Tag Archives: Roth IRA

Accessing Retirement Accounts Prior to Age 59 ½

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 of in 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.

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 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. 

Creates income for purposes of the FAFSA. 

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. 

They are somewhat inflexible. That said, if properly done they can be either increased (by creating a second 72(t) payment plan) or decreased (via a one-time switch in method). 

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. 

Does not create income for purposes of the FAFSA.

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

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.

San Diego Tax Delay

It’s deja vu all over again – Yogi Berra

Last year, most of California received several deadline delays when it came to 2022 tax returns, tax payments, and IRA and HSA contributions.

Sure enough, San Diego County now has a deadline delay for their 2023 tax returns, tax payments, and IRA and HSA contributions. Hat tip to Jennifer Mah’s Instagram for alerting me to this development. 

San Diego County Tax Deadline Delay

The IRS announced that because of early 2024 flooding in San Diego, San Diegons have an extended deadline, June 17, 2024, to perform most 2023 tax acts that otherwise would have been due early in 2024. The Franchise Tax Board has followed suit and also issued their own delay announcement. 

2023 Traditional and Roth IRA Contributions

The deadline for San Diegons to make 2023 contributions to traditional and/or Roth IRAs has been extended to June 17, 2024. As a practical matter, I wouldn’t encourage reliance on this particular deadline delay. Financial institutions may find it difficult to allow “late but timely” 2023 IRA contributions on their platform when it is available only to residents of a single county. 

If you are a San Diegon reading this in May 2024 and want to make an IRA contribution for 2023, I recommend initiating the process by calling the financial institution using a seldom used app on your phone, the phone.  

2023 Backdoor Roth IRAs

San Diegons now have until June 17, 2024 to execute the first step of a 2023 Backdoor Roth IRA, the nondeductible contribution to a traditional IRA for 2023. This would be a Split-Year Backdoor Roth IRA. 

2023 HSA Contributions

San Diegons now have until June 17, 2024 to contribute to a 2023 health savings account. The same comments that apply to traditional IRA and Roth IRA contributions made using the deadline extension apply to 2023 HSA contributions made using the deadline extension. 

2023 Tax Returns and Payments and 2024 Q1 Estimated Tax Payments

San Diegons now have until June 17, 2024 to (i) file their 2023 federal and California income tax returns, (ii) pay the amount due with their 2023 federal and California income tax returns, and (iii) make 2024 first quarter estimated payments. 

Who Benefits?

Residents of San Diego County qualify for the extended deadline. Taxpayers with records in San Diego County can also benefit. 

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

Follow me on Twitter: @SeanMoneyandTax

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

The Spousal IRA

Is earned income required to contribute to an individual retirement account (an “IRA”)? If you’re married, it may not be, thanks to the Spousal IRA. 

The Spousal IRA is a great opportunity for families to build financial stability, and perhaps get a juicy tax deduction, even if only one of the spouses work outside of the home. It can help families save for the future and prioritize other important goals such as raising children.

IRA Basics

There are two types of IRAs that most working Americans can consider. I did a primer about them here.

A traditional IRA offers tax-deferred growth and the possibility of a tax deduction for contributions. While distributions from a traditional IRA in retirement are taxable, many will find that traditional IRA distributions in retirement are only lightly taxed. 

A Roth IRA offers no tax deduction on the way in, but features tax-free growth and tax-free withdrawals in retirement. 

Both can be a great way to build up tax-advantaged wealth for retirement.

IRA Contribution Limits

The limit on IRA contributions for 2023 is the lesser of $6,500 or earned income ($7,500 or earned income if you are age 50 or older in 2023). The limit on IRA contributions for 2024 is the lesser of $7,000 or earned income ($8,000 or earned income if you are age 50 or older in 2024). Remember that traditional IRAs and Roth IRAs share that contribution limit, so a dollar contributed to a traditional IRA is a dollar that cannot be contributed to a Roth IRA and vice-versa. 

