Tag Archives: Tax Defense

2023 Retirement Tax Reform

An Open Letter to the Members of the 118th Congress

Dear Senators and Congressmen,

Congratulations on your victories in the Senate and House elections. I write with respect to one aspect of your legislative endeavors in the 118th Congress: reforming our tax-advantaged retirement savings system. As you will see, much of it is antiquated and in need of reform.

Before I discuss the problems, allow me to briefly recite my qualifications to write you this letter. My primary qualifications are that I am an American citizen and taxpayer. My secondary qualifications include:

  • I am a financial planner and advise clients on retirement planning and saving.
  • I am the author of a book on one of the tax-advantaged retirement savings accounts, Solo 401(k): The Solopreneur’s Retirement Account.
  • I am a CPA (licensed in California and Virginia) and I have a Juris Doctor degree and a LLM in Taxation degree. My background is on my LinkedIn page.
  • I write a four year-old blog (fitaxguy.com) focused on tax planning for individuals, particularly the use of retirement accounts. 

The views expressed in this open letter are mine only. I have not been compensated for writing this letter and my views are not necessarily the views of any of the clients of my financial planning firm. 

Problems with the Current Retirement Savings System

Limits Are Unequal and Unfair

There’s a myth that Congress and IRS inflation adjustments determine the retirement plan contribution limits every year. If one looks at the Internal Revenue Code and the IRS website, they’d walk away with that belief.

But is that really true? It turns out that one’s employer often defines just how much an employee can get into tax-advantaged retirement accounts every year. In practice, the current system disproportionately benefits a privileged few.

Here are two examples (using 2023 limits) that prove my point in a stark fashion. Josh is a 50 year-old employee of a large Fortune 500 company with a $300,000 salary. Josh maxes out contributions to his traditional 401(k) at work and maxes out his Backdoor Roth IRA and Mega Backdoor Roth (available through his employer’s 401(k)). Further, Josh receives a 3% match in his employer 401(k). Here are what his annual retirement savings contributions look like:

401(k) Employee Deferral: $30,000

401(k) Employer Match: $9,000

401(k) Mega Backdoor Roth: $34,500

Backdoor Roth IRA: $7,500

Total traditional deductible contributions: $39,000. Total Roth contributions: $42,000. Total contributions: $81,000.

Sarah, single, is a 50 year-old non-profit executive director with a $150,000 annual salary and no workplace retirement plan. Under today’s rules, Sarah can only contribute a maximum of $7,500 to a deductible traditional IRA. That’s it! She may be able to make a partial Roth IRA contribution or a Backdoor Roth IRA contribution, but if she does, it reduces her maximum allowed deductible traditional IRA contribution. Thus, her total contributions are, at a maximum, just $7,500 for the year.

Sadly, there are many more workers in the latter situation than in the former situation. 

Because of their choice in employers, Josh gets to put more than 10 times the amount Sarah can into tax-advantaged retirement accounts.

Yes, that is today’s reality. It makes absolutely no sense. Long term, a system that disproportionately rewards workers at some employers and barely covers workers at other employers is not sustainable. 

Where you work should not increase your tax-advantaged retirement account contributions by more than 10 times!

Many retirement provisions benefit a very select few. Most of the time, those select few are among the people who need the least amount of help in achieving a successful retirement. Retirement tax advantages should have broad applicability and should not disproportionately reward any particular subgroup, particularly very small subgroups. 

Other Retirement Account Problems

  • Complexity and confusion (Ever fill out a Form 8606?)
  • Penalties and penalty exceptions that are outdated and not entirely rational
  • Remedies for problems with retirement accounts are neither taxpayer nor IRS friendly

Goals for Retirement Account Reform

Here are the goals I believe the 118th Congress should have in enacting retirement account reform.

  • Reduce complexity and confusion. Simplify the mechanisms of retirement savings. “Backdoors” should be eliminated because retirement savings should occur through direct, simple transactions. 
  • Increase retirement savings, particularly among Americans who have struggled economically over the past three years.
  • Effective yet modest changes. While it is tempting to throw out all the rules, a complete rewrite of the rules would create tremendous confusion and likely reduce, rather than increase, tax-advantaged retirement savings. 
  • Democratize retirement account contributions while acknowledging the role employers can play in offering retirement savings for employees. That said, there should be at least some shift of dollars away from contributions to employer plans towards contributions to individual retirement accounts.
  • Reform cannot simply be a massive tax cut. The federal budget cannot afford a massive tax cut. 
  • Special advantages available to very limited groups should be reduced and eliminated.
  • Remove punitive rules and traps for the unwary. 
  • There are too many penalties in the retirement account system that are too high, too punitive, and too confusing. My proposal attempts to reduce the number of penalties, give the IRS and taxpayers more common sense tools to mitigate them, and make the rules simpler and fairer. 
  • Reduce the competition between funding expenses attendant to having a child and funding retirement savings. 
  • Avoid slogans. Our tax rules are now far too complicated to say “everyone gets a tax cut” or “no one below X income will have a tax increase.” Besides, slogans belong to the politics of the 80s and 90s. 

While my primary audience is the members of the 118th Congress, please allow me to direct a quick word to my fellow American taxpayers who might lose out on an opportunity described below and thus might oppose these proposals. I ask potential opponents of this proposal this question: how sustainable is a retirement system that gives a select few Americans 10 times the tax-advantaged savings capacity as other Americans? 

Why fight to preserve your special tax break when the myriad special tax breaks make the entire system less and less sustainable? Does my proposal make everything entirely fair? Surely not, but, as you will see below, it makes the system much fairer and simpler. I believe that will make the system more sustainable over the long run, which is good for everyone. 

Lastly, retirement savings are far from the only component of the U.S. tax system needing legislative change. But, as you can see from my secondary qualifications above, retirement savings are of particular interest to me, so I’ll mostly limit my commentary here to tax law changes on retirement savings. 

Retirement Tax Reform Proposals

Expanded Universal Roth IRAs and Closing Backdoors

1. Eliminate the MAGI Limitation on annual Roth IRA contributions. Why is there an income limit on contributing to a Roth IRA, which does not produce a tax deduction? Further, removing the income limitation will align the United States Roth account rules with Canadian tax-free savings account rules. Canada does not have an income limit on the ability to contribute. Why should the United States? This proposal also ends the Backdoor Roth IRA. 

2. Increase annual IRA contribution limit (traditional and Roth) to $10,000, then index annually. It is time to shift retirement savings towards individuals. This will help expand individual and spousal contributions to retirement accounts, particularly Roth IRAs, and give individuals more control over their own retirement savings. This proposal makes individuals less reliant on their employer to offer a good retirement savings plan. 

In the 10 year budget window, proposals 1 and 2 will cost some money, but I suspect not a whole lot. In fact, this expansion of Roth IRAs might make Roths more attractive and cause some taxpayers to direct what would have been traditional, deductible 401(k) contributions to their Roth IRA, increasing tax revenue in the early years. 

3. Eliminate nondeductible contributions to IRAs and qualified plans, effective January 1, 2024. This ends Mega Backdoor Roth IRAs as of January 1, 2024. The Mega Backdoor Roth benefits only those few whose employers offer it and can afford to make after-tax contributions. The Mega Backdoor Roth, which only came to prominence starting in 2014, turbocharges the unfair advantages the retirement account system currently confers on a select few Americans (such as Josh in the example above).

As a result of eliminating the Mega Backdoor Roth, most of these contributions will be diverted to taxable accounts, which is not a horrible outcome for those currently taking advantage of the Mega Backdoor Roth. Further, those losing the Mega Backdoor Roth under this proposal gain expanded access to Roth IRAs under proposals 1, 2, and 4. 

4. Increase age 50 or older IRA (traditional and Roth) annual catch-up contribution from $1,000 to $2,000, index for inflation annually. The current $1,000 annual catch-up contribution limit is not enough move the needle in terms of likelihood of financial success in retirement. 

Eliminate Traditional Retirement Account Basis

5. Eliminate IRA Basis / after-tax 401(k) basis, effective January 1, 2027. The Pro-Rata Rule is an unnecessarily complicated rule for retirement account withdrawals. It has even created litigation. Basis record keeping is challenging and creates confusion. Enough already! 

This proposal eliminates retirement account basis recovery as of January 1, 2027. To be fair to those with retirement account basis, this proposal allows elective withdrawal of basis amounts from traditional retirement accounts (including inherited traditional retirement accounts) to taxable accounts during the 2024, 2025, and 2026 tax years. Any elective withdrawals of basis for the year would not count towards RMDs and could not be converted to Roth accounts. Regular withdrawals, RMDs, and Roth conversions in the year of an elective withdrawal of basis could not access existing basis. 

