403(b) plans are offered by certain non-profit organizations such as universities and 501(c)(3) charities.There’s an odd rule that side hustlers covered by a 403(b) plan should be aware of.
Section 415(k)(4) provides that the all additions limit (sometimes referred to as the 415(c) limit) is applied by aggregating 403(b) contributions with any contributions a side hustler makes to their own self-employment retirement plan such as a SEP IRA or Solo 401(k). Recall that the 2025 all additions limit is the lesser of 100% of compensation or $70,000 for those under age 50.
Section 415(k)(4) is an exception to the general rule that unrelated employers are not aggregated for the all additions limit. Since side hustlers are not usually aggregated with their employers for all additions limit purposes, they can have the ability to make very substantial contributions to a Solo 401(k) without worrying about the overall contributions made into their workplace retirement plans.
Note, of course, the annual deferral limit (the Section 402(g) limit, which is $23,500 for those under age 50 in 2025) is always coordinated with all of one’s employers since it is a per person limit, not a per employer limit.
History of Section 415(k)(4)
The odd rule of Section 415(k)(4) dates back to Section 632(b) of the Economic Growth and Tax Relief Reconciliation Act of 2001. It’s clear that back then Congress was tinkering with the contribution limits on all defined contribution retirement accounts. The 403(b) rules back then were complicated and EGTRRA revised them. In my review of the legislative history, I have not found a particular reason for the self-employment/403(b) all additions limit aggregation rule. Nevertheless, it is the law of the land.
Another part of Section 632, Section 632(a)(1), is what opened the door to Solo 401(k)s having significantly greater contribution limits than SEP IRAs. Section 632(a)(1) increased the Section 415(c) annual limit from 25% to 100% of compensation, which meant that Solo 401(k)s could, for the first time, offer both significant employee contributions and employer contributions.
Section 415(k)(4) Often Has No Effect
As a practical matter, Section 415(k)(4) will often have no effect, even on highly compensated professionals. Even with very generous employer contributions to the 403(b) for highly compensated professionals with a side hustle, the numbers won’t add up to the top of the Section 415(c) limit. Here’s an illustrative example:
Dr. Funke works at a university hospital making $260,000 in annual salary and has $120,000 of Schedule C side hustle income in 2025. Dr. Funke maxes out his 403(b) at $23,500 (employee contributions) and the hospital contributes 5% of salary ($13,000). Dr. Funke also maxes out a SEP IRA or Solo 401(k) employer contribution at $23,678 for his Schedule C side hustle. Those rather healthy numbers only get the total contributions to $60,178, well under the 2025 all additions limit of $70,000.
You can see that without any “after-tax” contributions, it will be quite rare that Section 415(k)(4) bites, especially considering that few employers offer a full 5 percent match.
I’m not aware that many 403(b) plans offer after-tax contributions. Where the issue is more likely to come up is after-tax contributions to a Solo 401(k) as part of a Mega Backdoor Roth. Going back to Dr. Funke’s example, if he made after-tax contributions to a Solo 401(k) based on his $120,000 of Schedule C income, those combined with the other 403(b) and Solo 401(k) contributions could trip him over the combined $70,000 all additions limit.
I generally disfavor the Mega Backdoor Roth with the Solo 401(k) for two primary reasons.
First, most pre-approved Solo 401(k) plans do not offer after-tax contributions. I believe pre-approved plans tend to be the most desirable Solo 401(k) plans for most solopreneurs. Pre-approved plans tend to be the lowest cost plans (think Fidelity, Schwab, and Ascensus). They tend to offer low-cost, diversified index investments. Pre-approved plans also tend to have the lowest compliance risk. It’s difficult to have a prohibited transaction when the investment in the Solo 401(k) is one or more index funds. For most solopreneurs, avoiding pre-approved plans, the sacrifice required to do a Mega Backdoor Roth, is not worth it, in my opinion.
Second, the numbers often don’t work out when it comes to combining the Solo 401(k) with the Mega Backdoor Roth. This can be because the solopreneur doesn’t have enough cash flow to make the Mega Backdoor Roth a practical option. Or it could be because a solopreneur benefits from the high Solo 401(k) employee deferral and employer contribution limits to such an extent that the Mega Backdoor Roth does not add much value. That said, I do acknowledge that in Dr. Funke’s example, if his employer offered a 401(k) instead of a 403(b), the numbers work out to make the Mega Backdoor Roth in his a Solo 401(k) attractive from a tax standpoint.
Those with a 403(b) looking to “optimize” a Mega Backdoor Roth in a Solo 401(k) for a side hustle need to think twice and consider the impact of Section 415(k)(4).
Effect of Section 415(k)(4) Biting
The IRS and Treasury issued Treasury Regulation Section 1.415(g)-1(b)(3)(iv)(C)(2), which has an example illustrating how Section 415(k)(4) applies in an overcontribution situation. If the combined annual 403(b) contributions and SEP IRA/Solo 401(k) contributions exceed the aggregated all additions limit, the excess is deemed to have been made to the 403(b) plan, not to the SEP IRA or Solo 401(k).
If anyone in Congress is reading this, Section 415(k)(4) should be repealed. It’s a trap for the unwary that accomplishes next to nothing in furtherance of sound tax policy and revenue collection. If someone has a 401(k) their workplace 415(c) limit is not aggregated with their self-employment 415(c) limit. Why should people with 403(b)s instead of 401(k)s get worse treatment?
Let’s add Section 415(k)(4) repeal to Section 408A(d)(2)(B) repeal as easy wins for Congress to start simplifying the tax code at no significant cost to the fisc.
Conclusion
For those side hustlers covered by a 403(b) plan, it’s a good idea to ensure their total retirement plan contributions do not exceed the all additions limit. Unlike most side hustlers, those covered by a 403(b) plan only have one all additions limit shared between the 403(b) plan and their self-employment plan. The Mega Backdoor Roth is not very attractive for the Solo 401(k)s of side hustlers covered by a 403(b) because of the restrictions imposed by Section 415(k)(4).
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
Did you receive a Form 1099-DIV which lists an amount in Box 5 “Section 199A dividends”? If so, you might be asking, what the heck are Section 199A dividends?
You probably never came across the term “Section 199A dividends” in high school algebra. That’s okay. Below I discuss what a Section 199A dividend is and how to report it on your tax return.
Who Pays Section 199A Dividends?
Real estate investment trusts (“REITs”) pay Section 199A dividends. REITs are a special type of business entity. A REIT owns almost entirely real estate. Many office buildings, hotels, hospitals, malls, and apartment buildings are owned by REITs. Investors can own the stock of a single REIT, or they can own mutual funds or ETFs that are partly or entirely composed of REIT stock. For example, there are some REITs in the Vanguard Total Stock Market Index Fund (VTSAX).
REITs are advantageous from a tax perspective. In exchange for paying 90 plus percent of its income out to investors as dividends, the REIT itself does not pay federal corporate income taxes. This results in REITs often paying higher dividends than companies in other industries. The dividends paid by the REIT are Section 199A dividends.
What is the Tax Benefit of a Section 199A Dividend?
Here is an example of how the tax deduction works for Section 199A dividends.
