Tag Archives: Roth versus Traditional

Traditional Versus Roth 2023

The debate continues: what’s preferable, traditional retirement accounts or Roth retirement accounts?

Fortunately, there are plenty of shades of gray in this debate. There’s no “right” answer, but I do believe that there are good insights that can help individuals make the right planning decisions for themselves.

Traditional and Roth Retirement Basics

Before we dive into the traditional versus Roth debate, we should quickly survey the basics of these types of retirement accounts.

Traditional

Traditional retirement accounts feature a tax deduction on the way in (i.e., for contributions) and ordinary income tax on the way out (i.e., for withdrawals). At work these are known as traditional 401(k)s, 403(b), 457s, and occasionally have other names. At home these are known as traditional IRAs.

Additional twist: many working Americans do not qualify to deduct a traditional IRA contribution due to relatively low income limits on claiming a deduction. 

Part of the appeal of traditional retirement accounts includes: (i) the notion that many will have lower taxable income (and thus lower income tax) in retirement than they did during their working years and (ii) the tax saved by contributing to traditional accounts can be invested, potentially creating more wealth for retirement. 

Roth

Roth retirement accounts feature no tax deduction on the way in (i.e., for contributions) and tax free treatment on the way out (i.e., for withdrawals). At work these are known as Roth 401(k)s, 403(b), 457s, and (after SECURE 2.0 implementation) will occasionally have other names. At home these are known as Roth IRAs.

Additional twist: some working Americans do not qualify to make an annual Roth IRA contribution based on income limits, but many can get around this rule by implementing a Backdoor Roth IRA. 

Part of the appeal of contributions to Roth retirement accounts is the notion that it is better for our younger, healthier selves to pay the tax associated with retirement savings when cash flow is good and the investor knows they can bear the cost. 

The basics out of the way, we can get into 2023 insights on the debate between the two types of retirement accounts.

The Risk of Traditional Retirement Accounts is Vastly Overstated

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

Here’s the thing: rarely do commentators offer any sort of mathematical analysis backing up that contention. I ran the math, and I repeatedly find that many retirees with traditional retirement accounts are likely to pay Uncle Sam a very manageable amount of income taxes in retirement. 

You be the judge and jury. I believe a fair assessment of my posts and videos and the numbers behind them shows that most Americans do not face a high risk of crippling federal income taxes in retirement, even if the vast majority of their portfolio is in traditional 401(k)s and IRAs. 

While I cannot give readers of this blog individualized advice, I can say that if one considers themselves to be an “Average Joe” it is difficult to see how having significant amounts in traditional retirement accounts is a problem. 

The Needle Keeps Moving Towards Traditional

Picture it: United States, September 2017, six short years ago. You’re bright-eyed, bushy-tailed, and fear only one thing: incredibly high taxes on your traditional 401(k) and IRA in retirement.

Then a few things happened.

  • December 2017: TCJA increased the standard deduction and lowered the 15% bracket to 12%
  • December 2019: The SECURE Act (SECURE 1.0) delayed RMDs from age 70 ½ to 72
  • March 2020: CARES Act cancels 2020 RMDs and allows taken RMDs to be rolled back in
  • November 2020: IRS and Treasury issue a new Uniform Life Table, decreasing the amount of annual RMDs beginning in 2022
  • December 2022: SECURE 2.0 delays RMDs from age 72 to 73, and all the way to age 75 for those born in 1960 and later

Tax cut after tax cut for traditional retirement accounts and retirees! In the traditional versus Roth debate, DC keeps putting a thumb on the scale for traditional. 

Watch me assess recent tax law change history as it applies to retirees.

Taxable Roth Conversions Going Away?

One reason I like traditional 401(k) contributions is that they do not close the door on Roths. Rather, traditional retirement account contributions at work are a springboard for years of Roth conversions in retirement for many in the FI community! 

The idea is to take deductions at high marginal tax rates at work into a 401(k) and build up wealth for an early retirement. Then, in retirement, one’s tax rate is artificially low as they no longer have W-2 income to report. This opens up room for potentially very efficient Roth conversions (affirmatively moving money in traditional accounts to Roth accounts) taxed at the 10% or 12% federal income tax rate. 

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

Second, why would Congress eliminate most taxable Roth conversions? They “budget” tax bills in a 10 year window. Taxable Roth conversions create tax revenue inside that budget window, making it that much less likely a Congress would eliminate most of them.

While there is not zero risk taxable Roth conversions will go away, I believe that the risk is negligible. The greater one believes Roth conversion repeal risk is, the more attractive Roth contributions during one’s working years look. 

Special Years Favor Roths

I’ve written before about how workers in the early years of their careers may want to consider Roth 401(k) contributions prior to their income significantly increasing. Those in transition years, such as those starting a job after graduating college and those about to take a mini retirement may want to prioritize Roth 401(k) contributions over traditional 401(k) contributions.

Optimize for Known Trade-Offs

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

Here’s the thing: there are simply too many unknown future variables to come up with any precision in this regard. That said, I don’t believe we have to.

Why? Because in retirement planning, we can optimize for known trade-offs. Let me explain. At work, Americans under age 50 can contribute up to $22,500 (2023 number) to a 401(k). At most employers, that can be any combination of traditional or Roth contributions. Every dollar contributed to a Roth 401(k) is a dollar that cannot be contributed to a traditional deductible 401(k). That’s a known trade-off.

What about at home? For most working Americans covered by a 401(k), a dollar contributed to a Roth IRA is not a dollar that could have been contributed to a deductible traditional IRA. So a Roth IRA contribution is not subject to the trade-off downside that a Roth 401(k) contribution is.

Why not optimize for known trade-offs? Contribute to a traditional 401(k) at work and a Roth IRA (or Backdoor Roth IRA) at home. This approach optimizes for the known trade-offs and sets one up with both traditional and Roth assets heading into retirement. 

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

Roth Contributions End the Planning

Traditional retirement account contributions set up great optionality. A retiree may have years or decades of opportunity to strategically convert traditional accounts to Roth accounts. Or, a retiree might say, “thanks, but no thanks, on those Roth conversions, I’ll simply wait to withdraw for RMDs or living expenses later in retirement at a low tax rate.” Traditional retirement account contributions open the doors to several planning options.

Roth contributions end the planning. That’s it, the money is inside a Roth account. Considering the potential to have low tax years after the end of one’s working years, is that always a good thing?

Rothification Risks

Having all one’s retirement eggs in the Roth basket can create significant problems. This is an issue I do not believe receives sufficient attention. Previously I posited an example where an early retiree had almost all his wealth in Roth accounts (what I refer to as the Rothification Trap). 

Risks of having all of one’s eggs inside the Roth basket going into retirement include:

  • Missing out on standard deductions
  • Inability to qualify for ACA premium tax credits
  • Missing out on benefits of qualified charitable distributions (QCDs)
  • Missing out on tax efficient Roth conversions in retirement

Sufficiency

Much of the traditional versus Roth debate misses the forest for the trees. Rarely do commentators state that long before one worries about taxation in retirement they have to worry about sufficiency in retirement!

