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!

Expanded Tax Credits for Energy Efficient Improvements in 2023

Tax credits for making energy efficient improvements to the taxpayer’s home have been around for a while, but they got a boost at the end of last year. The Inflation Reduction Act of 2022 increased both the dollar value of the tax credits and the types of expenses that qualify for the tax credits. There are two separate home energy efficiency improvement tax credits in effect for 2023. They are known as the Energy Efficient Home Improvement Credit and the Residential Clean Energy Credit. This article highlights the particulars of those two credits.

The Energy Efficient Home Improvement Credit

The Energy Efficient Home Improvement Credit is a 30% credit for certain qualified expenses for energy efficient home improvements. As is always the case with tax laws, the details matter. Taxpayers can receive up to a $1200 credit each year for energy efficient improvements to exterior doors, windows, skylights, insulation, as well as home energy audits on their residences. Within that category the following limits are in effect:

• Maximum credit of $250 per door, maximum of 2 doors
• Maximum credit of $600 for windows
• Maximum credit of $150 for home energy audits

Taxpayers can also get up to $1200 of tax credit for insulation and air sealing materials, new central air conditioners, hot water heaters, furnaces, and hot water boilers that use propane, natural gas, or oil but there is a $600 per item limit.  

The maximum amount of the tax credit for all the above in any tax year is $1200. Taxpayers can get an additional $2,000 of Energy Efficient Home Improvement Credit for the purchase of qualified heat pumps, biomass stoves, or biomass boilers. Meaning that it would be possible to claim up to $3,200 of Energy Efficient Home Improvement Credit in one year. The Energy Efficient Home Improvement Credits are not refundable, and unused portions of the tax credits cannot be carried forward to future tax years. The credits are only for improvements to an existing home. They are not available for new construction.

The Residential Clean Energy Credit

The Residential Clean Energy Credit is for other improvements to the taxpayer’s residence, including a secondary residence as long as the residence is located in the United States. The Residential Clean Energy Credit is a 30% credit on the amount spent on solar electric panels, solar water heaters, wind turbines, geothermal heat pumps, fuel cells, and battery storage of at least 3 kilowatts.  

Unlike the Energy Efficient Home Improvement Credit, there is no limit on the value of the Residential Clean Energy Credit. It is 30% of whatever your qualified expenses are. This credit is also available for both existing homes and new construction. Like the Energy Efficient Home Improvement Credit, this credit is not refundable. It cannot exceed the amount of tax owed, but unused portions of the credit can be carried forward to future tax years until all the credits are used.

You may still qualify for the credit if you are using a portion of your residence as a business property by leasing part of it to a tenant or using it as a home office. If the percentage of the property being used for business is 20% or less, then the taxpayer may claim all the qualified expenses for the credit. If more than 20% of the residence is being used for business, then the qualified expenses must be divided between the business and residential portions of the property, and the credit calculated only on the qualified expenses applicable to the residential portion of the property. (Note that you could still deduct the expenses applicable to the business portion of the property on your business schedule or return.)

Additional Rules

Internal Revenue Service guidance indicates the credit cannot be taken until the installation of the qualifying property occurs. A taxpayer might pay for solar panels in December 2023 but not have the solar panels installed until February of 2024. The taxpayer would not be eligible for the credit until they filed their 2024 tax return.

Previous versions of these credits came with a lifetime limit. There is no lifetime limit for the newer versions, only some annual limits for the Energy Efficient Home Improvement Credit. Taxpayers could claim these credits every year if they have qualifying expenses in multiple tax years.

The credits are only valid for new energy efficient improvement property. You cannot purchase solar panels from your neighbor, have the panels moved from their roof to yours, and claim the credit. The energy efficient purchases must be new equipment.

Here is a useful example from the IRS fact sheet (https://www.irs.gov/pub/taxpros/fs-2022-40.pdf)

In one taxable year, a taxpayer purchases and installs the following: two exterior doors at a cost of $1,000 each, windows and skylights at a total cost of $2,200, and one central air conditioner at a cost of $5,000. All property installed meets the applicable energy efficiency and other requirements for qualifying for the Energy Efficient Home Improvement Credit. 

