Tag Archives: FI for Beginners

Paying Taxes When You’re Self-Employed

Thinking of shifting to self-employment? If you’re thinking about starting a business and being your own boss, one of the things you need to do is figure out how to pay taxes. The transition from W-2 work to self-employment significantly alters the tax landscape. 

Below I discuss the taxes self-employed solopreneurs are subject to and how to pay them. As always, the below is for educational purposes only and is not tax advice for any particular taxpayer. 

Taxes Paid by the Self-Employed

Federal Income Tax

The first tax is the exact same tax you paid as a W-2 worker: federal income tax. The determination of how much of your income is subject to this tax is a bit different. As a W-2 employee, you received a Form W-2, and, generally speaking, Box 1 of Form W-2 told you how much of your income was subject to federal income taxes. 

As a self-employed individual, you now need to track the income and expenses of your business. Solopreneurs should strongly consider practices such as having a separate bank account for the business and hiring a bookkeeper, possibly a virtual one. 

Income and expenses of the solopreneur’s business are reported annually on a Schedule C filed with Form 1040 every year. The amount of income computed on Schedule C is taxable on Form 1040.

Federal Self-Employment Tax

Congratulations on the transition to self-employment! You just signed up for a new tax: the federal self-employment tax. It’s actually (roughly speaking) the same FICA tax you paid as a W-2 employee, but now you pay it yourself (instead of through employer W-2 withholding), and you pay both halves of it. 

Here is an example of federal self-employment tax:

Leslie reports self-employment income of $80,000 on her Schedule C. Leslie has no W-2 income. Her self-employment tax is $11,304, computed as 14.13 percent of $80,000.

One’s self-employment tax will not always be approximately 14.13 percent of self-employment income. That said, in many cases 14.13 percent will be the approximate percentage. Self-employment tax is computed and reported annually on Schedule SE. Schedule SE is filed with the annual Form 1040. 

To account for the fact that the self-employed pay both halves of the payroll tax (the employee side and the employer side), they receive an income tax deduction (from adjusted gross income) on Schedule 1, line 14 for the “employer” half of the payroll tax. 

State Income Tax

Most states have an income tax, and the self-employed must pay it too, no different than when one is a W-2 employee. 

Local Taxes

Localities have various taxes solopreneurs may be subject to. First, there may be a general business tax which is often either a flat annual fee or a small percentage of revenue. Especially with the latter, there may be an exemption amount (usually, a revenue threshold) below which the solopreneur does not owe the tax. It is usually important to register with your locality to be able to claim any exemption from these taxes.

Second, localities sometimes impose a separate sales tax on particular industries or goods.

It is best to look into these taxes upfront. Localities know that sometimes small businesses miss these taxes and are usually willing to work with those who apply for relief for any missed filings or payments.

Paying Taxes

Now that we’ve discussed the broad categories of taxes the self-employed are subject to, the next step is to determine how and when to pay those taxes.

Federal Income Tax and Self-Employment Tax

This is one stop shopping. The federal tax rules require the self-employed to pay estimated taxes in quarterly payments (referred to as estimated tax payments). The dates they are due for each quarter of the year are as follows (assume the estimated tax payments account for Year 1):

QuarterDate Estimated Tax Payment is Due
First QuarterApril 15, Year 1
Second QuarterJune 15, Year 1
Third QuarterSeptember 15, Year 1
Fourth QuarterJanuary 15, Year 2

Note that if a payment due date occurs on a weekend or federal holiday, generally the due date is moved to the next day that is not a weekend and/or a federal holiday.

Generally speaking, the estimated tax payment must include both the estimated income tax due and the estimated self-employment tax due. Further, it must account for all taxable income (interest, dividends, capital gains, etc.), not just self-employment income.

Failure to pay in sufficient amounts on time can lead to an underpayment penalty computed on Form 2210. Usually, the amount required to avoid an underpayment penalty is the lesser of (i) 90 percent of the current year tax due (paid in timely, equal payments) or (ii) 110 percent of the previous year tax due (paid in timely, equal payments). These two standards are often referred to as safe harbors.

Note that if previous year adjusted gross income was less than $150,000, the 110 percent safe harbor drops to 100 percent. 