Recent reports indicate that many if not most Americans struggle to afford a comfortable retirement. A quick review of average retirement account balances indicates that many Americans are not set up for what I’d call a comfortable retirement. Further, according to a recent report, the median American adult has a wealth around $108,000. That means the median adult has a significant sufficiency concern when it comes to retirement planning. 

Most Americans will be lucky to have a tax problem in retirement! Most Americans need to build up retirement savings. The quickest, easiest way to do that is by making deductible traditional 401(k) contributions. That deduction makes the upfront sacrifice involved in retirement saving easier to stomach. Further, if one is not likely to have substantial retirement savings, they are not likely to be in a high marginal tax bracket in retirement. 

If all the above is true, what is the problem with having taxable retirement accounts? The tax savings in retirement from having Roth accounts is not likely to be very high for many Americans. 

Conclusion

Both traditional retirement accounts and Roth retirement accounts have significant benefits. When viewed over the spectrum of most Americans’ lifetimes, I believe that workplace retirement plan contributions should be biased toward traditional retirement accounts. For many Americans, either or both of the following will be true. First, there will be low tax years in retirement during which retirees can take advantage of low tax Roth conversions. Second, many Americans will be in a low tax bracket when taking retirement account withdrawals for living expenses and/or RMDs.

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

Follow me on Twitter at @SeanMoneyandTax

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

Traditional 401(k) Contributions Are Fine for Most Americans (Really!)

Yesterday I posted Time to Stop 401(k) Contributions?, arguing that as applied to many in the FI community, traditional deductible 401(k) contributions are fine.

Today two very interesting pieces of content hit my radar. First, one of my favorite personal finance content creators, Clark Howard, is advocating for Roth contributions instead of traditional contributions for most Americans.

Second, UBS and Credit Suisse issued their Global Wealth Report for 2023. Allow me to call your attention to page 16. The median American adult has personal wealth just a bit under $108,000. This means almost half of American adults have less than $100K of wealth, and the majority of American adults do not have $200K of wealth. For most Americans, deferred taxation is not the problem! Sufficiency is the problem!

For me this report cracks the case. If the median American adult does not have close to sufficient wealth to comfortably retire, why are they worried about taxes in retirement?

Assuming this report is anywhere near close to a correct measure of adult American wealth, I believe I am correct and personal finance legends Ed Slott and Clark Howard are wrong when it comes to the traditional 401(k) versus Roth 401(k) debate.

The best way for working Americans to address sufficiency problems is by contributing to traditional, deductible retirement accounts. As demonstrated below, one employing this sort of deduct, deduct, deduct strategy would need to be successful well beyond what most Americans accomplish in order to create a tax problem.

When one has insufficient resources for retirement, the traditional, deductible 401(k) makes the most sense. He or she needs to build up assets, not worry about future taxes! With relatively little in the way of resources, future taxes are not likely to be a problem (especially in retirement when compared to one’s working years). Further, by contributing to a traditional, deductible 401(k) instead of a Roth 401(k), one behind in retirement saving takes home more money to invest in additional saving mechanisms such as Roth IRAs and taxable brokerage accounts.

Let’s Break Down Some Retirement Numbers

I believe we need some numbers to figure out who’s right.

Example 1: I start with Single Sally, who is 75 years old. Since she is somewhat like the median American, but older, let’s assume she has $250,000 of wealth and receives $30,000 a year in Social Security. Assume further that all $250K is in a traditional IRA and Sally, age 75, wants to live for today: she isn’t constrained by the 4% rule but rather decides to withdraw 10 percent per year ($25,000). On that $55,000 annual gross income, Single Sally pays just over $2,000 in federal income taxes (an effective rate less than 4%).

Why would Sally pass on a 10%, 12%, or 22% deduction from a traditional 401(k) contribution during her working years? Why would Single Sally put the money in a Roth 401(k) so as to avoid a less than 4% federal income tax in retirement? And how different is Sally’s situation from that of many Americans?

Update 8/17/2023: Single Sally is in the Tax Torpedo, an interesting tax phenomenon with a modest impact on her total tax liability. I added a spreadsheet to look at this in more detail.

Example 2: But Sean, I’m reading your blog. I’m not shooting for just $250K in retirement wealth! Okay, let’s start testing it by considering wealth significantly above the mean and median adult Americans. Single Sarah is 75 years old. She receives $30,000 a year in Social Security. But now she also has a $1M traditional IRA and takes an RMD ($40,650) based on her age. Single Sarah also has some taxable accounts and thus has $4,000 of qualified dividend income and $1,000 of interest income. On that approximate $76,000 annual gross income, Single Sarah pays just over $7,200 in federal income taxes (an effective rate of a bit more than 9.5%).

In order to grow a $1M traditional IRA (likely rolled over from workplace 401(k)s), she almost certainly was in the 22% or greater federal marginal tax bracket while working. Why would Single Sarah switch from taking a 22% tax deduction (the traditional 401(k) contribution) to a Roth 401(k) contribution to avoid a 9.5% effective federal tax rate in retirement?

Example 3: Example 3 is Single Sarah at age 80. Her investments are doing so well her traditional IRA is still worth $1M, causing her to be required to take a $49,505 RMD. This causes her federal income tax to increase to $9,175, for an effective federal income tax rate of almost 11%.

How many Americans will get to age 80 with $1M or more in tax deferred accounts? Even if they do, how bad is the tax problem? If Single Sarah’s effective tax rate is 11%, a 50% tax hike gets her to about 16.5%. Will she enjoy paying that tax? No. Is it crippling? Hardly!

Still worried about contributing to a traditional 401(k)? I’ve got a video for you!

Conclusion

The next time you hear “30 or 40% of your 401(k) belongs to the government” you should consider my examples. For many Americans, “10%” will be much closer to the mark than 30% or 40%.

It’s time to step back and ask whether prioritizing Roth 401(k) contributions during one’s working career is the best advice for the majority of Americans. As demonstrated above, a tax increase of 50 percent (highly unlikely) would result in most Americans having an effective tax rate below 20% in retirement.

I believe for many Americans, the optimal retirement savings path combines deductible workplace 401(k) contributions with Roth IRA contributions at home.

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, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

Time to Stop 401(k) Contributions?

Ed Slott believes most Americans should not contribute to traditional 401(k)s. His recent essay on the subject is a great opportunity for the FI community to reassess its love for the traditional 401(k).

My conclusion is that for many in the FI community, traditional deductible 401(k) contributions are still the most logical path when it comes to workplace retirement saving. Below I explain my thinking. 

It is important to note it is impossible to make a blanket statement as applied to the entire FI community. 

Why the Traditional 401(k) Is Good for the FI Community

Many in the FI community have the very reasonable hope that in retirement they will have years, possibly decades, where their effective tax rate will be lower than their marginal tax rate in their working years. 

The above is true of many Americans, but it is particularly true if one retires early by conventional standards. The idea is deduct, deduct, deduct into the 401(k) during one’s working years (particularly the high earning years) and then retire early by conventional standards. Prior to collecting Social Security and/or required minimum distributions (“RMDs”), most retirees look artificially poor on their tax return. This opens up the door to affirmatively convert money from traditional retirement accounts to Roth accounts and pay tax at the lowest federal income tax brackets (currently 10% and 12%). For those who deducted contributions into the 401(k) at a 24% or greater marginal federal tax rate, this is great tax rate arbitrage planning.

