Tag Archives: Year-End Planning

It’s Not Too Late, California!

HUGE UPDATE: On October 16, 2023, the IRS issued this, extending the October 16, 2023 deadline for 2022 tax acts and filings to November 2023. The IRS announcement allows (most) Californians to make Roth IRA, traditional IRA, and HSA contributions for 2022 up to November 16, 2023 and delays the deadline for many 2022 federal income tax returns and income tax payments to November 16, 2023. Hat tip to Justin Miller on X for the news.

ADDITIONAL UPDATE 10/16/2023 7:06PM: California has also extended the 2022 filing and payment deadline to November 16, 2023. Hat tip to Kelly Phillips Erb.

Please enjoy below the rest of my post, as originally authored in August 2023, understanding that now you can replace “October 16” with “November 16” for most Californians.

I’m glad that title intrigued you enough to stop on by. It’s not too late for most Californians to make a 2022 IRA contribution, a 2022 Roth IRA contribution, a 2022 HSA contribution, and/or do a 2022 Backdoor Roth IRA contribution. 

You’re probably thinking “What the heck are you talking about? It’s the late summer 2023. Time to be thinking about football, not funding 2022 IRAs and HSAs.”

Your thoughts are correct as applied to most Americans. However, most Californians are the beneficiaries of a special situation. The IRS announced that because of early 2023 flooding in many areas of California, most Californians have an extended deadline, October 16, 2023, to perform most 2022 tax acts that otherwise would have been due early in 2023.

This extension opens the door for millions of Californians to consider 2022 contributions to tax-advantaged accounts. Of course, nothing increases the amount Californians can contribute. Thus, those who have already maxed out for 2022 do not benefit from this deadline extension. 

2022 Traditional IRA Contributions

Most working Californians can still make 2022 contributions to a traditional IRA. If the taxpayer has not yet filed their 2022 Form 1040, the deduction or the Form 8606 (for a nondeductible contribution) can simply be included with the to-be filed Form 1040.

But what if the taxpayer has already filed their Form 1040 for 2022? Then the question becomes: are they deducting their 2022 traditional IRA contribution? If no, then the taxpayer can simply file a Form 8606 as a standalone tax return to report the 2022 nondeductible contribution. 

However, if the contribution is tax deductible, then the taxpayer would need to file amended Forms 1040 and 540 (for California) to report the deductible IRA contribution and claim refunds from both the IRS and the Franchise Tax Board for the tax reduced because of the deductible traditional IRA deduction. 

2022 Roth IRA Contributions

Many working Californians can still make 2022 contributions to a Roth IRA. Since Roth IRA contributions are not deductible, and do not require a separate form to report them, the contribution likely would not require any amending of already-filed 2022 tax returns. One exception would be the case of a taxpayer with a low income in 2022. He or she could make a 2022 Roth IRA contribution and possibly qualify for the Saver’s Credit. In order to claim the credit, they would need to amend their Form 1040 if they already filed it for 2022. 

2022 Backdoor Roth IRAs

It’s not too late for a 2022 Backdoor Roth IRA for some Californians! This would be a Split-Year Backdoor Roth IRA. The pressing deadline as of late August 2023 is that the 2022 nondeductible traditional IRA contribution needs to be made by October 16, 2023. 

Anyone pursuing a Split-Year Backdoor Roth IRA for 2022 in 2023 should ensure they have no balances in traditional IRAs, SEP IRAs, and/or SIMPLE IRAs as of December 31, 2023. 

2022 HSA Contributions

Some Californians can still make 2022 contributions to a health savings account. If the taxpayer has not yet filed their 2022 Form 1040, the tax deduction can simply be added to the to-be filed Form 1040.

But what if the taxpayer has already filed their Form 1040 for 2022? Then the taxpayer would need to file amended Form 1040 to claim the tax deduction and the resulting tax refund from the IRS. Since California does not recognize HSAs, there’s no California tax deduction and no need to amend the California Form 540. 

Of course, the taxpayer must meet the eligibility requirements (generally, having had a high deductible health plan as their only medical insurance) in 2022 in order to contribute to a HSA for 2022. 

Practical Considerations

First, contributions to IRAs, Roth IRAs, and HSAs made in 2023 that are to count for 2022 must be specifically designated as being for 2022. 

Second, I believe that in many cases, in order for qualifying Californians to do this, it will be necessary to use the phone, not internet portals. I suspect most financial institutions’ internet portals will not accommodate a 2022 IRA/Roth IRA/HSA contribution this late. Remember, financial institutions would not want to encourage the vast majority of Americans who do not currently qualify to make 2022 contributions to make 2022 contributions.

Thus, I believe as a practical matter using the phone is a best practice in terms of making any 2022 contributions at this late date. 

Who Benefits?

Residents of all California counties except three qualify for the extended deadline. The vast majority of the population of the state qualifies for the extended deadline, but residents of Lassen, Modoc, and Shasta do not appear to qualify (don’t blame me, I don’t make the rules!). 

Note that some taxpayers in parts of Alabama and Georgia qualify for this opportunity, but I personally have not explored this in any detail. 

Conclusion

Many California residents should consider whether there is some extended last minute 2022 tax planning they can implement by October 16, 2023. 

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:

AssetAmountAnnual Taxable Income
401(k) Fund A (Equity)$80,000None
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:

AssetAmountAnnual Taxable Income
401(k) Fund A (Equity)$60,000None
401(k) Bond Fund$20,000None
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.

