The Tax Efficient Path to Financial Independence
I’m honored to be the featured guest on this week’s ChooseFI podcast. Brad, Jonathan, and I discussed careers in accounting, my professional journey, and some tax planning. I’m glad to say that I’ll be back on the podcast to discuss tax issues and planning in the future.
I hope you enjoy this episode. It is available at this website, YouTube, and wherever you listen to podcasts. https://www.choosefi.com/how-to-fund-your-childs-roth-ira/
There are limits to how much can be contributed to traditional IRAs and Roth IRAs. This post describes how excess contributions happen and how to resolve them.
Three introductory notes. First, if you find that you have made an excess contribution, you may be well advised to seek professional advice. Second, please don’t panic, but make sure to act swiftly. Excess contributions are resolvable but do not benefit from delays. Third, you should not plan to make an excess contribution for a variety of reasons.
There are (generally speaking) three situations that generate an excess contribution to a traditional IRA. They are:
This last category is not immediately obvious, but it does occasionally occur. For example, a taxpayer might inherit a taxable account and incorrectly roll it into an inherited IRA. Or a taxpayer might incorrectly roll an IRA they inherited into their own IRA. Or a taxpayer might attempt a 60-day rollover of amounts previously in an IRA and roll the money into an IRA after the 60-day deadline. Note that in some cases, this last mistake can be resolved by obtaining a private letter ruling from the IRS (doing so is beyond the scope of this post).
For 2019 and prior taxable years, there is an additional category: contributions to a traditional IRA when the taxpayer was 70 1/2 or older. The SECURE Act eliminates the prohibition on those 70 1/2 and older contributing to a traditional IRA.
Prior to the 2020 tax year, if you qualified to make a contribution to a Roth IRA, but not to a traditional IRA, you could direct your financial institution to recharacterize the contribution to a Roth IRA. This scenario only applied in situations where the taxpayer was over age 70 ½ when the contribution was made to the traditional IRA.
Now there is no scenario where this would be relevant. Anyone not qualifying to make a contribution to a traditional IRA would also not qualify to make a contribution to a Roth IRA.
However, recharacterizations of contributions from traditional IRAs to Roth IRAs can make sense for some taxpayers for tax planning reasons, and are allowable if done properly.
To recharacterize, you must contact the financial institution and direct them to move the contribution and its earnings to a Roth IRA. This must be disclosed in a white paper statement attached to your federal income tax return. The recharacterization deadline is the extended due date of the tax return (generally October 15th).
A second way to correct an excess contribution to a traditional IRA is to take a “corrective distribution” of the excess contribution and its earnings from the IRA. You will need to inform your financial institution of the excess contribution and request a corrective distribution of the excess contribution and the earnings attributable to the excess contribution. If the excess contribution is withdrawn prior to the extended filing deadline, the withdrawal of the contribution itself is generally not included in taxable income.
As observed in IRS Publication 590-A, page 34, in most cases the financial institution will compute the earnings attributable to the excess contribution. The earnings will be included in taxable income for the actual year the excess contribution was made. For example, if a 2023 IRA contribution is made in January 2024, and the taxpayer later takes a corrective distribution of that contribution and its earnings, the earnings will be includible in taxable income in 2024. In those cases where the taxpayer must compute the earnings, IRS Publication 590-A Worksheet 1-3 is a resource for figuring the earnings or loss.
See Example 1 in this article for insights on the reporting timing of earnings attributable to corrective distributions.
Up until the passage of SECURE 2.0, the earnings were also subject to the ten percent early withdrawal penalty (unless an exception otherwise applied). However, SECURE 2.0 Section 333 repealed the early withdrawal penalty with respect to withdrawals of earnings occurring pursuant to a corrective distribution. Note further that as of March 1, 2024 there is now some doubt as to the on going validity of SECURE 2.0.
If the corrective distribution occurs after the taxpayer files their tax return for the relevant taxable year, but before the extended filing deadline for the year (generally October 15th), the taxpayer must file an amended return which reports the corrective distribution.
A quick note on corrective distributions (as applied to both traditional IRAs and Roth IRAs): they can be done if the taxpayer has changed their mind. Natalie Choate makes this point in her excellent treatise Life and Death Planning for Retirement Benefits (8th ed. 2019, see page 132). Corrective distributions are not limited to simply those times when the taxpayer has made a contribution in excess of the allowed limits.
You can keep an excess contribution in a traditional IRA and apply it to a later year, if you are eligible to make a traditional IRA contribution in that later year. This method does not avoid the six percent penalty discussed below for the year of the contribution, but it allows the taxpayer to avoid taking a distribution of the excess contribution and stops additional impositions of the six percent excess contribution penalty. Generally, this method is only effective if the amount of the excess contribution is relatively modest, since a large excess contribution cannot be soaked up by only one year’s annual IRA contribution limit.
If you do not resolve the excess contribution prior to the extended deadline for filing your tax return, you must pay a six percent excise tax on the excess contribution annually until the excess contribution is withdrawn from the traditional IRA. You report and pay the excise tax by filing a Form 5329 with the IRS. Because this six percent tax is imposed each year the excess contribution stays in the traditional IRA, it is important to correct excess contributions to traditional IRAs promptly.
Note further that excess contributions withdrawn after the extended filing deadline are generally included in taxable income, though the taxpayer can recover a portion of any IRA basis they have under the Pro-Rata Rule.
There are (generally speaking) four situations that cause an excess contribution to a Roth IRA. They are:
A rather common excess contribution occurs when taxpayers contribute to a Roth IRA in a year they earn in excess of the MAGI limits. That can happen for a host of reasons, including end of year bonuses or other unanticipated income.
Another somewhat common mistake in this regard is made by those subject to required minimum distributions (“RMDs”) when trying to convert traditional IRAs to Roth IRAs. In early January a taxpayer might convert a chunk of their traditional IRA to a Roth IRA. This creates a problem if the taxpayer did not previously take out their annual RMD for the year. There is a rule providing that RMDs are the first money to come out of an IRA during the year, and RMDs may not be converted to Roth IRAs. Thus, “converting” the first dollars out of a traditional IRA (an RMD) during the year creates an excess contribution to a Roth IRA.
Assuming that the taxpayer qualifies to make a contribution to a traditional IRA, the excess contribution to a Roth IRA can be recharacterized as a contribution to a traditional IRA. Generally, the taxpayer must contact the financial institution and direct them to recharacterize the contribution and its earnings into a traditional IRA and must file a white paper statement with their tax return explaining the recharacterization.
When the taxpayer’s income puts him or her over the Roth IRA MAGI limits, recharacterization is often how excess contributions to Roth IRAs are resolved. In such cases, they will generally qualify to make a contribution to a traditional IRA, so a recharacterization is often the go-to method of correcting an excess contribution to a Roth IRA.
Note that the recharacterization deadline is the extended due date of the tax return (usually October 15th).
