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.
Worried about an early retirement based on the Four Percent Rule? Might the 4% Rule work because of natural backstops most early retirees enjoy?
The 4% Rule
The 4% Rule is a rule of thumb developed by the FI community. For example, JL Collins writes extensively about the 4% Rule in Chapter 29 of his classic book The Simple Path to Wealth.
Boiled down, the rule of thumb states that an investor can retire when he or she (or a couple) has 25 times their annual expenses invested in financial assets (equities and bonds). They would then spend down 4% of their wealth annually in retirement. The first year’s withdrawal forms a baseline and is increased annually for inflation.
The idea behind the 4% Rule is that the retiree would have a very strong chance of funding retirement expenses and never running out of money in retirement. As a result, some refer to 4% as a safe withdrawal rate.
Here’s how it could look:
Maury is 50. He has $1M saved in financial assets. He can spend $40,000 in the first year of retirement. If inflation is 3% at the end of his first year of retirement, he increases his withdrawal by 3% ($1,200) to $41,200 for the second year of retirement.
The 4% Rule has a nice elegance to it. Most investors aim for a greater than 4% return. In theory, with a 5% return every year, the 4% Rule would never fail a retiree. If you spend approximately 4% annually, and earn approximately 5% annually, you have, in theory, created a perpetual money making machine and guaranteed success in retirement.
Watch me discuss the Four Backstops to the 4% Rule
The theory is great. But in practice we know that investors are subject to ups and downs, gains and losses. What happens if there is a large dip in equity and/or bond prices during the first year or two of retirement? What if there are several down years in a row during retirement?
As a result of these risks, and stock market highs in late 2021, some are worried that the 4% Rule is too generous for many retirees. Christine Benz discussed her concerns on a recent episode of the Earn and Invest podcast.
This post adds a wrinkle to the discussion: the four backstops to the 4% Rule for early retirees. What if worries about the adequacy of the 4% Rule for early retirees can be addressed by factors outside of the 4% Rule safe withdrawal rate? And what if those factors quite naturally occur for early retirees?
Resources for the Four Percent Rule
These are links to articles addressing the 4% Rule and safe withdrawal rates
Below I discuss what I believe to be the four natural backstops to the 4% Rule.
Spending
A 4 percent spending rate in retirement is not preordained from on-high. Spending in retirement can be adjusted. Those adjustments can take on two flavors.
See that the stock market is down 10 percent this month? Okay, take a domestic vacation for 6 days instead of an international vacation for 9 days. Buy a used car instead of a new car. Scale down and/or delay the kitchen remodel.
There are levers early retirees can pull that can help compensate for declines in financial assets while not too radically altering quality of life.
The second flavor is, from a financial perspective, even better. As early retirees age, there will be natural reductions in spending. How many 80 year-olds decide to take a 12 hour flight to the tropics for the first time? There is a natural reduction in energy and interest in certain kinds of spending as one ages. It is likely that many retirees will experience very natural declines in expenses as they age.
Social Security
For the early retiree under 62 years old, the 4% Rule must disregard Social Security. Why? Because Social Security does not pay until age 62, and many in the financial independence community delay Social Security payments beyond age 62, perhaps all the way to age 70 (to increase the annual payment).
Here is an example of how that works.
Melinda is 55. She has accumulated $1.5M in financial assets and can live on $60,000 per year. If she retires at age 55 and lives off $60,000 a year increased annually for inflation, the only financial resources she has are her financial assets (what I refer to as her 4% assets). She cannot live off Social Security payments until age 62, and may choose to defer receiving Social Security up to age 70.
If Melinda defers Social Security until age 70, and receives $2,500 per month at age 70 from Social Security, her 4% assets now do not need to generate the full 4% once she turns 70, since Social Security will pay her $30,000 a year at age 70.
In theory, under the 4% Rule, Melinda’s Social Security is play money. Melinda funds her lifestyle with withdrawals from her financial assets, and now she’s getting additional Social Security payments. But, if her portfolio is struggling to produce the amount Melinda needs to live off of, Social Security payments provide a backstop and can help make up the difference.
