Tag Archives: FI

Tax Deductions for Individuals

Tax deductions can be a confusing topic considering the many types of tax deductions and the terminology for them. Below I explain the different types of tax deductions you can claim on your tax return. You may be taking several of these types without even knowing it.

Types of Individual Tax Deductions

Exclusions

Many things we think of tax deductions are not treated as tax deductions on a tax return. Instead, they are excluded from taxable income. An exclusion from taxable income has the exact same effect as a tax deduction.

The most common exclusion is the exclusion for employer provided benefits, including health insurance, retirement plan contributions, and health savings accounts contributions. Here is an example:

Example: Mark has a salary of $100,000. He contributes ten percent ($10,000) of his salary to his employer’s 401(k) plan. His W-2 for the year will report wages of $90,000, not $100,000, and he will enter $90,000 as wages on his Form 1040. The $10,000 Mark contributed to his 401(k) is excluded from his gross income. This exclusion has the same income tax effect as a deduction.

Exclusions are a great form of deduction in that they are generally unlimited on your tax return, though they may have their own limitations. For example, in 2021 the most an employee under age 50 can exclude for contributions to a 401(k), 403(b), or a 457 is $19,500.

For those at least 70 1/2 years old, the qualified charitable distribution (“QCD”), which I wrote about here, can be a great tax planning technique. 

Exclusions also reduce adjusted gross income (“AGI”). Items that reduce AGI are great because AGI (or modified AGI, “MAGI”) is usually the measuring stick for whether a taxpayer qualifies for many tax benefits (such as eligibility for making a deductible contribution to an IRA or making a contribution to a Roth IRA). Lowering AGI is an important tax planning objective, since lower AGI opens the door to several tax benefits. 

Business Deductions

Business deductions include trade or business deductions generated from self-employment and investments in partnerships and rental property. On a Form 1040, these deductions are reported on Schedule C or Schedule E. Business deductions include salaries, rent, depreciation (deducting the cost of a business asset over a useful life), and other ordinary and necessary expenses.

Business deductions are generally great tax deductions because they are subject to relatively few limitations on your tax return. That said, limitations such as the passive activity loss rules and the at-risk limitations can limit a taxpayer’s ability to claim some business losses. Further, business deductions reduce not only income tax but also self-employment income, and thus, self-employment tax.

Business deductions are also valuable because they reduce AGI.

“For AGI” or “Above the Line” Deductions

On your Form 1040 you deduct certain expenses from your gross income to determine your AGI. Prior to tax returns filed for 2018 and later, these deductions were at the bottom of page 1 of the Form 1040. Starting with tax returns for 2018, these deductions are presented on Schedule 1 which accompanies Form 1040.

Examples of these deductions include one-half of self-employment tax paid by self-employed individuals, deductible contributions to IRAs, and contributions to certain self-employed retirement plans.  

Capital losses, generally up to $3,000 on any one tax return, can be deducted for computing AGI. Capital losses in excess of $3,000 are carried over to future tax years to be deducted against capital gains and against up to $3,000 per year of ordinary income. 

Health Savings Accounts (“HSAs”) are their own special breed. If contributions to an HSA are made through workplace payroll withholding, they are excluded from taxable income. If contributions to an HSA are made through another means (such as a check or wire transfer to the HSA), the contributions are for AGI deductions reported on Schedule 1. Which is better? From an income tax perspective, there is no difference. But from a payroll tax perspective, using payroll withholding is the clear winner. Amounts contributed to an HSA through payroll withholding are not subject to the FICA tax, creating another HSA tax win!

Standard Deduction or Itemized Deductions

Tax reform changed the landscape of itemized deductions. As a result of the tax reform bill enacted in December 2017, far fewer taxpayers will claim itemized deductions, and will instead claim the standard deduction.

The most common itemized deductions are state and local taxes (income, property, and in some cases, sales taxes), charitable contributions, and mortgage interest.

Taxpayers generally itemize if the sum total of itemized deductions (reported on Schedule A) exceed the standard deduction. Tax reform did two things to increase the chance that the standard deduction will exceed a taxpayer’s itemized deductions. First, the amount of the standard deduction increased. It went from $6,350 for single taxpayers in 2017 to $12,000 for single taxpayers in 2018. For married filing joint taxpayers, the standard deduction went from $12,700 in 2017 to $24,000 in 2018.

The standard deduction for 2021 is $12,550 (single) and $25,100 (MFJ) for most taxpayers. 

In addition, several itemized deductions were significantly reduced. For example, starting in 2018 there is a deduction cap of $10,000 per tax return ($5,000 for married filing separate tax returns) for state and local taxes. This hits married taxpayers particularly hard and increases the chance that if you are married filing joint you will claim the standard deduction, since you will need over $15,100 in other itemized deductions to itemize (using the 2021 numbers).

In addition, miscellaneous deductions, such as unreimbursed employee expenses and tax return preparation fees, were eliminated as part of tax reform.

Thus, many taxpayers will find that they will often claim the standard deduction. As discussed below, there will be planning opportunities for taxpayers to essentially push many itemized deductions (such as charitable contributions) into one particular tax year, itemize for that year, and then claim the standard deduction for the next several years.

Neither the standard deduction nor itemized deductions reduce AGI.

Special Deductions

In a relatively new development in tax law, there are now deductions that apply only after AGI has been determined and separate and apart from the standard deduction or itemized deductions. 

QBI Deduction

Tax reform created an entirely new tax deduction: the qualified business income deduction (also known as the QBI deduction or the Section 199A deduction). I have written about the QBI deduction here and here. Subject to certain limitations, taxpayers can claim, as a deduction, 20 percent of qualified business income, which is generally income from domestic business activities (not wage income), income from publicly-traded partnerships, and qualified REIT (real estate investment trust) dividends.

The QBI deduction does not reduce AGI.