A second way to correct an excess contribution to a Roth IRA is to take a corrective distribution of the excess contribution. You will need to inform your financial institution of the excess contribution and request a corrective distribution of the excess contribution and the earnings attributable to the excess contribution. The withdrawal of the excess contribution itself is generally not taxable.
The financial institution will compute the earnings attributable to the excess contribution. The earnings will be included in taxable income for the actual year the excess contribution was made. The same inclusion timing rules applicable to traditional IRA corrective distributions (discussed above) apply to the earnings from a Roth IRA corrective distribution.
If the corrective distribution occurs after the taxpayer files their tax return for the relevant taxable year, but before the extended filing deadline for the year (generally October 15th), the taxpayer must file an amended return which reports the corrective distribution and includes the earnings in taxable income (if the original contribution actually occurred in the year covered by the tax return).
As with excess contributions to traditional IRAs, you can keep an excess contribution in a Roth IRA and apply it to a later year, if you are eligible to make a Roth IRA contribution in that later year. This method does not avoid the six percent penalty discussed below for the year of the contribution, but it allows the taxpayer to avoid taking a distribution of the excess contribution and stops additional impositions of the six percent excess contribution penalty. Generally, this method is only effective if the amount of the excess contribution is relatively modest, since a large excess contribution cannot be soaked up by only one year’s annual Roth IRA contribution limit.
As with excess contributions to traditional IRAs, if you do not resolve the excess contribution to your Roth IRA prior to the extended deadline for filing your tax return, you must pay a six percent excise tax on the excess contribution annually until the excess contribution is withdrawn. It is best to resolve an excess contribution to a Roth IRA sooner rather than later to avoid annual impositions of the penalty.
Corrective measures applied to traditional IRA and/or Roth IRA contributions may require tax return reporting. Such reporting is discussed in various sources. Examples of such sources include IRS Publication 590-A, the Instructions to the Form 8606, and/or the Instructions to the Form 5329.
Excess contributions to IRAs and Roth IRAs happen. They are not an occasion to panic. They are an occasion for prompt, well considered action. Hopefully this article provides enough background for you to start your decision process and, if necessary, have an informed conversation with a competent tax professional.
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.
Should you hold rental real estate in a self-directed retirement account? Is real estate a great asset to own in a Roth IRA? Is holding real estate in a self-directed retirement account a hack that can help supercharge your path to financial independence? Below I discuss what it looks like to hold real estate in a self-directed IRA or 401(k), with a particular focus on those looking to achieve FI.
Before I proceed, I need to lay a necessary predicate. Those actively pursuing financial independence will fall into one of the two following groups:
Group 1: Invest in a diversified portfolio of equities and bonds.
Group 2: Invest in real estate and a diversified portfolio of equities and bonds.
Why is there no third group, real estate investors only? For two main reasons. First, many pursuing FI have no interest in owning rental real estate and/or desire to only own a small number of properties. Second, as a general rule, investing in only one sector of the economy (technology, financials, pharmaceuticals, utilities, real estate, etc.) leaves an investor dangerously undiversified and vulnerable to very particular risks to a degree diversified investors are not.
The rest of this post focuses on tax basketing for individuals in Group 2: those pursuing FI and investing in rental real estate and a diversified portfolio of equities and bonds.
Recall that the basis of stock, bonds, mutual funds, and ETFs (what I will colloquially refer to as “stock basis”) is the amount you paid for the asset plus any distributions reinvested in the asset less any nondividend distributions (returns of capital). Stock basis is great, but for many in the FI community, its benefits are distant and significantly eroded by inflation.
Picture Jack and Jill, a married couple, each 25 years old and actively pursuing financial independence. They max out their IRAs and workplace retirement plans. They have a savings rate in excess of 50 percent, so they must invest in taxable accounts, and choose to invest in low-cost, well diversified index mutual funds. They target early retirement at age 40.
Other than very occasional tax loss harvesting, the basis Jack & Jill obtain in their taxable mutual fund accounts at age 25 will be meaningless to them until they are at least 40 years old. Even then, using something like the 4 percent withdrawal rule, they will touch only a small fraction of their basis every year. By then, the value of the basis they put in the mutual funds will have been significantly eroded by inflation.
But what if Jack and Jill instead decide that they will max out their IRAs and workplace retirement accounts (using stock and bond index funds), and then everything else will go into taxable rental real estate investments. What value does their basis have then? Much greater value, it turns out. Jack and Jill can immediately depreciate their rental real estate and start using their basis to reduce their taxable rental income from that property and other rental properties. Depending on their circumstances, they may be able to deduct some or all of any rental real estate loss against other taxable income.
When you invest in rental real estate in taxable accounts, your tax basis goes to work for you right away. When you invest in financial assets, your tax basis sits dormant, possibly for many years or the rest of your life. By the time you use your stock basis to obtain a tax benefit, the value of your stock basis (and thus the resulting tax benefit) may be severely diminished by inflation.
This strongly indicates you should house financial assets in retirement accounts and rental real estate in taxable accounts. House the rental real estate (pun intended) in taxable accounts where you can milk its basis for all it’s worth while housing the financial assets in retirement accounts.
You can use leverage to increase the tax value of rental real estate. A young couple will have to likely borrow some or all of the purchase price of their initial rental real estate investments. This can be advantageous from a tax perspective. Here’s an illustrative example:
Jack and Jill have $50,000 of cash to invest in a taxable account. They have decided to invest in a $250,000 fifth floor condominium to rent out. They borrow $200,000, purchase the property, and rent out the condo. In the first year they rent out the condo for a full year, they can get $9,091 ($250,000 divided by 27.5) in depreciation deductions and, assuming a 5% loan, almost $10,000 in interest deductions. Note this and all examples ignore any potential price allocation to land for simplicity.
Jack and Jill leveraged $50,000 into almost $19,000 in tax deductions in one year alone. Had they purchased $50,000 worth of financial assets, they would have received exactly nothing in tax deductions in the first full year, and the value of the $50,000 of basis would be eroding away to inflation. Even if they were able to tax loss harvest, at most the benefit would be a $3,000 deduction against their ordinary income.
In some cases, depreciation combined with other deductions causes rental real estate to produce a loss for tax purposes. Why put an asset that generates a tax loss in a retirement account?
If stock basis has such limited value, and rental real estate basis has such impactful, immediate value, why “exploit” stock basis in a taxable account while you neuter rental real estate basis in an IRA? It makes much more sense to utilize that rental real estate tax basis in a taxable account and put limited value stock basis in a retirement account.
When you leave your heirs rental real estate in taxable accounts, the government gives your heirs hundreds of thousands of dollars worth of free tax deductions!
There’s no lack of content discussing the many tax benefits of real estate. Some of it discusses the step-up in basis at death and the ability to hold real estate in a self-directed retirement account. What little of this content acknowledges is that if you hold real estate in a self-directed retirement account, you lose the step-up in basis at death!
If you are at all concerned about Second Generation FI for your children, you need to consider this issue. The step-up in tax basis at death is an incredible opportunity for your heirs. Upon your death, your heirs get to re-depreciate your rental real estate based on the fair market value of the property at your death.
