Tag Archives: Required Minimum Distributions

72(t) Series of Substantially Equal Periodic Payments Update

The IRS and Treasury have recently issued two updates to the rules for payments which avoid the 10 percent early withdrawal penalty from retirement accounts. These payments are referred to as a series of substantially equal periodic payments, SEPP, or 72(t) payments. This post discusses the updated rules.

72(t) Payments

Tax advantaged retirement accounts are fantastic. Who doesn’t love 401(k)s, IRAs, Roth IRAs, and the like?

However, investing through a tax advantaged account can have drawbacks. One big drawback is that taxable amounts withdrawn from a tax advantaged retirement account prior to the account owner turning age 59 ½ are generally subject to a 10 percent early withdrawal penalty. My home state of California adds a 2.5 percent early withdrawal penalty.

There are some exceptions to this penalty. One of them is taking 72(t) payments. The idea is that if the taxpayer takes a “series of substantially equal periodic payments” they can avoid the penalty.

72(t) payments must be taken annually. Further, they must last for the longer of (a) 5 years or (b) the time until the taxpayer turns age 59 ½. This creates years of locked-in taxable income.

There are three methods that can be used to compute the amount of the annual 72(t) payments. These methods compute an annual distribution amount generally keyed off three numbers: the balance in the relevant retirement account, the interest rate, and the table factor provided by the IRS. The factor is greater the younger the account owner is. The greater the factor, the less the account owner can withdraw from a retirement account in a 72(t) payment.

New 72(t) Payment Interest Rates

In January 2022, the IRS and Treasury issued Notice 2022-6. Hat tip to Ed Zollars for the alert. This notice provides some new 72(t) rules. The biggest, and most welcome, change is a new rule for determining the interest rate.

Previously, the rule had been that 72(t) payments were keyed off 120 percent of the mid-term applicable federal rate (“AFR”). The IRS publishes this rate every month. In recent years, that has been somewhat problematic, as interest rates have been historically low. For example, in September 2020, the mid-term AFR was just 0.42 percent. This made relying on a 72(t) payment somewhat perilous. How much juice can be squeezed from a large retirement account if the interest rate is just 0.42 percent?

Here is what a $1M traditional IRA could produce, under the fixed amortization method, in terms of an annual payment for a 53 year old starting a 72(t) payment if the interest rate is just 0.42 percent:

120% of Sept 2020 MidTerm AFR		0.42%
Single Life Expectancy Years at Age 53		33.4
Account Balance		$1,000,000.00

Annual Payment		$32,151.93

Notice 2022-6 makes a very significant change. It now allows taxpayers to pick the greater of (i) up to 5 percent or (ii) up to 120 percent of mid-term AFR. That one change makes a 72(t) payment a much more attractive option, since periods of low interest rates do not as adversely affect the calculation.

Here is what a $1M traditional IRA could produce, under the fixed amortization method, in terms of an annual payment for a 53 year old starting a 72(t) payment if the interest rate is 5 percent:

5% Interest Rate		5.00%
Single Life Expectancy Years at Age 53		33.4
Account Balance		$1,000,000.00

Annual Payment		$62,189.80

The new rule provides a 5 percent interest rate floor for those using the fixed amortization method and the fixed annuitization method to compute a 72(t) payment. Using a 5 percent interest rate under the fixed amortization method is generally going to produce a greater payment amount than using the required minimum distribution method for 72(t) payments.

The interest rate change provides taxpayers with much more flexibility with 72(t) payments, and a greater ability to extract more money penalty free prior to age 59 ½. Taxpayers already have the ability to “right-size” the traditional IRA out of which to take a 72(t) payment to help the numbers work out. In recent years, what has been much less flexible has been the interest rate. Under these new rules, taxpayers always have the ability to select anywhere from just above 0% to 5% regardless of what 120 percent of mid-term AFR is.

Watch me discuss the update to 72(t) payment interest rates.

New Tables

A second new development is that the IRS and Treasury have issued new life expectancy tables for required minimum distributions (“RMDs”) and 72(t) payments. Most of the new tables are found at Treasury Regulation Section 1.401(a)(9)-9, though one new table is found at the end of Notice 2022-6.

These tables reflect increasing life expectancies. As a result, they reduce the amount of RMDs, as the factors used to compute RMDs are greater as life expectancy increases.

From a 72(t) payment perspective, this development is a minor taxpayer unfavorable development. Long life expectancies in the tables means the tables slightly reduce the amount of juice that can be squeezed out of any particular retirement account.

This said, the downside to 72(t) payments coming from increasing life expectancy on the tables is more than overcome by the ability to always use an interest rate of up to 5 percent. These two developments in total are a great net win for taxpayers looking to use 72(t) payments during retirement.

Use of 72(t) Payments

Traditionally, I have viewed 72(t) payments as a life raft rather than as a desirable planning tool for those retiring prior to their 59 ½th birthday. Particularly for those in the FI community, my view has been that it is better to spend down taxable assets and even dip into Roth basis rather than employ a 72(t) payment plan.

These developments shift my view a bit. Yes, I still view 72(t) payments as a life raft. Now it is an upgraded life raft with a small flatscreen TV and mini-fridge. 😉

As a practical matter, some will get to retirement prior to age 59 ½ with little in taxable and Roth accounts, and the vast majority of their financial wealth in traditional retirement accounts. Notice 2022-6 just made their situation much better and much more flexible. Getting to retirement at a time of very low interest rates does not necessarily hamstring their retirement plans given that they will always have at least a 5 percent interest rate to use in calculating their 72(t) payments.

72(t) Payments and Roth IRAs

As Roth accounts grow in value, there will be at least some thought of marrying Roth IRAs with 72(t) payments.

At least initially, Roth IRAs have no need for 72(t) payments. Those retired prior to age 59 ½ can withdraw previous Roth contributions and Roth conversions aged at least 5 years at any time tax and penalty free for any reason. So off the bat, no particular issue, as nonqualified distributions will start-off as being tax and penalty free.

Only after all Roth contributions have been withdrawn are Roth conversions withdrawn, and they are withdrawn first-in, first-out. Only after all Roth conversions are withdrawn does a taxpayer withdraw Roth earnings.

For most, the odds of withdrawing (i) Roth conversions that are less than five years old, and then (ii) Roth earnings prior to age 59 ½ are slim. But, there could some who love Roths so much they largely or entirely eschew traditional retirement account contributions. One could imagine an early retiree with only Roth IRAs.

Being “Roth only” prior to age 59 ½ could present problems if contributions and conversions at least 5 years old have been fully depleted. Taxpayers left with withdrawing conversions less than 5 years old or earnings in a nonqualified distribution might opt to establish a 72(t) payment plan for their Roth IRA. Such a 72(t) payment plan could avoid the 10 percent penalty on the withdrawn amounts attributable insufficiently aged conversions or Roth earnings. Note, however, that Roth earnings withdrawn in a nonqualified distribution are subject to ordinary income tax, regardless of whether they are part of a 72(t) payment plan.

See Treasury Regulation Section 1.408A-6 Q&A 5 providing that Roth IRA distributions can be subject to both the 72(t) early withdrawal penalty and the exceptions to the 72(t) penalty. The exceptions include a 72(t) payment plan.

Additional Resource

Ed Zollars has an excellent post on the updated IRS rules for 72(t) payments here.

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

Follow me on Twitter: @SeanMoneyandTax

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

2021 YEAR-END TAX PLANNING

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

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

Backdoor Roth IRA Deadline 2021

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

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

Taxpayers on the Roth IRA MAGI Limit Borderline

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

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

December 31st and Backdoor Roth IRAs

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

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

IRAs and HSAs

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

Solo 401(k)

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

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

Charitable Contributions

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

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

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

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

Early Retirement Tax Planning

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

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

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

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

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

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

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

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

Roth Conversions, Tax Gain Harvesting, and Tax Loss Harvesting

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

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

Stimulus and Child Tax Credit Planning

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

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

Accelerate Payments

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

State Tax Planning

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

Required Minimum Distributions (“RMDs”)

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

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

Planning for Traditional Retirement Accounts Inherited in 2020 and 2021

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

2021 Federal Estimated Taxes

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

Review & Update Beneficiary Designation Forms

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

2022 and Beyond Tax Planning

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

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

Follow me on Twitter: @SeanMoneyandTax

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.

QCDs and the FI Community

Qualified charitable distributions (“QCDs”) are an exciting tax planning opportunity, particularly for the FI community. Below I describe what a qualified charitable distribution is and how members of the FI community should think about them when tax planning.

Of course, this post is educational in nature. Nothing in this blog post is tax advice for any particular taxpayer. Please consult your own tax advisor regarding your unique circumstances.

Qualified Charitable Distributions

QCDs are transfers from a traditional IRA directly to a charity. Up to $100K annually, they are (a) not included in the taxpayer’s taxable income, (b) not deductible as charitable contributions, and (c) qualify as “required minimum distributions” (“RMDs”) (to the lesser of the taxpayer’s required minimum distribution or the actual distribution to the charity). Here is an example:

Example 1: Jack and Jill are 75 years old and file their tax return married filing joint. Jack has a RMD from his traditional IRA of $40,000 in 2021. Jack directs his traditional IRA institution to transfer $40,000 during 2021 to a section 501(c)(3) charity. Jack and Jill recognize no taxable income on the transfer, and Jack does not have to take his 2021 RMD (the $40K QCD having covered it). Further, Jack and Jill receive no charitable contribution deduction for the transfer.

Considering that Jack & Jill (both age 75) enjoy a standard deduction of $27,800 in 2021, they get both the standard deduction and a $40K deduction for the charitable contribution from the traditional IRA (since they do not have to include the $40K in their taxable income). This is the best of both worlds. Further, excluding the $40K from “adjusted gross income” (“AGI”) is actually better than taking the $40K as an itemized deduction, since many tests for tax benefits are keyed off of AGI instead of taxable income.

Important QCD Considerations

Take QCDs Early

Generally speaking, it is best that QCDs come out of the traditional IRA early in the year. Why? Because under the tax rules, RMDs come out of a traditional IRA first. So it is usually optimal to take the QCD early in the year so it can fulfill all or part of the required minimum distribution for the year. Then you can do Roth conversion planning (if desired), so long as the full RMD has already been withdrawn (either or both through a QCD and a regular distribution) from the traditional IRA first.

No Trinkets

I don’t care how much you love your PBS tote bag: do not accept any gift or token of appreciation from the charity. The receipt of anything (other than satisfaction) from the charity blows the QCD treatment. So be sure not to accept anything from the charity in exchange for your QCD.

