Tag Archives: Retirement

TikTok Tax Advice

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

Retirement Saving Through Various Forms of Life Insurance

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

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

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

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

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

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

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

First, their rough 2022 federal income tax return:

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

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

2022 Income Taxes and Cash Flow (Estimated)
Federal Income Tax$ 27,100
Effective Tax Rate on AGI14.04%
Marginal Federal Income Tax Rate22%
California Taxable Income (Approximate):$ 149,000
California Income Tax (Approx.)$ 7,862
Effective CA Income Tax Rate on Fed AGI4.07%
Marginal CA Income Tax Rate9.30%
Total Fed & CA Effective Income Tax Rate18.11%
Cash Flow After Fed & CA Income Tax & QCDs$ 164,038

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

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

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

The Trade-Off Unstated on TikTok

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

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

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

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

Uncertainty

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

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

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

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

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

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

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

Roth Accounts

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

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

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

Roth Conversions

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

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

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

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

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

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

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

Conclusion

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

Further Reading

Forbes has recently published two articles on the sorts of insurance policies frequently promoted on TikTok. They are available here and here. 

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

Follow me on Twitter at @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, 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.

The Mystery of the Disappearing Tax Basis

Tax loss harvesting is all the rage in a down stock market. Did you know that it can create a mystery worthy of the Hardy Boys? Read on to find out how tax basis can disappear because of tax loss harvesting and the wash sale rule. 

Tax Loss Harvesting

I’ve previously written about tax loss harvesting. The idea is to sell a stock, bond, mutual fund, ETF, or other asset at a loss and report that loss on a tax return. That loss can offset other capital gains, and after having done that, it can offset ordinary income (W-2 income, interest income, etc.) up to $3,000 per year. Unused capital losses can be carried forward to subsequent tax returns indefinitely.

Tax loss harvesting is a nice tactic and in the right circumstances can be beneficial. That said, tax loss harvesting should not be a primary driver of one’s investment portfolio allocation. 

The Wash Sale Rule

The opportunity presented by tax loss harvesting has a major hurdle: the wash sale rule. Any acquisition of the same asset or a “substantially identical” asset 30 days before or 30 days after the sale at a loss denies the loss on the tax return. This is a very logical rule, considering the potential for abuse. Here’s an example:

Example 1: Sal owns 30 shares of Acme Corporation stock. He purchased it for $200 per share, and it is now worth $140 per share. Without the wash sale rule, Sal could sell all 30 shares for $140 on December 1st (triggering a $1,800 loss on his tax return) and then purchase 30 shares of Acme Corporation on December 2nd for its current value and have very little change in his economic position. 

Seen through the lens of Sal’s example, the wash sale rule makes sense. Why should Sal get to claim a loss on 30 shares of Acme stock he owns at year-end?

However, the wash sale rule can be implicated in less clear cut situations. Here’s one example:

Example 2: Cate owns 500 shares of IBM stock* in her taxable brokerage account. She purchased each share for $150 per share. On July 6, 2022, she sold 300 shares for $140 per share, realizing a $3,000 capital loss (300 times $10 loss per share). On July 29, 2022, IBM paid a dividend of $3 per share ($600 total on Cate’s remaining 200 shares), which Cate automatically reinvested in IBM stock, now valued again at $150 per share. 

In Cate’s case, the dividend reinvestment purchased 4 shares of IBM stock within the 61-day wash sale window. The taxable loss on 4 shares of the 300 sold ($40 total) is disallowed by the wash sale rule, and Cate will only be able to claim a taxable loss of $2,960 on the July 6th sale. 

* All values used in this blog post are hypothetical for purposes of the example. I did not look up IBM’s actual stock prices on these dates. The IBM dividend is also made up for the sake of the example.

One interesting tidbit about the wash sale rule in today’s environment: as the rule only applies to “securities” it does not apply to cryptocurrencies. Thus, an investor can sell a cryptocurrency at a loss on one day and repurchase it a day later and claim the entire loss on his or her tax return. There are proposals to do away with this treatment and subject cryptocurrencies to the wash sale rule. 

Retirement Accounts and the Wash Sale Rule

Let’s change Cate’s example just a bit, by having the repurchase occurring inside a Roth IRA.

Example 3: Cate owns 300 shares of IBM stock in her taxable brokerage account. She purchased each share for $150 per share. On July 6, 2022, she sold all 300 shares for $140 per share, realizing a $3,000 capital loss (300 times $10 loss per share). Separately, Cate owns 200 shares of IBM in her Roth IRA. On July 29, 2022, IBM paid a dividend of $3 per share ($600 total on Cate’s remaining 200 shares), which Cate’s Roth IRA automatically reinvested in IBM stock, now valued again at $150 per share. 

What result? The IRS has issued a Revenue Ruling, Rev. Rul. 2008-5, ruling that if the repurchase occurs inside the taxpayer’s Roth IRA or traditional IRA, the wash sale rule applies. Cate would suffer the exact same $40 wash sale rule loss disallowance. 

Note that a Revenue Ruling is not binding on taxpayers and the courts. Of course, a judge or appellate court may agree with the conclusion the IRS reaches in a Revenue Ruling, but they are not obligated to do so based solely on the IRS having issued the ruling. Rev. Rul. 2008-5 cites two 1930s court cases as authority for the conclusion reached in the ruling. Those cases involve a taxpayer using a controlled corporation to attempt to get around the wash sale rule, and the courts ruled that the wash sale rule applied regardless. 

In my research, I have not found any published court cases which have weighed in on Rev. Rul. 2008-5. The wash sale rule, as found in Section 1091, does not explicitly deem a retirement account and its owner to be the same person. Thus, there is at least some (perhaps quite small) risk to the IRS that a court would deem the primary result in Rev. Rul. 2008-5 to be too much of a stretch. That said, I certainly would not recommend taking a position counter to the ruling. I would struggle to advise that the wash sale rule does not apply if the security is repurchased in a retirement account. 