Taxpayers can claim the QBI deduction regardless of whether they elect itemized deductions or the standard deduction.

Special Deduction for Charitable Contributions

For the 2021 tax year, taxpayers who do not claim itemized deductions are eligible for a special deduction for charitable contributions. The deduction is limited to $300 for single filers and $600 for MFJ filers.

As discussed by Jeffrey Levine, this deduction, like the QBI deduction, neither reduces AGI nor is an itemized deduction. 

The statutory language for this new deduction is found at Section 170(p). I believe that there is a very good chance that this deduction is extended to years beyond 2021, though as of now, it is only applicable to the 2021 tax year. 

Planning

Tax deductions provide a great opportunity for impactful tax planning. Here are some examples.

Timing

If your marginal income tax rate is the same every year, then you generally want to accelerate deductions. Thus, if you have a sole proprietorship and are a cash basis taxpayer, you are generally better off paying rent due on January 1, 2022 on December 31, 2021 instead of January 1, 2022 since the deduction saves the same amount of tax regardless of which tax year you pay it, but you’ll get the cash tax benefit sooner – on your 2021 income tax return instead of on your 2022 income tax return.

But there can be situations where you anticipate that your marginal tax rate will be greater next year than this year. In those cases, it makes sense to delay deductions. For example, perhaps you would make a large charitable contribution next year instead of before the end of the current year. Or, in the above example, you would pay the rent on January 1, 2022 to ensure the deduction is in 2022 instead of 2021.

Bunching

For some taxpayers, it may make sense to bunch deductions to maximize the total benefit of itemizing deductions versus claiming the standard deduction over several years. My favorite example of this is the donor advised fund. I’m not alone in my fondness of the donor advised fund. It allows you to contribute to a fund in one year, claim a charitable deduction for the entire amount of the contribution, and then donate from that fund to charities in subsequent years. The big advantage is that you get an enhanced upfront deduction in the first year and then claim the standard deduction in several subsequent years. This strategy only works if the amount of the deduction for the contribution to the donor advised fund is sufficient such that your itemized deductions in the year of the contribution exceed the standard deduction by a healthy amount.

Deadlines, Deadlines, Deadlines!!!

Different deductions have different deadlines. Many deductions have December 31st deadlines, so it is important to make the contribution by year-end. For charitable contributions, it is best to make the contribution online with a credit or debit card before January 1st if you are running really late, though if you place the contribution in a U.S. Postal Service mailbox prior to January 1st that counts as prior to the near year (though it makes it harder to prove you beat the deadline if you drop it in the mailbox on December 31st).

For employee contributions to a 401(k), the deadline is December 31st. Thus, if you are reading this on December 5th and you want to significantly increase your 401(k) contribution for 2021, you ought to get in touch with your payroll administrator and increase your contribution rate for your last paycheck ASAP.

By contrast, the deadline for a 2021 contribution to a deductible IRA or a non-payroll 2021 contribution to a HSA is April 15, 2022 (the date tax returns are due).

Self-employed retirement plans have their own sets of deadlines that should be considered.

Conclusion

Tax deductions present several important tax planning considerations. These considerations should include the taxpayer’s current marginal tax rate and future marginal tax rate. They should also include consideration of maximizing the combination of itemized deductions and the standard deduction over multiple taxable years.

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.

Qualified Business Income Deduction Update

For those interested in tax planning for the FI community, some interesting news came from the Senate this week. Senator Ron Wyden, a Democrat and the Chairman of the Senate Finance Committee, released a proposal to modify the Section 199A qualified business income (“QBI”) deduction.

My view is that this is very good news, for reasons I will discuss below.

QBI Deduction

The Section 199A QBI deduction provides small business owners a deduction of up to 20 percent of their “qualified business income.” Usually, this is income from self-employment (reported on Schedule C) or income from a partnership or S corporation (reported on Form K-1). The deduction is subject to a host of limitations which tend to kick in hard for upper income taxpayers. 

I’ve written plenty on the Section 199A QBI deduction. My introductory post is here, and a more advanced post is here

The QBI deduction is good for the financial independence community. It lowers the federal income tax burden on those with small businesses and side hustles. 

Expiration

But there is one lurking issue with the QBI deduction: will it last? There are two reasons to worry that it will not. First, it was enacted by Republicans in late 2017 in a polarized political environment. While that means Washington Republicans generally support the deduction, it also means Washington Democrats may have no particular political reason to support it. Second, the deduction has an expiration date: December 31, 2025: The deduction is not available in tax years beginning after that date. 

While there are few things more permanent than a temporary tax deduction, obviously it is worrisome that if nothing else happens, we only have four and a half more years of the tax deduction. 

Wyden Proposal

Senator Wyden introduced a proposal to modify the Section 199A QBI deduction. The legislative language is available here and a summary of the legislation from Senator Wyden’s staff is available here.

I am still reviewing the language, so at this point (July 21, 2021) I only have a basic understanding of it. Please take the below as a preliminary analysis subject to change. 

The bill keeps the QBI deduction, but appears to eliminate it entirely (as related to qualified business income itself) if taxable income reported on the tax return is $500,000 or more. Between $400K and $500K of taxable income, the QBI deduction is phased out. It appears single taxpayers do very well with this provision, as the limits apply per tax return, and are not doubled for married filing joint taxpayers. 

The Wyden proposal eliminates the ability for married filing separately taxpayers and estates and trusts to claim the QBI deduction. 

The bill also eliminates the concept of a “specified service trade or business.” This simplifies the QBI deduction and will help many self-employed professionals qualify for the deduction where under current law they would not. 

See the example of Jackie I posted here. Without a deduction for Solo 401(k) contributions Jackie did not qualify for any QBI deduction at all because he was a single lawyer with a taxable income over $215K. If the Wyden proposal is enacted as written, Jackie could have up to $400K in taxable income and claim a full QBI deduction. Single moderate to high income professionals appear, at first glance, to be the big winners if the Wyden proposal is enacted. Some married professionals will also benefit from this provision. 