Eliminating basis eliminates page 1 of the Form 8606. This simplifies traditional retirement account withdrawals, inheriting traditional retirement accounts, and Roth conversions. In turn, this makes the retirement account provisions easier for the IRS to administer and easier for taxpayers to understand. 

Simplify and Rationalize Retirement Account Rules

6. Unify Roth account nonqualified withdrawal treatment such that the current Roth IRA nonqualified distribution rules apply to nonqualified Roth 401(k) distributions. The rules for Roth 401(k) nonqualified distributions are confusing, and can be avoided by rolling into a Roth IRA. Why not make them consistent?

7. Change the age for HSA catch-up contributions to age 50. Catch-up contributions to all accounts should kick-in at one, and only one, age. Make it age 50 for all accounts by changing the HSA catch-up contribution kick-in age from 55 to 50. Unifying the HSA/IRA/401(k) catch-up contribution age at age 50 makes the rules simpler. 

8. Unify rules for taking RMDs from traditional retirement accounts. Under this proposal, so long as the total required is taken during the year, it doesn’t matter which account (401(k), 403(b), IRA) or accounts the distributions come from. 

9. Eliminate NUA tax treatment. Net Unrealized Appreciation allows for employer stock in a 401(k) to get preferential tax treatment. As workers are already heavily economically tied to their employer (because of their salary and benefits), NUA treatment encourages something that probably should be discouraged (investing significantly in the stock of one’s own employer). Further, the NUA rules are complex. Removing them simplifies the tax code. 

10. Simplify treatment when spouses inherit a retirement account. Currently, there are three options and planning choices to be made when a spouse inherits a retirement account. The death of a spouse is challenging enough without having to make a complicated tax planning decision. New rule to simplify this: all retirement accounts inherited by spouses are deemed to be the inheriting spouse’s own retirement account as of the first spouse’s death. To prevent any early withdrawal penalties to surviving spouses under age 59 ½ due to this change, add a new 10% early withdrawal penalty exception: being widowed prior to age 59 ½. This new penalty exception applies to all widows and widowers for all pre-age 59 ½ retirement account distributions regardless of whether the widow/widower inherited a retirement account.  

11. Clarify the SECURE Act to provide that if the 10 year rule applies to an inherited account, RMDs do not apply to the account, other than in the final year of the 10 year window. The IRS came out with overly complicated proposed regulations requiring RMDs for many inherited accounts even though the 10 year rule applies to them. This clarification repeals the needlessly complicated proposed regulations, and the government’s interests are already adequately protected by the 10 year rule. 

12. Adopt a supercharged version of SECURE 2.0 Section 321. Allow the self-employed (generally those reporting self-employment income on Schedule C or through partnerships) to both establish a Solo 401(k) after year-end and make employee contributions to their Solo 401(k) before the tax return deadline for the taxable year. This eliminates the election required under Treas. Reg. Sec. 1.401(k)-1(a)(6)(iii). There’s no reason for a self-employed individual to have to make an election with themselves to make a retirement account contribution. This change would make the contribution deadline rules for self-employed employee contributions the exact same as the contribution deadline rules for self-employed employer contributions for every year (not just for the first year as Section 321 proposed to do). 

Combat Mega Retirement Accounts and Limit Benefits for the Very Rich

13. Eliminate (as of enactment) new tax-advantaged retirement account investments in private equity, venture capital, and companies 10% or more owned (by vote or value) by the account owner. These investments have allowed a very select few to accumulate hundreds of millions of dollars in IRAs. IRAs and qualified plans are best when they provide growth and capital preservation from diversified assets to fund retirement. They were never intended to create 9 figure-plus hoards of wealth sheltered from taxation. 

14. Required Accumulation Distribution (RAD) of 20 percent of the amount over $5M anytime all traditional accounts (IRAs and qualified plans) exceed $5M (indexed for inflation) at year-end for the following year prior to age 72. RAD of 20 percent of the amount over $5M anytime all Roth accounts (IRAs and qualified plans) exceed $5M (indexed for inflation) at year-end for the following year. Under this proposal, there would be no penalty on any RAD. RADs from Roths are treated as qualified distributions. This is much simpler than the Build Back Better proposals on mega retirement accounts. RADs from traditional accounts cannot be converted to Roth accounts. 

The hope is that after a while, there will be few, if any RADs. In a world without private equity and venture capital type investments in retirement accounts it will be quite difficult to accumulate in excess of $5M (adjusted for inflation) in either type of retirement account. The RAD rules do not need to apply to traditional retirement accounts at 72 and beyond, since the owner is already subject to the RMD rules. Inherited retirement accounts would be exempt from the RAD rules.  

Examples: Joe, age 65 in 2024, has $4.9 million in all traditional retirement accounts (401(k)s, IRAs, etc.) on December 31, 2023. He also has $4.9 million in all Roth retirement accounts (401(k)s, IRAs, etc.) on December 31, 2023. His 2024 RAD from traditional retirement accounts is $0, and his 2024 RAD from Roth retirement accounts is $0.

Sally, age 65 in 2024, has $7 million in all traditional retirement accounts (401(k)s, IRAs, etc.) on December 31, 2023. She also has $4 million in all Roth retirement accounts (401(k)s, IRAs, etc.) on December 31, 2023. Her 2024 RAD from traditional retirement accounts is $400,000 ($7M minus $5M times 20%), and her 2024 RAD from Roth retirement accounts is $0.

John, age 75 in 2024, has $7 million in all traditional retirement accounts (401(k)s, IRAs, etc.) on December 31, 2023. He also has $7 million in all Roth retirement accounts (401(k)s, IRAs, etc.) on December 31, 2023. His 2024 RAD from traditional retirement accounts is $0 (since he is 72 or older), and his 2024 RAD from Roth retirement accounts is $400,000. Under the existing rules (unchanged by this proposal), John is subject to RMDs in 2024 totalling $284,553 ($7M divided by 24.6) from his traditional retirement accounts (though see proposal 8 giving John more flexibility in terms of which account(s) he can take the RMDs from).

15. Cap at $25,000 the maximum annual amount that can be deferred by those with salaries (W-2, self-employment income) of $400K or more per year (indexed for inflation) under a Section 409A nonqualified deferred compensation plan. This rule change is logical considering (i) the tax law’s benefits for retirement saving have been too skewed towards helping a very affluent few who need the least amount of saving help, (ii) most of the beneficiaries of nonqualified deferred compensation plans are the ones doing best economically, and (iii) the need to provide more benefits of tax-advantaged retirement savings to a larger swath of Americans. Further, those losing a tax benefit because of this rule gain a significant benefit in the removal of income limits on Roth IRA contributions and the increased contribution limits. 

For administrative convenience, the new rule would not apply to any amount deferred at any time during one year and paid out at any time during the immediately following tax year.

Proposals 13, 14, and 15 raise revenue to expand the amounts that every worker can save in Roth IRAs, and some Americans will get increased deductible traditional IRA contributions because of proposals 2 and 4. 

Penalty Reform

16. New 20% penalty on all missed RADs and reduce the missed RMD penalty to 20%. The current 50% penalty on missed RMDs is unnecessarily punitive. 

17. Unify the exceptions to the 10 percent early withdrawal penalty so there is no difference between qualified plans and IRAs. It makes no sense that under current law there are some penalty exceptions only applicable to IRAs and some penalty exceptions applicable only to qualified plans. After this change, the only “plan only” exception would be the exception applicable to nonqualified 457(b) plans.

18. Change the Rule of 55 “separation from service” qualified plan penalty exception to be a broader, fairer age 55 need-based exception. Currently a 56 year-old CEO can leave their job and qualify for the penalty exception from their 401(k) but a 57 year-old teacher cannot qualify for the exception from an IRA. How does that make sense? 

New exception: Starting in the year one turns age 55, if AGI other than the taxpayer’s and/or their spouse’s potential Rule of 55 distribution(s) is less than $70K single, $110K MFJ (indexed for inflation), then the distribution (a “Rule of 55 distribution”) from the qualified plan or IRA is penalty free. Each person would have a $70K annual maximum (indexed for inflation) that could be accessed penalty free under this new, more rational Rule of 55 exception. In between $70K and $90K ($110K to $145K MFJ) of AGI (other than the potential Rule of 55 distributions), the $70K limitation per person is ratably reduced. 

The new Rule of 55 exception would be a Rule of 50 exception for public safety employees subject to the AGI limits described immediately above.

