Pondering a strategic 72(t) distribution

[ziggy29]

I'm trying to think through this completely and I'm hoping the braintrust here can poke some holes into my logic, or else find few holes and confirm the strategy I am pondering.

Right now our income (after taxes and retirement contributions) is close to our outgo. I have a part-time j*b at a local post office where I normally get around $25K a year (and perhaps more importantly, really good health insurance for almost nothing) and my wife is a pastor at a small church with a fairly modest income. We are both contributing to our retirements; I contribute 5% to my TSP (to get the full match) and she contributes 6% to her 403B, for about $2,500 a year. (Her employer contributes 10% of compensation to her 403B regardless of her contribution.)

DW's income is considered self-employment income for FICA purposes, so she pays income taxes AND self-employment taxes on her income. Solidly in the 15% marginal bracket, after considering the deduction of half her self-employment tax her income is taxed at approximately 29% on the margins because of the self-employment tax. Our other taxable income is taxed 15% on the margins. It would be nice if we could replace some of the self-employment income with other income so more of it is effectively taxed at the lower rate.

So here is what I am thinking. What if I started a 72(t) distribution from one of my IRAs (would generate about $16K per year), and used just about all of that to crank up DW's 403B contributions to the max? We would be taking income taxed at 15% in order to reduce a similar amount of income being taxed at about 29%. Basically, it's a self-employment tax avoidance mechanism which would be perfectly legal.

I know of two gotchas: first, I'm locked into this until 2025, the year I turn 59.5. (That is not a big deal as long as we have enough earned income to put it all back into a pretax retirement plan. And if we didn't, we'd probably need the money anyway.) Secondly, it will modestly reduce her SS benefits at retirement, though all the spreadsheet math I've done suggests our tax savings will considerably exceed the reduction in her benefits unless she lives to be something like 105.

Any more gotchas I haven't considered? I'm not really close to pulling the trigger, but it seems like a seductive idea at first glance, and so far I haven't encountered any negatives that outweigh the positives. If there's a serious problem I haven't considered, I'd love to hear it so I can kill the idea before it gets really serious.

I suppose we could partially or completely forego the 72(t) stuff and just go year by year eating a little of our savings each year, but negative cash flow and steadily declining savings balances make me nervous.

 

[Sunset]

If your Wife employment is self employment, then she is eligible to open a self-401K for example at Vanguard. It can be a ROTH or regular IRA type. The max limit on contributions for the "employee" portion is the same limit per year including all 401K contributions.

I find it odd that she is considered self employed and yet her employer offers a 403B she can participate in, do they match at all ? If not then a real self-401K might be better as the contribution limit is $60,000 per year including the catch up amount.

 

[ziggy29]

If your Wife employment is self employment, then she is eligible to open a self-401K for example at Vanguard. It can be a ROTH or regular IRA type. The max limit on contributions for the "employee" portion is the same limit per year including all 401K contributions.

I find it odd that she is considered self employed and yet her employer offers a 403B she can participate in, do they match at all ? If not then a real self-401K might be better as the contribution limit is $60,000 per year including the catch up amount.

Clergy are a unique occupation in the tax code. They are considered employees for the purposes of W-2 income, but are considered self-employed in terms of paying both halves of SS and Medicare taxes. This is why they have a 403B plan. And as I mentioned above, they contribute 10% of her compensation into it regardless of what we put in.

She is not self-employed in the "solo 401K" sense -- only in the sense that she has to pay both halves of FICA. In other words, for income tax purposes she is "employed" and has an employer -- but for the purposes of self-employment tax, she's on her own. Clear as mud, yes?

 

[cathy63]

... I find it odd that she is considered self employed and yet her employer offers a 403B she can participate in ...

I believe it's because she's a pastor. It's an oddity in the tax code that ministers are often considered to be self-employed, even though they work full-time at a single church, but they can still get some benefits that would normally only accrue to a regular employee. That fact may also limit her ability to open a solo 401K.

eta - and ziggy explained it better while I was typing this.

