Tag Archives: Roth versus Traditional

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.

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.

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.

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 VAT	No VAT	5% VAT	5% VAT
IRA Type	Amount Needed	Income Tax Due	Amount Needed	Income 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

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

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.

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.

Not all emergencies will look exactly like the Coronavirus emergency, and many of them will be individual emergencies, not global pandemics. The best, most accessible type of tax advantaged retirement account for an emergency is generally a Roth IRA. And it may be the case that your emergency fund is not sufficient to tide you over, so having that Roth IRA backup can be very valuable.

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 high income tomorrow (even in the FI community). And even if you anticipate being in a lower tax bracket tomorrow than you are today (a) that is simply a guess (we don’t know what future tax rates will be) and (b) you still benefit from the emergency access and years of tax free growth that a Roth IRA provides.

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.

Every American working adult should ask whether they have a Roth IRA, and if they do not have one, they should ask why that is. All working adults should strongly consider a Roth IRA contribution, a Backdoor Roth IRA, and/or a Roth conversion in 2020.

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.

From Tax Returns to Tax Planning

Many colloquially refer to the Winter and early Spring as “tax season.” To my mind, that is short sighted. Yes, for most the time from late January to mid-April are when their tax return is prepared and filed. But the most impactful tax work is not tax return preparation — it’s tax planning!

Below I discuss ways to use your current tax return as a springboard to tax planning.

Before we get started, two notes. First, there is some tax planning that can be “do it yourself” and some tax planning that is best considered and implemented with the help of a tax planning professional. When in doubt, the concept is probably the latter. Second, it is helpful to keep in mind the correct use of this blog or any other blog–as a tool to raise awareness. Blogs are not a substitute for professional advice, and are not advice for any particular person. Rather, this post and others should be viewed as a way to increase knowledge and help faciliate more informed conversations with professionals.

Your 2020 Tax Return

Your 2020 tax return is a great springboard for tax planning. Look at the following items on your tax return to jump start your tax planning.

Schedule D Line 13 Capital Gain Distributions

Everyone should review their own tax returns for the past few years and look at this line. If there is a substantial number on this line, it should raise a red flag.

I previously discussed capital gain distributions here. Generally, they come from mutual funds and ETFs in taxable accounts. These financial securities pass gains out to the shareholders, creating capital gains income on the shareholders’ tax returns. Actively managed funds tend to have much greater capital gain distributions than passively managed index funds.

The planning opportunity is to review the accounts that are generating significant capital gain distributions. If the realized gain in such accounts is low (or if there is a realized loss in those accounts), it might be advisable to sell the holding and replace it with a fund likely to have lower capital gain distributions. Taxpayers considering this strategy should be sure to fully understand the gain or loss in the securities before selling. Financial institutions do not have to report to investors (and the IRS) basis in mutual funds purchased prior to 2012, so sometimes it can be difficult to determine the taxable built-in gain or loss on older holdings.

Form 8889 Line 14c Distributions

Form 8889 is the tax return form for a FI favorite: the health savings account. Amounts other than $0 on Line 14c of Form 8889 should appear, in my opinion, only if the taxpayer is elderly or found themselves in a dire situation during the tax year. It is generally not optimal, from a tax perspective, to take distributions from an HSA to fund medical expenses when one is neither elder nor in a dire situation.

Amounts other than $0 on Line 14c can be a learning and planning opportunity. Future routine medical expenses are usually best paid from one’s checking account (a regular taxable account), and taxpayers should save the receipt. In the future, taxpayers can reimburse themselves tax free from their HSA for that expense. In the meantime, the money has grown in the HSA and enjoyed many years of tax free compounding.

Form 1040 Line 4b IRA Distributions Taxable Amount

Taxpayers who did a Backdoor Roth IRA and have a large amount on Line 4b of Form 1040 should review their transactions to make sure everything was correctly reported. Part of the idea behind a Backdoor Roth IRA is that, if properly executed, it should result in a very small amount of taxable income (as indicated on Line 4b).

It may be the case that the tax return improperly reported the Backdoor Roth IRA (and thus, the taxpayer should amend their return to obtain a refund). Or, it may be the case that the taxpayer did the steps of the Backdoor Roth IRA at a time they probably should not have (because they had a significant balance in a traditional IRA, SEP IRA, or SIMPLE IRA).

Discovering the problem can help effectively plan in the future, and if necessary take corrective action.

For those executing Roth Conversion Ladders, a large amount on Line 4b is the equivalent of Homer Simpson’s Everything OK Alarm. Roth Conversion Ladders are intended to create a significant amount of taxable income, and Line 4b is where that income is reported on Form 1040. Note further that all Roth IRA conversions require the completion of Part II of the Form 8606.

Schedule A Line 17 Total Deductions

Those who claimed itemized deductions in 2020 should review Line 17 of Schedule A. Is the number reported for the total itemized deductions close to the standard deduction amount (for 2021, single taxpayers have a standard deduction of $12,550 and married filing joint taxpayers have a standard deduction of $25,100)?

