One area that is insanely and needlessly complicated is the inherited retirement account rules. What happens when someone inherits a traditional IRA, Roth IRA, and/or qualified workplace retirement account? It depends on far too many factors and there are far too many potential outcomes! As just one example, financial planner Jeffrey Levine came up with a flow chart of possible outcomes when a successor beneficiary inherits a retirement account.
That Mr. Levine could come up with such a flow chart is an absolute disgrace (to the government, not to Mr. Levine).
Complexity in our tax and retirement account laws shifts power away from ordinary Americans towards lawyers, accountants, advisors (such as me), and the IRS. Let’s shift some power back to ordinary Americans!
It’s time to radically simplify and reform the inherited retirement account rules.
Current Inherited Retirement Account Rules
Upon the death of the owner of an IRA or qualified plan, the following are potential outcomes in terms of potential inherited retirement account distribution rules:
I propose that the current voluminous, complicated inherited retirement account rules be scrapped. They should be replaced by the following simple rules, all effective January 1, 2025 unless otherwise noted.
At the decedent spouse’s death, any retirement account left to a spouse becomes the surviving spouse’s retirement account in the surviving spouse’s own name automatically and immediately upon death.
All other beneficiaries inherit an inherited retirement account which must be emptied within 10 full years following the owner’s death with no RMDs in years 1 through 9.
The death of a spouse entitles the surviving spouse to a permanent exception to the Section 72(t) 10 percent early withdrawal penalty with respect to distributions from any retirement account.
This applies even if the widow/widower remarries.
For fairness and simplicity, this applies even if the spouse died prior to 2025.
Any inherited retirement account a widow or widower treats as an inherited retirement account instead of a spousal rollover account as of the end of 2024 automatically becomes the surviving spouse’s own retirement account in their own name as of January 1, 2025.
The death of the beneficiary of an inherited retirement account does not change the clock. Successor beneficiaries must empty the inherited retirement account by the end of the 10th full calendar year following the original owner’s death.
Existing inherited retirement accounts (as of the end of 2024) are no longer subject to both the 10 year rule and RMDs. For 2025 and beyond, such accounts are subject to only the 10 year rule.
For fairness and simplicity, any retirement account inherited prior to 2025 subject to a 5 year rule will switch to the 10 year rule (measured as of the owner’s date of death).
Reset Day for Inherited Retirement Accounts Subject to an RMD in 2025: If the original owner died in 2024 or earlier and the inherited retirement account is subject to only an RMD in the year 2025 (under any of the old rules), the inherited account will become subject to the 10 year rule, and no longer be subject to RMDs (both as of 2026), as if the original owner died on December 31, 2025.
The 2025 New Year’s Eve Reset Day applies to both beneficiaries and successor beneficiaries, including those who become successor beneficiaries during 2025.
Simplification
After my proposed reform, there will be two and only two potential treatments for an inherited retirement account: spousal rollovers for spouses and the 10 year rule for everyone else. Note: It takes 8 rules to get to a 2 rule system because in order to get to a 2 rule system there needs to be rules to account for the transition from a very complex system to an understandable system.
Replacing the existing rules with the above 2 rule system would significantly reduce the amount of federal regulations and reduce complexity. Congress stumbled into a great inherited retirement account rule in the SECURE Act: the 10 year rule. It’s time to make that the rule for all inherited retirement accounts except spousal rollovers.
Rules 4, 7, and 8 are simplification and consistency measures. They logically transition the inherited retirement accounts rules to a single, uniform system with only two outcomes: a spousal rollover or the 10 year rule.
Rapid Transition
I propose a rapid, though not overnight, transition to a uniform system. Assuming a bill is passed in early to mid-2025, 2025 can be a transition year and then by New Year’s Day 2026 all inherited retirement accounts would be on the new system, meaning all inherited retirement accounts, regardless of when inherited, would be subject to only one of two rules as of New Year’s Day 2026.
Protecting Young Widows and Widowers
Rule 3 is needed to avoid reform harming pre-age 59 ½ widows and widowers. Under today’s rules, surviving spouses can elect to treat a spouse’s retirement account as an “inherited” account instead of doing a spousal rollover. That inherited treatment avoids the 10 percent early withdrawal penalty on pre-age 59 ½ distributions.
If pre-age 59 ½ widows/widowers must do a spousal rollover (as I propose), they would be subject to the 10 percent early withdrawal penalty if they took taxable distributions prior to their 59 1/2th birthday. To avoid that outcome, why not make becoming a widow/widower an automatic, permanent exception to the 10 percent early withdrawal penalty?
Transition Entirely to a New Uniform System
Reform should clean the slate of complexity. Without rules 4, 7, and 8, there would be separate systems of rules for retirement accounts inherited prior to 2025 and those inherited in 2025 or later. There’s no need for two separate systems of rules. These three rules make the rules simple for all inherited retirement accounts going forward.
A Small Net Tax Increase
Rule 8 is a modest tax increase, mostly falling on the wealthiest Americans. Considering the hope that 2025 will bring some popular tax cuts, such as eliminating taxes on tips and Social Security, it is good to have at least some logical tax increases in 2025 that would not significantly impact ordinary Americans. Note also that rules 2 and 5 are also likely to be small tax increases while rules 3 and 7 are likely to be small tax cuts.
Regardless of the likely very modest net tax effect, the simplicity brought by this new system would greatly benefit the administration of the tax rules and ordinary Americans.
Rule 8 Transition Examples
Rule 8, eliminating inherited retirement account RMDs and switching to a 10 year rule as of 2026, is key to transitioning old inherited retirement accounts to the new, uniform system for taxing inherited retirement accounts. Here are three examples of how it would work.
Example 1: In 2017 Jock died and left his $1M traditional IRA to his son JR. JR, 23 years younger than Jock, turned 40 in 2017. JR started taking traditional IRA RMDs based on the IRS Single Life Table in 2018. In 2022 he redetermined the RMD factor such that by 2025 the factor was 37.8 (start with 44.8 for 2018 theoretically, subtract one annually to get down to 37.8 for 2025). For 2025, JR must take his RMD under the old rules (which still apply) by dividing the inherited traditional IRA 12/31/2024 balance by 37.8 and taking that amount by December 31, 2025. In 2026 JR becomes subject to the 10 year rule by Jock’s deemed death on December 31, 2025. Thus, JR has until the end of 2035 to empty the inherited traditional IRA. He has no RMDs other than in 2035 (the entire remaining balance).
Example 2: In 2022 Huey died and left his $1M traditional IRA to his brother Earl. Earl, two years younger than Huey, turned 66 in 2022. Earl, an “eligible designated beneficiary” under the SECURE Act, started taking inherited traditional IRA RMDs based on the IRS Single Life Table in 2023. For 2025, Earl must take his RMD under the old rules (which still apply) by dividing the inherited traditional IRA 12/31/2024 balance by 19.2 and taking that amount by December 31, 2025. In 2026 Earl becomes subject to the 10 year rule by Huey’s deemed death on December 31, 2025. Thus, Earl has until the end of 2035 to empty the inherited traditional IRA. He has no RMDs other than in 2035 (the entire remaining balance).
Example 3: In 2017 Al died and left his $1M traditional IRA to his son Barry. Barry has taken RMDs annually. During 2025 Barry dies and Carl becomes the successor beneficiary. In 2026 Carl becomes subject to the 10 year rule (as Al is deemed to have died December 31, 2025) and Carl has until the end of 2035 to empty the inherited traditional IRA. He has no RMDs other than in 2035 (the entire remaining balance).
Conclusion
The inherited retirement account rules are mindlessly and needlessly complicated. The complexity creates confusion shortly after the death of a loved one. Enough is enough!
It’s time for greatly simplified inherited retirement account rules. That simplifying these rules might help fund popular tax cuts such as eliminating taxes on tips and Social Security is the cherry on top of a great tax reform proposal.
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, investment, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, investment, and tax matters. Please also refer to the Disclaimer & Warning section found here.
Note that a version of this proposal will be posted to the crowd sourced policy website PoliciesforPeople.com. The views reflected in this post are only those of the author, Sean Mullaney, and are not the views of anyone else.
Some potential “early” retirees are thinking about the so-called “Rule of 55” and many of them have Roth 401(k)s.
How does the Roth 401(k) work with the Rule of 55? Is there a better option than the Rule of 55 for those looking to retire using in part or in whole a Roth 401(k) prior to turning age 59 ½?
We will explore both the Roth 401(k) and the Rule of 55, then we will discuss planning involving the potential combination of the Roth 401(k) and the Rule of 55. We will also discuss a planning alternative to combining the Roth 401(k) with the Rule of 55.
Roth 401(k)
The Roth 401(k) is a 401(k) that is taxed as a Roth. Employers offering a 401(k) are not required to offer a Roth 401(k) option, but many do.
Roth 401(k) Contributions
There are now three main potential sources of “Roth contributions” to a Roth 401(k).
Employee Deferrals: In 2024, these are limited to the lesser of earned income or $23,000 ($30,000 if age 50 or older). These are done through W-2 withholding into the Roth 401(k).
Mega Backdoor Roth: These are after-tax contributions by the employee (also through W-2 withholding) to the traditional 401(k) followed by a soon-in-time Roth conversion of the after-tax 401(k) amount to the Roth 401(k).
