Tag Archives: FI

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. 

ProvisionEffective DateSourceLimitsQualification
Minor Emergency Withdrawals2024SECURE 2.0 Sec. 115$1,000 per year, 1 distribution per yearExpenses incurred for an emergency
Domestic Abuse Victims2024SECURE 2.0 Sec. 314Lesser of $10K or 50% of account balance per yearMust be a victim of domestic abuse within the year preceding the distribution
Federally Declared Disaster AreaJanuary 26, 2021SECURE 2.0 Sec. 331$22,000 limit per disasterMust live in a federally declared disaster area and suffered an economic loss due to the disaster
Terminally Ill IndividualEnactment of SECURE 2.0SECURE 2.0 Sec. 326UnlimitedMust be terminally ill (generally, medicially expected to die within 7 years).
Qualified Birth or Adoption Distribution2020SECURE Sec. 113$5,000 per parent per birthDistribution 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

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

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

Be aware of the 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:

  1. What’s my age?
  2. What was my prior-year wage income from this employer?
  3. 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

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

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:

  1. 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. 
  2. 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. 

Further Reading

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

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

Follow me on Twitter at @SeanMoneyandTax

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

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

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

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

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

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. 

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

Follow me on Twitter: @SeanMoneyandTax

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

Sean on New Podcast Episodes

This week I’m on episodes of The Stacking Benjamins Show and the Earn & Invest podcast talking about taxes, retirement savings, and my new book, Solo 401(k): The Solopreneur’s Retirement Account.

I’ve also recently recorded, and will record, several other podcast episodes with some great podcast hosts, so please be on the lookout for those.

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

Follow me on Twitter at @SeanMoneyandTax

This post and the podcast episodes referenced in it, are for entertainment and educational purposes only. They do not constitute accounting, financial, legal, investment, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

Sean Presentation at CampFI

These are the slides for my presentation at CampFI in Julian, CA on October 8, 2022.

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

Follow me on Twitter at @SeanMoneyandTax

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

Three Ways the Solo 401(k) Supports Financial Independence

Financial independence encourages thinking about one’s financial future in a different way. You were told to “build a career and retire at age 65.” Financial independence says you should write your own financial script. The system, your parents, and a large employer should not be the authors of your financial future.

Guess what goes perfectly well with a financial independence mentality? The Solo 401(k)! The Solo 401(k) helps you control today’s tax burden and helps you plan for your retirement your way. 

Here are three ways the Solo 401(k) can support the financial independence journey. 

Choice and Low Fees

One advantage of working for yourself is you gain control over your workplace retirement account. Solopreneurs themselves determine where their Solo 401(k) is established and the investment options available to them. They determine contribution levels and whether or not to contribute to a Roth account.

Solopreneurs are no longer at the mercy of a large employer’s 401(k) plan, which may not have the investments they want, a Roth option, and/or low fees. 

Further, many Solo 401(k) providers offer low or no fees to establish a Solo 401(k) with their institution. For example, today neither Schwab nor Fidelity charges Solo 401(k) fees, other than the fees of the underlying investments (such as mutual fund expenses). Vanguard charges $20 per mutual fund inside a Solo 401(k) (other than the underlying fund fees), though the $20 fee can be waived if the solopreneur has enough qualifying assets invested with Vanguard. 

Tax Rate Arbitrage

The Solo 401(k) supports very significant tax deductions. For those at their peak earning years, contributions to Solo 401(k)s can benefit from high marginal tax rates. Further, in certain circumstances, traditional deductible Solo 401(k) contributions can help solopreneurs qualify for the qualified business income deduction, increasing the marginal tax rate benefit of traditional, deductible Solo 401(k) contributions. 

During early retirement, retired solopreneurs can convert traditional retirement accounts to Roth accounts. Those Roth conversions can be sheltered by the standard deduction, and then taxed at the 10 percent and 12 percent marginal federal income tax rate. This arbitrage opportunity (deduct contributions at high marginal rates, later convert the contributions and earnings to Roth accounts at lower tax rates) can supercharge the journey to financial independence. 

