit, the parent could then change the beneficiary to a child. Considering the 529 statutory language discussed above, I don’t believe that is a wise course of action. Such a course risks 529 account disqualification unless the IRS and Treasury come out with rules affirmatively blessing it. Further, all that’s been saved is tax on interest, dividends, and capital gains of $35,000 of Roth IRA contributions. Under today’s investment friendly tax rules, that will not be very much tax.

Don’t Plan on Using the 529-to-Roth IRA Maneuver if You Aren’t Going to College

The online world is full of scuttlebutt, and already I have seen social media posts inquiring as to whether adults should fund 529s for themselves with the idea of funding them today and starting 529-to-Roth IRAs rollovers 15 years later. I do not believe this is a wise course of action.

Based on the language in Section 529 quoted above, I am highly skeptical of planning to put money into the 529 looking to get it into a Roth IRA. Sorry to all those 40-somethings out there thinking about throwing $20,000 into a 529 to fund their Roth IRA annual contributions in their 50s and 60s.

Even if Congress were to change Section 529 tomorrow and explicitly allow 529 stuffing to get money into a Roth IRA, I don’t believe it makes much sense to affirmatively look to use a provision like this. It doesn’t increase the limit for Roth IRA contributions. If one is working 15 years from now, they will probably have the cash flow to fund their Roth IRA. Why do they need to invest through a 529 and get a very small tax break on the money for the 15+ years beforehand? Further, what if they aren’t working and don’t have compensation income in 15 years?

Without compensation income (or spousal compensation income), one cannot make a Roth IRA contribution (whether from their bank account or from a 529). At that point the money might be trapped inside the 529, and withdrawable only if the owner is willing to pay ordinary income tax and the 10 percent penalty on distributions of earnings.

Changing the Beneficiary to the Owner

Considering the language in Section 529 discussed above, I doubt the IRS will allow middle-age 529 owners whose schooling is far behind them to change the 529 beneficiary to themselves and then do the 529-to-Roth IRA maneuver. Yes, the IRS and Treasury may allow the successor beneficiary to step into the 15 year clock of the original beneficiary. But if the middle-age owner becomes the beneficiary, the 529 is no longer for the beneficiary to use for qualified educational expenses. At that point, it appears that there is a high risk the account may cease to be a good 529. If the owner then executes the rollover maneuver and their MAGI exceeds the annual Roth IRA contribution MAGI limit, they create an excess contribution to the Roth IRA.

It’s possible that the IRS will view this differently, but I would not count on it. Until the IRS and Treasury come out with more definitive guidance, I would expect that the benefit of this new rollover maneuver will largely be limited to those who completed their college education after the funding of a 529 for their benefit.

Changing the Beneficiary and the 15 Year Clock

Does changing the beneficiary on a 529 reset the 15 year clock?

My hope is that the IRS and Treasury allow a successor beneficiary to inherit the holding period the original beneficiary had. My view is that the IRS and Treasury are protected by the statutory language requiring 529s to be for the educational expenses of the beneficiary. If the successor beneficiary plans on using the 529 money only for their Roth IRA, the 529 can be disqualified. But if the successor beneficiary uses some of the money for education and then has leftover amounts, he or she should not need to wait until the passing of a new 15 year clock to get the money into a Roth IRA.

If the IRS and Treasury are worried about abuses here, one possible compromise would be to allow the successor beneficiary to inherit the original beneficiary’s clock only if (i) the successor beneficiary is no more than ten years older than the original beneficiary and (ii) the successor beneficiary is a member of the original beneficiary’s family.

A Critical Look at the 529

Watch me discuss on the 529 on YouTube

Conclusion

For those with an overfunded 529, the new 529-to-Roth IRA maneuver is very good news. That said, to my mind, it is just another tool in the tool box. In many cases, overfunded 529s are better used for another beneficiary, such as another child or a grandchild. But still, overfunded 529s are an issue, and it is good to have another bailout tool available, particularly if there is no successor beneficiary in the picture.

I generally do not view the 529-to-Roth IRA maneuver to be a great planning tool. Generally speaking, it does not increase the amount that can go into a Roth IRA. That alone significantly diminishes its value from a planning perspective. Of course, everyone needs to do their own analysis and planning considering the particulars of their own situation.

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A Critical Look at the 529

Thanks to the SECURE 2.0 bill, it’s time for the FI community to reexamine 529 plans. This post shares my two cents on 529s in general, and specifically as applied to the FI community. The next post, dropping February 15, 2023, addresses in detail the new 529-to-Roth IRA rollover enacted in SECURE 2.0.

Financial Independence

Before we talk about 529s, we have to talk about the primary goal of financial independence. For young parents, the primary goal is to secure Mom & Dad’s financial independence.

Achieving the parents’ primary goal has an incredible secondary effect. Mom and Dad buy Junior an incredible gift by securing their own financial independence. That gift is that Junior will never have to worry about Mom and Dad’s financial security as an adult. The greatest financial gift parents can ever give their children is the parents’ own financial stability.

Second, where possible, money and financial assets should be able to support multiple financial goals. We should be at least somewhat hesitant before locking up money such that it can only support one highly specific goal without incurring a penalty.

529s

529s are tax-advantaged savings accounts generally run by states to facilitate college savings. 529s are best understood as a Roth IRA for college education with far greater contribution limits. Sure, that is an overstatement of how they work, but that gives us a good conceptual framework from which to start the analysis.

A quick note on terminology: The IRS often refers to 529 plans as “Qualified Tuition Programs” or “QTPs.” I will use the more commonly used colloquialisms, 529 and 529s.

Contributions to a 529 are not tax deductible for federal income tax purposes. At least initially, there’s no federal income tax benefit to making a 529 contribution. However, money inside a 529 grows federal and state tax-free and can be withdrawn tax-free for qualified education expenses (such as college tuition).

Contributions are generally not limited by federal tax law, though contributions above the annual exclusion gift tax limit ($17,000 per donor per beneficiary per year in 2023) generally trigger Form 709 reporting requirements (though in 99.99% of cases there should not be a gift tax liability). States generally have lifetime contribution limits per beneficiary. Usually these limits are far in excess of what one would normally need for undergraduate college tuition.

Very generally speaking, qualified education expenses can be directly paid from the 529 to the educational institution or such expenses can be reimbursed from a 529 in the year the expenses are incurred. Payments for qualified educational expenses are generally tax and penalty free. 529s do not enjoy the rather unlimited reimbursement deadline that HSAs enjoy.

529s get similar tax treatment to the federal income tax treatment in most states. However, there can be an additional benefit: an annual state tax deduction or credit for some 529 contributions to the state’s own 529 plan (note 8 states allow a 529 tax deduction or credit for contributions to other states’ 529 plans). However, for many readers this will either be irrelevant or only of minor importance. Of the four most populous states (CA, TX, FL, NY), only residents of New York can obtain an up-to $5,000 per person per year state tax deduction for contributions to a home-state 529. California has no 529 tax deduction and Texas and Florida do not have an income tax.

