Tag Archives: SEP IRA

Backdoor Roth IRAs for Beginners

If you read enough FI blogs, you will eventually come across the term “Backdoor Roth IRA.” This post answers the question “What’s the deal with Backdoor Roth IRAs?”

Why Do a Backdoor Roth IRA?

Why would someone do a Backdoor Roth IRA? The Backdoor Roth IRA gets money into a Roth IRA in cases where the taxpayer earns too much to make a direct annual contribution to a Roth IRA. Doing the Backdoor Roth IRA gets money that would have been invested in a taxable account into a tax-free Roth account. Further, the money in the Roth account gets better creditor protection than money in a taxable account.

History of the Backdoor Roth IRA

Before 2010, what is now referred to as a Backdoor Roth IRA would have been permissible and/or necessary in only relatively limited circumstances, and then only in years prior to 2008. But a 2006 change in the law opened up the Backdoor Roth IRA in the form we know now (starting in 2010).

Two fundamental concepts must now be addressed. The first is a Roth IRA contribution.

Roth IRA Contributions

This post discusses Roth IRA contributions in detail. Simplified, U.S. citizens and residents with earned income can make an annual Roth IRA contribution of up to $7,000 in 2024 ($8,000 if 50 or older). Done for many years, it can be a tremendous wealth building tool, since it moves wealth into an account that is tax-free (if properly executed).

The one catch is that your “modified adjusted gross income” (or “MAGI”) must be below a certain threshold in order to make a Roth IRA contribution. To make a full contribution in 2024, your MAGI must be less than $146,000 (if single) or $230,000 (if married filing joint).

Because of these limits, many taxpayers are unable to make a Roth IRA contribution. Further, based on the qualification rules for traditional deductible IRA contributions, most taxpayers unable to make a Roth IRA contribution are also unable to make a deductible traditional IRA contribution.

Roth IRA Conversions

The second fundamental concept is a Roth IRA conversion. A Roth IRA conversion is a movement of amounts in traditional accounts to a Roth IRA. This creates a taxable event. The amount of the Roth IRA conversion, less any “basis” in the traditional account (more on that later), is taxable as ordinary income on the taxpayer’s tax return.

Prior to 2010, only taxpayers with a modified adjusted gross income of $100,000 or less were allowed to do a Roth IRA conversion. This amount was not indexed for inflation and applied per tax return, making it particularly difficult for many married couples to qualify.

In 2006, Congress changed the law, effective beginning in 2010. As of January 1, 2010, there is no modified adjusted gross income limitation on the ability to do a Roth IRA conversion. The richest, highest earning Americans now qualify to do a Roth IRA conversion just as easily as anyone else.

The Backdoor

Okay, so there’s no MAGI limitation on the ability to execute a Roth IRA conversion. So what? Aren’t they taxable? What’s the advantage of doing one?

Recall I mentioned a taxpayer’s basis in a traditional account. Basis in an IRA occurs when a taxpayer makes a nondeductible contribution to a traditional IRA. Here is an example.

Mike expects to earn $300,000 from his W-2 job in 2024, is covered by a workplace 401(k) plan, and expects to have some investment income. Mike has no balance in a traditional IRA, SEP IRA, or SIMPLE IRA.

Mike contributes $7,000 to a traditional IRA on April 20, 2024. The contribution is nondeductible. Because the contribution is nondeductible, Mike gets a $7,000 basis in his traditional IRA. Mike must file a Form 8606 with his 2024 tax return to report the nondeductible contribution.

The “backdoor” opens because of the confluence of two rules: the ability to make a nondeductible traditional IRA contribution and the ability to do a Roth IRA conversion regardless of your income level. Let’s extend Mike’s example a bit.

On May 2, 2024, Mike converts all the money in his traditional IRA to a Roth IRA (a Roth IRA conversion). At that time, Mike’s traditional IRA had a value of $7,011.47.

What result? To start, all $7,011.47 is taxable. All money converted in a Roth IRA conversion is taxable. Uh oh! But there’s good news for Mike. Mike gets to offset the $7,011.47 that is taxable by the $7,000 of basis in his traditional IRA. Thus, this Roth IRA conversion will only increase Mike’s taxable income by $11.47 ($7,011.47 minus $7,000).

The combination of these two separate, independent steps (a nondeductible traditional IRA contribution and a later Roth IRA conversion) is what many now refer to as the Backdoor Roth IRA. Notice this is only possible because of the repeal of the MAGI limitation on Roth IRA conversions. Under the rules effective prior to 2010, Mike would have been allowed to make the nondeductible traditional IRA contribution, but his income (north of $300,000) would have prohibited him from a Roth IRA conversion.