For those with growing incomes, the 110 percent safe harbor often works best. Those who have filed your Year 1 tax return by April 15, Year 2 (or at least have it just about ready to go) can take the total tax due number from the Form 1040, multiply it by 1.1, and divide it by 4 to get the amount of the required quarterly estimated tax payment to be good to go. Here is an example:

Josh is self-employed and filed his Year 1 tax return on April 1, Year 2. His business is growing. His total federal tax for Year 1 (including income tax and self-employment tax) was $45,000. Josh believes that his self-employment income could significantly increase in Year 2, so he has decided to rely upon the 110 percent safe harbor to pay his estimated tax. He multiplies $45,000 by 1.1 and then divides that product ($49,500) by 4 to get his quarterly estimated tax payment of $12,375). He makes four $12,375 payments to the IRS no later than April 15, Year 2, June 15, Year 2, September 15, Year 2, and January 15, Year 3.

The nice thing about this strategy is that Josh is now protected against the underpayment penalty even if he wins the lottery during Year 2. He simply makes those estimated payments and then, with his Year 2 Form 1040, he pays the IRS the balance due, which could be quite large. But regardless of the balance due, Josh’s underpayment penalty is $0. 

Taxpayers who might be subject to the underpayment penalty can request relief from it on the Form 2210 and/or “annualize” their income on Form 2210 to prove that the majority of their income came from later in the year (and thus estimated taxes paid later in year are sufficient for the current year’s estimated tax). Using the 110 percent safe harbor generally eliminates the need to look to mitigation tactics. 

Paying the IRS

Solopreneurs can mail estimated taxes to the IRS with a Form 1040-ES. Alternatively, solopreneurs can use the IRS DirectPay system and pay electronically at this IRS website. 

State Income Taxes

States with income taxes also generally require periodic or quarterly estimated tax payments. Many follow some or all of the IRS rules. My home state of California has its own timing rules for estimated tax payments. It generally requires taxpayers to pay 30 percent of their estimated income tax liability during the first quarter (April 15th due date), the next 40 percent of their estimated income tax liability during the second quarter (June 15th) and the remaining 30 percent after the end of the fourth quarter (the following January 15th). 

States, like the IRS, generally have website portals where solopreneurs can make estimated tax payments. 

The Transition Year

Transitions from W-2 work to solopreneurship presents many challenges and opportunities. One potential opportunity is the need to pay less or possibly no estimated taxes for the year of the transition. This can be true for several reasons. 

It may be that based on the W-2 withholding collected prior to leaving full time employment, the new solopreneur had enough withheld to cover the tax on their annual income. W-2 withholding generally assumes a full year of employment, but if one leaves full time employment and experiences start-up expenses and lower self-employment income as they build a business, it may be the case that they need to make little or no estimated tax payments in that first year.

Another source of tax payments is spousal W-2 withholding. If filing jointly with a spouse, the spouse’s W-2 withholding combined with the new solopreneur’s partial year W-2 withholding might be enough to cover the estimated taxes for the transition year. 

EINs and Forms 1099

In most cases, it makes sense for sole proprietors to obtain an employer identification number (“EIN”) from the IRS for their sole proprietorship. This EIN is used on the business’s Schedule C. Further, this number is used (instead of a Social Security number) to file any required Forms 1099s paid with respect to the business. Forms 1099 (such as the Form 1099-NEC) are required for cash payments of $600 or more during the year to individuals in the course of business. 

The IRS has an internet portal here for taxpayers to apply online for EINs. 

Tax Planning

The transition from W-2 employment to self-employment can provide several tax planning challenges and opportunities. Here is a brief overview of several challenges and opportunities.

Qualified Business Income Deduction

The Section 199A qualified business income deduction is a relatively new deduction for small businesses, including solopreneurs. I have previously blogged about this deduction here and here. 

Roth Conversions for the Self-Employed

The transition to self-employment may present Roth conversion opportunities, for two reasons. First, as a business starts up, the soloprenuer’s taxable income might be very low, and thus a start up year might be a great time to execute a Roth conversion (i.e., moving amounts from traditional IRAs/401(k)s etc. to Roth accounts) and enjoy a low marginal federal income tax rate on the converted amount.

Second, there are instances where Roth conversions by the self-employed can benefit from the Section 199A qualified business income deduction. I blogged about that opportunity here. 

S Corporations

Many solopreneurs will have the opportunity to operate out of what is referred to as an “S corporation” for U.S. federal tax purposes. There are several advantages to operating out of an S corporation, but there are also some disadvantages. 

Next month’s blog post discusses S corporations and some of the planning considerations involved. 

Solo 401(k)s

Solopreneurs are responsible for their own workplace retirement account. The Solo 401(k) is a great opportunity for many solopreneurs to stash significant amounts into tax-advantaged retirement accounts. 

