People worry about taxation in retirement. In particular, they worry about the taxation of required minimum distributions (RMDs), especially after the death of a spouse. Widows find themselves in the single tax brackets after decades of enjoying the more favorable married filing jointly tax brackets.
Widows and widowers finding themselves as single taxpayers is often referred to as the Widow’s Tax Trap.
RMDs require taxable withdrawals from traditional retirement accounts such as IRAs and 401(k)s. But just how bad are they when a widow or widower is in the Widow’s Tax Trap?
Let’s unpack just how bad the combination of the Widow’s Tax Trap and RMDs is for an 81 year-old widow with a very tax inefficient structure: almost $3.7 million of her approximately $4.5 million of financial wealth in a traditional IRA.
My experience tells me many financial planners and gurus will tell you this is a terrible outcome. That $3.7 million traditional IRA is infested with taxes!
But is it really?
81 Year-Old Widow in the Widow’s Tax Trap
I put together an analysis of an affluent widow in the Widow’s Tax Trap. Let’s call her Jane. Her traditional IRA causes her to have an RMD of almost $190,000. Wow!
What are the federal income tax rates on that feared RMD?
Isn’t it remarkable that an 81 year-old widow with almost $3.7 million in a traditional IRA has more of her RMD taxed in the 12 percent tax bracket than in the 32 percent tax bracket?
Despite all the fear of taxation of RMDs, that’s the reality when it comes to a very affluent, very inefficient 81 year-old widow.
Yes, Jane pays IRMAA of approximately $6,500 in two years because of her RMDs. And yes, the RMDs trigger approximately $500 of net investment income tax.
But do either of these have any impact on Jane’s lived experience and financial success?
Absolutely not!
The government scores some Garbage Time Touchdowns on Jane by collecting some IRMAA, some net investment income tax, and some income tax in the 32 percent bracket.
A Garbage Time Touchdown is a late in the game touchdown scored by a team that will lose the game regardless of the touchdown. As a New York Jets fan, sadly I’m an expert in Garbage Time Touchdowns.
Jane has some tax inefficiencies that are just Garbage Time Touchdowns.
Think about the lifetime arc of Jane’s taxes in today’s tax planning world:
As a single individual, Jane likely deducted workplace retirement plan contributions at a 22, 24, or 32 percent rate. Win versus the IRS!
As a married couple, Jane and her husband likely deduct into workplace retirement plans at a 22 or 24 percent rate. Win versus the IRS!
In early retirement, they live off taxable accounts and do not do Roth conversions. They may pay nothing in federal income tax! Win versus the IRS!
Once taxable accounts are depleted, traditional retirement account distributions could have benefitted from the Hidden Roth IRA. Win versus the IRS!
Even RMDs are likely subject to the 12 percent and 22 percent brackets while they are both alive. Win versus the IRS!
As a widow, the relatively minor tax inefficiencies creep in. These are Garbage Time Touchdowns.
This arc, which eschewed Roth 401(k) contributions and taxable Roth conversions, screams “Jane wins a blow out victory over the IRS” over the course of her lifetime.
Sure, at the end Jane gave up some Garbage Time Touchdowns to the IRS, but not after decades of defeating the IRS.
What’s more important than winning the spreadsheet is lived experience. Notice that Jane paying 32 percent on about six percent of her RMD has $200K of after-tax cash flow?
In order for the Widow’s Tax Trap to bite hard, the widow generally has to have about $200K or more of after-tax cash flow.
The taxes bite when widows can most afford them!
Watch me break down the tax analysis of our 81 year-old widow on YouTube.
Roth Conversions to Avoid the Widow’s Tax Trap
Should Jane and her husband have done taxable Roth Conversions in retirement to avoid the widow paying 32 percent federal income tax on some of her RMDs?
Here vocabulary becomes very important. Yes, some taxable Roth conversions taxed at 22 percent or 24 percent could have been beneficial. But they were hardly necessary.
Outside of cases where taxable Roth conversions create enough required income to qualify for a Premium Tax Credit, taxable Roth conversions are not necessary.
Yes, there are times where large taxable Roth conversions can be beneficial in that they mitigate harmful effects of the Widow’s Tax Trap. But the analysis above shows that the harmful effects of the Widow’s Tax Trap aren’t all that harmful for the vast, vast, vast majority of Americans. This is true even those with most of their financial wealth in traditional retirement accounts.
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.
It’s that time of year again. The air is cool and the New York Jets season is over. That can only mean one thing when it comes to personal finance: time to start thinking about year-end tax planning.
I’ll provide some commentary about year-end tax planning to consider, with headings corresponding to the timeframe required to execute.
As always, none of this is advice for your particular situation but rather it is educational information.
Urgent
By urgent, I mean those items that (i) need to happen before year-end and (ii) may not happen if taxpayers delay and try to accomplish them late in the year.
Yes, there can be some taxable Roth conversions that are highly advantageous. But they tend to be much more limited in scope and scale than most commentators acknowledge. In our book, Cody and I detail the sorts of taxable Roth conversions that tend to be beneficial.
Back to timing. For a Roth conversion to count as being for 2025, it must be done before January 1, 2026. That means New Year’s Eve is the deadline. However, taxable Roth conversions should be done well before New Year’s Eve because
It requires analysis (hopefully done with up-to-date thinking) to determine if a taxable Roth conversion is advantageous,
If advantageous, the proper amount to convert must be estimated, and
The financial institution needs time to execute the Roth conversion so it counts as having occurred in 2025.
For those age 65 or older by year-end, the Roth conversion calculus should consider the new senior deduction.
The donor advised fund is a great way to contribute to charity and accelerate a tax deduction. My favorite way to use the donor advised fund is to contribute appreciated stock directly to the donor advised fund. This gets the donor three tax benefits: 1) a potential upfront itemized tax deduction, 2) removing the unrealized capital gain from future income tax, and 3) removing the income produced by the assets inside the donor advised fund from the donor’s tax return.
In order to get the first benefit in 2025, the appreciated stock must be received by the donor advised fund prior to January 1, 2026. This deadline is no different than the normal charitable contribution deadline.
Due to much year end interest in donor advised fund contributions and processing time, different financial institutions will have different deadlines on when transfers must be initiated in order to count for 2025. Donor advised fund planning should be attended to sooner rather than later.
Adjust Withholding
This varies, but it is a good idea to look at how much tax you owed last year. If you are on pace to get 100% (110% if 2024 AGI is $150K or greater) or slightly more of that amount paid into Uncle Sam by the end of the year (take a look at your most recent pay stub), there’s likely no need for action. But what if you are likely to have much more or much less than 100%/110%? It may be that you want to reduce or increase your workplace withholdings for the rest of 2025. If you do, don’t forget to reassess your workplace withholdings for 2026 early in the year.
One great way to make up for underwithholding, particularly for retirees, is through an IRA withdrawal mostly directed to the IRS and/or a state taxing agency. Just note that for those under age 59 ½, this tactic may require special planning.