The Backdoor Roth IRA allows Mike to obtain the benefits of an annual Roth IRA contribution without qualifying to make a regular annual Roth IRA contribution.

December 31st

Any Backdoor Roth IRA planning should involve an additional diligence step: ensuring that as of December 31st of the year of the Roth conversion step, the taxpayer has a zero balance in all traditional IRAs, SEP IRAs, and SIMPLE IRAs. This helps ensure the Backdoor Roth IRA is a tax-efficient tactic.

The Pro-Rata Rule

The Backdoor Roth IRA works well for someone with Mike’s profile. But it does not work well for everyone. Let’s change up the example a bit.

Jennifer’s story is the same as Mike’s story above, except that she had a separate traditional IRA before she did her 2024 nondeductible IRA contribution. That separate IRA had no basis. As of December 31, 2024, that separate traditional IRA was worth $92,988.53.

This one change in facts dramatically increases Jennifer’s taxable income from the Roth IRA conversion. Jennifer must apply the so-called Pro-Rata Rule to the Roth IRA conversion. Even though her two IRAs are in separate accounts, they are treated as one IRA for purposes of determining how much of Jennifer’s $7,000 of basis she recovers upon her Roth IRA conversion.

Jennifer starts with $7,011.47 of income (the amount she converts). To determine the amount of her $7,000 of basis she gets to recover against the proceeds of the Roth IRA conversion, we must multiply that $7,000 times the amount converted ($7,011.47) divided by the sum of the amount converted and her traditional IRA balance at the end of the year ($7,011.47 plus $92,988.53). Thus, Jennifer gets to recover 7.00147 percent of the $7,000 of basis, which is only $490.80. This results in Jennifer’s Roth IRA conversion increasing her taxable income by $6,520.67 ($7,011.47 minus $490.80).

What was a great idea for Mike becomes a horrible idea for Jennifer when she has a significant balance in another traditional IRA.

Note further that Jennifer would have the same bad outcome if that $92,988.53 traditional IRA was instead in a traditional SEP IRA or in a traditional SIMPLE IRA.

Tax Reporting

Assume Mike did his Roth IRA conversion and did not have any other money in traditional IRAs in 2024. He will get a Form 1099-R from his financial institution. In box 1 it will report a gross distribution of $7,011.47 (the amount of the Roth IRA conversion).

In box 2a the Form 1099-R will say that the “taxable amount” is $7,011.47 and box 2b will be checked to indicate that the “taxable amount not determined.” Wait, what? How can $7,011.47 be the taxable amount while the next box claims the taxable amount is not determined? The answer is the basis concept discussed above.

Mike’s financial institution does not know the rest of Mike’s story (his income, retirement plan coverage at work, IRAs at other institutions, etc.), so it has no way of determining how much basis, if any, Mike recovers when he did the Roth IRA conversion. Box 2b simply means that Mike might have recovered some basis, but the institution is not in a position to determine if he did.

Form 8606 helps complete the tax reporting picture. By filing that form, Mike establishes that he was entitled to $6,000 of traditional IRA basis and how the pro-rata rule applies (if at all) to his Roth IRA conversion. It is important that Mike file a properly completed Form 8606 with his timely-filed 2024 federal income tax return.

When Mike files his 2024 Form 1040, he puts $7,011.47 on line 4a (“IRA distributions”) and $11.47 on line 4b (“Taxable amount”). Most tax return preparation software will round cents to the nearest whole dollar.

Note that failing to report the transactions on the Forms 8606 and 1040 in this way can result in Mike paying an incorrect amount of tax.

Further Reading

This post discusses what you can do if you find yourself in Jennifer’s situation to get a result similar to Mike’s result. I discuss how to properly report a Backdoor Roth IRA on your tax return and what to do if has been incorrectly reported here.

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

Follow me on Twitter: @SeanMoneyandTax

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


Section 199A and Retirement Plans

Previously I have blogged about small business retirement plans. This post (revised in January 2020) folds the new Section 199A qualified business income (“QBI”) deduction into the discussion.

For an introduction to Section 199A, please read this. For more on Section 199A, please read this additional post.

The Basics

Section 199A, enacted in December 2017 as part of tax reform, gives owners of businesses (including partners, owners of S corporations, and sole proprietors) that generate QBI a deduction in the amount of 20 percent of the QBI.

In January 2019, the IRS and Treasury issued regulations providing detailed rules under Section 199A. Those rules define QBI. As part of the definition of QBI, taxpayers must subtract contributions to self-employment retirement plans from QBI.

80% Deductions

When a self-employed individual contributes to a traditional retirement plan, they generally reduce the amount of their QBI deduction (because the retirement plan contribution lowers QBI).

Here’s a quick example (using 2018 tax numbers) of how that works.

