Tag Archives: FI for Beginners

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

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 ChooseFI Podcast

I’m honored to be the featured guest on this week’s ChooseFI podcast. Brad, Jonathan, and I discussed careers in accounting, my professional journey, and some tax planning. I’m glad to say that I’ll be back on the podcast to discuss tax issues and planning in the future.

I hope you enjoy this episode. It is available at this website, YouTube, and wherever you listen to podcasts. https://www.choosefi.com/how-to-fund-your-childs-roth-ira/

Understanding Your 401(k)

As an employee, your employer’s 401(k) plan can be your most important wealth building tool. Understanding how it functions will help you build your wealth in a tax efficient manner.

The Plan

A 401(k) plan is established by an employer. The employer provides the account, the account administration, and the investment choices. Usually, the investment options include a menu of stock and bond mutual funds and/or similar investments. In some plans, employer stock is one of the investment choices.

While the employer administers the plan, most of the assets in the plan (see Vesting below) belong the employees in individual accounts. Therefore, the employees, not the employer, enjoy the benefits and burdens of the economic appreciation and/or depreciation of the investments.

Creditor Protection

401(k) plans are subject to a host of rules, most of which (from a practical perspective) are the concern of the employer, not the employee. One important benefit of the rules for employees is that under ERISA, assets in a 401(k) plan are generally protected from creditors. During your lifetime only two creditors can access assets in your 401(k): the IRS and an ex-spouse.

Vesting

Contributions to a 401(k) made by the employee (referred to as “employee deferrals” and “after-tax contributions” — see numbers 1 and 3 below) are always immediately “100% vested.” This means that regardless of whether the employee leaves the employment of the employer tomorrow, he or she owns the money he or she contributed to the 401(k) and any related growth.

However, contributions to a 401(k) account made by the employer may be subject to a vesting schedule. Simply put, vesting means amounts become the property of the employee after the employee has been employed by the employer for a certain period of time.

Some plans use a gradual vesting schedule. The least generous of these is as follows:

Years of ServiceVesting Percentage
220%
340%
460%
580%
6100%

More generous (i.e., quicker) vesting is permissible.

Some plans use a “cliff” vesting schedule. This means that employer contributions go from 0% vested to 100% vested when the employee has been employed for a certain period. The longest permissible period is 3 years.

The growth associated with employer contributions is also subject to vesting.

Vesting incentivizes staying with the same employer for a sufficient period of time to capture all of the employer contributions to a 401(k) plan. It can also incentivize returning to a former employer if you have worked a number of vested years of service for them.

Some plans provide for 100% immediate vesting for employer contributions as well as employee contributions.

Contributions

There are five types of contributions to 401(k) plans, listed below in order of their prevalence (employee deferrals being the most prevalent).

1. Employee Deferrals

Employees can contribute, through payroll withholding, a portion of their salary to a 401(k) plan. All 401(k) plans offer “traditional” contributions, meaning employees can contribute amounts to the 401(k) plan and exclude those amounts from their taxable income for the year. Some plans, but certainly not all plans, also offer “Roth” contributions, which are not excludible from taxable income, but, if properly withdrawn, can be tax free in the future when withdrawn.

Employee deferrals are the only type of contribution to a 401(k) plan that can be done as a “Roth” contribution. All other contributions are “traditional” contributions.

Read here for more on the desirability of Roth contributions compared to traditional contributions.

Neither traditional nor Roth contributions reduce the amount of income subject to payroll (i.e., Social Security and Medicare) taxes.

2. Matching Contributions

Matching contributions are one of the most powerful ways employees can build wealth. Previously, I have written that if you participate in a 401(k) plan with an employer match, you must make it your top wealth building priority to contribute at least enough to your 401(k) to secure all of the employer match.

How does it work? Different employers have varying matching programs. There are two components: 1) the percentage of salary that is matched, and 2) the percentage of the match.

Here is an illustrative example:

Example 1: Elaine Benes works for Pendant Publishing. She is under 50 years old and earns $100,000 in annual W-2 wages. Pendant Publishing matches 100 percent of employee contributions up to 3 percent of salary, and matches 50 percent of employee contributions for the next 2 percent of salary. Based on this matching program, Elaine would be a fool not contribute at least 5 percent of her salary to Pendant Publishing’s 401(k) plan. Doing so will earn her $4,000 of matching contributions from Pendant Publishing on her $5,000 of employee contributions.

Employers vary in terms of when they match contributions. Some employers match employee contributions only once a year (usually at or after year-end). Other employers match employee contributions each pay period. If you work for an employer that does so, you need to be careful not to max-out your 401(k) early in the year, as each pay period requires an employee 401(k) contribution in order to obtain the match. Here is an example:

Example 2: The facts are the same as Example 1. In addition, Pendant Publishing’s matches 401(k) contributions every pay period, and has 24 pay periods per year. Elaine believes it is a good idea to accelerate her 401(k) contributions, and thus contributes $3,750.00 of her salary for each of the first 6 pay periods of the year ($22,500 total) and makes no contributions the rest of the year. For those 6 pay periods she receives an employee match of $166.67 each pay period ($100,000 divided by 24 times 4 percent) for a total annual match of $1,000. By doing this, Elaine misses out on $3,000 of her potential employer 401(k) match, because for the next 18 pay periods, she contributes nothing to her 401(k).

Some 401(k) plans adjust for this and would fully match Elaine’s contribution (in her case, by adding $3,000 to her 401(k) plan), but many do not. In Elaine’s case, she should have stretched out her contribution such that she contributed at least 5 percent of each pay period’s paycheck to her 401(k).

Note that employers are not required to provide a matching program. There are some employer 401(k) plans that provide no match at all.

Tax Treatment: Employer match contributions are traditional contributions. They are not subject to income tax when added to your 401(k), but they will be in the future when withdrawn (as will the growth on matching contributions). Matching contributions are not subject to payroll taxes.

3. After-Tax Contributions

Some 401(k) plans allow for employees to make so-called after-tax contributions to their 401(k) through payroll withholding. These contributions are not excluded from the employee’s taxable income, but do create basis in the 401(k) account. After-tax contributions are what make Mega Backdoor Roth IRA planning possible. Unless one is engaging in Mega Backdoor Roth IRA planning, in most cases after-tax contributions are not advisable.

Tax Treatment: After-tax contributions do not reduce the employee’s taxable income (for both income tax and payroll tax purposes). In the future after-tax contributions are taxable to the employee as withdrawn, but the employee can use the created basis to reduce the income inclusion. Depending on how the 401(k) account is disbursed, that basis recovery may be subject to the Pro-Rata Rule.

4. Profit-Sharing Contributions

Some 401(k) programs have a profit-sharing program, whereby the employer contributes additional amounts to each employee’s 401(k) account based on a formula.

Tax Treatment: Profit-sharing contributions are traditional contributions and are treated in the same manner as matching contributions, including being exempt from payroll tax.