2021 YEAR-END TAX PLANNING

It’s time to think about year-end tax planning. Year-end is a great time to get tax planning ducks in a row and take advantage of opportunities. This is particularly true for those in the financial independence community. FI principles often increase one’s tax planning opportunities.  

Remember, this post is for educational purposes only. None of it is advice directed towards any particular taxpayer. 

Backdoor Roth IRA Deadline 2021

As of now (December 7, 2021), the legal deadlines around Backdoor Roth IRAs have not changed: the nondeductible 2021 traditional IRA contribution must happen by April 18, 2022 and there is no legal deadline for the second step, the Roth conversion. However, from a planning perspective, the practical deadline to have both steps of a 2021 Backdoor Roth IRA completed is December 31, 2021. 

This is because of proposed legislation that eliminates the ability to convert nondeductible amounts in a traditional IRA effective January 1, 2022. As of December 7th, the proposed legislation has passed the House of Representatives but faces a very certain future in the Senate. Considering the risk that the Backdoor Roth elimination proposal is enacted, taxpayers planning on completing a 2021 Backdoor Roth IRA should act to ensure that the second step of the Backdoor Roth IRA (the Roth conversion) is completed before December 31st. 

Taxpayers on the Roth IRA MAGI Limit Borderline

In years prior to 2021, taxpayers unsure of whether their income would allow them to make a regular Roth IRA contribution could simply wait until tax return season to make the determination. At that point, they could either make the regular Roth IRA contribution for the prior year (if they qualified) or execute what I call a Split-Year Backdoor Roth IRA.  

With the proposed legislation looming, waiting is not a good option. The good news is that taxpayers executing a Backdoor Roth IRA during a year they actually qualify for a regular annual Roth IRA contribution suffer no material adverse tax consequences. Of course, in order for this to be true there must be zero balance, or at most a very small balance, in all traditional IRAs, SEP IRAs, and SIMPLE IRAs as of December 31, 2021. 

December 31st and Backdoor Roth IRAs

December 31st is a crucial date for those doing the Roth conversion step of a Backdoor Roth IRA during the year. It is the deadline to move any balances in traditional IRAs, SEP IRAs, and SIMPLE IRAs to workplace plans in order to ensure that the Roth conversion step of any Backdoor Roth IRA executed during the year is tax-efficient. 

This December 31st deadline applies regardless of the proposed legislation discussed above. 

IRAs and HSAs

Good news on regular traditional IRA contributions, Roth IRA contributions, and HSA contributions: they don’t have to be part of an end-of-2021 tax two-minute drill. The deadline for funding an HSA, a traditional IRA, and a Roth IRA for 2021 is April 18, 2022. 

Solo 401(k)

The self-employed should consider this one. Deadlines vary, but as a general rule, those eligible for a Solo 401(k) usually benefit from establishing one prior to year-end. The big takeaway should be this: if you are self-employed, your deadline to seriously consider a Solo 401(k) for 2021 is ASAP! Usually, such considerations benefit from professional assistance. 

Something to look forward to in 2022: my upcoming Solo 401(k) book!

Charitable Contributions

For those itemizing deductions in 2021 and either not itemizing in 2022 or in a lower marginal tax rate in 2022 than in 2021, it can be advantageous to accelerate charitable contributions late in the year. It can be as simple as a direct donation to a qualifying charity by December 31st. Or it could involve contributing to a donor advised fund by December 31st.  

A great donor advised fund planning technique is transferring appreciated securities (stocks, bonds, mutual funds, or ETFs) to a donor advised fund. Many donor advised fund providers accept securities. The tax benefits of making such a transfer usually include (a) eliminating the built-in capital gain from federal income taxation and (b) if you itemize, getting to take a current year deduction for the fair market value of the appreciated securities transferred to the donor advised fund. 

The elimination of the lurking capital gain makes appreciated securities a better asset to give to a donor advised fund than cash (from a tax perspective). Transfers of appreciated securities to 501(c)(3) charities can also have the same benefits.

The 2021 deadline for this sort of planning is December 31, 2021, though taxpayers may need to act much sooner to ensure the transfer occurs on time. This is particularly true if the securities are transferred from one financial institution to a donor advised fund at another financial institution. In these cases, the transfer may have to occur no later than mid-November, though deadlines will vary.

Early Retirement Tax Planning

For those in early retirement, the fourth quarter of the year is the time to do tax planning.  Failing to do so can leave a great opportunity on the table. 

Prior to taking Social Security, many early retirees have artificially low taxable income. Their only taxable income usually consists of interest, dividends, and capital gains. In today’s low-yield environment, without additional planning, early retirees’ taxable income can be very low (perhaps even below the standard deduction). 

Artificially low income gives early retirees runway to fill up lower tax brackets (think the 10 percent and 12 percent federal income tax brackets) with taxable income. Why pay more tax? The reason is simple: choose to pay tax when it is taxed at a low rate rather than defer it to a future when it might be taxable at a higher rate.

The two main levers in this regard are Roth conversions and tax gain harvesting. Roth conversions move amounts in traditional retirement accounts to Roth accounts via a taxable conversion. The idea is to pay tax at a very low tax rate while taxable income is artificially low, rather than leaving the money in deferred accounts to be taxed later in retirement at a higher rate under the required minimum distribution (“RMD”) rules. 

Tax gain harvesting is selling appreciated assets when one is in the 10 percent or 12 percent marginal tax bracket so as to incur a zero percent long term capital gains federal tax rate on the capital gain. 