Here’s a comprehensive example.
Jake buys a small rental condo for $100,000 in 2019. He fully depreciates it over 27.5 years, saving significantly on his taxes. He dies in 2049 when the condo is worth $400,000. He leaves the condo to his adult son Jake Jr. He also leaves a Roth IRA with financial assets to Jake Jr. worth $400,000.
What result? Jake Jr. inherits the condo with a $400,000 tax basis and gets to depreciate that new $400,000 basis for 27.5 more years! This drastically reduces his taxable income from the property and may create a currently useable taxable loss. While Jake Jr. must withdraw the inherited Roth IRA within 10 years, the money from the Roth IRA is tax free to Jake Jr. And because Jake Jr houses the inherited Roth IRA at a discount brokerage (such as Vanguard, Fidelity, or Schwab), the Roth IRA pays minimal fees.
What if instead Jake had housed the financial assets in his taxable accounts and the rental property in his Roth IRA. First, the financial assets will produce interest, dividends, and capital gain distributions that will be taxable to Jake Jr. every year. Second, Jake Jr. will pay more in annual fees to a self-directed Roth IRA custodian. Further, Jake Jr. will lose the ability to claim any tax loss generated by the condo against his other income.
The effect is magnified if Jake Jr. leaves the rental property to his son, Jake III. Jake III will again get to step-up the basis in the condo to its fair market value when Jake Jr. dies and re-depreciate it! Over several generations the step-up in basis cycle can create potentially millions of dollars of tax depreciation deductions!
If you are going to give up hundreds of thousands of dollars (possibly millions) of tax deductions for your heirs, you ought to have a compelling reason to do so. I do not believe there’s a compelling reason to house real estate in a retirement account and forego these free future tax deductions.
Roth IRAs are great for protecting the income generated by financial assets from taxation. The step-up in basis is great for protecting the income from rental real estate from taxation. Why waste a Roth IRA on real estate when your heirs will get a fantastic step-up in basis in your real estate to shield a significant portion of the income from taxation (and may possibly generate useable current real estate losses)?
All of this is magnified if the rental real estate is in a traditional IRA instead of a Roth IRA. Instead of depreciation and other deductions to shield rental income from taxation, every dollar you ever take from a traditional IRA will be subject to ordinary taxation (even if the underlying rental property is unprofitable). Combining this with self-directed retirement account custodian fees makes a traditional retirement account a terrible place to house rental real estate.
As discussed, the step-up in real estate basis is effective in reducing or eliminating taxable income rental real estate. But the step up in basis does nothing to reduce income from interest, dividends, and capital gain distributions generated by inherited financial assets. This further indicates that the step-up in basis is better used on real estate than on financial assets.
Tax basis is not the only consideration in determining where to tax basket assets. Below is a run through of several other important considerations.
As of 2023, costs for investing in well diversified index funds in retirement accounts at discount brokerages are approaching zero. Costs for self-directed IRAs and 401(k)s are more substantial. Costs can include a set-up fee, annual account fees, one-off service fees, and fees for valuations.
Starting at age 73, you must take RMDs from your traditional retirement accounts and employer Roth accounts. In the year after your death, certain heirs must take RMDs from your retirement accounts (including Roth IRAs). To do this, the recipient must know the value of each retirement account on December 31st of the prior year. For publicly-traded stock and bond based mutual funds and ETFs, the financial institution will simply report this information to you. For real estate, it is a very different ballgame. You will need to obtain a third party valuation, as the December 31st value of any particular piece of real estate is not readily apparent or known. This is an additional annual cost of owning real estate inside a retirement account.
If you sell financial assets in a taxable account, you’re stuck with the capital gain, which will increase your federal (and possibly state) income tax bill. There are narrow and/or costly exceptions, including, the qualified opportunity zone program, which requires you to invest in a very specific type of investment that you may have absolutely no interest in investing in, for a minimum period of time. The qualified opportunity zone program can also apply to real estate capital gains.
The other exceptions to stock capital gain, including donations to charities, donor advised funds, and/or charitable trusts, are expensive, in that they require you to relinquish some or all of your economic ownership in order to avoid a taxable capital gain.
If you want to sell your rental real estate, you can use a Section 1031 “like-kind exchange” and simply exchange the rental property for another piece (or pieces) of rental real estate. This defers the capital gain on the sold property for as long as you hold onto the substitute property. Section 1031 exchange treatment is not available for financial assets.
While Section 1031 exchanges may not satisfy investors in every instance, the availability of Section 1031 exchanges is a reason to keep real estate in taxable accounts.
If you put your real estate in a retirement account, you voluntarily subject yourself to a whole host of rules. One is that you are not allowed to use the rental real estate for personal use. Another is that not allowed to personally manage or repair the property. Any violation of these rules can disqualify the retirement plan, resulting in a distribution of the property to the plan owner. This can result in a large taxable income hit and/or early distribution penalties if the owner is under age 59 ½.
Is your rental property at all debt financed? If it is, and it is in an IRA, your IRA (including a Roth IRA) will be subject to income tax (the “unrelated business income tax”) on the portion of the taxable income that is attributable to the debt (the “unrelated debt financed income”). For example, if you have a condo that was purchased half with debt, half the income will be subject to tax (at the IRA level) as UDFI.
Further, as an entity your IRA is subject to taxation at very steep tax brackets. While the first $1,000 of UDFI is exempt from taxation, by the time the taxable UDFI exceeds $12,500, the IRA pays the highest individual marginal ordinary income tax rate (currently 37 percent) on the income.
There are UDFI workarounds. One is to roll a self directed IRA/Roth IRA to a self directed 401(k)/Roth 401(k). 401(k) plans are not subject to tax on UDFI generated by rental real estate. In order to move to a self directed 401(k)/Roth 401(k) plan, you must have a trade or business that can sustain the self directed 401(k) or self directed Roth 401(k).
If you roll from a Roth IRA to a self directed Roth 401(k), you solve your UDFI problem but you subject yourself to RMDs (and valuation issues) starting at age 73, reducing future tax free growth. You also added a requirement to file an annual Form 5500 tax return with the IRS if the self directed Roth 401(k) has $250,000 or more of assets. Another workaround is placing the real estate in the IRA/Roth IRA in a C corporation. This will lower the tax rate the UDFI is subject to down to 21 percent, but will also subject the non-UDFI income to that 21 percent tax rate.
In some cases, depreciation combined with other deductions causes rental real estate to produce a loss for tax purposes. This can occur even if the property is “cash-flow positive” i.e., it produces cash income in excess of its cash expenses.
Why put an asset that generates a loss in a retirement account? Often times losses are suspended, meaning the rental property nets to zero on the tax return for that particular year. But the suspended loss is tracked and can be used in the future. Read this post for more information on deducting real estate losses.
Is the ability to use real estate losses from real estate held in taxable accounts limited? Absolutely. But it is fully eliminated if the real estate is in a retirement plan. Such losses can never be used on an individual’s tax returns.
