Tag Archives: Roth IRA

2025 IRA Contributions for Beginners

There are only three types of annual contributions to individual retirement accounts (“IRAs”). They are:

  • Traditional, nondeductible contributions
  • Traditional, deductible contributions
  • Roth contributions

This post discusses when a taxpayer can make one or more of these types of annual contributions.

Let’s dispense with what we are not talking about. This post has nothing to do with annual contributions to employer retirement plans (401(k)s and the like) and self-employed retirement plans. We’re only talking about IRAs. The Individual in “IRA” is the key – anyone can set up their own IRA. IRAs are not pegged to any particular job or self-employment.

The above list is the exhaustive list of the possible types of annual contributions you can make to an IRA. But there is plenty of confusion about when you are eligible to make each of the three types of annual contributions.

Maximum IRA Contributions

The maximum amount anyone can contribute to an IRA (traditional and/or Roth) for 2025 is $7,000. For those age 50 or older by the end of 2025, the limit is $8,000.

Two notes on this. First the limit is shared between traditional IRAs and Roth IRAs. In theory, someone under age 50 could contribute $4,000 to a traditional IRA and $3,000 to a Roth IRA. In practice, contributions are rarely divided between the traditional and the Roth, but it does occasionally happen.

Second, the limits have an additional limit: the contribution cannot exceed earned income. This means that those fully retired cannot contribute to an IRA unless they have a spouse who has earned income. A fully retired person (or a homemaker) can use their spouse’s earned income as their earned income and contribute to what is often referred to as a Spousal IRA. 

Why Contribute to an IRA?

Why you would consider contributing to an IRA? The main reason is to build up tax-deferred wealth (traditional IRAs) and/or tax-free wealth (Roth IRAs) for your future, however you define it: financial independence, retirement, etc. A second potential benefit is the ability to deduct some annual contributions to traditional IRAs. A third benefit is some degree of creditor protection. States offer varying levels of creditor protection to traditional IRAs and Roth IRAs, while the federal government provides significant bankruptcy protection for traditional IRAs and Roth IRAs. 

Traditional Nondeductible IRA Annual Contributions

There’s are only one requirement to contribute to a traditional, nondeductible IRA for a taxable year:

  • You and/or your spouse have earned income during that taxable year.

That’s it! As long as you satisfy that requirement, you can contribute to a traditional nondeductible IRA, no further questions asked.

Example: Teve Torbes is the publisher of a successful magazine. He is paid a salary of $1,000,000 in 2025 and is covered by the magazine’s 401(k) plan. Teve can make up to a $7,000 nondeductible contribution to a traditional IRA, and Teve’s wife can also make up to a $7,000 nondeductible contribution to a traditional IRA.

There is no tax deduction for contributing to a traditional nondeductible IRA. The amount of your nondeductible contribution creates “basis” in the traditional IRA. When you withdraw money from the traditional IRA in retirement, a ratable portion of the withdrawal is treated as a return of basis and thus not taxable (the “Pro-Rata Rule”).

Example: Ted makes a $6,000 nondeductible traditional IRA contribution for each of 10 years ($60,000 total). When he retires, the traditional IRA is worth $100,000, and he takes a $5,000 distribution from the traditional IRA. Ted is over 59 ½ when he makes the withdrawal. Of the $5,000 withdrawal, Ted will include $2,000 in his taxable income, because 60 percent ($3,000 — $60,000 basis divided by $100,000 fair market value times the $5,000 withdrawn) will be treated as a withdrawal of basis and thus tax free.

Traditional nondeductible IRA contributions generally give taxpayers a rather limited tax benefit. However, since 2010 traditional nondeductible IRA contributions have become an important tax planning tool because of the availability of the Backdoor Roth IRA.

Making a nondeductible IRA contribution requires the filing of a Form 8606 with your federal income tax return.

Traditional Deductible IRA Annual Contributions

In order to make a deductible contribution to a traditional IRA, three sets of qualification rules apply.

ONE: No Workplace Retirement Plan

Here are the qualification rules if neither you nor your spouse is covered by an employer retirement plan (401(k)s and the like and self-employment retirement plans):

  • You and/or your spouse have earned income during that taxable year.

That’s it! As long as you satisfy that requirement and you and your spouse are not covered by an employer retirement plan, you can make a deductible contribution to a traditional IRA, no further questions asked.

Coverage by an employer retirement plan means either you or your employer contributed any amount to an employer retirement plan (on your behalf) during the taxable year. Coverage by an employer retirement plan includes coverage under a self-employment retirement plan.

Example: Teve Torbes is the publisher of a successful magazine. He and his wife are 45 years old. He is paid a salary of $1,000,000 in 2025. Neither he nor his wife is covered by an employer retirement plan. Teve can make up to a $7,000 deductible contribution to a traditional IRA, and Teve’s wife can also make up to a $7,000 deductible contribution to a traditional IRA.

