Tag Archives: Tax Basketing

FI Tax Strategies For Beginners

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.

But first, a caveat: none of this is advice for your specific situation, but rather, this comprises a list of the top four 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.

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!).

Find out why the Roth IRA might be much better than a Roth 401(k).

THREE: Contribute to an HSA

A health savings account is a very powerful saving vehicle. You have access to it if you have a high deductible health plan. To have an HDHP through your employer, you need to determine (i) if your employer offers a HDHP and (ii) whether the HDHP is appropriate medical insurance for you.

If you do not have employer provided insurance, you may be able to obtain an HDHP in the individual marketplace.

HSA contributions have several benefits. You receive an upfront income tax deduction for the money you contribute. If the funds in your HSA are used to pay qualified medical expenses, or are used to reimburse you for qualified medical expenses, the contributions and the earnings/growth are tax-free when paid out of the HSA. This tax-friendly combination means the HSA should be a high priority.

Here are a few additional considerations:

HDHP Benefit

I believe the HDHP is itself a great benefit in addition to the HSA. Why? One reason is that the HDHP reduces a known expense: medical insurance premiums! Why pay significant premiums for a low deductible plan when the point of medical insurance is not “coverage” but rather to avoid financial calamity in the event of injury or illness?

Dr. Suneel Dhand has a great YouTube channel. He has stated that as a doctor he is quite leery about getting treated for disease by Western medicine. I believe that is a very fair critique.

We over-medicalize our problems. Too often we run to the doctor looking for a solution when the answer lies in what we’re eating and/or our environment. We should work to avoid disease and doctor visits by taking control of our own health. That is very much in line with both the high deductible model of medical insurance and financial independence.

Part of “independence” (including financial independence) is questioning established systems. I am glad Dr. Dhand and others are starting to do just that when it comes to medicine. HDHPs help us do that while providing financial protection in the event of significant injury or illness.

Thinking about a future mini-retirement? One great way to lay the foundation today for tomorrow’s mini-retirement is to increase one’s financial independence from the medical system and decrease dependence on any one employer’s medical insurance.

State Income Taxes

In California and New Jersey, HSAs are treated as taxable accounts. Thus, in these states there are no state income tax deductions for contributions to an HSA. Furthermore, dividends, interest and other realized income and gains generated by HSA assets are subject to state income taxes. While detrimental, the federal income tax benefits are so powerful that even residents of these states should prioritize HSA contributions.

Employer Contributions

Check to see if your employer offers an employer contribution to your HSA. Many do. When the employer does, the employee leaves free money on the table if they do not enroll in the HDHP.

Reimbursements

In most cases, it is advisable to (i) pay current medical costs out of your own pocket (your checking account and other taxable accounts) and (ii) record and track these medical expenses. Leaving the money in the HSA during our working years allows it to grow tax-free!

Years later when the money has grown, you can reimburse yourself tax-free from your HSA for the Previously Unreimbursed Qualified Medical Expenses (PUQME), as there is no time limit on reimbursements. Note that only qualified medical expenses incurred after you first open the HSA are eligible for tax-free reimbursement.

FOUR: Save, Save, Save!!!

My last recommendation is simple: save, save, save! Are there ways to do it in a tax-efficient manner? Absolutely! But the absolute most important consideration is the act of saving and investing itself. Between retirement plans, lack of a payroll tax, and favored dividend and capital gain tax rates, saving and investing are often tax efficient without trying to be.

If in doubt, traditional 401(k) contributions are often fantastic.

Conclusion

Here are the top four tax moves I believe FI beginners should consider:

First, contribute 10 percent to your 401(k) or other workplace retirement plan

Second, establish a Roth IRA

Third, establish an HSA

Fourth, Save, Save, Save

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

Subscribe to my YouTube Channel: @SeanMullaneyVideos

Follow me on X: @SeanMoneyandTax

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

Tax Basketing for a 72(t) Payment Plan

Some retiring in their 50s will need to use a 72(t) payment plan. This often involves establishing a “72(t) IRA” and a “non-72(t) IRA.”

People wonder “how do you allocate your portfolio when you have a 72(t) payment plan?”

Below we tackle 72(t) IRAs from a tax basketing perspective. Most investors in the financial independence community want some allocation to bonds and some to equities.* Thus, questions emerge for those employing a 72(t) payment plan: what should be in my 72(t) IRA? What should be in my non-72(t) IRA?

* This post simply takes that as an assumption and is not investment advice for you or anyone else.

Watch me discuss portfolio allocation for 72(t) payments plans on YouTube.

72(t) Example

Monty, age 53, has a $2M traditional 401(k), $10,000 in a savings account, and a paid off house. He wants to retire and take his first annual $80,000 72(t) payment in February 2023. Monty also wants to have a 75/25 equity/bond allocation.

First, Monty would need to transfer his 401(k) to a traditional IRA (preferably through a direct trustee-to-trustee transfer).

Once the 401(k) is in the traditional IRA, Monty needs to split his traditional IRA into two traditional IRAs, one being the 72(t) IRA (out of which he takes the annual 72(t) payment) and one being the non-72(t) IRA.

To determine the size of the 72(t) IRA, Monty uses the commonly used fixed amortization method and decides to pick the following numbers:

Maximum allowable interest rate, 5.79%,
The Single Life Table factor for age 53 (33.4), and
The annual payment he’s selected, $80,000.

With those three numbers, Monty can do a calculation (see IRS Q&A 7 and my YouTube video on the calculation) and determine that the 72(t) IRA should be $1,170,848.59. Thus, the non-72(t) IRA should be $829,151.41.

72(t) Portfolio Allocation

How does Monty allocate the 72(t) IRA and the non-72(t) IRA such that (1) his overall financial asset portfolio ties out to the desired 75/25 allocation and (2) he is as tax optimized as possible.

I believe that Monty should aim to keep his 72(t) IRA as small as possible. Why? Because it is possible that Monty will not need his 72(t) payment at some point prior to turning age 59 ½.

Perhaps Monty inherits $300,000 when he is age 57. At that point, he can use that money to fund his lifestyle until age 59 ½. Why does he want to keep paying taxes on the $80,000 annual 72(t) payment?

Monty has an option available: a one-time change of the 72(t) payment to the RMD method. If Monty switches to the RMD method, he’s likely to dramatically reduce the annual amount of the required 72(t) payment. The RMD method keys off the account balance at the end of the prior year. The lower the balance, the lower the required annual payment under the RMD method.

Since Monty has decided to invest in equities and bonds, I believe that Monty should house his bonds inside his 72(t) IRA. While there are absolutely no guarantees when it comes to investment returns, equities tend to grow more than bonds. Since bonds tend to be lower growth, they are a great candidate for the 72(t) IRA.

It would stink if Monty wanted to reduce his annual 72(t) payment only to find that a 72(t) IRA composed entirely of equities had skyrocketed in value, increasing the amount of his revised annual payment under the RMD method.

Thus, I believe that Monty should put his entire bond allocation, $500,000, inside his 72(t) IRA. That makes the rest of the tax basketing easy: have the entire non 72(t) IRA be invested in equities, and have the remainder of his 72(t) IRA, $670,849, be invested in equities.

72(t), Sequence of Returns Risk, and Safe Withdrawal Rate

One must remember that 72(t) is entirely a tax concept. At least in theory, it has nothing to do with sequence of returns risk and safe withdrawal rate.

Some might look at the 72(t) IRA, $1,170,848.59, and say “Wait a minute: an $80K withdrawal is way more than 4% or 5% of that 72(t) IRA! Isn’t this a dangerous withdrawal rate? Doesn’t this amplify the sequence of returns risk?”

Remember, Monty’s withdrawal rate is $80,000 divided by the entire $2M portfolio (4%), not $80,000 divided by the $1,170,848.59 72(t) IRA. Further, Monty’s sequence of returns risk on this withdrawal rate exists regardless of the 72(t) plan. The greater the overall withdrawal rate, the greater the sequence of returns risk.

Lastly, the 5.79% interest rate Monty chooses has nothing to do with the withdrawal rate. It has everything to do with keeping the size of the 72(t) IRA as small as possible. The chosen interest rate doesn’t change the amount of the annual withdrawal ($80,000) but rather changes the size of the 72(t) IRA.

Conclusion

Tax basketing should be considered when crafting a 72(t) payment plan. I generally believe that investments that are less likely to have substantial gains sit better inside an investor’s 72(t) IRA rather than their non-72(t) IRA.

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

Follow me on Twitter: @SeanMoneyandTax

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

Health Savings Accounts and Las Vegas

Want to make a bad financial decision? I’ve got an account that can help you do that tax and penalty free!