Catherine owns shares of ABC REIT Mutual Fund. The mutual fund pays her $1,000.00 of dividends, all of which are Section 199A dividends reported to her in both Box 1a and Box 5 of Form 1099-DIV. She gets a $200 qualified business income deduction on her federal tax return (20 percent of $1,000.00) because of the $1,000.00 of Section 199A dividend.
There are several things to keep in mind when considering Section 199A dividends:
First, Section 199A dividends are a slice of the pie of dividends. The full pie of dividends, “total ordinary dividends,” is reported in Box 1a of Form 1099-DIV. Since Box 1a reports all of the dividends, Box 5 must be equal to or less than Box 1a.
Second, there is no income limit (taxable income, MAGI, or otherwise) on the ability to claim the Section 199A qualified business income deduction for Section 199A dividends. The QBI deduction for self-employment income is generally subject to taxable income limitations on the ability to claim the deduction. Not so with the Section 199A dividends.
Third, taxpayers get the Section 199A QBI deduction regardless of whether they claim the standard deduction or itemized deductions.
Fourth, there is no requirement to be engaged in a qualified trade or business to claim the QBI deduction for Section 199A dividends.
Sixth, Section 199A dividends are not qualified dividends (which are reported in Box 1b of Form 1099-DIV). They are taxed as ordinary income subject to the taxpayer’s ordinary income tax rates. They do not qualify for the preferred federal income tax rates for qualified dividends.
Seventh is a 2025 revision to this article: Some taxpayers cannot get the QBI deduction because their long-term capital gains exceed their ordinary income. This is usually a good outcome. See “An Exception: Too Little Ordinary Income to Claim a Section 199A Deduction” below.
Where Do I Report a Section 199A Dividend on My Tax Return?
Section 199A dividends create tax return reporting in three prominent places on a federal income tax return.
First, Form 1099-DIV Box 1a total ordinary dividends are reported on Form 1040 Line 3b. As Section 199A dividends are a component of Box 1a total ordinary dividends, they are thus reported on the Form 1040 on Line 3b. Section 199A dividends are not reported on Line 3a of Form 1040 because Section 199A dividends are not qualified dividends.
Second, Section 199A dividends are reported on either Line 6 of Form 8995 or Line 28 of Form 8995-A. In most cases, taxpayers will file the simpler Form 8995 to report qualified business income and Section 199A dividends. By reporting Section 199A dividends on one of those lines most tax return preparation software should flow the dividends through the rest of the form as appropriate (but it never hurts to double check).
Third, the QBI deduction, computed on either Form 8995 or Form 8995-A, is claimed on Line 13 of Form 1040.
Tax return software varies. Hopefully, by entering the Form 1099-DIV in full in the software’s Form 1099-DIV input form, all of the above will be generated. Ultimately, it is up to the taxpayer to review the return to ensure that the information has been properly input and properly reported on the tax return.
An Exception: Too Little Ordinary Income to Claim a Section 199A Deduction
In this 2025 article revision, I want to consider cases where a taxpayer might not be able to claim a QBI deduction for Section 199A dividends.
At first glance, you might think that this is a bad thing. But it’s usually indicative that someone has structured their tax basketing very effectively.
There is a limit on the Section 199A deduction. If your ordinary income is low vis-a-vis your long-term capital gain income, you lose the Section 199A for dividends and all other qualified business income. See Section 199A(a)(2) for the rule providing this result.
This sounds bad but it usually is good! Here’s an example:
Justin, an early retiree 56 years old in 2025. He has $90,000 of annual living expenses, which he funds by selling $90,000 of ABC Domestic Equity index fund in his taxable account. Those sales generate $50,000 of long-term capital gains. Further, he reports $13,000 of qualified dividend income, $1,000 of nonqualified dividends, and $1,000 of Section 199A dividends from his ABC Domestic Equity Index Fund. He also reports $2,000 of interest income.
Justin’s net taxable income is $52,000 ($67,000 of adjusted gross income less a $15,000 standard deduction), which is less than his long-term capital gain income of $63,000 ($50,000 long-term capital gains plus $13,000 qualified dividend income).
When long-term capital gain income exceeds net taxable income, the taxpayer cannot claim the QBI deduction, even for Section 199A dividends. This happens in situations where ordinary income is less than capital gain income. Justin is thus precluded from taking a QBI deduction, even for his Section 199A dividends.
Never fear, however. Justin’s total federal income tax for 2025 is just $746 on his AGI of $67,000. I put together a spreadsheet illustrating how his income is taxed, which I think you will find illuminating.
Does Justin need a $200 QBI deduction when his federal income tax effective rate is just 1.11%?
As I discussed in my Tax Basketing article, early retirees benefit from having as little ordinary income as possible. Any small QBI deduction on Section 199A dividends that sacrifices is well worth it, as Justin’s example illustrates.
Conclusion
Section 199A dividends create a taxpayer favorable federal income tax deduction. They are reported in Box 5 of Form 1099-DIV and should be reported on a taxpayer’s federal income tax return.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, investment, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
New to financial independence (FI or FIRE)? Are you steeped in financial independence, but confused about tax optimization?
If so, this is the post for you. It’s not “comprehensive tax planning for FI” but rather an initial primer on some basic financial independence tax planning tactics. I believe the three tactics here are the most compelling tactics for most pursuing financial independence.
But first, a caveat: none of this is advice for your specific situation, but rather, this comprises a list of the top three moves I believe those pursuing financial independence should consider. No blog post (this one included) is a substitute for your own and your advisors’ analysis and judgment of your own situation.
ONE: Contribute Ten Percent to Your Workplace Retirement Plan
To start, your top retirement savings priority in retirement should be to contribute at least 10 percent of your salary to your workplace retirement plan (401(k), 403(b), 457, etc.). I say this for several reasons.
It starts a great savings habit.
Subject to vesting requirements, it practically guarantees that you will get the employer match your 401(k) has, if any.
Assuming a traditional retirement account contribution, it gets you a valuable tax deduction at your marginal tax rate.
It will be incredibly difficult to get to financial independence without saving at least 10 percent of your salary.
Strive to eventually contribute the maximum allowed.
Here are some additional considerations.
Traditional or Roth
In some plans, the employee does not have a choice – employee contributions are “traditional” deductible contributions. Increasingly, plans are offering the Roth option where the contribution is not deductible today, but the contribution and its growth/earnings are tax-free in the future.
This post addresses the traditional versus Roth issue. I strongly favor traditional 401(k) contributions over Roth 401(k) contributions for most people. The “secret” is that most people pay much more in tax during their working years than they do during their retired years, even if they have significant balances in their traditional retirement accounts. Thus, it makes more sense to take the tax deduction when taxes are highest and pay the tax when taxes tend to be much lower (retirement).
Bad Investments
I’d argue that most people with bad investments and/or high fees in their 401(k) should still contribute to it. Why? First, consider the incredible benefits discussed above. Second, you’re probably not going to be at that job too long anyway. In this video, I discuss that the average/median employee tenure is under 5 years. When one leaves a job, they can roll a 401(k) out of the 401(k) to the new employer’s 401(k) or a traditional IRA and get access to better investment choices and lower fees.