Reducing MAGI for PTC Qualification

Many solopreneurs have their medical insurance through an Affordable Care Act plan. These plans often have hefty annual premiums. However, there is a Premium Tax Credit (“PTC”) that can significantly reduce the cost of those premiums.

PTCs decline as modified adjusted gross income (“MAGI”) increases. Very generally speaking, from a planning perspective, as MAGI increases, PTCs decline by approximately 10 to 15 percent. Solopreneurs can reduce MAGI by contributing to a traditional deductible Solo 401(k). That decrease in MAGI can significantly increase the PTC, defraying their ACA medical insurance premiums. 

Conclusion

The Solo 401(k) can help solopreneurs achieve financial independence. Chapter 13 of my new book, Solo 401(k): The Solopreneur’s Retirement Account, goes into further detail about marrying the Solo 401(k) with one’s own FI journey. The book is available from Amazon, Barnes & Noble, and other outlets. 

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

Follow me on Twitter at @SeanMoneyandTax

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

The Advantages of Living On Taxable Assets First in Early Retirement

The FIRE community loves the accumulation phase. Build up assets towards the goal of financial independence.

Questions increasingly creep in when it comes to the distribution phase. Members of the FIRE community wonder: what do I live on when I get to retirement? This is particularly true when one reaches early retirement prior to age 59 ½. 

Below I discuss the options and the reasons I believe that for many, the best assets to live off of first in early retirement are taxable assets. This analysis assumes the early retiree has access to some material amount of assets in each of the three tax baskets discussed below.

Early Retirement Drawdown Options

For most Americans reaching retirement prior to age 59 ½, there are three main tax baskets of assets that can be lived off prior to age 59 ½.

Taxable Assets: This can include cash in bank accounts, brokerage accounts (stocks, bonds, mutual funds, and ETFs), and for some, income from rental properties. For purposes of this blog post, I will assume the early retiree does not own any rental real estate. 

Roth Basis/HSAs: Early retirees can live off of what I colloquially refer to as “Roth Basis.” Generally, Roth Basis is the sum of previous annual contributions to Roth accounts and Roth conversions that are at least five years old. Further, early retirees can harvest amounts in HSAs tax and penalty free to the extent that they have allowable previously unreimbursed qualified medical expenses (what I refer to as PUQME). HSAs can also be used for qualified medical expenses incurred in early retirement. 

Traditional Retirement Assets: Assets such as traditional 401(k)s and traditional IRAs. Generally “inaccessible” prior to turning age 59 ½ due to being subject to both ordinary income tax and the 10% early withdrawal penalty. However, there are exceptions to the early withdrawal penalty. They include:

  • Rule of 55: Separation from service from an employer after turning age 55 (exception available for withdrawals from that workplace retirement plan only).
  • 72(t) Payments: Establishing a series of substantially equal periodic payments.
  • Governmental 457(b) Plans

Drawbacks of Using Roth Basis/HSAs

Some might argue for using tax-free withdrawals of Roth Basis and HSAs to fund early retirement. This allows the early retiree to pay no taxes on funds used for living expenses. 

To my mind, the main drawback of doing so is opportunity cost. Removing assets from Roths and HSAs cuts off the opportunity for future tax free growth. 

As a general planning objective, many will want to let their Roths and HSAs grow as long as possible to maximize tax-free growth. 

Using Roths and HSAs can also have a significant drawback from a creditor protection perspective, as I will discuss below. 

Drawbacks of Using Traditional Retirement Assets

The below analysis assumes that the early retiree qualifies for an exception from the 10% early withdrawal penalty.

The biggest drawback to using traditional retirement accounts to live off of in early retirement is all living expenses become subject to federal and state income taxes. It puts the most important consideration (funding living expenses) in opposition to the secondary (but still important) consideration: tax planning.

Living off traditional retirement accounts in early retirement reduces tax planning flexibility. It reduces the ability to do tax-optimized Roth conversions in early retirement. In addition, living off traditional retirement accounts during early retirement can reduce Premium Tax Credits for those on Affordable Care Act (“ACA”) medical insurance plans.

Premium Tax Credit Planning: Many early retirees will use an Affordable Care Act medical insurance plan. The premiums are subsidized through a tax code mechanism: the Premium Tax Credit (the “PTC”). PTCs are reduced as the taxpayer’s modified adjusted gross income (“MAGI”) increases. Very roughly speaking, for planning purposes, an additional dollar of MAGI often reduces the PTC by 10 to 15 cents, meaning early retirees using traditional retirement accounts to fund living expenses may be subject to a surtax of 10 to 15 percent on retirement account withdrawals due to PTC reduction. Resources for the PTC include this article and this spreadsheet. 

There’s an argument that it is good to live off traditional retirement accounts early because withdrawals used to fund living expenses reduce future required minimum distributions (“RMDs”). But one must consider that there are two types of withdrawals an early retiree can make from a traditional retirement account: an actual withdrawal or a Roth conversion. Both reduce future RMDs, but a Roth conversion is the most tax efficient withdrawal for the early retiree. Why? Because it sets up future tax-free growth! Actual withdrawals used for living expenses do not enhance future tax-free growth. 

Another drawback of using traditional retirement accounts to fund early retirement includes being constrained by the parameters of the applicable penalty exception. For example, needing to keep money inside a former employer’s retirement plan in order to qualify for the Rule of 55, or needing to withdraw precise amounts annually if using a 72(t) payment plan. Further, using traditional retirement accounts in early retirement has creditor protection drawbacks, discussed below. 

Advantages of Using Taxable Assets

Living off drawdowns of taxable assets can be a great way to fund the first expenses of early retirement. Here are some of the advantages. 

Zero Percent Long Term Capital Gains Rate

Early retirees worry: I need $60,000 of income to live my life. Won’t that create $60,000 of taxable income? 

If drawing from a taxable account, almost certainly it will not. Consider Judy, an early retiree needing $60,000 to pay her living expenses. If she sells $60,000 worth of the XYZ Mutual Fund (all of which she has owned for over a year), in which she has $40,000 of basis, her resulting taxable income is only $20,000. Not $60,000!

But it gets even better for Judy. The capital gain can qualify for the 0% federal long term capital gains tax rate. Outstanding! By using taxable assets, Judy may pay $0 federal income tax, and likely only a very small state income tax, on the money she uses to fund her living expenses. Pretty good. 

Even if Judy’s income puts her above the 0% federal capital gains tax bracket, (i) some of her capital gains will likely qualify for the 0% rate, and (ii) the next bracket is only a 15% tax rate.

Basis Recovery While Basis is Valuable

During 2022, we learned an important financial lesson: inflation is a thing. Retirement draw down planning should consider inflation. 

One way to fight inflation is to use tax basis before its value is inflated away. Tax basis is never adjusted for inflation. Thus, failing to harvest tax basis exposes the early retiree to the risk that future capital gains in taxable accounts will be subject to taxation on inflation gains. Early retirees should consider harvesting basis (like Judy in the above example) when the tax basis is its most valuable. 

Using taxable assets as the first assets to fund early retirement takes maximum advantage of tax basis, unless the U.S. dollar begins to deflate (a possible but not very likely long term outcome, in my opinion). 

Opens the Door for Roth Conversions

Now we get to the fun part. Roth conversions! Using taxable assets first for living expenses in early retirement facilitates conversions of amounts in traditional retirement accounts to Roth accounts. The idea is to have artificially low taxable income such that the taxpayer can do Roth conversions taxed at 0% federal (offset by the standard deduction) and then in the 10% or 12% tax bracket. Occasionally, it will be logical for the taxpayer to incur an even greater tax rate on such Roth conversions. 

These Roth conversions move assets to Roth accounts where they enjoy tax free growth. In addition, early retirement Roth conversions reduce future RMDs. 

There is a taxpayer-friendly rule that assists early retirement Roth conversion planning: long-term capital gains income is stacked on top of ordinary income in the tax computation. Thus, Roth conversions can benefit from being sheltered by the standard deduction (or itemized deductions if the taxpayer itemizes). This makes Roth conversion planning in early retirement that much better, as some Roth conversions can benefit from a 0% federal income tax rate. 

Further, this tells us it is generally better from a tax basketing perspective not to have bonds and other assets that generate ordinary income, since that income eats up part of the standard deduction, diminishing the opportunity to 0% taxed Roth conversions. One way to avoid having such ordinary income is to sell bonds, bond mutual funds, and other assets that generate ordinary income and use the proceeds to fund early retirement living expenses. 

Another advantage of early retirement Roth conversions is the reduction of the risk that future tax increases will drive up taxes on future traditional retirement account withdrawals.

Roth Conversions, ACA PTC Eligibility, and Medicaid

Lastly, there can be an ancillary benefit to Roth conversions. Taxpayers lose all ACA subsidies (thus, PTCs) if their MAGI is below certain thresholds. For example, a family of four in California with MAGI less than $41,400 (2023 number) would meet the income threshold for Medi-Cal (Medicaid in California) and thus would get no ACA PTC. 

Roth conversions can keep early retirees’ MAGI sufficiently high such that they do not meet the income threshold for Medicaid. By keeping MAGI above the Medicare threshold, early retirees can qualify for significant PTCs.

Creditor Protection

Financial assets can receive protection from creditors to varying degrees. Taxable brokerage accounts tend to have little, if any, creditor protection. 401(k) and other ERISA government workplace retirement accounts benefit from ERISA’s anti-alienation provisions. Generally speaking, only the IRS and an ex-spouse can get assets out of a 401(k). Traditional IRAs and Roth IRAs enjoy significant protection in bankruptcy. Traditional IRAs have varying degrees of non bankruptcy creditor protection, but in many states are fully protected. Roth IRAs are non bankruptcy protected in most states, but more states protect traditional IRAs than Roth IRAs.

HSAs do not enjoy federal bankruptcy protection, but do enjoy creditor protection in some states (to varying degrees).

By spending down taxable assets in early retirement, the early retiree optimizes for creditor protection in two ways. First, diminishing taxable assets by using them for living expenses reduces creditor vulnerable assets. Second, when an early retiree lives off taxable assets, they leave their more protected assets (traditional and Roth retirement accounts) to grow. Diminishing vulnerable assets while growing protected assets improves the early retiree’s balance sheet from a creditor protection perspective.

Lastly, early retirees should always consider personal umbrella liability insurance and other relevant property and casualty insurance for creditor protection. 

Premium Tax Credit Planning

Living off taxable assets in early retirement limits taxable income. This has a good side effect. It increases the potential PTC available for early retirees using an ACA medical insurance plan. 

Reducing Future Uncontrollable Taxable Income

Roths and HSAs are great because their taxable income is entirely controllable, and generally speaking should be $0. Even traditional retirement accounts have very controllable taxable income. There are no RMDs until age 72, and even then the amount of taxable income is quite modest for the first few years. 

Taxable assets, on the other hand, expose the early retiree to uncontrollable taxable income, in the form of interest, dividends, and capital gain distributions. You never know when a mutual fund or other investment will spit out a taxable dividend or capital gain distribution. Such income reduces the runway for tax planning and can reduce PTCs.

Further, in recent years, we have become accustomed to living in a low-yield world. In the past decade plus a taxable portfolio has kicked off (in many cases) income yields of 3%, 2%, or less. Thus, the tax hit from taxable assets has not been too bad for many. That said, low yields are not guaranteed in the future. It could be that yields will rise, and thus taxable assets will generate increasing amounts of taxable income. 

By living off taxable assets first, early retirees reduce and ultimately eliminate taxable interest, dividends, and capital gain distributions generated by holding assets in taxable accounts. This reduces the tax cost of the overall portfolio, and makes planning MAGI, taxable income, and tax paid annually an easier and potentially more beneficial exercise. 

I discuss the early retirement Roth Conversion Ladder strategy in this video.

Conclusion

In many cases, I believe that the tax optimal path for the early retiree is to live off taxable assets first in early retirement prior to accessing Roth Basis, HSAs, and traditional retirement accounts. Of course, this is not individualized advice for you or any other particular individual. Those considering early retirement are well advised to consider their future drawdown strategy as they are building their assets. Those already retired should consider their own particular circumstances and ways to optimize their drawdown strategy. 

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