These items can wait till close to year-end, though you don’t want to find yourself doing them on New Year’s Eve.
Tax Gain Harvesting
For those finding themselves in the federal 0% long-term capital gains tax bracket and with an asset in a taxable account with a built-in gain, tax gain harvesting prior to December 31, 2025 may be a good tax tactic to increase basis without incurring additional federal income tax. Remember, though, the gain itself increases one’s taxable income, making it harder to stay within the federal 0% long-term capital gains tax bracket.
I’m also quite fond of tax gain harvesting that reallocates one’s portfolio in a tax efficient manner.
Tax Loss Harvesting
The deadline for tax loss harvesting for 2025 is December 31, 2025. Just remember to navigate the wash sale rule.
RMDs from Your Own Retirement Account
The deadline to take any required minimum distributions from one’s own retirement account is December 31, 2025. Remember, the rules can get a bit confusing. Generally, IRAs can be aggregated for RMD purposes, but 401(k)s cannot.
RMDs from Inherited Accounts
The deadline to take any RMDs from inherited retirement accounts is December 31st.
Can Wait Till Next Year
Traditional IRA and Roth IRA Contribution Deadline
The deadline for funding either or both a traditional IRA and a Roth IRA for 2025 is April 15, 2026.
Backdoor Roth IRA Deadline
There’s no law saying “the deadline for the Backdoor Roth IRA is DATE X.” However, the deadline to make a nondeductible traditional IRA contribution for the 2025 tax year is April 15, 2026. Those doing the Backdoor Roth IRA for 2025 and doing the Roth conversion step in 2026 may want to consider the unique tax filing when that happens (what I refer to as a “Split-Year Backdoor Roth IRA”).
HSA Funding Deadline
The deadline to fund an HSA for 2025 is April 15, 2026. Those who have not maximized their HSA through payroll deductions during the year may want to look into establishing payroll withholding for their HSA so as to take advantage of the payroll tax break available when HSAs are funded through payroll.
The deadline for those age 55 and older to fund a Baby HSA for 2025 is April 16, 2026.
New for 2026! All Bronze and Catastrophic ACA plans will qualify as HDHPs!This opens the door for many self-employed and early retired individuals covered by these plans to make deductible HSA contributions. These deductible contributions can increase Premium Tax Credits and lower income taxes.
As I write this in mid-October 2025, the Premium Tax Credit is in flux. I do think many early retirees and self-employed individuals will benefit from considering a Bronze or Catastrophic plan. As I’ve said before, Bronze is Gold!
For those who already have a HDHP, now is a good time to review payroll withholding into the HSA. Many HSA owners will want to max this out through payroll deductions so as to qualify to reduce both income taxes and payroll taxes.
Self-Employment Tax Planning
Year-end is a great time for solopreneurs, particularly newer solopreneurs, to assess their business structure and retirement plans. Perhaps 2025 is the year to open a Solo 401(k). Often this type of analysis benefits from professional consultations.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, investment, medical, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, investment, medical, and tax matters. Please also refer to the Disclaimer & Warning section found here.
We will be on several more podcasts in the coming weeks and months discussing the book and its concepts.
One I’m particularly excited about is this Friday’s BiggerPockets Money podcast episode where we discuss tax planning for the five phases of retirement drawdown. You can find that episode on September 26th on the BiggerPockets Money YouTube channel and on podcast players.
I have also put two special YouTube videos on my YouTube channel discussing concepts from the book.
Today I posted a video discussing just how much tax a retired married couple might pay on a $40,700 Roth conversion using an example from the book. You might be very pleasantly surprised by the result.
A Favor Request
I speak for both Cody and myself when I say we are grateful for all of the support we have received for this project.
If you have purchased the book and read it, we humbly for one more favor. Please write an honest and objective review of the book on Amazon. The number and quality of reviews is vital to the book remaining one that Amazon recommends to its customers.
We want to get word out about Tax Planning To and Through Early Retirement. You can help us do that with an Amazon review!
Thank you for considering our request.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
The tax planning world has changed. Have I and my fellow advisors caught up?
Below I discuss three changes in the past three years. These recent changes make a big impact on retiree taxation. Most commentators and gurus have largely ignored these changes.
The world has changed. It’s time for financial planners and tax advisors to adjust their advice accordingly.
No RMDs Until Age 75
In September 2022 required minimum distributions (“RMDs”) began at age 72. RMDs make traditional retirement account balances in retirement accounts less desirable, since they require taxable distributions.
In December 2022, SECURE 2.0 became law. For those born in 1960 and later, it delayed the onset of RMDs until age 75. SECURE 2.0 moved the needle when it comes to the desirability of traditional retirement accounts since it cancelled the three most likely to occur RMDs.
How long do we expect people to live beyond age 75? Take a look at the most recent Social Security Trustees Report actuarial table. For the vast majority of Americans, RMDs will now impact a very small proportionate share of their lifetime.
It’s time for advisors to question prioritizing a planning concern, RMDs, that now impacts a very small slice of most Americans’ lives.
Permanently Extended Lower Tax Brackets and Higher Standard Deduction
In 2022, advisors were on alert.
Better do those Roth conversions before lower tax rates sunset in 2026 was the common refrain. To be fair, in 2022 the Internal Revenue Code stated that the lower tax rates and the higher standard deduction expired on New Year’s Day 2026.
Since 2022, both the world and the Internal Revenue Code have changed.
The sunset never happened! In July 2025, the One Big Beautiful Bill permanently extended the previously “temporary” lower tax brackets and the higher standard deduction. In fact, the new bill slightly increased the higher standard deduction ($750 for singles, $1,500 for those married filing jointly).
Let’s think about what that means for taxes in retirement. RMDs that would have been taxed at 15%, 25%, and/or 28% will now be taxed at 12%, 22%, and 24%. That makes a big difference in planning, as the taxation of RMDs becomes less harmful.
It gets better! Less of most Americans’ RMDs will be taxed in a taxpayer’s highest bracket, thanks to the higher standard deduction. The higher standard deduction drags taxable income down in retirement, decreasing the amount of an RMD subject to the taxpayer’s highest marginal tax bracket.
Senior Deduction
New for 2025 is the senior deduction. It is up to $6,000 per person for those 65 or older by year end. Yes, it is subject to modified adjusted gross income (“MAGI”) phaseouts between $75,000 and $175,000 for singles and $150,000 to $250,000 for those married filing jointly. But those income phase outs still allow many rather affluent retirees to claim some or all of the senior deduction.
Many affluent retired couples will not show $150,000 of MAGI, especially prior to claiming Social Security. Even those with $200,000 of MAGI, a very limited cohort of affluent retired couples, get $6,000 of the potential $12,000 deduction. While the senior deduction may be more limited for affluent single retirees, many will be able to control income so as to qualify for some of the senior deduction.