First, 30% of each $1,000 door’s costs is $300, but the per door limit of $250 applies to reduce the maximum possible credit for each door to $250 each. Thus, the taxpayer’s expenditures for exterior doors potentially qualify the taxpayer to claim up to a $500 tax credit. 

Next, 30% of the taxpayer’s total $2,200 of expenditures for windows and skylights is $660, but the $600 limit for all windows and skylights applies to limit the taxpayer’s credit for such expenditures to $600. Thus, the taxpayer’s expenditures for windows and skylights potentially qualify the taxpayer to claim up to $600. 

Finally, 30% of the taxpayer’s $5,000 cost paid for the central air conditioner is $1,500, but the $600 per item limit for energy property applies to limit the taxpayer’s credit for such expenditures to $600. 

Adding these credit amounts yields a sum of $1,700 ($500 + $600 + $600), but the aggregate limit of $1,200 applies to limit the taxpayer’s total amount of Energy Efficient Home Improvement Credit to $1,200

Tax planning is an integral part of financial planning. If you only think about taxes when it is time to prepare your income tax return for the prior year, then you are being reactive and not proactive. MFAA advisors are knowledgeable about tax strategies and can help you build a plan to reduce your tax burden over your entire lifetime, not just for the current or prior year. Find the advisor that’s right for you by checking out their online profiles here.

Congress passed the Omnibus Spending Bill on December 23, 2022.  Included in the monstrous 4,000+ document were numerous changes to retirement savings accounts collectively known as SECURE Act 2.0 (Setting Every Community Up for Retirement Enhancement Act).   It builds on the original SECURE Act, which was signed into law in December 2019.

Admittedly, most of these are small changes.  They don’t rise to the same level of the elimination of stretch IRAs in the original SECURE Act.  That doesn’t mean you shouldn’t be aware of the changes and how you it might impact your planning.

Here’s the TLDR Summary of this post and the most impactful SECURE Act 2.0 provisions:

1. Pushed back the age for starting required minimum distributions (RMDs) to 73 for those born between 1951 and 1959 and to 75 for those born in 1960 or later
2. Tax credits for military spouse employers
3. Reduced the penalty for missing a Required Minimum Distribution (RMD)
4. Employer matches to Roth accounts
5. Eliminates RMD requirements from employer Roth accounts
6. Increased the allowed contribution to a Qualified Lifetime Annuity Contract (QLAC)
7. Increased retirement plan catch-up contributions for those aged 60-63 starting in 2025
8. Allows a 529 to Roth IRA rollover starting in 2024
9. Allows for a $50,000 IRA Charitable Rollover to a Charitable Gift Annuity or Charitable Remainder Trust
10. Student Loan Debt “Matching”

1.  Pushed back the age for starting required minimum distributions (RMDs)

The SECURE Act 2.0 extends the required minimum distribution (RMD) age from 72 to 73 for those born between 1951 and 1959.  For those born in 1960 or later, the age is extended to 75.  RMDs are the minimum amount that must be withdrawn each year based on the owner’s age.   This applies to certain retirement accounts such as traditional IRAs, 401Ks, and Thrift Savings Plan.  The purpose of RMDs is to ensure that retirement accounts are eventually distributed and taxed.  This prevents them from being used as tax-deferred savings vehicles indefinitely.  The extension could allow for increased tax savings options by giving you an additional year (or 3) to perform Roth conversions or take distributions to draw down the account before it becomes mandatory.

2.  Tax credits for military spouse employers

There is a special provision for military spouse employers who offer retirement plan participation with immediate vesting or access within 2 months of hiring.  Employers can receive a tax credit of up to $500 for each military spouse.  This benefit will hopefully incentivize employers to offer retirement plan access to military spouses who often change jobs before they have met the requirements to fully participate in a company’s retirement plan.

3.  Reduced the penalty for missing a Required Minimum Distribution (RMD)

The SECURE Act 2.0 reduces the penalty for missing an RMD from 50% to 25%. If an individual fails to take the required minimum distribution from their retirement account, they were typically subject to a penalty equal to 50% of the amount that should have been withdrawn. Starting in 2023, the SECURE Act 2.0 reduces this penalty to 25%. It further reduces the penalty to 10% if the RMD is fixed within the “correction window.”  This change is intended to provide relief to individuals who may have missed an RMD due to unforeseen circumstances.