Employer Contributions: Employers contribute to 401(k)s. SECURE 2.0 allows for employers to contribute to Roth 401(k)s. Traditionally, employer contributions had always been to the traditional 401(k), but SECURE 2.0 established the possibility of Roth 401(k) employer contributions. Note that a February 2024 federal court decision has called SECURE 2.0 into question.
There’s a limit on the combination of 1 plus 2 plus 3. I refer to this limit as the “all additions limit” and some refer to it as the “415(c)” limit, as that’s where the limit lives in the Internal Revenue Code. For 2024, the all additions limit is $69,000. For those aged 50 or older, it is $76,500.
There’s a fourth potential source of Roth 401(k) funds: Taxable conversions from traditional 401(k)s. Taxable Roth conversions (traditional 401(k) to Roth 401(k)) have no limit. These are usually not done during one’s working years.
Roth 401(k) Withdrawals
If “done right” a Roth 401(k) withdrawal in retirement is fully tax and penalty free.
However, if a distribution from a Roth 401(k) occurs before either (or both) the account owner is 59 ½ years old or the owner has owned that particular Roth 401(k) for five years, the “earnings” portion of the distribution is subject to ordinary income tax and the potential 10 percent early withdrawal penalty.
Here’s a quick example illustrating that rule:
Ken is age 53. He’s early retired. At a time when his Roth 401(k) is worth $200,000 and he’s previously contributed $100,000 to it, Ken takes a $50,000 distribution from the Roth 401(k) to help fund his retirement. Fifty percent of the distribution ($25,000) is a return of Ken’s previous contributions and fully tax and penalty free. The other fifty percent of the distribution ($25,000) is earnings and since Ken is under age 59 ½ will be taxable to Ken and subject to the 10 percent early withdrawal penalty.
Rule of 55
The Rule of 55 is an exception to the 10 percent early withdrawal penalty. It applies to a specific employer’s qualified plan, such as a 401(k). It applies distributions from an employer’s qualified plan if
The qualified plan account owner separated from service from the employer no earlier than the beginning of his or her age 55 birthday year, and
The distribution occurs after the separation from service.
Here is an example:
Rob was born on June 7, 1969. On January 16, 2024, Rob retired from Acme Industries. 2024 is Rob’s 55th birthday year. Any distribution occurring after January 16, 2024 from the Acme Industries 401(k) to Rob qualifies for the Rule of 55 exception to the 10 percent early withdrawal penalty.
Note that a transfer from the former employer’s qualified plan to an IRA blows qualification for the Rule of 55. Distributions from an IRA are not distributions from the employer’s qualified plan. Further, the Rule of 55 applies only to the particular employer’s plan. If Rob had separated from Consolidated Industries at age 52 and still had a 401(k) there, distributions from that 401(k) would not qualify for the Rule of 55.
Perhaps you’re sitting at home saying “Roth 401(k)s are great. The Rule of 55 is great. Why not combine them?”
I have four reasons not to combine them.
Taxing Roth 401(k) Earnings
Paying tax on a Roth distribution is the planning equivalent of breaking into jail. Combining the Roth 401(k) with the Rule of 55 means taxing Roth earnings as ordinary income. That isn’t a great outcome, particularly when there was no tax deduction on the way into the Roth 401(k).
Here is an example:
Ted leaves Maple Industries at age 56. He withdraws $60,000 from his Maple Industries Roth 401(k) at a time it was worth $300,000 and had $120,000 of previous contributions. Forty percent of the withdrawal ($24,000) is a tax and penalty free return of contributions. Sixty percent of the withdrawal ($36,000) is penalty free under the Rule of 55 but is subject to income taxation.
Perhaps a significant portion of the taxable withdrawal is protected by the standard deduction (what I refer to as the Hidden Roth IRA in the context of traditional retirement account withdrawals). But even at a 10 or 12 percent marginal federal income tax rate, from a planning perspective having any sort of taxable distribution from a Roth account is a bad outcome.
Further, taking money out of a Roth in our 50s means foregoing additional years or decades of tax free growth on that money.
A Great, Easily Accessible Alternative Exists
Before age 59 ½, a Roth 401(k) represents a challenge and an opportunity for an early retiree.
First, the challenge. The challenge is the “cream-in-the-coffee” rule I previously discussed in this post. Distributions before age 59 ½ attract both old contributions and earnings. Earnings are subject to both ordinary income tax and the 10 percent early withdrawal penalty.
Here’s an example:
Moe is age 53. He has a $500,000 Roth 401(k). $200,000 is old contributions and $300,000 is growth on those contributions (earnings). If Moe takes a distribution of $10,000 from the Roth 401(k), $4,000 (40%) will be a tax and penalty free return of contributions and $6,000 (60%) will be a distribution of earnings, subject to both income taxation and a 10 percent early withdrawal penalty (add 2.5% if Moe lives in California).
Here’s the opportunity: Someone like Moe can “isolate” his $200,000 of Roth 401(k) basis and avoid taxation on his Roth withdrawals.
It’s pretty easy. Moe can simply transfer his entire Roth 401(k) to a Roth IRA. That will immediately give Moe $200,000 of “basis” in his Roth IRA (old annual contributions which can be removed at any time for any reason tax and penalty free). Once the Roth 401(k) is in a Roth IRA, Moe has $200,000 (plus any other Roth basis he has separately built up) he can withdraw entirely tax and penalty free for early retirement.
A Good, Not Too Difficult Alternative Exists
There’s another path to basis isolation and avoiding taxation on a Roth 401(k) distribution, but it will be more complicated. This path involves Moe keeping most of the money inside the Roth 401(k).
Returning to the facts of Moe’s example: Say Moe is 53 years old and early retired. If the Roth 401(k) plan allows partial pre-age 59 ½ withdrawals, and Moe wants $10,000 tax and penalty free, he could withdraw $25,000 from the Roth 401(k) and (i) keep $10,000 (40%) and (ii) transfer $15,000 (60%) to a Roth IRA. The transaction will be entirely tax and penalty free as Moe is deemed to get the basis ($10,000) distributed to him and to have transferred the earnings ($15,000) to his Roth IRA. See Exception 3: Roth 401(k) Withdrawal then Rollover in this post for more details.
Why Not Use Taxable Accounts, if Possible?
I’ve said it before and I’ll say it again: I prefer using taxable accounts, if possible, to fund retirement prior to using retirement accounts. While that will not be possible for everyone, why not save before retirement in a manner that facilitates (1) living off taxable accounts prior to age 59 ½ (and pay very low capital gains taxes) while (2) doing very low tax rate Roth conversions in retirement.
Obviously, there’s only so much tax planning anyone can do if they are in their mid-to-late 50s and a couple of months away from retirement. But for those in their 30s, 40s, and even early 50s, now is the time to plan to set up a retirement that is as tax advantageous as possible.
For anyone with a decent amount of time between now and retirement, I would not recommend planning into relying on using the Rule of 55 for a Roth 401(k).
In theory, the Rule of 55 could be a workaround to that problem. Imagine Jane retires at age 56, and other than a paid off house and $50,000 in a savings account she has a $2,000,000 Roth 401(k) and a $500,000 Roth IRA. How is she going to create any taxable income to qualify for the Premium Tax Credit?
The answer, for a few years, can be the Rule of 55. Jane could take from her Roth 401(k) (assuming it allows partial pre-age 59 ½ distributions), create taxable income on the “earnings” portion of the distribution as discussed above, and avoid the 10 percent early withdrawal penalty under the Rule of 55.
This is still not something that should be planned into. Why not? At age 59 ½, assuming Jane has had the Roth 401(k) for 5 or more years, she will qualify for a “qualified distribution” from the Roth 401(k), meaning that all distributions from it will be entirely tax free.
That’s bad news from a Premium Tax Credit perspective: at that point Jane will have hardly any taxable income (just some interest income from the small savings account) and thus will not generate sufficient income to qualify for the Premium Tax Credit!
Conclusion
It is good that the Roth 401(k) and the Rule of 55 are available options for retirement. Absent unique and extreme circumstances, they generally should not be combined when it comes to retirement planning.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
New to financial independence (FI or FIRE)? Are you steeped in financial independence, but confused about tax optimization?
If so, this is the post for you. It’s not “comprehensive tax planning for FI” but rather an initial primer on some basic financial independence tax planning tactics.
But first, a caveat: none of this is advice for your specific situation, but rather, this comprises a list of the top four moves I believe those pursuing financial independence should consider. No blog post (this one included) is a substitute for your own and your advisors’ analysis and judgment of your own situation.
ONE: Contribute Ten Percent to Your Workplace Retirement Plan
To start, your top retirement savings priority in retirement should be to contribute at least 10 percent of your salary to your workplace retirement plan (401(k), 403(b), 457, etc.). I say this for several reasons.
It starts a great savings habit.
Subject to vesting requirements, it practically guarantees that you will get the employer match your 401(k) has, if any.
Assuming a traditional retirement account contribution, it gets you a valuable tax deduction at your marginal tax rate.
It will be incredibly difficult to get to financial independence without saving at least 10 percent of your salary.