TWO: You Are Covered by a Workplace Retirement Plan

Here are the deductible traditional IRA qualification rules if you are covered by an employer retirement plan:

  • You and/or your spouse have earned income during that taxable year.
  • Your modified adjusted gross income (“MAGI”) for 2025 is less than $89,000 (if single), $146,000 (if married filing joint, “MFJ”), or $10,000 (if married filing separate, “MFS”). 

Note that in between $79,000 and $89,000 (single), $126,000 and $146,000 (MFJ) and $0 and $10,000 (MFS), your ability to make a deductible contribution to a traditional IRA phases out ratably. Here is an illustrative example.

Example: Mike is 30 years old, single, and is covered by a 401(k) plan at work. Mike has a MAGI of $84,000 in 2025, most of which is W-2 income. Based on a MAGI in the middle of the phaseout range, Mike is limited to a maximum $3,500 deductible contribution to a traditional IRA.

Assuming he makes a $3,500 deductible IRA contribution, Mike has $3,500 worth of IRA contributions left. He can either, or a combination of both (up to $3,500) (a) make a contribution to a nondeductible traditional IRA, since he meets the qualification requirement to contribute to a nondeductible traditional IRA or (b) make a contribution to a Roth IRA, since he meets the qualification requirements (discussed below) to contribute to a Roth IRA.

THREE: Only Your Spouse is Covered by a Workplace Retirement Plan

Here are the deductible traditional IRA qualification rules if you are not covered by an employer retirement plan but your spouse is covered by an employer retirement plan:

  • You and/or your spouse have earned income during that taxable year.
  • Your MAGI for 2025 is less than $246,000 (MFJ) or $10,000 (MFS). 

Note that in between $236,000 and $246,000 (MFJ) and $0 and $10,000 (MFS), your ability to make a deductible contribution to a traditional IRA phases out ratably. 

Roth IRA Annual Contributions

Here are the Roth IRA annual contribution qualification rules.

  • You and/or your spouse have earned income during that taxable year.
  • Your MAGI for 2025 is less than $165,000 (single), $246,000 (MFJ), or $10,000 (MFS). 

Note that in between $150,000 and $165,000 (single), $236,000 and $246,000 (MFJ), and $0 and $10,000 (MFS), your ability to make a Roth IRA contribution phases out ratably. 

Notice that whether you and/or your spouse are covered by an employer retirement plan (including a self-employment retirement plan) is irrelevant. You and your spouse can be covered by an employer retirement plan and you can still contribute to a Roth IRA (so long as you meet the other qualification requirements).

Here is an example illustrating your options in the Roth IRA MAGI phaseout range.

Example: Mike is 30 years old, single, and covered by a workplace retirement plan. Mike has a MAGI of $159,000 for 2025, most of which is W-2 income. Based on a MAGI 60 percent through the phaseout range, Mike is limited to a maximum $2,800 contribution to a Roth IRA.

Assuming he makes a $2,800 annual Roth IRA contribution, Mike has $4,200 worth of IRA contributions left. He can make up to $4,200 in annual contributions to a nondeductible traditional IRA, since he meets the qualification requirement to contribute to a nondeductible traditional IRA.

Deadlines

The deadline to make an IRA contribution for a particular year is April 15th of the year following the taxable year (thus, the deadline to make a 2025 IRA contribution is April 15, 2026). The deadline to make earned income for a taxable year is December 31st of that year.

Rollover Contributions

There’s a separate category of contributions to IRAs: rollover contributions. These can be from other accounts of the same type (traditional IRA to traditional IRA, Roth IRA to Roth IRA) or from a workplace retirement plan (for example, traditional 401(k) to traditional IRA, Roth 401(k) to Roth IRA). 

Rollover contributions do not require having earned income and have no income limits and should be generally tax-free. For a myriad of reasons, it is usually best to effectuate rollovers as direct trustee-to-trustee transfers. 

As a practical matter, it is often the case that IRAs serve at the retirement home for workplace retirement plans such as 401(k)s. 

Further Reading

Deductible traditional IRA or Roth IRA? If you qualify for both, it can be difficult to determine which is better. I’ve written here about some of the factors to consider in determining whether a deductible traditional contribution or a Roth contribution is better for you.

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

Follow me on X at @SeanMoneyandTax

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

The Constitution or Delayed RMDs?

The Constitution or delayed RMDs?

Incredibly, Donald Trump has signed up to make that choice, starting January 20th.

How can that be? It relates to SECURE 2.0. SECURE 2.0 made dozens of additions to the already complicated retirement account rules. Many like its delaying retirement account required minimum distributions (“RMDs”) for many Americans from age 72 to age 73 (and eventually to age 75). 

But there is a big time issue few have commented on. 

It has to do with the Omnibus Bill’s purported passage in December 2022. If the Omnibus, which contained SECURE 2.0, was not passed in a Constitutionally qualified manner, any Administration enforcing it would be acting counter to the Constitution and contrary to the rule of law. 