Minor litigation risks aside, this strategy just got even easier for those born in 1960 and later, who don’t have to take RMDs under SECURE 2.0 until age 75. With the new delayed RMD beginning date, even those retiring as late as age 65 will have a full decade prior to being required to take RMDs to do tax-efficient Roth conversions at low marginal tax rates. For some in the FI community, this opportunity window might not be a decade long but rather a quarter-century long (if they retire at age 50). 

How Bad is the Retiree Tax Problem?

As wonderful as FI tax rate arbitrate planning might be, Ed Slott’s concern that retiree taxes will increase is not entirely unwarranted. It is obvious that the government is not fiscally responsible, and it is obvious that tax increases could be coming in the future. 

Let’s assess the situation by looking at just how bad the problem of taxes is in retirement.

We begin with a baseline case. David and Hannah are in their 70s. They never did Roth conversions in early retirement and have the bulk of their financial assets in traditional IRAs and traditional 401(k)s. During most of their working years, David and Hannah maxed out 401(k)s and got deductions in the 24% bracket or greater. For 2023, they have taxable RMDs of $160,000, Social Security of $40,000, $4,000 of qualified dividends and $1,000 of interest income. How bad is their federal income tax situation?

Federal Income Tax Return
RMDs$ 160,000
Social Security$ 40,000
15% Social Security Exclusion$ (6,000)
Interest$ 1,000
Qualified Dividends$ 4,000
Adjusted Gross Income (“AGI”)$ 199,000
Standard Deduction$ (27,700)
Additional SD Age 65+$ (3,000)
Federal Taxable Income$ 168,300
Federal Income Tax (Estimated)$ 27,361
Effective Tax Rate on AGI13.75%
Marginal Federal Income Tax Rate22%

Under today’s rules, David and Hannah, who did no tax planning other than “deduct, deduct, deduct” are doing great. Their federal effective tax rate, even with $200K of RMDs and Social Security, is just 13.75%. They incur such a low effective tax rate because their RMDs go against the 10% tax bracket, the 12% bracket, and the 22% bracket. 

While I do think David and Hannah would be in a better position had they done some tax efficient Roth conversion planning earlier in retirement, their unbridled enthusiasm for traditional retirement accounts served them well. 

Note: David and Hannah are borderline IRMAA candidates: a $199K 2023 AGI might cost them approximately $2,000 in IRMAA surcharges in 2025 (but it is possible that inflation adjustments for 2025 will prevent that from happening). This is another reason to consider pre-RMD Roth conversions at lower marginal tax rates. 

Update 8/19/2023: But what about the widow’s tax trap? If David or Hannah die, won’t the survivor get crushed by tax increases? Check out this estimate. Assuming the survivor loses the lower-earning spouse’s Social Security benefits of at least $10,000, the survivor’s marginal federal income tax rate would climb from 22% all the way up to . . . 24%!

But what about future tax increases? Okay, let’s add four tax increases to the picture and see just how bad it looks:

  1. Eliminate the TCJA increase to the standard deduction (the law reverts to pre-2018 lower standard deduction and personal exemptions). This would reduce David and Hannah’s deductions by roughly $2,740, costing them approximately $602.80 in additional federal income tax (at today’s 22% marginal tax rate).
  2. Eliminate the TCJA decrease in the 15% tax bracket to 12%. This would cost David and Hannah $2,023.50 in additional federal income tax. I’m highly skeptical that either of these two tax increases will actually occur, but as written in today’s laws they are scheduled to happen in 2026. 
  3. Increase the 15% long term capital gains and qualified dividend income rate to 25%. While I believe that the real risk is an increase in the 20% long term capital gains and qualified dividend income rate, let’s stress test things and consider a large increase in the 15% rate. In David and Hannah’s case, this costs them $400 in additional federal income tax.
  4. Increase the 22% tax rate to 33%. Ed Slott is worried about large tax rate increases, so let’s consider one that I believe is politically infeasible, a 50% increase in the 22% tax bracket. This type of tax rate increase would hit millions of voters in a major way. But it’s helpful to consider what could be a worst case scenario. In this case, this tax rate increase costs David and Hannah an additional $8,233.50 in federal income tax.
  5. There’s one more tax hike to consider: the combination of tax increases numbers 1 and 4. If both occurred together, combined they would cost David and Hannah an additional $301.40 in federal income tax. 

Here’s what David and Hannah’s federal tax picture looks like if all of the above tax increases occur:

Federal Income Tax Return
RMDs$ 160,000
Social Security$ 40,000
15% Social Security Exclusion$ (6,000)
Interest$ 1,000
Qualified Dividends$ 4,000
Adjusted Gross Income (“AGI”)$ 199,000
Standard Deduction$ (15,240)
Additional SD Age 65+$ (3,000)
Personal Exemptions$ (9,720)
Federal Taxable Income$ 171,040
Federal Income Tax (Estimated)$ 38,922
Effective Tax Rate on AGI19.56%
Marginal Federal Income Tax Rate33%

Significant tax increases hurt David and Hannah, but how much? By my math, very significant tax increases, including a 50% increase in the 22% bracket, cost them about 6% of their income. Not nothing, but wow, they’re still doing very well. 

Yes, on the margin, the last dollars David and Hannah contributed to the traditional 401(k) were not ideal since they faced a 33% marginal federal tax rate in retirement. But let’s remember (i) their overall effective rate is still more than 4 percentage points lower than their working years’ marginal rate (at which they deducted their 401(k) contributions), (ii) they have income significantly above what most Americans will have in their 70s, and (iii) in my scenario they face four separate tax hikes and still pay a federal effective tax rate less than 20 percent.

Future Retirees’ Tax Risk

Do future tax hikes pose no threat to future retirees? Absolutely not! But my stress test shows that many Americans with substantial RMDs will not get walloped even if Congress enacts unpopular tax increases. Considering many in the FI community will have modest RMDs due to pre-RMD Roth conversions, the threat of future tax hikes is even less perilous for the FI community.

Further, many Americans, particularly those in the FI community, have a great tool that can mitigate this risk: Roth conversions during retirement! With RMDs now delayed to age 75 for those born in 1960 and later, many Americans will have years if not decades where money can be moved in a tax-efficient manner from old traditional accounts to Roth accounts. 

Further, many Americans can claim deductions at work and then at home contribute to a regular Roth IRA or a Backdoor Roth IRA. This too mitigates the risk of having all of one’s retirement eggs in the traditional basket. 

Last, do we really believe that Congress is just itching to raise taxes on future retirees? Sure, it’s possible. But to my mind taxes are more likely to be raised on (i) those in higher ordinary income tax brackets and/or (ii) long term capital gains and/or qualified dividends (particularly the current 20% bracket). If anything, the most Congress is likely to do to retirees is slightly increase their taxes so as to mitigate the political risk involved in raising taxes on retirees who tend to vote. 