Eliminate Loopholes Benefitting Very Few

19. Age 15 requirement for IRA (traditional and Roth) contributions. Today a very few advantaged families can fund a retirement account for young children. Sometimes this takes the form of paying an infant a salary, which is at best questionable. Even with the elimination of this loophole, the family’s total annual Roth IRA contributions may be greater under this proposal. Instead of $6,500 per person ($19,500 total for family of 3), each parent can contribute $10,000 into a Roth IRA ($20,000 total). Of note, Canada requires being at least age 18 to make contributions to a tax-free savings account.

20. Eliminate the “super HSA” by deeming all persons covered by a HDHP other than the policyholder and their spouse to be a dependent of the policyholder for purposes of determining HSA contribution limits. The super HSA allows young adults covered by their parents’ high deductible health plans to put more into an HSA than most single HSA owners can. That’s not fair and illogical, and the super HSA is a loophole created not by Congressional intent but rather by the drafting technicalities used to create HSAs in IRC Section 223. 

Reform, Expand, and Simplify Qualified Birth Distributions

21. Reform, expand, and simplify SECURE Act Qualified Birth Distributions. Repeal as written in the SECURE Act. Capped at only $5,000 and confusing in their details, the current qualified birth distribution rules are not effective for parents. The new qualified birth distribution and recontributions rules would be as follows: 

For those under age 59 ½, up to $30,000 of distributions from qualified plans, SEP IRAs, SIMPLE IRAs, traditional IRAs, and Roth IRAs per parent distributed within 18 months (9 months before and 9 months after) surrounding a birth and/or an adoption are presumed to be a qualified birth distribution (QBD) and as such (i) are not treated as distributions in the year of the distribution (and not subject to tax withholding) and (ii) can be rolled back into the account by the end of the third year following the distribution. Amounts not repaid to the account are treated as distributions from the account at the end of that third year (including for estimated tax purposes), and are excused from the 10% early withdrawal penalty (if the penalty would otherwise apply to the deemed distribution). No mandatory reporting requirements for the parents (other than for any deemed distribution at the end of the third year), but the IRS is authorized to provide a voluntary reporting form reporting qualified birth distributions and qualified birth recontributions. The new law would authorize financial institutions and plan providers to rely on taxpayer representations for both distributions and recontributions in issuing Forms 1099-R and 5498 and accepting recontributions. 

This is a good idea for several reasons. It means saving for retirement is not a hindrance to financial security when adults are considering whether to have children. Our country is facing a decline in births. This proposal helps parents use retirement accounts to help during pregnancy and after childbirth while not handicapping their retirement. People can invest in Roth IRAs, for example, knowing that the money can be available for both the initial expenses of childbirth and their future retirement. 

Unfortunately, saving for birth and saving for retirement can compete. New, more robust and parent-friendly qualified birth distributions can reduce this competition and allow retirement savings to help during pregnancy and the first nine months after birth. 

Here is an example of how it could work: Robert, age 30, is the father of Mark, born February 2, 2024. On December 1, 2023, Robert withdrew $30,000 from his Roth IRA. At the time of the distribution, Robert had previously made $23,000 of annual contributions to his Roth IRA. Robert’s recontribution deadline is December 31, 2026. On April 2, 2026, Robert recontributes $20,000 to the Roth IRA, and makes no other qualified birth recontributions. On December 31, 2026, the $10,000 Robert did not recontribute to the Roth IRA is deemed to be a distribution from the Roth IRA to Robert. Robert took no other distributions from his Roth IRA prior to December 31, 2026. Since Robert had $23,000 of previous Roth IRA contributions to his Roth IRA as of the end of 2023 and may have made further annual contributions to his Roth IRA after 2023, the deemed distribution of $10,000 is deemed to be return of old annual contributions (under the nonqualified distribution rules) on December 31, 2026 and thus not taxable to Robert. The deemed distribution reduces Robert’s previous annual Roth IRA contributions by $10,000 for purposes of the nonqualified distribution rules as applied to any future nonqualified distributions. 

As a practical matter, the combination of this proposal and proposals 1 and 2 are likely to result in most QBDs coming from Roth IRAs. Thus, most QBDs not recontributed to the Roth IRA will simply be nontaxable deemed distributions of previous Roth IRA annual contributions. 

The new QBD rules would include rules providing that retirement account direct trustee-to-trustee transfers, rollovers, and Roth conversions occurring during the QBD 18 month window are not considered QBDs so as to preserve each parent’s $30K limitation. For simplicity’s sake, each birth and adoption will be treated as a distinct event for QBD purposes. Under this simplicity convention, parents of twins can each take up to $60K of QBDs. In addition, the QBD rules will have no adverse effect on the adoption tax credit. Funds sourced from a QBD for qualified adoption expenses will remain fully eligible for adoption tax credits based on the existing adoption tax credit rules. Lastly, a birth for QBD purposes will include the birth of a baby the parents give up for adoption. 

Expand and Rationalize Remedial Measures for Retirement Accounts

22. Adopt a supercharged version of SECURE 2.0 Section 308. Enact section 308 (expanding the IRS Employee Plans Compliance Resolution System) and add a self-correction safe-harbor (available both before an IRS exam and during IRS examination activity) whereby all individual traditional IRAs and Roth IRAs, and SEP IRAs, SIMPLE IRAs, 401(k)s, and qualified plans involving 10 or fewer individuals/employees (including Solo 401(k)s) automatically qualify for self-correction and forgiveness of all penalties so long as (i) the account owner/plan sponsor implements reasonable corrections (such as refunding excess contributions and attributable earnings penalty free, subject to ordinary taxable income inclusion — in the year of the corrective distribution — for earnings and any returned contributions actually deducted on a tax return or previously excluded from taxable income), and (ii) the total amount in the plan or IRA has never exceeded $500,000 as of any year-end. For this purpose, accounts would only be aggregated for a person or plan sponsor at the same financial institution. The new rules would provide that financial institutions can rely on taxpayer representations in issuing Forms 1099-R to report corrective distributions. Financial institutions will continue to compute attributable earnings as they do under current regulations.

This proposal reduces penalties (such as excess contribution penalties) and helps ensure plans and IRAs remain qualified. Self-correction is much better for taxpayers and the IRS, particularly when accounts are relatively modest in size. Currently, the IRS offers the Voluntary Compliance Program for qualified plans. Since VCP covers very large employer plans, it is a very odd fit for Solo 401(k)s and would be an odd fit for traditional IRAs and Roth IRAs. It is much better to encourage the use of self-correction. This encourages compliance, makes correcting mistakes easier, reduces penalties, and makes the IRS’s oversight of modest sized retirement accounts easier and more effective. 

23. Repeal and reform section 403 of the SECURE Act as applied to Form 5500-EZ filings. The SECURE Act increased penalties for late filed Form 5500 Series filings by tenfold. While this may make sense for large employer plans, the increase in penalties drastically overshot the mark when it comes to small businesses filing the Form 5500-EZ. Under the new law, a self-employed Solo 401(k) owner could (theoretically) be liable for a $150,000 penalty for failing to file a two page informational tax return (the Form 5500-EZ). Such a penalty is excessive and obscene. While relief procedures are available, it is ridiculous that the penalty could be, at least in theory, so onerous. Replace the current $250 per day penalty with a flat $500 per late Form 5500-EZ penalty (capped at $2,000 per plan sponsor) that can be excused for either reasonable cause or a first time abatement distinct to the Form 5500-EZ return. Cap the IRS period to assess the penalty at four years from the original filing deadline. Further, make the new rules effective to all missed Form 5500-EZ filings regardless of when they occurred. In addition, increase the asset threshold whereby a Form 5500-EZ is required from $250,000 to $500,000 to account for the passage of time and inflation. The Form 5500-EZ would still be required at the closing of the plan under this proposal, regardless of account size. 

Repeal Traps for the Unwary

24. Eliminate the once-a-year IRA to IRA 60-day rollover limit. It’s a trap for the unwary and by eliminating it, the rules would be synchronized for all rollovers. The once-a-year limit makes no sense (as the 60-day time limit is sufficient to police money coming out of retirement accounts) and is punitive and unnecessary. 

25. Repeal the SIMPLE IRA 25% penalty for early distributions within the first two years of establishing the SIMPLE IRA. Under this rule, the 25% penalty even applies to rollovers to traditional IRAs within the first two years. It’s a trap for the unwary and should be fully repealed. 

Miscellaneous

26. Do not pass (or repeal if passed) the rest of SECURE 2.0, the EARN Act, and other related proposals, other than as discussed above. My opinion is that SECURE 2.0/EARN Act introduced changes that were at best marginally beneficial for Americans saving for retirement. Unfortunately, SECURE 2.0 has counterproductive provisions (such as eliminating the tax deduction for 401(k) catch-up contributions) and increases the complexity of the retirement account system. 

