Tag Archives: Roth IRA

TikTok Tax Advice

There’s tax advice available on TikTok. Is it worth following? Does it miss the big picture?

Retirement Saving Through Various Forms of Life Insurance

TikTok tax advice often boils down to something like the following: don’t save in traditional retirement accounts where you will get crushed by taxes in retirement. Rather, save for retirement through permanent life insurance products (such as indexed universal life insurance policies) to get tax free growth and tax free withdrawals during retirement. 

Watch me discuss two problems with TikTok tax advice on YouTube.

This advice is not just offered on TikTok, though, anecdotally, it appears TikTok is at least something of a hub for promoting indexed universal life (“IUL”) and other forms of permanent life insurance. 

One recent example of this sort of advice posits a retired couple making $160,000 a year in IRA/401(k) distributions and $40K in Social Security/pension income and worries that the couple will have a terrible tax problem. 

But is that really the case? Let’s play it out with a detailed example.

Sally and Joe both turn age 75 in 2022. They are California residents. During their working years, they were prodigious savers in their workplace 401(k) plans, and their employers offered generous matching contributions. As a result, in 2022 they have required minimum distributions (“RMDs”) of $160,000. They also will have $40,000 of Social Security income, $4,000 of qualified dividend income, and $1,000 of interest income. Further, being tax savvy, they contribute $500 a month to their church through qualified charitable distributions (“QCDs”) from their traditional IRAs. They claim the standard deduction as their home is paid off and thus have no mortgage interest deductions. 

Alright, let’s see what Sally and Joe’s 2022 tax picture (all numbers are estimates) looks like:

First, their rough 2022 federal income tax return:

Federal Income Tax Return
RMDs$ 160,000
Social Security$ 40,000
15% Social Security Exclusion$ (6,000)
Interest$ 1,000
Qualified Dividends$ 4,000
QCD RMD Exclusion$ (6,000)
Adjusted Gross Income (“AGI”)$ 193,000
Standard Deduction$ (25,900)
Additional SD Age 65+$ (2,800)
Federal Taxable Income$ 164,300

Let’s turn to what their $164,300 federal taxable income means in terms of federal and California income taxes paid and their 2022 cash flow:

2022 Income Taxes and Cash Flow (Estimated)
Federal Income Tax$ 27,100
Effective Tax Rate on AGI14.04%
Marginal Federal Income Tax Rate22%
California Taxable Income (Approximate):$ 149,000
California Income Tax (Approx.)$ 7,862
Effective CA Income Tax Rate on Fed AGI4.07%
Marginal CA Income Tax Rate9.30%
Total Fed & CA Effective Income Tax Rate18.11%
Cash Flow After Fed & CA Income Tax & QCDs$ 164,038

By my math, after paying both income taxes and charitable contributions, this retired couple has $164,000 in cash flow for living expenses. Considering that, like many retirees, they live in a paid-off home, do we really believe there is a significant risk they will not be able to pay their bills? This couple ought to be able to enjoy a very pleasant, comfortable lifestyle, including recreational activities and travel.

Are Sally and Joe really getting crushed by income taxes? As residents of a high tax state, they do pay about $35K in combined federal and state income taxes. Sure, if $35K was on the table in front of you, you’d grab it pretty quick. But considering the $200K plus in cash flow they generated during the year, paying $35K in income taxes to the IRS and California is hardly financially debilitating. 

Most retired couples, even financially successful couples, will not have federal adjusted gross income of $193,000. If Sally and Joe are not crushed by income taxes (paying just an 18.11% estimated effective rate even living in a high-tax state), it is likely most retirees will be able to withstand the tax hits at retirement from having significant savings in traditional deferred retirement accounts. 

The Trade-Off Unstated on TikTok

TikTok tax advice often presents the boogeyman of taxes in retirement. It says “don’t invest in your 401(k) because it will get crushed in retirement.” Even if that were true, it usually neglects an important consideration: the upfront benefit of investing in a 401(k). 

During their working careers, it is likely that Joe and Sally were subject to marginal income tax rates of 24% or more federal and 9.3% California. Had they used permanent life insurance to save instead of using their 401(k)s, they would have lost 33 cents (or more) on every dollar in immediate tax savings, as there is no tax deduction for amounts contributed to life insurance policies.

The existence of the tax deduction for amounts contributed to a traditional 401(k) does not automatically mean that using permanent life insurance products for retirement is a bad idea. However, in weighing the tax benefits of the traditional 401(k) approach compared to the permanent life insurance approach, one must consider the immediate, and potentially substantial, tax benefits of traditional 401(k) contributions. 

One consideration in weighing the pros and cons of each: traditional 401(k) contributions generally get a tax benefit at the taxpayer’s marginal tax rate, while withdrawals from traditional 401(k)s and IRAs are more generally taxed at a taxpayer’s lower effective rate. On the way out, withdrawals are taxed through the relatively progressive tax brackets existing today, getting the benefits of the 10%, 12%, and 22% federal income tax brackets. 

Uncertainty

But, Sean, what about future tax rate increases! The federal government is running a huge deficit and it’s not getting any better.

This is a valid point. But let’s consider a few things. First, in my example, Sally and Joe were subject to a 33.3% marginal tax rate during their working years, and barely over an 18% effective tax rate during their retirement. For the math to work out to make permanent life insurance more attractive (tax-wise) than traditional 401(k)s for them, tax rates would need to be increased substantially, by over 80%. Thus, even if tax rates on retirees such as Joe and Sally were to increase 85% from current levels, the tax math might only marginally favor using permanent life insurance instead of a traditional 401(k). 

Second, if there are going to be income tax rate increases, they are more likely to be to the upper tax brackets. There are fewer taxpayers (read: voters) subject to the higher tax brackets, so those are the ones the politicians are more likely to increase. Increasing the 10%, the 12%, and/or the 22% tax brackets will impact more voters and lead to more election risk for the politicians.

Third, recent history suggests that the politicians are not likely to target retirees. It’s true that Social Security went from being tax free to being largely subject to taxation, up to 85% taxable. Interestingly enough, the second Social Security tax increase, which subjected Social Security to possibly being 85% taxable, passed through a Democratic Congress in 1993. The following year the Democrats suffered historic losses in the House and Senate elections. Many factors came into play, but it is interesting that since 1994 tax policy has generally benefited retirees (no more tax increases on Social Security, increasingly progressive tax brackets, and the increased standard deduction). 

Perhaps the politicians in both parties have learned a lesson when it comes to retiree taxation.

Is there zero risk that retirees could be subject to higher taxes in the future? Absolutely not. But, is that risk great enough to eschew traditional 401(k) contributions in favor of permanent life insurance? Not in my opinion.

Further, there are simpler, less costly planning techniques other than permanent life insurance that those using 401(k)s for retirement planning can avail themselves of, including Roth accounts and health savings accounts. 

