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.
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 threequalify 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
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.
Yesterday I posted Time to Stop 401(k) Contributions?, arguing that as applied to many in the FI community, traditional deductible 401(k) contributions are fine.
Second, UBS and Credit Suisse issued their Global Wealth Report for 2023. Allow me to call your attention to page 16. The median American adult has personal wealth just a bit under $108,000. This means almost half of American adults have less than $100K of wealth, and the majority of American adults do not have $200K of wealth. For most Americans, deferred taxation is not the problem! Sufficiency is the problem!
For me this report cracks the case. If the median American adult does not have close to sufficient wealth to comfortably retire, why are they worried about taxes in retirement?
Assuming this report is anywhere near close to a correct measure of adult American wealth, I believe I am correct and personal finance legends Ed Slott and Clark Howard are wrong when it comes to the traditional 401(k) versus Roth 401(k) debate.
The best way for working Americans to address sufficiency problems is by contributing to traditional, deductible retirement accounts. As demonstrated below, one employing this sort of deduct, deduct, deduct strategy would need to be successful well beyond what most Americans accomplish in order to create a tax problem.
When one has insufficient resources for retirement, the traditional, deductible 401(k) makes the most sense. He or she needs to build up assets, not worry about future taxes! With relatively little in the way of resources, future taxes are not likely to be a problem (especially in retirement when compared to one’s working years). Further, by contributing to a traditional, deductible 401(k) instead of a Roth 401(k), one behind in retirement saving takes home more money to invest in additional saving mechanisms such as Roth IRAs and taxable brokerage accounts.
Let’s Break Down Some Retirement Numbers
I believe we need some numbers to figure out who’s right.
Example 1: I start with Single Sally, who is 75 years old. Since she is somewhat like the median American, but older, let’s assume she has $250,000 of wealth and receives $30,000 a year in Social Security. Assume further that all $250K is in a traditional IRA and Sally, age 75, wants to live for today: she isn’t constrained by the 4% rule but rather decides to withdraw 10 percent per year ($25,000). On that $55,000 annual gross income, Single Sally pays just over $2,000 in federal income taxes (an effective rate less than 4%).
Why would Sally pass on a 10%, 12%, or 22% deduction from a traditional 401(k) contribution during her working years? Why would Single Sally put the money in a Roth 401(k) so as to avoid a less than 4% federal income tax in retirement? And how different is Sally’s situation from that of many Americans?
Update 8/17/2023: Single Sally is in the Tax Torpedo, an interesting tax phenomenon with a modest impact on her total tax liability. I added a spreadsheet to look at this in more detail.
Example 2: But Sean, I’m reading your blog. I’m not shooting for just $250K in retirement wealth! Okay, let’s start testing it by considering wealth significantly above the mean and median adult Americans. Single Sarah is 75 years old. She receives $30,000 a year in Social Security. But now she also has a $1M traditional IRA and takes an RMD ($40,650) based on her age. Single Sarah also has some taxable accounts and thus has $4,000 of qualified dividend income and $1,000 of interest income. On that approximate $76,000 annual gross income, Single Sarah pays just over $7,200 in federal income taxes (an effective rate of a bit more than 9.5%).
In order to grow a $1M traditional IRA (likely rolled over from workplace 401(k)s), she almost certainly was in the 22% or greater federal marginal tax bracket while working. Why would Single Sarah switch from taking a 22% tax deduction (the traditional 401(k) contribution) to a Roth 401(k) contribution to avoid a 9.5% effective federal tax rate in retirement?
Example 3: Example 3 is Single Sarah at age 80. Her investments are doing so well her traditional IRA is still worth $1M, causing her to be required to take a $49,505 RMD. This causes her federal income tax to increase to $9,175, for an effective federal income tax rate of almost 11%.
How many Americans will get to age 80 with $1M or more in tax deferred accounts? Even if they do, how bad is the tax problem? If Single Sarah’s effective tax rate is 11%, a 50% tax hike gets her to about 16.5%. Will she enjoy paying that tax? No. Is it crippling? Hardly!
Still worried about contributing to a traditional 401(k)? I’ve got a video for you!
Conclusion
The next time you hear “30 or 40% of your 401(k) belongs to the government” you should consider my examples. For many Americans, “10%” will be much closer to the mark than 30% or 40%.
It’s time to step back and ask whether prioritizing Roth 401(k) contributions during one’s working career is the best advice for the majority of Americans. As demonstrated above, a tax increase of 50 percent (highly unlikely) would result in most Americans having an effective tax rate below 20% in retirement.
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
Ed Slott believes most Americans should not contribute to traditional 401(k)s. His recent essay on the subject is a great opportunity for the FI community to reassess its love for the traditional 401(k).
My conclusion is that for many in the FI community, traditional deductible 401(k) contributions are still the most logical path when it comes to workplace retirement saving. Below I explain my thinking.
It is important to note it is impossible to make a blanket statement as applied to the entire FI community.
Why the Traditional 401(k) Is Good for the FI Community
Many in the FI community have the very reasonable hope that in retirement they will have years, possibly decades, where their effective tax rate will be lower than their marginal tax rate in their working years.
The above is true of many Americans, but it is particularly true if one retires early by conventional standards. The idea is deduct, deduct, deduct into the 401(k) during one’s working years (particularly the high earning years) and then retire early by conventional standards. Prior to collecting Social Security and/or required minimum distributions (“RMDs”), most retirees look artificially poor on their tax return. This opens up the door to affirmatively convert money from traditional retirement accounts to Roth accounts and pay tax at the lowest federal income tax brackets (currently 10% and 12%). For those who deducted contributions into the 401(k) at a 24% or greater marginal federal tax rate, this is great tax rate arbitrage planning.
Minor litigation risks aside, this strategy just got even easier for those born in 1960 and later, who don’t have to take RMDs under SECURE 2.0 until age 75. With the new delayed RMD beginning date, even those retiring as late as age 65 will have a full decade prior to being required to take RMDs to do tax-efficient Roth conversions at low marginal tax rates. For some in the FI community, this opportunity window might not be a decade long but rather a quarter-century long (if they retire at age 50).
How Bad is the Retiree Tax Problem?
As wonderful as FI tax rate arbitrate planning might be, Ed Slott’s concern that retiree taxes will increase is not entirely unwarranted. It is obvious that the government is not fiscally responsible, and it is obvious that tax increases could be coming in the future.
Let’s assess the situation by looking at just how bad the problem of taxes is in retirement.
We begin with a baseline case. David and Hannah are in their 70s. They never did Roth conversions in early retirement and have the bulk of their financial assets in traditional IRAs and traditional 401(k)s. During most of their working years, David and Hannah maxed out 401(k)s and got deductions in the 24% bracket or greater. For 2023, they have taxable RMDs of $160,000, Social Security of $40,000, $4,000 of qualified dividends and $1,000 of interest income. How bad is their federal income tax situation?
Federal Income Tax Return
RMDs
$ 160,000
Social Security
$ 40,000
15% Social Security Exclusion
$ (6,000)
Interest
$ 1,000
Qualified Dividends
$ 4,000
Adjusted Gross Income (“AGI”)
$ 199,000
Standard Deduction
$ (27,700)
Additional SD Age 65+
$ (3,000)
Federal Taxable Income
$ 168,300
Federal Income Tax (Estimated)
$ 27,361
Effective Tax Rate on AGI
13.75%
Marginal Federal Income Tax Rate
22%
Under today’s rules, David and Hannah, who did no tax planning other than “deduct, deduct, deduct” are doing great. Their federal effective tax rate, even with $200K of RMDs and Social Security, is just 13.75%. They incur such a low effective tax rate because their RMDs go against the 10% tax bracket, the 12% bracket, and the 22% bracket.
While I do think David and Hannah would be in a better position had they done some tax efficient Roth conversion planning earlier in retirement, their unbridled enthusiasm for traditional retirement accounts served them well.
Note: David and Hannah are borderline IRMAA candidates: a $199K 2023 AGI might cost them approximately $2,000 in IRMAA surcharges in 2025 (but it is possible that inflation adjustments for 2025 will prevent that from happening). This is another reason to consider pre-RMD Roth conversions at lower marginal tax rates.
Update 8/19/2023: But what about thewidow’s tax trap? If David or Hannah die, won’t the survivor get crushed by tax increases? Check out this estimate. Assuming the survivor loses the lower-earning spouse’s Social Security benefits of at least $10,000, the survivor’s marginal federal income tax rate would climb from 22% all the way up to . . . 24%!
But what about future tax increases? Okay, let’s add four tax increases to the picture and see just how bad it looks:
Eliminate the TCJA increase to the standard deduction (the law reverts to pre-2018 lower standard deduction and personal exemptions). This would reduce David and Hannah’s deductions by roughly $2,740, costing them approximately $602.80 in additional federal income tax (at today’s 22% marginal tax rate).
Eliminate the TCJA decrease in the 15% tax bracket to 12%. This would cost David and Hannah $2,023.50 in additional federal income tax. I’m highly skeptical that either of these two tax increases will actually occur, but as written in today’s laws they are scheduled to happen in 2026.
Increase the 15% long term capital gains and qualified dividend income rate to 25%. While I believe that the real risk is an increase in the 20% long term capital gains and qualified dividend income rate, let’s stress test things and consider a large increase in the 15% rate. In David and Hannah’s case, this costs them $400 in additional federal income tax.
Increase the 22% tax rate to 33%. Ed Slott is worried about large tax rate increases, so let’s consider one that I believe is politically infeasible, a 50% increase in the 22% tax bracket. This type of tax rate increase would hit millions of voters in a major way. But it’s helpful to consider what could be a worst case scenario. In this case, this tax rate increase costs David and Hannah an additional $8,233.50 in federal income tax.
There’s one more tax hike to consider: the combination of tax increases numbers 1 and 4. If both occurred together, combined they would cost David and Hannah an additional $301.40 in federal income tax.
Here’s what David and Hannah’s federal tax picture looks like if all of the above tax increases occur:
Federal Income Tax Return
RMDs
$ 160,000
Social Security
$ 40,000
15% Social Security Exclusion
$ (6,000)
Interest
$ 1,000
Qualified Dividends
$ 4,000
Adjusted Gross Income (“AGI”)
$ 199,000
Standard Deduction
$ (15,240)
Additional SD Age 65+
$ (3,000)
Personal Exemptions
$ (9,720)
Federal Taxable Income
$ 171,040
Federal Income Tax (Estimated)
$ 38,922
Effective Tax Rate on AGI
19.56%
Marginal Federal Income Tax Rate
33%
Significant tax increases hurt David and Hannah, but how much? By my math, very significant tax increases, including a 50% increase in the 22% bracket, cost them about 6% of their income. Not nothing, but wow, they’re still doing very well.
Yes, on the margin, the last dollars David and Hannah contributed to the traditional 401(k) were not ideal since they faced a 33% marginal federal tax rate in retirement. But let’s remember (i) their overall effective rate is still more than 4 percentage points lower than their working years’ marginal rate (at which they deducted their 401(k) contributions), (ii) they have income significantly above what most Americans will have in their 70s, and (iii) in my scenario they face four separate tax hikes and still pay a federal effective tax rate less than 20 percent.
Future Retirees’ Tax Risk
Do future tax hikes pose no threat to future retirees? Absolutely not! But my stress test shows that many Americans with substantial RMDs will not get walloped even if Congress enacts unpopular tax increases. Considering many in the FI community will have modest RMDs due to pre-RMD Roth conversions, the threat of future tax hikes is even less perilous for the FI community.