The Constitutional Problem with SECURE 2.0

A federal judge, in a very well written and reasoned opinion, determined that the 2022 Omnibus Bill, was passed by the House of Representatives at a time the House did not have a required quorum to enact legislation. In Texas v. Garland (accessible here and here), Judge James W. Hendrix ruled for the State of Texas that the House of Representatives impermissibly used proxies to establish a quorum. The House did not have a majority of members physically present, and thus did not have a sufficient quorum to enact legislation at the time of Omnibus’s purported passage. 

The quorum rule isn’t contained in the back of a House of Representatives parliamentary procedure manual. Rather, it is contained in the Quorum Clause of the United States Constitution, making it the highest level of legal authority. 

This ruling has broad implications for SECURE 2.0. If the Omnibus was not enacted in a Constitutionally qualified manner, SECURE 2.0 is not the law of the land. Any Administration enforcing it would be enforcing a law that is simply not the law of the land.

I encourage the reader to read the Texas v. Garland opinion. I find it convincing, but you get to be the judge and jury in your own mind. 

Assuming the new Administration agrees with Judge Hendrix’s reasoning, they should announce they will not enforce SECURE 2.0 in order to avoid acting contrary to the law.

Proposed Action

I recommend that shortly after President Trump’s inauguration the IRS and Treasury issue a Notice announcing the following:

  • In order to uphold the Constitution and the rule of law, the IRS and Treasury will not enforce SECURE 2.0.
  • Considering the equities involved, the uniqueness of taxpayers having acted under an announced law that was not, in fact, the law, and the limited enforcement resources available, the IRS will not challenge any acts made, plan/account qualification, and tax return positions taken based on SECURE 2.0 prior to the issuance of the Notice. Plans and financial institutions will be allowed a reasonable amount of time to adequately account for the Notice.
  • In order to eliminate harm from detrimental reliance on SECURE 2.0, appropriate equitable remedies will be applied to prior acts taken under SECURE 2.0 with relevance going forward. For example, any Roth SEP IRAs and Roth SIMPLE IRAs properly created and funded under SECURE 2.0 will be deemed to be Roth IRAs with respect to which valid contributions were previously made.
  • The IRS and Treasury will exercise their authority under Sections 402(c)(3)(B) and 408(d)(3)(I) and waive the 60-day requirement with respect to rollovers for any SECURE 2.0 qualified distributions followed by three year repayments so long as the distribution occurred prior to the issuance of the Notice and repayment is made back to the retirement account no later than December 31, 2025. 
  • The IRS will not require RMDs and not enforce the failure to withdraw penalty for those who turned age 73 in 2023 and for those who turned age 73 in 2024.
  • The IRS will require RMDs and enforce the failure to withdraw penalty for those who turn age 73 starting in 2025. 
  • Relevant 2025 limits will be applied not factoring in provisions from SECURE 2.0. Thus, guidance such as Notice 2024-80 is modified accordingly. For example, the 2025 qualified charitable distribution limit is $100,000 and for those age 60-63 the catch-up contribution limit is $7,500.

I recommend the new Administration issue that notice shortly after Inauguration Day to uphold the Constitution regardless of whether the new Congress chooses to take additional action with respect to SECURE 2.0.

The question then becomes what to do in Congress, if anything, with respect to SECURE 2.0. Since it is likely Congress will enact significant tax legislation, there will be one or more opportunities to address the issue.

I propose that as part of the 2025 tax changes Congress passes, Congress include a provision repealing SECURE 2.0 for the avoidance of doubt. That will end any possible litigation around SECURE 2.0, since the IRS will have waived any challenges resulting from acts occurring prior to the Trump Administration, and Congress will have repealed it (in case it is the law, counter to my opinion) going forward. 

SECURE 2.0 had more to do with 401(k) plan administrators and lawyers securing full employment than securing retirement for working Americans. SECURE 2.0 being pushed to the side would be no tragedy. Perhaps Congress should salvage a few good provisions, but most of it should be left on the scrap heap while Congress focuses on more important tax reforms and extending Tax Cuts and Jobs Act individual tax cuts.

I am more ambivalent about the delays in RMDs. Congress could simply enact SECURE 2.0’s RMD delays as part of its 2025 tax reforms. That said, I believe that tax cuts such as eliminating the taxes on tips and overtime are much better tax policy and should be prioritized. 

Further, the tax benefit of eliminating the tax on Social Security potentially dwarfs the tax benefit of a one or three year delay in RMDs. There’s a very valid argument that eliminating taxes on Social Security and having RMDs start at age 72 is appropriate and will leave many seniors in a vastly improved tax position when compared to where they stood prior to 2025. 