The Risks of Not Having Money in Traditional Retirement Accounts

Risk isn’t a one-way street. There are some risks to not having money in traditional retirement accounts. I identify three below.

Qualification for Premium Tax Credits

Picture it: Joe, age 55, retires with the following assets: (i) a paid off car, (ii) a paid off house, (iii) a $40,000 emergency fund in an on-line savings account, and (iv), $2 million in Roth 401(k)s and Roth IRAs. He heard that Roth is the best, so he only ever contributed to Roth IRAs and Roth 401(k)s, including having all employer contributions directed to a Roth 401(k). Having fallen into the Rothification Trap, in retirement Joe must work in order to generate sufficient taxable income to qualify for any ACA Premium Tax Credit. 

For at least some early retirees, the ability to create modified adjusted gross income by doing Roth conversions will be the way they guarantee qualifying for significant Premium Tax Credits to offset ACA medical insurance premiums. 

Charitable Contributions

Many Americans are at least somewhat charitably inclined. Starting at age 70 ½, Americans can transfer money directly from a traditional IRA to a charity, exclude the distribution from taxable income, and still claim the standard deduction. Essentially, if you’re charitably inclined, at a minimum you would want to go into age 70 ½ with enough in your traditional IRAs (likely through contributions to traditional 401(k)s that are later transferred to an IRA) to fund your charitable contributions from 70 ½ until death. 

Why ever pay tax on that money (i.e., by making contributions to a Roth 401(k) that are later withdrawn to be donated) if the money is ultimately going to charity anyway?

Unused Standard Deductions

Currently, the government tells married couples, hey, you get to make $27,700 a year income tax free! Why not take advantage of that exclusion every year, especially prior to collecting Social Security (which, in many cases will eat up most, if not all, of the standard deduction). 

Why be retired at age 55 with only Roth accounts? By having at least some money in traditional retirement accounts going into retirement, you ensure you can turn traditional money into Roth money tax-free simply by converting (at any time) or even distributing (usually after age 59 1/2) the traditional retirement account against the standard deduction. 

Deduct at Work, Roth at Home

I think for many it makes sense to max out traditional 401(k)s at work and contribute to Roth IRAs or Backdoor Roth IRAs at home. Why? As discussed above, traditional 401(k)s can set up tax rate arbitrage in retirement, help early retirees qualify for Premium Tax Credits, and make charitable giving after age 70 ½ very tax efficient. At home, many working Americans do not qualify to deduct IRA contributions, so why not contribute to a Roth IRA or Backdoor Roth IRA, since (i) you aren’t giving up a tax deduction in order to do so and (ii) you establish assets growing tax free for the future. 

In this post I discuss why deduct at work, Roth at home can often make sense and I provide examples where Roth 401(k) contributions are likely to be better than traditional 401(k) contributions. 

Conclusion

I believe that for many in the FI community, a retirement savings plan that combines (i) traditional deductible 401(k) contributions during one’s working years and (ii) Roth conversions prior to collecting RMDs is likely to be a better path than simply making all workplace retirement contributions Roth contributions.

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

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.

Sean on the Catching Up to FI Podcast

Listen as I talk tax with Becky Heptig and Bill Yount on the Catching Up to FI podcast.

You can access the podcast on Apple Podcasts.

We discuss tax planning for financial independence, particularly planning for those catching up later in their careers.

The show notes include references to the following FI Tax Guy blog posts.

The Advantages of Living on Taxable Assets First in Early Retirement

TikTok Tax Advice

Early Retirement and Social Security

HSAs and Las Vegas

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

Inherited Roth IRAs

Inherit a Roth IRA in 2023 or later? Thinking about leaving a Roth IRA to heirs at your death? Then this article is for you. Note that it is an educational resource. It is not advice for any individual’s particular situation. Further, this article does not address situations where a person inherited a Roth IRA prior to the year 2023. 

Inheriting a Roth IRA is great, since distributions are always penalty free and tax-free 99.99% of the time. The only time a distribution from a non-spousal inherited Roth IRA could be subject to income tax is if the distribution is a distribution earnings from the Roth IRA prior to the passage of 5 years from January 1st of the year the original owner first contributed to a Roth IRA. See Treas. Reg. Section 1.408A-6 Q&A 1(b). As a practical matter, few distributions from inherited Roth IRAs will be both (i) earnings of the inherited Roth IRA and (ii) made prior to the end of the five year clock. 

Said differently, both the original owner and the beneficiary would have to be incredibly unlucky in order for a beneficiary to pay federal income tax on an inherited Roth IRA distribution. 

In theory, a spouse inheriting a Roth IRA could pay tax and/or a penalty on distributions from an inherited Roth IRA the spouse treated as their own, but even that occurrence is likely to be rare, as discussed in more detail below. 

Terminology and Titling

One inheriting a Roth IRA is a beneficiary. Yes, that inherited Roth IRA is now your property, but you are not the “owner” from a tax perspective. The original owner is the owner. You, the inheritor, are the beneficiary. If you die, the person inheriting the Roth IRA you inherited is a successor beneficiary.

Upon the owner’s death, the beneficiary should work with the Roth IRA’s financial institution to retitle the Roth IRA. The titling should indicate that the beneficiary is a beneficiary and should reference the owner. 

The above two paragraphs are not the case as applied to spouses who choose to treat an inherited Roth IRA as their own. In that case, the inheriting spouse becomes the owner, not the beneficiary. 

Types of Beneficiaries

To my mind, there are generally seven types of Roth IRA beneficiaries. Below, I use my own colloquialisms for each. You will not find the term “10-year beneficiary” in the Internal Revenue Code or the IRS website, for example. Rather, it is simply a term I colloquially use to refer to a particular type of inherited Roth IRA beneficiary. 

To understand what happens when one inherits a Roth IRA, one must first understand what type of beneficiary they are among the below seven categories. 

Watch me discuss Inherited Roth IRAs on YouTube.

Spouses

Spouses are generally favored inherited Roth IRA beneficiaries from a tax planning perspective. Married individuals should think long and hard prior to naming someone other than their spouse as their Roth IRA primary beneficiary for many reasons, including tax planning.

There are three options a spouse has when inheriting a Roth IRA. Two of those options entail the inherited IRA being treated as the inheriting spouse’s own Roth IRA. This is usually advantageous for several reasons, including the fact that an owner is never subject to required minimum distributions (“RMDs”) with respect to their own Roth IRA. Practically speaking, this is how most inherited Roth IRAs are handled by spouses.

SECURE 2.0 added a new fourth option for spouses to be treated as the deceased spouse when inheriting a retirement account. This change appears to matter as applied to RMDs, which the Roth IRA never has for an owner. Thus, I do not believe this change impacts spouses inheriting Roth IRAs to any significant degree.

The inheriting spouse could treat the inherited Roth IRA as an inherited account (i.e., become a beneficiary instead of being the owner). Practically speaking, an inheriting spouse would only consider this if they are under 59 ½ years old and they believe it is likely they would need to access earnings in their Roth IRAs (including the inherited accounts) prior to age 59 ½. 