Further, many Americans, particularly those in the FI community, have a great tool that can mitigate this risk: Roth conversions during retirement! With RMDs now delayed to age 75 for those born in 1960 and later, many Americans will have years if not decades where money can be moved in a tax-efficient manner from old traditional accounts to Roth accounts.
Further, many Americans can claim deductions at work and then at home contribute to a regular Roth IRA or a Backdoor Roth IRA. This too mitigates the risk of having all of one’s retirement eggs in the traditional basket.
Last, do we really believe that Congress is just itching to raise taxes on future retirees? Sure, it’s possible. But to my mind taxes are more likely to be raised on (i) those in higher ordinary income tax brackets and/or (ii) long term capital gains and/or qualified dividends (particularly the current 20% bracket). If anything, the most Congress is likely to do to retirees is slightly increase their taxes so as to mitigate the political risk involved in raising taxes on retirees who tend to vote.
The Risks of Not Having Money in Traditional Retirement Accounts
Risk isn’t a one-way street. There are some risks to not having money in traditional retirement accounts. I identify three below.
Qualification for Premium Tax Credits
Picture it: Joe, age 55, retires with the following assets: (i) a paid off car, (ii) a paid off house, (iii) a $40,000 emergency fund in an on-line savings account, and (iv), $2 million in Roth 401(k)s and Roth IRAs. He heard that Roth is the best, so he only ever contributed to Roth IRAs and Roth 401(k)s, including having all employer contributions directed to a Roth 401(k). Having fallen into the Rothification Trap, in retirement Joe must work in order to generate sufficient taxable income to qualify for any ACA Premium Tax Credit.
For at least some early retirees, the ability to create modified adjusted gross income by doing Roth conversions will be the way they guarantee qualifying for significant Premium Tax Credits to offset ACA medical insurance premiums.
Charitable Contributions
Many Americans are at least somewhat charitably inclined. Starting at age 70 ½, Americans can transfer money directly from a traditional IRA to a charity, exclude the distribution from taxable income, and still claim the standard deduction. Essentially, if you’re charitably inclined, at a minimum you would want to go into age 70 ½ with enough in your traditional IRAs (likely through contributions to traditional 401(k)s that are later transferred to an IRA) to fund your charitable contributions from 70 ½ until death.
Why ever pay tax on that money (i.e., by making contributions to a Roth 401(k) that are later withdrawn to be donated) if the money is ultimately going to charity anyway?
Unused Standard Deductions
Currently, the government tells married couples, hey, you get to make $27,700 a year income tax free! Why not take advantage of that exclusion every year, especially prior to collecting Social Security (which, in many cases will eat up most, if not all, of the standard deduction).
Why be retired at age 55 with only Roth accounts? By having at least some money in traditional retirement accounts going into retirement, you ensure you can turn traditional money into Roth money tax-free simply by converting (at any time) or even distributing (usually after age 59 1/2) the traditional retirement account against the standard deduction.
Deduct at Work, Roth at Home
I think for many it makes sense to max out traditional 401(k)s at work and contribute to Roth IRAs or Backdoor Roth IRAs at home. Why? As discussed above, traditional 401(k)s can set up tax rate arbitrage in retirement, help early retirees qualify for Premium Tax Credits, and make charitable giving after age 70 ½ very tax efficient. At home, many working Americans do not qualify to deduct IRA contributions, so why not contribute to a Roth IRA or Backdoor Roth IRA, since (i) you aren’t giving up a tax deduction in order to do so and (ii) you establish assets growing tax free for the future.
In this post I discuss why deduct at work, Roth at home can often make sense and I provide examples where Roth 401(k) contributions are likely to be better than traditional 401(k) contributions.
Conclusion
I believe that for many in the FI community, a retirement savings plan that combines (i) traditional deductible 401(k) contributions during one’s working years and (ii) Roth conversions prior to collecting RMDs is likely to be a better path than simply making all workplace retirement contributions Roth contributions.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
Roth IRAs allow tax-free distributions to fund retirement. However, to help secure retirement savings and avoid premature raiding of Roth IRAs, Congress did not give them blanket exemption from taxes and penalties. Thus, there are times where distributions from Roth IRAs are subject to either or both ordinary income tax and/or the 10% early withdrawal penalty. The IRS and Treasury have issued regulations governing the rules of the road for Roth IRAs, which interpret the rules Congress wrote in IRC Section 408A.
A Few Introductory Notes Before We Get Started
The below post is different from many posts on FITaxGuy.com in two respects. First, my posts tend to be planning focused, though they often dive into tax rules, as a good understanding of the rules helps with planning. This post is almost entirely rules focused rather than planning focused.
Second, the primary audience for this post is tax and financial advisors (though I welcome both laymen and professionals reading and questioning the post). I have recently observed that professionals seem to be confused about the Roth IRA distribution rules. It’s time to lay out the rules with citations to the relevant governing regulations!
Below I lay out my breakdown of the rules with extensive citation to the regulations so you can see where I’m getting my assertions from. You get to be the judge and jury as to whether I have properly presented the relevant rule.
Now, back to the show. Per Treas. Reg. Section 1.408A-6 Q&A 1(a) “[t]he taxability of a distribution from a Roth IRA generally depends on whether or not the distribution is a qualified distribution.”
Roth IRA Qualified Distributions
A qualified distribution is not included in the Roth IRA’s owner’s gross income (Treas. Reg. Section 1.408A-6 Q&A 1(b)) and is thus tax free and penalty free (see Treas. Reg. Section 1.408A-6 Q&A 5(a)).
The way most distributions from a Roth IRA qualify as a “qualified distribution” is by satisfying the requirements that the owner (1) is age 59 ½ or older (see Treas. Reg. Section 1.408A-6 Q&A 1(b)(2)) and (2) has owned a Roth IRA for at least 5 years (see Treas. Reg. Section 1.408A-6 Q&A 1(b)(1)).
Once one qualifies for a qualified distribution by satisfying both the age 59 ½ requirement and the 5 year requirement, he or she no longer has any need to consider either of the two Roth IRA 5-year rules (the so-called 5-Year Conversion Clockand the so-called 5-Year Earnings Clock).
Roth IRA Nonqualified Distributions
Now we turn to the taxation of distributions that do not qualify as qualified distributions (what I colloquially refer to as “nonqualified distributions”). As a very general matter, the taxation of these distributions is mostly governed by Treas. Reg. Section 1.408A-6 Q&As 1, 4, 5, 8, and 9.
Ordering Rule
Treas. Reg. Section 1.408A-6 Q&A 8 provides an ordering rule for distributions from a Roth IRA. This creates three layers. Each layer must be fully withdrawn prior to a subsequent layer being accessed. See Treas. Reg. Section 1.408A-6 Q&A 8(a).
First, all annual contributions are withdrawn. Second, all previous Roth conversions are withdrawn (first in, first out). Third, earnings (growth) in the Roth IRA are withdrawn.
Tax Free Withdrawal of Owner Contributions (Both Annual Contributions and Roth Conversions)
Annual contributions and Roth conversions are “contributions” that are always withdrawn income tax free. See Treas. Reg. Section 1.408A-6 Q&A 1(b) (contributions always are withdrawn tax free), Q&A 8(a) (annual contributions and Roth conversions are both “contributions”).
However, the withdrawal of taxable Roth conversions can be subject to the 10% early withdrawal penalty. See Treas. Reg. Section 1.408A-6 Q&A 5(b) (see also IRC Section 408A(d)(3)(F)). This is only true if the Roth conversion is withdrawn within 5 years. See Treas. Reg. Section 1.408A-6 Q&A 5(b) (the 5-Year Conversion Clock).
Per Treas. Reg. Section 1.408A-6 Q&A 5(b), the exceptions to the 10% early withdrawal penalty also apply. The most prominent such exception is having attained the age of 59 ½. Thus, a distribution from a Roth IRA received by an owner at least 59 ½ years old will never be subject to the 10% early withdrawal penalty.
Roth Earnings
Nonqualified distributions of earnings are subject to ordinary income tax (see Treas. Reg. Section 1.408A-6 Q&A 4) and potentially the 10% early withdrawal penalty (see Treas. Reg. Section 1.408A-6 Q&A 5(a)). Generally speaking, if one is either under age 59 ½ years old (see Treas. Reg. Section 1.408A-6 Q&A 1(b)(2)) or if the owner has not owned a Roth IRA for at least 5 years (see Treas. Reg. Section 1.408A-6 Q&A 1(b)(1), the 5-Year Earnings Clock), any withdrawal of earnings will be subject to ordinary income tax. Further, if one receives a distribution of earnings prior to age 59 ½, they are generally subject to the 10% early withdrawal penalty, unless they qualify for another exception.
Note that as a practical matter, distributions of earnings received prior to turning age 59 ½ are rare since all previous annual contributions and Roth conversions must be withdrawn prior to a distribution being considered a distribution of earnings.
A Quick Note on Roth IRA Aggregation
For purposes of assessing the taxation of a distribution from a Roth IRA, one aggregates all of their Roth IRAs and treats them together as a single Roth IRA. See IRC Section 408A(d)(4), Treas. Reg. Section 1.408A-6 Q&A 9(a) and (b), and my YouTube video on the subject.
UPDATE October 30, 2023: I appreciate Andy Ives’s post on IRAHelp.com. He lays out very simply the Roth IRA Distribution rules at the end of this short post. His analysis agrees with mine.
Application to Fact Patterns
Having now covered the universe of the taxation of Roth IRA distributions (both qualified distributions and nonqualified distributions), let’s apply the rules to four examples.
Example 1: Jorge celebrates his 65th birthday in the year 2023. After his birthday party, he converted $40,000 of his traditional 401(k) to a Roth IRA. The conversion is fully taxable. This is the first time Jorge has owned any Roth IRA. On January 1, 2024, Jorge withdrew $25,000 from his Roth IRA. On January 1, 2025, Jorge withdrew $25,000 from his Roth IRA.
What results in 2024 and 2025?
Jorge, as of both 2024 and 2025, does not meet the criteria for taking a qualified distribution because he has not owned a Roth IRA for at least 5 years. Thus, he has a nonqualified distribution in both years.
In 2024, the $25,000 withdrawal of Roth conversions is income tax free (see Treas. Reg. Section 1.408A-6 Q&A 1(b)) and is penalty free because Jorge is older than age 59 ½. This demonstrates that the 5-Year Conversion Clock is irrelevant once one turns age 59 ½. Check out Jorge’s 2024 Form 8606 Part III here (pardon the use of the 2022 version, it’s the latest one available as of this writing).
In 2025, the first $15,000 of Jorge’s withdrawal is a return of Roth conversions and thus not subject to ordinary income tax. Further, this withdrawal is not subject to the 10% early withdrawal penalty. The second $10,000 Jorge withdrew is a nonqualified distribution of earnings. Jorge must pay ordinary income tax on those $10,000 (see Treas. Reg. Section 1.408A-6 Q&A 4). This withdrawal of earnings violates the 5-Year Earnings Clock and is thus subject to ordinary income tax. However, this withdrawal of earnings is not subject to the 10% early withdrawal penalty as Jorge is older than age 59 ½. Check out Jorge’s 2025 Form 8606 Part III here.
Example 2: Samantha celebrates her 45th birthday in the year 2023. After her birthday party, she converted $60,000 of her old traditional 401(k) to a Roth IRA. The conversion is fully taxable. This is the first time Samantha has owned any Roth IRA. On January 1, 2024, Samantha withdrew $25,000 from her Roth IRA. On January 1, 2025, Samantha withdrew $40,000 from her Roth IRA.
