Many ask the question: should I contribute to a Roth 401(k) or contribute to a Roth IRA? Below I discuss why, in the vast majority of cases, I strongly favor Roth IRA contributions over Roth 401(k) contributions.
Roth Accounts
Who does not love tax free accounts? The Roth, properly distributed, can create tax free income.
The Roth is becoming particularly attractive for the early retiree trying to optimize Premium Tax Credits. Yes, you can potentially fund pre-65 retirement expenses from traditional retirement accounts or sales of taxable account assets. But (with uncommon exceptions) both trigger taxable income, increasing the possibility of going over the 400 percent of federal poverty level cliff.
Roth IRAs
Roth IRAs are an individual account and can be established at a plethora of financial institutions. Most working taxpayers qualify to make annual contributions to a Roth IRA. However, the ability to make an annual contribution to a Roth IRA phases out at certain income levels and is completely eliminated at $168,000 (single) or $252,000 (married filing joint) of modified adjusted gross income (2026 numbers).
The maximum annual contribution to a Roth IRA is $7,500 (if under age 50) or $8,600 (if age 50 or older) (2026 numbers).
Of course, considering their tax free growth, it is usually best to keep amounts in a Roth IRA for as long as possible, particularly during one’s working years.
Roth 401(k)s
Roth 401(k)s are a workplace retirement plan. Contributions can be made through payroll withholding.
The Roth 401(k) does enjoy some advantages when compared to its Roth IRA cousin. First, there is no income limit to worry about. Regardless of income level, an employee can contribute to a Roth 401(k). Second, the contribution limits are much higher than the contribution limits for Roth IRAs. As of 2026, the annual Roth 401(k) contribution limit is $24,500 (under age 50). Those aged 50 and older by year end qualify for additional catch-up contributions.
So which one should workers prioritize? Contributions to a Roth 401(k) or contributions to a Roth IRA?
To help us answer that question, let’s consider a young couple pursuing financial independence:
Stephen and Becky are both age 35, married (to each other), and pursuing financial independence. They both would like to retire at least somewhat early by conventional standards. They each have a W-2 salary of $110,000. They have approximately $2,000 of annual interest and dividend income. They claim the standard deduction of $32,200 in 2026. At this level of income, they have a 22 percent marginal federal income tax rate. Stephen and Becky each have access to a traditional 401(k) and a Roth 401(k) at work. They would like to maximize their retirement plan contributions.
How should Stephen and Becky allocate their retirement plan contributions? Should they contribute to a Roth 401(k) and/or to a Roth IRA?
To my mind, the best play here is to contribute to a Roth IRA ($7,500 each) and contribute to a traditional 401(k) ($24,500 each). Stephen and Becky should not contribute to a Roth 401(k).
There is a significant tax opportunity cost to making a Roth 401(k) contribution: the ability to deduct a traditional contribution to a 401(k). Remember, the Roth 401(k) shares the $24,500 annual contribution limit with the traditional 401(k). Every dollar contributed to a Roth 401(k) is a dollar that cannot be contributed to a traditional 401(k).
Contrast the significant tax opportunity cost of making a Roth 401(k) contribution to the tax opportunity cost of making a Roth IRA contribution: practically nothing.
Stephen and Becky have no ability to deduct a traditional IRA contribution because of their income level and the fact that they are covered by a workplace retirement plan. Thus, they aren’t losing much, from a tax perspective, by each making a $7,500 annual Roth IRA contribution.
For Stephen and Becky, the idea is to Pay Tax When You Pay Less Tax. As I’ve explored on my YouTube channel, it’s frequently the case that retirees are lightly taxed. The odds are that Stephen and Becky will pay the most tax when they are working. Thus, the better path is likely to be to take the tax deduction (the traditional 401(k) contribution) during their working years and then pay tax on traditional retirement accounts in retirement.
Trade Off Profile
The trade off profile of the traditional 401(k) versus Roth 401(k) tilts towards the traditional 401(k) contribution.
Every dollar contributed to a Roth 401(k) is a dollar that could not have been tax deducted into a traditional 401(k).
If I’m going to do Roth, don’t I want to do the Roth that does not sacrifice a tax deduction?
Situations Where the Roth 401(k) Contributions Make Sense
Generally there are four situations where choosing to contribute to a Roth 401(k) makes sense. In these situations, the tax rate arbitrage play available to Stephen and Becky isn’t available.
In the first three situations below, a Roth 401(k) contribution is likely preferable to a traditional 401(k) contribution. As compared to a Roth IRA contribution, (a) the first contributions should generally be to the Roth 401(k) to secure the employer match, and then after that, (b) generally both the Roth 401(k) and the Roth IRA work well. To my mind, the emergency-type fund feature of the Roth IRA is probably the tiebreaker in favor of making the next contributions to a Roth IRA.
Transition Years
Think about a year one graduates college, graduate school, law school, or medical school. Usually, the person works for only the last half or last quarter of the year. Thus, they have an artificially low taxable income (since they only work for a small portion of the year). Why take a tax deduction for a contribution to a traditional 401(k) in such a year, when one’s marginal federal income tax rate might only be 10 percent?
End of career wind downs where one reduces workload, and thus, taxable income, can be a great time to switch to the Roth 401(k) for retirement contributions.
Transition years are a great time to make Roth 401(k) contributions instead of traditional 401(k) contributions.
Mini-Retirements
Taking a year-long mini-retirement beginning February 1st? January 401(k) contributions might be best made to the Roth 401(k) instead of the traditional 401(k).
No Hope
Picture a charismatic franchise NFL quarterback. He’s got a $50M plus annual NFL contact, endorsement deals, business ventures, and likely a long TV career after his playing days are done. For him, there is no hope ( 😉 ). He will probably be in the top federal income tax bracket the rest of his life. He might be well advised to “lock-in” today’s low (by historical standards) 37% federal income tax marginal tax rate by choosing to contribute to a Roth 401(k) instead of to a traditional 401(k).
High Earners’ Catch-Up Contributions
This isn’t a question of “traditional versus Roth” preference. It’s a question of the tax law.
Starting in 2026, those making more than $150,000 in prior-year W-2 wages from an employer cannot make catch-up contributions to a traditional 401(k). Their catch-up contributions must be made to the Roth 401(k).
Sure, this rule takes away a valuable tax deduction. But having Roth money going into retirement is not a bad thing. Those high earners with cash flow sufficient to make Roth catch-up contributions should consider doing so.
Additional Resource
Cody Garrett and I did a deep dive on all things retirement planning, including Roth retirement accounts, in Tax Planning To and Through Early Retirement, available on Amazon and many other online sources.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters.Please also refer to the Disclaimer & Warning section found here.
Live in California? Do you wonder “how much personal liability umbrella insurance should I have?”
In this article, I cover the basics of personal liability umbrella insurance and then discuss five principles I believe to be most relevant in deciding how much personal liability umbrella insurance California residents should have.
Insurance for Personal Liabilities
Living our lives generates the possibility of liabilities to others. Accidents happen. It’s part of the human experience.
Most Californians have two primary insurances to guard against personal liability to others.
The first is homeowners insurance. For those who rent, this is renter’s insurance. This insurance can cover things like slip-and-fall accidents inside one’s home or one’s stoop.
The second is auto insurance, specifically liability insurance to third parties.
Often homeowners and auto insurance have limits on the amount of liabilities it will pay to third parties. These could be $300,000 or $500,000 per accident, for example.
In today’s environment, particularly in California, it is very possible that our liabilities to third parties through auto accidents or in-home accidents can exceed these liability caps. Thus, many can and should obtain additional insurance coverage in the form of personal liability umbrella insurance, often referred to as “umbrella insurance.”
Personal Liability Umbrella Insurance
An umbrella policy sits on top of, not “instead of” or “in addition to” primary insurance. Umbrella insurance is generally secondary coverage.
Here is an example of how that works in practice. Oscar has a car and has a $500,000 auto insurance liability policy. Further, Oscar has a $2 million personal liability umbrella policy. Dollars $1 through $500,000 of Oscar’s potential auto liability to third parties would be paid out by the auto policy. Dollars $500,001 through $2 million of liability would be paid out by the umbrella policy
It is not the case that Oscar now has $2.5 million worth of auto liability coverage. Oscar’s $2 million umbrella is not added to his primary auto insurance coverage. Rather, the umbrella fills in coverage up to its limit, in this case $2 million.
You can see that with respect to Oscar, the most likely insurance to pay out is his auto insurance. Say Oscar rear-ends another car and causes $25,000 worth of damage. His auto insurance policy would pay out $25,000 and his umbrella policy would pay $0.
Since umbrella insurance is generally a secondary policy, it tends to be somewhat affordable. That said, in California my experience has been that even umbrella insurance premiums are rising fast as of 2026.
Oftentimes it is logical to bundle home, auto, and umbrella. Carriers often give discounts when consumers bundle.
Umbrella carriers generally require minimum levels for home and auto protection. They don’t want consumers using an umbrella policy as a backdoor home and/or auto policy, so it is quite common for an umbrella carrier to require certain minimum coverage amounts with respect to home and auto policies.