Conclusion

I would pick the Constitution over delayed RMDs any day of the week. The Constitution is far more important than any retirement account tax rule. While it is not good to say dozens of rules that Americans have planned around are invalid, it is far worse to disregard the Constitution. 

My hope is that the new Administration’s tax policy staff, including the new Assistant Secretary for Tax Policy, work to uphold the Constitution.

The new Administration, consistent with Judge Hendrix’s ruling, should acknowledge the Constitutional problem with SECURE 2.0 and addresses it head on. Doing so will demonstrate President Trump’s commitment to honor the Constitution and the rule of law. 

Follow me on X at @SeanMoneyandTax

This post is for 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 has been 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.

2024 Year-End Tax Planning

It’s that time of year again. The air is cool and the Election is in the rear-view mirror. That can only mean one thing when it comes to personal finance: time to start thinking about year-end tax planning.

I’ll provide some commentary about year-end tax planning to consider, with headings corresponding to the timeframe required to execute. 

As always, none of this is advice for your particular situation but rather it is educational information. 

Urgent

By urgent, I mean those items that (i) need to happen before year-end and (ii) may not happen if taxpayers delay and try to accomplish them late in the year. 

Donor Advised Fund Contributions

The donor advised fund is a great way to contribute to charity and accelerate a tax deduction. My favorite way to use the donor advised fund is to contribute appreciated stock directly to the donor advised fund. This gets the donor three tax benefits: 1) a potential upfront itemized tax deduction, 2) removing the unrealized capital gain from future income tax, and 3) removing the income produced by the assets inside the donor advised fund from the donor’s tax return. 

In order to get the first benefit in 2024, the appreciated stock must be received by the donor advised fund prior to January 1, 2025. This deadline is no different than the normal charitable contribution deadline.

However, due to much year end interest in donor advised fund contributions and processing time, different financial institutions will have different deadlines on when transfers must be initiated in order to count for 2024. Donor advised fund planning should be attended to sooner rather than later. 

Taxable Roth Conversions

For a Roth conversion to count as being for 2024, it must be done before January 1, 2025. That means New Year’s Eve is the deadline. However, taxable Roth conversions should be done well before New Year’s Eve because 

  1. It requires analysis to determine if a taxable Roth conversion is advantageous, 
  2. If advantageous, the proper amount to convert must be estimated, and 
  3. The financial institution needs time to execute the Roth conversion so it counts as having occurred in 2024. 

Remember, generally speaking it is not good to have federal and/or state income taxes withheld when doing Roth conversions!

Gotta Happen Before 2026!!!

Before the Election, many commentators said “you’ve gotta get your Roth conversions done before tax rates go up in 2026!” If this were X (the artist formerly known as Twitter), the assertion would likely be accompanied by a hair-on-fire GIF. 😉

I have disagreed with the assertion. As I have stated before, there’s nothing more permanent than a temporary tax cut! Now with a second Trump presidency and a Republican Congress, it is likely that the higher standard deduction and rate cuts of the Tax Cuts and Jobs Act will be extended. 

Regardless of the particulars of 2025 tax changes, I recommend that you make your own personal taxable Roth conversion decisions based on your own personal situation and analysis of the landscape and not a fear of future tax hikes.

Adjust Withholding

This varies, but it is a good idea to look at how much tax you owed last year. If you are on pace to get 100% (110% if 2023 AGI is $150K or greater) or slightly more of that amount paid into Uncle Sam by the end of the year (take a look at your most recent pay stub), there’s likely no need for action. But what if you are likely to have much more or much less than 100%/110%? It may be that you want to reduce or increase your workplace withholdings for the rest of 2024. If you do, don’t forget to reassess your workplace withholdings for 2024 early in the year.

One great way to make up for underwithholding is through an IRA withdrawal mostly directed to the IRS and/or a state taxing agency. Just note that for those under age 59 ½, this tactic may require special planning.  

Backdoor Roth IRA Diligence

The deadline for the Backdoor Roth IRA for 2024 is not December 31st, as I will discuss below. But if you have already completed a Backdoor Roth IRA for 2023, the deadline to get to a zero balance in all traditional IRAs, SEP IRAs, and SIMPLE IRAs is December 31, 2024. 

Solo 401(k) Planning

There’s plenty of planning that needs to be done for solopreneurs in terms of retirement account contributions. 

The Solo 401(k) can get complicated. That’s why I wrote a book about them and post an annual update on Solo 401(k)s here on the blog. 

Year-End Deadline

These items can wait till close to year-end, though you don’t want to find yourself doing them on New Year’s Eve.

Tax Gain Harvesting

For those finding themselves in the 12% or lower federal marginal income tax bracket and with an asset in a taxable account with a built-in gain, tax gain harvesting prior to December 31, 2024 may be a good tax tactic to increase basis without incurring additional federal income tax. Remember, though, the gain itself increases one’s taxable income, making it harder to stay within the 12% or lower marginal income tax bracket. 