Here are some additional considerations.
Traditional or Roth
In some plans, the employee does not have a choice – employee contributions are “traditional” deductible contributions. Increasingly, plans are offering the Roth option where the contribution is not deductible today, but the contribution and its growth/earnings are tax-free in the future.
This post addresses the traditional versus Roth issue. I strongly favor traditional 401(k) contributions over Roth 401(k) contributions for most people. The “secret” is that most people pay much more in tax during their working years than they do during their retired years (even if they have significant balances in their traditional retirement accounts). Thus, it makes more sense to take the tax deduction when taxes are highest and pay the tax when taxes tend to be much lower (retirement).
BadInvestments
I’d argue that most people with bad investments and/or high fees in their 401(k) should still contribute to it. Why? First, consider the incredible benefits discussed above. Second, you’re probably not going to be at that job too long anyway. In this video, I discuss that the average/median employee tenure is under 5 years. When one leaves a job, they can roll a 401(k) out of the 401(k) to the new employer’s 401(k) or a traditional IRA and get access to better investment choices and lower fees.
Resource
Your workplace retirement plan should have a PDF document called a “Summary Plan Description” available in your workplace benefits online portal. Reviewing that document will help you figure out the contours of your 401(k) or other workplace retirement plan.
TWO: Establish a Roth IRA
For a primer on Roth IRAs, please read my Ode to the Roth IRA. Roth IRAs, like traditional IRAs, are “individual.” You establish one with a financial institution separate from your employer.
Generally speaking, a Roth IRA gives you tax-free growth, and if done correctly, money withdrawn from a Roth IRA is both tax and penalty free.
Roth IRA contributions can be withdrawn tax and penalty free at any time for any reason! The Roth IRA is the only retirement account that offers unfettered, tax-free access to prior contributions. Note, however, in most cases the best Roth IRA strategy is to keep money in the Roth IRA for as long as possible (so it continues to grow tax free!).
A health savings account is a very powerful saving vehicle. You have access to it if you have a high deductible health plan. To have an HDHP through your employer, you need to determine (i) if your employer offers a HDHP and (ii) whether the HDHP is appropriate medical insurance for you.
If you do not have employer provided insurance, you may be able to obtain an HDHP in the individual marketplace.
HSA contributions have several benefits. You receive an upfront income tax deduction for the money you contribute. If the funds in your HSA are used to pay qualified medical expenses, or are used to reimburse you for qualified medical expenses, the contributions and the earnings/growth are tax-free when paid out of the HSA. This tax-friendly combination means the HSA should be a high priority.
Here are a few additional considerations:
HDHP Benefit
I believe the HDHP is itself a great benefit in addition to the HSA. Why? One reason is that the HDHP reduces a known expense: medical insurance premiums! Why pay significant premiums for a low deductible plan when the point of medical insurance is not “coverage” but rather to avoid financial calamity in the event of injury or illness?
We over-medicalize our problems. Too often we run to the doctor looking for a solution when the answer lies in what we’re eating and/or our environment. We should work to avoid disease and doctor visits by taking control of our own health. That is very much in line with both the high deductible model of medical insurance and financial independence.
Part of “independence” (including financial independence) is questioning established systems. I am glad Dr. Dhand and others are starting to do just that when it comes to medicine. HDHPs help us do that while providing financial protection in the event of significant injury or illness.
Thinking about a future mini-retirement? One great way to lay the foundation today for tomorrow’s mini-retirement is to increase one’s financial independence from the medical system and decrease dependence on any one employer’s medical insurance.
State Income Taxes
In California and New Jersey, HSAs are treated as taxable accounts. Thus, in these states there are no state income tax deductions for contributions to an HSA. Furthermore, dividends, interest and other realized income and gains generated by HSA assets are subject to state income taxes. While detrimental, the federal income tax benefits are so powerful that even residents of these states should prioritize HSA contributions.
Employer Contributions
Check to see if your employer offers an employer contribution to your HSA. Many do. When the employer does, the employee leaves free money on the table if they do not enroll in the HDHP.
Reimbursements
In most cases, it is advisable to (i) pay current medical costs out of your own pocket (your checking account and other taxable accounts) and (ii) record and track these medical expenses. Leaving the money in the HSA during our working years allows it to grow tax-free!
Years later when the money has grown, you can reimburse yourself tax-free from your HSA for the Previously Unreimbursed Qualified Medical Expenses (PUQME), as there is no time limit on reimbursements. Note that only qualified medical expenses incurred after you first open the HSA are eligible for tax-free reimbursement.
FOUR: Save, Save, Save!!!
My last recommendation is simple: save, save, save! Are there ways to do it in a tax-efficient manner? Absolutely!But the absolute most important consideration is the act of saving and investing itself. Between retirement plans, lack of a payroll tax, and favored dividend and capital gain tax rates, saving and investing are often tax efficient without trying to be.
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, medical, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, medical, and tax matters. Please also refer to the Disclaimer & Warning section found here.
The conventional wisdom says to accumulators “Save through a Roth 401(k)! Don’t you dare contribute to traditional 401(k)s. Those things are infested with taxes!!!”
Doubt that prioritizing Roth 401(k) contributions over traditional deductible 401(k) contributions is the conventional wisdom? Let’s hear from some very prominent personal finance commentators:
These commentators have much bigger platforms than I have, and they are to be commended for their many solid contributions to the personal finance discourse. On this particular issue, however, I believe their conventional wisdom misses the mark. I believe most of those saving for retirement during their working years should prioritize traditional deductible 401(k) contributions.
Here are the eight reasons why I believe the conventional wisdom on the traditional 401(k) versus Roth 401(k) debate is wrong.
Traditional Retirement Account Distributions are Very Lightly Taxed
Those 401(k)s and traditional IRAs are infested with taxes, right!
I have run the numbers in several blog posts and YouTube videos. Long story short, while working contributions into traditional 401(k)s generally enjoy a tax benefit at the taxpayer’s highest marginal tax rate while traditional retirement account distributions are taxed going up the progressive tax brackets in retirement (including the 10% and 12% brackets). This results in surprisinglyloweffective tax rates on traditional 401(k) and traditional IRA withdrawals in retirement.
The Tax Hikes Aren’t Coming
If “experts” keep predicting A and the exact opposite of A, B, keeps occurring and A never occurs, then the experts constantly predicting A aren’t good at predicting the future!
That’s where we are when it comes to predicting future tax hikes on retirees. Experts keep predicting that taxes are going through the roof on retirees. Experts use those predictions to justify the Roth 401(k) contribution push.
There’s a problem with those predictions: they have been dead wrong!
I did a video on this. Not only does Congress avoid tax hikes on retirees, recent history indicates Washington is addicted to tax cuts on retirees. To wit:
December 2017: TCJA increases the standard deduction and reduces the 15% bracket to 12%. There are few better ways to cut retiree taxes!
December 2019: The SECURE Act delays required minimum distributions (“RMDs”) from age 70 ½ to age 72.
March 2020: The CARES Act cancels 2020 RMDs and allows those already taken to be rolled back into retirement accounts in a very liberal fashion.
November 2020: The Treasury gets into the act by publishing new RMD tables that reduce annual RMDs.
Sure, the federal government has too much debt. Does that mean that taxes must necessarily rise on retirees? Absolutely not!
There are many solutions that can leave retirees unscathed, including:
Raising tariffs.
Raising taxes on college endowments, private foundations, high income investors’ dividends and capital gains, and hedge fund managers.
Eliminating electric vehicle tax credits.
Spending cuts, particularly to military spending and foreign spending. These are becoming more likely as American politics continue to change.
Conventional Wisdom Misses the Sufficiency Problem
How much tax do you pay on an empty 401(k)? How much tax do you pay on a nearly empty 401(k)?
Those crying wolf over taxes in retirement miss the real issue: sufficiency! According to this report, the median American adult wealth is about $108,000 as of 2022 (see page 16).
Let’s imagine all that $108K is in a traditional retirement account. Few will take it all out at once. The rather annual modest withdrawals will hardly be taxed at all due to the standard deduction and/or the 10% tax bracket.
If people are behind in their retirement savings, what’s the best way to catch up? Deduct, deduct, deduct! Those deductions save taxes now, opening the door for more savings. For those behind in retirement savings, sacrificing the valuable tax deduction to make Roth contributions makes little sense in my opinion. Why? Because those behind in retirement savings will face very low taxes in retirement.
Sadly, the median American adult has a sufficiency problem and would be fortunate to one day have an (overblown) tax problem instead!
Missing Out on the Hidden Roth IRA
Q: What’s it called when I take money out of a retirement account and don’t pay tax on it?
A: A Roth IRA!!!
Well, many Americans have a Roth IRA that lives inside their traditional 401(k). I call this the Hidden Roth IRA.
Prior to collecting Social Security, many Americans will have the opportunity to take tax free distributions from their traditional IRA or 401(k) because they will be offset by the standard deduction.
Did you know that you might be able to do Roth conversions in retirement and pay federal income tax at a 6% or lower federal tax rate? It’s true! I break that opportunity down in this video.
If you’re telling a 22 year old college graduate that all of their 401(k) contributions should be Roth you’re foreclosing many or all future Roth conversions! Why? Shouldn’t younger workers be setting up low tax Roth conversions in retirement while they are working?
