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Using a Roth IRA for a Home Down Payment

A reader writes in, asking:

“What do you think about using a Roth IRA for a home down payment?”

This is a topic that generates endless disagreement, in part because when somebody asks this question, they can actually be asking either of two completely separate questions:

  • What do you think about taking money out of a Roth IRA, to use it as a down payment on a home?
  • For money that is already intended to be used as a down payment on a home, what do you think about contributing it to a Roth IRA (as opposed to simply leaving it in a taxable account)?

Let’s tackle the first question first, then the second. But before directly addressing either of those questions, we need to talk about the actual rules: how are distributions from a Roth IRA treated, when used for a home down payment?

Tax Treatment of Roth IRA Distributions When Used for a Home Purchase

Money that you contribute to a Roth IRA can come back out of the account at any time, free from tax and penalty. (Note: this is only for amounts that were contributed directly to the Roth IRA. For amounts that were contributed to a traditional IRA, then moved to a Roth IRA as a conversion, see this article.)

In addition, a distribution of earnings is free from the 10% penalty if it is a “qualified first-time homebuyer distribution.” And if you have satisfied the 5-year rule, the distribution will be free from regular income tax as well.

For a distribution to be a qualified first-time homebuyer distribution:

  • It must be used within 120 days of the distribution…
  • to pay “qualified acquisition costs”…
  • on a “principal residence”…
  • for a “first-time homebuyer.”
  • And the homebuyer in question must be yourself, your spouse, one of your (or your spouse’s) ancestors, or one of your (or your spouse’s) descendants.
  • Also, qualified first-time homebuyer distributions are limited to $10,000 over your lifetime. (Though if you’re married, your spouse gets his/her own $10,000 limit.)

As far as definitions:

  • “Qualified acquisition costs” means what you would expect: costs of acquiring, constructing, or reconstructing a residence. And it includes any usual or reasonable settlement, financing, or other closing costs.
  • “Principal residence” also means what you would expect: your main home. If you have more than one home, the IRS takes a “facts and circumstances” approach to determining which one is your main home. (You can find more information in Treasury Regulation 1.121-1(b) if you’re interested.)
  • A “first-time homebuyer” is anybody who had no present ownership interest in a principal residence during the 2-year period ending on the date of acquisition for the home in question. If you are married, your spouse must also meet this requirement in order for you to qualify.

Using Money from a Roth IRA for a Home Down Payment

The decision of whether to buy a home obviously has many factors involved, many of which are not financial at all. Let’s assume that that decision has already been made and that you do intend to buy a home, so the question remaining is simply whether you should use money from a Roth IRA for the down payment.

When it comes to using assets for a home down payment, the general order of preference is as follows:

  • Best to use taxable money (i.e., assets that are not in a retirement account at all — just regular checking/savings accounts and taxable brokerage accounts),
  • Next-best to use “qualified first-time homebuyer distributions” from a Roth IRA,
  • Next-best to use distributions of contributions from a Roth IRA — or distributions of converted amounts if those distributions would not be subject to the 10% penalty (e.g., because the conversion has satisfied its 5-year period or because the conversion was not taxable),
  • Next-best to use other distributions (e.g., distributions of earnings) from a Roth IRA, distributions from a traditional IRA, or distributions from an employer-sponsored plan such as a 401(k) or Roth 401(k).

So the question then is: how much taxable money is there? If you have sufficient money in taxable accounts that you can cover the down payment that you want to make (while still having an emergency fund), then it’s an easy decision: don’t take money out of your Roth IRA for the down payment. Use the taxable assets instead.

If, on the other hand, you do not have sufficient assets in taxable accounts to fund the down payment, then the question is essentially: should you use Roth IRA money or delay the home purchase? On the financial side, whether waiting would pay off depends on:

  • Whether another home comes available for sale that meets your criteria and which is approximately as affordable.
  • What rate of return you earn on the assets that stay invested in the Roth IRA while you wait to build up your savings.
  • Whether interest rates move upward or downward (because you will be getting a mortgage in the future, at those future interest rates, rather than at today’s rates).

