Author: Ben Gelbart

History of the Retirement Plan, Part V

Preface: “But a careful look at the historical record shows that the promise of American life came to be identified with social mobility only when more hopeful interpretations of opportunity had begun to fade, that the concept of social mobility embodies a fairly recent and sadly impoverished understanding of the ‘American Dream,’ and that its ascendancy, in our own time, measures the recession of the dream and not its fulfillment.” – Christopher Lasch, The Revolt of the Elites

History of the Retirement Plan, Part V

This is the fifth and final post in a series on the subject of retirement plans. The first four parts can be found here, here, here, and here. In this series, we have:

      • Briefly reviewed the history of government-defined retirement models in the United States,
      • Introduced the tax-deferred model, and
      • Explained the difference between Qualified plans and Individual Retirement Accounts (IRAs),
      • Discussed limits to deductibility of retirement contributions, and also
      • Tax treatment of non-deductible contributions, and introduced:
      • The Roth model, and even:
      • Roth conversions.

Why Retirement Accounts?

Now that you are more familiar with the variety of government-defined schemes that exist to help you save for retirement, you might also consider that you don’t actually need any special government-endorsed type of plan in order to accomplish this.

Any brokerage or savings account can be used to save for retirement. You can also invest in real estate or closely held businesses, anything that will retain its value or grow over time. Some people who are more worried about governmental collapse than about inflation will even withdraw all their money in cash or use it to buy gold and put it all in a safe. You can even put money in a cookie jar or hide it under the floorboards, although we don’t recommend this. As long as you can live within your means and not run through all of your savings before you retire, you have in some way saved for retirement.

And while these simpler and more direct savings methods don’t come with any special tax advantages, they also do not carry any of the restrictions and potential penalties to be found with specially designated retirement accounts.

Why Retirement Accounts Now?

At this point we might also ask why it was only in the 20th century that the government came to be so intimately involved in how we save for retirement, first with Social Security in 1935, and then in 1974 with ERISA and its later modifications.

One reason is that before the 20th century, people did not so often outlive their working years, and so “retirement” was not as much of an issue. Another is that, before the Industrial Revolution, more people tended to live in larger, multi-generational family units and had more children. Such a family structure was in effect a sort of retirement plan.

People were also more likely to own their own land, small businesses, and farms, what Karl Marx would call their “means of production.” These means, together with the families as mentioned earlier, likely meant that you might not see any drop in earnings just because you could no longer work.

In his book The Revolt of the Elites, Christopher Lasch suggests that some type of idealized self-sustaining middle-class existence such as this typified what was thought of as the “American Dream” during the first century and a half of American life and thought. Even if it was not attained or even attainable by most, it had still seemed realistic enough to endure as an ideal.

It was the movement of Americans to the cities and company towns in the late 19th century to seek wage employment that gave rise to the widespread indigent elderly population in the early 20th century, which grew to unbearable dimensions during the Great Depression and eventually led to the Social Security Act.

And it was at this time, according to Lasch, that the ideal of the yeoman farmer or craftsman faded to be replaced by the present-day association of the “American Dream” with a life of ease and plenty or even Cinderella-like rags-to-riches stories.

Lasch suggests the original purpose of American education was not “social mobility” as we conceive it now, but a strengthening of existing families and communities through both business and personal growth.

While the Social Security Act helped to alleviate the material suffering of those who could no longer work, it did not restore their status as members of an ownership class. Social Security did not owe its inspiration to earlier American ideals, but to European statist models pioneered in the 19th century by the Prussian philosopher G.W.F. Hegel and implemented in the German Empire by Kaiser Wilhelm III.

In the mid-20th century, this model was partially privatized as many employers and labor unions promised their workers pensions upon retirement. But by the second half of the century, it was clear that these promises were no better than the solvency of the employer or the political favors that labor muscle could leverage.

With ERISA, we have begun to come full circle, regaining control over our own “means of production” even if for many of us, this is only in the form of fractional ownership of publicly traded companies and government-issued debt. We can at least decide how we want to allocate our share of capital and can even vote by proxy in shareholder meetings. We at last regain the prospect of being middle-class again, not only in the sense of being middle-income, but of being masters of a fate, which, even if not high and majestic, is not subject to the whims and political fortunes of our betters.