Of course, I do not recommend making bad financial decisions. However, at times it is useful to look at extremes to help us better understand and analyze financial planning alternatives.

Health Savings Accounts

If you’ve spent any time on my blog or YouTube channel, you’re probably aware that I’m fond of HSAs. Contributions are tax deductible (or excludable if made through payroll withholding). Amounts inside the HSA grow tax free. Withdrawals for qualified medical expenses, or reimbursements of qualified medical expenses, are tax and penalty free.

As long as the HSA owner is alive, he or she can reimburse themselves from the HSA for qualified medical expenses incurred after they first owned an HSA. Generally speaking, there’s no time limit on HSA reimbursements, other than the owner must be alive to receive the tax and penalty free reimbursement. See “Distributions from an HSA” on page 9 of IRS Publication 969 and Notice 2004-50 Q&A 39.

HSAs are great because they combine the best feature of a traditional retirement account (deduction or exclusion on the way in) with the best feature of a Roth retirement account (tax free treatment on the way out). Further, the lack of a time limit on reimbursements from an HSA provides the owner with tremendous flexibility in terms of deciding when to take tax and penalty free distributions.

Health Savings Accounts PUQME

Previously Unreimbursed Qualified Medical Expenses (PUQME, pronounced “Puck Me”). HSA owners can reimburse themselves tax and penalty free from their HSA up to their amount of their PUQME. PUQME includes qualified medical expenses of the owner, their spouse, and their dependents incurred after the HSA was first established. Qualified medical expenses deducted as an itemized deduction on a tax return (quite rare) do not qualify to be reimbursed from an HSA and thus are not PUQME. PUQME is a technical term I made up. 😉

Restricted Accounts

When we think about taxable brokerage accounts, traditional retirement accounts, Roth retirement accounts, HSAs, and other available options, we should consider the restrictions in place on the use of the funds. The more restrictions in place, the worse the account.

Time Restrictions

Taxable accounts, traditional retirement accounts, and Roth retirement accounts face various time restrictions on withdrawals. For example, taxable accounts qualify for favored long-term capital gains rates if held for a year. Of course, that restriction is academic if there’s a loss or no gain in the account.

Traditional retirement accounts suffer the most stringent time restrictions. Withdrawals occurring prior to the owner turning age 59 ½ are usually subject to the 10 percent early withdrawal penalty. Roth IRAs are not all that time restricted, as amounts withdrawn prior to age 59 ½ are deemed to first be nontaxable withdrawals of prior contributions. Roth 401(k)s can be somewhat time restricted, as amounts withdrawn prior to age 59 ½ are partially deemed to be withdrawals of taxable earnings (usually subject to the 10 percent early withdrawal penalty).

HSAs are somewhat time restricted, though like Roth IRAs, they are not severely so. Once one has PUQME after having opened an HSA, he or she can withdraw money (up to their PUQME amount) from the HSA tax and penalty free.

Use Restrictions

Taxable accounts, traditional retirement accounts, and Roth retirement accounts are great in that they have absolutely no use restrictions. The government does not care what you spend the money on. The tax result is, at least generally speaking, unaffected by use.

There are some exceptions, such as the exceptions to the 10 percent early withdrawal penalty such that early withdrawals from retirement accounts can qualify to avoid the 10 percent penalty. Further, one might say that because of qualified charitable distributions, using traditional IRAs for charitable purposes is use-favored. The above exceptions noted, as a general rule, use does not significantly change the taxation of withdrawals from taxable accounts, traditional retirement accounts, and Roth retirement accounts.

HSA Use Restrictions

HSA distributions that are not used for qualified medical expenses are subject to both income tax and a 20% penalty if the owner is under age 65.

However, recall that there is no time limit on the ability to reimburse oneself tax and penalty free for previously incurred qualified medical expenses. As a practical matter, the lack of time limit results in relatively modest use restrictions on an HSA. Below I’ll illustrate that with an extreme example.

HSAs and Las Vegas

Perhaps you’re yearning for the hot sand, broken dreams, and $5 lobster of Las Vegas. Could an HSA help? Let’s explore that possibility.

Peter, age 70, wants a weekend getaway in Las Vegas. Between a hotel suite, comedy club tickets, airfare, steak dinners, some Texas Hold’em poker, and the breakfast buffet, he estimates it will cost him $10,000.

Peter was covered by a high deductible health plan from age 55 through age 65. He maxed out his HSA annually during that time, and he has never taken a distribution from his HSA. The HSA is now worth $50,000, and between age 55 and today Peter has $30,000 of PUQME.

Could Peter use his HSA to pay for the weekend? Absolutely!

Wait a minute, Sean. Vegas isn’t a qualified medical expense! Sure, it isn’t. But Peter has $30,000 of previously unreimbursed qualified medical expenses. He can take out $10,000 from his HSA tax and penalty free and use it to buy poker chips in Las Vegas. Once an HSA owner has previously unreimbursed qualified medical expenses, they generally do not have an HSA use restriction up to the level of that PUQME.

As a practical matter, even the healthiest Americans are eventually going to have qualified medical expenses. As a result, most HSA owners will have runway, particularly in retirement, to reimburse themselves for previously incurred qualified medical expenses. That reimbursement money is in no way use restricted–it can go for a weekend trip to Vegas if the HSA owner desires.

HSA Planning Risk

But Sean, there’s no way Congress won’t close the loophole! Surely, at some point in the future, Congress will time-limit tax and penalty free reimbursements from HSAs.

I don’t think so, for three reasons.

First, the HSA loophole is not that great. Consider the relatively modest HSA contribution limits. Sure, the government loses tax revenue due to HSAs, but it isn’t that much, particularly compared to vehicles such as Roth IRAs. Further, HSAs are, at most, a loophole during the owner’s lifetime and the lifetime of their surviving spouse. That’s it!

Left to a non-spouse, non-charity beneficiary, the entire HSA is immediately taxable income (typically at the beneficiary’s highest tax rate) in the year of the owner’s death. Death not only ends the loophole, it gives the government a significant revenue raiser by taxing the entire amount at ordinary rates on top of the inheriting beneficiary’s other taxable income.

Second, I suspect Congress wants taxpayers to bailout HSA money tax and penalty free prior to death. The immediate full taxation of HSA balances in the year of death is going to come as a nasty surprise to many beneficiaries.

Imagine significant taxes and perhaps dealing with the paperwork and hassle of reversing what becomes an excess contribution to a Roth IRA because of a surprise income hit due to the death of a loved one. Here’s what that could look like.

Mark and Laura are married and both turn age 47 in 2023. They anticipate about $200,000 of MAGI in 2023, in line with their 2022 income. Expecting their 2023 income to fall well within the Roth IRA modified adjusted gross income limits, each contributes $6,500 to a Roth IRA for 2023 on January 2, 2023. In September, Laura’s father passes away and leaves her an HSA worth $50,000. The HSA inheritance increases their 2023 MAGI to $250,000. The federal income tax hit on inheriting the HSA will be over $10,000.

As a result of their increased income, Mark and Laura are now ineligible to have made the 2023 Roth IRA contributions. The most likely remedial path involves Mark and Laura working with the financial institution to take a corrective distribution of the contributions and the earnings attributable to the contributions. The earnings will be included in Mark and Laura’s MAGI for 2023 as one last insult to inheriting a fully taxable HSA.

This is a lurking issue. If Congress puts 2 and 2 together, they will hope that HSA balances are small at death so as to avoid their constituents suffering a large, unexpected tax bill related to a loved one’s death. Time-limiting tax and penalty free HSA reimbursements would keep more money inside HSAs during an owner’s lifetime (and thus, at their death). At death, this would set up more beneficiaries to have nasty surprises when inheriting an HSA, a fate Congress most likely wants to avoid.

Third, time-limiting HSA reimbursements will go counter to the reason HSAs exist in the first place: to encourage the use of high deductible health plans. Time-limiting HSA reimbursements could trap amounts inside HSAs because taxpayers would lose amounts they could withdraw from the HSA without incurring tax (and a 20 percent penalty if under age 65). If taxpayers believe HSA money could become trapped, fewer will opt for a high deductible health plan. This will lead to increased medical costs as more and more Americans have lower deductibles and become sensitive to medical pricing.

Surviving Spouse’s HSA PUQME

I prepared a short 1-page technical write up providing my views on how previously unreimbursed qualified medical expenses are computed when a spouse inherits a health savings account.

HSA Resource

Kelley C. Long recently authored an excellent article on HSAs in the Journal of Accountancy.

Conclusion

Here’s hoping that you don’t take away the conclusion that HSA owners should spend their HSA money in Las Vegas!