“Roth, Roth, Roth!!!” sounds great and makes for a fun slogan. But it precludes incredibly valuable future tax planning!
The Widow’s Tax Trap and IRMAA are Overblown
The Widow’s Tax Trap is a phenomenon in American income taxation where surviving spouses pay more tax on less income. It’s real. But just how bad is it?
In one example, I found that an incredibly affluent 75 year-old married couple would be subject to a combined effective federal income tax/IRMAA rate of 15.44%. The surviving spouse would then be subject to a combined 19.87% effective rate after the first spouse’s death.
That’s the Widow’s Tax Trap. Real? Yes. Terrifying? No.
Few things are as overblown in American personal finance as IRMAA. IRMAA, income-related monthly adjustment amounts, are technically increases in Medicare premiums as one’s income exceeds certain thresholds. In practice, it is a nuisance tax on showing high income in retirement.
In one extreme example, I discussed a 90 year old widow with $304,000 of RMDs and Social Security income. Her IRMAA was about $5,500, a nuisance tax of about 1.8% on that income. Annoying? Sure. Something to factor into planning during the accumulation phase? Absolutely not.
Missing Out on Premium Tax Credits
Mark, age 22, graduates from college and buys into “Roth, Roth, Roth!!!” Every dollar he contributes to his 401(k) is in the Roth 401(k), and he elects to have all his employer 401(k) contributions put into the Roth 401(k) as well. At age 55, Mark decides to retire. He has a paid off house, $200,000 in a savings account, and $2.5 million in his Roth 401(k).
Mark will be on an ACA medical insurance plan from retirement (or the end of COBRA 18 months later) until the month he turns 65. There’s just one big snag: he has no income! Because of that he will not qualify for the combination of an ACA plan and a Premium Tax Credit, since, based on income, he’s eligible for Medicaid. Ouch!
Mark falls into this trap because he has no ability to create taxable income in retirement. Had he simply put some of his 401(k) into the traditional 401(k), he could have “turned on” taxable income by doing Roth conversions (mostly against the standard deduction!). Doing so would qualify Mark for hundreds of dollars in monthly Premium Tax Credits, greatly offsetting the significant cost of ACA medical insurance. Note Mark could turn on income by claiming Social Security at age 62, permanently reducing his annual Social Security income.
There are pressing priorities for retirement savers prior to retirement. You know what can help pay for them? The tax deduction offered by a traditional 401(k) contribution.
Conclusion
The Conventional Wisdom is wrong!
Traditional deductible contributions to 401(k)s and other workplace retirement plans are a great way to save and invest for the future. Future taxes are a drawback to that tactic. But they have to be assessed keeping in mind the eight reasons I raise above. To my mind, it’s more important to build up wealth than to be tax efficient. As discussed above, those aren’t mutually exclusive, including for those using traditional deductible 401(k) contributions for the majority of their retirement savings.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
One thing I like about the Financial Independence community is that members are not beholden to Conventional Wisdom.
Many in the Establishment believe retirement is for 65 year olds (and some basically think it’s not for anyone).
My response: Oh, heck no!
Sure, some people have jobs they very much enjoy. If that’s the case, then perhaps retirement isn’t your thing in your 50s. But many in the FI movement have accumulated assets such that they no longer have a financial need to work. Perhaps their job is not all that enjoyable – it happens. Or perhaps their job won’t exist in a year or two – that happens too.
The tax rules require some planning if one retires prior to turning age 59 ½. Age 59 ½ is the age at which the pesky 10 percent early withdrawal penalty no longer applies to tax-advantaged retirement account distributions.
Thus, there’s a need to consider what to live off of once one is age 59 ½. Below I list the possibilities in a general order of preference and availability. Several of these options (perhaps many of them) will simply not apply to many 50-something retirees. Further, some retirees may use a combination of the below discussed options.
Listen to Sean discuss accessing money in retirement prior to age 59 ½ on a recent ChooseFI episode! Part Two on the ChooseFI podcast is coming soon.
Taxable Accounts
The best retirement account to access if you retire before age 59 ½ isn’t even a “retirement” account: it’s a taxable account. I’m so fond of using taxable accounts first in retirement I wrote a post about the concept in 2022.
The idea is to use some combination of cash in taxable accounts (not at all taxable – it’s just going to the ATM!) and sales of brokerage assets (subject to low long term capital gains federal income tax rates) to fund your pre-59 ½ retirement. This keeps taxable income low and sets up potential additional tax planning.
Pros: Because of tax basis, living off $100,000 of taxable brokerage accounts doesn’t cause $100,000 of taxable income. Further, long term capital gains receive very favorable federal income tax treatment. Some may even qualify for the 0% long term capital gains tax rate!
But that’s not all. There are significant creditor protection benefits to living off taxable assets first. As we spend down taxable assets, we are reducing those assets that are most vulnerable to potential creditors. By not spending down tax-advantaged retirement accounts, we are generally letting them grow, thus growing the part of our balance sheet that tends to enjoy significant creditor protection. Note that personal liability umbrella insurance is usually a good thing to consider in the creditor protection context regardless of tax strategy.
Spending taxable assets first tends to limit taxable income, which can open the door to (1) a significant Premium Tax Credit in retirement (if covered by an Affordable Care Act medical insurance plan) and (2) very tax advantageous Roth conversions in early retirement.
There’s also a big benefit for those years after we turn 59 ½. By spending down taxable assets, we reduce future “uncontrolled income.” Taxable accounts are great. But they kick off interest, dividends, and capital gains income, even if we don’t spend them. By reducing taxable account balances, we reduce the future income that would otherwise show up on our tax return in an uncontrolled fashion.
Cons: To my mind, there are few cons to this strategy in retirement.
The one con in the accumulation phase is that when we choose to invest in taxable accounts instead ofin traditional deductible retirement accounts we forego a significant tax arbitrage opportunity. That said, these are not mutually exclusive. Members of the FI community can max out deductible retirement account contributions and also build up taxable accounts.
Ideal For: Someone who is able to save beyond tax-advantaged retirement accounts during their working years. This is the “ideal” for financial independence in my opinion, though it may be challenging for some.
Inherited Retirement Accounts
Withdrawals from inherited retirement accounts (other than those the spouse treats as their own) are never subject to the 10% early withdrawal penalty. Often they are subject to a 10-year drawdown rule, so usually they should be accessed prior to using many other draw down techniques.
Pros: If it’s a traditional retirement account inherited from a parent or anyone else more than 10 years older than you are, you generally have to take the money out within 10 years. Why not just live on that money? Simply living on that money, instead of letting the traditional inherited retirement grow for ten years, avoids a “Year 10 Time Bomb.” The time bomb possibility is that the inherited traditional retirement account grows to a huge balance that needs to come out in the tenth full year following death. Such a large distribution could subject the recipient subject to an abnormally high marginal federal income tax rate.
Cons: Not very many other than if the account is a Roth IRA, using the money for living expenses instead of letting it grow for 10 years sacrifices several years of tax free growth.
Ideal For: Someone who has inherited a retirement account prior to turning age 59 ½.
This is a great way to avoid the early withdrawal penalty. But remember, the money must stay in the workplace retirement account (and not be rolled over to a traditional IRA) to get the benefit.
Pros: Funds retirement prior to age 59 ½ without having to incur the 10 percent early withdrawal penalty.
Whittles down traditional retirement accounts in a manner that can help reduce future required minimum distributions (“RMDs”).
Cons: You’re handcuffed to the particular employer’s 401(k) (investments, fees, etc.) prior to age 59 ½. Review the plan’s Summary Plan Description prior to relying on this path to ensure flexible, periodic distributions are easily done after separation from service and prior to turning age 59 ½.
Limited availability as one must separate from service no sooner than the year they turn age 55.
Creates taxable income (assuming a traditional account is used), which is less than optimal from a Premium Tax Credit and Roth conversion perspective.
Ideal For: Those with (1) large balances in their current employer 401(k) (or other plan), (2) a quality current 401(k) or other plan in terms of investment selection and fees, (3) a plan with easily implemented Rule of 55 distributions, and (4) plans to retire in their mid-to-late 50s.
Governmental 457(b) Plans
Withdrawals from governmental 457(b) plans are generally not subject to the 10% early withdrawal penalty. This is the Rule of 55 exception but they deleted the “55” 😉
Like the Rule of 55, this is only available so long as the governmental 457(b) is not rolled to a traditional IRA.
Pros: Funds retirement prior to age 59 ½ without having to incur the 10 percent early withdrawal penalty. If you have a governmental 457(b), it’s better than the Rule of 55 because you don’t have to worry about your separation from service date.
Whittles down traditional retirement accounts in a manner that can help reduce future RMDs.
Cons: You’re handcuffed to the particular employer’s 457 (investments, fees, etc.) prior to age 59 ½. Review the plan’s Summary Plan Description prior to relying on this path to ensure flexible, periodic distributions are easily done after separation from service and prior to turning age 59 ½.
Creates taxable income (assuming a traditional account is used), which is less than optimal from a Premium Tax Credit and Roth conversion perspective.
