Tag Archives: Retirement

Roth 401(k)s and the Rule of 55

We live in a world where two things are true. First, more investors are using the Roth 401(k) to save and invest for retirement. Second, as demonstrated by the strength of the financial independence movement, many are interested in retiring early by conventional standards. 

Some potential “early” retirees are thinking about the so-called “Rule of 55” and many of them have Roth 401(k)s.

How does the Roth 401(k) work with the Rule of 55? Is there a better option than the Rule of 55 for those looking to retire using in part or in whole a Roth 401(k) prior to turning age 59 ½?

We will explore both the Roth 401(k) and the Rule of 55, then we will discuss planning involving the potential combination of the Roth 401(k) and the Rule of 55. We will also discuss a planning alternative to combining the Roth 401(k) with the Rule of 55.

Roth 401(k)

The Roth 401(k) is a 401(k) that is taxed as a Roth. Employers offering a 401(k) are not required to offer a Roth 401(k) option, but many do.

Roth 401(k) Contributions

There are now three main potential sources of “Roth contributions” to a Roth 401(k).

  1. Employee Deferrals: In 2024, these are limited to the lesser of earned income or $23,000 ($30,000 if age 50 or older). These are done through W-2 withholding into the Roth 401(k).
  2. Mega Backdoor Roth: These are after-tax contributions by the employee (also through W-2 withholding) to the traditional 401(k) followed by a soon-in-time Roth conversion of the after-tax 401(k) amount to the Roth 401(k). 
  3. Employer Contributions: Employers contribute to 401(k)s. SECURE 2.0 allows for employers to contribute to Roth 401(k)s. Traditionally, employer contributions had always been to the traditional 401(k), but SECURE 2.0 established the possibility of Roth 401(k) employer contributions. Note that a February 2024 federal court decision has called SECURE 2.0 into question. 

There’s a limit on the combination of 1 plus 2 plus 3. I refer to this limit as the “all additions limit” and some refer to it as the “415(c)” limit, as that’s where the limit lives in the Internal Revenue Code. For 2024, the all additions limit is $69,000. For those aged 50 or older, it is $76,500. 

Note that Roth IRAs cannot be rolled over to a Roth 401(k). 

There’s a fourth potential source of Roth 401(k) funds: Taxable conversions from traditional 401(k)s. Taxable Roth conversions (traditional 401(k) to Roth 401(k)) have no limit. These are usually not done during one’s working years.

Roth 401(k) Withdrawals

If “done right” a Roth 401(k) withdrawal in retirement is fully tax and penalty free. 

However, if a distribution from a Roth 401(k) occurs before either (or both) the account owner is 59 ½ years old or the owner has owned that particular Roth 401(k) for five years, the “earnings” portion of the distribution is subject to ordinary income tax and the potential 10 percent early withdrawal penalty. 

Here’s a quick example illustrating that rule: 

Ken is age 53. He’s early retired. At a time when his Roth 401(k) is worth $200,000 and he’s previously contributed $100,000 to it, Ken takes a $50,000 distribution from the Roth 401(k) to help fund his retirement. Fifty percent of the distribution ($25,000) is a return of Ken’s previous contributions and fully tax and penalty free. The other fifty percent of the distribution ($25,000) is earnings and since Ken is under age 59 ½ will be taxable to Ken and subject to the 10 percent early withdrawal penalty. 

Rule of 55

The Rule of 55 is an exception to the 10 percent early withdrawal penalty. It applies to a specific employer’s qualified plan, such as a 401(k). It applies distributions from an employer’s qualified plan if

  1. The qualified plan account owner separated from service from the employer no earlier than the beginning of his or her age 55 birthday year, and 
  2. The distribution occurs after the separation from service.

Here is an example:

Rob was born on June 7, 1969. On January 16, 2024, Rob retired from Acme Industries. 2024 is Rob’s 55th birthday year. Any distribution occurring after January 16, 2024 from the Acme Industries 401(k) to Rob qualifies for the Rule of 55 exception to the 10 percent early withdrawal penalty. 

Note that a transfer from the former employer’s qualified plan to an IRA blows qualification for the Rule of 55. Distributions from an IRA are not distributions from the employer’s qualified plan. Further, the Rule of 55 applies only to the particular employer’s plan. If Rob had separated from Consolidated Industries at age 52 and still had a 401(k) there, distributions from that 401(k) would not qualify for the Rule of 55.

