Tag Archives: HSA

Accessing Retirement Accounts Prior to Age 59 ½

One thing I like about the Financial Independence community is that members are not beholden to Conventional Wisdom.

Many in the Establishment believe retirement is for 65 year olds (and some basically think it’s not for anyone). 

My response: Oh, heck no! 

Sure, some people have jobs they very much enjoy. If that’s the case, then perhaps retirement isn’t your thing in your 50s. But many in the FI movement have accumulated assets such that they no longer have a financial need to work. Perhaps their job is not all that enjoyable – it happens. Or perhaps their job won’t exist in a year or two – that happens too.

The tax rules require some planning if one retires prior to turning age 59 ½. Age 59 ½ is the age at which the pesky 10 percent early withdrawal penalty no longer applies to tax-advantaged retirement account distributions.

Thus, there’s a need to consider what to live off of once one is age 59 ½. Below I list the possibilities in a general order of preference and availability. Several of these options (perhaps many of them) will simply not apply to many 50-something retirees. Further, some retirees may use a combination of the below discussed options. 

Listen to Sean discuss accessing money in retirement prior to age 59 ½ on a recent ChooseFI episode! Part Two on the ChooseFI podcast is coming soon. 

Taxable Accounts

The best retirement account to access if you retire before age 59 ½ isn’t even a “retirement” account: it’s a taxable account. I’m so fond of using taxable accounts first in retirement I wrote a post about the concept in 2022.

The idea is to use some combination of cash in taxable accounts (not at all taxable – it’s just going to the ATM!) and sales of brokerage assets (subject to low long term capital gains federal income tax rates) to fund your pre-59 ½ retirement. This keeps taxable income low and sets up potential additional tax planning. 

Pros: Because of tax basis, living off $100,000 of taxable brokerage accounts doesn’t cause $100,000 of taxable income. Further, long term capital gains receive very favorable federal income tax treatment. Some may even qualify for the 0% long term capital gains tax rate!

But that’s not all. There are significant creditor protection benefits to living off taxable assets first. As we spend down taxable assets, we are reducing those assets that are most vulnerable to potential creditors. By not spending down tax-advantaged retirement accounts, we are generally letting them grow, thus growing the part of our balance sheet that tends to enjoy significant creditor protection. Note that personal liability umbrella insurance is usually a good thing to consider in the creditor protection context regardless of tax strategy. 

Spending taxable assets first tends to limit taxable income, which can open the door to (1)  a significant Premium Tax Credit in retirement (if covered by an Affordable Care Act medical insurance plan) and (2) very tax advantageous Roth conversions in early retirement. 

There’s also a big benefit for those years after we turn 59 ½. By spending down taxable assets, we reduce future “uncontrolled income.” Taxable accounts are great. But they kick off interest, dividends, and capital gains income, even if we don’t spend them. By reducing taxable account balances, we reduce the future income that would otherwise show up on our tax return in an uncontrolled fashion. 

Cons: To my mind, there are few cons to this strategy in retirement. 

The one con in the accumulation phase is that when we choose to invest in taxable accounts instead of in traditional deductible retirement accounts we forego a significant tax arbitrage opportunity. That said, these are not mutually exclusive. Members of the FI community can max out deductible retirement account contributions and also build up taxable accounts.

Ideal For: Someone who is able to save beyond tax-advantaged retirement accounts during their working years. This is the “ideal” for financial independence in my opinion, though it may be challenging for some. 

Inherited Retirement Accounts

Withdrawals from inherited retirement accounts (other than those the spouse treats as their own) are never subject to the 10% early withdrawal penalty. Often they are subject to a 10-year drawdown rule, so usually they should be accessed prior to using many other draw down techniques.

Pros: If it’s a traditional retirement account inherited from a parent or anyone else more than 10 years older than you are, you generally have to take the money out within 10 years. Why not just live on that money? Simply living on that money, instead of letting the traditional inherited retirement grow for ten years, avoids a “Year 10 Time Bomb.” The time bomb possibility is that the inherited traditional retirement account grows to a huge balance that needs to come out in the tenth full year following death. Such a large distribution could subject the recipient subject to an abnormally high marginal federal income tax rate. 

Cons: Not very many other than if the account is a Roth IRA, using the money for living expenses instead of letting it grow for 10 years sacrifices several years of tax free growth. 

Ideal For: Someone who has inherited a retirement account prior to turning age 59 ½.

Rule of 55 Distributions

Only available from a qualified retirement plan such as a 401(k) from an employer the employee separates from service no sooner than the beginning of the year they turn age 55. 

This is a great way to avoid the early withdrawal penalty. But remember, the money must stay in the workplace retirement account (and not be rolled over to a traditional IRA) to get the benefit. 

Pros: Funds retirement prior to age 59 ½ without having to incur the 10 percent early withdrawal penalty. 

Whittles down traditional retirement accounts in a manner that can help reduce future required minimum distributions (“RMDs”).

Cons: You’re handcuffed to the particular employer’s 401(k) (investments, fees, etc.) prior to age 59 ½. Review the plan’s Summary Plan Description prior to relying on this path to ensure flexible, periodic distributions are easily done after separation from service and prior to turning age 59 ½. 

Limited availability as one must separate from service no sooner than the year they turn age 55. 

Creates taxable income (assuming a traditional account is used), which is less than optimal from a Premium Tax Credit and Roth conversion perspective.

Ideal For: Those with (1) large balances in their current employer 401(k) (or other plan), (2) a quality current 401(k) or other plan in terms of investment selection and fees, (3) a plan with easily implemented Rule of 55 distributions, and (4) plans to retire in their mid-to-late 50s.

Governmental 457(b) Plans

Withdrawals from governmental 457(b) plans are generally not subject to the 10% early withdrawal penalty. This is the Rule of 55 exception but they deleted the “55” 😉

Like the Rule of 55, this is only available so long as the governmental 457(b) is not rolled to a traditional IRA.

Pros: Funds retirement prior to age 59 ½ without having to incur the 10 percent early withdrawal penalty. If you have a governmental 457(b), it’s better than the Rule of 55 because you don’t have to worry about your separation from service date. 

Whittles down traditional retirement accounts in a manner that can help reduce future RMDs.

Cons: You’re handcuffed to the particular employer’s 457 (investments, fees, etc.) prior to age 59 ½. Review the plan’s Summary Plan Description prior to relying on this path to ensure flexible, periodic distributions are easily done after separation from service and prior to turning age 59 ½. 

Creates taxable income (assuming a traditional account is used), which is less than optimal from a Premium Tax Credit and Roth conversion perspective.

Ideal For: Those (1) with large balances in their current employer governmental 457(b) and (2) a quality current governmental 457(b) in terms of investment selection and fees.

Roth Basis

Old annual contributions and conversions that are at least 5 years old can be withdrawn from Roth IRAs tax and penalty free at any time for any reason. This can be part of the so-called Roth Conversion Ladder strategy, though it does not have to be, since many will have Roth Basis going into retirement. 

Pros: Roth Basis creates a tax free pool of money to access prior to turning age 59 ½. 

Cons: We like to let Roth accounts bake for years, if not decades, of tax free growth. Using Roth Basis in one’s 50s significantly reduces that opportunity. 

Some may need taxable income in early retirement to qualify for Premium Tax Credits. Relying solely on Roth Basis can be much less than optimal if Premium Tax Credits are a significant part of one’s early retirement plan. 

Roth 401(k) contributions, for many workers, are disadvantageous in my opinion. Many Americans will forego a significant tax rate arbitrage opportunity if they prioritize Roth 401(k) contributions over traditional 401(k) contributions. 

Creates income for purposes of the FAFSA. 

Ideal For: Those with significant previous contributions and conversions to Roth accounts. 

72(t) Payments

I did a lengthy post on this concept. The idea is to create an annual taxable distribution from a traditional IRA and avoid the 10 percent early withdrawal penalty.

Pros: Avoids the early withdrawal prior to turning age 59 ½. 

Whittles down traditional retirement accounts in a manner that can help reduce future RMDs.

Inside a traditional IRA, the investor controls the selection of financial institutions and investments and has great control on investment expenses. 

Cons: This opportunity may require professional assistance to a degree that many of the other concepts discussed do not.

There is a risk that if not done properly, previous years’ distributions may become subject to the 10 percent early withdrawal penalty and related interest charges. 

They are somewhat inflexible. That said, if properly done they can be either increased (by creating a second 72(t) payment plan) or decreased (via a one-time switch in method). 

Creates taxable income, which is less than optimal from a Premium Tax Credit and Roth conversion perspective.

Ideal For: Those with most of their financial wealth in traditional deferred retirement accounts prior to age 59 ½ and without easy access to other alternatives (such as the Rule of 55 and/or governmental 457(b) plans. 

HSA PUQME

Withdrawals of Previously Unreimbursed Qualified Medical Expenses (“PUQME”) from a health savings account are tax and penalty free at any time for any reason. Thanks to ChooseFI listener and correspondent Kristin Smith for suggesting the idea to use PUQME to help fund retirement in one’s 50s. 

Pros: Withdrawals of PUQME creates a tax free pool of money to access prior to turning age 59 ½. 

Does not create income for purposes of the FAFSA.

Reduces HSA balances in a way that can help to avoid the hidden HSA death tax in the future.

Cons: This is generally a limited opportunity. The amount of PUQME that can be used prior to age 59 ½ is limited to the smaller of one’s (1) PUQME and (2) HSA size. Because HSAs have relatively modest contribution limits, in many cases HSA PUQME withdrawals would need to be combined with one or more of the other planning concepts to fund retirement prior to age 59 ½.

We like to let HSAs bake for years, if not decades, of tax free growth. Using HSA PUQME in one’s 50s significantly reduces that opportunity. 

Some may need taxable income in early retirement to qualify for Premium Tax Credits. Relying on PUQME can be less than optimal if Premium Tax Credits are a significant part of one’s early retirement plan. 

Ideal For: Those with significant HSAs and significant PUQME. 

Net Unrealized Appreciation

Applies only to those with significantly appreciated employer stock in a 401(k), ESOP, or other workplace retirement plan. I’ve written about this opportunity before. That employer stock with the large capital gains can serve as a “Capital Gains IRA” in retirement. Retirees can possibly live off sales of employer stock subject to the 0% long term capital gains rate. 

This opportunity usually requires professional assistance, in my opinion. 

The move of the employer stock out of the retirement plan into a taxable brokerage account (which sets up what I colloquially refer to as the “Capital Gains IRA” may need to be paired with the Rule of 55 (or another penalty exception) to avoid the 10 percent early withdrawal penalty on the “basis” of the employer stock. 

Pros: Moves income from “ordinary” income to “long term capital gains” income, which can be very advantageous, particularly if one can keep their income entirely or mostly in the 0% long term capital gains marginal bracket. 

Cons: Remember Enron? NUA is essentially Enron if it goes fabulously well instead of failing spectacularly. 

Employer stock is problematic during the accumulation phase since your finances are heavily dependent on your employer without a single share of employer stock. People make their finances more risky by having both their income statement and their balance sheet highly dependent on a single corporation.

It keeps the retiree heavily invested in the stock of their former employer, which is much less than optimal from an investment diversification perspective.  

Another con is that this usually requires professional assistance (and fees) to a much greater degree than several of the other withdrawal options discussed on this post. 

Ideal For: Those with large balances of significantly appreciated employer stock in a workplace 401(k), ESOP, or other retirement plan. 

Pay the Penalty

The federal early withdrawal penalty is 10 percent. For those in California, add a 2.5 percent state penalty. For some, perhaps the best idea is to simply bite-the-bullet and pay the early withdrawal penalty. That said, anyone accessing a tax-advantaged retirement account in a way not covered above should always consult the IRS list to see if perhaps they qualify for one of the myriad penalty exceptions.  

Pros: Why let a 10 percent penalty prevent you from retiring at age 58 if you have sufficient assets to do so and you might be looking at a year or two of the penalty, tops? 

Whittles down traditional retirement accounts in a manner that can help reduce future RMDs.

Cons: Who wants to pay ordinary income tax and the early withdrawal penalty? Even for those close to the 59 ½ finish line, a 72(t) payment plan for five years might be a better option and would avoid the penalty if properly done. 

Ideal For: Those very close to age 59 ½ who don’t have a more readily available drawdown tactic to use. That said, even these retirees should consider a 72(t) payment plan, in my opinion. 

Combining Methods to Access Funds Prior to Age 59 1/2

For some, perhaps many, no single one of the above methods will be the optimal path. It may be that the optimal path will involve combining two or more of the above methods.

Here’s an example: Rob retires at age 56. He uses the Rule of 55 to fund most of his living expenses prior to turning age 59 ½. Late in the year, he finds that a distribution from his traditional 401(k) would push him up into the 22% federal income tax bracket for the year. Thus, for this last distribution he instead elects to take a recovery of Roth Basis from his Roth IRA. This allows him to stay in the 12% marginal federal income tax bracket for the year. 