And again, there are of course an assortment of non-financial factors that could, quite reasonably, affect your decision as to whether to wait or go ahead and buy the home in question now.

Contributing to a Roth IRA to Save for a Down Payment

A separate but related scenario is the case of somebody who plans to buy a home in the not-so-distant future, and they want to know whether it makes sense to put money into a Roth IRA when that money is likely to be used for a down payment. In other words, the question is basically “make Roth IRA contributions or do not make Roth IRA contributions.”

And the answer here is generally to go ahead and make the contributions, even if the money in question is intended to be used for a home down payment rather than retirement. There are a few reasons for this:

  1. There’s not much of a downside from a tax perspective, given the way that distributions are treated when used for a first-time home purchase.
  2. Making Roth IRA contributions may allow you to qualify for the retirement savings contribution credit.
  3. And perhaps most importantly, if you later change your mind about the home purchase (or decide to delay it for other reasons), you will not have missed out on your Roth contributions for the year(s) in question.

There are two related points to note here.

First, if the money in question is intended to be used in the relatively near-term future, it should of course be invested conservatively.

Second, this general concept does not apply to Roth 401(k) contributions. If you have money that you intend to use in the near future for a home down payment, do not contribute it to a 401(k) — even a Roth 401(k). In some cases you won’t be able to get money out of a 401(k) at all until you have left the employer in question. And the special tax treatment (discussed above) that sometimes applies to distributions from an IRA when used for a home purchase does not apply to distributions from a 401(k) (whether Roth or not).

For More Information, See My Related Book:

Book3Cover

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"

Beware of Tax Planning “Cliffs”

A tax cliff occurs when one additional dollar of income beyond a certain threshold causes a sudden increase in your tax bill (or, in some cases, health insurance costs).

Most tax provisions don’t include tax cliffs. Instead, the effect of additional income is “phased in” over time. For example, with the American Opportunity Credit (for higher education expenses), you can claim the full credit if your income falls below a given threshold ($80,000 if single, $160,000 if married filing jointly). Then, as your income passes that threshold, the amount of credit you can claim is gradually reduced (“phased out”) until it reaches zero.

But with provisions that include tax cliffs, the change happens all at once. You either get the full deduction/credit or no deduction/credit. There’s no room in between. In such situations, that one dollar of income that puts you beyond the threshold can cost you hundreds or even thousands of dollars.

For example, all of the following provisions include cliffs:

There are many at the state level as well.

Avoiding Tax Cliffs

When possible, the goal is to avoid a situation where you end up just barely on the wrong side of a given cliff threshold.

The area in which people are most likely to have flexibility (i.e., ability to adjust income on demand, in order to avoid a cliff) is with regard to retirement accounts (i.e., by adjusting the balance of Roth/tax-deferred contributions if still working or distributions if no longer working).

A tricky point, however, is that the income being measured varies from one provision to another.

  • The retirement savings contribution credit is concerned with your adjusted gross income;
  • The tuition and fees deduction is concerned with modified adjusted gross income;
  • ACA premium tax credit and cost-sharing reductions are concerned with household income;
  • IRMAA is concerned with modified adjusted gross income (but the “modifications” to adjusted gross income are different than they are for the tuition and fees deduction); and
  • The EITC cliff is concerned with investment income.

Using tax prep software can be a helpful way to test for such cliffs. For instance, it can be helpful to prepare a hypothetical return in advance (e.g., using the 2019 version of the software to prepare a hypothetical return now, for 2020). See what your projected tax bill would be, then see how it would change if, for instance, you made an additional $1,000, $2,000, $3,000 etc. of tax-deferred contributions. At some point you might find that there’s a sharp decrease in the projected tax bill.

To be clear though, that method is not perfect, for a few reasons. Firstly, it won’t catch cliffs that affect something other than your taxes (e.g., IRMAA or Affordable Care Act cost-sharing reductions). In addition, it’s imprecise given the fact that you’d be using 2019 software for a 2020 return, and the relevant thresholds can change from one year to the next. And in situations in which major tax legislation has been passed, the exercise could be entirely off the mark.