If so, there a tax planning opportunity. Why is that number what it is? Is it because of charitable contributions? If so, the donor advised fund might be a good opportunity. Here’s how it might work:

Example: Joe and Lisa file married filing joint. In 2020, they itemized based on $10K of state taxes, $9K of mortgage interest, and $6K of charitable contributions ($500 a month to their church). Thus, at $25,000 of itemized deductions, they were barely over the threshold to itemize. In 2021, they move a sizable amount into a donor advised fund ($25,000). They use the donor advised fund to fund their 2021, 2022, 2023, and 2024 monthly church donations.

From a tax perspective, Joe and Lisa itemize in 2021 (claiming total deductions of $44K – the state taxes, mortgage interest, and a $25K upfront deduction for contribution to the donor advised fund). In 2022, 2023, and 2024, they would claim the standard deduction, which is (roughly speaking) almost equivalent to their 2020 itemized deductions.

By using the donor advised fund, Joe and Lisa get essentially the same deduction in 2022 through 2024 that they would have received without the donor advised fund, and they get a tremendous one year increase in tax deductions in 2021.

Form 8995 or Form 8995-A Line 2

Those with any amount on Line 2 of the Form 8995 or the Form 8995-A should likely consider some tax planning. This line indicates that the taxpayer has qualified trade or business income that may qualify for the new Section 199A qualified business income deduction. Taxpayers in this situation might want to consider consulting with a professional, as there are several planning opportunities available to potentially increase any otherwise limited Section 199A qualified business income deduction.

2021 Adjusted Gross Income Planning to Maximize Stimulus Payments

Taxpayers should review line 11 (adjusted gross income or “AGI”) on their Form 1040 in concert with reviewing their stimulus checks. For those taxpayers who did not receive their maximum potential stimulus payments in 2021, there can be opportunities to lower AGI so as to qualify for additional stimulus payments and/or increased child tax credits. I blogged about one planning opportunity in that regard here.

The Shift to Tax Planning

Tax planning can take many shapes and sizes. But it needs to be driven by goals, not by tactics. Bad tax planning begins something like this: “I need a Solo 401(k), how do I set it up?” N.B. Opening a Solo 401(k) when you do not qualify for one is a great way to create a tax problem for yourself.

Good tax planning begins more like this: “I want to achieve financial independence. How do I best save for retirement in a tax advantaged way? I’ve heard a Solo 401(k) is a great option. As part of this process, we should consider it as a possible way to help me achieve my goal.”

Another point: I find there is far too much focus on “I had to pay [insert perceived sizable amount here] this year in taxes” and far too little focus on lifetime taxes. To my mind, the goal should not be to pay less tax in any one year. Rather, the goal should be to legitimately reduce lifetime tax burden. Sure, there can be tax planning that does both, but the best tax planning (whether DIY or with the help of a professional) places reducing lifetime tax burden as its primary goal.

Below are just some areas where taxpayers can begin their tax planning considerations.

Retirement Planning

This is a big one. Taxpayers should understand whether they contribute to a traditional IRA and/or Roth IRA, and why or why not. This post helps explain whether taxpayers qualify to make an annual contribution to a traditional IRA and/or a Roth IRA.

Taxpayers should consider their workplace retirement plans, which can provide several planning opportunities.

Small Business/Self-Employment Income

For those with a small business and/or significant self-employment income, tax planning is very important. I have written several posts about just some of the tax planning available to those with small businesses. People with small businesses often benefit from professional, holistic tax and financial planning.

Stock Options

Stock options and employer stock grants provide some good tax planning opportunities. I’ve previously written about ISOs, but all kinds of stock option programs can be an opportunity to do some tax planning, which often should be with a professional advisor.

Conclusion

Filing timely, accurate tax returns is important. But the best way to optimize one’s tax situation is to do quality, intentional tax planning. Tax planning should prioritize goals over tactics. There is some tax planning that can be done by yourself, but many areas of tax planning strongly benefit from professional assistance.

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.

Health Savings Accounts

Health savings accounts (“HSAs”) are a tremendous wealth building tool. For healthy individuals and families, a health savings account paired with a high deductible health plan (“HDHP”) can be a great way to manage medical costs and grow tax advantaged wealth.

HSA Basics

A health savings account is a tax advantaged account. Contributions to an HSA are tax deductible. The interest, dividends, capital gains, and other income generated by assets in an HSA is not currently taxable (the same as with a 401(k) or IRA). If withdrawn for qualified medical expenses (or to reimburse the owner for the payment of qualified medical expenses), withdrawals from an HSA are not taxable.

The HSA combines the best of a traditional retirement account (deductible contributions) and the best of Roth retirement accounts (tax-free withdrawals) if done properly.

The annual HSA contribution limits (including both employer and employee/individual contributions) are $3,650 for an individual HDHP and $7,300 for a family HDHP in 2022. Those aged 55 or older can make annual catch-up contributions of an additional $1,000 to their HSA.