Section 199A Dividends

The proposed bill appears to keep the 20 percent deduction for “Section 199A dividends” which are dividends paid by real estate investment trusts (“REITs”) and mutual funds and ETFs which own REITs. It appears, however, that a taxpayer’s ability to deduct Section 199A dividends would phase out between $400K and $500K of taxable income. Under current law there is no taxable income limit on the ability to deduct 20 percent of Section 199A dividends. 

Expiration 

The Wyden proposal does not eliminate the expiration date, December 31, 2025. To my mind, that is not too surprising. Eliminating the expiration date would increase the “cost” of the Wyden proposal and thus, under Congressional budgeting procedures, likely require cutting spending or raising other taxes. 

The Good News

To my mind, the Wyden proposal is good news for those fond of the QBI deduction. Instead of eliminating the QBI deduction, we now have a powerful Washington Democrat embracing large parts of the deduction, and expanding its availability for some taxpayers. If this were to pass (and that is very speculative), then both Republicans and Democrats would have passed a version of the QBI deduction. At that point, it is unlikely that either party would want to be responsible for the deduction dying in full in 2026. 

This legislative proposal is simply a first step: stay tuned for further developments. But for the FI community, I see a powerful Washington Democrat embracing a large portion of the QBI deduction to be a positive development. 

FI Tax Guy can be your financial advisor! 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 The Struggle is Real Podcast

I chatted with Justin Peters on The Struggle is Real Podcast regarding tax issues for those in their 20s to consider. You can access the episode here: https://justinleepeters.podbean.com/e/what-you-need-to-know-about-taxes-in-your-20s-e39-sean-mullaney/

As always, the discussion is general and educational in nature and does not constitute tax, investment, legal, or financial advice with respect to any particular individual or taxpayer. Please consult your own advisors regarding your own unique situation.

FI Tax Guy can be your financial advisor! 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

QCDs and the FI Community

Qualified charitable distributions (“QCDs”) are an exciting tax planning opportunity, particularly for the FI community. Below I describe what a qualified charitable distribution is and how members of the FI community should think about them when tax planning.

Of course, this post is educational in nature. Nothing in this blog post is tax advice for any particular taxpayer. Please consult your own tax advisor regarding your unique circumstances. 

Qualified Charitable Distributions

QCDs are transfers from a traditional IRA directly to a charity. Up to $100K annually, they are (a) not included in the taxpayer’s taxable income, (b) not deductible as charitable contributions, and (c) qualify as “required minimum distributions” (“RMDs”) (to the lesser of the taxpayer’s required minimum distribution or the actual distribution to the charity). Here is an example:

Example 1: Jack and Jill are 75 years old and file their tax return married filing joint. Jack has a RMD from his traditional IRA of $40,000 in 2021. Jack directs his traditional IRA institution to transfer $40,000 during 2021 to a section 501(c)(3) charity. Jack and Jill recognize no taxable income on the transfer, and Jack does not have to take his 2021 RMD (the $40K QCD having covered it). Further, Jack and Jill receive no charitable contribution deduction for the transfer.

Considering that Jack & Jill (both age 75) enjoy a standard deduction of $27,800 in 2021, they get both the standard deduction and a $40K deduction for the charitable contribution from the traditional IRA (since they do not have to include the $40K in their taxable income). This is the best of both worlds. Further, excluding the $40K from “adjusted gross income” (“AGI”) is actually better than taking the $40K as an itemized deduction, since many tests for tax benefits are keyed off of AGI instead of taxable income. 

Important QCD Considerations

Take QCDs Early

Generally speaking, it is best that QCDs come out of the traditional IRA early in the year. Why? Because under the tax rules, RMDs come out of a traditional IRA first. So it is usually optimal to take the QCD early in the year so it can fulfill all or part of the required minimum distribution for the year. Then you can do Roth conversion planning (if desired), so long as the full RMD has already been withdrawn (either or both through a QCD and a regular distribution) from the traditional IRA first. 

No Trinkets

I don’t care how much you love your PBS tote bag: do not accept any gift or token of appreciation from the charity. The receipt of anything (other than satisfaction) from the charity blows the QCD treatment. So be sure not to accept anything from the charity in exchange for your QCD.

QCDs Available Only from Traditional IRAs

In order to take advantage of QCD treatment, the account must be a traditional IRA. 401(k)s and other workplace plans do not qualify for QCDs. Further, SIMPLE IRAs and SEP IRAs do not qualify for QCD treatment. 

As a practical matter, this is not much of an issue. If you want to do a QCD out of a 401(k) or other tax advantaged account, generally all you need to do is rollover the account to a traditional IRA. 

QCD Age Requirement

In order to take advantage of the QCD opportunity, the traditional IRA owner must be aged 70 ½ or older. 

Inherited IRAs

QCDs are available to the beneficiary of an inherited IRA so long as the beneficiary is age 70 ½ or older. 

QCDs For Those Age 70 ½ and Older

If you are aged 70 ½ or older and charitably inclined, the QCD often is the go-to technique for charitable giving. In most cases, it makes sense to make your charitable contributions directly from your traditional IRA, up to $100,000 per year. QCDs help shield RMDs from taxation and help keep AGI low. 

QCDs and the Pro-Rata Rule

If you have made previous non-deductible contributions to your traditional IRA, distributions are generally subject to the pro-rata rule (i.e., the old contributions are recovered ratably as distributions come out of the traditional IRA). 