Disappearing Basis?

The wash sale rule disallows a loss, but it does not disallow basis. Section 1091(d) of the Internal Revenue Code and Treasury Regulation Section 1.1091-2 provide for a tax basis adjustment so that taxpayers are ultimately made whole after the application of the wash sale rule. Broadly speaking, the tax rules allow the disallowed loss to be added to the basis of the repurchased asset. In my Example 2 above, the basis of the 4 shares Cate repurchased is their historic cost ($150 per share) increased by the $10 per share disallowed loss. Thus, if Cate later sells those 4 shares, she will have a basis of $160 in those shares for purposes of determining gain or loss. 

In theory, the wash sale rule is simply a timing rule. It is inappropriate to allow a taxpayer to currently claim a loss when they wind up holding the exact same stock or securities. But, over time the tax basis rules should work out such that ultimately the correct amount is taxed to the taxpayer. 

What about basis adjustments when the wash sale occurs because of a repurchase made inside a retirement account? Rev. Rul. 2008-5 states that there is no basis adjustment with respect to a retirement account. There is an argument that Section 1091(d) should create Pro-Rata Rule basis in a traditional IRA. However, considering how highly technical and structured IRAs are, that is not a very likely outcome were the issue ever to be litigated. Further, that outcome would (quite oddly) give the taxpayer a different basis result based on whether they repurchased in a Roth retirement account or a traditional retirement account.

So what becomes of the basis? Does it just disappear? If the basis vanishes, the taxpayer obtains a worse wash sale result by repurchasing inside a retirement account. It seems odd that a taxpayer would receive a worse outcome for doing a repurchase through a retirement account instead of through a taxable brokerage account. 

Solving the Disappearing Basis Mystery

I have a theory that might solve the mystery. 

To get us started, consider that neither the Revenue Ruling nor Example 3 above discuss the “replacement property” in the taxable brokerage account. Here are two examples to ponder.

Example 4: Tim owns 1,000 shares of Domestic Equity Mutual Fund A (worth $50,000) he purchased for $60,000. It is held in a taxable brokerage account. On December 1, 2022, he sold Domestic Equity Mutual Fund A for $50,000 cash. He used the cash received to fund living expenses (food, clothing, heating bills, travel expenses, insurance, gasoline, etc.). On December 2, 2022, Tim purchased 1,000 shares of Domestic Equity Mutual Fund A in his Roth IRA. 

Example 5: Tim owns 1,000 shares of Domestic Equity Mutual Fund A (worth $50,000) he purchased for $60,000. It is held in a taxable brokerage account. On December 1, 2022, he exchanged all of his Domestic Equity Mutual Fund A for $50,000 worth of International Equity Mutual Fund B. On December 2, 2022, Tim purchased 1,000 shares of Domestic Equity Mutual Fund A in his Roth IRA. 

The wash sale rule disallows the $10,000 capital loss in both Example 4 and Example 5. But does Tim lose $10,000 of basis permanently? If he does, it’s an odd result considering that had he repurchased Domestic Equity Mutual Fund A in a taxable brokerage account (instead of in a retirement account), he would not lose that basis. 

I believe that there is a reasonable possibility that a court would rule that the $10,000 of basis shifts to the replacement property received in the wash sale. In Example 4, that conclusion leads Tim to no better position: he uses the cash for personal expenses, and there is no tax deduction for personal expenses. Further, I can’t imagine a court would give a step up in basis in Tim’s functional currency, the U.S. dollar. 

As applied to Example 5, where there has been a reinvestment in a taxable brokerage account, the equities of the situation might encourage some judges to find that Tim’s International Equity Mutual Fund B basis at a later sale is $60,000, not $50,000. 

Tim originally had $60,000 of basis in the system. While it is appropriate for a current loss to be disallowed, it is not appropriate for Tim’s basis in the system to be diminished in a situation where his overall taxable investment has not changed.

It’s one thing for the wash sale rule to operate to deny Tim a current loss deduction. It’s entirely another thing to interpret the wash sale rule to both deny current loss recognition and to permanently deny Tim $10,000 of basis. In its enactments of the wash sale rule and of the basis rules, Congress never manifested an intention for this one-two punch to bite Tim twice. If Tim sells the International Equity Mutual Fund B shares and recovers only $50,000 of basis he is inappropriately overtaxed. 

I believe some judges might determine that the IRS cannot have its cake (wash sale loss disallowance) and eat it too (permanent basis reduction). Basis exists to appropriately tax property transactions. Allowing Tim only $50,000 of future basis recovery over-taxes a later sale of his International Equity Mutual Fund B shares. While the IRS has a good argument that the wash sale rule disallowance should be spread to retirement account repurchases, it does not have a good argument that the overall result should be worsened if the repurchase occurs inside a retirement account.

Further, there is at least some risk to the IRS that a court would consider them to have reached just a bit by applying the wash sale rule to a repurchase inside a retirement account. The court might determine that what is good for the goose is good for the gander: if the IRS can reach a bit to apply the wash sale rule, the taxpayer can reach a bit to adjust the basis of the newly acquired securities in the taxable account.

The policies behind the rules point in the direction of allowing a taxpayer to add the disallowed loss to the basis of any replacement capital asset obtained through a direct exchange or a close-in-time use of the sales proceeds.

My proposed resolution has basis behave as it does in more familiar contexts. Say you received $50 from your grandmother when you were 12 years old. If you spent it on movie tickets and going bowling, the basis vanished for tax purposes. What if, instead, you purchased one share of stock of a publicly traded company for that $50? You’d get $50 of basis in that share of stock. Same with your first job: if you spend your first $1,000 W-2 paycheck on rent and groceries, tax basis disappears. But if you take that $1,000 and buy shares of ABC Mutual Fund in a taxable brokerage account, the basis stays attached to the mutual fund shares. Basis surviving when assets are reinvested in capital assets is a logical outcome.