Revenue Raisers (If Needed)

My hope is that my proposals would reduce federal revenue over the 10 year budget window by only a fairly modest amount, as there are provisions that would cost the government money and proposals that would increase revenue. If this nets out to costing too much money in Congress’s judgment, I recommend the following tax increase: an increase (starting in 2024) of the top capital gain/qualified dividend income rate (currently 20%) by the amount needed to close the gap. Considering that the highest earners have done the best in recent years, and do receive benefits under the overall proposal (see proposals 1, 2, and 4), this tax increase is fair and helps many Americans save for retirement by funding expansion of Roth IRAs and reduction of penalties.

If any other tax increases are deemed necessary, I recommend that Congress consider an increase to the rate of the corporate book minimum tax and/or a tax on investment income of college endowments comprised of $1 billion or more of assets. These two proposals shift the tax burden to those who have benefited the most from the American economy in recent years. 

Landscape After Retirement Account Reform

Let’s return to Josh and Sarah. What might their tax-advantaged retirement account contributions look like after my proposed reform. Here’s Josh’s contributions:

401(k) Employee Deferral: $30,000

401(k) Employer Match: $9,000

Roth IRA: $12,000

Total traditional deductible contributions: $39,000, total Roth contributions: $12,000, total contributions: $51,000. Yes, Josh lost his Mega Backdoor Roth IRA. But, now instead of a gimmicky $7,500 Backdoor Roth IRA, he gets to simply make a $12,000 annual contribution to a Roth IRA. Further, Josh did not lose any tax deductions under my proposal. Josh can invest the difference between $81,000 (his old tax-advantaged contribution total) and $51,000 (his new tax-advantaged contribution total), $30,000, in a taxable account.

Sarah has significantly increased the amount of her contributions. She goes from a $7,500 annual contribution to a traditional deductible IRA or Roth IRA to a $12,000 traditional deductible or Roth IRA contribution. 

Perfect? No. But instead of a 10.8 to 1 ratio we have moved the needle significantly such that the ratio is now 4.25 to 1. Further, many of the retirement account rules are simpler and fairer. If Josh, Sarah, or other Americans run into problems with their retirement accounts, their remedial paths are likely to be easier to navigate and they are more likely to avoid onerous and unfair penalties. 

I believe that our retirement system would be significantly better if Congress passes and the President signs the 26 proposals I outlined above in 2023. If any of you have questions about the above, I would be happy to communicate with you and/or your staff about these proposals.

To my fellow Americans reading this letter, I’d be honored to read your comments in the comments section below. I’m sure there are other ideas that could simplify and improve retirement accounts. 

Sincerely,

Sean Mullaney

This post 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.

Transferring a Primary Residence to Children

How do you pass your family’s house to your children? It’s a pressing question and involves significant tax, legal, and emotional considerations. Unfortunately, it is a topic about which there is much confusion.

This blog post discusses some of the important considerations. But as a blog post, it can only scratch the surface. Anyone looking to efficiently pass on their home is well advised to consult with their own lawyer, tax professional, and in some cases, their banker as well.

Minor Children

To my mind, the primary planning objective of married couples with minor children vis-a-vis their home is to account for what happens if both spouses die. Such couples would want their children taken care of in the most flexible manner possible.

Generally speaking, in such situations, it is often best to work with a lawyer to transfer the primary residence to a revocable living trust (explained below). In the event of both spouses’ deaths, the house would be held by the trust and managed by the trustee of the trust. It could be sold or rented for the benefit of the children, or kept so the children and their guardian(s) could live in the house. 

This resolution is generally preferable to leaving a house directly to minor children. 

Revocable Living Trusts

What is a revocable living trust? It is generally a written trust (drafted by a lawyer) that owns property the grantor(s) or settlor(s) transfers to the trust. For this sort of planning, usually spouses (the grantors) transfer their home to the trust and designate themselves as the primary beneficiaries of the trust. The trust provides that the grantors’ minor children are the successor beneficiaries. Upon both spouses’ deaths, the trust becomes irrevocable, and a trustee holds the assets and manages them on behalf of the beneficiaries (the minor children).

The best thing about a revocable living trust: as long as the grantor(s) is/are alive, the trust is fully revocable! So mistakes can be easily fixed (working with a lawyer). 

Revocable living trusts also generally avoid probate. 

Tax Effect

One nice thing about a revocable living trust is that it doesn’t change the grantor’s tax situation. All the income of the trust assets remain the taxable income of the grantor. Generally speaking, the grantor’s tax return does not change at all. Further, favorable tax rules, such as the $250K per person exclusion for capital gains on qualified primary residences, apply unchanged.

Parents placing their primary residence in their own revocable living trust does not necessitate the filing of a federal gift tax return (Form 709).

Upon inheriting a house as the beneficiary of a revocable living trust, the child takes a fair market value tax basis in the house (the so-called “step-up in basis”). This makes using a revocable living trust a tax-efficient way of passing a house to the next generation. 

Adult Children

Okay, but what about adult children? It’s readily apparent that five-year olds should not own real estate outright. But what about grown children? If a primary goal is simply avoiding probate, why not use a joint tenancy with rights of survivorship instead of a revocable living trust?

Putting an adult child’s name on the title of the parent(s) primary residence (and thus, creating a joint tenancy with rights of survivorship) can lead to a host of issues, but perhaps not the issues that initially come to mind. 

Capital Gains Tax

What about the adult child’s capital gain upon the sale of the house after the parent’s death? Is that a reason to use a revocable living trust to house the house (pun intended)? 

Well, it turns out the answer is generally No. Assuming the adult child did not contribute to the acquisition of the house, the adult child can take a full fair market value basis in a house acquired from a joint tenancy. Here is an example very loosely based on the example on page 10 of IRS Publication 551:

Example: Joan and Jane owned, as joint tenants with rights of survivorship, Joan’s home. Joan paid $300K for it, Jane paid nothing for it. Upon Joan’s death, the home has a fair market value of $600K. Jane inherits (as the surviving joint tenant) the house from Joan with a $600K basis (a fully stepped-up basis).

If interested, I’ve prepared a technical analysis as to why the surviving non-contributing non-spouse joint tenant receives a full step-up in basis here. 

Note that the above full stepped-up basis does not obtain if the gift of a portion of the house was through a tenancy-in-common (instead of through a joint tenancy with rights of survivorship). However, there is little reason to use a tenancy-in-common to transfer a house, because the original owner’s remaining share simply remains in his/her name, and absent other arrangements, passes through probate.

Other Problems with Joint Tenancies

If the capital gains tax upon the original owner’s death isn’t an issue, why not use a joint tenancy to transfer your house to your adult children? Here are some of the considerations.

Capital Gains Tax

Wait, what? I thought you said capital gains taxes were not an issue. They generally aren’t an issue after the original owner’s death. But they can be an issue before his or her death.

What if, during the owner’s lifetime, the house is sold? What if there’s a pressing need to sell the house, perhaps to help pay for long-term care? 

The owner/occupant is at least somewhat protected by the $250K per person primary residence gain exclusion. But the adult child is not protected by that exclusion if the home is not their primary residence. The adult child could have to pay capital gains tax (based on their share of the proceeds less their share of the owner’s historic tax basis) on the transaction if the house is sold prior to the owner/occupant’s death.  

Loss of Control

Simply put, transferring an interest in your home to another person relinquishes some of your control over the property. You never know if you will need that control in the future. Proceed with significant caution, and consult a trusted lawyer, prior to putting anyone else on the title of your home.

Gift Tax

While not a horrible problem, adding an adult child to the title of a house as a gift requires the filing of a Form 709 gift tax return. Due to the high estate and gift tax exemptions, in most cases it is highly unlikely the transfer would trigger actual gift tax. 

Disputes Among Adult Children

Adding multiple adult children to the title as joint tenants with rights of survivorship can create issues after the parent’s death. If siblings cannot agree amongst themselves how to handle and/or dispose of the house, the disagreement can be difficult to resolve. Using a revocable living trust (which becomes irrevocable upon the parent’s death) gives the parent the opportunity to work with their lawyer to put in place a trustee and ground rules for how the house is to be managed and/or disposed of after death.

Children’s Issues

Adult children are people. And people have problems. Divorces, liabilities, bankruptcies, etc. Putting an adult child on the title of a home could subject the home to the adult child’s creditors in a problematic manner. 

Summary

The above are just some of the considerations to weigh before adding adult children to the title of a home as a joint tenant with rights of survivorship.

Revocable living trusts keep control with the original owner. Further, they facilitate transferring real estate to the next generation in a tax-efficient manner. Based on these advantages and the issues that exist with joint tenancies, I generally prefer revocable living trusts over joint tenancies for primary residences. Using a will can also be effective from a tax perspective, but should be discussed with a lawyer considering state and local real estate laws. Some states have transfer-on-death type real estate deeds, which also should be considered with a lawyer (if that sort of deed is available).

