If that is the case, the Solo 401(k) should be rolled over to an IRA and there’s no ability to use the Rule of 55.
Until now, I’m not aware that anyone has done a deep dive to validate or disprove that concern. So I decided to do it myself. My research took me as close to the year 1962 as one can get without a flux capacitor, a DeLorean, and 1.21 gigawatts of electricity.
I’ve now changed my view on the Solo 401(k) Rule of 55 issue. The analysis is too complicated to write adequately in a blog post. Thus, I’m self-publishing an article, Solo 401(k)s and the Rule of 55: Does the Answer Lie in 1962? (accessible here), on the topic.
Of course, the article is not legal or tax advice for you, any other individual, and any plan.
For those of you who read my book, Solo 401(k): The Solopreneur’s Retirement Account (thank you!), please know the article is written differently. The book is a “101” and “201” level discussion of tax planning for the self-employed with some beginning and intermediate tax rule analysis. The article is much more akin to a “501” level discussion of a complex and somewhat uncertain tax issue emerging from ambiguities in the Internal Revenue Code
Enjoy the article and let me know what you think in the comments below.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post and the linked-to article are for entertainment and educational purposes only. They do not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
Happy National 529 College Savings Day! Let’s celebrate with five reasons to avoid 529s.
Cart Before the Horse
I’ve said it before and I’ll say it again: far too often new parents have relatives extolling the virtues of a 529 at the reception after the Baptism.
Those relatives rarely step back and ask “how are Mom and Dad’s finances?”
Picture a typical late-20s / early 30s Mom and Dad of a newborn. What are their financial pain points? What’s needed in their financial lives?
I can tell you what is not their financial pain point: taxes on investment income. Yet this is what the 529 solves for. The 529 for a newborn’s parents is often the equivalent of a cast for someone with a paper cut!
What do Mom and Dad need in their financial lives? If they are anything like the typical American adult, they probably need more in the way of retirement savings. Shouldn’t Mom and Dad prioritize their own compelling retirement needs over saving for a speculative potential future expense of their newborn baby, college education?
In 2024 we’re in a great time to own taxable investments. Long term capital gains and qualified dividend income are taxed at 0%, 15%, 18.8%, and 23.8% (when factoring in the potential net investment income tax). Having equities inside a 529 avoids that tax, which is quite modest by historical standards. That tax is particularly small considering the low dividend yield environment we currently have.
Further, the state tax benefits are usually modest. In our three largest states, California, Texas, and Florida, there’s no immediate state benefit for a 529 contribution.
Flexibility
As much as possible, a dollar ought to be able to serve multiple masters and multiple purposes.
Inside a taxable brokerage account, a dollar can efficiently support (i) Mom and Dad during their working years, (ii) Mom and Dad during their retirement, (iii) a new roof for the house, (iv) a family vacation to Yellowstone, and/or (v) Junior’s college education.
Inside a 529, a dollar can efficiently support (i) Junior’s college education.
Why should the parents of a newborn handcuff their money when the tax benefits are quite modest? Why shouldn’t Mom and Dad remain flexible for their own financial future and decide what to do with that dollar later on, when they have more knowledge and information?
Many things can happen in the future that could make having a large sum in a 529 a bad thing: maybe Junior went to trade school, Junior got a scholarship, and/or Mom and Dad had financial struggles and now need that dollar to support their own retirement.
The 529 Overfunding Problem
Scholarships happen. Some newborns don’t end up going to college. These are just two of the reasons that 529s get overfunded.
Taken for non-educational purposes, 529 distributions that represent earnings are subject to ordinary income tax rates and a 10 percent penalty. Ouch!
There are bailout techniques available to avoid negative tax consequences, but they are all limited to various degrees. The SECURE 2.0 529-to-Roth IRA rollover is very limited and, in my opinion, not something to be planned into.
Feeding the Beast
What grade would you give American higher education in 2024?
American higher education often produces graduates who are ill-equipped for the modern economy and/or have staggering student debt loads. Many colleges and universities have administrative bloat that has gotten wildly out of hand.
Why should newborns’ parents handcuff their money such that they can only avoid a penalty by paying it over to American higher education? How does that make sense? Very modest tax benefits are nowhere near sufficient to make that make sense.
Conclusion
I’m not here to say funding a 529 never makes sense. But I am here to say (1) I believe that 529s are wildly overhyped and (2) 529s rarely make sense for the financial profile and needs of the parents of newborns.
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 conventional wisdom says to accumulators “Save through a Roth 401(k)! Don’t you dare contribute to traditional 401(k)s. Those things are infested with taxes!!!”
Doubt that prioritizing Roth 401(k) contributions over traditional deductible 401(k) contributions is the conventional wisdom? Let’s hear from some very prominent personal finance commentators:
These commentators have much bigger platforms than I have, and they are to be commended for their many solid contributions to the personal finance discourse. On this particular issue, however, I believe their conventional wisdom misses the mark. I believe most of those saving for retirement during their working years should prioritize traditional deductible 401(k) contributions.
Here are the eight reasons why I believe the conventional wisdom on the traditional 401(k) versus Roth 401(k) debate is wrong.
Traditional Retirement Account Distributions are Very Lightly Taxed
Those 401(k)s and traditional IRAs are infested with taxes, right!
I have run the numbers in several blog posts and YouTube videos. Long story short, while working contributions into traditional 401(k)s generally enjoy a tax benefit at the taxpayer’s highest marginal tax rate while traditional retirement account distributions are taxed going up the progressive tax brackets in retirement (including the 10% and 12% brackets). This results in surprisinglyloweffective tax rates on traditional 401(k) and traditional IRA withdrawals in retirement.
The Tax Hikes Aren’t Coming
If “experts” keep predicting A and the exact opposite of A, B, keeps occurring and A never occurs, then the experts constantly predicting A aren’t good at predicting the future!
That’s where we are when it comes to predicting future tax hikes on retirees. Experts keep predicting that taxes are going through the roof on retirees. Experts use those predictions to justify the Roth 401(k) contribution push.
There’s a problem with those predictions: they have been dead wrong!
I did a video on this. Not only does Congress avoid tax hikes on retirees, recent history indicates Washington is addicted to tax cuts on retirees. To wit:
December 2017: TCJA increases the standard deduction and reduces the 15% bracket to 12%. There are few better ways to cut retiree taxes!
December 2019: The SECURE Act delays required minimum distributions (“RMDs”) from age 70 ½ to age 72.
March 2020: The CARES Act cancels 2020 RMDs and allows those already taken to be rolled back into retirement accounts in a very liberal fashion.
November 2020: The Treasury gets into the act by publishing new RMD tables that reduce annual RMDs.
Sure, the federal government has too much debt. Does that mean that taxes must necessarily rise on retirees? Absolutely not!
There are many solutions that can leave retirees unscathed, including:
Raising tariffs.
Raising taxes on college endowments, private foundations, high income investors’ dividends and capital gains, and hedge fund managers.