IRA Contribution Deadlines

Generally speaking, the deadline to contribute to either a traditional IRA or a Roth IRA is April 15th of the following year. The deadline cannot be extended even if the taxpayer files for an extension to file their own tax return. On rare occasions the IRS may provide a very limited exception to the April 15th IRA contribution deadline. 

The Spousal IRA

For purposes of having earned income allowing one to make an IRA contribution (tradition and/or Roth), a non-working spouse can use their spouse’s earned income for purposes of making either (or both) a traditional IRA or a Roth IRA contribution.

Here is an example:

Joe and Mary are married. Joe has a W-2 job and Mary does not. Mary can make an IRA contribution (a Spousal IRA) based on Joe’s W-2 earned income. 

The Spousal IRA can be used to increase tax-advantaged retirement savings. It can also be used to strategically optimize tax deductions. Many W-2 workers are covered by a workplace 401(k) plan. Thus, based on low income limits, it is difficult for them to deduct a traditional IRA contribution. 

However, when one is not covered by a workplace retirement plan, it is much easier to qualify to deduct a traditional IRA contribution. It is often the case that a Spousal IRA will offer a potential tax deduction when the working spouse is not able to deduct a traditional IRA contribution. 

Split-Year Spousal IRA Contribution Example

As I write this, the 2024 tax return season (for 2023 tax returns) is about to get started. Now’s the time to be thinking about 2023 IRA contributions if you have not yet made one!

There’s still plenty of time to contribute to an IRA (traditional or Roth) for the year 2023. Some of that planning might involve strategically employing a Spousal IRA. Here’s an example:

Mark and Theresa, both age 41, are married and have three children. They live in California. Mark works a W-2 job and Theresa does not have earned income. Mark is covered by a 401(k) at work. Their modified adjusted gross income (“MAGI”) for 2023 is $190,000. This puts them in the 22% marginal federal income tax bracket and the 9.3% marginal California income tax bracket. They have made no IRA contributions for either of them for 2023 going into tax season. 

It is early April 2024 and Mark and Theresa are about to file their tax returns. They see they have $8,500 in cash available to use to make 2023 IRA contributions. What they might want to do is contribute $6,500 to a 2023 deductible traditional IRA for Theresa (a Spousal IRA) and the remaining $2,000 to a 2023 Roth IRA for Mark, since he cannot deduct a traditional IRA contribution. By prioritizing a tax deduction, Mark and Theresa save $2,034.50 on their 2023 income taxes. 

The Spousal IRA as a Backdoor Roth IRA

The Spousal IRA can be executed as a Backdoor Roth IRA. Here is an example:

Jack and Betty, both age 42, are married. Jack works a W-2 job and Betty does not have earned income. Jack is covered by a 401(k) at work. Their MAGI for 2024 is $260,000 and thus neither of them qualify to make a regular annual contribution to a Roth IRA. 

Assuming Betty has no balances in traditional IRAs, SEP IRAs, and SIMPLE IRAs (and thus does not have a Pro-Rata Rule problem), Betty can contribute $7,000 to a nondeductible traditional IRA and then convert that amount (plus any growth) to a Roth IRA. Doing so uses a Spousal IRA to implement a Backdoor Roth IRA. 

Spousal IRA Tax Return Reporting

To report a deductible traditional Spousal IRA contribution, the amount of the contribution must be reported on Schedule 1, line 20, filed with the couple’s annual federal income tax return. 

To report a nondeductible traditional Spousal IRA contribution, the amount of the contribution must be reported on Part I of the Form 8606.

There is no required federal income tax return reporting for a Roth Spousal IRA contribution. However, such contributions should be entered into the tax return software to help determine the potential eligibility for a retirement savers’ credit. 

Conclusion

The Spousal IRA creates a great opportunity for married couples to save for retirement and possibly gain access to valuable tax deductions. It can help married couples focus on important priorities such as child rearing and still make significant contributions to retirement accounts.

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.

