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Roth 401(k)s for Beginners

Roth 401(k)s are gaining prominence as a tax-advantaged workplace retirement account. This post provides introductory information regarding Roth 401(k)s and their potential benefits as a retirement savings account.

Two important introductory notes. First, not all 401(k) plans offer a Roth option, so for some employees, a Roth 401(k) contribution is not an option. Second, this post is for educational purposes only and is not advice for any particular taxpayer.

Traditional 401(k) versus Roth 401(k)

In an ideal world, contributions by an employee to a traditional 401(k) result in a tax deduction when contributed, and taxable income when withdrawn.

Example 1: Tony makes $100,000 from his employer in W-2 wages in 2021. Tony contributes $15,000 during the course of 2021 to his employer’s traditional 401(k). Tony will receive a W-2 from his employer reporting $85,000 of taxable W-2 wages for 2021.

In an ideal world, contributions by an employee to a Roth 401(k) result in no tax deduction when contributed, and no taxable income when withdrawn.

Example 2: Rudy makes $100,000 from his employer in W-2 wages in 2021. Rudy contributes $15,000 during the course of 2021 to his employer’s Roth 401(k). Rudy will receive a W-2 from his employer reporting $100,000 of taxable W-2 wages for 2021.

Roth 401(k) Contributions

Employees can contribute the lesser of their earned income or $19,500 (2021 limit) to a Roth 401(k) in “employee deferrals.” For those 50 years old or older, the 2021 limit is the lesser of earned income or $26,000.

The employee deferral limit factors in both traditional 401(k) employee contributions and Roth 401(k) employee contributions. Here’s an illustrative example.

Example 3: Sarah, age 35, earns $100,000 in W-2 income in 2021 at Acme Industries, Inc. Sarah contributes the maximum to her 401(k) plan. Assuming Acme offers both a traditional 401(k) and a Roth 401(k), that maximum $19,500 contribution can be split up however Sarah chooses ($13,000 to the traditional 401(k) and $6,500 to the Roth 401(k), $5,000 to the traditional 401(k) and $14,500 to the Roth 401(k), etc.).

Any combination (including all in the traditional or all in the Roth) is permissible as long as the total does not exceed $19,500 (using 2021’s limits).

Roth 401(k) Contributions: Income Limits

There’s good news here. Unlike their Roth IRA cousins, Roth 401(k) contributions have no income limits. In theory, one could make $1 billion annually in W-2 income and still contribute $19,500 to a Roth 401(k).

Matching Contributions

Employer matching contributions are one of the best benefits of 401(k) plans.

It is important to keep in mind that matching contributions, profit sharing contributions, and forfeitures must go into employee accounts as traditional contributions. This is true regardless of whether the employee’s own contributions are traditional, Roth, or both.

Example 4: Elaine, age 35, works at Perry Publishing. She earns a salary of $50,000. Perry matches 50% of the first 6% of salary that Elaine contributes to her 401(k). Elaine decides to contribute $3,000 (6 percent) of her salary to the 401(k) as a Roth contribution. Perry contributes $1,500 as a matching contribution. The $1,500 employer match goes into the 401(k) as a traditional contribution. The $3,000 and its growth are treated as a Roth 401(k), and the $1,500 and its growth are treated as a traditional 401(k).

Matching contributions may be subject to vesting requirements, as described in this post. Employee contributions to a 401(k) (whether traditional or Roth) are always 100% vested.

Roth 401(k) Withdrawals

The greatest benefits of a Roth 401(k) are tax-free growth and tax-free withdrawals. Tax-free withdrawals are generally the goal, but they are not automatic. Recently, I wrote a post on Roth 401(k) withdrawals.

One important consideration regarding Roth 401(k) withdrawals: Roth 401(k)s are subject to the required minimum distribution rules starting at age 72. Thus, you must start withdrawing money from a Roth 401(k) at age 72. As a result, you will have less wealth growing tax-free. For this reason, many consider rolling Roth 401(k)s to Roth IRAs prior to age 72.

Conclusion

Roth 401(k)s provide a great opportunity to save and invest for retirement. Taxpayers should consider their own circumstances, and often consult with tax professionals, in deciding their own investment program.

Default Rule for Roth IRA Withdrawals: The Layers

Unless the distribution qualifies as a “qualified distribution” (see below), amounts come out of Roth IRAs in layers. Only after one layer has been exhausted can the next layer come out.

Here is the order of distributions that come out of a Roth IRA:

First Layer: Roth IRA contributions

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

Third Layer: Roth IRA earnings

Here’s a brief example:

Example 1: Steve has made five $5,000 contributions to his Roth IRA in previous years. He also made a $10,000 conversion from a traditional IRA to a Roth IRA in 2014. In 2021, at a time when his Roth IRA is worth $60,000 and Steve is 45 years old, he takes a $10,000 withdrawal from his Roth IRA. All $10,000 will be a recovery of his previous contributions (leaving him with $15,000 remaining of previous contributions). Thus, the entire distribution from the Roth IRA will be tax and penalty free.

The Roth IRA contributions come out tax and penalty free at any time for any reason!

A qualified distribution from a Roth IRA is usually one where the account holder both (i) has owned a Roth IRA for at least 5 years and (ii) is at least 59 ½ years old. If either condition is not satisfied, the default layering rules described above apply. Qualified distributions from a Roth IRA are tax and penalty free regardless of the layers inside the Roth IRA.

See page 31 of IRS Publication 590-B for more information about qualified distributions from Roth IRAs.

Roth 401(k) Withdrawals

First, a practical note: employers may restrict in-service Roth 401(k) withdrawals before age 59 1/2. Consider that before thinking about how the tax rules apply to withdrawals.

Default Rule: Cream-in-the-Coffee

Generally speaking, Roth 401(k)s have (1) investment in the contract (“IITC”), which is generally previous contributions and conversions and (2) earnings.

Unlike the sequenced layering of Roth IRA withdrawals, Roth 401(k) withdrawals generally default to what Ed Slott refers to as the “cream-in-the-coffee” rule (see Choate — discussed below, page 140).

As a result, withdrawals default to carrying out both some IITC and some earnings. Here’s an example:

Example 2: Lilly has made five $6,000 contributions to her Roth 401(k) in previous years. She also made a $10,000 conversion from a traditional 401(k) to her Roth 401(k) in 2014. In 2021, at a time when her Roth 401(k) is worth $60,000 and Lilly is 45 years old, she takes a $10,000 withdrawal from her Roth 401(k). Two-thirds ($6,667, computed as the fraction $40,000 divided by $60,000 times the withdrawal) of the $10,000 will be a recovery of her IITC (entirely tax and penalty free), and one-third ($3,333, computed as the fraction $20,000 divided by $60,000 times the withdrawal) of the $10,000 will be earnings, which are subject to both ordinary income taxation and a 10 percent penalty.

Quick Thought: Had Lilly’s Roth conversion occurred in 2017 or later, the portion attributable to the conversion ($1,667) would be subject to the 10 percent early withdrawal penalty (but not to ordinary income taxation). See Section 402A(c)(4)(D) and Section 408A(d)(3)(F). Note an earlier version had “2018 or earlier” where the bolded words are in error. I regret the error.

Quick Thought: The cream-in-the-coffee rule does not factor in amounts in traditional 401(k) accounts, even if they are within the same 401(k) plan.

Solving the Cream-in-the-Coffee Issue

We see that the cream-in-the-coffee rule has bad effects. It does not allow exclusive access to tax-favored amounts when there are non-tax favored amounts in an account. So what to do? There are three primary exceptions to the cream-in-the-coffee rule.

Exception 1: Wait for a Qualified Distribution

The cream-in-the-coffee rule can be waited out.

A qualified distribution from a Roth 401(k) is a withdrawal that occurs when the owner is age 59 ½ (see Treas. Reg. Sec. 1.402A-1 Q&A 2(b)(2)) and has had that particular Roth 401(k) account for five years (see Treas. Reg. Sec. 1.402A-1 Q&A 2(b)(1) and Q&A 4). Other qualified distributions can occur upon death or disability (if the 5 year test is satisfied), but for our purposes, we will assume for the rest of the article that any qualified distributions are qualified distributions occurring at or after age 59 ½ and after five years of ownership.

The owner of a Roth 401(k) who qualifies for a qualified distribution does not need to roll the Roth 401(k) to a Roth IRA to take a tax free withdrawal. Once the owner qualifies for a qualified distribution he or she can simply withdraw amounts from the Roth 401(k) tax-free.

However, as a practical matter, it is often the case that Roth 401(k)s are rolled into Roth IRAs (for several reasons). If the rollover from the Roth 401(k) to the Roth IRA would qualify as a qualified distribution if taken directly, then the entire amount in the Roth 401(k) (IITC and earnings) goes into the Roth IRA as a contribution. Ian Berger discussed this issue in an August 11, 2022 response to a question. His answer applies the rule in Treas. Reg. Sec. 1.408A-10 Q&A 3 (the sentence beginning with “Thus,”).