Early retirees can do some of both. In terms of a tiebreaker, if everything else is equal, I prefer Roth conversions to tax gain harvesting, for two primary reasons. First, traditional retirement accounts are subject to ordinary income tax rates in the future, which are likely to be higher than preferred capital gains tax rates. Second, large taxable capital gains in taxable accounts can be washed away through the step-up in basis at death. The step-up in basis at death doesn’t exist for traditional retirement accounts. 

One time to favor tax gain harvesting over Roth conversions is when the traditional retirement accounts have the early retiree’s desired investment assets but the taxable brokerage account has positions that the early retiree does not like anymore (for example, a concentrated position in a single stock). Why not take advantage of tax gain harvesting to reallocate into preferred investments in a tax-efficient way?

Long story short: during the fourth quarter, early retirees should consider their taxable income for the year and consider year-end Roth conversions and/or tax gain harvesting. Planning in this regard should be executed no later than December 31st, and likely earlier to ensure proper execution. 

Roth Conversions, Tax Gain Harvesting, and Tax Loss Harvesting

Early retired or not, the deadline for 2021 Roth conversions, tax gain harvesting, and tax loss harvesting is December 31, 2021. Taxpayers should always consider timely implementation: these are not tactics best implemented on December 30th! 

For some who find their income dipped significantly in 2021 (perhaps due to a job loss), 2021 might be the year to convert some amounts in traditional retirement accounts to Roth retirement accounts. Some who are self-employed might want to consider end-of-year Roth conversions to maximize their qualified business income deduction. 

Stimulus and Child Tax Credit Planning

Taxpayers who did not receive their full 2021 stimulus may want to look into ways to reduce their 2021 adjusted gross income so as to qualify for additional stimulus funds. I wrote in detail about one such opportunity in an earlier blog post. Lowering adjusted gross income can also qualify taxpayers for additional child tax credits. 

There are many factors you and your advisor should consider in tax planning. This opportunity may be one of them. For example, taxpayers considering a Roth conversion at the end of the 2021 might want to hold off in order to qualify for additional stimulus and/or child tax credits. 

Accelerate Payments

The self-employed and other small business owners may want to review business expenses and pay off expenses before January 1st, especially if they anticipate their marginal tax rate will decrease in 2022. Depending on structure and accounting method, doing so may not only reduce income taxes, it could also reduce self-employment taxes. 

State Tax Planning

For my fellow Californians, the big one here is property taxes. It may be advantageous to pay billed (but not yet due) property taxes in late 2021. This allows taxpayers to deduct the amount on their 2021 California income tax return. In California, the standard deduction ($4,601 for single taxpayers, $9,202 for married filing joint taxpayers) is much lower than the federal standard deduction, so consideration should be given to accelerating itemized deductions in California, regardless of whether the taxpayer itemizes for federal income tax purposes.

Required Minimum Distributions (“RMDs”)

They’re back!!! RMDs are back for 2021. The deadline to withdraw a required minimum distribution for 2021 is December 31, 2021. Failure to do so can result in a 50 percent penalty. 

Required minimum distributions apply to most retirement accounts (Roth IRAs are an exception). They apply once the taxpayer turns 72. Also, many inherited retirement accounts (including Roth IRAs) are subject to RMDs, regardless of the beneficiary’s age. 

Planning for Traditional Retirement Accounts Inherited in 2020 and 2021

Those inheriting traditional retirement accounts in 2020 or later often need to do some tax planning. The end of the year is a good time to do that planning. Many traditional retirement account beneficiaries will need to empty the retirement account in 10 years (instead of being on an RMD schedule), and thus will need to plan out distributions over the 10 year time frame to manage taxes rate on the distributions.

2021 Federal Estimated Taxes

For those with small business income, side hustle income, significant investment income, and other income that is not subject to tax withholding, the deadline for 2021 4th quarter estimated tax payments to the IRS is January 18, 2022. Such individuals should also consider making timely estimated tax payments to cover any state income taxes. 

Review & Update Beneficiary Designation Forms

Beneficiary designation forms control the disposition of financial assets (such as retirement accounts and brokerage accounts) upon death. Year-end is a great time to make sure the relevant institutions have up-to-date forms on file. While beneficiary designations should be updated anytime there is a significant life event (such as a marriage or a death of a loved one), year-end is a great time to ensure that has happened. 

2022 and Beyond Tax Planning

The best tax planning is long term planning that considers the entire financial picture. There’s always the temptation to maximize deductions on the current year tax return. But the best planning considers your current financial situation and your future plans and strives to reduce total lifetime taxes. 2022 is as good a time as any to do long-term planning.

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.

The Backdoor Roth IRA and December 31st

New Year’s Eve is an important day if you do a Backdoor Roth IRA. Read below to find out why.

The Backdoor Roth IRA

I’ve written before about the Backdoor Roth IRA. It is a two step process whereby those not qualifying for a regular Roth IRA contribution can qualify to get money into a Roth IRA. Done over several years, it can help taxpayers grow significant amounts of tax free wealth.

One of the best aspects of the Backdoor Roth IRA is that it does not forego a tax deduction. Most taxpayers ineligible to make a regular Roth IRA contribution are also ineligible to make a deductible traditional IRA contribution. In the vast majority of cases, the choice is between investing money in a taxable account versus investing in a Roth account. For most, a Roth is preferable, since Roths do not attract income taxes on the interest, dividends, and capital gains investments generate. 

The Basic Backdoor Roth IRA and the Form 8606

Let’s start with a fairly basic example. 

Example 1

Betsy, age 40, earns $300,000 from her W-2 job in 2021, is covered by a workplace 401(k) plan, and has some investment income. Betsy has no balance in a traditional IRA, SEP IRA, or SIMPLE IRA.