Example: Mike makes $50,000 from his sole proprietorship (as reported on Schedule C). He pays $7,065 in self-employment tax (Social Security and Medicare). He deducts half of his self-employment tax ($3,533) from his taxable income and his QBI. Mike is married to Jane. Jane has $34,000 of W-2 wages. Mike and Jane file jointly and take the $24,000 standard deduction.

Mike thus receives a QBI deduction of $9,293 (20% of $46,467). This makes Mike and Jane’s taxable income $47,174 ($50,000 less $3,533 plus $34,000 less $24,000 less $9,293).

Let’s assume that Mike wants to make a $10,000 employee contribution to his Solo 401(k) to lower his taxable income by $10,000. Sure enough, the math does not work that way due to the QBI deduction. Mike’s QBI is now $36,467 (the original QBI of $46,467 less the $10,000 traditional Solo 401(k) contribution). Thus, his QBI deduction is now reduced to $7,293 (20% of $36,467). This makes Mike and Jane’s taxable income $39,174 ($50,000 less $3,533 plus $34,000 less $24,000 less $10,000 less $7,293).

Notice that $39,174 is $8,000 less than $47,174, not $10,000 less than $47,174. The interaction of Section 199A and the small business retirement plan creates the oddity that a $10,000 deduction (the traditional Solo 401(k) contribution) reduces taxable income by only $8,000.

QBI has thus created a new class of deductions – what I call “80% deductions.” These deductions reduce QBI and thus (in total effect) are deductible at only 80 percent of their gross amount.

As applied to small business retirement plans, 80% deductions are particularly troublesome. Recall Mike put $10,000 into his Solo 401(k), netting him an $8,000 federal tax deduction. When Mike goes to take the $10,000 (and its growth) out of the Solo 401(k), all of it will be taxable.

Matching 80% deductions with 100% inclusions is usually not smart tax planning.

I’ve written more about this phenomenon (what I call the Solo 401(k) Trap) here.

Planning Options

In cases where taxpayers are below the taxable income limitations of Section 199A ($163,300 and $326,600 (MFJ) for 2020), taxpayers will have to weigh the benefit of the 80 percent deduction for a traditional contribution to a small business retirement plan versus other options. Some of those other options include (if eligible):

  1. Make employee contributions to a Roth IRA, Roth Solo 401(k), and/or after-tax contributions to a Solo 401(k)
  2. Make contributions to a health savings account (a “HSA”)
  3. Make contributions to a traditional IRA
  4. Invest the earnings in taxable accounts and/or pay off existing debt.

Roth Contributions

Roth versus traditional receives much Internet discussion, particularly in the FI community. All agree that a taxpayer’s current marginal tax rate is vitally important. 80% deductions lower marginal tax rates. Take Mike, who with his retirement plan contributions lowered his 2018 taxable income to $39,174. As a married filing joint taxpayer, his marginal federal income tax rate is 12 percent. However, the marginal rate on the $10,000 retirement plan traditional contribution is only 9.6 percent (80 percent of 12 percent). In order for the traditional contribution to be advisable, Mike better be pretty sure he can pull the money out of the Solo 401(k) at a marginal federal tax rate below 9.6 percent. Being that the lowest marginal tax rate is 10 percent today, that does not seem very likely.

In Mike’s case, he would have been much better advised to leave his taxable income at $47,174 and made the Solo 401(k) contribution a Roth Solo 401(k) contribution.

HSAs/IRAs/Small Business Retirement Plans

Many small business owners are looking for current tax deductions, and many are in marginal tax brackets much above the 12 percent bracket. The interaction between Section 199A and small business retirement plans creates a new pecking order for self-employed individuals looking to reduce taxable income through plan contributions. That order is as follows:

  1. HSA Contributions (if eligible)
  2. Deductible Traditional IRA Contributions (if eligible)
  3. Traditional Small Business Retirement Plan Contributions

HSA Contributions

I’ve written about my fondness for HSAs here. What’s important for this purpose is that contributions to HSAs do not reduce QBI. Thus, contributions to HSAs are “100 percent deductions” and not 80% deductions. In addition to all their other advantageous tax attributes, HSA contributions should be prioritized over small business retirement plan traditional contributions from a Section 199A perspective.

Deductible Traditional IRA Contributions

Deductible contributions to traditional IRAs (for those who qualify) also should be prioritized over traditional contributions to small business plans from a Section 199A perspective.

In the previous version of this post, I expressed the concern that deductible traditional IRA contributions might reduce QBI. Fortunately, there is nothing the IRS and Treasury has provided (including the instructions to the new Form 8995) indicating that the government believes deductible traditional IRA contributions reduce QBI. Based on my understanding of the tax law, which has been reinforced by IRS and Treasury silence on the matter, I am comfortable that deductible traditional IRA contributions should not reduce QBI.