Eliminating electric vehicle tax credits.
Spending cuts, particularly to military spending and foreign spending. These are becoming more likely as American politics continue to change.
Conventional Wisdom Misses the Sufficiency Problem
How much tax do you pay on an empty 401(k)? How much tax do you pay on a nearly empty 401(k)?
Those crying wolf over taxes in retirement miss the real issue: sufficiency! According to this report, the median American adult wealth is about $108,000 as of 2022 (see page 16).
Let’s imagine all that $108K is in a traditional retirement account. Few will take it all out at once. The rather annual modest withdrawals will hardly be taxed at all due to the standard deduction and/or the 10% tax bracket.
If people are behind in their retirement savings, what’s the best way to catch up? Deduct, deduct, deduct! Those deductions save taxes now, opening the door for more savings. For those behind in retirement savings, sacrificing the valuable tax deduction to make Roth contributions makes little sense in my opinion. Why? Because those behind in retirement savings will face very low taxes in retirement.
Sadly, the median American adult has a sufficiency problem and would be fortunate to one day have an (overblown) tax problem instead!
Missing Out on the Hidden Roth IRA
Q: What’s it called when I take money out of a retirement account and don’t pay tax on it?
A: A Roth IRA!!!
Well, many Americans have a Roth IRA that lives inside their traditional 401(k). I call this the Hidden Roth IRA.
Prior to collecting Social Security, many Americans will have the opportunity to take tax free distributions from their traditional IRA or 401(k) because they will be offset by the standard deduction.
Did you know that you might be able to do Roth conversions in retirement and pay federal income tax at a 6% or lower federal tax rate? It’s true! I break that opportunity down in this video.
If you’re telling a 22 year old college graduate that all of their 401(k) contributions should be Roth you’re foreclosing many or all future Roth conversions! Why? Shouldn’t younger workers be setting up low tax Roth conversions in retirement while they are working?
“Roth, Roth, Roth!!!” sounds great and makes for a fun slogan. But it precludes incredibly valuable future tax planning!
The Widow’s Tax Trap and IRMAA are Overblown
The Widow’s Tax Trap is a phenomenon in American income taxation where surviving spouses pay more tax on less income. It’s real. But just how bad is it?
In one example, I found that an incredibly affluent 75 year-old married couple would be subject to a combined effective federal income tax/IRMAA rate of 15.44%. The surviving spouse would then be subject to a combined 19.87% effective rate after the first spouse’s death.
That’s the Widow’s Tax Trap. Real? Yes. Terrifying? No.
Few things are as overblown in American personal finance as IRMAA. IRMAA, income-related monthly adjustment amounts, are technically increases in Medicare premiums as one’s income exceeds certain thresholds. In practice, it is a nuisance tax on showing high income in retirement.
In one extreme example, I discussed a 90 year old widow with $304,000 of RMDs and Social Security income. Her IRMAA was about $5,500, a nuisance tax of about 1.8% on that income. Annoying? Sure. Something to factor into planning during the accumulation phase? Absolutely not.
Missing Out on Premium Tax Credits
Mark, age 22, graduates from college and buys into “Roth, Roth, Roth!!!” Every dollar he contributes to his 401(k) is in the Roth 401(k), and he elects to have all his employer 401(k) contributions put into the Roth 401(k) as well. At age 55, Mark decides to retire. He has a paid off house, $200,000 in a savings account, and $2.5 million in his Roth 401(k).
Mark will be on an ACA medical insurance plan from retirement (or the end of COBRA 18 months later) until the month he turns 65. There’s just one big snag: he has no income! Because of that he will not qualify for the combination of an ACA plan and a Premium Tax Credit, since, based on income, he’s eligible for Medicaid. Ouch!
Mark falls into this trap because he has no ability to create taxable income in retirement. Had he simply put some of his 401(k) into the traditional 401(k), he could have “turned on” taxable income by doing Roth conversions (mostly against the standard deduction!). Doing so would qualify Mark for hundreds of dollars in monthly Premium Tax Credits, greatly offsetting the significant cost of ACA medical insurance. Note Mark could turn on income by claiming Social Security at age 62, permanently reducing his annual Social Security income.
There are pressing priorities for retirement savers prior to retirement. You know what can help pay for them? The tax deduction offered by a traditional 401(k) contribution.
Conclusion
The Conventional Wisdom is wrong!
Traditional deductible contributions to 401(k)s and other workplace retirement plans are a great way to save and invest for the future. Future taxes are a drawback to that tactic. But they have to be assessed keeping in mind the eight reasons I raise above. To my mind, it’s more important to build up wealth than to be tax efficient. As discussed above, those aren’t mutually exclusive, including for those using traditional deductible 401(k) contributions for the majority of their retirement savings.
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.
UPDATE October 12, 2024 The Ascensus Solo 401(k) contribution portal is not intuitive. I walk through tips for new Ascensus Solo 401(k) owners in this YouTube video.
My Solo 401(k) Book
If you’re interested in the Solo 401(k), I wrote a book about it.
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.
One thing I like about the Financial Independence community is that members are not beholden to Conventional Wisdom.
Many in the Establishment believe retirement is for 65 year olds (and some basically think it’s not for anyone).
My response: Oh, heck no!
Sure, some people have jobs they very much enjoy. If that’s the case, then perhaps retirement isn’t your thing in your 50s. But many in the FI movement have accumulated assets such that they no longer have a financial need to work. Perhaps their job is not all that enjoyable – it happens. Or perhaps their job won’t exist in a year or two – that happens too.
The tax rules require some planning if one retires prior to turning age 59 ½. Age 59 ½ is the age at which the pesky 10 percent early withdrawal penalty no longer applies to tax-advantaged retirement account distributions.
Thus, there’s a need to consider what to live off of once one is age 59 ½. Below I list the possibilities in a general order of preference and availability. Several of these options (perhaps many of them) will simply not apply to many 50-something retirees. Further, some retirees may use a combination of the below discussed options.
Listen to Sean discuss accessing money in retirement prior to age 59 ½ on a recent ChooseFI episode! Part Two on the ChooseFI podcast is coming soon.
Taxable Accounts
The best retirement account to access if you retire before age 59 ½ isn’t even a “retirement” account: it’s a taxable account. I’m so fond of using taxable accounts first in retirement I wrote a post about the concept in 2022.
The idea is to use some combination of cash in taxable accounts (not at all taxable – it’s just going to the ATM!) and sales of brokerage assets (subject to low long term capital gains federal income tax rates) to fund your pre-59 ½ retirement. This keeps taxable income low and sets up potential additional tax planning.
Pros: Because of tax basis, living off $100,000 of taxable brokerage accounts doesn’t cause $100,000 of taxable income. Further, long term capital gains receive very favorable federal income tax treatment. Some may even qualify for the 0% long term capital gains tax rate!