As I announced in March, I’m currently working on a book about Solo 401(k)s, which is tentatively set to be published in early 2022. 

Hiring Professionals

To my mind, the shift from W-2 employment to self-employment often signals the need to hire a tax return preparer, and possibly a (virtual) bookkeeper as well. Self-employment significantly increases the complexity of one’s tax return and thus it is often wise for the self-employed to hire a tax return preparer and a bookkeeper.

Conclusion

The shift to self-employment is both exciting and challenging. Yes, the self-employed have a more complicated tax picture. But with some intentional planning, managing and ultimately optimizing the tax picture is very much possible. 

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. 

QCDs and the FI Community

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

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

Qualified Charitable Distributions

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

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

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

Important QCD Considerations

Take QCDs Early

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

No Trinkets

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

QCDs Available Only from Traditional IRAs

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

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

QCD Age Requirement

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

Inherited IRAs

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

QCDs For Those Age 70 ½ and Older

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

QCDs and the Pro-Rata Rule

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

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

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

QCDs for Those Under Age 70 ½

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

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

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

Conclusion

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

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

Follow me on Twitter: @SeanMoneyandTax

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

Sean on the How to Money Podcast

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

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

Follow me on Twitter: @SeanMoneyandTax

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

Sean Discusses the Roth 401(k) on the ChooseFI Podcast

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

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

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

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

Roth 401(k)s for Beginners

Roth 401k Withdrawals

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

Follow me on Twitter: @SeanMoneyandTax

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

Luck, Credit, and the FIRE Movement

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

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

My Journey with FI

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

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

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

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

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

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

The Role of Luck

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

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

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

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

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

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

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

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

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

Credit versus Choices

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

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

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

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

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

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

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

Room for Improvement

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

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

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

The Future of FI

In May, I published the following: 

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

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

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

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

Follow me on Twitter: @SeanMoneyandTax

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

Transferring a Primary Residence to Children

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

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

Minor Children

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

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

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

Revocable Living Trusts

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

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

Revocable living trusts also generally avoid probate. 

Tax Effect

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

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

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

Adult Children

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

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

Capital Gains Tax

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

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

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

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

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

Other Problems with Joint Tenancies

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

Capital Gains Tax

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

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

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

Loss of Control

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

Gift Tax

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

Disputes Among Adult Children

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

Children’s Issues

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

Summary

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

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

Outright Gift

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

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

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

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

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

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

Conclusion

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

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

Follow me on Twitter: @SeanMoneyandTax

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

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. 

Further Reading

For more information about 401(k) plans, please read this post. 

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. 

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

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.

IRS Identity Protection PIN

UPDATE (January 13, 2021): The IRS has expanded the PIN program to all Americans. See https://www.irs.gov/newsroom/all-taxpayers-now-eligible-for-identity-protection-pins Hat Tip to Ed Zollars for the update: https://www.currentfederaltaxdevelopments.com/blog/2021/1/13/ip-pin-program-available-to-all-taxpayers

The post below has NOT been updated for the January 13, 2021 update. Please use the below for general background purposes only and refer to the IRS website and Mr. Zollars’ article.

Identity theft continues to be a significant 21st century concern. It can happen in many ways. One particularly nefarious way is that your identity might be stolen to file a tax return with the IRS. Below I discuss a relatively new program that the IRS has made available to many Americans to help prevent identity theft with the IRS. If you are eligible, you should give strong consideration to opting into the program.

Identity Theft and Tax Returns

Obviously identity theft is bad. But why would someone use your identity with the IRS?

The answer is a tax refund. The scam often works like this: a scammer steals your identity and files a tax return with your name and Social Security number early in the year, before you have a chance to file your tax return for the prior year. The scammer will report taxable income and tax payments such that the tax return claims you have a significant income tax refund due from the IRS. The phony tax return will direct the refund such that the scammer gets the tax refund.

This becomes a nightmare for the victim. Once the IRS accepts the tax return and issues the scammer a refund, the victim will not be able to file a tax return. The IRS will reject the valid return and will not issue any tax refunds owed to the victim. The victim now faces what is likely months of remedial action to correct the situation.

Identity Protection PINs

The IRS is aware of this problem. They have an optional program that allows certain people to obtain an Identity Protection Personal Identification Number (PIN). The PIN functions to protect a taxpayer. 