Taxable Accounts

There is no requirement to contribute to small business retirement plans. You can simply take profits and invest them in taxable accounts. Considering that traditional small business retirement plans contributions are now 80% deductions that must later create 100% income, you may opt to simply not make plan contributions and keep profits in taxable accounts. That may be very sensible if either or both the following are true: 1) you are currently in a very low marginal federal tax bracket and 2) you anticipate being in a much higher marginal federal tax bracket in the future.

S Corporation Owners

For S corporation owners, only the operating income after the owner’s W-2 salary is eligible for the Section 199A deduction. Small business retirement plan contributions are 80% deductions for the S corporation owner just as they are for the sole proprietor and for partners of partnerships with flow-through QBI.

Consideration should be given to employee versus employer contributions. To my mind, the new Section 199A deduction does not necessarily impact whether to make an employee contribution to a Solo 401(k) as a W-2 employee of your business. Yes, your salary is an 80% deduction. But what you from there with your salary (take it home, put it into a traditional Solo 401(k), or put it into a Roth Solo 401(k)) does not increase or decrease your qualified business income (though it could impact the taxable income limitations).

But an employer contribution to a Solo 401(k) (which must be a traditional contribution) does reduce your QBI. Employer contributions to Solo 401(k) plans often fall into the Solo 401(k) Trap.

In many cases, if you qualify for the QBI deduction you should give strong consideration to foregoing the employer contribution. Planning in this regard can benefit from professional consultations.

Your Employees

If you have employees, offering a SIMPLE IRA plan does not change the Section 199A result with respect to their salary. Normal operating expenses (including salaries) of QBI-generating businesses do create 80% deductions, but there is only so much that can be done about that. Unlike your own retirement plan contributions, which are (almost) entirely discretionary, operating expenses are necessary for the conduct of the business. Giving your employees the option of deferring some of their salaries through a SIMPLE IRA does not change the math on the Section 199A deduction, since employees’ salaries reduce QBI regardless of whether the employees contribute some of their salary to a SIMPLE IRA.

The relatively small mandatory employer contribution to employees’ SIMPLE IRAs are 80% deductions, making them a bit more expensive for the business owner (assuming the owner qualifies to claim the QBI deduction).

The Section 199A QBI deduction makes SEP IRA contributions more expensive for most self-employed business owners. In order to make contributions to his/her own SEP IRA, the owner must also make contributions (in an equal percentage of compensation) to the employees, and now those deductions are only 80% deductions (assuming the owner qualifies to claim the QBI deduction).

Upper Income Taxpayers

For some taxpayers, Section 199A will make their small business retirement plan contributions more, not less, valuable. In a previous post, I gave the example of Jackie, a sole proprietor lawyer whose 2020 taxable income (pre-retirement plan contributions) of $215,848 left him unable to claim any Section 199A QBI deduction. Maximum employer and employee traditional contributions of $57,000 to a Solo 401(k) lowered his taxable income such that he was able to qualify for a $31,770 QBI deduction (a 100% deduction) in addition to the $57,000 traditional retirement plan contribution deduction (an 80% deduction).

This interaction turned the $57,000 deduction into an effective $77,370 deduction (80 percent of $57,000 plus $31,770). In this case, Jackie’s retirement plan contributions are 136% deductions!

For upper income taxpayers near the QBI taxable income limitations, small business retirement plans may be a very powerful tool, and unlike those with more modest incomes, these upper income business owners may have an opportunity to maximize their Section 199A deduction by contributing to retirement plans.

Conclusion

The combination of Section 199A and small business retirement plans creates tax planning opportunities and challenges. Many small business owners will benefit from professional advice to determine the best path forward considering the new law, opportunities, and challenges.

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

Follow me on Twitter at @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters.

Small Business Retirement Plans

If you are self-employed or have a side hustle, you have great opportunities for tax-advantaged savings. Small business retirement planning has been an area of significant confusion due to the multitude of plans available and the different qualification rules for each.

Below I describe the three most important plans for most small businesses to consider, provide the qualification requirements, and discuss when each plan is the best option.

Fortunately, for roughly 90 percent of small businesses, there are only three options worth considering: the Solo 401(k), the SIMPLE IRA, and the SEP IRA. In many cases, one of the three options quickly becomes the advantageous option.

After I discuss the three main small business retirement plans, I will provide some commentary on other available plans, but for most small businesses, the playbook consists of these three plans.

The administrative burdens (forms, paperwork, fees to financial institutions) of all three of these programs are relatively light these days, though all three plans do have some forms that must be properly completed, signed, and filed.

