I knew I was off track when my 21-year-old daughter asked me, “Dad, how much do I get in taxes?” She was either being cheeky, pointing out that I’d failed to teach her about taxes, or both.  Then a week later, she drove it home with a meme picturing a young woman wondering: 

“I don’t get why people think taxes are hard… Step 1: Get your tax forms. Step 2: Give them to your dad.”

This tax season was good for an introspective dad laugh, but it occurs to me that I’m not the first parent who struggled to teach a basic level of tax understanding to his kids. 

If you’ve ever tried teaching your teenager anything that doesn’t come with a dopamine rush, you know the challenge. But like certain other facts of life, you probably don’t want your kid to learn all they know about taxes from things they see on their phone… So,  here’s a short guide for helping your teen understand taxes without over-going their attention span.

Phase 1: Reassurance

The first thing teens should hear is: “You’re not going to jail and we’ll help you.”

Let them know that you’ll help them navigate taxes until they’re ready to handle it themselves. This removes some of the fear because you’ll fly on their wing until they’re ready to solo. 

Phase 2: Taxes For Teenagers 101

Uncle Sam requires us to pay what we owe, no more, no less.  Some adults take a lot of risk trying to min-run their income reporting.  Others run out of time and interest, and they miss legitimate opportunities to suppress their tax bill.  The goal should be to pay just the right amount each month to avoid a big bill or big refund at tax filing time (April 15th). 

In addition to paying what we owe, we need to pay on time throughout the calendar year. Most of the time, our employers help us with this, but it’s ultimately our responsibility to determine and pay the correct amount. There are great free tools, such as calculators at https://www.dinkytown.net/, that can help “pre-game” the tax picture without a PhD in taxes. 

Phase  3: Name That Tax

Teens already know about sales tax from their purchases. But once they start working, they’ll see new taxes come out of their paycheck. Here are the big ones: 

Income Tax: Pays for things like roads, schools, and fighter jets.

FICA Tax: This includes Social Security and Medicare taxes. You might call it a “geezer tax”  because it pays (some) income and (some) medical expenses for the aged. (It also pays these to the poor and disabled.)

Self-Employment Tax: This is really just FICA tax times 2 since you need to pay both the employer share and your own share when you earn money from things like babysitting, lawnmowing and dog walking. 

You don’t need to overwhelm them with all the obscure taxes—like excise taxes or the details of inheritance taxes—but they should understand the ones that show up on their pay stub.

Phase 4: Tax Filing

Taxes tend to be in the background most of the year, then we start to get forms from our employers in January-February. We need to either use a software tool (free to cheap) for DIY’ers, a free service (often available to the military and low-income taxpayers), or a paid professional. 

Generally, taxes need to be filed by 15 April each year. You can always file a simple form to get a 6-month extension, but you’re still supposed pay what you owe by 15 April. “But Dad… how do I know what I owe?”  

Teens and young adults often don’t earn above the standard deduction, so it’s common that they don’t need to file, or they just get a refund of any income tax (not FICA) withholding. 

Phase 5: Don’t Embrace the Refund

Tax refund culture might as well be payday loan and credit-score-worship culture. Each tax season, advertisers glorify all the spending you can do with your tax refund. This teaches our kids that they should give Uncle Sam a negative-interest loan so they can splurge on widgets with a tax refund. 

We’re better off teaching them that while we don’t want to stroke a big check on April 15th, hoping for a refund is mismanagement. Writing Uncle Sam a check (or sending him an ACH… since our kids may not know what checks are) for one dollar is the best-case scenario. 

Cleared to Rejoin

Taxes scare most adults. While our tax situations are often more complicated than taxes for teenagers, our kids need us to teach this fact of life too. As soon as they start earning, it’s time to help them understand their pay stub and file their first return.  Want to find an advisor who could help help you navigate taxes and help with some intro to taxes for your kids?  Check out the MFAA Advisors here. Tax-savvy kids are on their way to being financially healthy adults!

Fight’s On!

The Million Dollar TSP

Are you approaching or reached a million dollars in your Thrift Savings Plan (TSP)?  Congratulations!  More than likely, your retirement goal is now funded.  If the entire account is allocated to pretax retirement savings, it’s time to speak with an advisor to do some tax planning.  There are several strategies that can be utilized to reduce the income taxes you will pay over your lifetime.

Meet John and Lisa, an active duty service member and a government employee wanting to retire in their 50’s.  Both are what we like to call super savers; for years they have been maxing out their TSP contributions and their IRA contributions.  In addition, they invested in non-retirement accounts every year.