But that’s not all. There are significant creditor protection benefits to living off taxable assets first. As we spend down taxable assets, we are reducing those assets that are most vulnerable to potential creditors. By not spending down tax-advantaged retirement accounts, we are generally letting them grow, thus growing the part of our balance sheet that tends to enjoy significant creditor protection. Note that personal liability umbrella insurance is usually a good thing to consider in the creditor protection context regardless of tax strategy.
Spending taxable assets first tends to limit taxable income, which can open the door to (1) a significant Premium Tax Credit in retirement (if covered by an Affordable Care Act medical insurance plan) and (2) very tax advantageous Roth conversions in early retirement.
There’s also a big benefit for those years after we turn 59 ½. By spending down taxable assets, we reduce future “uncontrolled income.” Taxable accounts are great. But they kick off interest, dividends, and capital gains income, even if we don’t spend them. By reducing taxable account balances, we reduce the future income that would otherwise show up on our tax return in an uncontrolled fashion.
Cons: To my mind, there are few cons to this strategy in retirement.
The one con in the accumulation phase is that when we choose to invest in taxable accounts instead ofin traditional deductible retirement accounts we forego a significant tax arbitrage opportunity. That said, these are not mutually exclusive. Members of the FI community can max out deductible retirement account contributions and also build up taxable accounts.
Ideal For: Someone who is able to save beyond tax-advantaged retirement accounts during their working years. This is the “ideal” for financial independence in my opinion, though it may be challenging for some.
Inherited Retirement Accounts
Withdrawals from inherited retirement accounts (other than those the spouse treats as their own) are never subject to the 10% early withdrawal penalty. Often they are subject to a 10-year drawdown rule, so usually they should be accessed prior to using many other draw down techniques.
Pros: If it’s a traditional retirement account inherited from a parent or anyone else more than 10 years older than you are, you generally have to take the money out within 10 years. Why not just live on that money? Simply living on that money, instead of letting the traditional inherited retirement grow for ten years, avoids a “Year 10 Time Bomb.” The time bomb possibility is that the inherited traditional retirement account grows to a huge balance that needs to come out in the tenth full year following death. Such a large distribution could subject the recipient subject to an abnormally high marginal federal income tax rate.
Cons: Not very many other than if the account is a Roth IRA, using the money for living expenses instead of letting it grow for 10 years sacrifices several years of tax free growth.
Ideal For: Someone who has inherited a retirement account prior to turning age 59 ½.
This is a great way to avoid the early withdrawal penalty. But remember, the money must stay in the workplace retirement account (and not be rolled over to a traditional IRA) to get the benefit.
Pros: Funds retirement prior to age 59 ½ without having to incur the 10 percent early withdrawal penalty.
Whittles down traditional retirement accounts in a manner that can help reduce future required minimum distributions (“RMDs”).
Cons: You’re handcuffed to the particular employer’s 401(k) (investments, fees, etc.) prior to age 59 ½. Review the plan’s Summary Plan Description prior to relying on this path to ensure flexible, periodic distributions are easily done after separation from service and prior to turning age 59 ½.
Limited availability as one must separate from service no sooner than the year they turn age 55.
Creates taxable income (assuming a traditional account is used), which is less than optimal from a Premium Tax Credit and Roth conversion perspective.
Ideal For: Those with (1) large balances in their current employer 401(k) (or other plan), (2) a quality current 401(k) or other plan in terms of investment selection and fees, (3) a plan with easily implemented Rule of 55 distributions, and (4) plans to retire in their mid-to-late 50s.
Governmental 457(b) Plans
Withdrawals from governmental 457(b) plans are generally not subject to the 10% early withdrawal penalty. This is the Rule of 55 exception but they deleted the “55” 😉
Like the Rule of 55, this is only available so long as the governmental 457(b) is not rolled to a traditional IRA.
Pros: Funds retirement prior to age 59 ½ without having to incur the 10 percent early withdrawal penalty. If you have a governmental 457(b), it’s better than the Rule of 55 because you don’t have to worry about your separation from service date.
Whittles down traditional retirement accounts in a manner that can help reduce future RMDs.
Cons: You’re handcuffed to the particular employer’s 457 (investments, fees, etc.) prior to age 59 ½. Review the plan’s Summary Plan Description prior to relying on this path to ensure flexible, periodic distributions are easily done after separation from service and prior to turning age 59 ½.
Creates taxable income (assuming a traditional account is used), which is less than optimal from a Premium Tax Credit and Roth conversion perspective.
Ideal For: Those (1) with large balances in their current employer governmental 457(b) and (2) a quality current governmental 457(b) in terms of investment selection and fees.
Roth Basis
Old annual contributions and conversions that are at least 5 years old can be withdrawn from Roth IRAs tax and penalty free at any time for any reason. This can be part of the so-called Roth Conversion Ladder strategy, though it does not have to be, since many will have Roth Basis going into retirement.
Pros: Roth Basis creates a tax free pool of money to access prior to turning age 59 ½.
Cons: We like to let Roth accounts bake for years, if not decades, of tax free growth. Using Roth Basis in one’s 50s significantly reduces that opportunity.
Some may need taxable income in early retirement to qualify for Premium Tax Credits. Relying solely on Roth Basis can be much less than optimal if Premium Tax Credits are a significant part of one’s early retirement plan.
Roth 401(k) contributions, for many workers, are disadvantageous in my opinion. Many Americans will forego a significant tax rate arbitrage opportunity if they prioritize Roth 401(k) contributions over traditional 401(k) contributions.
Ideal For: Those with significant previous contributions and conversions to Roth accounts.
72(t) Payments
I did a lengthy post on this concept. The idea is to create an annual taxable distribution from a traditional IRA and avoid the 10 percent early withdrawal penalty.
Pros: Avoids the early withdrawal prior to turning age 59 ½.
Whittles down traditional retirement accounts in a manner that can help reduce future RMDs.
Inside a traditional IRA, the investor controls the selection of financial institutions and investments and has great control on investment expenses.
Cons: This opportunity may require professional assistance to a degree that many of the other concepts discussed do not.
There is a risk that if not done properly, previous years’ distributions may become subject to the 10 percent early withdrawal penalty and related interest charges.
Creates taxable income, which is less than optimal from a Premium Tax Credit and Roth conversion perspective.
Ideal For: Those with most of their financial wealth in traditional deferred retirement accounts prior to age 59 ½ and without easy access to other alternatives (such as the Rule of 55 and/or governmental 457(b) plans.
HSA PUQME
Withdrawals of Previously Unreimbursed Qualified Medical Expenses (“PUQME”) from a health savings account are tax and penalty free at any time for any reason. Thanks to ChooseFI listener and correspondent Kristin Smith for suggesting the idea to use PUQME to help fund retirement in one’s 50s.
Pros: Withdrawals of PUQME creates a tax free pool of money to access prior to turning age 59 ½.
Reduces HSA balances in a way that can help to avoid the hidden HSA death tax in the future.
