Taking a 72(t) to avoid self-employment taxes?

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ziggy29
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Taking a 72(t) to avoid self-employment taxes?

Post by ziggy29 »

Being married to clergy is a challenging thing because of some unique tax situations. So any time I am looking to act on something I not only check with authoritative online sources and a friend who is a CPA familiar with clergy taxes, but also with other folks just to make sure no one thinks of something we may have missed.

Here is the situation: My wife is clergy. There are two relevant deviations from usual tax laws that pertain to clergy for this discussion:

(1) She is mostly considered employed and receives W-2 wages, but her income is subject to SECA (self-employment) taxes and we must pay both halves of the SS and Medicare taxes (15.3% less deduction for half the tax, about 14.15% effectively in our marginal 15% tax rate);

(2) Unlike most people (and Publication 517 confirms it), 403B contributions made for clergy directly by her church (including elective deferrals) are NOT subject to the SECA. So unlike most employees, a properly structured 403B contribution for clergy *does* reduce SS and Medicare tax liability as well as federal income tax liability.

This gives me an idea. Right now our income (after taxes and retirement contributions) is relatively equal to our outgo. We don't have the cash flow to max out her 403B contributions without hitting savings. (We could deplete savings for a while to do this, but prolonged negative cash flow makes me nervous.) So what if I took 72(t) contributions from one of my IRAs until I was 59.5 (I'm 52 now; she is 49), which would be about $15K a year, and used it to max out her 403B contributions? I would be taking a distribution from one retirement plan, paying 15% in taxes on it, and channeling it into a different retirement plan, avoiding more than a 29% tax. Next year she could do even more with the catchup contribution, as she will turn 50 in 2018.

I know some downsides. For one, I would be locked into taking these distributions until 2025. (But as long as we have enough earned income to plow it back into a different retirement account, it really doesn't impact our retirement nest egg or increase our taxes -- and if we didn't have enough earned income for that before I am 59.5, we probably needed the money anyway.) And it will reduce her SS benefit a little bit, but she'd have to live to well over 100 before the reduced benefit amount would more than offset the tax savings if my spreadsheet math is close to correct.

So, knowing the possible downsides... does anyone see a compelling reason *not* do this which I haven't considered above? It seems like a fairly "safe" and low-risk way to essentially cut our taxes by more than $2,000 a year.
Last edited by ziggy29 on Sun Nov 19, 2017 12:32 pm, edited 1 time in total.
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BolderBoy
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Re: Taking a 72(t) to avoid self-employment taxes?

Post by BolderBoy »

ziggy29 wrote: Sun Nov 19, 2017 8:13 amSo, knowing the possible downsides... does anyone see a compelling reason *not* do this which I haven't considered above? It seems like a fairly "safe" and low-risk way to essentially cut our taxes by more than $2,000 a year.
This is very clever. What does your CPA buddy think of it?
"Never underestimate one's capacity to overestimate one's abilities" - The Dunning-Kruger Effect
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ziggy29
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Re: Taking a 72(t) to avoid self-employment taxes?

Post by ziggy29 »

BolderBoy wrote: Sun Nov 19, 2017 11:46 am
ziggy29 wrote: Sun Nov 19, 2017 8:13 amSo, knowing the possible downsides... does anyone see a compelling reason *not* do this which I haven't considered above? It seems like a fairly "safe" and low-risk way to essentially cut our taxes by more than $2,000 a year.
This is very clever. What does your CPA buddy think of it?
Well, they said it appears legitimate (but may need confirmation that our specific 403B plan will qualify, though it probably would) and it will do what I suggest -- replace self-employment income with passive income to reduce the tax burden. I'm just wondering if there are any other "gotchas" that I may not be aware of. Because otherwise it almost seems like a "too good to be true" thing so I can't shake the feeling that there is *something* else I'm missing, even if the tax piece is correct. And before I actually make a more formal consultation with them to solidify it (i.e.paying for the advice as a client), I want to make sure there are no other minefields I may be stepping into.
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teen persuasion
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Re: Taking a 72(t) to avoid self-employment taxes?

Post by teen persuasion »

I keep trying to quantify the lost SS. It really depends on your details: how much you've each earned, which bend points you've passed, when you plan to claim SS, if one was a substantially larger earner than the other so that spousal benefits play into the calculations, etc.

