Tag Archives: Roth versus Traditional

72(t) Series of Substantially Equal Periodic Payments Update

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

72(t) Payments

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

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 One big drawback is that taxable amounts withdrawn from a tax advantaged retirement account prior to the account owner turning age 59 ½ are generally subject to a 10 percent early withdrawal penalty.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

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

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

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

New 72(t) Payment Interest Rates

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

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

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

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

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

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

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

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

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

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

New Tables

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

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

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

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

Use of 72(t) Payments

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

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

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

72(t) Payments and Roth IRAs

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

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

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

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

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

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

Additional Resource

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

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

Follow me on Twitter: @SeanMoneyandTax

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

FI Tax Guy Featured on the Optimal Finance Daily Podcast

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

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

Read my year-end tax planning blog post here.

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

Follow me on Twitter: @SeanMoneyandTax

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

Tax Planning for Inflation

In recent years, inflation existed but was not significant. Significant inflation was associated with wide lapels and eight-track tapes and thought to be left behind in the late 1970s and early 1980s.

But, sure enough, significant inflation is back. Inflation is 6.2 percent for the 12 months ending October 2021.  

Inflation has a tax angle. How does one use tax planning to minimize the impact of inflation? In this post, I review the issues associated with inflation and tactics to consider if one is concerned about inflation.

Inflation: The Tax Problem

Inflation increases the nominal (i.e., stated) value of assets without a corresponding increase in the real value of the asset. Here is an example:

Larry buys $100,000 worth of XYZ Mutual Fund on January 1, 2022. During the year 2022, there is 10 percent inflation. On January 1, 2023, the XYZ Mutual Fund is worth $110,000. Inflation-adjusted, the position has the same real value as it did when Larry purchased it. However, were Larry to sell the entire position, he would trigger a $10,000 capital gain ($110,000 sales price less $100,000 tax basis), which would be taxable to him. 

Hopefully you see the problem: Larry has not experienced a real increase in wealth. Larry’s taxable “gain” is not a gain. Rather, it is simply inflation! Larry will pay tax on inflation if he sells the asset. Ouch!

While inflation increases the nominal value of assets, there is no inflation adjustment to tax basis! Thus, inflation creates artificial gains subject to income tax. 

There are other tax problems with inflation. Inflation artificially increases amounts received as wages, self-employment income, interest, dividends, and retirement plan distributions. Those artificial increases are not real increases in income (as they do not represent increases in value) but they are subject to income tax as though they were real increases in income.

The tax law does provide some remedy to address the problem of taxing inflation. The IRS provides inflation adjustments to increase the size of progressive tax brackets. In addition, the standard deduction is adjusted annually for inflation. Recently the IRS released the inflation adjustments for 2022.  

IRS inflation adjustments are helpful, but they do not excuse inflation from taxation. Rather, they only soften the blow. Thus, they are not a full cure for the tax problems caused by inflation. 

Inflation and Traditional Retirement Accounts

Inflation is detrimental to traditional retirement accounts such as pre-tax 401(k)s and IRAs. Holding assets inside a traditional retirement account subjects the taxpayer to income tax on the growth in the assets caused by inflation.

Inflation artificially increases amounts in these accounts that will ultimately be subject to taxation. Inflation can also limit the opportunity to do Roth conversions in early retirement. Greater balances to convert from traditional to Roth accounts and increased dividend, capital gain, and interest income triggered by inflation makes early retiree Roth conversion planning more challenging. 

Inflation and Real Estate

There are several tax benefits of rental real estate. One of the main benefits is depreciation. For residential real estate, the depreciable basis is deducted in a straight-line over 27.5 years. For example, if the depreciable basis of a rental condo is $275,000, the annual depreciation tax deduction (for 27.5 years) is $10,000 (computed as $275,000 divided by 27.5). That number rarely changes, as most of the depreciable basis is determined at the time the property is purchased or constructed. 

Over time, inflation erodes the value of depreciation deductions. Inflation generally increases rental income, but the depreciation deduction stays flat nominally and decreases in real value. Increasing inflation reduces the tax benefits provided by rental real estate. 

Planning Techniques

There are planning techniques that can protect taxpayers against the tax threat posed by inflation. 

Roth Contributions and Conversions

Inflation is yet another tax villain the Roth can slay. Tax free growth inside a Roth account avoids the tax on inflation. 

Once inside a Roth, concerns about inflation increasing taxes generally vanish. Properly planned, Roths provide tax free growth and tax free withdrawals. Thus, Roths effectively eliminate the concern about paying tax on inflation. 

For those thinking of Roth conversions, inflation concerns point to accelerating Roth conversions. The sooner amounts inside traditional retirement accounts are converted to Roth accounts, the less exposure the amounts have to inflation taxes. 

Roth contributions and conversions provide tax insurance against the threat of inflation. For those very concerned about inflation, this consideration moves the needle toward the Roth in the ongoing Roth versus traditional debate. 

Watch me discuss using Roth accounts to help manage an investor’s exposure to inflation.

Health Savings Accounts

A Health Savings Account, like its Roth IRA cousin, offers tax free growth. HSAs also protect against taxes on inflation. Inflation is another argument to take advantage of an HSA. 

Basis Step Up Planning

There is another tax planning opportunity that can wipe away the taxes owed on years of inflation: the basis step up at death. At death, heirs receive a basis in inherited taxable assets which is usually the fair market value of the assets on the date of death. For taxable assets, death provides an opportunity to escape the tax on inflation.

It is important to note that traditional retirement accounts do not receive a basis step up. Inflation inside a traditional retirement account will eventually be subject to tax (either to the original owner or to a beneficiary after the original owner’s death). 

During one’s lifetime, there is the tax gain harvesting opportunity to step up basis and reduce inflation taxes. The tactic is to sell and repurchase an investment with a built-in gain at a time when the investor does not pay federal income tax on the capital gain. If one can keep their marginal federal income tax rate in the 12% or lower marginal tax bracket, they can pay a 0% federal income tax rate on the gain and “reset” the basis to the repurchase price of the sold and then repurchased asset. 

There is a second flavor of tax gain harvesting: triggering a capital gain (at an advantageous time from a tax perspective) by selling an asset and reinvesting the proceeds in a more desirable asset (essentially, investment reallocation). 

One inflation consideration with respect to tax gain harvesting: as inflation increases interest and dividends, there will be less room inside the 12 percent taxable income bracket to create capital gains that are federal income tax free.

Conclusion

Inflation is yet another tax planning consideration. As we are now in a period of significant inflation, taxpayers and advisors will need to weigh inflation’s potential impact on tax strategies. 