Rather, my primary conclusion is that investments and tax baskets should be assessed considering their time and use restrictions. The fewer the time and use restrictions, the better. Of course, time and use restrictions are not the only factors to consider, but they are significant factors.

Secondary conclusions include (i) the HSA tends to be very flexible and (ii) the tax breaks available to HSA owners are not likely to be repealed or limited by Congress anytime soon.

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

Follow me on Twitter: @SeanMoneyandTax

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

2022 Year-End Tax Planning

Below are the main tax planning items for the year 2022 as I see them. Of course, this is educational information for the reader, and not tax advice directed toward any particular individual.

The first two tax loss harvesting items are particularly unique to 2022 vis-a-vis recent years.

Tax Loss Harvesting

2022 has given us plenty of lemons. For some Americans, it’s time to make some lemonade through tax loss harvesting. The deadline to do this and obtain a benefit on one’s 2022 tax return is December 31, 2022.

Tax Loss Harvesting and Bonds

There is a tax loss harvesting opportunity in 2022 that has not existed in recent years to the scope and scale it exists today: tax loss harvesting with bonds and bond funds. In a recent post I went into that opportunity in detail and how it might create both a great tax loss harvesting opportunity and a great tax basketing opportunity.

Tax Loss Harvesting Crypto

Many cryptocurrencies have declined in value. This can create a tax loss harvesting opportunity, regardless of whether the taxpayer wants to remain invested in crypto. To harvest the loss if one wants to get out of crypto, it’s easy: just sell the asset. For those wanting to stay in crypto, it’s not that much harder: sell the crypto (by December 31, 2022 if wanting the loss on their 2022 tax return) and they rebuy the crypto shortly thereafter. Crypto is not a “security” for wash sale purposes, and thus, repurchases of crypto are not subject to the wash sale rule, regardless of when they occur.

Solo 401(k) Establishment

Quick Update 12/23/2022: My initial reading of SECURE 2.0 is that it does not change any 2022 Solo 401(k) deadlines. The one deadline it appears to change is effective starting for plan years beginning in 2023.

For Schedule C solopreneurs looking to make a 2022 employee contribution to a Solo 401(k), the Solo 401(k) must be established by December 31, 2022. This is NOT the sort of thing you want to try to do on December 30th. Almost certainly those trying to establish a Solo 401(k) will want to act well before the end of December, as it takes time to get the Solo 401(k) established prior to year-end.

The deadline to establish a Solo 401(k) for an employer contribution is the tax return filing deadline. For individuals, this is April 18, 2023, but can be extended to October 15, 2023. For S corporations, this is March 15, 2023, but can be extended to September 15, 2023.

Solo 401(k) Funding for Schedule C Solopreneurs

Employee elective deferral contributions (traditional and/or Roth) must meet one of two standards. Either (i) they must be made by December 31st or (ii) they are elected by December 31st and made by the tax return filing deadline, including any filed extensions.

Employer contributions must be made by the tax return filing deadline, including any filed extensions.

Roth Conversions

Taxpayers with lower income (relative to the rest of their lives) may want to consider taxable conversions of traditional retirement accounts to Roth accounts. The deadline to get the Roth conversion on one’s 2022 tax return is December 31st, though it is not wise to wait until the last minute.

For the self-employed, there may be a unique opportunity to use Roth conversions to optimize the qualified business income deduction.

Tax Gain Harvesting

For those finding themselves in the 12% or lower federal marginal income tax bracket and with an asset in a taxable account with a built-in gain, tax gain harvesting prior to December 31, 2022 may be a good tax tactic to increase basis without incurring additional federal income tax. Remember, though, the gain itself increases one’s taxable income, making it harder to stay within the 12% or lower marginal income tax bracket.

HSA Funding Deadline

The deadline to fund an HSA for 2022 is April 18, 2023. Those who have not maximized their HSA through payroll deductions during the year may want to look into establishing payroll withholding for their HSA so as to take advantage of the payroll tax break available when HSAs are funded through payroll.

The deadline for those age 55 and older to fund a Baby HSA for 2022 is April 18, 2023.

Roth IRA Contribution Deadline

The deadline for funding a Roth IRA for 2022 is April 18, 2023.

Backdoor Roth IRA

There’s no law saying “the deadline for the Backdoor Roth IRA is DATE X.” However, the deadline to make a nondeductible traditional IRA contribution for the 2022 tax year is April 18, 2023. Those doing the Backdoor Roth IRA for 2022 and doing the Roth conversion step in 2023 may want to consider the unique tax filing when that happens (what I refer to as a “Split-Year Backdoor Roth IRA”).

Anyone who has already completed a Backdoor Roth IRA for 2022 should consider New Year’s Eve. December 31st is the deadline to be “clean” for 2022. Anyone who has done the Roth conversion step of a Backdoor Roth IRA during 2022 will want to consider (to the extent possible and desirable) “cleaning up” all traditional IRAs, SEP IRAs, and SIMPLE IRAs as of December 31, 2022.

Charitable Contributions

The deadline to make charitable contributions that can potentially be deducted on one’s 2022 tax return is December 31, 2022. Planning in this regard could include contributions to donor advised funds. If one is considering establishing a donor advised fund to get a deduction in 2022, I recommend moving well before December 31st, since it takes time for financial institutions to process donations and establish donor advised funds.

RMDs from Your Own Retirement Account

The deadline to take any required minimum distributions from one’s own retirement account is December 31, 2022. Remember, the rules can get a bit confusing. Generally, IRAs can be aggregated for RMD purposes, but 401(k)s cannot.

RMDs from Inherited Accounts

The deadline to take any RMDs from inherited retirement accounts is December 31st. For some beneficiaries of retirement accounts inherited during 2020 and 2021, the IRS has waived 2022 RMDs. That said, all beneficiaries of inherited retirement accounts may want to consider affirmatively taking distributions (in addition to RMDs, if any) before the end of 2022 to put the income into a lower tax year, if 2022 happens to be a lower taxable income year vis-a-vis future tax years.

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

Follow me on Twitter at @SeanMoneyandTax

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

The Special Tax Loss Harvesting Opportunity for 2022

There is a tax loss harvesting opportunity in 2022 that has not existed in recent years to the scope and scale it exists today: tax loss harvesting with bonds and bond funds. In most recent years, many bonds and bond funds have not had significant built-in-losses. 2022 is different: now there are plenty of bonds and bond funds in taxable accounts with significant built-in-losses.

Tax Basketing for Bonds and Bond Funds

Bonds tend to be tax inefficient, for two reasons. First, they generate ordinary income, which is taxed at the taxpayer’s highest marginal tax rate. Second, they tend to have higher yields than equity investments. Thus, a dollar of a bond fund often produces more taxable income than a dollar of an equity fund, if they are both owned inside a taxable account.

As a result, holding bonds and bond funds in traditional retirement accounts is often logical from a tax basketing (or tax location) perspective. If they produce ordinary income anyways, why not hold them in a traditional retirement account (IRA, 401(k), etc.) where the owner can defer the timing of the ordinary income taxable event (through later Roth conversions and/or distributions)?

Tax Basketing for Stocks and Equity Funds

Bonds also don’t suffer from the “transmutation” problem equities have. Stocks and equity funds, in most cases, pay “qualified dividend income” which qualifies for the lower long term capital gains tax rates (including the 0% long term capital gains tax rate). Holding them in a traditional retirement account transmutes that preferred income into ordinary income, subject to the taxpayer’s marginal ordinary tax rate.

Now, as a practical matter, most Americans have most of their non-real estate financial wealth in traditional retirement accounts. Having some equities in traditional retirement accounts should not in any way cause despair. But, on the margins, it can be beneficial to review the overall portfolio to see if there can be some tax efficiency gains made by some tax rebasketing of assets.

Rebasketing and Tax Loss Harvesting

The deadline for tax loss harvesting for 2022 is December 31, 2022.

To my mind, some of the best 2022 tax loss harvesting will be selling bonds and bond funds at a loss in taxable accounts. Why is that? Because this sort of tax loss harvesting enjoys the main benefits of tax loss harvesting and it can achieve a great tax basketing result.

Bonds create ordinary income and are generally higher yielding than equities, which often produce tax favored qualified dividend income. Thus, from a tax basketing or tax location perspective, it can often make sense to hold bonds and bond funds in a traditional retirement account and hold equities in a taxable account. Today, many investors can do some tax loss harvesting and strategically reconfigure their portfolios to make them much more tax efficient. Here is an example of how this could play out.