Read more about the legislative history of the Rule of 55 on page 18 of my article Solo 401(k)s and the Rule of 55: Does the Answer Lie in 1962?

Planning

Perhaps you’re sitting at home saying “Roth 401(k)s are great. The Rule of 55 is great. Why not combine them?”

I have four reasons not to combine them.

Taxing Roth 401(k) Earnings

Paying tax on a Roth distribution is the planning equivalent of breaking into jail. Combining the Roth 401(k) with the Rule of 55 means taxing Roth earnings as ordinary income. That isn’t a great outcome, particularly when there was no tax deduction on the way into the Roth 401(k).

Here is an example:

Ted leaves Maple Industries at age 56. He withdraws $60,000 from his Maple Industries Roth 401(k) at a time it was worth $300,000 and had $120,000 of previous contributions. Forty percent of the withdrawal ($24,000) is a tax and penalty free return of contributions. Sixty percent of the withdrawal ($36,000) is penalty free under the Rule of 55 but is subject to income taxation. 

Perhaps a significant portion of the taxable withdrawal is protected by the standard deduction (what I refer to as the Hidden Roth IRA in the context of traditional retirement account withdrawals). But even at a 10 or 12 percent marginal federal income tax rate, from a planning perspective having any sort of taxable distribution from a Roth account is a bad outcome.

Further, taking money out of a Roth in our 50s means foregoing additional years or decades of tax free growth on that money. 

A Great, Easily Accessible Alternative Exists

Before age 59 ½, a Roth 401(k) represents a challenge and an opportunity for an early retiree. 

First, the challenge. The challenge is the “cream-in-the-coffee” rule I previously discussed in this post. Distributions before age 59 ½ attract both old contributions and earnings. Earnings are subject to both ordinary income tax and the 10 percent early withdrawal penalty. 

Here’s an example: 

Moe is age 53. He has a $500,000 Roth 401(k). $200,000 is old contributions and $300,000 is growth on those contributions (earnings). If Moe takes a distribution of $10,000 from the Roth 401(k), $4,000 (40%) will be a tax and penalty free return of contributions and $6,000 (60%) will be a distribution of earnings, subject to both income taxation and a 10 percent early withdrawal penalty (add 2.5% if Moe lives in California). 

Here’s the opportunity: Someone like Moe can “isolate” his $200,000 of Roth 401(k) basis and avoid taxation on his Roth withdrawals.

It’s pretty easy. Moe can simply transfer his entire Roth 401(k) to a Roth IRA. That will immediately give Moe $200,000 of “basis” in his Roth IRA (old annual contributions which can be removed at any time for any reason tax and penalty free). Once the Roth 401(k) is in a Roth IRA, Moe has $200,000 (plus any other Roth basis he has separately built up) he can withdraw entirely tax and penalty free for early retirement.

A Good, Not Too Difficult Alternative Exists

There’s another path to basis isolation and avoiding taxation on a Roth 401(k) distribution, but it will be more complicated. This path involves Moe keeping most of the money inside the Roth 401(k).

Returning to the facts of Moe’s example: Say Moe is 53 years old and early retired. If the Roth 401(k) plan allows partial pre-age 59 ½ withdrawals, and Moe wants $10,000 tax and penalty free, he could withdraw $25,000 from the Roth 401(k) and (i) keep $10,000 (40%) and (ii) transfer $15,000 (60%) to a Roth IRA. The transaction will be entirely tax and penalty free as Moe is deemed to get the basis ($10,000) distributed to him and to have transferred the earnings ($15,000) to his Roth IRA. See Exception 3: Roth 401(k) Withdrawal then Rollover in this post for more details. 

Why Not Use Taxable Accounts, if Possible?

I’ve said it before and I’ll say it again: I prefer using taxable accounts, if possible, to fund retirement prior to using retirement accounts. While that will not be possible for everyone, why not save before retirement in a manner that facilitates (1) living off taxable accounts prior to age 59 ½ (and pay very low capital gains taxes) while (2) doing very low tax rate Roth conversions in retirement. 

Obviously, there’s only so much tax planning anyone can do if they are in their mid-to-late 50s and a couple of months away from retirement. But for those in their 30s, 40s, and even early 50s, now is the time to plan to set up a retirement that is as tax advantageous as possible. 

For anyone with a decent amount of time between now and retirement, I would not recommend planning into relying on using the Rule of 55 for a Roth 401(k). 