QCDs Available Only from Traditional IRAs

In order to take advantage of QCD treatment, the account must be a traditional IRA. 401(k)s and other workplace plans do not qualify for QCDs. Further, SIMPLE IRAs and SEP IRAs do not qualify for QCD treatment.

As a practical matter, this is not much of an issue. If you want to do a QCD out of a 401(k) or other tax advantaged account, generally all you need to do is rollover the account to a traditional IRA.

QCD Age Requirement

In order to take advantage of the QCD opportunity, the traditional IRA owner must be aged 70 ½ or older.

Inherited IRAs

QCDs are available to the beneficiary of an inherited IRA so long as the beneficiary is age 70 ½ or older.

QCDs For Those Age 70 ½ and Older

If you are aged 70 ½ or older and charitably inclined, the QCD often is the go-to technique for charitable giving. In most cases, it makes sense to make your charitable contributions directly from your traditional IRA, up to $100,000 per year. QCDs help shield RMDs from taxation and help keep AGI low.

QCDs and the Pro-Rata Rule

If you have made previous non-deductible contributions to your traditional IRA, distributions are generally subject to the pro-rata rule (i.e., the old contributions are recovered ratably as distributions come out of the traditional IRA).

However, QCDs are not subject to the pro-rata rule! This has a positive effect on future taxable distributions from the traditional IRA. Here is an example of how this works:

Example 2: Mike is age 75. On January 1, 2021, he had a traditional IRA worth $500,000 to which he previously made $50,000 of nondeductible contributions. If Mike makes a $10,000 QCD to his favorite charity, his traditional IRA goes down in value to $490,000. However, his QCD does not take out any of his $50,000 of basis from nondeductible contributions. This has the nice effect of reducing the tax on future taxable distributions to Mike from the traditional IRA, since the QCD reduces denominator (by $10K) for determining how much basis is recovered, while the numerator ($50K) is unaffected.

QCDs for Those Under Age 70 ½

Those in the FI community considering early retirement need to strongly consider Roth conversions. The general idea is that if you can retire early with sufficient wealth to support your lifestyle, you can have several years before age 70 during which your taxable income is artificially low. During those years, you can convert old traditional retirement accounts Roth accounts while you are taxed at very low federal income tax brackets.

For the charitably inclined, the planning should account for the QCD opportunity. There is no reason to convert almost every dime to Roth accounts if you plan on giving significant sums to charity during your retirement. Why pay any federal or state income tax on amounts that you ultimately will give to charity?

If you are under the age of 70 ½ and are charitably inclined, QCDs should be part of your long term financial independence gameplan. You should leave enough in your traditional retirement accounts to support your charitable giving at age 70 ½ and beyond (up to $100K annually). These amounts can come out as tax-free QCDs at that point, so why pay any tax on these amounts in your 50s or 60s? Generally speaking, a Roth conversion strategy should account for QCDs for the charitably inclined.

Conclusion

For the charitably inclined, QCDs can be a great way to manage taxable income and qualify for tax benefits in retirement. QCDs also reduce the pressure on Roth conversion planning prior to age 72, since it provides a way to keep money in traditional accounts without having to pay tax on that money.

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

Follow me on Twitter: @SeanMoneyandTax

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

Roth IRA Withdrawals

The Roth IRA is 25 years old as of 2023 (its birthday was January 1st). Yet there is still confusion about the rules applicable whenever someone withdraws money from a Roth IRA prior to turning 59 ½. This blog post attempts to correct some misconceptions on the taxation of nonqualified Roth IRA withdrawals.

Watch me discuss Roth IRA withdrawals.

Roth IRAs: The Basics

A Roth IRA is a tax-advantaged account that generally offers tax-free growth for invested amounts. Taxpayers receive no upfront tax deduction for putting money into a Roth IRA. If properly executed, taxpayers can withdraw money from a Roth IRA entirely tax and penalty free, and can enjoy years of tax-free growth on the amounts invested in a Roth IRA.

I have previously blogged about why I believe the Roth IRA is a great tax-advantaged account in my An Ode to the Roth IRA.

Roth IRA Funding

How does one move money into a Roth IRA? There are three ways.

Annual Contributions

Generally speaking, if your income is below certain limits, you can contribute up to the lesser of $6,500 or your earned income (2023 limits) to a Roth IRA. If you are aged 50 or older, the limits are the lesser of $7,500 or earned income (2023 limits).

I discussed Roth IRA annual contributions, including the income limits on the ability to make Roth IRA contributions, in this post.

Conversions

Amounts can be converted from traditional retirement accounts into a Roth IRA. Any taxpayer can convert amounts from a traditional retirement account to a Roth IRA. There are no restrictions based on level of income and/or having had earned income.

Conversions are taxable in the year of the conversion.

There are several reasons you might want to do a Roth IRA conversion. One might be the anticipation of paying tax at a higher rate in the future. The planning concept is to “lock in” the lower tax rate in the year of the conversion rather than tomorrow’s (anticipated) higher tax rate, and to get all of the earnings on the contribution out of income taxation.

Unlimited Roth IRA conversions form the backbone of the Backdoor Roth IRA planning concept.

Note that inherited traditional IRAs cannot be converted to Roth IRAs.

Transfers from Workplace Retirement Accounts

A third way to get money into a Roth IRA is by using workplace retirement accounts. Amounts in Roth 401(k)s and other workplace Roth accounts can be transferred into a Roth IRA. Generally, it is best to use direct “trustee-to-trustee” transfers to accomplish this.

Further, after-tax contributions in workplace retirement plans can be directly transferred to Roth IRAs, as discussed in Notice 2014-54. The ability to transfer after-tax contributions into a Roth IRA has facilitated the use of the Mega Backdoor Roth IRA planning technique.

Roth IRA Withdrawals: The Confusion

You may have heard that you cannot take money out of a Roth IRA if the account is not 5 years old without paying tax and a penalty. Not true!

There are not one, but two, five (5) year rules applicable to Roth IRAs. But neither one of them prohibit you from taking money out of a Roth IRA you have previously contributed through annual contributions. First, I will illustrate the default Roth IRA withdrawal rules, and then I will discuss the two 5 year rules.

Quick Thought: Most of this blog post addresses situations where the taxpayer does not qualify for a qualified distribution. Generally, a taxpayer fails to qualify for a qualified distribution if he or she has not attained the age of 59 ½, and/or if he or she has not owned a Roth IRA for 5 years. The advantage of a qualified distribution is that it is automatically tax and penalty free.

Roth IRA Withdrawals: The Layers

Here is the default order of distributions that come out of a Roth IRA. These are the rules that apply in cases where the taxpayer does not qualify for a qualified distribution. All Roth IRAs (other than inherited Roth IRAs) the taxpayer owns are aggregated for purposes of determining his or her Roth IRA layers.

First Layer: Tax-free return of Roth IRA contributions

Second Layer: Roth IRA conversions (first-in, first-out)

Third Layer: Roth IRA earnings

Each layer must come out entirely before the subsequent layer is accessed.

Here’s a brief example:

Example 1: Samantha opened her only Roth IRA in 2018. Samantha has made three prior $5,000 contributions to her Roth IRA (one for each of 2018, 2019, and 2020). She also made a $5,000 conversion from a traditional IRA to a Roth IRA in 2018. In 2021, at a time when her Roth IRA is worth $30,000 and Samantha is 50 years old, she takes a $10,000 withdrawal from her Roth IRA. All $10,000 will be a recovery of her previous contributions (leaving her with $5,000 remaining of previous contributions). Thus, the entire $10,000 distribution from the Roth IRA will be tax and penalty free.

The Roth IRA contributions come out tax and penalty free at any time for any reason! The 5 year rules have nothing to do with whether a taxpayer can recover their previous Roth IRA contributions tax and penalty free!

For those wanting to dig deeper into the tax law, please refer to this technical slide deck discussing why the Roth IRA contributions are distributed tax and penalty free regardless of the 5 year rules.

Note that aggregation rules always apply. In making an analysis like the one provided in Example 1, one must account for all their Roth IRAs and treat all of their Roth IRAs as a single Roth IRA to determine their own Roth IRA layers. Roth 401(k)s and inherited Roth IRAs are not included in the analysis.

5 Year Rule for Roth IRA Earnings

The first five-year rule for Roth IRAs applies only to a withdrawal of earnings from a Roth IRA. If the account owner has not owned a Roth IRA for at least 5 years, the earnings withdrawn from the account are subject to ordinary income tax (and possibly a penalty).

Example 2: Joe is 62 years old in 2024. He has owned a Roth IRA since 2021. In 2024, after having made $14,000 in prior annual contributions to his Roth IRA, he withdrew $17,000 from the Roth IRA. Because Joe has not owned a Roth IRA for 5 years, the withdrawal is not a qualified distribution. Joe recovers his first $14,000 tax free as a return of contributions. The next $3,000 of earnings is taxable to Joe as ordinary income (because of the first five-year rule). Because Joe is over age 59 ½, he does not owe the ten percent penalty on the distribution. If Joe had not attained the age of 59 ½, he would owe the 10 percent penalty on the $3,000 of earnings he received.

5 Year Rule for Roth IRA Conversions

There is a five-year rule applicable to taxable money converted from a traditional retirement account to a Roth IRA (what I will colloquially refer to as the “second five-year rule”). The idea behind the second five-year rule is to protect the 10% early withdrawal penalty applicable when someone has a traditional retirement account. Here is an illustrative example.

Example 3: Milton has $100,000 in a traditional IRA, no basis in any IRA, and is age 50. If he were to withdraw $1,000 from his traditional IRA (assuming no penalty exception applies), he would owe (in addition to ordinary income tax) a $100 penalty (ten percent) on the withdrawal.

Okay, but what if Milton first converts that money from a traditional IRA to a Roth IRA (assume Milton has no other balance in a Roth IRA)? Would that get him out of the 10 percent penalty? No, it won’t, because of the second five-year rule.

Example 4: Milton has $100,000 in a traditional IRA, no basis in any IRA, has no Roth IRAs, and is age 50. In September 2024, he converts $1,000 to a Roth IRA. In October 2024, he withdraws $1,000 from that Roth IRA. Because of the five-year rule applicable to Roth IRA conversions, Milton will still owe the $100 penalty on the withdrawal from the Roth IRA.

Had Milton waited until 2029 or later, he would not have owed the penalty on the withdrawal of that $1,000.

The 5 Year Rule for Roth IRA Conversions and the Backdoor Roth IRA

The Backdoor Roth IRA is subject to the second five-year rule, but the penalty effect turns out to be very minor (or non-existent) if the Backdoor Roth IRA has been properly executed.