Okay, sounds great! Clearly there are tax benefits for 529 money used for qualified education expenses. But what about distributions that are used for anything other than qualified education expenses? Well, they are going to be subject to an income tax and likely a 10 percent penalty, in the following manner. A non-qualified distribution is deemed to come ratably out of the contributions to the 529 (tax and penalty free) and earnings of the 529 (subject to income tax and the 10 percent penalty, some penalty exceptions may apply).

Here’s an example illustrating the application of the nonqualified distribution rules:

Hal, the owner of a 529 account, takes $1,000 out of the 529 to help pay for vacation expenses. Previously, he had made $60,000 of contributions to the 529, and it had grown to $100,000 ($40,000 of earnings) prior to making the $1,000 non qualified distribution. Sixty percent of the distribution ($600) is a nontaxable return of contributions and 40 percent ($400) is subject to both income tax and a 10 percent penalty.

The taxation of non-qualified distributions is a significant drawback of using 529s.

529s and the FI Community

Let’s remember what is going on with a 529. It is a gift to the next generation. It comes with very modest tax benefits.

My thesis on the 529 is this: for most parents, including most of those in the FI community, the tax benefits offered by 529s are not sufficient to compensate for the use restrictions on 529s. Thus, my view is that 529s should generally be deployed once Mom and Dad are financially independent (or close to it), not when they are on the path to financial independence.

The idea behind the 529 is to provide tax-free growth for college savings. It solves for something that, frankly, isn’t much of a problem. Taxes are not why college is unaffordable for many Americans. College tends to be unaffordable not because investment taxes are high, but because tuition and fees are out of control.

One thing in parents’ favor when thinking about funding college educations is that income taxes on investments are relatively modest over a child’s childhood due to low long term capital gains rates and qualified dividend income rates. Hopefully, by age 22 or 23, the child’s undergraduate education is completed, providing a relatively modest investment time horizon (i.e., a modest tax exposure horizon), even if the parents start saving for college at birth.

Contrast that to the retirement time horizon of a 20-, 30- or 40-something parent saving for his or her own retirement. The money invested for retirement at age 25 might be accessed at age 60, 70, 80, or 90. Compared to educational savings, retirement savings (which are usually far greater than educational savings) are much more vulnerable to income taxes for a much longer time frame. Even at long term capital gains and qualified dividend income rates, exposing retirement savings to decades of taxation could be very expensive. Retirement savings are also exposed to tax law change risk for a much longer period of time. For example, there’s no guarantee that there will be favored long term capital gains and qualified dividend tax rates 30 years from now.

The tax risk profiles on educational savings and retirement savings are much different. Based on those risk profiles, for most I believe aggressive retirement tax planning makes sense. But I don’t see educational tax planning making as much sense, for the reasons discussed below.

Of course, tax-advantaged retirement savings can come with a juicy up-front federal income tax deduction. 529s do not offer the possibility of a federal income tax deduction, making them less impactful than tax-advantaged retirement savings regardless of the time frame involved.

Young Parents and 529s

Let’s consider young parents. Say Junior is born when Mom & Dad are age 30 and have saved 10 times their annual expenses in financial assets. Many, myself included, would say Mom and Dad are doing well with their finances. Here’s where I diverge from some others in the personal finance space: I would not recommend Mom & Dad save in a 529 shortly after Junior’s birth.

Notice I’m not saying Mom & Dad should not pay for Junior’s college. What I’m saying is Mom and Dad should stay flexible for their own financial future.

What’s so horrible about Mom & Dad starting to save for Junior’s college in a taxable brokerage account under their own names? At birth, they have no idea if Junior will get a scholarship, go to trade school, how Mom & Dad’s finances will be when Junior is ready to go to college, etc. By saving in financial assets that are in their own names–perhaps mentally segregated as potentially being for Junior’s college–Mom & Dad maintain great flexibility without sacrificing too much tax benefit.

If Junior gets a scholarship, great, the financial assets stay with Mom & Dad. If Mom & Dad are not financially successful when Junior goes to college, great, the financial assets can support Mom & Dad and Junior can figure out other ways to pay for college.

The Value of the 529’s Tax Benefits

How bad is the tax hit on holding investments for a child’s college education? Imagine owning a 60 / 40 equity to bond portfolio of $100,000 for a child’s college education. If held in the parents’ taxable brokerage account, how much taxable income might that generate annually? Very roughly, if dividend yields are 2 percent, the $60,000 in equities would produce $1,200 of dividend income, most of which is likely to qualify for qualified dividend income tax rates. The $40,000 of bonds would produce $1,800 of ordinary income at a 4.5 percent yield.

Is it desirable to add $3,000 of income to Mom and Dad’s tax return? Surely not. Cataclysmic? Also surely not.

Consider what a small amount of additional taxable income buys. If the money is held in the parents’ names, it can be used for anything without penalty. Perhaps Mom and Dad have not been financially successful. That $100,000 could help the parents achieve their own financial goals and retirement. What if the child gets a scholarship and does not need much in the way of tuition assistance from his or her parents? What if the child doesn’t go to college?

In exchange for paying tax on $3,000 of income annually (some of it at tax-favored QDI rates), and some long term capital gains when used to pay tuition, Mom and Dad have incredible flexibility with the $100,000. Maybe $50,000 goes for Junior’s college tuition, and $50,000 goes for Mom and Dad’s retirement. Further, for many it won’t be $3,000 of income annually. It will take most parents years before they could accumulate the sort of balance that would generate $3,000 of taxable income from educational savings. Thus, the tax hit for not using the 529 is likely to be that much less in the years well before the child is close to college age.

Outside of the handcuffs of the 529, assets can support multiple financial goals. Even better, as one financial goal is met, the money can be shifted to support another financial goal. Perhaps Mom and Dad are behind in their own savings when Junior is age 10. But things go well, and when Junior turns 16 Mom and Dad have wealth in excess of their FI number. In that case, money that might have been needed for the parents’ retirement now can be used for college tuition.

Use Restrictions

We need to consider the use restrictions on 529s. If not used for qualified education expenses, the growth is subject to both ordinary income tax and usually the 10 percent penalty.

Compare the tight use restrictions on 529s to the use restrictions on the other most prevalent tax baskets: taxable accounts, traditional retirement accounts, Roth accounts, and health savings accounts. Generally speaking, all of them (even HSAs) are not use-restricted or only partially use-restricted. All four of those tax baskets have a significant advantage over 529s in terms of use restrictions.

In many cases, I believe that the 529’s significant use restrictions are not adequately compensated by its tax advantages.

The 529 has rather onerous time restrictions, as distributions of earnings are generally subject to tax and the 10 percent penalty in those years there are no qualified education expenses.

Feeding the Beast

As much as we might want to, we can’t turn a blind eye towards hyperinflation in college tuition. With that in mind, shouldn’t we ask: Isn’t a hyperfocus on college savings feeding the beast?

It’s time to scrutinize American higher education. It’s not good for the country to have students graduating with mountains of debt. This is happening for many reasons, including significant administrative bloat in higher education. Clearly, American higher education is failing too many of its students. Is now the time to set aside money to pay American colleges and universities?

I get it: no one reader funding a 529 is the cause of the problems of American higher education.

But, if I’m a university used to collecting soaring tuition and fees, I’m all for 529s. 529s subsidize what has become bad behavior by university administrators. Less focus on 529s helps move the needle towards universities needing to act responsibly in order to attract students.