Discount brokerages have made this the best era to be a well diversified investor in equities and bonds. Costs associated with investing in index funds in retirement accounts are approaching zero.
This means equities and bonds reside in retirement accounts very well. Why do you need to gild the lily at that point? You have great investment options at a low cost.
To my mind, there is no compelling reason to reject this approach, particularly considering (1) depreciation and other tax advantages that help make rental real estate efficient in taxable accounts and (2) the burdens associated with housing real estate in retirement accounts.
In the vast majority of cases, if you want to own both financial assets (stocks/bonds/mutual funds/ETFs) and rental real estate as part of your portfolio, you are well advised to house your rental real estate in taxable accounts and save your retirement accounts for the financial assets.
It comes back to the tyranny of tactics. Real estate in an IRA sounds great, but when you peel back the onion, simplicity usually wins. Does this mean some with real estate in a retirement account will not achieve financial independence? Absolutely not. But the simpler path will keep your costs low and will likely be tax efficient.
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, 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.
In my last post, I discussed the basics of the Backdoor Roth IRA, which can be a great planning tool for some higher income Americans. But not everyone qualifies for a tax-efficient Backdoor Roth IRA. Recall Jennifer’s case:
Jennifer makes too much to qualify to make a Roth IRA contribution in 2022. She contributed $6,000 to a nondeductible traditional IRA on April 19, 2022. She also had a separate traditional IRA with no basis. As of December 31, 2022, that separate traditional IRA was worth $93,998.53.
If, in 2022, Jennifer were to convert the $6,000 that she put into the nondeductible traditional IRA to a Roth IRA she would increase her taxable income by over $5,600. Ouch!
Jennifer has two possible options to qualify for a much more tax efficient Backdoor Roth IRA. The first option is to use her workplace 401(k), 403(b), or 457 plan. Some 401(k) plans and other workplace plans allow participants to “roll in” amounts in traditional IRAs. Workplace plans are not required to offer participants this option. If a workplace plan does, it can be worthwhile to consider this option in order to facilitate Backdoor Roth IRA planning.
Of course, there are considerations that go beyond income tax planning, including the quality of the investment choices available in a traditional IRA versus a workplace 401(k) or other retirement plan, and the expenses associated with each option.
A second option is rolling the traditional IRA into a Solo 401(k) plan. Jennifer must have a Solo 401(k) plan from self-employment and the plan must accept IRA roll ins in order for her to do this. As with workplace retirement plans, Solo 401(k) plans are not required to accept traditional IRA roll ins, and any decision must appropriately consider the relevant non-tax issues (as discussed above). Further, a Solo 401(k) plan has several requirements (including the conduct of a trade or business) that should be carefully considered before opening a Solo 401(k).
If Jennifer wants to roll her traditional IRA into a workplace retirement plan or Solo 401(k), she should structure the transfer as a “trustee-to-trustee” direct rollover of the money between the financial institution holding the traditional IRA and the workplace retirement plan or Solo 401(k). If instead of a trustee-to-trustee direct rollover, Jennifer receives a check from her IRA financial institution payable to her, she has 60 days to roll over that check (i.e., to get it to her workplace retirement plan or Solo 401(k)). If she does not move the money within the 60 days, the distribution from the IRA is taxable, subject to early withdrawal penalties if Jennifer is under age 59 ½, and cannot be transferred into a retirement plan.
Roll ins should be completed by December 31st of the year of the Roth IRA conversion. Otherwise the pro-rata rule will bite, because there will be a balance in the taxpayer’s traditional IRAs at year-end. That balance will attract a sizable portion of the $6,000 of IRA basis established by the nondeductible traditional IRA contribution. This causes the Roth IRA conversion to grab little basis and thus be tax inefficient.
For simplicity’s sake, it is usually best to clean out traditional IRAs, SEP IRAs, and SIMPLE IRAs and then make the nondeductible traditional IRA contribution.
Prior to implementing a traditional IRA to 401(k) “roll-in” strategy, Jennifer should review all of her traditional IRAs to ensure that she has no basis in any existing traditional IRA. IRA basis amounts cannot be rolled into the 401(k) and must be left behind under the rule of Section 408(d)(3)(A)(ii) and this technical write up.
Those with amounts in SIMPLE IRAs, need to be careful. During the first two years of the SIMPLE IRA account, it cannot be rolled into a plan other than another SIMPLE IRA plan. Doing so would create a taxable event, subject to both early withdrawal and excess contribution penalties (on the transfer to the non-SIMPLE IRA).
Thus, if Jennifer’s traditional IRA balance is in a SIMPLE IRA and she first deposited into the SIMPLE IRA less than two years ago, she must wait until the two year window has expired to roll her SIMPLE IRA into a workplace retirement plan or a Solo 401(k).
In addition, those with a SIMPLE IRA (beyond the two year window) or a SEP IRA from their current employer may not be allowed in-service distributions. Thus, they would not be able to roll over those accounts into a 401(k)/Solo 401(k)/403(b)/457. Additionally, amounts may be added to these accounts prior to December 31st. These considerations make it difficult to successfully execute Backdoor Roth IRA planning for those currently covered by an employer’s SIMPLE IRA or SEP IRA.
Any Backdoor Roth IRA planning should involve an additional diligence step: ensuring that as of December 31st of the year of the Roth conversion step, the taxpayer has a zero balance in all traditional IRAs, SEP IRAs, and SIMPLE IRAs. This helps ensure the Backdoor Roth IRA is a tax-efficient tactic.
Jennifer expects to earn $300,000 from her W-2 job in 2022, is covered by a workplace 401(k) plan, and expects to have some investment income. On March 1, 2022, Jennifer has a $90,000 balance in a traditional IRA but otherwise has no balance in a traditional IRA, SEP IRA, or SIMPLE IRA.
On March 2, 2022, Jennifer directs her workplace 401(k) plan and her IRA custodian to roll her traditional IRA to her workplace 401(k) plan. Her traditional IRA is rolled into her workplace 401(k) through a trustee-to-trustee direct rollover.
Jennifer contributes $6,000 to a traditional IRA on April 20, 2022. The contribution is nondeductible. Because the contribution is nondeductible, Jennifer gets a $6,000 basis in her traditional IRA. Jennifer must file a Form 8606 with her 2022 tax return to report the nondeductible contribution.
On May 2, 2022, Jennifer converts all the money in her traditional IRA to a Roth IRA (a Roth IRA conversion). At that time, Jennifer’s traditional IRA had a value of $6,001.47. Jennifer also ensures that as of December 31, 2022, she has a $0 balance in all traditional IRAs, SEP IRAs, and SIMPLE IRAs.
If Jennifer executes the above steps as described above, she will get the desired result. Done in this manner, the Roth IRA conversion step results in an increase in Jennifer’s taxable income of just $1.47 ($6,001.47 fair market value less $6,000 of traditional IRA basis).