Conversions, the second layer of the Roth IRA stack, come out first-in, first out. Further, the taxable amount (potentially subject to the 10 percent penalty upon withdrawal) of any one particular Roth IRA conversion comes out first within the conversion amount. Thus, the second layer (the conversion layer) can be composed of several mini-layers.

Here is a quick example:

Example 5: Denzel made $6,000 nondeductible traditional IRA contributions on January 1, 2019 and January 1, 2020. On February 2, 2019 and February 2, 2020, Denzel converted the entire balance of the traditional IRA ($6,010 each time) to a Roth IRA. As of December 31, 2019 and December 31, 2020, Denzel had $0 balances in all traditional IRAs, SEP IRAs, and SIMPLE IRAs.

In 2021, at a time when Denzel is 35 years old and has made no other contributions or conversions to a Roth IRA, he withdraws $3,000 from his Roth IRA. The first $10 of the withdrawal will be from the taxable amount of his 2019 Roth conversion, and thus, will be subject to the 10 percent penalty as it violates the second five-year rule (Denzel will owe $1 in penalties). The next $2,990 is attributable to the non-taxable portion of his 2019 Roth conversion, and as such, will not be subject to the 10 percent penalty. None of the $3,000 will be subject to ordinary income tax.

Penalty Exceptions

From time to time you will hear things such as “you can withdraw only $10,000 from a Roth IRA for a first-time home purchase.” Does that mean everything else discussed above does not apply?

Fortunately, the answer is no!

So what is the $10,000 rule getting at? It is getting at amounts withdrawn from a Roth IRA that would otherwise be subject to the penalty (and possibly income taxes — see The Super Exceptions below).

There are several penalty exceptions applicable to taxable converted amounts and earnings that are withdrawn from a Roth IRA in a nonqualified distribution. But the penalty exception rules generally apply on top of the usual layering rules, not instead of the usual Roth IRA layering rules.

In a discussion on social media, I used a version of the following example.

Example 6: Jane Taxpayer, age 30, has had a Roth IRA since 2017. In 2020, she withdraws $30,000 from her Roth IRA to acquire her first home, and has never used traditional IRA and/or Roth IRA money for such a purchase. She has previously made $20,000 in annual contributions to the Roth IRA. The first $20,000 of the withdrawal is a tax-free return of those contributions (see the layers above). The next $10,000 is out of earnings (see the layers above). This $10,000 is taxable to her as ordinary income. But, because of the $10,000 “qualified first-time homebuyer distribution” exception, she does not owe the 10 percent penalty on the withdrawal of those earnings.

In this case, withdrawals used to fund certain home purchases can qualify for a penalty exception (the first-time homebuyer exception is subject to a $10,000 cap). Please visit this website for a list of the possible penalty exceptions applicable to withdrawals from a traditional IRA and a Roth IRA.

The Super Exceptions

If the taxpayer is relying on the disability, age 59 ½, death, or qualified first-time home purchase penalty exceptions, the earnings also come out income tax free so long as the taxpayer has owned a Roth IRA for five years. See slide 5 of the above referenced technical slide deck.

As applied to Jane Taxpayer in Example 6 above, if she had owned a Roth IRA since any time in 2015 or earlier, the distribution of $10,000 of earnings would not only have been penalty free, it would have also been income tax free.

60 Day Rollovers

A taxpayer might take money out of a Roth IRA and then reconsider. Perhaps he or she wants the money to grow tax-free. Or perhaps the taxpayer dipped into earnings and the distribution is not a qualified distribution, meaning that it will likely be subject to both ordinary income and a ten percent penalty.

He or she might be able to roll the money back into the Roth IRA. However, the tax rules allow only one 60 day rollover every 12 months. The IRS has a website here discussing some of the issues.

Because of the one-rollover-per-year rule, I generally advise against doing 60 day rollovers unless you need to. Generally, it is best to avoid them, and then have the option available as a life raft if money somehow comes out of a Roth IRA (or other IRA) when it should not have.

Required Minimum Distributions

There are no required minimum distributions from a Roth IRA! Every other non-HSA tax-advantaged retirement account, including the Roth 401(k), has required minimum distributions.

Note that required minimum distributions are generally required once the Roth IRA becomes an inherited Roth IRA (in the hands of anyone but certain surviving spouses).

Tax Planning

Okay, so taxpayers always have tax and penalty free access to old Roth IRA annual contributions. So what of it? As a practical matter, maybe nothing.

In most cases, it makes sense to simply keep the money in the Roth IRA and let it grow tax free!

That said, there can be instances where, as part of a well crafted financial plan, it can make sense to withdraw previous Roth IRA contributions prior to age 59 ½. Further, it is good to know that, in an emergency situation, those old Roth IRA contributions are accessible.

Of course, prior to taking an early withdrawal from a Roth IRA, it is usually best to consult with your own financial advisor and/or tax advisor.

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.

Roth 401k Withdrawals

We live in a Roth IRA world (or, at least I wish we did). We also live in a world where increasing numbers of people invest through a Roth 401(k).

The Roth 401(k) is still a relatively new account. Taxpayers and practitioners alike are still learning its contours. Things get even more complicated when you roll money from a workplace Roth 401(k) to a Roth IRA.

To get our feet wet, first I will illustrate the ordering rules for withdrawals from a Roth IRA. Then we will explore withdrawals from a Roth 401(k).

Note that much of this post discusses withdrawals before age 59 ½. In most cases, it is not wise to take a withdrawal from a retirement account before age 59 ½ unless (a) there is an emergency or (b) it is part of a well crafted financial plan.

Watch me discuss Roth 401(k) withdrawals.

Default Rule for Roth IRA Withdrawals: The Layers

Unless the distribution qualifies as a “qualified distribution” (see below), amounts come out of Roth IRAs in layers. Only after one layer has been exhausted can the next layer come out.

Here is the order of distributions that come out of a Roth IRA:

First Layer: Roth IRA contributions

Second Layer: Roth IRA conversions (first-in, first-out)

Third Layer: Roth IRA earnings

Here’s a brief example:

Example 1: Steve has made five $5,000 contributions to his Roth IRA in previous years. He also made a $10,000 conversion from a traditional IRA to a Roth IRA in 2014. In 2021, at a time when his Roth IRA is worth $60,000 and Steve is 45 years old, he takes a $10,000 withdrawal from his Roth IRA. All $10,000 will be a recovery of his previous contributions (leaving him with $15,000 remaining of previous contributions). Thus, the entire distribution from the Roth IRA will be tax and penalty free.

The Roth IRA contributions come out tax and penalty free at any time for any reason!

A qualified distribution from a Roth IRA is usually one where the account holder both (i) has owned a Roth IRA for at least 5 years and (ii) is at least 59 ½ years old. If either condition is not satisfied, the default layering rules described above apply. Qualified distributions from a Roth IRA are tax and penalty free regardless of the layers inside the Roth IRA.

See page 31 of IRS Publication 590-B for more information about qualified distributions from Roth IRAs.

Roth 401(k) Withdrawals

First, a practical note: employers may restrict in-service Roth 401(k) withdrawals before age 59 1/2. Consider that before thinking about how the tax rules apply to withdrawals.

Default Rule: Cream-in-the-Coffee

Generally speaking, Roth 401(k)s have (1) investment in the contract (“IITC”), which is generally previous contributions and conversions and (2) earnings.

Unlike the sequenced layering of Roth IRA withdrawals, Roth 401(k) withdrawals generally default to what Ed Slott refers to as the “cream-in-the-coffee” rule (see Choate — discussed below, page 140).

As a result, withdrawals default to carrying out both some IITC and some earnings. Here’s an example:

Example 2: Lilly has made five $6,000 contributions to her Roth 401(k) in previous years. She also made a $10,000 conversion from a traditional 401(k) to her Roth 401(k) in 2014. In 2021, at a time when her Roth 401(k) is worth $60,000 and Lilly is 45 years old, she takes a $10,000 withdrawal from her Roth 401(k). Two-thirds ($6,667, computed as the fraction $40,000 divided by $60,000 times the withdrawal) of the $10,000 will be a recovery of her IITC (entirely tax and penalty free), and one-third ($3,333, computed as the fraction $20,000 divided by $60,000 times the withdrawal) of the $10,000 will be earnings, which are subject to both ordinary income taxation and a 10 percent penalty.

Quick Thought: Had Lilly’s Roth conversion occurred in 2018 or earlier, the portion attributable to the conversion ($1,667) would be subject to the 10 percent early withdrawal penalty (but not to ordinary income taxation). See Section 402A(c)(4)(D) and Section 408A(d)(3)(F).

Quick Thought: The cream-in-the-coffee rule does not factor in amounts in traditional 401(k) accounts, even if they are within the same 401(k) plan.

Solving the Cream-in-the-Coffee Issue

We see that the cream-in-the-coffee rule has bad effects. It does not allow exclusive access to tax-favored amounts when there are non-tax favored amounts in an account. So what to do? There are three primary exceptions to the cream-in-the-coffee rule.

Exception 1: Wait for a Qualified Distribution

The cream-in-the-coffee rule can be waited out.

A qualified distribution from a Roth 401(k) is a withdrawal that occurs when the owner is age 59 ½ (see Treas. Reg. Sec. 1.402A-1 Q&A 2(b)(2)) and has had that particular Roth 401(k) account for five years (see Treas. Reg. Sec. 1.402A-1 Q&A 2(b)(1) and Q&A 4). Other qualified distributions can occur upon death or disability (if the 5 year test is satisfied), but for our purposes, we will assume for the rest of the article that any qualified distributions are qualified distributions occurring at or after age 59 ½ and after five years of ownership.

The owner of a Roth 401(k) who qualifies for a qualified distribution does not need to roll the Roth 401(k) to a Roth IRA to take a tax free withdrawal. Once the owner qualifies for a qualified distribution he or she can simply withdraw amounts from the Roth 401(k) tax-free.

However, as a practical matter, it is often the case that Roth 401(k)s are rolled into Roth IRAs (for several reasons). If the rollover from the Roth 401(k) to the Roth IRA would qualify as a qualified distribution if taken directly, then the entire amount in the Roth 401(k) (IITC and earnings) goes into the Roth IRA as a contribution. Ian Berger discussed this issue in an August 11, 2022 response to a question. His answer applies the rule in Treas. Reg. Sec. 1.408A-10 Q&A 3 (the sentence beginning with “Thus,”).

Up to the amount rolled into the Roth IRA can be distributed tax and penalty free. So long as the taxpayer has met the 5 year rule with respect to any Roth IRA, any future earnings beyond the amount rolled in can be withdrawn tax free at any time.

Quick Thought: I would be remiss if I didn’t insert the standard tax planner advice that rollovers from Roth 401(k)s to Roth IRAs are best accomplished through a direct trustee-to-trustee transfer.