Jorge is 30 years old. He currently owns a diversified equity fund (Fund A) inside his workplace traditional 401(k) plan worth $80,000. It has a 2% annual dividend yield, most of which is qualified dividend income (though of course it is tax deferred inside the 401(k) and will later be subject to ordinary income tax when withdrawn or Roth converted). Separately, he owns a diversified bond fund (Fund B) inside his taxable brokerage account. It is worth $20,000, and Jorge has a $24,000 tax basis in the fund. The bond fund has a 3% annual interest yield ($600), all of which is ordinary income. Jorge wants to have an 80% / 20% equity to bond allocation.

Here’s Jorge’s portfolio today:

Asset	Amount	Annual Taxable Income
401(k) Fund A (Equity)	$80,000	None
Taxable Fund B (Bond)	$20,000	$600
Total	$100,000	$600

Jorge, could, in theory, execute two transactions to both tax loss harvest and become more tax efficient from a tax basketing perspective. First, Jorge could exchange his $20K of Fund B for $20K of an equity fund inside his brokerage account with a dividend yield similar to Fund A. Second, inside his 401(k), he could exchange $20K worth of his Fund A holding for a bond fund with an income yield similar to Fund B. If Jorge’s new fund inside the 401(k) is not substantially identical to Fund B, he can claim most, if not all, of the $4,000 loss, though the prior month’s Fund B dividend might slightly reduce the loss under the wash sale rule.

Here’s Jorge’s portfolio after these two transactions:

Asset	Amount	Annual Taxable Income
401(k) Fund A (Equity)	$60,000	None
401(k) Bond Fund	$20,000	None
Taxable Equity Fund	$20,000	$400
Total	$100,000	$400

Jorge may obtain two tax benefits from these transactions. First, assuming he successfully navigates the wash sale rule, he may be able to deduct up to $3,000 against ordinary income by triggering the capital loss on the Fund B sale.

Second, regardless of whether he successfully navigated the wash sale rule, he has just made his portfolio more tax efficient. It used to be that he reported $600 of ordinary income (from Fund B) on his tax return. Now that sort of interest income is hidden inside the 401(k). If he now receives approximately $400 a year in qualified dividend income from the new equity fund inside the taxable brokerage account, he has (i) reduced his annual taxable income by $200 (and growing through compounding) and (ii) now has mostly qualified dividend income from the taxable account instead of ordinary income, lowering his federal tax rate on his portfolio income. He has done all that without disturbing his overall asset allocation.

Getting the tax basketing of his investments better without changing his investment allocation is likely to be worth it even if loses the tax loss due to the wash sale rule. He would want to review the options available to him inside his 401(k) to see if there is an acceptable (to him) bond fund that is not “substantially identical” to Fund B so as to avoid the wash sale rule being triggered by the investment in a bond fund inside the 401(k).

Conclusion

Declines in the stock and bond market are some of the lemons of 2022. But, there’s a chance to make some lemonade. When it comes to bonds held in taxable accounts, there may be an opportunity to obtain two benefits: tax loss harvesting and better tax basketing.

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

Follow me on Twitter at @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, 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.

The Advantages of Living On Taxable Assets First in Early Retirement

The FIRE community loves the accumulation phase. Build up assets towards the goal of financial independence.

Questions increasingly creep in when it comes to the distribution phase. Members of the FIRE community wonder: what do I live on when I get to retirement? This is particularly true when one reaches early retirement prior to age 59 ½.

Below I discuss the options and the reasons I believe that for many, the best assets to live off of first in early retirement are taxable assets. This analysis assumes the early retiree has access to some material amount of assets in each of the three tax baskets discussed below.

Early Retirement Drawdown Options

For most Americans reaching retirement prior to age 59 ½, there are three main tax baskets of assets that can be lived off prior to age 59 ½.

Taxable Assets: This can include cash in bank accounts, brokerage accounts (stocks, bonds, mutual funds, and ETFs), and for some, income from rental properties. For purposes of this blog post, I will assume the early retiree does not own any rental real estate.

Roth Basis/HSAs: Early retirees can live off of what I colloquially refer to as “Roth Basis.” Generally, Roth Basis is the sum of previous annual contributions to Roth accounts and Roth conversions that are at least five years old. Further, early retirees can harvest amounts in HSAs tax and penalty free to the extent that they have allowable previously unreimbursed qualified medical expenses (what I refer to as PUQME). HSAs can also be used for qualified medical expenses incurred in early retirement.

Traditional Retirement Assets: Assets such as traditional 401(k)s and traditional IRAs. Generally “inaccessible” prior to turning age 59 ½ due to being subject to both ordinary income tax and the 10% early withdrawal penalty. However, there are exceptions to the early withdrawal penalty. They include:

Rule of 55: Separation from service from an employer after turning age 55 (exception available for withdrawals from that workplace retirement plan only).
72(t) Payments: Establishing a series of substantially equal periodic payments.
Governmental 457(b) Plans

Drawbacks of Using Roth Basis/HSAs

Some might argue for using tax-free withdrawals of Roth Basis and HSAs to fund early retirement. This allows the early retiree to pay no taxes on funds used for living expenses.

To my mind, the main drawback of doing so is opportunity cost. Removing assets from Roths and HSAs cuts off the opportunity for future tax free growth.

As a general planning objective, many will want to let their Roths and HSAs grow as long as possible to maximize tax-free growth.

Using Roths and HSAs can also have a significant drawback from a creditor protection perspective, as I will discuss below.

Drawbacks of Using Traditional Retirement Assets

The below analysis assumes that the early retiree qualifies for an exception from the 10% early withdrawal penalty.

The biggest drawback to using traditional retirement accounts to live off of in early retirement is all living expenses become subject to federal and state income taxes. It puts the most important consideration (funding living expenses) in opposition to the secondary (but still important) consideration: tax planning.

Living off traditional retirement accounts in early retirement reduces tax planning flexibility. It reduces the ability to do tax-optimized Roth conversions in early retirement. In addition, living off traditional retirement accounts during early retirement can reduce Premium Tax Credits for those on Affordable Care Act (“ACA”) medical insurance plans.

Premium Tax Credit Planning: Many early retirees will use an Affordable Care Act medical insurance plan. The premiums are subsidized through a tax code mechanism: the Premium Tax Credit (the “PTC”). PTCs are reduced as the taxpayer’s modified adjusted gross income (“MAGI”) increases. Very roughly speaking, for planning purposes, an additional dollar of MAGI often reduces the PTC by 10 to 15 cents, meaning early retirees using traditional retirement accounts to fund living expenses may be subject to a surtax of 10 to 15 percent on retirement account withdrawals due to PTC reduction. Resources for the PTC include this article and this spreadsheet.

There’s an argument that it is good to live off traditional retirement accounts early because withdrawals used to fund living expenses reduce future required minimum distributions (“RMDs”). But one must consider that there are two types of withdrawals an early retiree can make from a traditional retirement account: an actual withdrawal or a Roth conversion. Both reduce future RMDs, but a Roth conversion is the most tax efficient withdrawal for the early retiree. Why? Because it sets up future tax-free growth! Actual withdrawals used for living expenses do not enhance future tax-free growth.

Another drawback of using traditional retirement accounts to fund early retirement includes being constrained by the parameters of the applicable penalty exception. For example, needing to keep money inside a former employer’s retirement plan in order to qualify for the Rule of 55, or needing to withdraw precise amounts annually if using a 72(t) payment plan. Further, using traditional retirement accounts in early retirement has creditor protection drawbacks, discussed below.

Advantages of Using Taxable Assets

Living off drawdowns of taxable assets can be a great way to fund the first expenses of early retirement. Here are some of the advantages.

Zero Percent Long Term Capital Gains Rate

Early retirees worry: I need $60,000 of income to live my life. Won’t that create $60,000 of taxable income?

If drawing from a taxable account, almost certainly it will not. Consider Judy, an early retiree needing $60,000 to pay her living expenses. If she sells $60,000 worth of the XYZ Mutual Fund (all of which she has owned for over a year), in which she has $40,000 of basis, her resulting taxable income is only $20,000. Not $60,000!

But it gets even better for Judy. The capital gain can qualify for the 0% federal long term capital gains tax rate. Outstanding! By using taxable assets, Judy may pay $0 federal income tax, and likely only a very small state income tax, on the money she uses to fund her living expenses. Pretty good.

Even if Judy’s income puts her above the 0% federal capital gains tax bracket, (i) some of her capital gains will likely qualify for the 0% rate, and (ii) the next bracket is only a 15% tax rate.

Basis Recovery While Basis is Valuable

During 2022, we learned an important financial lesson: inflation is a thing. Retirement draw down planning should consider inflation.