Roth vs Pretax Contributions

At this point in John and Lisa’s career, their salaries are nearing the career peak.  They are in a higher tax bracket than they were a few years ago and because of that had defaulted to making pretax contributions to the TSP.

We analyzed the income taxes they are paying while working vs projected income taxes in retirement.  Based on that analysis, we determined that pretax contributions were only reducing the annual tax bill by a small amount.  Changing to Roth TSP contributions increases current income taxes modestly but significantly reduces lifetime income taxes.

Retirement Income Plan

Beginning to withdraw 4-6% of the balance in the pretax retirement savings, as soon as they retire, can help to reduce required minimum distributions in the future.  This strategy will not only fund spending needs in retirement but will also reduce their lifetime tax burden.

Roth conversions

For those that want to leave a tax friendly estate to their heirs or are married, beginning to convert some of the pretax retirement savings to Roth can significantly reduce the lifetime tax burden.

Since John and Lisa are married, inheritance of the retirement plan in the event of one spouse’s death must be considered.  Doubling the amount of pretax retirement savings and moving to a higher tax bracket because of the death of the spouse, will significantly increase income taxes for the surviving spouse.  We analyzed how much more income they could realize and stay in the same tax bracket.  We convert this amount each year to a Roth so that the future growth of the assets converted will be income tax free.

Gifts To Charity

Giving back to the community is a priority for Lisa and John.  They make significant charitable gifts each year.  Unfortunately, cash gifts to charity, do not give as much of a tax break as they had in the past.

Lisa and John have some individual stocks that are carrying large capital gains.  We recommended that they gift shares of these stocks to a donor advised fund instead of making cash gifts to the charity.  The charity will still receive their gift, Lisa and John will take the same income tax deduction and as an added benefit, avoid realized capital gains from the sale of their stocks.

Once Lisa and John turn 70, we plan to make the charitable gifts from their pretax retirement accounts.  This will provide a larger tax deduction than making gifts from income or non-retirement savings.  These qualified charitable distributions will also will count towards meeting the required minimum distributions.

Benefits of Tax Planning

These combined strategies have the potential to save over $2,000,000 in lifetime taxes for Lisa and John.  More importantly, it will enable them to retire in their early 50’s and start living the life they have always wanted to live.

If you’re ready to explore how you save on your lifetime income taxes, the MFAA advisors can help.  Find the profiles here.

Military Veterans often face changing financial situations, from untaxed benefits and combat zone tax exclusions to special bonuses and, finally, the transition to retirement or a civilian career. As a result, taxes from one year to the next can look drastically different and Veterans should be proactive with their tax planning. Here are six essential tax moves for veterans to consider in 2025.

1. Regularly Update Tax Projections

Tax liabilities can fluctuate based on changes in taxable income, household status, and spouse employment or small business earnings. Staying proactive with tax projections helps avoid surprises and enables strategic financial planning. Many tax moves must be completed during a given calendar year and accurate tax projections are essential information to make decisions. A common mistake for veterans is withholding far too little or far too much from their paycheck for taxes. This can result in overly large tax refunds or tax payments that break the budget at tax filing time.

Why It Matters:

• Prevents penalties for underpayment of estimated taxes.
• Identifies if paycheck tax withholding is insufficient.
• Improves budgeting and cash flow management.
• Facilitates informed decisions about major expenses or investments.
• Enables informed decision-making.

Action Step: Develop tax projections for the year and update them whenever you experience major changes in taxable income. I generally develop these tax projections twice per year for clients, once in May and once in November or December`.

2. Switch Pre-Tax TSP Contributions to Roth Contributions if You Earn a Combat Zone Tax Exclusion

If you’re earning a combat zone tax exclusion for part of the year, switching your Thrift Savings Plan (TSP) contributions to Roth can be an effective move. The reduction in taxable income due to the deployment will likely decrease your marginal tax rate for the year, making pre-tax contributions less effective. Contributions made to a Roth TSP while in a combat zone grow tax-free and are withdrawn tax-free in retirement.

Why It Matters:

• Maximizes the tax-free growth potential of your combat zone income.
• Ensures you benefit fully from the unique tax advantages of the exclusion.
• Provides long-term savings flexibility and tax diversification.

Action Step: If you have a scheduled deployment to a combat zone or are in a combat zone, change your TSP contributions to Roth contributions.

3. Switch to Pre-Tax TSP Contributions if You Are Expecting a Retention Bonus

If you’re anticipating a retention bonus in 2025, you may move into a higher tax bracket for the year. Switching to pre-tax contributions in your Thrift Savings Plan (TSP) can help you earn tax deductions at the temporarily higher marginal tax rate.