SECURE 2.0 Comment Letter

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:

SECURE 2.0 Section 115

SECURE 2.0 Section 314

SECURE 2.0 Section 317

SECURE 2.0 Section 326

SECURE 2.0 Section 331

SECURE 2.0 Section 603

SECURE 1.0 Section 113

Follow me on Twitter: @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. 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 Basis Isolation Backdoor Roth IRA

If you have basis in an IRA, you will want to read this post. Basis in an IRA creates all sorts of confusion, but it also presents a great planning opportunity for many of those still working. I refer to this opportunity as the Basis Isolation Backdoor Roth IRA. 

Where Does IRA Basis Come From?

Basis in a traditional IRA generally emerges from two sources. The first source is old nondeductible traditional IRA contributions that have not been Roth converted or withdrawn. Nondeductible traditional IRA contributions should be reported on a Form 8606 filed with one’s annual federal income tax return. 

Many times this basis is simply exhausted annually by Backdoor Roth IRAs. Here’s a quick example:

Example 1: Becky contributed $6,500 to a traditional, nondeductible IRA on January 2, 2023. On February 1, 2023, when the traditional IRA was worth $6,504, she converted the entire traditional IRA balance to a Roth IRA. On December 31, 2023, she had $0 in all traditional IRAs, SEP IRAs, and SIMPLE IRAs. She successfully completed the Backdoor Roth IRA, which created $6,500 of IRA basis on January 2nd and exhausted all $6,500 of that basis on February 1st.

However, there are plenty of Americans who have existing and remaining IRA basis because they can’t do the Backdoor Roth IRA efficiently, or they never did the Backdoor Roth IRA. 

To sum up, those doing annual tax-efficient Backdoor Roth IRAs tend not to have any IRA basis at year-end. But some Americans do have existing and remaining IRA basis.

The second source of IRA basis is from after-tax 401(k) contributions that have been transferred to a traditional IRA (see Natalie B. Choate’s treatise Life and Death Benefits for Retirement Planning (8th Ed. 2019), page 150). 

There are Americans with existing IRA basis through transfers from a 401(k) (or other qualified plan) to a traditional IRA. However, going forward this should generally not occur. The IRS and Treasury issued Notice 2014-54, which provides that after-tax 401(k) contribution amounts can be rolled directly to a Roth IRA. From a planning perspective, after-tax 401(k) contributions (and other qualified plan after-tax contributions) should generally be directed into Roth IRAs if the plan participant prefers to exit the plan for IRAs (at retirement or a job change, for example). 

Example 2: Chris is age 53. He leaves employment at Consolidated Industries, Inc. on November 1, 2023. At that time, he had a traditional 401(k) at Consolidated worth $500,000. During his time at Consolidated, Chris made $75,000 of after-tax contributions to the traditional 401(k) which remain in the traditional 401(k). Chris prefers to manage the money himself in an IRA or IRAs. Thus, he has two options:

Option One: Transfer the money (preferably through a direct trustee-to-trustee transfer) to a single traditional IRA. Chris now has $75,000 of traditional IRA basis. 

Option Two: Transfer (preferably through direct trustee-to-trustee transfers) the after-tax money $75,000 to a Roth IRA and $425,000 to a traditional IRA. The $75,000 goes into the Roth IRA as a nontaxable conversion contribution (see also Notice 2014-54 Example 4). Chris receives no basis in his traditional IRA.

Which option is better for Chris? Clearly it is Option Two, which gives Chris tax-free growth on his $75,000. Further, Chris can withdraw the $75,000 from the Roth IRA tax and penalty free at any time while Chris would be subject to the hard bite of the Pro-Rata Rule if he used Option 1 and later withdrew $75,000 from the traditional IRA. Thus, while Chris is allowed to roll his $75K 401(k) basis into a traditional IRA, he would be much better served to roll the basis tax-free into a Roth IRA. 

A Current Employer Qualified Plan That Accepts Rollovers

In order to have an IRA basis isolation opportunity, one must be currently employed by an employer with a qualified plan (often a 401(k)) that accepts IRA roll-ins. Many qualified plans accept IRA roll-ins but not all do. 