One way to fight inflation is to use tax basis before its value is inflated away. Tax basis is never adjusted for inflation. Thus, failing to harvest tax basis exposes the early retiree to the risk that future capital gains in taxable accounts will be subject to taxation on inflation gains. Early retirees should consider harvesting basis (like Judy in the above example) when the tax basis is its most valuable.

Using taxable assets as the first assets to fund early retirement takes maximum advantage of tax basis, unless the U.S. dollar begins to deflate (a possible but not very likely long term outcome, in my opinion).

Opens the Door for Roth Conversions

Now we get to the fun part. Roth conversions! Using taxable assets first for living expenses in early retirement facilitates conversions of amounts in traditional retirement accounts to Roth accounts. The idea is to have artificially low taxable income such that the taxpayer can do Roth conversions taxed at 0% federal (offset by the standard deduction) and then in the 10% or 12% tax bracket. Occasionally, it will be logical for the taxpayer to incur an even greater tax rate on such Roth conversions.

These Roth conversions move assets to Roth accounts where they enjoy tax free growth. In addition, early retirement Roth conversions reduce future RMDs.

There is a taxpayer-friendly rule that assists early retirement Roth conversion planning: long-term capital gains income is stacked on top of ordinary income in the tax computation. Thus, Roth conversions can benefit from being sheltered by the standard deduction (or itemized deductions if the taxpayer itemizes). This makes Roth conversion planning in early retirement that much better, as some Roth conversions can benefit from a 0% federal income tax rate.

Further, this tells us it is generally better from a tax basketing perspective not to have bonds and other assets that generate ordinary income, since that income eats up part of the standard deduction, diminishing the opportunity to 0% taxed Roth conversions. One way to avoid having such ordinary income is to sell bonds, bond mutual funds, and other assets that generate ordinary income and use the proceeds to fund early retirement living expenses.

Another advantage of early retirement Roth conversions is the reduction of the risk that future tax increases will drive up taxes on future traditional retirement account withdrawals.

Roth Conversions, ACA PTC Eligibility, and Medicaid

Lastly, there can be an ancillary benefit to Roth conversions. Taxpayers lose all ACA subsidies (thus, PTCs) if their MAGI is below certain thresholds. For example, a family of four in California with MAGI less than $41,400 (2023 number) would meet the income threshold for Medi-Cal (Medicaid in California) and thus would get no ACA PTC.

Roth conversions can keep early retirees’ MAGI sufficiently high such that they do not meet the income threshold for Medicaid. By keeping MAGI above the Medicare threshold, early retirees can qualify for significant PTCs.

Creditor Protection

Financial assets can receive protection from creditors to varying degrees. Taxable brokerage accounts tend to have little, if any, creditor protection. 401(k) and other ERISA government workplace retirement accounts benefit from ERISA’s anti-alienation provisions. Generally speaking, only the IRS and an ex-spouse can get assets out of a 401(k). Traditional IRAs and Roth IRAs enjoy significant protection in bankruptcy. Traditional IRAs have varying degrees of non bankruptcy creditor protection, but in many states are fully protected. Roth IRAs are non bankruptcy protected in most states, but more states protect traditional IRAs than Roth IRAs.

HSAs do not enjoy federal bankruptcy protection, but do enjoy creditor protection in some states (to varying degrees).

By spending down taxable assets in early retirement, the early retiree optimizes for creditor protection in two ways. First, diminishing taxable assets by using them for living expenses reduces creditor vulnerable assets. Second, when an early retiree lives off taxable assets, they leave their more protected assets (traditional and Roth retirement accounts) to grow. Diminishing vulnerable assets while growing protected assets improves the early retiree’s balance sheet from a creditor protection perspective.

Lastly, early retirees should always consider personal umbrella liability insurance and other relevant property and casualty insurance for creditor protection.

Premium Tax Credit Planning

Living off taxable assets in early retirement limits taxable income. This has a good side effect. It increases the potential PTC available for early retirees using an ACA medical insurance plan.

Reducing Future Uncontrollable Taxable Income

Roths and HSAs are great because their taxable income is entirely controllable, and generally speaking should be $0. Even traditional retirement accounts have very controllable taxable income. There are no RMDs until age 72, and even then the amount of taxable income is quite modest for the first few years.

Taxable assets, on the other hand, expose the early retiree to uncontrollable taxable income, in the form of interest, dividends, and capital gain distributions. You never know when a mutual fund or other investment will spit out a taxable dividend or capital gain distribution. Such income reduces the runway for tax planning and can reduce PTCs.

Further, in recent years, we have become accustomed to living in a low-yield world. In the past decade plus a taxable portfolio has kicked off (in many cases) income yields of 3%, 2%, or less. Thus, the tax hit from taxable assets has not been too bad for many. That said, low yields are not guaranteed in the future. It could be that yields will rise, and thus taxable assets will generate increasing amounts of taxable income.

By living off taxable assets first, early retirees reduce and ultimately eliminate taxable interest, dividends, and capital gain distributions generated by holding assets in taxable accounts. This reduces the tax cost of the overall portfolio, and makes planning MAGI, taxable income, and tax paid annually an easier and potentially more beneficial exercise.

I discuss the early retirement Roth Conversion Ladder strategy in this video.

Conclusion

In many cases, I believe that the tax optimal path for the early retiree is to live off taxable assets first in early retirement prior to accessing Roth Basis, HSAs, and traditional retirement accounts. Of course, this is not individualized advice for you or any other particular individual. Those considering early retirement are well advised to consider their future drawdown strategy as they are building their assets. Those already retired should consider their own particular circumstances and ways to optimize their drawdown strategy.

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

Follow me on Twitter at @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, 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.

Real Estate in Retirement Accounts

Should you hold rental real estate in a self-directed retirement account? Is real estate a great asset to own in a Roth IRA? Is holding real estate in a self-directed retirement account a hack that can help supercharge your path to financial independence? Below I discuss what it looks like to hold real estate in a self-directed IRA or 401(k), with a particular focus on those looking to achieve FI.

A Necessary Predicate

Before I proceed, I need to lay a necessary predicate. Those actively pursuing financial independence will fall into one of the two following groups:

Group 1: Invest in a diversified portfolio of equities and bonds.

Group 2: Invest in real estate and a diversified portfolio of equities and bonds.

Why is there no third group, real estate investors only? For two main reasons. First, many pursuing FI have no interest in owning rental real estate and/or desire to only own a small number of properties. Second, as a general rule, investing in only one sector of the economy (technology, financials, pharmaceuticals, utilities, real estate, etc.) leaves an investor dangerously undiversified and vulnerable to very particular risks to a degree diversified investors are not.

The rest of this post focuses on tax basketing for individuals in Group 2: those pursuing FI and investing in rental real estate and a diversified portfolio of equities and bonds.

Stock Basis vs. Real Estate Basis

Recall that the basis of stock, bonds, mutual funds, and ETFs (what I will colloquially refer to as “stock basis”) is the amount you paid for the asset plus any distributions reinvested in the asset less any nondividend distributions (returns of capital). Stock basis is great, but for many in the FI community, its benefits are distant and significantly eroded by inflation.

Picture Jack and Jill, a married couple, each 25 years old and actively pursuing financial independence. They max out their IRAs and workplace retirement plans. They have a savings rate in excess of 50 percent, so they must invest in taxable accounts, and choose to invest in low-cost, well diversified index mutual funds. They target early retirement at age 40.

Other than very occasional tax loss harvesting, the basis Jack & Jill obtain in their taxable mutual fund accounts at age 25 will be meaningless to them until they are at least 40 years old. Even then, using something like the 4 percent withdrawal rule, they will touch only a small fraction of their basis every year. By then, the value of the basis they put in the mutual funds will have been significantly eroded by inflation.

But what if Jack and Jill instead decide that they will max out their IRAs and workplace retirement accounts (using stock and bond index funds), and then everything else will go into taxable rental real estate investments. What value does their basis have then? Much greater value, it turns out. Jack and Jill can immediately depreciate their rental real estate and start using their basis to reduce their taxable rental income from that property and other rental properties. Depending on their circumstances, they may be able to deduct some or all of any rental real estate loss against other taxable income.

When you invest in rental real estate in taxable accounts, your tax basis goes to work for you right away. When you invest in financial assets, your tax basis sits dormant, possibly for many years or the rest of your life. By the time you use your stock basis to obtain a tax benefit, the value of your stock basis (and thus the resulting tax benefit) may be severely diminished by inflation.

This strongly indicates you should house financial assets in retirement accounts and rental real estate in taxable accounts. House the rental real estate (pun intended) in taxable accounts where you can milk its basis for all it’s worth while housing the financial assets in retirement accounts.