Outright Gift

You might be saying, well, I have only one child I want to give my house to. Further, I don’t need to own my house. Why not simply give the house outright to that child during my life and avoid any legal events/issues occurring at my death? 

Besides some of the issues discussed above and the full loss of control (which are troublesome enough), an outright gift creates a significant capital gains tax issue for the adult child. This capital gains tax issue exists both before and after the original owner’s death.

Previously, I wrote this example on the blog illustrating the issue:

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.

Giving William’s house to Alan during William’s lifetime could increase the capital gains taxable to Alan by $900K! Ouch!

So, whatever you do (a) consult with your lawyer before determining how to pass your house to your children and (b) be very, very hesitant to outright give your house to your child. 

Conclusion

There are various ways in which you can transfer your home to your children. In many cases, I believe revocable living trusts are a great way to leave a house to children. You are always well advised to consult with your lawyer before making any decisions on how you want to title your house and how you want to transfer your house. If you do inherit a house from your parents, you should consult with a lawyer regarding titling issues and with your tax professional regarding the tax implications of selling the inherited home. 

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.

Top 5 HSA Tips

For those with a health savings account, December is a great time to review how it has been used and to see if there are ways to better optimize the account.

One: Let it Grow!!!

When it comes to HSAs, often the best advice is Let it Grow, Let it Grow!!! Sing it to the tune of the popular Disney movie song if it helps you to remember.

Adding an “r” and a “w” would make Elsa a tremendous HSA advisor.

Spend HSA money only if one of the following two adjectives apply: DIRE or ELDERLY. Those neither in a dire situation nor elderly should think twice before spending HSA money! Instead, Let it Grow!

The tax benefits of an HSA are so powerful that funds should stay in the HSA (to keep growing tax free) and only be removed in dire (medical or financial) circumstances or by the elderly. Unless you leave your HSA to your spouse or a charity, HSAs are not great assets of leave to heirs. Thus, HSAs are great to spend down in your later years (after years of tax-free growth). 

Two: Max Out Payroll Contributions by December 31st

While you can contribute via non-payroll contribution by April 15, 2020 for 2019, contributing to your HSA through payroll deductions is generally optimal since it secures both an income tax deduction and a payroll tax deduction for the money contributed.

If you didn’t max out your HSA through payroll deductions in 2019 and your employer allows HSA payroll deductions, write the check to your HSA in early 2020 (for 2019) and set up your 2020 payroll elections so as to max out your HSA through payroll deductions in 2020.

Three: Review HSA Investment Allocation

Those with low-cost diversified investment choices in their HSA are generally well advised to invest in higher growth assets inside their HSAs. The HSA is a great tax-protected vehicle. That tax protection is best used for high growth assets. 

Those who have invested their HSA funds solely or mostly in cash should consider reassessing their HSA investment strategy.

Four: Track Medical Expenses 

Medical expenses incurred after coverage begins under a high deductible health plan (a “HDHP”) can be reimbursed to you from an HSA many years in the future. There is no time limit on the reimbursement. Unless you are elderly, long-delayed reimbursement (instead of directly paying medical expenses with a HSA) is usually the tax-optimal strategy. Keep a digital record of your medical expenses and receipts to facilitate reimbursements out of the HSA many years in the future. 

Five: Properly Report HSA Income (CA, NJ, NH, TN)

HSAs are tax-protected vehicles for federal income tax purposes and in most states. On your federal tax return, you need to report your HSA contributions and distributions (see Form 8889). However, you are not taxed on the interest, dividends, and capital gains earned in the HSA, and you do not need to report these amounts. 

It is very different if you live in California and New Jersey. Neither California nor New Jersey recognize HSAs as having any sort of state income tax protection. They are simply treated as taxable accounts in those states. In preparing your California or New Jersey state tax return, you must (1) increase your federal wages for any excluded HSA contributions, (2) remove any deduction you took for HSA contributions (non-payroll contributions to your HSA), and (3) report (and pay state income tax on) your HSA interest, dividends, capital gains, and capital losses.

This last step will generally require accessing your HSA account online and pulling all of the income generating activity, including asset sales, in order to properly report it on your California or New Jersey tax return. 

Tennessee and New Hampshire do not impose a conventional income tax, but do tax residents on interest and dividends above certain levels. HSA interest and dividends are included in the interest and dividends subject to those taxes.

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

Follow me on Twitter at @SeanMoneyandTax

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

Fixing Backdoor Roth IRAs

Watch me discuss Backdoor Roth IRA tax return reporting on YouTube.

The word is out. The Backdoor Roth IRA is a powerful tax planning tool. You may believe that by previously executing Backdoor Roth IRAs, you have planned well and received a great tax benefit while building retirement savings.

Is it possible you are mistaken? It is possible you did not complete the Backdoor Roth IRA correctly? 

It may be true that you have successfully completed the two independent steps of a Backdoor Roth IRA: a traditional, non-deductible IRA contribution followed by a later Roth IRA conversion. It may also be true that you had no balances in a traditional IRA, SEP IRA, and/or SIMPLE IRA as of December 31st of the year you did the Backdoor Roth IRA. 

Year-end tip: The deadline to clean out traditional/SEP/SIMPLE IRAs (by rolling them into employer retirement plans such as 401(k)s) so as to optimize a Backdoor Roth IRA is December 31st of the year of the Roth IRA conversion step. As a practical matter, you should not complete the Roth IRA conversion step until you have cleaned out the traditional/SEP/SIMPLE IRAs. Life happens; there is simply no guarantee you complete the clean out before December 31st. Failing to do so will significantly increase the tax on your Backdoor Roth IRA. 

But you may not have correctly reported the Backdoor Roth IRA on your tax return. This last step is too-often overlooked. Below I discuss how to properly report a Backdoor Roth IRA, a potential tax return mistake that could have cost you thousands in erroneous taxes, and ways to fix the mistake. 

Backdoor Roth IRA Example

Charlie is single and 35 years old. He is covered by a retirement plan at work. In 2018 his W-2 salary was $200,000, and thus he did not qualify to make a Roth IRA contribution for 2018. He has no balance in a traditional IRA, SEP IRA, or SIMPLE IRA. He decides to do a Backdoor Roth IRA. 

On September 2, 2018, Charlie contributed $5,500 to a traditional, non-deductible IRA. On October 10, 2018, he converted the entire balance in the traditional IRA, then $5,510, to a Roth IRA. 

So far, so good with the Backdoor Roth IRA! But Charlie’s not done yet. Let’s look at how the Charlie should file his tax return and the pitfalls he should avoid.

Backdoor Roth IRA Tax Return Reporting

Early in the year, Charlie should receive a Form 1099-R that looks like the following from his financial institution.

Charlie’s Backdoor Roth IRA Form 1099-R should look something like this. Note that the “taxable amount” is the full conversion amount ($5,510) and the box indicating that the taxable amount has not been determined is checked.

This requires precise tax return reporting to ensure Charlie increases his taxable income by the correct amount to account for the Backdoor Roth IRA. An error in the tax return reporting could erroneously overstate his adjusted gross income and thus cause him to pay significantly more to the IRS and state tax agency than he owes.

There are two places Charlie needs to report the Backdoor Roth IRA: Pages 1 and 2 of Form 8606 and lines 4a and 4b of the Form 1040.

Let’s start with the Form 8606. Below is the correct way for Charlie to file Page 1 of his Form 8606.

Lines 1, 6, and 11 of the Form 8606 are crucial to properly reporting a Backdoor Roth IRA and computing the nontaxable portion of the Roth IRA conversion.

Notice a few things about this form. First, on line 1 Charlie reports his traditional, non-deductible IRA contribution of $5,500. Second, on line 6, Charlie reports the total combined value of his traditional IRAs, SEP IRAs, and SIMPLE IRAs as of December 31, 2018. He can find this number on the Forms 5498 that his financial institutions send him and the IRS regarding his IRA accounts. To have a very efficient Backdoor Roth IRA, ideally Charlie should no balance in these accounts on December 31, 2018, and thus Charlie can, and does, report zero on line 6. If Charlie has any such balances the total must be reported here and it will cause his Backdoor Roth IRA to be partially (maybe mostly) taxable. 