Before we begin, three quick notes. First, on limitations. Below I provide (in a general sense) the upper annual limits on contributions to the plans. It is important to note that contributions can be made in a manner below the limits – the plans are flexible in this regard. Second, generally you can contribute to a small business retirement plan and to a Roth and/or traditional IRA. Having access to a small business retirement plan does not prohibit a contribution to a Roth IRA or a traditional IRA. Third, before implementing a plan it is best to discuss your business and needs with the plan provider. Providers can have rules that are different from (and/or in addition to) the applicable tax rules.

Solo 401(k)

The Basics: A Solo 401(k) (sometimes referred to as an “Individual 401(k)”) is a 401(k) plan established by a self-employed individual for only their own benefit. Solo 401(k)s can be established by self-employed individuals in their own name and by corporations (usually S corporations in this context). Self-employment for this purpose includes a sole proprietorship, limited liability company (“LLC”), or other entity treated as disregarded from their single owner and reported on a Schedule C on their tax return.

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 $19,500 ($26,000 if 50 or older) in 2020. Employer contributions are limited to either 20 percent of self-employment income or 25 percent of W-2 wages (if the self-employed individual is paid through a corporation, including S corporations). Total employee and employer contributions are limited to $57,000 ($63,500 if age 50 or above) in 2020.

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

If eligible, the Solo 401(k) is almost always the best option for the self-employed individual. It offers the greatest potential for tax savings of the self-employed plans and it is relatively easy to administer.

An important note on the Solo 401(k) vis-a-vis the SIMPLE IRA and the SEP IRA: the Solo 401(k) is the only small business plan that allows Roth “employee” contributions. This allows self-employed individuals the ability to put away up to $19,500 ($26,000 if 50 or older) annually that will grow tax free. For all three plans, the “employer” contribution is always a traditional contribution (i.e., tax deductible today, taxable upon withdrawal). Note, however, that not all financial institutions offer the Roth employee contribution option in their Solo 401(k) plan, so it is important to check with the provider before signing up if the ability to make a Roth contribution is important to you.

Spouses employed by the self-employed individual (or their corporation) can also participate in the Solo 401(k) (only to the extent of their earnings from the business and subject to the above stated limitations), increasing the tax benefits of the plan.

Eligibility: In order to establish a Solo 401(k) plan, a person must have self-employment income, and must not have employees other than their spouse. For this purpose, an employee is anyone who works 1,000 hours during the year for the business. Starting in 2024, an employee also includes anyone who has worked 500 hours in each of 3 consecutive years.

Different plans have different rules on other employees. Some Solo 401(k) plans do not allow you to have any non-owner/non-spousal employees (regardless of the numbers of hours worked).

To have a Solo 401(k) in any tax year, the plan must be established by the deadline for the tax return, including extensions. That deadline also applies to employer contributions.

Generally, employee deferrals to a Solo 401(k) must be made by the end of the calendar year. There is an exception: if the Solo 401(k) is for a self-employed person (reporting self-employment income on Schedule C), the employee deferral must be formally designated by year-end, but then can be paid into the Solo 401(k) before the tax filing deadline (including extensions if the taxpayer extends his/her Form 1040).

Ideal for: Solo 401(k)s are ideal for anyone who is self-employed and does not have employees (other than a spouse).

SIMPLE IRA

The Basics: The SIMPLE IRA works in a manner somewhat similar to a 401(k) plan. It allows employees (including self-employed owners of the business) to defer up to $13,500 ($16,500 if 50 or older) of earnings in 2020 through traditional employee contributions. The SIMPLE IRA also has relatively modest required employer contributions to each eligible employee’s account (described below).

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

In order to have a SIMPLE IRA for the year, the employer must establish the SIMPLE IRA by October 1st of the year. One narrow exception is when the business is established after October 1st, in which case the plan must be established when administratively feasible.

The SIMPLE IRA has two main advantages over the SEP IRA. First, it gives the self-employed owner and any employees a valuable option – the option to make traditional contributions to the SIMPLE IRA account. By contrast, the SEP IRA (discussed below) does not allow for employee contributions. Second, the required employer contribution is relatively low. Employers must make either matching contributions of 3 percent of salary (in 2 out of every 5 years that percentage can be reduced to 1 percent) or automatic annual contributions of 2 percent of salary to each employee’s SIMPLE IRA. Thus, the SIMPLE IRA can give the self-employed owner(s) the option to defer up to $13,500 ($16,500 if 50 or over) of earnings in a relatively affordable manner.

Eligibility: In order to be eligible for a SIMPLE IRA, the employer must have no other retirement plan and must have 100 or fewer employers during the year.

Ideal for: Self-employed individuals that are not eligible for a Solo 401(k) and are looking to provide themselves and their employees the option to defer some taxable income at a relatively low cost to the employer. Partnerships where two or more owners (non-spouses) work in the business and/or small businesses with employees are good candidates for a SIMPLE IRA.