You might think “but wait a minute, didn’t Melinda significantly lower her Social Security benefits by retiring early by conventional standards? The answer is likely no, as I described in more detail in my post on early retirement and Social Security. First, only the 35 highest years of earnings count for Social Security benefits. At age 55 is it possible Melinda has 35 years of work in.
Second, and more importantly, Social Security benefits are progressive based on “bend points.” The first approximately $12,000 of average annual earnings are replaced by Social Security at a 90 percent rate. The next approximately $62,000 of average annual earnings are replaced by Social Security at a 32 percent rate, and remaining annual earnings are replaced at a 15 percent rate. This is a fancy way of saying that reducing later earnings, for many workers, will sacrifice Social Security benefits at a 15 percent, or maybe a 32 percent, replacement rate. Even early retirees are likely to have secured all of their 90 percent replacement bend point and a significant amount of their 32 percent replacement bend point.
Chuck is 55 years old and has 32 years of earnings recorded with Social Security. Those earnings, adjusted for inflation by Social Security, total $2,800,000. Divided by 35, they average $80,000. This means Chuck has filled the 90 percent replacement bend point (up to $12,288) and filled the 32 percent replacement bend point (from $12,288 to $74,064) of average annual earnings. If Chuck continues to work, his wages will be replaced at a 15 percent replacement rate by Social Security.
An additional year of work for Chuck at a $130,000 salary netted Chuck only $557 more in annual Social Security benefits at full retirement age!
Real Estate
Most early retirees own their own primary residence, usually with either significant equity or no mortgage. That primary residence can be a backstop to the 4% Rule.
For example, a retiree might live in a 2,000 square foot, $500,000 home with no mortgage. During their retirement, they might decide they don’t want to maintain such a large home, so they sell the 2,000 square foot home and move into a 1,000 square foot condominium at a cost of $350,000. The $150,000 difference in sale prices can become a financial asset to backstop 4% Rule assets and help the retiree succeed financially.
Alternatively, the early retiree could sell the $500,000 home and move into a smaller apartment with a $2,000 per month rent. While the retiree has increased their expenses, they also have created $500,000 worth of financial wealth to help pay that rent and fund their other expenses.
A third option is a reverse mortgage where the retiree stays in their primary residence but gets equity out of the home from a bank.
Real estate can serve as a natural backstop to help ensure retirees have financial security and success.
Death
It’s wet blanket time. You may be considering a 30, 40, or 50 year retirement. Unfortunately, there is a good chance that you will not live that long. Sadly, not all early retirees have a long retirement.
As demonstrated in these tables, there is a real chance that an early retiree will not live for 25 or 30 years. That factors into whether or not the 4% Rule will work for an early retiree.
Let’s consider a 55 year old considering early retirement using the 4% Rule. He believes that he will live 30 more years and there is a 95% chance that his assets will last 30 years. He believes that the 4% Rule has a 5% chance of failing him. Further, assume that he believes there is a 30% chance that he will die prior to age 85.
His own potential death reduces the chance that the 4% Rule will fail. Remember, failure requires that he has to both run out of assets and live long enough to run out of assets. By his estimation, the odds that both events will occur are just 3.5 percent. To figure this estimated probability, multiply the probability that he will run out of assets (5%) by the probability that he will live long enough to run out assets (70%).
A not insignificant number of early retirees will have an early retirement that lasts (sadly) only 10 years, 15 years, or 20 years. That (again, sadly) backstops the 4% Rule.
Early Retirees vs. Conventional Retirees
I’ve contended that early retirees have four natural backstops to the 4% Rule. What about more conventional retirees? I’ll define a “conventional retiree” as one who collects Social Security soon after retiring.
I believe conventional retirees enjoy three of the four backstops. Sadly, they “enjoy” the mortality backstop to a greater degree than early retirees.
Conventional retirees retiring on Social Security do not enjoy Social Security as a backstop to the 4% Rule in most cases. Here’s an example:
Robert is age 65 and is planning to retire on financial assets and Social Security. He will collect $36,000 a year in Social Security and will spend a total of $76,000 a year. To facilitate this, he will initially withdraw $40,000 from his $1M portfolio.