Whither Retirement Accounts?

A society of small claims wealth-holders, especially those who hold income-producing assets that they understand and can beneficially manage, is qualitatively very different than a society of pensioned, socially secured wage earners.

The former is not only a society of free citizens who cannot be intimidated by a government or an oligopoly that can threaten to withhold subsidies. It is also a society of true stakeholders in the country itself who are bound to make more responsible decisions about their collective future. These will not tend to be the kind of people who will sell their freedoms and their legacy at the ballot box for promises of free beer, as Edmund Burke has warned. It is also a society where knowledge and skill can be acquired piecemeal in the Jeffersonian sense, without credentials and without the pretensions of an expert class, to be brought to bear directly on the development of what is effectively each individual’s portion of the national wealth to manage with his own unique talents.

If we consider family ownership of publicly traded stock as a rough measure of small-scale ownership of the national wealth, there is a case to be made that we are already now in this new kind of ownership society. According to the Federal Reserve, in 2022:

      • 58% of U.S. families (about 72 million families) held stock.
      • 21% of U.S. families (about 26 million families) directly held stock.

Yet in reality, most of this “privately” owned stock is in fact owned through funds concentrated in a very small group of very large fund companies. Of course, the fund companies do not own the funds, the individual account holders do, many of them through retirement accounts. Unfortunately, many owners of retirement accounts do not take much interest or an active role in managing their ownership positions.

If we consider fund control of equity Exchange Traded Funds (ETFs) as a rough measure of fund control of individually owned wealth, we might wonder to what extent individual account holders can meaningfully be said to own anything. How many even see themselves as “owners”? According to U.S. News & World Report, in 2024 74% of the Equity ETF Market is controlled by just three fund companies: Vanguard, BlackRock, and State Street Corp.

How strange this situation would seem to Thomas Jefferson. We might explain it to him thus: Most Americans still own their farms and trades, as it were. However, they are afraid to set foot on their own land or to touch their own work tools. They believe that only a gentry class of experts are qualified to do these things on their behalf.

Those of us who are lucky enough to still own farms and small businesses that we materially participate in and understand enough to pass them and the knowledge to run them on to our children, can still partake in the American Dream as Christopher Lasch describes. For the rest of us, it will be incumbent not only to save income earned from our chosen professions and invest it, but to take an active interest in our investments and be able to understand them well enough to pass them and the knowledge to manage them on to our children.

History of the Retirement Plan, Part IV

Preface: “Some people shave before bathing.
         And about people who bathe before shaving they are scathing.
          While those who bathe before shaving,
          Well, they imply that those who shave before bathing are  misbehaving.”                – Ogden Nash

History of the Retirement Plan, Part IV

The following is the fourth in a series of blog posts on the subject of retirement plans. The first three installments can be found here, here, and here. In them we have:

    • Briefly reviewed the history of government-defined retirement models in the United States,
    • Introduced the tax-deferred model,
    • Explained the difference between Qualified plans and Individual Retirement Accounts (IRAs).
    • Discussed limits to deductibility of retirement contributions, and
    • Tax treatment of non-deductible contributions.
    • And introduced the Roth model.

In this fourth installment, we will conclude our discussion of Roth IRAs with a review of:

Roth Conversions

In the previous post in this series, we extolled the virtues of the Roth IRA and the advantages it offers account holders. In particular, it allows all money contributed to grow tax-free with no reporting requirement or tax due at any time. Given a sufficient time horizon, this advantage will more than compensate for the fact that contributions to Roth IRAs cannot be deducted from taxable income.

The Empire Strikes Back against Roth Account Holders

The government is aware of these rather unfair advantages that the Roth IRA gives to the taxpayer.  For this reason, they have placed limits on who can contribute to one. This is not a limit on deductibility of contributions, as exists with the traditional IRA, but a limit on the contribution itself.

For 2025, income limits are:

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The Roth Conversion

But have no fear. You can continue to contribute to your Roth no matter how high your AGI is. Yes. Really.

The way to do this legally is a provision, some would call it a loophole, known as a Roth conversion. A Roth conversion is really just a rollover, but one from a traditional to a Roth status.