I’m also quite fond of tax gain harvesting that reallocates one’s portfolio in a tax efficient manner. 

Tax Loss Harvesting

The deadline for tax loss harvesting for 2024 is December 31, 2024. Just remember to navigate the wash sale rule. 

RMDs from Your Own Retirement Account

The deadline to take any required minimum distributions from one’s own retirement account is December 31, 2024. Remember, the rules can get a bit confusing. Generally, IRAs can be aggregated for RMD purposes, but 401(k)s cannot. 

RMDs from Inherited Accounts

The deadline to take any RMDs from inherited retirement accounts is December 31st. For some beneficiaries of retirement accounts inherited during 2020, 2021, 2022, and 2023, the IRS has waived 2024 RMDs. That said, all beneficiaries of inherited retirement accounts may want to consider affirmatively taking distributions (in addition to RMDs, if any) before the end of 2024 to put the income into a lower tax year, if 2024 happens to be a lower taxable income year vis-a-vis future tax years. 

Can Wait Till Next Year

Traditional IRA and Roth IRA Contribution Deadline

The deadline for funding either or both a traditional IRA and a Roth IRA for 2024 is April 15, 2025. 

Backdoor Roth IRA Deadline

There’s no law saying “the deadline for the Backdoor Roth IRA is DATE X.” However, the deadline to make a nondeductible traditional IRA contribution for the 2024 tax year is April 15, 2025. Those doing the Backdoor Roth IRA for 2024 and doing the Roth conversion step in 2025 may want to consider the unique tax filing when that happens (what I refer to as a “Split-Year Backdoor Roth IRA”). 

HSA Funding Deadline

The deadline to fund an HSA for 2024 is April 15, 2025. Those who have not maximized their HSA through payroll deductions during the year may want to look into establishing payroll withholding for their HSA so as to take advantage of the payroll tax break available when HSAs are funded through payroll. 

The deadline for those age 55 and older to fund a Baby HSA for 2024 is April 15, 2025. 

2025 Tax Planning at the End of 2024

HDHP and HSA Open Enrollment

It’s open enrollment season. Now is a great time to assess whether a high deductible health plan (a HDHP) is a good medical insurance plan for you. One of the benefits of the HDHP is the health savings account (an HSA).

For those who already have a HDHP, now is a good time to review payroll withholding into the HSA. Many HSA owners will want to max this out through payroll deductions so as to qualify to reduce both income taxes and payroll taxes.

Self-Employment Tax Planning

Year-end is a great time for solopreneurs, particularly newer solopreneurs, to assess their business structure and retirement plans. Perhaps 2024 is the year to open a Solo 401(k). Often this type of analysis benefits from professional consultations.

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

Follow me on Twitter at @SeanMoneyandTax

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

Thoughts on Trump and Taxes

It happened. The frontrunner for the Presidency said “Sure, . . . why not?” when asked if he would eliminate the income tax on the Joe Rogan podcast. Whoa!!!

Okay, let’s calm down. Let’s not plan on never filing a tax return again just yet.

Tax planning is all about probabilities. Over the 2024 presidential campaign, probabilities have shifted. Below I’ll discuss the changing landscape, what it means for how Americans should approach their own planning (at year-end in 2024 and beyond), and a few thoughts on the future of American taxation.

Trump Tax Promises and Trend

Trump has been quite explicit with three individual income tax cut promises during the campaign:

  • No tax on tips
  • No tax on Social Security
  • No tax on overtime

Trump and his campaign have frequently mentioned these. It’s more than fair for the electorate to hold Trump to these promises.

Separately, Trump has been speaking quite fondly of tariffs. He did so during an interview with Dave Ramsey, which caught my attention.

I saw then what has become even clearer thanks to Donald Trump’s answer Joe Rogan’s question: the Trump Era would, to at least some degree, shift America away from income taxes and towards tariffs. 

I do not view Trump’s answer to Rogan as a promise. It was one line during a 3 hour interview. It should be taken seriously, not literally. Trump briefly stated it in response to Rogan’s question. Importantly, Trump then went into detail not on eliminating income taxes but rather on his fondness of tariffs.  

The above caveats aside, trend here is obvious. Much like with polling, trends matter much more than the top line. I have previously stated that tariffs might become very popular with politicians after Trump’s retirement. Voters don’t file tariff tax returns! That alone indicates future politicians might be more than happy to adopt pro-tariff positions, which could mean less in the way of income taxes. 

What this Means for Americans

Does a Joe Rogan episode radically change financial planning for most Americans? No. But considering the odds, I think it, combined with Trump’s other promises, gives us two insights to consider.

2024 Year-End Roth Conversions

First, there is little reason to rush year-end 2024 Roth conversions, particularly before Election Day. The conventional wisdom had been “better do those Roth conversions before taxes go up in 2026!” That conventional wisdom is now out the window. 