If a taxpayer has an Identity Protection PIN issued with the IRS, the IRS will only accept that taxpayer’s electronic tax return if the tax return provides the Identity Protection PIN. That stops the sort of scams described above. For paper returns, a missing or incorrect PIN will delay the IRS accepting the tax return while the IRS takes additional steps to verify that the tax return came from the taxpayer whose name and Social Security number appear on the tax return. Either way, obtaining a PIN provides a level of protection against tax return identity theft.

Spouses each separately apply for their own PIN and the IRS will issue each spouse a unique PIN. If the spouses file jointly, both PINs are included on the tax return. If you have an Identity Protection PIN and use a paid tax preparer, it is important that your paid tax preparer include the PIN on your tax return. 

Eligibility

You are eligible to apply for an Identity Protection PIN from the IRS if:

Arizona, California, Colorado, Connecticut, Delaware, District of Columbia, Florida, Georgia, Illinois, Maryland, Michigan, Nevada, New Jersey, New Mexico, New York, North Carolina, Pennsylvania, Rhode Island, Texas, and Washington.

The yellow states below are the ones in which all taxpayers may apply for an IRS Identity Protection PIN (hat tip to 270toWin.com).

PLEASE SEE UPDATE FROM JANUARY 13, 2021 ABOVE: NOW ALL AMERICANS CAN POTENTIALLY QUALIFY.

Application

To obtain an IRS Identity Protection PIN, you can start at this website.

You will need to establish an IRS electronic account. The IRS website will guide you through the process and will use some credit history information to verify your identity. Once you have your IRS electronic account, you can easily obtain an IRS Identity Protection PIN. 

Future Years

Your PIN changes every year. At the beginning of the year, the IRS will put your new PIN (for use in filing the prior year’s tax return) in your IRS electronic account and they will mail your PIN to your last address of record. This makes it crucial to file a Form 8822 with the IRS to officially change your address with the IRS anytime you move, so that any PIN related correspondence (including retrievals in the event you lose your PIN) are directed to your correct address. 

The IRS will change your PIN every year, so it is important to ensure you use the correct PIN when filing your tax return. A PIN received in October 2019 will be for 2018 and you will need to use the PIN issued early in 2020 to file your 2019 tax return. 

Conclusion

Taxpayers eligible for the IRS Identity Protection PIN program should strongly consider applying for a PIN. It can help protect you from the serious headache of having your identity stolen and used to file a false tax return in your name. 

Further Reading

Kay Bell wrote a great post about the IRS Identity Protection PIN program here. 

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

Follow me on Twitter at @SeanMoneyandTax

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

Health Savings Accounts

Health savings accounts (“HSAs”) are a tremendous wealth building tool. For healthy individuals and families, a health savings account paired with a high deductible health plan (“HDHP”) can be a great way to manage medical costs and grow tax advantaged wealth. 

HSA Basics

A health savings account is a tax advantaged account. Contributions to an HSA are tax deductible. The interest, dividends, capital gains, and other income generated by assets in an HSA is not currently taxable (the same as with a 401(k) or IRA). If withdrawn for qualified medical expenses (or to reimburse the owner for the payment of qualified medical expenses), withdrawals from an HSA are not taxable. 

The HSA combines the best of a traditional retirement account (deductible contributions) and the best of Roth retirement accounts (tax-free withdrawals) if done properly. 

The annual HSA contribution limits (including both employer and employee/individual contributions) are $3,650 for an individual HDHP and $7,300 for a family HDHP in 2022. Those aged 55 or older can make annual catch-up contributions of an additional $1,000 to their HSA. 

HSA Eligibility

Who is eligible to contribute to an HSA? Only those currently covered by a high deductible health plan. As a general matter, a high deductible health plan is medical insurance with an annual deductible of at least $1,400 (for individuals) or $2,800 (for families) (using 2021 numbers). The insurance plan document should specifically state that the plan qualifies as a high deductible health plan. You must be covered on the first day of the month in order to contribute to a HSA in that month.

Once you cease to be covered by a HDHP, you keep your HSA and can use the money in it. The only thing you lose is the ability to make further contributions to the HSA.

HDHPs may not be a good insurance plan if you have certain chronic medical conditions or otherwise anticipate having high medical expenses. But if you are relatively healthy, HDHPs often make sense, particularly if you are young. 

There are some other eligibility requirements. Those also covered by other medical insurance plans, those enrolled in Medicare, and those who can be claimed as a dependent on someone else’s tax return are not eligible to contribute to a HSA.

Benefits of an HSA

Tastes Great and Less Filling

If done right, an HSA is a super-charged tax advantaged account. You get a deduction on the front end (when the money is contributed to the HSA), tax free growth, and no taxation if the money is used for qualified medical expenses or to reimburse the owner for qualified medical expenses. 