Conclusion

Does anyone know for sure what happens to basis when the wash sale rule is tripped due to a repurchase in a retirement account? I believe it is still an unsolved mystery. 

Does basis vanish into the night? Or can it be preserved if the taxpayer reinvests in a capital asset in a brokerage account, as I have suggested?

Remember, the text of the Revenue Ruling does not affirmatively state that the basis simply disappears. Rather, all it says is that the basis does not get added to the taxpayer’s basis in the retirement account. To my mind, that’s a clue. It is not a definitive answer to the mystery. 

Now that we are 14 years removed from the issuance of Rev. Rul. 2008-5, it might be time for the IRS and Treasury Department to revisit the basis issue. The government could issue a regulation or another Revenue Ruling addressing the basis result in a situation similar to my Example 5. 

Of course, for taxpayers, this mystery is best avoided if possible. Repurchases should either (i) occur outside of the 61-day wash sale window or (ii) be of securities that are not the same or substantially identical to the sold securities.

I’ve also posted a video on YouTube with thoughts on this topic.

Lastly, the above is simply my technical analysis. It is not legal advice applicable to any one particular taxpayer or real life situation. 

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

Follow me on Twitter at @SeanMoneyandTax

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

Four Ways to Fight Inflation

Decisions you make today can subject you to more inflation tomorrow! Read below about ways to increase or decrease your exposure to inflation tomorrow.

Watch me discuss fighting back against inflation.

Tax Planning

As a practical matter, most Americans have the majority of their retirement savings in traditional, pre-tax vehicles such as the 401(k). Having money in a traditional 401(k) is not a bad thing. However, the traditional 401(k) involves trade offs: an upfront tax deduction is the primary benefit in exchange for future taxation when there is a withdrawal or Roth conversion.

Having money inside traditional retirement accounts subjects future inflation to taxation. Some of the future growth in a traditional retirement account is likely to be attributable to inflation, and thus there will be a tax on inflation. Further, there are no inflation adjustments when it comes to the taxation of traditional IRA and traditional 401(k) withdrawals. 

An antidote to this problem is the tax free growth offered by Roth accounts and health savings accounts. Getting money into Roths and HSAs excuses future growth from taxation, including growth attributable to inflation. 

Roth 401(k) versus Roth IRA

Of course, inflation is only one consideration. Many will do some traditional retirement account contributions and some Roth retirement account contributions. The question then arises: which Roth account to use? 

My view is that for many a Roth IRA contribution (whether a direct annual contribution or a Backdoor Roth IRA) is better than a Roth 401(k) contribution. Many do not qualify to deduct a traditional IRA contribution but can deduct a traditional 401(k) contribution. Considering that reality, why not combine a deductible traditional 401(k) contribution and a Roth IRA contribution? 

Long Term Fixed Rate Debt

Often we discuss how inflation hurts Americans, and we should be concerned about the bad effects of inflation. However, there is a way to become a beneficiary of inflation: using long-term, low interest fixed rate debt to your advantage.

That’s right: hold onto that low rate 30 year mortgage like it’s a life raft! Okay, that’s a bit hyperbolic, but the overall point holds. Inflationary environments are great for debtors, particularly those debtors who have locked in a low interest rate for a long term.

Here is an example: Sarah and Mike have a 30 year, $400,000 mortgage on their primary residence at a 2.9% fixed interest rate. By paying the required monthly payment, and no more, they benefit from any future inflation. By paying off the mortgage later rather than sooner, they are using devalued future money to pay the mortgage rather than more valuable current day dollars. 

Sarah and Mike benefit from inflation! Are there reasons to pay off a mortgage early? Sure. But in an inflationary environment, paying off the mortgage early gives the bank more valuable dollars to satisfy the debt.

To my mind, a fixed rate, long term mortgage is a great hedge against inflation.

That said, there are few perfect financial planning tactics. Most involve risk trade offs. One risk Sarah and Mike assume by not paying down the mortgage early is the risk of deflation. To obtain this inflation hedge, they expose themselves to the risk of deflation. If the U.S. dollar starts to deflate (i.e., it appreciates in value), Sarah and Mike will find themselves paying more valuable dollars to the bank in the future. 

Travel Rewards

Travel rewards can help fight inflation. One way is using sign-up bonuses and other accrued points to pay for hotel room nights or flights. Using points gets out of cash paying and thus inflation of the dollar hurts a bit less.

However, keep in mind that travel reward points are subject to their own inflation! The hotel chain or airline can devalue the redemption value of points at any time. Thus, if everything else is equal, those with significant travel rewards point balances might want to spend those points sooner rather than later for travel. 

A second consideration are the features of credit cards. Some travel branded credit cards come with certificates for free nights or a companion pass for a companion to receive free or discounted flights. If flighting inflation is a key goal, favoring cards that offer free-night certificates or companion passes can be a way to fight inflation. 

Spending that Leads to More or Less Future Spending

We’re used to assessing the price tag. $28,000 for that brand new car: “that’s a great deal!” or “that’s a terrible deal!” But the price tag is only one part of the financial picture.

If you buy a black cup of coffee at Starbucks, it might cost you $2.65. Fortunately, that’s it. The cup of coffee isn’t likely to cause you to incur later costs.

What about a $45,000 SUV? That purchase will cause later costs, many significant. For example, the cost to insure a $45,000 SUV might be significantly more than insuring a $22,000 sedan. What about gas? By purchasing a larger, less fuel-efficient car, you lock in more future spending, and thus more exposure to future inflation. 

Think about buying a large home with a pool in the backyard. That square footage attracts property tax, heating and cooling costs, and inflation in both costs. The pool in the backyard requires constant upkeep, subjecting the homeowner to another source of inflation. 