Why It Matters:

• Reduces your taxable income in the year you receive the bonus.
• Maximizes the immediate financial impact of the retention bonus.
• Gives you the opportunity to convert these contributions to Roth status at a lower tax rate in the future.

Action Step: Login to the TSP website and switch Roth contributions to Pre-tax/traditional. Ensure the pre-tax contributions align with your income projections and overall retirement strategy.

4. Take Advantage of Roth IRA Opportunities

Roth IRAs provide tax-free growth and withdrawals in retirement, making them a valuable option for veterans who meet income eligibility requirements. Additionally, contributions to Roth IRAs can be withdrawn at any time without taxes or penalties. Again, that applies to contributions only. This benefit is unique to Roth IRAs and means that contributions are not “locked up.” Contributions for 2024 can be made until April 2025, offering additional flexibility.

If you are regularly contributing to a traditional IRA, check the rules on the deductibility of those contributions. Often, veterans with access to TSP or another 401K may find that they earn too much income to receive a tax deduction for traditional IRA contributions.

Key Details:

• Income Limits for 2025: Single filers earning up to $150,000 can make full contributions, with a phase-out up to $165,000. Married filers’ phase-out range is $236,000 to $246,000.
• Earned Income Requirement: To contribute to a Roth IRA, at least one spouse must have earned income for the year, such as wages, salaries, or self-employment income. This rule allows both spouses to contribute, even if one has no earnings, provided the total earned income meets the contribution limits.
• 2024 Contribution Deadline: April 15, 2025.
• 2025 Contribution Deadline: April 15, 2026.

Action Step: Determine your eligibility and contribute to a Roth IRA. If your income exceeds the limits, explore a backdoor Roth IRA contribution. If you need to make a backdoor Roth contribution, work with a financial planner or tax adviser to ensure you don’t run into any tax surprises.

5. Utilize Tax Loss Harvesting

If you have investments in taxable brokerage accounts, tax-loss harvesting can offset capital gains and reduce taxable income.

Why It Matters:

• Offset capital gains realized during the calendar year.
• If realized capital losses exceed realized capital gains, you can reduce your other taxable income by up to $3,000 per calendar year.
• Net losses beyond $3,000 can be carried forward into future years.

Action Step: Review your portfolio before year-end. Identify opportunities to sell underperforming assets while maintaining your long-term investment strategy. Always consider your marginal tax rate as part of this decision. Tax loss harvesting at a low marginal tax rate may be relatively ineffective at reducing your lifetime tax liability.

6. Leverage Tax Gain Harvesting

Veterans with lower incomes in 2025 may qualify for the 0% federal long-term capital gains tax bracket. This means you can sell appreciated assets without incurring federal taxes on the gains, providing a valuable opportunity to reset your cost basis and optimize your portfolio.

How Long-Term Capital Gains Work:

• Long-term capital gains apply to investments held for more than one year before being sold.
• For 2025, the 0% tax bracket applies to single filers with taxable income up to $48,350 and married filers with taxable income up to $96,700.
• Gains beyond these thresholds are taxed at 15% or 20%, depending on your income level.

Why It Matters:

• Realizes gains tax-free at the federal level for those in the 0% bracket.
• Resets the cost basis, lowering future tax liabilities.

Special Opportunity for Veterans: This strategy is particularly beneficial for veterans who deploy to a combat zone during the year. Combat zone tax exclusions often lower taxable income significantly, making it easier to qualify for the 0% long-term capital gains bracket.

Action Step: Complete your tax projections before the end of the calendar year to determine if you will fall into the 0% bracket. If you do, sell assets at a gain without crossing into the 15% tax bracket.

Note that this strategy applies to federal taxes and is most beneficial for veterans who have tax residency in a state without income taxes or do not tax any income earned by active duty service members. Most states with income taxes also tax capital gains.

Final Thoughts

For military veterans, proactive tax planning is an essential part of building a secure financial future. Implementing these strategies in 2025 can help reduce your tax burden either in 2025 or over the course of your life.

The critical step in each case is to develop tax projections to facilitate these tax moves.  MFAA members are financial planners who works with military and veterans and can help with your tax moves and many other financial planning issues.  Click here to get started.

Note: This post provides information accurate as of the date of publication and is provided for educational purposes. For personalized advice, consult with your own tax advisor.