Some people will tell you that a Roth conversion is taxable. They are mostly correct. Specifically, the pre-tax portion of a Roth conversion is taxable. This is true since going from pre-tax to after-tax by definition means that tax is being paid in the process. There is not a special tax that applies to Roth conversions. It is the same tax that you would pay on any qualified withdrawal of pre-tax money. This is because, as mentioned, a Roth account must always have an entirely after-tax status.

You must report the Roth conversion on Form 8606, where you will compute the taxable amount.

Example: You have a traditional IRA with $20,000 in it. All of it is pre-tax. You decide to convert it all into a Roth. You can do this, regardless of your AGI, and regardless of the fact that the annual contribution limit to a Roth in 2025 is $7,000. The only catch is that this conversion will be taxed at your marginal rate. If you are in the 22% tax bracket, you are looking at an additional $4,400 in income tax.

Example: As above, but $10,000 of your traditional IRA has an after-tax status. Your tax rate is the same as before, but since only the pre-tax amount is subject to tax, you owe only $2,200 on the conversion.

If the logic here sounds eerily similar to our discussion of Tax Treatment of Withdrawals from Mixed-Status IRAs in Part Two of this series, that is because it is essentially the same issue. Just as a withdrawal from a traditional IRA is taxed only on its pre-tax proportion, so too is a Roth conversion, and for the same reason. And the calculation of the pre-tax proportion is done on the same tax form, Form 8606.

Roth conversions are also subject to the same mistake people make where they assume they can avoid paying taxes by designating which monies to convert. When converting a traditional IRA, you must consider the total value of all traditional, SEP, and SIMPLE-IRAs (but not qualified plans).

Example: You have two traditional IRAs, each worth exactly $10,000. One is wholly pre-tax and the other is wholly after tax. You want to convert one of them to a Roth. “I will convert the after-tax one,” you think happily to yourself, “That way I will not owe any tax on the conversion.”

Unfortunately, that is not how the IRS is going to see things. They consider that you have a total IRA value of $20,000 with a total after-tax basis of $10,000. Therefore, exactly 50% ($10,000/ $20,000) of any withdrawal or conversion from either account is taxable. No more. No less.

Another piece of advice you will sometimes hear is to wait until after retirement to convert your IRA to a Roth because you will be in a lower tax bracket then. But consider that the longer you wait, the more your pre-tax earnings grow, which means more taxable income later, even if it is taxed at a lower rate. Converting earlier means all future growth will be after-tax, which means you will never pay tax on it no matter how much it grows. If you are planning on retiring next year and withdrawing all the money within say, five years, then it is worth waiting the year or two and doing the conversion after you retire. But if your time horizon to withdrawal is longer than that, it might be more advantageous to not postpone the conversion. Conversion also gets you out of the Required Minimum Distribution, since there is no RMD on Roths.

Unlike traditional IRA and Roth IRA contributions which have an annual limit, there is no limit to how much existing traditional money you can covert to a Roth in a single year. However, larger conversions of pre-tax money mean more taxable income. In some cases, a large conversion can even move you into a higher tax bracket for the year. For this reason, people sometimes stagger conversion of an IRA over a number of years. Luckily, there is no limit on the number of times you can do a conversion.

The Back-Door Roth Conversion

Some of you may be thinking: “My income is too high to contribute directly to a Roth IRA. I would love to convert money from a traditional IRA, but I don’t have a traditional IRA.”

You’re in luck. You don’t need to have a pre-existing traditional IRA. You can create a traditional IRA for the express purpose of contributing to it and immediately converting it. This is sometimes known as a “back-door Roth conversion.” That is not a technical term. There is no box for you to check when you open the account that says “back-door.” It is just an informal term used to mean that the traditional IRA was opened solely to convert future contributions to Roth status. You can contribute the limit to the traditional, up to $7,000 in 2025, immediately roll it over to a Roth, and it’s as if you contributed directly to the Roth, with the one key difference that it is not limited by your AGI.

As long as you don’t deduct your contribution to the traditional IRA from your taxable income, and there is no requirement that you must deduct it, the conversion is entirely non-taxable because the contributed amount is entirely after tax. Just make sure you document the conversion on Form 8606.

If you leave the money in the traditional IRA for long enough for it to earn any kind of interest or other earnings, the earnings portion will be taxable at the time of conversion.