5. Forfeitures

Because of vesting, employees forfeit unvested amounts in their 401(k)s when they leave the employer’s employment prior to fully vesting in the 401(k). When that happens, the unvested amounts must be accounted for. In some plans, the unvested amounts are used to offset plan administrative costs. In other plans, forfeited amounts are added to the remaining participants’ accounts.

Tax Treatment: Forfeitures are traditional contributions and are treated in the same manner as matching contributions, including being exempt from payroll tax.

Contribution Limits

Contribution limits get a bit complicated because there are two distinct 401(k) plan contribution limits, not one. Numerical limits are updated annually by the IRS to account for inflation. The numbers provided below are the numbers for 2023.

Employee Deferrals

There is an annual employee deferral limitation. For 2023, that limit is the lesser of $22,500 or total compensation (if under age 50) and the lesser of $30,000 or total compensation (if 50 or older). The limit applies to Roth employee contributions, traditional employee contributions, or any combination thereof.

This limit is per person, not per employer. Thus, those with side hustlers must coordinate employee deferrals to their large employer 401(k) plan with employee deferrals to their Solo 401(k). I discuss this topic in detail in my book, Solo 401(k): The Solopreneur’s Retirement Account.

All Additions

There is a second, less understood limitation on 401(k) contribution. The annual limit for all additions to 401(k) and other employer retirement accounts is the lesser of $66,000 or total compensation (if under age 50) and the lesser of $73,500 or total compensation (if 50 or older).

The all additions limit applies to the sum of numbers 1 through 5 above (employee deferrals through forfeitures) plus a sixth amount. The sixth amount is the amount which is contributed by your employer to another qualified retirement plan account on your behalf.

Some employers offer additional qualified retirement plans. These plans often provide for a contribution to an account by the employer based on a stated percentage of compensation. Employers use various names for these plans. Contributions may be subject to vesting and are traditional contributions that are not subject to payroll tax.

The all additions limit applies per employer, not per employee as the employee deferrals limit does.

Watch me discuss the all additions limit on YouTube.

Auto Enrollment

Many employers now auto-enroll new employees in a 401(k) plan. This has two components: contribution level and investment choice. In most cases, new employees should not simply settle for auto-enrollment. When you start a job, you should review your new 401(k) plan and make informed decisions regarding contribution level and investment choice.

Contribution Level

Auto-enrollment will set a contribution level. Not all employers set the contribution level at a level that maximizes employer matching. Even if the automatic contribution level is set at a level that maximizes the employer match, that level might not be the appropriate level for any particular person.

Investment Selection

Plans typically have a default investment plan for new 401(k) participants. It is best to review your investment options when you start a new job and select an appropriate investment allocation for your circumstances.

Withdrawals from Traditional 401(k)s

When a taxpayer is 59 ½ years old or older, they can withdraw amounts in a traditional 401(k) penalty free. Withdrawals are included in taxable income as ordinary income. Beginning at age 72, taxpayers must take out a required minimum distribution (“RMD”) for each year. The RMD is computed based on IRS tables.

If a taxpayer withdraws money from a 401(k) prior to age 59 ½, the withdrawal is not only taxable, it is subject to a 10 percent early withdrawal penalty, unless a penalty exception applies.

Taxpayers may transfer amounts in a 401(k) to another 401(k) to an IRA. Amounts in traditional 401(k)s and IRAs can be converted to Roth accounts. Such conversions create taxable income, but are not subject to the early withdrawal penalty.

Conclusion

Your workplace 401(k) plan is a vitally important wealth building tool. It is important to be an informed user of your 401(k) in order to build tax advantaged wealth.

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. 

Tax Basis for Beginners

What is Tax Basis?

To answer that question, let me posit two hypotheticals:

Hypothetical 1: Mark buys one share of Acme Industries stock for $100 on Monday. The following Monday he sells that share for $100.

Hypothetical 2: Judy buys one share of Kramerica Industries for $20 on Monday. On Thursday, Kramerica Industries announces the release of a new bottle that dispenses both ketchup and mustard, and the stock soars. On the following Monday, Judy sells her share of Kramerica Industries for $100.

What tax result? Do both Mark and Judy have $100 of taxable income? Of course not. We know that Mark has no taxable income and Judy has $80 of taxable income? But how do we know that? The answer: Basis!

Basis is the tax concept that ensures amounts are not taxed twice when they should not be. In Mark’s case, he has no real income when he sells the stock. Judy however, does have income. When she sells the Kramerica stock, she realizes the $80 gain.

Basis is what allows us to measure the appropriate gain or income to the seller of property. While we have a sense that Mark should not have had taxable income and Judy should have, without basis we have no way of measuring whether a disposition of property should trigger a taxable gain, loss, or nothing.

Generally, the basis of an asset is its historic cost, plus any capital improvements or additions made to the asset. In the case of a financial asset in a taxable account, basis is simply the purchase price plus reinvested distributions less any nondividend distributions (returns of capital).

Depreciation

Basis serves another function. Business assets are usually subject to a depreciation allowance on the theory that assets waste away from wear and tear over a useful life. The method and time period for depreciating an asset varies based on the asset. Residential real estate is depreciated in a straight line over 27.5 years. Most non-real estate property is depreciated using an accelerated method and over a shorter period. One business asset that never depreciated is land, on the theory that land has an indefinite useful life.

Each asset is depreciated based on its depreciable basis, which is generally historic cost plus capital improvements. For example, if you purchase a fourth floor residential condominium for $1,000,000 and rent it out, each full year it is used in the rental business you divide the $1,000,000 depreciable basis over 27.5 to come up with a depreciation deduction of $36,364, which lowers the taxable income from the rental activity, and may even be currently deductible against other income if the rental property produces a loss. Note that some of the basis may be attributable to land, which is good basis that can be recovered upon a sale, but it cannot be depreciated.

Step-up at Death

The tax code offers a tremendous benefit for those looking to facilitate Second Generation FI. The tax basis of inherited assets is “stepped-up” to the fair market value of the asset on the original owner’s date of death. This means, among other things, it is usually much better to leave an asset to an heir at death rather than to gift that asset to an heir during life. The asset left upon death has a stepped-up asset basis, while the gifted asset only has the original owner’s basis in the hands of the recipient.

I previously wrote an example of how this works:

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.

Lastly, in order to qualify for the step-up at death, an asset must be held in a taxable account. Assets held in retirement accounts do not receive a step-up at death.

Tax Loss Harvesting

Basis is what makes tax loss harvesting possible. Picture Joey, who owns Blue Company stock worth $10,000. He purchased the stock a year ago for $13,000. He can sell his Blue Company stock and deduct the $3,000 loss on his tax return, realizing a nice benefit.

Tax loss harvesting is a neat tool in the tax planning tool box. But it’s a fools errand to succumb to the “tyranny of tactics” and arrange one’s portfolio around tax loss harvesting. At most, tax loss harvesting reduces your taxable income in any particular year by $3,000. Over the long run, that is not the way to build wealth and achieve financial freedom.

Sure, play the tax loss harvesting card when the right opportunity arises, but don’t structure your portfolio with dozens of holdings in the hopes you can get a $3,000 loss every year. Rather, structure your portfolio with your ultimate goal in mind, and if toward year-end an opportunity to do some tax loss harvesting arises, pounce on it.