ACA Premium Tax Credit Considerations

I’m concerned that some people take the Roth too far. If you get to retirement prior to age 65 and need to go on an ACA medical insurance plan, having every last penny in Roth accounts is not a good place to be. It can mean that you’re not able to generate taxable income in retirement, meaning you can’t qualify for a significant Premium Tax Credit against hefty ACA insurance premiums.

In theory, the Rule of 55 could be a workaround to that problem. Imagine Jane retires at age 56, and other than a paid off house and $50,000 in a savings account she has a $2,000,000 Roth 401(k) and a $500,000 Roth IRA. How is she going to create any taxable income to qualify for the Premium Tax Credit? 

The answer, for a few years, can be the Rule of 55. Jane could take from her Roth 401(k) (assuming it allows partial pre-age 59 ½ distributions), create taxable income on the “earnings” portion of the distribution as discussed above, and avoid the 10 percent early withdrawal penalty under the Rule of 55.

This is still not something that should be planned into. Why not? At age 59 ½, assuming Jane has had the Roth 401(k) for 5 or more years, she will qualify for a “qualified distribution” from the Roth 401(k), meaning that all distributions from it will be entirely tax free. 

That’s bad news from a Premium Tax Credit perspective: at that point Jane will have hardly any taxable income (just some interest income from the small savings account) and thus will not generate sufficient income to qualify for the Premium Tax Credit!

Conclusion

It is good that the Roth 401(k) and the Rule of 55 are available options for retirement. Absent unique and extreme circumstances, they generally should not be combined when it comes to retirement planning. 

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

Follow me on Twitter: @SeanMoneyandTax

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

New to Financial Independence? Start Here!

Financial independence is great. But sometimes it can be daunting. Personal finance itself can be daunting, and now we’re adding something called financial independence or “FIRE” to it?

I decided it was time to come up with an approachable, understandable, and cost free entry point into financial independence. With the four resources listed below, I believe one can rather quickly get up to speed without needing any sort of advanced knowledge or education. The four resources, including one podcast episode, one very short academic article, and two blog posts, are free and easy to digest.

ChooseFI Episode 100: Welcome to the FI Community

This podcast episode goes over the basics of financial independence. 

The Shockingly Simple Math Behind Early Retirement by Mr. Money Mustache

This blog post discusses the math behind early retirement.

The Arithmetic of Active Management by William F. Sharpe

This very brief academic article compares active investing versus passive investing (generally speaking, index funds).

FI Tax Strategies for Beginners by Sean Mullaney

My blog post goes over the basic tactics of tax planning for FI beginners.


Obviously there are plenty more FI resources, and I encourage you to explore them. But my hope is that these four resources comprise a relatively easy on-ramp into financial independence and personal finance for those starting out.

Subscribe to my YouTube Channel: @SeanMullaneyVideos

Follow me on X: @SeanMoneyandTax

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

FI Tax Strategies For Beginners

New to financial independence (FI or FIRE)? Are you steeped in financial independence, but confused about tax optimization?

If so, this is the post for you. It’s not “comprehensive tax planning for FI” but rather an initial primer on some basic financial independence tax planning tactics. 

But first, a caveat: none of this is advice for your specific situation, but rather, this comprises a list of the top four moves I believe those pursuing financial independence should consider. No blog post (this one included) is a substitute for your own and your advisors’ analysis and judgment of your own situation.

ONE: Contribute Ten Percent to Your Workplace Retirement Plan

To start, your top retirement savings priority in retirement should be to contribute at least 10 percent of your salary to your workplace retirement plan (401(k), 403(b), 457, etc.). I say this for several reasons.

  • It starts a great savings habit.
  • Subject to vesting requirements, it practically guarantees that you will get the employer match your 401(k) has, if any.
  • Assuming a traditional retirement account contribution, it gets you a valuable tax deduction at your marginal tax rate.
  • It will be incredibly difficult to get to financial independence without saving at least 10 percent of your salary. 

Here are some additional considerations.

Traditional or Roth 

In some plans, the employee does not have a choice – employee contributions are “traditional” deductible contributions. Increasingly, plans are offering the Roth option where the contribution is not deductible today, but the contribution and its growth/earnings are tax-free in the future.

This post addresses the traditional versus Roth issue. I strongly favor traditional 401(k) contributions over Roth 401(k) contributions for most people. The “secret” is that most people pay much more in tax during their working years than they do during their retired years (even if they have significant balances in their traditional retirement accounts). Thus, it makes more sense to take the tax deduction when taxes are highest and pay the tax when taxes tend to be much lower (retirement).