None of the above is advice for any particular taxpayer. Hopefully it provides some educational background to help assess the tax impact of inflation and consider tactical responses to inflation.

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

Follow me on Twitter: @SeanMoneyandTax

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

Roth 401(k) vs Roth IRA

Many taxpayers ask the question: should I contribute to a Roth 401(k) or contribute to a Roth IRA? While there is no universal answer to this question, for many in the financial independence (FI/FIRE) community, I believe there is a clear answer. 

Roth Accounts

What is not to love about Roths? If withdrawn properly, they promise tax free growth and tax free withdrawals. Further, Roths (be them 401(k)s or IRAs) give taxpayers tax insurance: income tax increases in the future are not a problem with respect to money invested in a Roth account. Roths even provide some ancillary benefits during retirement if the United States ever adopts a value added tax (a “VAT”). 

Roth IRAs

Roth IRAs are an individual account and can be established at a plethora of financial institutions. Most working taxpayers qualify to make annual contributions to a Roth IRA. However, the ability to make an annual contribution to a Roth IRA phases out at certain income levels and is completely eliminated at $140,000 (single) or $208,000 (married filing joint) of modified adjusted gross income (2021 numbers). 

The maximum annual contribution to a Roth IRA is $6,000 (if under age 50) or $7,000 (if age 50 or older) (2021 and 2022 numbers). 

I have previously written about my fondness for Roth IRAs. One reason for my fondness is that annual contributions can be withdrawn from the Roth IRA at any time for any reason tax and penalty free. Thus, Roth IRAs can perform double duty as both a retirement savings vehicle and as an emergency fund. This is an advantage of Roth IRAs over Roth 401(k)s. 

Of course, considering their tax free growth, it is usually best to keep amounts in a Roth IRA for as long as possible. 

Roth 401(k)s

Roth 401(k)s are a workplace retirement plan. Contributions can be made through payroll withholding. Many employers offer a Roth 401(k), though they are far from universally adopted. 

The Roth 401(k) does enjoy some advantages when compared to its Roth IRA cousin. First, there is no income limit to worry about. Regardless of income level, an employee can contribute to a Roth 401(k). Second, the contribution limits are much higher than the contribution limits for Roth IRAs. As of 2021, the annual Roth 401(k) contribution limit is $19,500 (under age 50) or $26,000 (age 50 and older). 

The Roth 401(k) is not a good account for emergency withdrawals. Withdrawals occurring prior to both the account holder turning 59 ½ years old and the account turning 5 years old generally pull out a mixture of previous contributions and taxable earnings.

Roth 401(k) vs Roth IRA

So which one should members of the FI/FIRE community prioritize? Contributions to a Roth 401(k) or contributions to a Roth IRA?

To help us answer that question, let’s consider a young couple pursuing financial independence:

Stephen and Becky are both age 30, married (to each other), and pursuing financial independence. They both would like to retire at least somewhat early by conventional standards. They each have a W-2 salary of $90,000. They have approximately $2,000 of annual interest and dividend income. They claim the standard deduction. At this level of income, they have a 22 percent marginal federal income tax rate. Stephen and Becky each have access to a traditional 401(k) and a Roth 401(k) at work. They would like to maximize their retirement plan contributions. 

How should Stephen and Becky allocate their retirement plan contributions? Should they contribute to a Roth 401(k) and/or to a Roth IRA?

To my mind, the best play here is to contribute to a Roth IRA ($6,000 each) and contribute to a traditional 401(k) ($19,500 each). Stephen and Becky should not contribute to a Roth 401(k). 

There is a significant tax opportunity cost to making a Roth 401(k) contribution: the ability to deduct a traditional contribution to a 401(k). Remember, the Roth 401(k) shares the $19,500 annual contribution limit with the traditional 401(k). Every dollar contributed to a Roth 401(k) is a dollar that cannot be contributed to a traditional 401(k). 

For Stephen and Becky, the hope is that in early retirement tax laws either stay the same as they are today or at least keep today’s flavor. The idea is to take a deduction while working at a 22 percent marginal tax rate (by contributing to the traditional deductible 401(k)). Then, in early retirement, they convert amounts in the traditional 401(k) to a Roth. At that point, hopefully they have a marginal federal income tax rate of 10 percent or 12 percent. Many early retirees have an artificially low taxable income (and thus, a low marginal income tax rate) prior to collecting Social Security. 

Contrast the significant tax opportunity cost of making a Roth 401(k) contribution to the tax opportunity cost of making a Roth IRA contribution: practically nothing. 

Stephen and Becky have no ability to deduct a traditional IRA contribution because of their income level and the fact that they are covered by a workplace retirement plan. Thus, they aren’t losing much, from a tax perspective, by each making a $6,000 annual Roth IRA contribution. 

Situations Where the Roth 401(k) Contributions Make Sense

For those in the financial independence community, generally there are four situations where choosing to contribute to a Roth 401(k) makes sense. In three of these situations, the tax rate arbitrage play available to Stephen and Becky isn’t available. In the fourth situation (tax insurance), there is a separate consideration causing the taxpayer to forgo an initial tax deduction to get assurance as to the tax rate they will be subject to. 

In the situations below, a Roth 401(k) contribution is likely preferable to a traditional 401(k) contribution. As compared to a Roth IRA contribution, (a) the first contributions should generally be to the Roth 401(k) to secure the employer match, and then after that, (b) generally both the Roth 401(k) and the Roth IRA work well. To my mind, the emergency-type fund feature of the Roth IRA, which I’ve previously discussed, is probably the tiebreaker in favor of making the next contributions to a Roth IRA.

Transition Years

Think about a year one graduates college, graduate school, law school, or medical school. Usually, the person works for only the last half or last quarter of the year. Thus, they have an artificially low taxable income (since they only work for a small portion of the year). Why take a tax deduction for a contribution to a traditional 401(k) in such a year, when one’s marginal federal income tax rate might only be 10 percent or 12 percent?

Transition years are a great time to make Roth 401(k) contributions instead of traditional 401(k) contributions. 

Young Earners with Low Incomes

Many careers start with modest salaries early but have the potential to experience significant salary increases over time. My previous career in public accounting is one example. Medicine is another example. Young accountants and doctors, among others, making modest starting salaries should consider Roth 401(k) contributions at the beginning of their careers. As their salaries increase, they should consider shifting their contributions to a traditional 401(k). 

As a *very general* rule of thumb, those in the 10 percent or 12 percent marginal federal income tax rate (particularly those not subject to a state income tax) should consider prioritizing Roth 401(k) contributions (regardless of occupation).