Ideal For: Those (1) with large balances in their current employer governmental 457(b) and (2) a quality current governmental 457(b) in terms of investment selection and fees.
Roth Basis
Old annual contributions and conversions that are at least 5 years old can be withdrawn from Roth IRAs tax and penalty free at any time for any reason. This can be part of the so-called Roth Conversion Ladder strategy, though it does not have to be, since many will have Roth Basis going into retirement.
Pros: Roth Basis creates a tax free pool of money to access prior to turning age 59 ½.
Cons: We like to let Roth accounts bake for years, if not decades, of tax free growth. Using Roth Basis in one’s 50s significantly reduces that opportunity.
Some may need taxable income in early retirement to qualify for Premium Tax Credits. Relying solely on Roth Basis can be much less than optimal if Premium Tax Credits are a significant part of one’s early retirement plan.
Roth 401(k) contributions, for many workers, are disadvantageous in my opinion. Many Americans will forego a significant tax rate arbitrage opportunity if they prioritize Roth 401(k) contributions over traditional 401(k) contributions.
Ideal For: Those with significant previous contributions and conversions to Roth accounts.
72(t) Payments
I did a lengthy post on this concept. The idea is to create an annual taxable distribution from a traditional IRA and avoid the 10 percent early withdrawal penalty.
Pros: Avoids the early withdrawal prior to turning age 59 ½.
Whittles down traditional retirement accounts in a manner that can help reduce future RMDs.
Inside a traditional IRA, the investor controls the selection of financial institutions and investments and has great control on investment expenses.
Cons: This opportunity may require professional assistance to a degree that many of the other concepts discussed do not.
There is a risk that if not done properly, previous years’ distributions may become subject to the 10 percent early withdrawal penalty and related interest charges.
Creates taxable income, which is less than optimal from a Premium Tax Credit and Roth conversion perspective.
Ideal For: Those with most of their financial wealth in traditional deferred retirement accounts prior to age 59 ½ and without easy access to other alternatives (such as the Rule of 55 and/or governmental 457(b) plans.
HSA PUQME
Withdrawals of Previously Unreimbursed Qualified Medical Expenses (“PUQME”) from a health savings account are tax and penalty free at any time for any reason. Thanks to ChooseFI listener and correspondent Kristin Smith for suggesting the idea to use PUQME to help fund retirement in one’s 50s.
Pros: Withdrawals of PUQME creates a tax free pool of money to access prior to turning age 59 ½.
Reduces HSA balances in a way that can help to avoid the hidden HSA death tax in the future.
Cons: This is generally a limited opportunity. The amount of PUQME that can be used prior to age 59 ½ is limited to the smaller of one’s (1) PUQME and (2) HSA size. Because HSAs have relatively modest contribution limits, in many cases HSA PUQME withdrawals would need to be combined with one or more of the other planning concepts to fund retirement prior to age 59 ½.
We like to let HSAs bake for years, if not decades, of tax free growth. Using HSA PUQME in one’s 50s significantly reduces that opportunity.
Some may need taxable income in early retirement to qualify for Premium Tax Credits. Relying on PUQME can be less than optimal if Premium Tax Credits are a significant part of one’s early retirement plan.
Ideal For: Those with significant HSAs and significant PUQME.
Net Unrealized Appreciation
Applies only to those with significantly appreciated employer stock in a 401(k), ESOP, or other workplace retirement plan. I’ve written about this opportunity before. That employer stock with the large capital gains can serve as a “Capital Gains IRA” in retirement. Retirees can possibly live off sales of employer stock subject to the 0% long term capital gains rate.
This opportunity usually requires professional assistance, in my opinion.
The move of the employer stock out of the retirement plan into a taxable brokerage account (which sets up what I colloquially refer to as the “Capital Gains IRA” may need to be paired with the Rule of 55 (or another penalty exception) to avoid the 10 percent early withdrawal penalty on the “basis” of the employer stock.
Pros: Moves income from “ordinary” income to “long term capital gains” income, which can be very advantageous, particularly if one can keep their income entirely or mostly in the 0% long term capital gains marginal bracket.
Cons: Remember Enron? NUA is essentially Enron if it goes fabulously well instead of failing spectacularly.
Employer stock is problematic during the accumulation phase since your finances are heavily dependent on your employer without a single share of employer stock. People make their finances more risky by having both their income statement and their balance sheet highly dependent on a single corporation.
It keeps the retiree heavily invested in the stock of their former employer, which is much less than optimal from an investment diversification perspective.
Another con is that this usually requires professional assistance (and fees) to a much greater degree than several of the other withdrawal options discussed on this post.
Ideal For: Those with large balances of significantly appreciated employer stock in a workplace 401(k), ESOP, or other retirement plan.
Pay the Penalty
The federal early withdrawal penalty is 10 percent. For those in California, add a 2.5 percent state penalty. For some, perhaps the best idea is to simply bite-the-bullet and pay the early withdrawal penalty. That said, anyone accessing a tax-advantaged retirement account in a way not covered above should always consult the IRS list to see if perhaps they qualify for one of the myriad penalty exceptions.
Pros: Why let a 10 percent penalty prevent you from retiring at age 58 if you have sufficient assets to do so and you might be looking at a year or two of the penalty, tops?
Whittles down traditional retirement accounts in a manner that can help reduce future RMDs.
Cons: Who wants to pay ordinary income tax and the early withdrawal penalty? Even for those close to the 59 ½ finish line, a 72(t) payment plan for five years might be a better option and would avoid the penalty if properly done.
Ideal For: Those very close to age 59 ½ who don’t have a more readily available drawdown tactic to use. That said, even these retirees should consider a 72(t) payment plan, in my opinion.
Combining Methods to Access Funds Prior to Age 59 1/2
For some, perhaps many, no single one of the above methods will be the optimal path. It may be that the optimal path will involve combining two or more of the above methods.
Here’s an example: Rob retires at age 56. He uses the Rule of 55 to fund most of his living expenses prior to turning age 59 ½. Late in the year, he finds that a distribution from his traditional 401(k) would push him up into the 22% federal income tax bracket for the year. Thus, for this last distribution he instead elects to take a recovery of Roth Basis from his Roth IRA. This allows him to stay in the 12% marginal federal income tax bracket for the year.
Conclusion
Don’t let anyone tell you you can’t retire in your 50s. If you have reached financial independence, why not? Of course, you will need to be very intentional about drawing down your assets and funding your living expenses. This is particularly important prior to your 59 1/2th birthday.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
SECURE 2.0, passed in December 2022, made dozens of changes to the rules governing tax-advantaged retirement accounts.
When Congress passes a major tax law change, the IRS and Treasury issue regulations and other guidance regarding the change. Practitioners and taxpayers often provide the IRS and Treasury comment letters bringing issues and concerns to the government’s attention.
I wrote a comment letter (which you can read here) to the IRS and Treasury addressing facets of the following provisions:
This post (and the linked-to comment letter) is for entertainment and educational purposes only. They do not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
Want to retire before age 59 ½? Have most of your wealth in traditional tax-deferred retirement accounts? Worried about the 10 percent early withdrawal penalty?
This post is for you!
Picture it: You’re age 53, have $50,000 in a savings account, a paid-off home, and $2.5M in a 401(k). Including income taxes, you spend about $80,000 a year. You want to retire, but you’re worried about paying the early withdrawal penalty, which would be about $8,000 a year (not factoring in the penalty on the penalty!).
72(t) payments can make retirement possible prior to age 59 ½ when one has most of their assets in traditional deferred retirement accounts. Done properly, these payments avoid the 10 percent early withdrawal penalty.
Below I explore some of the rules of 72(t) payments (sometimes referred to as a “72(t) SEPP” or “SEPP”) and lay out what I hope will be an informative case study.
** As always, none of this is personalized advice for you, but rather educational information for your consideration. Consult with your own advisors regarding your own situation.
72(t) Substantially Equal Periodic Payments
Methods
The IRS and Treasury provide three methods for computing a 72(t) payment. As a practical matter, the third one I discuss, the fixed amortization method, tends to be the most commonly used and most user friendly in my opinion.
The required minimum distribution method allows taxpayers to take a 72(t) payment just like an RMD. Take the prior year end-of-year balance and divide it by the factor off the IRS table. The biggest problems with this method are it tends to produce a smaller payment the younger you are and the payment changes every year and can decrease if the IRA portfolio declines in value. The fixed annuitization method usually requires actuarial assistance, making it more complicated and less desirable. See Choate, referenced below, at page 587.
We will focus the rest of the post on the fixed amortization method of computing 72(t) payments (other than a brief foray into the RMD method to account for changing circumstances)).
Computing Fixed Amortization 72(t) Payments
To compute a 72(t) payment and the size of the 72(t) IRA using the fixed amortization method, we will need to run through some math. Four numbers are required: the interest rate, the life expectancy, the annual payment, and the size of the 72(t) IRA.
Usually the IRS gives us the interest rate and the life expectancy and we need to solve for the 72(t) IRA size.
As a general rule, taxpayers will usually want to use the greatest interest rate permitted to as to decrease the size of the 72(t) IRA. Decreasing the size of the 72(t) IRA will usually be advantageous, for the reasons discussed below.
