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.
One thing I like about the Financial Independence community is that members are not beholden to Conventional Wisdom.
Many in the Establishment believe retirement is for 65 year olds (and some basically think it’s not for anyone).
My response: Oh, heck no!
Sure, some people have jobs they very much enjoy. If that’s the case, then perhaps retirement isn’t your thing in your 50s. But many in the FI movement have accumulated assets such that they no longer have a financial need to work. Perhaps their job is not all that enjoyable – it happens. Or perhaps their job won’t exist in a year or two – that happens too.
The tax rules require some planning if one retires prior to turning age 59 ½. Age 59 ½ is the age at which the pesky 10 percent early withdrawal penalty no longer applies to tax-advantaged retirement account distributions.
Thus, there’s a need to consider what to live off of once one is age 59 ½. Below I list the possibilities in a general order of preference and availability. Several of these options (perhaps many of them) will simply not apply to many 50-something retirees. Further, some retirees may use a combination of the below discussed options.
Listen to Sean discuss accessing money in retirement prior to age 59 ½ on a recent ChooseFI episode! Part Two on the ChooseFI podcast is coming soon.
Taxable Accounts
The best retirement account to access if you retire before age 59 ½ isn’t even a “retirement” account: it’s a taxable account. I’m so fond of using taxable accounts first in retirement I wrote a post about the concept in 2022.
The idea is to use some combination of cash in taxable accounts (not at all taxable – it’s just going to the ATM!) and sales of brokerage assets (subject to low long term capital gains federal income tax rates) to fund your pre-59 ½ retirement. This keeps taxable income low and sets up potential additional tax planning.
Pros: Because of tax basis, living off $100,000 of taxable brokerage accounts doesn’t cause $100,000 of taxable income. Further, long term capital gains receive very favorable federal income tax treatment. Some may even qualify for the 0% long term capital gains tax rate!
But that’s not all. There are significant creditor protection benefits to living off taxable assets first. As we spend down taxable assets, we are reducing those assets that are most vulnerable to potential creditors. By not spending down tax-advantaged retirement accounts, we are generally letting them grow, thus growing the part of our balance sheet that tends to enjoy significant creditor protection. Note that personal liability umbrella insurance is usually a good thing to consider in the creditor protection context regardless of tax strategy.
Spending taxable assets first tends to limit taxable income, which can open the door to (1) a significant Premium Tax Credit in retirement (if covered by an Affordable Care Act medical insurance plan) and (2) very tax advantageous Roth conversions in early retirement.
There’s also a big benefit for those years after we turn 59 ½. By spending down taxable assets, we reduce future “uncontrolled income.” Taxable accounts are great. But they kick off interest, dividends, and capital gains income, even if we don’t spend them. By reducing taxable account balances, we reduce the future income that would otherwise show up on our tax return in an uncontrolled fashion.
Cons: To my mind, there are few cons to this strategy in retirement.
The one con in the accumulation phase is that when we choose to invest in taxable accounts instead ofin traditional deductible retirement accounts we forego a significant tax arbitrage opportunity. That said, these are not mutually exclusive. Members of the FI community can max out deductible retirement account contributions and also build up taxable accounts.
Ideal For: Someone who is able to save beyond tax-advantaged retirement accounts during their working years. This is the “ideal” for financial independence in my opinion, though it may be challenging for some.
Inherited Retirement Accounts
Withdrawals from inherited retirement accounts (other than those the spouse treats as their own) are never subject to the 10% early withdrawal penalty. Often they are subject to a 10-year drawdown rule, so usually they should be accessed prior to using many other draw down techniques.
Pros: If it’s a traditional retirement account inherited from a parent or anyone else more than 10 years older than you are, you generally have to take the money out within 10 years. Why not just live on that money? Simply living on that money, instead of letting the traditional inherited retirement grow for ten years, avoids a “Year 10 Time Bomb.” The time bomb possibility is that the inherited traditional retirement account grows to a huge balance that needs to come out in the tenth full year following death. Such a large distribution could subject the recipient subject to an abnormally high marginal federal income tax rate.
Cons: Not very many other than if the account is a Roth IRA, using the money for living expenses instead of letting it grow for 10 years sacrifices several years of tax free growth.
Ideal For: Someone who has inherited a retirement account prior to turning age 59 ½.
This is a great way to avoid the early withdrawal penalty. But remember, the money must stay in the workplace retirement account (and not be rolled over to a traditional IRA) to get the benefit.
Pros: Funds retirement prior to age 59 ½ without having to incur the 10 percent early withdrawal penalty.
Whittles down traditional retirement accounts in a manner that can help reduce future required minimum distributions (“RMDs”).
Cons: You’re handcuffed to the particular employer’s 401(k) (investments, fees, etc.) prior to age 59 ½. Review the plan’s Summary Plan Description prior to relying on this path to ensure flexible, periodic distributions are easily done after separation from service and prior to turning age 59 ½.
Limited availability as one must separate from service no sooner than the year they turn age 55.
Creates taxable income (assuming a traditional account is used), which is less than optimal from a Premium Tax Credit and Roth conversion perspective.
Ideal For: Those with (1) large balances in their current employer 401(k) (or other plan), (2) a quality current 401(k) or other plan in terms of investment selection and fees, (3) a plan with easily implemented Rule of 55 distributions, and (4) plans to retire in their mid-to-late 50s.
Governmental 457(b) Plans
Withdrawals from governmental 457(b) plans are generally not subject to the 10% early withdrawal penalty. This is the Rule of 55 exception but they deleted the “55” 😉
Like the Rule of 55, this is only available so long as the governmental 457(b) is not rolled to a traditional IRA.
Pros: Funds retirement prior to age 59 ½ without having to incur the 10 percent early withdrawal penalty. If you have a governmental 457(b), it’s better than the Rule of 55 because you don’t have to worry about your separation from service date.
Whittles down traditional retirement accounts in a manner that can help reduce future RMDs.
Cons: You’re handcuffed to the particular employer’s 457 (investments, fees, etc.) prior to age 59 ½. Review the plan’s Summary Plan Description prior to relying on this path to ensure flexible, periodic distributions are easily done after separation from service and prior to turning age 59 ½.
Creates taxable income (assuming a traditional account is used), which is less than optimal from a Premium Tax Credit and Roth conversion perspective.
Ideal For: Those (1) with large balances in their current employer governmental 457(b) and (2) a quality current governmental 457(b) in terms of investment selection and fees.