To my mind, food is a big one in the fight against inflation. What you eat today could very well translate into medical costs tomorrow, exposing you to significant inflation. Spending on foods with vegetable oils and sugars today is likely to increase your future exposure to medical expense inflation. 

The lesson is this: you can use today’s spending to reduce your exposure to future inflation. 

Conclusion

Is there a perfect answer to inflation? No. But with some intentional planning and spending today, Americans can reduce their exposure to the harmful effects of future inflation. 

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

Follow me on Twitter: @SeanMoneyandTax

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

Sean Discusses the Four Percent Rule on the ChooseFI Podcast

Why was your grandparents’ furniture horribly out of date? There’s a reason that has to do with financial independence!

I had a great conversation about grandparents’ furniture, inflation, and the four percent rule with Brad and Jonathan on the ChooseFI podcast. You can access the episode on all major podcast players or on the ChooseFI website: https://www.choosefi.com/the-four-backstops-to-the-four-percent-rule-sean-mullaney-ep-376/

During the episode, we reference my recent blog post, The Four Backstops to the Four Percent Rule.

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.

The Tax Increase in SECURE 2.0

There’s a tax increase in the new SECURE Act 2.0 legislation. Unfortunately, it falls largely on those least equipped to shoulder it.

Catch-Up Contributions

Since enacted in 2001, “catch-up” contributions have been a great feature of 401(k) plans. Currently, they allow those age 50 or older to contribute an additional $6,500 annually to their 401(k) or similar plan. Those contributions can be traditional deductible contributions, Roth contributions, or a combination of both.

The idea is that by age 50, workers have much less time to make up for deficiencies in retirement savings. Thus, the law allows those workers to make catch-up contributions to have a better chance of financial success in retirement.

Other than age (must be at least 50 years old), there are no limits on the ability to make catch-up contributions. That could be viewed as a give-away to the rich. However, it is logical to keep retirement savings rules simple, especially those designed to help older workers behind in retirement savings.

Watch me discuss SECURE 2.0’s tax increase on catch-up contributions

Catch-Up Contributions for Those Behind in Retirement Savings

For those behind in retirement savings, deducting catch-up contributions usually makes the most sense. First, many in their 50s are in their highest earning years, and thus tax deductions are their most valuable. Second, those behind in retirement savings are not likely to be in a high tax bracket in retirement. With modest or low retirement income, they are likely to pay, at most, a 10% or 12% top federal income tax rate in retirement.

Here is an example of how that works:

Sarah, single and age 55, is behind in her retirement savings, so she maxes out her annual 401(k) contribution at $27,000 ($20,500 regular employee contribution and $6,500 catch-up contribution). Sarah currently earns $130,000 a year and lives in California. Since she deducts her catch-up contributions, she saves $2,165 a year in taxes ($6,500 times 24% federal marginal tax rate and 9.3% California marginal tax rate). That $2,165 in income tax savings makes catching up on her retirement savings much more affordable for Sarah.

Sarah’s approach is quite logical. If things work out, Sarah can make up the deficit in her retirement savings. Doing so might push her up to the 12% marginal federal tax bracket and the 8% marginal California tax bracket in retirement.

For someone like Sarah who is behind in their retirement savings, the Roth option on catch-up contributions is a very bad deal!

SECURE 2.0 and Catch-Up Contributions

SECURE 2.0 disallows the tax deduction that people like Sarah rely on. It requires all catch-up contributions to be Roth contributions. For the affluent, this makes some sense. Why should someone with very substantial assets get a tax deduction when they already have a well-funded retirement?

Sadly, many Americans in their 50s and 60s do not have well-funded retirements. Removing the tax deduction for catch-up contributions increases their taxes. These are people who can least afford to shoulder a new tax. The goal should be to make it easier for those behind in retirement savings to catch-up. Taking away this tax deduction makes it more difficult to build up sufficient savings for retirement.

Fortunately, as of this writing SECURE 2.0 has only passed the House. It has not passed the Senate. Hopefully this provision will be reconsidered and will not ultimately become law.

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

Follow me on Twitter at @SeanMoneyandTax

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

The Four Backstops to the Four Percent Rule

Introduction

Worried about an early retirement based on the Four Percent Rule? Might the 4% Rule work because of natural backstops most early retirees enjoy? 

The 4% Rule

The 4% Rule is a rule of thumb developed by the FI community. For example, JL Collins writes extensively about the 4% Rule in Chapter 29 of his classic book The Simple Path to Wealth.

Boiled down, the rule of thumb states that an investor can retire when he or she (or a couple) has 25 times their annual expenses invested in financial assets (equities and bonds). They would then spend down 4% of their wealth annually in retirement. The first year’s withdrawal forms a baseline and is increased annually for inflation.

The idea behind the 4% Rule is that the retiree would have a very strong chance of funding retirement expenses and never running out of money in retirement. As a result, some refer to 4% as a safe withdrawal rate. 

Here’s how it could look:

Maury is 50. He has $1M saved in financial assets. He can spend $40,000 in the first year of retirement. If inflation is 3% at the end of his first year of retirement, he increases his withdrawal by 3% ($1,200) to $41,200 for the second year of retirement.

The 4% Rule has a nice elegance to it. Most investors aim for a greater than 4% return. In theory, with a 5% return every year, the 4% Rule would never fail a retiree. If you spend approximately 4% annually, and earn approximately 5% annually, you have, in theory, created a perpetual money making machine and guaranteed success in retirement.

Watch me discuss the Four Backstops to the 4% Rule

The theory is great. But in practice we know that investors are subject to ups and downs, gains and losses. What happens if there is a large dip in equity and/or bond prices during the first year or two of retirement? What if there are several down years in a row during retirement? 

As a result of these risks, and stock market highs in late 2021, some are worried that the 4% Rule is too generous for many retirees. Christine Benz discussed her concerns on a recent episode of the Earn and Invest podcast. 