HSA Eligibility

Who is eligible to contribute to an HSA? Only those currently covered by a high deductible health plan. As a general matter, a high deductible health plan is medical insurance with an annual deductible of at least $1,400 (for individuals) or $2,800 (for families) (using 2021 numbers). The insurance plan document should specifically state that the plan qualifies as a high deductible health plan. You must be covered on the first day of the month in order to contribute to a HSA in that month.

Once you cease to be covered by a HDHP, you keep your HSA and can use the money in it. The only thing you lose is the ability to make further contributions to the HSA.

HDHPs may not be a good insurance plan if you have certain chronic medical conditions or otherwise anticipate having high medical expenses. But if you are relatively healthy, HDHPs often make sense, particularly if you are young.

There are some other eligibility requirements. Those also covered by other medical insurance plans, those enrolled in Medicare, and those who can be claimed as a dependent on someone else’s tax return are not eligible to contribute to a HSA.

Benefits of an HSA

Tastes Great and Less Filling

If done right, an HSA is a super-charged tax advantaged account. You get a deduction on the front end (when the money is contributed to the HSA), tax free growth, and no taxation if the money is used for qualified medical expenses or to reimburse the owner for qualified medical expenses.

There’s no need to debate traditional versus Roth with an HSA. If done right, you get both!

HSA Payroll Tax Benefit

As a tax planner, this is one of my favorite benefits. There are many ways to legally reduce income taxes. Reducing payroll taxes, on the other hand, is more difficult.

If you fund your HSA through payroll withholding, amounts contributed to the HSA are excluded from your salary for purposes of determining your Social Security and Medicare taxes. This results in saving on payroll taxes. HSA contributions enjoy this benefit while 401(k) elective deferrals do not.

Note that to qualify for the HSA payroll tax break, you must contribute to your HSA through payroll withholding. If, instead, you contribute through a direct personal contribution to your HSA, you do not get to deduct the contribution from your Social Security and Medicare taxable income, though you still get a federal income tax deduction for such contributions.

Employer Contributions

Many employers offer a contribution to your HSA account. Often these employer contributions are a flat amount, such as $650 or $700 annually. This amounts to essentially free money given to you in a tax advantaged manner.

Lower Insurance Costs

A great benefit of the combination of HDHPs and HSAs is lower medical insurance premium payments. By insuring with an HDHP, you usually save significant amounts on medical insurance.

The healthier you are and the wealthier you are, the less financial protection you need against unanticipated medical expenses. Thus, HDHPs are often a good option for those fortunate enough to be relatively healthy and/or wealthy.

Higher deductibles reduce the premium. The trade-off is that you self-fund more of your medical expenses. If those medical expenses are modest, the combination of saving on insurance premiums and the tax benefits can more than make up for the (potentially) higher medical expenses.

HSA Reimbursements

Take note of when you first establish your HSA. Qualifed medical expenses incurred on that date or later can be reimbursed from your HSA.

Why is this important? Because if you track your qualified medical expenses, you can build up years of expenses that you can reimburse yourself, tax-free, from your HSA. There is no time limit to pay yourself a tax-free reimbursement from your HSA. Here is an example:

Keith established an HSA in 2011, when he was 30 years old. In 2015, he had a medical procedure and his total qualified medical expenses were $4,000. In 2018, Keith had $500 worth of qualified medical expenses for two medical appointments. In 2019, Keith had $3,500 in qualified medical expenses for a procedure and various doctors’ appointments.

Assuming Keith had sufficient funds in taxable accounts when he incurred these expenses, Keith should (a) use those taxable funds to pay his medical expenses, (b) track his qualified medical expenses, and (c) after the money has had many years of tax-free growth, Keith should reimburse himself from his HSA for some or all of these $8,000 worth of qualified medical expenses.

Unless you are financially strapped or in a dire medical situation, you should strive to use taxable funds to pay current medical expenses and allow the funds in your HSA to enjoy years, possibly decades, of tax-free growth. With no time limit on HSA reimbursements, you can access the funds later in life tax-free.

Note, however, that in the relatively rare cases where a taxpayer deducts medical expenses on their income tax return, expenses paid with HSA money cannot be deducted. In addition, if you have previously deducted medical expenses, those expenses are not “qualified medical expenses” that can be reimbursed tax-free from an HSA. Deducing medical expenses is rare because you can only deduct medical expenses if (i) you itemize your deductions and (ii) to the extent your medical expenses exceed 7.5 percent of your adjusted gross income (“AGI”).

No RMDs

Every tax advantaged retirement account (other than the Roth IRA) is subject to required minimum distributions (“RMDs”) during the account owner’s lifetime. HSAs, fortunately, are not subject to RMDs. They provide incredible flexibility for your financial future, particularly when you carefully track your reimbursable qualified medical expenses for many years.

Qualified Medical Expenses

Qualified medical expenses are generally those expenses that qualify for the medical expense deduction. While this itself could be its own blog post, you can look to IRS Publication 502, which details which expenses qualify.