Retirement Accounts

The term “basis” means something a bit different in the context of retirement accounts. Two points: First, it is possible to have basis in a traditional account. Generally this means that nondeductible, or “after-tax” contributions have been made to the account, and thus, in the future when there are taxable distributions a portion of the distribution will be offset by that basis.

Second, the assets inside of a retirement account (including a Roth account) do not have basis to the owner of the account. These assets do have basis, but that basis is never directly accessible to the owner of the account (in the way that depreciable basis or stock basis is accessible to the owner). Importantly, assets inside of a retirement account do not enjoy the step-up in basis at the owner’s death that assets in taxable accounts enjoy.

Conclusion

Tax basis is an important attribute to understand as you do tax planning. In two weeks I will build on this post to discuss in detail important implications of tax basis for those pursuing financial independence.

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.

Backdoor Roth IRAs for Beginners

If you read enough FI blogs, you will eventually come across the term “Backdoor Roth IRA.” This post answers the question “What’s the deal with Backdoor Roth IRAs?”

Why Do a Backdoor Roth IRA?

Why would someone do a Backdoor Roth IRA? The Backdoor Roth IRA gets money into a Roth IRA in cases where the taxpayer earns too much to make a direct annual contribution to a Roth IRA. Doing the Backdoor Roth IRA gets money that would have been invested in a taxable account into a tax-free Roth account. Further, the money in the Roth account gets better creditor protection than money in a taxable account.

History of the Backdoor Roth IRA

Before 2010, what is now referred to as a Backdoor Roth IRA would have been permissible and/or necessary in only relatively limited circumstances, and then only in years prior to 2008. But a 2006 change in the law opened up the Backdoor Roth IRA in the form we know now (starting in 2010).

Two fundamental concepts must now be addressed. The first is a Roth IRA contribution.

Roth IRA Contributions

This post discusses Roth IRA contributions in detail. Simplified, U.S. citizens and residents with earned income can make an annual Roth IRA contribution of up to $7,000 in 2024 ($8,000 if 50 or older). Done for many years, it can be a tremendous wealth building tool, since it moves wealth into an account that is tax-free (if properly executed).

The one catch is that your “modified adjusted gross income” (or “MAGI”) must be below a certain threshold in order to make a Roth IRA contribution. To make a full contribution in 2024, your MAGI must be less than $146,000 (if single) or $230,000 (if married filing joint).

Because of these limits, many taxpayers are unable to make a Roth IRA contribution. Further, based on the qualification rules for traditional deductible IRA contributions, most taxpayers unable to make a Roth IRA contribution are also unable to make a deductible traditional IRA contribution.

Roth IRA Conversions

The second fundamental concept is a Roth IRA conversion. A Roth IRA conversion is a movement of amounts in traditional accounts to a Roth IRA. This creates a taxable event. The amount of the Roth IRA conversion, less any “basis” in the traditional account (more on that later), is taxable as ordinary income on the taxpayer’s tax return.

Prior to 2010, only taxpayers with a modified adjusted gross income of $100,000 or less were allowed to do a Roth IRA conversion. This amount was not indexed for inflation and applied per tax return, making it particularly difficult for many married couples to qualify.

In 2006, Congress changed the law, effective beginning in 2010. As of January 1, 2010, there is no modified adjusted gross income limitation on the ability to do a Roth IRA conversion. The richest, highest earning Americans now qualify to do a Roth IRA conversion just as easily as anyone else.

The Backdoor

Okay, so there’s no MAGI limitation on the ability to execute a Roth IRA conversion. So what? Aren’t they taxable? What’s the advantage of doing one?

Recall I mentioned a taxpayer’s basis in a traditional account. Basis in an IRA occurs when a taxpayer makes a nondeductible contribution to a traditional IRA. Here is an example.

Mike expects to earn $300,000 from his W-2 job in 2024, is covered by a workplace 401(k) plan, and expects to have some investment income. Mike has no balance in a traditional IRA, SEP IRA, or SIMPLE IRA.

Mike contributes $7,000 to a traditional IRA on April 20, 2024. The contribution is nondeductible. Because the contribution is nondeductible, Mike gets a $7,000 basis in his traditional IRA. Mike must file a Form 8606 with his 2024 tax return to report the nondeductible contribution.

The “backdoor” opens because of the confluence of two rules: the ability to make a nondeductible traditional IRA contribution and the ability to do a Roth IRA conversion regardless of your income level. Let’s extend Mike’s example a bit.

On May 2, 2024, Mike converts all the money in his traditional IRA to a Roth IRA (a Roth IRA conversion). At that time, Mike’s traditional IRA had a value of $7,011.47.

What result? To start, all $7,011.47 is taxable. All money converted in a Roth IRA conversion is taxable. Uh oh! But there’s good news for Mike. Mike gets to offset the $7,011.47 that is taxable by the $7,000 of basis in his traditional IRA. Thus, this Roth IRA conversion will only increase Mike’s taxable income by $11.47 ($7,011.47 minus $7,000).

The combination of these two separate, independent steps (a nondeductible traditional IRA contribution and a later Roth IRA conversion) is what many now refer to as the Backdoor Roth IRA. Notice this is only possible because of the repeal of the MAGI limitation on Roth IRA conversions. Under the rules effective prior to 2010, Mike would have been allowed to make the nondeductible traditional IRA contribution, but his income (north of $300,000) would have prohibited him from a Roth IRA conversion.

The Backdoor Roth IRA allows Mike to obtain the benefits of an annual Roth IRA contribution without qualifying to make a regular annual Roth IRA contribution.

December 31st

Any Backdoor Roth IRA planning should involve an additional diligence step: ensuring that as of December 31st of the year of the Roth conversion step, the taxpayer has a zero balance in all traditional IRAs, SEP IRAs, and SIMPLE IRAs. This helps ensure the Backdoor Roth IRA is a tax-efficient tactic.

The Pro-Rata Rule

The Backdoor Roth IRA works well for someone with Mike’s profile. But it does not work well for everyone. Let’s change up the example a bit.

Jennifer’s story is the same as Mike’s story above, except that she had a separate traditional IRA before she did her 2024 nondeductible IRA contribution. That separate IRA had no basis. As of December 31, 2024, that separate traditional IRA was worth $92,988.53.

This one change in facts dramatically increases Jennifer’s taxable income from the Roth IRA conversion. Jennifer must apply the so-called Pro-Rata Rule to the Roth IRA conversion. Even though her two IRAs are in separate accounts, they are treated as one IRA for purposes of determining how much of Jennifer’s $7,000 of basis she recovers upon her Roth IRA conversion.

Jennifer starts with $7,011.47 of income (the amount she converts). To determine the amount of her $7,000 of basis she gets to recover against the proceeds of the Roth IRA conversion, we must multiply that $7,000 times the amount converted ($7,011.47) divided by the sum of the amount converted and her traditional IRA balance at the end of the year ($7,011.47 plus $92,988.53). Thus, Jennifer gets to recover 7.00147 percent of the $7,000 of basis, which is only $490.80. This results in Jennifer’s Roth IRA conversion increasing her taxable income by $6,520.67 ($7,011.47 minus $490.80).