Conclusion

Don’t let anyone tell you you can’t retire in your 50s. If you have reached financial independence, why not? Of course, you will need to be very intentional about drawing down your assets and funding your living expenses. This is particularly important prior to your 59 1/2th birthday.

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.

San Diego Tax Delay

It’s deja vu all over again – Yogi Berra

Last year, most of California received several deadline delays when it came to 2022 tax returns, tax payments, and IRA and HSA contributions.

Sure enough, San Diego County now has a deadline delay for their 2023 tax returns, tax payments, and IRA and HSA contributions. Hat tip to Jennifer Mah’s Instagram for alerting me to this development. 

San Diego County Tax Deadline Delay

The IRS announced that because of early 2024 flooding in San Diego, San Diegons have an extended deadline, June 17, 2024, to perform most 2023 tax acts that otherwise would have been due early in 2024. The Franchise Tax Board has followed suit and also issued their own delay announcement. 

2023 Traditional and Roth IRA Contributions

The deadline for San Diegons to make 2023 contributions to traditional and/or Roth IRAs has been extended to June 17, 2024. As a practical matter, I wouldn’t encourage reliance on this particular deadline delay. Financial institutions may find it difficult to allow “late but timely” 2023 IRA contributions on their platform when it is available only to residents of a single county. 

If you are a San Diegon reading this in May 2024 and want to make an IRA contribution for 2023, I recommend initiating the process by calling the financial institution using a seldom used app on your phone, the phone.  

2023 Backdoor Roth IRAs

San Diegons now have until June 17, 2024 to execute the first step of a 2023 Backdoor Roth IRA, the nondeductible contribution to a traditional IRA for 2023. This would be a Split-Year Backdoor Roth IRA. 

2023 HSA Contributions

San Diegons now have until June 17, 2024 to contribute to a 2023 health savings account. The same comments that apply to traditional IRA and Roth IRA contributions made using the deadline extension apply to 2023 HSA contributions made using the deadline extension. 

2023 Tax Returns and Payments and 2024 Q1 Estimated Tax Payments

San Diegons now have until June 17, 2024 to (i) file their 2023 federal and California income tax returns, (ii) pay the amount due with their 2023 federal and California income tax returns, and (iii) make 2024 first quarter estimated payments. 

Who Benefits?

Residents of San Diego County qualify for the extended deadline. Taxpayers with records in San Diego County can also benefit. 

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.

2023 Year-End Tax Planning

It’s that time of year again. The air is crisp and my favorite football team is surging. That can only mean one thing when it comes to personal finance: time to start thinking about year-end tax planning.

I’ll break it down with three categories: Urgent, Year-End Deadline, and Can Wait Till Next Year. I will also provide some thoughts on 2024 tax planning that can/should be done before year-end in 2023.

As always, none of this is advice for your particular situation but rather it is educational information. 

Urgent

By urgent, I mean those items that (i) need to happen before year-end and (ii) may not happen if taxpayers delay and try to accomplish them late in the year. 

Donor Advised Fund Contributions

The donor advised fund is a great way to contribute to charity and accelerate a tax deduction. My favorite way to use the donor advised fund is to contribute appreciated stock directly to the donor advised fund. This gets the donor three tax benefits:

  1. A tax deduction for the fair market value of the contributed appreciated stock,
  2. Elimination of the built-in capital gain on the contributed appreciated stock, and
  3. Tax-free treatment of the income earned inside the donor advised fund.

In order to get the first benefit in 2023, the appreciated stock must be received by the donor advised fund prior to January 1, 2024. This deadline is no different than the normal charitable contribution deadline.

However, due to much year end interest in donor advised fund contributions and processing time, different financial institutions will have different deadlines on when transfers must be initiated in order to count for 2023. Donor advised fund planning should be attended to sooner rather than later. 

Taxable Roth Conversions

For a Roth conversion to count as being for 2023, it must be done before January 1, 2024. That means New Year’s Eve is the deadline. However, taxable Roth conversions should be done well before New Year’s Eve because 

  1. It requires analysis to determine if a taxable Roth conversion is advantageous, 
  2. If advantageous, the proper amount to convert must be estimated, and 
  3. The financial institution needs time to execute the Roth conversion so it counts as having occurred in 2023. 

Remember, generally speaking it is not good to have federal and/or state income taxes withheld when doing Roth conversions!

Roth Conversion Example: See slides 8 through 10 of this slide deck for an example of a Roth conversion in retirement. You might be surprised by just how little federal income tax is owed on a $23,000 Roth conversion.

Example Where I Disfavor Roth Conversions: I present an example of a 73-year old married couple with $400K in deferred retirement accounts and $87K in 2023 gross income. I would not recommend they do end-of-year Roth conversions. This spreadsheet computes the taxable Social Security with and without a $10K Roth conversion.

Gotta Happen Before 2026!!!

You will hear many commentators say “do more Roth conversions before tax rates go up in 2026!” If this were X (the artist formerly known as Twitter), the assertion would likely be accompanied by a hair-on-fire GIF. 😉

I disagree with the assertion. As I have stated before, there’s nothing more permanent than a temporary tax cut. You do your own risk assessment, but mine is this: members of Congress like to win reelection, and they are not going to want to face voters without having acted to ensure popular tax cuts, such as the reduction of the 15% tax rate down to 12% and the increased standard deduction, are extended. 

I recommend that you make your own personal taxable Roth conversion decisions based on your own personal situation and analysis of the landscape and not a fear of future tax hikes.

Learn all about the Pro-Rata Rule here.

Adjust Withholding

This varies, but it is a good idea to look at how much tax you owed last year (line 24 on the Form 1040). If you are on pace to get 100% (110% if 2022 AGI is $150K or greater) or slightly more of that amount paid into Uncle Sam by the end of the year (take a look at your most recent pay stub), there’s likely no need for action. But what if you are likely to have much more or much less than 100%/110%? It may be that you want to reduce or increase your workplace withholdings for the rest of 2023. If you do, don’t forget to reassess your workplace withholdings for 2024 early in the year. 

Backdoor Roth IRA Diligence

The deadline for the Backdoor Roth IRA for 2023 is not December 31st, as I will discuss below. But if you have already completed a Backdoor Roth IRA for 2023, the deadline to get to a zero balance in all traditional IRAs, SEP IRAs, and SIMPLE IRAs is December 31, 2023. 

Solo 401(k) Planning

There’s plenty of planning that needs to be done for solopreneurs in terms of retirement account contributions. Even though Schedule C solopreneurs can now establish a Solo 401(k) after year-end (up to April 15th), it is absolutely the case that it is better to do the planning upfront. For those Schedule C solopreneurs with a Solo 401(k) established, December 31st is the deadline to make 2023 employee deferral contributions or make a 2023 deferral election as an alternative to making the payments in 2023. December 31st is also the 2023 employee deferral contribution for solopreneurs operating out of S corporations.

The Solo 401(k) can get complicated. That’s why I wrote a book about them and post an annual update on Solo 401(k)s here on the blog. 

Year-End Deadline

These items can wait till close to year-end, though you don’t want to find yourself doing them on New Year’s Eve.

Tax Gain Harvesting

For those finding themselves in the 12% or lower federal marginal income tax bracket and with an asset in a taxable account with a built-in gain, tax gain harvesting prior to December 31, 2023 may be a good tax tactic to increase basis without incurring additional federal income tax. Remember, though, the gain itself increases one’s taxable income, making it harder to stay within the 12% or lower marginal income tax bracket. 

I’m also quite fond of tax gain harvesting that reallocates one’s portfolio in a tax efficient manner. 

Tax Gain Harvesting Example: See slide 15 of this slide deck for an example of tax gain harvesting in retirement.

Tax Loss Harvesting

The deadline for tax loss harvesting for 2023 is December 31, 2023. Just remember to navigate the wash sale rule. 

RMDs from Your Own Retirement Account

The deadline to take any required minimum distributions from one’s own retirement account is December 31, 2023. Remember, the rules can get a bit confusing. Generally, IRAs can be aggregated for RMD purposes, but 401(k)s cannot. 

RMDs from Inherited Accounts

The deadline to take any RMDs from inherited retirement accounts is December 31st. For some beneficiaries of retirement accounts inherited during 2020, 2021, and 2022, the IRS has waived 2023 RMDs. That said, all beneficiaries of inherited retirement accounts may want to consider affirmatively taking distributions (in addition to RMDs, if any) before the end of 2023 to put the income into a lower tax year, if 2023 happens to be a lower taxable income year vis-a-vis future tax years. 

Can Wait Till Next Year

Traditional IRA and Roth IRA Contribution Deadline

The deadline for funding either or both a traditional IRA and a Roth IRA for 2023 is April 15, 2024. 

Backdoor Roth IRA Deadline

There’s no law saying “the deadline for the Backdoor Roth IRA is DATE X.” However, the deadline to make a nondeductible traditional IRA contribution for the 2023 tax year is April 15, 2024. Those doing the Backdoor Roth IRA for 2023 and doing the Roth conversion step in 2024 may want to consider the unique tax filing when that happens (what I refer to as a “Split-Year Backdoor Roth IRA”). 

HSA Funding Deadline

The deadline to fund an HSA for 2023 is April 15, 2024. Those who have not maximized their HSA through payroll deductions during the year may want to look into establishing payroll withholding for their HSA so as to take advantage of the payroll tax break available when HSAs are funded through payroll. 

The deadline for those age 55 and older to fund a Baby HSA for 2023 is April 15, 2024. 

2024 Tax Planning at the End of 2023

HDHP and HSA Open Enrollment

It’s open enrollment season. Now is a great time to assess whether a high deductible health plan (a HDHP) is a good medical insurance plan for you. One of the benefits of the HDHP is the health savings account (an HSA).

For those who already have a HDHP, now is a good time to review payroll withholding into the HSA. Many HSA owners will want to max this out through payroll deductions so as to qualify to reduce both income taxes and payroll taxes.

Self-Employment Tax Planning

Year-end is a great time for solopreneurs, particularly newer solopreneurs, to assess their business structure and retirement plans. Perhaps 2024 is the year to open a Solo 401(k). Perhaps their business is growing such that an S corporation election makes sense. The best time to be thinking about these sorts of things for 2024 is late in 2023. Often this analysis benefits from professional consultations.

Additional Resource

Please see my November 11, 2023 ChooseFI Orange County year-end tax planning presentation slide deck.

FI Tax Guy can be your financial planner! 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, investment, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, investment, and tax matters. Please also refer to the Disclaimer & Warning section found here.

It’s Not Too Late, California!

HUGE UPDATE: On October 16, 2023, the IRS issued this, extending the October 16, 2023 deadline for 2022 tax acts and filings to November 2023. The IRS announcement allows (most) Californians to make Roth IRA, traditional IRA, and HSA contributions for 2022 up to November 16, 2023 and delays the deadline for many 2022 federal income tax returns and income tax payments to November 16, 2023. Hat tip to Justin Miller on X for the news.

ADDITIONAL UPDATE 10/16/2023 7:06PM: California has also extended the 2022 filing and payment deadline to November 16, 2023. Hat tip to Kelly Phillips Erb.

Please enjoy below the rest of my post, as originally authored in August 2023, understanding that now you can replace “October 16” with “November 16” for most Californians.

I’m glad that title intrigued you enough to stop on by. It’s not too late for most Californians to make a 2022 IRA contribution, a 2022 Roth IRA contribution, a 2022 HSA contribution, and/or do a 2022 Backdoor Roth IRA contribution. 

You’re probably thinking “What the heck are you talking about? It’s the late summer 2023. Time to be thinking about football, not funding 2022 IRAs and HSAs.”

Your thoughts are correct as applied to most Americans. However, most Californians are the beneficiaries of a special situation. The IRS announced that because of early 2023 flooding in many areas of California, most Californians have an extended deadline, October 16, 2023, to perform most 2022 tax acts that otherwise would have been due early in 2023.

This extension opens the door for millions of Californians to consider 2022 contributions to tax-advantaged accounts. Of course, nothing increases the amount Californians can contribute. Thus, those who have already maxed out for 2022 do not benefit from this deadline extension. 

2022 Traditional IRA Contributions

Most working Californians can still make 2022 contributions to a traditional IRA. If the taxpayer has not yet filed their 2022 Form 1040, the deduction or the Form 8606 (for a nondeductible contribution) can simply be included with the to-be filed Form 1040.

But what if the taxpayer has already filed their Form 1040 for 2022? Then the question becomes: are they deducting their 2022 traditional IRA contribution? If no, then the taxpayer can simply file a Form 8606 as a standalone tax return to report the 2022 nondeductible contribution. 

However, if the contribution is tax deductible, then the taxpayer would need to file amended Forms 1040 and 540 (for California) to report the deductible IRA contribution and claim refunds from both the IRS and the Franchise Tax Board for the tax reduced because of the deductible traditional IRA deduction. 