Camilla Jeffs raises an interesting point on her LinkedIn page: Part of the reason college is so expensive is because in many cases the customer (the student) does not bear the cost. 529s feed into that problem. Camilla’s recent podcast episode on 529s is also full of good food for thought.

529 Use Cases

The above limitations of the 529 noted, I do believe there are good use cases for the 529. These cases assume that the parents have decided to pay for their child’s college education.

Financially Independent Parents

Joe and Sally are married and 45 years old. They have saved 30 times their annual expenses in retirement accounts and taxable brokerage accounts. They have a 10 year old daughter they are reasonably sure will go to college, and they would like to pay for her college education.

This is a great use case for the 529. Mom and Dad’s financial future largely secured (generally speaking), it’s time to focus on (i) college savings, since they want to pay for college, and (ii) tax planning. Joe and Sally, already holding substantial taxable brokerage accounts, benefit from saving through the 529 so they avoid adding more dividend, interest, and capital gains income to their annual tax return.

Capturing State Tax Benefits

Aaron and Amanda are married and are 50 years old. They have saved 20 times their annual expenses in retirement accounts and taxable brokerage accounts. They have stable jobs. They have a 16 year old son who is very likely to go to college. Aaron and Amanda want to pay for their son’s college education. Since they live in New York State, if they contribute $10,000 annually to the New York 529 for his benefit ($5K each), they get an annual $10,000 state tax deduction on their New York state income tax return.

Aaron and Amanda are not financially independent by many metrics, but they are doing pretty well, and are likely (though not guaranteed) to be financially successful. In their case, paying for college is not financially ruinous. If Aaron and Amanda are going to pay for college, they might as well utilize the 529 annually to scoop up state tax deductions, particularly in a higher income tax state like New York. Further, beginning the 529 much closer to the start of college decreases the odds that the 529 will become over funded.

Contrast Aaron and Amanda to parents of newborns. Newborns’ parents are closer to the beginning of their financial journey. In most such cases, state tax benefits would not, in my opinion, be valuable enough to justify the use restrictions on 529 contributions.

Conclusion

My view is that the detriments of the use restrictions on 529s are not adequately compensated by the federal and state tax advantages offered by 529s in most cases. That’s certainly not to say there are not good use cases for the 529, but my view is that most parents should prioritize saving in their own names (even in taxable accounts) before making contributions to 529 accounts.

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

Follow me on Twitter: @SeanMoneyandTax

Health Savings Accounts and Las Vegas

Want to make a bad financial decision? I’ve got an account that can help you do that tax and penalty free!

Of course, I do not recommend making bad financial decisions. However, at times it is useful to look at extremes to help us better understand and analyze financial planning alternatives.

Health Savings Accounts

If you’ve spent any time on my blog or YouTube channel, you’re probably aware that I’m fond of HSAs. Contributions are tax deductible (or excludable if made through payroll withholding). Amounts inside the HSA grow tax free. Withdrawals for qualified medical expenses, or reimbursements of qualified medical expenses, are tax and penalty free.

As long as the HSA owner is alive, he or she can reimburse themselves from the HSA for qualified medical expenses incurred after they first owned an HSA. Generally speaking, there’s no time limit on HSA reimbursements, other than the owner must be alive to receive the tax and penalty free reimbursement. See “Distributions from an HSA” on page 9 of IRS Publication 969 and Notice 2004-50 Q&A 39.

HSAs are great because they combine the best feature of a traditional retirement account (deduction or exclusion on the way in) with the best feature of a Roth retirement account (tax free treatment on the way out). Further, the lack of a time limit on reimbursements from an HSA provides the owner with tremendous flexibility in terms of deciding when to take tax and penalty free distributions.

Health Savings Accounts PUQME

Previously Unreimbursed Qualified Medical Expenses (PUQME, pronounced “Puck Me”). HSA owners can reimburse themselves tax and penalty free from their HSA up to their amount of their PUQME. PUQME includes qualified medical expenses of the owner, their spouse, and their dependents incurred after the HSA was first established. Qualified medical expenses deducted as an itemized deduction on a tax return (quite rare) do not qualify to be reimbursed from an HSA and thus are not PUQME. PUQME is a technical term I made up. 😉

Restricted Accounts

When we think about taxable brokerage accounts, traditional retirement accounts, Roth retirement accounts, HSAs, and other available options, we should consider the restrictions in place on the use of the funds. The more restrictions in place, the worse the account.

Time Restrictions

Taxable accounts, traditional retirement accounts, and Roth retirement accounts face various time restrictions on withdrawals. For example, taxable accounts qualify for favored long-term capital gains rates if held for a year. Of course, that restriction is academic if there’s a loss or no gain in the account.

Traditional retirement accounts suffer the most stringent time restrictions. Withdrawals occurring prior to the owner turning age 59 ½ are usually subject to the 10 percent early withdrawal penalty. Roth IRAs are not all that time restricted, as amounts withdrawn prior to age 59 ½ are deemed to first be nontaxable withdrawals of prior contributions. Roth 401(k)s can be somewhat time restricted, as amounts withdrawn prior to age 59 ½ are partially deemed to be withdrawals of taxable earnings (usually subject to the 10 percent early withdrawal penalty).

HSAs are somewhat time restricted, though like Roth IRAs, they are not severely so. Once one has PUQME after having opened an HSA, he or she can withdraw money (up to their PUQME amount) from the HSA tax and penalty free.

Use Restrictions

Taxable accounts, traditional retirement accounts, and Roth retirement accounts are great in that they have absolutely no use restrictions. The government does not care what you spend the money on. The tax result is, at least generally speaking, unaffected by use.

There are some exceptions, such as the exceptions to the 10 percent early withdrawal penalty such that early withdrawals from retirement accounts can qualify to avoid the 10 percent penalty. Further, one might say that because of qualified charitable distributions, using traditional IRAs for charitable purposes is use-favored. The above exceptions noted, as a general rule, use does not significantly change the taxation of withdrawals from taxable accounts, traditional retirement accounts, and Roth retirement accounts.

HSA Use Restrictions

HSA distributions that are not used for qualified medical expenses are subject to both income tax and a 20% penalty if the owner is under age 65.

However, recall that there is no time limit on the ability to reimburse oneself tax and penalty free for previously incurred qualified medical expenses. As a practical matter, the lack of time limit results in relatively modest use restrictions on an HSA. Below I’ll illustrate that with an extreme example.

HSAs and Las Vegas

Perhaps you’re yearning for the hot sand, broken dreams, and $5 lobster of Las Vegas. Could an HSA help? Let’s explore that possibility.

Peter, age 70, wants a weekend getaway in Las Vegas. Between a hotel suite, comedy club tickets, airfare, steak dinners, some Texas Hold’em poker, and the breakfast buffet, he estimates it will cost him $10,000.

Peter was covered by a high deductible health plan from age 55 through age 65. He maxed out his HSA annually during that time, and he has never taken a distribution from his HSA. The HSA is now worth $50,000, and between age 55 and today Peter has $30,000 of PUQME.

Could Peter use his HSA to pay for the weekend? Absolutely!