At this level of income, Betsy does not qualify for a regular Roth IRA contribution, and she does not qualify to deduct a traditional IRA contribution. 

Betsy contributes $6,000 to a traditional IRA on May 20, 2021. The contribution is nondeductible. Because the contribution is nondeductible, Betsy gets a $6,000 basis in her traditional IRA. Betsy must file a Form 8606 with her 2021 tax return to report the nondeductible contribution.

On June 5, 2021, Betsy converts the entire balance in the traditional IRA, $6,003, to a Roth IRA. As of December 31, 2021, Betsy has no balance in a traditional IRA, SEP IRA, or SIMPLE IRA.

Betsy has successfully executed a Backdoor Roth IRA. Here is what page 1 of the Form 8606 Betsy should file with her 2021 income tax return should look like. 

Notice here that I am using the 2020 version of the Form 8606 for this and all examples. The 2021 Form 8606 is not yet available as of this writing. 

The most important line of page 1 of the Form 8606 is line 6. Line 6 reports the fair market value of all traditional IRAs, SEP IRAs, and SIMPLE IRAs Betsy owns as of year-end. Because Betsy had no traditional IRAs, SEP IRAs, and SIMPLE IRAs as of December 31, 2021, her Backdoor Roth IRA works and is tax efficient. This important number ($0) on line 6 of the Form 8606 is what ensures Betsy’s Backdoor Roth IRA is tax efficient. 

Note that Betsy’s Backdoor Roth IRA creates an innocuous $3 of taxable income, which is reported on the top of part 2 of the Form 8606. 

The Pro-Rata Rule and December 31st

But what if Betsy did have a balance inside a traditional IRA, SEP IRA, or SIMPLE IRA on December 31, 2021? Would her Backdoor Roth IRA still be tax efficient? Probably not, due to the Pro-Rata Rule.

The Pro-Rata Rule tells us just how much of the basis in her traditional IRA Betsy can recover when she does the Roth conversion step of the Backdoor Roth IRA. Betsy’s $6,000 nondeductible traditional IRA creates $6,000 of basis. As we saw above, Betsy was able to recover 100 percent of her $6,000 of basis against her Roth conversion. 

But the Pro-Rata Rule says “not so fast” if Betsy has another traditional IRA, SEP IRA, or SIMPLE IRA on December 31st of the year of any Roth conversion. The Pro-Rata Rule allocates IRA Basis between converted amounts (in Betsy’s case, $6,003) and amounts in traditional IRAs, SEP IRAs, and SIMPLE IRAs on December 31st. Here’s an example. 

Example 2

Betsy, age 40, earns $300,000 from her W-2 job in 2021, is covered by a workplace 401(k) plan, and has some investment income. Betsy has no balance in a traditional IRA, SEP IRA, or SIMPLE IRA.

Betsy contributes $6,000 to a traditional IRA on May 20, 2021. The contribution is nondeductible. Because the contribution is nondeductible, Betsy gets a $6,000 basis in her traditional IRA. Betsy must file a Form 8606 with her 2021 tax return to report the nondeductible contribution.

On June 5, 2021, Betsy converts the entire balance in the traditional IRA, $6,003, to a Roth IRA. 

On September 1, 2021, Betsy transfers an old 401(k) from a previous employer 401(k) plan to a traditional IRA. On December 31st, that traditional IRA is worth $100,000. The old 401(k) had no after-tax contributions. 

This one 401(k)-to-IRA rollover transaction dramatically changes both the taxation of Betsy’s Backdoor Roth IRA and her 2021 Form 8606. Here’s page 1 of the Form 8606.

Line 6 of the Form 8606 now has $100,000 on it instead of $0. That $100,000 causes Betsy to recover only 5.67 percent of the $6,000 of basis she created by making a nondeductible contribution to the traditional IRA. As a result, $5,663 of the $6,003 transferred to the Roth IRA in the Roth conversion step is taxable to Betsy as ordinary income. At a 35% tax rate, the 401(k) to IRA rollover (a nontaxable transaction) cost Betsy $1,982 in federal income tax on her Backdoor Roth IRA. Ouch!

Quick Lesson: The lesson here is that prior to rolling over a 401(k) or other workplace plan to an IRA, taxpayers should consider the impact on any Backdoor Roth IRA planning already done and/or planned for the future. One possible planning alternative is to transfer old employer 401(k) accounts to current employer 401(k) plans.

There is an antidote to the Pro-Rata Rule when one has amounts in traditional IRAs, SEP IRAs, and SIMPLE IRAs. It is transferring the traditional IRA, SEP IRA, or SIMPLE IRA to a qualified plan (such as a 401(k) plan) before December 31st. Here is what that might look like in Betsy’s example. 

Example 3

Betsy, age 40, earns $300,000 from her W-2 job in 2021, is covered by a workplace 401(k) plan, and has some investment income. Betsy has no balance in a traditional IRA, SEP IRA, or SIMPLE IRA.

Betsy contributes $6,000 to a traditional IRA on May 20, 2021. The contribution is nondeductible. Because the contribution is nondeductible, Betsy gets a $6,000 basis in her traditional IRA. Betsy must file a Form 8606 with her 2021 tax return to report the nondeductible contribution.

On June 5, 2021, Betsy converts the entire balance in the traditional IRA, $6,003, to a Roth IRA. 

On September 1, 2021, Betsy transfers an old 401(k) from a previous employer to a traditional IRA. The old 401(k) had no after-tax contributions. 