Roth Accounts

Savers worried about future tax rate hikes have a simple, easy to implement tool to hedge against future tax rate increases: the Roth IRA. The Roth IRA solves the same tax problem that permanent life insurance solves for. In today’s environment, Roth IRAs are available at a vast array of financial institutions with very low fees. 

As I have previously discussed, many savers will benefit from the combination of a maxed out traditional 401(k) and a maxed out annual Roth IRA. 

Many will point out the possibility of much greater contributions to an indexed universal life insurance policy than to a Roth IRA. While true, many of those concerned with getting large amounts into tax-free accounts while working can turn to the Roth 401(k), which has significantly greater annual contribution limits than the Roth IRA. 

Roth Conversions

Many in the FIRE community have access to Roth conversions during what are likely to lower taxable income years. The tax idea behind retiring early is to load up on traditional 401(k) contributions during working years, and then convert amounts inside traditional retirement accounts to Roth accounts during early retirement years prior to collecting Social Security. 

In early retirement years, many in the FIRE movement appear, at least initially, to be poor on their tax return. No longer working, and not yet collecting Social Security, one’s tax return only includes interest income, dividend income, and some capital gains income. If that income is relatively low (which it is likely to be for many early retirees), it likely leaves room for Roth conversions at the 10% or 12% tax brackets during early retirement. 

This is tax rate arbitrage. First, deduct 401(k) contributions in the 24% or greater federal income tax brackets during one’s working years. Then, during early retirement, convert amounts in the traditional retirement accounts at a 10%, 12%, or perhaps 22% marginal federal income tax rate. 

Two observations: A) using permanent life insurance instead of traditional 401(k) contributions followed by early retirement Roth conversions denies members of the FIRE community a significant tax rate arbitrage opportunity. While there is no taxable income inclusion when withdrawing from a permanent life insurance policy, there is also no tax deduction for contributions to IULs, whole life insurance, and other permanent life insurance policies. 

B) By doing Roth conversions during early retirement, FIRE members reduce the uncertainty risk described above. FIRE members face a shorter time frame during which significant savings are in traditional retirement accounts, as the goal is (generally speaking) to get the money (mostly) converted to Roths prior to age 70.

The Roth conversion tool reduces the risk that future tax increases will crush savers who mostly use traditional 401(k)s during their working years. While this is true for all savers, it is most especially true for members of the FIRE community. 

A note on tax optimization: Imagine Joe and Sally were retired at age 55, today’s tax laws existed, and they had many years with artificially low taxable income. Say they did not do Roth conversions during this time. Is that a mistake? From a tax optimization perspective, absolutely. They would have likely been able to do Roth conversions at a 10% or 12% federal income tax rate, which is lower than both their retirement 22% marginal federal income tax rate and 18.11% combined effective income tax rate. While they are not tax optimized, they are something more important in my example: financially successful. Yes, tax optimization is important, but it is not the be-all and end-all. My guess is that financially successful individuals do not regret the failure to tax optimize on their deathbeds, though I look forward to reading Jordan “Doc G” Grumet’s new book to be sure. 

Conclusion

I’m not here to tell you exactly how to save for retirement. But I am concerned that TikTok tax advice has two deficiencies. First, it overstates the problem of taxation in retirement. Is there a potential problem? Yes. Is it as severe as some make it out to be? Not under today’s laws. Further, there are tactics such as annual Roth IRA contributions and Roth conversions during early retirement that can address the problem. Second, TikTok tax advice understates the current benefit of deductible traditional 401(k) contributions during one’s working years. 

Further Reading

Forbes has recently published two articles on the sorts of insurance policies frequently promoted on TikTok. They are available here and here. 

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

Follow me on Twitter at @SeanMoneyandTax

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

The Mystery of the Disappearing Tax Basis

Tax loss harvesting is all the rage in a down stock market. Did you know that it can create a mystery worthy of the Hardy Boys? Read on to find out how tax basis can disappear because of tax loss harvesting and the wash sale rule. 

Tax Loss Harvesting

I’ve previously written about tax loss harvesting. The idea is to sell a stock, bond, mutual fund, ETF, or other asset at a loss and report that loss on a tax return. That loss can offset other capital gains, and after having done that, it can offset ordinary income (W-2 income, interest income, etc.) up to $3,000 per year. Unused capital losses can be carried forward to subsequent tax returns indefinitely.

Tax loss harvesting is a nice tactic and in the right circumstances can be beneficial. That said, tax loss harvesting should not be a primary driver of one’s investment portfolio allocation. 

The Wash Sale Rule

The opportunity presented by tax loss harvesting has a major hurdle: the wash sale rule. Any acquisition of the same asset or a “substantially identical” asset 30 days before or 30 days after the sale at a loss denies the loss on the tax return. This is a very logical rule, considering the potential for abuse. Here’s an example:

Example 1: Sal owns 30 shares of Acme Corporation stock. He purchased it for $200 per share, and it is now worth $140 per share. Without the wash sale rule, Sal could sell all 30 shares for $140 on December 1st (triggering a $1,800 loss on his tax return) and then purchase 30 shares of Acme Corporation on December 2nd for its current value and have very little change in his economic position. 

Seen through the lens of Sal’s example, the wash sale rule makes sense. Why should Sal get to claim a loss on 30 shares of Acme stock he owns at year-end?

However, the wash sale rule can be implicated in less clear cut situations. Here’s one example:

Example 2: Cate owns 500 shares of IBM stock* in her taxable brokerage account. She purchased each share for $150 per share. On July 6, 2022, she sold 300 shares for $140 per share, realizing a $3,000 capital loss (300 times $10 loss per share). On July 29, 2022, IBM paid a dividend of $3 per share ($600 total on Cate’s remaining 200 shares), which Cate automatically reinvested in IBM stock, now valued again at $150 per share. 

In Cate’s case, the dividend reinvestment purchased 4 shares of IBM stock within the 61-day wash sale window. The taxable loss on 4 shares of the 300 sold ($40 total) is disallowed by the wash sale rule, and Cate will only be able to claim a taxable loss of $2,960 on the July 6th sale. 

* All values used in this blog post are hypothetical for purposes of the example. I did not look up IBM’s actual stock prices on these dates. The IBM dividend is also made up for the sake of the example.

One interesting tidbit about the wash sale rule in today’s environment: as the rule only applies to “securities” it does not apply to cryptocurrencies. Thus, an investor can sell a cryptocurrency at a loss on one day and repurchase it a day later and claim the entire loss on his or her tax return. There are proposals to do away with this treatment and subject cryptocurrencies to the wash sale rule. 

Retirement Accounts and the Wash Sale Rule

Let’s change Cate’s example just a bit, by having the repurchase occurring inside a Roth IRA.

Example 3: Cate owns 300 shares of IBM stock in her taxable brokerage account. She purchased each share for $150 per share. On July 6, 2022, she sold all 300 shares for $140 per share, realizing a $3,000 capital loss (300 times $10 loss per share). Separately, Cate owns 200 shares of IBM in her Roth IRA. On July 29, 2022, IBM paid a dividend of $3 per share ($600 total on Cate’s remaining 200 shares), which Cate’s Roth IRA automatically reinvested in IBM stock, now valued again at $150 per share. 