Wait a minute, Sean. Vegas isn’t a qualified medical expense! Sure, it isn’t. But Peter has $30,000 of previously unreimbursed qualified medical expenses. He can take out $10,000 from his HSA tax and penalty free and use it to buy poker chips in Las Vegas. Once an HSA owner has previously unreimbursed qualified medical expenses, they generally do not have an HSA use restriction up to the level of that PUQME.

As a practical matter, even the healthiest Americans are eventually going to have qualified medical expenses. As a result, most HSA owners will have runway, particularly in retirement, to reimburse themselves for previously incurred qualified medical expenses. That reimbursement money is in no way use restricted–it can go for a weekend trip to Vegas if the HSA owner desires.

HSA Planning Risk

But Sean, there’s no way Congress won’t close the loophole! Surely, at some point in the future, Congress will time-limit tax and penalty free reimbursements from HSAs.

I don’t think so, for three reasons.

First, the HSA loophole is not that great. Consider the relatively modest HSA contribution limits. Sure, the government loses tax revenue due to HSAs, but it isn’t that much, particularly compared to vehicles such as Roth IRAs. Further, HSAs are, at most, a loophole during the owner’s lifetime and the lifetime of their surviving spouse. That’s it!

Left to a non-spouse, non-charity beneficiary, the entire HSA is immediately taxable income (typically at the beneficiary’s highest tax rate) in the year of the owner’s death. Death not only ends the loophole, it gives the government a significant revenue raiser by taxing the entire amount at ordinary rates on top of the inheriting beneficiary’s other taxable income.

Second, I suspect Congress wants taxpayers to bailout HSA money tax and penalty free prior to death. The immediate full taxation of HSA balances in the year of death is going to come as a nasty surprise to many beneficiaries.

Imagine significant taxes and perhaps dealing with the paperwork and hassle of reversing what becomes an excess contribution to a Roth IRA because of a surprise income hit due to the death of a loved one. Here’s what that could look like.

Mark and Laura are married and both turn age 47 in 2023. They anticipate about $200,000 of MAGI in 2023, in line with their 2022 income. Expecting their 2023 income to fall well within the Roth IRA modified adjusted gross income limits, each contributes $6,500 to a Roth IRA for 2023 on January 2, 2023. In September, Laura’s father passes away and leaves her an HSA worth $50,000. The HSA inheritance increases their 2023 MAGI to $250,000. The federal income tax hit on inheriting the HSA will be over $10,000.

As a result of their increased income, Mark and Laura are now ineligible to have made the 2023 Roth IRA contributions. The most likely remedial path involves Mark and Laura working with the financial institution to take a corrective distribution of the contributions and the earnings attributable to the contributions. The earnings will be included in Mark and Laura’s MAGI for 2023 as one last insult to inheriting a fully taxable HSA.

This is a lurking issue. If Congress puts 2 and 2 together, they will hope that HSA balances are small at death so as to avoid their constituents suffering a large, unexpected tax bill related to a loved one’s death. Time-limiting tax and penalty free HSA reimbursements would keep more money inside HSAs during an owner’s lifetime (and thus, at their death). At death, this would set up more beneficiaries to have nasty surprises when inheriting an HSA, a fate Congress most likely wants to avoid.

Third, time-limiting HSA reimbursements will go counter to the reason HSAs exist in the first place: to encourage the use of high deductible health plans. Time-limiting HSA reimbursements could trap amounts inside HSAs because taxpayers would lose amounts they could withdraw from the HSA without incurring tax (and a 20 percent penalty if under age 65). If taxpayers believe HSA money could become trapped, fewer will opt for a high deductible health plan. This will lead to increased medical costs as more and more Americans have lower deductibles and become sensitive to medical pricing.

Surviving Spouse’s HSA PUQME

I prepared a short 1-page technical write up providing my views on how previously unreimbursed qualified medical expenses are computed when a spouse inherits a health savings account.

HSA Resource

Kelley C. Long recently authored an excellent article on HSAs in the Journal of Accountancy.

Conclusion

Here’s hoping that you don’t take away the conclusion that HSA owners should spend their HSA money in Las Vegas!

Rather, my primary conclusion is that investments and tax baskets should be assessed considering their time and use restrictions. The fewer the time and use restrictions, the better. Of course, time and use restrictions are not the only factors to consider, but they are significant factors.

Secondary conclusions include (i) the HSA tends to be very flexible and (ii) the tax breaks available to HSA owners are not likely to be repealed or limited by Congress anytime soon.

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

Follow me on Twitter: @SeanMoneyandTax

Emergency Access to Retirement Accounts

The newly passed SECURE Act 2.0 has put a renewed focus on the use of retirement funds to cover pre-retirement emergencies. This post discusses the options available with respect to using tax-advantaged retirement accounts to fund emergency expenses.

To my mind, there are five primary ways to use retirement funds to pay for emergencies. Considering the complexities of our tax system, I don’t claim this covers every possible situation, but it does highlight the most readily available ways of using retirement funds for pre-retirement emergencies. For purposes of this post, a “pre-retirement emergency” is an emergency that occurs prior to turning age 59 ½.

ONE: Direct Distribution from a Non-Roth IRA Retirement Account

In theory, one can pay for emergencies from their non-Roth IRA retirement accounts. To my mind, this tends to be the worst way to use a retirement account to pay for a pre-retirement emergency. At least initially, the withdrawal will be subject to both the income tax and the 10 percent early withdrawal penalty. California residents can add an additional 2.5 percent early withdrawal penalty.

There are exceptions to the penalty, and the IRS maintains a website detailing them.

One practical consideration: 401(k)s and other qualified workplace retirement plans tend to limit or restrict in-service withdrawals, so the money may not be readily available if needed in an emergency. Traditional IRAs tend to be rather readily available, so long as the money is invested in relatively liquid assets and/or easily sold financial assets.

From traditional retirement accounts, the withdrawal is taxable and then the question becomes does one of the penalty exceptions apply. However, there is a way to avoid taxation and the penalty: putting the money back into a retirement account within 60 days. First off, one facing an emergency may not have the liquidity to return the money in 60 days even if they want to. Second, 60 day rollovers between IRA accounts are limited to once every 12 months. As a general rule, I recommend avoiding 60 day rollovers to keep that option open if money ever came out of an IRA for whatever reason.

If liquidity is not an issue within the 60 day rollover period, one way to avoid the once-per-year rule on a distribution from a traditional IRA is to rollover to a Roth IRA (essentially, a Roth conversion). This might make sense when one takes an emergency withdrawal from a traditional IRA within 12 months of a previous 60 day IRA-to-IRA rollover. In such a case, if the person cannot roll the money into a workplace retirement plan, the only options are (i) keep the money and pay income tax and likely the 10 percent penalty or (ii) convert over to a Roth IRA, get tax free growth in the future, and only pay the income tax. Roth conversions always avoid the 10 percent early withdrawal penalty.

3 Year Pay Back

SECURE 2.0 has changed the landscape in terms of refunding pre-retirement emergency withdrawals. In some limited situations, there may be a 3 year pay back window, not a 60 day pay back window.