Some items that you might not immediately think of, but are qualified medical expenses, are COBRA insurance premiums and Medicare Part B, Part D, and Medicare Advantage premiums. So if you ever pay COBRA premiums, it is great to pay them out of taxable accounts and keep a tally of the payments you made. Years later you can reimburse yourself for those premiums tax-free from your HSA (assuming you established the HSA prior to paying the COBRA premiums and you did not claim the COBRA premiums as an itemized deduction).

Taxation of Non-Medical Withdrawals

If you are under age 65, withdrawals from HSAs that are not used for qualified medical expenses are subject to income tax and subject to an early withdrawal penalty of 20 percent.

If you are under age 65, you can avoid these harsh tax results for an HSA withdrawal if you can find prior qualified medical expenses you can reimburse yourself for, and apply the withdrawal against those prior expenses. If such expenses do not exist, you can roll the money back into the HSA within 60 days (a 60-day rollover). Note you are limited to only one 60-day rollover during any 12 month period.

If you are age 65 or older, you are no longer subject to the 20 percent early withdrawal penalty. Withdrawals that are not for qualified medical expenses (or reimbursements thereof) are subject to income tax (in the same way a traditional IRA withdrawal would be).

At age 65, an HSA remains an HSA and also becomes an optional IRA (in effect) without RMDs. This, combined with the ability to use HSA funds to pay Medicare Part B, Part D, and Medicare Advantage premiums tax-free, make an HSA a great account to own if you are age 65 or older.

The Biggest HSA Mistake

Think twice before taking money out of an HSA!

An HSA and the investments in it can be analogized to an oven and a turkey. The HSA is like the oven. The investments are like the turkey. Putting the turkey in the oven is great. But it needs sufficient time to roast. If you take the turkey out of the oven too soon, you spoil it! The investments in your HSA are similar. They need time to bake tax-free in the HSA. If you take them out too soon, you spoil it!

Only the elderly, the financially strapped, and those facing medical emergencies and crises should withdraw HSA funds. Everyone else should keep money in an HSA to grow tax-free. If you are not in one of three listed categories, you should think long and hard before paying medical expenses with HSA money.

Why waste the tremendous tax benefits of an HSA for minor, non-emergency medical expenses? Doing so is the biggest HSA mistake. Pay those expenses out of pocket, track them, and years later reimburse yourself tax-free from your HSA after the funds have grown tax-free for decades!

The only potential way to correct this mistake is to do a 60-day rollover of the withdrawn amounts back into an HSA. Note that rollovers are limited to one per any 12 month period. Other than the 60-day rollover, the mistake is not correctable.

The Second Biggest HSA Mistake

The second biggest HSA mistake is not investing a significant percentage of your HSA funds in equities and/or bonds. According to this report, only four percent of HSAs had balances invested in something other than cash as of the end of 2017. Not good!

While I never provide investment advice on the blog, I do discuss the tax location of assets, in a general sense (not as applied to any particular investor). Cash is not a great asset to hold in an HSA. With today’s low interest rates, cash generates little in interest income. HSAs offer tax-free interest, dividends, capital gains, and growth! That makes them great for high growth, high income assets. Why waste that incredibly favorable tax treatment on very low-yielding cash?

I call this the second biggest mistake (not the first) because unlike the first mistake, this mistake is easily correctable.

Of course, investors must evaluate their HSA investment options and their own individual circumstances to determine if the other investments are preferable to cash based on their particular circumstances.

State Treatment of HSAs

Two states do not recognize HSAs: California and New Jersey. For purposes of these two states, HSAs are simply taxable accounts. On California and New Jersey state income tax returns (a) there is no deduction/exclusion for HSA contributions, (b) interest, dividends, and capital gain distributions generated by HSA assets are taxable, (c) sales of assets in a HSA generate taxable capital gains and losses, and (d) nonqualifying withdrawals of money from an HSA have no tax consequence.

Tennessee and New Hampshire do not impose a conventional income tax. But they do tax residents on interest and dividends above certain levels. Interest and dividends generated by HSAs are included in the interest and dividends subject to those taxes.

HSAs and Death

This is the good news/bad news section of the article.

First, the good news: HSAs are great assets to leave (through a beneficiary designation form) to a spouse or to a charity. If you leave your HSA to your spouse, he or she inherits it as an HSA and can use it (and benefit from it) just as you did. Charities also make for great HSA beneficiaries. They can use the money in the account and pay no tax on it. You will need to work with your financial institution to ensure the beneficiary designation form properly captures the charity as the intended beneficiary.

The bad news: HSAs are terrible assets to leave to anyone else. If you leave an HSA to a non-spouse/non-charity, the recipient includes the entire balance of the HSA in their taxable income in the year of your death.

Conclusion

With a little planning, an HSA can be a great asset to own, and can provide tremendous tax-free benefits. Generally speaking, time is a great asset if you own an HSA. Let your HSA bake tax-free for many years and you will be happy to receive tax-free money later in life to pay for medical expenses or as a reimbursement for many years of previous medical expenses.

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

Follow me on Twitter: @SeanMoneyandTax

SEP IRA Versus Solo 401(k)

If you qualify for both a SEP IRA and a Solo 401(k), is there a clear winner? In the past, it was often the case that the tax benefits of a SEP IRA and a Solo 401(k) were similar, particularly if you also had access to a 401(k) plan at a full-time employer. Today the landscape has changed, and in most cases, there’s a clear winner.