Leverage and Tax Basis

You can use leverage to increase the tax value of rental real estate. A young couple will have to likely borrow some or all of the purchase price of their initial rental real estate investments. This can be advantageous from a tax perspective. Here’s an illustrative example:

Jack and Jill have $50,000 of cash to invest in a taxable account. They have decided to invest in a $250,000 fifth floor condominium to rent out. They borrow $200,000, purchase the property, and rent out the condo. In the first year they rent out the condo for a full year, they can get $9,091 ($250,000 divided by 27.5) in depreciation deductions and, assuming a 5% loan, almost $10,000 in interest deductions. Note this and all examples ignore any potential price allocation to land for simplicity.

Jack and Jill leveraged $50,000 into almost $19,000 in tax deductions in one year alone. Had they purchased $50,000 worth of financial assets, they would have received exactly nothing in tax deductions in the first full year, and the value of the $50,000 of basis would be eroding away to inflation. Even if they were able to tax loss harvest, at most the benefit would be a $3,000 deduction against their ordinary income.

In some cases, depreciation combined with other deductions causes rental real estate to produce a loss for tax purposes. Why put an asset that generates a tax loss in a retirement account?

If stock basis has such limited value, and rental real estate basis has such impactful, immediate value, why “exploit” stock basis in a taxable account while you neuter rental real estate basis in an IRA? It makes much more sense to utilize that rental real estate tax basis in a taxable account and put limited value stock basis in a retirement account.

Step-Up at Death

When you leave your heirs rental real estate in taxable accounts, the government gives your heirs hundreds of thousands of dollars worth of free tax deductions!

There’s no lack of content discussing the many tax benefits of real estate. Some of it discusses the step-up in basis at death and the ability to hold real estate in a self-directed retirement account. What little of this content acknowledges is that if you hold real estate in a self-directed retirement account, you lose the step-up in basis at death!

If you are at all concerned about Second Generation FI for your children, you need to consider this issue. The step-up in tax basis at death is an incredible opportunity for your heirs. Upon your death, your heirs get to re-depreciate your rental real estate based on the fair market value of the property at your death.

Here’s a comprehensive example.

Jake buys a small rental condo for $100,000 in 2019. He fully depreciates it over 27.5 years, saving significantly on his taxes. He dies in 2049 when the condo is worth $400,000. He leaves the condo to his adult son Jake Jr. He also leaves a Roth IRA with financial assets to Jake Jr. worth $400,000.

What result? Jake Jr. inherits the condo with a $400,000 tax basis and gets to depreciate that new $400,000 basis for 27.5 more years! This drastically reduces his taxable income from the property and may create a currently useable taxable loss. While Jake Jr. must withdraw the inherited Roth IRA within 10 years, the money from the Roth IRA is tax free to Jake Jr. And because Jake Jr houses the inherited Roth IRA at a discount brokerage (such as Vanguard, Fidelity, or Schwab), the Roth IRA pays minimal fees.

What if instead Jake had housed the financial assets in his taxable accounts and the rental property in his Roth IRA. First, the financial assets will produce interest, dividends, and capital gain distributions that will be taxable to Jake Jr. every year. Second, Jake Jr. will pay more in annual fees to a self-directed Roth IRA custodian. Further, Jake Jr. will lose the ability to claim any tax loss generated by the condo against his other income.

The effect is magnified if Jake Jr. leaves the rental property to his son, Jake III. Jake III will again get to step-up the basis in the condo to its fair market value when Jake Jr. dies and re-depreciate it! Over several generations the step-up in basis cycle can create potentially millions of dollars of tax depreciation deductions!

Rental Real Estate: Taxable Accounts and Retirement Accounts

If you are going to give up hundreds of thousands of dollars (possibly millions) of tax deductions for your heirs, you ought to have a compelling reason to do so. I do not believe there’s a compelling reason to house real estate in a retirement account and forego these free future tax deductions.

Roth IRAs are great for protecting the income generated by financial assets from taxation. The step-up in basis is great for protecting the income from rental real estate from taxation. Why waste a Roth IRA on real estate when your heirs will get a fantastic step-up in basis in your real estate to shield a significant portion of the income from taxation (and may possibly generate useable current real estate losses)?

All of this is magnified if the rental real estate is in a traditional IRA instead of a Roth IRA. Instead of depreciation and other deductions to shield rental income from taxation, every dollar you ever take from a traditional IRA will be subject to ordinary taxation (even if the underlying rental property is unprofitable). Combining this with self-directed retirement account custodian fees makes a traditional retirement account a terrible place to house rental real estate.

Stepped-Up Stock Basis

As discussed, the step-up in real estate basis is effective in reducing or eliminating taxable income rental real estate. But the step up in basis does nothing to reduce income from interest, dividends, and capital gain distributions generated by inherited financial assets. This further indicates that the step-up in basis is better used on real estate than on financial assets.

Other Considerations

Tax basis is not the only consideration in determining where to tax basket assets. Below is a run through of several other important considerations.

Costs

As of 2023, costs for investing in well diversified index funds in retirement accounts at discount brokerages are approaching zero. Costs for self-directed IRAs and 401(k)s are more substantial. Costs can include a set-up fee, annual account fees, one-off service fees, and fees for valuations.

Valuations

Starting at age 73, you must take RMDs from your traditional retirement accounts and employer Roth accounts. In the year after your death, certain heirs must take RMDs from your retirement accounts (including Roth IRAs). To do this, the recipient must know the value of each retirement account on December 31st of the prior year. For publicly-traded stock and bond based mutual funds and ETFs, the financial institution will simply report this information to you. For real estate, it is a very different ballgame. You will need to obtain a third party valuation, as the December 31st value of any particular piece of real estate is not readily apparent or known. This is an additional annual cost of owning real estate inside a retirement account.

Capital Gains

If you sell financial assets in a taxable account, you’re stuck with the capital gain, which will increase your federal (and possibly state) income tax bill. There are narrow and/or costly exceptions, including, the qualified opportunity zone program, which requires you to invest in a very specific type of investment that you may have absolutely no interest in investing in, for a minimum period of time. The qualified opportunity zone program can also apply to real estate capital gains.

The other exceptions to stock capital gain, including donations to charities, donor advised funds, and/or charitable trusts, are expensive, in that they require you to relinquish some or all of your economic ownership in order to avoid a taxable capital gain.

If you want to sell your rental real estate, you can use a Section 1031 “like-kind exchange” and simply exchange the rental property for another piece (or pieces) of rental real estate. This defers the capital gain on the sold property for as long as you hold onto the substitute property. Section 1031 exchange treatment is not available for financial assets.

While Section 1031 exchanges may not satisfy investors in every instance, the availability of Section 1031 exchanges is a reason to keep real estate in taxable accounts.

Rules, Rules, Rules

If you put your real estate in a retirement account, you voluntarily subject yourself to a whole host of rules. One is that you are not allowed to use the rental real estate for personal use. Another is that not allowed to personally manage or repair the property. Any violation of these rules can disqualify the retirement plan, resulting in a distribution of the property to the plan owner. This can result in a large taxable income hit and/or early distribution penalties if the owner is under age 59 ½.

Unrelated Debt Financed Income (“UDFI”) Tax

Is your rental property at all debt financed? If it is, and it is in an IRA, your IRA (including a Roth IRA) will be subject to income tax (the “unrelated business income tax”) on the portion of the taxable income that is attributable to the debt (the “unrelated debt financed income”). For example, if you have a condo that was purchased half with debt, half the income will be subject to tax (at the IRA level) as UDFI.

Further, as an entity your IRA is subject to taxation at very steep tax brackets. While the first $1,000 of UDFI is exempt from taxation, by the time the taxable UDFI exceeds $12,500, the IRA pays the highest individual marginal ordinary income tax rate (currently 37 percent) on the income.

There are UDFI workarounds. One is to roll a self directed IRA/Roth IRA to a self directed 401(k)/Roth 401(k). 401(k) plans are not subject to tax on UDFI generated by rental real estate. In order to move to a self directed 401(k)/Roth 401(k) plan, you must have a trade or business that can sustain the self directed 401(k) or self directed Roth 401(k).

If you roll from a Roth IRA to a self directed Roth 401(k), you solve your UDFI problem but you subject yourself to RMDs (and valuation issues) starting at age 73, reducing future tax free growth. You also added a requirement to file an annual Form 5500 tax return with the IRS if the self directed Roth 401(k) has $250,000 or more of assets. Another workaround is placing the real estate in the IRA/Roth IRA in a C corporation. This will lower the tax rate the UDFI is subject to down to 21 percent, but will also subject the non-UDFI income to that 21 percent tax rate.