Cons: This is generally a limited opportunity. The amount of PUQME that can be used prior to age 59 ½ is limited to the smaller of one’s (1) PUQME and (2) HSA size. Because HSAs have relatively modest contribution limits, in many cases HSA PUQME withdrawals would need to be combined with one or more of the other planning concepts to fund retirement prior to age 59 ½.
We like to let HSAs bake for years, if not decades, of tax free growth. Using HSA PUQME in one’s 50s significantly reduces that opportunity.
Some may need taxable income in early retirement to qualify for Premium Tax Credits. Relying on PUQME can be less than optimal if Premium Tax Credits are a significant part of one’s early retirement plan.
Ideal For: Those with significant HSAs and significant PUQME.
Net Unrealized Appreciation
Applies only to those with significantly appreciated employer stock in a 401(k), ESOP, or other workplace retirement plan. I’ve written about this opportunity before. That employer stock with the large capital gains can serve as a “Capital Gains IRA” in retirement. Retirees can possibly live off sales of employer stock subject to the 0% long term capital gains rate.
This opportunity usually requires professional assistance, in my opinion.
The move of the employer stock out of the retirement plan into a taxable brokerage account (which sets up what I colloquially refer to as the “Capital Gains IRA” may need to be paired with the Rule of 55 (or another penalty exception) to avoid the 10 percent early withdrawal penalty on the “basis” of the employer stock.
Pros: Moves income from “ordinary” income to “long term capital gains” income, which can be very advantageous, particularly if one can keep their income entirely or mostly in the 0% long term capital gains marginal bracket.
Cons: Remember Enron? NUA is essentially Enron if it goes fabulously well instead of failing spectacularly.
Employer stock is problematic during the accumulation phase since your finances are heavily dependent on your employer without a single share of employer stock. People make their finances more risky by having both their income statement and their balance sheet highly dependent on a single corporation.
It keeps the retiree heavily invested in the stock of their former employer, which is much less than optimal from an investment diversification perspective.
Another con is that this usually requires professional assistance (and fees) to a much greater degree than several of the other withdrawal options discussed on this post.
Ideal For: Those with large balances of significantly appreciated employer stock in a workplace 401(k), ESOP, or other retirement plan.
Pay the Penalty
The federal early withdrawal penalty is 10 percent. For those in California, add a 2.5 percent state penalty. For some, perhaps the best idea is to simply bite-the-bullet and pay the early withdrawal penalty. That said, anyone accessing a tax-advantaged retirement account in a way not covered above should always consult the IRS list to see if perhaps they qualify for one of the myriad penalty exceptions.
Pros: Why let a 10 percent penalty prevent you from retiring at age 58 if you have sufficient assets to do so and you might be looking at a year or two of the penalty, tops?
Whittles down traditional retirement accounts in a manner that can help reduce future RMDs.
Cons: Who wants to pay ordinary income tax and the early withdrawal penalty? Even for those close to the 59 ½ finish line, a 72(t) payment plan for five years might be a better option and would avoid the penalty if properly done.
Ideal For: Those very close to age 59 ½ who don’t have a more readily available drawdown tactic to use. That said, even these retirees should consider a 72(t) payment plan, in my opinion.
Combining Methods to Access Funds Prior to Age 59 1/2
For some, perhaps many, no single one of the above methods will be the optimal path. It may be that the optimal path will involve combining two or more of the above methods.
Here’s an example: Rob retires at age 56. He uses the Rule of 55 to fund most of his living expenses prior to turning age 59 ½. Late in the year, he finds that a distribution from his traditional 401(k) would push him up into the 22% federal income tax bracket for the year. Thus, for this last distribution he instead elects to take a recovery of Roth Basis from his Roth IRA. This allows him to stay in the 12% marginal federal income tax bracket for the year.
Conclusion
Don’t let anyone tell you you can’t retire in your 50s. If you have reached financial independence, why not? Of course, you will need to be very intentional about drawing down your assets and funding your living expenses. This is particularly important prior to your 59 1/2th birthday.
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.
Last year, most of California received several deadline delays when it came to 2022 tax returns, tax payments, and IRA and HSA contributions.
Sure enough, San Diego County now has a deadline delay for their 2023 tax returns, tax payments, and IRA and HSA contributions. Hat tip to Jennifer Mah’s Instagram for alerting me to this development.
San Diego County Tax Deadline Delay
The IRSannounced that because of early 2024 flooding in San Diego, San Diegons have an extended deadline, June 17, 2024, to perform most 2023 tax acts that otherwise would have been due early in 2024. The Franchise Tax Board has followed suit and also issued their own delay announcement.
2023 Traditional and Roth IRA Contributions
The deadline for San Diegons to make 2023 contributions to traditional and/or Roth IRAs has been extended to June 17, 2024. 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” 2023 IRA contributions on their platform when it is available only to residents of a single county.
If you are a San Diegon reading this in May 2024 and want to make an IRA contribution for 2023, I recommend initiating the process by calling the financial institution using a seldom used app on your phone, the phone.
2023 Backdoor Roth IRAs
San Diegons now have until June 17, 2024 to execute the first step of a 2023 Backdoor Roth IRA, the nondeductible contribution to a traditional IRA for 2023. This would be a Split-Year Backdoor Roth IRA.
2023 HSA Contributions
San Diegons now have until June 17, 2024 to contribute to a 2023 health savings account. The same comments that apply to traditional IRA and Roth IRA contributions made using the deadline extension apply to 2023 HSA contributions made using the deadline extension.
2023 Tax Returns and Payments and 2024 Q1 Estimated Tax Payments
San Diegons now have until June 17, 2024 to (i) file their 2023 federal and California income tax returns, (ii) pay the amount due with their 2023 federal and California income tax returns, and (iii) make 2024 first quarter estimated payments.
Who Benefits?
Residents of San Diego County qualify for the extended deadline. Taxpayers with records in San Diego County can also benefit.
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.
Net unrealized appreciation is a tax planning opportunity that applies to the gain attributable to employer stock inside an employer retirement plan. Plans that can have employer stock in them include 401(k) plans and employee stock ownership plans (ESOPs).
Growth in tax deferred retirement accounts is great. But it comes with a cost: ordinary income tax on that growth. The tax code has one major exception: Net Unrealized Appreciation! The idea is this: an employee can transfer, in-kind, any employer stock from the employer retirement account to a taxable brokerage account.
Instead of the entire amount being subject to ordinary income tax, only the “basis,” i.e., the historic cost, of the stock is subject to ordinary income tax. The growth is only subject to capital gains tax when the stock is later sold. Obviously, if there has been a significant gain in the stock, NUA treatment, instead of ordinary income tax treatment on that growth, will be advantageous.
“In-kind” Transfer: An “in-kind” transfer is a transfer of the exact same thing. In this case, it is a transfer of the exact employer stock owned within the employer plan. Selling that stock and repurchasing it shortly thereafter blows the NUA planning opportunity.
