Tag Archives: HSA

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

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

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.

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.

The Advantages of Living On Taxable Assets First in Early Retirement

The FIRE community loves the accumulation phase. Build up assets towards the goal of financial independence.

Questions increasingly creep in when it comes to the distribution phase. Members of the FIRE community wonder: what do I live on when I get to retirement? This is particularly true when one reaches early retirement prior to age 59 ½.

Below I discuss the options and the reasons I believe that for many, the best assets to live off of first in early retirement are taxable assets. This analysis assumes the early retiree has access to some material amount of assets in each of the three tax baskets discussed below.

Early Retirement Drawdown Options

For most Americans reaching retirement prior to age 59 ½, there are three main tax baskets of assets that can be lived off prior to age 59 ½.

Taxable Assets: This can include cash in bank accounts, brokerage accounts (stocks, bonds, mutual funds, and ETFs), and for some, income from rental properties. For purposes of this blog post, I will assume the early retiree does not own any rental real estate.

Roth Basis/HSAs: Early retirees can live off of what I colloquially refer to as “Roth Basis.” Generally, Roth Basis is the sum of previous annual contributions to Roth accounts and Roth conversions that are at least five years old. Further, early retirees can harvest amounts in HSAs tax and penalty free to the extent that they have allowable previously unreimbursed qualified medical expenses (what I refer to as PUQME). HSAs can also be used for qualified medical expenses incurred in early retirement.

Traditional Retirement Assets: Assets such as traditional 401(k)s and traditional IRAs. Generally “inaccessible” prior to turning age 59 ½ due to being subject to both ordinary income tax and the 10% early withdrawal penalty. However, there are exceptions to the early withdrawal penalty. They include:

Rule of 55: Separation from service from an employer after turning age 55 (exception available for withdrawals from that workplace retirement plan only).
72(t) Payments: Establishing a series of substantially equal periodic payments.
Governmental 457(b) Plans

Drawbacks of Using Roth Basis/HSAs

Some might argue for using tax-free withdrawals of Roth Basis and HSAs to fund early retirement. This allows the early retiree to pay no taxes on funds used for living expenses.

To my mind, the main drawback of doing so is opportunity cost. Removing assets from Roths and HSAs cuts off the opportunity for future tax free growth.

As a general planning objective, many will want to let their Roths and HSAs grow as long as possible to maximize tax-free growth.

Using Roths and HSAs can also have a significant drawback from a creditor protection perspective, as I will discuss below.

Drawbacks of Using Traditional Retirement Assets

The below analysis assumes that the early retiree qualifies for an exception from the 10% early withdrawal penalty.

The biggest drawback to using traditional retirement accounts to live off of in early retirement is all living expenses become subject to federal and state income taxes. It puts the most important consideration (funding living expenses) in opposition to the secondary (but still important) consideration: tax planning.

Living off traditional retirement accounts in early retirement reduces tax planning flexibility. It reduces the ability to do tax-optimized Roth conversions in early retirement. In addition, living off traditional retirement accounts during early retirement can reduce Premium Tax Credits for those on Affordable Care Act (“ACA”) medical insurance plans.

Premium Tax Credit Planning: Many early retirees will use an Affordable Care Act medical insurance plan. The premiums are subsidized through a tax code mechanism: the Premium Tax Credit (the “PTC”). PTCs are reduced as the taxpayer’s modified adjusted gross income (“MAGI”) increases. Very roughly speaking, for planning purposes, an additional dollar of MAGI often reduces the PTC by 10 to 15 cents, meaning early retirees using traditional retirement accounts to fund living expenses may be subject to a surtax of 10 to 15 percent on retirement account withdrawals due to PTC reduction. Resources for the PTC include this article and this spreadsheet.

There’s an argument that it is good to live off traditional retirement accounts early because withdrawals used to fund living expenses reduce future required minimum distributions (“RMDs”). But one must consider that there are two types of withdrawals an early retiree can make from a traditional retirement account: an actual withdrawal or a Roth conversion. Both reduce future RMDs, but a Roth conversion is the most tax efficient withdrawal for the early retiree. Why? Because it sets up future tax-free growth! Actual withdrawals used for living expenses do not enhance future tax-free growth.

Another drawback of using traditional retirement accounts to fund early retirement includes being constrained by the parameters of the applicable penalty exception. For example, needing to keep money inside a former employer’s retirement plan in order to qualify for the Rule of 55, or needing to withdraw precise amounts annually if using a 72(t) payment plan. Further, using traditional retirement accounts in early retirement has creditor protection drawbacks, discussed below.

Advantages of Using Taxable Assets

Living off drawdowns of taxable assets can be a great way to fund the first expenses of early retirement. Here are some of the advantages.

Zero Percent Long Term Capital Gains Rate

Early retirees worry: I need $60,000 of income to live my life. Won’t that create $60,000 of taxable income?

If drawing from a taxable account, almost certainly it will not. Consider Judy, an early retiree needing $60,000 to pay her living expenses. If she sells $60,000 worth of the XYZ Mutual Fund (all of which she has owned for over a year), in which she has $40,000 of basis, her resulting taxable income is only $20,000. Not $60,000!

But it gets even better for Judy. The capital gain can qualify for the 0% federal long term capital gains tax rate. Outstanding! By using taxable assets, Judy may pay $0 federal income tax, and likely only a very small state income tax, on the money she uses to fund her living expenses. Pretty good.

Even if Judy’s income puts her above the 0% federal capital gains tax bracket, (i) some of her capital gains will likely qualify for the 0% rate, and (ii) the next bracket is only a 15% tax rate.

Basis Recovery While Basis is Valuable

During 2022, we learned an important financial lesson: inflation is a thing. Retirement draw down planning should consider inflation.

One way to fight inflation is to use tax basis before its value is inflated away. Tax basis is never adjusted for inflation. Thus, failing to harvest tax basis exposes the early retiree to the risk that future capital gains in taxable accounts will be subject to taxation on inflation gains. Early retirees should consider harvesting basis (like Judy in the above example) when the tax basis is its most valuable.