What results in 2024 and 2025?
Samantha, as of both 2024 and 2025, does not meet the criteria for taking a qualified distribution because she has not owned a Roth IRA for at least 5 years. Thus, she has a nonqualified distribution in both years.
In 2024, Samantha’s withdrawal is a return of Roth conversions and thus not subject to ordinary income tax. However, because the withdrawal is from Roth conversions younger than 5 years old, and Samantha is under age 59 ½, Samantha must pay the 10% early withdrawal penalty ($2,500) on the distribution (she violates the 5-Year Conversion Clock), unless an exception applies.
In 2025, the first $35,000 of Samantha’s withdrawal is a return of Roth conversions and thus not subject to ordinary income tax. However, because the withdrawal is from Roth conversions younger than 5 years old, Samantha must pay the 10% early withdrawal penalty ($3,500) on the distribution (she violates the 5-Year Conversion Clock), unless an exception applies.
The second $5,000 Samantha withdrew in 2025 is a nonqualified distribution of earnings. Samantha must pay ordinary income tax on those $5,000 (see Treas. Reg. Section 1.408A-6 Q&A 4) and generally must pay the 10% early withdrawal penalty ($500) on that $5,000 distribution of earnings, unless an exception applies.
Example 3: Ed celebrates his 65th birthday in the year 2023. After his birthday party, he converted $40,000 of his old traditional 401(k) to a Roth IRA. The conversion is fully taxable. Ed has owned a Roth IRA since 1998. On January 1, 2024, Ed withdrew $25,000 from his Roth IRA. On January 1, 2025, Ed withdrew $25,000 from his Roth IRA.
What results in 2024 and 2025?
Unlike Examples 1 & 2, we finally have a qualified distribution! Why? Ed has (i) owned a Roth IRA since 1998 (more than 5 years) and (ii) is over age 59 ½. Thus, the only type of distribution Ed can take from his Roth IRA is a qualified distribution. Per Treas. Reg. Section 1.408A-6 Q&A 1(b), a qualified distribution is tax free. Further, Ed cannot pay the early withdrawal penalty on a distribution from his Roth IRA as he is in his 60s (see also Treas. Reg. Section 1.408A-6 Q&A 5(a)). Thus, there is no tax and no penalty on either the 2024 distribution or the 2025 distribution.
Example 4: This example is based on my conversation with Brad Barrett on a recent episode of the ChooseFI podcast. Jonathan turns age 57 on July 1, 2023. He’s never had a Roth IRA. On July 1, 2023, he converted $50,000 from a traditional IRA to a Roth IRA. The conversion is fully taxable.
What withdrawal constraints does Jonathan have on his Roth IRA?
If Jonathan withdraws up to $50,000 from his Roth IRA prior to turning age 59 ½ on January 1, 2026, Jonathan will have to pay the 10% early withdrawal penalty as he violates the 5-Year Conversion Clock (unless an exception applies).
If Jonathan cumulatively withdraws amounts in excess of $50,000 from his Roth IRA prior to turning age 59 ½, he will pay ordinary income tax on the withdrawal of those earnings (as he violates the 5-Year Earnings Clock) and he will pay the 10% early withdrawal penalty (unless an exception applies).
From January 1, 2026 through December 31, 2027, if Jonathan cumulatively withdraws amounts in excess of $50,000 from his Roth IRA, he will pay ordinary income tax on the withdrawal of those earnings (as he violates the 5-Year Earnings Clock). However, Jonathan will not pay the 10% early withdrawal penalty. Starting on January 1, 2028, Jonathan satisfies the 5-Year Earnings Clock (see Treas. Reg. Section 1.408A-6 Q&A 2) and is now permanently able to take a qualified distribution from his Roth IRA going forward.
On January 16, 2024, Denzel withdrew $3,000 from his Roth IRA and made no contributions to his Roth IRA during 2024.
What results in 2024?
Denzel, as of 2024, does not meet the criteria for taking a qualified distribution because he has not owned a Roth IRA for at least 5 years. Thus, he has a nonqualified distribution in 2024.
Pursuant to Treas. Reg. Section 1.408A-6 Q&A 8(b), the taxable portion of the Roth conversion ($2 out of $6,502) comes out first. That $2 is subject to the 10% early withdrawal penalty (a $0.20 penalty which roundsdown to $0) since he violates the 5-Year Conversion Clock, unless an exception applies. This $2 constitutes what I colloquially refer to as a micro layer inside the Roth IRA: for 5 years it is subject to the 10% early withdrawal penalty if withdrawn (unless an exception applies).
However, the $2 recovery of the taxable Roth conversion is not subject to ordinary income tax. See Treas. Reg. Section 1.408A-6 Q&A 1(b).
Second, the $2,998 nontaxable portion of the Roth conversion is distributed out. This nonqualified distribution is subject to neither ordinary income tax nor the 10% early withdrawal penalty. See Treas. Reg. Section 1.408A-6 Q&A 1(b), 5(a), and 5(b). Check out Denzel’s 2024 Form 8606 Part III here.
There is some confusion on this latter result. Treas. Reg. Section 1.408A-6 Q&A 4 provides that only once all of the owner’s previous “contributions” have been withdrawn are nonqualified Roth IRA distributions subject to ordinary income tax. For this purpose, it is clear from reading Treas. Reg. Section 1.408A-6 Q&A 8(a) that “contributions” include both “annual contributions” and “Roth conversions.” See also Treas. Reg. Section 1.408A-6 Q&A 5(b) providing that the 10% early withdrawal penalty does not hit withdrawals of nontaxable converted amounts (“For purposes of applying the tax, only the amount of the conversion contribution includible in gross income as a result of the conversion is taken into account.”). Thus, the nontaxable portion of a Backdoor Roth IRA can be recovered tax and penalty free at any time for any reason.
Other than the minor potential Backdoor Roth IRA micro layer issue, a Backdoor Roth IRA could, in theory, serve as an emergency fund (though generally we want to plan for long term Roth IRA tax-free growth).
Roth IRA Distributions Summary Chart
Type of Distribution
Ordinary Income Tax
10% Early Withdrawal Penalty
Notes
Qualified Distribution
Never
Never
Main way to qualify: attain age 59 ½ and own Roth IRA for 5 years.
NQ Return of Annual Contributions
Never
Never
Comes out prior to returns of conversions and earnings.
NQ Return of Roth Conversions
Never
Can apply. Applies if the taxable conversion is less than 5 years old and the owner is under age 59 ½ (though exceptions can apply).
Come out only if all prior annual contributions and conversions have been withdrawn.
NQ stands for nonqualified
Exceptions to the 59 ½ Year Age Requirement
It is possible to qualify for a qualified distribution if one is younger than 59 ½ years of age. It happens if (1) the 5-Year Earnings Clock is satisfied and (2) the Roth IRA owner (i) is using the money for a first-time home purchase (limit of $10,000), or (ii) is disabled, or (iii) has died. See Treas. Reg. Section 1.408A-6 Q&A 1(b)(2). Outside of the owner’s death, these situations are rare.
Resources
Notice this post cites the to regulation and occasionally the Internal Revenue Code. That’s because they are the law of land! The Code is the primary law of the land, but it tends to be written in a manner inaccessible to most laymen and difficult for many professionals to understand. The regulations interpret the Code. While not an elementary school level read, Treas. Reg. Section 1.408A-6 is much more comprehensible than the Code. The regulation’s question and answer format makes it much easier to digest.
IRS Publication 590-B, Distributions from Individual Retirement Arrangements (IRAs), is an IRS publication. As such it is (i) informative and (ii) not binding authority on either the IRS or on taxpayers. Please understand both when using an IRS publication. I will note that Publication 590-B has an excellent flowchart (Figure 2-1) which can be used to help determine if a distribution from a Roth IRA is a qualified distribution.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
You know what gets too much attention in the personal finance space? The two five-year Roth IRA rules.
Why do I say that? Because the odds are extremely low that either rule will ever impact most Roth IRA owners. While the rules theoretically have wide effect, in practice, discussed further below, they rarely impact the taxation of Roth IRA distributions.
Before I get started, below is a summary table of the two five-year rules (or five-year clocks, use whichever terminology you prefer). The table is not comprehensive, but rather intended to cover the vast majority of situations. I hope you find this table to be a useful reference regarding the two five-year rules.
Rule
Tax Bite
Age
Code Section
Regulation
First Five-Year Rule
Ordinary income tax on withdrawal of earnings from Roth IRA only
Generally bites only if owner is over 59 ½ years old
First Five-Year Rule: Earnings Cannot Be Withdrawn Income Tax Free From a Roth IRA Unless the Account Holder has Owned a Roth IRA for Five Full Tax Years
At first, this rule seems daunting. As written, it applies to anyone owning a Roth IRA. But in practice, it rarely has any bite. First, the rule only serves to disqualify a distribution from being a “qualified distribution.”
Here’s the thing: outside of rare circumstances (see “Two Uncommon Situations” below), anyone under age 59 ½ cannot receive a “qualified distribution” from their own Roth IRA regardless of the first five-year rule.
Thus, as a general matter, the first five-year rule is a rule that only applies to those age 59 ½ and older.
For those doubting me, I’ll prove it with two examples:
Example 1: Ernestine turns age 25 in the year 2023. In March, she made a $6,500 annual contribution to a Roth IRA for the year 2023. This is her only ever Roth IRA contribution. In 2026, when the Roth IRA is worth $8,000 and Ernestine turns age 28, Ernestine withdraws all $8,000 from the Roth IRA. The first $6,500 is a nontaxable return of the $6,500 contribution, and the remaining $1,500 is a taxable distribution of earnings subject to both ordinary income tax and the 10 percent early withdrawal penalty.
Example 2: Hortense turns age 25 in the year 2023. In March, she made a $6,500 annual contribution to a Roth IRA for the year 2023. This is her only ever Roth IRA contribution. In 2030, when the Roth IRA is worth $8,000 and Hortense turns age 32, Hortense withdraws all $8,000 from the Roth IRA. The first $6,500 is a nontaxable return of the $6,500 contribution, and the remaining $1,500 is a taxable distribution of earnings subject to both ordinary income tax and the 10 percent early withdrawal penalty.
Ernestine did not satisfy the first five-year rule, Hortense did. Notice that it did not matter! Both must pay ordinary income tax and the 10% early withdrawal penalty on the $1,500 of earnings they each received from their Roth IRA. The first five-year rule had absolutely no impact on the taxation of the withdrawal because both Roth IRA owners are under age 59 ½. This proves that outside unusual circumstances, the first five-year rule has no impact on those under age 59 ½.
I’ve said it before and I’ll say it again: Previous annual contributions to a Roth IRA can be withdrawn from a Roth IRAtax and penalty free at any time for any reason! The first five-year rule has nothing to do with withdrawals of previously made contributions. See Treas. Reg. Sec. 1.408A-6 Q&A 1(b) (previous contributions are withdrawn tax free) and Q&A 5(a) (tax free withdrawals of previous regular annual contributions are not subject to the 10% early withdrawal penalty).
So when the heck does the first five-year rule matter? Here are two examples to help us figure it out.