Tax Planning Tips

Tax planning is crucial for small business owners, individuals making money selling things online and anyone earning income from a side hustle. The profit from these activities is considered taxable income and there are steps that you can take now to ensure a smooth tax season. Here are a few tips to get you started:

1. Start tracking your income and expenses – Utilize software programs or spreadsheets to help you stay organized.
2. Make quarterly tax payments – Quarterly payments, also known as estimated tax payments, are payments made by individuals or businesses to the Internal Revenue Service (IRS) on a quarterly basis to cover their tax liabilities. These payments are typically required when taxpayers do not have taxes withheld from their income through regular paycheck withholdings. Every state has different requirements so check your individual state to determine if you need to make payments to your state.
3. Track your mileage – Use an app or a good old-fashioned notebook to track your miles for work. Not sure if this applies to you? The IRS provides guidelines on who can deduct mileage or vehicle expenses for work here.
4. Open a retirement plan – Consider options like a SEP IRA or Individual 401(k) to reduce your tax burden and save for the future! Need help? Reach out to one of our MFAA advisors to help you put a plan in place.

Lastly, if you’re self-employed or have income from a side hustle, you may receive various forms such as 1099-NEC, 1099-MISC, and 1099-K. The remainder of this blog will focus on Form 1099-K and the upcoming changes implemented by the IRS.

Decoding Form 1099-K

The reporting threshold for third-party settlement organizations, which include payment apps (e.g., Zelle, Venmo, CashApp) and online marketplaces (e.g., eBay, Etsy, Facebook Marketplace), was changed to $600 by the American Rescue Plan Act of 2021. This act mandated that all third-party settlement organizations report payments of more than $600 for the sale of goods and services on a Form 1099-K starting in 2022. These forms would be submitted to the Internal Revenue Service (IRS) and provided to taxpayers to assist them in completing their tax returns. Prior to the American Rescue Plan, the reporting requirement applied only to the sale of goods and services involving more than 200 transactions per year, totaling over $20,000.

The implementation of this requirement has been delayed but the IRS has taken steps in 2023 and 2024 to begin phasing in this threshold (currently $5,000 for 2024).

Now that you are thoroughly asleep, let’s dive into how this might apply to you. 

What’s Taxable?

Any profit from the activities described above would be considered taxable income. For instance, if you bought a Tickle Me Elmo at the start of 1996 for $30 and sold it for $1,500 in December, the difference would be considered taxable income. However, if you sold it for $25, there would be no taxable income.

What’s NOT Taxable?

According to the IRS, “You shouldn’t receive a Form 1099-K for personal payments, including money received as a gift and for repayment of shared expenses.” This money wouldn’t be considered taxable, but that doesn’t mean you won’t accidentally receive a 1099-K! Good recordkeeping will prevent any frustration during tax season. Ensure you mark those payments as personal on third-party systems whenever possible.

Help! I Received a 1099-K and I Shouldn’t Have

Unfortunately, neither the IRS nor your tax preparer can correct your incorrect 1099-K. You’ll need to contact the issuer to rectify the error. They will need to issue you a 1099-K with a zero amount.

I Received a 1099-K But It’s Wrong

Your best course of action is to have the issuer send you a correct form. This is also not something the IRS or your tax preparer can do for you. To quote our favorite agency, “Don’t contact the IRS. We can’t correct your Form 1099-K.”

Keep in mind that tax laws and regulations may change over time. For personalized advice tailored to your specific circumstances, it’s always wise to consult with a qualified tax advisor.  Many of the MFAA advisors are tax planning experts, you can find them here..

Many military members and Veterans are venturing into business ownership these days. In fact, 5.5% of business owners in the U.S. were Veterans in 2024. With business ownership comes a host of important and complex decisions. One of which is what entity type to select.

Most businesses start as Limited Liability Companies (LLCs). As the business grows in employee headcount and revenue, it is important to re-assess your entity structure to ensure that it aligns with your personal and business goals. One of those decisions that a successful LLC owner may come up against is the decision to make an S Corporation (or “S Corp”) election.

The goal of this article is to demystify S Corp elections and empower business owners to make informed decisions about the direction of their business.

Why Should You Care About S Corp Elections?

The main reason behind making an S Corporation election is to lower your tax bill. Specifically, we are talking about self-employment taxes. The self employment taxes consist of a 12.4% social security tax up to the first $176,100 in profit in 2025 and a 2.9% Medicare tax on all income. This amounts to a 15.3% tax on the first $176,100 in profit. These profits are also subject to Federal and State tax, so the total tax bill can add up quickly.

Many business owners are confused about exactly when it makes the most sense to elect S Corporation status. Choosing the right time to make this election can save or cost thousands or tens of thousands of income tax.

What Is an S Corp Election?