Using taxable assets as the first assets to fund early retirement takes maximum advantage of tax basis, unless the U.S. dollar begins to deflate (a possible but not very likely long term outcome, in my opinion).

Opens the Door for Roth Conversions

Now we get to the fun part. Roth conversions! Using taxable assets first for living expenses in early retirement facilitates conversions of amounts in traditional retirement accounts to Roth accounts. The idea is to have artificially low taxable income such that the taxpayer can do Roth conversions taxed at 0% federal (offset by the standard deduction) and then in the 10% or 12% tax bracket. Occasionally, it will be logical for the taxpayer to incur an even greater tax rate on such Roth conversions.

These Roth conversions move assets to Roth accounts where they enjoy tax free growth. In addition, early retirement Roth conversions reduce future RMDs.

There is a taxpayer-friendly rule that assists early retirement Roth conversion planning: long-term capital gains income is stacked on top of ordinary income in the tax computation. Thus, Roth conversions can benefit from being sheltered by the standard deduction (or itemized deductions if the taxpayer itemizes). This makes Roth conversion planning in early retirement that much better, as some Roth conversions can benefit from a 0% federal income tax rate.

Further, this tells us it is generally better from a tax basketing perspective not to have bonds and other assets that generate ordinary income, since that income eats up part of the standard deduction, diminishing the opportunity to 0% taxed Roth conversions. One way to avoid having such ordinary income is to sell bonds, bond mutual funds, and other assets that generate ordinary income and use the proceeds to fund early retirement living expenses.

Another advantage of early retirement Roth conversions is the reduction of the risk that future tax increases will drive up taxes on future traditional retirement account withdrawals.

Roth Conversions, ACA PTC Eligibility, and Medicaid

Lastly, there can be an ancillary benefit to Roth conversions. Taxpayers lose all ACA subsidies (thus, PTCs) if their MAGI is below certain thresholds. For example, a family of four in California with MAGI less than $41,400 (2023 number) would meet the income threshold for Medi-Cal (Medicaid in California) and thus would get no ACA PTC.

Roth conversions can keep early retirees’ MAGI sufficiently high such that they do not meet the income threshold for Medicaid. By keeping MAGI above the Medicare threshold, early retirees can qualify for significant PTCs.

Creditor Protection

Financial assets can receive protection from creditors to varying degrees. Taxable brokerage accounts tend to have little, if any, creditor protection. 401(k) and other ERISA government workplace retirement accounts benefit from ERISA’s anti-alienation provisions. Generally speaking, only the IRS and an ex-spouse can get assets out of a 401(k). Traditional IRAs and Roth IRAs enjoy significant protection in bankruptcy. Traditional IRAs have varying degrees of non bankruptcy creditor protection, but in many states are fully protected. Roth IRAs are non bankruptcy protected in most states, but more states protect traditional IRAs than Roth IRAs.

HSAs do not enjoy federal bankruptcy protection, but do enjoy creditor protection in some states (to varying degrees).

By spending down taxable assets in early retirement, the early retiree optimizes for creditor protection in two ways. First, diminishing taxable assets by using them for living expenses reduces creditor vulnerable assets. Second, when an early retiree lives off taxable assets, they leave their more protected assets (traditional and Roth retirement accounts) to grow. Diminishing vulnerable assets while growing protected assets improves the early retiree’s balance sheet from a creditor protection perspective.

Lastly, early retirees should always consider personal umbrella liability insurance and other relevant property and casualty insurance for creditor protection.

Premium Tax Credit Planning

Living off taxable assets in early retirement limits taxable income. This has a good side effect. It increases the potential PTC available for early retirees using an ACA medical insurance plan.

Reducing Future Uncontrollable Taxable Income

Roths and HSAs are great because their taxable income is entirely controllable, and generally speaking should be $0. Even traditional retirement accounts have very controllable taxable income. There are no RMDs until age 72, and even then the amount of taxable income is quite modest for the first few years.

Taxable assets, on the other hand, expose the early retiree to uncontrollable taxable income, in the form of interest, dividends, and capital gain distributions. You never know when a mutual fund or other investment will spit out a taxable dividend or capital gain distribution. Such income reduces the runway for tax planning and can reduce PTCs.

Further, in recent years, we have become accustomed to living in a low-yield world. In the past decade plus a taxable portfolio has kicked off (in many cases) income yields of 3%, 2%, or less. Thus, the tax hit from taxable assets has not been too bad for many. That said, low yields are not guaranteed in the future. It could be that yields will rise, and thus taxable assets will generate increasing amounts of taxable income.

By living off taxable assets first, early retirees reduce and ultimately eliminate taxable interest, dividends, and capital gain distributions generated by holding assets in taxable accounts. This reduces the tax cost of the overall portfolio, and makes planning MAGI, taxable income, and tax paid annually an easier and potentially more beneficial exercise.

I discuss the early retirement Roth Conversion Ladder strategy in this video.

Conclusion

In many cases, I believe that the tax optimal path for the early retiree is to live off taxable assets first in early retirement prior to accessing Roth Basis, HSAs, and traditional retirement accounts. Of course, this is not individualized advice for you or any other particular individual. Those considering early retirement are well advised to consider their future drawdown strategy as they are building their assets. Those already retired should consider their own particular circumstances and ways to optimize their drawdown strategy.

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

Follow me on Twitter at @SeanMoneyandTax

Baby HSA

Are you married? Age 55 or older? You might have an opportunity to open up a small health savings account and get a $1,000 annual tax deduction!

HSA Contribution Limits

Health Savings Accounts (“HSAs”) have annual contribution limits. The limits depend on two things: medical insurance coverage through a high deductible health plan (a “HDHP”) and age. Here are the 2024 HSA contribution limits (hat tip to Kay Bell).