There’s no need to debate traditional versus Roth with an HSA. If done right, you get both!

HSA Payroll Tax Benefit

As a tax planner, this is one of my favorite benefits. There are many ways to legally reduce income taxes. Reducing payroll taxes, on the other hand, is more difficult. 

If you fund your HSA through payroll withholding, amounts contributed to the HSA are excluded from your salary for purposes of determining your Social Security and Medicare taxes. This results in saving on payroll taxes. HSA contributions enjoy this benefit while 401(k) elective deferrals do not.

Note that to qualify for the HSA payroll tax break, you must contribute to your HSA through payroll withholding. If, instead, you contribute through a direct personal contribution to your HSA, you do not get to deduct the contribution from your Social Security and Medicare taxable income, though you still get a federal income tax deduction for such contributions. 

Employer Contributions

Many employers offer a contribution to your HSA account. Often these employer contributions are a flat amount, such as $650 or $700 annually. This amounts to essentially free money given to you in a tax advantaged manner. 

Lower Insurance Costs

A great benefit of the combination of HDHPs and HSAs is lower medical insurance premium payments. By insuring with an HDHP, you usually save significant amounts on medical insurance. 

The healthier you are and the wealthier you are, the less financial protection you need against unanticipated medical expenses. Thus, HDHPs are often a good option for those fortunate enough to be relatively healthy and/or wealthy. 

Higher deductibles reduce the premium. The trade-off is that you self-fund more of your medical expenses. If those medical expenses are modest, the combination of saving on insurance premiums and the tax benefits can more than make up for the (potentially) higher medical expenses. 

HSA Reimbursements

Take note of when you first establish your HSA. Qualifed medical expenses incurred on that date or later can be reimbursed from your HSA.

Why is this important? Because if you track your qualified medical expenses, you can build up years of expenses that you can reimburse yourself, tax-free, from your HSA. There is no time limit to pay yourself a tax-free reimbursement from your HSA. Here is an example:

Keith established an HSA in 2011, when he was 30 years old. In 2015, he had a medical procedure and his total qualified medical expenses were $4,000. In 2018, Keith had $500 worth of qualified medical expenses for two medical appointments. In 2019, Keith had $3,500 in qualified medical expenses for a procedure and various doctors’ appointments. 

Assuming Keith had sufficient funds in taxable accounts when he incurred these expenses, Keith should (a) use those taxable funds to pay his medical expenses, (b) track his qualified medical expenses, and (c) after the money has had many years of tax-free growth, Keith should reimburse himself from his HSA for some or all of these $8,000 worth of qualified medical expenses. 

Unless you are financially strapped or in a dire medical situation, you should strive to use taxable funds to pay current medical expenses and allow the funds in your HSA to enjoy years, possibly decades, of tax-free growth. With no time limit on HSA reimbursements, you can access the funds later in life tax-free.

Note, however, that in the relatively rare cases where a taxpayer deducts medical expenses on their income tax return, expenses paid with HSA money cannot be deducted. In addition, if you have previously deducted medical expenses, those expenses are not “qualified medical expenses” that can be reimbursed tax-free from an HSA. Deducing medical expenses is rare because you can only deduct medical expenses if (i) you itemize your deductions and (ii) to the extent your medical expenses exceed 7.5 percent of your adjusted gross income (“AGI”).

No RMDs

Every tax advantaged retirement account (other than the Roth IRA) is subject to required minimum distributions (“RMDs”) during the account owner’s lifetime. HSAs, fortunately, are not subject to RMDs. They provide incredible flexibility for your financial future, particularly when you carefully track your reimbursable qualified medical expenses for many years. 

Qualified Medical Expenses

Qualified medical expenses are generally those expenses that qualify for the medical expense deduction. While this itself could be its own blog post, you can look to IRS Publication 502, which details which expenses qualify. 

Some items that you might not immediately think of, but are qualified medical expenses, are COBRA insurance premiums and Medicare Part B, Part D, and Medicare Advantage premiums. So if you ever pay COBRA premiums, it is great to pay them out of taxable accounts and keep a tally of the payments you made. Years later you can reimburse yourself for those premiums tax-free from your HSA (assuming you established the HSA prior to paying the COBRA premiums and you did not claim the COBRA premiums as an itemized deduction). 

Taxation of Non-Medical Withdrawals

If you are under age 65, withdrawals from HSAs that are not used for qualified medical expenses are subject to income tax and subject to an early withdrawal penalty of 20 percent. 