There are now, by my count, six provisions allowing taxpayers to pay back money distributed out of a retirement account within 3 years of the withdrawal. Please note that I and others are still digesting SECURE 2.0, so the below is intended only as an initial, introductory primer.

Qualification for the 3 year pay back is good because it generally means (i) no 10 percent penalty on the initial withdrawal and (ii) the money can be refunded to the retirement account within 3 years, resulting in (a) a refund of the income tax paid on the distribution and (ii) keeping the money growing tax-deferred (or tax-free for Roths) for retirement.

Please note that each of these is quite narrow. Despite the limited availability, in cases where a taxpayer has taken out a significant amount of money from a retirement account in an emergency, these rules should be reviewed to see if the taxpayer could qualify to avoid the 10 percent penalty and later get the money back into the retirement account and obtain a significant tax refund.

Jamie Hopkins detailed some of the new SECURE 2.0 provisions in a recent Forbes article. I’ve prepared the below chart to lay out the basics (as I understand them now) of the new 3 year pay back rules.

Provision	Effective Date	Source	Limits	Qualification
Minor Emergency Withdrawals	2024	SECURE 2.0 Sec. 115	$1,000 per year, 1 distribution per year	Expenses incurred for an emergency
Domestic Abuse Victims	2024	SECURE 2.0 Sec. 314	Lesser of $10K or 50% of account balance per year	Must be a victim of domestic abuse within the year preceding the distribution
Federally Declared Disaster Area	January 26, 2021	SECURE 2.0 Sec. 331	$22,000 limit per disaster	Must live in a federally declared disaster area and suffered an economic loss due to the disaster
Terminally Ill Individual	Enactment of SECURE 2.0	SECURE 2.0 Sec. 326	Unlimited	Must be terminally ill (generally, medicially expected to die within 7 years).
Qualified Birth or Adoption Distribution	2020	SECURE Sec. 113	$5,000 per parent per birth	Distribution must be within 1 year after birth or adoption of child
Coronavirus Related Distributions can no longer be made, but previously made CRDs can be paid back within 3 years of the distribution.

As all of the 3 year pay back provisions are new (several less than a month old as of this writing!), practitioners (myself included) are still learning about them. That learning will change when the IRS and Treasury issue regulations and/or other guidance on these new rules.

Future 3 Year Pay Back Regulations

I hope the regulations contain a waiver of excess contribution penalties when taxpayers pay back money into a retirement account and the IRS subsequently determines that the taxpayer did not qualify for 3 year pay back treatment. These provisions are complex and subjective, and it is not fair to assess an excess contribution penalty when a taxpayer’s interpretation of a complex and/or subjective provision is not the same as the IRS’s interpretation.

Further, any regulations should clarify that individual taxpayers over age 59 ½ qualify for the 3 year pay back provisions, even though they are exempt from the 72(t) penalty regardless of the application of a 3 year pay back provision.

Prior to the issuance of regulations or other guidance from the IRS and Treasury, taxpayers should proceed with caution and consult their tax advisors when applying the 3 year pay back provisions.

TWO: Plan Loans

Not available from IRAs and Roth IRAs, some employer plans allow for loans from the plan. If you read my book, you know I am generally not fond of 401(k) loans.

That said, in an emergency, if the plan allows it, a loan can be a tax-free way to access retirement account funds and later replenish them. Loans are generally limited to the lesser of half the account balance or $50,000 and require the payment of interest to the 401(k). One advantage of plan loans is that they can be spent on anything without restrictions.

I do not like relying on plan loans for several reasons. First, 401(k)s plans do not have to offer loans. Second, if the employee leaves the employer, the loan becomes due, and failure to repay it results in the entire outstanding balance becoming taxable income and is likely subject to the 10 percent early withdrawal penalty. Ouch! Third, the interest paid to the 401(k) is double taxed, as there’s generally no tax deduction for the payment of interest to the 401(k), and later in life the interest will be taxed to the 401(k) account owner when withdrawn or Roth converted.

THREE: SECURE 2.0 Minor Emergency Withdrawals

As mentioned in the chart above, Section 115 of SECURE 2.0 allows, beginning in 2024, one annual up-to $1,000 penalty free distribution from retirement accounts for an emergency. I refer to these as minor emergency withdrawals.

The distribution will be taxable if from a traditional retirement account. Further, the $1,000 withdrawn can be refunded into the retirement account up to 3 years from the original distribution. Refunding the distribution will allow the taxpayer to amend any tax return reporting the distribution as taxable income and obtain a refund.

As a practical matter, I suspect that most minor emergency withdrawals will come from traditional IRAs and Roth IRAs, as accessing money from them tends to be far easier than accessing money from workplace retirement accounts such as 401(k)s while someone is still working at the employer.

I previously Tweeted about this provision. Obviously, this provision is very limited as it is capped at one distribution per year and $1,000 per distribution. Here’s hoping everyone only faces emergencies costing $1,000 or less!

In theory, there’s a risk when taking a minor emergency withdrawal. What if the IRS disagrees with your view that you had an emergency? The IRS could (i) assess the 10 percent penalty on the distribution, (ii) deny any claimed tax refunds for repayments of the minor emergency withdrawal, and/or (iii) assess a 6 percent (per year) excess contribution penalty for repayments of the withdrawal back into the retirement account.

The IRS and Treasury will have to issue regulations defining emergency for this purpose. My hope is that they will define emergency quite broadly, which it appears Congress intended based on the wording of Section 115. Hopefully, the IRS and Treasury decide they want to limit fights with taxpayers over $1,000 distributions. The regulations should take the approach that anything that could plausibly be viewed as an emergency will count as an emergency for this purpose. Further, it would be very useful if the regulations contained safe-harbors and waive excess contribution penalties in cases where taxpayers wrongly believed they qualified as having an emergency.

FOUR: SECURE 2.0 401(k) Emergency Savings Accounts

Section 127 of SECURE 2.0 establishes a relatively limited emergency savings account as part of a 401(k) or other workplace retirement plan. It is the employer’s option to add this to their retirement plan, and this cannot be added until 2024 (see page 2199 of the Omnibus Bill text). These are not available from traditional IRAs and Roth IRAs.

For the reasons discussed below, I suspect very few plans will add this feature, and very few employees will want to use this account.

The account must be a Roth 401(k) (or other Roth employer account) and generally can only invest in cash and cash-type assets in order to preserve purchasing power. Employees’ unwithdrawn contributions cannot exceed $2,500, and highly compensated employees (those employees who made more than $150,000 in wages in the previous year) cannot contribute to the account.

From the employee’s perspective, these accounts are generally undesirable. The tax shelter is minimal: Roth treatment on cash accounts of no more than $2,500 of contributions. Sure, withdrawals are fully tax-free, but all that’s been saved is the tax on the interest income. In theory, one would want to contribute to one of these accounts to have more contributions that can get employer matches into their 401(k), but many participants have both the smarts and the liquidity to capture the entire employer match without contributing to this account.

More importantly, in an emergency situation, (i) $2,500 only goes so far and (ii) you probably do not want the hassle of dealing with your workplace 401(k) plan administrator. “In-service withdrawals” from 401(k)s are notoriously cumbersome. From a user-experience perspective, I strongly suspect emergency access to cash in a checking account or online savings account the owner controls will usually be much better than using money inside an employer’s 401(k) plan.