Former employees generally are not able to contribute to 401(k)s and other qualified plans, so having a 401(k) plan at a former employer is generally not sufficient for this planning opportunity. 

One should generally employ the Basis Isolation Backdoor Roth IRA if they have a 401(k) or other qualified plan at work they are satisfied with from both an investment choice standpoint and a fee standpoint. If one isn’t satisfied with their workplace retirement plan the Basis Isolation Backdoor Roth IRA may not be a good tactic to employ. 

Comprehensive Basis Isolation Backdoor Roth IRA Case Study

Having addressed the two prerequisites to do a Basis Isolation Backdoor Roth IRA, let’s dive in with a comprehensive case study. 

Imagine Ray has two (and only two) traditional IRAs. IRA 1 is a $100K traditional IRA rollover from an old 401(k). No basis came along in the rollover into IRA 1. IRA 2 is a traditional IRA worth $25K. It was established with three $6K nondeductible traditional IRA contributions for 2020 through 2022. He filed Forms 8606 reporting those contributions. 

Ray’s current employer (Acme) has a great 401(k) that accepts roll-ins of traditional IRAs. What could Ray do to take advantage of his traditional IRA basis? He will need to isolate that basis, and that’s where the Basis Isolation Backdoor Roth IRA comes in. 

Step 1

Ray transfers IRA 1 to the Acme 401(k), preferably through a direct trustee-to-trustee transfer. 

Step 2

Ray invests about $18,010 of IRA 2 in a money market account and invests the remainder of IRA 2 in any investment of his choice (Mutual Fund A).* 

By putting that $18,000 and a bit of change in a money market, Ray makes sure he “leaves behind” the IRA basis in the IRA! We will come back to why this “leave behind” asset is so critically important in the Step 3 discussion and analysis. 

* As a practical matter, it may be easier to split IRA 2 into IRA 2 and IRA 3, with the $18,010 in IRA 2 and Mutual Fund A in IRA 3. Either path can work, but splitting into IRA 2 and IRA 3 may be the easier path. 

Step 3

Ray transfers Mutual Fund A to the Acme 401(k), preferably through a direct trustee-to-trustee transfer. 

The money market account is crucial. The Internal Revenue Code provides that IRA basis cannot be transferred to a 401(k) (see also Natalie B. Choate’s treatise Life and Death Benefits for Retirement Planning (8th Ed. 2019), page 158). By establishing that IRA 2 will have at least $18K that will not be moved into the 401(k), Ray ensures that he “leaves behind” at least his basis inside the IRA. 

If the $18,010 was invested in an equity mutual fund (call it Mutual Fund B), there’s a risk that when Ray does Step 3 he will leave behind only Mutual Fund B, which could be less than his $18K basis if Mutual Fund B declines in value.

Example 3: Imagine Ray does Step 3 when Mutual Fund A is worth $10K and Mutual Fund B, originally worth $18K is now only worth $14K based on market declines. In such a case, $4K of basis would (theoretically) move into the Acme 401(k) with the $10K going from IRA 2 to the Acme 401(k). That would be a prohibited transfer of basis. 

IRA Aggregation: Remember that for tax purposes, the IRS looks at all of Ray’s traditional IRAs (whether he has one or ten) as a single traditional IRA. We can’t say that basis attaches to IRA 2 only, so it is important that Ray leave at least $18K behind in an IRA so that after the transfers from his IRAs to qualified plans he can demonstrate that his basis was left behind in one or more of his traditional IRAs. 

Step 4

Step 4: Ray converts the entire remaining balance in IRA 2 (likely to be $18,010 plus a bit of additional interest) to a Roth IRA. The only taxable amount is the small amount over $18,000.

Step 4 is reported on a Form 8606 (Parts 1 and 2). 

Step 5

Ray ensures that as of December 31st of the year Step 4 occurs, Ray has $0 balances in all traditional IRAs, SEP IRAs, and SIMPLE IRAs. 