Still, it’s often useful as an easy way to do a quick check.

More broadly though, it’s helpful to develop an awareness of which provisions involve cliffs, and then to be mindful of the one(s) that are most likely to affect you, so that you can look up the relevant threshold(s) when necessary. (For instance, if you buy health insurance on the exchange, you generally want to have Affordable Care Act subsidies in mind when making any tax-related decisions.)

For More Information, See My Related Book:

Book3Cover

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"

Inherited HSA Rules

A reader writes in, asking:

“After last week’s article discussing the rules for inherited IRAs, I would be interested to hear about the rules for inherited HSA accounts. We have been using my HSA effectively as a ‘third retirement account’ contributing the max each year regardless of likely medical expenses, since we can take no-penalty distributions for any purpose after age 65. So there’s a good chance that the account will outlive me…or even both of us.”

This is an easy one.

There’s no such thing as an inherited HSA — at least not in the sense that there is with an inherited IRA (in which a beneficiary can continue to own the inherited IRA, with its own set of special rules, for many years).

That is, after you die:

  • If your spouse is the beneficiary of your HSA, the account just becomes his/her HSA. (That is, it’s not an “inherited HSA.” It’s just a normal HSA, now owned by your surviving spouse.)
  • If somebody other than your spouse is the beneficiary of your HSA, the account is no longer an HSA. It just becomes a regular taxable account, and the full value of the account is taxable as income to the beneficiary in the year of your death.*
  • If your estate is the beneficiary of your HSA, the account ceases to be an HSA, and the value of the account is included as income on your final tax return.

There are two primary financial planning implications here:

  1. If you’re married, name your spouse as the beneficiary of your HSA!
  2. It’s a good idea to prioritize spending down this account (to the extent of your qualified medical expenses, and potentially beyond that extent once you reach age 65) rather than retirement accounts, because your children (or other non-spouse heirs) would rather inherit a retirement account than an HSA that immediately becomes fully taxable.

*If, within 1 year of the date of death, your non-spouse beneficiary (other than your estate) pays any of your qualified medical expenses that were incurred before your death, the amount of those expenses is subtracted from the amount that is taxable to the beneficiary.

For More Information, See My Related Book:

Book3Cover

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"

Can I Change the Beneficiary of My 529 Plan/Account?

A reader writes in, asking:

“Can I create a 529 account, contribute to it with my daughter named as the beneficiary, and then change the beneficiary to another family member if we end up wanting to help fund somebody else’s education?”

The short answer is: it depends on who exactly the family member is, but probably yes.

Naturally, Code section 529 is where we’d find information about 529 plans.

There, we find that there are no income tax consequences to changing the beneficiary of a 529 account, provided that you change the beneficiary to somebody who is a “member of the family” of the existing beneficiary. Members of the family include:

  • A child or a descendant of a child (i.e., a grandchild);
  • A brother, sister, stepbrother, or stepsister;
  • The father or mother, or an ancestor of either (i.e, grandparent);
  • A stepfather or stepmother;
  • A niece or nephew;
  • An aunt or uncle;
  • A son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law;
  • An individual who, for the taxable year of the beneficiary, has the same principal place of abode as the beneficiary and is a member of the beneficiary’s household;
  • The spouse of any of the above people;
  • The spouse of the existing beneficiary; or
  • A first cousin of the existing beneficiary.

Reminder: When going through this list, remember that these relationships are with regard to the existing beneficiary — not with regard to you or to any other person(s) contributing to the account.

If you change the beneficiary to somebody who is not in one of the above categories, the distribution will be taxable as income and will be subject to a 10% penalty.

Finally, section 529 also notes that the gift tax and generation-skipping transfer tax shall apply unless the new beneficiary is:

  1. In the same generation as (or a higher generation than) the existing beneficiary, and
  2. A member of the family of the existing beneficiary (as described above).