This post adds a wrinkle to the discussion: the four backstops to the 4% Rule for early retirees. What if worries about the adequacy of the 4% Rule for early retirees can be addressed by factors outside of the 4% Rule safe withdrawal rate? And what if those factors quite naturally occur for early retirees?  

Resources for the Four Percent Rule

These are links to articles addressing the 4% Rule and safe withdrawal rates

Cooley, Hubbard, and Waltz (Trinity University) 2011

Bengen 1994

Below I discuss what I believe to be the four natural backstops to the 4% Rule. 

Spending

A 4 percent spending rate in retirement is not preordained from on-high. Spending in retirement can be adjusted. Those adjustments can take on two flavors.

The first flavor are defensive spending reductions.  As Michael Kitces observed on an episode of The Bigger Pockets Money podcast, retirees will not blindly spend 4 percent annually without making adjustments in down stock markets.

See that the stock market is down 10 percent this month? Okay, take a domestic vacation for 6 days instead of an international vacation for 9 days. Buy a used car instead of a new car. Scale down and/or delay the kitchen remodel.

There are levers early retirees can pull that can help compensate for declines in financial assets while not too radically altering quality of life. 

The second flavor is, from a financial perspective, even better. As early retirees age, there will be natural reductions in spending. How many 80 year-olds decide to take a 12 hour flight to the tropics for the first time? There is a natural reduction in energy and interest in certain kinds of spending as one ages. It is likely that many retirees will experience very natural declines in expenses as they age. 

Social Security

For the early retiree under 62 years old, the 4% Rule must disregard Social Security. Why? Because Social Security does not pay until age 62, and many in the financial independence community delay Social Security payments beyond age 62, perhaps all the way to age 70 (to increase the annual payment).

Here is an example of how that works.

Melinda is 55. She has accumulated $1.5M in financial assets and can live on $60,000 per year. If she retires at age 55 and lives off $60,000 a year increased annually for inflation, the only financial resources she has are her financial assets (what I refer to as her 4% assets). She cannot live off Social Security payments until age 62, and may choose to defer receiving Social Security up to age 70. 

If Melinda defers Social Security until age 70, and receives $2,500 per month at age 70 from Social Security, her 4% assets now do not need to generate the full 4% once she turns 70, since Social Security will pay her $30,000 a year at age 70.

In theory, under the 4% Rule, Melinda’s Social Security is play money. Melinda funds her lifestyle with withdrawals from her financial assets, and now she’s getting additional Social Security payments. But, if her portfolio is struggling to produce the amount Melinda needs to live off of, Social Security payments provide a backstop and can help make up the difference. 

You might think “but wait a minute, didn’t Melinda significantly lower her Social Security benefits by retiring early by conventional standards? The answer is likely no, as I described in more detail in my post on early retirement and Social Security. First, only the 35 highest years of earnings count for Social Security benefits. At age 55 is it possible Melinda has 35 years of work in. 

Second, and more importantly, Social Security benefits are progressive based on “bend points.” The first approximately $12,000 of average annual earnings are replaced by Social Security at a 90 percent rate. The next approximately $62,000 of average annual earnings are replaced by Social Security at a 32 percent rate, and remaining annual earnings are replaced at a 15 percent rate. This is a fancy way of saying that reducing later earnings, for many workers, will sacrifice Social Security benefits at a 15 percent, or maybe a 32 percent, replacement rate. Even early retirees are likely to have secured all of their 90 percent replacement bend point and a significant amount of their 32 percent replacement bend point. 

I previously wrote the following example:

Chuck is 55 years old and has 32 years of earnings recorded with Social Security. Those earnings, adjusted for inflation by Social Security, total $2,800,000. Divided by 35, they average $80,000. This means Chuck has filled the 90 percent replacement bend point (up to $12,288) and filled the 32 percent replacement bend point (from $12,288 to $74,064) of average annual earnings. If Chuck continues to work, his wages will be replaced at a 15 percent replacement rate by Social Security. 

An additional year of work for Chuck at a $130,000 salary netted Chuck only $557 more in annual Social Security benefits at full retirement age! 

Real Estate

Most early retirees own their own primary residence, usually with either significant equity or no mortgage. That primary residence can be a backstop to the 4% Rule.

For example, a retiree might live in a 2,000 square foot, $500,000 home with no mortgage. During their retirement, they might decide they don’t want to maintain such a large home, so they sell the 2,000 square foot home and move into a 1,000 square foot condominium at a cost of $350,000. The $150,000 difference in sale prices can become a financial asset to backstop 4% Rule assets and help the retiree succeed financially.

Alternatively, the early retiree could sell the $500,000 home and move into a smaller apartment with a $2,000 per month rent. While the retiree has increased their expenses, they also have created $500,000 worth of financial wealth to help pay that rent and fund their other expenses.

A third option is a reverse mortgage where the retiree stays in their primary residence but gets equity out of the home from a bank. 

Real estate can serve as a natural backstop to help ensure retirees have financial security and success.

Death

It’s wet blanket time. You may be considering a 30, 40, or 50 year retirement. Unfortunately, there is a good chance that you will not live that long. Sadly, not all early retirees have a long retirement. 

As demonstrated in these tables, there is a real chance that an early retiree will not live for 25 or 30 years. That factors into whether or not the 4% Rule will work for an early retiree. 

Let’s consider a 55 year old considering early retirement using the 4% Rule. He believes that he will live 30 more years and there is a 95% chance that his assets will last 30 years. He believes that the 4% Rule has a 5% chance of failing him. Further, assume that he believes there is a 30% chance that he will die prior to age 85.

His own potential death reduces the chance that the 4% Rule will fail. Remember, failure requires that he has to both run out of assets and live long enough to run out of assets. By his estimation, the odds that both events will occur are just 3.5 percent. To figure this estimated probability, multiply the probability that he will run out of assets (5%) by the probability that he will live long enough to run out assets (70%). 