Resource
Your workplace retirement plan should have a PDF document called a “Summary Plan Description” available in your workplace benefits online portal. Reviewing that document will help you figure out the contours of your 401(k) or other workplace retirement plan.
TWO: Establish a Roth IRA
For a primer on Roth IRAs, please read my Ode to the Roth IRA. Roth IRAs, like traditional IRAs, are “individual.” You establish one with a financial institution separate from your employer.
Generally speaking, a Roth IRA gives you tax-free growth, and if done correctly, money withdrawn from a Roth IRA is both tax and penalty free.
Roth IRA contributions can be withdrawn tax and penalty free at any time for any reason! The Roth IRA is the only retirement account that offers unfettered, tax-free access to prior contributions. Note, however, in most cases the best Roth IRA strategy is to keep money in the Roth IRA for as long as possible (so it continues to grow tax free!).
Taxable accounts get a very bad rap. It turns out they can be incredibly valuable.
First, they tend to be lightly taxed, even during our working years. In 2025, a $1 million investment in a broad based domestic equity index fund is likely to produce less than $13,000 of taxable income. Most of that income will qualify as “qualified dividend income” and thus be taxed at favored long-term capital gains rates.
Second, taxable accounts are the perfect bridge from working to retirement. When an investor sells an asset in a taxable account, they don’t pay tax on the amount of the sale. They pay tax on the amount of the sale less their tax basis (their original investment plus reinvested dividends). Basis recovery, combined with favored long-term capital gains tax rates, makes living off taxable accounts first in retirement very tax efficient.
Conclusion
Here are the top three tax moves I believe FI beginners should consider:
First, contribute 10 percent to your traditional 401(k) or other traditional workplace retirement plan, striving to eventually contribute up to the maximum.
Second, establish a Roth IRA.
Third, invest in taxable brokerage accounts.
Of course, this post is not tailored for any particular taxpayer. Please consult with your own tax advisor(s) regarding your own tax matters.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
What some call “tax basketing” and others call “asset location” is becoming increasingly important, particularly for early retirees and those aspiring to be early retirees.
Tax basketing is not portfolio allocation. Tax basketing is the step after portfolio allocation. First the investor decides the assets he or she wants to invest in and in what proportion.
Once that decision is made, tax basketing starts. The idea is where to hold the desired assets within the available tax categories (Roth, Traditional, Taxable, HSA) that makes the most sense from a tax efficiency perspective and a tax planning perspective.
Early Retirees and Aspiring Early Retirees
To assess tax basketing for many early retirees, I will need to make a few assumptions. First, the aspiring early retiree and the early retiree (our avatars) want to hold three main assets: domestic equity index funds, international equity index funds, and domestic bond index funds. That is simply an assumption: it is not investment advice for you or anyone else.
Second, our avatars have at least 50 percent of their financial wealth in traditional retirement accounts. This assumption makes our avatars like most Americans when it comes to their financial assets, and, in my experience, most considering or in early retirement. Third, our avatars want to have less than 50 percent of their portfolio in domestic bond index funds (again, just an assumption, not investment advice).
Lastly, most of this analysis ignores HSAs unless specifically discussed, since the balances in them tend to be rather modest and most of the Roth analysis below applies equally to HSAs.
Let’s dive deep on where our avatars should hold their desired portfolio, considering that they are either striving for early retirement or in early retirement.
Asset Yield
Tax basketing should consider many things. Chief among them is annual asset yield. Financial assets such as stocks, bonds, mutual funds, and exchange traded funds (ETFs) typically kick off interest and/or dividend income annually (often referred to as “yield”).
The expected amount of that income and the nature of that income strongly inform where to best tax basket each type of asset.
Let’s explore the three assets our avatars want using Vanguard mutual funds as a reasonable proxy for their annual income (yield) profile (not presented as investment advice).
All numbers are as of this writing and subject to change. That said, they strongly inform where we might want to hold each of these types of assets.
Let’s start with VTSAX, our domestic equity index. Notice two things? First, it produces remarkably low yield. Say I owned $1M of VTSAX in a taxable account. How much taxable income does that produce for me? Just around $12,200 annually. Further, most of that is tax-preferred qualified dividend income!
People worry about tax drag when investing in taxable accounts. Tax basketing can solve for most tax drag! Why would you worry about tax drag when it takes $1M of VTSAX to wring out just $12,200 of mostly qualified dividend income on your tax return?
What about VTIAX? In today’s environment, it produces more than twice as much dividend income as VTSAX, and much more of that income will be ordinary income (since only about 61.16% qualifies as QDI).
Lastly, let’s think about VBTLX. Bonds typically produce the most income (bonds tend to pay more out than equities do as dividends) and bonds produce only ordinary income. You can see that from a tax basketing perspective, bonds in taxable accounts tend to be undesirable.
Tax Basketing Insights
Domestic Equity Funds
Domestic equity index funds do great inside a taxable account! They barely produce any income on the owner’s tax return. The small amount of income they produce mostly qualifies for the favored tax rates of 0%, 15%, 18.8%, and 23.8%.
Recall our avatar with $1M in VTSAX. He only gets $12,200 in taxable income from that holding. If that was his only income, he doesn’t have to file a tax return, as the standard deduction is large enough to cancel out that income.
An additional point: most early retirees and potential early retirees will probably have domestic equities in all three of the main baskets: Taxable, Traditional, and Roth. To my mind, that’s not a bad thing. Yes, inside a traditional retirement account, the qualified dividend income becomes tax deferred ordinary income, not a great outcome, but also not a horrible outcome.
The tax tail should not wag the investment dog. But it is logical for most early retirees and aspiring early retirees to only hold domestic equities in taxable accounts and then hold domestic equities in traditional and Roth accounts as needed for their overall asset allocation.
International Equity Funds
International equity funds sit well in retirement accounts, whether they are traditional, Roth, and/or HSAs. They are not awful in taxable accounts, but they are not great. Why do I say that? Compare the 3.22% yield on them to the 1.22% yield on domestic equity index funds. Wouldn’t you rather have the higher yielding asset’s income sheltered by the retirement account’s tax advantages and the lower yielding asset be the one subject to current income taxes?
What About the Foreign Tax Credit?
It is true that holding international equities in a retirement account sacrifices the foreign tax credit. In a world where yields were the same and future gains were the same, the foreign tax credit would be enough to favor holding international equities in a taxable account.
However, we don’t live in that world. Further, the foreign tax credit tends to be quite small. For example, the foreign taxes withheld by Japan when Japanese companies pay Americans a dividend is 10 percent. Not nothing, but considering that there is more than double the yield paid on international equities, not enough to make it highly desirable from a tax standpoint to have income in taxable accounts. Rates vary, but can be as low as zero. Consider that most dividends paid by United Kingdom companies to American shareholders attract no dividend withholding tax and thus create no foreign tax credit on federal income tax returns.
This video breaks down the math on the foreign tax credit.
Domestic Bond Funds
Domestic bonds and bond funds sit very well in traditional retirement accounts. Why waste the tax free growth of Roth accounts on bond funds? Bonds tend to have a lower expected return, making them great for traditional retirement accounts, not Roth accounts. Further, why put the highest yield assets with the worst type of income (none of it QDI) in taxable accounts? The stage is thus set: put all the bonds in traditional retirement accounts and don’t look back.