Up to the amount rolled into the Roth IRA can be distributed tax and penalty free. So long as the taxpayer has met the 5 year rule with respect to any Roth IRA, any future earnings beyond the amount rolled in can be withdrawn tax free at any time.

Quick Thought: I would be remiss if I didn’t insert the standard tax planner advice that rollovers from Roth 401(k)s to Roth IRAs are best accomplished through a direct trustee-to-trustee transfer.

There is one five year rule nuance to consider. If the taxpayer has never had a Roth IRA, he or she must wait 5 years (regardless of their age) to access later earnings generated by rollover contribution tax free. Here’s a quick example:

Example 3: John is 60 years old. He has never had a Roth IRA. He has had a Roth 401(k) with his employer for over five years. He has made $100,000 of contributions to the Roth 401(k) which has grown to $200,000. He does not need to roll his Roth 401(k) into a Roth IRA to take out money entirely tax and penalty free.

If John chooses to roll all $200,000 in his Roth 401(k) into a Roth IRA, all $200,000 goes into the Roth IRA as a contribution. If John withdraws more than $200,000 from the new Roth IRA before the Roth IRA turns 5 years old, those withdrawals of new earnings would be subject to income tax (though, of course, penalty free since John is over 59 ½ years old).

As a practical matter, as long as the taxpayer does not plan on withdrawing more than the rolled over amount in the first five years, this nuance is not likely to be a gating issue in determining whether the Roth 401(k) should be rolled over to a Roth IRA.

Exception 2: Roth 401(k) Rollover then Withdraw

The second strategy to overcome the cream-in-the-coffee rule is to rollover the Roth 401(k) to a Roth IRA without waiting.

If either the taxpayer is less than 59 ½ years old and/or has not held that particular Roth 401(k) for at least five years, the nonqualified distribution rules apply to the rollover. The Roth 401(k) goes into the Roth IRA as “contributions” to the extent of the IITC in the Roth 401(k), and as “earnings” to the extent of growth in the Roth 401(k).

Recall the example of Lilly above. Here is how it changes if she rolls the Roth 401(k) into a Roth IRA and then takes the withdrawal.

Example 4: Lilly has made five $6,000 contributions to her Roth 401(k) in previous years. She also made a $10,000 conversion from a traditional 401(k) to her Roth 401(k) in 2014. In 2021, at a time when her Roth 401(k) is worth $60,000 and Lilly is 45 years old, she rolls her Roth 401(k) over to a Roth IRA (her first ever). A month later, Lilly takes a $10,000 withdrawal from her Roth IRA. All $10,000 will be a recovery of her previous contributions (leaving her with $30,000 remaining of previous contributions). Thus, the entire withdrawal will be tax and penalty free.

While rollovers of nonqualified distributions do not eliminate Roth 401(k) earnings, they do eliminate the cream-in-the-coffee rule. As a result, Roth 401(k) to Roth IRA rollovers often make sense.

The Five Year Roth Earnings Rule

Where such rollovers can be disadvantageous is the five year rule as applied to earnings. Recall that being age 59 ½ is a necessary, but not sufficient, condition to withdrawing Roth earnings tax free. You also need to meet a 5 year rule.

If you have a Roth 401(k) that is 5 years old but have never had any Roth IRA, and you are less than 5 years away from attaining age 59 ½, rolling into a Roth IRA could subject withdrawals of earnings (after age 59 ½) in excess of IITC to ordinary income taxation. That said, often withdrawals do not exhaust contributions in the first five years after a rollover. Thus, often this will not be a gating issue.

Exception 3: Roth 401(k) Withdrawal then Rollover

There is a third way to overcome the cream-in-the-coffee rule. It is to take a withdrawal from the Roth 401(k) and then rollover the earnings component to a Roth IRA. Let’s see how that would affect Lilly:

Example 5: Lilly needs $10,000 and has decided to access it from her Roth 401(k). Lilly has made five $6,000 contributions to her Roth 401(k) in previous years. She also made a $10,000 conversion from a traditional 401(k) to her Roth 401(k) in 2014. In 2021, at a time when her Roth 401(k) is worth $60,000 and Lilly is 45 years old, Lilly takes a $15,000 withdrawal from her Roth 401(k). Based on her Roth 401(k) consisting of two-thirds IITC and one-third earnings, $5,000 of the withdrawal is taxable and subject to an early withdrawal penalty. However, Lilly can, within 60 days, rollover the $5,000 of earnings into a Roth IRA. The earnings will go into the Roth IRA as earnings, and Lilly avoids the tax and penalty on the withdrawal.

Note that if Lilly does this partial rollover, the rollover piece is not subject to the cream-in-the-coffee rule. The partial rollover attracts earnings before attracting any IITC (see Treasury Regulation Section 1.402A-1 Q&A 5).

Note further that if Lilly has no other Roth IRAs, she now has a Roth IRA that consists only of earnings. She will not (generally speaking) be able to touch this Roth IRA without ordinary income tax and a penalty until age 59 ½.

As a practical matter, the “withdraw then rollover” strategy may not be available to Lilly. The 401(k) plan may not allow partial distributions pre-age 59 1/2 after separation from service.

Coordination with the Rule of 55

Many like the Rule of 55, which is a rule that allows taxpayers to take amounts from workplace retirement plans such as 401(k)s without the early withdrawal penalty. It applies when a taxpayer separates from service at age 55 or older (up to age 59 ½, when withdrawals become penalty free), and the plan allows partial withdrawals.

So the question becomes, if you are in the 4.5 year Rule of 55 window (ages 55 to 59 ½) and you separate from service, should you leave a Roth 401(k) in the plan or roll it into a Roth IRA if you need to withdraw from it? Let’s consider an example.

Example 6: James is 56 years old and leaves his employment. He has contributed $100,000 over more than five years to his Roth 401(k), and it is currently worth $200,000. If he keeps the amounts in the Roth 401(k), every dollar he takes out will be half recovery of IITC (tax-free) and half a withdrawal of earnings (taxable, but qualifies for a penalty exception). If, instead, James follows the “rollover then withdraw” strategy and rolls his Roth 401(k) to a Roth IRA, the first $100,000 he withdraws before age 59 ½ will be a return of contributions, and only if he exceeds $100,000 in withdrawals will he have ordinary income and a penalty. A second option for James would be to do the “withdraw then rollover” strategy whereby James would direct half of each distribution (the earnings half) to a Roth IRA in order to avoid ordinary income taxation on the earnings portion.

This illustrates that numbers matter in this regard. It also shows that as long as the pre-age 59 ½ withdrawals will be less than the previous Roth 401(k) contributions, it is generally better to take the withdrawals from a rollover Roth IRA than from a Roth 401(k) penalty protected by the Rule of 55.

However, if one employs the “withdraw then rollover” strategy, keeping money in the Roth 401(k) can work as effectively as rolling over to a Roth IRA.

A Note on Rollovers

Any designated Roth account (401(k), 403(b), and/or 457) can be rolled into a Roth IRA. Designated Roth accounts can be rolled into other designated Roth accounts, though note there can some be some complexity in this regard.

Roth IRAs cannot be rolled into a designated Roth account, including a Roth 401(k).

The IRS has a handy rollover chart accessible here.

SECURE 2.0 Update

SECURE 2.0 makes three changes relating to Roth 401(k)s. First, it eliminates required minimum distributions (“RMDs”) from Roth 401(k)s during the owner’s lifetime. This change has little practical effect, as many Roth 401(k)s will ultimately be rolled to Roth IRAs anyway in order for the owner to obtain more investment choice and control of the account.

Second, SECURE 2.0 mandates that beginning in 2024, employee catch-up contributions to 401(k) accounts must be Roth contributions if the employee made more than $145,000 in wages the prior year.

Third, SECURE 2.0 allows employer contributions to Roth 401(k)s.

I suspect that based on the second and third changes, more employers may offer Roth 401(k)s in addition to traditional 401(k)s.

Conclusion

The rules around Roth 401(k)s are complex, and different than those applicable to Roth IRAs. This blog post only presents an educational introduction to those rules. Taxpayers should exercise extra caution, and often consult with tax professionals, before moving money out of a Roth 401(k).

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

Follow me on Twitter: @SeanMoneyandTax

An Ode to the Roth IRA

It won’t surprise many to find out that a tax-focused financial planner is fond of the Roth IRA. Below is a brief review of the advantages of a Roth IRA.

Tax Free Growth

Amounts in Roth IRAs grow tax free. Considering many Americans may now live into their 80s, 90s, and beyond, this is a tremendous benefit.

The only caveat is that in order for all distributions from Roth IRAs to be tax and penalty free, they generally have to be either (a) a return of contributions or of sufficiently aged conversions (see below), or (b) a distribution of earnings made in the Roth IRA (or other amounts in the Roth IRA) at a time when the owner of the account is 59 ½ or older and has owned a Roth IRA for at least five years.