On November 16, 2021, Betsy transfers the entire balance in this new traditional IRA to her current employer’s 401(k) plan in a direct trustee-to-trustee transfer. 

Here is Betsy’s 2021 Form 8606 (page 1) after all of these events:

Betsy got clean by December 31st, so her Backdoor Roth IRA now reverts to the optimized result (just $3 of taxable income) she obtained in Example 1. 

Pro-Rata Rule Clean Up

Implementation 

From a planning perspective, it is best to clean up old traditional IRAs/SEP IRAs/SIMPLE IRAs prior to, not after, executing the Roth conversion step of a Backdoor Roth IRA. I say that because things happen in life. There is absolutely no guarantee that those intending to roll amounts from IRAs to workplace qualified plans will get that accomplished by December 31st. 

Further, transfers from one retirement account to another are usually best done through a direct “trustee-to-trustee” transfer to minimize the risk that the money in the retirement account accidentally is distributed to the individual, causing potential tax and penalties. 

Before cleaning up old traditional IRAs, SEP IRAs, and SIMPLE IRAs, one should consider the investment choices and fees inside their employer retirement plan (such as a 401(k)). If the investment options are not good, and/or the fees are high, perhaps cleaning up an IRA to move money into less desirable investments is not worth it. This is a subjective judgment that must weigh the potential tax and investment benefits and drawbacks. 

Tax Issues

Amazingly enough, the Pro-Rata Rule is concerned with only one day: December 31st. A taxpayer can have a balance in a traditional IRA, SEP IRA, or SIMPLE IRA on any day other than December 31st, and it does not count for purposes of the Pro-Rata Rule. Perhaps December 31st should be called Pro-Rata Rule Day instead of New Year’s Eve. 😉

Betsy’s November 16th distribution from her traditional IRA to the 401(k) plan does not attract any of the basis created by the nondeductible traditional IRA contribution earlier in the year. This document provides a brief technical explanation of why rollovers to qualified plans do not reduce IRA basis. 

Extra care should be taken when cleaning up (a) large amounts in any type of IRA and (b) any SIMPLE IRA. While it is fairly obvious that significant sums should be moved only after considering all the relevant investment, tax, and execution issues, the SIMPLE IRA provides its own nuances. Any SIMPLE IRA cannot be rolled to an account other than a SIMPLE IRA within the SIMPLE IRA’s first two years of existence. Thus, SIMPLE IRAs must be appropriately aged before doing any sort of Backdoor Roth IRA clean up planning. 

Spouses are entirely separate for Pro-Rata Rule purposes, even in community property states. Cleaning up one spouse, or failing to clean up one spouse, has absolutely no impact on the taxation of the other spouse’s Backdoor Roth IRA.

Lastly, non spousal inherited IRAs do not factor into a taxpayer’s application of the Pro-Rata Rule. Each non spousal inherited IRA has its own separate, hermetically sealed Pro-Rata Rule calculation. The inheriting beneficiary does a Pro-Rata Rule calculation on all IRAs he/she owns as the original owner, separate from any inherited IRAs. In addition, non spousal inherited IRAs cannot be rolled into a 401(k).

Mega Backdoor Roth

Good news: the concerns addressed in this blog post generally do not apply with respect to the Mega Backdoor Roth (sometimes referred to as a Mega Backdoor Roth IRA, though a Roth IRA does not necessarily have to be involved). Qualified plans such as 401(k)s are not subject to the Pro-Rata Rule. 

While 401(k)s are not subject to the Pro-Rata Rule, amounts within a particular 401(k) plan’s after-tax 401(k) are subject to the “cream-in-the-coffee” rule I previously wrote about here. Thus, if there is growth on Mega Backdoor Roth contributions before they are moved out of the after-tax 401(k), generally speaking either the taxpayer must pay income tax on the growth (if moved to a Roth account) or the taxpayer can separately roll the growth to a traditional IRA (which could then create a rather small Pro-Rata Rule issue with future Backdoor Roth IRAs). Fortunately, the cream-in-the-coffee rule has a much narrower reach than the Pro-Rata Rule.

Backdoor Roth IRA Tax Return Reporting

Watch me discuss Backdoor Roth IRA tax return reporting.

Conclusion

Get your IRAs in order so you can enjoy New Year’s Eve! 

December 31st is an important date when it comes to Backdoor Roth IRA planning. It is important to plan to have no (or at a minimum, very small) balances in traditional IRAs, SEP IRAs, and SIMPLE IRAs on December 31st when planning Backdoor Roth IRAs. 

None of what is discussed in this blog post is advice for any particular taxpayer. Those working through Backdoor Roth IRA planning issues are often well advised to reach out to professional advisors regarding their own tax situation.

Further Reading

I did a blog post about Backdoor Roth IRA tax return reporting here.

I did a deep dive on the taxation of Roth IRA withdrawals here.

I did a deep dive on the Pro-Rata Rule here.

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

Follow me on Twitter: @SeanMoneyandTax

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

Tax Deductions for Individuals

Tax deductions can be a confusing topic considering the many types of tax deductions and the terminology for them. Below I explain the different types of tax deductions you can claim on your tax return. You may be taking several of these types without even knowing it.

Types of Individual Tax Deductions

Exclusions

Many things we think of tax deductions are not treated as tax deductions on a tax return. Instead, they are excluded from taxable income. An exclusion from taxable income has the exact same effect as a tax deduction.