However, QCDs are not subject to the pro-rata rule! This has a positive effect on future taxable distributions from the traditional IRA. Here is an example of how this works:

Example 2: Mike is age 75. On January 1, 2021, he had a traditional IRA worth $500,000 to which he previously made $50,000 of nondeductible contributions. If Mike makes a $10,000 QCD to his favorite charity, his traditional IRA goes down in value to $490,000. However, his QCD does not take out any of his $50,000 of basis from nondeductible contributions. This has the nice effect of reducing the tax on future taxable distributions to Mike from the traditional IRA, since the QCD reduces denominator (by $10K) for determining how much basis is recovered, while the numerator ($50K) is unaffected

QCDs for Those Under Age 70 ½

Those in the FI community considering early retirement need to strongly consider Roth conversions. The general idea is that if you can retire early with sufficient wealth to support your lifestyle, you can have several years before age 70 during which your taxable income is artificially low. During those years, you can convert old traditional retirement accounts Roth accounts while you are taxed at very low federal income tax brackets.

For the charitably inclined, the planning should account for the QCD opportunity. There is no reason to convert almost every dime to Roth accounts if you plan on giving significant sums to charity during your retirement. Why pay any federal or state income tax on amounts that you ultimately will give to charity?

If you are under the age of 70 ½ and are charitably inclined, QCDs should be part of your long term financial independence gameplan. You should leave enough in your traditional retirement accounts to support your charitable giving at age 70 ½ and beyond (up to $100K annually). These amounts can come out as tax-free QCDs at that point, so why pay any tax on these amounts in your 50s or 60s? Generally speaking, a Roth conversion strategy should account for QCDs for the charitably inclined. 

Conclusion

For the charitably inclined, QCDs can be a great way to manage taxable income and qualify for tax benefits in retirement. QCDs also reduce the pressure on Roth conversion planning prior to age 72, since it provides a way to keep money in traditional accounts without having to pay tax on that money. 

FI Tax Guy can be your financial advisor! 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 the How to Money Podcast

I recently discussed tax planning, financial independence, and entrepreneurship on the How to Money podcast. Please click the below link to listen. https://www.howtomoney.com/smart-tax-planning-moves-with-sean-mullaney/

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 Discusses the Roth 401(k) on the ChooseFI Podcast

Watch my recent segment on the ChooseFI podcast discussing the Roth 401(k)

I was privileged to join Brad and Jonathan on a recent episode of the ChooseFI podcast to discuss the Roth 401(k).

You can access the episode (Episode 289) on all major podcast players and here: https://www.choosefi.com/a-smorgasbord-of-fi-ep-289/

I have also blogged on the Roth 401(k). Here are two posts:

Roth 401(k)s for Beginners

Roth 401k Withdrawals

FI Tax Guy can be your financial advisor! 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

Luck, Credit, and the FIRE Movement

Recently, the FIRE movement has come in for some criticism. Here is one prominent example. While I don’t want to speak for the critics, some of the arguments boil down to a version of the following: FI or FIRE (I prefer FI, but let’s not argue over terminology) overemphasizes personal responsibility and individualism, as most financial outcomes are the result of luck and the work of others. For example, if you invest $250,000 in real estate and local property values skyrocket such that your investment is now worth $600,000, most of the value of your investment is not attributable to anything you did.

While I appreciate the perspective provided by these commentators, I respectfully disagree with the criticisms. 

My Journey with FI

Before I address the criticisms, I thought it would be helpful to share a bit of my perspective on FI. My journey with personal finance mostly starts in college, when I began to become interested in some of the tactics of personal finance. Things like the Roth IRA and passive investing. 

For me, the tactics were like the quartz countertops, cabinets, and ceiling beams on a home construction site: shiny objects drawing attention, but by themselves not all that impactful. As applied to personal finance, when you add in the FI framework, you transform shiny objects into a house. Having the FI framework and goals ultimately drives better choices and better luck. 

Getting introduced to FI in 2017 flipped a switch for me. It gave meaning to the personal finance tactics. More important, it encouraged me to make better choices. For me, it’s not about a FI number or a retirement deadline.* And it has never been about anyone who retired at a particularly early age. Rather, to me FI is all about making better choices that give me and my family more options and better financial luck. 

This is why I don’t believe “financial literacy” is an adequate substitute for FIRE. You can teach people about 401(k)s and HSAs until you’re blue in the face. Without something akin to the FI framework, financial knowledge by itself does not often materially improve choices and outcomes. Financial literacy without a framework and goals is sort of like teaching algebra in high school. There’s nothing wrong with it, but how much did algebra affect your adult life? 

Having shared a bit of my own FI journey, here are my thoughts on the recent criticisms of the FIRE movement. 

* Note: For some, FI is about hitting a FI number and/or retiring by a certain date. That’s great–to each their own. 

The Role of Luck

Michael Jordan won six NBA Championships. Wouldn’t we all say that he was a great basketball player?

But wait a minute. Wasn’t almost all of his success attributable to luck? First, Dr. James Naismith invented the sport of basketball. Then players, promoters, and team owners spread the sport throughout the United States such that professional leagues could become a way to earn an income. Then the founders, players, coaches, owners, television executives, and fans of the National Basketball Association had to build it and sustain it through some very challenging times. Without the work and support of countless people, Michael Jordan would not have been able to make a living playing basketball, much less win six championships playing basketball.

And what about Jordan’s height, good health, parents, coaches, and teammates? Talk about lucky . . .

Most of us, when confronted with all the luck Michael Jordan had in his basketball career, would simply acknowledge that luck played a role, but that in no way diminishes all the hard work he put into his craft and the fact that he was a great basketball player. 

In all situations, luck plays an important role. There is little anyone can do to avoid being subject to a significant degree of luck. All you can do is make choices based on judgment and what experience and history teach. Often, you will enjoy more good luck as you make better choices. 

Luck and choices are not entirely unrelated. The better financial choices you make, the more likely it is you will have good financial outcomes and enjoy better luck along the way. For example, you can’t get lucky with an investment if you don’t make the investment

Investment growth could** be thought of as luck. But without an individual financial choice (the decision to invest), you get absolutely none of that luck! The FIRE movement simply says “we have hundreds of years of economic data: we know diversified baskets of productive investments generally tend to grow over long periods of time, so start investing!”