A not insignificant number of early retirees will have an early retirement that lasts (sadly) only 10 years, 15 years, or 20 years. That (again, sadly) backstops the 4% Rule. 

Early Retirees vs. Conventional Retirees

I’ve contended that early retirees have four natural backstops to the 4% Rule. What about more conventional retirees? I’ll define a “conventional retiree” as one who collects Social Security soon after retiring. 

I believe conventional retirees enjoy three of the four backstops. Sadly, they “enjoy” the mortality backstop to a greater degree than early retirees. 

Conventional retirees retiring on Social Security do not enjoy Social Security as a backstop to the 4% Rule in most cases. Here’s an example:

Robert is age 65 and is planning to retire on financial assets and Social Security. He will collect $36,000 a year in Social Security and will spend a total of $76,000 a year. To facilitate this, he will initially withdraw $40,000 from his $1M portfolio.

In Robert’s case, Social Security is not a backstop to the 4% Rule. Rather, the 4% Rule is simply one of two necessary but not sufficient sources of funds for his retirement. A failure of the 4% Rule in Robert’s case would not be backstopped by Social Security. 

Conclusion

While there are no guarantees when it comes to safe withdrawal rates in retirement and the 4% Rule, it is possible that many early retirees will succeed with the 4% Rule, for two reasons. First, the 4% Rule may, by itself, be successful for many early retirees. The second reason is that even if the 4% Rule fails, there are four natural backstops in place for many early retirees that can step in and help retirees obtain financial success even if the 4% Rule fails on its own.

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

Follow me on Twitter at @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, 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.

House Passes SECURE Act 2.0

It appears some changes are likely coming to the tax-advantaged retirement savings landscape, as the House of Representatives passed (by a 414-5 vote) the Securing a Strong Retirement Act of 2022. It now goes the Senate where the Senate Finance Committee is likely to offer their own version of the bill. Commentators have referred to this bill as the SECURE Act 2.0 or SECURE 2.0.

Here is the bill text.

This bill is not a paradigm shift in retirement saving and planning. Rather it makes many changes to the tax-advantaged retirement savings rules, most of which are small changes.

Here is a some brief points to consider:

My thinking about the bill

What expanding Roths (“Rothification”) means to the FI/FIRE community

The bill does not include the repeal of the Backdoor Roth IRA.

Deloitte materials on SECURE 2.0.

A good Twitter thread from Ed Zollars.

A nice summary of the most important points from Jamie Hopkins.

Post on ten provisions in the bill.

Stay Tuned: Some version of SECURE 2.0 is likely to be enacted in 2022, but it could get seriously changed in the U.S. Senate.

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

Follow me on Twitter at @SeanMoneyandTax

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

Early Retirement and Social Security

UPDATE October 20, 2023: This post has been updated for the 2024 Social Security numbers.

I can’t retire early! I’ll destroy my Social Security!

Is that true? What happens to Social Security benefits when retirees retire early? Are significantly reduced Social Security benefits a drawback of the financial independence retire early (FIRE) movement? 

Below I explore how Social Security benefits are computed and the effects of retiring early on Social Security.

Social Security Earnings

Form W-2 reports to the government one’s earnings during the year. For the self-employed, the Schedule SE performs this function. The Social Security Administration tracks those earnings. 

Only a limited amount of earnings every year count as Social Security earnings. There is an annual maximum on the amount of earnings that can go on one’s Social Security record, regardless of the number of jobs one has. For 2024, the Social Security cap is $168,600. The cap is increased most years for inflation. Payroll taxes for Social Security (FICA for W-2 workers, self-employment taxes for the self-employed) are not due on earnings above the cap.

Social Security Benefits

A few very general rules need to be established as we consider the amount Social Security pays.

  1. Only the highest 35 years of earnings during one’s working years count in determining Social Security benefits.
  1. For most Americans reading this, full retirement age is 67. This means a person can collect his or her “full” Social Security benefits at age 67.
  1. Social Security benefits can be collected as early as age 62 and can be deferred as late as age 70. Collecting early reduces annual benefits (by roughly 5 to 7 percent per year) and collecting late increases benefits (by 8 percent per year).
  1. Annual earnings used in determining benefits are inflation adjusted through age 59. Earnings earned at age 60 and later are not inflation adjusted for purposes of computing Social Security benefits. 
  1. Very roughly speaking, the annual benefit is computed as follows: accumulated earnings (computed based on the rules described above) in the high 35 years are summed and then divided by 35. The resulting average annual earnings are applied against the Social Security “brackets” or “bend points.” Up to $14,088 (using 2024 numbers) of computed average annual earnings is replaced by Social Security at a 90% rate. The next $70,848 of average annual earnings are replaced at a 32% rate. Any additional amount of average annual earnings is replaced at a 15% replacement rate. The bend points are adjusted for inflation.

One need not be an expert on Social Security to see directionally how early retirement might impact Social Security benefits. Because of the progressive nature of Social Security benefits, leaving work early (by conventional standards) tends to reduce benefits less than one might initially expect. Additional earnings later in life tend to only slightly increase Social Security benefits.  

Early Retirement Social Security Example

Here’s an example to help us understand the impact of an early retirement on Social Security benefits. 

Chuck is 55 years old and has 32 years of earnings recorded with Social Security. Those earnings, adjusted (thus, nominally increased) for inflation by Social Security, total $3,100,000 as of 2024. Divided by 35, they average $88,571. This means Chuck has filled the 90 percent replacement bend point (up to $14,088) and filled the 32 percent replacement bend point (from $14,088 to $84,936) of average annual earnings. If Chuck continues to work, his wages will be replaced at a 15 percent replacement rate by Social Security. 