The rules for ordering distributions out of a Roth IRA generally provide that contributions come out first, and then the oldest conversions come out next. This means that in many cases Roth IRA distributions, even those occurring before age 59 ½, are tax and penalty free.

N.B. Generally speaking, you want to only take a distribution from a Roth IRA before age 59 ½ if it is either (i) a serious emergency or (ii) part of a well crafted, very intentional financial plan.

Ease of Administration and Withdrawal

There are many financial institutions that provide Roth IRAs. Investment expenses in low-cost index funds at financial institutions that provide Roth IRAs are approaching zero. Vanguard, Fidelity, and Schwab are among the very good providers of low-cost Roth IRAs (and there are others).

It is also relatively easy to access money inside a Roth IRA. This makes the Roth IRA a great account to have in an emergency. Of course, it is generally best to leave money inside a Roth IRA to let it grow tax free, but it is good to know that you can access money in a Roth IRA relatively easily if an emergency arises.

Tax Free Withdrawals of Contributions

This is a great benefit of the Roth IRA. Contributions to a Roth IRA can be withdrawn at any time for any reason tax and penalty free. Further, the first money deemed distributed from a Roth IRA is a contribution. Here is a quick example:

Mark is 35 years old in 2025. He made $6,000 contributions to his Roth IRA in each of 2020, 2021, 2022, 2023, and 2024 (for $30,000 total). In 2025, when his Roth IRA is worth $41,000, Mark withdraws $10,000 from his Roth IRA in 2025. All $10,000 will be deemed to be a return of contributions, and thus entirely tax free and penalty free.

The only exception is a taxpayer favorable exception: a timely withdrawal of an excess contribution (and related earnings) occurs before regular contributions are considered withdrawn.

N.B. Roth 401(k)s, 403(b)s, and 457s have different distribution rules — most pre-age 59 ½ distributions will take out some taxable earnings.

Tax Free Withdrawals of Sufficiently Aged Converted Amounts

If you convert an amount into a Roth IRA, you start a five year clock as of January 1st of the year of the conversion. Quick example:

Mike is 35 years old in 2025. Mike converts $10,000 from a traditional IRA to a Roth IRA on July 2, 2025. His five year conversion clock starts January 1, 2025. On January 1, 2030, Mike can withdraw the entire $10,000 he converted in 2025 tax and penalty free.

This feature of the Roth IRA, the tax free withdrawal of sufficiently aged conversions, is the basis for the Roth Conversion Ladder strategy. Sufficiently aged converted amounts are deemed to come out after contributions are exhausted and before more recent conversions and earnings come out.

No Required Minimum Distributions

During an account holder’s lifetime, there are no required minimum distributions from a Roth IRA. You can live to 150 and never be required to take money from a Roth IRA.

Creditor Protection

In federal bankruptcy proceedings, Roth IRAs are (as of 2024), protected up to $1,512,350.

Where there can be differences in liability protection are state general creditor claims (i.e., creditor protection in non-bankruptcy situations). In some states, Roth IRAs receive a level of creditor protection similar to that of ERISA plans. Generally, such protection is absolute against all creditors except for an ex-spouse or the IRS.

In other states, Roth IRAs receive no or limited creditor protection. In my home state of California, Roth IRAs are only creditor protected up to the amount necessary to provide for you and your dependents in your retirement (as determined by the court). Such protection is valuable but hardly airtight.

A Sneaky Way to Contribute More to Your Retirement

Yes, in theory everyone should save for retirement based on exacting calculations (i.e., I estimate I need $X in retirement, so based on projections I save $A in traditional accounts and $B in Roth accounts this year). That’s the theory.

In practice, it’s “I maxed out this account and that account” or “I put $C into this account and $D into that account.” There isn’t that much wrong with how we practically save for retirement, as long as we are saving sufficient amounts for retirement.

But not all “maxing out” is created equal. We know this because if Jane has $100,000 in a traditional IRA and Mary has $100,000 in a Roth IRA, who has more wealth? Mary! Unless Jane can always be in a zero percent income tax bracket, Mary has more than Jane, even though they both nominally have $100,000.

A Great Account to Leave to Heirs

While non-spouse heirs will have to take taxable required distributions from inherited IRAs (in many cases beginning in 2020 they will need to drain the account within 10 years of death), heirs are never taxed on distributions from Roth IRAs. This makes a Roth IRA a great account to leave to your heirs.

Compare with Other Retirement Accounts

No other retirement account combines ease of administration and withdrawal, low costs, significant tax benefits, creditor protection, and great emergency access the way the Roth IRA does. Most workplace retirement plans have some restrictions on withdrawals. Traditional account withdrawals do not have the tax advantages of a Roth IRA. Distributions from a traditional IRA, even one at a low-cost, easy to use discount brokerage, will trigger ordinary income taxes, and possible penalties, if withdrawn for emergency use.

Financial Planning Objectives

Personal finance is indeed personal. But I submit the following: pretty much every individual has some desire (and/or need) to not work at some point in his/her lifetime and every individual needs to be prepared for emergencies. Further, these are two very important financial planning objectives for most, if not all, individuals.

If the above is true, then we must ask “which account type best supports the combination of these two pressing financial planning objectives?” It appears to me that the answer is clearly the Roth IRA.

None of this is to say that a Roth IRA is the only way to plan for retirement and plan for emergencies, but rather, it is to say that, generally speaking, a Roth IRA ought to be a material element in such planning. Other tools, such as other retirement accounts, insurances, investments in taxable accounts, and sufficiently funded emergency funds are likely needed in addition to a Roth IRA.

Retirement Accounts and Emergencies

Let’s examine how a Roth IRA might help someone facing a very serious emergency.

Picture Jack, who is 52 years old, and has a full time job. He has $1M in a traditional 401(k) and $10,000 in cash in a taxable account. That’s it. Then picture Chuck, also 52 with a full time job. Chuck has $700,000 in a traditional 401(k), $250,000 in a Roth IRA, and $10,000 in cash.

Who is better situated to deal with an emergency? Far and away the answer is Chuck. 401(k)s are difficult to access in an emergency. First of all, the 401(k) plan might not allow in-service distributions, and it might not allow taking out a loan.

Even if the 401(k) allows in-service distributions, distributions from 401(k)s are immediately taxable, and often subject to penalties (10% federal, 2.5% in California, for example) if you are under age 59 ½. Loans, while not immediately taxable, can become taxable if not paid back.

Long story short, a 401(k) may be a tough nut to crack in an emergency.

What about a Roth IRA? In Chuck’s case, he can access his prior Roth IRA contributions and sufficiently aged contributions tax and penalty free at any time for any reason! And his Roth IRA is easy to access, particularly if it is at a low-cost discount brokerage.

When you combine tax-free growth, no requirement to take required minimum distributions during the account holder’s lifetime, and the best emergency access of any tax-advantaged retirement account, it is difficult to see why working adults should not have at least some money in a Roth IRA.

When a Roth IRA Doesn’t Make Sense

The short answer is: not often! I struggle to come up with profiles of individuals that would not benefit from having some amount in a Roth IRA.

I can think of two profiles. The first, a rare case, is someone with very large legal liabilities such that all of their wealth would benefit from the creditor protections offered by an ERISA retirement plan (such as a 401(k)) and who needs almost all of their wealth shielded from creditors.

First, if you have built up 6 figures or more in wealth, having creditors able to claim your entire wealth is relatively rare. Second, in most cases, good insurance coverage, including adequate medical insurance, professional liability insurance (as applicable), home and automobile insurance, and personal umbrella liability insurance, should protect the vast majority of people such that they could withstand any liability exposure caused by having money in a Roth IRA instead of an ERISA protected plan.

The second profile is someone with incredibly high income currently and very little anticipated income in the future (such that their future tax rate is much lower than today’s rate). This too is a bit of a unicorn – people with high income today tend to have decent income tomorrow (even in the FI community).

Health Savings Accounts

It will also come as no surprise that I am fond of health savings accounts. Health savings accounts share some of the attributes that make the Roth IRA such a winner for both retirement savings and emergency planning.

But, there are some drawbacks. First, the distribution ordering rules are not as taxpayer friendly. While it may be the case that you have sufficient old medical expenses that you can reimburse yourself for (and thus not pay tax and a penalty on the HSA distribution), that is not always going to be the case, and even if it is, does add a layer of complexity.

Second, the HSA is not for everyone. If a high deductible health plan is not good medical insurance for you, an HSA is generally off the table.

So, that leaves the HSA as a fantastic option for those who qualify for and use a high deductible health plan (and usually an option that should be part of a comprehensive financial plan if you use a HDHP). But it also means that the HSA is not quite as good as a tool for the combination of retirement saving and emergency planning.

Conclusion

Assuming that an individual (a) has retirement planning and emergency preparedness as financial planning objectives and (b) is not in a position where legal liabilities would cripple them without ERISA creditor protection, it is hard to argue against having at least some material amount in a Roth IRA.