What result? The IRS has issued a Revenue Ruling, Rev. Rul. 2008-5, ruling that if the repurchase occurs inside the taxpayer’s Roth IRA or traditional IRA, the wash sale rule applies. Cate would suffer the exact same $40 wash sale rule loss disallowance. 

Note that a Revenue Ruling is not binding on taxpayers and the courts. Of course, a judge or appellate court may agree with the conclusion the IRS reaches in a Revenue Ruling, but they are not obligated to do so based solely on the IRS having issued the ruling. Rev. Rul. 2008-5 cites two 1930s court cases as authority for the conclusion reached in the ruling. Those cases involve a taxpayer using a controlled corporation to attempt to get around the wash sale rule, and the courts ruled that the wash sale rule applied regardless. 

In my research, I have not found any published court cases which have weighed in on Rev. Rul. 2008-5. The wash sale rule, as found in Section 1091, does not explicitly deem a retirement account and its owner to be the same person. Thus, there is at least some (perhaps quite small) risk to the IRS that a court would deem the primary result in Rev. Rul. 2008-5 to be too much of a stretch. That said, I certainly would not recommend taking a position counter to the ruling. I would struggle to advise that the wash sale rule does not apply if the security is repurchased in a retirement account. 

Disappearing Basis?

The wash sale rule disallows a loss, but it does not disallow basis. Section 1091(d) of the Internal Revenue Code and Treasury Regulation Section 1.1091-2 provide for a tax basis adjustment so that taxpayers are ultimately made whole after the application of the wash sale rule. Broadly speaking, the tax rules allow the disallowed loss to be added to the basis of the repurchased asset. In my Example 2 above, the basis of the 4 shares Cate repurchased is their historic cost ($150 per share) increased by the $10 per share disallowed loss. Thus, if Cate later sells those 4 shares, she will have a basis of $160 in those shares for purposes of determining gain or loss. 

In theory, the wash sale rule is simply a timing rule. It is inappropriate to allow a taxpayer to currently claim a loss when they wind up holding the exact same stock or securities. But, over time the tax basis rules should work out such that ultimately the correct amount is taxed to the taxpayer. 

What about basis adjustments when the wash sale occurs because of a repurchase made inside a retirement account? Rev. Rul. 2008-5 states that there is no basis adjustment with respect to a retirement account. There is an argument that Section 1091(d) should create Pro-Rata Rule basis in a traditional IRA. However, considering how highly technical and structured IRAs are, that is not a very likely outcome were the issue ever to be litigated. Further, that outcome would (quite oddly) give the taxpayer a different basis result based on whether they repurchased in a Roth retirement account or a traditional retirement account.

So what becomes of the basis? Does it just disappear? If the basis vanishes, the taxpayer obtains a worse wash sale result by repurchasing inside a retirement account. It seems odd that a taxpayer would receive a worse outcome for doing a repurchase through a retirement account instead of through a taxable brokerage account. 

Solving the Disappearing Basis Mystery

I have a theory that might solve the mystery. 

To get us started, consider that neither the Revenue Ruling nor Example 3 above discuss the “replacement property” in the taxable brokerage account. Here are two examples to ponder.

Example 4: Tim owns 1,000 shares of Domestic Equity Mutual Fund A (worth $50,000) he purchased for $60,000. It is held in a taxable brokerage account. On December 1, 2022, he sold Domestic Equity Mutual Fund A for $50,000 cash. He used the cash received to fund living expenses (food, clothing, heating bills, travel expenses, insurance, gasoline, etc.). On December 2, 2022, Tim purchased 1,000 shares of Domestic Equity Mutual Fund A in his Roth IRA. 

Example 5: Tim owns 1,000 shares of Domestic Equity Mutual Fund A (worth $50,000) he purchased for $60,000. It is held in a taxable brokerage account. On December 1, 2022, he exchanged all of his Domestic Equity Mutual Fund A for $50,000 worth of International Equity Mutual Fund B. On December 2, 2022, Tim purchased 1,000 shares of Domestic Equity Mutual Fund A in his Roth IRA. 

The wash sale rule disallows the $10,000 capital loss in both Example 4 and Example 5. But does Tim lose $10,000 of basis permanently? If he does, it’s an odd result considering that had he repurchased Domestic Equity Mutual Fund A in a taxable brokerage account (instead of in a retirement account), he would not lose that basis. 

I believe that there is a reasonable possibility that a court would rule that the $10,000 of basis shifts to the replacement property received in the wash sale. In Example 4, that conclusion leads Tim to no better position: he uses the cash for personal expenses, and there is no tax deduction for personal expenses. Further, I can’t imagine a court would give a step up in basis in Tim’s functional currency, the U.S. dollar. 

As applied to Example 5, where there has been a reinvestment in a taxable brokerage account, the equities of the situation might encourage some judges to find that Tim’s International Equity Mutual Fund B basis at a later sale is $60,000, not $50,000. 

Tim originally had $60,000 of basis in the system. While it is appropriate for a current loss to be disallowed, it is not appropriate for Tim’s basis in the system to be diminished in a situation where his overall taxable investment has not changed.

It’s one thing for the wash sale rule to operate to deny Tim a current loss deduction. It’s entirely another thing to interpret the wash sale rule to both deny current loss recognition and to permanently deny Tim $10,000 of basis. In its enactments of the wash sale rule and of the basis rules, Congress never manifested an intention for this one-two punch to bite Tim twice. If Tim sells the International Equity Mutual Fund B shares and recovers only $50,000 of basis he is inappropriately overtaxed. 

I believe some judges might determine that the IRS cannot have its cake (wash sale loss disallowance) and eat it too (permanent basis reduction). Basis exists to appropriately tax property transactions. Allowing Tim only $50,000 of future basis recovery over-taxes a later sale of his International Equity Mutual Fund B shares. While the IRS has a good argument that the wash sale rule disallowance should be spread to retirement account repurchases, it does not have a good argument that the overall result should be worsened if the repurchase occurs inside a retirement account.

Further, there is at least some risk to the IRS that a court would consider them to have reached just a bit by applying the wash sale rule to a repurchase inside a retirement account. The court might determine that what is good for the goose is good for the gander: if the IRS can reach a bit to apply the wash sale rule, the taxpayer can reach a bit to adjust the basis of the newly acquired securities in the taxable account.

The policies behind the rules point in the direction of allowing a taxpayer to add the disallowed loss to the basis of any replacement capital asset obtained through a direct exchange or a close-in-time use of the sales proceeds.

My proposed resolution has basis behave as it does in more familiar contexts. Say you received $50 from your grandmother when you were 12 years old. If you spent it on movie tickets and going bowling, the basis vanished for tax purposes. What if, instead, you purchased one share of stock of a publicly traded company for that $50? You’d get $50 of basis in that share of stock. Same with your first job: if you spend your first $1,000 W-2 paycheck on rent and groceries, tax basis disappears. But if you take that $1,000 and buy shares of ABC Mutual Fund in a taxable brokerage account, the basis stays attached to the mutual fund shares. Basis surviving when assets are reinvested in capital assets is a logical outcome.