In Robert’s case, Social Security is not a backstop to the 4% Rule. Rather, the 4% Rule is simply one of two necessary but not sufficient sources of funds for his retirement. A failure of the 4% Rule in Robert’s case would not be backstopped by Social Security.
Conclusion
While there are no guarantees when it comes to safe withdrawal rates in retirement and the 4% Rule, it is possible that many early retirees will succeed with the 4% Rule, for two reasons. First, the 4% Rule may, by itself, be successful for many early retirees. The second reason is that even if the 4% Rule fails, there are four natural backstops in place for many early retirees that can step in and help retirees obtain financial success even if the 4% Rule fails on its own.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
UPDATE October 20, 2023: This post has been updated for the 2024 Social Security numbers.
I can’t retire early! I’ll destroy my Social Security!
Is that true? What happens to Social Security benefits when retirees retire early? Are significantly reduced Social Security benefits a drawback of the financial independence retire early (FIRE) movement?
Below I explore how Social Security benefits are computed and the effects of retiring early on Social Security.
Social Security Earnings
Form W-2 reports to the government one’s earnings during the year. For the self-employed, the Schedule SE performs this function. The Social Security Administration tracks those earnings.
Only a limited amount of earnings every year count as Social Security earnings. There is an annual maximum on the amount of earnings that can go on one’s Social Security record, regardless of the number of jobs one has. For 2024, the Social Security cap is $168,600. The cap is increased most years for inflation. Payroll taxes for Social Security (FICA for W-2 workers, self-employment taxes for the self-employed) are not due on earnings above the cap.
Social Security Benefits
A few very general rules need to be established as we consider the amount Social Security pays.
Only the highest 35 years of earnings during one’s working years count in determining Social Security benefits.
For most Americans reading this, full retirement age is 67. This means a person can collect his or her “full” Social Security benefits at age 67.
Social Security benefits can be collected as early as age 62 and can be deferred as late as age 70. Collecting early reduces annual benefits (by roughly 5 to 7 percent per year) and collecting late increases benefits (by 8 percent per year).
Very roughly speaking, the annual benefit is computed as follows: accumulated earnings (computed based on the rules described above) in the high 35 years are summed and then divided by 35. The resulting average annual earnings are applied against the Social Security “brackets” or “bend points.” Up to $14,088 (using 2024 numbers) of computed average annual earnings is replaced by Social Security at a 90% rate. The next $70,848 of average annual earnings are replaced at a 32% rate. Any additional amount of average annual earnings is replaced at a 15% replacement rate. The bend points are adjusted for inflation.
One need not be an expert on Social Security to see directionally how early retirement might impact Social Security benefits. Because of the progressive nature of Social Security benefits, leaving work early (by conventional standards) tends to reduce benefits less than one might initially expect. Additional earnings later in life tend to only slightly increase Social Security benefits.
Early Retirement Social Security Example
Here’s an example to help us understand the impact of an early retirement on Social Security benefits.
Chuck is 55 years old and has 32 years of earnings recorded with Social Security. Those earnings, adjusted (thus, nominally increased) for inflation by Social Security, total $3,100,000 as of 2024. Divided by 35, they average $88,571. This means Chuck has filled the 90 percent replacement bend point (up to $14,088) and filled the 32 percent replacement bend point (from $14,088 to $84,936) of average annual earnings. If Chuck continues to work, his wages will be replaced at a 15 percent replacement rate by Social Security.
If Chuck retires now and earns nothing more, his annual Social Security benefits, expressed in 2024 dollars, will look something like this at full retirement age:
Replacement Rate
Replaced Annual Income
Annual Social Security at Full Retirement Age
90%
$14,088
$12,679
32%
$70,848
$22,671
15%
$3,635
$545
Total
$88,571
$35,896
Note that I rounded each bend point’s calculation. With the cents Chuck gets in each bend point, his total is increased by almost a full dollar. Similar rounding applies to the examples below as well.
At age 67, Chuck’s annual Social Security will be $35,896 (expressed in 2024 dollars).