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

Follow me on Twitter: @SeanMoneyandTax

From Tax Returns to Tax Planning

Many colloquially refer to the Winter and early Spring as “tax season.” To my mind, that is short sighted. Yes, for most the time from late January to mid-April are when their tax return is prepared and filed. But the most impactful tax work is not tax return preparation — it’s tax planning!

Below I discuss ways to use your current tax return as a springboard to tax planning.

Before we get started, two notes. First, there is some tax planning that can be “do it yourself” and some tax planning that is best considered and implemented with the help of a tax planning professional. When in doubt, the concept is probably the latter. Second, it is helpful to keep in mind the correct use of this blog or any other blog–as a tool to raise awareness. Blogs are not a substitute for professional advice, and are not advice for any particular person. Rather, this post and others should be viewed as a way to increase knowledge and help faciliate more informed conversations with professionals.

Your 2020 Tax Return

Your 2020 tax return is a great springboard for tax planning. Look at the following items on your tax return to jump start your tax planning.

Schedule D Line 13 Capital Gain Distributions

Everyone should review their own tax returns for the past few years and look at this line. If there is a substantial number on this line, it should raise a red flag.

I previously discussed capital gain distributions here. Generally, they come from mutual funds and ETFs in taxable accounts. These financial securities pass gains out to the shareholders, creating capital gains income on the shareholders’ tax returns. Actively managed funds tend to have much greater capital gain distributions than passively managed index funds.

The planning opportunity is to review the accounts that are generating significant capital gain distributions. If the realized gain in such accounts is low (or if there is a realized loss in those accounts), it might be advisable to sell the holding and replace it with a fund likely to have lower capital gain distributions. Taxpayers considering this strategy should be sure to fully understand the gain or loss in the securities before selling. Financial institutions do not have to report to investors (and the IRS) basis in mutual funds purchased prior to 2012, so sometimes it can be difficult to determine the taxable built-in gain or loss on older holdings.

Form 8889 Line 14c Distributions

Form 8889 is the tax return form for a FI favorite: the health savings account. Amounts other than $0 on Line 14c of Form 8889 should appear, in my opinion, only if the taxpayer is elderly or found themselves in a dire situation during the tax year. It is generally not optimal, from a tax perspective, to take distributions from an HSA to fund medical expenses when one is neither elder nor in a dire situation.

Amounts other than $0 on Line 14c can be a learning and planning opportunity. Future routine medical expenses are usually best paid from one’s checking account (a regular taxable account), and taxpayers should save the receipt. In the future, taxpayers can reimburse themselves tax free from their HSA for that expense. In the meantime, the money has grown in the HSA and enjoyed many years of tax free compounding.

Form 1040 Line 4b IRA Distributions Taxable Amount

Taxpayers who did a Backdoor Roth IRA and have a large amount on Line 4b of Form 1040 should review their transactions to make sure everything was correctly reported. Part of the idea behind a Backdoor Roth IRA is that, if properly executed, it should result in a very small amount of taxable income (as indicated on Line 4b).

It may be the case that the tax return improperly reported the Backdoor Roth IRA (and thus, the taxpayer should amend their return to obtain a refund). Or, it may be the case that the taxpayer did the steps of the Backdoor Roth IRA at a time they probably should not have (because they had a significant balance in a traditional IRA, SEP IRA, or SIMPLE IRA).

Discovering the problem can help effectively plan in the future, and if necessary take corrective action.

For those executing Roth Conversion Ladders, a large amount on Line 4b is the equivalent of Homer Simpson’s Everything OK Alarm. Roth Conversion Ladders are intended to create a significant amount of taxable income, and Line 4b is where that income is reported on Form 1040. Note further that all Roth IRA conversions require the completion of Part II of the Form 8606.

Schedule A Line 17 Total Deductions

Those who claimed itemized deductions in 2020 should review Line 17 of Schedule A. Is the number reported for the total itemized deductions close to the standard deduction amount (for 2021, single taxpayers have a standard deduction of $12,550 and married filing joint taxpayers have a standard deduction of $25,100)?

If so, there a tax planning opportunity. Why is that number what it is? Is it because of charitable contributions? If so, the donor advised fund might be a good opportunity. Here’s how it might work:

Example: Joe and Lisa file married filing joint. In 2020, they itemized based on $10K of state taxes, $9K of mortgage interest, and $6K of charitable contributions ($500 a month to their church). Thus, at $25,000 of itemized deductions, they were barely over the threshold to itemize. In 2021, they move a sizable amount into a donor advised fund ($25,000). They use the donor advised fund to fund their 2021, 2022, 2023, and 2024 monthly church donations.

From a tax perspective, Joe and Lisa itemize in 2021 (claiming total deductions of $44K – the state taxes, mortgage interest, and a $25K upfront deduction for contribution to the donor advised fund). In 2022, 2023, and 2024, they would claim the standard deduction, which is (roughly speaking) almost equivalent to their 2020 itemized deductions.

By using the donor advised fund, Joe and Lisa get essentially the same deduction in 2022 through 2024 that they would have received without the donor advised fund, and they get a tremendous one year increase in tax deductions in 2021.

Form 8995 or Form 8995-A Line 2

Those with any amount on Line 2 of the Form 8995 or the Form 8995-A should likely consider some tax planning. This line indicates that the taxpayer has qualified trade or business income that may qualify for the new Section 199A qualified business income deduction. Taxpayers in this situation might want to consider consulting with a professional, as there are several planning opportunities available to potentially increase any otherwise limited Section 199A qualified business income deduction.

2021 Adjusted Gross Income Planning to Maximize Stimulus Payments

Taxpayers should review line 11 (adjusted gross income or “AGI”) on their Form 1040 in concert with reviewing their stimulus checks. For those taxpayers who did not receive their maximum potential stimulus payments in 2021, there can be opportunities to lower AGI so as to qualify for additional stimulus payments and/or increased child tax credits. I blogged about one planning opportunity in that regard here.

The Shift to Tax Planning

Tax planning can take many shapes and sizes. But it needs to be driven by goals, not by tactics. Bad tax planning begins something like this: “I need a Solo 401(k), how do I set it up?” N.B. Opening a Solo 401(k) when you do not qualify for one is a great way to create a tax problem for yourself.

Good tax planning begins more like this: “I want to achieve financial independence. How do I best save for retirement in a tax advantaged way? I’ve heard a Solo 401(k) is a great option. As part of this process, we should consider it as a possible way to help me achieve my goal.”

Another point: I find there is far too much focus on “I had to pay [insert perceived sizable amount here] this year in taxes” and far too little focus on lifetime taxes. To my mind, the goal should not be to pay less tax in any one year. Rather, the goal should be to legitimately reduce lifetime tax burden. Sure, there can be tax planning that does both, but the best tax planning (whether DIY or with the help of a professional) places reducing lifetime tax burden as its primary goal.

Below are just some areas where taxpayers can begin their tax planning considerations.

Retirement Planning

This is a big one. Taxpayers should understand whether they contribute to a traditional IRA and/or Roth IRA, and why or why not. This post helps explain whether taxpayers qualify to make an annual contribution to a traditional IRA and/or a Roth IRA.

Taxpayers should consider their workplace retirement plans, which can provide several planning opportunities.

Small Business/Self-Employment Income

For those with a small business and/or significant self-employment income, tax planning is very important. I have written several posts about just some of the tax planning available to those with small businesses. People with small businesses often benefit from professional, holistic tax and financial planning.

Stock Options

Stock options and employer stock grants provide some good tax planning opportunities. I’ve previously written about ISOs, but all kinds of stock option programs can be an opportunity to do some tax planning, which often should be with a professional advisor.

Conclusion

Filing timely, accurate tax returns is important. But the best way to optimize one’s tax situation is to do quality, intentional tax planning. Tax planning should prioritize goals over tactics. There is some tax planning that can be done by yourself, but many areas of tax planning strongly benefit from professional assistance.

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

Follow me on Twitter: @SeanMoneyandTax

Understanding Your Form 1099-DIV

If you’re reading this in the Winter of 2024, you may have already received a bill from your financial institution. It’s called a Form 1099-DIV. Oddly, the financial institution isn’t demanding a penny of payment. Rather, your 1099-DIV prompts the IRS and your state tax agency (in most states) to expect the payment of income tax with respect to your financial assets.

A Form 1099-DIV is a great window into your taxable investments. By learning how to read the major boxes of your 1099-DIV, you can gain valuable insights about your investments and their tax efficiency.

VTSAX Form 1099-DIV 2024 Update

The Basics

Form 1099-DIV exists so that taxpayers and the IRS know the income generated by financial assets in dividend paying accounts. These include stocks, mutual funds, and exchange traded funds (“ETFs”). The financial institution prepares the Form 1099-DIV and submits a copy to the IRS and a copy to the taxpayer.