Life Expectancy: The life expectancy comes to us from an IRS table. While we have three possible choices to use, generally speaking taxpayers will want to use the Single Life Table found at Treas. Reg. Section 1.401(a)(9)-9(b). See Choate, referenced below, at page 587. The taxpayer takes their age on their birthday of the year of the first 72(t) payment and uses the factor from the Single Life Table as the life expectancy.
Payment: Finally, we, not the IRS, get to determine a number! The payment is simply the annual payment we want to receive as a 72(t) payment every year. While this amount is rather inflexible, as discussed below it will be possible to establish additional 72(t) IRAs and payments to increase the amount received if desired.
Size of the 72(t) IRA: This is what we’re solving for to establish a “right-sized” IRA to produce the desired 72(t) payment. In Google Sheets, we do a present value calculation to solve for the size of the 72(t) IRA that generates the desired payment amount. The formula is rather simple: =-PV(Interest Rate Cell, Life Expectancy Cell, Annual Payment Cell). I put a negative sign in front of the PV to have the size of the 72(t) IRA appear as a positive number. It’s important that the formula be entered in that order and that the formatting be correct in each cell.
Note on 72(t) Payments with non-IRA Accounts: Setting up a 72(t) from a non-IRA is possible but not frequent in practice. It is not possible to divide up a 401(k) account in a manner conducive to establishing a “right-sized” 72(t) payment account. See Choate, referenced below, at page 595.
Annual Equal 72(t) Fixed Amortization Payments
The computed payments must be made annually and equally. This means that no more and no less than the computed payment comes out every year. I believe that taking an annual flat payment on or around the first payment anniversary date is a best practice. However, this best practice is not required. See also Choate, referenced below, at page 600. For example, monthly payments of the computed amount are allowable. See Choate, referenced below, at page 600.
Annual payments must be made for the longer of five years or until the taxpayer reaches age 59 ½.
72(t) Payments Case Study
Let’s return to the example discussed above: it is early November 2023 and you (let’s call you Pat) are 53 years old (your birthday was June 8th) and you want to retire, spending $80K a year from your $2.5M 401(k). Let’s solve for the size of the 72(t) IRA:
The size of the 72(t) IRA is $1,236,012.95. See IRS FAQ Q&A 7.
Pat would first transfer (preferably through a direct trustee-to-trustee transfer) the 401(k) to a traditional IRA worth $2.5M. Once in the traditional IRA, Pat would call their financial institution and ask them to divide the traditional IRA into two IRAs: one with exactly $1,236,012.95 (the “72(t) IRA”) and one with the reminder of the traditional IRA (the “non-72(t) IRA”). I recommend initially investing the 72(t) IRA in a money market fund so that it can be clearly established that the beginning account balance was exactly the $1,236,012.95 computed to yield the correct payment. Pat takes the first payment of $80,000 on November 29th from the 72(t) IRA in this hypothetical scenario.
Let’s keep going. Assume that in 2027, when Pat turns age 57 and interest rates are well below 5%, Pat wants to increase their November withdrawal from $80K to $90K. As discussed below, Pat can’t simply increase the withdrawal from the 72(t) IRA. But since Pat kept a non-72(t) IRA, Pat can slice that one up to create a second 72(t) IRA. That second 72(t) IRA can give Pat the extra $10,000 Pat wants to spend.
Here’s what that looks like.
Interest Rate: 5.00%
Life Expectancy: 30.6
Payment: $10,000
The size of the second 72(t) IRA is $155,059.55.
Pat would call their financial institution and ask them to divide the non-72(t) IRA into two IRAs: one with exactly $155,059.55 (the “Second 72(t) IRA”) and one with the remainder of the traditional IRA (the surviving non-72(t) IRA). Pat takes the additional payment of $10,000 also on November 29th from the Second 72(t) in this hypothetical scenario.
Here is what Pat’s withdrawals would look like:
Year
Birthday Age
Required First 72(t) November 29 Withdrawal
Required Second 72(t) November 29 Withdrawal
Total Annual Withdrawal
2023
53
$80,000
$0
$80,000
2024
54
$80,000
$0
$80,000
2025
55
$80,000
$0
$80,000
2026
56
$80,000
$0
$80,000
2027
57
$80,000
$10,000
$90,000
2028
58
$80,000
$10,000
$90,000
2029
59
$80,000
$10,000
$90,000
2030
60
$0
$10,000
$10,000
2031
61
$0
$10,000
$10,000
Remember that the First 72(t) IRA and the Second 72(t) are locked up for a period of time. See Locking the Cage below. The First 72(t) IRA is locked up until and through December 7, 2029, the day before Pat’s 59 ½ birthday. The Second 72(t) IRA is locked up until and through November 28, 2032, the day before the fifth anniversary of the first $10,000 payment from the Second 72(t) IRA. See IRS FAQ 13 on this point. Generally speaking, no amount other than the annual payment should go into, or out of, a 72(t) IRA until the end of the lock-up period.
Maintain Flexibility
I strongly recommend maintaining as much flexibility as possible. One way to do that is to have the 72(t) IRA be as small as possible, leaving as much as possible in a non-72(t) IRA or IRAs. Why?
First, the non-72(t) can be, in a flexible manner, sliced and diced to create a second 72(t) IRA if wanted or needed. Second, it is not abundantly clear what happens when a 72(t) IRA is used for partial Roth conversions. See Choate, referenced below, at page 384. As Ms. Choate discusses, the only clarity we have is that if the entire 72(t) IRA is Roth converted, the taxpayer must continue to take withdrawals from the Roth IRA for the remainder of the 72(t) term. Doing so limits the benefit of doing Roth conversions in the first place, since we usually want Roth converted amounts to stay in a Roth IRA to facilitate many years of tax-free growth.
Imagine if Pat did not divide the $2.5M traditional IRA into two IRAs. Pat could have simply used a smaller interest rate on the entire $2.5M traditional IRA to get the $80,000 annual payment out. However, then Pat would not have had the flexibility to create a second 72(t) payment stream. This is an important reason that it is usually best to use the highest possible interest rate to lower the 72(t) IRA size and maintain the most flexibility.
72(t) Payment Plan Disqualification
A “modification” to the 72(t) payment plan blows up the plan with unfavorable consequences. In the year of the modification the taxpayer owes the 10 percent early withdrawal penalty plus interest on the penalty on all the previously taken 72(t) payments. See Choate, referenced below, at page 596.
A blow up after age 59 ½, for those on the five year rule, is bad but tends to be less deleterious than a blow up occurring with respect to a SEPP ending at age 59 1/2. The early withdrawal penalty and related interest are not assessed on 72(t) payments taken after one’s 59 ½ birthday. See Choate, referenced below, at page 596.
There are a few modifications to a 72(t) payment plan that do not blow it up (i.e., they are permissible and don’t trigger the penalty and interest). See Choate, referenced below, at pages 597-601. Those looking to change the payment amount are often well advised to set up a second 72(t) payment plan (as Pat did) rather than seeking a modification to the existing 72(t) payment plan.
72(t) Payment Reduction
Imagine that instead of wanting an additional 72(t) payment amount, Pat wanted to reduce the 72(t) payment. This is not uncommon. Perhaps Pat has a significant inheritance in 2027 and thus no longer needs to take an $80,000 annual payment and pay tax on it.
Unfortunately, Pat is not allowed to simply discontinue or reduce the 72(t) payment without triggering the early withdrawal penalty (and interest charges) on the previously taken 72(t) payments.
But, the rules allow a one-time switch to the RMD method. Making the switch is likely to significantly reduce the annual 72(t) payment. For example, if Pat wants a smaller payment starting in 2027, Pat could take the 72(t) IRA balance on December 31, 2026 (imagine it is exactly $1M) and divide it by the age 57 factor off the Single Life Table (29.8) and get a 2027 72(t) payment of $33,557.05. Alternatively, Pat could use the age 57 factor off the Notice 2022-6 Uniform Life Table (41.6) and get a 2027 72(t) payment of $24,038.46.
If Pat makes this one-time switch, Pat will annually compute the 72(t) payment for the remainder of the 72(t) term using the table used in 2027 (see Notice 2022-6 page 6) and the prior-year end-of-year 72(t) IRA balance.
The one-time switch to the RMD method is helpful if the taxpayer wants to significantly reduce their 72(t) annual payment, perhaps because of an inheritance, marriage, YouTube channel blowing up, or returning to work. The availability of this method to reduce required 72(t) payments (if desired) is another reason to keep 72(t) IRAs as small as possible.
72(t) Locking The Cage
The 72(t) IRA should be thought of as a locked cage. No one goes in, and only the 72(t) payment comes out annually. The rigidity with which the IRS treats the 72(t) IRA gives early retirees incentive to use as high an interest rate as possible to get the highest annual payment out of the smallest 72(t) IRA possible.
Just how rigid is the IRS? In one case, the IRS disqualified a 72(t) SEPP because a taxpayer transferred a workplace retirement plan into the 72(t) IRA during the 72(t) payment period. See page 4 of this newsletter (page 4 is behind a paywall). Imagine paying penalties and interest on old 72(t) payments for what is seemingly an unrelated rollover!