SEP IRA

The Basics: A SEP IRA is allows only employer contributions. Generally, the employer can make annual contributions of up to 25 percent of eligible compensation (20 percent of a sole proprietor’s self-employment income), limited to $57,000 of contributions (in 2020).

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

The SEP IRA has two important advantages. First, it allows the employer to elect each year whether to make contributions. The employer can elect to forego contributions or reduce the contribution each year. Second, the SEP IRA has the latest deadlines of all the plans. A SEP IRA can be established for a tax year by the deadline for filing that tax year’s tax return, including extensions.

The main disadvantage of a SEP IRA is that it generally requires equal percentage contributions to all eligible employees. Said differently, in order for the self-employed owner of the business to make an employer contribution to his/her own account, the business must make the same percentage contribution to all eligible employees. This makes the SEP IRA an expensive way to save for your own retirement if you are self-employed and have employees. SEP IRAs are also subject to “top heavy” rules whereby the employer may be required to put in additional contributions to the rank-and-file employees’ SEP IRAs if the owners’ and executives’ SEP IRA balances are too high vis-a-vis the rest of the employees’ SEP IRA balances.

Eligibility: An employer (a sole proprietor, partnership, or corporation, including S corporations) can establish a SEP IRA program. Employees that are 21 years old, earn $600, and have worked for three of the previous five years for the employer must be allowed to participate.

Ideal for: There are three situations in which a SEP IRA can be highly advantageous. The first is for a side hustlers that maximize their 401(k)/403(b)/TSP contributions to their W-2 employer’s plan. The SEP IRA provides a mechanism for these side hustlers to defer more income. Note, however, that this can also be accomplished through a Solo 401(k), and in most cases the Solo 401(k) is preferable to the SEP IRA (if a taxpayer is eligible for both).

The second situation is when a self-employed person has not established a self-employed retirement plan by year-end. In such cases, the taxpayer can establish and fund a SEP IRA for the prior year before their tax return deadline (including extensions).

Third, a SEP IRA can be helpful in situations where a small business has a small number of employees, all or most of which are very important to the business. The SEP IRA provides a way to give highly valued employees a significant benefit.

Side Hustlers

For most side hustlers, the question becomes: are you covered by a retirement plan (such as a 401(k)) at your W-2 job? If you are not, the Solo 401(k) in most instances is likely your best option.

If you are covered by a workplace retirement plan, such as a 401(k), then the SEP IRA may be your best option, since you can defer up to the lesser of 20 percent of your side-hustle income or $57,000 (in 2020) while you can take advantage of your $19,500 ($26,000 if 50 or older) employee contributions through your workplace plan. While the “employer” contribution calculation is the same for a SEP IRA and a Solo 401(k), the administrative cost of the SEP IRA (including IRS filings) tends to be lighter than that of the Solo 401(k).

In some situations, side hustlers might want to forego a SEP IRA and use a Solo 401(k) (instead of a workplace 401(k)) for some or all of their annual employee contributions. That would be true if you want to make Roth employee contributions and your workplace plan does not allow them and/or you believe the investment options in your Solo 401(k) plan are better than the options in your employer’s plan. However, in all cases consideration should also be given to ensuring you at least get the full match in your employer’s 401(k) plan.

One important consideration for side hustlers and all self-employed individuals is what I call the Solo 401(k) Trap. Because of the new Section 199A deduction, many will want to forego deducting retirement plan contributions to self-employment retirement accounts (i.e., traditional employee contributions to Solo 401(k)s and employer contributions to Solo 401(k)s and SEP IRAs) and instead make Roth employee contributions to Solo 401(k)s.

Note that there is no benefit to having both a Solo 401(k) and a SEP IRA for your side hustle, because contributions to both plans count against the relevant limitations (i.e., having two separate plans does not increase a taxpayer’s contribution limitations).

Other Plans

There are other options available to small businesses. All (with the exception of the SIMPLE 401(k)) of them involve significantly more administrative burden and costs than the Solo 401(k), the SIMPLE IRA, and the SEP IRA. Often these plans are not feasible for small businesses and these plans are rarely feasible for side hustlers.

SIMPLE 401(k)s

SIMPLE 401(k)s are very similar to SIMPLE IRAs, with some differences on the margins not worth mentioning here. Most financial institutions offer SIMPLE IRAs instead of SIMPLE 401(k)s.

Keoghs

Keoghs come in both defined contribution and defined benefit (i.e., pension) models. Keoghs involve significant additional administrative burdens when compared to Solo 401(k)s, SIMPLE IRAs, and SEP IRAs.