 

[pb4uski]

But are you sure that voluntary 403b contributions dodge SE tax? Publication 571, Tax-Sheltered Annuity Plans (403(b) Plans) states:

Do I Report Contributions on My Tax Return?

Generally, you don’t report contributions to your 403(b) account (except Roth contributions) on your tax return. Your employer will report contributions on your 2016 Form W-2. Elective deferrals will be shown in box 12 with code E for pre-tax amounts and code BB for Roth amounts, and the Retirement plan box will be checked in box 13. If you are a self-employed minister or chaplain, see the discussions next.

Self-employed ministers. If you are a self-employed minister, you must report the total contributions as a deduction on your tax return. Deduct your contributions on line 28 of the 2016 Form 1040.

emphasis added

So this deduction would be outside Schedule C profit that SE tax is usually based on and is the way that they would subject earnings to SE tax but exclude it from income tax... the same as a regular employee pays SS taxes on their earnings before 401k contributions but income tax on their earnings after 401k contributions.

 

[Sunset]

Just trying to understand the issue here:

When you say she is taxed at 29% on the margin, aren't you including the 1/2 FICA tax rate , that yourself pays as well via your employee pay ?
So she is really paying approx 7.5% extra FICA tax above what yourself pay in your job. Meaning her tax rate is more like 22.5% while the rest of income you say (yours, interest) is at 15%

After all, 7.5% of the FICA tax she pays is deductible on the tax return, so off the top of my head when calculating the value of robbing Peter to pay Paul it seems it is misleading to count the full FICA amount. ?

 

[Sunset]

If she is self employed, perhaps you would be better off considering how you can view some expenses normally spent, as expenses from the self employment. This will reduce the SE tax.
You might be missing some deductions. ?

 

[ziggy29]

Actually, a properly structured clergy 403B plan's contributions *are*, as best as I can tell, deductible from all self-employment taxes otherwise owed. Our plan's literature, opinions from a CPA we know who has extensive experience in clergy tax returns and almost all of the literature I've seen about clergy taxes says the same thing.

This is something I have researched quite a bit already. Publication 517, which was written specifically for clergy, seems to agree; it states that elective contributions to a church-sponsored "tax-sheltered annuity plan" (which is a 403B) are deducted from gross income for SE tax purposes:

Amounts not included in gross income.

Don't include the following amounts in gross income when figuring your net earnings from self-employment.
* Offerings that others made to the church.
* Contributions by your church to a tax-sheltered annuity plan set up for you, including any salary reduction contributions (elective deferrals) that aren't included in your gross income.

Translation -- Elective 403B contributions that aren't included in W-2 gross income are not subject to self-employment tax for clergy.

 

[ziggy29]

Just trying to understand the issue here:

When you say she is taxed at 29% on the margin, aren't you including the 1/2 FICA tax rate , that yourself pays as well via your employee pay ?
So she is really paying approx 7.5% extra FICA tax above what yourself pay in your job. Meaning her tax rate is more like 22.5% while the rest of income you say (yours, interest) is at 15%

After all, 7.5% of the FICA tax she pays is deductible on the tax return, so off the top of my head when calculating the value of robbing Peter to pay Paul it seems it is misleading to count the full FICA amount. ?

Actually about 29.15%, with 14.15% being the effective self-employment tax rate after considering the deduction of half the tax at the 15% bracket:

(.153 / 2) * 15% = 1.1475%. And 15.3% - 1.1475% = 14.15%. Add that to income tax and it's 29.15%.

And yes, *my* earned income is subject to SS taxes and TSP will not reduce it. But a 403B plan for clergy will. And by replacing that clergy income with passive income, we go from 29.15% to 15% on its taxation.

 

[pb4uski]

I see the guidance that you are referring to but I also see in Publication 571:

Generally, employees must pay social security and Medicare tax on their contributions to a 403(b) plan, including those made under a salary reduction agreement. ...