For More Information, See My Related Book:

Book3Cover

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"

Retirement and 529 Changes from the SECURE Act

Last week Congress passed the Setting Every Community Up for Retirement Enhancement (SECURE) Act, which makes a list of changes to retirement account rules.

What follows is a brief explanation of some of the points that are likely to affect many readers. To be clear, there’s a lot of material that I will not be covering here. If you’re interested in reading the Act itself, you can find it here.

Traditional IRA Age Limit

For tax years 2020 and beyond, there will no longer be an age limit for making contributions to traditional IRAs.

Retirement Account RMDs

For anybody turning age 70.5 in 2020 or later, RMDs will begin with the year in which you reach age 72 rather than the year in which you reach age 70.5.

Retirement Account Distributions for Childbirth/Adoption

For tax years 2020 and beyond, there will be a new exception to the 10% penalty for early distributions from retirement accounts. Specifically, distributions of up to $5,000 will be penalty-free if made during the 1-year period beginning on the date on which your child is born or on which you legally adopt an eligible adoptee.

Relevant points about the new childbirth/adoption distributions:

  • “Eligible adoptee” means anybody under age 18 or who is physically or mentally incapable of self-support.
  • The $5,000 limit is per childbirth/adoption.
  • If you are married, each spouse can take such a penalty-free distribution.
  • You can put the money back into the plan/account later, and such a contribution would be treated as having made a direct trustee-to-trustee transfer of the distribution back into the plan. This means, firstly, that the contribution wouldn’t count against your normal contribution limit for the year. In addition though, in the case of such trustee-to-trustee transfers, the distribution isn’t taxable and the contribution is not deductible. But in this case the contribution could be coming years after the distribution — well after you would have already had to report the distribution as income. I’m interested to see what the IRS offers as guidance here.

Distribution Rules for Inherited Retirement Accounts

So-called “stretch IRA” distribution rules have mostly been eliminated. Specifically, if the owner of an IRA/401(k)/403(b) account dies in 2020 or later, then the beneficiary of the account will have to fully distribute the account within 10 years of the original account owner’s death.

Relevant points about the above change:

  • The new rule doesn’t apply to any designated beneficiary who is an “eligible beneficiary.” Eligible beneficiaries would be: the surviving spouse of the original account owner, a minor child of the original account owner, anybody who is disabled or chronically-ill (per the definition found in IRC 7702B(c)(2)), or any designated beneficiary who is not more than 10 years younger than the original account owner.
  • When the new rule does apply, the new rule is simply that the account must be distributed within 10 years. The distributions do not have to occur evenly over those 10 years. (There could be no distributions for the first 9 years, for instance.)

529 Plans

With regard to 529 plans, “qualified higher education expenses” will now also include:

  1. Fees, books, supplies, or equipment required for apprenticeship programs; and
  2.  Up to $10,000 used to repay student loans for the account beneficiary, plus another $10,000 for repayment of student loans for each of the beneficiary’s siblings.

Of note: if a 529 distribution is used for repayment of student loan interest, that same interest cannot be deducted under the student loan interest deduction.

Annuities

Defined contribution plans (e.g., 401(k) or 403(b) plans) will have to start providing a disclosure to participants about how much lifetime income could be provided if the entire account balance were used to purchase a single lifetime annuity or a qualified joint and survivor annuity for the employee and the employee’s surviving spouse.

In addition, the new law makes some changes that essentially make it easier for defined contribution plans to offer annuities as options to plan participants.

…And a lot of other stuff

Just to reiterate, what I’ve covered here is simply the collection of changes that I think are most likely to affect many of you. The Act makes a long list of changes that I haven’t covered here. Again, if you’re interested in reading the Act itself, you can find it here. (Scroll all the way down to Division O in the document.)

For More Information, See My Related Book:

Book3Cover

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"

2020 Tax Brackets, Standard Deduction, and Other Changes

Last week the IRS published the annual inflation updates for 2020. As was the case for 2019, it’s really just regular inflation adjustments, as opposed to the major legislative changes we had two years ago (i.e., effective for 2018).