No Hope

Picture a charismatic franchise NFL quarterback. He’s got a $40M plus annual NFL contact, endorsement deals, business ventures, and likely a long TV career after his playing days are done. For him, there is no hope ( 😉 ). He will probably be in the top federal income tax bracket the rest of his life. He might be well advised to “lock-in” today’s low (by historical standards) 37% federal income tax marginal tax rate by choosing to contribute to a Roth 401(k) instead of to a traditional 401(k).

Tax Insurance

We really do not know what the future holds. That includes future federal and state income tax rates. 

Thus, some workers may want to buy tax insurance. Roth 401(k) contributions are a way to do that. The extra tax paid (because the taxpayer did not deduct traditional 401(k) contributions) is an insurance premium. That insurance premium ensures that the taxpayer won’t be subject to future income tax (including potential tax rate increases) on amounts inside the Roth 401(k) and the growth thereon. 

Remember, none of this is “all or nothing” planning. Some may want to allocate a piece of their workplace retirement plan contributions to the Roth 401(k) to get some insurance coverage against future tax rate increases. 

Conclusion

In the FI community, a maxed out traditional 401(k) and a maxed out Roth IRA (whether through a regular annual contribution or through a Backdoor Roth IRA) can be the dynamic duo of retirement savings. This combination can provide tax flexibility while maximizing current tax deductions. Roth 401(k) contributions often have a significantly greater tax opportunity cost as compared to the tax opportunity cost of Roth IRA contributions. In such situations, the Roth IRA is preferable to my mind. 

Of course, each individual is unique and has different financial and tax goals and priorities. The above isn’t advice for any particular individual, but hopefully provides some educational insight regarding the issues to consider when allocating employee retirement account contributions. 

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

Follow me on Twitter: @SeanMoneyandTax

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

The Backdoor Roth IRA and December 31st

New Year’s Eve is an important day if you do a Backdoor Roth IRA. Read below to find out why.

The Backdoor Roth IRA

I’ve written before about the Backdoor Roth IRA. It is a two step process whereby those not qualifying for a regular Roth IRA contribution can qualify to get money into a Roth IRA. Done over several years, it can help taxpayers grow significant amounts of tax free wealth.

One of the best aspects of the Backdoor Roth IRA is that it does not forego a tax deduction. Most taxpayers ineligible to make a regular Roth IRA contribution are also ineligible to make a deductible traditional IRA contribution. In the vast majority of cases, the choice is between investing money in a taxable account versus investing in a Roth account. For most, a Roth is preferable, since Roths do not attract income taxes on the interest, dividends, and capital gains investments generate. 

The Basic Backdoor Roth IRA and the Form 8606

Let’s start with a fairly basic example. 

Example 1

Betsy, age 40, earns $300,000 from her W-2 job in 2021, is covered by a workplace 401(k) plan, and has some investment income. Betsy has no balance in a traditional IRA, SEP IRA, or SIMPLE IRA.

At this level of income, Betsy does not qualify for a regular Roth IRA contribution, and she does not qualify to deduct a traditional IRA contribution. 

Betsy contributes $6,000 to a traditional IRA on May 20, 2021. The contribution is nondeductible. Because the contribution is nondeductible, Betsy gets a $6,000 basis in her traditional IRA. Betsy must file a Form 8606 with her 2021 tax return to report the nondeductible contribution.

On June 5, 2021, Betsy converts the entire balance in the traditional IRA, $6,003, to a Roth IRA. As of December 31, 2021, Betsy has no balance in a traditional IRA, SEP IRA, or SIMPLE IRA.

Betsy has successfully executed a Backdoor Roth IRA. Here is what page 1 of the Form 8606 Betsy should file with her 2021 income tax return should look like. 

Notice here that I am using the 2020 version of the Form 8606 for this and all examples. The 2021 Form 8606 is not yet available as of this writing. 

The most important line of page 1 of the Form 8606 is line 6. Line 6 reports the fair market value of all traditional IRAs, SEP IRAs, and SIMPLE IRAs Betsy owns as of year-end. Because Betsy had no traditional IRAs, SEP IRAs, and SIMPLE IRAs as of December 31, 2021, her Backdoor Roth IRA works and is tax efficient. This important number ($0) on line 6 of the Form 8606 is what ensures Betsy’s Backdoor Roth IRA is tax efficient. 

Note that Betsy’s Backdoor Roth IRA creates an innocuous $3 of taxable income, which is reported on the top of part 2 of the Form 8606. 

The Pro-Rata Rule and December 31st

But what if Betsy did have a balance inside a traditional IRA, SEP IRA, or SIMPLE IRA on December 31, 2021? Would her Backdoor Roth IRA still be tax efficient? Probably not, due to the Pro-Rata Rule.

The Pro-Rata Rule tells us just how much of the basis in her traditional IRA Betsy can recover when she does the Roth conversion step of the Backdoor Roth IRA. Betsy’s $6,000 nondeductible traditional IRA creates $6,000 of basis. As we saw above, Betsy was able to recover 100 percent of her $6,000 of basis against her Roth conversion. 

But the Pro-Rata Rule says “not so fast” if Betsy has another traditional IRA, SEP IRA, or SIMPLE IRA on December 31st of the year of any Roth conversion. The Pro-Rata Rule allocates IRA Basis between converted amounts (in Betsy’s case, $6,003) and amounts in traditional IRAs, SEP IRAs, and SIMPLE IRAs on December 31st. Here’s an example. 

Example 2

Betsy, age 40, earns $300,000 from her W-2 job in 2021, is covered by a workplace 401(k) plan, and has some investment income. Betsy has no balance in a traditional IRA, SEP IRA, or SIMPLE IRA.

Betsy contributes $6,000 to a traditional IRA on May 20, 2021. The contribution is nondeductible. Because the contribution is nondeductible, Betsy gets a $6,000 basis in her traditional IRA. Betsy must file a Form 8606 with her 2021 tax return to report the nondeductible contribution.

On June 5, 2021, Betsy converts the entire balance in the traditional IRA, $6,003, to a Roth IRA. 

On September 1, 2021, Betsy transfers an old 401(k) from a previous employer 401(k) plan to a traditional IRA. On December 31st, that traditional IRA is worth $100,000. The old 401(k) had no after-tax contributions. 

This one 401(k)-to-IRA rollover transaction dramatically changes both the taxation of Betsy’s Backdoor Roth IRA and her 2021 Form 8606. Here’s page 1 of the Form 8606.

Line 6 of the Form 8606 now has $100,000 on it instead of $0. That $100,000 causes Betsy to recover only 5.67 percent of the $6,000 of basis she created by making a nondeductible contribution to the traditional IRA. As a result, $5,663 of the $6,003 transferred to the Roth IRA in the Roth conversion step is taxable to Betsy as ordinary income. At a 35% tax rate, the 401(k) to IRA rollover (a nontaxable transaction) cost Betsy $1,982 in federal income tax on her Backdoor Roth IRA. Ouch!