Next, Charlie reports his Roth IRA conversion amount on line 8. This is the total taxable amount he converted, reported to him in Box 2 of the Form 1099-R, $5,510. The mechanics of the Form 8606 then lead to lines 11 and 13, the nontaxable portion of Charlie’s Roth IRA conversion. In Charlie’s case, this is $5,500. This is because he is entitled to recover all $5,500 of basis he has in his traditional IRA (as computed in this part of the Form 8606). This $5,500 number is required to correctly prepare Page 2 of the Form 8606 and line 4b of the Form 1040.

Form 8606 Line 18 should be reported on Line 4b of Form 1040 for a 2018 Backdoor Roth IRA.

Page 1 computed how much of Charlie’s basis he can recover and the nontaxable portion of his Roth IRA conversion. Page 2 answers the second question: How much of Charlie’s Roth IRA conversion is taxable? Line 16 is simply line 8, and line 17 is simply line 11. Subtracting the nontaxable portion of the Roth IRA conversion from the total converted amount yields the amount of the Roth IRA conversion that is taxable. In Charlie’s case, it is only $10. This amount goes to Charlie’s Form 1040, line 4b. 

This is how a Backdoor Roth IRA should look on your Form 1040. Notice the very small number on Line 4b.

The Wrong Way

The following is what Charlie’s Form 1040 might look like if his Backdoor Roth IRA is misreported. 

Heed the warning of my chicken scratch: a four figure number on Line 4b after a Backdoor Roth IRA is likely an indication that either the tax planning or the tax reporting is off.

How might this happen? It could be that a Form 8606 simply was not prepared, or it was incorrectly prepared. Sometimes the Form 1099-R is misunderstood. People see that $5,510 is the “taxable amount” in line 2 of the Form 1099-R and believe that must be the taxable amount reported on line 4b. But remember, the Form 1099-R has a box checked indicating that the taxable amount is not determined. The Form 8606 is what determines the taxable amount created by the Backdoor Roth IRA (in Charlie’s case, $10). 

As a check, you should ensure that the Lines 18 of your previously filed Forms 8606 agree to the appropriate line on the Form 1040 (line 4b in 2018). If there are discrepancies (and/or a Form 8606 was not filed for a Backdoor Roth IRA), that is an indication there is likely an error on the tax return. If Line 18 on the Form 8606 is a four-figure or greater number after a Backdoor Roth IRA, it is very likely that either the tax planning or the tax return reporting went wrong somewhere.

We can see how deleterious this error is for Charlie. If he filed his tax return the wrong way, his federal taxable income is overstated by $5,500. In his case, this caused him to erroneously owe $1,760 more in federal income tax ($43,613 minus $41,853 — hat tip to ProConnect Tax Online for the tax calculations). If Charlie lives in a state with a state income tax, he will also overpay his state income taxes because of this error. 

Filing an Amended Tax Return

Imagine that Charlie filed his tax return as pictured in the Wrong!!! picture above. What can Charlie do?

Charlie’s remedy is to file an amended return. This entails refiling the Form 1040 and all of its related forms and schedules (including the Form 8606) with the correct amounts. It also entails filing a Form 1040X. This form presents amounts as originally filed and as corrected, with the difference illustrated. It also requires a narrative submission explaining the changes made on the amended tax return.

There are several things to keep in mind when filing an amended tax return. First, a taxpayer filing an amended return is under an obligation to correctly report amounts. If, as part of the exercise of fixing a Backdoor Roth IRA through an amended tax return, the taxpayer learns that other amounts on the originally filed tax return were incorrect, he or she must correct those amounts if they choose to file an amended return. 

Second, there is a deadline for amending a federal income tax return (the so-called statute of limitations). Generally, the deadline is three years from the later of the tax return due date (if originally filed on or prior to the initial tax return due date) or the filing date (if filed after the initial tax return due date). This later deadline applies anytime the taxpayer files after the initial due date (including, for example, a timely post-April 15th tax return filing made after filing for an extension). 

If the amended return claiming the refund (because of the corrected Backdoor Roth IRA tax return reporting) is filed after this three year deadline, the IRS cannot and will not issue a refund to the taxpayer due to the statute of limitations. There are limited exceptions to this rule (such as when the IRS and the taxpayer have mutually agreed to extend the statute of limitations). 

States have their own statutes of limitations, which may or may not be the same as the federal statute of limitations. In my home state of California, it is a four-year statute of limitations instead of a three-year statute of limitations. 

The statute of limitations means the clock is ticking to correct Backdoor Roth IRAs not correctly reported on previously filed tax returns. In many cases, taxpayers learning they have incorrectly filed a tax return (for whatever reason, including an erroneously reported Backdoor Roth IRA) are well advised to seek professional assistance in amending their tax returns. 

Further Reading

I have previously blogged about Backdoor Roth IRAs for beginners here and about tactics to employ if you want to do a Backdoor Roth IRA but currently have a balance in a traditional IRA, SEP IRA, and/or SIMPLE 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.

IRS Identity Protection PIN

UPDATE (January 13, 2021): The IRS has expanded the PIN program to all Americans. See https://www.irs.gov/newsroom/all-taxpayers-now-eligible-for-identity-protection-pins Hat Tip to Ed Zollars for the update: https://www.currentfederaltaxdevelopments.com/blog/2021/1/13/ip-pin-program-available-to-all-taxpayers

The post below has NOT been updated for the January 13, 2021 update. Please use the below for general background purposes only and refer to the IRS website and Mr. Zollars’ article.

Identity theft continues to be a significant 21st century concern. It can happen in many ways. One particularly nefarious way is that your identity might be stolen to file a tax return with the IRS. Below I discuss a relatively new program that the IRS has made available to many Americans to help prevent identity theft with the IRS. If you are eligible, you should give strong consideration to opting into the program.

Identity Theft and Tax Returns

Obviously identity theft is bad. But why would someone use your identity with the IRS?

The answer is a tax refund. The scam often works like this: a scammer steals your identity and files a tax return with your name and Social Security number early in the year, before you have a chance to file your tax return for the prior year. The scammer will report taxable income and tax payments such that the tax return claims you have a significant income tax refund due from the IRS. The phony tax return will direct the refund such that the scammer gets the tax refund.

This becomes a nightmare for the victim. Once the IRS accepts the tax return and issues the scammer a refund, the victim will not be able to file a tax return. The IRS will reject the valid return and will not issue any tax refunds owed to the victim. The victim now faces what is likely months of remedial action to correct the situation.

Identity Protection PINs

The IRS is aware of this problem. They have an optional program that allows certain people to obtain an Identity Protection Personal Identification Number (PIN). The PIN functions to protect a taxpayer. 

If a taxpayer has an Identity Protection PIN issued with the IRS, the IRS will only accept that taxpayer’s electronic tax return if the tax return provides the Identity Protection PIN. That stops the sort of scams described above. For paper returns, a missing or incorrect PIN will delay the IRS accepting the tax return while the IRS takes additional steps to verify that the tax return came from the taxpayer whose name and Social Security number appear on the tax return. Either way, obtaining a PIN provides a level of protection against tax return identity theft.

Spouses each separately apply for their own PIN and the IRS will issue each spouse a unique PIN. If the spouses file jointly, both PINs are included on the tax return. If you have an Identity Protection PIN and use a paid tax preparer, it is important that your paid tax preparer include the PIN on your tax return. 

Eligibility

You are eligible to apply for an Identity Protection PIN from the IRS if:

Arizona, California, Colorado, Connecticut, Delaware, District of Columbia, Florida, Georgia, Illinois, Maryland, Michigan, Nevada, New Jersey, New Mexico, New York, North Carolina, Pennsylvania, Rhode Island, Texas, and Washington.

The yellow states below are the ones in which all taxpayers may apply for an IRS Identity Protection PIN (hat tip to 270toWin.com).

PLEASE SEE UPDATE FROM JANUARY 13, 2021 ABOVE: NOW ALL AMERICANS CAN POTENTIALLY QUALIFY.

Application

To obtain an IRS Identity Protection PIN, you can start at this website.

You will need to establish an IRS electronic account. The IRS website will guide you through the process and will use some credit history information to verify your identity. Once you have your IRS electronic account, you can easily obtain an IRS Identity Protection PIN. 

Future Years

Your PIN changes every year. At the beginning of the year, the IRS will put your new PIN (for use in filing the prior year’s tax return) in your IRS electronic account and they will mail your PIN to your last address of record. This makes it crucial to file a Form 8822 with the IRS to officially change your address with the IRS anytime you move, so that any PIN related correspondence (including retrievals in the event you lose your PIN) are directed to your correct address. 

The IRS will change your PIN every year, so it is important to ensure you use the correct PIN when filing your tax return. A PIN received in October 2019 will be for 2018 and you will need to use the PIN issued early in 2020 to file your 2019 tax return. 