Conclusion

Does anyone know for sure what happens to basis when the wash sale rule is tripped due to a repurchase in a retirement account? I believe it is still an unsolved mystery. 

Does basis vanish into the night? Or can it be preserved if the taxpayer reinvests in a capital asset in a brokerage account, as I have suggested?

Remember, the text of the Revenue Ruling does not affirmatively state that the basis simply disappears. Rather, all it says is that the basis does not get added to the taxpayer’s basis in the retirement account. To my mind, that’s a clue. It is not a definitive answer to the mystery. 

Now that we are 14 years removed from the issuance of Rev. Rul. 2008-5, it might be time for the IRS and Treasury Department to revisit the basis issue. The government could issue a regulation or another Revenue Ruling addressing the basis result in a situation similar to my Example 5. 

Of course, for taxpayers, this mystery is best avoided if possible. Repurchases should either (i) occur outside of the 61-day wash sale window or (ii) be of securities that are not the same or substantially identical to the sold securities.

I’ve also posted a video on YouTube with thoughts on this topic.

Lastly, the above is simply my technical analysis. It is not legal advice applicable to any one particular taxpayer or real life situation. 

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

Follow me on Twitter at @SeanMoneyandTax

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

Four Ways to Fight Inflation

Decisions you make today can subject you to more inflation tomorrow! Read below about ways to increase or decrease your exposure to inflation tomorrow.

Watch me discuss fighting back against inflation.

Tax Planning

As a practical matter, most Americans have the majority of their retirement savings in traditional, pre-tax vehicles such as the 401(k). Having money in a traditional 401(k) is not a bad thing. However, the traditional 401(k) involves trade offs: an upfront tax deduction is the primary benefit in exchange for future taxation when there is a withdrawal or Roth conversion.

Having money inside traditional retirement accounts subjects future inflation to taxation. Some of the future growth in a traditional retirement account is likely to be attributable to inflation, and thus there will be a tax on inflation. Further, there are no inflation adjustments when it comes to the taxation of traditional IRA and traditional 401(k) withdrawals. 

An antidote to this problem is the tax free growth offered by Roth accounts and health savings accounts. Getting money into Roths and HSAs excuses future growth from taxation, including growth attributable to inflation. 

Roth 401(k) versus Roth IRA

Of course, inflation is only one consideration. Many will do some traditional retirement account contributions and some Roth retirement account contributions. The question then arises: which Roth account to use? 

My view is that for many a Roth IRA contribution (whether a direct annual contribution or a Backdoor Roth IRA) is better than a Roth 401(k) contribution. Many do not qualify to deduct a traditional IRA contribution but can deduct a traditional 401(k) contribution. Considering that reality, why not combine a deductible traditional 401(k) contribution and a Roth IRA contribution? 

Long Term Fixed Rate Debt

Often we discuss how inflation hurts Americans, and we should be concerned about the bad effects of inflation. However, there is a way to become a beneficiary of inflation: using long-term, low interest fixed rate debt to your advantage.

That’s right: hold onto that low rate 30 year mortgage like it’s a life raft! Okay, that’s a bit hyperbolic, but the overall point holds. Inflationary environments are great for debtors, particularly those debtors who have locked in a low interest rate for a long term.

Here is an example: Sarah and Mike have a 30 year, $400,000 mortgage on their primary residence at a 2.9% fixed interest rate. By paying the required monthly payment, and no more, they benefit from any future inflation. By paying off the mortgage later rather than sooner, they are using devalued future money to pay the mortgage rather than more valuable current day dollars. 

Sarah and Mike benefit from inflation! Are there reasons to pay off a mortgage early? Sure. But in an inflationary environment, paying off the mortgage early gives the bank more valuable dollars to satisfy the debt.

To my mind, a fixed rate, long term mortgage is a great hedge against inflation.

That said, there are few perfect financial planning tactics. Most involve risk trade offs. One risk Sarah and Mike assume by not paying down the mortgage early is the risk of deflation. To obtain this inflation hedge, they expose themselves to the risk of deflation. If the U.S. dollar starts to deflate (i.e., it appreciates in value), Sarah and Mike will find themselves paying more valuable dollars to the bank in the future. 

Travel Rewards

Travel rewards can help fight inflation. One way is using sign-up bonuses and other accrued points to pay for hotel room nights or flights. Using points gets out of cash paying and thus inflation of the dollar hurts a bit less.

However, keep in mind that travel reward points are subject to their own inflation! The hotel chain or airline can devalue the redemption value of points at any time. Thus, if everything else is equal, those with significant travel rewards point balances might want to spend those points sooner rather than later for travel. 

A second consideration are the features of credit cards. Some travel branded credit cards come with certificates for free nights or a companion pass for a companion to receive free or discounted flights. If flighting inflation is a key goal, favoring cards that offer free-night certificates or companion passes can be a way to fight inflation. 

Spending that Leads to More or Less Future Spending

We’re used to assessing the price tag. $28,000 for that brand new car: “that’s a great deal!” or “that’s a terrible deal!” But the price tag is only one part of the financial picture.

If you buy a black cup of coffee at Starbucks, it might cost you $2.65. Fortunately, that’s it. The cup of coffee isn’t likely to cause you to incur later costs.

What about a $45,000 SUV? That purchase will cause later costs, many significant. For example, the cost to insure a $45,000 SUV might be significantly more than insuring a $22,000 sedan. What about gas? By purchasing a larger, less fuel-efficient car, you lock in more future spending, and thus more exposure to future inflation. 

Think about buying a large home with a pool in the backyard. That square footage attracts property tax, heating and cooling costs, and inflation in both costs. The pool in the backyard requires constant upkeep, subjecting the homeowner to another source of inflation. 

To my mind, food is a big one in the fight against inflation. What you eat today could very well translate into medical costs tomorrow, exposing you to significant inflation. Spending on foods with vegetable oils and sugars today is likely to increase your future exposure to medical expense inflation. 

The lesson is this: you can use today’s spending to reduce your exposure to future inflation. 

Conclusion

Is there a perfect answer to inflation? No. But with some intentional planning and spending today, Americans can reduce their exposure to the harmful effects of future inflation. 

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

Follow me on Twitter: @SeanMoneyandTax

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

Recipe for Reporting a Backdoor Roth IRA

When it comes to the Backdoor Roth IRA, I’ve seen it all. Reporting a Backdoor Roth IRA on tax returns remains confusing for both taxpayers and tax return preparers. Here’s the recipe I recommend using to report the Backdoor Roth IRA on the tax return and avoid overpaying taxes.

Watch me discuss reporting Backdoor Roth IRAs on tax returns.

Let’s consider a hypothetical Backdoor Roth IRA on a 2021 tax return.