There is one five year rule nuance to consider. If the taxpayer has never had a Roth IRA, he or she must wait 5 years (regardless of their age) to access later earnings generated by rollover contribution tax free. Here’s a quick example:

Example 3: John is 60 years old. He has never had a Roth IRA. He has had a Roth 401(k) with his employer for over five years. He has made $100,000 of contributions to the Roth 401(k) which has grown to $200,000. He does not need to roll his Roth 401(k) into a Roth IRA to take out money entirely tax and penalty free.

If John chooses to roll all $200,000 in his Roth 401(k) into a Roth IRA, all $200,000 goes into the Roth IRA as a contribution. If John withdraws more than $200,000 from the new Roth IRA before the Roth IRA turns 5 years old, those withdrawals of new earnings would be subject to income tax (though, of course, penalty free since John is over 59 ½ years old).

As a practical matter, as long as the taxpayer does not plan on withdrawing more than the rolled over amount in the first five years, this nuance is not likely to be a gating issue in determining whether the Roth 401(k) should be rolled over to a Roth IRA.

Exception 2: Roth 401(k) Rollover then Withdraw

The second strategy to overcome the cream-in-the-coffee rule is to rollover the Roth 401(k) to a Roth IRA without waiting.

If either the taxpayer is less than 59 ½ years old and/or has not held that particular Roth 401(k) for at least five years, the nonqualified distribution rules apply to the rollover. The Roth 401(k) goes into the Roth IRA as “contributions” to the extent of the IITC in the Roth 401(k), and as “earnings” to the extent of growth in the Roth 401(k).

Recall the example of Lilly above. Here is how it changes if she rolls the Roth 401(k) into a Roth IRA and then takes the withdrawal.

Example 4: Lilly has made five $6,000 contributions to her Roth 401(k) in previous years. She also made a $10,000 conversion from a traditional 401(k) to her Roth 401(k) in 2014. In 2021, at a time when her Roth 401(k) is worth $60,000 and Lilly is 45 years old, she rolls her Roth 401(k) over to a Roth IRA (her first ever). A month later, Lilly takes a $10,000 withdrawal from her Roth IRA. All $10,000 will be a recovery of her previous contributions (leaving her with $30,000 remaining of previous contributions). Thus, the entire withdrawal will be tax and penalty free.

While rollovers of nonqualified distributions do not eliminate Roth 401(k) earnings, they do eliminate the cream-in-the-coffee rule. As a result, Roth 401(k) to Roth IRA rollovers often make sense.

The Five Year Roth Earnings Rule

Where such rollovers can be disadvantageous is the five year rule as applied to earnings. Recall that being age 59 ½ is a necessary, but not sufficient, condition to withdrawing Roth earnings tax free. You also need to meet a 5 year rule.

If you have a Roth 401(k) that is 5 years old but have never had any Roth IRA, and you are less than 5 years away from attaining age 59 ½, rolling into a Roth IRA could subject withdrawals of earnings (after age 59 ½) in excess of IITC to ordinary income taxation. That said, often withdrawals do not exhaust contributions in the first five years after a rollover. Thus, often this will not be a gating issue.

Exception 3: Roth 401(k) Withdrawal then Rollover

There is a third way to overcome the cream-in-the-coffee rule. It is to take a withdrawal from the Roth 401(k) and then rollover the earnings component to a Roth IRA. Let’s see how that would affect Lilly:

Example 5: Lilly needs $10,000 and has decided to access it from her Roth 401(k). Lilly has made five $6,000 contributions to her Roth 401(k) in previous years. She also made a $10,000 conversion from a traditional 401(k) to her Roth 401(k) in 2014. In 2021, at a time when her Roth 401(k) is worth $60,000 and Lilly is 45 years old, Lilly takes a $15,000 withdrawal from her Roth 401(k). Based on her Roth 401(k) consisting of two-thirds IITC and one-third earnings, $5,000 of the withdrawal is taxable and subject to an early withdrawal penalty. However, Lilly can, within 60 days, rollover the $5,000 of earnings into a Roth IRA. The earnings will go into the Roth IRA as earnings, and Lilly avoids the tax and penalty on the withdrawal.

Note that if Lilly does this partial rollover, the rollover piece is not subject to the cream-in-the-coffee rule. The partial rollover attracts earnings before attracting any IITC (see Treasury Regulation Section 1.402A-1 Q&A 5).

Note further that if Lilly has no other Roth IRAs, she now has a Roth IRA that consists only of earnings. She will not (generally speaking) be able to touch this Roth IRA without ordinary income tax and a penalty until age 59 ½.

As a practical matter, the “withdraw then rollover” strategy may not be available to Lilly. The 401(k) plan may not allow partial distributions pre-age 59 1/2 after separation from service.

Coordination with the Rule of 55

Many like the Rule of 55, which is a rule that allows taxpayers to take amounts from workplace retirement plans such as 401(k)s without the early withdrawal penalty. It applies when a taxpayer separates from service at age 55 or older (up to age 59 ½, when withdrawals become penalty free), and the plan allows partial withdrawals.

So the question becomes, if you are in the 4.5 year Rule of 55 window (ages 55 to 59 ½) and you separate from service, should you leave a Roth 401(k) in the plan or roll it into a Roth IRA if you need to withdraw from it? Let’s consider an example.

Example 6: James is 56 years old and leaves his employment. He has contributed $100,000 over more than five years to his Roth 401(k), and it is currently worth $200,000. If he keeps the amounts in the Roth 401(k), every dollar he takes out will be half recovery of IITC (tax-free) and half a withdrawal of earnings (taxable, but qualifies for a penalty exception). If, instead, James follows the “rollover then withdraw” strategy and rolls his Roth 401(k) to a Roth IRA, the first $100,000 he withdraws before age 59 ½ will be a return of contributions, and only if he exceeds $100,000 in withdrawals will he have ordinary income and a penalty. A second option for James would be to do the “withdraw then rollover” strategy whereby James would direct half of each distribution (the earnings half) to a Roth IRA in order to avoid ordinary income taxation on the earnings portion.

This illustrates that numbers matter in this regard. It also shows that as long as the pre-age 59 ½ withdrawals will be less than the previous Roth 401(k) contributions, it is generally better to take the withdrawals from a rollover Roth IRA than from a Roth 401(k) penalty protected by the Rule of 55.

However, if one employs the “withdraw then rollover” strategy, keeping money in the Roth 401(k) can work as effectively as rolling over to a Roth IRA.

A Note on Rollovers

Any designated Roth account (401(k), 403(b), and/or 457) can be rolled into a Roth IRA. Designated Roth accounts can be rolled into other designated Roth accounts, though note there can some be some complexity in this regard.

Roth IRAs cannot be rolled into a designated Roth account, including a Roth 401(k).

The IRS has a handy rollover chart accessible here.

SECURE 2.0 Update

SECURE 2.0 makes three changes relating to Roth 401(k)s. First, it eliminates required minimum distributions (“RMDs”) from Roth 401(k)s during the owner’s lifetime. This change has little practical effect, as many Roth 401(k)s will ultimately be rolled to Roth IRAs anyway in order for the owner to obtain more investment choice and control of the account.

Second, SECURE 2.0 mandates that beginning in 2024, employee catch-up contributions to 401(k) accounts must be Roth contributions if the employee made more than $145,000 in wages the prior year.

Third, SECURE 2.0 allows employer contributions to Roth 401(k)s.

I suspect that based on the second and third changes, more employers may offer Roth 401(k)s in addition to traditional 401(k)s.

Conclusion

The rules around Roth 401(k)s are complex, and different than those applicable to Roth IRAs. This blog post only presents an educational introduction to those rules. Taxpayers should exercise extra caution, and often consult with tax professionals, before moving money out of a Roth 401(k).

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.

An Ode to the Roth IRA

It won’t surprise many to find out that a tax-focused financial planner is fond of the Roth IRA. Below is a brief review of the advantages of a Roth IRA.

Tax Free Growth

Amounts in Roth IRAs grow tax free. Considering many Americans may now live into their 80s, 90s, and beyond, this is a tremendous benefit.

The only caveat is that in order for all distributions from Roth IRAs to be tax and penalty free, they generally have to be either (a) a return of contributions or of sufficiently aged conversions (see below), or (b) a distribution of earnings made in the Roth IRA (or other amounts in the Roth IRA) at a time when the owner of the account is 59 ½ or older and has owned a Roth IRA for at least five years.

The rules for ordering distributions out of a Roth IRA generally provide that contributions come out first, and then the oldest conversions come out next. This means that in many cases Roth IRA distributions, even those occurring before age 59 ½, are tax and penalty free.

N.B. Generally speaking, you want to only take a distribution from a Roth IRA before age 59 ½ if it is either (i) a serious emergency or (ii) part of a well crafted, very intentional financial plan.

Ease of Administration and Withdrawal

There are many financial institutions that provide Roth IRAs. Investment expenses in low-cost index funds at financial institutions that provide Roth IRAs are approaching zero. Vanguard, Fidelity, and Schwab are among the very good providers of low-cost Roth IRAs (and there are others).

It is also relatively easy to access money inside a Roth IRA. This makes the Roth IRA a great account to have in an emergency. Of course, it is generally best to leave money inside a Roth IRA to let it grow tax free, but it is good to know that you can access money in a Roth IRA relatively easily if an emergency arises.

Tax Free Withdrawals of Contributions

This is a great benefit of the Roth IRA. Contributions to a Roth IRA can be withdrawn at any time for any reason tax and penalty free. Further, the first money deemed distributed from a Roth IRA is a contribution. Here is a quick example:

Mark is 35 years old in 2025. He made $6,000 contributions to his Roth IRA in each of 2020, 2021, 2022, 2023, and 2024 (for $30,000 total). In 2025, when his Roth IRA is worth $41,000, Mark withdraws $10,000 from his Roth IRA in 2025. All $10,000 will be deemed to be a return of contributions, and thus entirely tax free and penalty free.

The only exception is a taxpayer favorable exception: a timely withdrawal of an excess contribution (and related earnings) occurs before regular contributions are considered withdrawn.

N.B. Roth 401(k)s, 403(b)s, and 457s have different distribution rules — most pre-age 59 ½ distributions will take out some taxable earnings.

Tax Free Withdrawals of Sufficiently Aged Converted Amounts

If you convert an amount into a Roth IRA, you start a five year clock as of January 1st of the year of the conversion. Quick example:

Mike is 35 years old in 2025. Mike converts $10,000 from a traditional IRA to a Roth IRA on July 2, 2025. His five year conversion clock starts January 1, 2025. On January 1, 2030, Mike can withdraw the entire $10,000 he converted in 2025 tax and penalty free.