If you are under age 65, you can avoid these harsh tax results for an HSA withdrawal if you can find prior qualified medical expenses you can reimburse yourself for, and apply the withdrawal against those prior expenses. If such expenses do not exist, you can roll the money back into the HSA within 60 days (a 60-day rollover). Note you are limited to only one 60-day rollover during any 12 month period.

If you are age 65 or older, you are no longer subject to the 20 percent early withdrawal penalty. Withdrawals that are not for qualified medical expenses (or reimbursements thereof) are subject to income tax (in the same way a traditional IRA withdrawal would be). 

At age 65, an HSA remains an HSA and also becomes an optional IRA (in effect) without RMDs. This, combined with the ability to use HSA funds to pay Medicare Part B, Part D, and Medicare Advantage premiums tax-free, make an HSA a great account to own if you are age 65 or older. 

The Biggest HSA Mistake

Think twice before taking money out of an HSA!

An HSA and the investments in it can be analogized to an oven and a turkey. The HSA is like the oven. The investments are like the turkey. Putting the turkey in the oven is great. But it needs sufficient time to roast. If you take the turkey out of the oven too soon, you spoil it! The investments in your HSA are similar. They need time to bake tax-free in the HSA. If you take them out too soon, you spoil it!

Only the elderly, the financially strapped, and those facing medical emergencies and crises should withdraw HSA funds. Everyone else should keep money in an HSA to grow tax-free. If you are not in one of three listed categories, you should think long and hard before paying medical expenses with HSA money. 

Why waste the tremendous tax benefits of an HSA for minor, non-emergency medical expenses? Doing so is the biggest HSA mistake. Pay those expenses out of pocket, track them, and years later reimburse yourself tax-free from your HSA after the funds have grown tax-free for decades!

The only potential way to correct this mistake is to do a 60-day rollover of the withdrawn amounts back into an HSA. Note that rollovers are limited to one per any 12 month period. Other than the 60-day rollover, the mistake is not correctable. 

The Second Biggest HSA Mistake

The second biggest HSA mistake is not investing a significant percentage of your HSA funds in equities and/or bonds. According to this report, only four percent of HSAs had balances invested in something other than cash as of the end of 2017. Not good!

While I never provide investment advice on the blog, I do discuss the tax location of assets, in a general sense (not as applied to any particular investor). Cash is not a great asset to hold in an HSA. With today’s low interest rates, cash generates little in interest income. HSAs offer tax-free interest, dividends, capital gains, and growth!  That makes them great for high growth, high income assets. Why waste that incredibly favorable tax treatment on very low-yielding cash?

I call this the second biggest mistake (not the first) because unlike the first mistake, this mistake is easily correctable.

Of course, investors must evaluate their HSA investment options and their own individual circumstances to determine if the other investments are preferable to cash based on their particular circumstances.

State Treatment of HSAs

Two states do not recognize HSAs: California and New Jersey. For purposes of these two states, HSAs are simply taxable accounts. On California and New Jersey state income tax returns (a) there is no deduction/exclusion for HSA contributions, (b) interest, dividends, and capital gain distributions generated by HSA assets are taxable, (c) sales of assets in a HSA generate taxable capital gains and losses, and (d) nonqualifying withdrawals of money from an HSA have no tax consequence.

Tennessee and New Hampshire do not impose a conventional income tax. But they do tax residents on interest and dividends above certain levels. Interest and dividends generated by HSAs are included in the interest and dividends subject to those taxes.

HSAs and Death

This is the good news/bad news section of the article. 

First, the good news: HSAs are great assets to leave (through a beneficiary designation form) to a spouse or to a charity. If you leave your HSA to your spouse, he or she inherits it as an HSA and can use it (and benefit from it) just as you did. Charities also make for great HSA beneficiaries. They can use the money in the account and pay no tax on it. You will need to work with your financial institution to ensure the beneficiary designation form properly captures the charity as the intended beneficiary. 

The bad news: HSAs are terrible assets to leave to anyone else. If you leave an HSA to a non-spouse/non-charity, the recipient includes the entire balance of the HSA in their taxable income in the year of your death. 

Conclusion

With a little planning, an HSA can be a great asset to own, and can provide tremendous tax-free benefits. Generally speaking, time is a great asset if you own an HSA. Let your HSA bake tax-free for many years and you will be happy to receive tax-free money later in life to pay for medical expenses or as a reimbursement for many years of previous medical expenses.

FI Tax Guy can be your financial planner! 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.