Let’s be clear about what we are talking about. We are not talking about assets in retirement accounts (401(k)s, IRAs, Roth accounts, HSAs, etc.). You do not receive a Form 1099-DIV from a retirement regardless of how much money the account earned during the year. This is one of the advantages of saving through a retirement account. Dividends and other income generated by assets in a retirement account are not taxable to the account holder when generated (so long as the funds stay in the retirement account).

Dividends

Corporations pay dividends to their shareholders as a return to the shareholders of their portion of some or all of the earnings of the corporation. The corporation’s Board of Directors vote from time to time to pay dividends to the shareholders. Boards determine dividends based on a variety of factors, including the company’s profitability, industry, stage in the corporate life cycle, and business cash needs.

All shareholders of a corporation receive dividends. Some of those shareholders are themselves mutual funds or ETFs. Mutual funds and ETFs distribute out dividends and certain other income they receive (such as interest) to their shareholders as dividends.

Box 1a and Box 1b

Box 1a lists the so-called “total ordinary dividends” received from the account. That is all of the dividends paid by the stocks, mutual funds, and ETFs in the account.

Box 1a should be understood as the entire pie. It represents all of the dividends received in the taxable account. The amounts in Box 1a are reported on line 3b of the Form 1040 (and on Schedule B if required).

Box 1b qualified dividends should be understood as a slice of the pie. It represents the portion of the total ordinary dividends that qualify for the long-term capital gains rates. Dividends create “ordinary income” for U.S. federal income tax purposes. However, certain “qualified dividends” (referred to as “QDI”) are taxed at preferential long term capital gains rates. As I have previously written, “[g]enerally, two requirements apply for the dividend to qualify for favorable QDI tax treatment. Very generally stated, they are:

The shareholder must own the stock for 60 of the 121 days around the “ex-dividend” date (the first date on which the stock sells without the right to receive the upcoming dividend); and,
The paying corporation must be incorporated either in the United States or in a foreign country with which the United States has a comprehensive income tax treaty.

Shareholders can obtain QDI treatment for stock owned through mutual funds and ETFs.

It may be that your qualified dividend slice is the entire pie. In most cases, there are usually some dividends that do not qualify for QDI treatment.

Amounts reported in Box 1b are reported on line 3a of the Form 1040.

Box 2a Capital Gain Distributions

Box 2a is the danger zone of the Form 1099-DIV. In a way, it is unavoidable to recognize dividends (even if such dividends are QDI) if one wants to invest in a broad based portfolio of equities in a taxable account. Eventually corporations pay out dividends. While younger companies tend not to pay dividends, as companies mature they tend to start paying dividends.

What are much more avoidable (at least to a degree) are capital gain distributions. Capital gain distributions come from mutual funds and ETFs (they do not come from individual stocks).

Capital gain distributions occur when fund managers sell individual holdings at a gain. The fund is required to (usually toward year end) pay out those gains to the shareholders. The paid out gains are reported in Box 2a.

Three things tend to increase capital gain distributions: 1) active management; 2) a bull market; and 3) fund redemptions.

Active Management

Usually, this is the most significant factor in capital gain distributions. In order to actively manage a mutual fund or ETF, fund managers generally need to buy and sell different holdings. The selling of holdings is what creates capital gain distributions.

Frequent trading can make certain actively managed mutual funds and ETFs very tax inefficient, because they trigger capital gain distributions that are currently taxed to the owner at capital gains rates.

From this, we can deduce the secret tax advantage of index funds. Index mutual funds and ETFs seek to simply replicate a widely known index. Other than occasional mergers and acquisitions of companies in the index, index fund managers rarely need to sell a holding to meet an investment objective. Thus, in many cases holding index funds in taxable accounts is tax efficient and will be better from a tax perspective than holding an actively managed fund.

Bull Market

Mutual funds and ETFs pass out capital gain distributions, not capital loss distributions. But in order for the shareholders to have a capital gain distribution, the mutual fund or ETF must (a) sell a holding and (b) must realize a gain on that sale.

In bear markets, it is often the case that the second requirement is not satisfied. The fund often realizes a loss on the sale of holding, meaning that the portfolio turnover does not generate a capital gain distribution reported in Box 2a. However, bear markets don’t always mean there will be no capital gain distributions, as active management and fund redemptions can still trigger capital gain distributions.

Fund Redemptions

There is an important distinction between mutual funds and ETFs in this regard. ETFs trade like public company stock — other than IPOs and secondary offerings, generally you buy and sell the stock of a public company and an ETF with an unrelated party that is not the issuer itself.

Mutual funds, on the other hand, are bought and sold from the issuer. If I own 100 shares of the XYZ mutual fund issued by Acme Financial, when I redeem my 100 shares, Acme Financial buys out my 100 shares.

In order to buy out mutual fund shares, the mutual fund must have cash on hand. If it runs out of cash from incoming investments into the fund, it will have to sell some of its underlying holdings to generate the cash to fund shareholder redemptions. This creates capital gain distributions for the remaining shareholders.

Interestingly, Vanguard has created a method to reduce the tax impact of mutual fund redemptions. Further, in recent times, fund redemptions have not caused significant capital gain distributions in many cases because in this current bull market mutual fund inflows often exceed outflows.

Box 3 Nondividend Distributions

There are occasions where corporations make distributions to shareholders during a time where the corporation does not have retained earnings (i.e., it either has not made net income or it has previously distributed out is net income). Such distributions are not taxable as dividends. Rather, such dividends first reduce the shareholder’s basis in their stock holding. Once the basis has been exhausted, the distribution causes a capital gain.

Box 5 Section 199A Dividends

Section 199A dividends are dividends from domestic real estate investment trusts (“REITs”) and mutual funds that own domestic REITs. These dividends are reported on Form 8995 or Form 8995-A and qualify for the Section 199A QBI deduction. The good news is that the taxpayer (generally) gets a federal income tax deduction equal to 20 percent of the amount in Box 5. This deduction does not reduce adjusted gross income but does reduce taxable income.

Section 199A dividends are another slice of the pie of Box 1a ordinary dividends.

Watch me explain Section 199A dividends

Box 7 Foreign Tax Paid

An amount in Box 7 is generally good news from a federal income tax perspective. Many countries impose a tax on the shareholder when the corporation pays a dividend is a non-resident shareholder. The corporation withholds a percentage of the dividend and then remits the net amount of the dividend to the shareholder.

The amount in Box 7 usually creates a foreign tax credit that reduces federal income tax dollar for dollar. If you have $300 or less in foreign tax credits ($600 or less if married filing joint) you can simply claim the foreign tax credit on your Form 1040 without any additional work. If your foreign tax credits exceed these amounts, you will also need to file a Form 1116 to claim the foreign tax credit.

The ability to claim foreign tax credits is a reason to hold international equities in taxable accounts.

Watch me discuss how VTIAX might generate a foreign tax credit on a US income tax return.

Boxes 11 and 12 Exempt-Interest Dividends and Private Activity Bond Interest

Box 11 represents all of the tax-exempt dividends received in the taxable account. Typically this is generated by state and municipal bond interest received by the mutual fund or ETF and passed out to the shareholders. This income is tax-exempt for federal income tax purposes.

This income may not be tax-exempt for state tax purposes. For example, in my home state of California, this income is taxable unless it is established that 50 percent or more of the funds assets are invested in California state and municipal bonds. In that case, the exempt-interest dividend attributable to California state and municipal bonds is tax-exempt for California purposes. The financial institution must separately provide the percentage of income attributable to California bonds to the shareholder in order to compute the amount of exempt-interest dividend exempt from California income tax.

Box 12 is a subset of Box 11 (Box 11 is the whole pie, Box 12 is a slice). Box 12 dividends are those attributable to private activity bonds. The significance is for alternative minimum tax (“AMT”) purposes. While this income is tax-exempt for regular federal income tax purposes, it is not tax-exempt for AMT purposes (and thus is subject to the AMT). After the December 2017 tax reform bill this issue still exists, though it affects far fewer taxpayers.

Conclusion

The Form 1099-DIV conveys important information, all of which must be properly assessed in order to correctly prepare your tax return. It can also provide valuable insights into the tax-efficiency of your investments.

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

Follow me on Twitter: @SeanMoneyandTax

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

Sean on the Corporate School Dropout Podcast

I recently chatted with Lauren Allen of the Corporate School Dropout podcast about my professional journey, entrepreneurship, and careers. You can listen here: https://www.corporateschooldropout.com/episodes/seanmullaney035

The SECURE Act’s Impact on the FI Community

In late December 2019 the President and Congress enacted the SECURE Act. The SECURE Act makes some significant revisions to the laws governing IRAs, 401(k)s, and other retirement accounts. This post discusses the impacts of these changes on those pursuing financial independence.

The Big Picture

The SECURE Act is a big win for the FI community, in my opinion.