What if Jennifer’s workplace retirement plan does not accept roll ins? What if Jennifer doesn’t have access to a Solo 401(k)? What if Jennifer’s workplace retirement plan accepts roll ins but does not have quality investment options and/or charges high fees?
Remember, Jennifer’s ultimate goal is not to do a Backdoor Roth IRA. Her goal is financial independence! She should not let what I call the “tyranny of tactics” distract her from her ultimate goal.
The Backdoor Roth IRA is a great tactic to employ toward achieving that goal. But it’s okay if you can’t use this particular tactic. Plenty of people have and will achieve financial independence without executing a Backdoor Roth IRA.
If you can’t use the Backdoor Roth IRA for whatever reason, simply use other appropriate tactics, including but not limited to a high savings rate, to achieve your financial goals.
I discuss how to properly report a Backdoor Roth IRA on a tax return and what to do if has been incorrectly reported 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.
If you read enough FI blogs, you will eventually come across the term “Backdoor Roth IRA.” This post answers the question “What’s the deal with Backdoor Roth IRAs?”
Why would someone do a Backdoor Roth IRA? The Backdoor Roth IRA gets money into a Roth IRA in cases where the taxpayer earns too much to make a direct annual contribution to a Roth IRA. Doing the Backdoor Roth IRA gets money that would have been invested in a taxable account into a tax-free Roth account. Further, the money in the Roth account gets better creditor protection than money in a taxable account.
Before 2010, what is now referred to as a Backdoor Roth IRA would have been permissible and/or necessary in only relatively limited circumstances, and then only in years prior to 2008. But a 2006 change in the law opened up the Backdoor Roth IRA in the form we know now (starting in 2010).
Two fundamental concepts must now be addressed. The first is a Roth IRA contribution.
This post discusses Roth IRA contributions in detail. Simplified, U.S. citizens and residents with earned income can make an annual Roth IRA contribution of up to $7,000 in 2024 ($8,000 if 50 or older). Done for many years, it can be a tremendous wealth building tool, since it moves wealth into an account that is tax-free (if properly executed).
The one catch is that your “modified adjusted gross income” (or “MAGI”) must be below a certain threshold in order to make a Roth IRA contribution. To make a full contribution in 2024, your MAGI must be less than $146,000 (if single) or $230,000 (if married filing joint).
Because of these limits, many taxpayers are unable to make a Roth IRA contribution. Further, based on the qualification rules for traditional deductible IRA contributions, most taxpayers unable to make a Roth IRA contribution are also unable to make a deductible traditional IRA contribution.
The second fundamental concept is a Roth IRA conversion. A Roth IRA conversion is a movement of amounts in traditional accounts to a Roth IRA. This creates a taxable event. The amount of the Roth IRA conversion, less any “basis” in the traditional account (more on that later), is taxable as ordinary income on the taxpayer’s tax return.
Prior to 2010, only taxpayers with a modified adjusted gross income of $100,000 or less were allowed to do a Roth IRA conversion. This amount was not indexed for inflation and applied per tax return, making it particularly difficult for many married couples to qualify.
In 2006, Congress changed the law, effective beginning in 2010. As of January 1, 2010, there is no modified adjusted gross income limitation on the ability to do a Roth IRA conversion. The richest, highest earning Americans now qualify to do a Roth IRA conversion just as easily as anyone else.
Okay, so there’s no MAGI limitation on the ability to execute a Roth IRA conversion. So what? Aren’t they taxable? What’s the advantage of doing one?
Recall I mentioned a taxpayer’s basis in a traditional account. Basis in an IRA occurs when a taxpayer makes a nondeductible contribution to a traditional IRA. Here is an example.
Mike expects to earn $300,000 from his W-2 job in 2024, is covered by a workplace 401(k) plan, and expects to have some investment income. Mike has no balance in a traditional IRA, SEP IRA, or SIMPLE IRA.
Mike contributes $7,000 to a traditional IRA on April 20, 2024. The contribution is nondeductible. Because the contribution is nondeductible, Mike gets a $7,000 basis in his traditional IRA. Mike must file a Form 8606 with his 2024 tax return to report the nondeductible contribution.
The “backdoor” opens because of the confluence of two rules: the ability to make a nondeductible traditional IRA contribution and the ability to do a Roth IRA conversion regardless of your income level. Let’s extend Mike’s example a bit.
On May 2, 2024, Mike converts all the money in his traditional IRA to a Roth IRA (a Roth IRA conversion). At that time, Mike’s traditional IRA had a value of $7,011.47.
What result? To start, all $7,011.47 is taxable. All money converted in a Roth IRA conversion is taxable. Uh oh! But there’s good news for Mike. Mike gets to offset the $7,011.47 that is taxable by the $7,000 of basis in his traditional IRA. Thus, this Roth IRA conversion will only increase Mike’s taxable income by $11.47 ($7,011.47 minus $7,000).
The combination of these two separate, independent steps (a nondeductible traditional IRA contribution and a later Roth IRA conversion) is what many now refer to as the Backdoor Roth IRA. Notice this is only possible because of the repeal of the MAGI limitation on Roth IRA conversions. Under the rules effective prior to 2010, Mike would have been allowed to make the nondeductible traditional IRA contribution, but his income (north of $300,000) would have prohibited him from a Roth IRA conversion.
The Backdoor Roth IRA allows Mike to obtain the benefits of an annual Roth IRA contribution without qualifying to make a regular annual Roth IRA contribution.
Any Backdoor Roth IRA planning should involve an additional diligence step: ensuring that as of December 31st of the year of the Roth conversion step, the taxpayer has a zero balance in all traditional IRAs, SEP IRAs, and SIMPLE IRAs. This helps ensure the Backdoor Roth IRA is a tax-efficient tactic.
The Backdoor Roth IRA works well for someone with Mike’s profile. But it does not work well for everyone. Let’s change up the example a bit.
Jennifer’s story is the same as Mike’s story above, except that she had a separate traditional IRA before she did her 2024 nondeductible IRA contribution. That separate IRA had no basis. As of December 31, 2024, that separate traditional IRA was worth $92,988.53.
This one change in facts dramatically increases Jennifer’s taxable income from the Roth IRA conversion. Jennifer must apply the so-called Pro-Rata Rule to the Roth IRA conversion. Even though her two IRAs are in separate accounts, they are treated as one IRA for purposes of determining how much of Jennifer’s $7,000 of basis she recovers upon her Roth IRA conversion.
Jennifer starts with $7,011.47 of income (the amount she converts). To determine the amount of her $7,000 of basis she gets to recover against the proceeds of the Roth IRA conversion, we must multiply that $7,000 times the amount converted ($7,011.47) divided by the sum of the amount converted and her traditional IRA balance at the end of the year ($7,011.47 plus $92,988.53). Thus, Jennifer gets to recover 7.00147 percent of the $7,000 of basis, which is only $490.80. This results in Jennifer’s Roth IRA conversion increasing her taxable income by $6,520.67 ($7,011.47 minus $490.80).