An S Corp election is a tax status that lets your business profits flow directly to your personal tax return, avoiding double taxation. To be eligible for an S Corporation, you must be U.S. based, have fewer than 100 shareholders, and have a single class of stock.

How this works is you pay yourself a reasonable salary on payroll, and then the excess profit flows to your return to be taxed at Federal and State levels, bypassing any self employment taxes.

For example, if a business owner has a profit of $100,000, the self employment tax on a simple single member LLC will be $15,300. However, if that business owner elects S Corporation status and pays themselves a reasonable salary of $50,000, the self employment taxes will be $7,650, which would save the business owner $7,650 in tax.

Who Should Consider an S Corp Election?

An S Corporation election is going to be most beneficial for small business owners that make a significant profit, usually defined as $50,000 to $100,000 and higher. It is not going to be best for those who have a side gig that may make profit one year and not the next, or for those with more complex ownership structures that require several different classes of stock and might be better suited by a C Corporation.

How to Make an S Corp Election

Here are the steps to file an S Corporation Election:

1. File IRS Form 2553 by March 15 or within 75 days of forming your business.

2. Set up payroll to pay yourself a reasonable salary. The definition of “reasonable salary” is not well defined by the IRS but should be reasonable if you were to get audited.

3. Update your bookkeeping, tax, and payroll practices. This includes keeping tight bookkeeping in a software like QuickBooks, filing an S Corporation return, and running payroll. This will all increase your administrative costs from a few hundred to few thousand dollars per year.

With these changes, you can expect more administrative burden, cost, and compliance concerns around paying yourself a reasonable salary. The S Corporation structure is certainly more complex than a simple Sole Proprietor, but the payoff can be well worth it in the right situation.

How Will This Benefit Your Business?

The primary benefit of making an S Corporation Election is lower self employment, otherwise known as payroll taxes. As discussed at the top of the article, this happens by lowering the amount of income coming to you in wages which is double taxed by both halves of the 6.2% Social Security tax and 1.45% Medicare tax for a total tax’s of 15.3% on the wage base of $176,100 in 2025. So instead of your entire pay being subject to payroll taxes, only the amount paid to you as a reasonable salary will be taxed at that 15.3% rate. The rest will come to you as an owner’s distribution to be taxed solely at your federal and state income tax rates.

Common Mistakes and How to Avoid Them

Making an S Corporation election is not without risk and mistakes, but with some planning and foresight you should be able to avoid these. The main mistake would be paying yourself an unreasonably low salary, thereby minimizing the percentage of your income that is subject to Social Security and Medicare taxes. If the IRS finds this in an audit and can be extremely costly in penalties.

Another mistake would be choosing S Corp status before your business is consistently profitable. If your business turns extraordinarily little in profit or even loses money, you will not be able to reap the benefits of taking owner’s distributions as your entire profit will go to paying your salary or paying business expenses. This results in you unnecessarily paying hundreds to thousands of dollars in payroll, tax preparation, and compliance costs.

Avoiding these mistakes is completely attainable. Here are three simple steps you can take:

1. Consult a financial advisor and/or trusted tax preparer.
2. Use professional payroll software to handle compliance.
3. Get a reasonable compensation study completed.

Conclusion

Making an S Corporation election can be extremely beneficial for military and veteran business owners. The main benefit is saving on payroll taxes by paying yourself a reasonable salary and then taking the rest as an owner’s distribution. You have to be careful to set a reasonable salary, setup a proper payroll system, and hire a tax preparer to file your S Corporation business return.

Ready to explore whether an S Corp election is right for you? Contact a trusted Military Financial Advisor’s Association member to map out a tax-saving plan that fits your business and personal goals.

In addition to being an investment advisor, I am also a tax professional. People will sometimes jokingly accuse me of preferring complicated tax laws because complicated tax laws help my tax business grow. If ordinary citizens struggle to prepare their own tax returns, they are more likely to pay me to do it for them. I understand their logic, but it doesn’t apply to me. I don’t like complicated tax laws. I am appalled that our Congress has created a tax system so complicated most Americans don’t understand it and will penalize us if we fail to comply with it. I am waiting for a class action lawsuit about this, and I will jump on it with both feet!

Fortunately, most military families do not have a terribly complicated federal tax return. With the broad array of free (or low cost) resources available most military families can get their tax returns reliably prepared and filed each year without consulting a tax professional. There are some exceptions, of course. Some military families have complicated financial lives and their tax returns become more complicated as a result. More often than not, however, military families can use one of the free software options available, step through the questions the software program asks, and get the correct result. I encourage military families to explore this option for their tax preparation. Not only is it free, but I think self- preparing your tax return helps you understand your financial situation a little better.