The senior deduction helps with several retirement tax planning tactics and objectives. For some, the senior deduction opens the door wider for significant tax free taxable Roth conversions prior to collecting Social Security. For others, it will open the door to very significant Hidden Roth IRA distributions prior to collecting Social Security. The senior deduction also reduces the tax hit on RMDs, since it lowers the amount of the RMD subject to the taxpayer’s highest marginal tax rate.
2025 Increased Deduction: Consider a married couple both turning 65 in 2025. On New Year’s Day, their 2025 standard deduction was $33,200. Pretty good. With the increased standard deduction and the new senior deduction, assuming their MAGI is $150,000 or less, their total combined 2025 “standard” deduction is now $46,700. Yes, the tax planning world has changed!
Senior Deduction Uncertainty
Some worry: doesn’t the senior deduction vanish in 2029?
Aren’t we back to the “temporary” tax cuts that lowered the tax brackets and increased the standard deduction?
“Temporary” was simply the weigh station to “permanent” in that case. I strongly suspect something similar will happen with the senior deduction.
Let’s play out the politics. If Congress does nothing, in 2029, the senior deduction, the new deduction for tipped income, and the new deduction for overtime income all vanish overnight. Is it politically wise for Congress to allow seniors, waiters, waitresses, and many blue collar workers to face tax hikes?
Congress tends to act in its own best interests. While there are no guarantees, the politics are well aligned for the senior deduction to be extended into 2029 and beyond.
Tax Planning Impact
Fewer RMDs. Lower tax rates and a higher standard deduction. The senior deduction.
Three big changes in three years change tax planning.
We’ve heard commentators push for Roth 401(k) contributions during the working years and aggressive Roth conversions during the early part of retirement. Both tactics optimize for taxes in the later part of retirement. But we’ve just seen three changes in three years that significantly lower taxes later in retirement.
If the goal is to pay tax when you pay less tax, it’s time to adjust our thinking.
This is particularly true when it comes to Roth 401(k) contributions. These contributions, for most taxpayers, tend to cost a tax deduction at the taxpayer’s highest lifetime marginal tax rate. In a changed world where retiree taxation has been significantly reduced, that’s not likely to be good planning for most Americans.
My view is that the new tax planning environment reduces the desirability of significant Roth conversions prior to collecting Social Security. As Mike Piper stated, one of the main benefits of Roth conversions is to reduce tax drag caused by RMDs. The new tax laws significantly reduce that tax drag. Thus, accelerating income tax through Roth conversions becomes much less desirable.
Tax Planning Resource For a Changed World
Cody Garrett, CFP(R), and I created a resource for the new tax planning landscape.
Tax Planning To and Through Early Retirement is a book that tackles the new realities of tax planning, including deep dives into accumulation planning, drawdown tactics, taxable Roth conversions, RMDs, the Widow’s Tax Trap, and the senior deduction.
We also have an entire chapter titled Planning for Uncertainty. In that chapter we tackle the “What about future tax hikes?” question using history, logic, and reason.
Conclusion
In football and in tax planning, the game changes. The recommendations advisors made four years ago may have been the right recommendations then. But big changes in the retirement tax landscape require advisors to reevaluate their strategies and tactics when it comes to tax planning.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
Starting in 2026, those with significant prior year W-2 incomes must make catch-up contributions to 401(k)s and other workplace retirement plans as Roth contributions.
Mandatory Roth catch-up contributions deny many workers 50 and older a valuable tax deduction.
The new rule originates with SECURE 2.0, a component of the Omnibus bill passed in December 2022.
Were the Omnibus were to be invalidated on Quorum Clause grounds, the rule requiring mandatory Roth catch-up contributions could not be sustained.
Judicial Results to Date
In the federal courts in Texas, four federal judges have weighed in. Two have opined that the Omnibus was passed in a Constitutionally qualified manner consistent with the Quorum Clause. Two have opined that the Omnibus was not passed in a Constitutionally qualified manner since the House did not have a sufficient quorum at the time of the Omnibus’s purported passage.
Here is how I assess where we are in September 2025.
First, it is likely that SECURE 2.0 will never be overturned. While I cannot say that definitively, I feel rather confident that it will survive, and I would plan around that outcome.
Let’s play out the future. As of this writing, I do not know if Ken Paxton, the Attorney General of the State of Texas, will appeal the August decision to an en banc panel of the Fifth Circuit and/or to the Supreme Court. But assuming it goes to the Supreme Court, just for analytical purposes, I suspect at least two of the institutionalist bloc of Justices Roberts, Kavanaugh, and Barrett would side with both the Biden and Trump Departments of Justice against overturning the Omnibus on Quorum Clause grounds.
From a planning perspective, it’s time for higher income W-2 workers to understand that they must make any 401(k) or other workplace retirement plan catch-up contributions as Roth contributions in 2026. The IRS confirmed this in recent guidance.
The threshold to be considered high income for this purpose is likely to be slightly more than $145,000 of W-2 wages from that employer in 2025. I suspect that in October the IRS will come out with the exact threshold 2025 W-2 wage threshold amount applicable in 2026 (this is adjusted based on inflation).
In late 2025, those subject to this potential restriction may want to prioritize W-2 income reduction planning opportunities such as making remaining 2025 401(k) contributions as traditional contributions to potentially fit under the 2026 threshold.
Silver Lining: Required Minimum Distributions
There’s a silver lining to SECURE 2.0 likely surviving Quorum Clause concerns: delayed RMDs. For those born in 1960 or later, SECURE 2.0 delays the onset of required minimum distributions (“RMDs”) from age 72 to age 75.
This delay requires all of us to step back from the inchoate fears about taxes in retirement and reassess RMDs and their impact.
Conclusion
While the final path of the Omnibus Quorum Clause litigation is not certain, it’s tilting heavily towards the Omnibus, and thus SECURE 2.0, surviving concerns about the House of Representatives’ use of proxies to establish a quorum in December 2022.
From a financial planning perspective, it is time to plan for higher income workers being required to make 401(k) catch-up contributions as Roth contributions. Further, it’s quite reasonable for those born in 1960 and later to plan on RMDs beginning at age 75.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
On July 4th, President Trump signed into law the reconciliation bill, commonly referred to as the One Big Beautiful Bill.
The Bill will drive a significant amount of my content creation this summer.
On my YouTube channel, I will devote my Saturday videos to discussions of how the One Big Beautiful Bill impacts financial planning and retirement planning. Already I did a video stating that the One Big Beautiful Bill ought to have us questioning our thinking about the future, and a video about how One Big Beautiful Bill changes the tax planning landscape for charitable giving.
Separately, I am working with Cody Garrett, CFP(R), to put the finishing touches on our forthcoming book, Tax Planning To and Through Early Retirement, which we anticipate publishing later this year. The book will devote significant space to how the new law changes retirement planning.
To find out when we are publishing the book, please sign up for an email alert here.
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.