I generally recommend Roth conversions when they make sense for the individual based on the individual’s circumstances. I don’t recommend Roth conversions based on “conventional wisdom” about tax changes in 2026.

Question Paying Tax to Get Into Roth

I have been fond of traditional retirement account contributions. I didn’t think I would get evidence supporting that view from a Joe Rogan episode, but that’s where we are.

If future income taxes are trending down, why not take the deduction while it is valuable? That’s where we are going into the 2024 Election.

Does this mean we should never go Roth? No! But now we must start to question paying tax to get into Roth. 

Please don’t read this to say “oh wow, FI Tax Guy is against Roth.” Far from it! But I must question paying federal income tax in 2024 to get into Roth.

There are times we pay tax to get into a Roth. Contributing to a Roth 401(k) instead of to a traditional 401(k) is paying tax to get into Roth, because we have foregone the tax deduction that we could have received for a traditional 401(k) contribution. Taxable Roth conversions are another time we pay tax to get into a Roth.

There are times we don’t pay tax to get into a Roth. For most people, an annual Roth IRA contribution involves no additional tax, since most Americans do not qualify to deduct contributions to traditional IRAs. Backdoor Roth IRA contributions are the same – there’s no forgone tax deduction. “Taxable” Roth conversions against the standard deduction are another example where there’s no additional federal income tax incurred to get money into a Roth. 

To my mind, these “tax free” ways are the best way to get money into Roth accounts, and in this environment should be favored. 

My Proposal

Many questions and challenges remain regardless of the outcome of the Election. It remains to be seen how much revenue can be raised by tariffs. The 47th President must prioritize significant cuts to federal spending, particularly foreign military spending. Oh, and the federal government has over $35 trillion of accumulated debt.

We are a long way away from axing the individual income tax. But, perhaps a relatively modest measure could get many Americans there. I propose doubling the standard deduction. The IRS just announced the 2025 standard deduction will be $15,000 for singles and $30,000 for married filing joint couples. Why not double it to $30K for singles and $60K for marrieds?

My proposal achieves some great outcomes. Combined with no taxes on Social Security, a doubled standard deduction would eliminate income taxes for most retired Americans. Trump could say he eliminated millions of tax returns with this one change.

Doubling the standard deduction would be a significant tax cut for millions of working Americans. Further, it would greatly reduce the number of Americans claiming itemized deductions, making the tax code easier to administer for the Internal Revenue Service.

Lastly, a government with $35 trillion plus of debt probably shouldn’t stop taxing the Elon Musks of the world. My proposal keeps taxing him and is no tax cut for him at all (assuming he makes more than $30,000 annually in charitable contributions). 

Assuming Congress passes significantly increased tariffs in 2025, I recommend a five year doubling of the standard deduction. That would give the government five years to test out the new system to see if increased tariffs and decreased income taxes, hopefully in concert with significant spending cuts, is successful. 

Conclusion

I will cry no tears if the income tax goes away. However, I don’t think we can plan for its demise.

While the income tax is likely here to stay, the trend is becoming obvious. Tariffs are likely on the way up and income taxes are likely on the way down. That informs retirement and tax planning. There’s little reason to rush Roth conversions, and traditional retirement account contributions are more attractive.

Of course, stay tuned. The Election is not over. There are no guarantees as I write this on October 26, 2024. I promise I’ll have plenty of commentary about year-end planning and more after the Election.

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

Follow me on Twitter at @SeanMoneyandTax

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

Inherited Retirement Account Rules Need Radical Reform

My hope is that 2025 ushers in an era of simplification when it comes to all federal laws. Justice Neil Gorsuch co-wrote a book arguing we have far too many laws, and I agree with him. The more numerous the laws, the more corrupt the state.

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:

  • Spousal Rollover
  • Required Minimum Distributions (“RMDs”)
  • 10 Year Rule
  • 10 Year Rule with RMDs
  • 5 Year Rule

Woah! That there are so many possible outcomes, which require significant analysis to determine, is absolutely ridiculous and an unnecessary burden on American taxpayers.

Proposed Inherited Retirement Account Reform

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.

  1. 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.
  1. 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. 
  1. 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. 
  1. 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. 
  1. 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.
  1. 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.
  1. 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).
  1. 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. 

Follow me on X at @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, investment, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, 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.

The Church IRA

“Repay to Caesar what belongs to Caesar and to God what belongs to God.” – Matthew 22:21

What happens with our IRAs and other retirement accounts when we die? Early in our financial journeys, it is incredibly important to plan for our retirement accounts to take care of our loved ones, particularly spouses and younger children. Those concerns should be the primary drivers of the planning for our retirement accounts early on.

But what about later in our lives, when our financial futures are secured and our children are adults? 

I believe it is time to be intentional about the destination of our tax deferred retirement accounts. It’s great to provide for adult children. But how much? And couldn’t retirement accounts help better the world? As discussed below, the Church IRA is a way to give wealth to adult children and to the Church. 