This post discusses whether a SEP IRA or a Solo 401(k) is better in situations where the self-employed person qualifies for both plans.

Note that both plans have eligibility requirements. For example, under the tax rules, if you employ anyone other than your spouse for 1,000 hours or more during the year you are ineligible for a Solo 401(k). There are additional tax rules and separate (and additional) plan rules to consider to determine if you are eligible for a particular SEP IRA and/or Solo 401(k).

The Basics

Both the SEP IRA and the Solo 401(k) are self-employed retirement plans. They can be established by legal entities (in this context, often S corporations) or they can be established by individuals that have self-employed income. That self-employment income generally must come through a sole proprietorship or through a limited liability company (“LLC”) that is disregarded for tax purposes and reported on a Schedule C filed with the individual’s tax return.

SEP IRAs

A SEP IRA allows only “employer” contributions. For this purpose, your own sole proprietorship or disregarded LLC can be your employer.

Generally, the employer can make annual contributions of up to 25 percent of eligible W-2 compensation (from a corporation) or 20 percent of an individual’s self-employment income, limited to $66,000 of contributions in 2023.

Today, many financial institutions (including Fidelity, Schwab, and Vanguard) offer low-cost SEP IRA options.

A SEP IRA can be established for a tax year by the deadline for filing that tax year’s tax return, including extensions.

The administrative compliance burden of a SEP IRA is generally very manageable.

History of the SEP IRA vs. the Solo 401(k)

Watch me discuss the history of both the SEP IRA and the Solo 401(k).

Solo 401(k)s

A Solo 401(k) (sometimes referred to as an “Individual 401(k)”) is a 401(k) plan established by a self-employed individual for their own benefit.

The main advantage of the Solo 401(k) is that it allows annual contributions by the self-employed individual in his/her role as the “employee” and annual contributions by the self-employed individual (or S corporation) in his/her role as “employer.”

Employee contributions are limited to the lesser of earned income or $22,500 ($30,000 if 50 or older) in 2023. Employer contributions are limited to up to 25 percent of eligible W-2 compensation (from a corporation) or 20 percent of an individual’s self-employment income, limited to $66,000 of contributions in 2023. Total employee and employer contributions are limited to $66,000 ($73,500 if age 50 or above) in 2022.

Today, many financial institutions (including Fidelity, Schwab, and Vanguard) offer low-cost Solo 401(k) options.

The administrative compliance burden of a Solo 401(k) is generally very manageable, but note that once there are more than $250,000 in the plan and/or the plan is closed, a Form 5500-EZ must be filed.

The Clear Winner

At this point, you might be saying, “Great, both the SEP IRA and Solo 401(k) are attractive. Is there really a big difference between them? Should I care too much about which plan I establish?”

The answer is that in most cases, the Solo 401(k) is the much better option for a self-employed person. If you are considering a SEP IRA over a Solo 401(k) in a situation where you qualify for both, you ought to think twice about that decision.

Here are the main reasons why the Solo 401(k) is much better than the SEP IRA in most cases.

Employee Contributions

The Solo 401(k) allows employee contributions. If your self-employment income is relatively modest, this greatly increases the amount you could contribute. For example, if Jane, under age 50, has a side-hustle that earns her $10,000 in 2023 after the deduction for one-half of self-employment taxes is accounted for, her maximum Solo 401(k) contribution is $10,000, while her maximum SEP IRA contribution is only $2,000 (20% of $10,000).

Note that this assumes that Jane has contributed $12,500 or less to a workplace 401(k) or similar retirement plan. Using the 2023 limitations, $22,500 is the maximum total employee deferrals Jane can make to her 401(k) and similar plans, so Jane’s other employer retirement accounts should also be considered.

Section 199A and 80% Deductions

I have previously written about the new Section 199A qualified business income (“QBI”) deduction and its impact on self-employed retirement plans. Traditional contributions to both Solo 401(k) plans and SEP IRAs create, for many taxpayers, deductions that are only “80% deductions.” Here is an example.

After self-employment taxes, Joe, a single taxpayer, earns $120,000 from his sole-proprietorship. Joe makes a 10 percent employer contribution ($12,000) to either his Solo 401(k) or SEP IRA. In the 24 percent marginal tax bracket, he expects to save $2,880 ($12,000 times 24%) on his federal income taxes. He is surprised to learn that he only saved $2,304 on his federal income taxes.

How is that possible? While Joe is correct that he receives a $12,000 retirement plan contribution tax deduction, he failed to consider that he lost $2,400 of his QBI deduction. A traditional Solo 401(k) contribution and a SEP IRA contribution is an 80% deduction. In Joe’s case, he received a net federal income tax deduction of only $9,600 (80 percent of $12,000).

Why then would Joe prefer a Solo 401(k) to a SEP IRA? Because the Solo 401(k) gives him a planning option that avoid the 80% deduction issue. Instead of making traditional contributions to a Solo 401(k), Joe can make Roth employee contributions to a Solo 401(k).