The Benefits of the Basis Isolation Backdoor Roth IRA

Ray has moved approximately $107K from traditional IRAs to the Acme 401(k). That is entirely tax free and does not change the future tax treatment of that money. Perfectly fine, but by itself this doesn’t improve Ray’s tax position.

Before this planning, Ray had $18K of IRA basis that was of limited value due to the Pro-Rata Rule. Future taxable distributions or conversions from his traditional IRAs would have picked up only a small portion of that $18K, meaning that it would only protect small portions of future distributions and conversions from current taxation. 

Example 4 The Pro-Rata Rule Bites Ray: If Ray had $18K of basis and $125K of total traditional IRAs and decided to do a $10K Roth conversion (without first doing the Basis Isolation Backdoor Roth IRA), approximately $1,440 of that Roth conversion would have been tax free and approximately $8,560 would have been taxable. See the mock Form 8606 Part I here and Form 8606 Part II here (though note that tax return software programs may use a separate statement instead of actually completing the form). 

But with the Basis Isolation Backdoor Roth IRA Ray puts $18K plus into a Roth IRA and paid almost no tax to do so! Ray successfully isolated all $18,000 of basis to get it all into a Roth IRA without being adversely affected by the Pro-Rata Rule. Further, that $18,000 can now grow tax free for the rest of Ray’s life. Previously, inside a traditional IRA that $18,000 was growing tax-deferred, not tax free. 

The Basis Isolation Backdoor Roth IRA improved Ray’s position by getting around the Pro-Rata Rule to get $18K plus into a Roth IRA for hardly any income tax. The only tax Ray pays is on the small amount the conversion amount in Step 4 exceeds $18,000.

The Basis Isolation Backdoor Roth IRA also opens another future tax planning opportunity. Going forward, Ray can do annual Backdoor Roth IRAs in a tax-efficient manner because he cleaned out his traditional IRAs into his workplace 401(k). 

Practical Considerations

The Basis Isolation Backdoor Roth IRA is not a tactic to be affirmatively planned into. Rather, it is a clean up tactic. It makes the best of a situation where one has both basis and pretax amounts in traditional IRAs. The Backdoor Roth IRA is an affirmative planning technique, though it may require similar clean-up steps prior to implementation. 

This planning is sophisticated and benefits from professional assistance. I recommend that most work with a professional if they are considering this sort of planning. Further, this planning does not occur every day. My experience suggests that most professionals are unfamiliar with this type of planning. Professionals will need to review resources such as this blog post and other sources and measure two or three times to dot I’s and cross T’s on this type of planning. 

Of course, this blog post is not advice for the reader or any particular individual. 

Additional IRA Basis and IRA Basis Isolation Resource

I went into detail on this planning in a June 2023 Measure Twice Planners presentation. While the presentation is mostly geared towards advisors, I hope I presented it in such a way that layman can also understand much of it and get value from it. The presentation and its slides, like this particular post, are for educational purposes only and are not intended as advice for any particular individual. 

Conclusion

Existing basis in IRAs is a planning opportunity if the investor has a good workplace 401(k) or other qualified plan that accepts IRA roll-ins. That planning requires intention and diligence, and measuring two or three times, even if working with a professional. 

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, 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.

2024 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.

Why Contribute to an IRA?

Before we dive into annual contributions to IRAs, let’s discuss 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. 

IRA Annual Contribution Requirement: Earned Income

In order to make any of the three types of IRA annual contributions for any particular year, you or your spouse must have earned income during that year. Earned income is generally that income that is reported to you on your Form W-2, or is reported by you on your tax return on Schedule C (self-employment income). It also includes self-employment income reported to you on a Form K-1 (because you are a self-employed partner in a partnership). It does not include income reported to you on a Form K-1 from an S corporation.

While wages, nontaxable combat income, and self-employment income qualify as earned income for this purpose, several types of income do not. Social security, pensions, rentals, royalties, interest, and dividends are not earned income. Income excluded from taxable income under the foreign earned income exclusion also does not constitute “earned income” for IRA purposes.