Umbrella insurance is generally offered in million dollar increments. In most cases, insurance companies will issue up to $5 million of umbrella insurance as long as the insured (a) has sufficient minimum home and auto coverage and (b) can write the check. Beyond $5 million generally requires additional underwriting.
Protected Assets and Umbrella Insurance
In theory, if all of one’s wealth was in protected assets in certain states, there’s not much need for any umbrella coverage. The person could be sued, but if every significant asset was protected, at least in theory there would be little to nothing to collect in litigation.
Depending on the state, creditor protected assets often include 401(k) and other ERISA protected retirement accounts. States also offer varying degrees of protection for one’s primary residence. In Florida, the entirety of one’s primary residence value is a protected asset.
Retirement account protection depends on both federal and state law.
Ultimately, the amount of retirement account wealth that will be protected in litigation in California is subjective and dependent on all the facts and circumstances, including whether bankruptcy has been declared. Limited retirement account protection is a risk of living in California.
The amounts protected by California’s homestead exemption vary by county and may not fully cover the value of one’s primary residence.
For Californians, residents of what is generally perceived as a litigious state, the question arises, how much umbrella insurance coverage should I have?
California Umbrella Insurance Principles
I don’t have the silver bullet formula for exactly how much personal liability umbrella insurance you or anyone else should have.
But I have some principles that I believe can be helpful in making that determination. Of course, these five principles are not the only potential considerations one has when determining umbrella insurance coverage level. But I do believe they can be helpful for many Californians.
The Most Important Million is the First Million
In my opinion, the most important million in umbrella coverage is the first million.
Why?
First, a $1 million personal liability umbrella insurance policy covers a significant swath of the liability probability curve.
Generally speaking, the liability probability curve is at its highest at lower levels of monetary liability and slopes down. The greater the amount of monetary liability, the lower the likelihood of incurring it.
Further, consider the practicalities of settlements, as discussed in the second principle. The potential to settle a liability claim at $1 million is very valuable.
Second, it is helpful to have a deep pocket in one’s corner if one has a liability event. The umbrella insurance company is on the hook for a significant amount of money if the insured has a liability event (such as a car accident) and thus has incentive to work through their legal team to limit the ultimate settlement amount. Obviously this is beneficial to the insured.
I look at umbrella insurance coverage level like an elementary school spelling test. When I went to Catholic elementary school, in second grade we had 20 word spelling tests on Friday mornings. Each word was worth 5 points.
For many Californians, having no personal liability umbrella insurance is like getting a 0 on the spelling test, while having $1 million of personal liability umbrella insurance is like getting a 100 on the spelling test.
For some more well-to-do Californians, the $1 million umbrella policy is like getting an 80, 85 or 90 on the spelling test. Increasing umbrella coverage to $2 million, $3 million, $4 million, or $5 million (depending on the circumstances) would get these well-to-do Californians to a 100 score on the test.
Consider Potential Exposure
Perhaps the most important question to ask is “how much could someone sue me for?”
For this reason I believe even the extremely wealthy rarely need more than $5 million worth of personal liability umbrella insurance, even in a litigious state like California.
One can never precisely predict the ultimate outcome of a future dispute. But settlement practicalities, including both sides’ desire to avoid a lengthy and costly legal process, do help define, to a certain degree, potential exposure.
Consider Unprotected Assets
I believe Californians should look at things like taxable accounts, HSAs, high housing values, rental real estate, etc. and consider protecting them with umbrella insurance. As discussed above, the extent to which retirement accounts are protected will depend on various facts and circumstances, including but not limited to whether bankruptcy has been declared.
The extent to which Californians should protect retirement accounts with umbrella insurance is highly subjective and should be considered, in today’s environment, very much in conjunction with the other principles mentioned here.
If In Doubt, Round Up in California
California is a challenging environment when it comes to cost of living, asset protection, litigation, and the like. No one precisely knows exactly how much personal liability umbrella insurance is optimal. Why not round up, not down, on umbrella insurance coverage level if in any doubt?
I believe Californians should frequently revisit coverage levels. People’s circumstances change. California law changes. The frequently evolving landscape both legally and personally strongly suggests Californians should frequently revisit umbrella insurance coverage levels.
Consider Driving Less
Risk mitigation is certainly not limited to personal liability umbrella insurance.
What’s the highest risk personal activity most Californians engage in? It’s easily driving.
Living in California usually requires time behind the wheel. But is every last mile behind the wheel necessary?
A personal anecdote: This Fall I am speaking at and attending a three day financial planner conference in San Diego. My original plan was to drive down from Los Angeles. The problem with that plan is it required 150 miles each way fighting Southern California traffic. That’s 300 miles for me to get into an accident, only to have my car sit in a hotel garage for three days incurring parking fees.
So I chose a different path: I’m taking the Amtrak Pacific Surfliner to and from the conference. I even upgraded (for just $20 each way) to Business Class. Instead of fighting traffic and risking an accident, I’m relaxing in Business Class drinking free coffee, catching up on work and/or listening to the Hindley Street Country Club.
Consideration should be given to taking an Uber or Lyft to the airport instead of driving and parking there. There are marginal tactics like these available that can reduce the miles we drive.
Conclusion
Asset protection is a significant financial planning consideration in California. Personal liability umbrella insurance is one of the best available tools to provide financial protection in the event of an accident. Californians often benefit from having personal liability umbrella insurance. There’s no precise science for determining exactly how much coverage to have. But I hope the five principles I provided in this article are helpful as Californians consider the appropriate level of coverage they should have.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
This post and the presentation (including Q&A) in the YouTube video are for entertainment and educational purposes only. They do not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
Basis in IRAs is a funny thing. It necessitates the Pro-Rata Rule, one of the least understood tax rules affecting financial planning. IRA basis creates all sorts of confusion, making traditional IRAs less user friendly.
Further, the value of basis in a traditional IRA is whittled away by inflation. Basis is generally the undistributed prior after-tax (or nondeductible) contributions in the IRA. Since basis might be distributed or converted years, perhaps decades, after the contribution, and is not increased for inflation, its value diminishes the longer it exists.
Thus, basis isolation techniques gain attention. The idea is to use the basis in an advantageous way to (1) harvest it prior to its value being eroded away by inflation and (2) move basis amounts into Roth IRAs relatively tax free.
Basis Isolation Techniques
The most basic basis isolation technique is a properly done Backdoor Roth IRA. IRA basis is created and quickly used to move money into Roth IRAs. The basis is fully used before inflation can erode its value.
The Backdoor Roth IRA is a simple tactic that, employed over many years, can be tremendously beneficial. It has very little downside risk and is relatively simple to implement.
Another basis isolation tactic is the qualified charitable distribution (“QCD”). This one is even easier than the Backdoor Roth IRA. QCDs do not take IRA basiswhen transferred to a charity. Thus, distributions the taxpayer receives and/or Roth conversions attract more of the available IRA basis to reduce the taxable amount. A small IRA basis benefit, but still helpful.
What about situations where someone has (1) significant basis in an IRA and (2) significant pretax amounts in an IRA? Now we have complexity, risk, and opportunity. The tactic I wrote about which could be useful in this situation is the Basis Isolation Backdoor Roth IRA.
The Basis Isolation Backdoor Roth IRA does the following:
Cleans up IRA basis and uses it before inflation reduces its value.
Creates a Roth IRA the owner can use for tax free withdrawals in retirement.
I believe advisors and IRA owners need to proceed with caution when it comes to the Basis Isolation Backdoor Roth IRA. What initially looks incredibly attractive may turn out to be an unattractive planning technique.
Note that some 401(k) and other qualified plans do not accept roll-ins of IRAs. Some other plans only accept roll-ins of a certain type of IRA, a “conduit IRA.” A conduit IRA is an IRA comprised only of old 401(k)s, 403(b)s, governmental 457s, and other qualified plans and the growth thereon. Thus, plans requiring that the rolled-in IRA be a conduit IRA cannot be used to facilitate isolation of IRA basis created by old nondeductible traditional IRA annual contributions, since the growth on nondeductible traditional IRA contributions is not eligible to be moved over to such plans.
Basis Isolation Backdoor Roth IRA Examples
To analyze whether employing a sophisticated IRA basis isolation technique is advisable, I’m going to present two examples. These examples will illustrate when I favor and when I disfavor using the Basis Isolation Backdoor Roth IRA.
Example 1: Basis Isolation Backdoor Roth IRA into a Large Employer 401(k)
April, age 48 in 2026, works for Apple Inc. She is a participant in their 401(k) plan. In 2022 through 2026 her adjusted gross income was such that she qualified for neither a deductible annual contribution to a traditional IRA nor an annual contribution to a Roth IRA. In 2022 she contributed $6,000 to a traditional IRA. In 2023 she contributed $6,500 to a traditional IRA. In 2024 she contributed $7,000 to a traditional IRA.