Age	HDHP Self Coverage	HDHP Family Coverage
Under Age 55	$4,150	$8,300
Age 55 or Older	$5,150	$9,300

Family HDHP Coverage

Family HDHP coverage is coverage of an insured plus either or both a spouse or a dependent(s). Coverage must be the only medical insurance coverage the person has.

HSA Catch-Up Contributions

Those age 55 or older can contribute an extra $1,000 per person to an HSA every year. While the “normal” contribution limits ($4,150 self / $8,300 family) are indexed for inflation, the $1,000 annual catch-up contribution limit is not indexed for inflation.

Two additional notes: First, as a practical matter, at age 65 a taxpayer will no longer qualify for an HSA (and thus, the catch-up contribution). This is because at age 65 most Americans switch from a HDHP to Medicare for their medical insurance.

Second, for IRAs and qualified plans (such as 401(k)s), the age to be eligible to make “catch-up” contributions is 50. For HSAs, the age is 55, not age 50.

HSA Contribution Limits for Married Couples

The normal contribution limits are coordinated. Thus, the family contribution maximum for a married couple is normally $8,300, not $8,300 times two. Here’s an example of how that works:

Example 1: Steven and Holly are married, both age 45, and covered by a family high deductible health plan for all of 2024. Thus, each has an HSA contribution limit of $8,300. However, when looking at Steven’s limit, we must look at what Holly has contributed to her HSA for 2024. If Holly contributes $8,300 to her HSA for 2024, then Steven’s HSA contribution limit is reduced by Holly’s contribution to $0.

Interestingly enough, catch-up contributions are not coordinated. Let’s change the example to have Steven and Holly be both age 55.

Example 2: Steven and Holly are married, both age 55, and covered by a family high deductible health plan (provided by Holly’s employer) for all of 2024. Thus, each has an HSA contribution limit of $9,300. Holly maxes out her 2024 HSA ($9,300) through payroll withholding (to get the payroll tax exclusion as well as the income tax exclusion). When looking at Steven’s normal contribution limit, we must look at what Holly has contributed to her HSA for 2024. Since Holly maxed out her HSA, Steven’s normal contribution limit is $0. However, Steven’s catch-up contribution limit is still $1,000, since it is not reduced for contributions Holly made to her HSA.

Steven is eligible for what I refer to as a Baby HSA. He will need to find a financial institution which offers HSAs. He can contribute up to $1,000 to his Baby HSA for 2024. Even better, Steven and Holly will get a $1,000 tax deduction on their 2024 tax return which lowers their adjusted gross income.

Note that Steven’s Baby HSA cannot just be simply added to Holly’s HSA. Each of them have their own limits, and an HSA is an account in the name of a single owner (the same as an IRA). Thus, Steven will need to reach out to a financial institution to establish his own HSA.

Benefits of the Baby HSA

Yes, a $1,000 tax deduction is nice, but it is not life changing. Let’s not pooh-pooh it too quickly, however. Steven might qualify for 10 years of that $1,000 Baby HSA, which is $10,000 of tax deductions. Second, Steven and Holly get this deduction against adjusted gross income, which means that they won’t have to claim itemized deductions to obtain it.

Third, most tax deductions require giving up money to get a tax benefit. Often we think about business deductions, charitable contributions, and home mortgage interest. It’s great to take tax deductions for those, but you are giving up the money. The deduction for a Baby HSA contribution is simply moving money from a taxable account to an HSA: it’s still your money!

Last, an HSA deduction/exclusion is better than a deduction/exclusion for a traditional 401(k) contribution. In exchange for the upfront tax benefit, the traditional 401(k) will be fully taxable when withdrawn later on. Not so with the HSA. As long as the HSA is used to pay qualified medical expenses and/or to reimburse PUQME, the money comes out tax-free. No wonder I’m so fond of HSAs!

One additional benefit for retirees is the $1,000 deducted for a Baby HSA is $1,000 more of Roth conversions that can be slotted in at a low tax rate. The HSA deduction also lowers both adjusted gross income and “modified adjusted gross income” for Premium Tax Credit purposes, making it valuable for early retiree tax planning.

One Spouse Under Age 55

What happens if one of the spouses is under age 55? Here’s an example:

Example 3: Steven (age 56) and Holly (age 52) are married and covered by a family high deductible health plan provided by Holly’s employer for all of 2024. Thus, Holly has an HSA contribution limit of $8,300. Steven has an HSA contribution limit of $9,300, computed as a $8,300 normal contribution limit plus a $1,000 catch-up contribution limit. Holly maxes out her 2024 HSA ($8,300) through payroll withholding. When looking at Steven’s normal contribution limit, we must look at what Holly has contributed to her HSA for 2024. Since Holly maxed out her HSA, Steven’s normal contribution limit is $0. However, Steven’s catch-up contribution limit is still $1,000, since it is not reduced for contributions Holly made to her HSA.

Because Steven was 55 or older during the year, he still gets to contribute $1,000 to his Baby HSA. Holly’s age and contributions are irrelevant because the catch-up contributions of one spouse are not limited by the age and contributions of the other spouse.

Watch me discuss the Baby HSA on YouTube. Stay to the end to see me butcher some 80’s movie trivia.

Conclusion

The Baby HSA is a nice tax planning tactic for married individuals with a HDHP as their only medical insurance between turning age 55 and going on Medicare. While limited in scale, the Baby HSA can provide real tax benefits and later tax-free growth. Of note, some ACA plans qualify as HDHPs. This means that the Baby HSA opportunity will exist for some using ACA plans in early retirement, as well as those covered by a HDHP through an employer.

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, 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.

TikTok Tax Advice

There’s tax advice available on TikTok. Is it worth following? Does it miss the big picture?

Retirement Saving Through Various Forms of Life Insurance

TikTok tax advice often boils down to something like the following: don’t save in traditional retirement accounts where you will get crushed by taxes in retirement. Rather, save for retirement through permanent life insurance products (such as indexed universal life insurance policies) to get tax free growth and tax free withdrawals during retirement.