So who is right? The FI Tax Guy or Scott Trench and Mindy Jensen of the BiggerPockets Money podcast?
This isn’t just a discussion in my mind or a late night debate at the Waffle House. It’s become a debate in the financial independence space. Just last week, the Middle Class Trap was the topic of the ChooseFI podcast.
We will return to that episode of ChooseFI later. For now, I want to start by defining the Middle Class Trap and providing the two reasons I don’t believe the Middle Class Trap is a trap. Then I will move onto several numerical examples, including four Mindy Jensen provided on ChooseFI.
The Middle Class Trap Defined
Scott Trench and Mindy Jensen walk through their definition of the Middle Class Trap from in this YouTube video. I encourage you to watch it.
Boiled down, the argument is that primary residence wealth is trapped and traditional retirement accounts are trapped until age 59 ½. Thus, many in the middle class have trapped wealth and cannot retire prior to age 59 ½ despite good numbers on paper.
There are two problems with their argument. First, primary residence wealth isn’t the owner’s wealth as we ordinarily conceive and define it. Second, traditional retirement accounts are not trapped prior to age 59 ½.
The Primary Residence Question
Too often we think of primary residences as investments. They are not, as Douglas Boneparth observes. They are a form of consumption.
People say “I have a million dollars in home equity so I am a millionaire.”
No, you are not.
I can prove it.
Peter has a $500 checking account, a car, clothes, and a $1 million home with no mortgage. He sells the home for $1 million. He immediately must get a hotel room to sleep in tonight.
John has a $500 checking account, a car, clothes, rents an apartment, and has $1 million in VTSAX in a taxable account. He sells $10,000 of VTSAX for cash. He now has a pile of cash and need not make any adjustments to have a bed for the night.
Is Peter’s home equity really his wealth when accessing causes significant life adjustments? John’s VTSAX is his wealth. His accessing it requires no life adjustments.
So what then is market driven appreciation in home equity? It’s growth in asset value that primarily benefits three classes of people:
The next generation
Owners willing to change geographies or willing to significantly downsize
Owners needing long-term care at the end of life
Market driven increases in home equity are not a trap. Rather, they are wealth that, in many cases, someone else gets to enjoy.
Imagine I’m writing a blog post and the doorbell rings. I answer and the delivery man says, “Mr. Mullaney, congratulations! You won a contest. The prize is $1,000 of Blippi toys!”
Those Blippi toys are my wealth that my toddler Goddaughter gets to enjoy.
It’s no different with market driven increases in home equity. It’s wealth that shows up on your doorstep that most likely will be enjoyed by the next generation.
In no way do those Blippi toys trap me. Same with market driven increases in home equity.
The 10% Early Withdrawal Penalty is No Bar to Early Retirement
I’ve written about the myriad ways to fund retirement prior to 59 ½ without incurring the 10 percent early withdrawal penalty. I’ve spoken about it on two episodes of the ChooseFI podcast (475 and 491).
But until now, I have never explicitly said the following:
Those 50 and older with sufficient assets are in no way barred from early retirement due to the 10 percent early withdrawal penalty even if all of their financial asset wealth is in traditional retirement accounts.
While 72(t) payment plans are not the ideal retirement plan, they are more than adequate enough to use to retire in the year one turns age 50 or later. Those 50 or older, with a simple spreadsheet and some diligence, are in no way barred from early retirement due to the 10 percent early withdrawal penalty.
What about those under age 50?
Few under age 50 will be able to retire on traditional retirement accounts alone because of sufficiency concerns. Tax concerns are not the problem when thinking about retiring prior to age 50 – it’s all about sufficiency!
Fortunately, the profile tends to resolve itself. To have enough financial wealth to retire in one’s 40s, the prospective early retiree most likely contributed to some combination of Roth accounts or taxable accounts prior to retirement. While not insignificant, traditional retirement account contribution limits are such that for many, it will be difficult to rely on them exclusively to build up sufficient assets for retirement prior to January 1st of the year of one’s 50th birthday. The 40-something early retiree can start their early retirement distributions from Roth accounts, taxable accounts, or a combination of both, obviously without penalty.
Summed up, when assessing the Middle Class Trap, for those under 50, their profile itself usually resolves the issue. For those 50 and older, the 72(t) payment plan rules are so advantageous (due to a major change in 2022) that a spreadsheet requiring one amortization calculation, some coordination with a financial institution, and a bit of ongoing additional diligence resolves the issue.
For both age cohorts, there is no tax trap.
Does this mean the 10 percent early withdrawal penalty has been, in effect, repealed? Hardly! If someone like me, in their late 40s, wants to take $20,000 from a traditional 401(k) to fly round-trip in a suite, I will pay a hefty 10 percent early withdrawal penalty. The penalty is still effective to discourage impulsive onetime withdrawals before retirement. But the penalty is not effective to prevent early retirements with a systematic, sustainable withdrawal plan. That’s the obvious intention behind the series of substantially equal periodic payments exception.
Examples from Mindy Jensen on ChooseFI Episode 543
During the ChooseFI episode, Mindy offered some numerical examples to argue for her case. That is a very legitimate tactic, and I personally love examples. Unfortunately, using numerical examples ran up against a limitation of the audio podcast format, since it can be difficult for participants and listeners to fully process multiple numbers while listening to an episode.
Mindy started sharing numerical examples around 25:00 in the podcast. I went back to the YouTube video and put Mindy’s numbers in the below table. I then added a row totaling financial assets and two rows laying out theoretically possible annual withdrawal rates.
Let’s use a range of withdrawal rates just for illustrative purposes. On the low end, we’ll use Morningstar at 3.7 percent, which can be fairly considered to be conservative. On the high end, let’s roll the dice a bit and use 6 percent.
Notice that the problem in the examples is not that the person has everything locked up in traditional accounts. The problem is sufficiency! Aside from Person C, it does not matter if all of the financial wealth is in Roth accounts, taxable accounts, or split between the two of them.
Persons A, B, and D are not in the Middle Class Trap. Rather, they are in a situation where they need to work longer unless their annual spending is incredibly modest, even by financial independence standards.
I believe that Person C could consider living on cash and later starting a 72(t) payment plan, but we really can’t tell without knowing much more information, including their age and their annual spending level in retirement.
Middle Class Trap 72(t) Payment Plan Examples
In one podcast episode, Mindy and Scott put the parameters of the Middle Class Trap at $1M to $1.5M of trapped wealth (see 3:19 of this video). How bad is the federal income tax result if we assume practically all of that wealth is in traditional deferred retirement accounts?
Using the old Four Percent Rule of Thumb for our 72(t) annual payment at both ends of the spectrum, and assuming a $40,000 taxable savings account and 5 percent interest on it and on the annual 72(t) payment taken at the beginning of the year and spent evenly during the year, here’s the 2025 federal income tax result by my estimation.