What was a great idea for Mike becomes a horrible idea for Jennifer when she has a significant balance in another traditional IRA.
Note further that Jennifer would have the same bad outcome if that $92,988.53 traditional IRA was instead in a traditional SEP IRA or in a traditional SIMPLE IRA.
Assume Mike did his Roth IRA conversion and did not have any other money in traditional IRAs in 2024. He will get a Form 1099-R from his financial institution. In box 1 it will report a gross distribution of $7,011.47 (the amount of the Roth IRA conversion).
In box 2a the Form 1099-R will say that the “taxable amount” is $7,011.47 and box 2b will be checked to indicate that the “taxable amount not determined.” Wait, what? How can $7,011.47 be the taxable amount while the next box claims the taxable amount is not determined? The answer is the basis concept discussed above.
Mike’s financial institution does not know the rest of Mike’s story (his income, retirement plan coverage at work, IRAs at other institutions, etc.), so it has no way of determining how much basis, if any, Mike recovers when he did the Roth IRA conversion. Box 2b simply means that Mike might have recovered some basis, but the institution is not in a position to determine if he did.
Form 8606 helps complete the tax reporting picture. By filing that form, Mike establishes that he was entitled to $6,000 of traditional IRA basis and how the pro-rata rule applies (if at all) to his Roth IRA conversion. It is important that Mike file a properly completed Form 8606 with his timely-filed 2024 federal income tax return.
When Mike files his 2024 Form 1040, he puts $7,011.47 on line 4a (“IRA distributions”) and $11.47 on line 4b (“Taxable amount”). Most tax return preparation software will round cents to the nearest whole dollar.
Note that failing to report the transactions on the Forms 8606 and 1040 in this way can result in Mike paying an incorrect amount of tax.
This post discusses what you can do if you find yourself in Jennifer’s situation to get a result similar to Mike’s result. I discuss how to properly report a Backdoor Roth IRA on your tax return and what to do if has been incorrectly reported 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.
THIS POST HAS NOT BEEN UPDATED FOR THE SECURE ACT, WHICH WAS ENACTED IN LATE 2019.
If you have significant assets, you need an estate plan. A good estate plan makes handling the financial aspects of your death much easier for your loved ones and creates the opportunity for multiple generation wealth creation.
For most, the need for good estate plan is not about the estate tax. Very few Americans, particularly very few actively seeking financial independence, will be subject to the federal estate tax, as there is now (as of 2019) a $11.4 million estate tax exemption. Thus, only the very largest of estates will pay the federal estate tax. For purposes of this post, assume that all estates are below this threshold.
If you are aren’t subject to the estate tax, why do you need to make a tax efficient estate plan? The answer is the income tax considerations of your heirs and beneficiaries. Some assets cause your heirs and beneficiaries to have very little or no additional income tax. Other assets can cause a significant increase in the income tax burdens of your heirs and beneficiaries. Below I analyze each of the tax baskets and discuss the estate planning considerations for each one.
Being that the FI community generally aims to build up significant assets to achieve financial independence, good estate planning is particularly important if you are on the road to (or have achieved) financial independence.
A quick caveat at the beginning – tax is only one consideration in estate planning. There are many others, including the needs of spouses, children, and other potential heirs, and the desires of the donor. Below I offer thoughts on tax optimal estate planning — of course the tax considerations need to be balanced with other estate planning objectives.
A quick note on leaving assets to spouses. Generally speaking, the tax laws favor leaving assets to spouses. A spouse is a tax-preferred heir in most situations (the main exception being leaving retirement accounts to younger beneficiaries with low RMDs). As the focus of this post is passing wealth to the second generation efficiently, most of the discussion, other than a few asides, will not address the tax consequences when leaving an asset to a spouse.
Below are the four main tax baskets (tax categories in which individuals can hold assets):
Baskets 1 through 3 require “ideal conditions” (i.e., compliance with the related tax rules) to operate as outlined above. Let’s assume for purposes of this post that no errors are made with respect to the account in question.
Of the four tax baskets, traditional accounts are often (from a tax perspective) the worst kind to leave to a spouse and the third worst to leave to non-spouse heirs. Why? Because traditional accounts, through required minimum distributions (“RMDs”), are eventually going to be entirely taxable to your beneficiaries and/or their beneficiaries. Non-spouse beneficiaries generally must take RMDs in the year following the donor’s death.
When passing traditional accounts to the next generation(s), a general rule of thumb is younger beneficiaries are better for such accounts, because the younger the beneficiary, the smaller their earlier RMDs, and thus the lower the tax hit of the RMD and the longer the tax-deferred growth.
Spousal beneficiaries, unlike non-spouse beneficiaries, have the option to delay RMDs until the year they turn 70 ½. However, once they turn 70 ½ they will be required to take taxable RMDs, increasing their taxable income.
For charitably inclined, traditional accounts (or portions thereof) are a great asset to leave to charity. As you will see, your individual beneficiaries would prefer to inherit Roth accounts (and in most cases will prefer to inherit taxable accounts), but the charity is generally indifferent to the tax basket of an asset, because charities pay no income tax. So all other things being equal, if you have money in traditional accounts, Roth accounts, and taxable accounts, the first money you should leave to a charity should be from your traditional accounts.
Lastly, whatever your plans, you are well advised to ensure that all your traditional, Roth, and HSA accounts have valid beneficiary designation forms on file with the employer plan or financial institution.
Roth accounts are fantastic accounts to inherit for both spouses and non-spouses. While non-spouses must take RMDs from the inherited Roth account in the year following death, the RMD is non-taxable to them. All beneficiaries benefit from tax-free growth of assets while they are in an inherited Roth account. This makes spouses (able to defer RMDs until age 70 ½) and younger beneficiaries ideal (from a tax perspective) to inherit Roth accounts.
Roth conversions are a potential strategy to save your heirs income tax. If you believe your heirs will have a higher marginal income tax rate than you do, and you do not need the tax on the Roth conversion, you can convert amounts in traditional accounts to Roth accounts, pay the tax, and lower the overall tax burden incurred by you and your family.
There are two, and only two, ideal people to leave an HSA to – your spouse or a charity. Spouses and charities are the only ones who do not pay tax immediately on an HSA in the year of death.
Unfortunately for non-spouse, non-charity beneficiaries, the entire account becomes taxable income to the beneficiary in the year of death and loses its status as an HSA. This can cause a significant one-time spike in marginal tax rates and cause the beneficiary to lose (to federal and state income taxes) a significant amount of the HSA. This makes the HSA the worst tax basket to leave to non-spouse, non-charitable beneficiaries.
Spouses are allowed to continue the HSA as their own HSA, and thus can use it to grow tax-free wealth that can cover (or reimburse) qualified medical expenses.
If you are charitably inclined and unmarried, the HSA should be the first account you consider leaving some or all of to charity.