Roth Basis
Old annual contributions and conversions that are at least 5 years old can be withdrawn from Roth IRAs tax and penalty free at any time for any reason. This can be part of the so-called Roth Conversion Ladder strategy, though it does not have to be, since many will have Roth Basis going into retirement.
Pros: Roth Basis creates a tax free pool of money to access prior to turning age 59 ½.
Cons: We like to let Roth accounts bake for years, if not decades, of tax free growth. Using Roth Basis in one’s 50s significantly reduces that opportunity.
Some may need taxable income in early retirement to qualify for Premium Tax Credits. Relying solely on Roth Basis can be much less than optimal if Premium Tax Credits are a significant part of one’s early retirement plan.
Roth 401(k) contributions, for many workers, are disadvantageous in my opinion. Many Americans will forego a significant tax rate arbitrage opportunity if they prioritize Roth 401(k) contributions over traditional 401(k) contributions.
Ideal For: Those with significant previous contributions and conversions to Roth accounts.
72(t) Payments
I did a lengthy post on this concept. The idea is to create an annual taxable distribution from a traditional IRA and avoid the 10 percent early withdrawal penalty.
Pros: Avoids the early withdrawal prior to turning age 59 ½.
Whittles down traditional retirement accounts in a manner that can help reduce future RMDs.
Inside a traditional IRA, the investor controls the selection of financial institutions and investments and has great control on investment expenses.
Cons: This opportunity may require professional assistance to a degree that many of the other concepts discussed do not.
There is a risk that if not done properly, previous years’ distributions may become subject to the 10 percent early withdrawal penalty and related interest charges.
Creates taxable income, which is less than optimal from a Premium Tax Credit and Roth conversion perspective.
Ideal For: Those with most of their financial wealth in traditional deferred retirement accounts prior to age 59 ½ and without easy access to other alternatives (such as the Rule of 55 and/or governmental 457(b) plans.
HSA PUQME
Withdrawals of Previously Unreimbursed Qualified Medical Expenses (“PUQME”) from a health savings account are tax and penalty free at any time for any reason. Thanks to ChooseFI listener and correspondent Kristin Smith for suggesting the idea to use PUQME to help fund retirement in one’s 50s.
Pros: Withdrawals of PUQME creates a tax free pool of money to access prior to turning age 59 ½.
Reduces HSA balances in a way that can help to avoid the hidden HSA death tax in the future.
Cons: This is generally a limited opportunity. The amount of PUQME that can be used prior to age 59 ½ is limited to the smaller of one’s (1) PUQME and (2) HSA size. Because HSAs have relatively modest contribution limits, in many cases HSA PUQME withdrawals would need to be combined with one or more of the other planning concepts to fund retirement prior to age 59 ½.
We like to let HSAs bake for years, if not decades, of tax free growth. Using HSA PUQME in one’s 50s significantly reduces that opportunity.
Some may need taxable income in early retirement to qualify for Premium Tax Credits. Relying on PUQME can be less than optimal if Premium Tax Credits are a significant part of one’s early retirement plan.
Ideal For: Those with significant HSAs and significant PUQME.
Net Unrealized Appreciation
Applies only to those with significantly appreciated employer stock in a 401(k), ESOP, or other workplace retirement plan. I’ve written about this opportunity before. That employer stock with the large capital gains can serve as a “Capital Gains IRA” in retirement. Retirees can possibly live off sales of employer stock subject to the 0% long term capital gains rate.
This opportunity usually requires professional assistance, in my opinion.
The move of the employer stock out of the retirement plan into a taxable brokerage account (which sets up what I colloquially refer to as the “Capital Gains IRA” may need to be paired with the Rule of 55 (or another penalty exception) to avoid the 10 percent early withdrawal penalty on the “basis” of the employer stock.
Pros: Moves income from “ordinary” income to “long term capital gains” income, which can be very advantageous, particularly if one can keep their income entirely or mostly in the 0% long term capital gains marginal bracket.
Cons: Remember Enron? NUA is essentially Enron if it goes fabulously well instead of failing spectacularly.
Employer stock is problematic during the accumulation phase since your finances are heavily dependent on your employer without a single share of employer stock. People make their finances more risky by having both their income statement and their balance sheet highly dependent on a single corporation.
It keeps the retiree heavily invested in the stock of their former employer, which is much less than optimal from an investment diversification perspective.
Another con is that this usually requires professional assistance (and fees) to a much greater degree than several of the other withdrawal options discussed on this post.
Ideal For: Those with large balances of significantly appreciated employer stock in a workplace 401(k), ESOP, or other retirement plan.
Pay the Penalty
The federal early withdrawal penalty is 10 percent. For those in California, add a 2.5 percent state penalty. For some, perhaps the best idea is to simply bite-the-bullet and pay the early withdrawal penalty. That said, anyone accessing a tax-advantaged retirement account in a way not covered above should always consult the IRS list to see if perhaps they qualify for one of the myriad penalty exceptions.
Pros: Why let a 10 percent penalty prevent you from retiring at age 58 if you have sufficient assets to do so and you might be looking at a year or two of the penalty, tops?
Whittles down traditional retirement accounts in a manner that can help reduce future RMDs.
Cons: Who wants to pay ordinary income tax and the early withdrawal penalty? Even for those close to the 59 ½ finish line, a 72(t) payment plan for five years might be a better option and would avoid the penalty if properly done.
Ideal For: Those very close to age 59 ½ who don’t have a more readily available drawdown tactic to use. That said, even these retirees should consider a 72(t) payment plan, in my opinion.
Combining Methods to Access Funds Prior to Age 59 1/2
For some, perhaps many, no single one of the above methods will be the optimal path. It may be that the optimal path will involve combining two or more of the above methods.
Here’s an example: Rob retires at age 56. He uses the Rule of 55 to fund most of his living expenses prior to turning age 59 ½. Late in the year, he finds that a distribution from his traditional 401(k) would push him up into the 22% federal income tax bracket for the year. Thus, for this last distribution he instead elects to take a recovery of Roth Basis from his Roth IRA. This allows him to stay in the 12% marginal federal income tax bracket for the year.
Conclusion
Don’t let anyone tell you you can’t retire in your 50s. If you have reached financial independence, why not? Of course, you will need to be very intentional about drawing down your assets and funding your living expenses. This is particularly important prior to your 59 1/2th birthday.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
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.
Some retiring in their 50s will need to use a 72(t) payment plan. This often involves establishing a “72(t) IRA” and a “non-72(t) IRA.”
People wonder “how do you allocate your portfolio when you have a 72(t) payment plan?”