Watch me discuss two problems with TikTok tax advice on YouTube.

This advice is not just offered on TikTok, though, anecdotally, it appears TikTok is at least something of a hub for promoting indexed universal life (“IUL”) and other forms of permanent life insurance.

One recent example of this sort of advice posits a retired couple making $160,000 a year in IRA/401(k) distributions and $40K in Social Security/pension income and worries that the couple will have a terrible tax problem.

But is that really the case? Let’s play it out with a detailed example.

Sally and Joe both turn age 75 in 2022. They are California residents. During their working years, they were prodigious savers in their workplace 401(k) plans, and their employers offered generous matching contributions. As a result, in 2022 they have required minimum distributions (“RMDs”) of $160,000. They also will have $40,000 of Social Security income, $4,000 of qualified dividend income, and $1,000 of interest income. Further, being tax savvy, they contribute $500 a month to their church through qualified charitable distributions (“QCDs”) from their traditional IRAs. They claim the standard deduction as their home is paid off and thus have no mortgage interest deductions.

Alright, let’s see what Sally and Joe’s 2022 tax picture (all numbers are estimates) looks like:

First, their rough 2022 federal income tax return:

Federal Income Tax Return
RMDs	$ 160,000
Social Security	$ 40,000
15% Social Security Exclusion	$ (6,000)
Interest	$ 1,000
Qualified Dividends	$ 4,000
QCD RMD Exclusion	$ (6,000)
Adjusted Gross Income (“AGI”)	$ 193,000
Standard Deduction	$ (25,900)
Additional SD Age 65+	$ (2,800)
Federal Taxable Income	$ 164,300

Let’s turn to what their $164,300 federal taxable income means in terms of federal and California income taxes paid and their 2022 cash flow:

2022 Income Taxes and Cash Flow (Estimated)
Federal Income Tax	$ 27,100
Effective Tax Rate on AGI	14.04%
Marginal Federal Income Tax Rate	22%
California Taxable Income (Approximate):	$ 149,000
California Income Tax (Approx.)	$ 7,862
Effective CA Income Tax Rate on Fed AGI	4.07%
Marginal CA Income Tax Rate	9.30%
Total Fed & CA Effective Income Tax Rate	18.11%
Cash Flow After Fed & CA Income Tax & QCDs	$ 164,038

By my math, after paying both income taxes and charitable contributions, this retired couple has $164,000 in cash flow for living expenses. Considering that, like many retirees, they live in a paid-off home, do we really believe there is a significant risk they will not be able to pay their bills? This couple ought to be able to enjoy a very pleasant, comfortable lifestyle, including recreational activities and travel.

Are Sally and Joe really getting crushed by income taxes? As residents of a high tax state, they do pay about $35K in combined federal and state income taxes. Sure, if $35K was on the table in front of you, you’d grab it pretty quick. But considering the $200K plus in cash flow they generated during the year, paying $35K in income taxes to the IRS and California is hardly financially debilitating.

Most retired couples, even financially successful couples, will not have federal adjusted gross income of $193,000. If Sally and Joe are not crushed by income taxes (paying just an 18.11% estimated effective rate even living in a high-tax state), it is likely most retirees will be able to withstand the tax hits at retirement from having significant savings in traditional deferred retirement accounts.

The Trade-Off Unstated on TikTok

TikTok tax advice often presents the boogeyman of taxes in retirement. It says “don’t invest in your 401(k) because it will get crushed in retirement.” Even if that were true, it usually neglects an important consideration: the upfront benefit of investing in a 401(k).

During their working careers, it is likely that Joe and Sally were subject to marginal income tax rates of 24% or more federal and 9.3% California. Had they used permanent life insurance to save instead of using their 401(k)s, they would have lost 33 cents (or more) on every dollar in immediate tax savings, as there is no tax deduction for amounts contributed to life insurance policies.

The existence of the tax deduction for amounts contributed to a traditional 401(k) does not automatically mean that using permanent life insurance products for retirement is a bad idea. However, in weighing the tax benefits of the traditional 401(k) approach compared to the permanent life insurance approach, one must consider the immediate, and potentially substantial, tax benefits of traditional 401(k) contributions.

One consideration in weighing the pros and cons of each: traditional 401(k) contributions generally get a tax benefit at the taxpayer’s marginal tax rate, while withdrawals from traditional 401(k)s and IRAs are more generally taxed at a taxpayer’s lower effective rate. On the way out, withdrawals are taxed through the relatively progressive tax brackets existing today, getting the benefits of the 10%, 12%, and 22% federal income tax brackets.

Uncertainty

But, Sean, what about future tax rate increases! The federal government is running a huge deficit and it’s not getting any better.

This is a valid point. But let’s consider a few things. First, in my example, Sally and Joe were subject to a 33.3% marginal tax rate during their working years, and barely over an 18% effective tax rate during their retirement. For the math to work out to make permanent life insurance more attractive (tax-wise) than traditional 401(k)s for them, tax rates would need to be increased substantially, by over 80%. Thus, even if tax rates on retirees such as Joe and Sally were to increase 85% from current levels, the tax math might only marginally favor using permanent life insurance instead of a traditional 401(k).

Second, if there are going to be income tax rate increases, they are more likely to be to the upper tax brackets. There are fewer taxpayers (read: voters) subject to the higher tax brackets, so those are the ones the politicians are more likely to increase. Increasing the 10%, the 12%, and/or the 22% tax brackets will impact more voters and lead to more election risk for the politicians.

Third, recent history suggests that the politicians are not likely to target retirees. It’s true that Social Security went from being tax free to being largely subject to taxation, up to 85% taxable. Interestingly enough, the second Social Security tax increase, which subjected Social Security to possibly being 85% taxable, passed through a Democratic Congress in 1993. The following year the Democrats suffered historic losses in the House and Senate elections. Many factors came into play, but it is interesting that since 1994 tax policy has generally benefited retirees (no more tax increases on Social Security, increasingly progressive tax brackets, and the increased standard deduction).