Example: On January 1, 2021, John Smith contributed $6,000.00 to a traditional IRA. On February 1, 2021, John Smith converted the entire amount in his traditional IRA, $6,001.00, to a Roth IRA. On December 31, 2021, John Smith had a zero balance in all his traditional IRAs, SEP IRAs, and SIMPLE IRAs. John Smith’s income is such that he qualifies for neither a deductible traditional IRA contribution nor a regular annual Roth IRA contribution. John has no existing basis in traditional IRAs as of January 1, 2021. 

Ingredients

Dry Ingredients

  • Taxpayer & Spouse Form W-2 and/or self-employed retirement contributions
  • The prior year’s Form 8606 (if the taxpayer has existing traditional IRA basis – most Backdoor Roth IRA taxpayers do not)

Wet Ingredients

  • Forms 5498 from financial institutions
    • If not available, substitute (i) end-of-year balances in all traditional IRAs, SEP IRAs, and SIMPLE IRAs and (ii) taxpayer knowledge or IRA account statement
  • Forms 1099-R from financial institutions

Directions

First, Enter the Dry Ingredients

In order to ensure that the tax return software has all the information to properly report the Backdoor Roth IRA, the taxpayer’s and spouse’s Forms W-2 (if any) should be properly entered into the tax return software. In particular, if Box 13 is checked, that should be indicated in the tax return software. Any qualifying self-employed retirement plan (Solo 401(k), SEP IRA, SIMPLE IRA) contributions should also be entered into the software. This requires the computation of the Schedule C to validate the correctness of the self-employment retirement contributions. 

Lastly, any established and still existing traditional IRA basis reported on previously filed Forms 8606 must be entered into the software. For those who have properly done Backdoor Roth IRAs in the past, this is extremely rare, but not impossible. Most such taxpayers enter the year with $0 of such basis. 

None of these steps directly report the current year’s Backdoor Roth IRA. However, without properly completing them, the tax return software will be unlikely to report the Backdoor Roth IRA correctly. 

Second, Enter The Traditional IRA Contribution

The first step in the tax return process is entering the traditional nondeductible IRA contribution into the tax return software. In theory, this should come off the Form 5498 (Box 1). In practice, that is not likely. The Form 5498 is not required to be filed by the financial institution until May 31st. Vanguard, for example, provides these forms in mid-May. 

If the taxpayer has a Form 5498 when preparing their tax return (perhaps because they are filing the return on extension), Box 1 of the form should report the traditional IRA contribution. In most circumstances, taxpayers will use their own knowledge of the transaction or their IRA account statement to report that they made a $6,000 nondeductible traditional IRA contribution.

By entering the $6,000.00 traditional IRA contribution into the tax return software, John’s tax return should generate a Form 8606. This is crucial for two reasons. First, the nondeductible traditional IRA contribution must be reported. Second, the nondeductible contribution establishes the “basis” that keeps John’s Backdoor Roth IRA as almost entirely tax free. 

Note further that IRAs are a single person item, meaning that there is no such thing as a “joint” IRA. Each spouse must enter his or her information separately, and must file his or her own individual Form 8606 as needed. Where spouses can impact the calculations and reporting is the ability to deduct an IRA contribution where one spouse is covered by a workplace retirement plan and the other spouse is not. 

Third, Enter the Roth Conversion

This is where the tax return reporting can go a bit off the rails if one is not careful. Tax return software usually has an input for Forms 1099-R. The Form 1099-R should be entered into the tax return software. 

John’s Form 1099-R should look like this (please pretend it is for 2021):

It is important to input all of the boxes on the Form 1099-R in the tax return software to help ensure that the software understands the transaction and no penalties are charged (there should be none as the transaction is a Roth conversion).

Some worry about Box 2a reporting $6,001.00 as the “taxable amount.” It’s okay! The taxable amount is in fact $6,001.00. However, it must be remembered that taxpayers must pay tax on the taxable amount reduced by the allowed available basis. 

How do we know what the allowed available basis is? By preparing and filing the Form 8606! To prepare the Form 8606, we must have all the ingredients above. It will be important that the following information is input into the Form 8606:

  • Current year traditional IRA contribution ($6,000.00)
  • Current year Roth IRA conversion ($6,001.00)
  • Balance in all traditional IRAs, SEP IRAs, and SIMPLE IRAs on December 31, 2021 ($0 in John’s case)

At this point the first two data points are in the tax return software. The last one must now be added to the software. Assuming the tax return is prepared prior to May, the taxpayer needs to review all of their existing traditional IRAs, SEP IRAs, and SIMPLE IRAs to ensure that as of December 31, 2021 there were no balances in those accounts. If there were balances, they must be added up and reported on line 6 of the Form 8606.

The Finished Product

Here is what page 1 of John’s Form 8606 should look like out of the oven.

Because Line 6 is $0, John’s allowed available basis is $6,000, the amount of 2021 nondeductible traditional IRA contribution. Separately, I blogged about the result if there is a substantial amount on Line 6 (hint: the allowed available basis decreases sharply, see Example 2). 

Unfortunately, I know that at least one tax return preparation software references a worksheet instead of populating the form in the output that the taxpayer sees. The correct information is (apparently) communicated to the IRS through electronic filing, but I wish all software providers simply populated the form to make it easier for review. 

Having successfully completed the first page of the Form 8606, the odds are that page 2 will also be successfully completed. Here’s what it should look like:

The final check on all of this comes from page 1 of Form 1040. If the Form 8606 is not correctly prepared, page 1 of Form 1040 will not correctly reflect the taxation of the Backdoor Roth IRA.

Assuming the taxpayer completed a 2021 Backdoor Roth IRA as John Smith did, page 1 of Form 1040 should look like this:

The key lines are Line 4a and Line 4b. Line 4a will simply be the sum of all Box 1’s from Forms 1099-R. In John’s case, that is $6,001. Line 4b is where the confusion comes. If the Form 8606 is properly prepared, the correct amount from Line 18 of Form 8606 should be the taxable amount reported on Line 4b of Form 8606. 

Fixing Backdoor Roth IRA Errors

Errors in previously filed tax returns can be fixed! I previously blogged about amending previously filed tax returns in cases where a Backdoor Roth IRA has been mistakenly reported. 

2023 Tax Season Backdoor Roth IRA Tax Return Reporting

Watch me discuss Backdoor Roth IRA tax return reporting.

Conclusion

Getting Backdoor Roth IRA tax return reporting is the last vital step in successfully executing a Backdoor Roth IRA. While it is not a simple exercise, it can be navigated with educational resources such as this blog post.

While tax return preparation software is great, it does not replace a taxpayer’s own judgment. Ultimately it is up to the taxpayer to ensure that the tax return properly reports the Backdoor Roth IRA. In many cases it will be wise to use a professional tax return preparer to prepare a tax return if the taxpayer has done a Backdoor Roth IRA.

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

Follow me on Twitter: @SeanMoneyandTax

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

Sean on the Stacking Benjamins Podcast

I talk tax with Joe Saul-Sehy on today’s episode of the Stacking Benjamins podcast. Available on YouTube and all major podcast players. https://www.stackingbenjamins.com/stories-from-our-stackers-1158/

This post, podcast, and video 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.