This feature of the Roth IRA, the tax free withdrawal of sufficiently aged conversions, is the basis for the Roth Conversion Ladder strategy. Sufficiently aged converted amounts are deemed to come out after contributions are exhausted and before more recent conversions and earnings come out.

No Required Minimum Distributions

During an account holder’s lifetime, there are no required minimum distributions from a Roth IRA. You can live to 150 and never be required to take money from a Roth IRA.

Creditor Protection

In federal bankruptcy proceedings, Roth IRAs are (as of 2024), protected up to $1,512,350.

Where there can be differences in liability protection are state general creditor claims (i.e., creditor protection in non-bankruptcy situations). In some states, Roth IRAs receive a level of creditor protection similar to that of ERISA plans. Generally, such protection is absolute against all creditors except for an ex-spouse or the IRS.

In other states, Roth IRAs receive no or limited creditor protection. In my home state of California, Roth IRAs are only creditor protected up to the amount necessary to provide for you and your dependents in your retirement (as determined by the court). Such protection is valuable but hardly airtight.

A Sneaky Way to Contribute More to Your Retirement

Yes, in theory everyone should save for retirement based on exacting calculations (i.e., I estimate I need $X in retirement, so based on projections I save $A in traditional accounts and $B in Roth accounts this year). That’s the theory.

In practice, it’s “I maxed out this account and that account” or “I put $C into this account and $D into that account.” There isn’t that much wrong with how we practically save for retirement, as long as we are saving sufficient amounts for retirement.

But not all “maxing out” is created equal. We know this because if Jane has $100,000 in a traditional IRA and Mary has $100,000 in a Roth IRA, who has more wealth? Mary! Unless Jane can always be in a zero percent income tax bracket, Mary has more than Jane, even though they both nominally have $100,000.

A Great Account to Leave to Heirs

While non-spouse heirs will have to take taxable required distributions from inherited IRAs (in many cases beginning in 2020 they will need to drain the account within 10 years of death), heirs are never taxed on distributions from Roth IRAs. This makes a Roth IRA a great account to leave to your heirs.

Compare with Other Retirement Accounts

No other retirement account combines ease of administration and withdrawal, low costs, significant tax benefits, creditor protection, and great emergency access the way the Roth IRA does. Most workplace retirement plans have some restrictions on withdrawals. Traditional account withdrawals do not have the tax advantages of a Roth IRA. Distributions from a traditional IRA, even one at a low-cost, easy to use discount brokerage, will trigger ordinary income taxes, and possible penalties, if withdrawn for emergency use.

Financial Planning Objectives

Personal finance is indeed personal. But I submit the following: pretty much every individual has some desire (and/or need) to not work at some point in his/her lifetime and every individual needs to be prepared for emergencies. Further, these are two very important financial planning objectives for most, if not all, individuals.

If the above is true, then we must ask “which account type best supports the combination of these two pressing financial planning objectives?” It appears to me that the answer is clearly the Roth IRA.

None of this is to say that a Roth IRA is the only way to plan for retirement and plan for emergencies, but rather, it is to say that, generally speaking, a Roth IRA ought to be a material element in such planning. Other tools, such as other retirement accounts, insurances, investments in taxable accounts, and sufficiently funded emergency funds are likely needed in addition to a Roth IRA.

Retirement Accounts and Emergencies

Let’s examine how a Roth IRA might help someone facing a very serious emergency.

Picture Jack, who is 52 years old, and has a full time job. He has $1M in a traditional 401(k) and $10,000 in cash in a taxable account. That’s it. Then picture Chuck, also 52 with a full time job. Chuck has $700,000 in a traditional 401(k), $250,000 in a Roth IRA, and $10,000 in cash.

Who is better situated to deal with an emergency? Far and away the answer is Chuck. 401(k)s are difficult to access in an emergency. First of all, the 401(k) plan might not allow in-service distributions, and it might not allow taking out a loan.

Even if the 401(k) allows in-service distributions, distributions from 401(k)s are immediately taxable, and often subject to penalties (10% federal, 2.5% in California, for example) if you are under age 59 ½. Loans, while not immediately taxable, can become taxable if not paid back.

Long story short, a 401(k) may be a tough nut to crack in an emergency.

What about a Roth IRA? In Chuck’s case, he can access his prior Roth IRA contributions and sufficiently aged contributions tax and penalty free at any time for any reason! And his Roth IRA is easy to access, particularly if it is at a low-cost discount brokerage.

When you combine tax-free growth, no requirement to take required minimum distributions during the account holder’s lifetime, and the best emergency access of any tax-advantaged retirement account, it is difficult to see why working adults should not have at least some money in a Roth IRA.

When a Roth IRA Doesn’t Make Sense

The short answer is: not often! I struggle to come up with profiles of individuals that would not benefit from having some amount in a Roth IRA.

I can think of two profiles. The first, a rare case, is someone with very large legal liabilities such that all of their wealth would benefit from the creditor protections offered by an ERISA retirement plan (such as a 401(k)) and who needs almost all of their wealth shielded from creditors.

First, if you have built up 6 figures or more in wealth, having creditors able to claim your entire wealth is relatively rare. Second, in most cases, good insurance coverage, including adequate medical insurance, professional liability insurance (as applicable), home and automobile insurance, and personal umbrella liability insurance, should protect the vast majority of people such that they could withstand any liability exposure caused by having money in a Roth IRA instead of an ERISA protected plan.

The second profile is someone with incredibly high income currently and very little anticipated income in the future (such that their future tax rate is much lower than today’s rate). This too is a bit of a unicorn – people with high income today tend to have decent income tomorrow (even in the FI community).

Health Savings Accounts

It will also come as no surprise that I am fond of health savings accounts. Health savings accounts share some of the attributes that make the Roth IRA such a winner for both retirement savings and emergency planning.

But, there are some drawbacks. First, the distribution ordering rules are not as taxpayer friendly. While it may be the case that you have sufficient old medical expenses that you can reimburse yourself for (and thus not pay tax and a penalty on the HSA distribution), that is not always going to be the case, and even if it is, does add a layer of complexity.

Second, the HSA is not for everyone. If a high deductible health plan is not good medical insurance for you, an HSA is generally off the table.

So, that leaves the HSA as a fantastic option for those who qualify for and use a high deductible health plan (and usually an option that should be part of a comprehensive financial plan if you use a HDHP). But it also means that the HSA is not quite as good as a tool for the combination of retirement saving and emergency planning.

Conclusion

Assuming that an individual (a) has retirement planning and emergency preparedness as financial planning objectives and (b) is not in a position where legal liabilities would cripple them without ERISA creditor protection, it is hard to argue against having at least some material amount in a 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.

The SECURE Act’s Impact on the FI Community

In late December 2019 the President and Congress enacted the SECURE Act. The SECURE Act makes some significant revisions to the laws governing IRAs, 401(k)s, and other retirement accounts. This post discusses the impacts of these changes on those pursuing financial independence.

The Big Picture

The SECURE Act is a big win for the FI community, in my opinion.

The FI community significantly benefits from IRAs, 401(k)s, and other tax-advantaged retirement accounts. However, the federal government is facing increasing debts and annual deficits. That puts tax-advantaged accounts in the crosshairs. What Congress gives in tax benefits Congress can take away.

So what does the SECURE Act do? First, it actually gives us a couple more tax advantages during our lifetimes (see “Opportunities” below). Second, it significantly reduces the tax advantages of inherited retirement accounts for our heirs.

For those either with large retirement account balances or planning to have large retirement account balances, any change in tax laws is a potential problem. We should be glad that this round of tax law changes has occurred without our own retirement accounts being negatively impacted. Congress has passed the bill to our heirs, which, right or wrong, is a victory for us.

When you see people in the financial press squawking about how awful the SECURE Act is, remember, it could be a whole lot worse–your retirement account could have been more heavily taxed during your lifetime!

For those pursuing FI, the ability to use tax-advantaged retirement accounts remains the same, and in a couple small ways, has been enhanced. The next generation still has all those retirement account opportunities, even if they won’t be able to benefit from inheriting retirement accounts as much as they do under current law.

Opportunities

Traditional IRA Contributions for those 70 ½ and Older

Starting in 2020, those aged 70 ½ and older will be able to contribute to a traditional IRA. This will open up Backdoor Roth IRA planning for those 70 ½ and older and still working. For those still working (or doing side hustles) at age 70 ½ or older, this is a nice change.

Remember, regardless of age, in order to contribute to an IRA, you or your spouse must have earned income.

RMDs Begin at 72

For those attaining age 70 ½ after December 31, 2019, the age at which they will need to take RMDs will be 72, not 70 ½. This gives retirement accounts a bit more time to bake tax-deferred. It also slightly expands the window to do Roth conversions before RMDs begin. However, this last benefit is tempered by the fact that you must take Social Security no later than age 70. Roth conversion planning to reduce taxable RMDs should be mostly completed well before age 70 ½, regardless of this change in the law.

Note that taxpayers can still make qualified charitable distributions (“QCD”) starting when they turn age 70 ½. While pre-age 72 QCDs won’t satisfy RMD requirements, they will (a) help optimize charitable giving from a tax perspective (by keeping adjusted gross income lower and avoiding the requirement to itemize to deduct the contribution) and (b) reduce future RMDs.

Annuities in 401(k)s

The new law provides rules facilitating annuities in 401(k) plans. This one requires proceeding with extreme caution. If your 401(k) plan decides to offer annuity products, you need to carefully assess whether an annuity is the right investment for you and you need to fully understand the fees charged.

Remember, just because the law changed doesn’t mean your asset allocation should change!

Leaving Retirement Accounts to Heirs

This is the where the SECURE Act raises taxes. The SECURE Act removes the so-called “stretch” for many retirement plan beneficiaries. For retirement accounts inherited after December 31, 2019, only certain beneficiaries will be able to stretch out distributions over their remaining life (or based on the age of the decedent if over 70 ½ at death). For nonqualified beneficiaries, the rule will simply be that the beneficiary must take the account within 10 years of the owner’s death (the “10-year rule”).

My overall opinion on the SECURE Act stated above, planning for the next generation is important. Particularly if you are already financially independent and want to help your children become financially independent, the SECURE Act has significant ramifications.

Spouses

If your current estate plan features your spouse as your retirement account primary beneficiary, the SECURE Act should in no way change that aspect of your plan. Fortunately, the many advantages applicable to spouses inheriting retirement accounts will not change. Spouses remain an excellent candidate to inherit a retirement account.

Minor Children

If you leave your retirement account to your minor children, they are exempt from the 10-year rule (and can generally take distributions based on IRS RMD tables that are generous to younger beneficiaries) while they are still minors. Once your children reach the age of majority, they will have ten years to empty the retirement account.