Example 3: Ernie turns age 58 in the year 2023. In March, he made a $7,500 annual contribution to a Roth IRA for the year 2023. This is his only ever Roth IRA contribution. In 2026, when the Roth IRA is worth $10,000 and Ernie turns age 61, Ernie withdraws all $10,000 from the Roth IRA. The first $7,500 is a nontaxable return of the $7,500 contribution, and the remaining $2,500 is a taxable distribution of earnings subject to ordinary income tax. Ernie does not pay the 10 percent early withdrawal penalty because he is over age 59 ½ when he receives the earnings.
Example 4: Harry turns age 58 in the year 2023. In March, he made a $7,500 annual contribution to a Roth IRA for the year 2023. This is his only ever Roth IRA contribution. In 2030, when the Roth IRA is worth $10,000 and Harry turns age 65, Harry withdraws all $10,000 from the Roth IRA. As Harry satisfies both the first five-year rule and is over age 59 ½, the entire $10,000 distribution is a qualified distribution and thus entirely tax and penalty free.
We’ve found where the first five-year rule matters! Generally speaking, the first-five year rule only bites when applied to a distribution of earnings if the recipient is over the age of 59 ½. Further, it only applies to subject the earnings to ordinary income tax, not the 10% early withdrawal penalty (as being age 59 ½ or older is always a valid exception to the early withdrawal penalty).
Remember, though, in most cases it is difficult to access Roth IRA earnings. Why? Because earnings come out of a Roth IRA last. Ernie’s fact pattern is rare. Many Roth IRA owners will have years of contributions and/or conversions inside their Roth IRA. As I have previously discussed, nonqualified distributions from Roth IRAs first access Roth IRA contributions and then access Roth IRA conversions before they can access a penny of earnings. See also Treas. Reg. Sec. 1.408A-6 Q&A 8 and Natalie B. Choate’s Life and Death Benefits for Retirement Planning (8th Ed. 2019), page 328.
Further, in today’s world, most (though not all) 59 ½ year old Roth IRA owners will satisfy the five-year rule. All Roth IRAs are aggregated for this purpose, so the funding (through a contribution or conversion) of any Roth IRA starts the five-year clock as of January 1st of the year for which the contribution was made. See Treas. Reg. Sec. 1.408A-6 Q&A 2.
Two Uncommon Situations: There are two uncommon situations in which a Roth IRA owner under age 59 ½ receiving a Roth IRA distribution could save the ordinary income tax by satisfying the first five-year rule. The first is the taking of an up-to $10,000 first-time home buyer distribution. See Choate, previously referenced, at page 612. The second is if the owner is disabled as defined by Section 72(m)(7). Both are rare situations. Further, in both such cases, satisfying the first five-year rule would be irrelevant if the distribution would have been a return of contributions, nontaxable conversions, and/or taxable conversions at least 5 years old.
Inherited Roth IRA Twist: The first five-year rule can affect distributions from an inherited Roth IRA. I’ve heard this referred to as the third Roth IRA five-year rule, but I view it as simply a continuation of the first five-year rule. A withdrawal of earnings by a beneficiary from an inherited Roth IRA made less than five tax years after the owner originally funded the Roth IRA is subject to ordinary income tax. See Treas. Reg. Sec. 1.408A-6 Q&A 7. These situations are quite rare.
If Anyone on Capitol Hill is Reading This . . .
The first five-year rule serves no compelling purpose, and is superfluous as applied to most taxpayers under the age of 59 ½.
Perhaps in 1997 Congress worried about quick withdrawals from Roth IRAs. Now that we fully understand that contributions and conversions come out of Roth IRAs first, and that being under age 59 ½ prevents a tax-free distribution of earnings in most cases, there’s no reason for the first five-year rule. Being age 59 ½ or older (or death, disability, or first-time home buyer) should be sufficient to receive a qualified distribution.
Second Five-Year Rule: Taxable Conversions Are Subject to the Ten Percent Early Withdrawal Penalty if Withdrawn from the Roth IRA Within Five Taxable Years
This rule is much more logical than the first five-year rule. The reason has nothing to do with Roth IRAs. Rather, the reason is to protect the 10% early withdrawal penalty as applied to traditional IRAs and traditional workplace plans such as 401(k)s and 403(b)s. Without the second five-year rule, taxpayers would never pay the 10% early withdrawal penalty.
Rather, taxpayers under age 59 1/2 would simply convert any money they want to withdraw from a traditional retirement account to a Roth IRA, and then shortly thereafter withdraw the amount from the Roth IRA tax-free as a return of old contributions or of the conversion itself.
The second five-year rule prevents the total evisceration of the 10% early withdrawal penalty.
The second five-year rule applies separately to each taxable Roth conversion. Each Roth conversion that occurs during a year is deemed to occur January 1st of that year for purposes of the second five-year rule. See Treas. Reg. Sec. 1.408A-6 Q&A 5(c).
Note further that the second five-year rule has nothing to do with income tax: its bite only triggers the distribution being subject to the 10% early withdrawal penalty.
When Might the Second Roth IRA Five-Year Rule Apply
I am not too worried about the application of the second five-year rule. Here’s why.
First, the second five-year rule is not likely to apply while one is working. During the accumulation phase, many are looking to contribute to, not withdraw from, Roth IRAs.
Second, for those retiring after age 59 ½, the second five-year rule will have practically no impact, as (i) they are not likely to take pre-retirement distributions from their Roth IRA, and (ii) distributions taken from the Roth IRA by the owner after turning age 59 ½ are never subject to the 10% early withdrawal penalty.
Third, many early retirees will choose to live off taxable assets first in early retirement. As a result, many will not access Roth accounts until age 59 ½ or later, and thus the second five-year rule will not be relevant.
However, some will choose to employ a Roth Conversion Ladder strategy with respect to an early retirement. Here the second five-year rule might bite. Let’s consider a quick example:
Example 5: Josh is considering retiring in 2024 when he turns age 50. In his 30s, he qualified to make an annual Roth IRA contribution and maxed out his Roth IRA each year. In his 40s, he made income in excess of the annual MAGI limits on Roth IRA contributions, so he maxed out the Backdoor Roth IRA for each year. He plans on living on taxable assets for the first five years of retirement and then living off Roth conversion ladders from age 55 through age 59 ½. Josh has never previously taken a distribution from a Roth IRA.
If Josh started withdrawing from his Roth IRA in 2024, he would first withdraw all $45,500 of previous annual contributions (all tax and penalty free) and then withdraw all $33,510 of his 2014 through 2019 Backdoor Roth IRAs (all tax and penalty free) before he could take a distribution with respect to which the second five-year rule could bite.
Note that for withdrawals of up to $79,010, it is irrelevant that Josh does not satisfy the second five-year rule with respect to the 2020 through 2023 Backdoor Roth IRAs. Josh can withdraw up to $79,010 entirely tax and penalty free in 2024. Perhaps the second five-year rule’s bark is worse than its bite . . .
If, in 2024, Josh withdraws both of the above listed amounts from his Roth IRA, then yes, the next $2 of withdrawals in 2024 would be from the $2 taxable amount of his 2020 Backdoor Roth IRA, which would be subject to the 10% early withdrawal penalty ($0.20) under the second five-year rule.
In Josh’s extreme example, the second five-year rule bites, but, as you can see, it barely bites!
As an aside, assuming Josh continues to withdraw money from his Roth IRA in 2024, the next $6,000 is a tax and penalty free return of the non-taxable portion of his 2020 Backdoor Roth IRA! See Treas. Reg. Sec. 1.408A-6 Q&A 8. The generosity of the Roth IRA nonqualified distribution rules is, by itself, a reason not to sweat the two Roth IRA five-year clocks too much.
Assuming Josh follows through with his plan and waits until age 55 (the year 2029) to start withdrawing from his Roth IRA, he can access all of his 30s Roth IRA annual contributions ($45,500), all of his 40s Backdoor Roth IRAs ($57,519), and whatever amount he converted to his Roth IRA in 2024 tax and penalty free in 2029! After that, however, the second five-year rule will bite ten cents on the dollar for amounts additionally distributed in 2029, since amounts converted in 2025 or later would still be subject to the second five-year rule if distributed in 2029.
In Josh’s early retirement example, assuming Josh takes no distributions from his Roth IRA until age 55, the second five-year rule can only possibly bite from age 55 to 59 ½, and even then, the combination of years of built up Roth basis and affirmative planning make that possibility at least somewhat remote.
Don’t over think it: If the owner of a Roth IRA is 59 1/2 years old or older, and has owned a Roth IRA for at least 5 years, all distributions they receive from a Roth IRA are qualified distributions and thus fully tax and penalty free. In such circumstances, the 5-year clocks are entirely irrelevant.
Conclusion
It’s perfectly cromulent to proceed with financial planning without too much worry about the two Roth IRA five-year rules. For personal finance nerds (myself included), the two Roth IRA five-year clocks can be fun to dive into. But from a practical standpoint, they rarely impact the taxation of distributions from Roth IRAs. The two five-year clocks are best understood as sporadically applicable exceptions to the general rule that most nonqualified distributions from Roth IRAs are tax and penalty free.
Further Reading
For even more on Roth IRA distributions, please read this post, which goes through the details of Roth IRA distributions, including citations to the relevant regulations and links to three example Forms 8606 Part III.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
This post, and the above mentioned podcast episode, are 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.
Considering the HSA is less than 20 years old (as of this writing) and contribution limits are relatively modest, inherited HSAs have not been much of an issue in the personal finance world. I suspect that will soon change, as HSAs and their account owners age and HSA balances grow.
HSA Planning
There is something very fundamental one must keep in mind: planning for traditional retirement accounts and Roth retirement accounts is two sided. There is planning that owners should do for those retirement accounts prior to death and there is planning that inheriting beneficiaries should do after the owner’s death.
HSA planning, as you will see below, is mostly prior to the owner’s death. Other than a spouse, anyone else inheriting an HSA has relatively few planning opportunities.
Spousal Beneficiaries
The tax rules generally favor spousal beneficiaries, and the world of HSAs is no different. Section 223(f)(8)(A) has a very specific rule that changes the HSA account owner to the spouse as of death. This means the continuation of HSA account status, and thus continued tax free growth and future tax free withdrawals for payments of qualified medical expenses and for payments of previously unreimbursed qualified medical expenses (what I refer to as PUQME, pronounced “puck-me”).
Obviously, HSA tax-free carryover treatment is very favorable. It is difficult to imagine circumstances where a married HSA owner would want to name anyone other than their spouse as the 100 percent primary beneficiary of their HSA. In theory, leaving an HSA to a charity at the first spouse’s death could be neutral when compared to leaving to the surviving spouse, if the couple is both very affluent and charitably inclined. Even then, it’s hard to see much of a drawback to naming the spouse as the primary beneficiary.
Other Individuals
Section 223(f)(8)(B) has some bad news for an individual, other than the surviving spouse, inheriting an HSA. Sure, they get the assets in the HSA. But, (i) the account loses its status as an HSA, and (ii) even worse, the entire amount of the HSA is included in the recipient’s taxable income in the year of the original owner’s death.
This is the hidden HSA death tax. As the HSA is under 20 years old, and frequently owed by younger people, the issue of the hidden HSA death tax has not come to the forefront of the personal finance space. To my mind, this is a lurking issue that many aren’t aware of.
The tax hit from an HSA inheritance could be quite significant. Here is one theoretical example.
Jack and Meghan are married, both age 51 in 2023, file joint, and claim the standard deduction. Planning on having an AGI of approximately $155K for 2023, they each contributed $7,500 to a Roth IRA for 2023 on January 2, 2023. They have one child in college and thus plan on getting a $2,500 AOTC tax credit for tuition paid.