Quick Lesson: The lesson here is that prior to rolling over a 401(k) or other workplace plan to an IRA, taxpayers should consider the impact on any Backdoor Roth IRA planning already done and/or planned for the future. One possible planning alternative is to transfer old employer 401(k) accounts to current employer 401(k) plans.

There is an antidote to the Pro-Rata Rule when one has amounts in traditional IRAs, SEP IRAs, and SIMPLE IRAs. It is transferring the traditional IRA, SEP IRA, or SIMPLE IRA to a qualified plan (such as a 401(k) plan) before December 31st. Here is what that might look like in Betsy’s example. 

Example 3

Betsy, age 40, earns $300,000 from her W-2 job in 2021, is covered by a workplace 401(k) plan, and has some investment income. Betsy has no balance in a traditional IRA, SEP IRA, or SIMPLE IRA.

Betsy contributes $6,000 to a traditional IRA on May 20, 2021. The contribution is nondeductible. Because the contribution is nondeductible, Betsy gets a $6,000 basis in her traditional IRA. Betsy must file a Form 8606 with her 2021 tax return to report the nondeductible contribution.

On June 5, 2021, Betsy converts the entire balance in the traditional IRA, $6,003, to a Roth IRA. 

On September 1, 2021, Betsy transfers an old 401(k) from a previous employer to a traditional IRA. The old 401(k) had no after-tax contributions. 

On November 16, 2021, Betsy transfers the entire balance in this new traditional IRA to her current employer’s 401(k) plan in a direct trustee-to-trustee transfer. 

Here is Betsy’s 2021 Form 8606 (page 1) after all of these events:

Betsy got clean by December 31st, so her Backdoor Roth IRA now reverts to the optimized result (just $3 of taxable income) she obtained in Example 1. 

Pro-Rata Rule Clean Up

Implementation 

From a planning perspective, it is best to clean up old traditional IRAs/SEP IRAs/SIMPLE IRAs prior to, not after, executing the Roth conversion step of a Backdoor Roth IRA. I say that because things happen in life. There is absolutely no guarantee that those intending to roll amounts from IRAs to workplace qualified plans will get that accomplished by December 31st. 

Further, transfers from one retirement account to another are usually best done through a direct “trustee-to-trustee” transfer to minimize the risk that the money in the retirement account accidentally is distributed to the individual, causing potential tax and penalties. 

Before cleaning up old traditional IRAs, SEP IRAs, and SIMPLE IRAs, one should consider the investment choices and fees inside their employer retirement plan (such as a 401(k)). If the investment options are not good, and/or the fees are high, perhaps cleaning up an IRA to move money into less desirable investments is not worth it. This is a subjective judgment that must weigh the potential tax and investment benefits and drawbacks. 

Tax Issues

Amazingly enough, the Pro-Rata Rule is concerned with only one day: December 31st. A taxpayer can have a balance in a traditional IRA, SEP IRA, or SIMPLE IRA on any day other than December 31st, and it does not count for purposes of the Pro-Rata Rule. Perhaps December 31st should be called Pro-Rata Rule Day instead of New Year’s Eve. 😉

Betsy’s November 16th distribution from her traditional IRA to the 401(k) plan does not attract any of the basis created by the nondeductible traditional IRA contribution earlier in the year. This document provides a brief technical explanation of why rollovers to qualified plans do not reduce IRA basis. 

Extra care should be taken when cleaning up (a) large amounts in any type of IRA and (b) any SIMPLE IRA. While it is fairly obvious that significant sums should be moved only after considering all the relevant investment, tax, and execution issues, the SIMPLE IRA provides its own nuances. Any SIMPLE IRA cannot be rolled to an account other than a SIMPLE IRA within the SIMPLE IRA’s first two years of existence. Thus, SIMPLE IRAs must be appropriately aged before doing any sort of Backdoor Roth IRA clean up planning. 

Spouses are entirely separate for Pro-Rata Rule purposes, even in community property states. Cleaning up one spouse, or failing to clean up one spouse, has absolutely no impact on the taxation of the other spouse’s Backdoor Roth IRA.

Lastly, non spousal inherited IRAs do not factor into a taxpayer’s application of the Pro-Rata Rule. Each non spousal inherited IRA has its own separate, hermetically sealed Pro-Rata Rule calculation. The inheriting beneficiary does a Pro-Rata Rule calculation on all IRAs he/she owns as the original owner, separate from any inherited IRAs. In addition, non spousal inherited IRAs cannot be rolled into a 401(k).

Mega Backdoor Roth

Good news: the concerns addressed in this blog post generally do not apply with respect to the Mega Backdoor Roth (sometimes referred to as a Mega Backdoor Roth IRA, though a Roth IRA does not necessarily have to be involved). Qualified plans such as 401(k)s are not subject to the Pro-Rata Rule. 

While 401(k)s are not subject to the Pro-Rata Rule, amounts within a particular 401(k) plan’s after-tax 401(k) are subject to the “cream-in-the-coffee” rule I previously wrote about here. Thus, if there is growth on Mega Backdoor Roth contributions before they are moved out of the after-tax 401(k), generally speaking either the taxpayer must pay income tax on the growth (if moved to a Roth account) or the taxpayer can separately roll the growth to a traditional IRA (which could then create a rather small Pro-Rata Rule issue with future Backdoor Roth IRAs). Fortunately, the cream-in-the-coffee rule has a much narrower reach than the Pro-Rata Rule.

Backdoor Roth IRA Tax Return Reporting

Watch me discuss Backdoor Roth IRA tax return reporting.

Conclusion

Get your IRAs in order so you can enjoy New Year’s Eve! 

December 31st is an important date when it comes to Backdoor Roth IRA planning. It is important to plan to have no (or at a minimum, very small) balances in traditional IRAs, SEP IRAs, and SIMPLE IRAs on December 31st when planning Backdoor Roth IRAs. 

None of what is discussed in this blog post is advice for any particular taxpayer. Those working through Backdoor Roth IRA planning issues are often well advised to reach out to professional advisors regarding their own tax situation.

Further Reading

I did a blog post about Backdoor Roth IRA tax return reporting here.

I did a deep dive on the taxation of Roth IRA withdrawals here.

I did a deep dive on the Pro-Rata Rule here.

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

Follow me on Twitter: @SeanMoneyandTax

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

Roth IRAs and the VAT Boogeyman

The Roth IRA: tax free retirement income. What’s not to love? 