What was a great idea for Mike becomes a horrible idea for Jennifer when she has a significant balance in another traditional IRA.

Note further that Jennifer would have the same bad outcome if that $92,988.53 traditional IRA was instead in a traditional SEP IRA or in a traditional SIMPLE IRA.

Tax Reporting

Assume Mike did his Roth IRA conversion and did not have any other money in traditional IRAs in 2024. He will get a Form 1099-R from his financial institution. In box 1 it will report a gross distribution of $7,011.47 (the amount of the Roth IRA conversion).

In box 2a the Form 1099-R will say that the “taxable amount” is $7,011.47 and box 2b will be checked to indicate that the “taxable amount not determined.” Wait, what? How can $7,011.47 be the taxable amount while the next box claims the taxable amount is not determined? The answer is the basis concept discussed above.

Mike’s financial institution does not know the rest of Mike’s story (his income, retirement plan coverage at work, IRAs at other institutions, etc.), so it has no way of determining how much basis, if any, Mike recovers when he did the Roth IRA conversion. Box 2b simply means that Mike might have recovered some basis, but the institution is not in a position to determine if he did.

Form 8606 helps complete the tax reporting picture. By filing that form, Mike establishes that he was entitled to $6,000 of traditional IRA basis and how the pro-rata rule applies (if at all) to his Roth IRA conversion. It is important that Mike file a properly completed Form 8606 with his timely-filed 2024 federal income tax return.

When Mike files his 2024 Form 1040, he puts $7,011.47 on line 4a (“IRA distributions”) and $11.47 on line 4b (“Taxable amount”). Most tax return preparation software will round cents to the nearest whole dollar.

Note that failing to report the transactions on the Forms 8606 and 1040 in this way can result in Mike paying an incorrect amount of tax.

Further Reading

This post discusses what you can do if you find yourself in Jennifer’s situation to get a result similar to Mike’s result. I discuss how to properly report a Backdoor Roth IRA on your tax return and what to do if has been incorrectly reported here.

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.


Small Business Retirement Plans

If you are self-employed or have a side hustle, you have great opportunities for tax-advantaged savings. Small business retirement planning has been an area of significant confusion due to the multitude of plans available and the different qualification rules for each.

Below I describe the three most important plans for most small businesses to consider, provide the qualification requirements, and discuss when each plan is the best option.

Fortunately, for roughly 90 percent of small businesses, there are only three options worth considering: the Solo 401(k), the SIMPLE IRA, and the SEP IRA. In many cases, one of the three options quickly becomes the advantageous option.

After I discuss the three main small business retirement plans, I will provide some commentary on other available plans, but for most small businesses, the playbook consists of these three plans.

The administrative burdens (forms, paperwork, fees to financial institutions) of all three of these programs are relatively light these days, though all three plans do have some forms that must be properly completed, signed, and filed.

Before we begin, three quick notes. First, on limitations. Below I provide (in a general sense) the upper annual limits on contributions to the plans. It is important to note that contributions can be made in a manner below the limits – the plans are flexible in this regard. Second, generally you can contribute to a small business retirement plan and to a Roth and/or traditional IRA. Having access to a small business retirement plan does not prohibit a contribution to a Roth IRA or a traditional IRA. Third, before implementing a plan it is best to discuss your business and needs with the plan provider. Providers can have rules that are different from (and/or in addition to) the applicable tax rules.

Solo 401(k)

The Basics: A Solo 401(k) (sometimes referred to as an “Individual 401(k)”) is a 401(k) plan established by a self-employed individual for only their own benefit. Solo 401(k)s can be established by self-employed individuals in their own name and by corporations (usually S corporations in this context). Self-employment for this purpose includes a sole proprietorship, limited liability company (“LLC”), or other entity treated as disregarded from their single owner and reported on a Schedule C on their tax return.

The main advantage of the Solo 401(k) is that it allows annual contributions by the self-employed individual in his/her role as the “employee” and annual contributions by the self-employed individual (or S corporation) in his/her role as “employer.”

Employee contributions are limited to the lesser of earned income or $19,500 ($26,000 if 50 or older) in 2020. Employer contributions are limited to either 20 percent of self-employment income or 25 percent of W-2 wages (if the self-employed individual is paid through a corporation, including S corporations). Total employee and employer contributions are limited to $57,000 ($63,500 if age 50 or above) in 2020.

Today, many financial institutions (including Fidelity, Schwab, and Vanguard) offer low-cost Solo 401(k) options.

If eligible, the Solo 401(k) is almost always the best option for the self-employed individual. It offers the greatest potential for tax savings of the self-employed plans and it is relatively easy to administer.

An important note on the Solo 401(k) vis-a-vis the SIMPLE IRA and the SEP IRA: the Solo 401(k) is the only small business plan that allows Roth “employee” contributions. This allows self-employed individuals the ability to put away up to $19,500 ($26,000 if 50 or older) annually that will grow tax free. For all three plans, the “employer” contribution is always a traditional contribution (i.e., tax deductible today, taxable upon withdrawal). Note, however, that not all financial institutions offer the Roth employee contribution option in their Solo 401(k) plan, so it is important to check with the provider before signing up if the ability to make a Roth contribution is important to you.

Spouses employed by the self-employed individual (or their corporation) can also participate in the Solo 401(k) (only to the extent of their earnings from the business and subject to the above stated limitations), increasing the tax benefits of the plan.

Eligibility: In order to establish a Solo 401(k) plan, a person must have self-employment income, and must not have employees other than their spouse. For this purpose, an employee is anyone who works 1,000 hours during the year for the business. Starting in 2024, an employee also includes anyone who has worked 500 hours in each of 3 consecutive years.

Different plans have different rules on other employees. Some Solo 401(k) plans do not allow you to have any non-owner/non-spousal employees (regardless of the numbers of hours worked).

To have a Solo 401(k) in any tax year, the plan must be established by the deadline for the tax return, including extensions. That deadline also applies to employer contributions.

Generally, employee deferrals to a Solo 401(k) must be made by the end of the calendar year. There is an exception: if the Solo 401(k) is for a self-employed person (reporting self-employment income on Schedule C), the employee deferral must be formally designated by year-end, but then can be paid into the Solo 401(k) before the tax filing deadline (including extensions if the taxpayer extends his/her Form 1040).

Ideal for: Solo 401(k)s are ideal for anyone who is self-employed and does not have employees (other than a spouse).

SIMPLE IRA

The Basics: The SIMPLE IRA works in a manner somewhat similar to a 401(k) plan. It allows employees (including self-employed owners of the business) to defer up to $13,500 ($16,500 if 50 or older) of earnings in 2020 through traditional employee contributions. The SIMPLE IRA also has relatively modest required employer contributions to each eligible employee’s account (described below).

Today, many financial institutions (including Fidelity, Schwab, and Vanguard) offer low-cost SIMPLE IRA options.  