FI provides a framework for capturing financial luck. Why shouldn’t there be a “movement” (if you want to call it that) of people who are intentional about making better choices that increase the odds that they and others will experience financial luck and success? 

** Note: I do not believe investment growth is luck. I simply acknowledge that some might think of investment growth as luck. 

Credit versus Choices

The FIRE movement is not about claiming credit for financial outcomes. It’s about encouraging good financial choices. 

To my mind, arguing that the FIRE movement is lacking because most of the credit belongs to others misses the point. The point of the Financial Independence movement is not to “deserve” financial success. Rather, the point is to make choices that increase the odds of financial success and having more financial options

If I wear a seatbelt, I’m making a choice that increases my odds of staying safe. 

I (hopefully) don’t demand credit for being safe. Rather, I simply make an informed choice that makes my life incrementally better. 

That is what the FIRE movement is all about: make good choices in your financial life, and, generally speaking, your financial life tends to have good outcomes. If someone wants to give you credit for the resulting outcomes, that’s fine, but that credit is not what the FIRE movement is all about.

None of this makes financial independence easy, and financial independence as an end goal will be more difficult for some than for others

But practically everyone has financial choices to make. Thus, the FIRE movement can speak to everyone. The FIRE movement offers a framework and encouragement to make good choices. Regardless of the luck you have had up to now, it is better to be intentional about your financial choices and seek to improve your future financial choices. 

Room for Improvement

Is everything perfect in the FIRE movement? Surely not. For example, extreme examples of FIRE tend to get overemphasized in the media and within the movement (in my opinion). 

Overemphasizing certain stories causes a distorted view of financial independence. But podcasts, YouTube, blogs, and other forums help all sorts of FI stories to get out there. The FIRE movement is constantly developing and different FIRE voices appeal to different listeners (and hopefully to a growing number of listeners). 

My hope is that the movement and the media reduce the emphasis on some of the more extreme FIRE examples (while still acknowledging their validity) and choose to promote a diverse array of FIRE perspectives. No one has all the answers, but everyone can make a contribution. 

The Future of FI

In May, I published the following: 

FI/FIRE will survive out of economic necessity. What else are people to do? Tie their entire economic future to one job that can be gone in an instant? The economic downturn occurring due to Coronavirus demonstrates that you need multiple sources of economic support. Part of FI (or FIRE) is that you ultimately build up so many sources of support (essentially, a well-diversified portfolio) that your job becomes an unnecessary source of support.

I stand by that. Some argue that FIRE is unrealistic. I’d argue that tying your financial future to a single job (or, more broadly, to your ability to always earn an income from your labor) is unrealistic. 

The FIRE movement provides a framework for improving your financial condition through better choices. That is a movement worth staying in. 

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

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 the Earn & Invest Podcast

Really enjoyed this year-end tax planning conversation with Doc G on the Earn & Invest podcast. Stay tuned to the end for some candid behind the scenes podcast recording.

https://www.earnandinvest.com/episodes-2/year-end-tax-moves-that-count

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

Follow me on Twitter: @SeanMoneyandTax

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

Roth IRA Withdrawals

The Roth IRA is 25 years old as of 2023 (its birthday was January 1st). Yet there is still confusion about the rules applicable whenever someone withdraws money from a Roth IRA prior to turning 59 ½. This blog post attempts to correct some misconceptions on the taxation of nonqualified Roth IRA withdrawals.

Watch me discuss Roth IRA withdrawals.

Roth IRAs: The Basics

A Roth IRA is a tax-advantaged account that generally offers tax-free growth for invested amounts. Taxpayers receive no upfront tax deduction for putting money into a Roth IRA. If properly executed, taxpayers can withdraw money from a Roth IRA entirely tax and penalty free, and can enjoy years of tax-free growth on the amounts invested in a Roth IRA.

I have previously blogged about why I believe the Roth IRA is a great tax-advantaged account in my An Ode to the Roth IRA.

Roth IRA Funding

How does one move money into a Roth IRA? There are three ways.

Annual Contributions

Generally speaking, if your income is below certain limits, you can contribute up to the lesser of $6,500 or your earned income (2023 limits) to a Roth IRA. If you are aged 50 or older, the limits are the lesser of $7,500 or earned income (2023 limits). 

I discussed Roth IRA annual contributions, including the income limits on the ability to make Roth IRA contributions, in this post

Conversions

Amounts can be converted from traditional retirement accounts into a Roth IRA. Any taxpayer can convert amounts from a traditional retirement account to a Roth IRA. There are no restrictions based on level of income and/or having had earned income. 

Conversions are taxable in the year of the conversion. 

There are several reasons you might want to do a Roth IRA conversion. One might be the anticipation of paying tax at a higher rate in the future. The planning concept is to “lock in” the lower tax rate in the year of the conversion rather than tomorrow’s (anticipated) higher tax rate, and to get all of the earnings on the contribution out of income taxation.

Unlimited Roth IRA conversions form the backbone of the Backdoor Roth IRA planning concept. 

Note that inherited traditional IRAs cannot be converted to Roth IRAs.

Transfers from Workplace Retirement Accounts

A third way to get money into a Roth IRA is by using workplace retirement accounts. Amounts in Roth 401(k)s and other workplace Roth accounts can be transferred into a Roth IRA. Generally, it is best to use direct “trustee-to-trustee” transfers to accomplish this. 

Further, after-tax contributions in workplace retirement plans can be directly transferred to Roth IRAs, as discussed in Notice 2014-54. The ability to transfer after-tax contributions into a Roth IRA has facilitated the use of the Mega Backdoor Roth IRA planning technique. 

Roth IRA Withdrawals: The Confusion

You may have heard that you cannot take money out of a Roth IRA if the account is not 5 years old without paying tax and a penalty. Not true!