Taxable accounts, including real estate and securities, are generally good assets to leave to beneficiaries because of the so-called “step-up” in basis. As a general matter, when a person dies, their heirs inherit assets in taxable accounts with a “stepped-up” basis. This gives the heirs a basis of the fair market value of the property on the date of death.
As a result, a beneficiary can generally sell inherited assets shortly after receiving them and incur relatively little, if any, capital gains tax.
A couple of additional notes. First, leaving appreciated taxable assets at death to heirs is much better than gifting such assets to heirs during your life. A quick example: William lives in a house he purchased in 1970 for $50,000. In 2019 the house is worth $950,000. If William gifts the house to his son Alan in 2019, Alan’s basis in the house is $50,000. However, if William leaves the house to Alan at William’s death, Alan’s basis in the house will be the fair market value of the house at William’s death.
Second, the step-up in basis at death benefits spouses in both “common law” states and community property states. In all states, separately held property receives a full step up in basis when inherited by a spouse. For residents of common law states, jointly held property receives a half step-up – the deceased spouse’s portion is receives a step-up in basis while the surviving spouse’s half does not. For residents in community property states, the entirety of community property receives a full basis step-up at the death of one spouse.
Generally speaking, in most cases spouses will prefer to inherit assets in the following order:
In most cases, non-spouses will prefer to inherit assets in the following order:
The best two tax baskets to leave to charities are HSAs and traditional accounts.
You can obtain significant tax benefits for your heirs by being intentional regarding which tax baskets you leave to which beneficiaries. Some relatively simple estate planning can save your heirs a significant amount of federal and state income tax.
FI Tax Guy can be your financial advisor! FI Tax Guy can prepare your tax return! 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.
As this is being re-published (January 2021), we are in the third filing season of the new Section 199A qualified business income deduction. It is an area of the tax law that practitioners are still digesting.
I have previously written on the basics of the Section 199A deduction. This post builds on that introductory post. It provides analysis on rules from the IRS and Treasury and gives examples of how the deduction works in specific situations.
Below are examples and commentary addressing Section 199A.
Mike works a full-time job. His W-2 for 2018 reports $90,000 of wages. Mike also receives $1,000 of qualified dividend income (“QDI”) in his taxable account. Mike has a side hustle where he nets $10,000 in Schedule C profit. Mike pays $1,413 in self-employment tax on that profit. Mike claims the standard deduction.
Recall that the Section 199A deduction is the lesser of:
The deduction for one-half of self-employment taxes is factored into the determination of QBI. Thus, in Mike’s case, his Section 199A deduction is the lesser of:
In this case, Mike’s Section 199A deduction is $1,859.
Mike’s taxable income is determined by deducting, for adjusted gross income, one-half of the self-employment taxes ($707) he pays with respect to his side hustle income. However, that deduction for half of his self-employment tax must also be subtracted in determining his QBI.
Note further that the Section 199A deduction does not reduce self-employment taxes. The Section 199A deduction is only an income tax deduction. It does not reduce the amount subject to self-employment taxes (in Mike’s case, $10,000).
Lisa owns a sole-proprietorship that generates $100,000 of business income in 2020 as reported on Schedule C. Lisa pays $14,130 in self-employment taxes. Lisa contributed $19,500 to her traditional Solo 401(k), and makes an employer contribution to her traditional Solo 401(k) of $18,587. Lisa is married to Joe who makes $75,000 in W-2 wages. Lisa and Joe claim the standard deduction.
The deduction for retirement plan contributions is factored into the determination of QBI. Thus, in Lisa’s case, her Section 199A deduction is the lesser of:
In this case, Lisa’s Section 199A deduction is $10,970.
QBI has the effect of making certain income “80% income.” What I mean by that term is that only 80% of the income is subject to income tax. This has a flip side – some deductions become only “80% deductions,” meaning that only 80% of the deduction generates a tax break.
Notice that the Solo 401(k) contributions reduce the QBI deduction. Thus, Solo 401(k) contributions are now “80% deductions” due to the QBI regime. For example, if your marginal tax rate is 22 percent, the marginal tax rate savings on your traditional 401(k) employee contribution is only 17.6 percent. But years later, when you withdraw the money from the Solo 401(k) the money will be “100% income.” You will not get a QBI deduction for those withdrawals.
I blogged more about the 80% deduction phenomenon here.
This will cause many sole proprietors to consider Roth Solo 401(k) employee contributions instead of traditional Solo 401(k) employee contributions, since the the tax savings on traditional self-employed employee contributions is reduced as a result of the QBI deduction.
Note further that for the Solo 401(k) employer contribution there is no choice to be made because there is no option to make a Roth employer contribution. All employer contributions must be traditional contributions.
Another observation: If Lisa and Joe had a low enough adjusted gross income (under $105,000) and Lisa made a deductible $6,000 contribution to a traditional IRA, that contribution would not have counted against her QBI. A contribution to a health savings account would also not have lowered her QBI.
For taxpayers whose Section 199A deduction is limited by 20% of QBI, contributions to traditional IRAs and HSAs should be favored over self-employment retirement plan contributions, since the IRA and HSA deductions are 100% deductions while the self-employment retirement plan contributions are 80% deductions. Hat tip to Jeff Levine who made the retirement plan contribution prioritization point on Twitter.
For taxpayers whose Section 199A deduction is limited by 20% of taxable income, contributions to traditional IRAs, HSAs, and self-employment retirement plans are all 80% deductions, and thus Section 199A normally does not factor into determining how to prioritize these contributions. However, all of these are tools taxpayers may be able to use to lower taxable income to qualify for a Section 199A deduction, as discussed in the Managing Taxable Income section below.
Assume the facts are the same as the previous example, except for the following differences. Lisa operates her business as a wholly-owned S corporation instead of as sole proprietorship. Before any sort of compensation, the S corporation makes $100,000. Assume that in this case, the S corporation pays Lisa $50,000 of W-2 wages, which is further assumed to be reasonable. Lisa makes employee contributions of $19,500 to her traditional Solo 401(k) from those wages. The S corporation makes the maximum employer contribution of $12,500 (computed as $30,500 of Box 1 W-2 wages plus $19,500 of elective deferrals times 25 percent). Thus, Lisa will have flow-through income from the S corporation (reported to her on a Schedule K-1) of $33,675 ($50,000 less $12,500 less $3,825 — the employer portion of the payroll tax).
Thus, in Lisa’s case, her Section 199A deduction is the lesser of:
In this case, Lisa’s Section 199A deduction is $6,735 because in the S corporation structure, the business income is split between a salary the S corporation pays her (which is not QBI) and the flow through profit of the S corporation, which is QBI (assuming it is domestic trade or business income).
The S corporation has various pros and cons from a tax perspective. Lower employment (payroll) taxes are a significant benefit, while lower maximum employer retirement plan contributions and lower Section 199A deductions are drawbacks.