The most common exclusion is the exclusion for employer provided benefits, including health insurance, retirement plan contributions, and health savings accounts contributions. Here is an example:

Example: Mark has a salary of $100,000. He contributes ten percent ($10,000) of his salary to his employer’s 401(k) plan. His W-2 for the year will report wages of $90,000, not $100,000, and he will enter $90,000 as wages on his Form 1040. The $10,000 Mark contributed to his 401(k) is excluded from his gross income. This exclusion has the same income tax effect as a deduction.

Exclusions are a great form of deduction in that they are generally unlimited on your tax return, though they may have their own limitations. For example, in 2021 the most an employee under age 50 can exclude for contributions to a 401(k), 403(b), or a 457 is $19,500.

For those at least 70 1/2 years old, the qualified charitable distribution (“QCD”), which I wrote about here, can be a great tax planning technique. 

Exclusions also reduce adjusted gross income (“AGI”). Items that reduce AGI are great because AGI (or modified AGI, “MAGI”) is usually the measuring stick for whether a taxpayer qualifies for many tax benefits (such as eligibility for making a deductible contribution to an IRA or making a contribution to a Roth IRA). Lowering AGI is an important tax planning objective, since lower AGI opens the door to several tax benefits. 

Business Deductions

Business deductions include trade or business deductions generated from self-employment and investments in partnerships and rental property. On a Form 1040, these deductions are reported on Schedule C or Schedule E. Business deductions include salaries, rent, depreciation (deducting the cost of a business asset over a useful life), and other ordinary and necessary expenses.

Business deductions are generally great tax deductions because they are subject to relatively few limitations on your tax return. That said, limitations such as the passive activity loss rules and the at-risk limitations can limit a taxpayer’s ability to claim some business losses. Further, business deductions reduce not only income tax but also self-employment income, and thus, self-employment tax.

Business deductions are also valuable because they reduce AGI.

“For AGI” or “Above the Line” Deductions

On your Form 1040 you deduct certain expenses from your gross income to determine your AGI. Prior to tax returns filed for 2018 and later, these deductions were at the bottom of page 1 of the Form 1040. Starting with tax returns for 2018, these deductions are presented on Schedule 1 which accompanies Form 1040.

Examples of these deductions include one-half of self-employment tax paid by self-employed individuals, deductible contributions to IRAs, and contributions to certain self-employed retirement plans.  

Capital losses, generally up to $3,000 on any one tax return, can be deducted for computing AGI. Capital losses in excess of $3,000 are carried over to future tax years to be deducted against capital gains and against up to $3,000 per year of ordinary income. 

Health Savings Accounts (“HSAs”) are their own special breed. If contributions to an HSA are made through workplace payroll withholding, they are excluded from taxable income. If contributions to an HSA are made through another means (such as a check or wire transfer to the HSA), the contributions are for AGI deductions reported on Schedule 1. Which is better? From an income tax perspective, there is no difference. But from a payroll tax perspective, using payroll withholding is the clear winner. Amounts contributed to an HSA through payroll withholding are not subject to the FICA tax, creating another HSA tax win!

Standard Deduction or Itemized Deductions

Tax reform changed the landscape of itemized deductions. As a result of the tax reform bill enacted in December 2017, far fewer taxpayers will claim itemized deductions, and will instead claim the standard deduction.

The most common itemized deductions are state and local taxes (income, property, and in some cases, sales taxes), charitable contributions, and mortgage interest.

Taxpayers generally itemize if the sum total of itemized deductions (reported on Schedule A) exceed the standard deduction. Tax reform did two things to increase the chance that the standard deduction will exceed a taxpayer’s itemized deductions. First, the amount of the standard deduction increased. It went from $6,350 for single taxpayers in 2017 to $12,000 for single taxpayers in 2018. For married filing joint taxpayers, the standard deduction went from $12,700 in 2017 to $24,000 in 2018.

The standard deduction for 2021 is $12,550 (single) and $25,100 (MFJ) for most taxpayers. 

In addition, several itemized deductions were significantly reduced. For example, starting in 2018 there is a deduction cap of $10,000 per tax return ($5,000 for married filing separate tax returns) for state and local taxes. This hits married taxpayers particularly hard and increases the chance that if you are married filing joint you will claim the standard deduction, since you will need over $15,100 in other itemized deductions to itemize (using the 2021 numbers).

In addition, miscellaneous deductions, such as unreimbursed employee expenses and tax return preparation fees, were eliminated as part of tax reform.

Thus, many taxpayers will find that they will often claim the standard deduction. As discussed below, there will be planning opportunities for taxpayers to essentially push many itemized deductions (such as charitable contributions) into one particular tax year, itemize for that year, and then claim the standard deduction for the next several years.

Neither the standard deduction nor itemized deductions reduce AGI.

Special Deductions

In a relatively new development in tax law, there are now deductions that apply only after AGI has been determined and separate and apart from the standard deduction or itemized deductions. 

QBI Deduction

Tax reform created an entirely new tax deduction: the qualified business income deduction (also known as the QBI deduction or the Section 199A deduction). I have written about the QBI deduction here and here. Subject to certain limitations, taxpayers can claim, as a deduction, 20 percent of qualified business income, which is generally income from domestic business activities (not wage income), income from publicly-traded partnerships, and qualified REIT (real estate investment trust) dividends.

The QBI deduction does not reduce AGI.

Taxpayers can claim the QBI deduction regardless of whether they elect itemized deductions or the standard deduction.

Special Deduction for Charitable Contributions

For the 2021 tax year, taxpayers who do not claim itemized deductions are eligible for a special deduction for charitable contributions. The deduction is limited to $300 for single filers and $600 for MFJ filers.