But wait a minute. What Congress gives Congress can take away, right? Might Congress, looking for tax revenues to pay off the debt, simply make Roth distributions in retirement taxable? Not very likely. 

While I have no evidence to support this proposition, my guess is that Roth account owners vote at very high rates. Voting to tax Roth withdrawals in retirement seems to be a good way to create a motivated constituency to deny members of Congress re-election. I’m hardly the first person to argue that it is very unlikely that Congress will ever subject Roth withdrawals to income taxation.

The Value Added Tax

There are indirect ways for Congress to attack Roths and tax some of that otherwise tax free account value. One way some worry about is the value-added tax, otherwise known as the VAT. The VAT is a consumption tax on goods and services. The EU has a website here describing the VAT in the European Union. A VAT functions like a sales tax and can be added at any or all levels of production. Many developed countries have a VAT, but the United States does not. 

Roths and the VAT

A VAT has the potential to increase the price of goods and/or services, and thus, to potentially eat away at value inside Roth accounts. 

Here is a simplified example of how that would work. 

Maria is retired. Her annual consumption is approximately $95,000, $5,000 of which is property taxes. She lives off $25,000 a year in Social Security income and $70,000 a year in withdrawals from her Roth IRA. She pays no income taxes on those withdrawals. If a 10 percent VAT were enacted on retail sales, she would need to withdraw approximately $9,000 (10 percent of her current $90,000 non-property tax annual consumption) more from her Roth IRA to pay for her current level of consumption. Instead of using an income tax, the government collects $9,000 from her Roth IRA annually by imposing a VAT.

The VAT functions as a tax on a Roth IRA. As Maria has to withdraw more from her Roth to maintain the same level of consumption, the VAT also reduces the value of amounts inside a Roth IRA. Does this mean a Roth IRA is less desirable?

For the reasons argued below, I believe that the answer is No. First, it should be remembered that were a VAT to be implemented, is almost certain to be implemented in addition to the current federal income tax. Sure, if the United States were to switch from an income tax to a VAT traditional IRA owners would win big (having previously received an income tax deduction without a later income tax charge) and Roth IRA owners would lose big. But a switch from an income tax to a VAT is almost certainly not happening. 

Second, when assessing the value of Roth accounts in a United States with a VAT, one must compare them to the alternatives: traditional retirement accounts and taxable accounts. 

Traditional Versus Roth with a VAT

Let’s start out by examining the difference between a Roth IRA and a traditional IRA if there is a federal VAT. Here is an example. 

Joe is 65 years old and retired. He is a lifelong New York Jets fan, and decides he wants to go Super Bowl LVI, to see his Jets, presumably the AFC representatives in the game. One ticket costs $10,000 and Joe’s only source of funds for the purchase is his retirement account. Joe’s marginal federal income tax rate is 22 percent. Here are the results if Joe has a traditional IRA and a Roth IRA both without a federal VAT on the ticket and with a 5 percent federal VAT on the ticket:

No VATNo VAT5% VAT5% VAT
IRA TypeAmount NeededIncome Tax DueAmount NeededIncome Tax Due
Traditional$12,821$2,821$13,462$2,962
Roth$10,000$0$10,500$0

Hopefully you can see what is going on in the table. With a traditional IRA, one cannot simply withdraw $10,000 to pay for a $10,000 expense. There will be income tax due on the withdrawal. In order to net out $10,000 to pay for the ticket, Joe must withdraw $12,821, which covers the cost of the ticket and the 22 percent federal income tax (assume Joe lives in Florida so there’s no state income tax). This is computed as the amount needed ($10,000) divided by 1 minus the tax rate (1 minus .22), which equals $12,821. 

With a 5 percent VAT, Joe must pay $10,500 for the Super Bowl ticket. From his traditional IRA, he must withdraw $13,462, computed as the amount needed ($10,500) divided by 1 minus the tax rate (1 minus .22). 

As we are about to learn, paying a VAT with a traditional IRA creates a new tax: income tax on the VAT. Paying a VAT with a Roth IRA avoids this new tax.

If Joe pays for his Super Bowl ticket with a traditional IRA, he needs $641 more from his traditional IRA in a VAT environment to pay for the Super Bowl ticket. He must pay $141 in additional income tax to cover this additional withdrawal. The income tax on the VAT is $110 (22 percent of $500), the income tax on the income tax on the VAT is $24 (22 percent of $110), and there is approximately $7 of income tax on the remainder of the income tax required. 

See this spreadsheet for the income tax calculation. Incredibly, it is possible to pay income tax on the income tax on the income tax on the income tax on the VAT if you pay the VAT from a traditional IRA. It will get much worse as expenses increase beyond the $10,000 tackled in this example. 

The first lesson: a VAT hurts those with traditional IRAs, since they will have to increase their taxable withdrawals to pay for goods and services subject to the VAT. When paid with a traditional retirement account, VAT creates several new taxes: the VAT itself, the income tax on the VAT, the income tax on the income tax on the VAT, etc.

The second lesson: if a VAT is enacted, the Roth protects retirees from the income tax payable on the VAT. The 5 percent VAT increases the total tax cost of the $10,000 ticket by $641 if one uses a traditional IRA but only by $500 if one uses a Roth IRA. Having a Roth protects against income tax on the VAT itself. This makes a Roth an even more desirable planning alternative if there is a VAT than if there is no VAT. 

The income tax on the VAT is another tax villain the Roth can successfully defeat.

Roth Versus Taxable with a VAT

I believe the logic applied in the Roth versus Traditional VAT environment applies in assessing Roths versus taxable accounts in a VAT environment. To fund consumption, retirees will have to sell more of their taxable brokerage accounts to pay for the now increased price of goods and services, resulting in higher capital gains (and thus, more capital gains taxes) in many cases. Using a Roth withdrawal to pay a VAT protects against those additional capital gains taxes. 

Planning

If one believes that a VAT is coming, there is not much, to my mind, to be done from a financial planning perspective, other than increasing amounts in Roth accounts. One might purchase durable goods in advance of the enactment of a VAT, but that sort of planning is of limited value. How many refrigerators can you stockpile for your future use? For those worried about a VAT, the tactics that appear effective are to increase Roth contributions and/or conversions.

While a VAT would not be good news, it makes the Roth planning decision more likely to be the advantageous planning decision.

Paying a VAT out of a Roth avoids the income tax on the VAT (and the resulting additional income taxes) retirees incur when paying the VAT out of a traditional IRA. A Roth also avoids increased capital gains taxes resulting from using taxable brokerage accounts to pay a VAT. 