72(t) Payment Funding for Expenses Other Than Federal Income Tax
$36,878
$54,416
$38,700
$56,457
Effective Federal Income Tax Rate
7.26%
8.79%
3.02%
5.58%
AGI as a Percent of 2025 Federal Poverty Level
274.76%
405.75%
203.31%
300.24%
I believe this table strongly supports my contention that the tax laws want you to retire early. Look how light the taxation is on 72(t) payments!
You may ask “I thought federal tax rates started at 10 percent – how do these people pay effective rates less than that?” The answer is the standard deduction, which loves early retirees. Because of the standard deduction, all four taxpayers enjoy what I refer to as the Hidden Roth IRA. They take some amounts from their traditional IRAs and pay 0 percent federal income tax on them.
I will note two things. First, I am not arguing anyone should simply plan on getting to an early retirement age and have every last penny in traditional retirement accounts. I am arguing that it is hardly a trap if someone gets to age 50, has every penny in traditional retirement accounts, and wants to retire using a reasonable withdrawal rate.
Second, managing for Premium Tax Credit can be a concern. At the high end of Mindy and Scott’s Middle Class Trap range, a single taxpayer would be shut out of a Premium Tax Credit (having gone a bit over the 400 percent of FPL cliff) if they were on an ACA medical insurance plan in 2026, unless later tax law changes in 2025 amend Section 36B. This person could turn on Premium Tax Credits by electing a slightly lower initial 72(t) annual payment.
Sufficiency Is The Real Problem
We should spend more time on the real problem: retirement sufficiency. According to UBS, median adult wealth in the United States in 2023 was just $112,157. Even considering that older Americans are likely to have greater wealth than younger adults, the median wealth statistic means many Americans of all ages are significantly behind in retirement savings. The best way to catch up is by making traditional retirement account contributions.
Update May 1, 2025
Thank you to Mindy Jensen who wrote a thoughtful response to this blog post. You can read it over at BiggerPockets.
Stay Tuned
This won’t be the last time you hear from me on this topic. Cody Garrett and I are currently writing Tax Planning To and Through Early Retirement, a book we hope to publish later this year. We will address all sorts of issues when it comes to accessing wealth and tax planning for those retiring prior to turning 59 ½.
What questions do you have about retiring prior to 59 ½? Let us know in the comments below and we might just answer your questions in Tax Planning To and Through Early Retirement!
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
New to financial independence (FI or FIRE)? Are you steeped in financial independence, but confused about tax optimization?
If so, this is the post for you. It’s not “comprehensive tax planning for FI” but rather an initial primer on some basic financial independence tax planning tactics. I believe the three tactics here are the most compelling tactics for most pursuing financial independence.
But first, a caveat: none of this is advice for your specific situation, but rather, this comprises a list of the top three moves I believe those pursuing financial independence should consider. No blog post (this one included) is a substitute for your own and your advisors’ analysis and judgment of your own situation.
ONE: Contribute Ten Percent to Your Workplace Retirement Plan
To start, your top retirement savings priority in retirement should be to contribute at least 10 percent of your salary to your workplace retirement plan (401(k), 403(b), 457, etc.). I say this for several reasons.
It starts a great savings habit.
Subject to vesting requirements, it practically guarantees that you will get the employer match your 401(k) has, if any.
Assuming a traditional retirement account contribution, it gets you a valuable tax deduction at your marginal tax rate.
It will be incredibly difficult to get to financial independence without saving at least 10 percent of your salary.
Strive to eventually contribute the maximum allowed.
Here are some additional considerations.
Traditional or Roth
In some plans, the employee does not have a choice – employee contributions are “traditional” deductible contributions. Increasingly, plans are offering the Roth option where the contribution is not deductible today, but the contribution and its growth/earnings are tax-free in the future.
This post addresses the traditional versus Roth issue. I strongly favor traditional 401(k) contributions over Roth 401(k) contributions for most people. The “secret” is that most people pay much more in tax during their working years than they do during their retired years, even if they have significant balances in their traditional retirement accounts. Thus, it makes more sense to take the tax deduction when taxes are highest and pay the tax when taxes tend to be much lower (retirement).
Bad Investments
I’d argue that most people with bad investments and/or high fees in their 401(k) should still contribute to it. Why? First, consider the incredible benefits discussed above. Second, you’re probably not going to be at that job too long anyway. In this video, I discuss that the average/median employee tenure is under 5 years. When one leaves a job, they can roll a 401(k) out of the 401(k) to the new employer’s 401(k) or a traditional IRA and get access to better investment choices and lower fees.
Resource
Your workplace retirement plan should have a PDF document called a “Summary Plan Description” available in your workplace benefits online portal. Reviewing that document will help you figure out the contours of your 401(k) or other workplace retirement plan.
TWO: Establish a Roth IRA
For a primer on Roth IRAs, please read my Ode to the Roth IRA. Roth IRAs, like traditional IRAs, are “individual.” You establish one with a financial institution separate from your employer.
Generally speaking, a Roth IRA gives you tax-free growth, and if done correctly, money withdrawn from a Roth IRA is both tax and penalty free.
Roth IRA contributions can be withdrawn tax and penalty free at any time for any reason! The Roth IRA is the only retirement account that offers unfettered, tax-free access to prior contributions. Note, however, in most cases the best Roth IRA strategy is to keep money in the Roth IRA for as long as possible (so it continues to grow tax free!).
Taxable accounts get a very bad rap. It turns out they can be incredibly valuable.
First, they tend to be lightly taxed, even during our working years. In 2025, a $1 million investment in a broad based domestic equity index fund is likely to produce less than $13,000 of taxable income. Most of that income will qualify as “qualified dividend income” and thus be taxed at favored long-term capital gains rates.
Second, taxable accounts are the perfect bridge from working to retirement. When an investor sells an asset in a taxable account, they don’t pay tax on the amount of the sale. They pay tax on the amount of the sale less their tax basis (their original investment plus reinvested dividends). Basis recovery, combined with favored long-term capital gains tax rates, makes living off taxable accounts first in retirement very tax efficient.
Conclusion
Here are the top three tax moves I believe FI beginners should consider:
First, contribute 10 percent to your traditional 401(k) or other traditional workplace retirement plan, striving to eventually contribute up to the maximum.
Second, establish a Roth IRA.
Third, invest in taxable brokerage accounts.
Of course, this post is not tailored for any particular taxpayer. Please consult with your own tax advisor(s) regarding your own tax matters.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
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.
What some call “tax basketing” and others call “asset location” is becoming increasingly important, particularly for early retirees and those aspiring to be early retirees.
Tax basketing is not portfolio allocation. Tax basketing is the step after portfolio allocation. First the investor decides the assets he or she wants to invest in and in what proportion.
Once that decision is made, tax basketing starts. The idea is where to hold the desired assets within the available tax categories (Roth, Traditional, Taxable, HSA) that makes the most sense from a tax efficiency perspective and a tax planning perspective.