On September 2, 2023, Meghan’s widowed father died and left his HSA, worth $75K, to Meghan. As a result, their AGI increases by $75K. On March 1, 2024, informed by their tax return preparer they did not qualify to make the Roth IRA contributions, they withdrew the contributions and the earnings attributable to the contributions ($750 each based on 10 percent growth). They also lose the ability to claim a credit for the college tuition they paid.
Here’s the tax consequences of Meghan inheriting the HSA.
Item
W/o HSA Inheritance
With HSA Inheritance
Ordinary Income (Initial)
$153,000
$153,000
Qualified Dividend Income
$2,000
$2,000
AGI (Initial)
$155,000
$155,000
HSA Inheritance
$0
$75,000
Roth IRA Earnings
$0
$1,500
AGI
$155,000
$231,500
Standard Deduction
$27,700
$27,700
Taxable Income
$127,300
$203,800
Tentative Tax
$18,481
$35,572
AOTC
$2,500
$0
Federal Income Tax
$15,981
$35,572
Federal Tax Increase
$0
$19,591
Effective Rate on AGI
10.31%
15.37%
The tax hit on inheriting the HSA is almost $20,000! Jack and Meghan pay more federal income tax on inheriting the HSA than they do on the rest of their income! Further, because tax benefits such as being able to contribute to a Roth IRA and AOTC qualification are based on MAGI, and inherited HSA income increases MAGI, Jack and Meghan (i) lost their 2023 AOTC and (ii) had to withdraw $15,000 in 2023 Roth IRA contributions and the related earnings.
Deduction Planning: Yes, Jack and Meghan could potentially tax loss harvest(getting a current deduction of up to $3,000) and/or increase contributions to charities and/or donor advised funds to itemize their deductions in a year they are now in the 24% bracket. This planning is only marginally helpful (particularly in a high standard deduction world) and does not lower their MAGI sufficient to still qualify for the AOTC and to make most of the annual Roth IRA contributions. Further, if Meghan inherited the HSA late in the year, there may not be enough time to execute such planning.
Inherited HSA Tax Exception
There is a narrow exception to full income inclusion. The inheriting non-spouse beneficiary can reduce the inherited HSA income inclusion by the amount of medical expenses incurred by the original owner prior to death and paid by the inheriting beneficiary in the year after the death.
The Estate
In theory, an HSA could be left to the estate of the HSA owner if (i) the owner elected such treatment on the beneficiary designation form or (ii) they failed to file a beneficiary designation form with the HSA provider.
The original owner’s final income tax return must include the fair market value of the HSA in taxable income if the HSA is left to the estate. See IRS Publication 969, page 10.
Obviously, this is not a great result. In theory, if the owner is low income and the ultimate intended beneficiary is high income, one might want to name their estate as the beneficiary of the HSA. Considering that the are planning alternatives that can avoid anyone paying income tax on an HSA, this is not likely to be a good “go-to” planning option.
Charitable Beneficiaries
Many HSA owners are at least somewhat charitably inclined. The inherited HSA rules present a planning opportunity: leave HSA balances to charity if the HSA owner is not married. Charities pay no income tax when inheriting an HSA.
As discussed above, the optimal planning for a charitably inclined married couple is likely to be to name the spouse as the primary beneficiary. Only after the death of the first spouse would the primary beneficiary be changed to the charity.
Note that HSA owners should discuss naming a charity or charities as a primary or secondary beneficiary with their HSA account provider.
Later In Life HSA Planning
What could Meghan’s widowed father have done to avoid costing his daughter and son-in-law almost $20,000 in federal income taxes?
First, strong consideration should be given to bailing out HSAs during old age, particularly if the HSA owner is not married. HSAs will not be too difficult to deplete tax and penalty free. Reimbursements of PUQME can access thousands of dollars of old qualified medical expenses, and the elderly will have plenty of new qualified medical expenses, including final medical expenses of deceased spouses. Further, Medicare Parts B and D premiums qualify as qualified medical expenses, so even the healthy elderly should be able to reimburse themselves tax-free from their HSA annually for some qualified medical expenses.
Had Meghan’s father reimbursed himself tax-free for PUQME instead of leaving the money inside the HSA, Meghan could have inherited the money (now in a taxable account) income tax free.
Second, Meghan’s widowed father could have named a charity as the primary beneficiary on the HSA, and left taxable brokerage accounts, Roth retirement accounts, and even traditional retirement accounts to Meghan. Even the traditional retirement accounts would not have either created no taxable income to Meghan in 2023, or, at worst, would have required Meghan to take the RMD her father was required to take in 2023 (if her father died before taking it).
I recently wrote about strategic planning in this regard. If one is not married, accounts such as Roth IRAs and taxable brokerage accounts are great to leave to individual beneficiaries. HSAs are great for unmarried people to leave to a charity if one is charitably inclined.
Conclusion
HSAs are arguably the most tax favored accounts during one’s lifetime. This remains true when passing an HSA to a spouse. However, the tax advantage of an HSA can turn into a tax bomb if left to a non-spouse. I refer to this as the hidden HSA death tax.
Planning to avoid the hidden HSA death tax includes taking reimbursements of PUQME from the HSA later in life and/or naming a charity as the primary beneficiary on an HSA if the owner is not married.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, investment, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
Inherit a Roth IRA in 2023 or later? Thinking about leaving a Roth IRA to heirs at your death? Then this article is for you. Note that it is an educational resource. It is not advice for any individual’s particular situation. Further, this article does not address situations where a person inherited a Roth IRA prior to the year 2023.
Inheriting a Roth IRA is great, since distributions are always penalty free and tax-free 99.99% of the time. The only time a distribution from a non-spousal inherited Roth IRA could be subject to income tax is if the distribution is a distribution earnings from the Roth IRA prior to the passage of 5 years from January 1st of the year the original owner first contributed to a Roth IRA. See Treas. Reg. Section 1.408A-6 Q&A 1(b). As a practical matter, few distributions from inherited Roth IRAs will be both (i) earnings of the inherited Roth IRA and (ii) made prior to the end of the five year clock.
Said differently, both the original owner and the beneficiary would have to be incredibly unlucky in order for a beneficiary to pay federal income tax on an inherited Roth IRA distribution.
In theory, a spouse inheriting a Roth IRA could pay tax and/or a penalty on distributions from an inherited Roth IRA the spouse treated as their own, but even that occurrence is likely to be rare, as discussed in more detail below.
Terminology and Titling
One inheriting a Roth IRA is a beneficiary. Yes, that inherited Roth IRA is now your property, but you are not the “owner” from a tax perspective. The original owner is the owner. You, the inheritor, are the beneficiary. If you die, the person inheriting the Roth IRA you inherited is a successor beneficiary.
Upon the owner’s death, the beneficiary should work with the Roth IRA’s financial institution to retitle the Roth IRA. The titling should indicate that the beneficiary is a beneficiary and should reference the owner.
The above two paragraphs are not the case as applied to spouses who choose to treat an inherited Roth IRA as their own. In that case, the inheriting spouse becomes the owner, not the beneficiary.
Types of Beneficiaries
To my mind, there are generally seven types of Roth IRA beneficiaries. Below, I use my own colloquialisms for each. You will not find the term “10-year beneficiary” in the Internal Revenue Code or the IRS website, for example. Rather, it is simply a term I colloquially use to refer to a particular type of inherited Roth IRA beneficiary.
To understand what happens when one inherits a Roth IRA, one must first understand what type of beneficiary they are among the below seven categories.
Watch me discuss Inherited Roth IRAs on YouTube.
Spouses
Spouses are generally favored inherited Roth IRA beneficiaries from a tax planning perspective. Married individuals should think long and hard prior to naming someone other than their spouse as their Roth IRA primary beneficiary for many reasons, including tax planning.
There are three options a spouse has when inheriting a Roth IRA. Two of those options entail the inherited IRA being treated as the inheriting spouse’s own Roth IRA. This is usually advantageous for several reasons, including the fact that an owner is never subject to required minimum distributions (“RMDs”) with respect to their own Roth IRA. Practically speaking, this is how most inherited Roth IRAs are handled by spouses.
SECURE 2.0 added a new fourth option for spouses to be treated as the deceased spouse when inheriting a retirement account. This change appears to matter as applied to RMDs, which the Roth IRA never has for an owner. Thus, I do not believe this change impacts spouses inheriting Roth IRAs to any significant degree.
The inheriting spouse could treat the inherited Roth IRA as an inherited account (i.e., become a beneficiary instead of being the owner). Practically speaking, an inheriting spouse would only consider this if they are under 59 ½ years old and they believe it is likely they would need to access earnings in their Roth IRAs (including the inherited accounts) prior to age 59 ½.
One potential planning option for the spouse is to roll the decedent spouse’s Roth IRA to an inherited Roth IRA and later (presumably at age 59 ½) roll it into their own Roth IRA. See Choate, referenced below, page 225. This offers the inheriting spouse protection as it allows him or her to access Roth earnings tax-free prior to the spouse turning age 59 ½ and then later avoids RMDs to the spouse (see discussion of that possibility below).
In Proposal 10 of my retirement tax reform proposal, I offer suggestions to simplify the treatment when spouses inherit retirement accounts.
RMD Beneficiaries
The SECURE Act set up a new standard to be an RMD beneficiary (what the SECURE Act termed an “eligible designated beneficiary”). Some practitioners use the term “EDB” for these beneficiaries, but I prefer the term “RMD beneficiary” because these are the beneficiaries that are allowed to (i) avoid the new 10-year rule discussed below and (ii) withdraw from the inherited Roth IRA RMDs based on their own remaining life expectancy.
Who qualifies as an RMD beneficiary? These include:
A spouse electing to treat the inherited Roth IRA as an inherited Roth IRA
Any individual not more than 10 years younger than the owner (think parents and adult siblings, but it can be others)
Anyone chronically ill or disabled
An RMD beneficiary must start taking RMDs from the inherited IRA in the year after the owner died. He or she goes to the IRS Single Life Table and finds the factor for their age in the year following the owner’s death. The RMD for that first year is the prior-year end-of-year account balance divided by that factor. The following year’s RMD is the prior-year end-of-year account balance divided by the first year’s factor minus one. See Choate, referenced below, at pages 67-68 and 73-74. Here’s an example of how it works.
Jack died on December 1, 2023. He was 65 at his passing. He leaves his Roth IRA to his brother Jim. In 2024, Jim turns 62. Jim is an RMD beneficiary and should* take an RMD based on his IRS Single Life Table factor at age 62, 25.4. If the inherited Roth IRA balance on December 31, 2023 is $500,000, Jim’s 2024 inherited Roth IRA RMD is $19,685.04 ($500,000 divided by 25.4). If the balance in the inherited Roth IRA is $510,000 on December 31, 2024, Jim’s 2025 RMD is $20,901.65 ($510,000 divided by 24.4). Jim takes annual RMDs in a similar fashion in subsequent years.
As Natalie Choate notes in her treatise referenced below (see page 74), Jim only looks at the IRS Single Life Table once: for the first RMD year. After that, he simply subtracts 1 from the factor every year. Thus, those using the Single Life Table only look at it a single time.