There is one trap on the self-preparation trail that I want you to know about and avoid, though. The software is not a panacea. It does not know everything, and it will allow you to prepare and file an incorrect return. Do not believe that just because your tax prep software allowed you to claim certain deductions or credits that you have reasonable authority to do so. The tax software often does not know that you have entered incorrect information. The software company takes no responsibility for your incorrect return if you entered incorrect information. Likewise, the IRS will hold you responsible for the return. They do not accept, “My software let me do it, so I thought it was correct” as an excuse.

The US Tax Court recently reaffirmed this position when they issued TC Summary Opinion 2024-15 in the case of Pope vs Commissioner of Internal Revenue. The Popes self-prepared and filed their 2020 tax return using tax preparation software. On their 2020 tax return the Popes claimed a $14,000 adjustment on Schedule 1 for IRA contributions. This was done in error. The contributions were to Mr. Pope’s 401(k) retirement plan through his employer, and not to an IRA. The contributions to the employer-sponsored plan should not have been recorded as an adjustment on Schedule 1. The IRS recognized this error, disallowed the adjustment, and charged the Popes additional taxes and interest.

The Popes challenged the IRS decision in Tax Court. At trial Mrs. Pope testified that she entered the amount of the 401(k) contribution believing the tax preparation software would alert her if it was incorrect. Unfortunately, tax prep software does not work like that. User errors will often go unchecked. In the Pope’s case, the amount entered exceeded the legal limit for 2020 contributions to an IRA, yet the software did not alert the user. In the Summary Opinion, the Tax Court pointed out the IRS publishes instructions for form 1040 each year, and taxpayers are advised to consult those instructions even if they are using tax preparation software. The Tax Court ruled in favor of the IRS, and the Popes were required to pay the additional tax plus interest.

Do not avoid self-preparing your tax return just because things went poorly for the Popes but learn from their mistakes. If you feel confident you can prepare an accurate tax return, then you can definitely save time and money doing it yourself. If you are not sure about a question you are being asked by the software, don’t guess. Get clarification from the software company for the brand you are using or look it up yourself. You can usually find the answer using the current year instructions for form 1040. They are found online (IRS.gov) and give line by line instructions for filling out that form. Avoid relying on sources that are not authoritative. Thousands of bloggers and social media gurus are offering free tax advice. Much of it is inaccurate and even more of it is outdated and no longer applicable. Ony use sources that would hold up in court if you had to tell a judge where you got the information that you relied upon to prepare your tax return!

If you have a complicated situation, you might consider hiring a tax professional to prepare your return for you. If you are searching for a tax professional who understands military tax issues, check out the Military Tax Experts Alliance. You can submit a question or find a tax professional to work with. It’s a great organization, and I just happen to be a member!

No matter how you get your taxes prepared, just remember to get them submitted on time. The IRS is not very friendly to late filers!

If you’ve got financial questions that are (or aren’t) tax-related, the MFAA financial planners are a great source of help.

If you really want to upset someone, use the C-Word. Or the other C-Word. If you want to really get them spinning, use the other, other C-Word.  Of course, we’re talking about Contribution, Conversion, and (Re-)Characterization and how they apply to your IRA. This is a personal finance article, not edgy British banter but these C-Words cause untold confusion, consternation, and conundrums for IRA investors. Wouldn’t be great to finally comprehend the C-words?

IRAs and the C-Words

The C-Words crop up for IRA investors because each C-Word has considerable IRS-driven rules and limits that affect what you can and can’t do with your IRA. Let’s break down each C-Word.

C-Word #1–Contribution

Contribution: A Contribution to an IRA is new cash conveyed into the IRA. You transfer money from say, your checking account, to your IRA each year if you meet certain criteria:

1. Calendar Year: Contributions are limited to the calendar year, plus the time to the personal income tax filing deadline, usually April 15th. I.e., you get 15 ½ months from January 1, 2023 to April 15, 2024 to Contribute cash to the coffer. 
2. Ceiling: No matter how much you earn, you can’t Contribute more than the annual Contribution limit. In 2023, that’s $6,500 or $7,500 if you’re over age 50 (including the year you turn 50). 
3. Compensation: Depending on how much you earn, your Contributions can be limited. Common compensation limits (for 2023) include:
   1. $218K—above this, you need to bring Backdoor Roth IRA into your crosscheck ($138K for single tax filers). 
   2. $116K—above this, you can’t deduct the whole Contribution… if you have an employer plan too such as the TSP or 401(k). ($73K for single tax filers). 
   3. $6,500—below this level of earnings, you can’t Contribute the full amount to your IRA. Except for a non-working spouse, you must have earned income to Contribute to your IRA. For two spouses, $13K is the number and over age 50, add $1K-$2K for single and married.
   4. There are many other limits, but these are the most common.
4. Company: If you work for an employer that offers a plan such as a pension, 401(k), TSP, etc., then the existence of their plan affects whether you can Contribute to, and DEDUCT from income, any amount to an IRA. Most larger employers offer some sort of plan, but not all. 
5. Combo: While you can Contribute to both a Traditional IRA and Roth IRA in the same year, it’s uncommon do so. You have the same overall cap: $6,500 or $7,500 in 2023, so you would be splitting it between both types of accounts.  In some novel cases, this could make sense. 