Below we tackle 72(t) IRAs from a tax basketing perspective. Most investors in the financial independence community want some allocation to bonds and some to equities.* Thus, questions emerge for those employing a 72(t) payment plan: what should be in my 72(t) IRA? What should be in my non-72(t) IRA?
* This post simply takes that as an assumption and is not investment advice for you or anyone else.
Watch me discuss portfolio allocation for 72(t) payments plans on YouTube.
72(t) Example
Monty, age 53, has a $2M traditional 401(k), $10,000 in a savings account, and a paid off house. He wants to retire and take his first annual $80,000 72(t) payment in February 2023. Monty also wants to have a 75/25 equity/bond allocation.
First, Monty would need to transfer his 401(k) to a traditional IRA (preferably through a direct trustee-to-trustee transfer).
Once the 401(k) is in the traditional IRA, Monty needs to split his traditional IRA into two traditional IRAs, one being the 72(t) IRA (out of which he takes the annual 72(t) payment) and one being the non-72(t) IRA.
To determine the size of the 72(t) IRA, Monty uses the commonly used fixed amortization method and decides to pick the following numbers:
With those three numbers, Monty can do a calculation (see IRS Q&A 7 and my YouTube video on the calculation) and determine that the 72(t) IRA should be $1,170,848.59. Thus, the non-72(t) IRA should be $829,151.41.
72(t) Portfolio Allocation
How does Monty allocate the 72(t) IRA and the non-72(t) IRA such that (1) his overall financial asset portfolio ties out to the desired 75/25 allocation and (2) he is as tax optimized as possible.
I believe that Monty should aim to keep his 72(t) IRA as small as possible. Why? Because it is possible that Monty will not need his 72(t) payment at some point prior to turning age 59 ½.
Perhaps Monty inherits $300,000 when he is age 57. At that point, he can use that money to fund his lifestyle until age 59 ½. Why does he want to keep paying taxes on the $80,000 annual 72(t) payment?
Since Monty has decided to invest in equities and bonds, I believe that Monty should house his bonds inside his 72(t) IRA. While there are absolutely no guarantees when it comes to investment returns, equities tend to grow more than bonds. Since bonds tend to be lower growth, they are a great candidate for the 72(t) IRA.
It would stink if Monty wanted to reduce his annual 72(t) payment only to find that a 72(t) IRA composed entirely of equities had skyrocketed in value, increasing the amount of his revised annual payment under the RMD method.
Thus, I believe that Monty should put his entire bond allocation, $500,000, inside his 72(t) IRA. That makes the rest of the tax basketing easy: have the entire non 72(t) IRA be invested in equities, and have the remainder of his 72(t) IRA, $670,849, be invested in equities.
72(t), Sequence of Returns Risk, and Safe Withdrawal Rate
One must remember that 72(t) is entirely a tax concept. At least in theory, it has nothing to do with sequence of returns risk and safe withdrawal rate.
Some might look at the 72(t) IRA, $1,170,848.59, and say “Wait a minute: an $80K withdrawal is way more than 4% or 5% of that 72(t) IRA! Isn’t this a dangerous withdrawal rate? Doesn’t this amplify the sequence of returns risk?”
Remember, Monty’s withdrawal rate is $80,000 divided by the entire $2M portfolio (4%), not $80,000 divided by the $1,170,848.59 72(t) IRA. Further, Monty’s sequence of returns risk on this withdrawal rate exists regardless of the 72(t) plan. The greater the overall withdrawal rate, the greater the sequence of returns risk.
Lastly, the 5.79% interest rate Monty chooses has nothing to do with the withdrawal rate. It has everything to do with keeping the size of the 72(t) IRA as small as possible. The chosen interest rate doesn’t change the amount of the annual withdrawal ($80,000) but rather changes the size of the 72(t) IRA.
Conclusion
Tax basketing should be considered when crafting a 72(t) payment plan. I generally believe that investments that are less likely to have substantial gains sit better inside an investor’s 72(t) IRA rather than their non-72(t) IRA.
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.
Net unrealized appreciation is a tax planning opportunity that applies to the gain attributable to employer stock inside an employer retirement plan. Plans that can have employer stock in them include 401(k) plans and employee stock ownership plans (ESOPs).
Growth in tax deferred retirement accounts is great. But it comes with a cost: ordinary income tax on that growth. The tax code has one major exception: Net Unrealized Appreciation! The idea is this: an employee can transfer, in-kind, any employer stock from the employer retirement account to a taxable brokerage account.
Instead of the entire amount being subject to ordinary income tax, only the “basis,” i.e., the historic cost, of the stock is subject to ordinary income tax. The growth is only subject to capital gains tax when the stock is later sold. Obviously, if there has been a significant gain in the stock, NUA treatment, instead of ordinary income tax treatment on that growth, will be advantageous.
“In-kind” Transfer: An “in-kind” transfer is a transfer of the exact same thing. In this case, it is a transfer of the exact employer stock owned within the employer plan. Selling that stock and repurchasing it shortly thereafter blows the NUA planning opportunity.
NUA Planning Example
Mark works at Acme Corporation. Inside his Acme retirement account he has $1M worth of Acme stock. He and Acme paid $100,000 for that stock.
Mark is 53 years old and leaves employment at Acme. His NUA opportunity is as follows: he can transfer all his Acme retirement accounts invested in assets other than Acme stock to IRAs (or a new employer’s retirement account) and transfer, in-kind, the Acme stock to a taxable brokerage account (the “NUA distribution”).
Mark creates a $100,000 income hit on this year’s tax return and will owe the 10% early withdrawal penalty (unless he qualifies for an exception) if he does this. However, the $900K of capital gains in that Acme stock gets two big tax benefits. First, it will never be subject to RMDs. Second, when the Acme stock is sold that gain will be taxed at capital gains rates instead of ordinary income tax rates. That is a tremendous advantage to using the NUA strategy.
Does NUA Treatment Make Sense?
NUA does not always make sense when it comes to employer stock in retirement accounts. In fact, in most cases it is likely not to make sense. You saw in Mark’s example there was a real price to pay: ordinary income tax and the possible 10 percent early withdrawal penalty.
What if, instead of paying $100K for the Acme stock over the years, Mark and Acme had paid $700K? There’s no way Mark should use NUA treatment to get $300K of gain into capital gains tax when it would trigger immediate taxation on $700,000 and a $70,000 penalty!
But if the “basis” number is low, being subject to the 0%, 15%, and 20% marginal capital gains tax on the employer stock gain inside the plan can be a great outcome.