All of these contributions were nondeductible. In 2025 April learned about the Backdoor Roth IRA and the Pro-Rata Rule. Thus, she did not make any contributions to a traditional IRA for 2025.
April is planning on retiring in five years. She has a sizable balance in her 401(k). Her taxable brokerage account is worth $100,000, and her traditional IRA is worth $100,000, consisting of (1) the three nondeductible contributions ($19,500 total), (2) a $20,000 401(k) rollover from a former employer plan and (3) investment growth on both 1 and 2. April has no Roth IRAs or health savings accounts.
Only for sake of this analysis, assume Apple’s 401(k) both accepts all IRA roll-ins (other than IRA basis) and offers satisfactory low-cost investment options.
April proceeds as follows:
Step 1: In May 2026, April contacts her IRA custodian and splits her $100,000 traditional IRA into two IRAs. The first is $19,700 invested in a money market account (her basis amount of $19,500 plus a small $200 round up). This IRA is the Leave Behind IRA. The second IRA (IRA 2) is worth $80,300 and can be invested in whatever April desires.
Step 2: April works with the Apple 401(k) plan and her IRA custodian to arrange a direct trustee-to-trustee transfer of IRA 2 from the traditional IRA to April’s Apple 401(k) account.
Step 3: After the completion of Step 2, April converts the entire Leave Behind IRA (now worth $19,900 due to interest accruing on the money market fund) to a Roth IRA. Due to IRA basis isolation, only $400 of the $19,900 is taxable to April on her 2026 federal income tax return.
Steps 1 through 3 are the Basis Isolation Backdoor Roth IRA.
Step 4: April executes the two steps of a 2026 Backdoor Roth IRA, getting another $7,500 (plus a small amount of interest) into her Roth IRA.
Step 5: April ensures that as of December 31, 2026, she has $0 balances in all traditional IRAs, traditional SEP IRAs, and traditional SIMPLE IRAs.
I’m drafting this at the end of the Winter Olympics. Recall that many of the figure skaters make the “heart sign” gesture after their skates. You can feel free to picture me making the heart sign gesture when thinking about April’s Basis Isolation Backdoor Roth IRA.
Why do I like this basis isolation play for April? Let me list the reasons.
Reason One: Helpful to April in early retirement. Recall that April intends to retire at age 53. Recall further that April has just $100,000 in a taxable brokerage account and no Roth IRA or HSA. Steps 1 through 4 create approximately $27,500 in Roth IRA basis that April can access in early retirement prior to age 59 ½ without tax or penalty. Further, the Basis Isolation Backdoor Roth IRA opens up the Backdoor Roth IRA for the last five years of her career, allowing her to create even more Roth IRA basis that can help fund early retirement advantageously from a Premium Tax Credit perspective and an income tax perspective.
Reason Two: Relatively modest IRA transfer. April moves approximately $80,000 of pretax IRA money. Any movement of pretax IRA money involves, however small, an element of risk. While $80,000 is not a tiny sum, it is also not a huge sum. It’s not the lion’s share of April’s wealth. Execution risk is mitigated in April’s case by the modesty of the sum moving into the Apple 401(k).
Reason Three: Using a large employer 401(k). Unless you work at Apple, you, like me, have little insight as to the contours and compliance record of Apple’s 401(k). Regardless, we would be absolutely shocked if we woke up tomorrow morning and read that the IRS and/or the Department of Labor challenged Apple’s 401(k) plan qualification.
Why? Disqualifying Apple’s 401(k) plan would create problems for thousands of voters. Congressmen from multiple Congressional districts, and perhaps even Senators, would strongly question the IRS and/or the Department of Labor about the issue. We know the motivations of the IRS and Department of Labor in this regard. They have every incentive to avoid significant headaches and work with Apple to get to a place where Apple’s 401(k) qualifies as a 401(k).
None of this is to cast aspersions at IRS and/or Department of Labor personnel. It’s simply acknowledging reality. How often do you look to stir up a hornet’s nest at your place of work?
As discussed above, I have absolutely no knowledge or opinion about the qualification of Apple’s 401(k) and/or the quality of the investments in it. I simply raise possibilities and discuss pivotal actors’ motivations to explore planning where one uses a workplace 401(k) to facilitate an IRA basis isolation transaction.
Helping fund early retirement. Relatively low risk of transferring pretax amounts. Parking assets in a stable, established, large employer 401(k) to achieve the objective.
April’s Basis Isolation Backdoor Roth IRA is quite attractive, in my opinion.
Example 2: Basis Isolation Backdoor Roth IRA into a Solo 401(k)
Jack, age 66 in 2026, and his wife, Becky, also age 66 in 2026, retired two years ago. Jack made $80,000 of nondeductible traditional IRA contributions over the years. With rollovers of prior large employer 401(k)s, today Jack’s traditional IRA is worth $2 million. Jack is very happy with the financial institution holding the traditional IRA and the investments offered by that institution.
Jack and Becky currently live off taxable brokerage accounts, currently worth $1 million. Becky also has $500,000 in a traditional IRA with no basis. Neither Jack nor Becky has a Roth IRA or an HSA.
Jack is interested in isolating his $80,000 traditional IRA basis and getting it into a Roth IRA. He’s heard about the Solo 401(k) and is intrigued. He concocts an idea. He will drive for Lyft part time for three months. Doing so brings in $3,000 of revenue. After expenses and a deduction for half of his self-employment taxes, he has $2,000 of net profit.
Jack proceeds as follows:
Step 1: Jack takes the position that he has self-employment income in 2026 and thus opens a Solo 401(k). He makes a maximum $2,000 employee deferral contribution for 2026.
Step 2: In August 2026, Jack contacts his IRA custodian and splits his $2 million traditional IRA into two IRAs. The first is $80,200 invested in a money market account (his basis amount of $80,000 plus a small $200 round up). This IRA is the Leave Behind IRA. The second IRA (IRA 2) is worth $1,920,000 and can be invested in whatever Jack desires.
Step 3: Jack works with the Solo 401(k) plan custodian and his IRA custodian to arrange a direct trustee-to-trustee transfer of IRA 2 from the traditional IRA to Jack’s Solo 401(k) account.
Step 4: After the completion of Step 3, Jack converts the entire Leave Behind IRA (now worth $80,500 due to interest accruing on the money market fund) to a Roth IRA. Due to IRA basis isolation, Jack takes the position that only $500 of the $80,500 is taxable to him on his 2026 federal income tax return.
Steps 2 through 4 are the Basis Isolation Backdoor Roth IRA.
Step 5: Jack ensures that as of December 31, 2026, he has $0 balances in all traditional IRAs, traditional SEP IRAs, and traditional SIMPLE IRAs.
Jack’s Basis Isolation Backdoor Roth IRA makes me feel the way my New York Jets fandom has in recent years. For those unaware, the Jets currently have the longest streak of missing the playoffs in North American major sports.
Why do I disfavor this basis isolation play for Jack? Let me list the reasons.
Reason One: No help solving retirement funding issues. Jack and Becky’s retirement is well funded. Unlike April, they do not need to control income for Premium Tax Credit purposes. Jack and Becky are currently living off taxable accounts. As I have previously discussed, they may pay practically no federal income tax doing so.
Why are Jack and Becky moving a large account and doing sophisticated distribution planning when they already have years of paying hardly any federal income tax?
Reason Two: Large IRA transfer. Jack moves approximately $1.92M of pretax IRA money. Any movement of pretax IRA money involves, however small, an element of risk. $1.92 million is the lion’s share of Jack and Becky’s financial wealth. Execution risk on a $1.92 million transfer ofassets already in a satisfactory location, a traditional IRA with a liked institution, is not something I favor successful retirees affirmatively planning into.
Reason Three: Using a Solo 401(k). Compare the IRS disqualifying Jack’s Solo 401(k) with disqualifying Apple’s Solo 401(k). No Congressman is reaching out to the IRS if they disqualify Jack’s Solo 401(k). Further, the success of Jack’s strategy depends on him successfully maintaining his Solo 401(k) in the future. Rocket science? No. But guaranteed? Also, no.
Is Jack’s Solo 401(k) Valid?
Contributions of Self-Employment Income
I strongly question whether Jack would have a valid Solo 401(k) in this fact pattern. Consider the Congressional intent behind Solo 401(k)s. Solo 401(k)s allow the self-employed to make significant contributionsof self-employment income to retirement accounts. Solo 401(k)s solve for the problem of the self-employed not having access to large employer 401(k) plans.
Jack’s use of a Solo 401(k) is hardly reflective of the intent behind the Solo 401(k). Jack accumulated years of retirement account contributions in a traditional IRA. He had no need for the Solo 401(k) to accumulate and maintain retirement savings. Further, about a tenth of a percent of the Solo 401(k) balance is funded by “self-employment income.” About 99.9 percent of the balance of Jack’s Solo 401(k) has nothing to do with self-employment.
These numbers indicate that Jack’s Solo 401(k) has little to do with contributions of self-employment income to save for retirement.
Is Jack Self-Employed?