The only way I got a break even age approaching 100 was assuming she was already past the second bend point and planning to claim SS as early as possible, with no spousal $ for simplicity.

It's a tough thing to calculate.
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Re: Taking a 72(t) to avoid self-employment taxes?

Post by KlangFool »

teen persuasion wrote: Sun Nov 19, 2017 4:23 pm I keep trying to quantify the lost SS. It really depends on your details: how much you've each earned, which bend points you've passed, when you plan to claim SS, if one was a substantially larger earner than the other so that spousal benefits play into the calculations, etc.

The only way I got a break even age approaching 100 was assuming she was already past the second bend point and planning to claim SS as early as possible, with no spousal $ for simplicity.

It's a tough thing to calculate.
+1.

Before OP go down this route, he/she need to calculate whether it makes sense to skip the self-employment tax. At the minimum, OP should make sure that the spouse has the 40 credits necessary to qualify for social security income.

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Re: Taking a 72(t) to avoid self-employment taxes?

Post by KlangFool »

ziggy29 wrote: Sun Nov 19, 2017 12:24 pm
BolderBoy wrote: Sun Nov 19, 2017 11:46 am
ziggy29 wrote: Sun Nov 19, 2017 8:13 amSo, knowing the possible downsides... does anyone see a compelling reason *not* do this which I haven't considered above? It seems like a fairly "safe" and low-risk way to essentially cut our taxes by more than $2,000 a year.
This is very clever. What does your CPA buddy think of it?
Well, they said it appears legitimate (but may need confirmation that our specific 403B plan will qualify, though it probably would) and it will do what I suggest -- replace self-employment income with passive income to reduce the tax burden. I'm just wondering if there are any other "gotchas" that I may not be aware of. Because otherwise it almost seems like a "too good to be true" thing so I can't shake the feeling that there is *something* else I'm missing, even if the tax piece is correct. And before I actually make a more formal consultation with them to solidify it (i.e.paying for the advice as a client), I want to make sure there are no other minefields I may be stepping into.
ziggy29,

The "gotchas" is you may get a larger return by paying that $2,000 tax or a portion of it.

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ziggy29
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Re: Taking a 72(t) to avoid self-employment taxes?

Post by ziggy29 »

KlangFool wrote: Sun Nov 19, 2017 4:32 pmThe "gotchas" is you may get a larger return by paying that $2,000 tax or a portion of it.
Thanks for the reply, but -- larger return from what? From Social Security? Every time I run estimates through a spreadsheet, it seems to tell us that she would have to live to over 100 before the "return" from larger SS payments would offset the tax savings. Or are you talking about a different return, somewhere else?
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Re: Taking a 72(t) to avoid self-employment taxes?

Post by KlangFool »

ziggy29 wrote: Sun Nov 19, 2017 4:39 pm
KlangFool wrote: Sun Nov 19, 2017 4:32 pmThe "gotchas" is you may get a larger return by paying that $2,000 tax or a portion of it.
Thanks for the reply, but -- larger return from what? From Social Security? Every time I run estimates through a spreadsheet, it seems to tell us that she would have to live to over 100 before the "return" from larger SS payments would offset the tax savings. Or are you talking about a different return, somewhere else?
ziggy29,

It is from social security. If I am you, I would post those estimate to a new topic and let others verify the number first before you proceed. Based on your posts so far, I doubt that your estimate calculation and/or assumption are correct. It is hard to beat the return if you do not pass the first bend point yet.

1) Does she have the 40 credits necessary to qualify the benefits?

2) Has she passed the first bend point?

3) Are you married for more than 10 years?

KlangFool

P.S.: Please note that the answer may not be 0% or 100%. For example, it may be worthwhile to pay enough tax so that she qualifies for the 40 credits but not much more than that.
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ziggy29
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Re: Taking a 72(t) to avoid self-employment taxes?

