Tag Archives: Required Minimum Distributions

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 If withdrawn for qualified medical expenses (or to reimburse the owner for the payment of qualified medical expenses), withdrawals from an HSA are not taxable.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

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.

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

Follow me on Twitter: @SeanMoneyandTax

Tax-Efficient Charitable Giving

Introduction

Charitable giving is fantastic! Why not give some of your assets to improve a part of our world? And while you’re at it, why not save a few bucks in income taxes? As is to be expected, this requires some thoughtfulness. For some people, this can drive significant tax savings.

Lay of the Land after Tax Reform

The December 2017 tax reform legislation (often referred to as “tax reform,” the Tax Cuts and Jobs Act, or “TCJA”) significantly altered the landscape for claiming itemized deductions. For 2017, before tax reform became effective, the standard deduction for single taxpayers was $6,350 and $12,700 for married filing joint (“MFJ”) taxpayers. Thus, in order to claim itemized deductions, the taxpayer’s total itemized deductions (such as mortgage interest, state and local taxes, and charitable contributions) had to exceed these thresholds for the 2017 tax year. Many itemized simply because their state tax withholding alone put them in a position to equal or exceed these thresholds. This matters with respect to charitable contributions because if you don’t itemize, you don’t get any tax benefit for your charitable contributions.

Post tax reform, things are different. First, tax reform significantly increased the standard deduction. In 2018 the standard deduction increased to $12,000 for single taxpayers and $24,000 for MFJ taxpayers. Second, the deductible amount of state and local taxes (including individual income and property taxes) is capped at $10,000 per tax return. Thus, for MFJ filers and who paid $10,000 or more in state and local taxes still need $14,001 more in itemized deductions (mostly mortgage interest and charitable contributions) to itemize.

Thus, many will now find that they will take the standard deduction instead of itemizing. The downside is losing the tax benefits of charitable contributions. However, there are several planning opportunities whereby taxpayers can still reap significant income tax benefits of charitable contributions.

Donor Advised Fund (“DAF”)

Ideal for: People (a) with standard deductions very close to their itemized deduction amount or greater and (b) who makes regular, predictable (weekly, monthly, quarterly, or yearly) donations to charities or plan to donate to charities in the future.

How it Works and Tax Benefits: A donor establishes a donor advised fund with a financial institution that has established a charitable institution for the purpose of managing donor advised funds. The donor provides assets to the DAF. Then the donor “advises the fund,” meaning that he or she requests that the fund make disbursements to particular charities in particular amounts. While the institution in control of the DAF could, theoretically, reject the request, as a practical matter as long as the requested charity is a valid, properly registered section 501(c)(3) public charity, the DAF will send money to the charity. There is no explicit time requirement for the DAF to disburse its funds, and thus the DAF can make donations to public charities for several years.

The DAF gives the donor a significant tax benefit in today’s high standard deduction environment. The donor receives an upfront tax deduction for the fair market value of the assets contributed to the DAF in the year of the contribution. It is a way for a donor to bring forward, for tax purposes, the charitable deduction for contributions to a charity or charities occurring over several years. For tax purposes, the DAF aggregates several years’ worth of charitable contributions in a single year without a future tax cost, since the donor is covered by the high standard deduction in the later years when the DAF contributes to the charities.

Example: Jane and Joe Smith attend Mass every Sunday at St. Joseph’s Catholic Church. Every time they attend Mass they put money in the collection basket as a charitable donation. In November 2018 Jane and Joe add up their projected 2018 itemized deductions (mortgage interest, state taxes, and charitable contributions) and project that they are at $24,000, exactly the same as the standard deduction. They anticipate their itemized deductions in 2019 will only be $18,000. If they make a $5,000 contribution to a DAF in early December 2018, their 2018 itemized deductions will increase to $29,000. Going forward until the DAF is exhausted, the DAF will make disbursements to St. Joseph’s instead of the Smiths making the contributions.

The contribution to the DAF provides the Smiths a significant tax benefit in 2018 ($5,000 reduction to taxable income) and will cost them nothing in 2019, since they will take the standard deduction for 2019 regardless. Forgoing 2019 tax deductions (by accelerating them to 2018 through the DAF contribution) did not cost Jane and Joe Smith any additional tax in 2019 and saved them tax in 2018.

If Jane and Joe were initially at $18,000 in 2018 itemized deductions instead of at $24,000, a $5,000 DAF contribution would not have made sense, because the Smiths would not have enough itemized deductions ($23,000) to exceed the standard deduction.

Another DAF tax benefit for the donor is that income earned by the DAF (i.e., interest, dividends, and capital gains) is not taxable to the donor. That income increases the charitable impact of the original DAF contribution.

Some caveats: First, a transfer to a donor advised fund is an irrevocable transfer. While the donor retains the right to advise the DAF regarding disbursements to charities, the donor cannot reclaim the funds for him or herself. Second, the institution holding the DAF will charge fees against the DAF assets. Finally, institutions usually require a minimum initial contribution in order to form a DAF.

Donation of Appreciated Stock

Ideal for: Charitably inclined people owning appreciated stock, bonds, ETFs, or mutual funds.