Conclusion

A VAT is not good news for Roth IRA owners, but it is worse news for traditional IRA owners. Roths limit the tax damage of a VAT to the VAT itself in a way neither traditional retirement accounts nor taxable accounts are capable of. In the age-old traditional versus Roth debate, the possibility of a future VAT moves the needle (if ever so slightly) in the direction of the Roth. 

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.

QCDs and the FI Community

Qualified charitable distributions (“QCDs”) are an exciting tax planning opportunity, particularly for the FI community. Below I describe what a qualified charitable distribution is and how members of the FI community should think about them when tax planning.

Of course, this post is educational in nature. Nothing in this blog post is tax advice for any particular taxpayer. Please consult your own tax advisor regarding your unique circumstances. 

Qualified Charitable Distributions

QCDs are transfers from a traditional IRA directly to a charity. Up to $100K annually, they are (a) not included in the taxpayer’s taxable income, (b) not deductible as charitable contributions, and (c) qualify as “required minimum distributions” (“RMDs”) (to the lesser of the taxpayer’s required minimum distribution or the actual distribution to the charity). Here is an example:

Example 1: Jack and Jill are 75 years old and file their tax return married filing joint. Jack has a RMD from his traditional IRA of $40,000 in 2021. Jack directs his traditional IRA institution to transfer $40,000 during 2021 to a section 501(c)(3) charity. Jack and Jill recognize no taxable income on the transfer, and Jack does not have to take his 2021 RMD (the $40K QCD having covered it). Further, Jack and Jill receive no charitable contribution deduction for the transfer.

Considering that Jack & Jill (both age 75) enjoy a standard deduction of $27,800 in 2021, they get both the standard deduction and a $40K deduction for the charitable contribution from the traditional IRA (since they do not have to include the $40K in their taxable income). This is the best of both worlds. Further, excluding the $40K from “adjusted gross income” (“AGI”) is actually better than taking the $40K as an itemized deduction, since many tests for tax benefits are keyed off of AGI instead of taxable income. 

Important QCD Considerations

Take QCDs Early

Generally speaking, it is best that QCDs come out of the traditional IRA early in the year. Why? Because under the tax rules, RMDs come out of a traditional IRA first. So it is usually optimal to take the QCD early in the year so it can fulfill all or part of the required minimum distribution for the year. Then you can do Roth conversion planning (if desired), so long as the full RMD has already been withdrawn (either or both through a QCD and a regular distribution) from the traditional IRA first. 

No Trinkets

I don’t care how much you love your PBS tote bag: do not accept any gift or token of appreciation from the charity. The receipt of anything (other than satisfaction) from the charity blows the QCD treatment. So be sure not to accept anything from the charity in exchange for your QCD.

QCDs Available Only from Traditional IRAs

In order to take advantage of QCD treatment, the account must be a traditional IRA. 401(k)s and other workplace plans do not qualify for QCDs. Further, SIMPLE IRAs and SEP IRAs do not qualify for QCD treatment. 

As a practical matter, this is not much of an issue. If you want to do a QCD out of a 401(k) or other tax advantaged account, generally all you need to do is rollover the account to a traditional IRA. 

QCD Age Requirement

In order to take advantage of the QCD opportunity, the traditional IRA owner must be aged 70 ½ or older. 

Inherited IRAs

QCDs are available to the beneficiary of an inherited IRA so long as the beneficiary is age 70 ½ or older. 

QCDs For Those Age 70 ½ and Older

If you are aged 70 ½ or older and charitably inclined, the QCD often is the go-to technique for charitable giving. In most cases, it makes sense to make your charitable contributions directly from your traditional IRA, up to $100,000 per year. QCDs help shield RMDs from taxation and help keep AGI low. 

QCDs and the Pro-Rata Rule

If you have made previous non-deductible contributions to your traditional IRA, distributions are generally subject to the pro-rata rule (i.e., the old contributions are recovered ratably as distributions come out of the traditional IRA). 

However, QCDs are not subject to the pro-rata rule! This has a positive effect on future taxable distributions from the traditional IRA. Here is an example of how this works:

Example 2: Mike is age 75. On January 1, 2021, he had a traditional IRA worth $500,000 to which he previously made $50,000 of nondeductible contributions. If Mike makes a $10,000 QCD to his favorite charity, his traditional IRA goes down in value to $490,000. However, his QCD does not take out any of his $50,000 of basis from nondeductible contributions. This has the nice effect of reducing the tax on future taxable distributions to Mike from the traditional IRA, since the QCD reduces denominator (by $10K) for determining how much basis is recovered, while the numerator ($50K) is unaffected. 

QCDs for Those Under Age 70 ½

Those in the FI community considering early retirement need to strongly consider Roth conversions. The general idea is that if you can retire early with sufficient wealth to support your lifestyle, you can have several years before age 70 during which your taxable income is artificially low. During those years, you can convert old traditional retirement accounts Roth accounts while you are taxed at very low federal income tax brackets.

For the charitably inclined, the planning should account for the QCD opportunity. There is no reason to convert almost every dime to Roth accounts if you plan on giving significant sums to charity during your retirement. Why pay any federal or state income tax on amounts that you ultimately will give to charity?

If you are under the age of 70 ½ and are charitably inclined, QCDs should be part of your long term financial independence gameplan. You should leave enough in your traditional retirement accounts to support your charitable giving at age 70 ½ and beyond (up to $100K annually). These amounts can come out as tax-free QCDs at that point, so why pay any tax on these amounts in your 50s or 60s? Generally speaking, a Roth conversion strategy should account for QCDs for the charitably inclined. 

Conclusion

For the charitably inclined, QCDs can be a great way to manage taxable income and qualify for tax benefits in retirement. QCDs also reduce the pressure on Roth conversion planning prior to age 72, since it provides a way to keep money in traditional accounts without having to pay tax on that money. 

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

Follow me on Twitter: @SeanMoneyandTax

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

Sean on the How to Money Podcast

I recently discussed tax planning, financial independence, and entrepreneurship on the How to Money podcast. Please click the below link to listen. https://www.howtomoney.com/smart-tax-planning-moves-with-sean-mullaney/

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. 

Roth 401(k)s for Beginners

Roth 401(k)s are gaining prominence as a tax-advantaged workplace retirement account. This post provides introductory information regarding Roth 401(k)s and their potential benefits as a retirement savings account.

Two important introductory notes. First, not all 401(k) plans offer a Roth option, so for some employees, a Roth 401(k) contribution is not an option. Second, this post is for educational purposes only and is not advice for any particular taxpayer. 

Traditional 401(k) versus Roth 401(k)

In an ideal world, contributions by an employee to a traditional 401(k) result in a tax deduction when contributed, and taxable income when withdrawn.