2022 Roth IRA Contributions

Many working Californians can still make 2022 contributions to a Roth IRA. Since Roth IRA contributions are not deductible, and do not require a separate form to report them, the contribution likely would not require any amending of already-filed 2022 tax returns. One exception would be the case of a taxpayer with a low income in 2022. He or she could make a 2022 Roth IRA contribution and possibly qualify for the Saver’s Credit. In order to claim the credit, they would need to amend their Form 1040 if they already filed it for 2022. 

2022 Backdoor Roth IRAs

It’s not too late for a 2022 Backdoor Roth IRA for some Californians! This would be a Split-Year Backdoor Roth IRA. The pressing deadline as of late August 2023 is that the 2022 nondeductible traditional IRA contribution needs to be made by October 16, 2023. 

Anyone pursuing a Split-Year Backdoor Roth IRA for 2022 in 2023 should ensure they have no balances in traditional IRAs, SEP IRAs, and/or SIMPLE IRAs as of December 31, 2023. 

2022 HSA Contributions

Some Californians can still make 2022 contributions to a health savings account. If the taxpayer has not yet filed their 2022 Form 1040, the tax deduction can simply be added to the to-be filed Form 1040.

But what if the taxpayer has already filed their Form 1040 for 2022? Then the taxpayer would need to file amended Form 1040 to claim the tax deduction and the resulting tax refund from the IRS. Since California does not recognize HSAs, there’s no California tax deduction and no need to amend the California Form 540. 

Of course, the taxpayer must meet the eligibility requirements (generally, having had a high deductible health plan as their only medical insurance) in 2022 in order to contribute to a HSA for 2022. 

Practical Considerations

First, contributions to IRAs, Roth IRAs, and HSAs made in 2023 that are to count for 2022 must be specifically designated as being for 2022. 

Second, I believe that in many cases, in order for qualifying Californians to do this, it will be necessary to use the phone, not internet portals. I suspect most financial institutions’ internet portals will not accommodate a 2022 IRA/Roth IRA/HSA contribution this late. Remember, financial institutions would not want to encourage the vast majority of Americans who do not currently qualify to make 2022 contributions to make 2022 contributions.

Thus, I believe as a practical matter using the phone is a best practice in terms of making any 2022 contributions at this late date. 

Who Benefits?

Residents of all California counties except three qualify for the extended deadline. The vast majority of the population of the state qualifies for the extended deadline, but residents of Lassen, Modoc, and Shasta do not appear to qualify (don’t blame me, I don’t make the rules!). 

Note that some taxpayers in parts of Alabama and Georgia qualify for this opportunity, but I personally have not explored this in any detail. 

Conclusion

Many California residents should consider whether there is some extended last minute 2022 tax planning they can implement by October 16, 2023. 

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 Catching Up to FI Podcast

Listen as I talk tax with Becky Heptig and Bill Yount on the Catching Up to FI podcast.

You can access the podcast on Apple Podcasts.

We discuss tax planning for financial independence, particularly planning for those catching up later in their careers.

The show notes include references to the following FI Tax Guy blog posts.

The Advantages of Living on Taxable Assets First in Early Retirement

TikTok Tax Advice

Early Retirement and Social Security

HSAs and Las Vegas

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

Inherited Health Savings Accounts

Folks love health savings accounts, and why not? A tax deduction or exclusion on the way in, tax-free growth, and then tax-free withdrawals when used for qualified medical expenses or reimbursements of qualified medical expenses. 

Tastes great and less filling! 

Considering the HSA is less than 20 years old (as of this writing) and contribution limits are relatively modest, inherited HSAs have not been much of an issue in the personal finance world. I suspect that will soon change, as HSAs and their account owners age and HSA balances grow. 

HSA Planning

There is something very fundamental one must keep in mind: planning for traditional retirement accounts and Roth retirement accounts is two sided. There is planning that owners should do for those retirement accounts prior to death and there is planning that inheriting beneficiaries should do after the owner’s death.

HSA planning, as you will see below, is mostly prior to the owner’s death. Other than a spouse, anyone else inheriting an HSA has relatively few planning opportunities.

Spousal Beneficiaries

The tax rules generally favor spousal beneficiaries, and the world of HSAs is no different. Section 223(f)(8)(A) has a very specific rule that changes the HSA account owner to the spouse as of death. This means the continuation of HSA account status, and thus continued tax free growth and future tax free withdrawals for payments of qualified medical expenses and for payments of previously unreimbursed qualified medical expenses (what I refer to as PUQME, pronounced “puck-me”). 

As Notice 2004-50 Q&A 39 makes clear, there is no time limit on PUQME reimbursement. Thus, inheriting spouses should, generally speaking, be able to reimburse themselves for built up PUQME unaffected by their spouse’s death. For example, the surviving spouse should be able to reimburse him/herself tax and penalty free from the HSA for medical expenses of the decedent spouse incurred on their deathbed.

Obviously, HSA tax-free carryover treatment is very favorable. It is difficult to imagine circumstances where a married HSA owner would want to name anyone other than their spouse as the 100 percent primary beneficiary of their HSA. In theory, leaving an HSA to a charity at the first spouse’s death could be neutral when compared to leaving to the surviving spouse, if the couple is both very affluent and charitably inclined. Even then, it’s hard to see much of a drawback to naming the spouse as the primary beneficiary. 

Other Individuals

Section 223(f)(8)(B) has some bad news for an individual, other than the surviving spouse, inheriting an HSA. Sure, they get the assets in the HSA. But, (i) the account loses its status as an HSA, and (ii) even worse, the entire amount of the HSA is included in the recipient’s taxable income in the year of the original owner’s death. 

This is the hidden HSA death tax. As the HSA is under 20 years old, and frequently owed by younger people, the issue of the hidden HSA death tax has not come to the forefront of the personal finance space. To my mind, this is a lurking issue that many aren’t aware of.

The tax hit from an HSA inheritance could be quite significant. Here is one theoretical example. 

Jack and Meghan are married, both age 51 in 2023, file joint, and claim the standard deduction.  Planning on having an AGI of approximately $155K for 2023, they each contributed $7,500 to a Roth IRA for 2023 on January 2, 2023. They have one child in college and thus plan on getting a $2,500 AOTC tax credit for tuition paid. 

On September 2, 2023, Meghan’s widowed father died and left his HSA, worth $75K, to Meghan. As a result, their AGI increases by $75K. On March 1, 2024, informed by their tax return preparer they did not qualify to make the Roth IRA contributions, they withdrew the contributions and the earnings attributable to the contributions ($750 each based on 10 percent growth). They also lose the ability to claim a credit for the college tuition they paid.

Here’s the tax consequences of Meghan inheriting the HSA.

ItemW/o HSA InheritanceWith HSA Inheritance
Ordinary Income (Initial)$153,000$153,000
Qualified Dividend Income$2,000$2,000
AGI (Initial)$155,000$155,000
HSA Inheritance$0$75,000
Roth IRA Earnings$0$1,500
AGI$155,000$231,500
Standard Deduction$27,700$27,700
Taxable Income$127,300$203,800
Tentative Tax$18,481$35,572
AOTC$2,500$0
Federal Income Tax$15,981$35,572
Federal Tax Increase$0$19,591
Effective Rate on AGI10.31%15.37%

The tax hit on inheriting the HSA is almost $20,000! Jack and Meghan pay more federal income tax on inheriting the HSA than they do on the rest of their income! Further, because tax benefits such as being able to contribute to a Roth IRA and AOTC qualification are based on MAGI, and inherited HSA income increases MAGI, Jack and Meghan (i) lost their 2023 AOTC and (ii) had to withdraw $15,000 in 2023 Roth IRA contributions and the related earnings. 

Deduction Planning: Yes, Jack and Meghan could potentially tax loss harvest (getting a current deduction of up to $3,000) and/or increase contributions to charities and/or donor advised funds to itemize their deductions in a year they are now in the 24% bracket. This planning is only marginally helpful (particularly in a high standard deduction world) and does not lower their MAGI sufficient to still qualify for the AOTC and to make most of the annual Roth IRA contributions. Further, if Meghan inherited the HSA late in the year, there may not be enough time to execute such planning.

Inherited HSA Tax Exception

There is a narrow exception to full income inclusion. The inheriting non-spouse beneficiary can reduce the inherited HSA income inclusion by the amount of medical expenses incurred by the original owner prior to death and paid by the inheriting beneficiary in the year after the death. 

The Estate

In theory, an HSA could be left to the estate of the HSA owner if (i) the owner elected such treatment on the beneficiary designation form or (ii) they failed to file a beneficiary designation form with the HSA provider. 

The original owner’s final income tax return must include the fair market value of the HSA in taxable income if the HSA is left to the estate. See IRS Publication 969, page 10.

Obviously, this is not a great result. In theory, if the owner is low income and the ultimate intended beneficiary is high income, one might want to name their estate as the beneficiary of the HSA. Considering that the are planning alternatives that can avoid anyone paying income tax on an HSA, this is not likely to be a good “go-to” planning option.

Charitable Beneficiaries

Many HSA owners are at least somewhat charitably inclined. The inherited HSA rules present a planning opportunity: leave HSA balances to charity if the HSA owner is not married. Charities pay no income tax when inheriting an HSA.

As discussed above, the optimal planning for a charitably inclined married couple is likely to be to name the spouse as the primary beneficiary. Only after the death of the first spouse would the primary beneficiary be changed to the charity.

Note that HSA owners should discuss naming a charity or charities as a primary or secondary beneficiary with their HSA account provider. 

Later In Life HSA Planning

What could Meghan’s widowed father have done to avoid costing his daughter and son-in-law almost $20,000 in federal income taxes?

First, strong consideration should be given to bailing out HSAs during old age, particularly if the HSA owner is not married. HSAs will not be too difficult to deplete tax and penalty free. Reimbursements of PUQME can access thousands of dollars of old qualified medical expenses, and the elderly will have plenty of new qualified medical expenses, including final medical expenses of deceased spouses. Further, Medicare Parts B and D premiums qualify as qualified medical expenses, so even the healthy elderly should be able to reimburse themselves tax-free from their HSA annually for some qualified medical expenses. 

Had Meghan’s father reimbursed himself tax-free for PUQME instead of leaving the money inside the HSA, Meghan could have inherited the money (now in a taxable account) income tax free.

Second, Meghan’s widowed father could have named a charity as the primary beneficiary on the HSA, and left taxable brokerage accounts, Roth retirement accounts, and even traditional retirement accounts to Meghan. Even the traditional retirement accounts would not have either created no taxable income to Meghan in 2023, or, at worst, would have required Meghan to take the RMD her father was required to take in 2023 (if her father died before taking it). 

I recently wrote about strategic planning in this regard. If one is not married, accounts such as Roth IRAs and taxable brokerage accounts are great to leave to individual beneficiaries. HSAs are great for unmarried people to leave to a charity if one is charitably inclined.

Conclusion

HSAs are arguably the most tax favored accounts during one’s lifetime. This remains true when passing an HSA to a spouse. However, the tax advantage of an HSA can turn into a tax bomb if left to a non-spouse. I refer to this as the hidden HSA death tax.

Planning to avoid the hidden HSA death tax includes taking reimbursements of PUQME from the HSA later in life and/or naming a charity as the primary beneficiary on an HSA if the owner is not married.

FI Tax Guy can be your financial planner! 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, investment, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

Inherited Roth IRAs

Inherit a Roth IRA in 2023 or later? Thinking about leaving a Roth IRA to heirs at your death? Then this article is for you. Note that it is an educational resource. It is not advice for any individual’s particular situation. Further, this article does not address situations where a person inherited a Roth IRA prior to the year 2023. 

Inheriting a Roth IRA is great, since distributions are always penalty free and tax-free 99.99% of the time. The only time a distribution from a non-spousal inherited Roth IRA could be subject to income tax is if the distribution is a distribution earnings from the Roth IRA prior to the passage of 5 years from January 1st of the year the original owner first contributed to a Roth IRA. See Treas. Reg. Section 1.408A-6 Q&A 1(b). As a practical matter, few distributions from inherited Roth IRAs will be both (i) earnings of the inherited Roth IRA and (ii) made prior to the end of the five year clock. 

Said differently, both the original owner and the beneficiary would have to be incredibly unlucky in order for a beneficiary to pay federal income tax on an inherited Roth IRA distribution. 

In theory, a spouse inheriting a Roth IRA could pay tax and/or a penalty on distributions from an inherited Roth IRA the spouse treated as their own, but even that occurrence is likely to be rare, as discussed in more detail below. 

Terminology and Titling

One inheriting a Roth IRA is a beneficiary. Yes, that inherited Roth IRA is now your property, but you are not the “owner” from a tax perspective. The original owner is the owner. You, the inheritor, are the beneficiary. If you die, the person inheriting the Roth IRA you inherited is a successor beneficiary.

Upon the owner’s death, the beneficiary should work with the Roth IRA’s financial institution to retitle the Roth IRA. The titling should indicate that the beneficiary is a beneficiary and should reference the owner. 