Example: You open a traditional IRA and contribute $7,000 to it. You do not deduct any of this from your taxable income. The account earns $10 in interest. You convert the entire $7,010 to your Roth IRA.

Remember that the IRS considers your entire IRA value and your entire pre-tax basis. So in this case $10 of the conversion will be taxable at your marginal rate because that is 0.14% ($10/$7,010) of the $7,010 conversion.

Even if you convert only the $7,000 and leave $10 in the traditional IRA, $9.99 of the conversion will still be taxable at your marginal rate because that is 0.14% ($10/$7,010) of the $7,000 conversion.

So what happened to that missing one cent of taxable income? It remains with the traditional IRA. Another way to look at it is: we are partitioning out the $7,000 in after-tax basis so that 6990.01 is allocated to the conversion and $9.99 to the traditional IRA. So going forward, the traditional IRA as it continues to grow will have a $9.99 after-tax basis.

Bottom Line: the IRS will not allow you to avoid or decrease tax due on a conversion by choosing which part of the money you are converting.

Beware of Pre-Existing Traditional Accounts

When figuring the taxable proportion of a Roth conversion, the IRS requires that you consider the value of “all your traditional, traditional SEP, and traditional SIMPLE IRAs”. This makes the back-door conversion not a particularly good strategy for those with pre-existing IRA-type accounts.

Example: You open a traditional IRA and contribute $7,000 to it. You do not deduct any of this from your taxable income. You convert the entire $7,000 to your Roth IRA.

It turns out you had a SEP-IRA from a past job that is now worth $100,000, all pre-tax. So $6,542.06 your conversion will be taxable at your marginal rate because that is 93.46% ($100,000/$107,000) of the $7,000 conversion.

Note that this does not apply to Qualified plans, which can be ignored for purposes of Roth conversions.

If you have a pre-existing IRA with a large pre-tax component, you can increase the after-tax proportion each year by contributing after-tax amounts to it or to any other traditional IRA. However, any future earnings in these accounts will count towards the pre-tax component, because that is the nature of traditional IRAs.

See Part Two of this series for two possible strategies to directly decrease the pre-tax component of a traditional IRA. However, be forewarned that these strategies might not be applicable to all taxpayers.

History of the Retirement Plan, Part III

Preface: “Go Roth, young man!” –  paraphrasing Horace Greeley

History of the Retirement Plan, Part III

The following is the third in a series of blog posts on the subject of retirement plans. The first two installments can be found here and here. In them we have:

    • Briefly reviewed the history of government-defined retirement models in the United States,
    • Introduced the tax-deferred model,
    • Explained the difference between Qualified plans and Individual Retirement Accounts (IRAs).
    • Discussed limits to deductibility of retirement contributions, and also
    • Tax treatment of non-deductible contributions.

In this third installment, we introduce:

The Roth model

The Story so Far

We have already seen how the Employee Retirement Income Security Act (ERISA) of 1974 introduced the tax-deferred model of retirement savings, including two kinds of tax-deferred accounts: job-based Qualified plans and Individual Retirement Accounts (IRAs). Contributions to these accounts are generally tax-deductible. Withdrawals are then taxed as ordinary income when withdrawn after retirement age is reached.

We have also seen how the government got cold feet about allowing taxpayers to deduct the full amount of their IRA contributions. This led to a complex situation in which the tax status of money within an IRA has to be tracked so that a taxability percentage can be computed upon withdrawal.

Enter Roth

Perhaps because of the complexities of having to track IRAs that contain both pre- and after-tax money, or perhaps because the government realized that they kind of liked the idea of taxing money when it was contributed instead of having to wait until people retired, the Taxpayer Relief Act of 1997 included a proposal that had been submitted by Senators William Roth of Delaware and Bob Packwood of Oregon. Perhaps because Roth’s was the shorter name, this new kind of account came to be named after him and not after Senator Packwood.

The main innovation of the Roth IRA is that all contributions have to be included in taxable income in the year they are contributed. No amount may be excluded or deducted. As a result, all money in a Roth IRA has an after-tax status.

Once the Roth IRA came into existence, the older kind of IRA came to be known as a “traditional IRA”. The two types of IRA are often contrasted as one where you pay taxes now vs. one where you pay taxes later. But the difference between the two models is far greater than just the timing of taxation.