If Chuck continues to work for one more year at a $130,000 salary, and then retires his annual Social Security benefits at full retirement age, expressed in 2024 dollars, looks something like this:
Replacement Rate
Replaced Annual Income
Annual Social Security at Full Retirement Age
90%
$14,088
$12,679
32%
$70,848
$22,671
15%
$7,349
$1,102
Total
$92,285
$36,453
Interestingly, an additional year of work only increased Chuck’s annual Social Security benefit by $557. Why is that? Remember that every dollar earned is divided by 35 for purposes of computing Social Security benefits. You can see that Chuck’s replaced income increased by $3,714 (from $88,571 to $92,285). By earning $130,000 in 2024, Chuck increased his Social Security average annual income by $3,714, which is $130,000 divided by 35.
Multiplying the increase in replaced income ($3,714) by the replacement rate (15%) gets us the additional $557 in annual Social Security benefits.
Okay, but what about three more years of earnings. Say Chuck can work for three more years at an average annual salary of $135,000. What result (in 2024 dollars) then?
Replacement Rate
Replaced Annual Income
Annual Social Security at Full Retirement Age
90%
$14,088
$12,679
32%
$70,848
$22,671
15%
$18,920
$2,838
Total
$103,856
$38,188
Where I come from, $1,735 ($38,188 minus $36,453) in increased annual Social Security benefits at full retirement age is not nothing. But is it worth delaying retirement for three full years if one is otherwise financially independent? To my mind, probably not.
Spousal Benefits
What if Chuck is married to Mary? How does that impact the analysis?
During Chuck and Mary’s joint lifetimes, it depends on whether Mary collects spousal benefits. If Mary has Social Security earnings of greater than 50 percent of Chuck’s Social Security earnings, she will likely collect benefits under her own earnings record, and not a spousal benefit. Thus, Chuck’s Social Security earnings will be irrelevant to the Social Security benefit Mary collects.
If, however, Mary’s lifetime Social Security earnings are less than 50 percent of Chuck’s, Mary is likely to collect a spousal benefit of roughly half of Chuck’s annual benefit. In this case, Chuck working 3 more years creates $2,603 of additional annual Social Security income ($1,735 for Chuck and $868 as Mary’s spousal benefit). Even $2,603 in additional annual income isn’t likely to justify Chuck working for three more years.
At Chuck’s death, assuming Chuck predeceases Mary, Mary will collect the greater of her own Social Security benefit or Chuck’s Social Security benefit. Thus, Chuck increasing his Social Security earnings could increase Mary’s Social Security benefit as a widow.
Most people I know cannot tell you their Social Security earnings record off the top of their head. But, this information is accessible by creating an account at ssa.gov. From there, Americans can obtain their Social Security statement which includes their Social Security earnings (though the statement does not adjust those annual earnings for inflation). The 2024 factors to increase annual earnings for inflation can be found by entering “2024” in the search box at the bottom of this SSA.gov website.
Conclusion
There are many factors to consider before retiring early. It is helpful to understand how Social Security benefits are computed so early retirees can understand the potential impact of retiring on their Social Security benefits.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, investment, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
This post, and all videos, text, and comments on my YouTube channel, are for entertainment and educational purposes only. They do 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.
Enjoy videos on my brand new YouTube Channel. The channel will focus on tax and personal finance topics. I have ten tax videos up there to watch. My goal is to post a new tax or personal finance video every Saturday morning at 7AM Pacific.
This post, and all videos, text, and comments on my YouTube channel, are for entertainment and educational purposes only. They do 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.
The IRS and Treasury have recently issued two updates to the rules for payments which avoid the 10 percent early withdrawal penalty from retirement accounts. These payments are referred to as a series of substantially equal periodic payments, SEPP, or 72(t) payments. This post discusses the updated rules.
72(t) Payments
Tax advantaged retirement accounts are fantastic. Who doesn’t love 401(k)s, IRAs, Roth IRAs, and the like?
However, investing through a tax advantaged account can have drawbacks. One big drawback is that taxable amounts withdrawn from a tax advantaged retirement account prior to the account owner turning age 59 ½ are generally subject to a 10 percent early withdrawal penalty. My home state of California adds a 2.5 percent early withdrawal penalty.
There are some exceptions to this penalty. One of them is taking 72(t) payments. The idea is that if the taxpayer takes a “series of substantially equal periodic payments” they can avoid the penalty.