The FI community significantly benefits from IRAs, 401(k)s, and other tax-advantaged retirement accounts. However, the federal government is facing increasing debts and annual deficits. That puts tax-advantaged accounts in the crosshairs. What Congress gives in tax benefits Congress can take away.

So what does the SECURE Act do? First, it actually gives us a couple more tax advantages during our lifetimes (see “Opportunities” below). Second, it significantly reduces the tax advantages of inherited retirement accounts for our heirs.

For those either with large retirement account balances or planning to have large retirement account balances, any change in tax laws is a potential problem. We should be glad that this round of tax law changes has occurred without our own retirement accounts being negatively impacted. Congress has passed the bill to our heirs, which, right or wrong, is a victory for us.

When you see people in the financial press squawking about how awful the SECURE Act is, remember, it could be a whole lot worse–your retirement account could have been more heavily taxed during your lifetime!

For those pursuing FI, the ability to use tax-advantaged retirement accounts remains the same, and in a couple small ways, has been enhanced. The next generation still has all those retirement account opportunities, even if they won’t be able to benefit from inheriting retirement accounts as much as they do under current law.

Opportunities

Traditional IRA Contributions for those 70 ½ and Older

Starting in 2020, those aged 70 ½ and older will be able to contribute to a traditional IRA. This will open up Backdoor Roth IRA planning for those 70 ½ and older and still working. For those still working (or doing side hustles) at age 70 ½ or older, this is a nice change.

Remember, regardless of age, in order to contribute to an IRA, you or your spouse must have earned income.

RMDs Begin at 72

For those attaining age 70 ½ after December 31, 2019, the age at which they will need to take RMDs will be 72, not 70 ½. This gives retirement accounts a bit more time to bake tax-deferred. It also slightly expands the window to do Roth conversions before RMDs begin. However, this last benefit is tempered by the fact that you must take Social Security no later than age 70. Roth conversion planning to reduce taxable RMDs should be mostly completed well before age 70 ½, regardless of this change in the law.

Note that taxpayers can still make qualified charitable distributions (“QCD”) starting when they turn age 70 ½. While pre-age 72 QCDs won’t satisfy RMD requirements, they will (a) help optimize charitable giving from a tax perspective (by keeping adjusted gross income lower and avoiding the requirement to itemize to deduct the contribution) and (b) reduce future RMDs.

Annuities in 401(k)s

The new law provides rules facilitating annuities in 401(k) plans. This one requires proceeding with extreme caution. If your 401(k) plan decides to offer annuity products, you need to carefully assess whether an annuity is the right investment for you and you need to fully understand the fees charged.

Remember, just because the law changed doesn’t mean your asset allocation should change!

Leaving Retirement Accounts to Heirs

This is the where the SECURE Act raises taxes. The SECURE Act removes the so-called “stretch” for many retirement plan beneficiaries. For retirement accounts inherited after December 31, 2019, only certain beneficiaries will be able to stretch out distributions over their remaining life (or based on the age of the decedent if over 70 ½ at death). For nonqualified beneficiaries, the rule will simply be that the beneficiary must take the account within 10 years of the owner’s death (the “10-year rule”).

My overall opinion on the SECURE Act stated above, planning for the next generation is important. Particularly if you are already financially independent and want to help your children become financially independent, the SECURE Act has significant ramifications.

Spouses

If your current estate plan features your spouse as your retirement account primary beneficiary, the SECURE Act should in no way change that aspect of your plan. Fortunately, the many advantages applicable to spouses inheriting retirement accounts will not change. Spouses remain an excellent candidate to inherit a retirement account.

Minor Children

If you leave your retirement account to your minor children, they are exempt from the 10-year rule (and can generally take distributions based on IRS RMD tables that are generous to younger beneficiaries) while they are still minors. Once your children reach the age of majority, they will have ten years to empty the retirement account.

The exception to the 10-year rule applies only to your minor children. It does not apply to your grandchildren, your adult children, and the children of others (including nieces and nephews).

Other Eligible Beneficiaries

The exceptions to the 10-year rule apply to your spouse, your minor children, the disabled, the chronically ill, and persons not more than 10 years younger than you at your death. All others will need to empty retirement accounts within 10 years of inheritance. This will require some significant planning in cases where the beneficiary has inherited a traditional retirement account to strategically empty the account over the 10 year window to manage adjusted gross income, taxable income, and total tax.

Planning

For those of you with estate plans involving adult children, the passage of the SECURE Act may well require revisions to your plans. First off, as a practical matter, your revocable living trust may need modifications. Many have designated a trust as a retirement account beneficiary. To do so properly requires conforming with specific income tax rules. Those with trusts as the beneficiary of their retirement account would be well advised to, at a minimum, consult with their lawyer to determine if the language of the trust needs updating.

Second, understanding that inheriting a traditional retirement account will now mean accelerated, and possibly significantly increased, taxation for their heirs, many will want to consider Roth conversion planning. Roth accounts will be subject to the 10-year rule, but the good news is that the beneficiary can keep the assets in the Roth account for 10 years, let it grow tax free, and then take out the money in 10 years tax free. Not too bad.

Roth conversion planning to optimize your heirs’ income tax picture is now even more important. However, it should not be done if it will impose a financial hardship on the account owner during their lifetime. The first priority should be securing the account owner’s retirement. Only if the account owner is financially secure should they consider Roth conversion planning to reduce their heirs’ tax liability.

Conclusion

Tax rules are always changing. This round of changes is a victory for those pursuing financial independence. Any tax law change that does not negatively impact your path to financial independence is a win.

For those considering the financial health of their heirs, particularly their adult children, the SECURE Act should prompt some reconsideration of estate plans. Often it is wise to consult with professional advisors in this regard.

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

Follow me on Twitter: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters.

Roth Conversions for the Self-Employed

Are you self-employed? Is your self-employment income your primary source of income? If so, you might want to consider doing a Roth conversion before the end of the year.

Takeaways

If most of your taxable income is self-employment income (either reported on Schedule C or from a partnership), you might want to consider year-end Roth conversions to maximize your QBI deduction and pay a lower-than-expected federal income tax rate on the conversion.
To optimize this strategy, convert traditional IRAs to Roth IRAs (or do in-plan traditional 401(k) to Roth 401(k) conversions) to increase your QBI deduction.

Why? Because of the still relatively new qualified business income (“QBI”) deduction (also known as the Section 199A deduction).

QBI Deduction and Initial Limitation

Starting in 2018, there is a deduction for “qualified business income.” This is generally income from a qualified trade or business received from a sole proprietorship (and reported on Schedule C), from a partnership, or from a S Corporation (in these cases, generally reported to the taxpayer on a Form K-1 and reported on the Schedule E with the tax return).

Important for this purpose is the initial limit on the QBI deduction. It is the lesser of following two amounts:

20 percent of taxable income less “net capital gain” which is generally capital gains plus qualified dividend income (“QDI”) (the “Income Limit”) or
20 percent of QBI (the “QBI Limit”).

As a practical matter, in most cases the limit will be determined by the second limitation (such taxpayers are what I call “QBI Limited”). Many taxpayers will have much more taxable income than they have QBI. Consider spouses where one has self-employment income and the other has W-2 income. Unless the W-2 income is very small, their combined taxable income is likely to be in excess of their combined QBI, and thus they will be QBI Limited.

Alternatively, consider a situation where a single person has QBI from an S corporation (say $50,000) and the S corporation also pays him or her a W-2 salary (say $60,000). In such a case the QBI is $50,000 (20% of which is $10,000) and the taxable income might be $97,450 ($110,000 total from the S corporation less a $12,550 standard deduction), 20% of which is $19,490. This taxpayer would also be QBI Limited.

Income Limited

But what if you are not QBI Limited, but rather, limited by the Income Limit listed above (what I call “Income Limited”)? Here is an illustrative example.

Example 1: Seth is single and self-employed. He claims the standard deduction in 2021. He reports a business profit of $100,000 on his Schedule C. He also has $1,000 of interest income.

His Income Limit is computed as follows:

Schedule C Income: $100,000

Interest Income: $1,000

Deduction for ½ Self-Employment Taxes: ($7,065)

Standard Deduction: ($12,550)

Taxable Income: $81,385

20% Limit: $16,277

Seth’s QBI Limit is computed as follows:

Schedule C Income: $100,000

Deduction for ½ Self-Employment Taxes: ($7,065)

QBI: $92,935

20% Limit: $18,587

In this case, Seth’s QBI deduction is only $16,277 (he is Income Limited), the lesser of these two calculated limits.

Roth Conversion Planning

Is there anything Seth can do to increase his limitation and optimize his QBI deduction?