If Chuck retires now and earns nothing more, his annual Social Security benefits, expressed in 2024 dollars, will look something like this at full retirement age:

Replacement RateReplaced Annual IncomeAnnual Social Security at Full Retirement Age
90%$14,088$12,679
32%$70,848$22,671
15%$3,635$545
Total$88,571$35,896

Note that I rounded each bend point’s calculation. With the cents Chuck gets in each bend point, his total is increased by almost a full dollar. Similar rounding applies to the examples below as well.

At age 67, Chuck’s annual Social Security will be $35,896 (expressed in 2024 dollars).

If Chuck continues to work for one more year at a $130,000 salary, and then retires his annual Social Security benefits at full retirement age, expressed in 2024 dollars, looks something like this:

Replacement RateReplaced Annual IncomeAnnual Social Security at Full Retirement Age
90%$14,088$12,679
32%$70,848$22,671
15%$7,349$1,102
Total$92,285$36,453

Interestingly, an additional year of work only increased Chuck’s annual Social Security benefit by $557. Why is that? Remember that every dollar earned is divided by 35 for purposes of computing Social Security benefits. You can see that Chuck’s replaced income increased by $3,714 (from $88,571 to $92,285). By earning $130,000 in 2024, Chuck increased his Social Security average annual income by $3,714, which is $130,000 divided by 35.

Multiplying the increase in replaced income ($3,714) by the replacement rate (15%) gets us the additional $557 in annual Social Security benefits. 

Okay, but what about three more years of earnings. Say Chuck can work for three more years at an average annual salary of $135,000. What result (in 2024 dollars) then? 

Replacement RateReplaced Annual IncomeAnnual Social Security at Full Retirement Age
90%$14,088$12,679
32%$70,848$22,671
15%$18,920$2,838
Total$103,856$38,188

Where I come from, $1,735 ($38,188 minus $36,453) in increased annual Social Security benefits at full retirement age is not nothing. But is it worth delaying retirement for three full years if one is otherwise financially independent? To my mind, probably not. 

Spousal Benefits

What if Chuck is married to Mary? How does that impact the analysis?

During Chuck and Mary’s joint lifetimes, it depends on whether Mary collects spousal benefits. If Mary has Social Security earnings of greater than 50 percent of Chuck’s Social Security earnings, she will likely collect benefits under her own earnings record, and not a spousal benefit. Thus, Chuck’s Social Security earnings will be irrelevant to the Social Security benefit Mary collects.

If, however, Mary’s lifetime Social Security earnings are less than 50 percent of Chuck’s, Mary is likely to collect a spousal benefit of roughly half of Chuck’s annual benefit. In this case, Chuck working 3 more years creates $2,603 of additional annual Social Security income ($1,735 for Chuck and $868 as Mary’s spousal benefit). Even $2,603 in additional annual income isn’t likely to justify Chuck working for three more years.

At Chuck’s death, assuming Chuck predeceases Mary, Mary will collect the greater of her own Social Security benefit or Chuck’s Social Security benefit. Thus, Chuck increasing his Social Security earnings could increase Mary’s Social Security benefit as a widow.

I’ve got a plan to save Social Security and Medicare.

Resource

Most people I know cannot tell you their Social Security earnings record off the top of their head. But, this information is accessible by creating an account at ssa.gov. From there, Americans can obtain their Social Security statement which includes their Social Security earnings (though the statement does not adjust those annual earnings for inflation). The 2024 factors to increase annual earnings for inflation can be found by entering “2024” in the search box at the bottom of this SSA.gov website.

Conclusion

There are many factors to consider before retiring early. It is helpful to understand how Social Security benefits are computed so early retirees can understand the potential impact of retiring on their Social Security benefits. 

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

Follow me on Twitter at @SeanMoneyandTax

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

Recipe for Reporting a Backdoor Roth IRA

When it comes to the Backdoor Roth IRA, I’ve seen it all. Reporting a Backdoor Roth IRA on tax returns remains confusing for both taxpayers and tax return preparers. Here’s the recipe I recommend using to report the Backdoor Roth IRA on the tax return and avoid overpaying taxes.

Watch me discuss reporting Backdoor Roth IRAs on tax returns.

Let’s consider a hypothetical Backdoor Roth IRA on a 2021 tax return.

Example: On January 1, 2021, John Smith contributed $6,000.00 to a traditional IRA. On February 1, 2021, John Smith converted the entire amount in his traditional IRA, $6,001.00, to a Roth IRA. On December 31, 2021, John Smith had a zero balance in all his traditional IRAs, SEP IRAs, and SIMPLE IRAs. John Smith’s income is such that he qualifies for neither a deductible traditional IRA contribution nor a regular annual Roth IRA contribution. John has no existing basis in traditional IRAs as of January 1, 2021. 

Ingredients

Dry Ingredients

  • Taxpayer & Spouse Form W-2 and/or self-employed retirement contributions
  • The prior year’s Form 8606 (if the taxpayer has existing traditional IRA basis – most Backdoor Roth IRA taxpayers do not)

Wet Ingredients

  • Forms 5498 from financial institutions
    • If not available, substitute (i) end-of-year balances in all traditional IRAs, SEP IRAs, and SIMPLE IRAs and (ii) taxpayer knowledge or IRA account statement
  • Forms 1099-R from financial institutions

Directions

First, Enter the Dry Ingredients

In order to ensure that the tax return software has all the information to properly report the Backdoor Roth IRA, the taxpayer’s and spouse’s Forms W-2 (if any) should be properly entered into the tax return software. In particular, if Box 13 is checked, that should be indicated in the tax return software. Any qualifying self-employed retirement plan (Solo 401(k), SEP IRA, SIMPLE IRA) contributions should also be entered into the software. This requires the computation of the Schedule C to validate the correctness of the self-employment retirement contributions. 