First up is the transfer of the employer stock from the workplace retirement plan to a taxable brokerage account (the NUA distribution). This must be an in-kind transfer by the employer plan of the employer stock to the taxable brokerage account.. The NUA distribution results in some amount of taxable income. The employer plan issues a Form 1099-R to report the NUA distribution. The Form 1099-R reports the gross distribution amount in Box 1. The taxable amount reported in Box 2a. The Box 2a amount is the amount that the employee and employer contributed to buy the employer stock and is taxable in the year of the NUA distribution. The Net Unrealized Appreciation, the difference between Box 1 and Box 2a, is reported in Box 6. The Net Unrealized Appreciation is the gain that will be subject to long-term capital gains rates in any post-NUA distribution sale of the employer stock.
Reporting on the Taxpayer’s Form 1040
On the individual’s Form 1040 tax return, the gross distribution will be reported on the line for pensions & annuities (line 5a for the tax year 2023 Form 1040), with the taxable amount showing on line 5b.
Now, what about that 10% early withdrawal penalty? There are several exceptions, all of which are reported on Form 5329, Part 1. If, for example, Mark was 55 years old when he left his employment at Acme, qualifies for exception 01 – separation from service distribution in or after the year of reaching 55 (age 50 for qualified public safety employees).
Disposition of Employer Stock
Information Reporting to the Taxpayer and the IRS
These transactions are reported on Form 1099-B. This form will include the number of shares sold, the date they were sold, and the proceeds from the sale.
Reporting on the Taxpayer’s Form 1040
When the employer stock is actually sold, two gains on the sale of that stock must be recognized. The first is the net unrealized appreciation in the employer stock. That amount is crystalized at the time of the NUA distribution from the plan to the taxable account. This gain is always a long-term capital gain, regardless of when the post-distribution sale occurs. The gain is reported by the taxpayer on Form 8949 and Schedule D.
There is a second potential gain. It could be a gain or a loss. It is the amount of the increase (or decrease) in value the stock has experienced since the NUA distribution into the taxable account.
Continuing with Mark’s example, assume the NUA distribution occurred on January 16, 2024. At that time, Mark owned 1,000 Acme shares, each worth $1,000 and each with Net Unrealized Appreciation of $900. On February 20, 2024, Mark sells 40 Acme shares for $1,040 each. This triggers two gains: $36,000 of Net Unrealized Appreciation ($900 NUA times 40), which is taxed as long term capital gain, and $1,600 of short term capital gain ($40 times 40), which is taxed as ordinary income.
Post-NUA Distribution Losses
What if, instead of a post-NUA distribution gain, there’s a loss? The loss simply reduces the NUA recognized on each sale. For example, if Mark’s sale of 40 shares on February 16, 2024 was for $960 per share, the NUA triggered on each share is $860 per share instead of $900 per share.
As part of the NUA process, all the other qualified plan assets need to be transferred to a traditional IRA (or Roth IRA if there are Roth qualified plan assets). Assuming this occurs via a direct trustee-to-trustee transfer, it is reported on Form 1099-R with a box 7 code “G” (direct rollover). Box 1 of the 1099-R will indicate the gross distribution, and box 2a, Taxable amount, will be $0, since it’s a direct rollover.
Reporting on the Taxpayer’s Form 1040
On the individual’s tax return, the gross distribution should show up on the line for pensions and annuities (line 5a for the tax year 2023 Form 1040), with $0 showing on line 5b for taxable amount.
Conclusion
For the right situation, NUA is a potentially great tax planning opportunity. For those taking advantage of the opportunity, it is important to get the tax return reporting correct. We leave with one parting thought: those considering NUA are usually well advised to consider working with professional advisors, and those who have implemented an NUA planning process often benefit from working with a professional tax return preparer.
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, investment, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
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 and prioritize other 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 2023 is the lesser of $6,500 or earned income ($7,500 or earned income if you are age 50 or older in 2023). The limit on IRA contributions for 2024 is the lesser of $7,000 or earned income ($8,000 or earned income if you are age 50 or older in 2024). 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.
Split-Year Spousal IRA Contribution Example
As I write this, the 2024 tax return season (for 2023 tax returns) is about to get started. Now’s the time to be thinking about 2023 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 2023. Some of that planning might involve strategically employing a Spousal IRA. Here’s an example:
It is early April 2024 and Mark and Theresa are about to file their tax returns. They see they have $8,500 in cash available to use to make 2023 IRA contributions. What they might want to do is contribute $6,500 to a 2023 deductible traditional IRA for Theresa (a Spousal IRA) and the remaining $2,000 to a 2023 Roth IRA for Mark, since he cannot deduct a traditional IRA contribution. By prioritizing a tax deduction, Mark and Theresa save $2,034.50 on their 2023 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 2024 is $260,000 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 $7,000 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.
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.
SECURE 2.0, passed in December 2022, made dozens of changes to the rules governing tax-advantaged retirement accounts.
When Congress passes a major tax law change, the IRS and Treasury issue regulations and other guidance regarding the change. Practitioners and taxpayers often provide the IRS and Treasury comment letters bringing issues and concerns to the government’s attention.
I wrote a comment letter (which you can read here) to the IRS and Treasury addressing facets of the following provisions:
This post (and the linked-to comment letter) is 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) 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 usually requires actuarial assistance, making it more complicated and less desirable. See Choate, referenced below, at page 587.
We will focus the rest of the post on the fixed amortization method of computing 72(t) payments (other than a brief foray into the RMD method to account for changing circumstances)).
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.
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 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.
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 November 2023 and you (let’s call you Pat) are 53 years old (your birthday was June 8th) 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 $1,236,012.95. 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 $1,236,012.95 (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 $1,236,012.95 computed to yield the correct payment. Pat takes the first payment of $80,000 on November 29th from the 72(t) IRA in this hypothetical scenario.
Let’s keep going. Assume that in 2027, when Pat turns age 57 and interest rates are well below 5%, Pat wants to increase their November 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 $155,059.55.
Pat would call their financial institution and ask them to divide the non-72(t) IRA into two IRAs: one with exactly $155,059.55 (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 November 29th 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) November 29 Withdrawal
Required Second 72(t) November 29 Withdrawal
Total Annual Withdrawal
2023
53
$80,000
$0
$80,000
2024
54
$80,000
$0
$80,000
2025
55
$80,000
$0
$80,000
2026
56
$80,000
$0
$80,000
2027
57
$80,000
$10,000
$90,000
2028
58
$80,000
$10,000
$90,000
2029
59
$80,000
$10,000
$90,000
2030
60
$0
$10,000
$10,000
2031
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 December 7, 2029, the day before Pat’s 59 ½ birthday. The Second 72(t) IRA is locked up until and through November 28, 2032, 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, it is not abundantly clear what happens when a 72(t) IRA is used for partial Roth conversions. See Choate, referenced below, at page 384. As Ms. Choate discusses, the only clarity we have is that if the entire 72(t) IRA is Roth converted, the taxpayer must continue to take withdrawals from the Roth IRA for the remainder of the 72(t) term. Doing so limits the benefit of doing Roth conversions in the first place, since we usually want Roth converted amounts to stay in a Roth IRA to facilitate many years of tax-free growth.