Two traditional accounts domestic bonds do particularly well in are inherited IRAs and 72(t) IRAs!
Tax-Exempt Bonds
High income people ask: should I hold tax-exempt bonds since I have such high income? In the early 1980s, it might have made sense to alter investment allocation for tax planning reasons and invest in lower yielding tax-exempt bonds instead of high yielding taxable bonds. Back then tax rates were higher and most affluent Americans had most of their money in taxable accounts and pensions. The era of the IRA and the 401(k) was in its infancy and few had large balances in tax deferred defined contribution accounts such as traditional IRAs and traditional 401(k)s.
The world of the mid-2020s is quite different. Many pensions are gone, and affluent early retirees and aspiring early retirees tend to have much of their financial wealth in traditional IRAs and traditional 401(k)s.
That sets the stage beautifully for holding bonds in traditional retirement accounts. Income generated by bonds is tax deferred inside the traditional retirement account. Further, there’s usually plenty of headroom in the traditional IRAs and 401(k)s to hold all of the investor’s desired bond allocation. So why not hold all of the desired bond allocation inside traditional retirement accounts?
This means that for most people, there’s little reason to adjust a desired asset allocation in order to hold tax-exempt bonds and thereby sacrifice yield. Tax-exempt bonds receive no preference over taxable bonds inside a traditional 401(k) or IRA.
Keeping Ordinary Income Low
Do you see what tax basketing can do for the early retiree? If the only thing he or she owns in taxable accounts are domestic equity index funds (perhaps with a small savings account), he or she will have low taxable income and almost no ordinary income.
Or perhaps it is the Hidden Roth IRA where a retirees uses the standard deduction to live off of traditional retirement accounts. It allows the early retiree to use the standard deduction to fund living expenses from a traditional IRA and pay no federal income tax. Again, who’s complaining about paying no income tax?
Lastly, tax basketing can keep those qualified dividends and long-term capital gains at a 0% long term capital gains rate. For married couples with $96,700 or less of taxable income, the federal income tax rate on all long term capital gains and qualified dividends is 0%. One way to help ensure that outcome is tax basketing. Ordinary income from higher yielding bond funds pushes qualified dividends and long term capital gains up (through income stacking) and can subject some of it to the 15% rate. Why not hide out that ordinary income in traditional retirement accounts and only hold low yielding domestic equities in taxable accounts?
Aspiring Early Retirees
For the still working aspiring early retiree, having taxable investments generate low yield and preferred yield (qualified dividend income) can help save taxes during peak earning years. The high earner would prefer to have less QDI (through dividends paid by domestic equities) rather than more ordinary income (through dividends of ordinary income paid by domestic bond funds) hit their annual income tax return. This keeps taxable income lower, keeps the tax rate better on the portfolio income, and reduces or potentially eliminates exposure to the Net Investment Income tax.
In theory, the early retiree can fund their living expenses in three extreme manners: all from traditional retirement accounts, all from Roth retirement accounts, or all from taxable accounts. Testing these three from a Premium Tax Credit perspective can inform us about which tax basket is the best to spend from first in early retirement.
If Goldilocks funds her early retirement first from traditional IRAs and 401(k)s, she will find it’s too hot from a PTC perspective. All her spending creates taxable income, which reduces her Premium Tax Credit.
If Goldilocks funds her early retirement from Roth IRAs, she will find it’s too cold from a PTC perspective. Her spending creates no taxable income in all likelihood. That’s a huge problem from a PTC perspective. If one’s income is too low, they will not qualify for any PTC, creating a big problem in early retirement.
If Goldilocks funds her early retirement from taxable accounts, she’s likely to find it just right from a PTC perspective. Say she has $60,000 of living expenses. Will that create $60,000 of “modified adjusted gross income”? Absolutely not. It will create $60,000 less her tax basis in the assets she sold in modified adjusted gross income. This gives her an outstanding chance of having a low enough income to qualify for a significant PTC. If her basis was too high and she did not create enough income to qualify for a PTC, she could, prior to year-end, execute some Roth conversions to get her income to the requisite level.
What Goldilocks’ example demonstrates is that it is a good thing to have amounts, perhaps significant amounts, in the taxable basket heading into early retirement. While there is absolutely hope for those with little in the taxable basket, it will require some additional planning in many cases.
You know what can help mitigate RMDs? Tax basketing!
By holding all of one’s domestic bond investments in traditional IRAs and traditional 401(k)s, retirees can keep the future growth inside traditional retirement accounts modest. When compared to equities, bonds have a lower expected return and thus a lower expected future value. This, in turn, reduces future traditional account balances, reducing future required minimum distributions. Recall that RMDs are computed using the account balance from the prior year as the numerator. Keeping that numerator more modest reduces future RMDs.
Sequence of Returns Risk and Tax Basketing
Some worry about sequence of returns (“SoR”) risk: what if I retire and the equity markets happen to have a year like 1987 or 2008 right as I’m retiring? At least in theory this is a risk of retiring at any time and the risk is magnified by an early retirement.
Say Maury, age 50, is about to retire and worried about SoR risk so he wants to have three years of cash going into retirement (again, not an investment recommendation, just a hypothetical). Cash generates interest income, which is bad from a tax efficiency perspective. Can Maury use tax basketing to manage for SoR risk and stay tax efficient? Sure!
Imagine Maury retires with $500K in a domestic equity index fund in a taxable brokerage, $240,000 of cash and/or money markets in a traditional IRA (3 years of expenses), $500K of domestic bonds in a traditional IRA, and about $1M in a combination of domestic and international equities in a traditional IRA.
Maury can live on the cash and only live on his taxable brokerage account. Wait, what? I thought the cash lives in the traditional IRA. It does.
But Maury can simply sell $80,000 of the domestic equity index fund annually and report mostly long term capital gains and (rather modest) qualified dividend income on his tax return. His income might be so low he wants or needs to do Roth conversions! Separately inside the traditional IRA he “spends down” the cash by annually buying $80,000 of any desired combination of domestic equities, international equities, and/or domestic bonds inside his traditional IRA.
Maury just used tax basketing to live off almost a quarter million of cash for three years without reporting a penny of interest income to the IRS!
Announcement
You have just read a sneak preview of part of the new book! Cody Garrett, CFP(R) and I are working on, tentatively titled Tax Planning To and Through Early Retirement. In 2025 the retirement tax planning landscape is changing, and Cody and I want to be on the cutting edge as retirement tax planning changes.
This post will, in modified form, constitute part of the book’s tax basketing (a/k/a asset location) chapter.
When will the book come out? Well, that’s a question better asked of elected officials in Washington DC than of your authors. 😉
What topics would you like us to cover in the book? Let us know in the comments below!
Stay tuned to me on X and LinkedIn and Cody on LinkedIn for updates on when the book will be available!
Conclusion
Tax basketing can be a great driver of success to and through early retirement. From a purely tax basketing perspective, domestic equity index funds tend to sit well in taxable accounts, international equity index funds tend to sit well in retirement accounts, and domestic bond index funds tend to sit well in traditional retirement accounts. Premium Tax Credit considerations tend to favor having some money in taxable accounts in early retirement. Good tax basketing can keep taxable income low and facilitate excellent early retirement tax planning.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
Retirement planning rarely intersects with the Constitution.