If you have questions about a particular amount that I do not mention here, you can likely find it in the official IRS announcements: Rev. Proc. 2019-44 (which contains most inflation adjustment figures) and Notice 2019-59 (for figures relating to retirement accounts).

Single 2020 Tax Brackets

Taxable Income
Tax Bracket:
$0-$9,875 10%
$9,875-$40,125 12%
$40,125-$85,525 22%
$85,525-$163,300 24%
$163,300-$207,350 32%
$207,350-$518,400 35%
$518,400+ 37%

 

Married Filing Jointly 2020 Tax Brackets

Taxable Income
Tax Bracket:
$0-$19,750 10%
$19,750-$80,250 12%
$80,250-$171,050 22%
$171,050-$326,600 24%
$326,600-$414,700 32%
$414,700-$622,050 35%
$622,050+ 37%

 

Head of Household 2020 Tax Brackets

Taxable Income
Tax Bracket:
$0-$14,100 10%
$14,100-$53,700 12%
$53,700-$85,500 22%
$85,500-$163,300 24%
$163,300-$207,350 32%
$207,350-$518,400 35%
$518,400+ 37%

 

Married Filing Separately 2020 Tax Brackets

Taxable Income
Marginal Tax Rate:
$0-$9,875 10%
$9,875-$40,125 12%
$40,125-$85,525 22%
$85,525-$163,300 24%
$163,300-$207,350 32%
$207,350-$311,025 35%
$311,025+ 37%

 

Standard Deduction Amounts

The 2020 standard deduction amounts are as follows:

  • Single or married filing separately: $12,400
  • Married filing jointly: $24,800
  • Head of household: $18,650

The additional standard deduction for people who have reached age 65 (or who are blind) is $1,300 for each married taxpayer or $1,650 for unmarried taxpayers.

IRA Contribution Limits

The contribution limit for Roth IRA and traditional IRA accounts is unchanged at $6,000.

The catch-up contribution limit for people age 50 or over does not get inflation adjustments and therefore is still $1,000.

401(k), 403(b), 457(b) Contribution Limits

The salary deferral limit for 401(k) and other similar plans has increased to $19,500.

The catch-up contribution limit for 401(k) and other similar plans for people age 50 and over has increased to $6,500.

The maximum possible contribution for defined contribution plans (e.g., for a self-employed person with a sufficiently high income contributing to a solo 401(k)) is increased to $57,000.

Child Tax Credit

The child tax credit ($2,000 per child) and the related phaseout threshold ($200,000 of modified adjusted gross income, $400,000 if married filing jointly) do not get inflation adjustments. The portion of the credit that can be refundable (up to $1,400 per child) does receive inflation adjustments, but it is still $1,400 for 2020.

Capital Gains and Qualified Dividends

For 2020, long-term capital gains and qualified dividends face the following tax rates:

  • 0% tax rate if they fall below $80,000 of taxable income if married filing jointly, $53,600 if head of household, or $40,000 if filing as single or married filing separately.
  • 15% tax rate if they fall above the 0% threshold but below $496,600 if married filing jointly, $469,050 if head of household, $441,450 if single, or $248,300 if married filing separately.
  • 20% tax rate if they fall above the 15% threshold.

Alternative Minimum Tax (AMT)

The AMT exemption amount is increased to:

  • $72,900 for single people and people filing as head of household,
  • $113,400 for married people filing jointly, and
  • $56,700 for married people filing separately.

Estate Tax

The estate tax exclusion is increased to $11,580,000 per decedent.

Pass-Through Business Income

With respect to the 20% deduction for qualified pass-through income, for 2020, the threshold amount at which the “specified service trade or business” phaseout and the wage (or wage+property) limitations begin to kick in will be $326,600 for married taxpayers filing jointly and $163,300 for single taxpayers, people filing as head of household, or married people filing separately.

For More Information, See My Related Book:

Book3Cover

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"
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