There are not one, but two, five (5) year rules applicable to Roth IRAs. But neither one of them prohibit you from taking money out of a Roth IRA you have previously contributed through annual contributions. First, I will illustrate the default Roth IRA withdrawal rules, and then I will discuss the two 5 year rules. 

Quick Thought: Most of this blog post addresses situations where the taxpayer does not qualify for a qualified distribution. Generally, a taxpayer fails to qualify for a qualified distribution if he or she has not attained the age of 59 ½, and/or if he or she has not owned a Roth IRA for 5 years. The advantage of a qualified distribution is that it is automatically tax and penalty free. 

Roth IRA Withdrawals: The Layers

Here is the default order of distributions that come out of a Roth IRA. These are the rules that apply in cases where the taxpayer does not qualify for a qualified distribution. All Roth IRAs (other than inherited Roth IRAs) the taxpayer owns are aggregated for purposes of determining his or her Roth IRA layers.

First Layer: Tax-free return of Roth IRA contributions

Second Layer: Roth IRA conversions (first-in, first-out)

Third Layer: Roth IRA earnings

Each layer must come out entirely before the subsequent layer is accessed.

Here’s a brief example:

Example 1: Samantha opened her only Roth IRA in 2018. Samantha has made three prior $5,000 contributions to her Roth IRA (one for each of 2018, 2019, and 2020). She also made a $5,000 conversion from a traditional IRA to a Roth IRA in 2018. In 2021, at a time when her Roth IRA is worth $30,000 and Samantha is 50 years old, she takes a $10,000 withdrawal from her Roth IRA. All $10,000 will be a recovery of her previous contributions (leaving her with $5,000 remaining of previous contributions). Thus, the entire $10,000 distribution from the Roth IRA will be tax and penalty free.

The Roth IRA contributions come out tax and penalty free at any time for any reason! The 5 year rules have nothing to do with whether a taxpayer can recover their previous Roth IRA contributions tax and penalty free!

For those wanting to dig deeper into the tax law, please refer to this technical slide deck discussing why the Roth IRA contributions are distributed tax and penalty free regardless of the 5 year rules. 

Note that aggregation rules always apply. In making an analysis like the one provided in Example 1, one must account for all their Roth IRAs and treat all of their Roth IRAs as a single Roth IRA to determine their own Roth IRA layers. Roth 401(k)s and inherited Roth IRAs are not included in the analysis. 

5 Year Rule for Roth IRA Earnings

The first five-year rule for Roth IRAs applies only to a withdrawal of earnings from a Roth IRA. If the account owner has not owned a Roth IRA for at least 5 years, the earnings withdrawn from the account are subject to ordinary income tax (and possibly a penalty). 

Example 2: Joe is 62 years old in 2024. He has owned a Roth IRA since 2021. In 2024, after having made $14,000 in prior annual contributions to his Roth IRA, he withdrew $17,000 from the Roth IRA. Because Joe has not owned a Roth IRA for 5 years, the withdrawal is not a qualified distribution. Joe recovers his first $14,000 tax free as a return of contributions. The next $3,000 of earnings is taxable to Joe as ordinary income (because of the first five-year rule). Because Joe is over age 59 ½, he does not owe the ten percent penalty on the distribution. If Joe had not attained the age of 59 ½, he would owe the 10 percent penalty on the $3,000 of earnings he received. 

5 Year Rule for Roth IRA Conversions

There is a five-year rule applicable to taxable money converted from a traditional retirement account to a Roth IRA (what I will colloquially refer to as the “second five-year rule”). The idea behind the second five-year rule is to protect the 10% early withdrawal penalty applicable when someone has a traditional retirement account. Here is an illustrative example.

Example 3: Milton has $100,000 in a traditional IRA, no basis in any IRA, and is age 50. If he were to withdraw $1,000 from his traditional IRA (assuming no penalty exception applies), he would owe (in addition to ordinary income tax) a $100 penalty (ten percent) on the withdrawal. 

Okay, but what if Milton first converts that money from a traditional IRA to a Roth IRA (assume Milton has no other balance in a Roth IRA)? Would that get him out of the 10 percent penalty? No, it won’t, because of the second five-year rule.

Example 4: Milton has $100,000 in a traditional IRA, no basis in any IRA, has no Roth IRAs, and is age 50. In September 2024, he converts $1,000 to a Roth IRA. In October 2024, he withdraws $1,000 from that Roth IRA. Because of the five-year rule applicable to Roth IRA conversions, Milton will still owe the $100 penalty on the withdrawal from the Roth IRA. 

Had Milton waited until 2029 or later, he would not have owed the penalty on the withdrawal of that $1,000.

The 5 Year Rule for Roth IRA Conversions and the Backdoor Roth IRA

The Backdoor Roth IRA is subject to the second five-year rule, but the penalty effect turns out to be very minor (or non-existent) if the Backdoor Roth IRA has been properly executed.  

Conversions, the second layer of the Roth IRA stack, come out first-in, first out. Further, the taxable amount (potentially subject to the 10 percent penalty upon withdrawal) of any one particular Roth IRA conversion comes out first within the conversion amount. Thus, the second layer (the conversion layer) can be composed of several mini-layers.

Here is a quick example:

Example 5: Denzel made $6,000 nondeductible traditional IRA contributions on January 1, 2019 and January 1, 2020. On February 2, 2019 and February 2, 2020, Denzel converted the entire balance of the traditional IRA ($6,010 each time) to a Roth IRA. As of December 31, 2019 and December 31, 2020, Denzel had $0 balances in all traditional IRAs, SEP IRAs, and SIMPLE IRAs.