NUA Planning Example
Mark works at Acme Corporation. Inside his Acme retirement account he has $1M worth of Acme stock. He and Acme paid $100,000 for that stock.
Mark is 53 years old and leaves employment at Acme. His NUA opportunity is as follows: he can transfer all his Acme retirement accounts invested in assets other than Acme stock to IRAs (or a new employer’s retirement account) and transfer, in-kind, the Acme stock to a taxable brokerage account (the “NUA distribution”).
Mark creates a $100,000 income hit on this year’s tax return and will owe the 10% early withdrawal penalty (unless he qualifies for an exception) if he does this. However, the $900K of capital gains in that Acme stock gets two big tax benefits. First, it will never be subject to RMDs. Second, when the Acme stock is sold that gain will be taxed at capital gains rates instead of ordinary income tax rates. That is a tremendous advantage to using the NUA strategy.
Does NUA Treatment Make Sense?
NUA does not always make sense when it comes to employer stock in retirement accounts. In fact, in most cases it is likely not to make sense. You saw in Mark’s example there was a real price to pay: ordinary income tax and the possible 10 percent early withdrawal penalty.
What if, instead of paying $100K for the Acme stock over the years, Mark and Acme had paid $700K? There’s no way Mark should use NUA treatment to get $300K of gain into capital gains tax when it would trigger immediate taxation on $700,000 and a $70,000 penalty!
But if the “basis” number is low, being subject to the 0%, 15%, and 20% marginal capital gains tax on the employer stock gain inside the plan can be a great outcome.
First up is the transfer of the employer stock from the workplace retirement plan to a taxable brokerage account (the NUA distribution). This must be an in-kind transfer by the employer plan of the employer stock to the taxable brokerage account.. The NUA distribution results in some amount of taxable income. The employer plan issues a Form 1099-R to report the NUA distribution. The Form 1099-R reports the gross distribution amount in Box 1. The taxable amount reported in Box 2a. The Box 2a amount is the amount that the employee and employer contributed to buy the employer stock and is taxable in the year of the NUA distribution. The Net Unrealized Appreciation, the difference between Box 1 and Box 2a, is reported in Box 6. The Net Unrealized Appreciation is the gain that will be subject to long-term capital gains rates in any post-NUA distribution sale of the employer stock.
Reporting on the Taxpayer’s Form 1040
On the individual’s Form 1040 tax return, the gross distribution will be reported on the line for pensions & annuities (line 5a for the tax year 2023 Form 1040), with the taxable amount showing on line 5b.
Now, what about that 10% early withdrawal penalty? There are several exceptions, all of which are reported on Form 5329, Part 1. If, for example, Mark was 55 years old when he left his employment at Acme, qualifies for exception 01 – separation from service distribution in or after the year of reaching 55 (age 50 for qualified public safety employees).
Disposition of Employer Stock
Information Reporting to the Taxpayer and the IRS
These transactions are reported on Form 1099-B. This form will include the number of shares sold, the date they were sold, and the proceeds from the sale.
Reporting on the Taxpayer’s Form 1040
When the employer stock is actually sold, two gains on the sale of that stock must be recognized. The first is the net unrealized appreciation in the employer stock. That amount is crystalized at the time of the NUA distribution from the plan to the taxable account. This gain is always a long-term capital gain, regardless of when the post-distribution sale occurs. The gain is reported by the taxpayer on Form 8949 and Schedule D.
There is a second potential gain. It could be a gain or a loss. It is the amount of the increase (or decrease) in value the stock has experienced since the NUA distribution into the taxable account.
Continuing with Mark’s example, assume the NUA distribution occurred on January 16, 2024. At that time, Mark owned 1,000 Acme shares, each worth $1,000 and each with Net Unrealized Appreciation of $900. On February 20, 2024, Mark sells 40 Acme shares for $1,040 each. This triggers two gains: $36,000 of Net Unrealized Appreciation ($900 NUA times 40), which is taxed as long term capital gain, and $1,600 of short term capital gain ($40 times 40), which is taxed as ordinary income.
Post-NUA Distribution Losses
What if, instead of a post-NUA distribution gain, there’s a loss? The loss simply reduces the NUA recognized on each sale. For example, if Mark’s sale of 40 shares on February 16, 2024 was for $960 per share, the NUA triggered on each share is $860 per share instead of $900 per share.
As part of the NUA process, all the other qualified plan assets need to be transferred to a traditional IRA (or Roth IRA if there are Roth qualified plan assets). Assuming this occurs via a direct trustee-to-trustee transfer, it is reported on Form 1099-R with a box 7 code “G” (direct rollover). Box 1 of the 1099-R will indicate the gross distribution, and box 2a, Taxable amount, will be $0, since it’s a direct rollover.
Reporting on the Taxpayer’s Form 1040
On the individual’s tax return, the gross distribution should show up on the line for pensions and annuities (line 5a for the tax year 2023 Form 1040), with $0 showing on line 5b for taxable amount.
Conclusion
For the right situation, NUA is a potentially great tax planning opportunity. For those taking advantage of the opportunity, it is important to get the tax return reporting correct. We leave with one parting thought: those considering NUA are usually well advised to consider working with professional advisors, and those who have implemented an NUA planning process often benefit from working with a professional tax return preparer.
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, investment, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
Is earned income required to contribute to an individual retirement account (an “IRA”)? If you’re married, it may not be, thanks to the Spousal IRA.
The Spousal IRA is a great opportunity for families to build financial stability, and perhaps get a juicy tax deduction, even if only one of the spouses work outside of the home. It can help families save for the future and prioritize other important goals such as raising children.
IRA Basics
There are two types of IRAs that most working Americans can consider. I did a primer about them here.
A Roth IRA offers no tax deduction on the way in, but features tax-free growth and tax-free withdrawals in retirement.
Both can be a great way to build up tax-advantaged wealth for retirement.
IRA Contribution Limits
The limit on IRA contributions for 2023 is the lesser of $6,500 or earned income ($7,500 or earned income if you are age 50 or older in 2023). The limit on IRA contributions for 2024 is the lesser of $7,000 or earned income ($8,000 or earned income if you are age 50 or older in 2024). Remember that traditional IRAs and Roth IRAs share that contribution limit, so a dollar contributed to a traditional IRA is a dollar that cannot be contributed to a Roth IRA and vice-versa.
IRA Contribution Deadlines
Generally speaking, the deadline to contribute to either a traditional IRA or a Roth IRA is April 15th of the following year. The deadline cannot be extended even if the taxpayer files for an extension to file their own tax return. On rare occasions the IRS may provide a very limited exception to the April 15th IRA contribution deadline.
The Spousal IRA
For purposes of having earned income allowing one to make an IRA contribution (tradition and/or Roth), a non-working spouse can use their spouse’s earned income for purposes of making either (or both) a traditional IRA or a Roth IRA contribution.