Would you believe me if I told you that earnings on Roth contributions are never taxed? Well, it’s true. Really. NEVER. EVER. Not only that, but you don’t even have to report them. Once after-tax money is contributed to a Roth, you can keep growing and investing it in a parallel universe where taxes don’t exist.

Here is a schematic view:

The Case for Roth

The previous post in this series made the point that unless your time remaining to retirement is very short, the value of your IRA by retirement will likely be more than twice the amount of your total contributions. Therefore, even if you cannot deduct your IRA contributions, it is still worth contributing and paying the “higher rate” now so you can get the “lower rate” on the withdrawal of the earnings. How much more so is this then true of Roth IRAs, where the “lower rate” paid on withdrawals is always zero.

Let’s consider a conservative example of someone who contributes $1,000 a year for 30 years at a growth rate of 7% a year. This is a conservative assumption since between 1995-2025 the S&P 500 has averaged better than 10% a year. But even at 7%, you would more than triple your money with an ending balance of $101,073 after 30 years of contributing $1,000 per year.

Let’s assume a taxpayer who is in the 22% tax bracket while working and in the 10% tax bracket during retirement.

If this were a taxable account, your contributions would be made from after-tax money, corresponding to $6,600 ($1000 x 30 x 22%) in income tax paid on 30 years of contributions. In addition to this, tax would be due on the earnings that grew in the account each year. Taxed at your marginal rate, this would total $15,636.07 (($101,073 – $30,000) x 22%) paid as it is earned. In reality, tax on earnings might be slightly less because some of it would likely be eligible for the lower rate on qualified dividends and long-term capital gains.

If the account were a traditional IRA with no deductions taken, you would have paid the same $6,600 on contributions as with the taxable account. The earnings, however, would be taxed at the lower rate as they’re withdrawn during retirement: a total of $7,107.30 (($101,073 – $30,000) x 10%).

If the account were a traditional IRA with all possible deductions, the only tax paid would be on withdrawals during retirement: a total of $10,107.30 ($101,073 x 10%).

If this were a Roth IRA, you would pay nothing on earnings and nothing at withdrawal. The only tax involved would be that same $6,600 you paid on income that you used to make the contributions over 30 years.

Here is a graphic view:

Of course, the numbers here are arbitrary, but the dynamics should be clear. As your time horizon is longer and your annual contributions and percent growth are larger, these differences become more pronounced.

If you expect to retire into poverty to the extent that you will never be subject to tax on withdrawals from your IRA, then by all means open a traditional IRA so you can at least deduct some of your contributions. But if you expect to have taxable income in retirement, and especially if you can begin saving early in life, you are almost certainly better off with a Roth. And you are almost certainly better off contributing the maximum allowed to your Roth each year.

In the spirit of manifest destiny and the Homestead Act of 1862, we might even say: “Go Roth, young man, and grow up with your tax-free earnings!”

When considering the annual limit on contributions to IRAs, note that contributions to Roth IRAs are included for this purpose. You may contribute to any number of traditional and Roth IRA accounts in the same year, but total contributions may not exceed the annual limit, which is $7,000 in 2025 for taxpayers under 50.

Another advantage of the Roth is that because there is no tax after you retire, there is no required minimum distribution either.

The Roth Legacy

Not everyone will be won over by the mathematical arguments that favor the Roth IRA over the tax-deferred “traditional” IRA. But consider that since the introduction of Roth in 1997, its influence has only been growing, while “traditional” becomes more of a circumscribed concept.

Newer types of tax-advantaged savings vehicles such as 529 college plans, first introduced in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), work according to the Roth model. Contributions are not deductible, but earnings are never taxed if the money is used for qualified purposes. This is essentially a Roth-type plan. The only difference is that the qualified purpose of a 529 account is education, not retirement. The only reason no one talks about a “Roth 529” is that there is no such thing as non-Roth 529.

Even Qualified plans available through employers are showing up in Roth variations. Many companies now offer a Roth 401(k). As you can imagine, this is just like a “traditional” 401(k) except that the contribution is not excluded from taxable income and the earnings are tax-free if not withdrawn before retirement.