Note further that Joe could possibly implement Mega Backdoor Roth IRA planning by making after-tax contributions to his Solo 401(k). Many Solo 401(k) plans do not offer this option, but some do.

The SEP IRA does not offer these options.

Not all financial institutions offer the Roth Solo 401(k) and the after-tax Solo 401(k) contribution options. It is important to understand the features of any particular Solo 401(k) before you adopt it as your plan.

For upper income taxpayers, the 80% deduction phenomenon may not be an issue, considering that the ability to claim the QBI deduction is reduced or eliminated above certain income thresholds. These taxpayers need not prefer the Solo 401(k) to a SEP IRA for QBI deduction reasons, but may prefer to have the increased planning ability, such as the ability to make Roth and/or after tax contributions to the Solo 401(k) that a SEP IRA does not offer. They may also prefer the Solo 401(k) for the reasons discussed below.

Backdoor Roth IRA Planning

The Backdoor Roth IRA is a great planning tool. But the Pro-Rata Rule can cause significant snags. For example, if you execute the two independent steps of a $6,500 Backdoor Roth IRA in a year when you have a separate significant traditional IRA, SEP IRA, or SIMPLE IRA at year-end, you will cause most of the Backdoor Roth IRA to be taxable.

The SEP IRA is a significant roadblock to the ability to execute an efficient Backdoor Roth IRA. A Solo 401(k) does not cause this problem with the Backdoor Roth IRA. For this reason alone many will want to choose a Solo 401(k) instead of a SEP IRA, even if they plan on making traditional deductible contributions to the plan.

Catch Up Contributions

If you are age 50 or older, you can make up to $7,500 (in 2022) in catch up employee contributions to a Solo 401(k).

This option does not exist for a SEP IRA. Thus, for high earning self-employed persons age 50 or older, a Solo 401(k) has an additional advantage over the SEP IRA.

Solo 401(k) Book

This post was originally published in 2019. In 2022 I published Solo 401(k): The Solopreneur’s Retirement Account, a book that goes into much more depth about Solo 401(k)s.

Conclusion

If you qualify for both, generally the Solo 401(k) is better than a SEP IRA. If you are going with a SEP IRA over a Solo 401(k), you should understand the reasons for doing so. Finally, self-employed retirement plans is an area that taxpayers usually benefit from receiving personal advice from a qualified tax advisor.

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

Follow me on Twitter at @SeanMoneyandTax

Understanding Your 401(k)

As an employee, your employer’s 401(k) plan can be your most important wealth building tool. Understanding how it functions will help you build your wealth in a tax efficient manner.

The Plan

A 401(k) plan is established by an employer. The employer provides the account, the account administration, and the investment choices. Usually, the investment options include a menu of stock and bond mutual funds and/or similar investments. In some plans, employer stock is one of the investment choices.

While the employer administers the plan, most of the assets in the plan (see Vesting below) belong the employees in individual accounts. Therefore, the employees, not the employer, enjoy the benefits and burdens of the economic appreciation and/or depreciation of the investments.

Creditor Protection

401(k) plans are subject to a host of rules, most of which (from a practical perspective) are the concern of the employer, not the employee. One important benefit of the rules for employees is that under ERISA, assets in a 401(k) plan are generally protected from creditors. During your lifetime only two creditors can access assets in your 401(k): the IRS and an ex-spouse.

Vesting

Contributions to a 401(k) made by the employee (referred to as “employee deferrals” and “after-tax contributions” — see numbers 1 and 3 below) are always immediately “100% vested.” This means that regardless of whether the employee leaves the employment of the employer tomorrow, he or she owns the money he or she contributed to the 401(k) and any related growth.

However, contributions to a 401(k) account made by the employer may be subject to a vesting schedule. Simply put, vesting means amounts become the property of the employee after the employee has been employed by the employer for a certain period of time.

Some plans use a gradual vesting schedule. The least generous of these is as follows:

Years of Service	Vesting Percentage
2	20%
3	40%
4	60%
5	80%
6	100%

More generous (i.e., quicker) vesting is permissible.

Some plans use a “cliff” vesting schedule. This means that employer contributions go from 0% vested to 100% vested when the employee has been employed for a certain period. The longest permissible period is 3 years.

The growth associated with employer contributions is also subject to vesting.

Vesting incentivizes staying with the same employer for a sufficient period of time to capture all of the employer contributions to a 401(k) plan. It can also incentivize returning to a former employer if you have worked a number of vested years of service for them.

Some plans provide for 100% immediate vesting for employer contributions as well as employee contributions.

Contributions

There are five types of contributions to 401(k) plans, listed below in order of their prevalence (employee deferrals being the most prevalent).

1. Employee Deferrals

Employees can contribute, through payroll withholding, a portion of their salary to a 401(k) plan. All 401(k) plans offer “traditional” contributions, meaning employees can contribute amounts to the 401(k) plan and exclude those amounts from their taxable income for the year. Some plans, but certainly not all plans, also offer “Roth” contributions, which are not excludible from taxable income, but, if properly withdrawn, can be tax free in the future when withdrawn.