Here is an example:
Joe and Mary are married. Joe has a W-2 job and Mary does not. Mary can make an IRA contribution (a Spousal IRA) based on Joe’s W-2 earned income.
The Spousal IRA can be used to increase tax-advantaged retirement savings. It can also be used to strategically optimize tax deductions. Many W-2 workers are covered by a workplace 401(k) plan. Thus, based on low income limits, it is difficult for them to deduct a traditional IRA contribution.
However, when one is not covered by a workplace retirement plan, it is much easier to qualify to deduct a traditional IRA contribution. It is often the case that a Spousal IRA will offer a potential tax deduction when the working spouse is not able to deduct a traditional IRA contribution.
Split-Year Spousal IRA Contribution Example
As I write this, the 2024 tax return season (for 2023 tax returns) is about to get started. Now’s the time to be thinking about 2023 IRA contributions if you have not yet made one!
There’s still plenty of time to contribute to an IRA (traditional or Roth) for the year 2023. Some of that planning might involve strategically employing a Spousal IRA. Here’s an example:
It is early April 2024 and Mark and Theresa are about to file their tax returns. They see they have $8,500 in cash available to use to make 2023 IRA contributions. What they might want to do is contribute $6,500 to a 2023 deductible traditional IRA for Theresa (a Spousal IRA) and the remaining $2,000 to a 2023 Roth IRA for Mark, since he cannot deduct a traditional IRA contribution. By prioritizing a tax deduction, Mark and Theresa save $2,034.50 on their 2023 income taxes.
The Spousal IRA as a Backdoor Roth IRA
The Spousal IRA can be executed as a Backdoor Roth IRA. Here is an example:
Jack and Betty, both age 42, are married. Jack works a W-2 job and Betty does not have earned income. Jack is covered by a 401(k) at work. Their MAGI for 2024 is $260,000 and thus neither of them qualify to make a regular annual contribution to a Roth IRA.
Assuming Betty has no balances in traditional IRAs, SEP IRAs, and SIMPLE IRAs (and thus does not have a Pro-Rata Rule problem), Betty can contribute $7,000 to a nondeductible traditional IRA and then convert that amount (plus any growth) to a Roth IRA. Doing so uses a Spousal IRA to implement a Backdoor Roth IRA.
Spousal IRA Tax Return Reporting
To report a deductible traditional Spousal IRA contribution, the amount of the contribution must be reported on Schedule 1, line 20, filed with the couple’s annual federal income tax return.
To report a nondeductible traditional Spousal IRA contribution, the amount of the contribution must be reported on Part I of the Form 8606.
There is no required federal income tax return reporting for a Roth Spousal IRA contribution. However, such contributions should be entered into the tax return software to help determine the potential eligibility for a retirement savers’ credit.
Conclusion
The Spousal IRA creates a great opportunity for married couples to save for retirement and possibly gain access to valuable tax deductions. It can help married couples focus on important priorities such as child rearing and still make significant contributions to retirement accounts.
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.
SECURE 2.0, passed in December 2022, made dozens of changes to the rules governing tax-advantaged retirement accounts.
When Congress passes a major tax law change, the IRS and Treasury issue regulations and other guidance regarding the change. Practitioners and taxpayers often provide the IRS and Treasury comment letters bringing issues and concerns to the government’s attention.
I wrote a comment letter (which you can read here) to the IRS and Treasury addressing facets of the following provisions:
This post (and the linked-to comment letter) is for entertainment and educational purposes only. They do not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
Want to retire before age 59 ½? Have most of your wealth in traditional tax-deferred retirement accounts? Worried about the 10 percent early withdrawal penalty?
This post is for you!
Picture it: You’re age 53, have $50,000 in a savings account, a paid-off home, and $2.5M in a 401(k). Including income taxes, you spend about $80,000 a year. You want to retire, but you’re worried about paying the early withdrawal penalty, which would be about $8,000 a year (not factoring in the penalty on the penalty!).
72(t) payments can make retirement possible prior to age 59 ½ when one has most of their assets in traditional deferred retirement accounts. Done properly, these payments avoid the 10 percent early withdrawal penalty.
Below I explore some of the rules of 72(t) payments (sometimes referred to as a “72(t) SEPP” or “SEPP”) and lay out what I hope will be an informative case study.
** As always, none of this is personalized advice for you, but rather educational information for your consideration. Consult with your own advisors regarding your own situation.
72(t) Substantially Equal Periodic Payments
Methods
The IRS and Treasury provide three methods for computing a 72(t) payment. As a practical matter, the third one I discuss, the fixed amortization method, tends to be the most commonly used and most user friendly in my opinion.
The required minimum distribution method allows taxpayers to take a 72(t) payment just like an RMD. Take the prior year end-of-year balance and divide it by the factor off the IRS table. The biggest problems with this method are it tends to produce a smaller payment the younger you are and the payment changes every year and can decrease if the IRA portfolio declines in value. The fixed annuitization method usually requires actuarial assistance, making it more complicated and less desirable. See Choate, referenced below, at page 587.
We will focus the rest of the post on the fixed amortization method of computing 72(t) payments (other than a brief foray into the RMD method to account for changing circumstances)).
Computing Fixed Amortization 72(t) Payments
To compute a 72(t) payment and the size of the 72(t) IRA using the fixed amortization method, we will need to run through some math. Four numbers are required: the interest rate, the life expectancy, the annual payment, and the size of the 72(t) IRA.
Usually the IRS gives us the interest rate and the life expectancy and we need to solve for the 72(t) IRA size.
As a general rule, taxpayers will usually want to use the greatest interest rate permitted to as to decrease the size of the 72(t) IRA. Decreasing the size of the 72(t) IRA will usually be advantageous, for the reasons discussed below.
Life Expectancy: The life expectancy comes to us from an IRS table. While we have three possible choices to use, generally speaking taxpayers will want to use the Single Life Table found at Treas. Reg. Section 1.401(a)(9)-9(b). See Choate, referenced below, at page 587. The taxpayer takes their age on their birthday of the year of the first 72(t) payment and uses the factor from the Single Life Table as the life expectancy.
Payment: Finally, we, not the IRS, get to determine a number! The payment is simply the annual payment we want to receive as a 72(t) payment every year. While this amount is rather inflexible, as discussed below it will be possible to establish additional 72(t) IRAs and payments to increase the amount received if desired.
Size of the 72(t) IRA: This is what we’re solving for to establish a “right-sized” IRA to produce the desired 72(t) payment. In Google Sheets, we do a present value calculation to solve for the size of the 72(t) IRA that generates the desired payment amount. The formula is rather simple: =-PV(Interest Rate Cell, Life Expectancy Cell, Annual Payment Cell). I put a negative sign in front of the PV to have the size of the 72(t) IRA appear as a positive number. It’s important that the formula be entered in that order and that the formatting be correct in each cell.