One advantage of these accounts is that there is no “emergency” requirement for withdrawals. The employee can withdraw the money for any reason. Another advantage is that, in theory, this creates head room for getting $2,500 more (plus interest) into Roth accounts. If not used, the balance can be rolled into the regular Roth 401(k) when the employee leaves employment. See page 2130 of the Omnibus bill text.

As undesirable as these accounts are for employees, they are much more so from the employer perspective. Why would a retirement plan administrator want to sign up to field calls from employees for emergency distributions? If I’m a plan administrator and I want my employees to have flexibility and resources in an emergency, I don’t amend my plan document and encourage them to come to my plan when easier to use alternatives already exist (checking accounts and savings accounts). Employers adopting these accounts are signing up to become emergency distributors, which fundamentally is not what a retirement plan is. Further, the amounts involved (maximum contributions of just $2,500) and the fact that many employees, including decision makers, generally can’t be covered because of the prohibition on offering emergency accounts to highly compensated employees discourage employer plans from incurring the hassle and administrative costs to add these accounts.

Note that the emergency account feature is not available for Solo 401(k)s, because anyone owning more than 5% of a business is, by definition, a highly compensated employee, regardless of their earnings.

FIVE: Roth IRA Basis

If one wants to access retirement accounts in an emergency, my favored technique of the five discussed in this post is to use Roth IRA basis. Generally speaking, Roth IRA basis is the sum of previous annual contributions plus all previous Roth conversions, less any previous Roth IRA withdrawals.

Recall that previous annual contributions to Roth IRAs and Roth conversions that are at least 5 years old can be accessed at any time for any reason tax and penalty free. Further, withdrawals from Roth IRAs occurring prior to turning age 59 ½ access prior contributions first (until exhausted), then old conversions (first in, first out, and until exhausted), and last access Roth earnings.

As a result of this pecking order, most non qualified Roth IRA withdrawals will simply be nontaxable returns of old contributions. This makes the Roth IRA the best retirement account to use in the event of an emergency. Taking advantage of Roth basis results in no tax and no penalty, and simply requires the filing of a Part III of the Form 8606 when filing one’s tax return.

The downside of accessing Roth IRA basis is that outside of a 60 day rollover, a $1,000 refund of a minor emergency withdrawal, and/or a possible 3 year pay back, tapping Roth basis reduces the amount inside the Roth IRA growing tax free for the taxpayer’s retirement. Further, do not forget the once-every-12 months limit on IRA to IRA 60 day rollovers (including Roth IRAs) and the fact that Roth IRAs cannot be transferred to workplace retirement Roth accounts.

Roth IRA Basis and the Minor Emergency Withdrawal Rule

Starting in 2024, perhaps the best approach for those taxpayers experiencing emergencies is to combine using Roth IRA basis with the minor emergency withdrawal rule. Taxpayers making emergency withdrawals from a Roth IRA should consider refunding up to $1,000 to the Roth IRA within 3 years. From a risk perspective, this tactic is relatively low risk. Withdrawals of Roth IRA basis are tax and penalty free. The only tax risk is the 6% excess contribution penalty on putting the money back into the Roth IRA. For a non-qualifying $1,000 refund back into the Roth IRA, that penalty is only $60 annually. One would hope the IRS will not be overly strict in assessing taxpayers’ contentions that the withdrawals were in fact for an emergency.

Roth IRA Basis and Other 3 Year Pay Back Rules

In limited circumstances, one or more of the 3 year pay back rules may be available to get the money back into the Roth IRA. This keeps the money available for retirement in a tax-free account. One advantage of combining a withdrawal of Roth IRA basis with a 3 year pay back is that the IRS should not require the filing of an amended return, since no items of income, deduction, or tax should change. In theory, the IRS could require the filing of an amended Form 8606, since that form can be filed as a standalone tax return. In regulations or other guidance, the IRS and Treasury should make clear their position on what amended tax return filings are needed, if any.

Taxable Accounts

Here’s the thing. One should not look to use retirement accounts for emergency expenses. I understand that sometimes it is necessary to do so. But generally speaking, if one has adequate financial resources, they should set up a savings account to have funds available to handle emergencies. One tax benefit of doing so is that in today’s low-yield environment, a savings account can protect against emergencies without generating much in the way of taxable income.

Conclusion

The hope is tax-advantaged savings never need to be accessed in an emergency. Of course, life does not always go to hope or to plan, so there are times when retirement accounts are accessed in an emergency. Taxpayers and practitioners should research options when taking pre-retirement emergency withdrawals from tax-advantaged retirement accounts. The IRS and Treasury will (hopefully soon) issue regulations and/or other guidance on the many new SECURE 2.0 emergency withdrawal rules and pay back rules.

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

Follow me on Twitter: @SeanMoneyandTax

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

2023 RMDs and Roth Conversions

As I write this, we’re nearing the beginning of 2023. The stock and bond markets are down over the past year. For 2023, that means two things:

2023 required minimum distributions (“RMDs”) will, in many cases, be lower than they were in 2022, as 2023 RMDs are based on traditional retirement account values on December 31, 2022.
Roth conversions are now “cheaper” in a sense. 10,000 shares of XYZ mutual fund might have been worth $100,000 on December 31, 2021, but going into 2023 perhaps they are now worth only $90,000. Thus, the tax cost of converting 10,000 shares from a traditional retirement account to a Roth account is lower today than it was a year ago.

Some retirees may think that they will have lower taxable income in 2023 (due to reduced RMDs). It might occur to them to wake up on New Year’s Day and do a Roth conversion. Is that wise?

Tax Rules: RMDs Come Out First and Cannot be Converted

There are two important tax rules those 73* and older should consider when thinking about 2023 RMDs and Roth conversions. The first rule is that the RMD is the first distribution that comes out of a traditional retirement account during the year. See Choate, referenced below, page 185. All distributions are RMDs until the total RMD has been satisfied. See Choate, page 320. Further, all of a person’s traditional IRAs are treated as a single IRA for this purpose, so there’s no cherry picking that can solve this issue with respect to IRAs.

The second rule is that an RMD cannot be converted to a Roth account. See Choate, referenced below, page 320. Anyone doing a Roth conversion prior to taking an RMD generally creates an excess contribution to a Roth IRA, subject to an annual 6% penalty unless properly withdrawn.

*Note that effective January 1, 2023, SECURE 2.0 changed the age one must begin taking RMDs from age 72 to age 73.

Properly Roth Converting After Taking the RMDs

How does one avoid this fate? By properly taking their total RMD for the year prior to doing any Roth conversions. Sorry, no New Year’s Day Roth conversions.

The RMD can be taken through an actual distribution (or distributions) or through a qualified charitable distribution.

Income Risk, Reversibility, and Market Risk

In most cases, I prefer taxable Roth conversions to occur in the fourth quarter of the year. There are several reasons for this. By October or November, there is more understanding of the year’s income and deductions. By the fourth quarter there will be fewer surprises in terms of income, bonuses, unexpected gains, etc. that can occur before year-end. The later in the year the Roth conversion occurs, the less likely the risk that there’s an income spike during the year unaccounted for in the planning process prior to executing the Roth conversion.