Real Estate Losses

In some cases, depreciation combined with other deductions causes rental real estate to produce a loss for tax purposes. This can occur even if the property is “cash-flow positive” i.e., it produces cash income in excess of its cash expenses.

Why put an asset that generates a loss in a retirement account? Often times losses are suspended, meaning the rental property nets to zero on the tax return for that particular year. But the suspended loss is tracked and can be used in the future. Read this post for more information on deducting real estate losses.

Is the ability to use real estate losses from real estate held in taxable accounts limited? Absolutely. But it is fully eliminated if the real estate is in a retirement plan. Such losses can never be used on an individual’s tax returns.

Gilding the Lily

Discount brokerages have made this the best era to be a well diversified investor in equities and bonds. Costs associated with investing in index funds in retirement accounts are approaching zero.

This means equities and bonds reside in retirement accounts very well. Why do you need to gild the lily at that point? You have great investment options at a low cost.

To my mind, there is no compelling reason to reject this approach, particularly considering (1) depreciation and other tax advantages that help make rental real estate efficient in taxable accounts and (2) the burdens associated with housing real estate in retirement accounts.

Conclusion

In the vast majority of cases, if you want to own both financial assets (stocks/bonds/mutual funds/ETFs) and rental real estate as part of your portfolio, you are well advised to house your rental real estate in taxable accounts and save your retirement accounts for the financial assets.

It comes back to the tyranny of tactics. Real estate in an IRA sounds great, but when you peel back the onion, simplicity usually wins. Does this mean some with real estate in a retirement account will not achieve financial independence? Absolutely not. But the simpler path will keep your costs low and will likely be tax efficient.

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

Follow me on Twitter at @SeanMoneyandTax

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

Tax Efficient Estate Planning

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

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

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

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

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

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

Spouses

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

Tax Baskets

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

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

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

Traditional Accounts

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

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

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

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

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

Roth Accounts

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

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

Health Savings Accounts

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

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

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

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

Taxable Accounts

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

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

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

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

Conclusion

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

Roth
HSA
Taxable
Traditional

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

Roth
Taxable
Traditional
HSA

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

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

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

Follow me on Twitter at @SeanMoneyandTax

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

Section 199A Examples and Lessons

Introduction

As this is being re-published (January 2021), we are in the third filing season of the new Section 199A qualified business income deduction. It is an area of the tax law that practitioners are still digesting.

I have previously written on the basics of the Section 199A deduction. This post builds on that introductory post. It provides analysis on rules from the IRS and Treasury and gives examples of how the deduction works in specific situations.

Takeaways

Deductions such as the deduction for one-half of self-employment taxes paid and the deduction for self-employed retirement plan contributions reduce the qualified business income (“QBI”) qualifying for the Section 199A deduction.

In many cases, Section 199A reduces the tax savings on traditional retirement plan contributions. Taxpayers may want to consider Roth employee contributions instead of traditional employee contributions to retirement plans because of this change.

Some taxpayers may want to prioritize contributions to traditional IRAs and HSAs instead of contributions to self-employed and small business retirement plans to maximize their Section 199A deduction.

Potentially powerful tax planning opportunities exist whereby taxpayers can reduce their taxable incomes such that they can go from no Section 199A deduction to a significant deduction. See Managing Taxable Income below for one example.

Many small businesses (including many sole proprietorships and S corporations) should not make charitable contributions, since these reduce qualified business income deduction. Rather, the owners of these small businesses should make charitable contributions in their own names.

The IRS and Treasury have provided a safe harbor under which rental real estate activities can qualify for the Section 199A deduction.

Dividends received from mutual funds and ETFs investing in domestic REITs can qualify for the Section 199A deduction.

Below are examples and commentary addressing Section 199A.

Side Hustler

Mike works a full-time job. His W-2 for 2018 reports $90,000 of wages. Mike also receives $1,000 of qualified dividend income (“QDI”) in his taxable account. Mike has a side hustle where he nets $10,000 in Schedule C profit. Mike pays $1,413 in self-employment tax on that profit. Mike claims the standard deduction.

Recall that the Section 199A deduction is the lesser of:

20 percent of your taxable income less your “net capital gain” which is generally your capital gains plus your QDI; or,
20 percent of your qualified business income (“QBI”).

The deduction for one-half of self-employment taxes is factored into the determination of QBI. Thus, in Mike’s case, his Section 199A deduction is the lesser of:

20% of Taxable Income: 20% times ($90,000 plus $10,000 plus $1,000 less $707 less $1,000 less $12,000 = $87,293) = $17,459; or,

20% of QBI: 20% times ($10,000 less $707 = $9,293) = $1,859

In this case, Mike’s Section 199A deduction is $1,859.

Mike’s taxable income is determined by deducting, for adjusted gross income, one-half of the self-employment taxes ($707) he pays with respect to his side hustle income. However, that deduction for half of his self-employment tax must also be subtracted in determining his QBI.

Note further that the Section 199A deduction does not reduce self-employment taxes. The Section 199A deduction is only an income tax deduction. It does not reduce the amount subject to self-employment taxes (in Mike’s case, $10,000).

Sole Proprietor with a Solo 401(k)

Lisa owns a sole-proprietorship that generates $100,000 of business income in 2020 as reported on Schedule C. Lisa pays $14,130 in self-employment taxes. Lisa contributed $19,500 to her traditional Solo 401(k), and makes an employer contribution to her traditional Solo 401(k) of $18,587. Lisa is married to Joe who makes $75,000 in W-2 wages. Lisa and Joe claim the standard deduction.

The deduction for retirement plan contributions is factored into the determination of QBI. Thus, in Lisa’s case, her Section 199A deduction is the lesser of:

20% of Taxable Income: 20% times ($100,000 plus $75,000 less $7,065 less $19,500 less $18,587 less $24,800 = $105,048) = $21,010; or,

20% of QBI: 20% times ($100,000 less $7,065 less $19,500 less $18,587 = $54,848) = $10,970

In this case, Lisa’s Section 199A deduction is $10,970.

QBI has the effect of making certain income “80% income.” What I mean by that term is that only 80% of the income is subject to income tax. This has a flip side – some deductions become only “80% deductions,” meaning that only 80% of the deduction generates a tax break.

Notice that the Solo 401(k) contributions reduce the QBI deduction. Thus, Solo 401(k) contributions are now “80% deductions” due to the QBI regime. For example, if your marginal tax rate is 22 percent, the marginal tax rate savings on your traditional 401(k) employee contribution is only 17.6 percent. But years later, when you withdraw the money from the Solo 401(k) the money will be “100% income.” You will not get a QBI deduction for those withdrawals.

I blogged more about the 80% deduction phenomenon here.

This will cause many sole proprietors to consider Roth Solo 401(k) employee contributions instead of traditional Solo 401(k) employee contributions, since the the tax savings on traditional self-employed employee contributions is reduced as a result of the QBI deduction.

Note further that for the Solo 401(k) employer contribution there is no choice to be made because there is no option to make a Roth employer contribution. All employer contributions must be traditional contributions.

Another observation: If Lisa and Joe had a low enough adjusted gross income (under $105,000) and Lisa made a deductible $6,000 contribution to a traditional IRA, that contribution would not have counted against her QBI. A contribution to a health savings account would also not have lowered her QBI.

For taxpayers whose Section 199A deduction is limited by 20% of QBI, contributions to traditional IRAs and HSAs should be favored over self-employment retirement plan contributions, since the IRA and HSA deductions are 100% deductions while the self-employment retirement plan contributions are 80% deductions. Hat tip to Jeff Levine who made the retirement plan contribution prioritization point on Twitter.

For taxpayers whose Section 199A deduction is limited by 20% of taxable income, contributions to traditional IRAs, HSAs, and self-employment retirement plans are all 80% deductions, and thus Section 199A normally does not factor into determining how to prioritize these contributions. However, all of these are tools taxpayers may be able to use to lower taxable income to qualify for a Section 199A deduction, as discussed in the Managing Taxable Income section below.

S Corporation

Assume the facts are the same as the previous example, except for the following differences. Lisa operates her business as a wholly-owned S corporation instead of as sole proprietorship. Before any sort of compensation, the S corporation makes $100,000. Assume that in this case, the S corporation pays Lisa $50,000 of W-2 wages, which is further assumed to be reasonable. Lisa makes employee contributions of $19,500 to her traditional Solo 401(k) from those wages. The S corporation makes the maximum employer contribution of $12,500 (computed as $30,500 of Box 1 W-2 wages plus $19,500 of elective deferrals times 25 percent). Thus, Lisa will have flow-through income from the S corporation (reported to her on a Schedule K-1) of $33,675 ($50,000 less $12,500 less $3,825 — the employer portion of the payroll tax).