Even state-employers are getting in on the Roth model and offering Roth-type Qualified plans for state employees. The general term for these is “Roth-designated accounts”. A “Roth-designated” portion of an account will work just like the non-Roth part except that the contributions are not excluded from taxable income and the earnings are tax-free if used for qualified purposes.

Rollovers and conversions between all these types of accounts should follow the same general principles as for more well-established types of account. There is as of yet not a lot of documentation on every possible type of rollover or conversion.

In the next post in this series, we will review conversions from traditional IRAs to Roth IRAs (“Roth conversions”).

History of the Retirement Plan, Part II

Preface: “As in all successful ventures, the foundation of a good retirement is planning.” – Earl Nightingale

History of the Retirement Plan, Part II

The following is the second in a series of blog posts on the subject of retirement plans. The first installment, which can be found here:

    • Briefly reviewed the history of government-defined retirement models in the United States,
    • Introduced the tax-deferred model, and
    • Explained the difference between Qualified plans and Individual Retirement Accounts (IRAs).

This second installment will discuss:

    • Limits to deductibility of retirement contributions, and
    • Tax treatment of non-deductible contributions.

Future posts in this series will address:

    • The Roth model.

Non-Deductible Contributions to IRAs

Within a decade after the creation of the Individual Retirement Account (IRA) in 1974, the government began having second thoughts about letting individuals deduct the entirety of their IRA contributions from taxable income. They were especially concerned with higher-income employees who already had generous qualified retirement plans through their jobs. If you or your spouse could already exclude five figures worth of your wages from your taxable income, why should you also be allowed to deduct your IRA contributions?

The Tax Reform Act of 1986 introduced income limits on deductibility for individuals who were covered by Qualified plans at work and for their spouses, even if the spouse is not covered by a qualified plan.

The dollar amount limits set forth in 1986 are increased every year or so for inflation, but the basic three-tiered system introduced in 1986 is still with us. Here are the 2025 income limits for married filers:

MFJ, neither covered by Qualified plan MFJ, covered by Qualified plan MFJ, not covered by Qualified plan but spouse is
All of IRA contribution is deductible with no income limit. All of IRA contribution is deductible if combined AGI is less than $126,000 All of IRA contribution is deductible if combined AGI is less than $236,000.
None of IRA contribution is deductible if combined AGI is more than $146,000. None of IRA contribution is deductible if combined AGI is more than $246,000.

And for single filers:

Single, not covered by Qualified plan Single, covered by Qualified plan
All of IRA contribution is deductible with no income limit. All of IRA contribution is deductible if combined AGI is less than $79,000
None of IRA contribution is deductible if combined AGI is more than $89,000.

Under this system, not all money in all IRAs is tax-deferred. Individuals who are limited from deducting their contributions in whole or in part must pay tax on those amounts in the current year. Therefore, some of the money in their IRAs going forward is after-tax money.

This is bad because it means you have to pay tax on it this year. However, it is also beneficial, as you will never have to pay any tax on it again. And the earnings from the after-tax portion of the contribution will have the same tax-deferred status as the earnings from the pre-tax portion.

An IRA is Worth More Than Just Its Deduction

People will sometimes say that they don’t want to contribute anything to an IRA that they cannot deduct on their current year tax return. But consider that if you don’t take the deduction on a contribution now, you will not have to pay tax on it when it is withdrawn. You are in effect taking the deduction after you retire instead of taking it now. Of course, if you expect to be in a lower tax bracket in retirement, the deduction now is worth more than it will be then. But if you cannot take the deduction now, you can still get it later. It is not lost forever. And by contributing the maximum today, you still get the maximum amount of earnings growing tax-deferred.

Example: You contribute $1,000 to your IRA. Of this, you are only able to deduct $500. Over the years, your IRA grows in value to $4,000. After reaching retirement age, you withdraw the $4,000. The $500 you could not deduct is withdrawn tax-free, since tax has already been paid on it. The remaining $3,500 is taxed as ordinary income upon withdrawal.

If you are in a lower tax bracket when you retire, you might feel bad that you had to pay tax on $500 of the contribution back in the day when you were in a higher tax bracket. However, the $3,000 of earnings is still all taxed at the lower rate, even though the non-deducted portion of the contribution generated half of it.

Imagine you had not contributed that $500 because you couldn’t deduct it, but had invested it instead in a taxable brokerage account. Then the $1,500 of earnings it generated would be taxed when you earned it, at the rates you were subject to at the time.