I just find it hard to fathom that regular employees (and their employers) must pay SS and Medicare tax on wages earned contributed to 401k or 403b plans and that those who are self-employed get a free pass and don't have to pay self employment tax in an almost identical situation... it doesn't make sense.

But, IF it is true, then I think your plan makes sense.

 

[Sunset]

Actually about 29.15%, with 14.15% being the effective self-employment tax rate after considering the deduction of half the tax at the 15% bracket:

(.153 / 2) * 15% = 1.1475%. And 15.3% - 1.1475% = 14.15%. Add that to income tax and it's 29.15%.

And yes, *my* earned income is subject to SS taxes and TSP will not reduce it. But a 403B plan for clergy will. And by replacing that clergy income with passive income, we go from 29.15% to 15% on its taxation.

So her both sides of FICA are visible , whereas your employer side is not visible since your employer pays it, instead of handing it to you, so you could pay it. In which case you would state your taxes were higher.

However, whichever way it's looked at, the 72t would be at a lower tax rate, so IF this works for you then it does reduce the tax.

The big problem I see is if you start it, and the IRS disagrees, then you are stuck doing the 72t for 5 years. However, this is not likely the IRS disagrees, as surely your wife has been funding her 403B for years and therefore reducing the SE tax by the appropriate amount.

As an alternative, have you run the numbers to get a HELOC, and use that extra so your wife can fund her 403B fully to reduce her taxes paid ?

 

[pb4uski]

I like the HELOC idea as it woudl be more flexible. Or a mortgage or cash out refinancing.

 

[ziggy29]

I like the HELOC idea as it woudl be more flexible. Or a mortgage or cash out refinancing.

We live in a church parsonage. We don't own a home.

Also I have double checked and triple checked it and indeed, this *is* true -- in a church sponsored 403B for clergy, elective contributions paid out directly by the church (out of your salary BUT before it hits your paycheck) are indeed excluded from income for SECA purposes. Many church 403B plans explicitly outline this, too. Maxing out her 403B contributions could have reduced self-employment income by $18,000 in 2017 -- and 2018, by up to $24,500 since she will turn 50 next year.

That said it all still seems too good to be true, so there must be some reason why it is.... isn't there?

 

[cathy63]

It sounds like you've done the research and it's a legal way to decrease your current taxes. The only gotcha I can see, other than the ones you've identified, is that since you're effectively moving funds from your retirement accounts to your wife's, there will be some effect on your RMDs. It depends on the age difference between you and the relative sizes of the accounts; and it's moot if you were planning to deplete them before age 70 anyway.

 

[ziggy29]

It sounds like you've done the research and it's a legal way to decrease your current taxes. The only gotcha I can see, other than the ones you've identified, is that since you're effectively moving funds from your retirement accounts to your wife's, there will be some effect on your RMDs. It depends on the age difference between you and the relative sizes of the accounts; and it's moot if you were planning to deplete them before age 70 anyway.

It would actually reduce RMDs for a couple years, since she turns 70.5 two years after I do (2038 versus 2036). Of course, it would increase RMDs starting in 2038 by a little bit since a little of what would have been an RMD in '36 and '37 would be pushed into '38 and beyond.

 

[Sunset]

Sounds good and I believe you when you say it is tax legal, as you have really been doing it for however long she has already been contributing to the 403B.

Just be sure to be careful with the 72t, as they are picky rule plans with big consequences. At least isolate all the $$ you want to use in a single IRA, so you have another IRA for whatever drastic thing life throws at you.

 

[evilanne]

Has your wife ever requested an exemption from SE taxes from the IRS? See page 3 of https://www.irs.gov/pub/irs-pdf/p517.pdf Not sure how likely approval would be but it may be easier option than tapping your IRA. With 72t from an IRA, you need to be careful in figuring the annual amount, see https://www.irahelp.com/slottreport/10-rules-know-about-72t particularly #8. Given that you would be locked in until 2025, suggest you discuss your plan with a tax or financial advisor before taking any action. In order to obtain $16K/year in your early 50s, your IRA would need to be ~ $500K using life expectancy calculation.