The above two paragraphs are not the case as applied to spouses who choose to treat an inherited Roth IRA as their own. In that case, the inheriting spouse becomes the owner, not the beneficiary. 

Types of Beneficiaries

To my mind, there are generally seven types of Roth IRA beneficiaries. Below, I use my own colloquialisms for each. You will not find the term “10-year beneficiary” in the Internal Revenue Code or the IRS website, for example. Rather, it is simply a term I colloquially use to refer to a particular type of inherited Roth IRA beneficiary. 

To understand what happens when one inherits a Roth IRA, one must first understand what type of beneficiary they are among the below seven categories. 

Watch me discuss Inherited Roth IRAs on YouTube.

Spouses

Spouses are generally favored inherited Roth IRA beneficiaries from a tax planning perspective. Married individuals should think long and hard prior to naming someone other than their spouse as their Roth IRA primary beneficiary for many reasons, including tax planning.

There are three options a spouse has when inheriting a Roth IRA. Two of those options entail the inherited IRA being treated as the inheriting spouse’s own Roth IRA. This is usually advantageous for several reasons, including the fact that an owner is never subject to required minimum distributions (“RMDs”) with respect to their own Roth IRA. Practically speaking, this is how most inherited Roth IRAs are handled by spouses.

SECURE 2.0 added a new fourth option for spouses to be treated as the deceased spouse when inheriting a retirement account. This change appears to matter as applied to RMDs, which the Roth IRA never has for an owner. Thus, I do not believe this change impacts spouses inheriting Roth IRAs to any significant degree.

The inheriting spouse could treat the inherited Roth IRA as an inherited account (i.e., become a beneficiary instead of being the owner). Practically speaking, an inheriting spouse would only consider this if they are under 59 ½ years old and they believe it is likely they would need to access earnings in their Roth IRAs (including the inherited accounts) prior to age 59 ½. 

Considering a spouse treating an inherited Roth IRA as their own can recover their own and their decedent spouse’s Roth IRA contributions and 5 year-old conversions tax and penalty free at any time and recovers these amounts before Roth earnings are ever accessed, most inheriting spouses will not need to elect inherited Roth IRA (i.e., beneficiary) treatment. This may be true even in situations where the inheriting spouse is under 59 ½ years old and needs access to some of the inherited Roth IRA funds prior to age 59 ½. Further, treating the inherited Roth IRA as one’s own Roth IRA instead of keeping it as an inherited IRA will generally be advantageous from a creditor protection standpoint.

One potential planning option for the spouse is to roll the decedent spouse’s Roth IRA to an inherited Roth IRA and later (presumably at age 59 ½) roll it into their own Roth IRA. See Choate, referenced below, page 225. This offers the inheriting spouse protection as it allows him or her to access Roth earnings tax-free prior to the spouse turning age 59 ½ and then later avoids RMDs to the spouse (see discussion of that possibility below). 

In Proposal 10 of my retirement tax reform proposal, I offer suggestions to simplify the treatment when spouses inherit retirement accounts. 

RMD Beneficiaries

The SECURE Act set up a new standard to be an RMD beneficiary (what the SECURE Act termed an “eligible designated beneficiary”). Some practitioners use the term “EDB” for these beneficiaries, but I prefer the term “RMD beneficiary” because these are the beneficiaries that are allowed to (i) avoid the new 10-year rule discussed below and (ii) withdraw from the inherited Roth IRA RMDs based on their own remaining life expectancy. 

Who qualifies as an RMD beneficiary? These include:

  • A spouse electing to treat the inherited Roth IRA as an inherited Roth IRA
  • Any individual not more than 10 years younger than the owner (think parents and adult siblings, but it can be others)
  • Anyone chronically ill or disabled

An RMD beneficiary must start taking RMDs from the inherited IRA in the year after the owner died. He or she goes to the IRS Single Life Table and finds the factor for their age in the year following the owner’s death. The RMD for that first year is the prior-year end-of-year account balance divided by that factor. The following year’s RMD is the prior-year end-of-year account balance divided by the first year’s factor minus one. See Choate, referenced below, at pages 67-68 and 73-74. Here’s an example of how it works. 

Jack died on December 1, 2023. He was 65 at his passing. He leaves his Roth IRA to his brother Jim. In 2024, Jim turns 62. Jim is an RMD beneficiary and should* take an RMD based on his IRS Single Life Table factor at age 62, 25.4. If the inherited Roth IRA balance on December 31, 2023 is $500,000, Jim’s 2024 inherited Roth IRA RMD is $19,685.04 ($500,000 divided by 25.4). If the balance in the inherited Roth IRA is $510,000 on December 31, 2024, Jim’s 2025 RMD is $20,901.65 ($510,000 divided by 24.4). Jim takes annual RMDs in a similar fashion in subsequent years. 

As Natalie Choate notes in her treatise referenced below (see page 74), Jim only looks at the IRS Single Life Table once: for the first RMD year. After that, he simply subtracts 1 from the factor every year. Thus, those using the Single Life Table only look at it a single time.

*Note that an RMD beneficiary can, instead of taking RMDs, elect the 10-year rule discussed below. See Choate supplement, page 12, Andy Ives at IRAHelp.com, and Ian Berger at IRAHelp.com. In many cases, I suspect taking relatively modest tax-free RMDs will facilitate more tax-free growth than avoiding RMDs and emptying the inherited Roth IRA within 10 years. This is because taking RMDs allows a large portion of the inherited Roth IRA to survive well beyond 10 years in cases where the beneficiary is not themselves rather elderly. That said, the older the beneficiary is, the more likely electing into the 10-year rule is to be advantageous. It is not clear how the beneficiary makes the election (see Choate supplement, page 50), though presumably failing to take RMDs would do it.

Spouses electing beneficiary treatment (which is RMD beneficiary treatment in their case) are generally not required to take the annual RMD until the later of (i) the year after the decedent spouse’s death or (ii) the year the decedent spouse would have reached age 72. See Choate, referenced below, page 97, Prop. Reg. Section 1.401(a)(9)-3(d) on page 109 of this PDF file (also see Prop. Reg. Section 1.408-8(b)(2)(ii) on page 253 of the PDF file). 

Successor Beneficiaries

Successor beneficiaries of RMD beneficiaries must, in most cases, empty the inherited Roth IRA by the end of the 10th calendar year following the RMD beneficiary’s death. See Natalie Choate supplement page 43 and Prop. Reg. Section 1.401(a)(9)-5(e)(3) on page 142 of this PDF file. Update August 4, 2023: In addition to being subject to the 10-year rule, the successor beneficiary must continue to take the annual RMDs the RMD beneficiary would have been required to take had they lived. See Natalie Choate supplement page 51.

Update July 10, 2023: Sarah Brenner of IRAHelp.com raises an interesting possibility. What if the RMD beneficiary elects the 10-year rule? If that happens, the successor beneficiary must empty the inherited Roth IRA by the end of the 10th year after the original owner’s death!

Minor Children of the Owner

If a minor child of the owner inherits a Roth IRA, he or she gets to take RMDs for all the years through the year he or she turns 21. Then the inherited Roth IRA must be emptied by the end of the 10th calendar year following the beneficiary turning age 21. See Prop. Reg. Section 1.401(a)(9)-5(e)(4) on pages 142-43 of this PDF file. Update September 11, 2023: the minor child starting the RMDs prior to turning age 21 triggers RMDs during the later 10-year period.

This treatment is quite favorable considering the relatively low RMDs during one’s youth, as the RMD is based on their relatively long life expectancy. 

The only children qualifying for this treatment are the children of the owner. Grandchildren, nieces, nephews, etc. will not qualify, and in most cases will be 10-year beneficiaries. These children could qualify for RMD beneficiary treatment if they are chronically ill or disabled. 

Note that technically minor children of the owner qualify as “eligible designated beneficiaries” but since the treatment they receive is, to my mind, quite different from the treatment RMD beneficiaries receive, I mentally carve them out as their own distinct category. 

Successor Beneficiaries

Natalie Choate observes on page 43 of her supplement that in the case of a minor-child RMD beneficiary, the successor beneficiary must empty the account by the earlier of (i) the end of the 10th full year following the minor-child’s death or (ii) the end of the 10th full year following the former minor child turning age 21. Update August 4, 2023: If the minor-child beneficiary dies while collecting RMDs, it appears the successor beneficiary would also be subject to annual RMDs using the decedent minor-child’s life expectancy during the 10-year time frame.

10-year Beneficiaries

10-year beneficiaries are those individuals who are not spouses, minor children of the owner, and RMD beneficiaries. They are everyone else. From a practical perspective, most 10-year beneficiaries are the adult children of the owner. 

10-year beneficiaries are not subject to RMDs. However, they must empty the inherited Roth IRA by the end of the 10th year following death. From a purely tax planning perspective, the beneficiary will want to leave the money inside the inherited Roth IRA and withdraw the money in December of the 10th full year following the owner’s death to get as much tax-free growth out of the inherited Roth IRA as possible. Of course, distributions prior to the end of the 10th year are permitted, and, as discussed above, should be tax-free in practically all cases. 

Successor Beneficiaries 

Successor beneficiaries of 10-year beneficiaries must empty the inherited Roth IRA by the end of the 10th calendar year following the owner’s death. See Prop. Reg. Section 1.401(a)(9)-5(e)(2) on page 142 of this PDF file. Thus, the death of a 10-year beneficiary does not extend the time to empty an inherited Roth IRA. 

Estates

A pulse is worth at least 5 years of tax-free growth! 

Roth IRAs can be left to one’s own estate, but generally speaking, they should not be. In order to qualify for the 10-year rule or better treatment (see the first four categories of beneficiaries), the beneficiary designation form must leave the Roth IRA to a human being. Estates can become the Roth IRA beneficiary if no beneficiary designation form is filed, or if the filed beneficiary designation form names the estate as the beneficiary. When an estate inherits a Roth IRA, the inherited Roth IRA is subject to a 5-year payout rule. See Choate, referenced below, pages 77 and 104. 

If left to one’s estate, the Roth IRA must be paid out by the end of the fifth full calendar year following death. See Choate supplement page 100. This is true even if the estate will ultimately pay the money out to actual humans who could have, on their own, qualified as 10-year beneficiaries, RMD beneficiaries, and/or spousal beneficiaries. 

Trusts

If you want to see some tax complexity, look at inherited retirement accounts and trusts. Trusts themselves often have human beneficiaries, but the trust mechanism is used to protect the beneficiary and/or the assets inside the trust. There are valid reasons to name a trust as a retirement account beneficiary (usually surrounding the nature of the potential beneficiaries), but naming a trust should not be done lightly. 

The tax risk is that the inherited Roth IRA will be subject to the 5-year rule. Properly structured (including the provisions required by Treas. Reg. Sec. 1.401(a)(9)-4 Q&A 5(b)), the human beneficiaries of the trust can qualify for the applicable treatment offered by one of the first four categories of beneficiary. However, if the trust is not properly structured, the trust and the human beneficiaries of the trust will be subject to the 5-year rule and lose out on 5 or more years of tax-free growth. 

Charities

A charity must take an inherited Roth IRA in 5 years, but it does not care, as it is not generally subject to income tax. From a planning perspective, Roth IRAs are the assets that are least advantageous to leave to charity. Your human heirs like to inherit Roth accounts and generally would prefer to inherit a Roth over an account such as a traditional IRA or a HSA. Here’s an example of how that could play out.

Walter, age 80, is a widow and has one adult son, Paul, age 50. Walter has the following assets:

Asset LocationAmount
Roth IRA$100,000
Taxable Brokerage$100,000
Traditional IRA$50,000
HSA$50,000
Total$300,000

Walter intends on leaving two-thirds of his assets to Paul and one-third of his assets to his Catholic parish, a 501(c)(3) charitable organization. From Paul’s perspective, he’d prefer to inherit the $100,000 Roth IRA (10 more years of tax-free growth, no income tax and full step up in basis when the assets are distributed to him) and $100,000 taxable brokerage (no income tax and full step up in basis). Paul would prefer that the $100,000 left to the parish be the $50,000 traditional IRA (which would be taxable to Paul through RMDs and the 10-year rule) and the $50,000 HSA (which is immediately fully taxable to Paul in the year of Walter’s death if Paul inherits). 

Why waste the Roth’s step-up in basis, tax-free treatment, and 10 years of additional tax-free growth on a charity when you can give the charity assets that are otherwise less favorable to the human beneficiary (the traditional IRA and the HSA)?

Planning

For Owners

Retirement account owners may want to think about inter-generational planning, for two reasons. First, if the owner is in a relatively low marginal tax bracket, and their beneficiaries (perhaps successful adult children) are in relatively high marginal tax brackets, they may want to think about Roth conversions during their lifetimes to move money from traditional retirement accounts to Roth IRAs. This can reduce the income tax paid with respect to the traditional retirement accounts. Second, it eliminates the chance that adult children could be subject to both the 10-year rule and to RMDs (see this article for more details). 