The exception to the 10-year rule applies only to your minor children. It does not apply to your grandchildren, your adult children, and the children of others (including nieces and nephews).

Other Eligible Beneficiaries

The exceptions to the 10-year rule apply to your spouse, your minor children, the disabled, the chronically ill, and persons not more than 10 years younger than you at your death. All others will need to empty retirement accounts within 10 years of inheritance. This will require some significant planning in cases where the beneficiary has inherited a traditional retirement account to strategically empty the account over the 10 year window to manage adjusted gross income, taxable income, and total tax.

Planning

For those of you with estate plans involving adult children, the passage of the SECURE Act may well require revisions to your plans. First off, as a practical matter, your revocable living trust may need modifications. Many have designated a trust as a retirement account beneficiary. To do so properly requires conforming with specific income tax rules. Those with trusts as the beneficiary of their retirement account would be well advised to, at a minimum, consult with their lawyer to determine if the language of the trust needs updating.

Second, understanding that inheriting a traditional retirement account will now mean accelerated, and possibly significantly increased, taxation for their heirs, many will want to consider Roth conversion planning. Roth accounts will be subject to the 10-year rule, but the good news is that the beneficiary can keep the assets in the Roth account for 10 years, let it grow tax free, and then take out the money in 10 years tax free. Not too bad.

Roth conversion planning to optimize your heirs’ income tax picture is now even more important. However, it should not be done if it will impose a financial hardship on the account owner during their lifetime. The first priority should be securing the account owner’s retirement. Only if the account owner is financially secure should they consider Roth conversion planning to reduce their heirs’ tax liability.

Conclusion

Tax rules are always changing. This round of changes is a victory for those pursuing financial independence. Any tax law change that does not negatively impact your path to financial independence is a win.

For those considering the financial health of their heirs, particularly their adult children, the SECURE Act should prompt some reconsideration of estate plans. Often it is wise to consult with professional advisors in this regard.

FI Tax Guy can be your financial advisor! FI Tax Guy can prepare your tax return! 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, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters.

Health Savings Accounts

Health savings accounts (“HSAs”) are a tremendous wealth building tool. For healthy individuals and families, a health savings account paired with a high deductible health plan (“HDHP”) can be a great way to manage medical costs and grow tax advantaged wealth.

HSA Basics

A health savings account is a tax advantaged account. Contributions to an HSA are tax deductible. The interest, dividends, capital gains, and other income generated by assets in an HSA is not currently taxable (the same as with a 401(k) or IRA). If withdrawn for qualified medical expenses (or to reimburse the owner for the payment of qualified medical expenses), withdrawals from an HSA are not taxable.

The HSA combines the best of a traditional retirement account (deductible contributions) and the best of Roth retirement accounts (tax-free withdrawals) if done properly.

The annual HSA contribution limits (including both employer and employee/individual contributions) are $3,650 for an individual HDHP and $7,300 for a family HDHP in 2022. Those aged 55 or older can make annual catch-up contributions of an additional $1,000 to their HSA.

HSA Eligibility

Who is eligible to contribute to an HSA? Only those currently covered by a high deductible health plan. As a general matter, a high deductible health plan is medical insurance with an annual deductible of at least $1,400 (for individuals) or $2,800 (for families) (using 2021 numbers). The insurance plan document should specifically state that the plan qualifies as a high deductible health plan. You must be covered on the first day of the month in order to contribute to a HSA in that month.

Once you cease to be covered by a HDHP, you keep your HSA and can use the money in it. The only thing you lose is the ability to make further contributions to the HSA.

HDHPs may not be a good insurance plan if you have certain chronic medical conditions or otherwise anticipate having high medical expenses. But if you are relatively healthy, HDHPs often make sense, particularly if you are young.

There are some other eligibility requirements. Those also covered by other medical insurance plans, those enrolled in Medicare, and those who can be claimed as a dependent on someone else’s tax return are not eligible to contribute to a HSA.

Benefits of an HSA

Tastes Great and Less Filling

If done right, an HSA is a super-charged tax advantaged account. You get a deduction on the front end (when the money is contributed to the HSA), tax free growth, and no taxation if the money is used for qualified medical expenses or to reimburse the owner for qualified medical expenses.

There’s no need to debate traditional versus Roth with an HSA. If done right, you get both!

HSA Payroll Tax Benefit

As a tax planner, this is one of my favorite benefits. There are many ways to legally reduce income taxes. Reducing payroll taxes, on the other hand, is more difficult.

If you fund your HSA through payroll withholding, amounts contributed to the HSA are excluded from your salary for purposes of determining your Social Security and Medicare taxes. This results in saving on payroll taxes. HSA contributions enjoy this benefit while 401(k) elective deferrals do not.

Note that to qualify for the HSA payroll tax break, you must contribute to your HSA through payroll withholding. If, instead, you contribute through a direct personal contribution to your HSA, you do not get to deduct the contribution from your Social Security and Medicare taxable income, though you still get a federal income tax deduction for such contributions.

Employer Contributions

Many employers offer a contribution to your HSA account. Often these employer contributions are a flat amount, such as $650 or $700 annually. This amounts to essentially free money given to you in a tax advantaged manner.

Lower Insurance Costs

A great benefit of the combination of HDHPs and HSAs is lower medical insurance premium payments. By insuring with an HDHP, you usually save significant amounts on medical insurance.

The healthier you are and the wealthier you are, the less financial protection you need against unanticipated medical expenses. Thus, HDHPs are often a good option for those fortunate enough to be relatively healthy and/or wealthy.

Higher deductibles reduce the premium. The trade-off is that you self-fund more of your medical expenses. If those medical expenses are modest, the combination of saving on insurance premiums and the tax benefits can more than make up for the (potentially) higher medical expenses.

HSA Reimbursements

Take note of when you first establish your HSA. Qualifed medical expenses incurred on that date or later can be reimbursed from your HSA.

Why is this important? Because if you track your qualified medical expenses, you can build up years of expenses that you can reimburse yourself, tax-free, from your HSA. There is no time limit to pay yourself a tax-free reimbursement from your HSA. Here is an example:

Keith established an HSA in 2011, when he was 30 years old. In 2015, he had a medical procedure and his total qualified medical expenses were $4,000. In 2018, Keith had $500 worth of qualified medical expenses for two medical appointments. In 2019, Keith had $3,500 in qualified medical expenses for a procedure and various doctors’ appointments.

Assuming Keith had sufficient funds in taxable accounts when he incurred these expenses, Keith should (a) use those taxable funds to pay his medical expenses, (b) track his qualified medical expenses, and (c) after the money has had many years of tax-free growth, Keith should reimburse himself from his HSA for some or all of these $8,000 worth of qualified medical expenses.

Unless you are financially strapped or in a dire medical situation, you should strive to use taxable funds to pay current medical expenses and allow the funds in your HSA to enjoy years, possibly decades, of tax-free growth. With no time limit on HSA reimbursements, you can access the funds later in life tax-free.

Note, however, that in the relatively rare cases where a taxpayer deducts medical expenses on their income tax return, expenses paid with HSA money cannot be deducted. In addition, if you have previously deducted medical expenses, those expenses are not “qualified medical expenses” that can be reimbursed tax-free from an HSA. Deducing medical expenses is rare because you can only deduct medical expenses if (i) you itemize your deductions and (ii) to the extent your medical expenses exceed 7.5 percent of your adjusted gross income (“AGI”).

No RMDs

Every tax advantaged retirement account (other than the Roth IRA) is subject to required minimum distributions (“RMDs”) during the account owner’s lifetime. HSAs, fortunately, are not subject to RMDs. They provide incredible flexibility for your financial future, particularly when you carefully track your reimbursable qualified medical expenses for many years.

Qualified Medical Expenses

Qualified medical expenses are generally those expenses that qualify for the medical expense deduction. While this itself could be its own blog post, you can look to IRS Publication 502, which details which expenses qualify.

Some items that you might not immediately think of, but are qualified medical expenses, are COBRA insurance premiums and Medicare Part B, Part D, and Medicare Advantage premiums. So if you ever pay COBRA premiums, it is great to pay them out of taxable accounts and keep a tally of the payments you made. Years later you can reimburse yourself for those premiums tax-free from your HSA (assuming you established the HSA prior to paying the COBRA premiums and you did not claim the COBRA premiums as an itemized deduction).

Taxation of Non-Medical Withdrawals

If you are under age 65, withdrawals from HSAs that are not used for qualified medical expenses are subject to income tax and subject to an early withdrawal penalty of 20 percent.

If you are under age 65, you can avoid these harsh tax results for an HSA withdrawal if you can find prior qualified medical expenses you can reimburse yourself for, and apply the withdrawal against those prior expenses. If such expenses do not exist, you can roll the money back into the HSA within 60 days (a 60-day rollover). Note you are limited to only one 60-day rollover during any 12 month period.

If you are age 65 or older, you are no longer subject to the 20 percent early withdrawal penalty. Withdrawals that are not for qualified medical expenses (or reimbursements thereof) are subject to income tax (in the same way a traditional IRA withdrawal would be).

At age 65, an HSA remains an HSA and also becomes an optional IRA (in effect) without RMDs. This, combined with the ability to use HSA funds to pay Medicare Part B, Part D, and Medicare Advantage premiums tax-free, make an HSA a great account to own if you are age 65 or older.

The Biggest HSA Mistake

Think twice before taking money out of an HSA!

An HSA and the investments in it can be analogized to an oven and a turkey. The HSA is like the oven. The investments are like the turkey. Putting the turkey in the oven is great. But it needs sufficient time to roast. If you take the turkey out of the oven too soon, you spoil it! The investments in your HSA are similar. They need time to bake tax-free in the HSA. If you take them out too soon, you spoil it!

Only the elderly, the financially strapped, and those facing medical emergencies and crises should withdraw HSA funds. Everyone else should keep money in an HSA to grow tax-free. If you are not in one of three listed categories, you should think long and hard before paying medical expenses with HSA money.

Why waste the tremendous tax benefits of an HSA for minor, non-emergency medical expenses? Doing so is the biggest HSA mistake. Pay those expenses out of pocket, track them, and years later reimburse yourself tax-free from your HSA after the funds have grown tax-free for decades!

The only potential way to correct this mistake is to do a 60-day rollover of the withdrawn amounts back into an HSA. Note that rollovers are limited to one per any 12 month period. Other than the 60-day rollover, the mistake is not correctable.

The Second Biggest HSA Mistake

The second biggest HSA mistake is not investing a significant percentage of your HSA funds in equities and/or bonds. According to this report, only four percent of HSAs had balances invested in something other than cash as of the end of 2017. Not good!