Perhaps the politicians in both parties have learned a lesson when it comes to retiree taxation.

Is there zero risk that retirees could be subject to higher taxes in the future? Absolutely not. But, is that risk great enough to eschew traditional 401(k) contributions in favor of permanent life insurance? Not in my opinion.

Further, there are simpler, less costly planning techniques other than permanent life insurance that those using 401(k)s for retirement planning can avail themselves of, including Roth accounts and health savings accounts.

Roth Accounts

Savers worried about future tax rate hikes have a simple, easy to implement tool to hedge against future tax rate increases: the Roth IRA. The Roth IRA solves the same tax problem that permanent life insurance solves for. In today’s environment, Roth IRAs are available at a vast array of financial institutions with very low fees.

As I have previously discussed, many savers will benefit from the combination of a maxed out traditional 401(k) and a maxed out annual Roth IRA.

Many will point out the possibility of much greater contributions to an indexed universal life insurance policy than to a Roth IRA. While true, many of those concerned with getting large amounts into tax-free accounts while working can turn to the Roth 401(k), which has significantly greater annual contribution limits than the Roth IRA.

Roth Conversions

Many in the FIRE community have access to Roth conversions during what are likely to lower taxable income years. The tax idea behind retiring early is to load up on traditional 401(k) contributions during working years, and then convert amounts inside traditional retirement accounts to Roth accounts during early retirement years prior to collecting Social Security.

In early retirement years, many in the FIRE movement appear, at least initially, to be poor on their tax return. No longer working, and not yet collecting Social Security, one’s tax return only includes interest income, dividend income, and some capital gains income. If that income is relatively low (which it is likely to be for many early retirees), it likely leaves room for Roth conversions at the 10% or 12% tax brackets during early retirement.

This is tax rate arbitrage. First, deduct 401(k) contributions in the 24% or greater federal income tax brackets during one’s working years. Then, during early retirement, convert amounts in the traditional retirement accounts at a 10%, 12%, or perhaps 22% marginal federal income tax rate.

Two observations: A) using permanent life insurance instead of traditional 401(k) contributions followed by early retirement Roth conversions denies members of the FIRE community a significant tax rate arbitrage opportunity. While there is no taxable income inclusion when withdrawing from a permanent life insurance policy, there is also no tax deduction for contributions to IULs, whole life insurance, and other permanent life insurance policies.

B) By doing Roth conversions during early retirement, FIRE members reduce the uncertainty risk described above. FIRE members face a shorter time frame during which significant savings are in traditional retirement accounts, as the goal is (generally speaking) to get the money (mostly) converted to Roths prior to age 70.

The Roth conversion tool reduces the risk that future tax increases will crush savers who mostly use traditional 401(k)s during their working years. While this is true for all savers, it is most especially true for members of the FIRE community.

A note on tax optimization: Imagine Joe and Sally were retired at age 55, today’s tax laws existed, and they had many years with artificially low taxable income. Say they did not do Roth conversions during this time. Is that a mistake? From a tax optimization perspective, absolutely. They would have likely been able to do Roth conversions at a 10% or 12% federal income tax rate, which is lower than both their retirement 22% marginal federal income tax rate and 18.11% combined effective income tax rate. While they are not tax optimized, they are something more important in my example: financially successful. Yes, tax optimization is important, but it is not the be-all and end-all. My guess is that financially successful individuals do not regret the failure to tax optimize on their deathbeds, though I look forward to reading Jordan “Doc G” Grumet’s new book to be sure.

Conclusion

I’m not here to tell you exactly how to save for retirement. But I am concerned that TikTok tax advice has two deficiencies. First, it overstates the problem of taxation in retirement. Is there a potential problem? Yes. Is it as severe as some make it out to be? Not under today’s laws. Further, there are tactics such as annual Roth IRA contributions and Roth conversions during early retirement that can address the problem. Second, TikTok tax advice understates the current benefit of deductible traditional 401(k) contributions during one’s working years.

FI Tax Guy Featured on the Optimal Finance Daily Podcast

Today and tomorrow my year-end tax planning post will be featured on the Optimal Finance Daily podcast.

Listen to today’s episode on podcast players and here.

Read my year-end tax planning blog post here.

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

Follow me on Twitter: @SeanMoneyandTax

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

Sean Talks Tax with DocG

Listen to my discussion with DocG on the latest episode of the Earn and Invest podcast. Available on all major podcast players and at this link: https://www.earnandinvest.com/episodes/five-tax-questions-you-must-ask

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

Follow me on Twitter: @SeanMoneyandTax

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

Tax Planning for Inflation

In recent years, inflation existed but was not significant. Significant inflation was associated with wide lapels and eight-track tapes and thought to be left behind in the late 1970s and early 1980s.

But, sure enough, significant inflation is back. Inflation is 6.2 percent for the 12 months ending October 2021.

Inflation has a tax angle. How does one use tax planning to minimize the impact of inflation? In this post, I review the issues associated with inflation and tactics to consider if one is concerned about inflation.

Inflation: The Tax Problem

Inflation increases the nominal (i.e., stated) value of assets without a corresponding increase in the real value of the asset. Here is an example:

Larry buys $100,000 worth of XYZ Mutual Fund on January 1, 2022. During the year 2022, there is 10 percent inflation. On January 1, 2023, the XYZ Mutual Fund is worth $110,000. Inflation-adjusted, the position has the same real value as it did when Larry purchased it. However, were Larry to sell the entire position, he would trigger a $10,000 capital gain ($110,000 sales price less $100,000 tax basis), which would be taxable to him.

Hopefully you see the problem: Larry has not experienced a real increase in wealth. Larry’s taxable “gain” is not a gain. Rather, it is simply inflation! Larry will pay tax on inflation if he sells the asset. Ouch!