Considering a spouse treating an inherited Roth IRA as their own can recover their own and their decedent spouse’s Roth IRA contributions and 5 year-old conversions tax and penalty free at any time and recovers these amounts before Roth earnings are ever accessed, most inheriting spouses will not need to elect inherited Roth IRA (i.e., beneficiary) treatment. This may be true even in situations where the inheriting spouse is under 59 ½ years old and needs access to some of the inherited Roth IRA funds prior to age 59 ½. Further, treating the inherited Roth IRA as one’s own Roth IRA instead of keeping it as an inherited IRA will generally be advantageous from a creditor protection standpoint.

One potential planning option for the spouse is to roll the decedent spouse’s Roth IRA to an inherited Roth IRA and later (presumably at age 59 ½) roll it into their own Roth IRA. See Choate, referenced below, page 225. This offers the inheriting spouse protection as it allows him or her to access Roth earnings tax-free prior to the spouse turning age 59 ½ and then later avoids RMDs to the spouse (see discussion of that possibility below). 

In Proposal 10 of my retirement tax reform proposal, I offer suggestions to simplify the treatment when spouses inherit retirement accounts. 

RMD Beneficiaries

The SECURE Act set up a new standard to be an RMD beneficiary (what the SECURE Act termed an “eligible designated beneficiary”). Some practitioners use the term “EDB” for these beneficiaries, but I prefer the term “RMD beneficiary” because these are the beneficiaries that are allowed to (i) avoid the new 10-year rule discussed below and (ii) withdraw from the inherited Roth IRA RMDs based on their own remaining life expectancy. 

Who qualifies as an RMD beneficiary? These include:

  • A spouse electing to treat the inherited Roth IRA as an inherited Roth IRA
  • Any individual not more than 10 years younger than the owner (think parents and adult siblings, but it can be others)
  • Anyone chronically ill or disabled

An RMD beneficiary must start taking RMDs from the inherited IRA in the year after the owner died. He or she goes to the IRS Single Life Table and finds the factor for their age in the year following the owner’s death. The RMD for that first year is the prior-year end-of-year account balance divided by that factor. The following year’s RMD is the prior-year end-of-year account balance divided by the first year’s factor minus one. See Choate, referenced below, at pages 67-68 and 73-74. Here’s an example of how it works. 

Jack died on December 1, 2023. He was 65 at his passing. He leaves his Roth IRA to his brother Jim. In 2024, Jim turns 62. Jim is an RMD beneficiary and should* take an RMD based on his IRS Single Life Table factor at age 62, 25.4. If the inherited Roth IRA balance on December 31, 2023 is $500,000, Jim’s 2024 inherited Roth IRA RMD is $19,685.04 ($500,000 divided by 25.4). If the balance in the inherited Roth IRA is $510,000 on December 31, 2024, Jim’s 2025 RMD is $20,901.65 ($510,000 divided by 24.4). Jim takes annual RMDs in a similar fashion in subsequent years. 

As Natalie Choate notes in her treatise referenced below (see page 74), Jim only looks at the IRS Single Life Table once: for the first RMD year. After that, he simply subtracts 1 from the factor every year. Thus, those using the Single Life Table only look at it a single time.

*Note that an RMD beneficiary can, instead of taking RMDs, elect the 10-year rule discussed below. See Choate supplement, page 12, Andy Ives at IRAHelp.com, and Ian Berger at IRAHelp.com. In many cases, I suspect taking relatively modest tax-free RMDs will facilitate more tax-free growth than avoiding RMDs and emptying the inherited Roth IRA within 10 years. This is because taking RMDs allows a large portion of the inherited Roth IRA to survive well beyond 10 years in cases where the beneficiary is not themselves rather elderly. That said, the older the beneficiary is, the more likely electing into the 10-year rule is to be advantageous. It is not clear how the beneficiary makes the election (see Choate supplement, page 50), though presumably failing to take RMDs would do it.

Spouses electing beneficiary treatment (which is RMD beneficiary treatment in their case) are generally not required to take the annual RMD until the later of (i) the year after the decedent spouse’s death or (ii) the year the decedent spouse would have reached age 72. See Choate, referenced below, page 97, Prop. Reg. Section 1.401(a)(9)-3(d) on page 109 of this PDF file (also see Prop. Reg. Section 1.408-8(b)(2)(ii) on page 253 of the PDF file). 

Successor Beneficiaries

Successor beneficiaries of RMD beneficiaries must, in most cases, empty the inherited Roth IRA by the end of the 10th calendar year following the RMD beneficiary’s death. See Natalie Choate supplement page 43 and Prop. Reg. Section 1.401(a)(9)-5(e)(3) on page 142 of this PDF file. Update August 4, 2023: In addition to being subject to the 10-year rule, the successor beneficiary must continue to take the annual RMDs the RMD beneficiary would have been required to take had they lived. See Natalie Choate supplement page 51.

Update July 10, 2023: Sarah Brenner of IRAHelp.com raises an interesting possibility. What if the RMD beneficiary elects the 10-year rule? If that happens, the successor beneficiary must empty the inherited Roth IRA by the end of the 10th year after the original owner’s death!

Minor Children of the Owner

If a minor child of the owner inherits a Roth IRA, he or she gets to take RMDs for all the years through the year he or she turns 21. Then the inherited Roth IRA must be emptied by the end of the 10th calendar year following the beneficiary turning age 21. See Prop. Reg. Section 1.401(a)(9)-5(e)(4) on pages 142-43 of this PDF file. Update September 11, 2023: the minor child starting the RMDs prior to turning age 21 triggers RMDs during the later 10-year period.

This treatment is quite favorable considering the relatively low RMDs during one’s youth, as the RMD is based on their relatively long life expectancy. 

The only children qualifying for this treatment are the children of the owner. Grandchildren, nieces, nephews, etc. will not qualify, and in most cases will be 10-year beneficiaries. These children could qualify for RMD beneficiary treatment if they are chronically ill or disabled. 

Note that technically minor children of the owner qualify as “eligible designated beneficiaries” but since the treatment they receive is, to my mind, quite different from the treatment RMD beneficiaries receive, I mentally carve them out as their own distinct category. 

Successor Beneficiaries

Natalie Choate observes on page 43 of her supplement that in the case of a minor-child RMD beneficiary, the successor beneficiary must empty the account by the earlier of (i) the end of the 10th full year following the minor-child’s death or (ii) the end of the 10th full year following the former minor child turning age 21. Update August 4, 2023: If the minor-child beneficiary dies while collecting RMDs, it appears the successor beneficiary would also be subject to annual RMDs using the decedent minor-child’s life expectancy during the 10-year time frame.

10-year Beneficiaries

10-year beneficiaries are those individuals who are not spouses, minor children of the owner, and RMD beneficiaries. They are everyone else. From a practical perspective, most 10-year beneficiaries are the adult children of the owner. 

10-year beneficiaries are not subject to RMDs. However, they must empty the inherited Roth IRA by the end of the 10th year following death. From a purely tax planning perspective, the beneficiary will want to leave the money inside the inherited Roth IRA and withdraw the money in December of the 10th full year following the owner’s death to get as much tax-free growth out of the inherited Roth IRA as possible. Of course, distributions prior to the end of the 10th year are permitted, and, as discussed above, should be tax-free in practically all cases. 