Any planning in this regard should consider that tax planning for one’s adult children is a second order planning priority. The first planning priority should be the financial success of the retirement account owner. His or her financial success should be prioritized ahead of tax planning geared toward a better result for one’s adult children. 

For Beneficiaries

Generally speaking, beneficiaries and successor beneficiaries will want to leave funds inside an inherited Roth IRA for as long as possible. For many in a SECURE Act world, that will be 10 years following the end of the year of death. Here’s a quick example of how that works: Joe dies on August 1, 2023. His 10-year beneficiary has until the end of the 10th year following his death, December 31, 2033, to empty the Roth IRA he inherits from Joe.

Of course, tax is just one consideration. If the money is needed sooner than that, at least the beneficiary knows that the distribution is tax-free in all but the rarest of situations.

As discussed above, beneficiaries should understand how long the owner had any Roth IRA. Once the beneficiary is sure 5 years have passed since January 1st of the year of the original owner’s first contribution, he or she can take Roth earnings out of the inherited Roth IRA and know that it is tax free. Even if the Roth IRA is less than 5 years old, the beneficiary can take old contributions and conversions tax free. Such amounts come out first under the ordering rules prior to the removal of any earnings. 

Further Reading

Natalie B. Choate’s treatise Life and Death Benefits for Retirement Planning (8th Ed. 2019), frequently referenced above, is an absolutely invaluable resource regarding retirement account withdrawals, including inherited Roth IRA withdrawals.

The IRS and Treasury issued controversial proposed regulations on the SECURE Act in 2022. Fortunately, those proposed regulations do not require RMDs with respect to 10-year beneficiaries of inherited Roth IRAs. Jeffrey Levine wrote a great blog post on the proposed regulations here. 

FI Tax Guy can be your financial planner! 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, investment, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, investment, and tax matters. Please also refer to the Disclaimer & Warning section found here.

A Critical Look at the 529

Thanks to the SECURE 2.0 bill, it’s time for the FI community to reexamine 529 plans. This post shares my two cents on 529s in general, and specifically as applied to the FI community. The next post, dropping February 15, 2023, addresses in detail the new 529-to-Roth IRA rollover enacted in SECURE 2.0.

Financial Independence

Before we talk about 529s, we have to talk about the primary goal of financial independence. For young parents, the primary goal is to secure Mom & Dad’s financial independence. 

Achieving the parents’ primary goal has an incredible secondary effect. Mom and Dad buy Junior an incredible gift by securing their own financial independence. That gift is that Junior will never have to worry about Mom and Dad’s financial security as an adult. The greatest financial gift parents can ever give their children is the parents’ own financial stability. 

Second, where possible, money and financial assets should be able to support multiple financial goals. We should be at least somewhat hesitant before locking up money such that it can only support one highly specific goal without incurring a penalty. 

529s

529s are tax-advantaged savings accounts generally run by states to facilitate college savings. 529s are best understood as a Roth IRA for college education with far greater contribution limits. Sure, that is an overstatement of how they work, but that gives us a good conceptual framework from which to start the analysis. 

A quick note on terminology: The IRS often refers to 529 plans as “Qualified Tuition Programs” or “QTPs.” I will use the more commonly used colloquialisms, 529 and 529s. 

Contributions to a 529 are not tax deductible for federal income tax purposes. At least initially, there’s no federal income tax benefit to making a 529 contribution. However, money inside a 529 grows federal and state tax-free and can be withdrawn tax-free for qualified education expenses (such as college tuition). 

Contributions are generally not limited by federal tax law, though contributions above the annual exclusion gift tax limit ($17,000 per donor per beneficiary per year in 2023) generally trigger Form 709 reporting requirements (though in 99.99% of cases there should not be a gift tax liability). States generally have lifetime contribution limits per beneficiary. Usually these limits are far in excess of what one would normally need for undergraduate college tuition. 

Very generally speaking, qualified education expenses can be directly paid from the 529 to the educational institution or such expenses can be reimbursed from a 529 in the year the expenses are incurred. Payments for qualified educational expenses are generally tax and penalty free. 529s do not enjoy the rather unlimited reimbursement deadline that HSAs enjoy. 

529s get similar tax treatment to the federal income tax treatment in most states. However, there can be an additional benefit: an annual state tax deduction or credit for some 529 contributions to the state’s own 529 plan (note 8 states allow a 529 tax deduction or credit for contributions to other states’ 529 plans). However, for many readers this will either be irrelevant or only of minor importance. Of the four most populous states (CA, TX, FL, NY), only residents of New York can obtain an up-to $5,000 per person per year state tax deduction for contributions to a home-state 529. California has no 529 tax deduction and Texas and Florida do not have an income tax.  

Okay, sounds great! Clearly there are tax benefits for 529 money used for qualified education expenses. But what about distributions that are used for anything other than qualified education expenses? Well, they are going to be subject to an income tax and likely a 10 percent penalty, in the following manner. A non-qualified distribution is deemed to come ratably out of the contributions to the 529 (tax and penalty free) and earnings of the 529 (subject to income tax and the 10 percent penalty, some penalty exceptions may apply). 

Here’s an example illustrating the application of the nonqualified distribution rules:

Hal, the owner of a 529 account, takes $1,000 out of the 529 to help pay for vacation expenses. Previously, he had made $60,000 of contributions to the 529, and it had grown to $100,000 ($40,000 of earnings) prior to making the $1,000 non qualified distribution. Sixty percent of the distribution ($600) is a nontaxable return of contributions and 40 percent ($400) is subject to both income tax and a 10 percent penalty.

The taxation of non-qualified distributions is a significant drawback of using 529s. 

529s and the FI Community

Let’s remember what is going on with a 529. It is a gift to the next generation. It comes with very modest tax benefits. 

My thesis on the 529 is this: for most parents, including most of those in the FI community, the tax benefits offered by 529s are not sufficient to compensate for the use restrictions on 529s. Thus, my view is that 529s should generally be deployed once Mom and Dad are financially independent (or close to it), not when they are on the path to financial independence. 

The idea behind the 529 is to provide tax-free growth for college savings. It solves for something that, frankly, isn’t much of a problem. Taxes are not why college is unaffordable for many Americans. College tends to be unaffordable not because investment taxes are high, but because tuition and fees are out of control. 

One thing in parents’ favor when thinking about funding college educations is that income taxes on investments are relatively modest over a child’s childhood due to low long term capital gains rates and qualified dividend income rates. Hopefully, by age 22 or 23, the child’s undergraduate education is completed, providing a relatively modest investment time horizon (i.e., a modest tax exposure horizon), even if the parents start saving for college at birth. 

Contrast that to the retirement time horizon of a 20-, 30- or 40-something parent saving for his or her own retirement. The money invested for retirement at age 25 might be accessed at age 60, 70, 80, or 90. Compared to educational savings, retirement savings (which are usually far greater than educational savings) are much more vulnerable to income taxes for a much longer time frame. Even at long term capital gains and qualified dividend income rates, exposing retirement savings to decades of taxation could be very expensive. Retirement savings are also exposed to tax law change risk for a much longer period of time. For example, there’s no guarantee that there will be favored long term capital gains and qualified dividend tax rates 30 years from now.

The tax risk profiles on educational savings and retirement savings are much different. Based on those risk profiles, for most I believe aggressive retirement tax planning makes sense. But I don’t see educational tax planning making as much sense, for the reasons discussed below. 

Of course, tax-advantaged retirement savings can come with a juicy up-front federal income tax deduction. 529s do not offer the possibility of a federal income tax deduction, making them less impactful than tax-advantaged retirement savings regardless of the time frame involved. 

Young Parents and 529s

Let’s consider young parents. Say Junior is born when Mom & Dad are age 30 and have saved 10 times their annual expenses in financial assets. Many, myself included, would say Mom and Dad are doing well with their finances. Here’s where I diverge from some others in the personal finance space: I would not recommend Mom & Dad save in a 529 shortly after Junior’s birth.

Notice I’m not saying Mom & Dad should not pay for Junior’s college. What I’m saying is Mom and Dad should stay flexible for their own financial future. 

What’s so horrible about Mom & Dad starting to save for Junior’s college in a taxable brokerage account under their own names? At birth, they have no idea if Junior will get a scholarship, go to trade school, how Mom & Dad’s finances will be when Junior is ready to go to college, etc. By saving in financial assets that are in their own names–perhaps mentally segregated as potentially being for Junior’s college–Mom & Dad maintain great flexibility without sacrificing too much tax benefit. 

If Junior gets a scholarship, great, the financial assets stay with Mom & Dad. If Mom & Dad are not financially successful when Junior goes to college, great, the financial assets can support Mom & Dad and Junior can figure out other ways to pay for college. 

The Value of the 529’s Tax Benefits

How bad is the tax hit on holding investments for a child’s college education? Imagine owning a 60 / 40 equity to bond portfolio of $100,000 for a child’s college education. If held in the parents’ taxable brokerage account, how much taxable income might that generate annually? Very roughly, if dividend yields are 2 percent, the $60,000 in equities would produce $1,200 of dividend income, most of which is likely to qualify for qualified dividend income tax rates. The $40,000 of bonds would produce $1,800 of ordinary income at a 4.5 percent yield. 

Is it desirable to add $3,000 of income to Mom and Dad’s tax return? Surely not. Cataclysmic? Also surely not. 

Consider what a small amount of additional taxable income buys. If the money is held in the parents’ names, it can be used for anything without penalty. Perhaps Mom and Dad have not been financially successful. That $100,000 could help the parents achieve their own financial goals and retirement. What if the child gets a scholarship and does not need much in the way of tuition assistance from his or her parents? What if the child doesn’t go to college? 

In exchange for paying tax on $3,000 of income annually (some of it at tax-favored QDI rates), and some long term capital gains when used to pay tuition, Mom and Dad have incredible flexibility with the $100,000. Maybe $50,000 goes for Junior’s college tuition, and $50,000 goes for Mom and Dad’s retirement. Further, for many it won’t be $3,000 of income annually. It will take most parents years before they could accumulate the sort of balance that would generate $3,000 of taxable income from educational savings. Thus, the tax hit for not using the 529 is likely to be that much less in the years well before the child is close to college age. 

Outside of the handcuffs of the 529, assets can support multiple financial goals. Even better, as one financial goal is met, the money can be shifted to support another financial goal. Perhaps Mom and Dad are behind in their own savings when Junior is age 10. But things go well, and when Junior turns 16 Mom and Dad have wealth in excess of their FI number. In that case, money that might have been needed for the parents’ retirement now can be used for college tuition.

Use Restrictions

We need to consider the use restrictions on 529s. If not used for qualified education expenses, the growth is subject to both ordinary income tax and usually the 10 percent penalty.

Compare the tight use restrictions on 529s to the use restrictions on the other most prevalent tax baskets: taxable accounts, traditional retirement accounts, Roth accounts, and health savings accounts. Generally speaking, all of them (even HSAs) are not use-restricted or only partially use-restricted. All four of those tax baskets have a significant advantage over 529s in terms of use restrictions.

In many cases, I believe that the 529’s significant use restrictions are not adequately compensated by its tax advantages. 

The 529 has rather onerous time restrictions, as distributions of earnings are generally subject to tax and the 10 percent penalty in those years there are no qualified education expenses.

Feeding the Beast

As much as we might want to, we can’t turn a blind eye towards hyperinflation in college tuition. With that in mind, shouldn’t we ask: Isn’t a hyperfocus on college savings feeding the beast? 

It’s time to scrutinize American higher education. It’s not good for the country to have students graduating with mountains of debt. This is happening for many reasons, including significant administrative bloat in higher education. Clearly, American higher education is failing too many of its students. Is now the time to set aside money to pay American colleges and universities?

I get it: no one reader funding a 529 is the cause of the problems of American higher education. 

But, if I’m a university used to collecting soaring tuition and fees, I’m all for 529s. 529s subsidize what has become bad behavior by university administrators. Less focus on 529s helps move the needle towards universities needing to act responsibly in order to attract students. 

Camilla Jeffs raises an interesting point on her LinkedIn page: Part of the reason college is so expensive is because in many cases the customer (the student) does not bear the cost. 529s feed into that problem. Camilla’s recent podcast episode on 529s is also full of good food for thought. 

529 Use Cases

The above limitations of the 529 noted, I do believe there are good use cases for the 529. These cases assume that the parents have decided to pay for their child’s college education.

Financially Independent Parents

Joe and Sally are married and 45 years old. They have saved 30 times their annual expenses in retirement accounts and taxable brokerage accounts. They have a 10 year old daughter they are reasonably sure will go to college, and they would like to pay for her college education.

This is a great use case for the 529. Mom and Dad’s financial future largely secured (generally speaking), it’s time to focus on (i) college savings, since they want to pay for college, and (ii) tax planning. Joe and Sally, already holding substantial taxable brokerage accounts, benefit from saving through the 529 so they avoid adding more dividend, interest, and capital gains income to their annual tax return. 