SECURE 2.0, the component of the late December 2022 Omnibus bill with dozens of retirement account rule changes, does.
As discussed by Judge James W. Hendrix in his excellent opinion in Texas v. Garland, the House of Representatives used proxies to establish a quorum to pass the Omnibus, in violation of the Constitution’s Quorum Clause.
The Constitutional issue with SECURE 2.0 is now ripe for the new Trump Administration. On its way out the door, the Biden Administration issued proposed regulations under Section 603 of SECURE 2.0 (mandatory Rothification of certain catch-up contributions) on January 13th.
Typically, the government gets comments on proposed regulations and considers changes around the edges before finalizing the regulations. But SECURE 2.0 presents a unique case.
I wrote a comment letter in response to the proposed regulations asking the government to withdraw the proposed regulations since the underlying statute was not passed in a Constitutionally qualified manner. You can read the comment letter here and here.
Let me know what you think about the Constitutionality of SECURE 2.0 in the comments.
This post and the linked-to comment letter do not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
Did you know that if you’re reading this before April 16, 2025 (before October 16, 2025 if you live in Los Angeles), it’s still possible to do a 2024 Backdoor Roth IRA?
Below I go through an example with a theoretical step plan to do two Backdoor Roth IRAs in 2025!
Everything below is academic information and opinion provided for your education and entertainment. It is not individualized tax, legal, or investment advice for you or anyone else.
2024 and 2025 Backdoor Roth IRA Example
Brad is 38. In early 2025, he learned about the Backdoor Roth IRA. He makes approximately $300,000 of adjusted gross income in each of 2024 and 2025, so he does not qualify for an annual Roth IRA contribution. Brad has no traditional IRAs, SEP IRAs, and/or SIMPLE IRAs.
Brad takes the following steps to implement two Backdoor Roth IRAs in 2025.
Step 1: Brad contributes $7,000 to a traditional IRA in February 2025. He codes the contribution as being for 2024. Brad invests it in a money market fund.
Step 2: In March 2025, Brad converted the entire traditional IRA balance, now $7,020, to a Roth IRA.
Step 3: In April 2025, Brad files his 2024 federal income tax return with a Form 8606 reporting the $7,000 2024 nondeductible traditional IRA contribution.
Step 7: Brad files a Form 8606 with his 2025 federal income tax return. It reports (1) the 2025 nondeductible traditional IRA contribution and (2) both Roth conversions.
It’s almost too easy 😉 . . .
Here is what Brad’s 2025 Form 8606 looks like (pardon the use of the 2024 version of the form, as I cannot currently access the 2025 version without a DeLeorean, a flux-capacitor, and 1.21 gigawatts of electricity).
What Has Brad Accomplished?
I believe this planning can be quite beneficial for Brad’s financial future. He just got $14,000 out of taxable accounts and into a tax free account for the rest of his life. Further, that $14,000 now enjoys a significant degree of creditor protection (note this does vary state to state).
Two years of a Backdoor Roth IRA don’t make that much of a difference. But what about 5 years? 10 years? 20 years? Now we are talking about significant numbers that can help Brad accomplish his financial goals.
Conclusion
In early 2025 it is not too late to do a Backdoor Roth IRA for 2024. I refer to this as the Split-Year Backdoor Roth IRA. It can be combined with a current year Backdoor Roth IRA.The taxpayer has to have the right profile, including no balances in traditional IRAs, SEP IRA, and/or SIMPLE IRAs.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
Late 2022 ushered in a new type of contribution to Solo 401(k)s: Roth employer contributions. Traditional employee and employer contributions have been available for all of the Solo 401(k)’s post-EGTRRA history. Roth employee contributions have been available since 2006, even if plan providers were slow to adopt them.
Should the availability of Roth employer contributions change planning for most solopreneurs? Not to my mind.
I have three concerns with making Roth employer contributions to Solo 401(k)s.
First Concern: Validity
Roth employer contributions were part of SECURE 2.0, which was part of the Omnibus bill passed in December 2022. That Omnibus bill has been subject to litigation. In Texas v. Garland (accessible here and here), Judge James W. Hendrix ruled for the State of Texas that the House of Representatives impermissibly used proxies to establish a quorum in order to pass the Omnibus, in violation of the Constitution’s Quorum Clause.
I encourage you to read the Texas v. Garland opinion. It is very convincing in my opinion.
While Texas v. Garland does not technically apply to SECURE 2.0, its reasoning does. Any taxpayer in the country facing harm under SECURE 2.0 (perhaps because they were denied the deduction for catch-up contributions under SECURE 2.0 Section 603) can pick it up and ask another federal judge to invalidate SECURE 2.0. That leaves SECURE 2.0 on shaky footing.
Short of litigation, there’s the question of what the new Administration will do with the Omnibus and SECURE 2.0. Texas v. Garland is litigation between the old Department of Justice and Ken Paxton, the Attorney General of Texas. Ken Paxton is much closer aligned politically with the Trump Administration. Will the Trump DoJ continue to litigate against Ken Paxton? The Trump Administration may simply refuse to uphold the Omnibus, including SECURE 2.0.
My hope is that if that happens taxpayers who have relied on SECURE 2.0 will be held harmless. For example, amounts in Roth 401(k)s (including Solo 401(k)s) attributable to employer contributions should be deemed to be amounts validly within the Roth 401(k) plan, so past reliance does not cause future harms (such as failed plan qualification). That said, my hope, a reasonable hope, is just a hope.
Regardless of one’s views on the Quorum Clause litigation, there’s at least some doubt as to SECURE 2.0’s validity, including the validity of Roth employer contributions to Solo 401(k)s. That makes planning into them difficult, in my opinion.
Second Concern: Section 199A Problem
Ben Henry-Moreland of Kitces.com wrote a thoughtful article on Roth employer contributions to Solo 401(k)s potentially reducing a solopreneur’s Section 199A qualified business income deduction.
I both agree and disagree with Mr. Henry-Moreland. I agree in a general sense that recent IRS guidance has muddied the waters when it comes to tax return reporting of Roth employer contributions to Solo 401(k)s. I disagree with his conclusion that this guidance results in non-deductible Roth employer contributions to Solo 401(k)s reducing the Section 199A qualified business income deduction.
The concern is Roth employer contributions might reduce the amount of qualified business income that then determines the Section 199A QBI deduction. Mr. Henry-Moreland is concerned about this because of Notice 2024-2 Q&A L9 (page 76 of this file). It tells plans how to report Roth 401(k) employer contributions in general. The question is “what reporting obligations apply to [Roth employer] contributions?”
Before I state the concerning answer, one must remember the context. This particular Q&A is about reporting, not about taxation. In theory, Roth employer contributions (taxable to the employee) should be simply added to W-2 income for most employees. But that creates a huge headache from a large employer systems perspective. That’s W-2 income that is income tax taxable but not payroll tax taxable. Ugh!