72(t) payments must be taken annually. Further, they must last for the longer of (a) 5 years or (b) the time until the taxpayer turns age 59 ½. This creates years of locked-in taxable income.
There are three methods that can be used to compute the amount of the annual 72(t) payments. These methods compute an annual distribution amount generally keyed off three numbers: the balance in the relevant retirement account, the interest rate, and the table factor provided by the IRS. The factor is greater the younger the account owner is. The greater the factor, the less the account owner can withdraw from a retirement account in a 72(t) payment.
New 72(t) Payment Interest Rates
In January 2022, the IRS and Treasury issued Notice 2022-6. Hat tip to Ed Zollars for the alert. This notice provides some new 72(t) rules. The biggest, and most welcome, change is a new rule for determining the interest rate.
Previously, the rule had been that 72(t) payments were keyed off 120 percent of the mid-term applicable federal rate (“AFR”). The IRS publishes this rate every month. In recent years, that has been somewhat problematic, as interest rates have been historically low. For example, in September 2020, the mid-term AFR was just 0.42 percent. This made relying on a 72(t) payment somewhat perilous. How much juice can be squeezed from a large retirement account if the interest rate is just 0.42 percent?
Here is what a $1M traditional IRA could produce, under the fixed amortization method, in terms of an annual payment for a 53 year old starting a 72(t) payment if the interest rate is just 0.42 percent:
120% of Sept 2020 MidTerm AFR
0.42%
Single Life Expectancy Years at Age 53
33.4
Account Balance
$1,000,000.00
Annual Payment
$32,151.93
Notice 2022-6 makes a very significant change. It now allows taxpayers to pick the greater of (i) up to 5 percent or (ii) up to 120 percent of mid-term AFR. That one change makes a 72(t) payment a much more attractive option, since periods of low interest rates do not as adversely affect the calculation.
Here is what a $1M traditional IRA could produce, under the fixed amortization method, in terms of an annual payment for a 53 year old starting a 72(t) payment if the interest rate is 5 percent:
5% Interest Rate
5.00%
Single Life Expectancy Years at Age 53
33.4
Account Balance
$1,000,000.00
Annual Payment
$62,189.80
The new rule provides a 5 percent interest rate floor for those using the fixed amortization method and the fixed annuitization method to compute a 72(t) payment. Using a 5 percent interest rate under the fixed amortization method is generally going to produce a greater payment amount than using the required minimum distribution method for 72(t) payments.
The interest rate change provides taxpayers with much more flexibility with 72(t) payments, and a greater ability to extract more money penalty free prior to age 59 ½. Taxpayers already have the ability to “right-size” the traditional IRA out of which to take a 72(t) payment to help the numbers work out. In recent years, what has been much less flexible has been the interest rate. Under these new rules, taxpayers always have the ability to select anywhere from just above 0% to 5% regardless of what 120 percent of mid-term AFR is.
Watch me discuss the update to 72(t) payment interest rates.
New Tables
A second new development is that the IRS and Treasury have issued new life expectancy tables for required minimum distributions (“RMDs”) and 72(t) payments. Most of the new tables are found at Treasury Regulation Section 1.401(a)(9)-9, though one new table is found at the end of Notice 2022-6.
These tables reflect increasing life expectancies. As a result, they reduce the amount of RMDs, as the factors used to compute RMDs are greater as life expectancy increases.
From a 72(t) payment perspective, this development is a minor taxpayer unfavorable development. Long life expectancies in the tables means the tables slightly reduce the amount of juice that can be squeezed out of any particular retirement account.
This said, the downside to 72(t) payments coming from increasing life expectancy on the tables is more than overcome by the ability to always use an interest rate of up to 5 percent. These two developments in total are a great net win for taxpayers looking to use 72(t) payments during retirement.
Use of 72(t) Payments
Traditionally, I have viewed 72(t) payments as a life raft rather than as a desirable planning tool for those retiring prior to their 59 ½th birthday. Particularly for those in the FI community, my view has been that it is better to spend down taxable assets and even dip into Roth basis rather than employ a 72(t) payment plan.