72(t) Series of Substantially Equal Periodic Payments Update

The IRS and Treasury have recently issued two updates to the rules for payments which avoid the 10 percent early withdrawal penalty from retirement accounts. These payments are referred to as a series of substantially equal periodic payments, SEPP, or 72(t) payments. This post discusses the updated rules. 

72(t) Payments

Tax advantaged retirement accounts are fantastic. Who doesn’t love 401(k)s, IRAs, Roth IRAs, and the like?

However, investing through a tax advantaged account can have drawbacks. One big drawback is that taxable amounts withdrawn from a tax advantaged retirement account prior to the account owner turning age 59 ½ are generally subject to a 10 percent early withdrawal penalty. My home state of California adds a 2.5 percent early withdrawal penalty. 

There are some exceptions to this penalty. One of them is taking 72(t) payments. The idea is that if the taxpayer takes a “series of substantially equal periodic payments” they can avoid the penalty. 

72(t) payments must be taken annually. Further, they must last for the longer of (a) 5 years or (b) the time until the taxpayer turns age 59 ½. This creates years of locked-in taxable income. 

There are three methods that can be used to compute the amount of the annual 72(t) payments. These methods compute an annual distribution amount generally keyed off three numbers: the balance in the relevant retirement account, the interest rate, and the table factor provided by the IRS. The factor is greater the younger the account owner is. The greater the factor, the less the account owner can withdraw from a retirement account in a 72(t) payment.

New 72(t) Payment Interest Rates

In January 2022, the IRS and Treasury issued Notice 2022-6. Hat tip to Ed Zollars for the alert. This notice provides some new 72(t) rules. The biggest, and most welcome, change is a new rule for determining the interest rate.

Previously, the rule had been that 72(t) payments were keyed off 120 percent of the mid-term applicable federal rate (“AFR”). The IRS publishes this rate every month. In recent years, that has been somewhat problematic, as interest rates have been historically low. For example, in September 2020, the mid-term AFR was just 0.42 percent. This made relying on a 72(t) payment somewhat perilous. How much juice can be squeezed from a large retirement account if the interest rate is just 0.42 percent?

Here is what a $1M traditional IRA could produce, under the fixed amortization method, in terms of an annual payment for a 53 year old starting a 72(t) payment if the interest rate is just 0.42 percent:

120% of Sept 2020 MidTerm AFR0.42%
Single Life Expectancy Years at Age 5333.4
Account Balance$1,000,000.00
Annual Payment$32,151.93

Notice 2022-6 makes a very significant change. It now allows taxpayers to pick the greater of (i) up to 5 percent or (ii) up to 120 percent of mid-term AFR. That one change makes a 72(t) payment a much more attractive option, since periods of low interest rates do not as adversely affect the calculation. 

Here is what a $1M traditional IRA could produce, under the fixed amortization method, in terms of an annual payment for a 53 year old starting a 72(t) payment if the interest rate is 5 percent:

5% Interest Rate5.00%
Single Life Expectancy Years at Age 5333.4
Account Balance$1,000,000.00
Annual Payment$62,189.80

The new rule provides a 5 percent interest rate floor for those using the fixed amortization method and the fixed annuitization method to compute a 72(t) payment. Using a 5 percent interest rate under the fixed amortization method is generally going to produce a greater payment amount than using the required minimum distribution method for 72(t) payments. 

The interest rate change provides taxpayers with much more flexibility with 72(t) payments, and a greater ability to extract more money penalty free prior to age 59 ½. Taxpayers already have the ability to “right-size” the traditional IRA out of which to take a 72(t) payment to help the numbers work out. In recent years, what has been much less flexible has been the interest rate. Under these new rules, taxpayers always have the ability to select anywhere from just above 0% to 5% regardless of what 120 percent of mid-term AFR is. 

Watch me discuss the update to 72(t) payment interest rates.

New Tables

A second new development is that the IRS and Treasury have issued new life expectancy tables for required minimum distributions (“RMDs”) and 72(t) payments. Most of the new tables are found at Treasury Regulation Section 1.401(a)(9)-9, though one new table is found at the end of Notice 2022-6. 

These tables reflect increasing life expectancies. As a result, they reduce the amount of RMDs, as the factors used to compute RMDs are greater as life expectancy increases. 

From a 72(t) payment perspective, this development is a minor taxpayer unfavorable development. Long life expectancies in the tables means the tables slightly reduce the amount of juice that can be squeezed out of any particular retirement account.

This said, the downside to 72(t) payments coming from increasing life expectancy on the tables is more than overcome by the ability to always use an interest rate of up to 5 percent. These two developments in total are a great net win for taxpayers looking to use 72(t) payments during retirement. 

Use of 72(t) Payments

Traditionally, I have viewed 72(t) payments as a life raft rather than as a desirable planning tool for those retiring prior to their 59 ½th birthday. Particularly for those in the FI community, my view has been that it is better to spend down taxable assets and even dip into Roth basis rather than employ a 72(t) payment plan. 

These developments shift my view a bit. Yes, I still view 72(t) payments as a life raft. Now it is an upgraded life raft with a small flatscreen TV and mini-fridge. 😉

As a practical matter, some will get to retirement prior to age 59 ½ with little in taxable and Roth accounts, and the vast majority of their financial wealth in traditional retirement accounts. Notice 2022-6 just made their situation much better and much more flexible. Getting to retirement at a time of very low interest rates does not necessarily hamstring their retirement plans given that they will always have at least a 5 percent interest rate to use in calculating their 72(t) payments. 

72(t) Payments and Roth IRAs

As Roth accounts grow in value, there will be at least some thought of marrying Roth IRAs with 72(t) payments. 

At least initially, Roth IRAs have no need for 72(t) payments. Those retired prior to age 59 ½ can withdraw previous Roth contributions and Roth conversions aged at least 5 years at any time tax and penalty free for any reason. So off the bat, no particular issue, as nonqualified distributions will start-off as being tax and penalty free.

Only after all Roth contributions have been withdrawn are Roth conversions withdrawn, and they are withdrawn first-in, first-out. Only after all Roth conversions are withdrawn does a taxpayer withdraw Roth earnings.  

For most, the odds of withdrawing (i) Roth conversions that are less than five years old, and then (ii) Roth earnings prior to age 59 ½ are slim. But, there could some who love Roths so much they largely or entirely eschew traditional retirement account contributions. One could imagine an early retiree with only Roth IRAs. 

Being “Roth only” prior to age 59 ½ could present problems if contributions and conversions at least 5 years old have been fully depleted. Taxpayers left with withdrawing conversions less than 5 years old or earnings in a nonqualified distribution might opt to establish a 72(t) payment plan for their Roth IRA. Such a 72(t) payment plan could avoid the 10 percent penalty on the withdrawn amounts attributable insufficiently aged conversions or Roth earnings. Note, however, that Roth earnings withdrawn in a nonqualified distribution are subject to ordinary income tax, regardless of whether they are part of a 72(t) payment plan. 