To avoid the payroll systems issue (which is mostly a large employer issue rather than a Solo 401(k) issue), the Notice provides that Roth employer contributions are reported “as if: (1) the contribution had been the only contribution made to an individual’s account under the plan, and (2) the contribution, upon allocation to that account, had been directly rolled over to a designated Roth account in the plan as an in-plan Roth rollover.” (emphases added). The Notice goes on to state that because of this treatment the Roth employer contribution is reported to the employee as taxable on a Form 1099-R.
Mr. Henry-Moreland is concerned that as applied to a Schedule C solopreneur, this is reported by deducting the contribution from net self-employment income (presumably on Schedule 1, Line 16) and then taxing the amount on Form 1040 Lines 5a and 5b. This reduction of net self-employment income would result in a reduction in the Section 199A QBI deduction.
While I hear Mr. Henry-Moreland’s concern, I disagree with it for several reasons. First, the Q&A in question applies to reporting by plans. It does not appear to apply to (1) determining taxable income or other tax relevant amounts and (2) tax return reporting by individuals. It is telling that the answer is silent as to any forms filed by individuals while it goes into depth as to how the Form 1099-R is to be filed.
Second, the words “as if” in the Notice’s answer are illuminating. The reporting is done “as if” X and Y happened for tax purposes. That means X and Y did not happen for tax purposes, which is good news from a Section 199A perspective. Third, the Notice does not purport to affect Section 199A in any way. Fourth, qualified business income is determined under Section 199A and Treas. Reg. Section 1.199A-3. Neither SECURE 2.0 Section 604 nor Notice 2024-2 mention Section 199A and qualified business income. Thus, I believe that Notice 2024-2 and Roth employer contributions to Solo 401(k)s do not reduce the qualified business income deduction.
The above views voiced, there may be some small risk that Roth employer contributions to Solo 401(k)s are not only nondeductible, they also reduce the qualified business income deduction. That’s a negative when assessing their desirability from a planning perspective.
How to Report Solo 401(k) Roth Employer Contributions on 2024 Tax Returns
What follows is my academic opinion, not advice for you or anyone else. To properly report Roth employer contributions to a Solo 401(k) made in 2024 for 2024 and arrive at the correct Section 199A QBI deduction, I believe the following is the best way to proceed:
(1) Report Schedule C income and deductions as normal. This should help generate the appropriate Section 199A QBI deduction.
(2) Report the amount of the Roth employer contribution to the Solo 401(k) in full in Box 5a of Form 1040.
(3) Assuming no other pension, annuity, 401(k), or other qualified plan distributions, report $0 for the taxable amount of pension and annuity distributions in Box 5b of Form 1040.
My view is that the above will properly report that which must be reported to the IRS while also (i) avoiding any double counting and (ii) properly computing the Section 199A QBI deduction that the taxpayer is entitled to.
If anyone at the IRS or the Treasury Office of Tax Policy is reading this, it would very helpful for the government issuing guidance (1) clarifying that no, Roth employer contributions to Solo 401(k)s do not reduce the Section 199A qualified business income deduction and (2) illustrating the proper tax return reporting for Roth employer contributions to Solo 401(k)s.
Third Concern: Planning Desirability
For this section, let’s assume that I am wrong when it comes to the first concern and I am correct regarding the second concern. Making those two assumptions, Roth employer contributions to Solo 401(k)s are valid and do not reduce the Section 199A QBI deduction.
Great!
Does that mean we should plan into such contributions? I believe the answer is generally “No” for most solopreneurs.
Even with the “deduction-reduction problem” issue with traditional Solo 401(k) contributions, traditional Solo 401(k) contributions are often going to be better than Roth Solo 401(k) contributions.
Picture a solopreneur in the 24% marginal tax bracket. He or she can make employer contributions to a traditional Solo 401(k) and save 19.2 cents on the dollar (24% times 80% to account for the reduction to the Section 199A QBI deduction).
Okay, well, how is that money taxed in retirement? I’ve done blog posts and YouTube videos about this subject. Some of that money could be taxed at 0% because of the standard deduction (the Hidden Roth IRA), then against the 10% bracket and then against the 12% bracket. We can hardly say traditional contributions are always the “right answer,” but we can acknowledge that (1) retirees tend to be lightly taxed in retirement and (2) retirees greatly benefit from today’s tax environment, including large standard deductions and progressive tax brackets.
I question the planning value of Roth employer contributions. Say you disagree with me. You still have Roth employee contributions. Why not hedge your bets by making Roth employee contributions and deductible traditional employer contributions? Both of these types of contributions are well established under the law.
Conclusion
Roth employer contributions to Solo 401(k)s are on shaky legal ground and are not that desirable from a planning perspective. There’s even a chance they reduce the Section 199A QBI deduction. Based on those concerns, I believe Roth employer contributions to Solo 401(k)s are undesirable for most solopreneurs.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
The 2025 fires in Los Angeles have been devastating. My heart goes out to all those affected, and you are in my prayers.
Los Angeles County now has a deadline delay for their 2024 tax returns, 2024 and 2025 tax payments, and IRA contributions.
Los Angeles County Tax Deadline Delay
The IRS announced that because of the January 2025 fires in Los Angeles, Angelenos have an extended deadline, October 15, 2025, to perform most 2024 tax acts that otherwise would have been due early in 2025. The Franchise Tax Board has followed suit and also issued their own delay announcement with respect to California state income tax returns and payments.
2024 Traditional and Roth IRA Contributions
The deadline for Los Angeles County residents to make 2024 contributions to traditional and/or Roth IRAs has been extended to October 15, 2025. As a practical matter, I wouldn’t encourage reliance on this particular deadline delay. Financial institutions may find it difficult to allow “late but timely” 2024 IRA contributions on their platform when it is available only to residents of a single county.
If you are an Angeleno reading this after April 15, 2025 and want to make an IRA contribution for 2024, I recommend initiating the process by calling the financial institution rather than using the financial institution’s website.
2024 Backdoor Roth IRAs
Los Angeles County residents now have until October 15, 2025 to execute the first step of a 2024 Backdoor Roth IRA, the nondeductible contribution to a traditional IRA for 2024. This would be a Split-Year Backdoor Roth IRA.
2024 Tax Returns and Payments and 2025 Q1 Through Q3 Estimated Tax Payments
Los Angeles County residents now have until October 15, 2025 to (i) file their 2024 federal and California income tax returns, (ii) pay the amount due with their 2024 federal and California income tax returns, (iii) make fourth quarter 2024 estimated tax payments, and (iv) make 2025 first through third quarter estimated tax payments.
Who Benefits?
Residents of Los Angeles County qualify for the extended deadline. Note (1) there’s no need to have suffered any loss or damage due to the fires and (2) the extensions apply to the entirety of Los Angeles County. It is not just limited to residents of the City of Los Angeles.
Taxpayers with records in Los Angeles County can also benefit.
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.
Happy New Year! It’s Backdoor Roth IRA season, so let’s talk about the issue that refuses to go away . . . the timing of the two steps of the Backdoor Roth IRA.
Recall that the Backdoor Roth IRA is a two-step transaction. First, there is a nondeductible contribution to a traditional IRA. The second step is a relatively close-in-time conversion of the nondeductible traditional IRA contribution and any minor growth to a Roth IRA. Assuming the correct profile, this can move money into a Roth IRA for a year the person exceeds the Roth IRA contribution MAGI limits.