While inflation increases the nominal value of assets, there is no inflation adjustment to tax basis! Thus, inflation creates artificial gains subject to income tax.

There are other tax problems with inflation. Inflation artificially increases amounts received as wages, self-employment income, interest, dividends, and retirement plan distributions. Those artificial increases are not real increases in income (as they do not represent increases in value) but they are subject to income tax as though they were real increases in income.

The tax law does provide some remedy to address the problem of taxing inflation. The IRS provides inflation adjustments to increase the size of progressive tax brackets. In addition, the standard deduction is adjusted annually for inflation. Recently the IRS released the inflation adjustments for 2022.

IRS inflation adjustments are helpful, but they do not excuse inflation from taxation. Rather, they only soften the blow. Thus, they are not a full cure for the tax problems caused by inflation.

Inflation and Traditional Retirement Accounts

Inflation is detrimental to traditional retirement accounts such as pre-tax 401(k)s and IRAs. Holding assets inside a traditional retirement account subjects the taxpayer to income tax on the growth in the assets caused by inflation.

Inflation artificially increases amounts in these accounts that will ultimately be subject to taxation. Inflation can also limit the opportunity to do Roth conversions in early retirement. Greater balances to convert from traditional to Roth accounts and increased dividend, capital gain, and interest income triggered by inflation makes early retiree Roth conversion planning more challenging.

Inflation and Real Estate

There are several tax benefits of rental real estate. One of the main benefits is depreciation. For residential real estate, the depreciable basis is deducted in a straight-line over 27.5 years. For example, if the depreciable basis of a rental condo is $275,000, the annual depreciation tax deduction (for 27.5 years) is $10,000 (computed as $275,000 divided by 27.5). That number rarely changes, as most of the depreciable basis is determined at the time the property is purchased or constructed.

Over time, inflation erodes the value of depreciation deductions. Inflation generally increases rental income, but the depreciation deduction stays flat nominally and decreases in real value. Increasing inflation reduces the tax benefits provided by rental real estate.

Planning Techniques

There are planning techniques that can protect taxpayers against the tax threat posed by inflation.

Roth Contributions and Conversions

Inflation is yet another tax villain the Roth can slay. Tax free growth inside a Roth account avoids the tax on inflation.

Once inside a Roth, concerns about inflation increasing taxes generally vanish. Properly planned, Roths provide tax free growth and tax free withdrawals. Thus, Roths effectively eliminate the concern about paying tax on inflation.

For those thinking of Roth conversions, inflation concerns point to accelerating Roth conversions. The sooner amounts inside traditional retirement accounts are converted to Roth accounts, the less exposure the amounts have to inflation taxes.

Roth contributions and conversions provide tax insurance against the threat of inflation. For those very concerned about inflation, this consideration moves the needle toward the Roth in the ongoing Roth versus traditional debate.

Watch me discuss using Roth accounts to help manage an investor’s exposure to inflation.

Health Savings Accounts

A Health Savings Account, like its Roth IRA cousin, offers tax free growth. HSAs also protect against taxes on inflation. Inflation is another argument to take advantage of an HSA.

Basis Step Up Planning

There is another tax planning opportunity that can wipe away the taxes owed on years of inflation: the basis step up at death. At death, heirs receive a basis in inherited taxable assets which is usually the fair market value of the assets on the date of death. For taxable assets, death provides an opportunity to escape the tax on inflation.

It is important to note that traditional retirement accounts do not receive a basis step up. Inflation inside a traditional retirement account will eventually be subject to tax (either to the original owner or to a beneficiary after the original owner’s death).

During one’s lifetime, there is the tax gain harvesting opportunity to step up basis and reduce inflation taxes. The tactic is to sell and repurchase an investment with a built-in gain at a time when the investor does not pay federal income tax on the capital gain. If one can keep their marginal federal income tax rate in the 12% or lower marginal tax bracket, they can pay a 0% federal income tax rate on the gain and “reset” the basis to the repurchase price of the sold and then repurchased asset.

There is a second flavor of tax gain harvesting: triggering a capital gain (at an advantageous time from a tax perspective) by selling an asset and reinvesting the proceeds in a more desirable asset (essentially, investment reallocation).

One inflation consideration with respect to tax gain harvesting: as inflation increases interest and dividends, there will be less room inside the 12 percent taxable income bracket to create capital gains that are federal income tax free.

Conclusion

Inflation is yet another tax planning consideration. As we are now in a period of significant inflation, taxpayers and advisors will need to weigh inflation’s potential impact on tax strategies.

None of the above is advice for any particular taxpayer. Hopefully it provides some educational background to help assess the tax impact of inflation and consider tactical responses to inflation.

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

Follow me on Twitter: @SeanMoneyandTax

2021 YEAR-END TAX PLANNING

It’s time to think about year-end tax planning. Year-end is a great time to get tax planning ducks in a row and take advantage of opportunities. This is particularly true for those in the financial independence community. FI principles often increase one’s tax planning opportunities.

Remember, this post is for educational purposes only. None of it is advice directed towards any particular taxpayer.

Backdoor Roth IRA Deadline 2021

As of now (December 7, 2021), the legal deadlines around Backdoor Roth IRAs have not changed: the nondeductible 2021 traditional IRA contribution must happen by April 18, 2022 and there is no legal deadline for the second step, the Roth conversion. However, from a planning perspective, the practical deadline to have both steps of a 2021 Backdoor Roth IRA completed is December 31, 2021.

This is because of proposed legislation that eliminates the ability to convert nondeductible amounts in a traditional IRA effective January 1, 2022. As of December 7th, the proposed legislation has passed the House of Representatives but faces a very certain future in the Senate. Considering the risk that the Backdoor Roth elimination proposal is enacted, taxpayers planning on completing a 2021 Backdoor Roth IRA should act to ensure that the second step of the Backdoor Roth IRA (the Roth conversion) is completed before December 31st.