While I never provide investment advice on the blog, I do discuss the tax location of assets, in a general sense (not as applied to any particular investor). Cash is not a great asset to hold in an HSA. With today’s low interest rates, cash generates little in interest income. HSAs offer tax-free interest, dividends, capital gains, and growth! That makes them great for high growth, high income assets. Why waste that incredibly favorable tax treatment on very low-yielding cash?

I call this the second biggest mistake (not the first) because unlike the first mistake, this mistake is easily correctable.

Of course, investors must evaluate their HSA investment options and their own individual circumstances to determine if the other investments are preferable to cash based on their particular circumstances.

State Treatment of HSAs

Two states do not recognize HSAs: California and New Jersey. For purposes of these two states, HSAs are simply taxable accounts. On California and New Jersey state income tax returns (a) there is no deduction/exclusion for HSA contributions, (b) interest, dividends, and capital gain distributions generated by HSA assets are taxable, (c) sales of assets in a HSA generate taxable capital gains and losses, and (d) nonqualifying withdrawals of money from an HSA have no tax consequence.

Tennessee and New Hampshire do not impose a conventional income tax. But they do tax residents on interest and dividends above certain levels. Interest and dividends generated by HSAs are included in the interest and dividends subject to those taxes.

HSAs and Death

This is the good news/bad news section of the article.

First, the good news: HSAs are great assets to leave (through a beneficiary designation form) to a spouse or to a charity. If you leave your HSA to your spouse, he or she inherits it as an HSA and can use it (and benefit from it) just as you did. Charities also make for great HSA beneficiaries. They can use the money in the account and pay no tax on it. You will need to work with your financial institution to ensure the beneficiary designation form properly captures the charity as the intended beneficiary.

The bad news: HSAs are terrible assets to leave to anyone else. If you leave an HSA to a non-spouse/non-charity, the recipient includes the entire balance of the HSA in their taxable income in the year of your death.

Conclusion

With a little planning, an HSA can be a great asset to own, and can provide tremendous tax-free benefits. Generally speaking, time is a great asset if you own an HSA. Let your HSA bake tax-free for many years and you will be happy to receive tax-free money later in life to pay for medical expenses or as a reimbursement for many years of previous medical expenses.

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.

Understanding Your 401(k)

As an employee, your employer’s 401(k) plan can be your most important wealth building tool. Understanding how it functions will help you build your wealth in a tax efficient manner.

The Plan

A 401(k) plan is established by an employer. The employer provides the account, the account administration, and the investment choices. Usually, the investment options include a menu of stock and bond mutual funds and/or similar investments. In some plans, employer stock is one of the investment choices.

While the employer administers the plan, most of the assets in the plan (see Vesting below) belong the employees in individual accounts. Therefore, the employees, not the employer, enjoy the benefits and burdens of the economic appreciation and/or depreciation of the investments.

Creditor Protection

401(k) plans are subject to a host of rules, most of which (from a practical perspective) are the concern of the employer, not the employee. One important benefit of the rules for employees is that under ERISA, assets in a 401(k) plan are generally protected from creditors. During your lifetime only two creditors can access assets in your 401(k): the IRS and an ex-spouse.

Vesting

Contributions to a 401(k) made by the employee (referred to as “employee deferrals” and “after-tax contributions” — see numbers 1 and 3 below) are always immediately “100% vested.” This means that regardless of whether the employee leaves the employment of the employer tomorrow, he or she owns the money he or she contributed to the 401(k) and any related growth.

However, contributions to a 401(k) account made by the employer may be subject to a vesting schedule. Simply put, vesting means amounts become the property of the employee after the employee has been employed by the employer for a certain period of time.

Some plans use a gradual vesting schedule. The least generous of these is as follows:

Years of Service	Vesting Percentage
2	20%
3	40%
4	60%
5	80%
6	100%

More generous (i.e., quicker) vesting is permissible.

Some plans use a “cliff” vesting schedule. This means that employer contributions go from 0% vested to 100% vested when the employee has been employed for a certain period. The longest permissible period is 3 years.

The growth associated with employer contributions is also subject to vesting.

Vesting incentivizes staying with the same employer for a sufficient period of time to capture all of the employer contributions to a 401(k) plan. It can also incentivize returning to a former employer if you have worked a number of vested years of service for them.

Some plans provide for 100% immediate vesting for employer contributions as well as employee contributions.

Contributions

There are five types of contributions to 401(k) plans, listed below in order of their prevalence (employee deferrals being the most prevalent).

1. Employee Deferrals

Employees can contribute, through payroll withholding, a portion of their salary to a 401(k) plan. All 401(k) plans offer “traditional” contributions, meaning employees can contribute amounts to the 401(k) plan and exclude those amounts from their taxable income for the year. Some plans, but certainly not all plans, also offer “Roth” contributions, which are not excludible from taxable income, but, if properly withdrawn, can be tax free in the future when withdrawn.

Employee deferrals are the only type of contribution to a 401(k) plan that can be done as a “Roth” contribution. All other contributions are “traditional” contributions.

Read here for more on the desirability of Roth contributions compared to traditional contributions.

Neither traditional nor Roth contributions reduce the amount of income subject to payroll (i.e., Social Security and Medicare) taxes.

2. Matching Contributions

Matching contributions are one of the most powerful ways employees can build wealth. Previously, I have written that if you participate in a 401(k) plan with an employer match, you must make it your top wealth building priority to contribute at least enough to your 401(k) to secure all of the employer match.

How does it work? Different employers have varying matching programs. There are two components: 1) the percentage of salary that is matched, and 2) the percentage of the match.

Here is an illustrative example:

Example 1: Elaine Benes works for Pendant Publishing. She is under 50 years old and earns $100,000 in annual W-2 wages. Pendant Publishing matches 100 percent of employee contributions up to 3 percent of salary, and matches 50 percent of employee contributions for the next 2 percent of salary. Based on this matching program, Elaine would be a fool not contribute at least 5 percent of her salary to Pendant Publishing’s 401(k) plan. Doing so will earn her $4,000 of matching contributions from Pendant Publishing on her $5,000 of employee contributions.

Employers vary in terms of when they match contributions. Some employers match employee contributions only once a year (usually at or after year-end). Other employers match employee contributions each pay period. If you work for an employer that does so, you need to be careful not to max-out your 401(k) early in the year, as each pay period requires an employee 401(k) contribution in order to obtain the match. Here is an example:

Example 2: The facts are the same as Example 1. In addition, Pendant Publishing’s matches 401(k) contributions every pay period, and has 24 pay periods per year. Elaine believes it is a good idea to accelerate her 401(k) contributions, and thus contributes $3,750.00 of her salary for each of the first 6 pay periods of the year ($22,500 total) and makes no contributions the rest of the year. For those 6 pay periods she receives an employee match of $166.67 each pay period ($100,000 divided by 24 times 4 percent) for a total annual match of $1,000. By doing this, Elaine misses out on $3,000 of her potential employer 401(k) match, because for the next 18 pay periods, she contributes nothing to her 401(k).

Some 401(k) plans adjust for this and would fully match Elaine’s contribution (in her case, by adding $3,000 to her 401(k) plan), but many do not. In Elaine’s case, she should have stretched out her contribution such that she contributed at least 5 percent of each pay period’s paycheck to her 401(k).

Note that employers are not required to provide a matching program. There are some employer 401(k) plans that provide no match at all.

Tax Treatment: Employer match contributions are traditional contributions. They are not subject to income tax when added to your 401(k), but they will be in the future when withdrawn (as will the growth on matching contributions). Matching contributions are not subject to payroll taxes.

3. After-Tax Contributions

Some 401(k) plans allow for employees to make so-called after-tax contributions to their 401(k) through payroll withholding. These contributions are not excluded from the employee’s taxable income, but do create basis in the 401(k) account. After-tax contributions are what make Mega Backdoor Roth IRA planning possible. Unless one is engaging in Mega Backdoor Roth IRA planning, in most cases after-tax contributions are not advisable.

Tax Treatment: After-tax contributions do not reduce the employee’s taxable income (for both income tax and payroll tax purposes). In the future after-tax contributions are taxable to the employee as withdrawn, but the employee can use the created basis to reduce the income inclusion. Depending on how the 401(k) account is disbursed, that basis recovery may be subject to the Pro-Rata Rule.

4. Profit-Sharing Contributions

Some 401(k) programs have a profit-sharing program, whereby the employer contributes additional amounts to each employee’s 401(k) account based on a formula.

Tax Treatment: Profit-sharing contributions are traditional contributions and are treated in the same manner as matching contributions, including being exempt from payroll tax.

5. Forfeitures

Because of vesting, employees forfeit unvested amounts in their 401(k)s when they leave the employer’s employment prior to fully vesting in the 401(k). When that happens, the unvested amounts must be accounted for. In some plans, the unvested amounts are used to offset plan administrative costs. In other plans, forfeited amounts are added to the remaining participants’ accounts.

Tax Treatment: Forfeitures are traditional contributions and are treated in the same manner as matching contributions, including being exempt from payroll tax.

Contribution Limits

Contribution limits get a bit complicated because there are two distinct 401(k) plan contribution limits, not one. Numerical limits are updated annually by the IRS to account for inflation. The numbers provided below are the numbers for 2023.

Employee Deferrals

There is an annual employee deferral limitation. For 2023, that limit is the lesser of $22,500 or total compensation (if under age 50) and the lesser of $30,000 or total compensation (if 50 or older). The limit applies to Roth employee contributions, traditional employee contributions, or any combination thereof.

This limit is per person, not per employer. Thus, those with side hustlers must coordinate employee deferrals to their large employer 401(k) plan with employee deferrals to their Solo 401(k). I discuss this topic in detail in my book, Solo 401(k): The Solopreneur’s Retirement Account.

All Additions

There is a second, less understood limitation on 401(k) contribution. The annual limit for all additions to 401(k) and other employer retirement accounts is the lesser of $66,000 or total compensation (if under age 50) and the lesser of $73,500 or total compensation (if 50 or older).

The all additions limit applies to the sum of numbers 1 through 5 above (employee deferrals through forfeitures) plus a sixth amount. The sixth amount is the amount which is contributed by your employer to another qualified retirement plan account on your behalf.

Some employers offer additional qualified retirement plans. These plans often provide for a contribution to an account by the employer based on a stated percentage of compensation. Employers use various names for these plans. Contributions may be subject to vesting and are traditional contributions that are not subject to payroll tax.

The all additions limit applies per employer, not per employee as the employee deferrals limit does.

Watch me discuss the all additions limit on YouTube.