Employee deferrals are the only type of contribution to a 401(k) plan that can be done as a “Roth” contribution. All other contributions are “traditional” contributions.

Read here for more on the desirability of Roth contributions compared to traditional contributions.

Neither traditional nor Roth contributions reduce the amount of income subject to payroll (i.e., Social Security and Medicare) taxes.

2. Matching Contributions

Matching contributions are one of the most powerful ways employees can build wealth. Previously, I have written that if you participate in a 401(k) plan with an employer match, you must make it your top wealth building priority to contribute at least enough to your 401(k) to secure all of the employer match.

How does it work? Different employers have varying matching programs. There are two components: 1) the percentage of salary that is matched, and 2) the percentage of the match.

Here is an illustrative example:

Example 1: Elaine Benes works for Pendant Publishing. She is under 50 years old and earns $100,000 in annual W-2 wages. Pendant Publishing matches 100 percent of employee contributions up to 3 percent of salary, and matches 50 percent of employee contributions for the next 2 percent of salary. Based on this matching program, Elaine would be a fool not contribute at least 5 percent of her salary to Pendant Publishing’s 401(k) plan. Doing so will earn her $4,000 of matching contributions from Pendant Publishing on her $5,000 of employee contributions.

Employers vary in terms of when they match contributions. Some employers match employee contributions only once a year (usually at or after year-end). Other employers match employee contributions each pay period. If you work for an employer that does so, you need to be careful not to max-out your 401(k) early in the year, as each pay period requires an employee 401(k) contribution in order to obtain the match. Here is an example:

Example 2: The facts are the same as Example 1. In addition, Pendant Publishing’s matches 401(k) contributions every pay period, and has 24 pay periods per year. Elaine believes it is a good idea to accelerate her 401(k) contributions, and thus contributes $3,750.00 of her salary for each of the first 6 pay periods of the year ($22,500 total) and makes no contributions the rest of the year. For those 6 pay periods she receives an employee match of $166.67 each pay period ($100,000 divided by 24 times 4 percent) for a total annual match of $1,000. By doing this, Elaine misses out on $3,000 of her potential employer 401(k) match, because for the next 18 pay periods, she contributes nothing to her 401(k).

Some 401(k) plans adjust for this and would fully match Elaine’s contribution (in her case, by adding $3,000 to her 401(k) plan), but many do not. In Elaine’s case, she should have stretched out her contribution such that she contributed at least 5 percent of each pay period’s paycheck to her 401(k).

Note that employers are not required to provide a matching program. There are some employer 401(k) plans that provide no match at all.

Tax Treatment: Employer match contributions are traditional contributions. They are not subject to income tax when added to your 401(k), but they will be in the future when withdrawn (as will the growth on matching contributions). Matching contributions are not subject to payroll taxes.

3. After-Tax Contributions

Some 401(k) plans allow for employees to make so-called after-tax contributions to their 401(k) through payroll withholding. These contributions are not excluded from the employee’s taxable income, but do create basis in the 401(k) account. After-tax contributions are what make Mega Backdoor Roth IRA planning possible. Unless one is engaging in Mega Backdoor Roth IRA planning, in most cases after-tax contributions are not advisable.

Tax Treatment: After-tax contributions do not reduce the employee’s taxable income (for both income tax and payroll tax purposes). In the future after-tax contributions are taxable to the employee as withdrawn, but the employee can use the created basis to reduce the income inclusion. Depending on how the 401(k) account is disbursed, that basis recovery may be subject to the Pro-Rata Rule.

4. Profit-Sharing Contributions

Some 401(k) programs have a profit-sharing program, whereby the employer contributes additional amounts to each employee’s 401(k) account based on a formula.

Tax Treatment: Profit-sharing contributions are traditional contributions and are treated in the same manner as matching contributions, including being exempt from payroll tax.

5. Forfeitures

Because of vesting, employees forfeit unvested amounts in their 401(k)s when they leave the employer’s employment prior to fully vesting in the 401(k). When that happens, the unvested amounts must be accounted for. In some plans, the unvested amounts are used to offset plan administrative costs. In other plans, forfeited amounts are added to the remaining participants’ accounts.

Tax Treatment: Forfeitures are traditional contributions and are treated in the same manner as matching contributions, including being exempt from payroll tax.

Contribution Limits

Contribution limits get a bit complicated because there are two distinct 401(k) plan contribution limits, not one. Numerical limits are updated annually by the IRS to account for inflation. The numbers provided below are the numbers for 2023.

Employee Deferrals

There is an annual employee deferral limitation. For 2023, that limit is the lesser of $22,500 or total compensation (if under age 50) and the lesser of $30,000 or total compensation (if 50 or older). The limit applies to Roth employee contributions, traditional employee contributions, or any combination thereof.

This limit is per person, not per employer. Thus, those with side hustlers must coordinate employee deferrals to their large employer 401(k) plan with employee deferrals to their Solo 401(k). I discuss this topic in detail in my book, Solo 401(k): The Solopreneur’s Retirement Account.