As I discussed on page 24 of this article, one needs self-employment to have a Solo 401(k). I strongly question whether Jack’s Lyft driving qualifies as self-employment allowing him to open a Solo 401(k).
Consider making the case to respect Jack’s Lyft activities as “self-employment.” How is a retired person self-employed? What do Jack and Becky live off of? Accumulated retirement assets or Lyft income? That Jack and Becky live off their retirement savings and not off Jack’s Lyft income is instructive in determining whether that income comes from an activity sufficient to be considered a business to allow Jack to have a Solo 401(k).
IRA Basis Isolation and Solo 401(k) Stuffing
I’m not shy when I see the IRS in a weak position. In this article, I strongly argue the IRS has a very weak position if they attempt to enforce the literal terms of Notice 2022-6 governing 72(t) payment plans.
I’m also not shy in acknowledging situations where the IRS may have a strong position. When it comes to stuffing Solo 401(k)s for distribution motivated reasons, I believe the IRS has a strong position. I previously wrote about this when it comes to stuffing a Solo 401(k) for Rule of 55 planning. See pages 24 through 26 of this article.
I believe the IRS would have a high likelihood of success were they to challenge the validity of Jack’s Solo 401(k). Can you imagine taxing a $2 million traditional IRA through an attempted rollover into an invalid Solo 401(k) just to get $80,000 into a Roth IRA?
After considering Solo 401(k) stuffing in the contexts of both the Rule of 55 and the Basis Isolation Backdoor Roth IRA, I’ve come up with Mullaney’s Solo 401(k) Distribution Planning Principle:
Do not use a Solo 401(k) for distribution planning.
Solo 401(k)s can be distributed out of (as I argue in this article), but I disfavor using them to facilitate sophisticated distribution planning such as a Basis Isolation Backdoor Roth IRA.
Fortunately, Solo 401(k)s remain a great option for accumulation planning for the fully self-employed.
Tax Planning and New Businesses
I disfavor tax planning that necessitates the starting of a business to achieve retirement tax benefits.
Picture a financial planner, Jill, recommending to Jane, a self-employed lawyer, that she opens a Solo 401(k). Jill’s recommendation does not necessitate Jane starting a business. Jill simply is recommending a potentially advantageous tactic that Jane’s preexisting business opens the door to.
Contrast Jane’s preexisting business with Jack’s new “business” of Lyft driving. There are legitimate Lyft businesses operated by thousands of Americans. But in Jack’s case, his Lyft activity does not strike me as likely to be considered a trade or business sufficient to open a Solo 401(k).
Even if the Lyft activity is a sufficient trade or business, why do tax planning that requires changes in lived experience when the retiree is already financially successful?
Basis Isolation Backdoor Roth IRA Planning
Factors I view as favorable indicators that the Basis Isolation Backdoor Roth IRA may be a good planning tactic:
Need for Roth basis in early retirement
Relatively modest pretax amounts in traditional IRAs
Possibility of opening up several years worth of Backdoor Roth IRAs
Rolling pretax amounts into a large employer 401(k) with good investment selections
Factors I view as indicative that the Basis Isolation Backdoor Roth IRA should be disfavored:
No compelling need for Roth basis in early retirement
Significant pretax amounts in traditional IRAs
No ability to do future Backdoor Roth IRAs
Rolling pretax amounts into a Solo 401(k)
The necessity to start a business to achieve a tax benefit in retirement
The above are my opinions. None of this should be read as advice for you or anyone else. Further, none of this should be read as to say any previously implemented planning in this regard is “wrong.” Rather, all this is intended to provide is my views as to what is desirable and what is not desirable from a planning perspective.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
Booming stock markets. Job dissatisfaction. The explosion of 401(k)s since the 1980s. The itch to travel. The desire not to worry about Monday morning.
We may be on the threshold of an early retirement boom. Many potential early retirees will find the lion’s share of their financial assets are in a traditional 401(k) or traditional 401(k)s. The concern becomes the 10 percent early withdrawal penalty.
How can I access my retirement accounts prior to age 59 ½ without paying the 10 percent penalty?
Enter the 72(t) payment plan, sometimes called a series of substantially equal periodic payments or “SEPP.” In today’s environment, they are a very viable option for those looking to retire early primarily on traditional retirement accounts.
There is a drawback: impermissible modifications of a 72(t) payment plan trigger the previously avoided 10 percent penalty and related interest charges. This risks potentially paying the IRS thousands of dollars for a misstep.
Of course, the article is not legal or tax advice for you or any other individual.
For those of you who read Tax Planning To and Through Early Retirement, which I recently published with Cody Garrett, CFP(R), please know the article is written differently. The book is very focused on planning covering a plethora of retirement tax planning topics, including planning for 72(t) payment plans. The article is much more akin to a “501” level discussion of the risks of a 72(t) payment plan and the ambiguities in the tax law surrounding 72(t) payment plans.
This post and the linked-to article are for entertainment and educational purposes only. They do not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
Want to retire before age 59 ½? Have most of your wealth in traditional tax-deferred retirement accounts? Worried about the 10 percent early withdrawal penalty?
This post is for you!
Picture it: You’re age 53, have $50,000 in a savings account, a paid-off home, and $2.5M in a 401(k). Including income taxes, you spend about $80,000 a year. You want to retire, but you’re worried about paying the early withdrawal penalty, which would be about $8,000 a year (not factoring in the penalty on the penalty!).
72(t) payments can make retirement possible prior to age 59 ½ when one has most of their assets in traditional deferred retirement accounts. Done properly, these payments avoid the 10 percent early withdrawal penalty.
Below I explore some of the rules of 72(t) payments (sometimes referred to as a “72(t) payment plan,” “72(t) SEPP,” or “SEPP”) and lay out what I hope will be an informative case study.
** As always, none of this is personalized advice for you, but rather educational information for your consideration. Consult with your own advisors regarding your own situation.
72(t) Substantially Equal Periodic Payments
Methods
The IRS and Treasury provide three methods for computing a 72(t) payment. As a practical matter, the third one I discuss, the fixed amortization method, tends to be the most commonly used and most user friendly in my opinion.
The required minimum distribution method allows taxpayers to take a 72(t) payment just like an RMD. Take the prior year end-of-year balance and divide it by the factor off the IRS table. The biggest problems with this method are it tends to produce a smaller payment the younger you are and the payment changes every year and can decrease if the IRA portfolio declines in value. The fixed annuitization method is complex and generally yields a payment less than that of the fixed amortization method from the same sized retirement account.
The rest of the post focuses on the fixed amortization method of computing 72(t) payments (other than a brief foray into the RMD method to account for changing circumstances)).
Resource: The MyFRS 72(t) calculator can be helpful to early retirees and those planning an early retirement. While I have not validated the calculator’s coding, I have never seen it produce results that I know to be incorrect.
Computing Fixed Amortization 72(t) Payments
To compute a 72(t) payment and the size of the 72(t) IRA using the fixed amortization method, we will need to run through some math. Four numbers are required: the interest rate, the life expectancy, the annual payment, and the size of the 72(t) IRA.
Usually the IRS gives us the interest rate and the life expectancy and we need to solve for the 72(t) IRA size.
Interest Rate: Notice 2022-6 allows taxpayers to always use an interest rate anywhere from just above 0% to 5%, or, if greater, up to 120% of mid-term federal rate for either of the two months preceding the first 72(t) payment distribution. The IRS publishes that rate on a monthly basis.
As a general rule, taxpayers will usually want to use the greatest interest rate permitted to as to decrease the size of the 72(t) IRA. Decreasing the size of the 72(t) IRA will usually be advantageous, for the reasons discussed below.
Life Expectancy: The life expectancy comes to us from an IRS table. While we have three possible choices to use, generally speaking taxpayers will want to use the Single Life Table found at Treas. Reg. Section 1.401(a)(9)-9(b). See Choate, referenced below, at page 587. The taxpayer takes their age on their birthday of the year of the first 72(t) payment and uses the factor from the Single Life Table as the life expectancy.
Payment: Finally, we, not the IRS, get to determine a number! The payment is simply the annual payment we want to receive as a 72(t) payment every year. While this amount is rather inflexible, as discussed below it will be possible to establish additional 72(t) IRAs and payments to increase the amount received if desired.
Size of the 72(t) IRA: This is what we’re solving for in order to establish a “right-sized” IRA to produce the desired 72(t) payment. In Google Sheets, we do a present value calculation to solve for the size of the 72(t) IRA that generates the desired payment amount. The formula is rather simple: =-PV(Interest Rate Cell, Life Expectancy Cell, Annual Payment Cell). I put a negative sign in front of the PV to have the size of the 72(t) IRA appear as a positive number. It’s important that the formula be entered in that order and that the formatting be correct in each cell. Further, it is important the interest rate cell has a percentage sign in it.
Validating a Google Sheets 72(t) IRA Calculation: One technique I recommend to validate a 72(t) IRA calculation in Google Sheets is to use the same formula in Google Sheets on the numbers provided by the IRS FAQ 7. I did that on YouTube here. Note that as applied to the IRS numbers, the final 72(t) size is $6.97 off – an immaterial difference caused by the IRS not using cents.