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 2024 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 2024. 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 2024 is less than $87,000 (if single), $143,000 (if married filing joint, “MFJ”), or $10,000 (if married filing separate, “MFS”). 

Note that in between $77,000 and $87,000 (single), $123,000 and $143,000 (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 $82,000 in 2024, 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. In such a case, Mike would be likely to favor a Roth IRA contribution over a nondeductible traditional IRA contribution.

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 2024 is less than $240,000 (MFJ) or $10,000 (MFS). 

Note that in between $230,000 and $240,000 (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 2024 is less than $161,000 (single), $240,000 (MFJ), or $10,000 (MFS). 

Note that in between $146,000 and $161,000 (single), $230,000 and $240,000 (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 $155,000 for 2024, 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.

IRA Annual Contribution Limits

For taxpayers younger than 50 years old during the entire year, the maximum (for 2024) that can be contributed to the combination of all three types of IRAs is the lesser of:

  • The taxpayer’s and their spouse’s combined earned income, or
  • $7,000.

Thus, if both spouses are younger than 50 years old, the maximum IRA contributions for a married couple is $14,000.

For taxpayers 50 years old or older during any part of the taxable year the maximum (for 2024) that can be contributed to the combination of all three types of IRAs is the lesser of:

  • The taxpayer’s and their spouse’s combined earned income, or
  • $8,000.

Thus, if both spouses are 50 or older, the maximum IRA contributions for a married couple is $16,000.

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 2024 IRA contribution is April 15, 2025). 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. 

Correction

A previous version of this blog post, titled “IRA Contributions for Beginners” erroneously stated that one must be a citizen or resident of the United States to make an IRA contribution. I regret the error. 

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 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.

2023 Year-End Tax Planning

It’s that time of year again. The air is crisp and my favorite football team is surging. That can only mean one thing when it comes to personal finance: time to start thinking about year-end tax planning.

I’ll break it down with three categories: Urgent, Year-End Deadline, and Can Wait Till Next Year. I will also provide some thoughts on 2024 tax planning that can/should be done before year-end in 2023.

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 tax deduction for the fair market value of the contributed appreciated stock,
  2. Elimination of the built-in capital gain on the contributed appreciated stock, and
  3. Tax-free treatment of the income earned inside the donor advised fund.

In order to get the first benefit in 2023, the appreciated stock must be received by the donor advised fund prior to January 1, 2024. 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 2023. Donor advised fund planning should be attended to sooner rather than later. 

Taxable Roth Conversions

For a Roth conversion to count as being for 2023, it must be done before January 1, 2024. 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 2023. 

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

Roth Conversion Example: See slides 8 through 10 of this slide deck for an example of a Roth conversion in retirement. You might be surprised by just how little federal income tax is owed on a $23,000 Roth conversion.

Example Where I Disfavor Roth Conversions: I present an example of a 73-year old married couple with $400K in deferred retirement accounts and $87K in 2023 gross income. I would not recommend they do end-of-year Roth conversions. This spreadsheet computes the taxable Social Security with and without a $10K Roth conversion.

Gotta Happen Before 2026!!!

You will hear many commentators say “do more Roth conversions 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 disagree with the assertion. As I have stated before, there’s nothing more permanent than a temporary tax cut. You do your own risk assessment, but mine is this: members of Congress like to win reelection, and they are not going to want to face voters without having acted to ensure popular tax cuts, such as the reduction of the 15% tax rate down to 12% and the increased standard deduction, are extended. 

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.

Learn all about the Pro-Rata Rule here.

Adjust Withholding

This varies, but it is a good idea to look at how much tax you owed last year (line 24 on the Form 1040). If you are on pace to get 100% (110% if 2022 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 2023. If you do, don’t forget to reassess your workplace withholdings for 2024 early in the year. 

Backdoor Roth IRA Diligence

The deadline for the Backdoor Roth IRA for 2023 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, 2023. 