Example 1: Tony makes $100,000 from his employer in W-2 wages in 2021. Tony contributes $15,000 during the course of 2021 to his employer’s traditional 401(k). Tony will receive a W-2 from his employer reporting $85,000 of taxable W-2 wages for 2021.

In an ideal world, contributions by an employee to a Roth 401(k) result in no tax deduction when contributed, and no taxable income when withdrawn.

Example 2: Rudy makes $100,000 from his employer in W-2 wages in 2021. Rudy contributes $15,000 during the course of 2021 to his employer’s Roth 401(k). Rudy will receive a W-2 from his employer reporting $100,000 of taxable W-2 wages for 2021.

Roth 401(k) Contributions

Employees can contribute the lesser of their earned income or $19,500 (2021 limit) to a Roth 401(k) in “employee deferrals.” For those 50 years old or older, the 2021 limit is the lesser of earned income or $26,000.

The employee deferral limit factors in both traditional 401(k) employee contributions and Roth 401(k) employee contributions. Here’s an illustrative example.

Example 3: Sarah, age 35, earns $100,000 in W-2 income in 2021 at Acme Industries, Inc. Sarah contributes the maximum to her 401(k) plan. Assuming Acme offers both a traditional 401(k) and a Roth 401(k), that maximum $19,500 contribution can be split up however Sarah chooses ($13,000 to the traditional 401(k) and $6,500 to the Roth 401(k), $5,000 to the traditional 401(k) and $14,500 to the Roth 401(k), etc.). 

Any combination (including all in the traditional or all in the Roth) is permissible as long as the total does not exceed $19,500 (using 2021’s limits).

Roth 401(k) Contributions: Income Limits

There’s good news here. Unlike their Roth IRA cousins, Roth 401(k) contributions have no income limits. In theory, one could make $1 billion annually in W-2 income and still contribute $19,500 to a Roth 401(k). 

Matching Contributions

Employer matching contributions are one of the best benefits of 401(k) plans. 

It is important to keep in mind that matching contributions, profit sharing contributions, and forfeitures must go into employee accounts as traditional contributions. This is true regardless of whether the employee’s own contributions are traditional, Roth, or both. 

Example 4: Elaine, age 35, works at Perry Publishing. She earns a salary of $50,000. Perry matches 50% of the first 6% of salary that Elaine contributes to her 401(k). Elaine decides to contribute $3,000 (6 percent) of her salary to the 401(k) as a Roth contribution. Perry contributes $1,500 as a matching contribution. The $1,500 employer match goes into the 401(k) as a traditional contribution. The $3,000 and its growth are treated as a Roth 401(k), and the $1,500 and its growth are treated as a traditional 401(k). 

Matching contributions may be subject to vesting requirements, as described in this post. Employee contributions to a 401(k) (whether traditional or Roth) are always 100% vested. 

Roth 401(k) Withdrawals

The greatest benefits of a Roth 401(k) are tax-free growth and tax-free withdrawals. Tax-free withdrawals are generally the goal, but they are not automatic. Recently, I wrote a post on Roth 401(k) withdrawals. 

One important consideration regarding Roth 401(k) withdrawals: Roth 401(k)s are subject to the required minimum distribution rules starting at age 72. Thus, you must start withdrawing money from a Roth 401(k) at age 72. As a result, you will have less wealth growing tax-free. For this reason, many consider rolling Roth 401(k)s to Roth IRAs prior to age 72. 

Conclusion

Roth 401(k)s provide a great opportunity to save and invest for retirement. Taxpayers should consider their own circumstances, and often consult with tax professionals, in deciding their own investment program. 

Further Reading

For more information about 401(k) plans, please read this post. 

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. 

An Ode to the Roth IRA

It won’t surprise many to find out that a tax-focused financial planner is fond of the Roth IRA. Below is a brief review of the advantages of a Roth IRA.

Tax Free Growth

Amounts in Roth IRAs grow tax free. Considering many Americans may now live into their 80s, 90s, and beyond, this is a tremendous benefit. 

The only caveat is that in order for all distributions from Roth IRAs to be tax and penalty free, they generally have to be either (a) a return of contributions or of sufficiently aged conversions (see below), or (b) a distribution of earnings made in the Roth IRA (or other amounts in the Roth IRA) at a time when the owner of the account is 59 ½ or older and has owned a Roth IRA for at least five years.

The rules for ordering distributions out of a Roth IRA generally provide that contributions come out first, and then the oldest conversions come out next. This means that in many cases Roth IRA distributions, even those occurring before age 59 ½, are tax and penalty free. 

N.B. Generally speaking, you want to only take a distribution from a Roth IRA before age 59 ½ if it is either (i) a serious emergency or (ii) part of a well crafted, very intentional financial plan. 

Ease of Administration and Withdrawal 

There are many financial institutions that provide Roth IRAs. Investment expenses in low-cost index funds at financial institutions that provide Roth IRAs are approaching zero. Vanguard, Fidelity, and Schwab are among the very good providers of low-cost Roth IRAs (and there are others). 

It is also relatively easy to access money inside a Roth IRA. This makes the Roth IRA a great account to have in an emergency. Of course, it is generally best to leave money inside a Roth IRA to let it grow tax free, but it is good to know that you can access money in a Roth IRA relatively easily if an emergency arises. 

Tax Free Withdrawals of Contributions

This is a great benefit of the Roth IRA. Contributions to a Roth IRA can be withdrawn at any time for any reason tax and penalty free. Further, the first money deemed distributed from a Roth IRA is a contribution. Here is a quick example:

Mark is 35 years old in 2025. He made $6,000 contributions to his Roth IRA in each of 2020, 2021, 2022, 2023, and 2024 (for $30,000 total). In 2025, when his Roth IRA is worth $41,000, Mark withdraws $10,000 from his Roth IRA in 2025. All $10,000 will be deemed to be a return of contributions, and thus entirely tax free and penalty free.

The only exception is a taxpayer favorable exception: a timely withdrawal of an excess contribution (and related earnings) occurs before regular contributions are considered withdrawn. 

N.B. Roth 401(k)s, 403(b)s, and 457s have different distribution rules — most pre-age 59 ½ distributions will take out some taxable earnings.

Tax Free Withdrawals of Sufficiently Aged Converted Amounts 

If you convert an amount into a Roth IRA, you start a five year clock as of January 1st of the year of the conversion. Quick example:

Mike is 35 years old in 2025. Mike converts $10,000 from a traditional IRA to a Roth IRA on July 2, 2025. His five year conversion clock starts January 1, 2025. On January 1, 2030, Mike can withdraw the entire $10,000 he converted in 2025 tax and penalty free. 