Bad Investments

I’d argue that most people with bad investments and/or high fees in their 401(k) should still contribute to it. Why? First, consider the incredible benefits discussed above. Second, you’re probably not going to be at that job too long anyway. In this video, I discuss that the average/median employee tenure is under 5 years. When one leaves a job, they can roll a 401(k) out of the 401(k) to the new employer’s 401(k) or a traditional IRA and get access to better investment choices and lower fees. 

Resource

Your workplace retirement plan should have a PDF document called a “Summary Plan Description” available in your workplace benefits online portal. Reviewing that document will help you figure out the contours of your 401(k) or other workplace retirement plan.

TWO: Establish a Roth IRA

For a primer on Roth IRAs, please read my Ode to the Roth IRA. Roth IRAs, like traditional IRAs, are “individual.” You establish one with a financial institution separate from your employer. 

Generally speaking, a Roth IRA gives you tax-free growth, and if done correctly, money withdrawn from a Roth IRA is both tax and penalty free. 

Roth IRA contributions can be withdrawn tax and penalty free at any time for any reason! The Roth IRA is the only retirement account that offers unfettered, tax-free access to prior contributions. Note, however, in most cases the best Roth IRA strategy is to keep money in the Roth IRA for as long as possible (so it continues to grow tax free!). 

Find out why the Roth IRA might be much better than a Roth 401(k). 

THREE: Contribute to an HSA 

A health savings account is a very powerful saving vehicle. You have access to it if you have a high deductible health plan. To have an HDHP through your employer, you need to determine (i) if your employer offers a HDHP and (ii) whether the HDHP is appropriate medical insurance for you. 

If you do not have employer provided insurance, you may be able to obtain an HDHP in the individual marketplace.

HSA contributions have several benefits. You receive an upfront income tax deduction for the money you contribute. If the funds in your HSA are used to pay qualified medical expenses, or are used to reimburse you for qualified medical expenses, the contributions and the earnings/growth are tax-free when paid out of the HSA. This tax-friendly combination means the HSA should be a high priority. 

Here are a few additional considerations:

HDHP Benefit

I believe the HDHP is itself a great benefit in addition to the HSA. Why? One reason is that the HDHP reduces a known expense: medical insurance premiums! Why pay significant premiums for a low deductible plan when the point of medical insurance is not “coverage” but rather to avoid financial calamity in the event of injury or illness?

Dr. Suneel Dhand has a great YouTube channel. He has stated that as a doctor he is quite leery about getting treated for disease by Western medicine. I believe that is a very fair critique.

We over-medicalize our problems. Too often we run to the doctor looking for a solution when the answer lies in what we’re eating and/or our environment. We should work to avoid disease and doctor visits by taking control of our own health. That is very much in line with both the high deductible model of medical insurance and financial independence. 

Part of “independence” (including financial independence) is questioning established systems. I am glad Dr. Dhand and others are starting to do just that when it comes to medicine. HDHPs help us do that while providing financial protection in the event of significant injury or illness.  

Thinking about a future mini-retirement? One great way to lay the foundation today for tomorrow’s mini-retirement is to increase one’s financial independence from the medical system and decrease dependence on any one employer’s medical insurance.

State Income Taxes

In California and New Jersey, HSAs are treated as taxable accounts. Thus, in these states there are no state income tax deductions for contributions to an HSA. Furthermore, dividends, interest and other realized income and gains generated by HSA assets are subject to state income taxes. While detrimental, the federal income tax benefits are so powerful that even residents of these states should prioritize HSA contributions.

Employer Contributions

Check to see if your employer offers an employer contribution to your HSA. Many do. When the employer does, the employee leaves free money on the table if they do not enroll in the HDHP.

Reimbursements

In most cases, it is advisable to (i) pay current medical costs out of your own pocket (your checking account and other taxable accounts) and (ii) record and track these medical expenses. Leaving the money in the HSA during our working years allows it to grow tax-free!

Years later when the money has grown, you can reimburse yourself tax-free from your HSA for the Previously Unreimbursed Qualified Medical Expenses (PUQME), as there is no time limit on reimbursements. Note that only qualified medical expenses incurred after you first open the HSA are eligible for tax-free reimbursement.

FOUR: Save, Save, Save!!!

My last recommendation is simple: save, save, save! Are there ways to do it in a tax-efficient manner? Absolutely! But the absolute most important consideration is the act of saving and investing itself. Between retirement plans, lack of a payroll tax, and favored dividend and capital gain tax rates, saving and investing are often tax efficient without trying to be. 