In order to have a SIMPLE IRA for the year, the employer must establish the SIMPLE IRA by October 1st of the year. One narrow exception is when the business is established after October 1st, in which case the plan must be established when administratively feasible.

The SIMPLE IRA has two main advantages over the SEP IRA. First, it gives the self-employed owner and any employees a valuable option – the option to make traditional contributions to the SIMPLE IRA account. By contrast, the SEP IRA (discussed below) does not allow for employee contributions. Second, the required employer contribution is relatively low. Employers must make either matching contributions of 3 percent of salary (in 2 out of every 5 years that percentage can be reduced to 1 percent) or automatic annual contributions of 2 percent of salary to each employee’s SIMPLE IRA. Thus, the SIMPLE IRA can give the self-employed owner(s) the option to defer up to $13,500 ($16,500 if 50 or over) of earnings in a relatively affordable manner.

Eligibility: In order to be eligible for a SIMPLE IRA, the employer must have no other retirement plan and must have 100 or fewer employers during the year.

Ideal for: Self-employed individuals that are not eligible for a Solo 401(k) and are looking to provide themselves and their employees the option to defer some taxable income at a relatively low cost to the employer. Partnerships where two or more owners (non-spouses) work in the business and/or small businesses with employees are good candidates for a SIMPLE IRA.

SEP IRA

The Basics: A SEP IRA is allows only employer contributions. Generally, the employer can make annual contributions of up to 25 percent of eligible compensation (20 percent of a sole proprietor’s self-employment income), limited to $57,000 of contributions (in 2020).

Today, many financial institutions (including Fidelity, Schwab, and Vanguard) offer low-cost SEP IRA options.  

The SEP IRA has two important advantages. First, it allows the employer to elect each year whether to make contributions. The employer can elect to forego contributions or reduce the contribution each year. Second, the SEP IRA has the latest deadlines of all the plans. A SEP IRA can be established for a tax year by the deadline for filing that tax year’s tax return, including extensions.

The main disadvantage of a SEP IRA is that it generally requires equal percentage contributions to all eligible employees. Said differently, in order for the self-employed owner of the business to make an employer contribution to his/her own account, the business must make the same percentage contribution to all eligible employees. This makes the SEP IRA an expensive way to save for your own retirement if you are self-employed and have employees. SEP IRAs are also subject to “top heavy” rules whereby the employer may be required to put in additional contributions to the rank-and-file employees’ SEP IRAs if the owners’ and executives’ SEP IRA balances are too high vis-a-vis the rest of the employees’ SEP IRA balances.

Eligibility: An employer (a sole proprietor, partnership, or corporation, including S corporations) can establish a SEP IRA program. Employees that are 21 years old, earn $600, and have worked for three of the previous five years for the employer must be allowed to participate.

Ideal for: There are three situations in which a SEP IRA can be highly advantageous. The first is for a side hustlers that maximize their 401(k)/403(b)/TSP contributions to their W-2 employer’s plan. The SEP IRA provides a mechanism for these side hustlers to defer more income. Note, however, that this can also be accomplished through a Solo 401(k), and in most cases the Solo 401(k) is preferable to the SEP IRA (if a taxpayer is eligible for both).

The second situation is when a self-employed person has not established a self-employed retirement plan by year-end. In such cases, the taxpayer can establish and fund a SEP IRA for the prior year before their tax return deadline (including extensions).

Third, a SEP IRA can be helpful in situations where a small business has a small number of employees, all or most of which are very important to the business. The SEP IRA provides a way to give highly valued employees a significant benefit.

Side Hustlers

For most side hustlers, the question becomes: are you covered by a retirement plan (such as a 401(k)) at your W-2 job? If you are not, the Solo 401(k) in most instances is likely your best option.

If you are covered by a workplace retirement plan, such as a 401(k), then the SEP IRA may be your best option, since you can defer up to the lesser of 20 percent of your side-hustle income or $57,000 (in 2020) while you can take advantage of your $19,500 ($26,000 if 50 or older) employee contributions through your workplace plan. While the “employer” contribution calculation is the same for a SEP IRA and a Solo 401(k), the administrative cost of the SEP IRA (including IRS filings) tends to be lighter than that of the Solo 401(k).

In some situations, side hustlers might want to forego a SEP IRA and use a Solo 401(k) (instead of a workplace 401(k)) for some or all of their annual employee contributions. That would be true if you want to make Roth employee contributions and your workplace plan does not allow them and/or you believe the investment options in your Solo 401(k) plan are better than the options in your employer’s plan. However, in all cases consideration should also be given to ensuring you at least get the full match in your employer’s 401(k) plan.

One important consideration for side hustlers and all self-employed individuals is what I call the Solo 401(k) Trap. Because of the new Section 199A deduction, many will want to forego deducting retirement plan contributions to self-employment retirement accounts (i.e., traditional employee contributions to Solo 401(k)s and employer contributions to Solo 401(k)s and SEP IRAs) and instead make Roth employee contributions to Solo 401(k)s.

Note that there is no benefit to having both a Solo 401(k) and a SEP IRA for your side hustle, because contributions to both plans count against the relevant limitations (i.e., having two separate plans does not increase a taxpayer’s contribution limitations).

Other Plans

There are other options available to small businesses. All (with the exception of the SIMPLE 401(k)) of them involve significantly more administrative burden and costs than the Solo 401(k), the SIMPLE IRA, and the SEP IRA. Often these plans are not feasible for small businesses and these plans are rarely feasible for side hustlers.

SIMPLE 401(k)s

SIMPLE 401(k)s are very similar to SIMPLE IRAs, with some differences on the margins not worth mentioning here. Most financial institutions offer SIMPLE IRAs instead of SIMPLE 401(k)s.

Keoghs

Keoghs come in both defined contribution and defined benefit (i.e., pension) models. Keoghs involve significant additional administrative burdens when compared to Solo 401(k)s, SIMPLE IRAs, and SEP IRAs.

401(k)s

There is nothing stopping a small business from establishing a 401(k) plan just like the largest employers. However, as a practical matter, it is difficult for most small businesses to do so. First, they involve significant set-up and maintenance costs. Second, 401(k)s are subject to discrimination testing to prevent business owners and high compensated employees from enjoying the benefits of the plan to a much greater degree than rank-and-file employees. This testing can lead to either reversals of previous contributions to the plan or additional employer contributions to rank-and-file employees.

Defined Benefit Pension Plans

A defined benefit plan (where the employee receives a stated benefit during retirement years and the employer funds the plan during the employee’s working years) is another option. These plans require significant compliance costs, including actuarial calculations. Further, if you have employees, these plans can be quite expensive for the self-employed business owner. In addition, these plans often work against the financial independence model in that they tie up assets until the account owner reaches a certain retirement age. However, given the right set of circumstances (usually older, highly compensated earners), these plans can be advantageous and create large current tax deductions.

Conclusion

Small businesses have a great opportunity to create tax advantaged retirement savings. For those eligible for a Solo 401(k), in most cases significant consideration should be given to establishing one. Depending on your circumstances, the SIMPLE IRA or the SEP IRA might be a great solution.