Capturing State Tax Benefits

Aaron and Amanda are married and are 50 years old. They have saved 20 times their annual expenses in retirement accounts and taxable brokerage accounts. They have stable jobs. They have a 16 year old son who is very likely to go to college. Aaron and Amanda want to pay for their son’s college education. Since they live in New York State, if they contribute $10,000 annually to the New York 529 for his benefit ($5K each), they get an annual $10,000 state tax deduction on their New York state income tax return.

Aaron and Amanda are not financially independent by many metrics, but they are doing pretty well, and are likely (though not guaranteed) to be financially successful. In their case, paying for college is not financially ruinous. If Aaron and Amanda are going to pay for college, they might as well utilize the 529 annually to scoop up state tax deductions, particularly in a higher income tax state like New York. Further, beginning the 529 much closer to the start of college decreases the odds that the 529 will become over funded.  

Contrast Aaron and Amanda to parents of newborns. Newborns’ parents are closer to the beginning of their financial journey. In most such cases, state tax benefits would not, in my opinion, be valuable enough to justify the use restrictions on 529 contributions. 

Conclusion

My view is that the detriments of the use restrictions on 529s are not adequately compensated by the federal and state tax advantages offered by 529s in most cases. That’s certainly not to say there are not good use cases for the 529, but my view is that most parents should prioritize saving in their own names (even in taxable accounts) before making contributions to 529 accounts. 

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.

Health Savings Accounts and Las Vegas

Want to make a bad financial decision? I’ve got an account that can help you do that tax and penalty free!

Of course, I do not recommend making bad financial decisions. However, at times it is useful to look at extremes to help us better understand and analyze financial planning alternatives. 

Health Savings Accounts

If you’ve spent any time on my blog or YouTube channel, you’re probably aware that I’m fond of HSAs. Contributions are tax deductible (or excludable if made through payroll withholding). Amounts inside the HSA grow tax free. Withdrawals for qualified medical expenses, or reimbursements of qualified medical expenses, are tax and penalty free. 

As long as the HSA owner is alive, he or she can reimburse themselves from the HSA for qualified medical expenses incurred after they first owned an HSA. Generally speaking, there’s no time limit on HSA reimbursements, other than the owner must be alive to receive the tax and penalty free reimbursement. See “Distributions from an HSA” on page 9 of IRS Publication 969 and Notice 2004-50 Q&A 39. 

HSAs are great because they combine the best feature of a traditional retirement account (deduction or exclusion on the way in) with the best feature of a Roth retirement account (tax free treatment on the way out). Further, the lack of a time limit on reimbursements from an HSA provides the owner with tremendous flexibility in terms of deciding when to take tax and penalty free distributions. 

Health Savings Accounts PUQME

Previously Unreimbursed Qualified Medical Expenses (PUQME, pronounced “Puck Me”). HSA owners can reimburse themselves tax and penalty free from their HSA up to their amount of their PUQME. PUQME includes qualified medical expenses of the owner, their spouse, and their dependents incurred after the HSA was first established. Qualified medical expenses deducted as an itemized deduction on a tax return (quite rare) do not qualify to be reimbursed from an HSA and thus are not PUQME. PUQME is a technical term I made up. 😉

Restricted Accounts

When we think about taxable brokerage accounts, traditional retirement accounts, Roth retirement accounts, HSAs, and other available options, we should consider the restrictions in place on the use of the funds. The more restrictions in place, the worse the account.

Time Restrictions

Taxable accounts, traditional retirement accounts, and Roth retirement accounts face various time restrictions on withdrawals. For example, taxable accounts qualify for favored long-term capital gains rates if held for a year. Of course, that restriction is academic if there’s a loss or no gain in the account.

Traditional retirement accounts suffer the most stringent time restrictions. Withdrawals occurring prior to the owner turning age 59 ½ are usually subject to the 10 percent early withdrawal penalty. Roth IRAs are not all that time restricted, as amounts withdrawn prior to age 59 ½ are deemed to first be nontaxable withdrawals of prior contributions. Roth 401(k)s can be somewhat time restricted, as amounts withdrawn prior to age 59 ½ are partially deemed to be withdrawals of taxable earnings (usually subject to the 10 percent early withdrawal penalty). 

HSAs are somewhat time restricted, though like Roth IRAs, they are not severely so. Once one has PUQME after having opened an HSA, he or she can withdraw money (up to their PUQME amount) from the HSA tax and penalty free. 

Use Restrictions

Taxable accounts, traditional retirement accounts, and Roth retirement accounts are great in that they have absolutely no use restrictions. The government does not care what you spend the money on. The tax result is, at least generally speaking, unaffected by use. 

There are some exceptions, such as the exceptions to the 10 percent early withdrawal penalty such that early withdrawals from retirement accounts can qualify to avoid the 10 percent penalty. Further, one might say that because of qualified charitable distributions, using traditional IRAs for charitable purposes is use-favored. The above exceptions noted, as a general rule, use does not significantly change the taxation of withdrawals from taxable accounts, traditional retirement accounts, and Roth retirement accounts. 

HSA Use Restrictions

HSA distributions that are not used for qualified medical expenses are subject to both income tax and a 20% penalty if the owner is under age 65. 

However, recall that there is no time limit on the ability to reimburse oneself tax and penalty free for previously incurred qualified medical expenses. As a practical matter, the lack of time limit results in relatively modest use restrictions on an HSA. Below I’ll illustrate that with an extreme example. 

HSAs and Las Vegas

Perhaps you’re yearning for the hot sand, broken dreams, and $5 lobster of Las Vegas. Could an HSA help? Let’s explore that possibility.

Peter, age 70, wants a weekend getaway in Las Vegas. Between a hotel suite, comedy club tickets, airfare, steak dinners, some Texas Hold’em poker, and the breakfast buffet, he estimates it will cost him $10,000. 

Peter was covered by a high deductible health plan from age 55 through age 65. He maxed out his HSA annually during that time, and he has never taken a distribution from his HSA. The HSA is now worth $50,000, and between age 55 and today Peter has $30,000 of PUQME.

Could Peter use his HSA to pay for the weekend? Absolutely! 

Wait a minute, Sean. Vegas isn’t a qualified medical expense! Sure, it isn’t. But Peter has $30,000 of previously unreimbursed qualified medical expenses. He can take out $10,000 from his HSA tax and penalty free and use it to buy poker chips in Las Vegas. Once an HSA owner has previously unreimbursed qualified medical expenses, they generally do not have an HSA use restriction up to the level of that PUQME. 

As a practical matter, even the healthiest Americans are eventually going to have qualified medical expenses. As a result, most HSA owners will have runway, particularly in retirement, to reimburse themselves for previously incurred qualified medical expenses. That reimbursement money is in no way use restricted–it can go for a weekend trip to Vegas if the HSA owner desires. 

HSA Planning Risk

But Sean, there’s no way Congress won’t close the loophole! Surely, at some point in the future, Congress will time-limit tax and penalty free reimbursements from HSAs.

I don’t think so, for three reasons. 

First, the HSA loophole is not that great. Consider the relatively modest HSA contribution limits. Sure, the government loses tax revenue due to HSAs, but it isn’t that much, particularly compared to vehicles such as Roth IRAs. Further, HSAs are, at most, a loophole during the owner’s lifetime and the lifetime of their surviving spouse. That’s it! 

Left to a non-spouse, non-charity beneficiary, the entire HSA is immediately taxable income (typically at the beneficiary’s highest tax rate) in the year of the owner’s death. Death not only ends the loophole, it gives the government a significant revenue raiser by taxing the entire amount at ordinary rates on top of the inheriting beneficiary’s other taxable income. 

Second, I suspect Congress wants taxpayers to bailout HSA money tax and penalty free prior to death. The immediate full taxation of HSA balances in the year of death is going to come as a nasty surprise to many beneficiaries. 

Imagine significant taxes and perhaps dealing with the paperwork and hassle of reversing what becomes an excess contribution to a Roth IRA because of a surprise income hit due to the death of a loved one. Here’s what that could look like.

Mark and Laura are married and both turn age 47 in 2023. They anticipate about $200,000 of MAGI in 2023, in line with their 2022 income. Expecting their 2023 income to fall well within the Roth IRA modified adjusted gross income limits, each contributes $6,500 to a Roth IRA for 2023 on January 2, 2023. In September, Laura’s father passes away and leaves her an HSA worth $50,000. The HSA inheritance increases their 2023 MAGI to $250,000. The federal income tax hit on inheriting the HSA will be over $10,000. 

As a result of their increased income, Mark and Laura are now ineligible to have made the 2023 Roth IRA contributions. The most likely remedial path involves Mark and Laura working with the financial institution to take a corrective distribution of the contributions and the earnings attributable to the contributions. The earnings will be included in Mark and Laura’s MAGI for 2023 as one last insult to inheriting a fully taxable HSA. 

This is a lurking issue. If Congress puts 2 and 2 together, they will hope that HSA balances are small at death so as to avoid their constituents suffering a large, unexpected tax bill related to a loved one’s death. Time-limiting tax and penalty free HSA reimbursements would keep more money inside HSAs during an owner’s lifetime (and thus, at their death). At death, this would set up more beneficiaries to have nasty surprises when inheriting an HSA, a fate Congress most likely wants to avoid. 

Third, time-limiting HSA reimbursements will go counter to the reason HSAs exist in the first place: to encourage the use of high deductible health plans. Time-limiting HSA reimbursements could trap amounts inside HSAs because taxpayers would lose amounts they could withdraw from the HSA without incurring tax (and a 20 percent penalty if under age 65). If taxpayers believe HSA money could become trapped, fewer will opt for a high deductible health plan. This will lead to increased medical costs as more and more Americans have lower deductibles and become sensitive to medical pricing. 

Surviving Spouse’s HSA PUQME

I prepared a short 1-page technical write up providing my views on how previously unreimbursed qualified medical expenses are computed when a spouse inherits a health savings account.

HSA Resource

Kelley C. Long recently authored an excellent article on HSAs in the Journal of Accountancy.

Conclusion

Here’s hoping that you don’t take away the conclusion that HSA owners should spend their HSA money in Las Vegas!

Rather, my primary conclusion is that investments and tax baskets should be assessed considering their time and use restrictions. The fewer the time and use restrictions, the better. Of course, time and use restrictions are not the only factors to consider, but they are significant factors.

Secondary conclusions include (i) the HSA tends to be very flexible and (ii) the tax breaks available to HSA owners are not likely to be repealed or limited by Congress anytime soon.

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.

2023 Retirement Tax Reform

An Open Letter to the Members of the 118th Congress

Dear Senators and Congressmen,

Congratulations on your victories in the Senate and House elections. I write with respect to one aspect of your legislative endeavors in the 118th Congress: reforming our tax-advantaged retirement savings system. As you will see, much of it is antiquated and in need of reform.

Before I discuss the problems, allow me to briefly recite my qualifications to write you this letter. My primary qualifications are that I am an American citizen and taxpayer. My secondary qualifications include:

  • I am a financial planner and advise clients on retirement planning and saving.
  • I am the author of a book on one of the tax-advantaged retirement savings accounts, Solo 401(k): The Solopreneur’s Retirement Account.
  • I am a CPA (licensed in California and Virginia) and I have a Juris Doctor degree and a LLM in Taxation degree. My background is on my LinkedIn page.
  • I write a four year-old blog (fitaxguy.com) focused on tax planning for individuals, particularly the use of retirement accounts. 

The views expressed in this open letter are mine only. I have not been compensated for writing this letter and my views are not necessarily the views of any of the clients of my financial planning firm. 

Problems with the Current Retirement Savings System

Limits Are Unequal and Unfair

There’s a myth that Congress and IRS inflation adjustments determine the retirement plan contribution limits every year. If one looks at the Internal Revenue Code and the IRS website, they’d walk away with that belief.

But is that really true? It turns out that one’s employer often defines just how much an employee can get into tax-advantaged retirement accounts every year. In practice, the current system disproportionately benefits a privileged few.

Here are two examples (using 2023 limits) that prove my point in a stark fashion. Josh is a 50 year-old employee of a large Fortune 500 company with a $300,000 salary. Josh maxes out contributions to his traditional 401(k) at work and maxes out his Backdoor Roth IRA and Mega Backdoor Roth (available through his employer’s 401(k)). Further, Josh receives a 3% match in his employer 401(k). Here are what his annual retirement savings contributions look like:

401(k) Employee Deferral: $30,000

401(k) Employer Match: $9,000

401(k) Mega Backdoor Roth: $34,500

Backdoor Roth IRA: $7,500

Total traditional deductible contributions: $39,000. Total Roth contributions: $42,000. Total contributions: $81,000.