Contributing is the main C-Word most of us do each year. We earn cash, cogitate about Contributing, then convey the dollars from our checking to our IRA account. It’s quite possible you’ll never have a merge with the other C-Words, but let’s check them out anyway!

C-Word #2–Conversion

Conversion: A Conversion in IRA parlance is the act of transferring money from a pre-tax (Traditional) account such as an IRA, TSP, or 401(k) into a Roth account, usually an IRA. The logic of a Conversion is that you decide it’s better to pay taxes on the Converted amount today rather than some future date, e.g., retirement. Considerations for Conversions cover the spectrum:

1. Cost: Converting costs money in the form of additional tax dollars paid that year. If you Convert $100K from a pre-tax account to a Roth account and you’re in the low portion of the 24% federal bracket, you know the Conversion will cost at least $24K.
2. Customs: Most of the rules for Contributions come from Aunt IRS. Many of the Conversion rules do as well. But employer plans can have their own Conversion rules. E.g., many airline 401(k) plans allow “Mega Backdoor Roth IRA” Conversions inside the plan. The main rules that apply to Conversions include:
   1. One 60-day rollover per year. It’s possible to have your Traditional IRA/401(k) custodian cut you a check for the Conversion amount. You then have 60 days from receipt to deposit the entire amount into the Roth IRA. In the intervening 60 days, you can buy whatever vapor investment your troops are telling you about and hope it goes to the moon… but you still must come up with the whole rollover amount by day 60 or you’ll not only pay tax on the Conversion but an additional 10% if you’re under age 59 ½. 
   2. No limit on amount Converted. One of the main sources of C-word confusion is that IRAs have Contribution limits, e.g., $6,500 per person in 2023 but you can theoretically Convert infinity dollars per year.  
   3. No interplay between Contributions and Conversions. Just as there is no interplay between the amount you Contribute to your IRA and the amount you Contribute your TSP/401(k)/403(b), there is no governing limit between the amount you Contribute to your IRA and the amount you Convert to your Roth IRA in a year.  You might self-impose a limit based on the amount of tax you want to pay, but Tax Uncle won’t cap your Conversions. 
   4. Unlimited trustee-to-trustee Conversions. While you can only take personal possession of your Traditional dollars as part of a rollover once per year, you can have your brokerage (e.g., Vanguard, Fidelity, Schwab, etc.) perform Conversions as often as you like (to pay taxes…). 
3. Cinco Year Rule: There are many five-year rules in the IRA world, and for younger investors, they’re generally irrelevant. Nonetheless, Converted dollars must stay in the IRA five years before being pulled out or they incur a 10% penalty tax.  The reason why this rarely matters is that IRS rules for ordering the dollars coming out of an IRA stipulate that Contributions precede Conversions which precede earnings on exit from a Roth IRA. As long as you’ve been Contributing for a few decades by the time you start pulling money from your Roth IRA, you’ll have a low pK of transgressing the 5-year rule.
4. Counting: Tax professionals often caution against Roth Conversions because they increase your tax bill in a single year. The core reason for the Conversion is to lower the lifetime tax bill by boosting the current year tax bill. If you don’t count the expected cost of your taxes over your lifetime, you can’t really assess whether the Conversion makes mathematical sense. 
5. Common: Once you join Backdoor Roth Club, you’ll be doing both a Contribution and Conversion each year. This will be your normal practice.

Conversion is the second most common C-Word. Younger savers that have had access to Roth IRA and TSP/401(k) their whole working lives may never have to Convert. The rest of us old codgers need to understand Conversions to max-perform them.

C-Word #3—(Re)Characterization

Characterize is the third C-Word. It’s most often found in its “re-“ format in IRA world, so we’re going to count “Recharacterize” as a C-Word. Recharacterize is the C-Word that trips many a tax return self-preparer up because it’s both similar to Conversion with its “C-ness” and with its definition. 