Taxpayers on the Roth IRA MAGI Limit Borderline

In years prior to 2021, taxpayers unsure of whether their income would allow them to make a regular Roth IRA contribution could simply wait until tax return season to make the determination. At that point, they could either make the regular Roth IRA contribution for the prior year (if they qualified) or execute what I call a Split-Year Backdoor Roth IRA.

With the proposed legislation looming, waiting is not a good option. The good news is that taxpayers executing a Backdoor Roth IRA during a year they actually qualify for a regular annual Roth IRA contribution suffer no material adverse tax consequences. Of course, in order for this to be true there must be zero balance, or at most a very small balance, in all traditional IRAs, SEP IRAs, and SIMPLE IRAs as of December 31, 2021.

December 31st and Backdoor Roth IRAs

December 31st is a crucial date for those doing the Roth conversion step of a Backdoor Roth IRA during the year. It is the deadline to move any balances in traditional IRAs, SEP IRAs, and SIMPLE IRAs to workplace plans in order to ensure that the Roth conversion step of any Backdoor Roth IRA executed during the year is tax-efficient.

This December 31st deadline applies regardless of the proposed legislation discussed above.

IRAs and HSAs

Good news on regular traditional IRA contributions, Roth IRA contributions, and HSA contributions: they don’t have to be part of an end-of-2021 tax two-minute drill. The deadline for funding an HSA, a traditional IRA, and a Roth IRA for 2021 is April 18, 2022.

Solo 401(k)

The self-employed should consider this one. Deadlines vary, but as a general rule, those eligible for a Solo 401(k) usually benefit from establishing one prior to year-end. The big takeaway should be this: if you are self-employed, your deadline to seriously consider a Solo 401(k) for 2021 is ASAP! Usually, such considerations benefit from professional assistance.

Something to look forward to in 2022: my upcoming Solo 401(k) book!

Charitable Contributions

For those itemizing deductions in 2021 and either not itemizing in 2022 or in a lower marginal tax rate in 2022 than in 2021, it can be advantageous to accelerate charitable contributions late in the year. It can be as simple as a direct donation to a qualifying charity by December 31st. Or it could involve contributing to a donor advised fund by December 31st.

A great donor advised fund planning technique is transferring appreciated securities (stocks, bonds, mutual funds, or ETFs) to a donor advised fund. Many donor advised fund providers accept securities. The tax benefits of making such a transfer usually include (a) eliminating the built-in capital gain from federal income taxation and (b) if you itemize, getting to take a current year deduction for the fair market value of the appreciated securities transferred to the donor advised fund.

The elimination of the lurking capital gain makes appreciated securities a better asset to give to a donor advised fund than cash (from a tax perspective). Transfers of appreciated securities to 501(c)(3) charities can also have the same benefits.

The 2021 deadline for this sort of planning is December 31, 2021, though taxpayers may need to act much sooner to ensure the transfer occurs on time. This is particularly true if the securities are transferred from one financial institution to a donor advised fund at another financial institution. In these cases, the transfer may have to occur no later than mid-November, though deadlines will vary.

Early Retirement Tax Planning

For those in early retirement, the fourth quarter of the year is the time to do tax planning. Failing to do so can leave a great opportunity on the table.

Prior to taking Social Security, many early retirees have artificially low taxable income. Their only taxable income usually consists of interest, dividends, and capital gains. In today’s low-yield environment, without additional planning, early retirees’ taxable income can be very low (perhaps even below the standard deduction).

Artificially low income gives early retirees runway to fill up lower tax brackets (think the 10 percent and 12 percent federal income tax brackets) with taxable income. Why pay more tax? The reason is simple: choose to pay tax when it is taxed at a low rate rather than defer it to a future when it might be taxable at a higher rate.

The two main levers in this regard are Roth conversions and tax gain harvesting. Roth conversions move amounts in traditional retirement accounts to Roth accounts via a taxable conversion. The idea is to pay tax at a very low tax rate while taxable income is artificially low, rather than leaving the money in deferred accounts to be taxed later in retirement at a higher rate under the required minimum distribution (“RMD”) rules.

Tax gain harvesting is selling appreciated assets when one is in the 10 percent or 12 percent marginal tax bracket so as to incur a zero percent long term capital gains federal tax rate on the capital gain.

Early retirees can do some of both. In terms of a tiebreaker, if everything else is equal, I prefer Roth conversions to tax gain harvesting, for two primary reasons. First, traditional retirement accounts are subject to ordinary income tax rates in the future, which are likely to be higher than preferred capital gains tax rates. Second, large taxable capital gains in taxable accounts can be washed away through the step-up in basis at death. The step-up in basis at death doesn’t exist for traditional retirement accounts.

One time to favor tax gain harvesting over Roth conversions is when the traditional retirement accounts have the early retiree’s desired investment assets but the taxable brokerage account has positions that the early retiree does not like anymore (for example, a concentrated position in a single stock). Why not take advantage of tax gain harvesting to reallocate into preferred investments in a tax-efficient way?

Long story short: during the fourth quarter, early retirees should consider their taxable income for the year and consider year-end Roth conversions and/or tax gain harvesting. Planning in this regard should be executed no later than December 31st, and likely earlier to ensure proper execution.

Roth Conversions, Tax Gain Harvesting, and Tax Loss Harvesting

Early retired or not, the deadline for 2021 Roth conversions, tax gain harvesting, and tax loss harvesting is December 31, 2021. Taxpayers should always consider timely implementation: these are not tactics best implemented on December 30th!

For some who find their income dipped significantly in 2021 (perhaps due to a job loss), 2021 might be the year to convert some amounts in traditional retirement accounts to Roth retirement accounts. Some who are self-employed might want to consider end-of-year Roth conversions to maximize their qualified business income deduction.