Solo 401(k) Planning

There’s plenty of planning that needs to be done for solopreneurs in terms of retirement account contributions. Even though Schedule C solopreneurs can now establish a Solo 401(k) after year-end (up to April 15th), it is absolutely the case that it is better to do the planning upfront. For those Schedule C solopreneurs with a Solo 401(k) established, December 31st is the deadline to make 2023 employee deferral contributions or make a 2023 deferral election as an alternative to making the payments in 2023. December 31st is also the 2023 employee deferral contribution for solopreneurs operating out of S corporations.

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, 2023 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 Gain Harvesting Example: See slide 15 of this slide deck for an example of tax gain harvesting in retirement.

Tax Loss Harvesting

The deadline for tax loss harvesting for 2023 is December 31, 2023. 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, 2023. 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, and 2022, the IRS has waived 2023 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 2023 to put the income into a lower tax year, if 2023 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 2023 is April 15, 2024. 

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 2023 tax year is April 15, 2024. Those doing the Backdoor Roth IRA for 2023 and doing the Roth conversion step in 2024 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 2023 is April 15, 2024. 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 2023 is April 15, 2024. 

2024 Tax Planning at the End of 2023

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). Perhaps their business is growing such that an S corporation election makes sense. The best time to be thinking about these sorts of things for 2024 is late in 2023. Often this analysis benefits from professional consultations.

Additional Resource

Please see my November 11, 2023 ChooseFI Orange County year-end tax planning presentation slide deck.

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.

CampFI 2023 Presentation

Here are my presentation slides for my presentation delivered October 7, 2023 at CampFI Southwest.

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.

Traditional Versus Roth 2023

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

We hear it time and again: be worried about all the tax lurking inside traditional retirement accounts such as 401(k)s and IRAs!

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. 

That’s a great plan, in theory. But couldn’t Congress take it away? Sure, they could, but I seriously doubt they will in an effective way. First, let’s look at recent history. In 2021 the Democratic Congress proposed, but did not pass, a provision to eliminate (starting a decade in the future) taxable Roth conversions for those north of $400K of annual income. Such a rule would have had no effect on most retirees, who will never have anything approaching $400K of income in retirement.

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.

Optimize for Known Trade-Offs

People want to know: what’s the optimal income for switching from traditional to Roth? What’s the optimal percentage to have each of traditional, Roth, and taxable accounts?

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 deductible traditional 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. 

Further, Roth IRA contributions and Backdoor Roth IRAs can serve as emergency funds, while traditional IRAs, traditional 401(k)s, and Roth 401(k)s do not serve well as emergency funds. Roth IRA contributions do not suffer from an adverse trade-off when it comes to emergency withdrawals, unlike Roth 401(k) contributions. 

Roth Contributions End the Planning

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

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.

It’s Not Too Late, California!

HUGE UPDATE: On October 16, 2023, the IRS issued this, extending the October 16, 2023 deadline for 2022 tax acts and filings to November 2023. The IRS announcement allows (most) Californians to make Roth IRA, traditional IRA, and HSA contributions for 2022 up to November 16, 2023 and delays the deadline for many 2022 federal income tax returns and income tax payments to November 16, 2023. Hat tip to Justin Miller on X for the news.

ADDITIONAL UPDATE 10/16/2023 7:06PM: California has also extended the 2022 filing and payment deadline to November 16, 2023. Hat tip to Kelly Phillips Erb.

Please enjoy below the rest of my post, as originally authored in August 2023, understanding that now you can replace “October 16” with “November 16” for most Californians.

I’m glad that title intrigued you enough to stop on by. It’s not too late for most Californians to make a 2022 IRA contribution, a 2022 Roth IRA contribution, a 2022 HSA contribution, and/or do a 2022 Backdoor Roth IRA contribution. 

You’re probably thinking “What the heck are you talking about? It’s the late summer 2023. Time to be thinking about football, not funding 2022 IRAs and HSAs.”