Another technique to consider is, after doing one’s own calculations to redo the same calculations using the MyFlorida Retirement 72(t) Calculator.
Note on 72(t) Payments with non-IRA Accounts: Setting up a 72(t) from a non-IRA is possible but not frequent in practice. It is not possible to divide up a 401(k) account in a manner conducive to establishing a “right-sized” 72(t) payment account. See Choate, referenced below, at page 595.
Annual Equal 72(t) Fixed Amortization Payments
The computed payments must be made annually and equally. This means that no more and no less than the computed payment comes out every year. I believe that taking an annual flat payment on or around the first payment anniversary date is a best practice. However, this best practice is not required. See also Choate, referenced below, at page 600. For example, monthly payments of the computed amount are allowable. See Choate, referenced below, at page 600.
Annual payments must be made for the longer of five years or until the taxpayer reaches age 59 ½.
72(t) Payments Case Study
Let’s return to the example discussed above: it is early January 2026 and you (let’s call you Pat) are 53 years old (your birthday was January 5th) and you want to retire, spending $80K a year from your $2.5M 401(k). Let’s solve for the size of the 72(t) IRA:
The size of the 72(t) IRA is $1,286,384.59. See IRS FAQ Q&A 7.
Pat would first transfer (preferably through a direct trustee-to-trustee transfer) the 401(k) to a traditional IRA worth $2.5M. Once in the traditional IRA, Pat would call their financial institution and ask them to divide the traditional IRA into two IRAs: one with exactly $1,286,384.59 (the “72(t) IRA”) and one with the reminder of the traditional IRA (the “non-72(t) IRA”). I recommend initially investing the 72(t) IRA in a money market fund so that it can be clearly established that the beginning account balance was exactly the $1,286,384.59 computed to yield the correct payment. Pat takes the first payment of $80,000 on January 29th from the 72(t) IRA in this hypothetical scenario.
Let’s keep going. Assume that in 2030, when Pat turns age 57 and interest rates are well below 5%, Pat wants to increase their annual withdrawal from $80K to $90K. As discussed below, Pat can’t simply increase the withdrawal from the 72(t) IRA. But since Pat kept a non-72(t) IRA, Pat can slice that one up to create a second 72(t) IRA. That second 72(t) IRA can give Pat the extra $10,000 Pat wants to spend.
Here’s what that looks like.
Interest Rate: 5.00%
Life Expectancy: 30.6
Payment: $10,000
The size of the second 72(t) IRA is $153,270.74.
Pat would call their financial institution and ask them to divide the non-72(t) IRA into two IRAs: one with exactly $153,270.74 (the “Second 72(t) IRA”) and one with the remainder of the traditional IRA (the surviving non-72(t) IRA). Pat takes the additional payment of $10,000 also on January 28th from the Second 72(t) in this hypothetical scenario.
Here is what Pat’s withdrawals would look like:
Year
Birthday Age
Required First 72(t) January 29 Withdrawal
Required Second 72(t) January 28 Withdrawal
Total Annual Withdrawal
2026
53
$80,000
$0
$80,000
2027
54
$80,000
$0
$80,000
2028
55
$80,000
$0
$80,000
2029
56
$80,000
$0
$80,000
2030
57
$80,000
$10,000
$90,000
2031
58
$80,000
$10,000
$90,000
2032
59
$80,000
$10,000
$90,000
2033
60
$0
$10,000
$10,000
2034
61
$0
$10,000
$10,000
Remember that the First 72(t) IRA and the Second 72(t) are locked up for a period of time. See Locking the Cage below. The First 72(t) IRA is locked up until and through July 4, 2032, the day before Pat’s 59 ½ birthday. The Second 72(t) IRA is locked up until and through January 27, 2035, the day before the fifth anniversary of the first $10,000 payment from the Second 72(t) IRA. See IRS FAQ 13 on this point. Generally speaking, no amount other than the annual payment should go into, or out of, a 72(t) IRA until the end of the lock-up period.
Maintain Flexibility
I strongly recommend maintaining as much flexibility as possible. One way to do that is to have the 72(t) IRA be as small as possible, leaving as much as possible in a non-72(t) IRA or IRAs. Why?
First, the non-72(t) can be, in a flexible manner, sliced and diced to create a second 72(t) IRA if wanted or needed. Second, for a variety of reasons Roth conversions are generally to be avoided out of a 72(t) IRA. While those on a 72(t) payment plan often have little need to do Roth conversions, if they are so inclined they are better done out of a non-72(t) IRA.
Second, it is important to maintain future payment flexibility. Imagine if Pat did not divide the $2.5M traditional IRA into two IRAs. Pat could have simply used a smaller interest rate on the entire $2.5M traditional IRA to get the $80,000 annual payment out. However, then Pat would not have had the flexibility to create a second 72(t) payment stream. This is an important reason that it is usually best to use the highest possible interest rate to lower the 72(t) IRA size and maintain the most flexibility.
72(t) Payment Plan Disqualification
A “modification” to the 72(t) payment plan blows up the plan with unfavorable consequences. In the year of the modification the taxpayer owes the 10 percent early withdrawal penalty plus interest on the penalty on all the previously taken 72(t) payments. See Choate, referenced below, at page 596.
A blow up after age 59 ½, for those on the five year rule, is bad but tends to be less deleterious than a blow up occurring with respect to a SEPP ending at age 59 1/2. The early withdrawal penalty and related interest are not assessed on 72(t) payments taken after one’s 59 ½ birthday. See Choate, referenced below, at page 596.
There are a few modifications to a 72(t) payment plan that do not blow it up (i.e., they are permissible and don’t trigger the penalty and interest). See Choate, referenced below, at pages 597-601. Those looking to change the payment amount are often well advised to set up a second 72(t) payment plan (as Pat did) rather than seeking a modification to the existing 72(t) payment plan.
72(t) Payment Reduction
Imagine that instead of wanting an additional 72(t) payment amount, Pat wanted to reduce the 72(t) payment. This is not uncommon. Perhaps Pat has a significant inheritance in 2030 and thus no longer needs to take an $80,000 annual payment and pay tax on it.
Unfortunately, Pat is not allowed to simply discontinue or reduce the 72(t) payment without triggering the early withdrawal penalty (and interest charges) on the previously taken 72(t) payments.
But, the rules allow a one-time switch to the RMD method. Making the switch is likely to significantly reduce the annual 72(t) payment. For example, if Pat wants a smaller payment starting in 2030, Pat could take the 72(t) IRA balance on December 31, 2029 (imagine it is exactly $1M) and divide it by the age 57 factor off the Single Life Table (29.8) and get a 2030 72(t) payment of $33,557.05. Alternatively, Pat could use the age 57 factor off the Notice 2022-6 Uniform Life Table (41.6) and get a 2030 72(t) payment of $24,038.46.
If Pat makes this one-time switch, Pat will annually compute the 72(t) payment for the remainder of the 72(t) term using the table used in 2030 (see Notice 2022-6 page 6) and the prior-year end-of-year 72(t) IRA balance.
The one-time switch to the RMD method is helpful if the taxpayer wants to significantly reduce their 72(t) annual payment, perhaps because of an inheritance, marriage, YouTube channel blowing up, or returning to work. The availability of this method to reduce required 72(t) payments (if desired) is another reason to keep 72(t) IRAs as small as possible.
72(t) Locking The Cage
The 72(t) IRA should be thought of as a locked cage. No one goes in, and only the 72(t) payment comes out annually. The rigidity with which the IRS treats the 72(t) IRA gives early retirees incentive to use as high an interest rate as possible to get the highest annual payment out of the smallest 72(t) IRA possible.
Just how rigid is the IRS? In one case, the IRS disqualified a 72(t) SEPP because a taxpayer transferred a workplace retirement plan into the 72(t) IRA during the 72(t) payment period. See page 4 of this newsletter (page 4 is behind a paywall). Right, wrong, or other, Notice 2022-6 Section 3.02(e) has not been updated for SECURE 2.0’s adding Section 72(t)(4)(C), which clearly allows for some roll outs from 72(t) IRAs. Thus, this is an area where early retirees should proceed with caution.
Further, the 72(t) lockup does not end with the taking of the last payment. Rather, as described in IRS FAQ 13, it ends at the end of the lock up period. So if Sean, age 57 in 2023, takes his first 72(t) SEPP of $10,000 from IRA 1 on July 15, 2023, his taking of payment number 5 ($10,000) on July 15, 2027 does not end the lock up. Sean can’t take any additional money out of IRA 1 until July 1, 2028 (the fifth anniversary of his first $10,000 72(t) payment).
Practice Point: As of this writing, it is not a good idea to add money to a 72(t) IRA during the lockup period due to Notice 2022-6 Section 3.02(e). This includes never making an annual contribution to a 72(t) IRA and never rolling an IRA, 401(k), or other qualified plan into a 72(t) IRA. Incredibly enough, current IRS guidance prohibits breaking into jail in this regard.