Note on 72(t) Payments with non-IRA Accounts: Setting up a 72(t) from a non-IRA is possible but not frequent in practice. It is not possible to divide up a 401(k) account in a manner conducive to establishing a “right-sized” 72(t) payment account. See Choate, referenced below, at page 595.
Annual Equal 72(t) Fixed Amortization Payments
The computed payments must be made annually and equally. This means that no more and no less than the computed payment comes out every year. I believe that taking an annual flat payment on or around the first payment anniversary date is a best practice. However, this best practice is not required. See also Choate, referenced below, at page 600. For example, monthly payments of the computed amount are allowable. See Choate, referenced below, at page 600.
Annual payments must be made for the longer of five years or until the taxpayer reaches age 59 ½.
72(t) Payments Case Study
Let’s return to the example discussed above: it is early November 2023 and you (let’s call you Pat) are 53 years old (your birthday was June 8th) and you want to retire, spending $80K a year from your $2.5M 401(k). Let’s solve for the size of the 72(t) IRA:
The size of the 72(t) IRA is $1,236,012.95. See IRS FAQ Q&A 7.
Pat would first transfer (preferably through a direct trustee-to-trustee transfer) the 401(k) to a traditional IRA worth $2.5M. Once in the traditional IRA, Pat would call their financial institution and ask them to divide the traditional IRA into two IRAs: one with exactly $1,236,012.95 (the “72(t) IRA”) and one with the reminder of the traditional IRA (the “non-72(t) IRA”). I recommend initially investing the 72(t) IRA in a money market fund so that it can be clearly established that the beginning account balance was exactly the $1,236,012.95 computed to yield the correct payment. Pat takes the first payment of $80,000 on November 29th from the 72(t) IRA in this hypothetical scenario.
Let’s keep going. Assume that in 2027, when Pat turns age 57 and interest rates are well below 5%, Pat wants to increase their November withdrawal from $80K to $90K. As discussed below, Pat can’t simply increase the withdrawal from the 72(t) IRA. But since Pat kept a non-72(t) IRA, Pat can slice that one up to create a second 72(t) IRA. That second 72(t) IRA can give Pat the extra $10,000 Pat wants to spend.
Here’s what that looks like.
Interest Rate: 5.00%
Life Expectancy: 30.6
Payment: $10,000
The size of the second 72(t) IRA is $155,059.55.
Pat would call their financial institution and ask them to divide the non-72(t) IRA into two IRAs: one with exactly $155,059.55 (the “Second 72(t) IRA”) and one with the remainder of the traditional IRA (the surviving non-72(t) IRA). Pat takes the additional payment of $10,000 also on November 29th from the Second 72(t) in this hypothetical scenario.
Here is what Pat’s withdrawals would look like:
Year
Birthday Age
Required First 72(t) November 29 Withdrawal
Required Second 72(t) November 29 Withdrawal
Total Annual Withdrawal
2023
53
$80,000
$0
$80,000
2024
54
$80,000
$0
$80,000
2025
55
$80,000
$0
$80,000
2026
56
$80,000
$0
$80,000
2027
57
$80,000
$10,000
$90,000
2028
58
$80,000
$10,000
$90,000
2029
59
$80,000
$10,000
$90,000
2030
60
$0
$10,000
$10,000
2031
61
$0
$10,000
$10,000
Remember that the First 72(t) IRA and the Second 72(t) are locked up for a period of time. See Locking the Cage below. The First 72(t) IRA is locked up until and through December 7, 2029, the day before Pat’s 59 ½ birthday. The Second 72(t) IRA is locked up until and through November 28, 2032, the day before the fifth anniversary of the first $10,000 payment from the Second 72(t) IRA. See IRS FAQ 13 on this point. Generally speaking, no amount other than the annual payment should go into, or out of, a 72(t) IRA until the end of the lock-up period.
Maintain Flexibility
I strongly recommend maintaining as much flexibility as possible. One way to do that is to have the 72(t) IRA be as small as possible, leaving as much as possible in a non-72(t) IRA or IRAs. Why?
First, the non-72(t) can be, in a flexible manner, sliced and diced to create a second 72(t) IRA if wanted or needed. Second, it is not abundantly clear what happens when a 72(t) IRA is used for partial Roth conversions. See Choate, referenced below, at page 384. As Ms. Choate discusses, the only clarity we have is that if the entire 72(t) IRA is Roth converted, the taxpayer must continue to take withdrawals from the Roth IRA for the remainder of the 72(t) term. Doing so limits the benefit of doing Roth conversions in the first place, since we usually want Roth converted amounts to stay in a Roth IRA to facilitate many years of tax-free growth.
Imagine if Pat did not divide the $2.5M traditional IRA into two IRAs. Pat could have simply used a smaller interest rate on the entire $2.5M traditional IRA to get the $80,000 annual payment out. However, then Pat would not have had the flexibility to create a second 72(t) payment stream. This is an important reason that it is usually best to use the highest possible interest rate to lower the 72(t) IRA size and maintain the most flexibility.
72(t) Payment Plan Disqualification
A “modification” to the 72(t) payment plan blows up the plan with unfavorable consequences. In the year of the modification the taxpayer owes the 10 percent early withdrawal penalty plus interest on the penalty on all the previously taken 72(t) payments. See Choate, referenced below, at page 596.
A blow up after age 59 ½, for those on the five year rule, is bad but tends to be less deleterious than a blow up occurring with respect to a SEPP ending at age 59 1/2. The early withdrawal penalty and related interest are not assessed on 72(t) payments taken after one’s 59 ½ birthday. See Choate, referenced below, at page 596.
There are a few modifications to a 72(t) payment plan that do not blow it up (i.e., they are permissible and don’t trigger the penalty and interest). See Choate, referenced below, at pages 597-601. Those looking to change the payment amount are often well advised to set up a second 72(t) payment plan (as Pat did) rather than seeking a modification to the existing 72(t) payment plan.
72(t) Payment Reduction
Imagine that instead of wanting an additional 72(t) payment amount, Pat wanted to reduce the 72(t) payment. This is not uncommon. Perhaps Pat has a significant inheritance in 2027 and thus no longer needs to take an $80,000 annual payment and pay tax on it.
Unfortunately, Pat is not allowed to simply discontinue or reduce the 72(t) payment without triggering the early withdrawal penalty (and interest charges) on the previously taken 72(t) payments.
But, the rules allow a one-time switch to the RMD method. Making the switch is likely to significantly reduce the annual 72(t) payment. For example, if Pat wants a smaller payment starting in 2027, Pat could take the 72(t) IRA balance on December 31, 2026 (imagine it is exactly $1M) and divide it by the age 57 factor off the Single Life Table (29.8) and get a 2027 72(t) payment of $33,557.05. Alternatively, Pat could use the age 57 factor off the Notice 2022-6 Uniform Life Table (41.6) and get a 2027 72(t) payment of $24,038.46.