If in doubt, traditional 401(k) contributions are often fantastic.

Conclusion

Here are the top four tax moves I believe FI beginners should consider:

First, contribute 10 percent to your 401(k) or other workplace retirement plan

Second, establish a Roth IRA

Third, establish an HSA

Fourth, Save, Save, Save

Of course, this post is not tailored for any particular taxpayer. Please consult with your own tax advisor(s) regarding your own tax matters.

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

Subscribe to my YouTube Channel: @SeanMullaneyVideos

Follow me on X: @SeanMoneyandTax

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

Revisiting Solo 401(k)s and the Rule of 55

On a recent episode of ChooseFI, I stated my then-held view that it is unlikely a distribution from a Solo 401(k) qualifies for the Rule of 55. My concern was this: once the Schedule C solopreneur retires, there does not appear to be an “employer” remaining in the picture to sponsor the Solo 401(k).

If that is the case, the Solo 401(k) should be rolled over to an IRA and there’s no ability to use the Rule of 55.

Until now, I’m not aware that anyone has done a deep dive to validate or disprove that concern. So I decided to do it myself. My research took me as close to the year 1962 as one can get without a flux capacitor, a DeLorean, and 1.21 gigawatts of electricity. 

I’ve now changed my view on the Solo 401(k) Rule of 55 issue. The analysis is too complicated to write adequately in a blog post. Thus, I’m self-publishing an article, Solo 401(k)s and the Rule of 55: Does the Answer Lie in 1962? (accessible here), on the topic.

Of course, the article is not legal or tax advice for you, any other individual, and any plan. 

For those of you who read my book, Solo 401(k): The Solopreneur’s Retirement Account (thank you!), please know the article is written differently. The book is a “101” and “201” level discussion of tax planning for the self-employed with some beginning and intermediate tax rule analysis. The article is much more akin to a “501” level discussion of a complex and somewhat uncertain tax issue emerging from ambiguities in the Internal Revenue Code

Enjoy the article and let me know what you think in the comments below. 

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

Follow me on Twitter: @SeanMoneyandTax

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.

Five Reasons to Avoid the 529

Happy National 529 College Savings Day! Let’s celebrate with five reasons to avoid 529s.

Cart Before the Horse

I’ve said it before and I’ll say it again: far too often new parents have relatives extolling the virtues of a 529 at the reception after the Baptism.

Those relatives rarely step back and ask “how are Mom and Dad’s finances?”

Picture a typical late-20s / early 30s Mom and Dad of a newborn. What are their financial pain points? What’s needed in their financial lives? 

I can tell you what is not their financial pain point: taxes on investment income. Yet this is what the 529 solves for. The 529 for a newborn’s parents is often the equivalent of a cast for someone with a paper cut! 

What do Mom and Dad need in their financial lives? If they are anything like the typical American adult, they probably need more in the way of retirement savings. Shouldn’t Mom and Dad prioritize their own compelling retirement needs over saving for a speculative potential future expense of their newborn baby, college education? 

Listen to me discuss the 529 on The Personal Finance Podcast. 

The Tax Benefits Aren’t That Great

In 2024 we’re in a great time to own taxable investments. Long term capital gains and qualified dividend income are taxed at 0%, 15%, 18.8%, and 23.8% (when factoring in the potential net investment income tax). Having equities inside a 529 avoids that tax, which is quite modest by historical standards. That tax is particularly small considering the low dividend yield environment we currently have. 

Further, the state tax benefits are usually modest. In our three largest states, California, Texas, and Florida, there’s no immediate state benefit for a 529 contribution.

Flexibility

As much as possible, a dollar ought to be able to serve multiple masters and multiple purposes.

Inside a taxable brokerage account, a dollar can efficiently support (i) Mom and Dad during their working years, (ii) Mom and Dad during their retirement, (iii) a new roof for the house, (iv) a family vacation to Yellowstone, and/or (v) Junior’s college education. 

Inside a 529, a dollar can efficiently support (i) Junior’s college education.

Why should the parents of a newborn handcuff their money when the tax benefits are quite modest? Why shouldn’t Mom and Dad remain flexible for their own financial future and decide what to do with that dollar later on, when they have more knowledge and information?

Many things can happen in the future that could make having a large sum in a 529 a bad thing: maybe Junior went to trade school, Junior got a scholarship, and/or Mom and Dad had financial struggles and now need that dollar to support their own retirement. 