See Treasury Regulation Section 1.408A-6 Q&A 5 providing that Roth IRA distributions can be subject to both the 72(t) early withdrawal penalty and the exceptions to the 72(t) penalty. The exceptions include a 72(t) payment plan. 

Additional Resource

Ed Zollars has an excellent post on the updated IRS rules for 72(t) payments here.

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

Follow me on Twitter: @SeanMoneyandTax

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

2022 Backdoor Roth IRA

The Backdoor Roth IRA lives! The proposal to repeal the Backdoor Roth IRA as of January 1, 2022 will not be enacted in 2021, as it is now abundantly clear that the Build Back Better legislative program will not be enacted anytime soon. 

But could the proposal come back in 2022? How does one do financial planning in this regard in this climate of uncertainty?

Below I discuss how I approach the issue of whether one should execute a Backdoor Roth IRA in early 2022. What follows is my opinion of the possibilities that could play out. They are simply one person’s opinion in the face of a somewhat uncertain situation. 

Nothing below is tax advice for any individual taxpayer to rely upon. 

Update February 5, 2022: Watch my updated assessment of the 2022 Backdoor Roth IRA landscape on YouTube.

Planning for Uncertainty

To tackle the issue of whether to execute a Backdoor Roth IRA in early 2022, I believe it is best to think of a hypothetical example and then consider all of the (currently known) possibilities in terms of law changes and their probabilities of occuring. So here’s a hypothetical example:

Single Nurse is 35 years old, single, and makes $170,000 at her W-2 job in 2022. She is covered by a 401(k) at work. Her 2022 modified adjusted gross income (“MAGI”) makes her ineligible to make an annual contribution to a Roth IRA. On January 1, 2022, Single Nurse contributes $6,000 to a traditional IRA. On January 5, 2022, Single Nurse converts the entire balance in her traditional IRA, $6,000.23, to a Roth IRA. Assuming Single Nurse takes no other action, she will have $0 in all traditional IRAs, SEP IRAs, and SIMPLE IRAs on December 31, 2022. 

Will Single Nurse be happy she executed a Backdoor Roth IRA early in 2022?

Let’s analyze the various possibilities in terms of new laws during 2022 and how they could impact Single Nurse’s 2022 Backdoor Roth IRA. Many thanks to Pixabay.com for the emoji reaction pictures and the featured image!

Note that Possible Outcomes #3 through #6 include the small possibility that Congress enacts a repeal of the Backdoor Roth IRA separate from the Build Back Better program.

Possible Outcome #1: No Portion of Build Back Better is Enacted in 2022

Sean’s Estimated Probability of Occurring: 70%

Under this outcome, Single Nurse is quite pleased with her 2022 Backdoor Roth IRA. She’s happy she executed it, even though she could have done it much later in the year.

Single Nurse’s reaction:


Possible Outcome #2: A New Version of Build Back Better is Enacted in 2022 Which Does Not Repeal the Backdoor Roth IRA

Sean’s Estimated Probability: 15%

Single Nurse is again quite pleased with her 2022 Backdoor Roth IRA in January, even though she could have waited. 

Single Nurse’s reaction:


Possible Outcome #3: A New Version of Build Back Better is Enacted in 2022 Which Repeals the Backdoor Roth IRA Effective January 1, 2023

Sean’s Estimated Probability: 10%

Single Nurse is again quite pleased with her 2022 Backdoor Roth IRA in January, though she’ll miss the Backdoor Roth IRA in 2023. 

If Congress does enact legislation in 2022 to repeal the Backdoor Roth IRA, I agree with Steven Rosenthal that the most likely effective date is January 1, 2023, which would be the easiest to implement. Changing tax laws during a year creates needless complexity and confusion, and thus I believe a January 1, 2023 effective date is the most likely effective date. 

Single Nurse’s reaction:


Possible Outcome #4: A New Version of Build Back Better is Enacted in 2022 Which Repeals the Backdoor Roth IRA Effective On the Date of Enactment

Sean’s Estimated Probability: 3%

Single Nurse breathes a huge sigh of relief! If she had waited until later in 2022 to execute her 2022 Backdoor Roth IRA, she would not have been able to. She got her 2022 Backdoor Roth IRA in under the wire, and is very happy she executed the Backdoor Roth IRA early in January. 

Single Nurse’s reaction:

Possible Outcome #5: A New Version of Build Back Better is Enacted in 2022 Which Repeals the Backdoor Roth IRA Effective January 1, 2022 and the IRS Treats an Early 2022 Backdoor Roth IRA as a Correctable Excess Contribution to a Roth IRA

Sean’s Estimated Probability: 1.6%

This is where it gets really interesting. First of all, a law retroactively repealing a tax law benefit would likely face some sort of legal challenge were to be enforced retroactively. For now, I will put an analysis of that outcome to the side. 

How would the IRS enforce a repeal of the Backdoor Roth IRA as applied to Backdoor Roth IRAs executed prior to the law change but after a January 1, 2022 effective date? Single Nurse’s Backdoor Roth IRA is both post-effective date and prior to the enactment of the law change. 

This situation would require an administrative transition rule from the IRS and Treasury. I believe the only feasible transition rule would be for the IRS to treat any pre-enactment/post-effective date 2022 Backdoor Roth IRA as an excess contribution to a Roth IRA. Under the excess contribution rules, excess contributions are generally correctable.

This treatment would give Single Nurse three potential courses of action:

  1. Withdraw the $6,000 and the growth on the $6,000 from the Roth IRA (a corrective distribution) by October 16, 2023.* Any growth on the $6,000 originally contributed is taxable to Single Nurse as ordinary income in 2022; or
  2. Recharacterize the $6,000 and the growth on the $6,000 as a traditional IRA by October 16, 2023. This will result in Single Nurse having a traditional IRA with a basis of $6,000; or,
  3. If neither Option 1 or Option 2 is timely executed by October 16, 2023, Single Nurse owes a six percent penalty on the $6,000 excess contribution ($360) and will owe an additional six percent penalty for every additional year the $6,000 Roth contribution (but not the earnings) is not withdrawn from the Roth IRA. 

I do not see another administratively feasible alternative for the IRS to enforce a retroactive repeal of the Backdoor Roth IRA in 2022. 

I believe the IRS and Treasury would also apply this treatment (or a similar treatment) to any split-year Backdoor Roth IRAs completed in 2022 for the 2021 tax year.

*Update 1/6/2022: Upon further reflection, I believe remedial action to correct an excess Roth IRA contribution in this hypothetical situation can occur by the extended tax return due date. See the bottom of page 42 of IRS Publication 590-A. An earlier version of this post used April 15, 2023 as the deadline date for all three remedial courses of action.

This outcome is not all that bad for Single Nurse. An opportunity taken away for sure, but the “downside” consequences are not all that deleterious. The downside appears limited to ordinary income tax on a few months of growth on $6,000. 