4.  Employer matches to Roth accounts

The new law allows employer matching contributions to be made to a Roth 401(k) or Roth 403(b) account. Currently, employer matching contributions can only be made to a traditional 401(k) or 403(b) account, which are funded with pre-tax contributions and are taxed as ordinary income when withdrawn. The SECURE Act 2.0 would allow employers to make matching contributions to a Roth 401(k) or Roth 403(b) account, which are funded with after-tax contributions and are tax-free when withdrawn if certain conditions are met. This change is intended to give employees the option to receive their employer’s matching contributions in a tax-free account, rather than a traditional account that is taxed as ordinary income when withdrawn.  Any employer money contributed to a Roth will be reflected as income to the employee for current-year tax purposes.

5.  Eliminates RMD requirements from employer Roth accounts

The RMD requirement for employer-sponsored Roth plans (Roth 401K, Roth 403B, Roth TSP, etc) will be eliminated in 2024.  This eliminates the disparity between Roth employer plans and Roth IRAs which do not have an RMD requirement.  It will allow employees who are happy with their plan to not have to roll over their accounts to Roth IRAs to avoid forced distribution.  This is great because it allows for continued tax-free growth.

6.  Increased the allowed contribution to a Qualified Lifetime Annuity Contract (QLAC)

The SECURE Act 2.0 increases the maximum contribution to a qualified longevity annuity contract (QLAC) to $200,000.  It also eliminates the maximum percentage of an individual’s retirement plan balance that can be used.  QLACs are a type of annuity that provides a guaranteed stream of income starting at an advanced age, such as 85 or 90. The purpose of a QLAC is to provide a guaranteed source of income in retirement, which can help individuals ensure that they have enough money to cover their expenses in old age. By increasing the maximum contribution to a QLAC, the SECURE Act 2.0 allows individuals to set aside more money for their retirement and provides them with the option to purchase a QLAC with a larger payout.

7.  Increased retirement plan catch-up contributions for those aged 60-63 starting in 2025

The law also increases the retirement plan catch-up contributions for those aged 60 to 63 in 2025. Currently, individuals aged 50 and over are eligible to make catch-up contributions, which are additional contributions above the regular contribution limit. The SECURE Act 2.0 increases the catch-up contribution limit for individuals aged 60 to 63 in 2025 from $6,500 to $10,000. This change is intended to give individuals in this age range the opportunity to save more for retirement and potentially make up for any shortfall in their retirement savings.

Additionally, catch-up contributions for higher-earning employees (currently above $145,000) must have contributions made to a Roth portion of the plan.  This will require these employees to use after-tax dollars for these contributions.

8.  Allows a 529 to Roth IRA rollover starting in 2024

The SECURE Act 2.0 allows for a 529 to Roth IRA rollover starting in 2024. Currently, 529 plans (education savings plans) can only be rolled over to another 529 plan or used for qualified education expenses. The SECURE Act 2.0 would allow individuals to roll over funds from a 529 plan to a Roth IRA tax-free.  The lifetime maximum transfer amount is $35,000.

9.  Allows for a $50,000 IRA Charitable Rollover to a Charitable Gift Annuity or Charitable Remainder Trust

The SECURE Act 2.0 creates Roth SEP IRA and SIMPLE IRA options. Currently, SEP IRAs and SIMPLE IRAs (retirement plans for small businesses) can only be traditional IRAs.  Traditional IRAs are funded with pre-tax contributions and are taxed as ordinary income when withdrawn. The SECURE Act 2.0 allows individuals to open a Roth SEP IRA or SIMPLE IRA.  These are funded with after-tax contributions and are tax-free when withdrawn if certain conditions are met.

10.  Student Loan Debt “Matching”

In 2024, employers can provide matching retirement contributions for employees who are making student loan payments.  Employees who weren’t able to pay down their loans and save for retirement will not lose the matching dollars from employers.

There are other many other more nuanced topics in the new law.  These are the ones I felt had the most applicability to the broadest population.  If you’d like to read more about some of the more nuanced topics like the expansion of annuities in retirement plans, improving the access to retirement plans for part-time employees, distributions for long-term care, or provisions around small business retirement plans check out this article.

If you have questions about how this impacts you and your retirement planning consider setting up a call with one of the MFAA advisors who can help you navigate all of these changes.  You can find them here.