As discussed by Jeffrey Levine, this deduction, like the QBI deduction, neither reduces AGI nor is an itemized deduction. 

The statutory language for this new deduction is found at Section 170(p). I believe that there is a very good chance that this deduction is extended to years beyond 2021, though as of now, it is only applicable to the 2021 tax year. 

Planning

Tax deductions provide a great opportunity for impactful tax planning. Here are some examples.

Timing

If your marginal income tax rate is the same every year, then you generally want to accelerate deductions. Thus, if you have a sole proprietorship and are a cash basis taxpayer, you are generally better off paying rent due on January 1, 2022 on December 31, 2021 instead of January 1, 2022 since the deduction saves the same amount of tax regardless of which tax year you pay it, but you’ll get the cash tax benefit sooner – on your 2021 income tax return instead of on your 2022 income tax return.

But there can be situations where you anticipate that your marginal tax rate will be greater next year than this year. In those cases, it makes sense to delay deductions. For example, perhaps you would make a large charitable contribution next year instead of before the end of the current year. Or, in the above example, you would pay the rent on January 1, 2022 to ensure the deduction is in 2022 instead of 2021.

Bunching

For some taxpayers, it may make sense to bunch deductions to maximize the total benefit of itemizing deductions versus claiming the standard deduction over several years. My favorite example of this is the donor advised fund. I’m not alone in my fondness of the donor advised fund. It allows you to contribute to a fund in one year, claim a charitable deduction for the entire amount of the contribution, and then donate from that fund to charities in subsequent years. The big advantage is that you get an enhanced upfront deduction in the first year and then claim the standard deduction in several subsequent years. This strategy only works if the amount of the deduction for the contribution to the donor advised fund is sufficient such that your itemized deductions in the year of the contribution exceed the standard deduction by a healthy amount.

Deadlines, Deadlines, Deadlines!!!

Different deductions have different deadlines. Many deductions have December 31st deadlines, so it is important to make the contribution by year-end. For charitable contributions, it is best to make the contribution online with a credit or debit card before January 1st if you are running really late, though if you place the contribution in a U.S. Postal Service mailbox prior to January 1st that counts as prior to the near year (though it makes it harder to prove you beat the deadline if you drop it in the mailbox on December 31st).

For employee contributions to a 401(k), the deadline is December 31st. Thus, if you are reading this on December 5th and you want to significantly increase your 401(k) contribution for 2021, you ought to get in touch with your payroll administrator and increase your contribution rate for your last paycheck ASAP.

By contrast, the deadline for a 2021 contribution to a deductible IRA or a non-payroll 2021 contribution to a HSA is April 15, 2022 (the date tax returns are due).

Self-employed retirement plans have their own sets of deadlines that should be considered.

Conclusion

Tax deductions present several important tax planning considerations. These considerations should include the taxpayer’s current marginal tax rate and future marginal tax rate. They should also include consideration of maximizing the combination of itemized deductions and the standard deduction over multiple taxable years.

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.

Sean Discusses Tax Planning on the ChooseFI Podcast

I was honored to discuss using tax returns as a springboard to tax planning on a recent episode of the ChooseFI podcast. Click here for the episode website.

During the conversation we referenced this blog post.

As always, the discussion is general and educational in nature and does not constitute tax, investment, legal, or financial advice with respect to any particular individual or taxpayer. Please consult your own advisors regarding your own unique situation. Sean Mullaney and ChooseFI Publishing are currently under contract to publish a book authored by Sean Mullaney.

FI Tax Guy can be your financial advisor! 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. 

Sean on the Earn & Invest Podcast

Really enjoyed this year-end tax planning conversation with Doc G on the Earn & Invest podcast. Stay tuned to the end for some candid behind the scenes podcast recording.

https://www.earnandinvest.com/episodes-2/year-end-tax-moves-that-count

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

Follow me on Twitter: @SeanMoneyandTax

This post (and this podcast episode) 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. 

Roth Conversions for the Self-Employed

Are you self-employed? Is your self-employment income your primary source of income? If so, you might want to consider doing a Roth conversion before the end of the year.

Takeaways

  • If most of your taxable income is self-employment income (either reported on Schedule C or from a partnership), you might want to consider year-end Roth conversions to maximize your QBI deduction and pay a lower-than-expected federal income tax rate on the conversion.
  • To optimize this strategy, convert traditional IRAs to Roth IRAs (or do in-plan traditional 401(k) to Roth 401(k) conversions) to increase your QBI deduction. 

Why? Because of the still relatively new qualified business income (“QBI”) deduction (also known as the Section 199A deduction). 

QBI Deduction and Initial Limitation

Starting in 2018, there is a deduction for “qualified business income.” This is generally income from a qualified trade or business received from a sole proprietorship (and reported on Schedule C), from a partnership, or from a S Corporation (in these cases, generally reported to the taxpayer on a Form K-1 and reported on the Schedule E with the tax return). 

Important for this purpose is the initial limit on the QBI deduction. It is the lesser of following two amounts:

  1. 20 percent of taxable income less “net capital gain” which is generally capital gains plus qualified dividend income (“QDI”) (the “Income Limit”) or
  2. 20 percent of QBI (the “QBI Limit”).

As a practical matter, in most cases the limit will be determined by the second limitation (such taxpayers are what I call “QBI Limited”). Many taxpayers will have much more taxable income than they have QBI. Consider spouses where one has self-employment income and the other has W-2 income. Unless the W-2 income is very small, their combined taxable income is likely to be in excess of their combined QBI, and thus they will be QBI Limited.