Single Nurse’s reaction:

Possible Outcome #6: A New Version of Build Back Better is Enacted in 2022 Which Repeals the Backdoor Roth IRA Effective January 1, 2022 and the IRS Treats Early 2022 Backdoor Roth IRAs in a Different Manner

Sean’s Estimated Probability: 0.4%

This outcome accounts for the unknown. The IRS and Treasury might take a different approach than the one I outline in Possible Outcome #5. To my mind, the absolute worst outcome would be the six percent penalty tax on an excess contribution. Even then, it is difficult to imagine a scenario where the IRS would not allow remedial action to avoid the six percent penalty.

Single Nurse’s reaction:

Single Nurse’s Assessment

Single Nurse will need to make a subjective assessment of the possibilities and the risks. She is likely to assign somewhat different probabilities to the various possible outcomes than I do. Further, she will have to determine how much she values the possible benefit of an early Backdoor Roth IRA (Possible Outcome #4 in particular, and Possible Outcomes #1 through #3) versus the costs of an early Backdoor Roth IRA (Possible Outcomes #5 and 6). 

My own assessment is that Single Nurse is more likely to benefit from executing an early Backdoor Roth IRA than she is to be (slightly) harmed by it, because I believe that Possible Outcome #4 is more likely than Possible Outcomes #5 and #6. 

Conclusion

Of course, none of the above is advice for any particular taxpayer. Rather, it serves to illustrate how one financial planner would go about systematically assessing the probabilities, risks, and rewards associated with an early 2022 Backdoor Roth IRA.

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

Follow me on Twitter: @SeanMoneyandTax

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

The End of the End of the Backdoor Roth IRA?

Update as of December 20, 2021: I originally posted this article on Saturday morning, December 18th. On Sunday, developments occurred which called into question the use of a question mark in the article’s title.

Senator Joe Manchin appeared on Fox News Sunday and very publicly indicated he is a No on Build Back Better. He followed that with a written statement outlining his opposition to Build Back Better. The White House issued a statement in response to Senator Manchin.

A fair assessment indicates the parties are not at all close on this one. This is not a situation where Senator Manchin is bargaining to get A, B, and C into the bill and the White House is hoping to only have to give B and C. While anything is possible with tax legislation, it is quite difficult to argue that the Build Back Better program (which includes Backdoor Roth IRA repeal) has a realistic possibility of passage in this Congress in anything resembling its current form.

Update February 5, 2022: Watch my updated assessment of the lay of the land on 2022 Backdoor Roth IRAs.

Below is the original post posted on December 18, 2021.

There’s an early Christmas present for tax efficient investors. The proposal to end the Backdoor Roth IRA is on life support, and as of now (December 18, 2021) it appears that even if the proposal passes, it will not pass until 2022 at the earliest.

Latest Developments

The White House has now issued a written statement that the so-called Build Back Better program will not be signed into law this year. The proposal to repeal the Backdoor Roth IRA is one of many tax proposals contained within the overall Build Back Better legislative program. As this Deloitte write-up discusses, it is clear the Senate will not pass the legislation any time in the near-term. Thus, for the time being, the Backdoor Roth IRA is in the clear. 

Prospects for 2022

Update December 28, 2021: Read my assessment of 2022 Backdoor Roth IRAs.

There is a reason the Build Back Better program will not be enacted during 2021: it’s not broadly popular. This is reflected in the current opposition of all 50 Senate Republicans and Democrat Senator Joe Manchin. Further, it is not at all clear that Democrat Senator Kyrsten Sinema will ultimately support Build Back Better. 

If the Build Back Better program were to become popular, the dynamics in the U.S. Senate would likely change. But one must ask: is there something that could occur in early 2022 that would make the legislation popular then when it was not popular in late 2021? 

Another issue the legislation has is the unlikelihood of any potential tax increase passing during an election year. New tax laws have proponents and opponents: in recent years Congress has hesitated to create opponents during election years by enacting significant tax legislation. 

What If?

What if the legislation is enacted in early 2022? What happens to Backdoor Roth IRAs? That is highly, highly speculative. My guess is that if the legislation (at that point) bans Backdoor Roth IRAs, either (i) Backdoor Roth IRAs will be prohibited as of January 1, 2023 (instead of January 1, 2022 in the current legislation) or (ii) prohibited as of the enactment of the law. 

But all sorts of alternative possibilities exist. A much smaller version of the Build Back Better program could be enacted, and that version could omit the Backdoor Roth IRA repeal. Or there will be no legislation enacted at all. 

Why Are We Here?

Is the Backdoor Roth IRA gimmicky? Absolutely it is!

But there is a bigger issue. Why the heck is there any income limitation on the ability to make a $6,000 annual contribution to a Roth IRA? Consider these two examples.

Wealthy Investor controls a large public company and is known for his ability to earn good investment returns. He is worth billions of dollars and is 80 years old. He can direct the large public company to offer a Roth 401(k), and on January 1st of 2022 he can have payroll issued to him, of which he can put $27,000 into his Roth 401(k). 

Single Nurse, age 35, is a nurse and earns $170,000 from her W-2 job. Her employer offers a traditional 401(k) but no Roth 401(k). Single Nurse earns too much (due to the Roth IRA modified adjusted gross income limit) to make an annual $6,000 contribution to a Roth IRA. As a result, Single Nurse’s annual Roth contributions are limited to $0.

Wealthy Investor can contribute $27,000 to a Roth 401(k) but Single Nurse can’t contribute $6,000 to a Roth IRA?

To borrow an exasperated quote from Cosmo Kramer, “What’s going on!!!”

The Backdoor Roth IRA solves this problem for Single Nurse and many other Americans. This workaround does not work for all Americans, as I have previously written. 

The simplest solution is to eliminate the modified adjusted gross income limit for all Roth IRA contributions. So some very wealthy Americans will get a few thousand dollars into Roth IRAs every year. Is this a horribly worrisome outcome considering many very wealthy Americans already have access to much greater workplace retirement plan contributions with absolutely no income limitation?

Once the income limit on the ability to make a Roth IRA contribution is repealed, there will be no need for Backdoor Roth IRAs. 

Conclusion

The only constant in the tax world is change. We shall see what the future holds for the Backdoor Roth IRA, but the coast appears to be clear for the rest of the year. Stay tuned!

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

Follow me on Twitter: @SeanMoneyandTax

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

FI Tax Guy Featured on the Optimal Finance Daily Podcast

Today and tomorrow my year-end tax planning post will be featured on the Optimal Finance Daily podcast.

Listen to today’s episode on podcast players and here.

Read my year-end tax planning blog post here.

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

Follow me on Twitter: @SeanMoneyandTax

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

Sean Talks Tax with DocG

Listen to my discussion with DocG on the latest episode of the Earn and Invest podcast. Available on all major podcast players and at this link: https://www.earnandinvest.com/episodes/five-tax-questions-you-must-ask

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

Follow me on Twitter: @SeanMoneyandTax

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