My hope is that this post has given you some working knowledge of the three main options for small businesses. Small business owners will often benefit from obtaining professional advice regarding their retirement planning and the programs they ought to establish.

Next Week

Next week’s post (click here) explores small business retirement plans in light of the new Section 199A qualified business income deduction and how the two concepts interact.

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.


Cosmo Kramer and Financial Independence

I’m not aware that there’s ever been a television show or movie about a financially independent character. However, one particular character strikes me as embodying, if inadvertently, many aspects of FI – Cosmo Kramer of the hit comedy Seinfeld.

Two introductory points. First, I’m an avid fan of Seinfeld, but I’m no expert. I’m sure I’ll miss pertinent information in this post – please feel free to add relevant Seinfeld/Kramer info in the comments.

Second, financial independence is not Cosmo Kramer’s lodestar. Quirkiness is. Many things influenced the character, but none more so than his overwhelming quirkiness, which led to many laughs on the show.

Kramer’s Origin

Cosmo Kramer is based on Larry David’s former real life neighbor, Kenny Kramer. Actor Michael Richards put his own spin on the character. The first episodes feature a shut-in motiff for Kramer, but quickly the character became much more social and confident. Kramer believes he’s smarter than everyone else, but he does not brag about it. He simply presents his version of the world as if it is everyone else’s (it’s not).

Kramer does not have a job. In an early episode, The Truth, Kramer claims to not pay taxes. Jerry responds that it is easy not to pay taxes when you don’t have income. 

Kramer’s Finances

In The Visa, George gives some insight into Kramer’s financial situation. According to George, Kramer’s life is sort of like a fantasy camp, and he reveals the following nuggets about Kramer’s financial life: “Do nothing, fall ass-backwards into money, mooch food off your neighbors.”

Kramer may not be a millionaire. There’s no indication that Kramer simply sold a lucrative business and is now living off the proceeds. Kramer claims not to be a millionaire when he discovers Calvin Klein is selling a perfume called “The Ocean.” Kramer previously pitched a cologne named “The Beach” to Calvin Klein, and complains to Jerry that “I could’ve been a millionaire! I could’ve been a fragrance millionaire, Jerry!” when he believes Calvin Klein stole his idea.

Later, in The Van Buren Boys, Kramer sells his life stories to J. Peterman for $750 and hosts a get-together to celebrate his financial upturn. Even in the 1990’s, few thousandaires (much less millionaires) would assemble their friends to celebrate a $750 score, but Kramer is quirky enough to do it.

Kramer never seems very anxious financially, but on two occasions he doesn’t appear to have the liquidity to pay unexpected bills. In The Diplomat’s Club Kramer runs up a $3,200 debt gambling on airplane arrivals and departures. He calls Newman to provide a unique piece of U.S. Postal Service memorabilia as collateral so he can make one more bet. In The Seven, Jerry bills Kramer for all his mooching. In order to pay the bill, Kramer sells Newman a bicycle for $50. Perhaps when you have trouble covering an unexpected bill for $50 it’s normal to celebrate a $750 financial upturn . . .

Kramer did have a gambling addiction, but it generally appears to be under control throughout the series. During its rare flare-ups, Kramer either gambles with Jerry’s money or uses Newman’s most valuable asset as collateral.

While the show never uses “FI” to describe Kramer, it once featured the character retiring early to Florida. In The Wizard, Kramer retires (from what, the other characters have no idea) to Del Boca Vista after having sold the movie rights to his coffee table book about coffee tables. Sure enough, Florida living doesn’t agree with Kramer, and he moves back to New York. In the next episode, The Burning, Kramer has a part-time job as an actor portraying diseased patients for medical school students.

Kramer’s Professional Background

Little is known about Kramer from prior to the start of the Seinfeld series. He appears to have little particular business knowledge or training. In The Package, Kramer acknowledges that he does not know what a “write off” is. Assessing Kramer’s work product in The Bizarro Jerry, Mr. Leland surmises that Kramer has “no business training at all.”

Kramer worked at Brandt Leland

Kramer’s Lifestyle

Kramer is known for mooching off his neighbor Jerry. In The Dealership, he test drives a new car Jerry is considering. Kramer wants to know how long the car can run with the gas gauge on “E,” since he doesn’t “want to be the one responsible for purchasing costly gasoline” when borrowing Jerry’s car. Kramer frequently helps himself to Jerry’s food and beverages, thus keeping his grocery bill low.

Kramer appears to live a relatively low cost lifestyle. He wears vintage clothes and drives older cars. In The Nap he swims in the East River for exercise.

Kramer is not immune from frivolous and/or luxury purchases. He purchases a hot tub for his living room. He enjoys Cuban cigars, though he never pays cash for them. Initially, he obtains them from George (who received them as a gift from Mr. Ross). Later, Kramer barters with the Cuban consulate to obtain cigars in exchange for clothing.

One defining Kramer characteristic is that he’s always up for making some additional income. In The Beard he gladly accepts $50 to pose in a police lineup. In The Rye he drives a friend’s hansom cab in order to make $250 a day. In The Bookstore, Kramer and Newman attempt to operate a rickshaw business in New York. Kramer and Morty Seinfeld sell vintage raincoats in The Raincoats. 

Kramer frequently does odd jobs with his friend Mickey Abbott. In The Race, Kramer works as a Coleman’s department store Santa, with Mickey as his elf. In The Burning he and Mickey portray diseased patients for medical school students. In The Stand In he and Mickey work as stand-ins on All My Children. Mickey hooks Kramer up with a seat-filler job at the Tony Awards in The Summer of George.

Kramer is also an arbitrager. In The Bottle Deposit he and Newman collect bottles and cans in New York (where the refund is 5 cents a bottle and can) and plan to drive them to Michigan to collect a 10 cent refund per bottle and can. They joyfully sing “at ten cents a bottle and ten cents a can we’re pulling in $500 a man!!!”

None of these pursuits are what we would call a side-hustle. They are very “one-off” and do not create a consistent stream of income. To my mind, a great modern Seinfeld episode plot would be Kramer offering his services on Fiverr – that would give him odd jobs where hilarity would ensue.

Kramer at His Most FI

The Keys and The Trip (Parts 1 and 2)

In a three episode arc spanning from the end of Season 3 to the beginning of Season 4, Kramer moves to Los Angeles to pursue a Hollywood career. His motivation appears to be two-fold. He’s angry with Jerry over a dispute regarding spare keys, and he is genuinely interested in becoming an actor and producer. Kramer hitch hikes (after his car breaks down) and lives in a rather dilapidated apartment. He certainly isn’t flush with money in California, but he’s willing to sacrifice to pursue his Hollywood dream. Kramer’s is able to follow his dream because he is so financially independent. 

The Voice

In The Voice, Kramer establishes a corporation (Kramerica Industries), hires an intern, and earnestly attempts to invent a bladder system for tankers to prevent oil spills. He and his intern Darren even do some ill-fated research and development on the concept. When the idea fails, Kramer suggests an alternative invention – a bottle that dispenses both ketchup and mustard.