IRS FAQ 13 is instructive in terms of when the lock up ends. The IRS is clear that the lock up ends on the date of the 59 ½ birthday, not on January 1st of that year. Say Rob, born January 14, 1971, takes his first SEPP of $40,000 on August 16, 2023. His 72(t) IRA is free on his 59 ½ birthday, which is July 14, 2030. Presumably, Rob takes his last $40,000 SEPP on or around August 16, 2029. Nevertheless, he can’t add to or withdraw from his 72(t) IRA prior to July 14, 2030 without blowing up his 72(t) payment plan and incurring significant penalties and interest under the approach of IRS FAQ 13.
As discussed above, the one-time switch to the RMD method is a permissible modification to the 72(t) payment terms that does not trigger the early withdrawal penalty and related interest on previously taken 72(t) payments.
A Note on the 72(t) Risk Profile
The earlier in life the 72(t) payment plan starts, the greater the risk profile on the 72(t) payment plan. The opposite is also true: the later in life a 72(t) payment plan starts, the lower the risk profile.
Why?
Because the sooner the 72(t) payment plan starts, the more years (and more interest) that can be blown up by a future modification requiring the payment of the 10 percent early withdrawal penalty and interest.
Consider Pat’s example. If Pat blows up the First 72(t) payment plan in early 2031, Pat owes the 10% early withdrawal penalty and interest on five previously taken 72(t) payments from the First 72(t) IRA (2026 through 2030). If Pat blows up the Second 72(t) payment plan in early 2035, Pat only owes the early withdrawal penalty and interest on the three 72(t) payments received before Pat turned age 59 ½.
In February 2026 I self-published a 38-page article on the risks presented by 72(t) payment plans. You can access the article here.
72(t) Payment Tax Return Reporting
Taxpayers should keep the computations they and/or their advisors have done to document the 72(t) payment plan. Distributions should be reported as taxable income and on Form 5329. Code 02 should be entered on Line 2 of Form 5329.
72(t) Is An Exception to More Than One Rule
72(t) payment plans are an exception to the 10 percent early withdrawal penalty. They are also an exception to the general rule that the IRS views all of your IRAs as a single IRA. The 72(t) IRA is the 72(t) IRA. If you have a separate IRA and take ten dollars out of it prior to age 59 ½, you trigger ordinary income tax and a $1 penalty. If you take an additional ten dollars out of the 72(t) IRA prior to the end of the 72(t) lock up, you blow up the 72(t) payment plan and owe the 10 percent early withdrawal penalty and interest on all the pre-59 ½ 72(t) payments.
Other Penalty Free Sources of Early Retirement Funding
Let’s remember that 72(t) payments are a tool. In many cases they are not a “go-to” strategy. I’ve written this post not because 72(t) payments are a go-to strategy but rather because I know there are many in their 50s thinking about retirement but daunted by the prospect of accessing traditional retirement accounts prior to age 59 ½.
Generally speaking, I encourage using resources other than 72(t) payments if you are able to. They include:
Taxable Accounts: This video discusses why I’m so fond of spending down taxable accounts first in early retirement.
Inherited Retirement Accounts: Withdrawals from inherited retirement accounts (other than those the spouse treats as their own) are never subject to the 10% early withdrawal penalty. Often they are subject to a 10-year draw down rule, so usually they should be accessed prior to implementing a 72(t) payment plan from one’s own accounts.
Rule of 55 Distributions: Only available from a qualified retirement plan such as a 401(k) from an employer the employee separates from service no sooner than the beginning of the year they turn age 55. This is a great workaround from the early withdrawal penalty, and much more flexible than a 72(t) payment plan. But remember, the money must stay in the workplace retirement account (and not be rolled over to a traditional IRA) to get the benefit.
Governmental 457(b) Plans: Withdrawals from governmental 457(b) plans are generally not subject to the 10% early withdrawal penalty.
I previously discussed using a 72(t) payment plan to bail out Roth IRA earnings penalty-free prior to age 59 ½. This is a tactic that I would not recommend unless absolutely necessary (which I believe is a very rare situation).
72(t) Landscape Change
It should be noted that the issuance of Notice 2022-6 in early 2022 changed the landscape when it comes to 72(t) payments. Before the 5 percent safe harbor, it was possible that taxpayers could be subject to sub-0.5 percent interest rates, meaning that it would take almost $1M in a retirement account to generate just $30,000 in an annual payment in one’s mid-50s. Now with the availability of the 5 percent interest rate much more modest account balances can be used to generate significant 72(t) payments in one’s mid-50s.
Sean Mullaney, What are the Risks of a 72(t) Payment Plan?, an article that goes into detail on the risks presented by a 72(t) payment plan and ways to mitigate those risks.
Correction
The previous version of this post published in November 2023 incorrectly used 30.6 as the age 57 factor in one of the calculations. The correct factor is 29.8. I regret the error.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters.Please also refer to the Disclaimer & Warning section found here.
Is earned income required to contribute to an individual retirement account (an “IRA”)? If you’re married, it may not be, thanks to the Spousal IRA.
The Spousal IRA is a great opportunity for families to build financial stability, and perhaps get a juicy tax deduction, even if only one of the spouses work outside of the home. It can help families save for the future, qualify for Premium Tax Credits, and prioritize important goals such as raising children.
IRA Basics
There are two types of IRAs that most working Americans can consider. I did a primer about them here.
A Roth IRA offers no tax deduction on the way in, but features tax-free growth and tax-free withdrawals in retirement.
Both can be a great way to build up tax-advantaged wealth for retirement.
IRA Contribution Limits
The limit on IRA contributions for 2025 is the lesser of $7,000 or earned income ($8,000 or earned income if you are age 50 or older in 2025). The limit on IRA contributions for 2026 is the lesser of $7,500 or earned income ($8,600 or earned income if you are age 50 or older in 2026). Remember that traditional IRAs and Roth IRAs share that contribution limit, so a dollar contributed to a traditional IRA is a dollar that cannot be contributed to a Roth IRA and vice-versa.
IRA Contribution Deadlines
Generally speaking, the deadline to contribute to either a traditional IRA or a Roth IRA is April 15th of the following year. The deadline cannot be extended even if the taxpayer files for an extension to file their own tax return. On rare occasions the IRS may provide a very limited exception to the April 15th IRA contribution deadline.
The Spousal IRA
For purposes of having earned income allowing one to make an IRA contribution (tradition and/or Roth), a non-working spouse can use their spouse’s earned income for purposes of making either (or both) a traditional IRA or a Roth IRA contribution.
Here is an example:
Joe and Mary are married. Joe has a W-2 job and Mary does not. Mary can make an IRA contribution (a Spousal IRA) based on Joe’s W-2 earned income.
The Spousal IRA can be used to increase tax-advantaged retirement savings. It can also be used to strategically optimize tax deductions. Many W-2 workers are covered by a workplace 401(k) plan. Thus, based on low income limits, it is difficult for them to deduct a traditional IRA contribution.
However, when one is not covered by a workplace retirement plan, it is much easier to qualify to deduct a traditional IRA contribution. It is often the case that a Spousal IRA will offer a potential tax deduction when the working spouse is not able to deduct a traditional IRA contribution.
IRA Contributions to Increase Premium Tax Credits
For early retirees, planning for the Premium Tax Credit in order to save thousands of dollars on ACA medical insurance premiums can be a challenge. This is particularly true in 2026 with the return of the 400 percent of federal poverty level cliff. A dollar of income over the 400 percent of federal poverty level cliff could cause a married couple $10,000 of Premium Tax Credits.
One tool in the tool box of those with side hustles or part time jobs in early retirement is the deductible traditional IRA contribution. An example can illustrate how a married couple could use deductible traditional IRA contributions, including a deductible spousal IRA contribution, to qualify for thousands of dollars of Premium Tax Credits.
Larry and Cheryl, both age 55, are retired in 2026. They have capital gains, interest, and dividends in 2026 of $80,000. Cheryl works part time and earns $20,000 in W-2 income. She is not covered by a workplace retirement plan.
Larry and Cheryl’s $100,000 of adjusted gross income puts them above 400% of the 2025 federal poverty level ($84,600). However, they can each make a deductible $8,600 traditional IRA contribution. Larry’s deductible traditional IRA contribution is a Spousal IRA.
Those deductible contributions lower Larry and Cheryl’s adjusted gross income to $82,800, allowing them to qualify for thousands of dollars of Premium Tax Credits for 2026.
Split-Year Spousal IRA Contribution Example
As I write this, the 2026 tax return season (for 2025 tax returns) is about to get started. Now’s the time to be thinking about 2025 IRA contributions if you have not yet made one!
There’s still plenty of time to contribute to an IRA (traditional or Roth) for the year 2025. Some of that planning might involve strategically employing a Spousal IRA. Here’s an example:
It is early April 2026 and Mark and Theresa are about to file their tax returns. They see they have $9,000 in cash available to use to make 2025 IRA contributions. What they might want to do is contribute $7,000 to a 2025 deductible traditional IRA for Theresa (a Spousal IRA) and the remaining $2,000 to a 2025 Roth IRA for Mark, since he cannot deduct a traditional IRA contribution. By prioritizing a tax deduction, Mark and Theresa save $2,191 on their 2025 income taxes.
The Spousal IRA as a Backdoor Roth IRA
The Spousal IRA can be executed as a Backdoor Roth IRA. Here is an example:
Jack and Betty, both age 42, are married. Jack works a W-2 job and Betty does not have earned income. Jack is covered by a 401(k) at work. Their MAGI for 2026 is $265,000 and thus neither of them qualify to make a regular annual contribution to a Roth IRA.
Assuming Betty has no balances in traditional IRAs, SEP IRAs, and SIMPLE IRAs (and thus does not have a Pro-Rata Rule problem), Betty can contribute $7,500 to a nondeductible traditional IRA and then convert that amount (plus any growth) to a Roth IRA. Doing so uses a Spousal IRA to implement a Backdoor Roth IRA.
Spousal IRA Tax Return Reporting
To report a deductible traditional Spousal IRA contribution, the amount of the contribution must be reported on Schedule 1, line 20, filed with the couple’s annual federal income tax return.
To report a nondeductible traditional Spousal IRA contribution, the amount of the contribution must be reported on Part I of the Form 8606.
There is no required federal income tax return reporting for a Roth Spousal IRA contribution. However, such contributions should be entered into the tax return software to help determine the potential eligibility for a retirement savers’ credit.
Conclusion
The Spousal IRA creates a great opportunity for married couples to save for retirement and possibly gain access to valuable tax deductions. It can help married couples focus on important priorities such as child rearing and still make significant contributions to retirement accounts. For the early retired with small amounts of earned income, it can help reduce income in order to qualify for a Premium Tax Credit or increase the amount of a Premium Tax Credit.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, 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.
People worry about taxation in retirement. In particular, they worry about the taxation of required minimum distributions (RMDs), especially after the death of a spouse. Widows find themselves in the single tax brackets after decades of enjoying the more favorable married filing jointly tax brackets.
Widows and widowers finding themselves as single taxpayers is often referred to as the Widow’s Tax Trap.
RMDs require taxable withdrawals from traditional retirement accounts such as IRAs and 401(k)s. But just how bad are they when a widow or widower is in the Widow’s Tax Trap?
Let’s unpack just how bad the combination of the Widow’s Tax Trap and RMDs is for an 81 year-old widow with a very tax inefficient structure: almost $3.7 million of her approximately $4.5 million of financial wealth in a traditional IRA.
My experience tells me many financial planners and gurus will tell you this is a terrible outcome. That $3.7 million traditional IRA is infested with taxes!
But is it really?
81 Year-Old Widow in the Widow’s Tax Trap
I put together an analysis of an affluent widow in the Widow’s Tax Trap. Let’s call her Jane. Her traditional IRA causes her to have an RMD of almost $190,000. Wow!
What are the federal income tax rates on that feared RMD?
Isn’t it remarkable that an 81 year-old widow with almost $3.7 million in a traditional IRA has more of her RMD taxed in the 12 percent tax bracket than in the 32 percent tax bracket?
Despite all the fear of taxation of RMDs, that’s the reality when it comes to a very affluent, very inefficient 81 year-old widow.
Yes, Jane pays IRMAA of approximately $6,500 in two years because of her RMDs. And yes, the RMDs trigger approximately $500 of net investment income tax.
But do either of these have any impact on Jane’s lived experience and financial success?
Absolutely not!
The government scores some Garbage Time Touchdowns on Jane by collecting some IRMAA, some net investment income tax, and some income tax in the 32 percent bracket.
A Garbage Time Touchdown is a late in the game touchdown scored by a team that will lose the game regardless of the touchdown. As a New York Jets fan, sadly I’m an expert in Garbage Time Touchdowns.
Jane has some tax inefficiencies that are just Garbage Time Touchdowns.
Think about the lifetime arc of Jane’s taxes in today’s tax planning world:
As a single individual, Jane likely deducted workplace retirement plan contributions at a 22, 24, or 32 percent rate. Win versus the IRS!
As a married couple, Jane and her husband likely deduct into workplace retirement plans at a 22 or 24 percent rate. Win versus the IRS!
In early retirement, they live off taxable accounts and do not do Roth conversions. They may pay nothing in federal income tax! Win versus the IRS!
Once taxable accounts are depleted, traditional retirement account distributions could have benefitted from the Hidden Roth IRA. Win versus the IRS!
Even RMDs are likely subject to the 12 percent and 22 percent brackets while they are both alive. Win versus the IRS!
As a widow, the relatively minor tax inefficiencies creep in. These are Garbage Time Touchdowns.
This arc, which eschewed Roth 401(k) contributions and taxable Roth conversions, screams “Jane wins a blow out victory over the IRS” over the course of her lifetime.
Sure, at the end Jane gave up some Garbage Time Touchdowns to the IRS, but not after decades of defeating the IRS.
What’s more important than winning the spreadsheet is lived experience. Notice that Jane paying 32 percent on about six percent of her RMD has $200K of after-tax cash flow?
In order for the Widow’s Tax Trap to bite hard, the widow generally has to have about $200K or more of after-tax cash flow.
The taxes bite when widows can most afford them!
Watch me break down the tax analysis of our 81 year-old widow on YouTube.
Roth Conversions to Avoid the Widow’s Tax Trap
Should Jane and her husband have done taxable Roth Conversions in retirement to avoid the widow paying 32 percent federal income tax on some of her RMDs?
Here vocabulary becomes very important. Yes, some taxable Roth conversions taxed at 22 percent or 24 percent could have been beneficial. But they were hardly necessary.
Outside of cases where taxable Roth conversions create enough required income to qualify for a Premium Tax Credit, taxable Roth conversions are not necessary.
Yes, there are times where large taxable Roth conversions can be beneficial in that they mitigate harmful effects of the Widow’s Tax Trap. But the analysis above shows that the harmful effects of the Widow’s Tax Trap aren’t all that harmful for the vast, vast, vast majority of Americans. This is true even those with most of their financial wealth in traditional retirement accounts.
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.
The Christmas season (ending January 11th this year) coincides with the beginning of personal finance’s Backdoor Roth IRA season.
Many readers look forward to New Year’s Day not to watch the Rose Bowl but rather to contribute to a traditional IRA, the first step of the Backdoor Roth IRA.
The question then becomes: how long should I wait to do the second step of the Backdoor Roth IRA, the conversion of the traditional IRA contribution and any small growth to a Roth IRA?
Below I discuss my views on the matter as they apply to 2026 Backdoor Roth IRAs.
Backdoor Roth IRA Timing Concerns
The Backdoor Roth IRA involves three accounts and two steps. First, the investor transfers money from a bank account (A) to a traditional IRA (B) as a regular annual contribution to the traditional IRA. Second, the investor converts the entire traditional IRA balance to a Roth IRA (C).
Written out logically, the Backdoor Roth IRA sequence is as follows:
A→B→C
The question is “do we respect the transfer to B or do we disregard the transfer to B and say, instead, that there was a single transfer from A to C?
Michael Kitces, in 2015, wrote an article stating that he was, at that time, concerned that, if the Roth conversion step was done close in time to the traditional IRA contribution, the transfer to the traditional IRA would be disregarded. For high income individuals, this would create an excess contribution to a Roth IRA subject to a 6% annual penalty.
I do not share his concern. My perception is that most financial planners, financial advisors, and tax return preparers also do not share his concern.
My Approach
I wrote a detailed blog post stating that I do not believe the step transaction doctrine invalidates the Backdoor Roth IRA. Of particular note is Section 408(d)(2)(B), which provides that all IRA distributions (including Roth conversions) during the year are aggregated into a single distribution.
This rule tells us that timing within the year is irrelevant for determining tax treatment. Why would a judicial doctrine change the Backdoor Roth IRA’s tax treatment based on a timing concern when the Code itself says timing is irrelevant?
Favored Backdoor Roth IRA Timing
Here is my favored approach: Make the traditional IRA contribution at any time during a particular month and then wait until the following calendar month to do the Roth conversion step. Usually the traditional IRA is invested in a low yielding stable cash or cash equivalent type of asset, creating a small bit of income in between the two steps.
Here is how that plays out with an example:
Keith, age 47, wakes up on New Year’s Day 2026 and contributes $7,500 to a traditional IRA invested in a money market fund. On February 2, 2026, when the traditional IRA has grown to $7,525, he converts all of it to a Roth IRA.
Yes, Keith could have converted the $7,500 to a traditional IRA on January 2, 2026. I would strongly argue that he has a good Backdoor Roth IRA in that scenario.
But my favored approach is for him to wait until February. Why not? What’s the downside to my favored approach? Practically none. My favored approach increases Keith’s taxable income by $25, which is obviously no big deal. It also buys Keith a bit more protection against the step transaction doctrine concern (which, admittedly, I believe to be a minimal concern).
Backdoor Roth IRA Diligence
Allow me to touch on two important diligence points when doing the Backdoor Roth IRA.
The first is to ensure that as of December 31st of the year of any Roth conversion step (so 2026 in Keith’s example), it is important to have $0 (or close to $0) in all traditional IRAs, SEP IRAs, and SIMPLE IRAs. For more discussion as to why that’s important, see this post.
Second, it is important to properly complete the Form 8606 and file it with the annual federal income tax return. This post has an example of how a Form 8606 is completed to reflect a Backdoor Roth IRA.
Further Reading
In early 2026 many Americans will find they made too much to have made their 2025 Roth IRA contribution. Having contributed in 2025, they now need to remedy the overcontribution. Further, they may still want to do a Backdoor Roth IRA for 2025 in 2026, what I refer to as a Split-Year Backdoor Roth IRA.
Read here to find out my favored approach when facing this situation.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, investment, medical, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, investment, medical, and tax matters. Please also refer to the Disclaimer & Warning section found here.
There are two primary ways to correct this situation. They are a recharacterization and a corrective distribution. Both are entirely valid remedial paths when it turns out that one contributed to a Roth IRA and their income was too high to have done so.
But which remedial path makes the most sense if the investor wants to also do a Backdoor Roth IRA for the year in question?
As I am posting this in late 2025, this is about to become very relevant as applied to excess Roth IRA contributions occurring in 2025. Many will find out in early 2026 as they work through their 2025 tax return that they did not qualify for a previously made 2025 Roth IRA contribution.
Below I explore this topic with two examples.
Recharacterization
Let’s consider Rich and Rebecca, married and both age 48 in 2025. At least one of them was covered by a workplace retirement plan in 2025. Rich and Rebecca each contributed $7,000 to a Roth IRA on January 2, 2025 anticipating their 2025 modified adjusted gross income would be approximately $225,000. Due to a year-end bonus and unexpected capital gains distributions, their 2025 MAGI turned out to be $250,000, which they discovered after talking to their income tax return preparer in February 2026.
Having exceeded the 2025 Roth IRA MAGI contribution limit of $246,000, they need to remedy the situation. Since neither of them has any balance in a traditional IRA, SEP IRA, and/or SIMPLE IRA, they are also interested in doing a Backdoor Roth IRA for 2025 (what I refer to as a Split-Year Backdoor Roth IRA).
They proceed as follows. First, they ask their financial institution to recharacterize their 2025 Roth IRA contributions and related earnings ($550 in Rich’s case, $600 in Rebecca’s case) as traditional IRAs in late February 2026. This event does not create any 2025 or 2026 taxable income.
Second, in early March 2026, Rich converts the balance in his traditional IRA, now $7,560, from his traditional IRA to a Roth IRA. Likewise, Rebecca converts the balance in her traditional IRA, now $7,612 from her traditional IRA to a Roth IRA. This creates $560 of 2026 taxable income for Rich and $612 of 2026 taxable income for Rebecca.
I believe that it’s helpful to illustrate the sequence logically using letters. A is a checking account, B is a traditional IRA, and C is a Roth IRA.
Here is how the entire sequence looks when Rich and Rebecca first contribute to a Roth IRA, correct it through a recharacterization, and then do the Split-Year Backdoor Roth IRA.
A→C→B→C
Corrective Distribution
Let’s consider Carl and Debbie, married and both age 47 in 2025. At least one of them was covered by a workplace retirement plan in 2025. Carl and Debbie each contributed $7,000 to a Roth IRA on January 2, 2025 anticipating their 2025 modified adjusted gross income would be approximately $225,000. Due to a year-end bonus and unexpected capital gains distributions, their 2025 MAGI turned out to be $255,000, which they discovered after talking to their income tax return preparer in February 2026.
Having exceeded the 2025 Roth IRA MAGI contribution limit of $246,000, they need to remedy the situation. Since neither of them has any balance in a traditional IRA, SEP IRA, and/or SIMPLE IRA, they are also interested in doing a Backdoor Roth IRA for 2025.
They proceed as follows. First, they ask their financial institution to send them a corrective distribution of their 2025 Roth IRA contributions and related earnings ($650 in Carl’s case, $700 in Debbie’s case) in late February 2026.
Second, in late February 2026, both Carl and Debbie make a $7,000 contribution to their traditional IRAs and code the contribution as being for 2025.
Third, Carl converts the balance in his traditional IRA, now $7,010, from his traditional IRA to a Roth IRA. Likewise, Debbie converts the balance in her traditional IRA, now $7,010, from her traditional IRA to a Roth IRA. This creates $10 of 2026 taxable income for Carl and $10 of 2026 taxable income for Debbie.
Both Carl and Debbie have $0 balances in all traditional IRAs, SEP IRAs, and SIMPLE IRAs as of December 31, 2026.
Here is how the entire sequence looks when Carl and Debbie first contribute to a Roth IRA, correct it through a corrective distribution, and then do the Split-Year Backdoor Roth IRA.
A→C→A→B→C
Critical Assessment
Let’s step back. Logically, what is the Backdoor Roth IRA? It boils down to the following formulation:
A→B→C
I and others have argued that “B” should be respected. I’m unaware that the IRS disagrees with this view. At this point, after a decade and a half of Backdoor Roth IRAs, it would be exceedingly odd for the IRS to start aggressively challenging the transaction.
Assessing the Corrective Distribution Remedial Path
Viewed logically, the “corrective distribution followed by the Split-Year Backdoor Roth IRA” is just as strong as the Backdoor Roth IRA itself. It simply appends two additional transactions, an (ultimately excess) Roth IRA annual contribution followed by a corrective distribution. If one can defend the Backdoor Roth IRA, one should be able to defend the corrective distribution followed by the Split-Year Backdoor Roth IRA.
You might argue that the money was in a Roth IRA and ultimately ends up back in a Roth IRA. That can be true, though the investor need not use the exact same dollars received in the corrective distribution to initiate the later Split-Year Backdoor Roth IRA.
Regardless, in order to “collapse” steps, the IRS would need to successfully defeat not one, but two, steps. First the IRS would need to successfully disregard the corrective distribution on which the investor most likely reports taxable income. Second, the IRS would need to disregard the transfer to the traditional IRA.
The IRS has not aggressively tried to disregard a single step (the traditional IRA contribution) when it comes to the Backdoor Roth IRA transaction for the past 15 years. It’s difficult to imagine the IRS would try to aggressively disregard two distinct steps, which is what it would take to defeat the “corrective distribution followed by the Split-Year Backdoor Roth IRA” path.
Assessing the Recharacterization Remedial Path
Where I get much more concerned is the “recharacterization followed by the Backdoor Roth IRA” path.
In all of these analyses, the key issue is “do we respect “B”?” Recall the recharacterization followed by the Backdoor Roth IRA formulation:
A→C→B→C
Notice what’s on both sides of B?
C!
We have a case where funds are in a Roth IRA, temporarily rest in a traditional IRA, and then end up right back in a Roth IRA.
Yes, the Internal Revenue Code allows recharacterizations. But could the IRS successfully disregard a recharacterization into a traditional IRA when both immediately before and immediately after those funds are in a Roth IRA?
I believe that a recharacterization followed by a Split-Year Backdoor Roth IRA dramatically increases the risk to the investor. The risk is that the recharacterization would be disregarded, exposing the investor to the annual 6% excess Roth IRA contribution penalty.
Favored Approach
I strongly favor the corrective distribution remedial path if one is looking to do a Backdoor Roth IRA after having made an excess contribution to the Roth IRA for the year.
What are the drawbacks to my favored approach? It requires three steps instead of two, since the investor must initiate the corrective distribution, contribute to a traditional IRA, and then convert the traditional IRA.
Further, my favored approach generally accelerates the tax on the “net income attributable” to the excess contribution. Recall Rich and Rebecca pay that tax in 2026 while Carl and Debbie pay practically all of that tax with their 2025 federal income tax returns.
My favored approach generally does not increase the small tax created by the combination of the remediation and the Split-Year Backdoor Roth IRA. It simply accelerates it by one year. In a low yield world, that is a tiny drawback.
I believe that the corrective distribution remedial path is very strong. I do not believe that the IRS would stand a very good chance of disregarding two steps to create an excess contribution to a Roth IRA. Further, I believe that respecting time spent in a traditional IRA is much more challenging when that money is in a Roth IRA immediately before and immediately after being in the traditional IRA.
When both corrective distributions and recharacterizations are available to those looking to ultimately do a Backdoor Roth IRA, why not choose the corrective distribution path?
Finally, note that this blog post is not advice for you or anyone else. I am not writing that the recharacterization remedial path cannot work. Rather, I am, in an academic sense, simply stating two things.
First, the recharacterization followed by a Split-Year Backdoor Roth IRA path increases the risk to the investor.
Second, the corrective distribution path appears to be preferable to the recharacterization path if one is looking to do the Split-Year Backdoor Roth IRA after an excess contribution to the Roth IRA for the same year.
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, investment, medical, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, investment, medical, and tax matters. Please also refer to the Disclaimer & Warning section found here.