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 2027 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 2027, Pat could take the 72(t) IRA balance on December 31, 2026 (imagine it is exactly $1M) and divide it by the age 57 factor off the Single Life Table (29.8) and get a 2027 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 2027 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 2027 (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). Imagine paying penalties and interest on old 72(t) payments for what is seemingly an unrelated rollover!
Remember, the “series of substantially equal periodic payments” requires not just an annual payment. It requires that the 72(t) IRA be locked up. Assuming one is using the fixed amortization method for their 72(t) payments, not a dollar more than the 72(t) SEPP should come out each year. It appears the IRS expects the amount to be equal each tax year, see page 5 of this PLR.
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: Never add money to a 72(t) IRA during the lockup period. 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.
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.
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 2028, Pat owes the 10% early withdrawal penalty and interest on five previously taken 72(t) payments from the First 72(t) IRA (2023 through 2027). If Pat blows up the Second 72(t) payment plan in 2032, Pat only owes the early withdrawal penalty and interest on the three 72(t) payments received before Pat turned age 59 ½.
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: I’m so fond of using taxable accounts first in retirement I wrote a post about the concept in 2022.
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.
What if Pat’s 401(k) contained significant amounts of employer stock? What if that employer stock had significantly appreciated in value since the time Pat and/or Pat’s employer contributed that stock? If so, a 72(t) payment plan may not be ideal. Rather, Pat may want to work with Pat’s advisor(s) to look into a separate and distinct tax planning opportunity, net unrealized appreciation (“NUA”).
I collaborated with Andrea MacDonald to discuss the tax return reporting requirements for NUA here.
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.
If you have basis in an IRA, you will want to read this post. Basis in an IRA creates all sorts of confusion, but it also presents a great planning opportunity for many of those still working. I refer to this opportunity as the Basis Isolation Backdoor Roth IRA.
Where Does IRA Basis Come From?
Basis in a traditional IRA generally emerges from two sources. The first source is old nondeductible traditional IRA contributions that have not been Roth converted or withdrawn. Nondeductible traditional IRA contributions should be reported on a Form 8606 filed with one’s annual federal income tax return.
Many times this basis is simply exhausted annually by Backdoor Roth IRAs. Here’s a quick example:
Example 1: Becky contributed $6,500 to a traditional, nondeductible IRA on January 2, 2023. On February 1, 2023, when the traditional IRA was worth $6,504, she converted the entire traditional IRA balance to a Roth IRA. On December 31, 2023, she had $0 in all traditional IRAs, SEP IRAs, and SIMPLE IRAs. She successfully completed the Backdoor Roth IRA, which created $6,500 of IRA basis on January 2nd and exhausted all $6,500 of that basis on February 1st.
However, there are plenty of Americans who have existing and remaining IRA basis because they can’t do the Backdoor Roth IRA efficiently, or they never did the Backdoor Roth IRA.
To sum up, those doing annual tax-efficient Backdoor Roth IRAs tend not to have any IRA basis at year-end. But some Americans do have existing and remaining IRA basis.
There are Americans with existing IRA basis through transfers from a 401(k) (or other qualified plan) to a traditional IRA. However, going forward this should generally not occur. The IRS and Treasury issued Notice 2014-54, which provides that after-tax 401(k) contribution amounts can be rolled directly to a Roth IRA. From a planning perspective, after-tax 401(k) contributions (and other qualified plan after-tax contributions) should generally be directed into Roth IRAs if the plan participant prefers to exit the plan for IRAs (at retirement or a job change, for example).
Example 2: Chris is age 53. He leaves employment at Consolidated Industries, Inc. on November 1, 2023. At that time, he had a traditional 401(k) at Consolidated worth $500,000. During his time at Consolidated, Chris made $75,000 of after-tax contributions to the traditional 401(k) which remain in the traditional 401(k). Chris prefers to manage the money himself in an IRA or IRAs. Thus, he has two options:
Option One: Transfer the money (preferably through a direct trustee-to-trustee transfer) to a single traditional IRA. Chris now has $75,000 of traditional IRA basis.
Option Two: Transfer (preferably through direct trustee-to-trustee transfers) the after-tax money $75,000 to a Roth IRA and $425,000 to a traditional IRA. The $75,000 goes into the Roth IRA as a nontaxable conversion contribution (see also Notice 2014-54 Example 4). Chris receives no basis in his traditional IRA.
Which option is better for Chris? Clearly it is Option Two, which gives Chris tax-free growth on his $75,000. Further, Chris can withdraw the $75,000 from the Roth IRA tax and penalty free at any time while Chris would be subject to the hard bite of the Pro-Rata Rule if he used Option 1 and later withdrew $75,000 from the traditional IRA. Thus, while Chris is allowed to roll his $75K 401(k) basis into a traditional IRA, he would be much better served to roll the basis tax-free into a Roth IRA.
A Current Employer Qualified Plan That Accepts Rollovers
In order to have an IRA basis isolation opportunity, one must be currently employed by an employer with a qualified plan (often a 401(k)) that accepts IRA roll-ins. Many qualified plans accept IRA roll-ins but not all do.
One should generally employ the Basis Isolation Backdoor Roth IRA if they have a 401(k) or other qualified plan at work they are satisfied with from both an investment choice standpoint and a fee standpoint. If one isn’t satisfied with their workplace retirement plan the Basis Isolation Backdoor Roth IRA may not be a good tactic to employ.
Comprehensive Basis Isolation Backdoor Roth IRA Case Study
Having addressed the two prerequisites to do a Basis Isolation Backdoor Roth IRA, let’s dive in with a comprehensive case study.
Imagine Ray has two (and only two) traditional IRAs. IRA 1 is a $100K traditional IRA rollover from an old 401(k). No basis came along in the rollover into IRA 1. IRA 2 is a traditional IRA worth $25K. It was established with three $6K nondeductible traditional IRA contributions for 2020 through 2022. He filed Forms 8606 reporting those contributions.