Early Retirees and Aspiring Early Retirees
To assess tax basketing for many early retirees, I will need to make a few assumptions. First, the aspiring early retiree and the early retiree (our avatars) want to hold three main assets: domestic equity index funds, international equity index funds, and domestic bond index funds. That is simply an assumption: it is not investment advice for you or anyone else.
Second, our avatars have at least 50 percent of their financial wealth in traditional retirement accounts. This assumption makes our avatars like most Americans when it comes to their financial assets, and, in my experience, most considering or in early retirement. Third, our avatars want to have less than 50 percent of their portfolio in domestic bond index funds (again, just an assumption, not investment advice).
Lastly, most of this analysis ignores HSAs unless specifically discussed, since the balances in them tend to be rather modest and most of the Roth analysis below applies equally to HSAs.
Let’s dive deep on where our avatars should hold their desired portfolio, considering that they are either striving for early retirement or in early retirement.
Asset Yield
Tax basketing should consider many things. Chief among them is annual asset yield. Financial assets such as stocks, bonds, mutual funds, and exchange traded funds (ETFs) typically kick off interest and/or dividend income annually (often referred to as “yield”).
The expected amount of that income and the nature of that income strongly inform where to best tax basket each type of asset.
Let’s explore the three assets our avatars want using Vanguard mutual funds as a reasonable proxy for their annual income (yield) profile (not presented as investment advice).
All numbers are as of this writing and subject to change. That said, they strongly inform where we might want to hold each of these types of assets.
Let’s start with VTSAX, our domestic equity index. Notice two things? First, it produces remarkably low yield. Say I owned $1M of VTSAX in a taxable account. How much taxable income does that produce for me? Just around $12,200 annually. Further, most of that is tax-preferred qualified dividend income!
People worry about tax drag when investing in taxable accounts. Tax basketing can solve for most tax drag! Why would you worry about tax drag when it takes $1M of VTSAX to wring out just $12,200 of mostly qualified dividend income on your tax return?
What about VTIAX? In today’s environment, it produces more than twice as much dividend income as VTSAX, and much more of that income will be ordinary income (since only about 61.16% qualifies as QDI).
Lastly, let’s think about VBTLX. Bonds typically produce the most income (bonds tend to pay more out than equities do as dividends) and bonds produce only ordinary income. You can see that from a tax basketing perspective, bonds in taxable accounts tend to be undesirable.
Tax Basketing Insights
Domestic Equity Funds
Domestic equity index funds do great inside a taxable account! They barely produce any income on the owner’s tax return. The small amount of income they produce mostly qualifies for the favored tax rates of 0%, 15%, 18.8%, and 23.8%.
Recall our avatar with $1M in VTSAX. He only gets $12,200 in taxable income from that holding. If that was his only income, he doesn’t have to file a tax return, as the standard deduction is large enough to cancel out that income.
An additional point: most early retirees and potential early retirees will probably have domestic equities in all three of the main baskets: Taxable, Traditional, and Roth. To my mind, that’s not a bad thing. Yes, inside a traditional retirement account, the qualified dividend income becomes tax deferred ordinary income, not a great outcome, but also not a horrible outcome.
The tax tail should not wag the investment dog. But it is logical for most early retirees and aspiring early retirees to only hold domestic equities in taxable accounts and then hold domestic equities in traditional and Roth accounts as needed for their overall asset allocation.
International Equity Funds
International equity funds sit well in retirement accounts, whether they are traditional, Roth, and/or HSAs. They are not awful in taxable accounts, but they are not great. Why do I say that? Compare the 3.22% yield on them to the 1.22% yield on domestic equity index funds. Wouldn’t you rather have the higher yielding asset’s income sheltered by the retirement account’s tax advantages and the lower yielding asset be the one subject to current income taxes?
What About the Foreign Tax Credit?
It is true that holding international equities in a retirement account sacrifices the foreign tax credit. In a world where yields were the same and future gains were the same, the foreign tax credit would be enough to favor holding international equities in a taxable account.
However, we don’t live in that world. Further, the foreign tax credit tends to be quite small. For example, the foreign taxes withheld by Japan when Japanese companies pay Americans a dividend is 10 percent. Not nothing, but considering that there is more than double the yield paid on international equities, not enough to make it highly desirable from a tax standpoint to have income in taxable accounts. Rates vary, but can be as low as zero. Consider that most dividends paid by United Kingdom companies to American shareholders attract no dividend withholding tax and thus create no foreign tax credit on federal income tax returns.
This video breaks down the math on the foreign tax credit.
Domestic Bond Funds
Domestic bonds and bond funds sit very well in traditional retirement accounts. Why waste the tax free growth of Roth accounts on bond funds? Bonds tend to have a lower expected return, making them great for traditional retirement accounts, not Roth accounts. Further, why put the highest yield assets with the worst type of income (none of it QDI) in taxable accounts? The stage is thus set: put all the bonds in traditional retirement accounts and don’t look back.
Two traditional accounts domestic bonds do particularly well in are inherited IRAs and 72(t) IRAs!
Tax-Exempt Bonds
High income people ask: should I hold tax-exempt bonds since I have such high income? In the early 1980s, it might have made sense to alter investment allocation for tax planning reasons and invest in lower yielding tax-exempt bonds instead of high yielding taxable bonds. Back then tax rates were higher and most affluent Americans had most of their money in taxable accounts and pensions. The era of the IRA and the 401(k) was in its infancy and few had large balances in tax deferred defined contribution accounts such as traditional IRAs and traditional 401(k)s.
The world of the mid-2020s is quite different. Many pensions are gone, and affluent early retirees and aspiring early retirees tend to have much of their financial wealth in traditional IRAs and traditional 401(k)s.
That sets the stage beautifully for holding bonds in traditional retirement accounts. Income generated by bonds is tax deferred inside the traditional retirement account. Further, there’s usually plenty of headroom in the traditional IRAs and 401(k)s to hold all of the investor’s desired bond allocation. So why not hold all of the desired bond allocation inside traditional retirement accounts?
This means that for most people, there’s little reason to adjust a desired asset allocation in order to hold tax-exempt bonds and thereby sacrifice yield. Tax-exempt bonds receive no preference over taxable bonds inside a traditional 401(k) or IRA.
Keeping Ordinary Income Low
Do you see what tax basketing can do for the early retiree? If the only thing he or she owns in taxable accounts are domestic equity index funds (perhaps with a small savings account), he or she will have low taxable income and almost no ordinary income.
Or perhaps it is the Hidden Roth IRA where a retirees uses the standard deduction to live off of traditional retirement accounts. It allows the early retiree to use the standard deduction to fund living expenses from a traditional IRA and pay no federal income tax. Again, who’s complaining about paying no income tax?