Recharacterizing an IRA Contribution is the act of Contributing to a Roth IRA or Traditional IRA, then deciding to switch to the other type in the same tax year before filing your tax return. When contemplating Recharacterization, consider the following:

1. Contributions only:  Congress cancelled the ability to Recharacterize Conversions some years ago. You can only Recharacterize amounts that you Contributed in the current year.  This prevents a strategy of continuously flopping money from one tax status to another based on market conditions and other tax events.
2. Common Cause: The most common reason for Recharacterization is that you Contributed to a Roth IRA but were over the income limit for that year and needed to charge your dollars into Backdoor Roth Club. When you originally Contribute to a Roth IRA but change those dollars back to a Traditional IRA in the same year, that’s not a Conversion, it’s a Recharacterization.  The same is true if you Contribute to a Traditional IRA thinking you’ll receive a deduction, but after realizing that you’re over the income limit to deduct a Traditional IRA, you decide to Recharacterize the Contribution to a Roth IRA before the tax deadline (April 15th most years). 
3. Complications: When Recharacterizing, you must account for not just the Contribution, but losses and gains as well.  
   1. Losses are easier to handle (mathematically, not emotionally). If your $6,500 Contribution to a Roth IRA becomes $6,000 because of market conditions, you can not only Recharacterize the $6,000 to your Traditional IRA (probably as part of a Backdoor Roth IRA maneuver) but you can top off the $6,000 back to $6,500 so that your ultimate Contribution amount for the year is at the annual limit (2023). 
   2. Gains have complexity. If you Contribute $6,500 to your Roth IRA and the market goes up before you realize the need to Recharacterize, then you’ll have to remove the $6,500 Contribution (to Recharacterize it) and the earnings associated with the Contribution. There’s a specific formula for determining which gains are caused by your recent Contribution versus gains associated with the prior balance of the account, so it’s often best to consult a professional for help. 
      1. You’ll likely pay income tax on the gains plus 10% penalty tax on the gains when you remove them from the Roth IRA if you’re under 59 ½. You won’t pay any additional tax on the principal amount (e.g., $6,500) if you remove it prior to the tax filing deadline (plus extensions, so usually October 15th) since you should have already included that amount in your income. 
4. Chance: You get one chance to Recharacterize without a truly unholy mess. Let’s say you Contributed to a Roth IRA in 2022 but upon consideration, you earned over the income limit. You can Recharacterize before October 15th (really the 16th due to holidays) without starting to pay a 6% tax on the Contribution… per year until you remove it. At least you can still Recharacterize last year’s Contribution and still get it inside an IRA wrapper for preferential tax treatment.  Often, high income families realize, “Fiddlesticks… we weren’t just over the Roth IRA limit last year… we’ve been Contributing while earning over the income limit for several years!” 

Unfortunately, you can’t Recharacterize Contributions from a year prior to the prior tax year. I.e., you can’t Recharacterize 2021 and prior year excess Roth IRA Contributions (Excess Contributions is the IRS term for a Contribution you weren’t allowed to make.) You must withdraw those Contributions and pay the 6% excise tax plus interest.  While you do get to leave the earnings in the Roth IRA, you’ve forever lost the opportunity to maintain Roth treatment for the Contributions. 

Imagine a dual-military couple that first earned over the Roth IRA limit in 2013. Ten years of excess Roth IRA Contributions could be at least $57K each that is now nakedly hanging around exposed to the (tax) elements each year. 

Recharacterization trips up many a taxpayer. It’s easily confused with Conversion but is considerably and consequentially contrasted. Recharacterization commonly chases Contributions caused by confusion over compensation ceilings.  If your cranium is currently circling concentrically about this… call for help!

Cleared to Rejoin

Congratulations on conquering the C-Words. Clearly, Contribution, Conversion, and Recharacterization confusion has been corrected now, right? Okay, so consternation could continue, but let’s recap the crucial considerations:

• Contributions have several limits. Measure twice before Contributing.
• Conversions have tax consequences, but they can be good ones.  Consult help before Converting.
• Recharacterization often happens after a (series of) mistake(s). This can be bad news that ages poorly.  If you were told there would be no math, you may be disappointed as you navigate Recharacterization…

It’s a catastrophe that the collector of taxes creates conditions such that you’re culpable for comprehension of colossal chunks of tax-related C-Words, but such is the condition of which we must constantly and cautiously conscious!

If you want help with your IRA rules or some other financial topics, consider contacting one of the numerous MFAA financial planners that specialize in helping military clients.

Fight’s On!