Imagine Seth has $20,000 in a traditional IRA (with zero basis). He could convert some of that traditional IRA to a Roth IRA by December 31, 2021. This would create taxable income, which would increase Seth’s Income Limit. Here is how that could play out:

Without Roth Conversion

Schedule C Income	$ 100,000
Interest Income	$ 1,000
Deduction for ½ Self-Employment Taxes	$ (7,065)
Adjusted Gross Income	$ 93,935
Standard Deduction	$ (12,550)
Qualified Business Income Deduction (see above)	$ (16,277)
Taxable Income	$ 65,108
Federal Income Tax	$ 10,072

With Roth Conversion

Schedule C Income	$ 100,000
Interest Income	$ 1,000
Deduction for ½ Self-Employment Taxes	$ (7,065)
Roth IRA Conversion	$ 11,550
Adjusted Gross Income	$ 105,485
Standard Deduction	$ (12,550)
Qualified Business Income Deduction	$ (18,587)
Taxable Income	$ 74,348
Federal Income Tax	$ 12,105

What has the $11,550 Roth IRA conversion done? First, it has made the Income Limit ($18,587) the exact same as the QBI Limit ($18,587). Thus, Seth’s QBI deduction increases from $16,227 to $18,587.

Second, notice that Seth’s taxable income has increased, but not by $11,550! Usually one would expect that a Roth IRA conversion with no basis recovery would simply increase taxable income by the amount converted. But not here! The interaction with the QBI deduction caused Seth’s taxable income to increase only $9,240 ($74,348 minus $65,108).

This example illustrates that, under the right circumstances, a Roth IRA conversion can receive the benefit of the QBI deduction!

As a result, at Seth’s 22 percent marginal federal income tax bracket, his total federal income tax increased only $2,033. In effect, Seth pays only a 17.6 percent rate on his Roth IRA conversion ($2,033 of federal income tax on a $11,550 Roth IRA conversion). This is true even though Seth is in the 22 percent marginal tax bracket. His Roth IRA conversion is only 80 percent taxable. This is the flip-side of the 80% deduction phenomenon I previously blogged about here.

Is it advantageous for Seth to convert his traditional IRA? Well, it depends on Seth’s expected future tax rates. If Seth’s future marginal tax bracket is anticipated to be 22 percent, then absolutely. Why not convert at a 17.6 percent instead of face a 22 percent rate on future traditional IRA withdrawals?

Strategy

Seth’s Roth IRA conversion is optimized. The takeaway is that the Roth IRA conversion gets the benefit of the QBI deduction, but only for amounts that increase the Income Limit up to the QBI Limit.

A *very general* rule of thumb for solving for the optimal Roth conversion amount is to multiply the difference between the QBI Limit and the Income Limit (without a Roth conversion) by 5. In Seth’s case, that was $18,587 minus $16,277 (which equals $2,310) times 5.

In this case, converting exactly $11,550 made Seth’s Income Limit exactly equal his QBI Limit. As long as the Roth conversion increases the Income Limit toward the QBI Limit, the conversion benefits from the QBI deduction.

But the first dollar of the Roth conversion that pushes the Income Limit above the QBI Limit does not receive the benefit. If Seth converted $11,551 from his traditional IRA to his Roth IRA, that last dollar above $11,550 would be taxed at Seth’s full 22 percent federal marginal tax bracket.

Note that instead of / in addition to a Roth IRA conversion, Seth could do an in-plan traditional 401(k) to Roth 401(k) conversion, if he had sufficient funds in a traditional 401(k), and the 401(k) plan permits Roth 401(k) conversions.

Also note that the strategic considerations with QBI deductions become much more complicated once taxpayers exceed the initial QBI taxable income limitations (in 2021, those are $164,900 for single taxpayers and $329,800 for married filing joint taxpayers).

Conclusion

Taxpayers whose taxable income consists mostly or exclusively of self-employment income should consider Roth conversions toward year-end. This is often an area that benefits from consulting with a professional tax advisor before taking action.

One: Let it Grow!!!

When it comes to HSAs, often the best advice is Let it Grow, Let it Grow!!! Sing it to the tune of the popular Disney movie song if it helps you to remember.

Adding an “r” and a “w” would make Elsa a tremendous HSA advisor.

Spend HSA money only if one of the following two adjectives apply: DIRE or ELDERLY. Those neither in a dire situation nor elderly should think twice before spending HSA money! Instead, Let it Grow!

The tax benefits of an HSA are so powerful that funds should stay in the HSA (to keep growing tax free) and only be removed in dire (medical or financial) circumstances or by the elderly. Unless you leave your HSA to your spouse or a charity, HSAs are not great assets of leave to heirs. Thus, HSAs are great to spend down in your later years (after years of tax-free growth).

Two: Max Out Payroll Contributions by December 31st

While you can contribute via non-payroll contribution by April 15, 2020 for 2019, contributing to your HSA through payroll deductions is generally optimal since it secures both an income tax deduction and a payroll tax deduction for the money contributed.

If you didn’t max out your HSA through payroll deductions in 2019 and your employer allows HSA payroll deductions, write the check to your HSA in early 2020 (for 2019) and set up your 2020 payroll elections so as to max out your HSA through payroll deductions in 2020.

Three: Review HSA Investment Allocation

Those with low-cost diversified investment choices in their HSA are generally well advised to invest in higher growth assets inside their HSAs. The HSA is a great tax-protected vehicle. That tax protection is best used for high growth assets.

Those who have invested their HSA funds solely or mostly in cash should consider reassessing their HSA investment strategy.

Four: Track Medical Expenses

Medical expenses incurred after coverage begins under a high deductible health plan (a “HDHP”) can be reimbursed to you from an HSA many years in the future. There is no time limit on the reimbursement. Unless you are elderly, long-delayed reimbursement (instead of directly paying medical expenses with a HSA) is usually the tax-optimal strategy. Keep a digital record of your medical expenses and receipts to facilitate reimbursements out of the HSA many years in the future.

Five: Properly Report HSA Income (CA, NJ, NH, TN)

HSAs are tax-protected vehicles for federal income tax purposes and in most states. On your federal tax return, you need to report your HSA contributions and distributions (see Form 8889). However, you are not taxed on the interest, dividends, and capital gains earned in the HSA, and you do not need to report these amounts.

It is very different if you live in California and New Jersey. Neither California nor New Jersey recognize HSAs as having any sort of state income tax protection. They are simply treated as taxable accounts in those states. In preparing your California or New Jersey state tax return, you must (1) increase your federal wages for any excluded HSA contributions, (2) remove any deduction you took for HSA contributions (non-payroll contributions to your HSA), and (3) report (and pay state income tax on) your HSA interest, dividends, capital gains, and capital losses.

This last step will generally require accessing your HSA account online and pulling all of the income generating activity, including asset sales, in order to properly report it on your California or New Jersey tax return.

Tennessee and New Hampshire do not impose a conventional income tax, but do tax residents on interest and dividends above certain levels. HSA interest and dividends are included in the interest and dividends subject to those taxes.

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

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

Fixing Backdoor Roth IRAs

Watch me discuss Backdoor Roth IRA tax return reporting on YouTube.

The word is out. The Backdoor Roth IRA is a powerful tax planning tool. You may believe that by previously executing Backdoor Roth IRAs, you have planned well and received a great tax benefit while building retirement savings.

Is it possible you are mistaken? It is possible you did not complete the Backdoor Roth IRA correctly?

It may be true that you have successfully completed the two independent steps of a Backdoor Roth IRA: a traditional, non-deductible IRA contribution followed by a later Roth IRA conversion. It may also be true that you had no balances in a traditional IRA, SEP IRA, and/or SIMPLE IRA as of December 31st of the year you did the Backdoor Roth IRA.

Year-end tip: The deadline to clean out traditional/SEP/SIMPLE IRAs (by rolling them into employer retirement plans such as 401(k)s) so as to optimize a Backdoor Roth IRA is December 31st of the year of the Roth IRA conversion step. As a practical matter, you should not complete the Roth IRA conversion step until you have cleaned out the traditional/SEP/SIMPLE IRAs. Life happens; there is simply no guarantee you complete the clean out before December 31st. Failing to do so will significantly increase the tax on your Backdoor Roth IRA.

But you may not have correctly reported the Backdoor Roth IRA on your tax return. This last step is too-often overlooked. Below I discuss how to properly report a Backdoor Roth IRA, a potential tax return mistake that could have cost you thousands in erroneous taxes, and ways to fix the mistake.

Backdoor Roth IRA Example

Charlie is single and 35 years old. He is covered by a retirement plan at work. In 2018 his W-2 salary was $200,000, and thus he did not qualify to make a Roth IRA contribution for 2018. He has no balance in a traditional IRA, SEP IRA, or SIMPLE IRA. He decides to do a Backdoor Roth IRA.

On September 2, 2018, Charlie contributed $5,500 to a traditional, non-deductible IRA. On October 10, 2018, he converted the entire balance in the traditional IRA, then $5,510, to a Roth IRA.

So far, so good with the Backdoor Roth IRA! But Charlie’s not done yet. Let’s look at how the Charlie should file his tax return and the pitfalls he should avoid.