Thus, in Lisa’s case, her Section 199A deduction is the lesser of:

20% of Taxable Income: 20% times ($50,000 plus $33,675 plus $75,000 less $19,500 less $24,800 = $114,375) = $22,875; or,

20% of QBI: 20% times ($33,675 — the QBI) = $6,735

In this case, Lisa’s Section 199A deduction is $6,735 because in the S corporation structure, the business income is split between a salary the S corporation pays her (which is not QBI) and the flow through profit of the S corporation, which is QBI (assuming it is domestic trade or business income).

The S corporation has various pros and cons from a tax perspective. Lower employment (payroll) taxes are a significant benefit, while lower maximum employer retirement plan contributions and lower Section 199A deductions are drawbacks.

Managing Taxable Income

Jackie is a lawyer operating as a sole proprietor. Law is one of several specified service trade or businesses (“SSTBs”) where the benefits of Section 199A are completely phased out if your taxable income exceeds $213,300 ($426,600 for married filing joint taxpayers using 2020 numbers). In 2020 Jackie has $240,000 of Schedule C income from the business. His self-employment taxes are $17,075 in Social Security taxes and $6,428 in Medicare taxes, for a total of $23,503 reported on Schedule SE. Jackie takes the standard deduction.

Jackie’s taxable income is thus $215,848 ($240,000 less $11,752 less $12,400). Because Jackie’s QBI is from an SSTB and his taxable income is above $213,300, he cannot claim any Section 199A deduction.

Now let’s add some tax planning to the scenario. Imagine that early in 2020 Jackie realizes he won’t qualify for the Section 199A deduction based on his numbers. He decides to open a Solo 401(k), which he can make an $19,500 employee traditional contribution to, and he can make an employer contribution of $37,500 for total contributions of $57,000 (the maximum allowed). This radically changes his Section 199A math, since (as will be demonstrated) his taxable income is now below $163,300. Once your income is below $163,300, you qualify for the Section 199A deduction only subject to the computational limits. Thus, in Jackie’s case, his Section 199A deduction is the lesser of:

20% of Taxable Income: 20% times ($240,000 less $11,752 less $12,400 less $57,000 = $158,848) = $31,770; or,

20% of QBI: 20% times ($240,000 less $11,752 less $57,000 = $171,248) = $34,250

Thus, Jackie’s Section 199A deduction is now $31,770! By managing his taxable income (by maximizing retirement savings), Jackie turned a $57,000 deduction into a more than $88,000 of deductions. Sure, the $57,000 deduction for retirement plan contributions is an “80% deduction,” but it creates the additional $31,770 of a Section 199A deduction (which is itself a “100 percent” deduction).

Jackie also lowered his marginal federal income tax rate from 35 percent to 24 percent and reduced his taxable income from $215,848 to $127,078!

Note that contributions to a health savings account would be another tool to deploy to lower your taxable income if you are concerned about Section 199A’s taxable income limitations.

Taxpayers bumping up against Section 199A taxable income limitations will likely need to prioritize traditional employee contributions to Solo 401(k) plans over Roth employee contributions. In addition, self-employed taxpayers bumping up against the taxable income limits in 2021 may want to establish 2021 Solo 401(k)s (if they are eligible to do so) to lower taxable income in order to qualify for the Section 199A deduction.

It will be wise for taxpayers to consult with tax advisors to run the numbers on Section 199A and other tax planning considering the complexity of the rules and the potential benefits of successful planning.

Charitable Contributions

The IRS gave us a bit of a head-scratcher in the instructions to the new Form 8995. The Form 8995 is used (starting with 2019 tax returns) to compute the QBI deduction. In the instructions, it states that charitable contributions reduce QBI.

Here is an example of how that rule would play out:

Cosmo is the sole shareholder of Acme Industries, an S corporation. In 2019, Acme reports QBI operating income of $100,000 to Cosmo on his Form K-1. It also reports $1,000 of charitable contributions made by Acme during 2019. The total QBI Cosmo can claim from Acme Industries is only $99,000, as the charitable contribution reduces QBI, according to the IRS. This is true even if Cosmo claims the standard deduction and thus has no use for the charitable contribution on his 2019 tax return.

Personally, I believe the IRS is on questionable ground in claiming charitable contributions reduce qualified business income. However, with some rather simple tax planning (which I generally believe to be prudent), you can avoid this issue altogether. If you want to make a charitable contribution, simply do so in your own name. Do not have your business — whether an S corporation, a small partnership, or a sole proprietorship, make the charitable contribution.

Rental Real Estate

The IRS and Treasury issued Notice 2019-7 and Revenue Procedure 2019-38 providing a safe harbor under which rental real estate activity can qualify for the Section 199A deduction. A safe harbor is a set of requirements, which, if satisfied, automatically qualify a taxpayer for a particular benefit. Stated differently, a safe harbor is a sufficient, but not necessary condition, to receive a benefit.

While rental activities that constitute a trade or business can still qualify for the deduction if they do not meet the requirements of the safe harbor, as a practical matter it will be much easier to sustain the deduction if you can qualify for the safe harbor.

Requirements

The requirements to satisfy the safe harbor with respect to any “rental real estate enterprise” (a “RREE”) are as follows:

Separate books and records documenting the income and expenses of the RREE must be maintained.

At least 250 hours per year of qualifying activity must be done with respect to the RREE.

Starting in 2020, detailed records documenting the time spent on the RREE must be maintained (see Revenue Procedure 2019-38).

A statement electing the application of the safe harbor must be attached to the tax return.

Multiple Rental Properties

Rental property can be combined for purposes of determining if you have an RREE. However, residential and commercial real estate cannot be aggregated and must be kept separate. Thus, at a minimum if you own both commercial and residential property, you have two RREEs, and you must apply the tests to each separately to determine if each RREE qualifies for the safe harbor.

Qualifying Activities

In a bit of good news, the 250 hours can be done by the owner, agents, employees, and/or independent contractors. However, many activities do not count toward the 250 hours, including building and long-term redevelopment, finding properties to rent, and arranging financing. Qualifying activities include collecting rent, daily operation of property, negotiating leases, screening tenants, and maintenance and repairs.

Triple Net Leases

Triple net leases do not qualify for the safe harbor. For purposes of the rule, these include “a lease agreement that requires the tenant or lessee to pay taxes, fees, and insurance, and to be responsible for maintenance activities for a property in addition to rent and utilities.”

House Hacking

For those using house hacking to pursue financial independence, there are several considerations. If you house hack by renting spare bedrooms in your primary residence (tenants, Airbnb, etc.), then you do not qualify for the safe harbor with respect to the rent generated by your primary residence. However, if your house hack consists of renting out separate units in a single building, the rental income could qualify for the safe harbor if (i) those other units are separate residences and not your own residence for any part of the year and (ii) you otherwise satisfy the requirements of the safe harbor.

REIT Mutual Fund Dividends

Dividends from REITs and REIT mutual funds can qualify for the QBI deduction. Generally, box 5 of Form 1099-DIV will indicate those REIT dividends which qualify as Section 199A dividends.

Example

In 2018 Luke makes $50,000 from his W-2 job. He operates a sole proprietorship that generates a $4,000 taxable loss (which would have been QBI had it been net income). Luke also receives $3,000 of dividends from the Acme Real Estate Mutual Fund, which he holds in a taxable account. Acme’s Form 1099-DIV provided to Luke indicates in box 5 that $2,400 of the dividends are Section 199A dividends. Luke claims the standard deduction. In Luke’s case, his Section 199A deduction is the lesser of:

20% of Taxable Income: 20% times ($50,000 less $4,000 plus $3,000 less $12,000 = $37,000) = $7,400; or,

20% of REIT Dividends: 20% times $2,400 = $480

Thus, Luke’s Section 199A deduction is $480. He gets this deduction even though the dividend was paid by a mutual fund and even though he had a QBI loss. His QBI loss will carryover to 2019, and will reduce his 2019 QBI that potentially qualifies for the Section 199A deduction.

Lastly, note that if Luke held the Acme mutual fund shares in a retirement account (traditional and/or Roth IRA/401(k), etc.) or a health savings account, the REIT dividend would not have qualified for the Section 199A deduction.

Conclusion

Even as of January 2021, taxpayers and practitioners are learning new wrinkles in the Section 199A QBI deduction. For taxpayers with side hustles and small businesses, it can represent a significant income tax break. Some taxpayers will need professional help to determine how best to maximize the deduction.