Successor Beneficiaries 

Successor beneficiaries of 10-year beneficiaries must empty the inherited Roth IRA by the end of the 10th calendar year following the owner’s death. See Prop. Reg. Section 1.401(a)(9)-5(e)(2) on page 142 of this PDF file. Thus, the death of a 10-year beneficiary does not extend the time to empty an inherited Roth IRA. 

Estates

A pulse is worth at least 5 years of tax-free growth! 

Roth IRAs can be left to one’s own estate, but generally speaking, they should not be. In order to qualify for the 10-year rule or better treatment (see the first four categories of beneficiaries), the beneficiary designation form must leave the Roth IRA to a human being. Estates can become the Roth IRA beneficiary if no beneficiary designation form is filed, or if the filed beneficiary designation form names the estate as the beneficiary. When an estate inherits a Roth IRA, the inherited Roth IRA is subject to a 5-year payout rule. See Choate, referenced below, pages 77 and 104. 

If left to one’s estate, the Roth IRA must be paid out by the end of the fifth full calendar year following death. See Choate supplement page 100. This is true even if the estate will ultimately pay the money out to actual humans who could have, on their own, qualified as 10-year beneficiaries, RMD beneficiaries, and/or spousal beneficiaries. 

Trusts

If you want to see some tax complexity, look at inherited retirement accounts and trusts. Trusts themselves often have human beneficiaries, but the trust mechanism is used to protect the beneficiary and/or the assets inside the trust. There are valid reasons to name a trust as a retirement account beneficiary (usually surrounding the nature of the potential beneficiaries), but naming a trust should not be done lightly. 

The tax risk is that the inherited Roth IRA will be subject to the 5-year rule. Properly structured (including the provisions required by Treas. Reg. Sec. 1.401(a)(9)-4 Q&A 5(b)), the human beneficiaries of the trust can qualify for the applicable treatment offered by one of the first four categories of beneficiary. However, if the trust is not properly structured, the trust and the human beneficiaries of the trust will be subject to the 5-year rule and lose out on 5 or more years of tax-free growth. 

Charities

A charity must take an inherited Roth IRA in 5 years, but it does not care, as it is not generally subject to income tax. From a planning perspective, Roth IRAs are the assets that are least advantageous to leave to charity. Your human heirs like to inherit Roth accounts and generally would prefer to inherit a Roth over an account such as a traditional IRA or a HSA. Here’s an example of how that could play out.

Walter, age 80, is a widow and has one adult son, Paul, age 50. Walter has the following assets:

Asset LocationAmount
Roth IRA$100,000
Taxable Brokerage$100,000
Traditional IRA$50,000
HSA$50,000
Total$300,000

Walter intends on leaving two-thirds of his assets to Paul and one-third of his assets to his Catholic parish, a 501(c)(3) charitable organization. From Paul’s perspective, he’d prefer to inherit the $100,000 Roth IRA (10 more years of tax-free growth, no income tax and full step up in basis when the assets are distributed to him) and $100,000 taxable brokerage (no income tax and full step up in basis). Paul would prefer that the $100,000 left to the parish be the $50,000 traditional IRA (which would be taxable to Paul through RMDs and the 10-year rule) and the $50,000 HSA (which is immediately fully taxable to Paul in the year of Walter’s death if Paul inherits). 

Why waste the Roth’s step-up in basis, tax-free treatment, and 10 years of additional tax-free growth on a charity when you can give the charity assets that are otherwise less favorable to the human beneficiary (the traditional IRA and the HSA)?

Planning

For Owners

Retirement account owners may want to think about inter-generational planning, for two reasons. First, if the owner is in a relatively low marginal tax bracket, and their beneficiaries (perhaps successful adult children) are in relatively high marginal tax brackets, they may want to think about Roth conversions during their lifetimes to move money from traditional retirement accounts to Roth IRAs. This can reduce the income tax paid with respect to the traditional retirement accounts. Second, it eliminates the chance that adult children could be subject to both the 10-year rule and to RMDs (see this article for more details). 

Any planning in this regard should consider that tax planning for one’s adult children is a second order planning priority. The first planning priority should be the financial success of the retirement account owner. His or her financial success should be prioritized ahead of tax planning geared toward a better result for one’s adult children. 

For Beneficiaries

Generally speaking, beneficiaries and successor beneficiaries will want to leave funds inside an inherited Roth IRA for as long as possible. For many in a SECURE Act world, that will be 10 years following the end of the year of death. Here’s a quick example of how that works: Joe dies on August 1, 2023. His 10-year beneficiary has until the end of the 10th year following his death, December 31, 2033, to empty the Roth IRA he inherits from Joe.

Of course, tax is just one consideration. If the money is needed sooner than that, at least the beneficiary knows that the distribution is tax-free in all but the rarest of situations.

As discussed above, beneficiaries should understand how long the owner had any Roth IRA. Once the beneficiary is sure 5 years have passed since January 1st of the year of the original owner’s first contribution, he or she can take Roth earnings out of the inherited Roth IRA and know that it is tax free. Even if the Roth IRA is less than 5 years old, the beneficiary can take old contributions and conversions tax free. Such amounts come out first under the ordering rules prior to the removal of any earnings. 

Further Reading

Natalie B. Choate’s treatise Life and Death Benefits for Retirement Planning (8th Ed. 2019), frequently referenced above, is an absolutely invaluable resource regarding retirement account withdrawals, including inherited Roth IRA withdrawals.

The IRS and Treasury issued controversial proposed regulations on the SECURE Act in 2022. Fortunately, those proposed regulations do not require RMDs with respect to 10-year beneficiaries of inherited Roth IRAs. Jeffrey Levine wrote a great blog post on the proposed regulations here. 

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

Follow me on Twitter at @SeanMoneyandTax

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

SECURE 2.0 and the FI Community

Congress just passed a very long retirement tax bill, colloquially referred to as SECURE 2.0 or the SECURE Act 2.0. The FI community is interested in anything affecting tax-advantaged retirement accounts. This post dives in on the impact of SECURE 2.0 on the FI community. 

SECURE 2.0 Big Picture

SECURE 2.0 tinkers. It contains dozens of new rules. It’s easy to get lost in the weeds of the new rules, but I don’t recommend it. Many new rules have very little impact on financial planning for those in the FI community.

Here’s one example: SECURE 2.0 eliminates (effective 2024) required minimum distributions (“RMDs”) from Roth 401(k)s during the owner’s lifetime. Since Roth IRAs never had RMDs during the owner’s lifetime, and Roth 401(k)s are easily transferable to Roth IRAs at or after retirement, this is a rule change without much practical impact for most from a planning perspective.

However, there are two main takeaways those in the FI community should focus on when it comes to SECURE 2.0. First, SECURE 2.0 makes traditional, deductible retirement account contributions even more attractive. Second, SECURE 2.0 sets what I refer to as the Rothification Trap. Don’t fall into the Rothification Trap!

Traditional Retirement Account Contributions Are Even More Attractive

In the classic traditional versus Roth debate, SECURE 2.0 moves the needle towards traditional deductible retirement account contributions. Why?

SECURE 2.0 delays the required beginning date for RMDs! Starting in 2023, RMDs must begin at age 73, buying those born from 1951 through 1959 one more year to do tax-efficient Roth conversions prior to being required to take RMDs. But for most of the readers of this blog, the news is much better. Those born in 1960 or later now must take RMDs starting at age 75.

This is a big win for the FI community! Why? Many in the FI community will have artificially low taxable income in retirement prior to having to take RMDs at age 75. That increases the window for Roth conversions while a retiree otherwise has low taxable income. 

Delaying RMDs makes traditional FI tax planning even more attractive, particularly for those born after 1959. Retirees will have through the year of their 74th birthday to make Roth conversions to (i) get tax rate arbitrage on traditional retirement accounts and (ii) lower RMDs when they are ultimately required.

The planning runway to do Roth conversions prior to taking RMDs just got three years longer. This gives both early retirees and conventional retirees that much more of an opportunity to do Roth conversions at low income tax rates prior to being required to take RMDs. There are three additional years of progressive tax brackets to absorb efficient Roth conversions and reduce future RMDs. 

Rothification Trap

Be aware of the Rothification Trap!

SECURE 2.0 promotes even more in the way of Roth contributions. It allows employees to elect to have their employer 401(k) and other workplace plan contributions be Roth contributions, effective immediately. See Section 604 of SECURE 2.0. Plans will have to affirmatively add this feature (if they so choose), so it won’t be immediately effective in most cases. I predict that at least some plans will offer this option. I suspect some plans will not offer this option, since Roth employer contributions must be immediately vested. Some employers will be hesitant to eliminate vesting requirements for employer contributions, though it must be remembered that some employers immediately vest all employer contributions.

In addition, effective starting in 2023, SEP IRAs and SIMPLE IRAs can be Roth SEP IRAs and Roth SIMPLE IRAs. See Section 601 of SECURE 2.0. 

Here’s the thing: for those planning an early retirement, Rothification is a trap! The name of the game for those thinking about early retirement is to max out deductions while working and later do Roth conversions in early retirement. This maximizes deductions while one is subject to their highest marginal tax rate (their working years) and moves income to one’s lower taxable income years (the early retirement years). The combination of these opportunities creates tax rate arbitrage. 

I’m worried some in the FI community will say “I really love Roth, so I’ll make all my contributions–IRA, employee 401(k), and employer 401(k))–Roth now!” I believe that path is likely to be a mistake for many in the FI community, for two reasons. First, this foregoes the great tax planning opportunity presented by deducting retirement contributions at one’s highest lifetime marginal tax rates while working and then converting to Roths at low early retirement tax rates. 

Second, it sets one up to have difficulty qualifying for Affordable Care Act Premium Tax Credits. In order to qualify for Premium Tax Credits, which could be worth thousands of dollars in early retirement, one must have income above their state’s applicable Medicaid threshold. For example, in 2023 a family of four in California with a modified adjusted gross income (“MAGI”) of less than $39,750 would qualify for MediCal (California’s Medicaid) and thus get $0 Premium Tax Credits if they choose to use an Affordable Care Act insurance plan. Most early retirees will want to be on an ACA plan instead of their state’s Medicaid insurance for a variety of reasons. 

In a low-yield world, an early retiree with only taxable accounts and Roth accounts may find it difficult to generate sufficient MAGI, even with tax gain harvesting, to avoid Medicaid and qualify for a Premium Tax Credit. The earlier the retirement, the more likely having only taxable accounts and Roth accounts will eventually lead to an inability to generate sufficient MAGI to qualify for Premium Tax Credits. 

Rothification Trap Antidote

How might one qualify for the Premium Tax Credit in early retirement? By doing Roth conversions of traditional retirement accounts! If there’s no money in traditional retirement accounts, there’s nothing to Roth convert. 

I discussed the issue of early retirees not having enough income to qualify for Premium Tax Credits, and the Roth conversion fix, with Brad Barrett on a recent episode of the ChooseFI podcast (recorded before SECURE 2.0 passed). 

Previously, I’ve stated that for many in the FI movement, the “dynamic duo” of tax-advantaged retirement account savings is to max out a traditional deductible 401(k) at work and max out a Roth IRA contribution (regular or Backdoor) at home. Now that SECURE 2.0 has passed, I believe this is still very much the case. 

At the very least, those shooting for an early retirement should strongly consider leaving employer contributions to 401(k)s and other workplace retirement plans as traditional, deductible contributions. This would give them at least some runway to increase MAGI in early retirement sufficient to create enough taxable income to qualify for a Premium Tax Credit. 

401(k), 403(b), and 457 Max Contributions Age 50 and Older

The two most significant takeaways from SECURE 2.0 out of the way, we now get to several other changes members of the FI community should consider. 

First, for those age 50 and older, determining one’s maximum workplace retirement account contributions is about to get complicated. By 2025, there will be up to three questions to ask to determine what one’s maximum retirement contribution, and how it can be allocated (traditional and/or Roth), will look like:

  1. What’s my age?
  2. What was my prior-year wage income from this employer?
  3. Does my employer offer a Roth version of the retirement plan?

Specifically, the changes to 401(k) and other workplace employee contributions are as follows:

Increased Catch-Up Contributions Ages 60, 61, 62, and 63

SECURE 2.0 Section 109 (see page 2087) increases workplace retirement plan catch-up contributions for those aged 60 through 63 to 150% of the regular catch-up contribution limit, starting in 2025.

Catch-Up Contributions Must be Roth if Prior-Year Income Too High

Starting in 2024, 401(k) and other workplace retirement plan catch-up contributions (starting at age 50) must be Roth contributions if the worker made more than $145,000 (indexed for inflation) in wages from the employer during the prior year. Interestingly enough, if the employer plan does not offer a Roth component, then the worker is not able to make a catch-up contribution regardless of whether they made more than $145,000 from the employer during the previous year. Hat tip to Josh Scandlen and Jeffrey Levine for making this latter point, which the flow-chart I featured in the originally published version of this post missed. Sorry for the error as we are all learning about the many intricate contours of SECURE 2.0, myself included!

I do anticipate that many 401(k) plans that do not currently offer a Roth component will start to offer one to allow age 50 and older workers to qualify for catch-up contributions (even if they now must be Roth contributions for those at higher incomes).

From a planning perspective, I still believe that catch-up contributions will make sense for many required to make them as Roth contributions. In such a case, the option is either (i) make the Roth catch-up contribution or (ii) invest the money in a taxable brokerage account. Generally speaking, I believe that it is advantageous to put the money in a Roth account. However, one can easily imagine a situation where someone is thinking about an early retirement and does not have much in taxable accounts such that it might be better to simply invest the money in a taxable account.

Note that the prior-year wage restriction on deducting catch-up contributions does not appear to apply to the Solo 401(k) of a Schedule C solopreneur, but it does appear to apply to the Solo 401(k) of a solopreneur operating out of an S corporation.

No Changes to Backdoor Roths

In another win for the FI community, the Backdoor Roth IRA and the Mega Backdoor Roth are not changed or curtailed by SECURE 2.0.

Rolling 529 Plans to Roth IRAs

SECURE 2.0 has a notable provision allowing up to $35,000 of a 529 plan to be rolled over to the Roth IRA of the beneficiary. I agree with Sarah Brenner that this rule is not one to get too excited about. Why I feel that way is another story for another day. That day is February 15, 2023, when my post on the 529-to-Roth IRA rollover drops on the blog. 

SECURE 2.0 and the FIRE Movement on YouTube

Resources

Sarah Brenner’s helpful summary: https://www.irahelp.com/slottreport/happy-holidays-congress-gifts-secure-20

The Groom Law Group goes through SECURE 2.0 section by section: https://www.jdsupra.com/legalnews/secure-2-0-hitches-a-ride-just-in-the-9280743/

Final Omnibus (which contained SECURE 2.0) text: https://www.appropriations.senate.gov/imo/media/doc/JRQ121922.PDF

Jeffrey Levine’s detailed blog post on SECURE 2.0: https://www.kitces.com/blog/secure-act-2-omnibus-2022-hr-2954-rmd-75-529-roth-rollover-increase-qcd-student-loan-match/

Jeffrey Levine’s detailed Twitter thread on SECURE 2.0: https://twitter.com/CPAPlanner/status/1605609788183924738

My video about the two biggest problems with SECURE 2.0: https://www.youtube.com/watch?v=Zsy1SQXogAg

My December 2022 SECURE 2.0 Resources post: https://fitaxguy.com/secure-2-0-resources/

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.

2023 RMDs and Roth Conversions

As I write this, we’re nearing the beginning of 2023. The stock and bond markets are down over the past year. For 2023, that means two things:

  1. 2023 required minimum distributions (“RMDs”) will, in many cases, be lower than they were in 2022, as 2023 RMDs are based on traditional retirement account values on December 31, 2022. 
  2. Roth conversions are now “cheaper” in a sense. 10,000 shares of XYZ mutual fund might have been worth $100,000 on December 31, 2021, but going into 2023 perhaps they are now worth only $90,000. Thus, the tax cost of converting 10,000 shares from a traditional retirement account to a Roth account is lower today than it was a year ago. 

Some retirees may think that they will have lower taxable income in 2023 (due to reduced RMDs). It might occur to them to wake up on New Year’s Day and do a Roth conversion. Is that wise?

Tax Rules: RMDs Come Out First and Cannot be Converted

There are two important tax rules those 73* and older should consider when thinking about 2023 RMDs and Roth conversions. The first rule is that the RMD is the first distribution that comes out of a traditional retirement account during the year. See Choate, referenced below, page 185. All distributions are RMDs until the total RMD has been satisfied. See Choate, page 320.  Further, all of a person’s traditional IRAs are treated as a single IRA for this purpose, so there’s no cherry picking that can solve this issue with respect to IRAs. 

The second rule is that an RMD cannot be converted to a Roth account. See Choate, referenced below, page 320. Anyone doing a Roth conversion prior to taking an RMD generally creates an excess contribution to a Roth IRA, subject to an annual 6% penalty unless properly withdrawn. 

*Note that effective January 1, 2023, SECURE 2.0 changed the age one must begin taking RMDs from age 72 to age 73.

Properly Roth Converting After Taking the RMDs

How does one avoid this fate? By properly taking their total RMD for the year prior to doing any Roth conversions. Sorry, no New Year’s Day Roth conversions.

The RMD can be taken through an actual distribution (or distributions) or through a qualified charitable distribution. 

Income Risk, Reversibility, and Market Risk

In most cases, I prefer taxable Roth conversions to occur in the fourth quarter of the year. There are several reasons for this. By October or November, there is more understanding of the year’s income and deductions. By the fourth quarter there will be fewer surprises in terms of income, bonuses, unexpected gains, etc. that can occur before year-end. The later in the year the Roth conversion occurs, the less likely the risk that there’s an income spike during the year unaccounted for in the planning process prior to executing the Roth conversion. 

Further, Roth conversions are irreversible. The Tax Cuts and Jobs Act eliminated the ability to reverse a Roth conversion. I don’t like the idea of locking into Roth conversions early in the year. If you win the lottery in July, you might not like that January Roth conversion 😉

Of course, there are trade-offs when it comes to delaying Roth conversions to the fourth quarter. There’s always the risk that the stock market and/or the bond market could grow between the early part of the year and later part of the year. While there is a risk the market can go down later in the year (which is favorable from a Roth conversion perspective), in theory over time one expects invested assets to grow (why else invest in them?). Thus, at least theoretically, delaying Roth conversions reduces the amount of shares that can be converted at a specified amount of Roth conversion income. 

Inherited Retirement Accounts

First, one facing an RMD with respect to an inherited retirement account need not worry about taking the inherited account RMD first prior to doing Roth conversions out of their own traditional retirement accounts. Inherited retirement accounts are hermetically sealed off from one’s own retirement accounts when considering the tax ramifications of distributions and conversions from one’s own retirement accounts.

Second, generally speaking, inherited traditional retirement accounts cannot be converted to Roth accounts. There is no opportunity to convert inherited traditional IRAs to Roth IRAs.

There is one major exception to the no conversion of inherited retirement accounts rule: the ability to convert inherited traditional qualified plans (such as 401(k)s) to a Roth IRA. See Choate, referenced below, page 271. Once the inherited 401(k) money is in an inherited traditional IRA, the Roth conversion opportunity is gone. But, the beneficiary can elect to have the 401(k) or other qualified plan transfer the money to an inherited Roth IRA, essentially converting it in a taxable transaction from traditional to Roth. 

Further Reading

Natalie B. Choate’s treatise Life and Death Benefits for Retirement Planning (8th Ed. 2019), frequently referenced above, is an absolutely invaluable resource regarding retirement account withdrawals.

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

Follow me on Twitter at @SeanMoneyandTax

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

Sean on New Podcast Episodes

This week I’m on episodes of The Stacking Benjamins Show and the Earn & Invest podcast talking about taxes, retirement savings, and my new book, Solo 401(k): The Solopreneur’s Retirement Account.

I’ve also recently recorded, and will record, several other podcast episodes with some great podcast hosts, so please be on the lookout for those.

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

Follow me on Twitter at @SeanMoneyandTax

This post and the podcast episodes referenced in it, are for entertainment and educational purposes only. They do not constitute accounting, financial, legal, investment, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

Sean Presentation at CampFI

These are the slides for my presentation at CampFI in Julian, CA on October 8, 2022.

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.

Four Ways to Fight Inflation

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

Watch me discuss fighting back against inflation.

Tax Planning

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

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

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

Roth 401(k) versus Roth IRA

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

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

Long Term Fixed Rate Debt

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

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

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

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

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

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

Travel Rewards

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

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

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

Spending that Leads to More or Less Future Spending

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

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

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

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

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

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

Conclusion

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

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

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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.