Post by ziggy29 »

KlangFool wrote: Sun Nov 19, 2017 4:46 pm
ziggy29 wrote: Sun Nov 19, 2017 4:39 pm
KlangFool wrote: Sun Nov 19, 2017 4:32 pmThe "gotchas" is you may get a larger return by paying that $2,000 tax or a portion of it.
Thanks for the reply, but -- larger return from what? From Social Security? Every time I run estimates through a spreadsheet, it seems to tell us that she would have to live to over 100 before the "return" from larger SS payments would offset the tax savings. Or are you talking about a different return, somewhere else?
ziggy29,

It is from social security. If I am you, I would post those estimate to a new topic and let others verify the number first before you proceed. Based on your posts so far, I doubt that your estimate calculation and/or assumption are correct. It is hard to beat the return if you do not pass the first bend point yet.

1) Does she have the 40 credits necessary to qualify the benefits?

2) Has she passed the first bend point?

3) Are you married for more than 10 years?

KlangFool

P.S.: Please note that the answer may not be 0% or 100%. For example, it may be worthwhile to pay enough tax so that she qualifies for the 40 credits but not much more than that.
Ah. The answers are yes, yes and yes to these three. As for the bend point, her AIME is $1,003 over 420 months (and rising) and the first bend point for 2017 is at $885 straight from the SSA's own website. Even doing this, her AIME would continue to rise considerably compared to the first bend point.

Still, good stuff to know. I sort of checked this in the "what ifs" when I changed her projected future income, but didn't have the specific formula.

My calculations are far from perfect but I made some future assumptions, which I deem fairly reasonable, about expected future rates of return and the time value of money. I see no way, even if making the most conservative estimates, that the break-even point wouldn't be *at least* into her 90s.
Last edited by ziggy29 on Sun Nov 19, 2017 5:55 pm, edited 4 times in total.
Alan S.
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Re: Taking a 72(t) to avoid self-employment taxes?

Post by Alan S. »

Other possible pitfalls:

1) She does not continue at this church for whatever reason, including health issues, a move to another state, etc.
2) The 72t plan is busted either due to a faulty initial calculation or an error in executing the plan. A busted 72t plan results in retroactive penalties back to the first distribution plus late interest.

Note that since you have multiple IRA accounts, you would partition them into an account holding a balance that generates the ideal amount you want distributed. Currently, an IRA balance generates somewhat less than 5% of the balance in annual distributions. Avoiding IRS attention to your plan is wise, so you would not do partial transfers to another custodian, converting to a Roth within the 72t plan IRA etc. You ARE allowed on one time switch to the RMD calculation method should you want to reduce your annual distribution for some reason, such a preserving your IRA assets. This usually results in a reduction of the distribution by roughly 35% if the account value has stated flat.
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ziggy29
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Re: Taking a 72(t) to avoid self-employment taxes?

Post by ziggy29 »

Alan S. wrote: Sun Nov 19, 2017 5:32 pm Other possible pitfalls:

1) She does not continue at this church for whatever reason, including health issues, a move to another state, etc.
2) The 72t plan is busted either due to a faulty initial calculation or an error in executing the plan. A busted 72t plan results in retroactive penalties back to the first distribution plus late interest.

Note that since you have multiple IRA accounts, you would partition them into an account holding a balance that generates the ideal amount you want distributed. Currently, an IRA balance generates somewhat less than 5% of the balance in annual distributions. Avoiding IRS attention to your plan is wise, so you would not do partial transfers to another custodian, converting to a Roth within the 72t plan IRA etc. You ARE allowed on one time switch to the RMD calculation method should you want to reduce your annual distribution for some reason, such a preserving your IRA assets. This usually results in a reduction of the distribution by roughly 35% if the account value has stated flat.
Well, she may (and probably will) eventually serve a different church, but within the same church body they would be in the same 403B plan. And if she were temporarily unemployed between calls or had health issues, we'd probably need the distribution anyway though if she were employed when becoming disabled, she is covered by disability insurance. The one thing I see which could theoretically blow up this plan is if we ever failed to have enough earned income to cover these distributions where we didn't need the income, since we couldn't just turn around and put them right back into an IRA/403B/TSP.

We have several retirement accounts. The one I am looking at has a balance of about $320K and would generate close to $15K using current interest rates and our ages (52 and 49) -- I targeted that once since it would throw out close to the income needed to do this. There would still be over $800K in retirement accounts (IRA/401K/TSP, both traditional and Roth) not touched by this.
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