If there are two steps of the Backdoor Roth IRA, that begs a question: Just how long do I have to wait between the two steps, i.e., how long does the nondeductible traditional IRA contribution have to sit in the traditional IRA prior to the Roth conversion step? A minute? A day? A month? A year?
The Backdoor Roth IRA and the Step Transaction Doctrine
There has been a concern with the Backdoor Roth IRA: the step transaction doctrine, which can collapse steps into a single step. In theory, the two steps of the Backdoor Roth IRA can be viewed as a single step (a direct contribution to a Roth IRA), which creates an excess contribution(subject to a potential 6 percent penalty). Michael Kitces has written that he is concerned that, because the Roth conversion step might occur so soon after the nondeductible traditional IRA contribution, the step transaction doctrine can apply to the Backdoor Roth IRA. Kitces generally advocates waiting a year between the steps based on his step transaction doctrine concern. To my knowledge he has never changed his view on the issue.
Two late 2010’s developments moved the needle in the practitioner community towards Mr. Levine’s view. First, the IRS, in informal comments, indicated they were not too concerned with the Backdoor Roth IRA. Second, the legislative history to 2017’s Tax Cuts and Jobs Act indicated that Congressional staffers believed the Backdoor Roth IRA was valid. I believe this second development was overblown, as legislative history, to the extent relevant, is relevant to the legislation then being passed. It is not relevant, to my mind, to prior legislation (the Backdoor Roth IRA enabling legislation passed in 2006 – see Section 512). That said, both developments were informative, though certainly not binding.
Sean’s Take
I have never been too concerned with the Step Transaction Doctrine and the Backdoor Roth IRA. In 2019, I co-wrote a Tax Notes article (available behind a paywall) about the issue with Ben Willis, my former PwC colleague. We concluded that it is not appropriate to apply the step transaction doctrine to a taxpayer’s use of the explicit, taxpayer favorable IRA rules. I believe we made a good case that the step transaction should not apply to the Backdoor Roth IRA based on the contours of the doctrine.
The Backdoor Roth IRA and Section 408(d)(2)(B)
Since 2019, I have further developed my thinking. I now believe a little commented-on rule in the IRA statute is very instructive: Section 408(d)(2)(B).
Section 408(d)(2)(B) provides that all IRA distributions during the year are treated as a single distribution. As a result, the timing of IRA distributions is irrelevant. A January 1st distribution is treated the same as a March 29th distribution, which is treated the same as a December 31st distribution. Roth conversions are distributions from an IRA.
By grouping all IRA distributions into a single distribution, the Internal Revenue Code tells us the timing of IRA distributions, including Roth conversions, during the year is irrelevant.
It would be exceedingly odd to apply a judicial doctrine (the step transaction doctrine) to give that timing relevance when the Code strips away that relevance. Anyone arguing the step transaction doctrine applies to a Backdoor Roth IRA is saying that the step transaction doctrine should override the specific rule of Section 408(d)(2)(B) in determining the degree of relevance afforded to the timing of the Roth conversion step.
I strongly believe it is not appropriate to apply the step transaction doctrine when the Internal Revenue Code itself gives us a rule telling us the timing of the Roth conversion is irrelevant.
Backdoor Roth IRA Favored Timing
I have two beliefs. First, timing is irrelevant when doing the Backdoor Roth IRA. Second, my views are not guaranteed to yield a 9-0 Supreme Court decision 😉
Based on those two beliefs, I have a third. The most desirable Backdoor Roth IRA path is to wait until the end of a month passes and then do the Roth conversion step of the Backdoor Roth IRA. This is the old Ed Slott tactic and locks in an end-of-month statement showing some interest or dividends in the traditional IRA.
It could look something like this:
Roger contributes $7,000 to his traditional nondeductible IRA on January 2, 2025 for 2025 and invests it in a money market fund. On February 1, 2025, he converts the entire amount, now $7,027, to a Roth IRA. He has no other IRA transactions during the year and on December 31, 2025 he has $0 balances in any and all traditional IRAs, SEP IRAs, and SIMPLE IRAs.
Oh no, Roger created $27 of taxable income on his Backdoor Roth IRA. We’ve finally found something worse than IRMAA!
All kidding aside, here’s what Roger’s 2025 Form 8606 could look like (pardon the use of the 2023 form, the latest version available as of this writing): 8606 Page 18606 Page 2And, yes, Roger should convert the entire traditional IRA balance, not just the $7,000 originally contributed to the traditional IRA.
To my mind, this works as a good Backdoor Roth IRA. So now you say, But Sean, what about your first belief? I thought timing was irrelevant!
I respond, (A) see my second belief and (B) what’s the downside of my desired approach?
$27 of taxable income creates $10 of federal income tax if Roger is in the highest federal tax bracket, and Roger will have $27 more protected from future tax by the Roth IRA.
The Backdoor Roth IRA Should Not Exist
That the Backdoor Roth IRA exists is ridiculous. It is obnoxious that our tax laws are so complicated that one of the most prominent financial planners, Michael Kitces, could plausibly claim the step transaction doctrine adversely impacts the Backdoor Roth IRA.
Let’s end all of this and adopt a rule that notorious tax haven, Canada, has adopted: Eliminate the income limit on the ability to make an annual Roth IRA contribution! Canada’s Tax-Free Savings Account (their version of a Roth IRA) has absolutely no income limit on the ability to make a contribution. America should adopt that rule as a small part of what hopefully will be a dramatic simplification of American income tax laws in 2025.
Conclusion
I do not believe that the step transaction doctrine should apply to the Backdoor Roth IRA. I do not believe that the timing of the two steps is relevant for determining their ultimate federal income taxation. That said, I like waiting until the following month to do the Roth conversion step.
Of course, the entirety of this article is simply academic commentary. It is not tax, legal, or investment advice for you or anyone else.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
There are only three types of annual contributions to individual retirement accounts (“IRAs”). They are:
Traditional, nondeductible contributions
Traditional, deductible contributions
Roth contributions
This post discusses when a taxpayer can make one or more of these types of annual contributions.
Let’s dispense with what we are not talking about. This post has nothing to do with annual contributions to employer retirement plans (401(k)s and the like) and self-employed retirement plans. We’re only talking about IRAs. The Individual in “IRA” is the key – anyone can set up their own IRA. IRAs are not pegged to any particular job or self-employment.
The above list is the exhaustive list of the possible types of annual contributions you can make to an IRA. But there is plenty of confusion about when you are eligible to make each of the three types of annual contributions.
Two notes on this. First the limit is shared between traditional IRAs and Roth IRAs. In theory, someone under age 50 could contribute $4,000 to a traditional IRA and $3,000 to a Roth IRA. In practice, contributions are rarely divided between the traditional and the Roth, but it does occasionally happen.
Second, the limits have an additional limit: the contribution cannot exceed earned income. This means that those fully retired cannot contribute to an IRA unless they have a spouse who has earned income. A fully retired person (or a homemaker) can use their spouse’s earned income as their earned income and contribute to what is often referred to as a Spousal IRA.
Why Contribute to an IRA?