*Note that an RMD beneficiary can, instead of taking RMDs, elect the 10-year rule discussed below. See Choate supplement, page 12, Andy Ives at IRAHelp.com, and Ian Berger at IRAHelp.com. In many cases, I suspect taking relatively modest tax-free RMDs will facilitate more tax-free growth than avoiding RMDs and emptying the inherited Roth IRA within 10 years. This is because taking RMDs allows a large portion of the inherited Roth IRA to survive well beyond 10 years in cases where the beneficiary is not themselves rather elderly. That said, the older the beneficiary is, the more likely electing into the 10-year rule is to be advantageous. It is not clear how the beneficiary makes the election (see Choate supplement, page 50), though presumably failing to take RMDs would do it.
Spouses electing beneficiary treatment (which is RMD beneficiary treatment in their case) are generally not required to take the annual RMD until the later of (i) the year after the decedent spouse’s death or (ii) the year the decedent spouse would have reached age 72. See Choate, referenced below, page 97, Prop. Reg. Section 1.401(a)(9)-3(d) on page 109 of this PDF file (also see Prop. Reg. Section 1.408-8(b)(2)(ii) on page 253 of the PDF file).
Successor Beneficiaries
Successor beneficiaries of RMD beneficiaries must, in most cases, empty the inherited Roth IRA by the end of the 10th calendar year following the RMD beneficiary’s death.See Natalie Choate supplement page 43 and Prop. Reg. Section 1.401(a)(9)-5(e)(3) on page 142 of this PDF file. Update August 4, 2023: In addition to being subject to the 10-year rule, the successor beneficiary must continue to take the annual RMDs the RMD beneficiary would have been required to take had they lived. See Natalie Choate supplement page 51.
Update July 10, 2023: Sarah Brenner of IRAHelp.com raises an interesting possibility. What if the RMD beneficiary elects the 10-year rule? If that happens, the successor beneficiary must empty the inherited Roth IRA by the end of the 10th year after the original owner’s death!
Minor Children of the Owner
If a minor child of the owner inherits a Roth IRA, he or she gets to take RMDs for all the years through the year he or she turns 21. Then the inherited Roth IRA must be emptied by the end of the 10th calendar year following the beneficiary turning age 21. See Prop. Reg. Section 1.401(a)(9)-5(e)(4) on pages 142-43 of this PDF file. Update September 11, 2023: the minor child starting the RMDs prior to turning age 21 triggers RMDs during the later 10-year period.
This treatment is quite favorable considering the relatively low RMDs during one’s youth, as the RMD is based on their relatively long life expectancy.
The only children qualifying for this treatment are the children of the owner. Grandchildren, nieces, nephews, etc. will not qualify, and in most cases will be 10-year beneficiaries. These children could qualify for RMD beneficiary treatment if they are chronically ill or disabled.
Note that technically minor children of the owner qualify as “eligible designated beneficiaries” but since the treatment they receive is, to my mind, quite different from the treatment RMD beneficiaries receive, I mentally carve them out as their own distinct category.
Successor Beneficiaries
Natalie Choate observes on page 43 of her supplement that in the case of a minor-child RMD beneficiary, the successor beneficiary must empty the account by the earlier of (i) the end of the 10th full year following the minor-child’s death or (ii) the end of the 10th full year following the former minor child turning age 21. Update August 4, 2023: If the minor-child beneficiary dies while collecting RMDs, it appears the successor beneficiary would also be subject to annual RMDs using the decedent minor-child’s life expectancy during the 10-year time frame.
10-year Beneficiaries
10-year beneficiaries are those individuals who are not spouses, minor children of the owner, and RMD beneficiaries. They are everyone else. From a practical perspective, most 10-year beneficiaries are the adult children of the owner.
10-year beneficiaries are not subject to RMDs. However, they must empty the inherited Roth IRA by the end of the 10th year following death. From a purely tax planning perspective, the beneficiary will want to leave the money inside the inherited Roth IRA and withdraw the money in December of the 10th full year following the owner’s death to get as much tax-free growth out of the inherited Roth IRA as possible. Of course, distributions prior to the end of the 10th year are permitted, and, as discussed above, should be tax-free in practically all cases.
Successor Beneficiaries
Successor beneficiaries of 10-year beneficiaries must empty the inherited Roth IRA by the end of the 10th calendar year following the owner’s death. See Prop. Reg. Section 1.401(a)(9)-5(e)(2) on page 142 of this PDF file. Thus, the death of a 10-year beneficiary does not extend the time to empty an inherited Roth IRA.
Estates
A pulse is worth at least 5 years of tax-free growth!
Roth IRAs can be left to one’s own estate, but generally speaking, they should not be. In order to qualify for the 10-year rule or better treatment (see the first four categories of beneficiaries), the beneficiary designation form must leave the Roth IRA to a human being. Estates can become the Roth IRA beneficiary if no beneficiary designation form is filed, or if the filed beneficiary designation form names the estate as the beneficiary. When an estate inherits a Roth IRA, the inherited Roth IRA is subject to a 5-year payout rule. See Choate, referenced below, pages 77 and 104.
If left to one’s estate, the Roth IRA must be paid out by the end of the fifth full calendar year following death. See Choate supplement page 100. This is true even if the estate will ultimately pay the money out to actual humans who could have, on their own, qualified as 10-year beneficiaries, RMD beneficiaries, and/or spousal beneficiaries.
Trusts
If you want to see some tax complexity, look at inherited retirement accounts and trusts. Trusts themselves often have human beneficiaries, but the trust mechanism is used to protect the beneficiary and/or the assets inside the trust. There are valid reasons to name a trust as a retirement account beneficiary (usually surrounding the nature of the potential beneficiaries), but naming a trust should not be done lightly.
The tax risk is that the inherited Roth IRA will be subject to the 5-year rule. Properly structured (including the provisions required by Treas. Reg. Sec. 1.401(a)(9)-4 Q&A 5(b)), the human beneficiaries of the trust can qualify for the applicable treatment offered by one of the first four categories of beneficiary. However, if the trust is not properly structured, the trust and the human beneficiaries of the trust will be subject to the 5-year rule and lose out on 5 or more years of tax-free growth.
Charities
A charity must take an inherited Roth IRA in 5 years, but it does not care, as it is not generally subject to income tax. From a planning perspective, Roth IRAs are the assets that are least advantageous to leave to charity. Your human heirs like to inherit Roth accounts and generally would prefer to inherit a Roth over an account such as a traditional IRA or a HSA. Here’s an example of how that could play out.
Walter, age 80, is a widow and has one adult son, Paul, age 50. Walter has the following assets:
Asset Location
Amount
Roth IRA
$100,000
Taxable Brokerage
$100,000
Traditional IRA
$50,000
HSA
$50,000
Total
$300,000
Walter intends on leaving two-thirds of his assets to Paul and one-third of his assets to his Catholic parish, a 501(c)(3) charitable organization. From Paul’s perspective, he’d prefer to inherit the $100,000 Roth IRA (10 more years of tax-free growth, no income tax and full step up in basis when the assets are distributed to him) and $100,000 taxable brokerage (no income tax and full step up in basis). Paul would prefer that the $100,000 left to the parish be the $50,000 traditional IRA (which would be taxable to Paul through RMDs and the 10-year rule) and the $50,000 HSA (which is immediately fully taxable to Paul in the year of Walter’s death if Paul inherits).
Why waste the Roth’s step-up in basis, tax-free treatment, and 10 years of additional tax-free growth on a charity when you can give the charity assets that are otherwise less favorable to the human beneficiary (the traditional IRA and the HSA)?
Planning
For Owners
Retirement account owners may want to think about inter-generational planning, for two reasons. First, if the owner is in a relatively low marginal tax bracket, and their beneficiaries (perhaps successful adult children) are in relatively high marginal tax brackets, they may want to think about Roth conversions during their lifetimes to move money from traditional retirement accounts to Roth IRAs. This can reduce the income tax paid with respect to the traditional retirement accounts. Second, it eliminates the chance that adult children could be subject to both the 10-year rule and to RMDs (see this article for more details).
Any planning in this regard should consider that tax planning for one’s adult children is a second order planning priority. The first planning priority should be the financial success of the retirement account owner. His or her financial success should be prioritized ahead of tax planning geared toward a better result for one’s adult children.
For Beneficiaries
Generally speaking, beneficiaries and successor beneficiaries will want to leave funds inside an inherited Roth IRA for as long as possible. For many in a SECURE Act world, that will be 10 years following the end of the year of death. Here’s a quick example of how that works: Joe dies on August 1, 2023. His 10-year beneficiary has until the end of the 10th year following his death, December 31, 2033, to empty the Roth IRA he inherits from Joe.
Of course, tax is just one consideration. If the money is needed sooner than that, at least the beneficiary knows that the distribution is tax-free in all but the rarest of situations.
As discussed above, beneficiaries should understand how long the owner had any Roth IRA. Once the beneficiary is sure 5 years have passed since January 1st of the year of the original owner’s first contribution, he or she can take Roth earnings out of the inherited Roth IRA and know that it is tax free. Even if the Roth IRA is less than 5 years old, the beneficiary can take old contributions and conversions tax free. Such amounts come out first under the ordering rules prior to the removal of any earnings.
The IRS and Treasury issued controversial proposed regulations on the SECURE Act in 2022. Fortunately, those proposed regulations do not require RMDs with respect to 10-year beneficiaries of inherited Roth IRAs. Jeffrey Levine wrote a great blog post on the proposed regulations here.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, investment, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, investment, and tax matters. Please also refer to the Disclaimer & Warning section found here.
Below I’ll discuss the ins and outs of the new SECURE 2.0 529-to-Roth IRA rollover provision. While an understanding of the details is great, the more important issue is this: does this new rule fundamentally change financial decision making and planning?
UPDATE 1 March 1, 2024: There are now significant doubts as to the validity of SECURE 2.0, including the 529-to-Roth IRA rollover provision. See my YouTube video on a very important court decision that puts SECURE 2.0 on very shaky ground (though it is still the law of the land as of March 1, 2024).
UPDATE 2 March 1, 2024: As of now, the IRS and Treasury have not issued significant guidance on the 529-to-Roth IRA Rollover. Thus, many questions remain on how it works.
529-to-Roth IRA Rollover Introduction
SECURE 2.0 has a special rule (see Section 126 on page 2161), first effective in 2024, allowing a tax-free transfer of money inside a 529 to a Roth IRA. This provision has been met with some unbridled enthusiasm that, to my mind, should be scaled back.
Before we get started, it’s important to note that (i) this is a very new rule and (ii) at any time the IRS and Treasury could issue guidance concerning this new rule. For both those reasons, everything discussed in this post is subject to change.
The above said, let’s discuss the parameters of this new rule, adding in the context of the already existing Section 529 rules.
First, consider the statutory definition of a 529. From Section 529(b)(1)(A)(ii): an account which is established for the purpose of meeting the qualified higher education expenses of the designated beneficiary of the account.
A program shall not be treated as a qualified tuition program unless it provides adequate safeguards to prevent contributions on behalf of a designated beneficiary in excess of those necessary to provide for the qualified higher education expenses of the beneficiary.
To my mind, the combination of these two rules* and how the IRS views them in a new environment where money can go tax-free from a 529 to a Roth IRA tamps down on any affirmative planning to stuff 529s with a primary purpose of getting money into Roth IRAs. I would not be surprised to see the IRS and Treasury come out with regulations more explicitly prohibiting stuffing 529s in this way.
What I believe is very much allowed is parents rounding up when funding a child’s 529. The above-cited Section 529 language should not be read to require parents to be conservative when funding 529s. Future higher education expenses are quite speculative. What will future college tuition be? Will the child go to grad school? Will the child graduate undergrad 3 years, 4 years, or 5 years? Will the child get scholarships?