In 2021, at a time when Denzel is 35 years old and has made no other contributions or conversions to a Roth IRA, he withdraws $3,000 from his Roth IRA. The first $10 of the withdrawal will be from the taxable amount of his 2019 Roth conversion, and thus, will be subject to the 10 percent penalty as it violates the second five-year rule (Denzel will owe $1 in penalties). The next $2,990 is attributable to the non-taxable portion of his 2019 Roth conversion, and as such, will not be subject to the 10 percent penalty. None of the $3,000 will be subject to ordinary income tax. 

Penalty Exceptions

From time to time you will hear things such as “you can withdraw only $10,000 from a Roth IRA for a first-time home purchase.” Does that mean everything else discussed above does not apply?

Fortunately, the answer is no! 

So what is the $10,000 rule getting at? It is getting at amounts withdrawn from a Roth IRA that would otherwise be subject to the penalty (and possibly income taxes — see The Super Exceptions below). 

There are several penalty exceptions applicable to taxable converted amounts and earnings that are withdrawn from a Roth IRA in a nonqualified distribution. But the penalty exception rules generally apply on top of the usual layering rules, not instead of the usual Roth IRA layering rules. 

In a discussion on social media, I used a version of the following example.

Example 6: Jane Taxpayer, age 30, has had a Roth IRA since 2017. In 2020, she withdraws $30,000 from her Roth IRA to acquire her first home, and has never used traditional IRA and/or Roth IRA money for such a purchase. She has previously made $20,000 in annual contributions to the Roth IRA. The first $20,000 of the withdrawal is a tax-free return of those contributions (see the layers above). The next $10,000 is out of earnings (see the layers above). This $10,000 is taxable to her as ordinary income. But, because of the $10,000 “qualified first-time homebuyer distribution” exception, she does not owe the 10 percent penalty on the withdrawal of those earnings.

In this case, withdrawals used to fund certain home purchases can qualify for a penalty exception (the first-time homebuyer exception is subject to a $10,000 cap). Please visit this website for a list of the possible penalty exceptions applicable to withdrawals from a traditional IRA and a Roth IRA.

The Super Exceptions

If the taxpayer is relying on the disability, age 59 ½, death, or qualified first-time home purchase penalty exceptions, the earnings also come out income tax free so long as the taxpayer has owned a Roth IRA for five years. See slide 5 of the above referenced technical slide deck

As applied to Jane Taxpayer in Example 6 above, if she had owned a Roth IRA since any time in 2015 or earlier, the distribution of $10,000 of earnings would not only have been penalty free, it would have also been income tax free. 

60 Day Rollovers

A taxpayer might take money out of a Roth IRA and then reconsider. Perhaps he or she wants the money to grow tax-free. Or perhaps the taxpayer dipped into earnings and the distribution is not a qualified distribution, meaning that it will likely be subject to both ordinary income and a ten percent penalty. 

He or she might be able to roll the money back into the Roth IRA. However, the tax rules allow only one 60 day rollover every 12 months. The IRS has a website here discussing some of the issues. 

Because of the one-rollover-per-year rule, I generally advise against doing 60 day rollovers unless you need to. Generally, it is best to avoid them, and then have the option available as a life raft if money somehow comes out of a Roth IRA (or other IRA) when it should not have.

Required Minimum Distributions

There are no required minimum distributions from a Roth IRA! Every other non-HSA tax-advantaged retirement account, including the Roth 401(k), has required minimum distributions. 

Note that required minimum distributions are generally required once the Roth IRA becomes an inherited Roth IRA (in the hands of anyone but certain surviving spouses). 

Tax Planning

Okay, so taxpayers always have tax and penalty free access to old Roth IRA annual contributions. So what of it? As a practical matter, maybe nothing. 

In most cases, it makes sense to simply keep the money in the Roth IRA and let it grow tax free!

That said, there can be instances where, as part of a well crafted financial plan, it can make sense to withdraw previous Roth IRA contributions prior to age 59 ½. Further, it is good to know that, in an emergency situation, those old Roth IRA contributions are accessible.

Of course, prior to taking an early withdrawal from a Roth IRA, it is usually best to consult with your own financial advisor and/or tax advisor. 

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.

Transferring a Primary Residence to Children

How do you pass your family’s house to your children? It’s a pressing question and involves significant tax, legal, and emotional considerations. Unfortunately, it is a topic about which there is much confusion.

This blog post discusses some of the important considerations. But as a blog post, it can only scratch the surface. Anyone looking to efficiently pass on their home is well advised to consult with their own lawyer, tax professional, and in some cases, their banker as well.

Minor Children

To my mind, the primary planning objective of married couples with minor children vis-a-vis their home is to account for what happens if both spouses die. Such couples would want their children taken care of in the most flexible manner possible.

Generally speaking, in such situations, it is often best to work with a lawyer to transfer the primary residence to a revocable living trust (explained below). In the event of both spouses’ deaths, the house would be held by the trust and managed by the trustee of the trust. It could be sold or rented for the benefit of the children, or kept so the children and their guardian(s) could live in the house. 

This resolution is generally preferable to leaving a house directly to minor children. 

Revocable Living Trusts

What is a revocable living trust? It is generally a written trust (drafted by a lawyer) that owns property the grantor(s) or settlor(s) transfers to the trust. For this sort of planning, usually spouses (the grantors) transfer their home to the trust and designate themselves as the primary beneficiaries of the trust. The trust provides that the grantors’ minor children are the successor beneficiaries. Upon both spouses’ deaths, the trust becomes irrevocable, and a trustee holds the assets and manages them on behalf of the beneficiaries (the minor children).

The best thing about a revocable living trust: as long as the grantor(s) is/are alive, the trust is fully revocable! So mistakes can be easily fixed (working with a lawyer). 

Revocable living trusts also generally avoid probate. 

Tax Effect

One nice thing about a revocable living trust is that it doesn’t change the grantor’s tax situation. All the income of the trust assets remain the taxable income of the grantor. Generally speaking, the grantor’s tax return does not change at all. Further, favorable tax rules, such as the $250K per person exclusion for capital gains on qualified primary residences, apply unchanged.