The Strike

Kramer’s back to work!

The Strike, known most for its Festivus angle, is where Kramer is at his most and at his least FI. Kramer receives a call that the strike is over. Apparently, he was an employee of H&H Bagels. Over a decade ago Kramer went on strike for $5.35 an hour. Since the minimum wage recently increased to $5.35 an hour, Kramer ends his strike and goes back to work. It’s the rare occasion where Kramer puts work ahead of his everyday quirky life, and his mindlessly going to work just because they now pay $5.35 an hour strikes me as very un-FI.

Later that episode, Kramer acts in a more FI manner. He strikes when his boss won’t let him take off to celebrate Festivus. Prioritizing Festivus over work is very FI (although obviously it’s much more quirky than it is FI). That said, simply leaving the job, instead of staging a strike and picketing, is the more FI path. Kramer eventually ends his strike, but not because of financial concerns. He caved because he really had to go to the bathroom.

How Did Kramer Achieve His Version of FI

It’s hard to understand why Kramer does not need to have a steady job and yet is quite comfortable. He certainly does not seem to have had a lucrative career, and he’s too young to be a pensioner. One would think the show would have mentioned it if he won the lottery. In The Maestro, Jerry tells Kramer that he’s surprised Kramer is “so litigious.” That quote seemingly rules out Kramer being the beneficiary of a lawsuit judgment or large settlement.

My best guess is that Kramer is the beneficiary of a trust, perhaps established by his father, an aunt or an uncle, or a grandparent. He has access to money, but his difficulty with coming up with money in a pinch in The Diplomat’s Club and The Seven indicates that perhaps he receives income to support himself but does not have access to significant assets. Thus, my best working theory is that Kramer is the beneficiary of a trust or otherwise has access to a stream of income, one that is sufficient but not overly generous. In terms of assets and liabilities, it appears that Kramer probably has a relatively modest amount of assets and little in the way of liabilities. 

Do you agree that Kramer embodies many aspects of FI? Are there other fictional characters that are financially independent?

Photo of Michael Richards by Alan Light

Tax Gain Harvesting

Last week’s post addressed the concept of tax loss harvesting – selling stock or securities (in a taxable account) to create a beneficial tax loss. This post addresses tax gain harvesting – selling stock or securities (in a taxable account) to create a beneficial tax gain.

Beneficial tax gain? How could it be good to create a taxable gain?

Fortunately, not all taxable gains create federal income tax. Below I discuss two scenarios where incurring a taxable gain may not increase a taxpayer’s current tax liability and would have other favorable consequences.

0% Capital Gains Tax

Under current law, some taxpayers pay a 0% federal income tax rate on long-term capital gains. Based on the new tax numbers effective after tax reform, more and more taxpayers will find themselves in relatively low marginal tax brackets.

Single taxpayers with a taxable income of $39,475 or less and married filing joint (“MFJ”) taxpayers with a taxable income of $78,950 are currently (using 2019 numbers) subject to a 0 percent federal long-term capital gains tax rate. Because the calculation is based on taxable income and not adjusted gross income, taxpayers get the benefit of the standard deduction (or itemized deductions, if greater). Thus, single taxpayers with adjusted gross income of $51,675 (including a standard deduction of $12,200) or less and MFJ taxpayers with an adjusted gross income of $103,350 (including the $24,400 standard deduction) or less qualify for the 0% federal capital gains.

This presents a great planning opportunity if the taxpayer has an appreciated security (such as a stock, bond, mutual fund, or ETF). Here is an illustrative example:

Example 1: Joe and Mary file their 2019 tax return MFJ. In 2019 Joe and Mary will together have $81,000 of W-2 wages. They have $1,000 of interest and dividends. They take the standard deduction (which is $24,400 for MFJ in 2019). Thus, their 2019 taxable income is $57,600 ($81,000 plus $1,000 less $24,400). Assume Joe and Mary own 100 shares of Acme Corp., which they purchased five years ago for $10 per share ($1,000 total). Assume further that the stock is worth $11,000 on December 1, 2019. Joe and Mary could sell the stock on December 1st, realize a taxable gain of $10,000 ($11,000 less $1,000 cost basis), thus increasing their taxable income to $67,600.

Since their taxable income is still $78,950 or less, the entire $10,000 capital gain is subject to the 0 percent federal capital gains tax. This result obtains regardless of whether Joe and Mary purchase 100 Acme shares two days later for $11,000. Unlike tax loss harvesting, which is subject to the wash sale rules, there are no wash sale rules as applied to taxable gains.

Why might Joe and Mary sell at a tax-free gain and then repurchase? While they don’t pay tax, they don’t save on their 2019 taxes. However, the sale/repurchase significantly increases their tax basis and decreases the taxable gain they will have on a future sale of Acme stock. There’s no way to know if a future sale of Acme stock will be subject to a 0 percent federal capital gains tax rate. By tax gain harvesting, Joe and Mary have dramatically increased their basis in the Acme stock from $1,000 to $11,000 tax-free. Thus, a future taxable sale will incur much less tax.

If, alternatively, Joe and Mary decide that they want to exit their Acme stock holding (thinking that perhaps its meteoric rise has concluded), tax gain harvesting provides them with a tax-free exit. Tax gain harvesting, if you qualify for a 0 percent capital gains tax rate, provides a way to reallocate your portfolio’s holdings without paying federal capital gains tax on appreciated holdings.

Caveats

Three caveats about tax gain harvesting are worth mentioning. First, the determination of whether your taxable income is low enough to qualify for the 0 percent capital gains rate includes the gain itself. Referencing Joe and Mary, if instead of $81,000 of W-2 wages, they had $100,000 of W-2 wages, their tax gain harvesting opportunity is dramatically decreased. In this case, their taxable income before the gain ($76,700 – computed as $100,000 plus $1,000 less $24,400)) appears to qualify for the 0 percent capital gains rate, once you add the $10,000 gain, the taxable income is $86,600, and the gain no longer qualifies for the 0 percent capital gains tax rate.

Second, the gain causes your “adjusted gross income” and “modified adjusted gross income” to increase, and thus have negative consequences on other preferential tax items, including deductions, credits, and qualifying for certain tax benefits. In some cases it may be worth it to run the numbers through a tax forecasting program and/or consult with a professional advisor before pulling the trigger to help understand the impacts on other parts of your tax picture.

Third, state income taxes must always be considered when tax gain harvesting. There are some states that impose no income tax, and thus there’s no problem. But in most states there is an income tax, and there’s no preferential rate for capital gains. States generally tax capital gains like any other type of income. Thus, there can be a (usually small) state income tax on capital gains triggered through tax gain harvesting.

Depending on the state, the tax rate on the harvested gain might be small enough to make tax gain harvesting still well worth it. In any event, it is always advisable to consider what the state income tax effects of potential tax gain harvesting will be before pulling the trigger.