529-to-Roth IRA Rollover Details
First, the rule provides that, in any year, the beneficiary of the 529 can be given up to the annual maximum allowed Roth IRA contribution as a Roth IRA contribution from the 529. If done, the contribution from the 529 becomes the beneficiary’s annual Roth IRA contribution for the year. Thus, this new rule does not create additional Roth IRA limits for the beneficiary.
One advantage is that the contribution is not subject to the Roth IRA MAGI limits. This advantage is not all that great, considering most young adult beneficiaries will not earn income exceeding the Roth IRA MAGI limits. Even if the beneficiary is very high income, he or she may be able to use the Backdoor Roth IRA to get around the MAGI limits.
Second, in order to execute this maneuver, the 529 must be at least 15 years old, and the amount contributed is limited to the amount of contributions (and earnings attributable to those contributions) occurring at least 5 years prior to the transfer to the Roth IRA. The 5 year rule defeats the idea of “oh, my daughter’s a senior in college, let me contribute $30K to her near-empty-529 and now have runway to make 5 annual Roth IRA contributions for her for her first 5 years after college graduation.”
Third, the total that can be transferred to the beneficiary’s Roth IRA is $35,000. The $35,000 is not adjusted for inflation, significantly limiting the benefit of this new rule.
As a planning tool, this technique is quite limited because the technique does not create any new Roth IRA contribution limitation. The new rule does not, generally speaking, increase Roth IRA contribution limits. Further, parents thinking of supporting young adult children can simply gift their adult children their annual Roth IRA contribution out of Mom and Dad’s bank account.
529 Rollovers as Roth Contributions and Roth Earnings
The new 529-to-Roth IRA maneuver preserves earnings in the 529 as “earnings” inside the Roth IRA. I refer to this as the “earnings-to-earnings rule.” This impacts how any future nonqualified withdrawals are made from the Roth IRA. From the now adult child’s perspective, a regular annual Roth IRA contribution is better than a 529-to-Roth rollover, because the 529-to-Roth rollover limits how much of the contribution is easily withdrawn as a return of prior contributions.
Here are two examples to illustrate the concept:
Example 1: Mark graduated college and started his first full time job in 2024. He contributes $6,500 to a Roth IRA for 2024. If Mark ever has an emergency, he can withdraw the $6,500 from the Roth IRA at any time for any reason tax and penalty free.
Example 2: Julile graduated from college and started her first full time job in 2024. Her father named her the beneficiary of a 529. Assuming the 15 year rule and the 5 year rule are satisfied, her father can direct $6,500* from the 529 to Julie’s Roth IRA for 2024. At the time of the transfer, the 529 consisted of $30,000, $15,000 of previous contributions and $15,000 of earnings. The $6,500 goes into the Roth IRA as $3,250 of contributions and $3,250 of earnings. Assuming Julie has made no other Roth IRA contributions, the most she can withdraw from the Roth IRA tax and penalty free for any reason prior to age 59 1/2 is $3,250.
*Note the 2024 Roth IRA contribution limits have not been published as of this writing. This uses the 2023 contribution limit as the 2024 contribution limit for illustrative purposes only.
The earnings-to-earnings rule makes sense to (somewhat) protect the 529 earnings rule. If 529 rollovers went into Roth IRAs entirely as contributions, the 529-to-Roth maneuver could be used to bail out 529 earnings by rolling to a Roth IRA and then immediately withdrawing, taking advantage of the Roth IRA nonqualified withdrawal rules to get the 529 earnings out tax free.
The above said, the hope for most receiving the benefit of the 529-to-Roth IRA rollover is that they do not make withdrawals from their Roth IRA for many years, making the new earnings-to-earnings rule mostly academic.
Sean’s Take
So how do I view the 529-to-Roth IRA rollover? I view this as a helpful, though quite limited, bailout technique for overfunded 529s. As a bailout technique, it’s a nice tool to have in the toolbox. The people who should be happy about it are those parents/grandparents with either a student in college today and/or a recent graduate and an overfunded 529.
The above said, the 529-to-Roth IRA is not a technique that provides much, if any, value from a planning perspective. I do not believe that this new maneuver significantly impacts financial planning for most parents, as I don’t believe it makes the 529 all that much more attractive.
Compare (i) 529s and this provision with (ii) simply investing money in taxable mutual funds and then using that money to fund a child’s college education and giving them $35K to be invested in Roth IRAs as a young adult. Yes, the 529 plus the 529-to-Roth is better than using taxable accounts, but not by enough for me to get very excited. Remember, in the FI community, the primary goal is not to optimize your child’s tax situation. Rather, for most parents, the primary goals are to secure Mom & Dad’s financial independence and be sure that Junior never has to worry about Mom & Dad’s financial security during Junior’s adulthood.
Second, those parents with extra money in 529s after a child graduates college should still consider changing beneficiaries to younger children or grandchildren primarily, and use the new 529-to-Roth IRA bailout technique as an alternative if no other beneficiary needing tuition assistance is readily available. To my mind, if there’s a successor beneficiary readily available, changing the beneficiary will usually be the preferable option, as it can be done instantaneously without worrying about limits and holding periods, and there’s no need to coordinate with the Roth IRA’s financial institution.
529 Seasoning
Some are discussing new parents opening a 529 at birth just to season the account so the account qualifies for the 529-to-Roth IRA maneuver sooner rather than later (before the child’s 16th birthday). As I believe young parents should be focused (financially) on securing their own financial future, I do not believe it should be a priority to do this. My (financial) hope for most young parents is that they first secure their own financial future during their child’s childhood.
If the parents’ financial future is secured by the time the child is in high school, the parents can start 529 funding to grab some state tax deductions or credits (if applicable). In such cases, when the funding occurs closer in time to college, it should be much easier for the parents to “right size” the 529 such that it is not overfunded for college. In those cases, any small remaining 529 balance can be bailed out by changing the beneficiary or using the 529-to-Roth IRA maneuver, even if it does take a few more years to satisfy the 15 year rule.
In addition, what’s the rush? So what if you have to wait 10 years until after Junior graduates college to execute the 529-to-Roth IRA rollover? In those 10 years you get tax free growth, and even if Junior has become the CEO you can still execute the maneuver, since the annual contribution MAGI limit has been eliminated for those doing the 529-to-Roth IRA rollover.
The downside of foregoing several years of pre-graduation seasoning is that additional time could cause growth such that the total in the 529 exceeds $35K by the time the 15 year clock is satisfied. I’d argue a 529 established much closer to the beginning of college is less likely to be significantly overfunded, mitigating this downside concern.
Multiple Beneficiaries
I think multiple beneficiary planning for the 529-to-Roth IRA maneuver is going to be very challenging. Consider the following situation:
Example 3: Dad owns a 529 and Son, age 21 is the beneficiary. Dad has paid for Son’s first three years of college through the 529. Daughter, age 25, is already a college graduate and in the workforce. If Dad’s 529 is now worth $100,000, in theory Dad could do a partial rollout of $30,000 to a 529 naming the Daughter as beneficiary with an eye towards the 529-to-Roth IRA rollover for Daughter’s benefit. However, remember the 15 year rule. The new 529 could not seed Daughter’s Roth IRA until Daughter is age 40. Further, if Daughter never uses any of the money for qualified educational expenses, the account is likely to run into issues being a valid 529.
529 plans cannot have multiple beneficiaries. This alone makes split-up planning for the 529-to-Roth IRA maneuver quite difficult. That said, if Daughter attended a year of graduate school at age 27 largely funded by this new 529, then Dad’s maneuver works, though remember that Daughter can only get the money into her own Roth IRA starting at age 40.
Starting with Owner as Beneficiary
Some might consider a parent opening a 529 before the child is born naming the parent as both owner and beneficiary. After 15 years, the parent can make annual 529 to Roth IRA rollovers to their own Roth IRA. Once the $35K maximum has been hit, the parent could then change the beneficiary to a child. Considering the 529 statutory language discussed above, I don’t believe that is a wise course of action. Such a course risks 529 account disqualification unless the IRS and Treasury come out with rules affirmatively blessing it. Further, all that’s been saved is tax on interest, dividends, and capital gains of $35,000 of Roth IRA contributions. Under today’s investment friendly tax rules, that will not be very much tax.
Don’t Plan on Using the 529-to-Roth IRA Maneuver if You Aren’t Going to College
The online world is full of scuttlebutt, and already I have seen social media posts inquiring as to whether adults should fund 529s for themselves with the idea of funding them today and starting 529-to-Roth IRAs rollovers 15 years later. I do not believe this is a wise course of action.
Based on the language in Section 529 quoted above, I am highly skeptical of planning to put money into the 529 looking to get it into a Roth IRA. Sorry to all those 40-somethings out there thinking about throwing $20,000 into a 529 to fund their Roth IRA annual contributions in their 50s and 60s.
Even if Congress were to change Section 529 tomorrow and explicitly allow 529 stuffing to get money into a Roth IRA, I don’t believe it makes much sense to affirmatively look to use a provision like this. It doesn’t increase the limit for Roth IRA contributions. If one is working 15 years from now, they will probably have the cash flow to fund their Roth IRA. Why do they need to invest through a 529 and get a very small tax break on the money for the 15+ years beforehand? Further, what if they aren’t working and don’t have compensation income in 15 years?
Considering the language in Section 529 discussed above, I doubt the IRS will allow middle-age 529 owners whose schooling is far behind them to change the 529 beneficiary to themselves and then do the 529-to-Roth IRA maneuver. Yes, the IRS and Treasury may allow the successor beneficiary to step into the 15 year clock of the original beneficiary. But if the middle-age owner becomes the beneficiary, the 529 is no longer for the beneficiary to use for qualified educational expenses. At that point, it appears that there is a high risk the account may cease to be a good 529. If the owner then executes the rollover maneuver and their MAGI exceeds the annual Roth IRA contribution MAGI limit, they create an excess contribution to the Roth IRA.
It’s possible that the IRS will view this differently, but I would not count on it. Until the IRS and Treasury come out with more definitive guidance, I would expect that the benefit of this new rollover maneuver will largely be limited to those who completed their college education after the funding of a 529 for their benefit.
Changing the Beneficiary and the 15 Year Clock
Does changing the beneficiary on a 529 reset the 15 year clock?
My hope is that the IRS and Treasury allow a successor beneficiary to inherit the holding period the original beneficiary had. My view is that the IRS and Treasury are protected by the statutory language requiring 529s to be for the educational expenses of the beneficiary. If the successor beneficiary plans on using the 529 money only for their Roth IRA, the 529 can be disqualified. But if the successor beneficiary uses some of the money for education and then has leftover amounts, he or she should not need to wait until the passing of a new 15 year clock to get the money into a Roth IRA.
If the IRS and Treasury are worried about abuses here, one possible compromise would be to allow the successor beneficiary to inherit the original beneficiary’s clock only if (i) the successor beneficiary is no more than ten years older than the original beneficiary and (ii) the successor beneficiary is a member of the original beneficiary’s family.
A Critical Look at the 529
Watch me discuss on the 529 on YouTube
Conclusion
For those with an overfunded 529, the new 529-to-Roth IRA maneuver is very good news. That said, to my mind, it is just another tool in the tool box. In many cases, overfunded 529s are better used for another beneficiary, such as another child or a grandchild. But still, overfunded 529s are an issue, and it is good to have another bailout tool available, particularly if there is no successor beneficiary in the picture.