401(k)s

There is nothing stopping a small business from establishing a 401(k) plan just like the largest employers. However, as a practical matter, it is difficult for most small businesses to do so. First, they involve significant set-up and maintenance costs. Second, 401(k)s are subject to discrimination testing to prevent business owners and high compensated employees from enjoying the benefits of the plan to a much greater degree than rank-and-file employees. This testing can lead to either reversals of previous contributions to the plan or additional employer contributions to rank-and-file employees.

Defined Benefit Pension Plans

A defined benefit plan (where the employee receives a stated benefit during retirement years and the employer funds the plan during the employee’s working years) is another option. These plans require significant compliance costs, including actuarial calculations. Further, if you have employees, these plans can be quite expensive for the self-employed business owner. In addition, these plans often work against the financial independence model in that they tie up assets until the account owner reaches a certain retirement age. However, given the right set of circumstances (usually older, highly compensated earners), these plans can be advantageous and create large current tax deductions.

Conclusion

Small businesses have a great opportunity to create tax advantaged retirement savings. For those eligible for a Solo 401(k), in most cases significant consideration should be given to establishing one. Depending on your circumstances, the SIMPLE IRA or the SEP IRA might be a great solution.

My hope is that this post has given you some working knowledge of the three main options for small businesses. Small business owners will often benefit from obtaining professional advice regarding their retirement planning and the programs they ought to establish.

Next Week

Next week’s post (click here) explores small business retirement plans in light of the new Section 199A qualified business income deduction and how the two concepts interact.

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

Follow me on Twitter at @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters.


Tax Efficient Estate Planning

THIS POST HAS NOT BEEN UPDATED FOR THE SECURE ACT, WHICH WAS ENACTED IN LATE 2019.

If you have significant assets, you need an estate plan. A good estate plan makes handling the financial aspects of your death much easier for your loved ones and creates the opportunity for multiple generation wealth creation.

For most, the need for good estate plan is not about the estate tax. Very few Americans, particularly very few actively seeking financial independence, will be subject to the federal estate tax, as there is now (as of 2019) a $11.4 million estate tax exemption. Thus, only the very largest of estates will pay the federal estate tax. For purposes of this post, assume that all estates are below this threshold.

If you are aren’t subject to the estate tax, why do you need to make a tax efficient estate plan? The answer is the income tax considerations of your heirs and beneficiaries. Some assets cause your heirs and beneficiaries to have very little or no additional income tax. Other assets can cause a significant increase in the income tax burdens of your heirs and beneficiaries. Below I analyze each of the tax baskets and discuss the estate planning considerations for each one.

Being that the FI community generally aims to build up significant assets to achieve financial independence, good estate planning is particularly important if you are on the road to (or have achieved) financial independence.

A quick caveat at the beginning – tax is only one consideration in estate planning. There are many others, including the needs of spouses, children, and other potential heirs, and the desires of the donor. Below I offer thoughts on tax optimal estate planning — of course the tax considerations need to be balanced with other estate planning objectives.

Spouses

A quick note on leaving assets to spouses. Generally speaking, the tax laws favor leaving assets to spouses. A spouse is a tax-preferred heir in most situations (the main exception being leaving retirement accounts to younger beneficiaries with low RMDs). As the focus of this post is passing wealth to the second generation efficiently, most of the discussion, other than a few asides, will not address the tax consequences when leaving an asset to a spouse.

Tax Baskets

Below are the four main tax baskets (tax categories in which individuals can hold assets):

  1. Traditional (a/k/a Deductible) Retirement Accounts: These include workplace plans such as the 401(k), the 403(b), the 457, and the TSP, and IRAs. Under ideal conditions, the contributions, when earned, are not taxed but the contributions and earnings are taxed when later withdrawn.
  2. Roth Retirement Accounts: These include workplace plans such as the Roth 401(k), the Roth 403(b), and the Roth TSP, and Roth IRAs. Under ideal conditions, the contributions, when earned, are taxed but the contributions and earnings are tax-free when later withdrawn.
  3. Health Savings Accounts: HSAs are tax-advantaged accounts only available to you if you have a high deductible health plan (a “HDHP”) as your health insurance. Under ideal conditions, the contributions, when earned, are not taxed and the contributions and earnings are tax-free when later withdrawn.
  4. Taxable Accounts: Holding financial assets in your own name or otherwise not in a tax-advantaged account (tax baskets 1 through 3). The basic concept is taxable in, taxable on “realized” earnings (rental income, business income, dividends, interest, etc.) while in the account, and partially taxable (value less “tax basis”) on the way out.

Baskets 1 through 3 require “ideal conditions” (i.e., compliance with the related tax rules) to operate as outlined above. Let’s assume for purposes of this post that no errors are made with respect to the account in question.