Ray’s current employer (Acme) has a great 401(k) that accepts roll-ins of traditional IRAs. What could Ray do to take advantage of his traditional IRA basis? He will need to isolate that basis, and that’s where the Basis Isolation Backdoor Roth IRA comes in.
Step 1
Ray transfers IRA 1 to the Acme 401(k), preferably through a direct trustee-to-trustee transfer.
Step 2
Ray invests about $18,010 of IRA 2 in a money market account and invests the remainder of IRA 2 in any investment of his choice (Mutual Fund A).*
By putting that $18,000 and a bit of change in a money market, Ray makes sure he “leaves behind” the IRA basis in the IRA! We will come back to why this “leave behind” asset is so critically important in the Step 3 discussion and analysis.
* As a practical matter, it may be easier to split IRA 2 into IRA 2 and IRA 3, with the $18,010 in IRA 2 and Mutual Fund A in IRA 3. Either path can work, but splitting into IRA 2 and IRA 3 may be the easier path.
Step 3
Ray transfers Mutual Fund A to the Acme 401(k), preferably through a direct trustee-to-trustee transfer.
If the $18,010 was invested in an equity mutual fund (call it Mutual Fund B), there’s a risk that when Ray does Step 3 he will leave behind only Mutual Fund B, which could be less than his $18K basis if Mutual Fund B declines in value.
Example 3: Imagine Ray does Step 3 when Mutual Fund A is worth $10K and Mutual Fund B, originally worth $18K is now only worth $14K based on market declines. In such a case, $4K of basis would (theoretically) move into the Acme 401(k) with the $10K going from IRA 2 to the Acme 401(k). That would be a prohibited transfer of basis.
IRA Aggregation: Remember that for tax purposes, the IRS looks at all of Ray’s traditional IRAs (whether he has one or ten) as a single traditional IRA. We can’t say that basis attaches to IRA 2 only, so it is important that Ray leave at least $18K behind in an IRA so that after the transfers from his IRAs to qualified plans he can demonstrate that his basis was left behind in one or more of his traditional IRAs.
Step 4
Step 4: Ray converts the entire remaining balance in IRA 2 (likely to be $18,010 plus a bit of additional interest) to a Roth IRA. The only taxable amount is the small amount over $18,000.
Step 4 is reported on a Form 8606 (Parts 1 and 2).
The Benefits of the Basis Isolation Backdoor Roth IRA
Ray has moved approximately $107K from traditional IRAs to the Acme 401(k). That is entirely tax free and does not change the future tax treatment of that money. Perfectly fine, but by itself this doesn’t improve Ray’s tax position.
Before this planning, Ray had $18K of IRA basis that was of limited value due to the Pro-Rata Rule. Future taxable distributions or conversions from his traditional IRAs would have picked up only a small portion of that $18K, meaning that it would only protect small portions of future distributions and conversions from current taxation.
Example 4 The Pro-Rata Rule Bites Ray: If Ray had $18K of basis and $125K of total traditional IRAs and decided to do a $10K Roth conversion (without first doing the Basis Isolation Backdoor Roth IRA), approximately $1,440 of that Roth conversion would have been tax free and approximately $8,560 would have been taxable. See the mock Form 8606 Part I here and Form 8606 Part II here (though note that tax return software programs may use a separate statement instead of actually completing the form).
But with the Basis Isolation Backdoor Roth IRA Ray puts $18K plus into a Roth IRA and paid almost no tax to do so! Ray successfully isolated all $18,000 of basis to get it all into a Roth IRA without being adversely affected by the Pro-Rata Rule. Further, that $18,000 can now grow tax free for the rest of Ray’s life. Previously, inside a traditional IRA that $18,000 was growing tax-deferred, not tax free.
The Basis Isolation Backdoor Roth IRA improved Ray’s position by getting around the Pro-Rata Rule to get $18K plus into a Roth IRA for hardly any income tax. The only tax Ray pays is on the small amount the conversion amount in Step 4 exceeds $18,000.
The Basis Isolation Backdoor Roth IRA also opens another future tax planning opportunity. Going forward, Ray can do annual Backdoor Roth IRAs in a tax-efficient manner because he cleaned out his traditional IRAs into his workplace 401(k).
Practical Considerations
The Basis Isolation Backdoor Roth IRA is not a tactic to be affirmatively planned into. Rather, it is a clean up tactic. It makes the best of a situation where one has both basis and pretax amounts in traditional IRAs. The Backdoor Roth IRA is an affirmative planning technique, though it may require similar clean-up steps prior to implementation.
This planning is sophisticated and benefits from professional assistance. I recommend that most work with a professional if they are considering this sort of planning. Further, this planning does not occur every day. My experience suggests that most professionals are unfamiliar with this type of planning. Professionals will need to review resources such as this blog post and other sources and measure two or three times to dot I’s and cross T’s on this type of planning.
Of course, this blog post is not advice for the reader or any particular individual.
Additional IRA Basis and IRA Basis Isolation Resource
I went into detail on this planning in a June 2023 Measure Twice Planners presentation. While the presentation is mostly geared towards advisors, I hope I presented it in such a way that layman can also understand much of it and get value from it. The presentation and its slides, like this particular post, are for educational purposes only and are not intended as advice for any particular individual.
Conclusion
Existing basis in IRAs is a planning opportunity if the investor has a good workplace 401(k) or other qualified plan that accepts IRA roll-ins. That planning requires intention and diligence, and measuring two or three times, even if working with a professional.
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, 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.
There are some new developments in the world of the Solo 401(k). Here are the highlights:
New Solo 401(k) Employee Contributions Limit for 2024
The IRS announced that for 2024, the employee deferral limit for all 401(k)s, including Solo 401(k)s, will be $23,000.
Solo 401(k) Catch-Up Contributions Limit for 2024
The IRS also announced that for 2024, the employee deferrals catch-up contribution limit remains $7,500. As a result, those aged 50 or older can contribute, in employee contributions, a maximum of the lesser of $30,500 ($23,000 plus $7,500) or earned income.
New Solo 401(k) All Additions Limit for 2024
The new all-additions limit for Solo 401(k)s is $69,000 (or earned income, whichever is less). For those aged 50 or older during 2024, the $66,000 number is $76,500 ($69,000 plus $7,500).
Wither Roth Employer Contributions?
One of the changes SECURE 2.0 ushered in was allowing Roth employer contributions to 401(k) plans, including Solo 401(k)s. Interestingly enough, three of the largest institutions offering Solo 401(k)s, Fidelity, Schwab, and Vanguard, have not added that feature to their Solo 401(k)s. Vanguard’s website goes so far as to affirmatively state it will not add the Roth employer contribution feature to their Solo 401(k) at this time.