Remember, the “series of substantially equal periodic payments” requires not just an annual payment. It requires that the 72(t) IRA be locked up. Assuming one is using the fixed amortization method for their 72(t) payments, not a dollar more than the 72(t) SEPP should come out each year. It appears the IRS expects the amount to be equal each tax year, see page 5 of this PLR.
Further, the 72(t) lockup does not end with the taking of the last payment. Rather, as described in IRS FAQ 13, it ends at the end of the lock up period. So if Sean, age 57 in 2023, takes his first 72(t) SEPP of $10,000 from IRA 1 on July 15, 2023, his taking of payment number 5 ($10,000) on July 15, 2027 does not end the lock up. Sean can’t take any additional money out of IRA 1 until July 1, 2028 (the fifth anniversary of his first $10,000 72(t) payment).
Practice Point: Never add money to a 72(t) IRA during the lockup period. This includes never making an annual contribution to a 72(t) IRA and never rolling an IRA, 401(k), or other qualified plan into a 72(t) IRA.
IRS FAQ 13 is instructive in terms of when the lock up ends. The IRS is clear that the lock up ends on the date of the 59 ½ birthday, not on January 1st of that year. Say Rob, born January 14, 1971, takes his first SEPP of $40,000 on August 16, 2023. His 72(t) IRA is free on his 59 ½ birthday, which is July 14, 2030. Presumably, Rob takes his last $40,000 SEPP on or around August 16, 2029. Nevertheless, he can’t add to or withdraw from his 72(t) IRA prior to July 14, 2030 without blowing up his 72(t) payment plan and incurring significant penalties and interest.
As discussed above, the one-time switch to the RMD method is a permissible modification to the 72(t) payment terms that does not trigger the early withdrawal penalty and related interest on previously taken 72(t) payments.
A Note on the 72(t) Risk Profile
The earlier in life the 72(t) payment plan starts, the greater the risk profile on the 72(t) payment plan. The opposite is also true: the later in life a 72(t) payment plan starts, the lower the risk profile.
Why?
Because the sooner the 72(t) payment plan starts, the more years (and more interest) that can be blown up by a future modification requiring the payment of the 10 percent early withdrawal penalty and interest.
Consider Pat’s example. If Pat blows up the First 72(t) payment plan in early 2028, Pat owes the 10% early withdrawal penalty and interest on five previously taken 72(t) payments from the First 72(t) IRA (2023 through 2027). If Pat blows up the Second 72(t) payment plan in 2032, Pat only owes the early withdrawal penalty and interest on the three 72(t) payments received before Pat turned age 59 ½.
72(t) Payment Tax Return Reporting
Taxpayers should keep the computations they and/or their advisors have done to document the 72(t) payment plan. Distributions should be reported as taxable income and on Form 5329. Code 02 should be entered on Line 2 of Form 5329.
72(t) Is An Exception to More Than One Rule
72(t) payment plans are an exception to the 10 percent early withdrawal penalty. They are also an exception to the general rule that the IRS views all of your IRAs as a single IRA. The 72(t) IRA is the 72(t) IRA. If you have a separate IRA and take ten dollars out of it prior to age 59 ½, you trigger ordinary income tax and a $1 penalty. If you take an additional ten dollars out of the 72(t) IRA prior to the end of the 72(t) lock up, you blow up the 72(t) payment plan and owe the 10 percent early withdrawal penalty and interest on all the pre-59 ½ 72(t) payments.
Other Penalty Free Sources of Early Retirement Funding
Let’s remember that 72(t) payments are a tool. In many cases they are not a “go-to” strategy. I’ve written this post not because 72(t) payments are a go-to strategy but rather because I know there are many in their 50s thinking about retirement but daunted by the prospect of accessing traditional retirement accounts prior to age 59 ½.
Generally speaking, I encourage using resources other than 72(t) payments if you are able to. They include:
Taxable Accounts: I’m so fond of using taxable accounts first in retirement I wrote a post about the concept in 2022.
Inherited Retirement Accounts: Withdrawals from inherited retirement accounts (other than those the spouse treats as their own) are never subject to the 10% early withdrawal penalty. Often they are subject to a 10-year draw down rule, so usually they should be accessed prior to implementing a 72(t) payment plan from one’s own accounts.
Rule of 55 Distributions: Only available from a qualified retirement plan such as a 401(k) from an employer the employee separates from service no sooner than the beginning of the year they turn age 55. This is a great workaround from the early withdrawal penalty, and much more flexible than a 72(t) payment plan. But remember, the money must stay in the workplace retirement account (and not be rolled over to a traditional IRA) to get the benefit.
Governmental 457(b) Plans: Withdrawals from governmental 457(b) plans are generally not subject to the 10% early withdrawal penalty.
I previously discussed using a 72(t) payment plan to bail out Roth IRA earnings penalty-free prior to age 59 ½. This is a tactic that I would not recommend unless absolutely necessary (which I believe is a very rare situation).
72(t) Landscape Change
It should be noted that the issuance of Notice 2022-6 in early 2022 changed the landscape when it comes to 72(t) payments. Before the 5 percent safe harbor, it was possible that taxpayers could be subject to sub-0.5 percent interest rates, meaning that it would take almost $1M in a retirement account to generate just $30,000 in an annual payment in one’s mid-50s. Now with the availability of the 5 percent interest rate much more modest account balances can be used to generate significant 72(t) payments in one’s mid-50s.
What if Pat’s 401(k) contained significant amounts of employer stock? What if that employer stock had significantly appreciated in value since the time Pat and/or Pat’s employer contributed that stock? If so, a 72(t) payment plan may not be ideal. Rather, Pat may want to work with Pat’s advisor(s) to look into a separate and distinct tax planning opportunity, net unrealized appreciation (“NUA”).
I collaborated with Andrea MacDonald to discuss the tax return reporting requirements for NUA here.
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters.Please also refer to the Disclaimer & Warning section found here.
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 debate continues: what’s preferable, traditional retirement accounts or Roth retirement accounts?
Fortunately, there are plenty of shades of gray in this debate. There’s no “right” answer, but I do believe that there are good insights that can help individuals make the right planning decisions for themselves.
Traditional and Roth Retirement Basics
Before we dive into the traditional versus Roth debate, we should quickly survey the basics of these types of retirement accounts.
Traditional
Traditional retirement accounts feature a tax deduction on the way in (i.e., for contributions) and ordinary income tax on the way out (i.e., for withdrawals). At work these are known as traditional 401(k)s, 403(b), 457s, and occasionally have other names. At home these are known as traditional IRAs.
Additional twist: many working Americans do not qualify to deduct a traditional IRA contribution due to relatively low income limits on claiming a deduction.
Part of the appeal of traditional retirement accounts includes: (i) the notion that many will have lower taxable income (and thus lower income tax) in retirement than they did during their working years and (ii) the tax saved by contributing to traditional accounts can be invested, potentially creating more wealth for retirement.
Roth
Roth retirement accounts feature no tax deduction on the way in (i.e., for contributions) and tax free treatment on the way out (i.e., for withdrawals). At work these are known as Roth 401(k)s, 403(b), 457s, and (after SECURE 2.0 implementation) will occasionally have other names. At home these are known as Roth IRAs.
Additional twist: some working Americans do not qualify to make an annual Roth IRA contribution based on income limits, but many can get around this rule by implementing a Backdoor Roth IRA.
Part of the appeal of contributions to Roth retirement accounts is the notion that it is better for our younger, healthier selves to pay the tax associated with retirement savings when cash flow is good and the investor knows they can bear the cost.
The basics out of the way, we can get into 2023 insights on the debate between the two types of retirement accounts.
The Risk of Traditional Retirement Accounts is Vastly Overstated
Here’s the thing: rarely do commentators offer any sort of mathematical analysis backing up that contention. I ran the math, and I repeatedly find that many retirees with traditional retirement accounts are likely to pay Uncle Sam a very manageable amount of income taxes in retirement.
You be the judge and jury. I believe a fair assessment of my posts and videos and the numbers behind them shows that most Americans do not face a high risk of crippling federal income taxes in retirement, even if the vast majority of their portfolio is in traditional 401(k)s and IRAs.
While I cannot give readers of this blog individualized advice, I can say that if one considers themselves to be an “Average Joe” it is difficult to see how having significant amounts in traditional retirement accounts is a problem.
The Needle Keeps Moving Towards Traditional
Picture it: United States, September 2017, six short years ago. You’re bright-eyed, bushy-tailed, and fear only one thing: incredibly high taxes on your traditional 401(k) and IRA in retirement.
Then a few things happened.
December 2017: TCJA increased the standard deduction and lowered the 15% bracket to 12%
December 2019: The SECURE Act (SECURE 1.0) delayed RMDs from age 70 ½ to 72
March 2020: CARES Act cancels 2020 RMDs and allows taken RMDs to be rolled back in
November 2020: IRS and Treasury issue a new Uniform Life Table, decreasing the amount of annual RMDs beginning in 2022
December 2022: SECURE 2.0 delays RMDs from age 72 to 73, and all the way to age 75 for those born in 1960 and later
Tax cut after tax cut for traditional retirement accounts and retirees! In the traditional versus Roth debate, DC keeps putting a thumb on the scale for traditional.