Here is a schematic view of the differences:

IRA – deducted on contribution IRA – not deducted Taxable account
Contributions Taxed on withdrawal

(lower rate)

 Taxed on contribution

(higher rate)

 Taxed on contribution

(higher rate)
Earnings Taxed on withdrawal

(lower rate)

 Taxed on withdrawal (lower rate) Taxed as earned

(higher rate)

Unless your time remaining to retirement is very short, the value of your IRA during retirement resulting from this year’s contribution will likely be more than twice the amount of the contribution. So unless you have reason to think you will not be in a lower tax bracket after you retire, the value of contributing to an IRA is likely greater than the value of your current year deduction. So it is likely still worth contributing the maximum each year, even if you can’t deduct all of it.

Tax Treatment of Withdrawals from Mixed-Status IRAs

If you ever make a contribution to your IRA that is not completely deductible, you are supposed to file Form 8606 every year with your tax return to track the after-tax amount in your IRA from year to year. If you do not track the after-tax portion throughout the life of the IRA, you may have to pay tax on the entirety of your withdrawals.

When you attain retirement age and make a withdrawal, you are supposed to prorate the taxable amount of the withdrawal. The calculation is likewise done on Form 8606.

Example: You contribute $1,000 to your IRA. Of this, you are only able to deduct $500. Over the years, your IRA grows in value to $4,000. After reaching retirement age, you withdraw the $4,000. You have dutifully filed Form 8606 each year of your working life so you can prove that exactly $500 has an after-tax status. The $500 you could not deduct is withdrawn tax-free. The remaining $3,500 is taxed as ordinary income upon withdrawal.

But wait! Let’s say you don’t want to withdraw the entire $4,000. Let’s say you only want to withdraw $1,000. You might think: “I will withdraw the $500 that is after-tax and $500 of the pre-tax money. That way, I will only have to pay tax on half of my withdrawal.”

Unfortunately, that is not how the IRS will see things. Any amount you withdraw from a mixed-status IRA needs to be prorated based on the ratio of total after-tax holdings to the total IRA value. Therefore, only 12.5% ($500/$4,000) (which is to say $125) of your $1,000 withdrawal is tax-free. The other $875 is taxable. You then reduce the after-tax amount of your IRA by the $125 you withdrew and carry the result to next year’s Form 8606

The taxable ratio is computed based on the total pre-tax holdings in all your IRA accounts over the total value of all your IRA accounts. This includes all SEP-IRA and SIMPLE-IRA accounts, but not qualified plans. So you cannot manipulate the taxable proportion of your withdrawals by keeping separate IRA accounts and making withdrawals from the one with the desired taxable proportion.

There are, however, several ways to increase the after-tax proportion of an IRA. One of these is the Qualified Charitable Distribution (QCD).

Strategy #1 for Increasing the After-Tax Proportion of an IRA: Introducing the QCD

The QCD is available to owners of IRAs who are at least 70 years old. They must be made to tax-deductible charitable organizations, and the transfer must be made directly from the IRA. You cannot just write a check to your favorite charity and declare it a QCD. A properly made QCD is entirely pre-tax and cannot be used as an itemized deduction. It is excluded income, which is why none of it can have an after-tax status.

A QCD can be used to fulfill a Required Minimum distribution.

Example: You have $4,000 in your IRA and you have attained retirement age. You have dutifully filed Form 8606 each year of your working life so you can prove that exactly $500 has an after-tax status. The company that administers your IRA informs you that in the current year, you must make a required minimum distribution of $500 to avoid penalties.

You direct your IRA administrator to send a QCD of $500 to your favorite charity. This distribution will not be taxable to you. Furthermore, it reduces the pre-tax part of your IRA by $500 without reducing the after-tax part. After this QCD is made, you are left with a balance of $3,500 in your IRA, $500 of which remains after tax, just as before. You have effectively increased the after-tax proportion of your IRA.

Strategy #2 for Increasing the After-Tax Proportion of an IRA: Rollover to a Qualified Plan

Another way to increase the after-tax portion of your IRA is to make a rollover to a qualified plan. A rollover is simply a transfer of funds from one account to another account with a similar tax status. Because a Qualified plan is pre-tax, all rollover amounts to a Qualified plan must also be pre-tax.