Sarah, single, is a 50 year-old non-profit executive director with a $150,000 annual salary and no workplace retirement plan. Under today’s rules, Sarah can only contribute a maximum of $7,500 to a deductible traditional IRA. That’s it! She may be able to make a partial Roth IRA contribution or a Backdoor Roth IRA contribution, but if she does, it reduces her maximum allowed deductible traditional IRA contribution. Thus, her total contributions are, at a maximum, just $7,500 for the year.

Sadly, there are many more workers in the latter situation than in the former situation. 

Because of their choice in employers, Josh gets to put more than 10 times the amount Sarah can into tax-advantaged retirement accounts.

Yes, that is today’s reality. It makes absolutely no sense. Long term, a system that disproportionately rewards workers at some employers and barely covers workers at other employers is not sustainable. 

Where you work should not increase your tax-advantaged retirement account contributions by more than 10 times!

Many retirement provisions benefit a very select few. Most of the time, those select few are among the people who need the least amount of help in achieving a successful retirement. Retirement tax advantages should have broad applicability and should not disproportionately reward any particular subgroup, particularly very small subgroups. 

Other Retirement Account Problems

  • Complexity and confusion (Ever fill out a Form 8606?)
  • Penalties and penalty exceptions that are outdated and not entirely rational
  • Remedies for problems with retirement accounts are neither taxpayer nor IRS friendly

Goals for Retirement Account Reform

Here are the goals I believe the 118th Congress should have in enacting retirement account reform.

  • Reduce complexity and confusion. Simplify the mechanisms of retirement savings. “Backdoors” should be eliminated because retirement savings should occur through direct, simple transactions. 
  • Increase retirement savings, particularly among Americans who have struggled economically over the past three years.
  • Effective yet modest changes. While it is tempting to throw out all the rules, a complete rewrite of the rules would create tremendous confusion and likely reduce, rather than increase, tax-advantaged retirement savings. 
  • Democratize retirement account contributions while acknowledging the role employers can play in offering retirement savings for employees. That said, there should be at least some shift of dollars away from contributions to employer plans towards contributions to individual retirement accounts.
  • Reform cannot simply be a massive tax cut. The federal budget cannot afford a massive tax cut. 
  • Special advantages available to very limited groups should be reduced and eliminated.
  • Remove punitive rules and traps for the unwary. 
  • There are too many penalties in the retirement account system that are too high, too punitive, and too confusing. My proposal attempts to reduce the number of penalties, give the IRS and taxpayers more common sense tools to mitigate them, and make the rules simpler and fairer. 
  • Reduce the competition between funding expenses attendant to having a child and funding retirement savings. 
  • Avoid slogans. Our tax rules are now far too complicated to say “everyone gets a tax cut” or “no one below X income will have a tax increase.” Besides, slogans belong to the politics of the 80s and 90s. 

While my primary audience is the members of the 118th Congress, please allow me to direct a quick word to my fellow American taxpayers who might lose out on an opportunity described below and thus might oppose these proposals. I ask potential opponents of this proposal this question: how sustainable is a retirement system that gives a select few Americans 10 times the tax-advantaged savings capacity as other Americans? 

Why fight to preserve your special tax break when the myriad special tax breaks make the entire system less and less sustainable? Does my proposal make everything entirely fair? Surely not, but, as you will see below, it makes the system much fairer and simpler. I believe that will make the system more sustainable over the long run, which is good for everyone. 

Lastly, retirement savings are far from the only component of the U.S. tax system needing legislative change. But, as you can see from my secondary qualifications above, retirement savings are of particular interest to me, so I’ll mostly limit my commentary here to tax law changes on retirement savings. 

Retirement Tax Reform Proposals

Expanded Universal Roth IRAs and Closing Backdoors

1. Eliminate the MAGI Limitation on annual Roth IRA contributions. Why is there an income limit on contributing to a Roth IRA, which does not produce a tax deduction? Further, removing the income limitation will align the United States Roth account rules with Canadian tax-free savings account rules. Canada does not have an income limit on the ability to contribute. Why should the United States? This proposal also ends the Backdoor Roth IRA. 

2. Increase annual IRA contribution limit (traditional and Roth) to $10,000, then index annually. It is time to shift retirement savings towards individuals. This will help expand individual and spousal contributions to retirement accounts, particularly Roth IRAs, and give individuals more control over their own retirement savings. This proposal makes individuals less reliant on their employer to offer a good retirement savings plan. 

In the 10 year budget window, proposals 1 and 2 will cost some money, but I suspect not a whole lot. In fact, this expansion of Roth IRAs might make Roths more attractive and cause some taxpayers to direct what would have been traditional, deductible 401(k) contributions to their Roth IRA, increasing tax revenue in the early years. 

3. Eliminate nondeductible contributions to IRAs and qualified plans, effective January 1, 2024. This ends Mega Backdoor Roth IRAs as of January 1, 2024. The Mega Backdoor Roth benefits only those few whose employers offer it and can afford to make after-tax contributions. The Mega Backdoor Roth, which only came to prominence starting in 2014, turbocharges the unfair advantages the retirement account system currently confers on a select few Americans (such as Josh in the example above).

As a result of eliminating the Mega Backdoor Roth, most of these contributions will be diverted to taxable accounts, which is not a horrible outcome for those currently taking advantage of the Mega Backdoor Roth. Further, those losing the Mega Backdoor Roth under this proposal gain expanded access to Roth IRAs under proposals 1, 2, and 4. 

4. Increase age 50 or older IRA (traditional and Roth) annual catch-up contribution from $1,000 to $2,000, index for inflation annually. The current $1,000 annual catch-up contribution limit is not enough move the needle in terms of likelihood of financial success in retirement. 

Eliminate Traditional Retirement Account Basis

5. Eliminate IRA Basis / after-tax 401(k) basis, effective January 1, 2027. The Pro-Rata Rule is an unnecessarily complicated rule for retirement account withdrawals. It has even created litigation. Basis record keeping is challenging and creates confusion. Enough already! 

This proposal eliminates retirement account basis recovery as of January 1, 2027. To be fair to those with retirement account basis, this proposal allows elective withdrawal of basis amounts from traditional retirement accounts (including inherited traditional retirement accounts) to taxable accounts during the 2024, 2025, and 2026 tax years. Any elective withdrawals of basis for the year would not count towards RMDs and could not be converted to Roth accounts. Regular withdrawals, RMDs, and Roth conversions in the year of an elective withdrawal of basis could not access existing basis. 

Eliminating basis eliminates page 1 of the Form 8606. This simplifies traditional retirement account withdrawals, inheriting traditional retirement accounts, and Roth conversions. In turn, this makes the retirement account provisions easier for the IRS to administer and easier for taxpayers to understand. 

Simplify and Rationalize Retirement Account Rules

6. Unify Roth account nonqualified withdrawal treatment such that the current Roth IRA nonqualified distribution rules apply to nonqualified Roth 401(k) distributions. The rules for Roth 401(k) nonqualified distributions are confusing, and can be avoided by rolling into a Roth IRA. Why not make them consistent?

7. Change the age for HSA catch-up contributions to age 50. Catch-up contributions to all accounts should kick-in at one, and only one, age. Make it age 50 for all accounts by changing the HSA catch-up contribution kick-in age from 55 to 50. Unifying the HSA/IRA/401(k) catch-up contribution age at age 50 makes the rules simpler. 

8. Unify rules for taking RMDs from traditional retirement accounts. Under this proposal, so long as the total required is taken during the year, it doesn’t matter which account (401(k), 403(b), IRA) or accounts the distributions come from. 

9. Eliminate NUA tax treatment. Net Unrealized Appreciation allows for employer stock in a 401(k) to get preferential tax treatment. As workers are already heavily economically tied to their employer (because of their salary and benefits), NUA treatment encourages something that probably should be discouraged (investing significantly in the stock of one’s own employer). Further, the NUA rules are complex. Removing them simplifies the tax code. 

10. Simplify treatment when spouses inherit a retirement account. Currently, there are three options and planning choices to be made when a spouse inherits a retirement account. The death of a spouse is challenging enough without having to make a complicated tax planning decision. New rule to simplify this: all retirement accounts inherited by spouses are deemed to be the inheriting spouse’s own retirement account as of the first spouse’s death. To prevent any early withdrawal penalties to surviving spouses under age 59 ½ due to this change, add a new 10% early withdrawal penalty exception: being widowed prior to age 59 ½. This new penalty exception applies to all widows and widowers for all pre-age 59 ½ retirement account distributions regardless of whether the widow/widower inherited a retirement account.  

11. Clarify the SECURE Act to provide that if the 10 year rule applies to an inherited account, RMDs do not apply to the account, other than in the final year of the 10 year window. The IRS came out with overly complicated proposed regulations requiring RMDs for many inherited accounts even though the 10 year rule applies to them. This clarification repeals the needlessly complicated proposed regulations, and the government’s interests are already adequately protected by the 10 year rule. 

12. Adopt a supercharged version of SECURE 2.0 Section 321. Allow the self-employed (generally those reporting self-employment income on Schedule C or through partnerships) to both establish a Solo 401(k) after year-end and make employee contributions to their Solo 401(k) before the tax return deadline for the taxable year. This eliminates the election required under Treas. Reg. Sec. 1.401(k)-1(a)(6)(iii). There’s no reason for a self-employed individual to have to make an election with themselves to make a retirement account contribution. This change would make the contribution deadline rules for self-employed employee contributions the exact same as the contribution deadline rules for self-employed employer contributions for every year (not just for the first year as Section 321 proposed to do). 

Combat Mega Retirement Accounts and Limit Benefits for the Very Rich

13. Eliminate (as of enactment) new tax-advantaged retirement account investments in private equity, venture capital, and companies 10% or more owned (by vote or value) by the account owner. These investments have allowed a very select few to accumulate hundreds of millions of dollars in IRAs. IRAs and qualified plans are best when they provide growth and capital preservation from diversified assets to fund retirement. They were never intended to create 9 figure-plus hoards of wealth sheltered from taxation. 

14. Required Accumulation Distribution (RAD) of 20 percent of the amount over $5M anytime all traditional accounts (IRAs and qualified plans) exceed $5M (indexed for inflation) at year-end for the following year prior to age 72. RAD of 20 percent of the amount over $5M anytime all Roth accounts (IRAs and qualified plans) exceed $5M (indexed for inflation) at year-end for the following year. Under this proposal, there would be no penalty on any RAD. RADs from Roths are treated as qualified distributions. This is much simpler than the Build Back Better proposals on mega retirement accounts. RADs from traditional accounts cannot be converted to Roth accounts. 

The hope is that after a while, there will be few, if any RADs. In a world without private equity and venture capital type investments in retirement accounts it will be quite difficult to accumulate in excess of $5M (adjusted for inflation) in either type of retirement account. The RAD rules do not need to apply to traditional retirement accounts at 72 and beyond, since the owner is already subject to the RMD rules. Inherited retirement accounts would be exempt from the RAD rules.  

Examples: Joe, age 65 in 2024, has $4.9 million in all traditional retirement accounts (401(k)s, IRAs, etc.) on December 31, 2023. He also has $4.9 million in all Roth retirement accounts (401(k)s, IRAs, etc.) on December 31, 2023. His 2024 RAD from traditional retirement accounts is $0, and his 2024 RAD from Roth retirement accounts is $0.

Sally, age 65 in 2024, has $7 million in all traditional retirement accounts (401(k)s, IRAs, etc.) on December 31, 2023. She also has $4 million in all Roth retirement accounts (401(k)s, IRAs, etc.) on December 31, 2023. Her 2024 RAD from traditional retirement accounts is $400,000 ($7M minus $5M times 20%), and her 2024 RAD from Roth retirement accounts is $0.

John, age 75 in 2024, has $7 million in all traditional retirement accounts (401(k)s, IRAs, etc.) on December 31, 2023. He also has $7 million in all Roth retirement accounts (401(k)s, IRAs, etc.) on December 31, 2023. His 2024 RAD from traditional retirement accounts is $0 (since he is 72 or older), and his 2024 RAD from Roth retirement accounts is $400,000. Under the existing rules (unchanged by this proposal), John is subject to RMDs in 2024 totalling $284,553 ($7M divided by 24.6) from his traditional retirement accounts (though see proposal 8 giving John more flexibility in terms of which account(s) he can take the RMDs from).

15. Cap at $25,000 the maximum annual amount that can be deferred by those with salaries (W-2, self-employment income) of $400K or more per year (indexed for inflation) under a Section 409A nonqualified deferred compensation plan. This rule change is logical considering (i) the tax law’s benefits for retirement saving have been too skewed towards helping a very affluent few who need the least amount of saving help, (ii) most of the beneficiaries of nonqualified deferred compensation plans are the ones doing best economically, and (iii) the need to provide more benefits of tax-advantaged retirement savings to a larger swath of Americans. Further, those losing a tax benefit because of this rule gain a significant benefit in the removal of income limits on Roth IRA contributions and the increased contribution limits. 

For administrative convenience, the new rule would not apply to any amount deferred at any time during one year and paid out at any time during the immediately following tax year.