Lastly, tax basketing can keep those qualified dividends and long-term capital gains at a 0% long term capital gains rate. For married couples with $96,700 or less of taxable income, the federal income tax rate on all long term capital gains and qualified dividends is 0%. One way to help ensure that outcome is tax basketing. Ordinary income from higher yielding bond funds pushes qualified dividends and long term capital gains up (through income stacking) and can subject some of it to the 15% rate. Why not hide out that ordinary income in traditional retirement accounts and only hold low yielding domestic equities in taxable accounts?
Aspiring Early Retirees
For the still working aspiring early retiree, having taxable investments generate low yield and preferred yield (qualified dividend income) can help save taxes during peak earning years. The high earner would prefer to have less QDI (through dividends paid by domestic equities) rather than more ordinary income (through dividends of ordinary income paid by domestic bond funds) hit their annual income tax return. This keeps taxable income lower, keeps the tax rate better on the portfolio income, and reduces or potentially eliminates exposure to the Net Investment Income tax.
In theory, the early retiree can fund their living expenses in three extreme manners: all from traditional retirement accounts, all from Roth retirement accounts, or all from taxable accounts. Testing these three from a Premium Tax Credit perspective can inform us about which tax basket is the best to spend from first in early retirement.
If Goldilocks funds her early retirement first from traditional IRAs and 401(k)s, she will find it’s too hot from a PTC perspective. All her spending creates taxable income, which reduces her Premium Tax Credit.
If Goldilocks funds her early retirement from Roth IRAs, she will find it’s too cold from a PTC perspective. Her spending creates no taxable income in all likelihood. That’s a huge problem from a PTC perspective. If one’s income is too low, they will not qualify for any PTC, creating a big problem in early retirement.
If Goldilocks funds her early retirement from taxable accounts, she’s likely to find it just right from a PTC perspective. Say she has $60,000 of living expenses. Will that create $60,000 of “modified adjusted gross income”? Absolutely not. It will create $60,000 less her tax basis in the assets she sold in modified adjusted gross income. This gives her an outstanding chance of having a low enough income to qualify for a significant PTC. If her basis was too high and she did not create enough income to qualify for a PTC, she could, prior to year-end, execute some Roth conversions to get her income to the requisite level.
What Goldilocks’ example demonstrates is that it is a good thing to have amounts, perhaps significant amounts, in the taxable basket heading into early retirement. While there is absolutely hope for those with little in the taxable basket, it will require some additional planning in many cases.
You know what can help mitigate RMDs? Tax basketing!
By holding all of one’s domestic bond investments in traditional IRAs and traditional 401(k)s, retirees can keep the future growth inside traditional retirement accounts modest. When compared to equities, bonds have a lower expected return and thus a lower expected future value. This, in turn, reduces future traditional account balances, reducing future required minimum distributions. Recall that RMDs are computed using the account balance from the prior year as the numerator. Keeping that numerator more modest reduces future RMDs.
Sequence of Returns Risk and Tax Basketing
Some worry about sequence of returns (“SoR”) risk: what if I retire and the equity markets happen to have a year like 1987 or 2008 right as I’m retiring? At least in theory this is a risk of retiring at any time and the risk is magnified by an early retirement.
Say Maury, age 50, is about to retire and worried about SoR risk so he wants to have three years of cash going into retirement (again, not an investment recommendation, just a hypothetical). Cash generates interest income, which is bad from a tax efficiency perspective. Can Maury use tax basketing to manage for SoR risk and stay tax efficient? Sure!
Imagine Maury retires with $500K in a domestic equity index fund in a taxable brokerage, $240,000 of cash and/or money markets in a traditional IRA (3 years of expenses), $500K of domestic bonds in a traditional IRA, and about $1M in a combination of domestic and international equities in a traditional IRA.
Maury can live on the cash and only live on his taxable brokerage account. Wait, what? I thought the cash lives in the traditional IRA. It does.
But Maury can simply sell $80,000 of the domestic equity index fund annually and report mostly long term capital gains and (rather modest) qualified dividend income on his tax return. His income might be so low he wants or needs to do Roth conversions! Separately inside the traditional IRA he “spends down” the cash by annually buying $80,000 of any desired combination of domestic equities, international equities, and/or domestic bonds inside his traditional IRA.
Maury just used tax basketing to live off almost a quarter million of cash for three years without reporting a penny of interest income to the IRS!
Announcement
You have just read a sneak preview of part of the new book! Cody Garrett, CFP(R) and I are working on, tentatively titled Tax Planning To and Through Early Retirement. In 2025 the retirement tax planning landscape is changing, and Cody and I want to be on the cutting edge as retirement tax planning changes.
This post will, in modified form, constitute part of the book’s tax basketing (a/k/a asset location) chapter.
When will the book come out? Well, that’s a question better asked of elected officials in Washington DC than of your authors. 😉
What topics would you like us to cover in the book? Let us know in the comments below!
Stay tuned to me on X and LinkedIn and Cody on LinkedIn for updates on when the book will be available!
Conclusion
Tax basketing can be a great driver of success to and through early retirement. From a purely tax basketing perspective, domestic equity index funds tend to sit well in taxable accounts, international equity index funds tend to sit well in retirement accounts, and domestic bond index funds tend to sit well in traditional retirement accounts. Premium Tax Credit considerations tend to favor having some money in taxable accounts in early retirement. Good tax basketing can keep taxable income low and facilitate excellent early retirement tax planning.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
Late 2022 ushered in a new type of contribution to Solo 401(k)s: Roth employer contributions. Traditional employee and employer contributions have been available for all of the Solo 401(k)’s post-EGTRRA history. Roth employee contributions have been available since 2006, even if plan providers were slow to adopt them.
Should the availability of Roth employer contributions change planning for most solopreneurs? Not to my mind.
I have three concerns with making Roth employer contributions to Solo 401(k)s.
First Concern: Validity
Update March 13, 2026: Two federal judges agree with me. Two disagree with me. Thus, my view loses! The first concern discussed in this article, originally published in January 2025, is no longer a concern. I discussed a major development occurring after this article was originally published in this blog post.
Roth employer contributions were part of SECURE 2.0, which was part of the Omnibus bill passed in December 2022. That Omnibus bill has been subject to litigation. In Texas v. Garland (accessible here and here), Judge James W. Hendrix ruled for the State of Texas that the House of Representatives impermissibly used proxies to establish a quorum in order to pass the Omnibus, in violation of the Constitution’s Quorum Clause.
I encourage you to read the Texas v. Garland opinion. It is very convincing in my opinion.
While Texas v. Garland does not technically apply to SECURE 2.0, its reasoning does. Any taxpayer in the country facing harm under SECURE 2.0 (perhaps because they were denied the deduction for catch-up contributions under SECURE 2.0 Section 603) can pick it up and ask another federal judge to invalidate SECURE 2.0. That leaves SECURE 2.0 on shaky footing.
Short of litigation, there’s the question of what the new Administration will do with the Omnibus and SECURE 2.0. Texas v. Garland is litigation between the old Department of Justice and Ken Paxton, the Attorney General of Texas. Ken Paxton is much closer aligned politically with the Trump Administration. Will the Trump DoJ continue to litigate against Ken Paxton? The Trump Administration may simply refuse to uphold the Omnibus, including SECURE 2.0.
My hope is that if that happens taxpayers who have relied on SECURE 2.0 will be held harmless. For example, amounts in Roth 401(k)s (including Solo 401(k)s) attributable to employer contributions should be deemed to be amounts validly within the Roth 401(k) plan, so past reliance does not cause future harms (such as failed plan qualification). That said, my hope, a reasonable hope, is just a hope.
Regardless of one’s views on the Quorum Clause litigation, there’s at least some doubt as to SECURE 2.0’s validity, including the validity of Roth employer contributions to Solo 401(k)s. That makes planning into them difficult, in my opinion.
Second Concern: Section 199A Problem
Ben Henry-Moreland of Kitces.com wrote a thoughtful article on Roth employer contributions to Solo 401(k)s potentially reducing a solopreneur’s Section 199A qualified business income deduction.
I both agree and disagree with Mr. Henry-Moreland. I agree in a general sense that recent IRS guidance has muddied the waters when it comes to tax return reporting of Roth employer contributions to Solo 401(k)s. I disagree with his conclusion that this guidance results in non-deductible Roth employer contributions to Solo 401(k)s reducing the Section 199A qualified business income deduction.
The concern is Roth employer contributions might reduce the amount of qualified business income that then determines the Section 199A QBI deduction. Mr. Henry-Moreland is concerned about this because of Notice 2024-2 Q&A L9 (page 76 of this file). It tells plans how to report Roth 401(k) employer contributions in general. The question is “what reporting obligations apply to [Roth employer] contributions?”
Before I state the concerning answer, one must remember the context. This particular Q&A is about reporting, not about taxation. In theory, Roth employer contributions (taxable to the employee) should be simply added to W-2 income for most employees. But that creates a huge headache from a large employer systems perspective. That’s W-2 income that is income tax taxable but not payroll tax taxable. Ugh!
To avoid the payroll systems issue (which is mostly a large employer issue rather than a Solo 401(k) issue), the Notice provides that Roth employer contributions are reported “as if: (1) the contribution had been the only contribution made to an individual’s account under the plan, and (2) the contribution, upon allocation to that account, had been directly rolled over to a designated Roth account in the plan as an in-plan Roth rollover.” (emphases added). The Notice goes on to state that because of this treatment the Roth employer contribution is reported to the employee as taxable on a Form 1099-R.
Mr. Henry-Moreland is concerned that as applied to a Schedule C solopreneur, this is reported by deducting the contribution from net self-employment income (presumably on Schedule 1, Line 16) and then taxing the amount on Form 1040 Lines 5a and 5b. This reduction of net self-employment income would result in a reduction in the Section 199A QBI deduction.
While I hear Mr. Henry-Moreland’s concern, I disagree with it for several reasons. First, the Q&A in question applies to reporting by plans. It does not appear to apply to (1) determining taxable income or other tax relevant amounts and (2) tax return reporting by individuals. It is telling that the answer is silent as to any forms filed by individuals while it goes into depth as to how the Form 1099-R is to be filed.
Second, the words “as if” in the Notice’s answer are illuminating. The reporting is done “as if” X and Y happened for tax purposes. That means X and Y did not happen for tax purposes, which is good news from a Section 199A perspective. Third, the Notice does not purport to affect Section 199A in any way. Fourth, qualified business income is determined under Section 199A and Treas. Reg. Section 1.199A-3. Neither SECURE 2.0 Section 604 nor Notice 2024-2 mention Section 199A and qualified business income. Thus, I believe that Notice 2024-2 and Roth employer contributions to Solo 401(k)s do not reduce the qualified business income deduction.
The above views voiced, there may be some small risk that Roth employer contributions to Solo 401(k)s are not only nondeductible, they also reduce the qualified business income deduction. That’s a negative when assessing their desirability from a planning perspective.
How to Report Solo 401(k) Roth Employer Contributions on 2024 Tax Returns
What follows is my academic opinion, not advice for you or anyone else. To properly report Roth employer contributions to a Solo 401(k) made in 2024 for 2024 and arrive at the correct Section 199A QBI deduction, I believe the following is the best way to proceed:
(1) Report Schedule C income and deductions as normal. This should help generate the appropriate Section 199A QBI deduction.
(2) Report the amount of the Roth employer contribution to the Solo 401(k) in full in Box 5a of Form 1040.
(3) Assuming no other pension, annuity, 401(k), or other qualified plan distributions, report $0 for the taxable amount of pension and annuity distributions in Box 5b of Form 1040.
My view is that the above will properly report that which must be reported to the IRS while also (i) avoiding any double counting and (ii) properly computing the Section 199A QBI deduction that the taxpayer is entitled to.
If anyone at the IRS or the Treasury Office of Tax Policy is reading this, it would very helpful for the government issuing guidance (1) clarifying that no, Roth employer contributions to Solo 401(k)s do not reduce the Section 199A qualified business income deduction and (2) illustrating the proper tax return reporting for Roth employer contributions to Solo 401(k)s.
Third Concern: Planning Desirability
For this section, let’s assume that I am wrong when it comes to the first concern and I am correct regarding the second concern. Making those two assumptions, Roth employer contributions to Solo 401(k)s are valid and do not reduce the Section 199A QBI deduction.
Great!
Does that mean we should plan into such contributions? I believe the answer is generally “No” for most solopreneurs.
Even with the “deduction-reduction problem” issue with traditional Solo 401(k) contributions, traditional Solo 401(k) contributions are often going to be better than Roth Solo 401(k) contributions.
Picture a solopreneur in the 24% marginal tax bracket. He or she can make employer contributions to a traditional Solo 401(k) and save 19.2 cents on the dollar (24% times 80% to account for the reduction to the Section 199A QBI deduction).
Okay, well, how is that money taxed in retirement? I’ve done blog posts and YouTube videos about this subject. Some of that money could be taxed at 0% because of the standard deduction (the Hidden Roth IRA), then against the 10% bracket and then against the 12% bracket. We can hardly say traditional contributions are always the “right answer,” but we can acknowledge that (1) retirees tend to be lightly taxed in retirement and (2) retirees greatly benefit from today’s tax environment, including large standard deductions and progressive tax brackets.
I question the planning value of Roth employer contributions. Say you disagree with me. You still have Roth employee contributions. Why not hedge your bets by making Roth employee contributions and deductible traditional employer contributions? Both of these types of contributions are well established under the law.
Conclusion
Roth employer contributions to Solo 401(k)s are on shaky legal ground and are not that desirable from a planning perspective. There’s even a chance they reduce the Section 199A QBI deduction. Based on those concerns, I believe Roth employer contributions to Solo 401(k)s are undesirable for most solopreneurs.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