Offsetting Losses

Another time it may be worth it to tax gain harvest is when you already have incurred a significant taxable loss during the taxable year. Here is an illustrative example:

Example 2: In March 2019, Eileen sold shares of the XYZ Mutual Fund and realized a $13,000 capital loss. She has no other capital gains or losses in 2019. If she does nothing else, she will be able to deduct $3,000 of the loss against her ordinary income and carryforward $10,000 of the capital loss to 2019. If Eileen owns shares in the ABC Mutual Fund with a $10,000 built-in gain, she could sell those shares in December 2019, incur no marginal federal or state income tax, and still claim a $3,000 capital loss on her 2019 federal income tax return.

Eileen is now positioned to realize the benefits of tax gain harvesting. She can either restructure her portfolio in 2019 with no additional tax cost on the ABC Mutual Fund gain, or can repurchase ABC Mutual Fund shares shortly after the sale and increase her basis by $10,000.

It is worthwhile to note that by tax gain harvesting here, Eileen does cost herself in tax in the future, since she won’t have the $10,000 capital loss carryforward to use to offset future capital gains (and up to $3,000 in ordinary income) in 2020 and beyond. Thus, tax gain harvesting to offset current year capital losses involves tradeoffs, and taxpayers considering it are often well advised to run the numbers through a tax forecasting program and/or consult with a professional advisor before pulling the trigger.

Conclusion

Those with appreciated assets in taxable accounts should consider tax gain harvesting. One or both of the following need to be true: the taxpayer is in a relatively low tax bracket or has a capital loss in the current taxable year. If either or both are true, there may be an opportunity to save on future capital gains taxes and/or restructure a portfolio at no or low tax cost. As always, it is best to run the numbers and/or consult with a professional advisor before pulling the trigger.

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.

Tax Loss Harvesting

If you have individual stocks or other securities that have a loss in them, you may have a tax planning opportunity: tax loss harvesting.

First off, it is important to keep in mind that tax loss harvesting only applies to assets (such as stocks, bonds, mutual funds, ETFs, etc.) in taxable accounts. It does not apply to assets in retirement accounts and health savings accounts.

If you have assets in taxable accounts that have declined in value relative to your purchase price, you have an opportunity to tax loss harvest. Here’s a basic example:

Example 1: Mark purchased 100 shares of Kramerica stock two years ago for $100 a share ($10,000 total). Based on a disappointing test of an oil-tanker bladder system, Kramerica’s stock is now worth $70 per share. If Mark sells all 100 shares for $70, his total basis in the stock ($10,000) exceeds the amount he realizes on the sale ($7,000) by $3,000.

In Mark’s case, he has a $3,000 capital loss for tax purposes. Capital gains and losses from the sale of property (for most individuals, from securities) are different for tax purposes than other types of income, such as wages, rents, self-employment income, interest, and dividends (collectively, usually referred to as “ordinary income”). Federal income tax law does two things to capital gains and losses. First, it taxes capital gains at a lower tax rate than most other types of income. Second, and most importantly for the purposes of tax loss harvesting, it limits the ability of a capital loss to offset ordinary income.

Capital losses, such as Mark’s loss on Kramerica stock, can offset either capital gains or ordinary income, but only to the extent of $3,000 ($1,500 if the taxpayer files married filing separate) of ordinary income a year.

Thus, tax loss harvesting is a great play in two situations:

  1. A taxpayer has a large capital gain in a taxable year; and,
  2. A taxpayer has ordinary income and can trigger a $3,000 capital loss.

A second example can illustrate the first situation.

Example 2: Lucy sells stock with a historic cost basis of $30,000 for $50,000 in March. Thus, she will have to report a $20,000 capital gain on her tax return. If, however, Lucy has another stock/bond/mutual fund/ETF with a historic cost of $100,000 and a fair market value of $80,000, and she sells it by year-end, she will harvest the $20,000 loss in time to offset the previous $20,000 gain.

Taxpayers with significant capital gains during a year should review their taxable accounts towards year-end to see if there are any opportunities to harvest losses and offset existing capital gains.

For those taxpayers without capital gains, there still can be some opportunity to tax loss harvest.

Example 3: Edward anticipates making approximately $100,000 in 2021 in wages from his employer. If Edward can identify a stock/bond/mutual-fund/ETF with a built-in loss, he can sell the security and reduce his taxable income up to the lesser of the loss or $3,000 in 2021. If Edward owns the XYZ mutual fund with a historic basis of $5,000 and a current value of $2,000, he can sell it before year-end and reduce his taxable ordinary income from approximately $100,000 to approximately $97,000. The capital loss deduction is one taken on the first page of the Form 1040 and is not an “itemized deduction.” Thus, Edward gets the deduction regardless of whether he itemizes his deductions.

Note that Edward is limited in his ability to deduct capital losses in any one taxable year to $3,000. Let’s slightly revise the previous example.

Example 3A: The facts are the same as in Example 3, except the the stock Edward sells has a basis of $10,000. Thus, Edward’s current year capital loss is $8,000 ($10,000 basis less $2,000 sales price) instead of $3,000. However, Edward still can only deduct $3,000 because of the limit on taking capital losses against ordinary income. Thus, Edward’s 2021 taxable income is still approximately $97,000.

Edward can carry forward the excess unused capital loss ($5,000, which is the $8,000 actual loss less the $3,000 used loss) into future tax years. Thus, in 2022, he can offset capital gains and up to $3,000 of ordinary income by the $5,000 capital loss carried forward. If Edward has no capital gains or losses in 2022, he can deduct $3,000 of the $5,000 against his 2022 ordinary income, and then carryforward a $2,000 capital loss into 2023. Edward carries forward the capital loss until it is fully used.

Wash Sales

Tax loss harvesting sounds great, right? But with tax, there’s almost always a catch, and one exists here. The so-called “wash sale” rules.

They are best understood by understanding the concern they address. Say in our first Example Mark sells his 100 shares of Kramerica stock on December 15th to trigger the capital loss. Then on December 16th Mark buys 100 shares of Kramerica stock. Absent the wash sale rules, Mark has had no change in his overall economic position (he still owns 100 shares of Kramerica) yet he’s realized a $3,000 capital loss for tax purposes.

The wash sale rules step in to prevent this sort of gamesmanship. They disallow any loss on the sale of securities when the taxpayer buys the same or similar securities within the period starting 30 days before the loss sale and going through 30 days after the loss sale. The rule applies broadly. It applies to similar securities — for example, selling Vanguard’s S&P 500 index mutual fund at a loss and buying Fidelity’s S&P 500 index mutual fund. It applies to purchases of the same or similar securities by the taxpayer, the taxpayer’s spouse, and by entities controlled by the taxpayer and the taxpayer’s spouse. It can also potentially apply to purchases inside retirement accounts. The wash sale rule also bites to the extent of shares purchased through a dividend reinvestment program where the reinvestment occurs within the 61 day window described above.

Conclusion

Tax loss harvesting provides taxpayers a great opportunity to offset capital gains and possibly up to $3,000 of ordinary income. To work effectively for 2021, taxpayers must sell loss securities by December 31st and must be careful to avoid repurchasing the same or similar securities in a manner that triggers the wash sale rules and disallows the capital loss.

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.