I mention this development to inform the reader, not to criticize Solo 401(k) providers. If you’ve read some of my other work, you may know I don’t think a lack of Roth employer contributions in Solo 401(k)s is a problem.
UPDATE March 2, 2024: Today I learned that Schwab now offers Roth employee contributions (a change) and Roth employer contributions (also a change). Based on this January 21, 2024 post, I suspect this change occurred prior to the federal district court’s publishing of its decision in Texas v. Garland on February 27, 2024.
Ambiguity on New Schedule C Solo 401(k) Funding Deadline
UPDATE December 14, 2023: I Tweeted a thread about the provision that allows Schedule C solopreneurs to establish and fund a new Solo 401(k) with an employee deferral contribution after year-end. There is at least some concern that if one is diligent enough to establish a new Solo 401(k) prior to year-end they might not get the benefit of Section 401(b)(2)‘s funding deadline extension. If that is true (and to my mind this is an ambiguous issue), then the solopreneur establishing the new Solo 401(k) prior to year-end would need to either fund the employee contribution prior to year-end or elect to make an employee deferral contribution prior to year-end.
UPDATE March 2, 2024: There’s new uncertainty when it comes to the new Solo 401(k) establishment deadline for Schedule C solopreneurs looking to make a first-time employee contribution. A federal district court in Texas held on February 27, 2024, in Texas v. Garland, that the House of Representatives did not have a sufficient Quorum when it passed the Omnibus, which includes SECURE 2.0 and the Solo 401(k) deadline extension in SECURE 2.0 Section 317. Here’s my X/Twitter thread on the case and here’s my YouTube video on the case. Stay tuned to my YouTube channel for future updates!
2024 Update to Solo 401(k): The Solopreneur’s Retirement Account
Solo 401(k): The Solopreneur’s Retirement Account explores the nooks and crannies of Solo 401(k)s. On page 16 of the paperback edition, I provide an example of the Solo 401(k) limits for 2022 if a solopreneur makes $100,000 of Schedule C income. Here is a revised version (in italics) of the example (with the footnote omitted) applying the new 2024 employee contribution limit:
Lionel, age 35, is self-employed. His self-employment income (as reported on the Schedule C he files with his tax return) is $100,000. Lionel works with a financial institution to establish his own Solo 401(k) plan and choose investments for the plan. Lionel can contribute $23,000 to his Solo 401(k) as an employee deferral (2024 limit) and can choose to contribute, as an employer contribution, anywhere from 0-20% of his self-employment income.
Lionel’s maximum potential tax-advantaged Solo 401(k) contribution for 2024 is $41,587! That is a $23,000 employee contribution and a $18,587 employer contribution. Note there’s no change in the computation of the employer contribution for 2024 in this example.
On page 18 I provide an example of the Solo 401(k) contribution limits factoring in catch-up contributions. Here’s the example revised for 2024:
If Lionel turned 50 during the year, his limits are as follows:
Employee contribution: lesser of self-employment income ($92,935) or $30,500: $30,500
Employer contribution: 20% of net self-employment income (20% X $92,935): $18,587
Overall contribution limit: lesser of net self-employment income ($92,935) or $76,500: $76,500
Amazon Reviews
If you have read Solo 401(k): The Solopreneur’s Retirement Account, you can help more solopreneurs find the book! How? By writing an honest, objective review of the book on Amazon.com. Reviews help other readers find the book!
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, 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.
There are only three types of annual contributions to individual retirement accounts (“IRAs”). They are:
Traditional, nondeductible contributions
Traditional, deductible contributions
Roth contributions
This post discusses when a taxpayer can make one or more of these types of annual contributions.
Let’s dispense with what we are not talking about. This post has nothing to do with annual contributions to employer retirement plans (401(k)s and the like) and self-employed retirement plans. We’re only talking about IRAs. The Individual in “IRA” is the key – anyone can set up their own IRA. IRAs are not pegged to any particular job or self-employment.
The above list is the exhaustive list of the possible types of annual contributions you can make to an IRA. But there is plenty of confusion about when you are eligible to make each of the three types of annual contributions.
Why Contribute to an IRA?
Before we dive into annual contributions to IRAs, let’s discuss why you would consider contributing to an IRA. The main reason is to build up tax-deferred wealth (traditional IRAs) and/or tax-free wealth (Roth IRAs) for your future, however you define it: financial independence, retirement, etc. A second potential benefit is the ability to deduct some annual contributions to traditional IRAs. A third benefit is some degree of creditor protection. States offer varying levels of creditor protection to traditional IRAs and Roth IRAs, while the federal government provides significant bankruptcy protection for traditional IRAs and Roth IRAs.
IRA Annual Contribution Requirement: Earned Income
In order to make any of the three types of IRA annual contributions for any particular year, you or your spouse must have earned income during that year. Earned income is generally that income that is reported to you on your Form W-2, or is reported by you on your tax return on Schedule C (self-employment income). It also includes self-employment income reported to you on a Form K-1 (because you are a self-employed partner in a partnership). It does not include income reported to you on a Form K-1 from an S corporation.
While wages, nontaxable combat income, and self-employment income qualify as earned income for this purpose, several types of income do not. Social security, pensions, rentals, royalties, interest, and dividends are not earned income. Income excluded from taxable income under the foreign earned income exclusion also does not constitute “earned income” for IRA purposes.
Traditional Nondeductible IRA Annual Contributions
There’s are only one requirement to contribute to a traditional, nondeductible IRA for a taxable year:
You and/or your spouse have earned income during that taxable year.
That’s it! As long as you satisfy that requirement, you can contribute to a traditional nondeductible IRA, no further questions asked.
Example: Teve Torbes is the publisher of a successful magazine. He is paid a salary of $1,000,000 in 2024 and is covered by the magazine’s 401(k) plan. Teve can make up to a $7,000 nondeductible contribution to a traditional IRA, and Teve’s wife can also make up to a $7,000 nondeductible contribution to a traditional IRA.
There is no tax deduction for contributing to a traditional nondeductible IRA. The amount of your nondeductible contribution creates “basis” in the traditional IRA. When you withdraw money from the traditional IRA in retirement, a ratable portion of the withdrawal is treated as a return of basis and thus not taxable (the “Pro-Rata Rule”).