Conclusion

Taxpayers eligible for the IRS Identity Protection PIN program should strongly consider applying for a PIN. It can help protect you from the serious headache of having your identity stolen and used to file a false tax return in your name. 

Further Reading

Kay Bell wrote a great post about the IRS Identity Protection PIN program here. 

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

Follow me on Twitter at @SeanMoneyandTax

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

The Tax Challenges of ISOs

Incentive stock options (“ISOs”) are a great employee benefit. ISOs are very powerful because they provide the possibility of compensating employees at preferential long term capital gains rates instead of at ordinary income tax rates, and they avoid Social Security and Medicare taxes. ISOs can also help build wealth by allowing employees to purchase employer stock at a discount. However, ISOs can create several tax challenges, and reporting them on your tax return can be confusing.

Incentive Stock Options

Employers grant employees incentive stock options as an incentive to stay with the company. The company grants the employee an option to purchase the stock of the company at a certain price (the “exercise price” or the “strike price”). That price is no less than the company’s current stock price (i.e., the stock price on the grant date, defined below). 

There is a $100,000 annual limit on the fair market value of stock subject to ISO treatment per employee. If an employee leaves the employer’s employment, he or she must exercise or forfeit their ISOs within three months.

Three dates matter when considering ISOs. 

Grant Date: The date the employee is granted the option (i.e., the first date the employee has the option to purchase the stock at the strike price).

Exercise Date: The date the employee exercises the ISO (i.e., the date the employee purchases the stock of the company under the terms of the ISO at the strike price). 

Disposition Date: The date the employee sells the stock acquired by the previous exercise of the ISO.

Tax Treatment

Grant: There is no tax consequence to the employee upon the grant of the ISO.

Exercise: Upon exercise, there is no income tax consequence to the employee. However, the difference between the fair market value of the ISO and its strike price is an adjustment that creates income for alternative minimum tax purposes (the dreaded AMT). Fortunately, the late-2017 tax reform bill increased AMT exemptions (i.e., the amount of income below which the AMT does not apply), thus reducing, but not eliminating, the potential negative impact AMT can have on ISO exercises. 

Further, the AMT issue is removed if the exercise and later stock disposition occur in the same year. As a practical matter, it is often the case that the later stock disposition occurs almost instantaneously after exercise, which takes the AMT issue off the table. 

Dispositions: ISOs have very favorable tax treatment upon disposition if the disposition of the shares satisfies both of the following rules.

  1. The disposition is at least two years from the grant date; and,
  2. The disposition is at least one year from the exercise date.

If both rules are satisfied, the employee has long term capital gain or loss upon the disposition of the shares. Long term capital gains are taxed at preferential rates for federal income tax purposes.

Example: Gary works for Acme Explosives, Inc. Acme grants Gary 10,000 ISOs at an exercise price of $10 per share on January 1, 2018. Gary exercises the ISOs on June 1, 2018 at a time when the fair market value of the stock is $15 per share. On February 1, 2020, Gary sells each share acquired through the ISO exercise at a price of $20 per share. Assume that Gary was not subject to AMT in 2018. 

Because Gary sold the Acme shares at least one year after exercise and at least two years after the ISO grant, Gary’s sale qualifies entirely for long term capital gain treatment (creating a $100,000 capital gain — $200,000 sales proceeds less $100,000 basis) and creates no taxable ordinary income.

Early Dispositions

Often employees will dispose the ISO stock before the time required to get favorable income tax treatment. As a practical matter, employees often exercise the ISO and immediately sell the stock. 

Employees are exposed to the economic performance of their employer through their job and possibly other equity holdings. Thus, they often want to reduce the risk associated with their employer’s performance and dispose of their ISO stock as soon as possible. Most view the tax cost as well worth it considering that (i) the employee immediately pockets (net of tax) the difference between the fair market value of the stock and the strike price, and (ii) the diversification benefits of investing the ISO proceeds into other investments.

If the employee disposes of the ISO stock early (referred to as a “disqualifying disposition”), what result? The difference between the strike price and the fair market value of the stock at exercise becomes ordinary income to the employee reported to the employee as compensation income included in Box 1 of the employee’s Form W-2. The remaining amounts create long or short term capital gain or loss.

Example: Angela works for Acme Anvils, Inc. Acme grants Angela 10,000 ISOs at an exercise price of $10 per share on January 1, 2019. Angela exercises the ISOs on June 1, 2019 at a time when the fair market value of the stock is $15 per share. On December 1, 2019, Angela sells each share acquired through the ISO exercise at a price of $20 per share. 

Because Angela’s December 2019 sale violates both timing tests, Angela’s sale does not qualify for long term capital gain treatment. Thus, Angela has $50,000 of compensation income ($15 fair market value less $10 strike price times 10,000 shares) of ordinary compensation income. The remaining $50,000 of gain is short term capital gain. 

Fortunately, the compensation income is not included in compensation income for purposes of Social Security and Medicare payroll taxes (and, thus, is not included in Boxes 3 and 5 on the Form W-2). Because Angela sold the ISO shares in the same year she exercised the ISOs, there will not be a separate AMT consequence of the ISOs. 

Tax Reporting

Staying with Angela’s example, the $50,000 of ordinary income will be reported as compensation income in Angela’s Form W-2 Box 1, but not in Boxes 3 and 5. Box 14 should indicate “ISO DISQ” and $50,000 as the amount.

Angela should also receive two other tax reporting documents. First, Angela should receive a Form 1099-B. The form should indicate $200,000 of sales proceeds ($20 per share times 10,000 shares) and should indicate a basis of $100,000 (Angela’s historic cost basis, as she paid $10 per share for 10,000 shares). Angela should also receive a Form 3921. This form should indicate the exercise price per share ($10) and the fair market value per share on the date of the exercise ($15).

The IRS will expect to see at least two numbers on Angela’s tax return. First, the compensation income must be reported on Angela’s Form 1040 box 1. Second, the $200,000 stock sale should be reported on Schedule D and on Form 8949. 

This is where it gets interesting. If Angela simply reports $200,000 as gross proceeds and $100,000 as basis on her Schedule D and her Form 8949, she is going to have a very bad tax result. Why? Angela’s W-2 includes $50,000 of the overall $100,000 of income she recognized on the ISO exercise and disposition. If she simply reports a $100,000 gain on her Schedule D/Form 8949, her total reported income will be $150,000, creating $50,000 in over-reported taxable income. 

Thus, Angela must increase the basis she reports on Schedule D and Form 8949 by the $50,000 of ordinary compensation income reported on her Form W-2. Her Schedule D and Form 8949 should report both the $200,000 of gross proceeds and $150,000 of basis in the disposed of Acme shares. 

Estimated Taxes

Even though the gain on a disqualifying disposition of an ISO is taxable as ordinary income in Box 1 of the Form W-2, there is no requirement that the employer withhold any income tax with respect to the gain. Thus, the onus falls to the employee to ensure he or she pays the proper amount of federal and state estimated income tax to avoid penalties. The good news is that there is a safe harbor under which employees can avoid underpayment penalties. 

For federal income tax purposes, there will not be an underpayment of estimated tax penalty if the employee has paid in at least 90 percent of their current year total tax liability and/or 100 percent of their prior year total tax liability. If current year income is $150,000 or more, 100 percent becomes 110 percent. 

Regardless of whether there is a qualifying disposition triggering long term capital gain or a disqualifying disposition triggering ordinary income, the employee should endeavor through a combination of estimated tax payments, additional workplace withholding, and/or additional spousal workplace withholding to ensure that he or she has withheld enough during the year to avoid federal and state underpayment penalties. 

Conclusion

ISOs can be a great wealth building tool. But because of the tax rules and at times confusing tax reporting, they present a challenge. Anyone with ISOs (or with clients that own ISOs) should step back and fully understand the tax ramifications of selling them. It is often advisable to work with a professional advisor as you sell ISOs and manage the tax ramifications of the sale. 

Further Reading

The IRS provides some tax resources on ISOs starting on page 12 of Publication 525.

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.

Excess Contributions to an IRA

There are limits to how much can be contributed to traditional IRAs and Roth IRAs. This post describes how excess contributions happen and how to resolve them.

Three introductory notes. First, if you find that you have made an excess contribution, you may be well advised to seek professional advice. Second, please don’t panic, but make sure to act swiftly. Excess contributions are resolvable but do not benefit from delays. Third, you should not plan to make an excess contribution for a variety of reasons.

Traditional IRAs

There are (generally speaking) three situations that generate an excess contribution to a traditional IRA. They are:

  • Contributions are made for a year the taxpayer (and their spouse) does not have earned income.
  • Contributions are made in excess of the annual contribution limits.
  • Rolling into an IRA an amount that did not qualify to be rolled in.