I generally do not view the 529-to-Roth IRA maneuver to be a great planning tool. Generally speaking, it does not increase the amount that can go into a Roth IRA. That alone significantly diminishes its value from a planning perspective. Of course, everyone needs to do their own analysis and planning considering the particulars of their own situation.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
Thanks to the SECURE 2.0 bill, it’s time for the FI community to reexamine 529 plans. This post shares my two cents on 529s in general, and specifically as applied to the FI community. The next post, dropping February 15, 2023, addresses in detail the new 529-to-Roth IRA rollover enacted in SECURE 2.0.
Financial Independence
Before we talk about 529s, we have to talk about the primary goal of financial independence. For young parents, the primary goal is to secure Mom & Dad’s financial independence.
Achieving the parents’ primary goal has an incredible secondary effect. Mom and Dad buy Junior an incredible gift by securing their own financial independence. That gift is that Junior will never have to worry about Mom and Dad’s financial security as an adult. The greatest financial gift parents can ever give their children is the parents’ own financial stability.
Second, where possible, money and financial assets should be able to support multiple financial goals. We should be at least somewhat hesitant before locking up money such that it can only support one highly specific goal without incurring a penalty.
529s
529s are tax-advantaged savings accounts generally run by states to facilitate college savings. 529s are best understood as a Roth IRA for college education with far greater contribution limits. Sure, that is an overstatement of how they work, but that gives us a good conceptual framework from which to start the analysis.
Contributions to a 529 are not tax deductible for federal income tax purposes. At least initially, there’s no federal income tax benefit to making a 529 contribution. However, money inside a 529 grows federal and state tax-free and can be withdrawn tax-free for qualified education expenses (such as college tuition).
Contributions are generally not limited by federal tax law, though contributions above the annual exclusion gift tax limit ($17,000 per donor per beneficiary per year in 2023) generally trigger Form 709 reporting requirements (though in 99.99% of cases there should not be a gift tax liability). States generally have lifetime contribution limits per beneficiary. Usually these limits are far in excess of what one would normally need for undergraduate college tuition.
Okay, sounds great! Clearly there are tax benefits for 529 money used for qualified education expenses. But what about distributions that are used for anything other than qualified education expenses? Well, they are going to be subject to an income tax and likely a 10 percent penalty, in the following manner. A non-qualified distribution is deemed to come ratably out of the contributions to the 529 (tax and penalty free) and earnings of the 529 (subject to income tax and the 10 percent penalty, some penalty exceptions may apply).
Here’s an example illustrating the application of the nonqualified distribution rules:
Hal, the owner of a 529 account, takes $1,000 out of the 529 to help pay for vacation expenses. Previously, he had made $60,000 of contributions to the 529, and it had grown to $100,000 ($40,000 of earnings) prior to making the $1,000 non qualified distribution. Sixty percent of the distribution ($600) is a nontaxable return of contributions and 40 percent ($400) is subject to both income tax and a 10 percent penalty.
The taxation of non-qualified distributions is a significant drawback of using 529s.
529s and the FI Community
Let’s remember what is going on with a 529. It is a gift to the next generation. It comes with very modest tax benefits.
My thesis on the 529 is this: for most parents, including most of those in the FI community, the tax benefits offered by 529s are not sufficient to compensate for the use restrictions on 529s. Thus, my view is that 529s should generally be deployed once Mom and Dad are financially independent (or close to it), not when they are on the path to financial independence.
The idea behind the 529 is to provide tax-free growth for college savings. It solves for something that, frankly, isn’t much of a problem. Taxes are not why college is unaffordable for many Americans. College tends to be unaffordable not because investment taxes are high, but because tuition and fees are out of control.
One thing in parents’ favor when thinking about funding college educations is that income taxes on investments are relatively modest over a child’s childhood due to low long term capital gains rates and qualified dividend income rates. Hopefully, by age 22 or 23, the child’s undergraduate education is completed, providing a relatively modest investment time horizon (i.e., a modest tax exposure horizon), even if the parents start saving for college at birth.
Contrast that to the retirement time horizon of a 20-, 30- or 40-something parent saving for his or her own retirement. The money invested for retirement at age 25 might be accessed at age 60, 70, 80, or 90. Compared to educational savings, retirement savings (which are usually far greater than educational savings) are much more vulnerable to income taxes for a much longer time frame. Even at long term capital gains and qualified dividend income rates, exposing retirement savings to decades of taxation could be very expensive. Retirement savings are also exposed to tax law change risk for a much longer period of time. For example, there’s no guarantee that there will be favored long term capital gains and qualified dividend tax rates 30 years from now.
The tax risk profiles on educational savings and retirement savings are much different. Based on those risk profiles, for most I believe aggressive retirement tax planning makes sense. But I don’t see educational tax planning making as much sense, for the reasons discussed below.
Of course, tax-advantaged retirement savings can come with a juicy up-front federal income tax deduction. 529s do not offer the possibility of a federal income tax deduction, making them less impactful than tax-advantaged retirement savings regardless of the time frame involved.
Young Parents and 529s
Let’s consider young parents. Say Junior is born when Mom & Dad are age 30 and have saved 10 times their annual expenses in financial assets. Many, myself included, would say Mom and Dad are doing well with their finances. Here’s where I diverge from some others in the personal finance space: I would not recommend Mom & Dad save in a 529 shortly after Junior’s birth.
Notice I’m not saying Mom & Dad should not pay for Junior’s college. What I’m saying is Mom and Dad should stay flexible for their own financial future.
What’s so horrible about Mom & Dad starting to save for Junior’s college in a taxable brokerage account under their own names? At birth, they have no idea if Junior will get a scholarship, go to trade school, how Mom & Dad’s finances will be when Junior is ready to go to college, etc. By saving in financial assets that are in their own names–perhaps mentally segregated as potentially being for Junior’s college–Mom & Dad maintain great flexibility without sacrificing too much tax benefit.
If Junior gets a scholarship, great, the financial assets stay with Mom & Dad. If Mom & Dad are not financially successful when Junior goes to college, great, the financial assets can support Mom & Dad and Junior can figure out other ways to pay for college.
The Value of the 529’s Tax Benefits
How bad is the tax hit on holding investments for a child’s college education? Imagine owning a 60 / 40 equity to bond portfolio of $100,000 for a child’s college education. If held in the parents’ taxable brokerage account, how much taxable income might that generate annually? Very roughly, if dividend yields are 2 percent, the $60,000 in equities would produce $1,200 of dividend income, most of which is likely to qualify for qualified dividend income tax rates. The $40,000 of bonds would produce $1,800 of ordinary income at a 4.5 percent yield.
Is it desirable to add $3,000 of income to Mom and Dad’s tax return? Surely not. Cataclysmic? Also surely not.
Consider what a small amount of additional taxable income buys. If the money is held in the parents’ names, it can be used for anything without penalty. Perhaps Mom and Dad have not been financially successful. That $100,000 could help the parents achieve their own financial goals and retirement. What if the child gets a scholarship and does not need much in the way of tuition assistance from his or her parents? What if the child doesn’t go to college?
In exchange for paying tax on $3,000 of income annually (some of it at tax-favored QDI rates), and some long term capital gains when used to pay tuition, Mom and Dad have incredible flexibility with the $100,000. Maybe $50,000 goes for Junior’s college tuition, and $50,000 goes for Mom and Dad’s retirement. Further, for many it won’t be $3,000 of income annually. It will take most parents years before they could accumulate the sort of balance that would generate $3,000 of taxable income from educational savings. Thus, the tax hit for not using the 529 is likely to be that much less in the years well before the child is close to college age.
Outside of the handcuffs of the 529, assets can support multiple financial goals. Even better, as one financial goal is met, the money can be shifted to support another financial goal. Perhaps Mom and Dad are behind in their own savings when Junior is age 10. But things go well, and when Junior turns 16 Mom and Dad have wealth in excess of their FI number. In that case, money that might have been needed for the parents’ retirement now can be used for college tuition.
Use Restrictions
We need to consider the use restrictions on 529s. If not used for qualified education expenses, the growth is subject to both ordinary income tax and usually the 10 percent penalty.
Compare the tight use restrictions on 529s to the use restrictions on the other most prevalent tax baskets: taxable accounts, traditional retirement accounts, Roth accounts, and health savings accounts. Generally speaking, all of them (even HSAs) are not use-restricted or only partially use-restricted. All four of those tax baskets have a significant advantage over 529s in terms of use restrictions.
In many cases, I believe that the 529’s significant use restrictions are not adequately compensated by its tax advantages.
As much as we might want to, we can’t turn a blind eye towards hyperinflation in college tuition. With that in mind, shouldn’t we ask: Isn’t a hyperfocus on college savings feeding the beast?
It’s time to scrutinize American higher education. It’s not good for the country to have students graduating with mountains of debt. This is happening for many reasons, including significant administrative bloat in higher education. Clearly, American higher education is failing too many of its students. Is now the time to set aside money to pay American colleges and universities?
I get it: no one reader funding a 529 is the cause of the problems of American higher education.
But, if I’m a university used to collecting soaring tuition and fees, I’m all for 529s. 529s subsidize what has become bad behavior by university administrators. Less focus on 529s helps move the needle towards universities needing to act responsibly in order to attract students.
Camilla Jeffs raises an interesting point on her LinkedIn page: Part of the reason college is so expensive is because in many cases the customer (the student) does not bear the cost. 529s feed into that problem. Camilla’s recent podcast episode on 529s is also full of good food for thought.
529 Use Cases
The above limitations of the 529 noted, I do believe there are good use cases for the 529. These cases assume that the parents have decided to pay for their child’s college education.
Financially Independent Parents
Joe and Sally are married and 45 years old. They have saved 30 times their annual expenses in retirement accounts and taxable brokerage accounts. They have a 10 year old daughter they are reasonably sure will go to college, and they would like to pay for her college education.
This is a great use case for the 529. Mom and Dad’s financial future largely secured (generally speaking), it’s time to focus on (i) college savings, since they want to pay for college, and (ii) tax planning. Joe and Sally, already holding substantial taxable brokerage accounts, benefit from saving through the 529 so they avoid adding more dividend, interest, and capital gains income to their annual tax return.
Capturing State Tax Benefits
Aaron and Amanda are married and are 50 years old. They have saved 20 times their annual expenses in retirement accounts and taxable brokerage accounts. They have stable jobs. They have a 16 year old son who is very likely to go to college. Aaron and Amanda want to pay for their son’s college education. Since they live in New York State, if they contribute $10,000 annually to the New York 529 for his benefit ($5K each), they get an annual $10,000 state tax deduction on their New York state income tax return.
Aaron and Amanda are not financially independent by many metrics, but they are doing pretty well, and are likely (though not guaranteed) to be financially successful. In their case, paying for college is not financially ruinous. If Aaron and Amanda are going to pay for college, they might as well utilize the 529 annually to scoop up state tax deductions, particularly in a higher income tax state like New York. Further, beginning the 529 much closer to the start of college decreases the odds that the 529 will become over funded.
Contrast Aaron and Amanda to parents of newborns. Newborns’ parents are closer to the beginning of their financial journey. In most such cases, state tax benefits would not, in my opinion, be valuable enough to justify the use restrictions on 529 contributions.
Conclusion
My view is that the detriments of the use restrictions on 529s are not adequately compensated by the federal and state tax advantages offered by 529s in most cases. That’s certainly not to say there are not good use cases for the 529, but my view is that most parents should prioritize saving in their own names (even in taxable accounts) before making contributions to 529 accounts.
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