These developments shift my view a bit. Yes, I still view 72(t) payments as a life raft. Now it is an upgraded life raft with a small flatscreen TV and mini-fridge. 😉
As a practical matter, some will get to retirement prior to age 59 ½ with little in taxable and Roth accounts, and the vast majority of their financial wealth in traditional retirement accounts. Notice 2022-6 just made their situation much better and much more flexible. Getting to retirement at a time of very low interest rates does not necessarily hamstring their retirement plans given that they will always have at least a 5 percent interest rate to use in calculating their 72(t) payments.
72(t) Payments and Roth IRAs
As Roth accounts grow in value, there will be at least some thought of marrying Roth IRAs with 72(t) payments.
At least initially, Roth IRAs have no need for 72(t) payments. Those retired prior to age 59 ½ can withdraw previous Roth contributions and Roth conversions aged at least 5 years at any time tax and penalty free for any reason. So off the bat, no particular issue, as nonqualified distributions will start-off as being tax and penalty free.
Only after all Roth contributions have been withdrawn are Roth conversions withdrawn, and they are withdrawn first-in, first-out. Only after all Roth conversions are withdrawn does a taxpayer withdraw Roth earnings.
For most, the odds of withdrawing (i) Roth conversions that are less than five years old, and then (ii) Roth earnings prior to age 59 ½ are slim. But, there could some who love Roths so much they largely or entirely eschew traditional retirement account contributions. One could imagine an early retiree with only Roth IRAs.
Being “Roth only” prior to age 59 ½ could present problems if contributions and conversions at least 5 years old have been fully depleted. Taxpayers left with withdrawing conversions less than 5 years old or earnings in a nonqualified distribution might opt to establish a 72(t) payment plan for their Roth IRA. Such a 72(t) payment plan could avoid the 10 percent penalty on the withdrawn amounts attributable insufficiently aged conversions or Roth earnings. Note, however, that Roth earnings withdrawn in a nonqualified distribution are subject to ordinary income tax, regardless of whether they are part of a 72(t) payment plan.
See Treasury Regulation Section 1.408A-6 Q&A 5 providing that Roth IRA distributions can be subject to both the 72(t) early withdrawal penalty and the exceptions to the 72(t) penalty. The exceptions include a 72(t) payment plan.
Additional Resource
Ed Zollars has an excellent post on the updated IRS rules for 72(t) payments here.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters.Please also refer to the Disclaimer & Warning section found here.
This post 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.
Listen to me discuss year-end tax planning with Brad and Jonathan on the ChooseFI podcast. The episode is available on all major podcast players, YouTube, and on the ChooseFI website (https://www.choosefi.com/year-end-tax-planning-2021-ep-351/).
During the conversation we referenced this blog post.
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. Sean Mullaney and ChooseFI Publishing are currently under contract to publish a book authored by Sean Mullaney.
FI Tax Guy can be your financial advisor! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters.Please also refer to the Disclaimer & Warning section found here.
It’s time to think about year-end tax planning. Year-end is a great time to get tax planning ducks in a row and take advantage of opportunities. This is particularly true for those in the financial independence community. FI principles often increase one’s tax planning opportunities.
Remember, this post is for educational purposes only. None of it is advice directed towards any particular taxpayer.
Backdoor Roth IRA Deadline 2021
As of now (December 7, 2021), the legal deadlines around Backdoor Roth IRAs have not changed: the nondeductible 2021 traditional IRA contribution must happen by April 18, 2022 and there is no legal deadline for the second step, the Roth conversion. However, from a planning perspective, the practical deadline to have both steps of a 2021 Backdoor Roth IRA completed is December 31, 2021.
This is because of proposed legislation that eliminates the ability to convert nondeductible amounts in a traditional IRA effective January 1, 2022. As of December 7th, the proposed legislation has passed the House of Representatives but faces a very certain future in the Senate. Considering the risk that the Backdoor Roth elimination proposal is enacted, taxpayers planning on completing a 2021 Backdoor Roth IRA should act to ensure that the second step of the Backdoor Roth IRA (the Roth conversion) is completed before December 31st.
Taxpayers on the Roth IRA MAGI Limit Borderline
In years prior to 2021, taxpayers unsure of whether their income would allow them to make a regular Roth IRA contribution could simply wait until tax return season to make the determination. At that point, they could either make the regular Roth IRA contribution for the prior year (if they qualified) or execute what I call a Split-Year Backdoor Roth IRA.