Alternatively, consider a situation where a single person has QBI from an S corporation (say $50,000) and the S corporation also pays him or her a W-2 salary (say $60,000). In such a case the QBI is $50,000 (20% of which is $10,000) and the taxable income might be $97,450 ($110,000 total from the S corporation less a $12,550 standard deduction), 20% of which is $19,490. This taxpayer would also be QBI Limited. 

Income Limited

But what if you are not QBI Limited, but rather, limited by the Income Limit listed above (what I call “Income Limited”)? Here is an illustrative example.

Example 1: Seth is single and self-employed. He claims the standard deduction in 2021. He reports a business profit of $100,000 on his Schedule C. He also has $1,000 of interest income.

His Income Limit is computed as follows:

Schedule C Income: $100,000

Interest Income: $1,000

Deduction for ½ Self-Employment Taxes: ($7,065)

Standard Deduction: ($12,550)

Taxable Income: $81,385

20% Limit: $16,277

Seth’s QBI Limit is computed as follows:

Schedule C Income: $100,000

Deduction for ½ Self-Employment Taxes: ($7,065)

QBI: $92,935

20% Limit: $18,587

In this case, Seth’s QBI deduction is only $16,277 (he is Income Limited), the lesser of these two calculated limits. 

Roth Conversion Planning

Is there anything Seth can do to increase his limitation and optimize his QBI deduction?

Imagine Seth has $20,000 in a traditional IRA (with zero basis). He could convert some of that traditional IRA to a Roth IRA by December 31, 2021. This would create taxable income, which would increase Seth’s Income Limit. Here is how that could play out:

Without Roth Conversion

Schedule C Income$ 100,000
Interest Income$ 1,000
Deduction for ½ Self-Employment Taxes$ (7,065)
Adjusted Gross Income$ 93,935
Standard Deduction$ (12,550)
Qualified Business Income Deduction (see above)$ (16,277)
Taxable Income$ 65,108
Federal Income Tax$ 10,072

With Roth Conversion

Schedule C Income$ 100,000
Interest Income$ 1,000
Deduction for ½ Self-Employment Taxes$ (7,065)
Roth IRA Conversion$ 11,550
Adjusted Gross Income$ 105,485
Standard Deduction$ (12,550)
Qualified Business Income Deduction$ (18,587)
Taxable Income$ 74,348
Federal Income Tax$ 12,105

What has the $11,550 Roth IRA conversion done? First, it has made the Income Limit ($18,587) the exact same as the QBI Limit ($18,587). Thus, Seth’s QBI deduction increases from $16,227 to $18,587. 

Second, notice that Seth’s taxable income has increased, but not by $11,550! Usually one would expect that a Roth IRA conversion with no basis recovery would simply increase taxable income by the amount converted. But not here! The interaction with the QBI deduction caused Seth’s taxable income to increase only $9,240 ($74,348 minus $65,108). 

This example illustrates that, under the right circumstances, a Roth IRA conversion can receive the benefit of the QBI deduction!

As a result, at Seth’s 22 percent marginal federal income tax bracket, his total federal income tax increased only $2,033. In effect, Seth pays only a 17.6 percent rate on his Roth IRA conversion ($2,033 of federal income tax on a $11,550 Roth IRA conversion). This is true even though Seth is in the 22 percent marginal tax bracket. His Roth IRA conversion is only 80 percent taxable. This is the flip-side of the 80% deduction phenomenon I previously blogged about here. 

Is it advantageous for Seth to convert his traditional IRA? Well, it depends on Seth’s expected future tax rates. If Seth’s future marginal tax bracket is anticipated to be 22 percent, then absolutely. Why not convert at a 17.6 percent instead of face a 22 percent rate on future traditional IRA withdrawals?

Strategy

Seth’s Roth IRA conversion is optimized. The takeaway is that the Roth IRA conversion gets the benefit of the QBI deduction, but only for amounts that increase the Income Limit up to the QBI Limit.

A *very general* rule of thumb for solving for the optimal Roth conversion amount is to multiply the difference between the QBI Limit and the Income Limit (without a Roth conversion) by 5. In Seth’s case, that was $18,587 minus $16,277 (which equals $2,310) times 5.

In this case, converting exactly $11,550 made Seth’s Income Limit exactly equal his QBI Limit. As long as the Roth conversion increases the Income Limit toward the QBI Limit, the conversion benefits from the QBI deduction.

But the first dollar of the Roth conversion that pushes the Income Limit above the QBI Limit does not receive the benefit. If Seth converted $11,551 from his traditional IRA to his Roth IRA, that last dollar above $11,550 would be taxed at Seth’s full 22 percent federal marginal tax bracket. 

Note that instead of / in addition to a Roth IRA conversion, Seth could do an in-plan traditional 401(k) to Roth 401(k) conversion, if he had sufficient funds in a traditional 401(k), and the 401(k) plan permits Roth 401(k) conversions.

Also note that the strategic considerations with QBI deductions become much more complicated once taxpayers exceed the initial QBI taxable income limitations (in 2021, those are $164,900 for single taxpayers and $329,800 for married filing joint taxpayers). 

Conclusion

Taxpayers whose taxable income consists mostly or exclusively of self-employment income should consider Roth conversions toward year-end. This is often an area that benefits from consulting with a professional tax advisor before taking action.

Further Reading

I have blogged about the QBI deduction and retirement plans here. After the IRS and Treasury provided some QBI deduction regulations in January 2019, I provided some QBI deduction examples and lessons here. 

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, 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. 

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.

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