Further, Roth conversions are irreversible. The Tax Cuts and Jobs Act eliminated the ability to reverse a Roth conversion. I don’t like the idea of locking into Roth conversions early in the year. If you win the lottery in July, you might not like that January Roth conversion 😉

Of course, there are trade-offs when it comes to delaying Roth conversions to the fourth quarter. There’s always the risk that the stock market and/or the bond market could grow between the early part of the year and later part of the year. While there is a risk the market can go down later in the year (which is favorable from a Roth conversion perspective), in theory over time one expects invested assets to grow (why else invest in them?). Thus, at least theoretically, delaying Roth conversions reduces the amount of shares that can be converted at a specified amount of Roth conversion income.

Inherited Retirement Accounts

First, one facing an RMD with respect to an inherited retirement account need not worry about taking the inherited account RMD first prior to doing Roth conversions out of their own traditional retirement accounts. Inherited retirement accounts are hermetically sealed off from one’s own retirement accounts when considering the tax ramifications of distributions and conversions from one’s own retirement accounts.

Second, generally speaking, inherited traditional retirement accounts cannot be converted to Roth accounts. There is no opportunity to convert inherited traditional IRAs to Roth IRAs.

There is one major exception to the no conversion of inherited retirement accounts rule: the ability to convert inherited traditional qualified plans (such as 401(k)s) to a Roth IRA. See Choate, referenced below, page 271. Once the inherited 401(k) money is in an inherited traditional IRA, the Roth conversion opportunity is gone. But, the beneficiary can elect to have the 401(k) or other qualified plan transfer the money to an inherited Roth IRA, essentially converting it in a taxable transaction from traditional to Roth.

2023 Solo 401(k) Update

There are some new developments in the world of the Solo 401(k). Here are the highlights:

SECURE 2.0 First Year Establishment Deadline for Schedule C Solopreneurs

Section 317 of SECURE 2.0 provides that for the 2023 year and later, a solopreneur reporting their business income and deductions on Schedule C can open a Solo 401(k) after year-end and make employee contributions as long as the Solo 401(k) is established and funded before the tax return filing deadline for the year. See page 2262 of the Omnibus bill.

SECURE 317’s deadline extension does not factor in any extensions.

Thus, for 2023, the deadline to establish and make employee contributions for the first year of a Solo 401(k) is April 15, 2024. However, the deadline to establish and make employer contributions for the first year of a Solo 401(k) is October 15, 2024.

UPDATE December 14, 2023: I Tweeted a thread about the provision that allows Schedule C solopreneurs to establish and fund a new Solo 401(k) with an employee deferral contribution after year-end. There is at least some concern that if one is diligent enough to establish a new Solo 401(k) prior to year-end they might not get the benefit of Section 401(b)(2)‘s funding deadline extension. If that is true (and to my mind this is an ambiguous issue), then the solopreneur establishing the new Solo 401(k) prior to year-end would need to either fund the employee contribution prior to year-end or elect to make an employee deferral contribution prior to year-end.

Note that Section 317 of SECURE 2.0 does not apply for 2022 and does not apply to years beyond the first year of a Solo 401(k).

Based on the wording of SECURE 2.0 Section 317, it is not initially clear if spouses who work in the Schedule C business qualify for the new deadline. I believe the IRS and Treasury may issue regulations clarifying this point.

New Solo 401(k) Employee Contributions Limit for 2023

The IRS announced that for 2023, the employee deferral limit for all 401(k)s, including Solo 401(k)s, will be $22,500.

New Solo 401(k) Catch-Up Contributions Limit for 2023

The IRS also announced that for 2023, the employee deferrals catch-up contribution limit increased from $6,500 (2022) to $7,500. As a result, those age 50 or older can contribute, in employee contributions, a maximum of the lesser of $30,000 ($22,500 plus $7,500) or earned income.

New Solo 401(k) All Additions Limit

The new all-additions limit for Solo 401(k)s is $66,000 (or earned income, whichever is less). For those aged 50 or older during 2023, the $66,000 number is $73,500 ($66,000 plus $7,500).

2023 Update to Solo 401(k): The Solopreneur’s Retirement Account

On sale now, Solo 401(k): The Solopreneur’s Retirement Account explores the nooks and crannies of Solo 401(k)s. On page 16 of the paperback edition, I provide an example of the Solo 401(k) limits for 2022 if a solopreneur makes $100,000 of Schedule C income. Here is a revised version (in italics) of the example (with the footnote omitted) applying the new 2023 employee contribution limit:

Lionel, age 35, is self-employed. His self-employment income (as reported on the Schedule C he files with his tax return) is $100,000. Lionel works with a financial institution to establish his own Solo 401(k) plan and choose investments for the plan. Lionel can contribute $22,500 to his Solo 401(k) as an employee deferral (2023 limit) and can choose to contribute, as an employer contribution, anywhere from 0-20% of his self-employment income.

Lionel’s maximum potential tax-advantaged Solo 401(k) contribution for 2023 is $41,087! That is a $22,500 employee contribution and a $18,587 employer contribution. Note there’s no change in the computation of the employer contribution for 2023 in this example.

On page 18 I provide an example of the Solo 401(k) contribution limits factoring in catch-up contributions. Here’s the example revised for 2023:

If Lionel turned 50 during the year, his limits are as follows:

Employee contribution: lesser of self-employment income ($92,935) or $30,000: $30,000
Employer contribution: 20% of net self-employment income (20% X $92,935): $18,587
Overall contribution limit: lesser of net self-employment income ($92,935) or $73,500: $73,500

Amazon Reviews

If you have read Solo 401(k): The Solopreneur’s Retirement Account, you can help more solopreneurs find the book! How? By writing an honest, objective review of the book on Amazon.com. Reviews help other readers find the book!

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

Follow me on Twitter at @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.

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

Follow me on Twitter at @SeanMoneyandTax

The MAGI Limitation on Roth IRA Contributions

During a recent Econome Encore presentation, a questioner asked a question that caused me to do a double take: Do Roth conversions create MAGI (modified adjusted gross income) for purposes of determining whether someone exceeds the MAGI thresholds to make an annual contribution to a Roth IRA?

I did a double take for several reasons. First, the presentation was early on a Sunday morning 😉 . Second, in practice, the issue rarely comes up, for reasons we will discuss later. Third, why wouldn’t income created by a Roth conversion count as MAGI for this purpose? It is taxable income, after all. Fourth, I was pretty sure the rule states that no, Roth conversions do not create MAGI for this purpose.

I quickly stated that I thought the rule does not consider Roth conversions to be included in MAGI, but I looked it up to be sure. My initial take was correct. Roth conversions are not included in MAGI for purposes of determining whether one can make an annual contribution to a Roth IRA. See IRC Section 408A(c)(3)(B)(i).

The Creation of the Roth IRA in 1997

It’s a bit of an odd rule, though. Why carve out Roth conversion income from the Roth IRA MAGI test? It’s especially odd considering that actual taxable withdrawals from a traditional IRA or 401(k) create MAGI for this purpose. Why carve out income from Roth conversions of traditional IRAs and 401(k)s?