Backdoor Roth IRA Tax Return Reporting

Early in the year, Charlie should receive a Form 1099-R that looks like the following from his financial institution.

Charlie’s Backdoor Roth IRA Form 1099-R should look something like this. Note that the “taxable amount” is the full conversion amount ($5,510) and the box indicating that the taxable amount has not been determined is checked.

This requires precise tax return reporting to ensure Charlie increases his taxable income by the correct amount to account for the Backdoor Roth IRA. An error in the tax return reporting could erroneously overstate his adjusted gross income and thus cause him to pay significantly more to the IRS and state tax agency than he owes.

There are two places Charlie needs to report the Backdoor Roth IRA: Pages 1 and 2 of Form 8606 and lines 4a and 4b of the Form 1040.

Let’s start with the Form 8606. Below is the correct way for Charlie to file Page 1 of his Form 8606.

*Lines 1, 6, and 11 of the Form 8606 are crucial to properly reporting a Backdoor Roth IRA and computing the nontaxable portion of the Roth IRA conversion.*

Notice a few things about this form. First, on line 1 Charlie reports his traditional, non-deductible IRA contribution of $5,500. Second, on line 6, Charlie reports the total combined value of his traditional IRAs, SEP IRAs, and SIMPLE IRAs as of December 31, 2018. He can find this number on the Forms 5498 that his financial institutions send him and the IRS regarding his IRA accounts. To have a very efficient Backdoor Roth IRA, ideally Charlie should no balance in these accounts on December 31, 2018, and thus Charlie can, and does, report zero on line 6. If Charlie has any such balances the total must be reported here and it will cause his Backdoor Roth IRA to be partially (maybe mostly) taxable.

Next, Charlie reports his Roth IRA conversion amount on line 8. This is the total taxable amount he converted, reported to him in Box 2 of the Form 1099-R, $5,510. The mechanics of the Form 8606 then lead to lines 11 and 13, the nontaxable portion of Charlie’s Roth IRA conversion. In Charlie’s case, this is $5,500. This is because he is entitled to recover all $5,500 of basis he has in his traditional IRA (as computed in this part of the Form 8606). This $5,500 number is required to correctly prepare Page 2 of the Form 8606 and line 4b of the Form 1040.

*Form 8606 Line 18 should be reported on Line 4b of Form 1040 for a 2018 Backdoor Roth IRA.*

Page 1 computed how much of Charlie’s basis he can recover and the nontaxable portion of his Roth IRA conversion. Page 2 answers the second question: How much of Charlie’s Roth IRA conversion is taxable? Line 16 is simply line 8, and line 17 is simply line 11. Subtracting the nontaxable portion of the Roth IRA conversion from the total converted amount yields the amount of the Roth IRA conversion that is taxable. In Charlie’s case, it is only $10. This amount goes to Charlie’s Form 1040, line 4b.

*This is how a Backdoor Roth IRA should look on your Form 1040. Notice the very small number on Line 4b.*

The Wrong Way

The following is what Charlie’s Form 1040 might look like if his Backdoor Roth IRA is misreported.

*Heed the warning of my chicken scratch: a four figure number on Line 4b after a Backdoor Roth IRA is likely an indication that either the tax planning or the tax reporting is off.*

How might this happen? It could be that a Form 8606 simply was not prepared, or it was incorrectly prepared. Sometimes the Form 1099-R is misunderstood. People see that $5,510 is the “taxable amount” in line 2 of the Form 1099-R and believe that must be the taxable amount reported on line 4b. But remember, the Form 1099-R has a box checked indicating that the taxable amount is not determined. The Form 8606 is what determines the taxable amount created by the Backdoor Roth IRA (in Charlie’s case, $10).

As a check, you should ensure that the Lines 18 of your previously filed Forms 8606 agree to the appropriate line on the Form 1040 (line 4b in 2018). If there are discrepancies (and/or a Form 8606 was not filed for a Backdoor Roth IRA), that is an indication there is likely an error on the tax return. If Line 18 on the Form 8606 is a four-figure or greater number after a Backdoor Roth IRA, it is very likely that either the tax planning or the tax return reporting went wrong somewhere.

We can see how deleterious this error is for Charlie. If he filed his tax return the wrong way, his federal taxable income is overstated by $5,500. In his case, this caused him to erroneously owe $1,760 more in federal income tax ($43,613 minus $41,853 — hat tip to ProConnect Tax Online for the tax calculations). If Charlie lives in a state with a state income tax, he will also overpay his state income taxes because of this error.

Filing an Amended Tax Return

Imagine that Charlie filed his tax return as pictured in the Wrong!!! picture above. What can Charlie do?

Charlie’s remedy is to file an amended return. This entails refiling the Form 1040 and all of its related forms and schedules (including the Form 8606) with the correct amounts. It also entails filing a Form 1040X. This form presents amounts as originally filed and as corrected, with the difference illustrated. It also requires a narrative submission explaining the changes made on the amended tax return.

There are several things to keep in mind when filing an amended tax return. First, a taxpayer filing an amended return is under an obligation to correctly report amounts. If, as part of the exercise of fixing a Backdoor Roth IRA through an amended tax return, the taxpayer learns that other amounts on the originally filed tax return were incorrect, he or she must correct those amounts if they choose to file an amended return.

Second, there is a deadline for amending a federal income tax return (the so-called statute of limitations). Generally, the deadline is three years from the later of the tax return due date (if originally filed on or prior to the initial tax return due date) or the filing date (if filed after the initial tax return due date). This later deadline applies anytime the taxpayer files after the initial due date (including, for example, a timely post-April 15th tax return filing made after filing for an extension).

If the amended return claiming the refund (because of the corrected Backdoor Roth IRA tax return reporting) is filed after this three year deadline, the IRS cannot and will not issue a refund to the taxpayer due to the statute of limitations. There are limited exceptions to this rule (such as when the IRS and the taxpayer have mutually agreed to extend the statute of limitations).

States have their own statutes of limitations, which may or may not be the same as the federal statute of limitations. In my home state of California, it is a four-year statute of limitations instead of a three-year statute of limitations.

The statute of limitations means the clock is ticking to correct Backdoor Roth IRAs not correctly reported on previously filed tax returns. In many cases, taxpayers learning they have incorrectly filed a tax return (for whatever reason, including an erroneously reported Backdoor Roth IRA) are well advised to seek professional assistance in amending their tax returns.

Traditional 401(k) versus Roth 401(k)

Roth 401(k) Contributions

Roth 401(k) Contributions: Income Limits

Matching Contributions

Roth 401(k) Withdrawals

Conclusion

Further Reading

Default Rule for Roth IRA Withdrawals: The Layers

Roth 401(k) Withdrawals

Default Rule: Cream-in-the-Coffee

Solving the Cream-in-the-Coffee Issue

Exception 1: Wait for a Qualified Distribution

Exception 2: Roth 401(k) Rollover then Withdraw

The Five Year Roth Earnings Rule

Exception 3: Roth 401(k) Withdrawal then Rollover

Coordination with the Rule of 55

A Note on Rollovers

SECURE 2.0 Update

Further Reading

Conclusion

Tax Free Growth

Ease of Administration and Withdrawal

Tax Free Withdrawals of Contributions

Tax Free Withdrawals of Sufficiently Aged Converted Amounts

No Required Minimum Distributions

Creditor Protection

A Sneaky Way to Contribute More to Your Retirement

A Great Account to Leave to Heirs

Compare with Other Retirement Accounts

Financial Planning Objectives

Retirement Accounts and Emergencies

When a Roth IRA Doesn’t Make Sense

Health Savings Accounts

Conclusion

Your 2020 Tax Return

Schedule D Line 13 Capital Gain Distributions

Form 8889 Line 14c Distributions

Form 1040 Line 4b IRA Distributions Taxable Amount

Schedule A Line 17 Total Deductions

Form 8995 or Form 8995-A Line 2

2021 Adjusted Gross Income Planning to Maximize Stimulus Payments

The Shift to Tax Planning

Retirement Planning

Small Business/Self-Employment Income

Stock Options

Conclusion

VTSAX Form 1099-DIV 2024 Update

The Basics

Dividends

Box 1a and Box 1b

Box 2a Capital Gain Distributions

Active Management

Bull Market

Fund Redemptions

Box 3 Nondividend Distributions

Box 5 Section 199A Dividends

Box 7 Foreign Tax Paid

Boxes 11 and 12 Exempt-Interest Dividends and Private Activity Bond Interest

Conclusion

The Big Picture

Opportunities

Traditional IRA Contributions for those 70 ½ and Older

RMDs Begin at 72

Annuities in 401(k)s

Leaving Retirement Accounts to Heirs

Spouses

Minor Children

Other Eligible Beneficiaries

Planning

Conclusion

Takeaways

QBI Deduction and Initial Limitation

Income Limited

Roth Conversion Planning

Without Roth Conversion

With Roth Conversion

Strategy

Conclusion

Further Reading

One: Let it Grow!!!