Watch me assess recent tax law change history as it applies to retirees.
Taxable Roth Conversions Going Away?
One reason I like traditional 401(k) contributions is that they do not close the door on Roths. Rather, traditional retirement account contributions at work are a springboard for years of Roth conversions in retirement for many in the FI community!
The idea is to take deductions at high marginal tax rates at work into a 401(k) and build up wealth for an early retirement. Then, in retirement, one’s tax rate is artificially low as they no longer have W-2 income to report. This opens up room for potentially very efficient Roth conversions (affirmatively moving money in traditional accounts to Roth accounts) taxed at the 10% or 12% federal income tax rate.
Second, why would Congress eliminate most taxable Roth conversions? They “budget” tax bills in a 10 year window. Taxable Roth conversions create tax revenue inside that budget window, making it that much less likely a Congress would eliminate most of them.
While there is not zero risk taxable Roth conversions will go away, I believe that the risk is negligible. The greater one believes Roth conversion repeal risk is, the more attractive Roth contributions during one’s working years look.
Special Years Favor Roths
I’ve written before about how workers in the early years of their careers may want to consider Roth 401(k) contributions prior to their income significantly increasing. Those in transition years, such as those starting a job after graduating college and those about to take a mini retirement may want to prioritize Roth 401(k) contributions over traditional 401(k) contributions.
Here’s the thing: there are simply too many unknown future variables to come up with any precision in this regard. That said, I don’t believe we have to.
Why? Because in retirement planning, we can optimize for known trade-offs. Let me explain. At work, Americans under age 50 can contribute up to $22,500 (2023 number) to a 401(k). At most employers, that can be any combination of traditional or Roth contributions. Every dollar contributed to a Roth 401(k) is a dollar that cannot be contributed to a traditional deductible 401(k). That’s a known trade-off.
What about at home? For most working Americans covered by a 401(k), a dollar contributed to a Roth IRA is not a dollar that could have been contributed to a deductibletraditional IRA. So a Roth IRA contribution is not subject to the trade-off downside that a Roth 401(k) contribution is.
Why not optimize for known trade-offs? Contribute to a traditional 401(k) at work and a Roth IRA (or Backdoor Roth IRA) at home. This approach optimizes for the known trade-offs and sets one up with both traditional and Roth assets heading into retirement.
Traditional retirement account contributions set up great optionality. A retiree may have years or decades of opportunity to strategically convert traditional accounts to Roth accounts. Or, a retiree might say, “thanks, but no thanks, on those Roth conversions, I’ll simply wait to withdraw for RMDs or living expenses later in retirement at a low tax rate.” Traditional retirement account contributions open the doors to several planning options.
Roth contributions end the planning. That’s it, the money is inside a Roth account. Considering the potential to have low tax years after the end of one’s working years, is that always a good thing?
Rothification Risks
Having all one’s retirement eggs in the Roth basket can create significant problems. This is an issue I do not believe receives sufficient attention. Previously I posited an example where an early retiree had almost all his wealth in Roth accounts (what I refer to as the Rothification Trap).
Risks of having all of one’s eggs inside the Roth basket going into retirement include:
Missing out on standard deductions
Inability to qualify for ACA premium tax credits
Missing out on benefits of qualified charitable distributions (QCDs)
Missing out on tax efficient Roth conversions in retirement
Sufficiency
Much of the traditional versus Roth debate misses the forest for the trees. Rarely do commentators state that long before one worries about taxation in retirement they have to worry about sufficiency in retirement!
Recent reports indicate that many if not most Americans struggle to afford a comfortable retirement. A quick review of average retirement account balances indicates that many Americans are not set up for what I’d call a comfortable retirement. Further, according to a recent report, the median American adult has a wealth around $108,000. That means the median adult has a significant sufficiency concern when it comes to retirement planning.
Most Americans will be lucky to have a tax problem in retirement! Most Americans need to build up retirement savings. The quickest, easiest way to do that is by making deductible traditional 401(k) contributions. That deduction makes the upfront sacrifice involved in retirement saving easier to stomach. Further, if one is not likely to have substantial retirement savings, they are not likely to be in a high marginal tax bracket in retirement.
If all the above is true, what is the problem with having taxable retirement accounts? The tax savings in retirement from having Roth accounts is not likely to be very high for many Americans.
Conclusion
Both traditional retirement accounts and Roth retirement accounts have significant benefits. When viewed over the spectrum of most Americans’ lifetimes, I believe that workplace retirement plan contributions should be biased toward traditional retirement accounts. For many Americans, either or both of the following will be true. First, there will be low tax years in retirement during which retirees can take advantage of low tax Roth conversions. Second, many Americans will be in a low tax bracket when taking retirement account withdrawals for living expenses and/or RMDs.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, investment, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, investment, and tax matters. Please also refer to the Disclaimer & Warning section found here.
Yesterday I posted Time to Stop 401(k) Contributions?, arguing that as applied to many in the FI community, traditional deductible 401(k) contributions are fine.
Second, UBS and Credit Suisse issued their Global Wealth Report for 2023. Allow me to call your attention to page 16. The median American adult has personal wealth just a bit under $108,000. This means almost half of American adults have less than $100K of wealth, and the majority of American adults do not have $200K of wealth. For most Americans, deferred taxation is not the problem! Sufficiency is the problem!
For me this report cracks the case. If the median American adult does not have close to sufficient wealth to comfortably retire, why are they worried about taxes in retirement?
Assuming this report is anywhere near close to a correct measure of adult American wealth, I believe I am correct and personal finance legends Ed Slott and Clark Howard are wrong when it comes to the traditional 401(k) versus Roth 401(k) debate.
The best way for working Americans to address sufficiency problems is by contributing to traditional, deductible retirement accounts. As demonstrated below, one employing this sort of deduct, deduct, deduct strategy would need to be successful well beyond what most Americans accomplish in order to create a tax problem.
When one has insufficient resources for retirement, the traditional, deductible 401(k) makes the most sense. He or she needs to build up assets, not worry about future taxes! With relatively little in the way of resources, future taxes are not likely to be a problem (especially in retirement when compared to one’s working years). Further, by contributing to a traditional, deductible 401(k) instead of a Roth 401(k), one behind in retirement saving takes home more money to invest in additional saving mechanisms such as Roth IRAs and taxable brokerage accounts.
Let’s Break Down Some Retirement Numbers
I believe we need some numbers to figure out who’s right.
Example 1: I start with Single Sally, who is 75 years old. Since she is somewhat like the median American, but older, let’s assume she has $250,000 of wealth and receives $30,000 a year in Social Security. Assume further that all $250K is in a traditional IRA and Sally, age 75, wants to live for today: she isn’t constrained by the 4% rule but rather decides to withdraw 10 percent per year ($25,000). On that $55,000 annual gross income, Single Sally pays just over $2,000 in federal income taxes (an effective rate less than 4%).
Why would Sally pass on a 10%, 12%, or 22% deduction from a traditional 401(k) contribution during her working years? Why would Single Sally put the money in a Roth 401(k) so as to avoid a less than 4% federal income tax in retirement? And how different is Sally’s situation from that of many Americans?
Update 8/17/2023: Single Sally is in the Tax Torpedo, an interesting tax phenomenon with a modest impact on her total tax liability. I added a spreadsheet to look at this in more detail.
Example 2: But Sean, I’m reading your blog. I’m not shooting for just $250K in retirement wealth! Okay, let’s start testing it by considering wealth significantly above the mean and median adult Americans. Single Sarah is 75 years old. She receives $30,000 a year in Social Security. But now she also has a $1M traditional IRA and takes an RMD ($40,650) based on her age. Single Sarah also has some taxable accounts and thus has $4,000 of qualified dividend income and $1,000 of interest income. On that approximate $76,000 annual gross income, Single Sarah pays just over $7,200 in federal income taxes (an effective rate of a bit more than 9.5%).
In order to grow a $1M traditional IRA (likely rolled over from workplace 401(k)s), she almost certainly was in the 22% or greater federal marginal tax bracket while working. Why would Single Sarah switch from taking a 22% tax deduction (the traditional 401(k) contribution) to a Roth 401(k) contribution to avoid a 9.5% effective federal tax rate in retirement?
Example 3: Example 3 is Single Sarah at age 80. Her investments are doing so well her traditional IRA is still worth $1M, causing her to be required to take a $49,505 RMD. This causes her federal income tax to increase to $9,175, for an effective federal income tax rate of almost 11%.
How many Americans will get to age 80 with $1M or more in tax deferred accounts? Even if they do, how bad is the tax problem? If Single Sarah’s effective tax rate is 11%, a 50% tax hike gets her to about 16.5%. Will she enjoy paying that tax? No. Is it crippling? Hardly!
Still worried about contributing to a traditional 401(k)? I’ve got a video for you!
Conclusion
The next time you hear “30 or 40% of your 401(k) belongs to the government” you should consider my examples. For many Americans, “10%” will be much closer to the mark than 30% or 40%.
It’s time to step back and ask whether prioritizing Roth 401(k) contributions during one’s working career is the best advice for the majority of Americans. As demonstrated above, a tax increase of 50 percent (highly unlikely) would result in most Americans having an effective tax rate below 20% in retirement.
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