The 529 Overfunding Problem

Scholarships happen. Some newborns don’t end up going to college. These are just two of the reasons that 529s get overfunded.

Taken for non-educational purposes, 529 distributions that represent earnings are subject to ordinary income tax rates and a 10 percent penalty. Ouch!

There are bailout techniques available to avoid negative tax consequences, but they are all limited to various degrees. The SECURE 2.0 529-to-Roth IRA rollover is very limited and, in my opinion, not something to be planned into. 

Feeding the Beast

What grade would you give American higher education in 2024?

American higher education often produces graduates who are ill-equipped for the modern economy and/or have staggering student debt loads. Many colleges and universities have administrative bloat that has gotten wildly out of hand.

Why should newborns’ parents handcuff their money such that they can only avoid a penalty by paying it over to American higher education? How does that make sense? Very modest tax benefits are nowhere near sufficient to make that make sense. 

Conclusion

I’m not here to say funding a 529 never makes sense. But I am here to say (1) I believe that 529s are wildly overhyped and (2) 529s rarely make sense for the financial profile and needs of the parents of newborns. 

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

Follow me on Twitter: @SeanMoneyandTax

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

Accumulators Should Ignore the Conventional Wisdom

The conventional wisdom says to accumulators “Save through a Roth 401(k)! Don’t you dare contribute to traditional 401(k)s. Those things are infested with taxes!!!”

Doubt that prioritizing Roth 401(k) contributions over traditional deductible 401(k) contributions is the conventional wisdom? Let’s hear from some very prominent personal finance commentators:

These commentators have much bigger platforms than I have, and they are to be commended for their many solid contributions to the personal finance discourse. On this particular issue, however, I believe their conventional wisdom misses the mark. I believe most of those saving for retirement during their working years should prioritize traditional deductible 401(k) contributions. 

Here are the eight reasons why I believe the conventional wisdom on the traditional 401(k) versus Roth 401(k) debate is wrong.

Traditional Retirement Account Distributions are Very Lightly Taxed

Those 401(k)s and traditional IRAs are infested with taxes, right!

Wrong!!!

I have run the numbers in several blog posts and YouTube videos. Long story short, while working contributions into traditional 401(k)s generally enjoy a tax benefit at the taxpayer’s highest marginal tax rate while traditional retirement account distributions are taxed going up the progressive tax brackets in retirement (including the 10% and 12% brackets). This results in surprisingly low effective tax rates on traditional 401(k) and traditional IRA withdrawals in retirement.

The Tax Hikes Aren’t Coming

If “experts” keep predicting A and the exact opposite of A, B, keeps occurring and A never occurs, then the experts constantly predicting A aren’t good at predicting the future!

That’s where we are when it comes to predicting future tax hikes on retirees. Experts keep predicting that taxes are going through the roof on retirees. Experts use those predictions to justify the Roth 401(k) contribution push. 

There’s a problem with those predictions: they have been dead wrong!

I did a video on this. Not only does Congress avoid tax hikes on retirees, recent history indicates Washington is addicted to tax cuts on retirees. To wit:

  • December 2017: TCJA increases the standard deduction and reduces the 15% bracket to 12%. There are few better ways to cut retiree taxes!
  • December 2019: The SECURE Act delays required minimum distributions (“RMDs”) from age 70 ½ to age 72.
  • March 2020: The CARES Act cancels 2020 RMDs and allows those already taken to be rolled back into retirement accounts in a very liberal fashion.
  • November 2020: The Treasury gets into the act by publishing new RMD tables that reduce annual RMDs.
  • December 2022: SECURE 2.0 purports to delay RMDs from age 72 to ages 73 or 75 (for those born in 1960 or later). Congress was in such a rush to cut taxes on retirees the House didn’t dot the Is and cross the Ts from a Constitutional perspective!

Sure, the federal government has too much debt. Does that mean that taxes must necessarily rise on retirees? Absolutely not! 

There are many solutions that can leave retirees unscathed, including:

  1. Raising tariffs.
  2. Raising taxes on college endowments, private foundations, high income investors’ dividends and capital gains, and hedge fund managers.
  3. Eliminating electric vehicle tax credits.
  4. Spending cuts, particularly to military spending and foreign spending. These are becoming more likely as American politics continue to change. 

Conventional Wisdom Misses the Sufficiency Problem

How much tax do you pay on an empty 401(k)? How much tax do you pay on a nearly empty 401(k)?