Why you would consider contributing to an IRA? The main reason is to build up tax-deferred wealth (traditional IRAs) and/or tax-free wealth (Roth IRAs) for your future, however you define it: financial independence, retirement, etc. A second potential benefit is the ability to deduct some annual contributions to traditional IRAs. A third benefit is some degree of creditor protection. States offer varying levels of creditor protection to traditional IRAs and Roth IRAs, while the federal government provides significant bankruptcy protection for traditional IRAs and Roth IRAs.
Traditional Nondeductible IRA Annual Contributions
There’s are only one requirement to contribute to a traditional, nondeductible IRA for a taxable year:
You and/or your spouse have earned income during that taxable year.
That’s it! As long as you satisfy that requirement, you can contribute to a traditional nondeductible IRA, no further questions asked.
Example: Teve Torbes is the publisher of a successful magazine. He is paid a salary of $1,000,000 in 2025 and is covered by the magazine’s 401(k) plan. Teve can make up to a $7,000 nondeductible contribution to a traditional IRA, and Teve’s wife can also make up to a $7,000 nondeductible contribution to a traditional IRA.
There is no tax deduction for contributing to a traditional nondeductible IRA. The amount of your nondeductible contribution creates “basis” in the traditional IRA. When you withdraw money from the traditional IRA in retirement, a ratable portion of the withdrawal is treated as a return of basis and thus not taxable (the “Pro-Rata Rule”).
Example: Ted makes a $6,000 nondeductible traditional IRA contribution for each of 10 years ($60,000 total). When he retires, the traditional IRA is worth $100,000, and he takes a $5,000 distribution from the traditional IRA. Ted is over 59 ½ when he makes the withdrawal. Of the $5,000 withdrawal, Ted will include $2,000 in his taxable income, because 60 percent ($3,000 — $60,000 basis divided by $100,000 fair market value times the $5,000 withdrawn) will be treated as a withdrawal of basis and thus tax free.
Traditional nondeductible IRA contributions generally give taxpayers a rather limited tax benefit. However, since 2010 traditional nondeductible IRA contributions have become an important tax planning tool because of the availability of the Backdoor Roth IRA.
Making a nondeductible IRA contribution requires the filing of a Form 8606 with your federal income tax return.
Traditional Deductible IRA Annual Contributions
In order to make a deductible contribution to a traditional IRA, three sets of qualification rules apply.
ONE: No Workplace Retirement Plan
Here are the qualification rules if neither you nor your spouse is covered by an employer retirement plan (401(k)s and the like and self-employment retirement plans):
You and/or your spouse have earned income during that taxable year.
That’s it! As long as you satisfy that requirement and you and your spouse are not covered by an employer retirement plan, you can make a deductible contribution to a traditional IRA, no further questions asked.
Example: Teve Torbes is the publisher of a successful magazine. He and his wife are 45 years old. He is paid a salary of $1,000,000 in 2025. Neither he nor his wife is covered by an employer retirement plan. Teve can make up to a $7,000 deductible contribution to a traditional IRA, and Teve’s wife can also make up to a $7,000 deductible contribution to a traditional IRA.
TWO: You Are Covered by a Workplace Retirement Plan
Here are the deductible traditional IRA qualification rules if you are covered by an employer retirement plan:
You and/or your spouse have earned income during that taxable year.
Your modified adjusted gross income (“MAGI”) for 2025 is less than $89,000 (if single), $146,000 (if married filing joint, “MFJ”), or $10,000 (if married filing separate, “MFS”).
Note that in between $79,000 and $89,000 (single), $126,000 and $146,000 (MFJ) and $0 and $10,000 (MFS), your ability to make a deductible contribution to a traditional IRA phases out ratably. Here is an illustrative example.
Example: Mike is 30 years old, single, and is covered by a 401(k) plan at work. Mike has a MAGI of $84,000 in 2025, most of which is W-2 income. Based on a MAGI in the middle of the phaseout range, Mike is limited to a maximum $3,500 deductible contribution to a traditional IRA.
Assuming he makes a $3,500 deductible IRA contribution, Mike has $3,500 worth of IRA contributions left. He can either, or a combination of both (up to $3,500) (a) make a contribution to a nondeductible traditional IRA, since he meets the qualification requirement to contribute to a nondeductible traditional IRA or (b) make a contribution to a Roth IRA, since he meets the qualification requirements (discussed below) to contribute to a Roth IRA.
THREE: Only Your Spouse is Covered by a Workplace Retirement Plan
Here are the deductible traditional IRA qualification rules if you are not covered by an employer retirement plan but your spouse is covered by an employer retirement plan:
You and/or your spouse have earned income during that taxable year.
Your MAGI for 2025 is less than $246,000 (MFJ) or $10,000 (MFS).
Note that in between $236,000 and $246,000 (MFJ) and $0 and $10,000 (MFS), your ability to make a deductible contribution to a traditional IRA phases out ratably.
Roth IRA Annual Contributions
Here are the Roth IRA annual contribution qualification rules.
You and/or your spouse have earned income during that taxable year.
Your MAGI for 2025 is less than $165,000 (single), $246,000 (MFJ), or $10,000 (MFS).
Note that in between $150,000 and $165,000 (single), $236,000 and $246,000 (MFJ), and $0 and $10,000 (MFS), your ability to make a Roth IRA contribution phases out ratably.
Notice that whether you and/or your spouse are covered by an employer retirement plan (including a self-employment retirement plan) is irrelevant. You and your spouse can be covered by an employer retirement plan and you can still contribute to a Roth IRA (so long as you meet the other qualification requirements).
Here is an example illustrating your options in the Roth IRA MAGI phaseout range.
Example: Mike is 30 years old, single, and covered by a workplace retirement plan. Mike has a MAGI of $159,000 for 2025, most of which is W-2 income. Based on a MAGI 60 percent through the phaseout range, Mike is limited to a maximum $2,800 contribution to a Roth IRA.
Assuming he makes a $2,800 annual Roth IRA contribution, Mike has $4,200 worth of IRA contributions left. He can make up to $4,200 in annual contributions to a nondeductible traditional IRA, since he meets the qualification requirement to contribute to a nondeductible traditional IRA.
Deadlines
The deadline to make an IRA contribution for a particular year is April 15th of the year following the taxable year (thus, the deadline to make a 2025 IRA contribution is April 15, 2026). The deadline to make earned income for a taxable year is December 31st of that year.
Rollover Contributions
There’s a separate category of contributions to IRAs: rollover contributions. These can be from other accounts of the same type (traditional IRA to traditional IRA, Roth IRA to Roth IRA) or from a workplace retirement plan (for example, traditional 401(k) to traditional IRA, Roth 401(k) to Roth IRA).
Rollover contributions do not require having earned income and have no income limits and should be generally tax-free. For a myriad of reasons, it is usually best to effectuate rollovers as direct trustee-to-trustee transfers.
As a practical matter, it is often the case that IRAs serve at the retirement home for workplace retirement plans such as 401(k)s.
Further Reading
Deductible traditional IRA or Roth IRA? If you qualify for both, it can be difficult to determine which is better. I’ve written here about some of the factors to consider in determining whether a deductible traditional contribution or a Roth contribution is better for you.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