This last category is not immediately obvious, but it does occasionally occur. For example, a taxpayer might inherit a taxable account and incorrectly roll it into an inherited IRA. Or a taxpayer might incorrectly roll an IRA they inherited into their own IRA. Or a taxpayer might attempt a 60-day rollover of amounts previously in an IRA and roll the money into an IRA after the 60-day deadline. Note that in some cases, this last mistake can be resolved by obtaining a private letter ruling from the IRS (doing so is beyond the scope of this post).

For 2019 and prior taxable years, there is an additional category: contributions to a traditional IRA when the taxpayer was 70 1/2 or older. The SECURE Act eliminates the prohibition on those 70 1/2 and older contributing to a traditional IRA.

Resolutions

Recharacterization

Prior to the 2020 tax year, if you qualified to make a contribution to a Roth IRA, but not to a traditional IRA, you could direct your financial institution to recharacterize the contribution to a Roth IRA. This scenario only applied in situations where the taxpayer was over age 70 ½ when the contribution was made to the traditional IRA.

Now there is no scenario where this would be relevant. Anyone not qualifying to make a contribution to a traditional IRA would also not qualify to make a contribution to a Roth IRA.

However, recharacterizations of contributions from traditional IRAs to Roth IRAs can make sense for some taxpayers for tax planning reasons, and are allowable if done properly.

To recharacterize, you must contact the financial institution and direct them to move the contribution and its earnings to a Roth IRA. This must be disclosed in a white paper statement attached to your federal income tax return. The recharacterization deadline is the extended due date of the tax return (generally October 15th).

Withdrawal

A second way to correct an excess contribution to a traditional IRA is to take a “corrective distribution” of the excess contribution and its earnings from the IRA. You will need to inform your financial institution of the excess contribution and request a corrective distribution of the excess contribution and the earnings attributable to the excess contribution. If the excess contribution is withdrawn prior to the extended filing deadline, the withdrawal of the contribution itself is generally not included in taxable income.

As observed in IRS Publication 590-A, page 34, in most cases the financial institution will compute the earnings attributable to the excess contribution. The earnings will be included in taxable income for the actual year the excess contribution was made. For example, if a 2023 IRA contribution is made in January 2024, and the taxpayer later takes a corrective distribution of that contribution and its earnings, the earnings will be includible in taxable income in 2024. In those cases where the taxpayer must compute the earnings, IRS Publication 590-A Worksheet 1-3 is a resource for figuring the earnings or loss.

See Example 1 in this article for insights on the reporting timing of earnings attributable to corrective distributions.

Up until the passage of SECURE 2.0, the earnings were also subject to the ten percent early withdrawal penalty (unless an exception otherwise applied). However, SECURE 2.0 Section 333 repealed the early withdrawal penalty with respect to withdrawals of earnings occurring pursuant to a corrective distribution. Note further that as of March 1, 2024 there is now some doubt as to the on going validity of SECURE 2.0.

If the corrective distribution occurs after the taxpayer files their tax return for the relevant taxable year, but before the extended filing deadline for the year (generally October 15th), the taxpayer must file an amended return which reports the corrective distribution.

A quick note on corrective distributions (as applied to both traditional IRAs and Roth IRAs): they can be done if the taxpayer has changed their mind. Natalie Choate makes this point in her excellent treatise Life and Death Planning for Retirement Benefits (8th ed. 2019, see page 132). Corrective distributions are not limited to simply those times when the taxpayer has made a contribution in excess of the allowed limits.

Apply the Contribution to a Later Year

You can keep an excess contribution in a traditional IRA and apply it to a later year, if you are eligible to make a traditional IRA contribution in that later year. This method does not avoid the six percent penalty discussed below for the year of the contribution, but it allows the taxpayer to avoid taking a distribution of the excess contribution and stops additional impositions of the six percent excess contribution penalty. Generally, this method is only effective if the amount of the excess contribution is relatively modest, since a large excess contribution cannot be soaked up by only one year’s annual IRA contribution limit.

Penalties

If you do not resolve the excess contribution prior to the extended deadline for filing your tax return, you must pay a six percent excise tax on the excess contribution annually until the excess contribution is withdrawn from the traditional IRA. You report and pay the excise tax by filing a Form 5329 with the IRS. Because this six percent tax is imposed each year the excess contribution stays in the traditional IRA, it is important to correct excess contributions to traditional IRAs promptly.

Note further that excess contributions withdrawn after the extended filing deadline are generally included in taxable income, though the taxpayer can recover a portion of any IRA basis they have under the Pro-Rata Rule.

Roth IRAs

There are (generally speaking) four situations that cause an excess contribution to a Roth IRA. They are:

  • Contributions are made for a year the taxpayer (and their spouse) does not have earned income.
  • Contributions are made in excess of the annual contribution limits.
  • Contributions are made for a year the taxpayer exceeds the modified adjusted gross income (“MAGI”) limitations to make a Roth IRA contribution)
  • Rolling into a Roth IRA an amount that did not qualify to be rolled in.

A rather common excess contribution occurs when taxpayers contribute to a Roth IRA in a year they earn in excess of the MAGI limits. That can happen for a host of reasons, including end of year bonuses or other unanticipated income.

Another somewhat common mistake in this regard is made by those subject to required minimum distributions (“RMDs”) when trying to convert traditional IRAs to Roth IRAs. In early January a taxpayer might convert a chunk of their traditional IRA to a Roth IRA. This creates a problem if the taxpayer did not previously take out their annual RMD for the year. There is a rule providing that RMDs are the first money to come out of an IRA during the year, and RMDs may not be converted to Roth IRAs. Thus, “converting” the first dollars out of a traditional IRA (an RMD) during the year creates an excess contribution to a Roth IRA.

Resolutions

Recharacterization

Assuming that the taxpayer qualifies to make a contribution to a traditional IRA, the excess contribution to a Roth IRA can be recharacterized as a contribution to a traditional IRA. Generally, the taxpayer must contact the financial institution and direct them to recharacterize the contribution and its earnings into a traditional IRA and must file a white paper statement with their tax return explaining the recharacterization.

When the taxpayer’s income puts him or her over the Roth IRA MAGI limits, recharacterization is often how excess contributions to Roth IRAs are resolved. In such cases, they will generally qualify to make a contribution to a traditional IRA, so a recharacterization is often the go-to method of correcting an excess contribution to a Roth IRA.

Note that the recharacterization deadline is the extended due date of the tax return (usually October 15th).

Withdrawal

A second way to correct an excess contribution to a Roth IRA is to take a corrective distribution of the excess contribution. You will need to inform your financial institution of the excess contribution and request a corrective distribution of the excess contribution and the earnings attributable to the excess contribution. The withdrawal of the excess contribution itself is generally not taxable.

The financial institution will compute the earnings attributable to the excess contribution. The earnings will be included in taxable income for the actual year the excess contribution was made. The same inclusion timing rules applicable to traditional IRA corrective distributions (discussed above) apply to the earnings from a Roth IRA corrective distribution.

If the corrective distribution occurs after the taxpayer files their tax return for the relevant taxable year, but before the extended filing deadline for the year (generally October 15th), the taxpayer must file an amended return which reports the corrective distribution and includes the earnings in taxable income (if the original contribution actually occurred in the year covered by the tax return).

Apply the Contribution to a Later Year

As with excess contributions to traditional IRAs, you can keep an excess contribution in a Roth IRA and apply it to a later year, if you are eligible to make a Roth IRA contribution in that later year. This method does not avoid the six percent penalty discussed below for the year of the contribution, but it allows the taxpayer to avoid taking a distribution of the excess contribution and stops additional impositions of the six percent excess contribution penalty. Generally, this method is only effective if the amount of the excess contribution is relatively modest, since a large excess contribution cannot be soaked up by only one year’s annual Roth IRA contribution limit.

Penalties

As with excess contributions to traditional IRAs, if you do not resolve the excess contribution to your Roth IRA prior to the extended deadline for filing your tax return, you must pay a six percent excise tax on the excess contribution annually until the excess contribution is withdrawn. It is best to resolve an excess contribution to a Roth IRA sooner rather than later to avoid annual impositions of the penalty.

Tax Return Considerations

Corrective measures applied to traditional IRA and/or Roth IRA contributions may require tax return reporting. Such reporting is discussed in various sources. Examples of such sources include IRS Publication 590-A, the Instructions to the Form 8606, and/or the Instructions to the Form 5329.

Conclusion

Excess contributions to IRAs and Roth IRAs happen. They are not an occasion to panic. They are an occasion for prompt, well considered action. Hopefully this article provides enough background for you to start your decision process and, if necessary, have an informed conversation with a competent tax professional.

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.