Proposals 13, 14, and 15 raise revenue to expand the amounts that every worker can save in Roth IRAs, and some Americans will get increased deductible traditional IRA contributions because of proposals 2 and 4. 

Penalty Reform

16. New 20% penalty on all missed RADs and reduce the missed RMD penalty to 20%. The current 50% penalty on missed RMDs is unnecessarily punitive. 

17. Unify the exceptions to the 10 percent early withdrawal penalty so there is no difference between qualified plans and IRAs. It makes no sense that under current law there are some penalty exceptions only applicable to IRAs and some penalty exceptions applicable only to qualified plans. After this change, the only “plan only” exception would be the exception applicable to nonqualified 457(b) plans.

18. Change the Rule of 55 “separation from service” qualified plan penalty exception to be a broader, fairer age 55 need-based exception. Currently a 56 year-old CEO can leave their job and qualify for the penalty exception from their 401(k) but a 57 year-old teacher cannot qualify for the exception from an IRA. How does that make sense? 

New exception: Starting in the year one turns age 55, if AGI other than the taxpayer’s and/or their spouse’s potential Rule of 55 distribution(s) is less than $70K single, $110K MFJ (indexed for inflation), then the distribution (a “Rule of 55 distribution”) from the qualified plan or IRA is penalty free. Each person would have a $70K annual maximum (indexed for inflation) that could be accessed penalty free under this new, more rational Rule of 55 exception. In between $70K and $90K ($110K to $145K MFJ) of AGI (other than the potential Rule of 55 distributions), the $70K limitation per person is ratably reduced. 

The new Rule of 55 exception would be a Rule of 50 exception for public safety employees subject to the AGI limits described immediately above.

Eliminate Loopholes Benefitting Very Few

19. Age 15 requirement for IRA (traditional and Roth) contributions. Today a very few advantaged families can fund a retirement account for young children. Sometimes this takes the form of paying an infant a salary, which is at best questionable. Even with the elimination of this loophole, the family’s total annual Roth IRA contributions may be greater under this proposal. Instead of $6,500 per person ($19,500 total for family of 3), each parent can contribute $10,000 into a Roth IRA ($20,000 total). Of note, Canada requires being at least age 18 to make contributions to a tax-free savings account.

20. Eliminate the “super HSA” by deeming all persons covered by a HDHP other than the policyholder and their spouse to be a dependent of the policyholder for purposes of determining HSA contribution limits. The super HSA allows young adults covered by their parents’ high deductible health plans to put more into an HSA than most single HSA owners can. That’s not fair and illogical, and the super HSA is a loophole created not by Congressional intent but rather by the drafting technicalities used to create HSAs in IRC Section 223. 

Reform, Expand, and Simplify Qualified Birth Distributions

21. Reform, expand, and simplify SECURE Act Qualified Birth Distributions. Repeal as written in the SECURE Act. Capped at only $5,000 and confusing in their details, the current qualified birth distribution rules are not effective for parents. The new qualified birth distribution and recontributions rules would be as follows: 

For those under age 59 ½, up to $30,000 of distributions from qualified plans, SEP IRAs, SIMPLE IRAs, traditional IRAs, and Roth IRAs per parent distributed within 18 months (9 months before and 9 months after) surrounding a birth and/or an adoption are presumed to be a qualified birth distribution (QBD) and as such (i) are not treated as distributions in the year of the distribution (and not subject to tax withholding) and (ii) can be rolled back into the account by the end of the third year following the distribution. Amounts not repaid to the account are treated as distributions from the account at the end of that third year (including for estimated tax purposes), and are excused from the 10% early withdrawal penalty (if the penalty would otherwise apply to the deemed distribution). No mandatory reporting requirements for the parents (other than for any deemed distribution at the end of the third year), but the IRS is authorized to provide a voluntary reporting form reporting qualified birth distributions and qualified birth recontributions. The new law would authorize financial institutions and plan providers to rely on taxpayer representations for both distributions and recontributions in issuing Forms 1099-R and 5498 and accepting recontributions. 

This is a good idea for several reasons. It means saving for retirement is not a hindrance to financial security when adults are considering whether to have children. Our country is facing a decline in births. This proposal helps parents use retirement accounts to help during pregnancy and after childbirth while not handicapping their retirement. People can invest in Roth IRAs, for example, knowing that the money can be available for both the initial expenses of childbirth and their future retirement. 

Unfortunately, saving for birth and saving for retirement can compete. New, more robust and parent-friendly qualified birth distributions can reduce this competition and allow retirement savings to help during pregnancy and the first nine months after birth. 

Here is an example of how it could work: Robert, age 30, is the father of Mark, born February 2, 2024. On December 1, 2023, Robert withdrew $30,000 from his Roth IRA. At the time of the distribution, Robert had previously made $23,000 of annual contributions to his Roth IRA. Robert’s recontribution deadline is December 31, 2026. On April 2, 2026, Robert recontributes $20,000 to the Roth IRA, and makes no other qualified birth recontributions. On December 31, 2026, the $10,000 Robert did not recontribute to the Roth IRA is deemed to be a distribution from the Roth IRA to Robert. Robert took no other distributions from his Roth IRA prior to December 31, 2026. Since Robert had $23,000 of previous Roth IRA contributions to his Roth IRA as of the end of 2023 and may have made further annual contributions to his Roth IRA after 2023, the deemed distribution of $10,000 is deemed to be return of old annual contributions (under the nonqualified distribution rules) on December 31, 2026 and thus not taxable to Robert. The deemed distribution reduces Robert’s previous annual Roth IRA contributions by $10,000 for purposes of the nonqualified distribution rules as applied to any future nonqualified distributions. 

As a practical matter, the combination of this proposal and proposals 1 and 2 are likely to result in most QBDs coming from Roth IRAs. Thus, most QBDs not recontributed to the Roth IRA will simply be nontaxable deemed distributions of previous Roth IRA annual contributions. 

The new QBD rules would include rules providing that retirement account direct trustee-to-trustee transfers, rollovers, and Roth conversions occurring during the QBD 18 month window are not considered QBDs so as to preserve each parent’s $30K limitation. For simplicity’s sake, each birth and adoption will be treated as a distinct event for QBD purposes. Under this simplicity convention, parents of twins can each take up to $60K of QBDs. In addition, the QBD rules will have no adverse effect on the adoption tax credit. Funds sourced from a QBD for qualified adoption expenses will remain fully eligible for adoption tax credits based on the existing adoption tax credit rules. Lastly, a birth for QBD purposes will include the birth of a baby the parents give up for adoption. 

Expand and Rationalize Remedial Measures for Retirement Accounts

22. Adopt a supercharged version of SECURE 2.0 Section 308. Enact section 308 (expanding the IRS Employee Plans Compliance Resolution System) and add a self-correction safe-harbor (available both before an IRS exam and during IRS examination activity) whereby all individual traditional IRAs and Roth IRAs, and SEP IRAs, SIMPLE IRAs, 401(k)s, and qualified plans involving 10 or fewer individuals/employees (including Solo 401(k)s) automatically qualify for self-correction and forgiveness of all penalties so long as (i) the account owner/plan sponsor implements reasonable corrections (such as refunding excess contributions and attributable earnings penalty free, subject to ordinary taxable income inclusion — in the year of the corrective distribution — for earnings and any returned contributions actually deducted on a tax return or previously excluded from taxable income), and (ii) the total amount in the plan or IRA has never exceeded $500,000 as of any year-end. For this purpose, accounts would only be aggregated for a person or plan sponsor at the same financial institution. The new rules would provide that financial institutions can rely on taxpayer representations in issuing Forms 1099-R to report corrective distributions. Financial institutions will continue to compute attributable earnings as they do under current regulations.

This proposal reduces penalties (such as excess contribution penalties) and helps ensure plans and IRAs remain qualified. Self-correction is much better for taxpayers and the IRS, particularly when accounts are relatively modest in size. Currently, the IRS offers the Voluntary Compliance Program for qualified plans. Since VCP covers very large employer plans, it is a very odd fit for Solo 401(k)s and would be an odd fit for traditional IRAs and Roth IRAs. It is much better to encourage the use of self-correction. This encourages compliance, makes correcting mistakes easier, reduces penalties, and makes the IRS’s oversight of modest sized retirement accounts easier and more effective. 

23. Repeal and reform section 403 of the SECURE Act as applied to Form 5500-EZ filings. The SECURE Act increased penalties for late filed Form 5500 Series filings by tenfold. While this may make sense for large employer plans, the increase in penalties drastically overshot the mark when it comes to small businesses filing the Form 5500-EZ. Under the new law, a self-employed Solo 401(k) owner could (theoretically) be liable for a $150,000 penalty for failing to file a two page informational tax return (the Form 5500-EZ). Such a penalty is excessive and obscene. While relief procedures are available, it is ridiculous that the penalty could be, at least in theory, so onerous. Replace the current $250 per day penalty with a flat $500 per late Form 5500-EZ penalty (capped at $2,000 per plan sponsor) that can be excused for either reasonable cause or a first time abatement distinct to the Form 5500-EZ return. Cap the IRS period to assess the penalty at four years from the original filing deadline. Further, make the new rules effective to all missed Form 5500-EZ filings regardless of when they occurred. In addition, increase the asset threshold whereby a Form 5500-EZ is required from $250,000 to $500,000 to account for the passage of time and inflation. The Form 5500-EZ would still be required at the closing of the plan under this proposal, regardless of account size. 

Repeal Traps for the Unwary

24. Eliminate the once-a-year IRA to IRA 60-day rollover limit. It’s a trap for the unwary and by eliminating it, the rules would be synchronized for all rollovers. The once-a-year limit makes no sense (as the 60-day time limit is sufficient to police money coming out of retirement accounts) and is punitive and unnecessary. 

25. Repeal the SIMPLE IRA 25% penalty for early distributions within the first two years of establishing the SIMPLE IRA. Under this rule, the 25% penalty even applies to rollovers to traditional IRAs within the first two years. It’s a trap for the unwary and should be fully repealed. 

Miscellaneous

26. Do not pass (or repeal if passed) the rest of SECURE 2.0, the EARN Act, and other related proposals, other than as discussed above. My opinion is that SECURE 2.0/EARN Act introduced changes that were at best marginally beneficial for Americans saving for retirement. Unfortunately, SECURE 2.0 has counterproductive provisions (such as eliminating the tax deduction for 401(k) catch-up contributions) and increases the complexity of the retirement account system. 

Revenue Raisers (If Needed)

My hope is that my proposals would reduce federal revenue over the 10 year budget window by only a fairly modest amount, as there are provisions that would cost the government money and proposals that would increase revenue. If this nets out to costing too much money in Congress’s judgment, I recommend the following tax increase: an increase (starting in 2024) of the top capital gain/qualified dividend income rate (currently 20%) by the amount needed to close the gap. Considering that the highest earners have done the best in recent years, and do receive benefits under the overall proposal (see proposals 1, 2, and 4), this tax increase is fair and helps many Americans save for retirement by funding expansion of Roth IRAs and reduction of penalties.

If any other tax increases are deemed necessary, I recommend that Congress consider an increase to the rate of the corporate book minimum tax and/or a tax on investment income of college endowments comprised of $1 billion or more of assets. These two proposals shift the tax burden to those who have benefited the most from the American economy in recent years. 

Landscape After Retirement Account Reform

Let’s return to Josh and Sarah. What might their tax-advantaged retirement account contributions look like after my proposed reform. Here’s Josh’s contributions:

401(k) Employee Deferral: $30,000

401(k) Employer Match: $9,000

Roth IRA: $12,000

Total traditional deductible contributions: $39,000, total Roth contributions: $12,000, total contributions: $51,000. Yes, Josh lost his Mega Backdoor Roth IRA. But, now instead of a gimmicky $7,500 Backdoor Roth IRA, he gets to simply make a $12,000 annual contribution to a Roth IRA. Further, Josh did not lose any tax deductions under my proposal. Josh can invest the difference between $81,000 (his old tax-advantaged contribution total) and $51,000 (his new tax-advantaged contribution total), $30,000, in a taxable account.

Sarah has significantly increased the amount of her contributions. She goes from a $7,500 annual contribution to a traditional deductible IRA or Roth IRA to a $12,000 traditional deductible or Roth IRA contribution. 

Perfect? No. But instead of a 10.8 to 1 ratio we have moved the needle significantly such that the ratio is now 4.25 to 1. Further, many of the retirement account rules are simpler and fairer. If Josh, Sarah, or other Americans run into problems with their retirement accounts, their remedial paths are likely to be easier to navigate and they are more likely to avoid onerous and unfair penalties. 

I believe that our retirement system would be significantly better if Congress passes and the President signs the 26 proposals I outlined above in 2023. If any of you have questions about the above, I would be happy to communicate with you and/or your staff about these proposals.

To my fellow Americans reading this letter, I’d be honored to read your comments in the comments section below. I’m sure there are other ideas that could simplify and improve retirement accounts. 

Sincerely,

Sean Mullaney

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