Stimulus and Child Tax Credit Planning

Taxpayers who did not receive their full 2021 stimulus may want to look into ways to reduce their 2021 adjusted gross income so as to qualify for additional stimulus funds. I wrote in detail about one such opportunity in an earlier blog post. Lowering adjusted gross income can also qualify taxpayers for additional child tax credits.

There are many factors you and your advisor should consider in tax planning. This opportunity may be one of them. For example, taxpayers considering a Roth conversion at the end of the 2021 might want to hold off in order to qualify for additional stimulus and/or child tax credits.

Accelerate Payments

The self-employed and other small business owners may want to review business expenses and pay off expenses before January 1st, especially if they anticipate their marginal tax rate will decrease in 2022. Depending on structure and accounting method, doing so may not only reduce income taxes, it could also reduce self-employment taxes.

State Tax Planning

For my fellow Californians, the big one here is property taxes. It may be advantageous to pay billed (but not yet due) property taxes in late 2021. This allows taxpayers to deduct the amount on their 2021 California income tax return. In California, the standard deduction ($4,601 for single taxpayers, $9,202 for married filing joint taxpayers) is much lower than the federal standard deduction, so consideration should be given to accelerating itemized deductions in California, regardless of whether the taxpayer itemizes for federal income tax purposes.

Required Minimum Distributions (“RMDs”)

They’re back!!! RMDs are back for 2021. The deadline to withdraw a required minimum distribution for 2021 is December 31, 2021. Failure to do so can result in a 50 percent penalty.

Required minimum distributions apply to most retirement accounts (Roth IRAs are an exception). They apply once the taxpayer turns 72. Also, many inherited retirement accounts (including Roth IRAs) are subject to RMDs, regardless of the beneficiary’s age.

Planning for Traditional Retirement Accounts Inherited in 2020 and 2021

Those inheriting traditional retirement accounts in 2020 or later often need to do some tax planning. The end of the year is a good time to do that planning. Many traditional retirement account beneficiaries will need to empty the retirement account in 10 years (instead of being on an RMD schedule), and thus will need to plan out distributions over the 10 year time frame to manage taxes rate on the distributions.

2021 Federal Estimated Taxes

For those with small business income, side hustle income, significant investment income, and other income that is not subject to tax withholding, the deadline for 2021 4th quarter estimated tax payments to the IRS is January 18, 2022. Such individuals should also consider making timely estimated tax payments to cover any state income taxes.

Review & Update Beneficiary Designation Forms

Beneficiary designation forms control the disposition of financial assets (such as retirement accounts and brokerage accounts) upon death. Year-end is a great time to make sure the relevant institutions have up-to-date forms on file. While beneficiary designations should be updated anytime there is a significant life event (such as a marriage or a death of a loved one), year-end is a great time to ensure that has happened.

2022 and Beyond Tax Planning

The best tax planning is long term planning that considers the entire financial picture. There’s always the temptation to maximize deductions on the current year tax return. But the best planning considers your current financial situation and your future plans and strives to reduce total lifetime taxes. 2022 is as good a time as any to do long-term planning.

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

Follow me on Twitter: @SeanMoneyandTax

Sean Presentation at CampFI

My presentation to CampFI Southwest in October 2021.

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

Health Savings Accounts PUQME

Restricted Accounts

Time Restrictions

Use Restrictions

HSA Use Restrictions

HSAs and Las Vegas

HSA Planning Risk

Surviving Spouse’s HSA PUQME

HSA Resource

Conclusion

An Open Letter to the Members of the 118th Congress

Problems with the Current Retirement Savings System

Limits Are Unequal and Unfair

Other Retirement Account Problems

Goals for Retirement Account Reform

Retirement Tax Reform Proposals

Expanded Universal Roth IRAs and Closing Backdoors

Eliminate Traditional Retirement Account Basis

Simplify and Rationalize Retirement Account Rules

Combat Mega Retirement Accounts and Limit Benefits for the Very Rich

Penalty Reform

Eliminate Loopholes Benefitting Very Few

Reform, Expand, and Simplify Qualified Birth Distributions

Expand and Rationalize Remedial Measures for Retirement Accounts

Repeal Traps for the Unwary

Miscellaneous

Revenue Raisers (If Needed)

Landscape After Retirement Account Reform

Early Retirement Drawdown Options

Drawbacks of Using Roth Basis/HSAs

Drawbacks of Using Traditional Retirement Assets

Advantages of Using Taxable Assets

Zero Percent Long Term Capital Gains Rate

Basis Recovery While Basis is Valuable

Opens the Door for Roth Conversions

Roth Conversions, ACA PTC Eligibility, and Medicaid

Creditor Protection

Premium Tax Credit Planning

Reducing Future Uncontrollable Taxable Income

Conclusion

HSA Contribution Limits

Family HDHP Coverage

HSA Catch-Up Contributions

HSA Contribution Limits for Married Couples

Benefits of the Baby HSA

One Spouse Under Age 55

Conclusion

Retirement Saving Through Various Forms of Life Insurance

The Trade-Off Unstated on TikTok

Uncertainty

Roth Accounts

Roth Conversions

Conclusion

Further Reading

Inflation: The Tax Problem

Inflation and Traditional Retirement Accounts

Inflation and Real Estate

Planning Techniques

Roth Contributions and Conversions

Health Savings Accounts

Basis Step Up Planning

Conclusion

Backdoor Roth IRA Deadline 2021

Taxpayers on the Roth IRA MAGI Limit Borderline

December 31st and Backdoor Roth IRAs

IRAs and HSAs

Solo 401(k)

Charitable Contributions

Early Retirement Tax Planning

Roth Conversions, Tax Gain Harvesting, and Tax Loss Harvesting

Stimulus and Child Tax Credit Planning

Accelerate Payments

State Tax Planning

Required Minimum Distributions (“RMDs”)

Planning for Traditional Retirement Accounts Inherited in 2020 and 2021

2021 Federal Estimated Taxes

Review & Update Beneficiary Designation Forms

2022 and Beyond Tax Planning