With the proposed legislation looming, waiting is not a good option. The good news is that taxpayers executing a Backdoor Roth IRA during a year they actually qualify for a regular annual Roth IRA contribution suffer no material adverse tax consequences. Of course, in order for this to be true there must be zero balance, or at most a very small balance, in all traditional IRAs, SEP IRAs, and SIMPLE IRAs as of December 31, 2021.
December 31st and Backdoor Roth IRAs
December 31st is a crucial date for those doing the Roth conversion step of a Backdoor Roth IRA during the year. It is the deadline to move any balances in traditional IRAs, SEP IRAs, and SIMPLE IRAs to workplace plans in order to ensure that the Roth conversion step of any Backdoor Roth IRA executed during the year is tax-efficient.
This December 31st deadline applies regardless of the proposed legislation discussed above.
The self-employed should consider this one. Deadlines vary, but as a general rule, those eligible for a Solo 401(k) usually benefit from establishing one prior to year-end. The big takeaway should be this: if you are self-employed, your deadline to seriously consider a Solo 401(k) for 2021 is ASAP! Usually, such considerations benefit from professional assistance.
Something to look forward to in 2022: my upcoming Solo 401(k) book!
Charitable Contributions
For those itemizing deductions in 2021 and either not itemizing in 2022 or in a lower marginal tax rate in 2022 than in 2021, it can be advantageous to accelerate charitable contributions late in the year. It can be as simple as a direct donation to a qualifying charity by December 31st. Or it could involve contributing to a donor advised fund by December 31st.
A great donor advised fund planning technique is transferring appreciated securities (stocks, bonds, mutual funds, or ETFs) to a donor advised fund. Many donor advised fund providers accept securities. The tax benefits of making such a transfer usually include (a) eliminating the built-in capital gain from federal income taxation and (b) if you itemize, getting to take a current year deduction for the fair market value of the appreciated securities transferred to the donor advised fund.
The elimination of the lurking capital gain makes appreciated securities a better asset to give to a donor advised fund than cash (from a tax perspective). Transfers of appreciated securities to 501(c)(3) charities can also have the same benefits.
The 2021 deadline for this sort of planning is December 31, 2021, though taxpayers may need to act much sooner to ensure the transfer occurs on time. This is particularly true if the securities are transferred from one financial institution to a donor advised fund at another financial institution. In these cases, the transfer may have to occur no later than mid-November, though deadlines will vary.
Early Retirement Tax Planning
For those in early retirement, the fourth quarter of the year is the time to do tax planning. Failing to do so can leave a great opportunity on the table.
Prior to taking Social Security, many early retirees have artificially low taxable income. Their only taxable income usually consists of interest, dividends, and capital gains. In today’s low-yield environment, without additional planning, early retirees’ taxable income can be very low (perhaps even below the standard deduction).
Artificially low income gives early retirees runway to fill up lower tax brackets (think the 10 percent and 12 percent federal income tax brackets) with taxable income. Why pay more tax? The reason is simple: choose to pay tax when it is taxed at a low rate rather than defer it to a future when it might be taxable at a higher rate.
The two main levers in this regard are Roth conversions and tax gain harvesting. Roth conversions move amounts in traditional retirement accounts to Roth accounts via a taxable conversion. The idea is to pay tax at a very low tax rate while taxable income is artificially low, rather than leaving the money in deferred accounts to be taxed later in retirement at a higher rate under the required minimum distribution (“RMD”) rules.
Tax gain harvesting is selling appreciated assets when one is in the 10 percent or 12 percent marginal tax bracket so as to incur a zero percent long term capital gains federal tax rate on the capital gain.
Early retirees can do some of both. In terms of a tiebreaker, if everything else is equal, I prefer Roth conversions to tax gain harvesting, for two primary reasons. First, traditional retirement accounts are subject to ordinary income tax rates in the future, which are likely to be higher than preferred capital gains tax rates. Second, large taxable capital gains in taxable accounts can be washed away through the step-up in basis at death. The step-up in basis at death doesn’t exist for traditional retirement accounts.