This feature of the Roth IRA, the tax free withdrawal of sufficiently aged conversions, is the basis for the Roth Conversion Ladder strategy. Sufficiently aged converted amounts are deemed to come out after contributions are exhausted and before more recent conversions and earnings come out.  

No Required Minimum Distributions

During an account holder’s lifetime, there are no required minimum distributions from a Roth IRA. You can live to 150 and never be required to take money from a Roth IRA.

Creditor Protection

In federal bankruptcy proceedings, Roth IRAs are (as of 2024), protected up to $1,512,350. 

Where there can be differences in liability protection are state general creditor claims (i.e., creditor protection in non-bankruptcy situations). In some states, Roth IRAs receive a level of creditor protection similar to that of ERISA plans. Generally, such protection is absolute against all creditors except for an ex-spouse or the IRS. 

In other states, Roth IRAs receive no or limited creditor protection. In my home state of California, Roth IRAs are only creditor protected up to the amount necessary to provide for you and your dependents in your retirement (as determined by the court). Such protection is valuable but hardly airtight. 

A Sneaky Way to Contribute More to Your Retirement

Yes, in theory everyone should save for retirement based on exacting calculations (i.e., I estimate I need $X in retirement, so based on projections I save $A in traditional accounts and $B in Roth accounts this year). That’s the theory.

In practice, it’s “I maxed out this account and that account” or “I put $C into this account and $D into that account.” There isn’t that much wrong with how we practically save for retirement, as long as we are saving sufficient amounts for retirement.

But not all “maxing out” is created equal. We know this because if Jane has $100,000 in a traditional IRA and Mary has $100,000 in a Roth IRA, who has more wealth? Mary! Unless Jane can always be in a zero percent income tax bracket, Mary has more than Jane, even though they both nominally have $100,000. 

A Great Account to Leave to Heirs

While non-spouse heirs will have to take taxable required distributions from inherited IRAs (in many cases beginning in 2020 they will need to drain the account within 10 years of death), heirs are never taxed on distributions from Roth IRAs. This makes a Roth IRA a great account to leave to your heirs. 

Compare with Other Retirement Accounts

No other retirement account combines ease of administration and withdrawal, low costs, significant tax benefits, creditor protection, and great emergency access the way the Roth IRA does. Most workplace retirement plans have some restrictions on withdrawals. Traditional account withdrawals do not have the tax advantages of a Roth IRA. Distributions from a traditional IRA, even one at a low-cost, easy to use discount brokerage, will trigger ordinary income taxes, and possible penalties, if withdrawn for emergency use. 

Financial Planning Objectives

Personal finance is indeed personal. But I submit the following: pretty much every individual has some desire (and/or need) to not work at some point in his/her lifetime and every individual needs to be prepared for emergencies. Further, these are two very important financial planning objectives for most, if not all, individuals.

If the above is true, then we must ask “which account type best supports the combination of these two pressing financial planning objectives?” It appears to me that the answer is clearly the Roth IRA. 

None of this is to say that a Roth IRA is the only way to plan for retirement and plan for emergencies, but rather, it is to say that, generally speaking, a Roth IRA ought to be a material element in such planning. Other tools, such as other retirement accounts, insurances, investments in taxable accounts, and sufficiently funded emergency funds are likely needed in addition to a Roth IRA. 

Retirement Accounts and Emergencies

Let’s examine how a Roth IRA might help someone facing a very serious emergency. 

Picture Jack, who is 52 years old, and has a full time job. He has $1M in a traditional 401(k) and $10,000 in cash in a taxable account. That’s it. Then picture Chuck, also 52 with a full time job. Chuck has $700,000 in a traditional 401(k), $250,000 in a Roth IRA, and $10,000 in cash.

Who is better situated to deal with an emergency? Far and away the answer is Chuck. 401(k)s are difficult to access in an emergency. First of all, the 401(k) plan might not allow in-service distributions, and it might not allow taking out a loan. 

Even if the 401(k) allows in-service distributions, distributions from 401(k)s are immediately taxable, and often subject to penalties (10% federal, 2.5% in California, for example) if you are under age 59 ½. Loans, while not immediately taxable, can become taxable if not paid back. 

Long story short, a 401(k) may be a tough nut to crack in an emergency.

What about a Roth IRA? In Chuck’s case, he can access his prior Roth IRA contributions and sufficiently aged contributions tax and penalty free at any time for any reason! And his Roth IRA is easy to access, particularly if it is at a low-cost discount brokerage.

When you combine tax-free growth, no requirement to take required minimum distributions during the account holder’s lifetime, and the best emergency access of any tax-advantaged retirement account, it is difficult to see why working adults should not have at least some money in a Roth IRA. 

When a Roth IRA Doesn’t Make Sense

The short answer is: not often! I struggle to come up with profiles of individuals that would not benefit from having some amount in a Roth IRA. 

I can think of two profiles. The first, a rare case, is someone with very large legal liabilities such that all of their wealth would benefit from the creditor protections offered by an ERISA retirement plan (such as a 401(k)) and who needs almost all of their wealth shielded from creditors. 

First, if you have built up 6 figures or more in wealth, having creditors able to claim your entire wealth is relatively rare. Second, in most cases, good insurance coverage, including adequate medical insurance, professional liability insurance (as applicable), home and automobile insurance, and personal umbrella liability insurance, should protect the vast majority of people such that they could withstand any liability exposure caused by having money in a Roth IRA instead of an ERISA protected plan. 

The second profile is someone with incredibly high income currently and very little anticipated income in the future (such that their future tax rate is much lower than today’s rate). This too is a bit of a unicorn – people with high income today tend to have decent income tomorrow (even in the FI community).

Health Savings Accounts

It will also come as no surprise that I am fond of health savings accounts. Health savings accounts share some of the attributes that make the Roth IRA such a winner for both retirement savings and emergency planning.

But, there are some drawbacks. First, the distribution ordering rules are not as taxpayer friendly. While it may be the case that you have sufficient old medical expenses that you can reimburse yourself for (and thus not pay tax and a penalty on the HSA distribution), that is not always going to be the case, and even if it is, does add a layer of complexity.

Second, the HSA is not for everyone. If a high deductible health plan is not good medical insurance for you, an HSA is generally off the table.

So, that leaves the HSA as a fantastic option for those who qualify for and use a high deductible health plan (and usually an option that should be part of a comprehensive financial plan if you use a HDHP). But it also means that the HSA is not quite as good as a tool for the combination of retirement saving and emergency planning. 

Conclusion

Assuming that an individual (a) has retirement planning and emergency preparedness as financial planning objectives and (b) is not in a position where legal liabilities would cripple them without ERISA creditor protection, it is hard to argue against having at least some material amount in a Roth IRA. 

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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.