Jackie is a lawyer operating as a sole proprietor. Law is one of several specified service trade or businesses (“SSTBs”) where the benefits of Section 199A are completely phased out if your taxable income exceeds $213,300 ($426,600 for married filing joint taxpayers using 2020 numbers). In 2020 Jackie has $240,000 of Schedule C income from the business. His self-employment taxes are $17,075 in Social Security taxes and $6,428 in Medicare taxes, for a total of $23,503 reported on Schedule SE. Jackie takes the standard deduction.
Jackie’s taxable income is thus $215,848 ($240,000 less $11,752 less $12,400). Because Jackie’s QBI is from an SSTB and his taxable income is above $213,300, he cannot claim any Section 199A deduction.
Now let’s add some tax planning to the scenario. Imagine that early in 2020 Jackie realizes he won’t qualify for the Section 199A deduction based on his numbers. He decides to open a Solo 401(k), which he can make an $19,500 employee traditional contribution to, and he can make an employer contribution of $37,500 for total contributions of $57,000 (the maximum allowed). This radically changes his Section 199A math, since (as will be demonstrated) his taxable income is now below $163,300. Once your income is below $163,300, you qualify for the Section 199A deduction only subject to the computational limits. Thus, in Jackie’s case, his Section 199A deduction is the lesser of:
Thus, Jackie’s Section 199A deduction is now $31,770! By managing his taxable income (by maximizing retirement savings), Jackie turned a $57,000 deduction into a more than $88,000 of deductions. Sure, the $57,000 deduction for retirement plan contributions is an “80% deduction,” but it creates the additional $31,770 of a Section 199A deduction (which is itself a “100 percent” deduction).
Jackie also lowered his marginal federal income tax rate from 35 percent to 24 percent and reduced his taxable income from $215,848 to $127,078!
Note that contributions to a health savings account would be another tool to deploy to lower your taxable income if you are concerned about Section 199A’s taxable income limitations.
Taxpayers bumping up against Section 199A taxable income limitations will likely need to prioritize traditional employee contributions to Solo 401(k) plans over Roth employee contributions. In addition, self-employed taxpayers bumping up against the taxable income limits in 2021 may want to establish 2021 Solo 401(k)s (if they are eligible to do so) to lower taxable income in order to qualify for the Section 199A deduction.
It will be wise for taxpayers to consult with tax advisors to run the numbers on Section 199A and other tax planning considering the complexity of the rules and the potential benefits of successful planning.
The IRS gave us a bit of a head-scratcher in the instructions to the new Form 8995. The Form 8995 is used (starting with 2019 tax returns) to compute the QBI deduction. In the instructions, it states that charitable contributions reduce QBI.
Here is an example of how that rule would play out:
Cosmo is the sole shareholder of Acme Industries, an S corporation. In 2019, Acme reports QBI operating income of $100,000 to Cosmo on his Form K-1. It also reports $1,000 of charitable contributions made by Acme during 2019. The total QBI Cosmo can claim from Acme Industries is only $99,000, as the charitable contribution reduces QBI, according to the IRS. This is true even if Cosmo claims the standard deduction and thus has no use for the charitable contribution on his 2019 tax return.
Personally, I believe the IRS is on questionable ground in claiming charitable contributions reduce qualified business income. However, with some rather simple tax planning (which I generally believe to be prudent), you can avoid this issue altogether. If you want to make a charitable contribution, simply do so in your own name. Do not have your business — whether an S corporation, a small partnership, or a sole proprietorship, make the charitable contribution.
The IRS and Treasury issued Notice 2019-7 and Revenue Procedure 2019-38 providing a safe harbor under which rental real estate activity can qualify for the Section 199A deduction. A safe harbor is a set of requirements, which, if satisfied, automatically qualify a taxpayer for a particular benefit. Stated differently, a safe harbor is a sufficient, but not necessary condition, to receive a benefit.
While rental activities that constitute a trade or business can still qualify for the deduction if they do not meet the requirements of the safe harbor, as a practical matter it will be much easier to sustain the deduction if you can qualify for the safe harbor.
The requirements to satisfy the safe harbor with respect to any “rental real estate enterprise” (a “RREE”) are as follows:
Rental property can be combined for purposes of determining if you have an RREE. However, residential and commercial real estate cannot be aggregated and must be kept separate. Thus, at a minimum if you own both commercial and residential property, you have two RREEs, and you must apply the tests to each separately to determine if each RREE qualifies for the safe harbor.
In a bit of good news, the 250 hours can be done by the owner, agents, employees, and/or independent contractors. However, many activities do not count toward the 250 hours, including building and long-term redevelopment, finding properties to rent, and arranging financing. Qualifying activities include collecting rent, daily operation of property, negotiating leases, screening tenants, and maintenance and repairs.
Triple net leases do not qualify for the safe harbor. For purposes of the rule, these include “a lease agreement that requires the tenant or lessee to pay taxes, fees, and insurance, and to be responsible for maintenance activities for a property in addition to rent and utilities.”
For those using house hacking to pursue financial independence, there are several considerations. If you house hack by renting spare bedrooms in your primary residence (tenants, Airbnb, etc.), then you do not qualify for the safe harbor with respect to the rent generated by your primary residence. However, if your house hack consists of renting out separate units in a single building, the rental income could qualify for the safe harbor if (i) those other units are separate residences and not your own residence for any part of the year and (ii) you otherwise satisfy the requirements of the safe harbor.
Dividends from REITs and REIT mutual funds can qualify for the QBI deduction. Generally, box 5 of Form 1099-DIV will indicate those REIT dividends which qualify as Section 199A dividends.
In 2018 Luke makes $50,000 from his W-2 job. He operates a sole proprietorship that generates a $4,000 taxable loss (which would have been QBI had it been net income). Luke also receives $3,000 of dividends from the Acme Real Estate Mutual Fund, which he holds in a taxable account. Acme’s Form 1099-DIV provided to Luke indicates in box 5 that $2,400 of the dividends are Section 199A dividends. Luke claims the standard deduction. In Luke’s case, his Section 199A deduction is the lesser of:
Thus, Luke’s Section 199A deduction is $480. He gets this deduction even though the dividend was paid by a mutual fund and even though he had a QBI loss. His QBI loss will carryover to 2019, and will reduce his 2019 QBI that potentially qualifies for the Section 199A deduction.
Lastly, note that if Luke held the Acme mutual fund shares in a retirement account (traditional and/or Roth IRA/401(k), etc.) or a health savings account, the REIT dividend would not have qualified for the Section 199A deduction.
Even as of January 2021, taxpayers and practitioners are learning new wrinkles in the Section 199A QBI deduction. For taxpayers with side hustles and small businesses, it can represent a significant income tax break. Some taxpayers will need professional help to determine how best to maximize the deduction.
I have written several blog posts addressing the Section 199A QBI deduction. Here are the links below:
Section 199A and Retirement Plans
Read why the Section 199A QBI deduction may mean a Solo 401(k) is better than a SEP IRA
For the self-employed, the Section 199A QBI deduction may present an opportunity to do more efficient Roth IRA conversions.
FI Tax Guy can be your financial advisor! 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.