Parents placing their primary residence in their own revocable living trust does not necessitate the filing of a federal gift tax return (Form 709).

Upon inheriting a house as the beneficiary of a revocable living trust, the child takes a fair market value tax basis in the house (the so-called “step-up in basis”). This makes using a revocable living trust a tax-efficient way of passing a house to the next generation. 

Adult Children

Okay, but what about adult children? It’s readily apparent that five-year olds should not own real estate outright. But what about grown children? If a primary goal is simply avoiding probate, why not use a joint tenancy with rights of survivorship instead of a revocable living trust?

Putting an adult child’s name on the title of the parent(s) primary residence (and thus, creating a joint tenancy with rights of survivorship) can lead to a host of issues, but perhaps not the issues that initially come to mind. 

Capital Gains Tax

What about the adult child’s capital gain upon the sale of the house after the parent’s death? Is that a reason to use a revocable living trust to house the house (pun intended)? 

Well, it turns out the answer is generally No. Assuming the adult child did not contribute to the acquisition of the house, the adult child can take a full fair market value basis in a house acquired from a joint tenancy. Here is an example very loosely based on the example on page 10 of IRS Publication 551:

Example: Joan and Jane owned, as joint tenants with rights of survivorship, Joan’s home. Joan paid $300K for it, Jane paid nothing for it. Upon Joan’s death, the home has a fair market value of $600K. Jane inherits (as the surviving joint tenant) the house from Joan with a $600K basis (a fully stepped-up basis).

If interested, I’ve prepared a technical analysis as to why the surviving non-contributing non-spouse joint tenant receives a full step-up in basis here

Note that the above full stepped-up basis does not obtain if the gift of a portion of the house was through a tenancy-in-common (instead of through a joint tenancy with rights of survivorship). However, there is little reason to use a tenancy-in-common to transfer a house, because the original owner’s remaining share simply remains in his/her name, and absent other arrangements, passes through probate.

Other Problems with Joint Tenancies

If the capital gains tax upon the original owner’s death isn’t an issue, why not use a joint tenancy to transfer your house to your adult children? Here are some of the considerations.

Capital Gains Tax

Wait, what? I thought you said capital gains taxes were not an issue. They generally aren’t an issue after the original owner’s death. But they can be an issue before his or her death.

What if, during the owner’s lifetime, the house is sold? What if there’s a pressing need to sell the house, perhaps to help pay for long-term care? 

The owner/occupant is at least somewhat protected by the $250K per person primary residence gain exclusion. But the adult child is not protected by that exclusion if the home is not their primary residence. The adult child could have to pay capital gains tax (based on their share of the proceeds less their share of the owner’s historic tax basis) on the transaction if the house is sold prior to the owner/occupant’s death.  

Loss of Control

Simply put, transferring an interest in your home to another person relinquishes some of your control over the property. You never know if you will need that control in the future. Proceed with significant caution, and consult a trusted lawyer, prior to putting anyone else on the title of your home.

Gift Tax

While not a horrible problem, adding an adult child to the title of a house as a gift requires the filing of a Form 709 gift tax return. Due to the high estate and gift tax exemptions, in most cases it is highly unlikely the transfer would trigger actual gift tax. 

Disputes Among Adult Children

Adding multiple adult children to the title as joint tenants with rights of survivorship can create issues after the parent’s death. If siblings cannot agree amongst themselves how to handle and/or dispose of the house, the disagreement can be difficult to resolve. Using a revocable living trust (which becomes irrevocable upon the parent’s death) gives the parent the opportunity to work with their lawyer to put in place a trustee and ground rules for how the house is to be managed and/or disposed of after death.

Children’s Issues

Adult children are people. And people have problems. Divorces, liabilities, bankruptcies, etc. Putting an adult child on the title of a home could subject the home to the adult child’s creditors in a problematic manner. 

Summary

The above are just some of the considerations to weigh before adding adult children to the title of a home as a joint tenant with rights of survivorship.

Revocable living trusts keep control with the original owner. Further, they facilitate transferring real estate to the next generation in a tax-efficient manner. Based on these advantages and the issues that exist with joint tenancies, I generally prefer revocable living trusts over joint tenancies for primary residences. Using a will can also be effective from a tax perspective, but should be discussed with a lawyer considering state and local real estate laws. Some states have transfer-on-death type real estate deeds, which also should be considered with a lawyer (if that sort of deed is available).

Outright Gift

You might be saying, well, I have only one child I want to give my house to. Further, I don’t need to own my house. Why not simply give the house outright to that child during my life and avoid any legal events/issues occurring at my death? 

Besides some of the issues discussed above and the full loss of control (which are troublesome enough), an outright gift creates a significant capital gains tax issue for the adult child. This capital gains tax issue exists both before and after the original owner’s death.

Previously, I wrote this example on the blog illustrating the issue:

William lives in a house he purchased in 1970 for $50,000. In 2019 the house is worth $950,000. If William gifts the house to his son Alan in 2019, Alan’s basis in the house is $50,000. However, if William leaves the house to Alan at William’s death, Alan’s basis in the house will be the fair market value of the house at William’s death.

Giving William’s house to Alan during William’s lifetime could increase the capital gains taxable to Alan by $900K! Ouch!

So, whatever you do (a) consult with your lawyer before determining how to pass your house to your children and (b) be very, very hesitant to outright give your house to your child. 

Conclusion

There are various ways in which you can transfer your home to your children. In many cases, I believe revocable living trusts are a great way to leave a house to children. You are always well advised to consult with your lawyer before making any decisions on how you want to title your house and how you want to transfer your house. If you do inherit a house from your parents, you should consult with a lawyer regarding titling issues and with your tax professional regarding the tax implications of selling the inherited home. 

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

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.