Those crying wolf over taxes in retirement miss the real issue: sufficiency! According to this report, the median American adult wealth is about $108,000 as of 2022 (see page 16). 

Let’s imagine all that $108K is in a traditional retirement account. Few will take it all out at once. The rather annual modest withdrawals will hardly be taxed at all due to the standard deduction and/or the 10% tax bracket.

If people are behind in their retirement savings, what’s the best way to catch up? Deduct, deduct, deduct! Those deductions save taxes now, opening the door for more savings. For those behind in retirement savings, sacrificing the valuable tax deduction to make Roth contributions makes little sense in my opinion. Why? Because those behind in retirement savings will face very low taxes in retirement. 

Sadly, the median American adult has a sufficiency problem and would be fortunate to one day have an (overblown) tax problem instead!

Missing Out on the Hidden Roth IRA

Q: What’s it called when I take money out of a retirement account and don’t pay tax on it?

A: A Roth IRA!!!

Well, many Americans have a Roth IRA that lives inside their traditional 401(k). I call this the Hidden Roth IRA. 

Prior to collecting Social Security, many Americans will have the opportunity to take tax free distributions from their traditional IRA or 401(k) because they will be offset by the standard deduction. 

If all your 401(k) contributions (and possible employer contributions) are Roth, you miss out on the Hidden Roth IRA. 

I break down the phenomenon of the Hidden Roth IRA in this video. 

Missing Out on Incredible Roth Conversions

Did you know that you might be able to do Roth conversions in retirement and pay federal income tax at a 6% or lower federal tax rate? It’s true! I break that opportunity down in this video.

If you’re telling a 22 year old college graduate that all of their 401(k) contributions should be Roth you’re foreclosing many or all future Roth conversions! Why? Shouldn’t younger workers be setting up low tax Roth conversions in retirement while they are working?

“Roth, Roth, Roth!!!” sounds great and makes for a fun slogan. But it precludes incredibly valuable future tax planning!

The Widow’s Tax Trap and IRMAA are Overblown

The Widow’s Tax Trap is a phenomenon in American income taxation where surviving spouses pay more tax on less income. It’s real. But just how bad is it?

In one example, I found that an incredibly affluent 75 year-old married couple would be subject to a combined effective federal income tax/IRMAA rate of 15.44%. The surviving spouse would then be subject to a combined 19.87% effective rate after the first spouse’s death. 

That’s the Widow’s Tax Trap. Real? Yes. Terrifying? No.

Few things are as overblown in American personal finance as IRMAA. IRMAA, income-related monthly adjustment amounts, are technically increases in Medicare premiums as one’s income exceeds certain thresholds. In practice, it is a nuisance tax on showing high income in retirement.

In one extreme example, I discussed a 90 year old widow with $304,000 of RMDs and Social Security income. Her IRMAA was about $5,500, a nuisance tax of about 1.8% on that income. Annoying? Sure. Something to factor into planning during the accumulation phase? Absolutely not.

Missing Out on Premium Tax Credits

Mark, age 22, graduates from college and buys into “Roth, Roth, Roth!!!” Every dollar he contributes to his 401(k) is in the Roth 401(k), and he elects to have all his employer 401(k) contributions put into the Roth 401(k) as well. At age 55, Mark decides to retire. He has a paid off house, $200,000 in a savings account, and $2.5 million in his Roth 401(k).

Mark will be on an ACA medical insurance plan from retirement (or the end of COBRA 18 months later) until the month he turns 65. There’s just one big snag: he has no income! Because of that he will not qualify for the combination of an ACA plan and a Premium Tax Credit, since, based on income, he’s eligible for Medicaid. Ouch!

Mark falls into this trap because he has no ability to create taxable income in retirement. Had he simply put some of his 401(k) into the traditional 401(k), he could have “turned on” taxable income by doing Roth conversions (mostly against the standard deduction!). Doing so would qualify Mark for hundreds of dollars in monthly Premium Tax Credits, greatly offsetting the significant cost of ACA medical insurance. Note Mark could turn on income by claiming Social Security at age 62, permanently reducing his annual Social Security income. 

Retirement Isn’t the Only Priority

The tax savings from a traditional 401(k) contribution can go to tremendously important things before retirement. Perhaps a Mom wants to step back from the workforce to spend valuable time with her infant son or daughter. Maybe Mom & Dad want to pay for a weeklong vacation with their children. Maybe a single Mom wants to qualify her son for scholarship money. 