One time to favor tax gain harvesting over Roth conversions is when the traditional retirement accounts have the early retiree’s desired investment assets but the taxable brokerage account has positions that the early retiree does not like anymore (for example, a concentrated position in a single stock). Why not take advantage of tax gain harvesting to reallocate into preferred investments in a tax-efficient way?
Long story short: during the fourth quarter, early retirees should consider their taxable income for the year and consider year-end Roth conversions and/or tax gain harvesting. Planning in this regard should be executed no later than December 31st, and likely earlier to ensure proper execution.
Roth Conversions, Tax Gain Harvesting, and Tax Loss Harvesting
Early retired or not, the deadline for 2021 Roth conversions, tax gain harvesting, and tax loss harvesting is December 31, 2021. Taxpayers should always consider timely implementation: these are not tactics best implemented on December 30th!
For some who find their income dipped significantly in 2021 (perhaps due to a job loss), 2021 might be the year to convert some amounts in traditional retirement accounts to Roth retirement accounts. Some who are self-employed might want to consider end-of-year Roth conversions to maximize their qualified business income deduction.
Stimulus and Child Tax Credit Planning
Taxpayers who did not receive their full 2021 stimulus may want to look into ways to reduce their 2021 adjusted gross income so as to qualify for additional stimulus funds. I wrote in detail about one such opportunity in an earlier blog post. Lowering adjusted gross income can also qualify taxpayers for additional child tax credits.
There are many factors you and your advisor should consider in tax planning. This opportunity may be one of them. For example, taxpayers considering a Roth conversion at the end of the 2021 might want to hold off in order to qualify for additional stimulus and/or child tax credits.
Accelerate Payments
The self-employed and other small business owners may want to review business expenses and pay off expenses before January 1st, especially if they anticipate their marginal tax rate will decrease in 2022. Depending on structure and accounting method, doing so may not only reduce income taxes, it could also reduce self-employment taxes.
State Tax Planning
For my fellow Californians, the big one here is property taxes. It may be advantageous to pay billed (but not yet due) property taxes in late 2021. This allows taxpayers to deduct the amount on their 2021 California income tax return. In California, the standard deduction ($4,601 for single taxpayers, $9,202 for married filing joint taxpayers) is much lower than the federal standard deduction, so consideration should be given to accelerating itemized deductions in California, regardless of whether the taxpayer itemizes for federal income tax purposes.
Required Minimum Distributions (“RMDs”)
They’re back!!! RMDs are back for 2021. The deadline to withdraw a required minimum distribution for 2021 is December 31, 2021. Failure to do so can result in a 50 percent penalty.
Required minimum distributions apply to most retirement accounts (Roth IRAs are an exception). They apply once the taxpayer turns 72. Also, many inherited retirement accounts (including Roth IRAs) are subject to RMDs, regardless of the beneficiary’s age.
Planning for Traditional Retirement Accounts Inherited in 2020 and 2021
Those inheriting traditional retirement accounts in 2020 or later often need to do some tax planning. The end of the year is a good time to do that planning. Many traditional retirement account beneficiaries will need to empty the retirement account in 10 years (instead of being on an RMD schedule), and thus will need to plan out distributions over the 10 year time frame to manage taxes rate on the distributions.
2021 Federal Estimated Taxes
For those with small business income, side hustle income, significant investment income, and other income that is not subject to tax withholding, the deadline for 2021 4th quarter estimated tax payments to the IRS is January 18, 2022. Such individuals should also consider making timely estimated tax payments to cover any state income taxes.
Review & Update Beneficiary Designation Forms
Beneficiary designation forms control the disposition of financial assets (such as retirement accounts and brokerage accounts) upon death. Year-end is a great time to make sure the relevant institutions have up-to-date forms on file. While beneficiary designations should be updated anytime there is a significant life event (such as a marriage or a death of a loved one), year-end is a great time to ensure that has happened.
2022 and Beyond Tax Planning
The best tax planning is long term planning that considers the entire financial picture. There’s always the temptation to maximize deductions on the current year tax return. But the best planning considers your current financial situation and your future plans and strives to reduce total lifetime taxes. 2022 is as good a time as any to do long-term planning.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
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).
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
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.