The Origins of an Idea

In August 2023 the combination of a West Coast hurricane and the Podcast Movement conference resulted in my flying to Denver, Colorado on a Saturday to ensure I could attend the conference. As a result, I attended Sunday Mass far from home at St. Gianna Beretta Molla Church in Denver. At that Mass, the homilist, Deacon Steve Stemper, had an idea that spoke to me: treat the Church as one of your children in your estate plans.

The Church IRA

As frequent readers of the blog know, I’m quite interested in tax-advantaged retirement accounts. The idea to treat the Church as one of your children in your estate strikes me as particularly well suited for traditional IRAs.

Let’s illustrate with an example:

Chuck and Joy are married and both are 85 years old. They have a $3M traditional IRA in Chuck’s name, and they have three adult sons: Abe, Barry, and Charlie, in their late 50s and early 60s. 

Obviously, if Chuck dies, Joy needs support. Why not name Joy as the primary beneficiary of the traditional IRA? That leaves a remaining question: who should be the secondary beneficiaries? 

Each of Abe, Barry, and Charlie could be a one-third secondary beneficiary. At the second death, they would get about $1M each. What if instead Chuck names each of Abe, Barry, and Charlie one-quarter secondary beneficiaries (about $750K each) and names his Catholic parish or diocese as a one-quarter secondary beneficiary (also about $750K)?

This is the beginning of what I refer to as the Church IRA.

How much different will Abe, Barry, and Charlie’s lived experience be by inheriting a $750K traditional IRA instead of a $1M traditional IRA?

Further, the “hit” to Abe, Barry, and Charlie is likely to be less than a 25% reduction. Why? Because of taxes!

Each of Abe, Barry, and Charlie will have 10 years to drain the inherited IRA. Odds are they will want to take more than 10% per year from the IRA to manage a potential “Year 10 Tax Time Bomb.” Say Abe is single and otherwise has annual income of $150,000.

If Abe takes 12.5% of the account in the first full year after death, he takes $125,000 if he inherits a $1M traditional IRA. Assuming he takes the standard deduction, Abe will be in the 35% marginal tax bracket. 

If, instead, Abe inherits a $750K traditional IRA, he only takes $93,750 in the first year. With the other $150K of AGI, Abe will find himself in the 32% marginal tax bracket. 

The $31,250 that the Church IRA costs Abe during the year would have been taxed at 32% and 35% federal income tax rates. This illustrates that reducing Abe’s inherited IRA by 25% is not likely to cost him 25% of the after-tax wealth since it is likely he would pay a significantly higher tax rate on those last dollars. 

You could say Chuck and Joy “took” money from Abe, Barry, and Charlie by employing the Church IRA. The money they took from Abe, Barry, and Chuck and gave to the Church is the highest taxed money, making the Church IRA tax efficient. 

The Church IRA and the Owner’s Needs

One of the advantages of the Church IRA is it need not risk the owners’ own retirement sufficiency. Joy has a legitimate interest in her own financial future. The initial Church IRA structure has the advantage of reducing Chuck and Joy’s ability to fund the remainder of their own lives in no way. The Church gets money only after they have both passed. 

Church IRA Implementation

To my mind, the biggest question here is whether to create the Church IRA during our lives or at death. In Chuck and Joy’s case, assuming they want to, at a minimum, employ the Church IRA at death, there are three options:

PATH ONE: Keep everything in a single IRA during their lifetimes. Have the four equal secondary beneficiaries.

PATH TWO: Split the single IRA into four IRAs, each with its own 100% secondary beneficiary (Abe, Barry, Charlie, and the Church IRA)

PATH THREE: Split the single IRA into two IRAs (one worth $2.25M with Abe, Barry, and Charlie as the secondary beneficiaries and a second IRA worth $750K with the Catholic Church as the sole secondary beneficiary).

One of the advantages of the second and third paths is the Church IRA can serve additional purposes. One additional Church IRA purpose is that it be used during Chuck and Joy’s lifetimes to make their routine contributions to the Church (whether that be weekly or monthly). Those contributions can be made through qualified charitable distributions (“QCDs”).

QCDs are a great tax planning tactic during one’s own lifetime for the charitably inclined. They get money out of a traditional IRA tax-free and count against required minimum distributions (“RMDs”). 

Regardless of the chosen path, the Church IRA can also be used during Chuck and Joy’s lifetime to help them fund their own living expenses.

We see that the Church IRA can be simply used at death through beneficiary designation forms. Or the Church IRA can also work during one’s own life to either or both (i) provide for routine lifetime Church donations (preferably through QCDs) and (ii) provide for the owner’s own living expenses. 

Splitting IRAs

IRA owners can work with their financial institution to split an existing IRA into two or more IRAs. This can be done for any reason. Perhaps it’s simply for mental accounting to facilitate a Church IRA like the one in Paths Two and Three described above. 