Example: Ted makes a $6,000 nondeductible traditional IRA contribution for each of 10 years ($60,000 total). When he retires, the traditional IRA is worth $100,000, and he takes a $5,000 distribution from the traditional IRA. Ted is over 59 ½ when he makes the withdrawal. Of the $5,000 withdrawal, Ted will include $2,000 in his taxable income, because 60 percent ($3,000 — $60,000 basis divided by $100,000 fair market value times the $5,000 withdrawn) will be treated as a withdrawal of basis and thus tax free.
Traditional nondeductible IRA contributions generally give taxpayers a rather limited tax benefit. However, since 2010 traditional nondeductible IRA contributions have become an important tax planning tool because of the availability of the Backdoor Roth IRA.
Making a nondeductible IRA contribution requires the filing of a Form 8606 with your federal income tax return.
Traditional Deductible IRA Annual Contributions
In order to make a deductible contribution to a traditional IRA, three sets of qualification rules apply.
ONE: No Workplace Retirement Plan
Here are the qualification rules if neither you nor your spouse is covered by an employer retirement plan (401(k)s and the like and self-employment retirement plans):
You and/or your spouse have earned income during that taxable year.
That’s it! As long as you satisfy that requirement and you and your spouse are not covered by an employer retirement plan, you can make a deductible contribution to a traditional IRA, no further questions asked.
Example: Teve Torbes is the publisher of a successful magazine. He and his wife are 45 years old. He is paid a salary of $1,000,000 in 2024. Neither he nor his wife is covered by an employer retirement plan. Teve can make up to a $7,000 deductible contribution to a traditional IRA, and Teve’s wife can also make up to a $7,000 deductible contribution to a traditional IRA.
TWO: You Are Covered by a Workplace Retirement Plan
Here are the deductible traditional IRA qualification rules if you are covered by an employer retirement plan:
You and/or your spouse have earned income during that taxable year.
Your modified adjusted gross income (“MAGI”) for 2024 is less than $87,000 (if single), $143,000 (if married filing joint, “MFJ”), or $10,000 (if married filing separate, “MFS”).
Note that in between $77,000 and $87,000 (single), $123,000 and $143,000 (MFJ) and $0 and $10,000 (MFS), your ability to make a deductible contribution to a traditional IRA phases out ratably. Here is an illustrative example.
Example: Mike is 30 years old, single, and is covered by a 401(k) plan at work. Mike has a MAGI of $82,000 in 2024, most of which is W-2 income. Based on a MAGI in the middle of the phaseout range, Mike is limited to a maximum $3,500 deductible contribution to a traditional IRA.
Assuming he makes a $3,500 deductible IRA contribution, Mike has $3,500 worth of IRA contributions left. He can either, or a combination of both (up to $3,500) (a) make a contribution to a nondeductible traditional IRA, since he meets the qualification requirement to contribute to a nondeductible traditional IRA or (b) make a contribution to a Roth IRA, since he meets the qualification requirements (discussed below) to contribute to a Roth IRA. In such a case, Mike would be likely to favor a Roth IRA contribution over a nondeductible traditional IRA contribution.
THREE: Only Your Spouse is Covered by a Workplace Retirement Plan
Here are the deductible traditional IRA qualification rules if you are not covered by an employer retirement plan but your spouse is covered by an employer retirement plan:
You and/or your spouse have earned income during that taxable year.
Your MAGI for 2024 is less than $240,000 (MFJ) or $10,000 (MFS).
Note that in between $230,000 and $240,000 (MFJ) and $0 and $10,000 (MFS), your ability to make a deductible contribution to a traditional IRA phases out ratably.
Roth IRA Annual Contributions
Here are the Roth IRA annual contribution qualification rules.
You and/or your spouse have earned income during that taxable year.
Your MAGI for 2024 is less than $161,000 (single), $240,000 (MFJ), or $10,000 (MFS).
Note that in between $146,000 and $161,000 (single), $230,000 and $240,000 (MFJ), and $0 and $10,000 (MFS), your ability to make a Roth IRA contribution phases out ratably.
Notice that whether you and/or your spouse are covered by an employer retirement plan (including a self-employment retirement plan) is irrelevant. You and your spouse can be covered by an employer retirement plan and you can still contribute to a Roth IRA (so long as you meet the other qualification requirements).
Here is an example illustrating your options in the Roth IRA MAGI phaseout range.
Example: Mike is 30 years old, single, and covered by a workplace retirement plan. Mike has a MAGI of $155,000 for 2024, most of which is W-2 income. Based on a MAGI 60 percent through the phaseout range, Mike is limited to a maximum $2,800 contribution to a Roth IRA.
Assuming he makes a $2,800 annual Roth IRA contribution, Mike has $4,200 worth of IRA contributions left. He can make up to $4,200 in annual contributions to a nondeductible traditional IRA, since he meets the qualification requirement to contribute to a nondeductible traditional IRA.
IRA Annual Contribution Limits
For taxpayers younger than 50 years old during the entire year, the maximum (for 2024) that can be contributed to the combination of all three types of IRAs is the lesser of:
The taxpayer’s and their spouse’s combined earned income, or
$7,000.
Thus, if both spouses are younger than 50 years old, the maximum IRA contributions for a married couple is $14,000.
For taxpayers 50 years old or older during any part of the taxable year the maximum (for 2024) that can be contributed to the combination of all three types of IRAs is the lesser of:
The taxpayer’s and their spouse’s combined earned income, or
$8,000.
Thus, if both spouses are 50 or older, the maximum IRA contributions for a married couple is $16,000.
Deadlines
The deadline to make an IRA contribution for a particular year is April 15th of the year following the taxable year (thus, the deadline to make a 2024 IRA contribution is April 15, 2025). The deadline to make earned income for a taxable year is December 31st of that year.
Rollover Contributions
There’s a separate category of contributions to IRAs: rollover contributions. These can be from other accounts of the same type (traditional IRA to traditional IRA, Roth IRA to Roth IRA) or from a workplace retirement plan (for example, traditional 401(k) to traditional IRA, Roth 401(k) to Roth IRA).
Rollover contributions do not require having earned income and have no income limits and should be generally tax-free. For a myriad of reasons, it is usually best to effectuate rollovers as direct trustee-to-trustee transfers.
As a practical matter, it is often the case that IRAs serve at the retirement home for workplace retirement plans such as 401(k)s.
Correction
A previous version of this blog post, titled “IRA Contributions for Beginners” erroneously stated that one must be a citizen or resident of the United States to make an IRA contribution. I regret the error.
Further Reading
Deductible traditional IRA or Roth IRA? If you qualify for both, it can be difficult to determine which is better. I’ve written here about some of the factors to consider in determining whether a deductible traditional contribution or a Roth contribution is better for you.
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.