If Pat makes this one-time switch, Pat will annually compute the 72(t) payment for the remainder of the 72(t) term using the table used in 2027 (see Notice 2022-6 page 6) and the prior-year end-of-year 72(t) IRA balance.
The one-time switch to the RMD method is helpful if the taxpayer wants to significantly reduce their 72(t) annual payment, perhaps because of an inheritance, marriage, YouTube channel blowing up, or returning to work. The availability of this method to reduce required 72(t) payments (if desired) is another reason to keep 72(t) IRAs as small as possible.
72(t) Locking The Cage
The 72(t) IRA should be thought of as a locked cage. No one goes in, and only the 72(t) payment comes out annually. The rigidity with which the IRS treats the 72(t) IRA gives early retirees incentive to use as high an interest rate as possible to get the highest annual payment out of the smallest 72(t) IRA possible.
Just how rigid is the IRS? In one case, the IRS disqualified a 72(t) SEPP because a taxpayer transferred a workplace retirement plan into the 72(t) IRA during the 72(t) payment period. See page 4 of this newsletter (page 4 is behind a paywall). Imagine paying penalties and interest on old 72(t) payments for what is seemingly an unrelated rollover!
Remember, the “series of substantially equal periodic payments” requires not just an annual payment. It requires that the 72(t) IRA be locked up. Assuming one is using the fixed amortization method for their 72(t) payments, not a dollar more than the 72(t) SEPP should come out each year. It appears the IRS expects the amount to be equal each tax year, see page 5 of this PLR.
Further, the 72(t) lockup does not end with the taking of the last payment. Rather, as described in IRS FAQ 13, it ends at the end of the lock up period. So if Sean, age 57 in 2023, takes his first 72(t) SEPP of $10,000 from IRA 1 on July 15, 2023, his taking of payment number 5 ($10,000) on July 15, 2027 does not end the lock up. Sean can’t take any additional money out of IRA 1 until July 1, 2028 (the fifth anniversary of his first $10,000 72(t) payment).
Practice Point: Never add money to a 72(t) IRA during the lockup period. This includes never making an annual contribution to a 72(t) IRA and never rolling an IRA, 401(k), or other qualified plan into a 72(t) IRA.
IRS FAQ 13 is instructive in terms of when the lock up ends. The IRS is clear that the lock up ends on the date of the 59 ½ birthday, not on January 1st of that year. Say Rob, born January 14, 1971, takes his first SEPP of $40,000 on August 16, 2023. His 72(t) IRA is free on his 59 ½ birthday, which is July 14, 2030. Presumably, Rob takes his last $40,000 SEPP on or around August 16, 2029. Nevertheless, he can’t add to or withdraw from his 72(t) IRA prior to July 14, 2030 without blowing up his 72(t) payment plan and incurring significant penalties and interest.
As discussed above, the one-time switch to the RMD method is a permissible modification to the 72(t) payment terms that does not trigger the early withdrawal penalty and related interest on previously taken 72(t) payments.
A Note on the 72(t) Risk Profile
The earlier in life the 72(t) payment plan starts, the greater the risk profile on the 72(t) payment plan. The opposite is also true: the later in life a 72(t) payment plan starts, the lower the risk profile.
Why?
Because the sooner the 72(t) payment plan starts, the more years (and more interest) that can be blown up by a future modification requiring the payment of the 10 percent early withdrawal penalty and interest.
Consider Pat’s example. If Pat blows up the First 72(t) payment plan in early 2028, Pat owes the 10% early withdrawal penalty and interest on five previously taken 72(t) payments from the First 72(t) IRA (2023 through 2027). If Pat blows up the Second 72(t) payment plan in 2032, Pat only owes the early withdrawal penalty and interest on the three 72(t) payments received before Pat turned age 59 ½.
72(t) Payment Tax Return Reporting
Taxpayers should keep the computations they and/or their advisors have done to document the 72(t) payment plan. Distributions should be reported as taxable income and on Form 5329. Code 02 should be entered on Line 2 of Form 5329.
72(t) Is An Exception to More Than One Rule
72(t) payment plans are an exception to the 10 percent early withdrawal penalty. They are also an exception to the general rule that the IRS views all of your IRAs as a single IRA. The 72(t) IRA is the 72(t) IRA. If you have a separate IRA and take ten dollars out of it prior to age 59 ½, you trigger ordinary income tax and a $1 penalty. If you take an additional ten dollars out of the 72(t) IRA prior to the end of the 72(t) lock up, you blow up the 72(t) payment plan and owe the 10 percent early withdrawal penalty and interest on all the pre-59 ½ 72(t) payments.
Other Penalty Free Sources of Early Retirement Funding
Let’s remember that 72(t) payments are a tool. In many cases they are not a “go-to” strategy. I’ve written this post not because 72(t) payments are a go-to strategy but rather because I know there are many in their 50s thinking about retirement but daunted by the prospect of accessing traditional retirement accounts prior to age 59 ½.
Generally speaking, I encourage using resources other than 72(t) payments if you are able to. They include:
Taxable Accounts: I’m so fond of using taxable accounts first in retirement I wrote a post about the concept in 2022.
Inherited Retirement Accounts: Withdrawals from inherited retirement accounts (other than those the spouse treats as their own) are never subject to the 10% early withdrawal penalty. Often they are subject to a 10-year draw down rule, so usually they should be accessed prior to implementing a 72(t) payment plan from one’s own accounts.
Rule of 55 Distributions: Only available from a qualified retirement plan such as a 401(k) from an employer the employee separates from service no sooner than the beginning of the year they turn age 55. This is a great workaround from the early withdrawal penalty, and much more flexible than a 72(t) payment plan. But remember, the money must stay in the workplace retirement account (and not be rolled over to a traditional IRA) to get the benefit.
Governmental 457(b) Plans: Withdrawals from governmental 457(b) plans are generally not subject to the 10% early withdrawal penalty.
I previously discussed using a 72(t) payment plan to bail out Roth IRA earnings penalty-free prior to age 59 ½. This is a tactic that I would not recommend unless absolutely necessary (which I believe is a very rare situation).
72(t) Landscape Change
It should be noted that the issuance of Notice 2022-6 in early 2022 changed the landscape when it comes to 72(t) payments. Before the 5 percent safe harbor, it was possible that taxpayers could be subject to sub-0.5 percent interest rates, meaning that it would take almost $1M in a retirement account to generate just $30,000 in an annual payment in one’s mid-50s. Now with the availability of the 5 percent interest rate much more modest account balances can be used to generate significant 72(t) payments in one’s mid-50s.
What if Pat’s 401(k) contained significant amounts of employer stock? What if that employer stock had significantly appreciated in value since the time Pat and/or Pat’s employer contributed that stock? If so, a 72(t) payment plan may not be ideal. Rather, Pat may want to work with Pat’s advisor(s) to look into a separate and distinct tax planning opportunity, net unrealized appreciation (“NUA”).
I collaborated with Andrea MacDonald to discuss the tax return reporting requirements for NUA here.
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.