How It Works and Tax Benefits: Donations of appreciated securities to an eligible charity allow the donor to deduct the entire FMV of the stock, up to 30% of adjusted gross income (“AGI”). Alternatively the donor can elect to deduct the basis of the stock, up to 60% of AGI. Further, the donor avoids recognizing the capital gain on the securities on his or her tax return. Thus, this strategy has a benefit from an income perspective (avoids recognition of a gain) and a benefit from a deduction perspective (the itemized charitable deduction).

For those looking to get rid of securities that no longer fit their desired investment portfolio, this can be a very tax efficient manner to do so.

Note that built-in loss securities should not be donated to charities. Rather, they should be sold first in order to trigger the capital loss for tax purposes, and then the proceeds should be donated to the charity.

Hyper Donor Advised Fund

Ideal for: Charitably inclined people owning appreciated stock, bonds, ETFs, or mutual funds that make routine charitable contributions or are interested in making future charitable contributions.

How It Works and Tax Benefits: The “hyper donor advised fund” (my pet name for this technique) simply combines the first two planning techniques.

Here is an example: Sammy owns 100 shares of Kramerica Industries. It is worth $50 per share ($5,000 total) and Sammy paid $5 per share ($500 total). Sammy has determined that he will have $11,000 of itemized deductions in 2018 and is likely to have no more than that in 2019 and 2020. Sammy plans to donate approximately $1,000 to his favorite charity, The Human Fund, annually.

Sammy can transfer the appreciated Kramerica stock to a DAF in December, 2018 and claim $16,000 of itemized deductions on his 2018 tax return without lowering his tax deductions in 2019 and 2020. Sammy also avoids recognizing on a tax return the $4,500 ($5,000 less $500 cost basis) gain he has in the Kramerica stock. The DAF can sell the Kramerica stock, invest the proceeds, and make, at Sammy’s recommendation, annual donations to The Human Fund.

Qualified Charitable Distribution (“QCD”)

Ideal for: (a) those 70 ½ or older and (b) those nearing age 70 ½ who cannot yet do a QCD, but should consider future QCDs when doing current tax planning.

How it Works and Tax Benefits: Donors 70 ½ years old and older can contribute up to $100,000 annually to charity directly from their traditional IRA without the amounts contributed being included in taxable income. The main advantage of this strategy is that the taxpayer’s “required minimum distribution” (“RMD”) can be satisfied by the QCD without a taxable income inclusion to the donor. While the donor does not receive a charitable deduction, that is made up for by excluding the amount of the QCD from taxable income. Given the new higher standard deduction, the taxpayer essentially gets the benefit of a charitable deduction without having to itemize.

While the QCD can satisfy the RMD, it does not have to – if a taxpayer has a RMD of $10,000 for the year but wants to make a $20,000 donation from their IRA to a charity, they can do so and the entire $20,000 amount qualifies for QCD treatment.

QCDs also present a planning opportunity for those not yet 70 ½ years old. Many do Roth Conversions (converting traditional IRAs and other traditional accounts to Roth IRAs) prior to age 70 ½ to reduce future RMDs. Doing so creates current taxable income, but lowers the future balance in the traditional IRA or 401(k) such that in the future RMDs are lower. For those charitably inclined, they may want to limit current Roth Conversions designed to mitigate future RMDs, since future QCDs can be used to eliminate the tax impact of RMDs in the future. Thus, charitably inclined individuals in their 60s may want to leave some amounts in traditional IRAs for future charitable donations. Then, when they turn 70 ½ they can make QCDs to avoid RMD taxable income.

It is important to note that to qualify for QCD treatment, the donor must be 70 ½ or older on the date of the distribution. Second, gifts to private foundations and DAFs do not qualify for QCD treatment. Third, inherited IRAs qualify for QCDs as long as the beneficiary inheriting the IRA is 70 ½ or older at the time of the distribution.

Lastly, the charity should never give any token gift of appreciation for the QCD donation because the receipt of anything in return for the donation disqualifies the distribution from favorable QCD tax treatment.

Bunching Contributions

Ideal for: Charitably inclined people with excess cash at year end.

How it Works and Tax Benefits: For taxpayers at or over the standard deduction threshold near year end, it may be advisable to make next year’s planned charitable donations this year to accelerate the tax deduction and take advantage of the next year’s higher standard deduction. Similar to some of the above techniques, the technique picks a year to itemize deduction and then picks a year (or years) to utilize the standard deduction in a manner the optimizes the total tax deductions taken over a period of time.

Charitable Remainder Trust

Ideal for: Wealthy charitably inclined people looking for a large current tax deduction, often in cases where they have a one-time significant income event, such as the sale of a significant asset or business or a very significant bonus.

How it Works and Tax Benefits: Taxpayers can contribute assets to a trust whereby the donor receives the income from the trust assets for a period of time and a designated charity receives the assets of the trust at the end of a period of years. This technique gives the donor a large upfront one-time deduction based on IRS rules.

This is generally not a strategy very applicable in the FI community, but for certain wealthy taxpayers looking for a significant tax deduction and willing to engage the right legal and tax professionals, it can create significant benefits.

Conclusion

Charitable giving illustrates the need to always consider whether there is a tax angle to a transaction. Contributions, if structured in particular way, can provide significant tax benefits while fulfilling their main purpose — the improvement of society and the advancement of the charity’s eleemosynary cause.

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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.