It has to do with how Roth IRAs were created. In 1997, Congress created the Roth IRA to be effective starting in 1998. Roths were new. There was likely a concern along the lines of “a vehicle with tax-free growth could be abused.” Thus, there were two features of the Roth IRA subject to a MAGI limitation. Both the ability to make a direct annual contribution to a Roth IRA and the ability to convert amounts from a traditional retirement account to a Roth IRA were subject to a MAGI limitation. See page 40 of the 1997 Taxpayer Relief Act text.

The MAGI limitations begged the question: how to define MAGI for this purpose? The bill drafters started with a common technique: they found another relevant definition of MAGI already existing in the Internal Revenue Code. Why reinvent the wheel? They started with the MAGI definition used to determine the ability to make a deductible traditional IRA contribution.

By itself, however, this definition would create a circular definition problem with respect to Roth conversions, as the IRA deduction MAGI definition used starts with AGI and then kicks out certain items. Roth conversions are included in AGI, so to avoid a circular calculation, the bill drafters had to kick Roth conversion income out of the Roth MAGI definition.

If Roth conversion income was included in the MAGI definition, then the taxpayer would have to test Roth conversions against themselves to determine if Roth conversions were allowed! For example, if AGI was $90K prior to a $40K Roth conversion, the $40K Roth conversion would disqualify itself, as the MAGI limitation on the ability to convert was $100K of MAGI.

Further, the bill drafters decided to create one MAGI definition for the two different limitations. They could have created two different MAGI definitions, but this would have made a new Code section even more lengthy and complicated. Remember, none of this existed as of 1997 when the bill was written. So, the final bill only had one MAGI definition for both limits. That one definition kicked out Roth conversion income, which it had to do to avoid the circular definition problem with respect to Roth conversions.

Changes to Roth IRAs

In 2006, Congress repealed the MAGI limitation on the ability to do Roth conversions, effective 2010. See pages 21 and 22 of this PDF of the Tax Increase Protection and Reconciliation Act of 2005. This is what opened the door to the Backdoor Roth IRA starting in 2010.

Interestingly enough, had there never been a MAGI limitation on the ability to do a Roth conversion, the kick out of Roth conversion income from the MAGI limitation on the ability to make an annual contribution to a Roth IRA might not exist. First, there would have been no circular definition problem to solve. Second, it would have been neater to simply reference the deductible traditional IRA contribution MAGI definition and leave it at that.

But, that’s not how the history of the Roth IRA transpired. We will never know if there would not have been a kick out of Roth conversion income in defining MAGI for annual Roth contribution purposes had today’s rules been the original Roth IRA rules.

Roth Conversions and Annual Roth IRA Contributions

For *many* taxpayers, particularly those in the FI community, the time to do Roth conversions is not while one is working. When one is working, he or she is likely to (a) qualify for annual Roth contributions and (b) to be in their highest lifetime marginal tax brackets. Usually, the best time to do a Roth conversion is during early retirement rather than during one’s highest earning years.

As a practical matter, at the time many Americans qualify to make a Roth contribution, they are not likely to be in an optimal Roth conversion posture. Of course, your circumstances could vary. For example, consider someone taking a 12 month sabbatical from the workforce (starting March 1st) who has 2 months of earned income during the year. Perhaps he or she should (a) make a Roth IRA contribution based on their 2 months of earnings and also (b) do Roth conversions based on having a relatively low income for the year.

Click here for the IRS website detailing the 2023 MAGI limitations on the ability to contribute to a Roth IRA.

While We’re On the Subject of the Annual MAGI Limit on Roth IRA Contributions . . .

My belief is that one of the next changes Congress should make to Roth IRAs is to remove the MAGI limit on contributions.

Let’s think about this. A 50+ year old billionaire can contribute up to $30,000 to a workplace traditional or Roth 401(k) regardless of their income level. If this is possible, why is there a MAGI limitation on the ability to contribute $6,500 or $7,500 (age 50 or older, 2023 numbers) to a Roth IRA? It makes absolutely no sense, especially considering that some people, though not all people, can get around the MAGI limitation through the Backdoor Roth IRA.

Further, our neighbors to the north have no income limitation on the ability to contribute to a Tax-Free Savings Account, Canada’s equivalent of the Roth IRA. It’s time for Congress to repeal the MAGI limitation on the ability to make an annual Roth IRA contribution.

Watch me discuss the real answer to the Backdoor Roth IRA gimmick, which is the repeal of the MAGI limitation on the ability to make an annual Roth IRA contribution.

Conclusion

There’s a bit of an odd rule when it comes to determining MAGI for purposes of determining whether a taxpayer can make a contribution to a Roth IRA. It stems from the creation of the Roth IRA in 1997 and the fact that back then, there was also a MAGI limitation on the ability to convert amounts to a Roth IRA. Today, the kick out of Roth conversion income is a taxpayer favorable rule that is rarely significant in practice. More broadly speaking, I hope Congress repeals the MAGI limitation on the ability to make an annual Roth IRA contribution.

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Terminology and Titling

Types of Beneficiaries

Spouses

RMD Beneficiaries

Successor Beneficiaries

Minor Children of the Owner

Successor Beneficiaries

10-year Beneficiaries

Successor Beneficiaries

Estates

Trusts

Charities

Planning

For Owners

For Beneficiaries

Further Reading

529-to-Roth IRA Rollover Introduction

529-to-Roth IRA Rollover Details

529 Rollovers as Roth Contributions and Roth Earnings

Sean’s Take

529 Seasoning

Multiple Beneficiaries

Starting with Owner as Beneficiary

Don’t Plan on Using the 529-to-Roth IRA Maneuver if You Aren’t Going to College

Changing the Beneficiary to the Owner

Changing the Beneficiary and the 15 Year Clock

A Critical Look at the 529

Conclusion

Financial Independence

529s

529s and the FI Community

Young Parents and 529s

The Value of the 529’s Tax Benefits

Use Restrictions

Feeding the Beast

529 Use Cases

Financially Independent Parents

Capturing State Tax Benefits

Conclusion

Health Savings Accounts

Health Savings Accounts PUQME

Restricted Accounts

Time Restrictions

Use Restrictions

HSA Use Restrictions

HSAs and Las Vegas

HSA Planning Risk

Surviving Spouse’s HSA PUQME

HSA Resource

Conclusion

ONE: Direct Distribution from a Non-Roth IRA Retirement Account

3 Year Pay Back

Future 3 Year Pay Back Regulations

TWO: Plan Loans

THREE: SECURE 2.0 Minor Emergency Withdrawals

FOUR: SECURE 2.0 401(k) Emergency Savings Accounts

FIVE: Roth IRA Basis

Roth IRA Basis and the Minor Emergency Withdrawal Rule

Roth IRA Basis and Other 3 Year Pay Back Rules

Taxable Accounts

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 Rules: RMDs Come Out First and Cannot be Converted

Properly Roth Converting After Taking the RMDs

Income Risk, Reversibility, and Market Risk

Inherited Retirement Accounts

Further Reading

SECURE 2.0 First Year Establishment Deadline for Schedule C Solopreneurs

New Solo 401(k) Employee Contributions Limit for 2023

New Solo 401(k) Catch-Up Contributions Limit for 2023