Auto Enrollment

Many employers now auto-enroll new employees in a 401(k) plan. This has two components: contribution level and investment choice. In most cases, new employees should not simply settle for auto-enrollment. When you start a job, you should review your new 401(k) plan and make informed decisions regarding contribution level and investment choice.

Contribution Level

Auto-enrollment will set a contribution level. Not all employers set the contribution level at a level that maximizes employer matching. Even if the automatic contribution level is set at a level that maximizes the employer match, that level might not be the appropriate level for any particular person.

Investment Selection

Plans typically have a default investment plan for new 401(k) participants. It is best to review your investment options when you start a new job and select an appropriate investment allocation for your circumstances.

Withdrawals from Traditional 401(k)s

When a taxpayer is 59 ½ years old or older, they can withdraw amounts in a traditional 401(k) penalty free. Withdrawals are included in taxable income as ordinary income. Beginning at age 72, taxpayers must take out a required minimum distribution (“RMD”) for each year. The RMD is computed based on IRS tables.

If a taxpayer withdraws money from a 401(k) prior to age 59 ½, the withdrawal is not only taxable, it is subject to a 10 percent early withdrawal penalty, unless a penalty exception applies.

Taxpayers may transfer amounts in a 401(k) to another 401(k) to an IRA. Amounts in traditional 401(k)s and IRAs can be converted to Roth accounts. Such conversions create taxable income, but are not subject to the early withdrawal penalty.

Conclusion

Your workplace 401(k) plan is a vitally important wealth building tool. It is important to be an informed user of your 401(k) in order to build tax advantaged wealth.

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.

Excess Contributions to an IRA

There are limits to how much can be contributed to traditional IRAs and Roth IRAs. This post describes how excess contributions happen and how to resolve them.

Three introductory notes. First, if you find that you have made an excess contribution, you may be well advised to seek professional advice. Second, please don’t panic, but make sure to act swiftly. Excess contributions are resolvable but do not benefit from delays. Third, you should not plan to make an excess contribution for a variety of reasons.

Traditional IRAs

There are (generally speaking) three situations that generate an excess contribution to a traditional IRA. They are:

Contributions are made for a year the taxpayer (and their spouse) does not have earned income.
Contributions are made in excess of the annual contribution limits.
Rolling into an IRA an amount that did not qualify to be rolled in.

This last category is not immediately obvious, but it does occasionally occur. For example, a taxpayer might inherit a taxable account and incorrectly roll it into an inherited IRA. Or a taxpayer might incorrectly roll an IRA they inherited into their own IRA. Or a taxpayer might attempt a 60-day rollover of amounts previously in an IRA and roll the money into an IRA after the 60-day deadline. Note that in some cases, this last mistake can be resolved by obtaining a private letter ruling from the IRS (doing so is beyond the scope of this post).

For 2019 and prior taxable years, there is an additional category: contributions to a traditional IRA when the taxpayer was 70 1/2 or older. The SECURE Act eliminates the prohibition on those 70 1/2 and older contributing to a traditional IRA.

Resolutions

Recharacterization

Prior to the 2020 tax year, if you qualified to make a contribution to a Roth IRA, but not to a traditional IRA, you could direct your financial institution to recharacterize the contribution to a Roth IRA. This scenario only applied in situations where the taxpayer was over age 70 ½ when the contribution was made to the traditional IRA.

Now there is no scenario where this would be relevant. Anyone not qualifying to make a contribution to a traditional IRA would also not qualify to make a contribution to a Roth IRA.

However, recharacterizations of contributions from traditional IRAs to Roth IRAs can make sense for some taxpayers for tax planning reasons, and are allowable if done properly.

To recharacterize, you must contact the financial institution and direct them to move the contribution and its earnings to a Roth IRA. This must be disclosed in a white paper statement attached to your federal income tax return. The recharacterization deadline is the extended due date of the tax return (generally October 15th).

Withdrawal

A second way to correct an excess contribution to a traditional IRA is to take a “corrective distribution” of the excess contribution and its earnings from the IRA. You will need to inform your financial institution of the excess contribution and request a corrective distribution of the excess contribution and the earnings attributable to the excess contribution. If the excess contribution is withdrawn prior to the extended filing deadline, the withdrawal of the contribution itself is generally not included in taxable income.

As observed in IRS Publication 590-A, page 34, in most cases the financial institution will compute the earnings attributable to the excess contribution. The earnings will be included in taxable income for the actual year the excess contribution was made. For example, if a 2023 IRA contribution is made in January 2024, and the taxpayer later takes a corrective distribution of that contribution and its earnings, the earnings will be includible in taxable income in 2024. In those cases where the taxpayer must compute the earnings, IRS Publication 590-A Worksheet 1-3 is a resource for figuring the earnings or loss.

See Example 1 in this article for insights on the reporting timing of earnings attributable to corrective distributions.

Up until the passage of SECURE 2.0, the earnings were also subject to the ten percent early withdrawal penalty (unless an exception otherwise applied). However, SECURE 2.0 Section 333 repealed the early withdrawal penalty with respect to withdrawals of earnings occurring pursuant to a corrective distribution. Note further that as of March 1, 2024 there is now some doubt as to the on going validity of SECURE 2.0.

A quick note on corrective distributions (as applied to both traditional IRAs and Roth IRAs): they can be done if the taxpayer has changed their mind. Natalie Choate makes this point in her excellent treatise Life and Death Planning for Retirement Benefits (8th ed. 2019, see page 132). Corrective distributions are not limited to simply those times when the taxpayer has made a contribution in excess of the allowed limits.

Apply the Contribution to a Later Year

You can keep an excess contribution in a traditional IRA and apply it to a later year, if you are eligible to make a traditional IRA contribution in that later year. This method does not avoid the six percent penalty discussed below for the year of the contribution, but it allows the taxpayer to avoid taking a distribution of the excess contribution and stops additional impositions of the six percent excess contribution penalty. Generally, this method is only effective if the amount of the excess contribution is relatively modest, since a large excess contribution cannot be soaked up by only one year’s annual IRA contribution limit.

Penalties

If you do not resolve the excess contribution prior to the extended deadline for filing your tax return, you must pay a six percent excise tax on the excess contribution annually until the excess contribution is withdrawn from the traditional IRA. You report and pay the excise tax by filing a Form 5329 with the IRS. Because this six percent tax is imposed each year the excess contribution stays in the traditional IRA, it is important to correct excess contributions to traditional IRAs promptly.

Note further that excess contributions withdrawn after the extended filing deadline are generally included in taxable income, though the taxpayer can recover a portion of any IRA basis they have under the Pro-Rata Rule.

Roth IRAs

There are (generally speaking) four situations that cause an excess contribution to a Roth IRA. They are:

Contributions are made for a year the taxpayer (and their spouse) does not have earned income.
Contributions are made in excess of the annual contribution limits.
Contributions are made for a year the taxpayer exceeds the modified adjusted gross income (“MAGI”) limitations to make a Roth IRA contribution)
Rolling into a Roth IRA an amount that did not qualify to be rolled in.

A rather common excess contribution occurs when taxpayers contribute to a Roth IRA in a year they earn in excess of the MAGI limits. That can happen for a host of reasons, including end of year bonuses or other unanticipated income.

Another somewhat common mistake in this regard is made by those subject to required minimum distributions (“RMDs”) when trying to convert traditional IRAs to Roth IRAs. In early January a taxpayer might convert a chunk of their traditional IRA to a Roth IRA. This creates a problem if the taxpayer did not previously take out their annual RMD for the year. There is a rule providing that RMDs are the first money to come out of an IRA during the year, and RMDs may not be converted to Roth IRAs. Thus, “converting” the first dollars out of a traditional IRA (an RMD) during the year creates an excess contribution to a Roth IRA.

Resolutions

Recharacterization

Assuming that the taxpayer qualifies to make a contribution to a traditional IRA, the excess contribution to a Roth IRA can be recharacterized as a contribution to a traditional IRA. Generally, the taxpayer must contact the financial institution and direct them to recharacterize the contribution and its earnings into a traditional IRA and must file a white paper statement with their tax return explaining the recharacterization.

When the taxpayer’s income puts him or her over the Roth IRA MAGI limits, recharacterization is often how excess contributions to Roth IRAs are resolved. In such cases, they will generally qualify to make a contribution to a traditional IRA, so a recharacterization is often the go-to method of correcting an excess contribution to a Roth IRA.

Note that the recharacterization deadline is the extended due date of the tax return (usually October 15th).

Withdrawal

A second way to correct an excess contribution to a Roth IRA is to take a corrective distribution of the excess contribution. You will need to inform your financial institution of the excess contribution and request a corrective distribution of the excess contribution and the earnings attributable to the excess contribution. The withdrawal of the excess contribution itself is generally not taxable.

The financial institution will compute the earnings attributable to the excess contribution. The earnings will be included in taxable income for the actual year the excess contribution was made. The same inclusion timing rules applicable to traditional IRA corrective distributions (discussed above) apply to the earnings from a Roth IRA corrective distribution.

If the corrective distribution occurs after the taxpayer files their tax return for the relevant taxable year, but before the extended filing deadline for the year (generally October 15th), the taxpayer must file an amended return which reports the corrective distribution and includes the earnings in taxable income (if the original contribution actually occurred in the year covered by the tax return).

Apply the Contribution to a Later Year

As with excess contributions to traditional IRAs, you can keep an excess contribution in a Roth IRA and apply it to a later year, if you are eligible to make a Roth IRA contribution in that later year. This method does not avoid the six percent penalty discussed below for the year of the contribution, but it allows the taxpayer to avoid taking a distribution of the excess contribution and stops additional impositions of the six percent excess contribution penalty. Generally, this method is only effective if the amount of the excess contribution is relatively modest, since a large excess contribution cannot be soaked up by only one year’s annual Roth IRA contribution limit.

Penalties

As with excess contributions to traditional IRAs, if you do not resolve the excess contribution to your Roth IRA prior to the extended deadline for filing your tax return, you must pay a six percent excise tax on the excess contribution annually until the excess contribution is withdrawn. It is best to resolve an excess contribution to a Roth IRA sooner rather than later to avoid annual impositions of the penalty.

Tax Return Considerations

Corrective measures applied to traditional IRA and/or Roth IRA contributions may require tax return reporting. Such reporting is discussed in various sources. Examples of such sources include IRS Publication 590-A, the Instructions to the Form 8606, and/or the Instructions to the Form 5329.

Conclusion

Excess contributions to IRAs and Roth IRAs happen. They are not an occasion to panic. They are an occasion for prompt, well considered action. Hopefully this article provides enough background for you to start your decision process and, if necessary, have an informed conversation with a competent tax professional.

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

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

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