There are pressing priorities for retirement savers prior to retirement. You know what can help pay for them? The tax deduction offered by a traditional 401(k) contribution. 

Conclusion

The Conventional Wisdom is wrong!

Traditional deductible contributions to 401(k)s and other workplace retirement plans are a great way to save and invest for the future. Future taxes are a drawback to that tactic. But they have to be assessed keeping in mind the eight reasons I raise above. To my mind, it’s more important to build up wealth than to be tax efficient. As discussed above, those aren’t mutually exclusive, including for those using traditional deductible 401(k) contributions for the majority of their retirement savings.

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

Follow me on Twitter: @SeanMoneyandTax

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

Vanguard Exits the Solo 401(k) Business

Big news in the Solo 401(k) world! Vanguard is closing their Solo 401(k) and will exit the Solo 401(k) business in July.

On April 19th I recorded a YouTube video with my initial reaction.

On April 20th I posted a lengthy X thread and a LinkedIn post with additional thoughts.

UPDATE July 22, 2024: The Vanguard to Ascensus transfer is now complete. For those with a new Ascensus account, it’s vitally important to file a new beneficiary designation form!

UPDATE October 12, 2024 The Ascensus Solo 401(k) contribution portal is not intuitive. I walk through tips for new Ascensus Solo 401(k) owners in this YouTube video.

My Solo 401(k) Book

If you’re interested in the Solo 401(k), I wrote a book about it.

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

Follow me on Twitter: @SeanMoneyandTax

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

Accessing Retirement Accounts Prior to Age 59 ½

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

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

My response: Oh, heck no! 

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

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

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

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

Taxable Accounts

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

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

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

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

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

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

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

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

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

Inherited Retirement Accounts

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

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

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

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

Rule of 55 Distributions

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

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

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

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

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

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

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

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

Governmental 457(b) Plans

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

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

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

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

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

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

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

Roth Basis

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

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

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

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

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

Creates income for purposes of the FAFSA. 

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

72(t) Payments

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

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

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

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

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

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

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

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

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

HSA PUQME

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

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

Does not create income for purposes of the FAFSA.

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

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

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

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

Ideal For: Those with significant HSAs and significant PUQME. 

Net Unrealized Appreciation

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

This opportunity usually requires professional assistance, in my opinion. 

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

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

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

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

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

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

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

Pay the Penalty

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

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

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

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

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

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

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

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

Conclusion

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

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

Follow me on Twitter: @SeanMoneyandTax

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

Tax Basketing for a 72(t) Payment Plan

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: 

  • Maximum allowable interest rate, 5.79%, 
  • The Single Life Table factor for age 53 (33.4), and 
  • The annual payment he’s selected, $80,000. 

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?

Monty has an option available: a one-time change of the 72(t) payment to the RMD method. If Monty switches to the RMD method, he’s likely to dramatically reduce the annual amount of the required 72(t) payment. The RMD method keys off the account balance at the end of the prior year. The lower the balance, the lower the required annual payment under the RMD method. 

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

Follow me on Twitter: @SeanMoneyandTax

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

Tax Return Reporting for Net Unrealized Appreciation

By Sean Mullaney and Andrea MacDonald

Net Unrealized Appreciation Planning

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. 

NUA treatment has requirements, such as emptying all retirement accounts from the employer in the same year. Thus, oftentimes those with significant amounts of employer stock in a retirement plan should work with professional advisors. For more information on the planning surrounding NUA treatment, read Michael Kitces’ great blog post on the subject. 

Tax Return Reporting

Transfer of Employer Stock to Taxable Account

Information Reporting to the Taxpayer and the IRS

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. 

NUA and the Net Investment Income Tax (Form 8960)

One more form may be required: Form 8960. If the seller’s modified adjusted gross income (“MAGI”) is above $200K (single) or $250K (married filing joint), the gain on top of the NUA ($40 per share in Mark’s example) is subject to the 3.8% net investment income tax. However, the NUA gain itself is not subject to the net investment income tax. See Treas. Reg. Sec. 1.1411-8(b)(4)(ii). 

Transfer of Other Employer Plan Assets to IRAs

Information Reporting to the Taxpayer and the IRS

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 a collaboration by Sean Mullaney, CPA and Andrea MacDonald, CPA. It is posted on fitaxguy.com and on Steadfast Bookkeeping’s blog.

Follow Sean on X at @SeanMoneyandTax

Follow Andrea on X at @Andreamacdcpa

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.