Your thoughts are correct as applied to most Americans. However, most Californians are the beneficiaries of a special situation. The IRS announced that because of early 2023 flooding in many areas of California, most Californians have an extended deadline, October 16, 2023, to perform most 2022 tax acts that otherwise would have been due early in 2023.

This extension opens the door for millions of Californians to consider 2022 contributions to tax-advantaged accounts. Of course, nothing increases the amount Californians can contribute. Thus, those who have already maxed out for 2022 do not benefit from this deadline extension. 

2022 Traditional IRA Contributions

Most working Californians can still make 2022 contributions to a traditional IRA. If the taxpayer has not yet filed their 2022 Form 1040, the deduction or the Form 8606 (for a nondeductible contribution) can simply be included with the to-be filed Form 1040.

But what if the taxpayer has already filed their Form 1040 for 2022? Then the question becomes: are they deducting their 2022 traditional IRA contribution? If no, then the taxpayer can simply file a Form 8606 as a standalone tax return to report the 2022 nondeductible contribution. 

However, if the contribution is tax deductible, then the taxpayer would need to file amended Forms 1040 and 540 (for California) to report the deductible IRA contribution and claim refunds from both the IRS and the Franchise Tax Board for the tax reduced because of the deductible traditional IRA deduction. 

2022 Roth IRA Contributions

Many working Californians can still make 2022 contributions to a Roth IRA. Since Roth IRA contributions are not deductible, and do not require a separate form to report them, the contribution likely would not require any amending of already-filed 2022 tax returns. One exception would be the case of a taxpayer with a low income in 2022. He or she could make a 2022 Roth IRA contribution and possibly qualify for the Saver’s Credit. In order to claim the credit, they would need to amend their Form 1040 if they already filed it for 2022. 

2022 Backdoor Roth IRAs

It’s not too late for a 2022 Backdoor Roth IRA for some Californians! This would be a Split-Year Backdoor Roth IRA. The pressing deadline as of late August 2023 is that the 2022 nondeductible traditional IRA contribution needs to be made by October 16, 2023. 

Anyone pursuing a Split-Year Backdoor Roth IRA for 2022 in 2023 should ensure they have no balances in traditional IRAs, SEP IRAs, and/or SIMPLE IRAs as of December 31, 2023. 

2022 HSA Contributions

Some Californians can still make 2022 contributions to a health savings account. If the taxpayer has not yet filed their 2022 Form 1040, the tax deduction can simply be added to the to-be filed Form 1040.

But what if the taxpayer has already filed their Form 1040 for 2022? Then the taxpayer would need to file amended Form 1040 to claim the tax deduction and the resulting tax refund from the IRS. Since California does not recognize HSAs, there’s no California tax deduction and no need to amend the California Form 540. 

Of course, the taxpayer must meet the eligibility requirements (generally, having had a high deductible health plan as their only medical insurance) in 2022 in order to contribute to a HSA for 2022. 

Practical Considerations

First, contributions to IRAs, Roth IRAs, and HSAs made in 2023 that are to count for 2022 must be specifically designated as being for 2022. 

Second, I believe that in many cases, in order for qualifying Californians to do this, it will be necessary to use the phone, not internet portals. I suspect most financial institutions’ internet portals will not accommodate a 2022 IRA/Roth IRA/HSA contribution this late. Remember, financial institutions would not want to encourage the vast majority of Americans who do not currently qualify to make 2022 contributions to make 2022 contributions.

Thus, I believe as a practical matter using the phone is a best practice in terms of making any 2022 contributions at this late date. 

Who Benefits?

Residents of all California counties except three qualify for the extended deadline. The vast majority of the population of the state qualifies for the extended deadline, but residents of Lassen, Modoc, and Shasta do not appear to qualify (don’t blame me, I don’t make the rules!). 

Note that some taxpayers in parts of Alabama and Georgia qualify for this opportunity, but I personally have not explored this in any detail. 

Conclusion

Many California residents should consider whether there is some extended last minute 2022 tax planning they can implement by October 16, 2023. 

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.