All Additions

There is a second, less understood limitation on 401(k) contribution. The annual limit for all additions to 401(k) and other employer retirement accounts is the lesser of $66,000 or total compensation (if under age 50) and the lesser of $73,500 or total compensation (if 50 or older).

The all additions limit applies to the sum of numbers 1 through 5 above (employee deferrals through forfeitures) plus a sixth amount. The sixth amount is the amount which is contributed by your employer to another qualified retirement plan account on your behalf.

Some employers offer additional qualified retirement plans. These plans often provide for a contribution to an account by the employer based on a stated percentage of compensation. Employers use various names for these plans. Contributions may be subject to vesting and are traditional contributions that are not subject to payroll tax.

The all additions limit applies per employer, not per employee as the employee deferrals limit does.

Watch me discuss the all additions limit on YouTube.

Auto Enrollment

Many employers now auto-enroll new employees in a 401(k) plan. This has two components: contribution level and investment choice. In most cases, new employees should not simply settle for auto-enrollment. When you start a job, you should review your new 401(k) plan and make informed decisions regarding contribution level and investment choice.

Contribution Level

Auto-enrollment will set a contribution level. Not all employers set the contribution level at a level that maximizes employer matching. Even if the automatic contribution level is set at a level that maximizes the employer match, that level might not be the appropriate level for any particular person.

Investment Selection

Plans typically have a default investment plan for new 401(k) participants. It is best to review your investment options when you start a new job and select an appropriate investment allocation for your circumstances.

Withdrawals from Traditional 401(k)s

When a taxpayer is 59 ½ years old or older, they can withdraw amounts in a traditional 401(k) penalty free. Withdrawals are included in taxable income as ordinary income. Beginning at age 72, taxpayers must take out a required minimum distribution (“RMD”) for each year. The RMD is computed based on IRS tables.

If a taxpayer withdraws money from a 401(k) prior to age 59 ½, the withdrawal is not only taxable, it is subject to a 10 percent early withdrawal penalty, unless a penalty exception applies.

Taxpayers may transfer amounts in a 401(k) to another 401(k) to an IRA. Amounts in traditional 401(k)s and IRAs can be converted to Roth accounts. Such conversions create taxable income, but are not subject to the early withdrawal penalty.

Conclusion

Your workplace 401(k) plan is a vitally important wealth building tool. It is important to be an informed user of your 401(k) in order to build tax advantaged wealth.

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

Follow me on Twitter: @SeanMoneyandTax

The Backdoor Roth IRA

The Basic Backdoor Roth IRA and the Form 8606

Example 1

The Pro-Rata Rule and December 31st

Example 2

Example 3

Pro-Rata Rule Clean Up

Implementation

Tax Issues

Mega Backdoor Roth

Backdoor Roth IRA Tax Return Reporting

Conclusion

Further Reading

The Value Added Tax

Roths and the VAT

Traditional Versus Roth with a VAT

Roth Versus Taxable with a VAT

Planning

Conclusion

Qualified Charitable Distributions

Important QCD Considerations

Take QCDs Early

No Trinkets

QCDs Available Only from Traditional IRAs

QCD Age Requirement

Inherited IRAs

QCDs For Those Age 70 ½ and Older

QCDs and the Pro-Rata Rule

QCDs for Those Under Age 70 ½

Conclusion

Traditional 401(k) versus Roth 401(k)

Roth 401(k) Contributions

Roth 401(k) Contributions: Income Limits

Matching Contributions

Roth 401(k) Withdrawals

Conclusion

Further Reading

Tax Free Growth

Ease of Administration and Withdrawal

Tax Free Withdrawals of Contributions

Tax Free Withdrawals of Sufficiently Aged Converted Amounts

No Required Minimum Distributions

Creditor Protection

A Sneaky Way to Contribute More to Your Retirement

A Great Account to Leave to Heirs

Compare with Other Retirement Accounts

Financial Planning Objectives

Retirement Accounts and Emergencies

When a Roth IRA Doesn’t Make Sense

Health Savings Accounts

Conclusion

Your 2020 Tax Return

Schedule D Line 13 Capital Gain Distributions

Form 8889 Line 14c Distributions

Form 1040 Line 4b IRA Distributions Taxable Amount

Schedule A Line 17 Total Deductions

Form 8995 or Form 8995-A Line 2

2021 Adjusted Gross Income Planning to Maximize Stimulus Payments

The Shift to Tax Planning

Retirement Planning

Small Business/Self-Employment Income

Stock Options

Conclusion

HSA Basics

HSA Eligibility

Benefits of an HSA

Tastes Great and Less Filling

HSA Payroll Tax Benefit

Employer Contributions

Lower Insurance Costs

HSA Reimbursements

No RMDs

Qualified Medical Expenses

Taxation of Non-Medical Withdrawals

The Biggest HSA Mistake

The Second Biggest HSA Mistake

State Treatment of HSAs

HSAs and Death

Conclusion

The Basics