One does not need to split IRAs to facilitate the Church IRA (see Path One above). But there can be simplicity advantages to having each beneficiary have their own separate and distinct IRA they inherit separate from other siblings and/or the Church. 

RMDs from Split IRAs

Here the tax rules are quite flexible. The tax rules treat all of one’s traditional IRAs as a single traditional IRA for RMD purposes. So Chuck and Joy would have tremendous flexibility in terms of which IRA or IRAs to take their overall RMD for the year from. They could take the RMD from the Church IRA or from one or more of the non-Church IRAs, or they can split it among their various IRAs however they want to. 

Changing Beneficiaries at the First Death

In Chuck and Joy’s situation, there is an important additional consideration. What if Chuck dies first? Joy would inherit the traditional IRA. She would then need to work with the financial institution to appropriately roll the inherited IRA into an IRA into her own IRA.

From there, she should name primary beneficiaries in accord with her Church IRA intention. She has the three paths described above as possibilities for structuring her Church IRA. 

Roth Versus Traditional

Absent incredibly rare circumstances, the Church IRA should be a traditional IRA. Roths are tax-free to individual beneficiaries. Traditional IRAs are taxable to individual beneficiaries. If your adult children are getting some and the Church is getting some, why not leave Roths to the adult children and some or all of the traditional IRAs to the Church? 

The adult children pay income tax and the Church does not. Why waste the tax-free attribute of the Roth on a tax-free entity, the Church? The Church does not benefit from Roth treatment while the adult children do. 

Perhaps the beneficiary designation forms split the Roth IRA only among the adult children and split the traditional IRA among the adult children and the Church, and leave a greater percentage of the traditional IRA to the Church. 

Conclusion

The Church IRA can flexibly leave a share of one’s financial wealth to the Church or other 501(c)(3) charity. It can help us repay to God what is God’s while reducing what is owed to Caesar.

To determine whether the Church IRA is appropriate for us, we need to ask ourselves several questions. How much do my adult children need? Should I leave a significant amount to my Church or other charities? Are there tax-efficient ways to provide for both the Church and my adult children?

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.

SECURE 2.0 and Section 72(t) Comment Letter

Recently, the IRS and Treasury issued Notice 2024-55. This notice provided initial rules for SECURE 2.0 emergency personal expense distributions (“EPEDs”), domestic abuse victim distributions, and repayments into retirement accounts. The Notice also asked for comments on the above and on Section 72(t) in general.

I wrote a comment letter (which you can read here) to the IRS and Treasury obliging that request. The letter addresses EPEDs, repayments into retirement accounts, and the impact of Texas v. Garland on SECURE 2.0. Further, the comment letter requests clarification that Solo 401(k)s of retired solopreneurs qualify for the Rule of 55 exception to the Section 72(t) ten percent early withdrawal penalty.

Follow me on X: @SeanMoneyandTax

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 for you or any other individual. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

Roth 401(k)s and the Rule of 55

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

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

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

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

Roth 401(k)

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

Roth 401(k) Contributions

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

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

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

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

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

Roth 401(k) Withdrawals

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

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

Here’s a quick example illustrating that rule: 

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

Rule of 55

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

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

Here is an example:

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

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

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

Planning

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

I have four reasons not to combine them.

Taxing Roth 401(k) Earnings

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

Here is an example:

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

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

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

A Great, Easily Accessible Alternative Exists

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

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

Here’s an example: 

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

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

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

A Good, Not Too Difficult Alternative Exists

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

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

Why Not Use Taxable Accounts, if Possible?

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

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

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

ACA Premium Tax Credit Considerations

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

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

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

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

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

Conclusion

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

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

Follow me on Twitter: @SeanMoneyandTax

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

New to Financial Independence? Start Here!

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

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

ChooseFI Episode 100: Welcome to the FI Community

This podcast episode goes over the basics of financial independence. 

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

This blog post discusses the math behind early retirement.

The Arithmetic of Active Management by William F. Sharpe

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

FI Tax Strategies for Beginners by Sean Mullaney

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


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

Subscribe to my YouTube Channel: @SeanMullaneyVideos

Follow me on X: @SeanMoneyandTax

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

FI Tax Strategies For Beginners

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

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

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

ONE: Contribute Ten Percent to Your Workplace Retirement Plan

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

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

Here are some additional considerations.

Traditional or Roth 

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

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

Bad Investments

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

Resource

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

TWO: Establish a Roth IRA

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

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

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

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

THREE: Contribute to an HSA 

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

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

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

Here are a few additional considerations:

HDHP Benefit

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

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

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

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

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

State Income Taxes

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

Employer Contributions

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

Reimbursements

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

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

FOUR: Save, Save, Save!!!

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

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

Conclusion

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

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

Second, establish a Roth IRA

Third, establish an HSA

Fourth, Save, Save, Save

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

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

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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.