Traditional Accounts

Of the four tax baskets, traditional accounts are often (from a tax perspective) the worst kind to leave to a spouse and the third worst to leave to non-spouse heirs. Why? Because traditional accounts, through required minimum distributions (“RMDs”), are eventually going to be entirely taxable to your beneficiaries and/or their beneficiaries. Non-spouse beneficiaries generally must take RMDs in the year following the donor’s death.

When passing traditional accounts to the next generation(s), a general rule of thumb is younger beneficiaries are better for such accounts, because the younger the beneficiary, the smaller their earlier RMDs, and thus the lower the tax hit of the RMD and the longer the tax-deferred growth.  

Spousal beneficiaries, unlike non-spouse beneficiaries, have the option to delay RMDs until the year they turn 70 ½. However, once they turn 70 ½ they will be required to take taxable RMDs, increasing their taxable income.

For charitably inclined, traditional accounts (or portions thereof) are a great asset to leave to charity. As you will see, your individual beneficiaries would prefer to inherit Roth accounts (and in most cases will prefer to inherit taxable accounts), but the charity is generally indifferent to the tax basket of an asset, because charities pay no income tax. So all other things being equal, if you have money in traditional accounts, Roth accounts, and taxable accounts, the first money you should leave to a charity should be from your traditional accounts.

Lastly, whatever your plans, you are well advised to ensure that all your traditional, Roth, and HSA accounts have valid beneficiary designation forms on file with the employer plan or financial institution.

Roth Accounts

Roth accounts are fantastic accounts to inherit for both spouses and non-spouses. While non-spouses must take RMDs from the inherited Roth account in the year following death, the RMD is non-taxable to them. All beneficiaries benefit from tax-free growth of assets while they are in an inherited Roth account. This makes spouses (able to defer RMDs until age 70 ½) and younger beneficiaries ideal (from a tax perspective) to inherit Roth accounts.

Roth conversions are a potential strategy to save your heirs income tax. If you believe your heirs will have a higher marginal income tax rate than you do, and you do not need the tax on the Roth conversion, you can convert amounts in traditional accounts to Roth accounts, pay the tax, and lower the overall tax burden incurred by you and your family.

Health Savings Accounts

There are two, and only two, ideal people to leave an HSA to – your spouse or a charity. Spouses and charities are the only ones who do not pay tax immediately on an HSA in the year of death.

Unfortunately for non-spouse, non-charity beneficiaries, the entire account becomes taxable income to the beneficiary in the year of death and loses its status as an HSA. This can cause a significant one-time spike in marginal tax rates and cause the beneficiary to lose (to federal and state income taxes) a significant amount of the HSA. This makes the HSA the worst tax basket to leave to non-spouse, non-charitable beneficiaries.

Spouses are allowed to continue the HSA as their own HSA, and thus can use it to grow tax-free wealth that can cover (or reimburse) qualified medical expenses.

If you are charitably inclined and unmarried, the HSA should be the first account you consider leaving some or all of to charity.

Taxable Accounts

Taxable accounts, including real estate and securities, are generally good assets to leave to beneficiaries because of the so-called “step-up” in basis. As a general matter, when a person dies, their heirs inherit assets in taxable accounts with a “stepped-up” basis. This gives the heirs a basis of the fair market value of the property on the date of death.

As a result, a beneficiary can generally sell inherited assets shortly after receiving them and incur relatively little, if any, capital gains tax.

A couple of additional notes. First, leaving appreciated taxable assets at death to heirs is much better than gifting such assets to heirs during your life. A quick example: William lives in a house he purchased in 1970 for $50,000. In 2019 the house is worth $950,000. If William gifts the house to his son Alan in 2019, Alan’s basis in the house is $50,000. However, if William leaves the house to Alan at William’s death, Alan’s basis in the house will be the fair market value of the house at William’s death.

Second, the step-up in basis at death benefits spouses in both “common law” states and community property states. In all states, separately held property receives a full step up in basis when inherited by a spouse. For residents of common law states, jointly held property receives a half step-up – the deceased spouse’s portion is receives a step-up in basis while the surviving spouse’s half does not. For residents in community property states, the entirety of community property receives a full basis step-up at the death of one spouse.

Conclusion

Generally speaking, in most cases spouses will prefer to inherit assets in the following order:

  1. Roth
  2. HSA
  3. Taxable
  4. Traditional

In most cases, non-spouses will prefer to inherit assets in the following order:

  1. Roth
  2. Taxable
  3. Traditional
  4. HSA

The best two tax baskets to leave to charities are HSAs and traditional accounts.

You can obtain significant tax benefits for your heirs by being intentional regarding which tax baskets you leave to which beneficiaries. Some relatively simple estate planning can save your heirs a significant amount of federal and state income tax.

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

Follow me on Twitter at @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters.