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taking an RMD generally creates an excess contribution to a Roth IRA, subject to an annual 6% penalty unless properly withdrawn.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.
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.
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.
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
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.
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 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
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.
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.
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.
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
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.
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.
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.
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.
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
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 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).
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.
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.
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.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
Family HDHP coverage is coverage of an insured plus either or both a spouse or a dependent(s). Coverage must be the only medical insurance coverage the person has.
HSA Catch-Up Contributions
Those age 55 or older can contribute an extra $1,000 per person to an HSA every year. While the “normal” contribution limits ($4,150 self / $8,300 family) are indexed for inflation, the $1,000 annual catch-up contribution limit is not indexed for inflation.
Two additional notes: First, as a practical matter, at age 65 a taxpayer will no longer qualify for an HSA (and thus, the catch-up contribution). This is because at age 65 most Americans switch from a HDHP to Medicare for their medical insurance.
Second, for IRAs and qualified plans (such as 401(k)s), the age to be eligible to make “catch-up” contributions is 50. For HSAs, the age is 55, not age 50.
HSA Contribution Limits for Married Couples
The normal contribution limits are coordinated. Thus, the family contribution maximum for a married couple is normally $8,300, not $8,300 times two. Here’s an example of how that works:
Example 1: Steven and Holly are married, both age 45, and covered by a family high deductible health plan for all of 2024. Thus, each has an HSA contribution limit of $8,300. However, when looking at Steven’s limit, we must look at what Holly has contributed to her HSA for 2024. If Holly contributes $8,300 to her HSA for 2024, then Steven’s HSA contribution limit is reduced by Holly’s contribution to $0.
Interestingly enough, catch-up contributions are notcoordinated. Let’s change the example to have Steven and Holly be both age 55.
Example 2: Steven and Holly are married, both age 55, and covered by a family high deductible health plan (provided by Holly’s employer) for all of 2024. Thus, each has an HSA contribution limit of $9,300. Holly maxes out her 2024 HSA ($9,300) through payroll withholding (to get the payroll tax exclusion as well as the income tax exclusion). When looking at Steven’s normal contribution limit, we must look at what Holly has contributed to her HSA for 2024. Since Holly maxed out her HSA, Steven’s normal contribution limit is $0. However, Steven’s catch-up contribution limit is still $1,000, since it is not reduced for contributions Holly made to her HSA.
Note that Steven’s Baby HSA cannot just be simply added to Holly’s HSA. Each of them have their own limits, and an HSA is an account in the name of a single owner (the same as an IRA). Thus, Steven will need to reach out to a financial institution to establish his own HSA.
Benefits of the Baby HSA
Yes, a $1,000 tax deduction is nice, but it is not life changing. Let’s not pooh-pooh it too quickly, however. Steven might qualify for 10 years of that $1,000 Baby HSA, which is $10,000 of tax deductions. Second, Steven and Holly get this deduction against adjusted gross income, which means that they won’t have to claim itemized deductions to obtain it.
Third, most tax deductions require giving up money to get a tax benefit. Often we think about business deductions, charitable contributions, and home mortgage interest. It’s great to take tax deductions for those, but you are giving up the money. The deduction for a Baby HSA contribution is simply moving money from a taxable account to an HSA: it’s still your money!
Last, an HSA deduction/exclusion is better than a deduction/exclusion for a traditional 401(k) contribution. In exchange for the upfront tax benefit, the traditional 401(k) will be fully taxable when withdrawn later on. Not so with the HSA. As long as the HSA is used to pay qualified medical expenses and/or to reimburse PUQME, the money comes out tax-free. No wonder I’m so fond of HSAs!
One additional benefit for retirees is the $1,000 deducted for a Baby HSA is $1,000 more of Roth conversions that can be slotted in at a low tax rate. The HSA deduction also lowers both adjusted gross income and “modified adjusted gross income” for Premium Tax Credit purposes, making it valuable for early retiree tax planning.
One Spouse Under Age 55
What happens if one of the spouses is under age 55? Here’s an example:
Example 3: Steven (age 56) and Holly (age 52) are married and covered by a family high deductible health plan provided by Holly’s employer for all of 2024. Thus, Holly has an HSA contribution limit of $8,300. Steven has an HSA contribution limit of $9,300, computed as a $8,300 normal contribution limit plus a $1,000 catch-up contribution limit. Holly maxes out her 2024 HSA ($8,300) through payroll withholding. When looking at Steven’s normal contribution limit, we must look at what Holly has contributed to her HSA for 2024. Since Holly maxed out her HSA, Steven’s normal contribution limit is $0. However, Steven’s catch-up contribution limit is still $1,000, since it is not reduced for contributions Holly made to her HSA.
Because Steven was 55 or older during the year, he still gets to contribute $1,000 to his Baby HSA. Holly’s age and contributions are irrelevant because the catch-up contributions of one spouse are not limited by the age and contributions of the other spouse.
Watch me discuss the Baby HSA on YouTube. Stay to the end to see me butcher some 80’s movie trivia.
Conclusion
The Baby HSA is a nice tax planning tactic for married individuals with a HDHP as their only medical insurance between turning age 55 and going on Medicare. While limited in scale, the Baby HSA can provide real tax benefits and later tax-free growth. Of note, some ACA plans qualify as HDHPs. This means that the Baby HSA opportunity will exist for some using ACA plans in early retirement, as well as those covered by a HDHP through an employer.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
There’s tax advice available on TikTok. Is it worth following? Does it miss the big picture?
Retirement Saving Through Various Forms of Life Insurance
TikTok tax advice often boils down to something like the following: don’t save in traditional retirement accounts where you will get crushed by taxes in retirement. Rather, save for retirement through permanent life insurance products (such as indexed universal life insurance policies) to get tax free growth and tax free withdrawals during retirement.
Watch me discuss two problems with TikTok tax advice on YouTube.
This advice is not just offered on TikTok, though, anecdotally, it appears TikTok is at least something of a hub for promoting indexed universal life (“IUL”) and other forms of permanent life insurance.
One recent example of this sort of advice posits a retired couple making $160,000 a year in IRA/401(k) distributions and $40K in Social Security/pension income and worries that the couple will have a terrible tax problem.
But is that really the case? Let’s play it out with a detailed example.
Sally and Joe both turn age 75 in 2022. They are California residents. During their working years, they were prodigious savers in their workplace 401(k) plans, and their employers offered generous matching contributions. As a result, in 2022 they have required minimum distributions (“RMDs”) of $160,000. They also will have $40,000 of Social Security income, $4,000 of qualified dividend income, and $1,000 of interest income. Further, being tax savvy, they contribute $500 a month to their church through qualified charitable distributions (“QCDs”) from their traditional IRAs. They claim the standard deduction as their home is paid off and thus have no mortgage interest deductions.
Alright, let’s see what Sally and Joe’s 2022 tax picture (all numbers are estimates) looks like:
First, their rough 2022 federal income tax return:
Federal Income Tax Return
RMDs
$ 160,000
Social Security
$ 40,000
15% Social Security Exclusion
$ (6,000)
Interest
$ 1,000
Qualified Dividends
$ 4,000
QCD RMD Exclusion
$ (6,000)
Adjusted Gross Income (“AGI”)
$ 193,000
Standard Deduction
$ (25,900)
Additional SD Age 65+
$ (2,800)
Federal Taxable Income
$ 164,300
Let’s turn to what their $164,300 federal taxable income means in terms of federal and California income taxes paid and their 2022 cash flow:
2022 Income Taxes and Cash Flow (Estimated)
Federal Income Tax
$ 27,100
Effective Tax Rate on AGI
14.04%
Marginal Federal Income Tax Rate
22%
California Taxable Income (Approximate):
$ 149,000
California Income Tax (Approx.)
$ 7,862
Effective CA Income Tax Rate on Fed AGI
4.07%
Marginal CA Income Tax Rate
9.30%
Total Fed & CA Effective Income Tax Rate
18.11%
Cash Flow After Fed & CA Income Tax & QCDs
$ 164,038
By my math, after paying both income taxes and charitable contributions, this retired couple has $164,000 in cash flow for living expenses. Considering that, like many retirees, they live in a paid-off home, do we really believe there is a significant risk they will not be able to pay their bills? This couple ought to be able to enjoy a very pleasant, comfortable lifestyle, including recreational activities and travel.
Are Sally and Joe really getting crushed by income taxes? As residents of a high tax state, they do pay about $35K in combined federal and state income taxes. Sure, if $35K was on the table in front of you, you’d grab it pretty quick. But considering the $200K plus in cash flow they generated during the year, paying $35K in income taxes to the IRS and California is hardly financially debilitating.
Most retired couples, even financially successful couples, will not have federal adjusted gross income of $193,000. If Sally and Joe are not crushed by income taxes (paying just an 18.11% estimated effective rate even living in a high-tax state), it is likely most retirees will be able to withstand the tax hits at retirement from having significant savings in traditional deferred retirement accounts.
The Trade-Off Unstated on TikTok
TikTok tax advice often presents the boogeyman of taxes in retirement. It says “don’t invest in your 401(k) because it will get crushed in retirement.” Even if that were true, it usually neglects an important consideration: the upfront benefit of investing in a 401(k).
During their working careers, it is likely that Joe and Sally were subject to marginal income tax rates of 24% or more federal and 9.3% California. Had they used permanent life insurance to save instead of using their 401(k)s, they would have lost 33 cents (or more) on every dollar in immediate tax savings, as there is no tax deduction for amounts contributed to life insurance policies.
The existence of the tax deduction for amounts contributed to a traditional 401(k) does not automatically mean that using permanent life insurance products for retirement is a bad idea. However, in weighing the tax benefits of the traditional 401(k) approach compared to the permanent life insurance approach, one must consider the immediate, and potentially substantial, tax benefits of traditional 401(k) contributions.
One consideration in weighing the pros and cons of each: traditional 401(k) contributions generally get a tax benefit at the taxpayer’s marginal tax rate, while withdrawals from traditional 401(k)s and IRAs are more generally taxed at a taxpayer’s lower effective rate. On the way out, withdrawals are taxed through the relatively progressive tax brackets existing today, getting the benefits of the 10%, 12%, and 22% federal income tax brackets.
Uncertainty
But, Sean, what about future tax rate increases! The federal government is running a huge deficit and it’s not getting any better.
This is a valid point. But let’s consider a few things. First, in my example, Sally and Joe were subject to a 33.3% marginal tax rate during their working years, and barely over an 18% effective tax rate during their retirement. For the math to work out to make permanent life insurance more attractive (tax-wise) than traditional 401(k)s for them, tax rates would need to be increased substantially, by over 80%. Thus, even if tax rates on retirees such as Joe and Sally were to increase 85% from current levels, the tax math might only marginally favor using permanent life insurance instead of a traditional 401(k).
Second, if there are going to be income tax rate increases, they are more likely to be to the upper tax brackets. There are fewer taxpayers (read: voters) subject to the higher tax brackets, so those are the ones the politicians are more likely to increase. Increasing the 10%, the 12%, and/or the 22% tax brackets will impact more voters and lead to more election risk for the politicians.
Third, recent history suggests that the politicians are not likely to target retirees. It’s true that Social Security went from being tax free to being largely subject to taxation, up to 85% taxable. Interestingly enough, the second Social Security tax increase, which subjected Social Security to possibly being 85% taxable, passed through a Democratic Congress in 1993. The following year the Democrats suffered historic losses in the House and Senate elections. Many factors came into play, but it is interesting that since 1994 tax policy has generally benefited retirees (no more tax increases on Social Security, increasingly progressive tax brackets, and the increased standard deduction).
Perhaps the politicians in both parties have learned a lesson when it comes to retiree taxation.
Is there zero risk that retirees could be subject to higher taxes in the future? Absolutely not. But, is that risk great enough to eschew traditional 401(k) contributions in favor of permanent life insurance? Not in my opinion.
Further, there are simpler, less costly planning techniques other than permanent life insurance that those using 401(k)s for retirement planning can avail themselves of, including Roth accounts and health savings accounts.
Roth Accounts
Savers worried about future tax rate hikes have a simple, easy to implement tool to hedge against future tax rate increases: the Roth IRA. The Roth IRA solves the same tax problem that permanent life insurance solves for. In today’s environment, Roth IRAs are available at a vast array of financial institutions with very low fees.
Many will point out the possibility of much greater contributions to an indexed universal life insurance policy than to a Roth IRA. While true, many of those concerned with getting large amounts into tax-free accounts while working can turn to the Roth 401(k), which has significantly greater annual contribution limits than the Roth IRA.
Roth Conversions
Many in the FIRE community have access to Roth conversions during what are likely to lower taxable income years. The tax idea behind retiring early is to load up on traditional 401(k) contributions during working years, and then convert amounts inside traditional retirement accounts to Roth accounts during early retirement years prior to collecting Social Security.
In early retirement years, many in the FIRE movement appear, at least initially, to be poor on their tax return. No longer working, and not yet collecting Social Security, one’s tax return only includes interest income, dividend income, and some capital gains income. If that income is relatively low (which it is likely to be for many early retirees), it likely leaves room for Roth conversions at the 10% or 12% tax brackets during early retirement.
This is tax rate arbitrage. First, deduct 401(k) contributions in the 24% or greater federal income tax brackets during one’s working years. Then, during early retirement, convert amounts in the traditional retirement accounts at a 10%, 12%, or perhaps 22% marginal federal income tax rate.
Two observations: A) using permanent life insurance instead of traditional 401(k) contributions followed by early retirement Roth conversions denies members of the FIRE community a significant tax rate arbitrage opportunity. While there is no taxable income inclusion when withdrawing from a permanent life insurance policy, there is also no tax deduction for contributions to IULs, whole life insurance, and other permanent life insurance policies.
B) By doing Roth conversions during early retirement, FIRE members reduce the uncertainty risk described above. FIRE members face a shorter time frame during which significant savings are in traditional retirement accounts, as the goal is (generally speaking) to get the money (mostly) converted to Roths prior to age 70.
The Roth conversion tool reduces the risk that future tax increases will crush savers who mostly use traditional 401(k)s during their working years. While this is true for all savers, it is most especially true for members of the FIRE community.
A note on tax optimization: Imagine Joe and Sally were retired at age 55, today’s tax laws existed, and they had many years with artificially low taxable income. Say they did not do Roth conversions during this time. Is that a mistake? From a tax optimization perspective, absolutely. They would have likely been able to do Roth conversions at a 10% or 12% federal income tax rate, which is lower than both their retirement 22% marginal federal income tax rate and 18.11% combined effective income tax rate. While they are not tax optimized, they are something more important in my example: financially successful. Yes, tax optimization is important, but it is not the be-all and end-all. My guess is that financially successful individuals do not regret the failure to tax optimize on their deathbeds, though I look forward to reading Jordan “Doc G” Grumet’s new book to be sure.
Conclusion
I’m not here to tell you exactly how to save for retirement. But I am concerned that TikTok tax advice has two deficiencies. First, it overstates the problem of taxation in retirement. Is there a potential problem? Yes. Is it as severe as some make it out to be? Not under today’s laws. Further, there are tactics such as annual Roth IRA contributions and Roth conversions during early retirement that can address the problem. Second, TikTok tax advice understates the current benefit of deductible traditional 401(k) contributions during one’s working years.
Further Reading
Forbes has recently published two articles on the sorts of insurance policies frequently promoted on TikTok. They are available here and here.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