Lastly, any established and still existing traditional IRA basis reported on previously filed Forms 8606 must be entered into the software. For those who have properly done Backdoor Roth IRAs in the past, this is extremely rare, but not impossible. Most such taxpayers enter the year with $0 of such basis. 

None of these steps directly report the current year’s Backdoor Roth IRA. However, without properly completing them, the tax return software will be unlikely to report the Backdoor Roth IRA correctly. 

Second, Enter The Traditional IRA Contribution

The first step in the tax return process is entering the traditional nondeductible IRA contribution into the tax return software. In theory, this should come off the Form 5498 (Box 1). In practice, that is not likely. The Form 5498 is not required to be filed by the financial institution until May 31st. Vanguard, for example, provides these forms in mid-May. 

If the taxpayer has a Form 5498 when preparing their tax return (perhaps because they are filing the return on extension), Box 1 of the form should report the traditional IRA contribution. In most circumstances, taxpayers will use their own knowledge of the transaction or their IRA account statement to report that they made a $6,000 nondeductible traditional IRA contribution.

By entering the $6,000.00 traditional IRA contribution into the tax return software, John’s tax return should generate a Form 8606. This is crucial for two reasons. First, the nondeductible traditional IRA contribution must be reported. Second, the nondeductible contribution establishes the “basis” that keeps John’s Backdoor Roth IRA as almost entirely tax free. 

Note further that IRAs are a single person item, meaning that there is no such thing as a “joint” IRA. Each spouse must enter his or her information separately, and must file his or her own individual Form 8606 as needed. Where spouses can impact the calculations and reporting is the ability to deduct an IRA contribution where one spouse is covered by a workplace retirement plan and the other spouse is not. 

Third, Enter the Roth Conversion

This is where the tax return reporting can go a bit off the rails if one is not careful. Tax return software usually has an input for Forms 1099-R. The Form 1099-R should be entered into the tax return software. 

John’s Form 1099-R should look like this (please pretend it is for 2021):

It is important to input all of the boxes on the Form 1099-R in the tax return software to help ensure that the software understands the transaction and no penalties are charged (there should be none as the transaction is a Roth conversion).

Some worry about Box 2a reporting $6,001.00 as the “taxable amount.” It’s okay! The taxable amount is in fact $6,001.00. However, it must be remembered that taxpayers must pay tax on the taxable amount reduced by the allowed available basis. 

How do we know what the allowed available basis is? By preparing and filing the Form 8606! To prepare the Form 8606, we must have all the ingredients above. It will be important that the following information is input into the Form 8606:

  • Current year traditional IRA contribution ($6,000.00)
  • Current year Roth IRA conversion ($6,001.00)
  • Balance in all traditional IRAs, SEP IRAs, and SIMPLE IRAs on December 31, 2021 ($0 in John’s case)

At this point the first two data points are in the tax return software. The last one must now be added to the software. Assuming the tax return is prepared prior to May, the taxpayer needs to review all of their existing traditional IRAs, SEP IRAs, and SIMPLE IRAs to ensure that as of December 31, 2021 there were no balances in those accounts. If there were balances, they must be added up and reported on line 6 of the Form 8606.

The Finished Product

Here is what page 1 of John’s Form 8606 should look like out of the oven.

Because Line 6 is $0, John’s allowed available basis is $6,000, the amount of 2021 nondeductible traditional IRA contribution. Separately, I blogged about the result if there is a substantial amount on Line 6 (hint: the allowed available basis decreases sharply, see Example 2). 

Unfortunately, I know that at least one tax return preparation software references a worksheet instead of populating the form in the output that the taxpayer sees. The correct information is (apparently) communicated to the IRS through electronic filing, but I wish all software providers simply populated the form to make it easier for review. 

Having successfully completed the first page of the Form 8606, the odds are that page 2 will also be successfully completed. Here’s what it should look like:

The final check on all of this comes from page 1 of Form 1040. If the Form 8606 is not correctly prepared, page 1 of Form 1040 will not correctly reflect the taxation of the Backdoor Roth IRA.

Assuming the taxpayer completed a 2021 Backdoor Roth IRA as John Smith did, page 1 of Form 1040 should look like this:

The key lines are Line 4a and Line 4b. Line 4a will simply be the sum of all Box 1’s from Forms 1099-R. In John’s case, that is $6,001. Line 4b is where the confusion comes. If the Form 8606 is properly prepared, the correct amount from Line 18 of Form 8606 should be the taxable amount reported on Line 4b of Form 8606. 

Fixing Backdoor Roth IRA Errors

Errors in previously filed tax returns can be fixed! I previously blogged about amending previously filed tax returns in cases where a Backdoor Roth IRA has been mistakenly reported. 

2023 Tax Season Backdoor Roth IRA Tax Return Reporting

Watch me discuss Backdoor Roth IRA tax return reporting.

Conclusion

Getting Backdoor Roth IRA tax return reporting is the last vital step in successfully executing a Backdoor Roth IRA. While it is not a simple exercise, it can be navigated with educational resources such as this blog post.

While tax return preparation software is great, it does not replace a taxpayer’s own judgment. Ultimately it is up to the taxpayer to ensure that the tax return properly reports the Backdoor Roth IRA. In many cases it will be wise to use a professional tax return preparer to prepare a tax return if the taxpayer has done a Backdoor Roth 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.

Sean Launches YouTube Channel

Enjoy videos on my brand new YouTube Channel. The channel will focus on tax and personal finance topics. I have ten tax videos up there to watch. My goal is to post a new tax or personal finance video every Saturday morning at 7AM Pacific.

Highlights include an update on 2022 Backdoor Roth IRAs, news on 72(t) payments, and one way to use tax planning to fight inflation.

Videos will usually be anywhere from 2 to 5 minutes.

I appreciate your viewing and liking my videos. Please subscribe to my channel.

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

Follow me on Twitter: @SeanMoneyandTax

This post, and all videos, text, and comments on my YouTube channel, 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.