A rollover is not a distribution and cannot be used to fulfill a Required Minimum distribution.

Example: You have $4,000 in your IRA and you have attained retirement age. You have dutifully filed Form 8606 each year of your working life so you can prove that exactly $500 has an after-tax status. The company that administers your IRA informs you that in the current year, you must make a required minimum distribution of $500 to avoid penalties.

You decide that first you will roll over some of the IRA into a Qualified plan you have from a job. The rollover to the Qualified plan can only be from the pre-tax part of the IRA, so you will not be able to roll over more than $3,500. Any amount you do roll over will increase to proportion of the IRA that is after-tax.

If you roll over the entire $3,500, only the $500 of after-tax money will remain in the IRA. This can then be withdrawn to fulfill the RMD, and it is now 100% tax-free. The $3,500 that you rolled over retains its pre-tax status within the Qualified plan, so the rollover is itself a tax-free event.

If you are aware of any alternative methods to increase the after-tax portion of an IRA beyond a QCD or a rollover to a qualified plan, please contact me at bgelbart@saudercpa.com and let me know.

History of the Retirement Plan, Part I

Preface: “The Congress shall have Power To lay and collect Taxes, Duties, Imposts and Excises, to pay the Debts and provide for the common Defence and general Welfare of the United States” – US Constitution art. I, §8, cl.1

History of the Retirement Plan, Part I

The following is the first in a series of blog posts on the subject of retirement plans. This first installment:

      • Briefly reviews the history of government-defined retirement models in the United States,
      • Introduces the tax-deferred model, and
      • Explains the difference between Qualified plans and Individual Retirement Accounts (IRAs).

Future posts in this series will address:

      • Limits to deductibility of retirement contributions,
      • Tax treatment of non-deductible contributions, and
      • The Roth model.

A Brief History of Government-Defined Retirement

Most Americans do not save enough for retirement. Over the years, the government has established several tax-advantaged financial models to encourage saving for retirement.

The oldest of these is Social Security, which was introduced in 1935 and is administered by the government itself. It is implemented by employers and by the self-employed. It is mandatory. Employers who do not remit payroll tax on behalf of their employees and self-employed people who do not pay self-employment tax will face stiff penalties. These additional taxes are collected by the government, which then pays benefits to individuals when they become eligible.

Tax-Deferred Plans

The next major governmental push to help Americans save for retirement was the Employee Retirement Income Security Act (ERISA) of 1974. This legislation introduced the tax-deferred model of retirement saving. This type of account is not run by the government, and it is not mandatory.

As the name itself suggests, the money in a tax-deferred account is not permanently spared from taxation; it is taxed later rather than sooner. Contributions to a tax-deferred account are not included in current-year taxable income. Furthermore, investment earnings on the contributions are not included in taxable income in the year they are earned. Rather, both contributions and investment earnings are taxed as a single income source when you withdraw money from the account after you retire.

For tax-deferred accounts, 59½ is the magic age at which you may begin making withdrawals without incurring penalties.

Example: You have $10,000 in taxable earned income. However, if you contribute $1,000 of it to a tax-deferred account, then only the remaining $9,000 is taxable in the current year.

Additionally, unlike a standard brokerage account, you do not need to worry about reporting portfolio income generated within your retirement account as it grows.

Example: You invest $1,000 in a brokerage account.

You buy $500 worth of government bonds and use the other $500 to buy stock in your favorite publicly traded corporation. The bonds pay $20 worth of interest and mature with $4 of original issue discount. The stock pays a $15 dividend. You then sell the stock for $600, resulting in a $100 capital gain.

You now have $139 of taxable income in the form of interest, OID income, dividends, and capital gains, which all need to be reported separately on your tax return.

OR

When you open the brokerage account, you check the box that says “IRA”. This makes the account tax-deferred. You then buy exactly the same stocks and bonds as above that yield $139 of the same types and amounts of income. However, since the account is tax-deferred, none of the earnings are taxable in the current year, and you don’t even need to report any of them.

When you retire and eventually withdraw money from the account, each withdrawal you make will be taxed as ordinary income. You will never have to report how much was earned from stocks vs. bonds, interest vs. dividends, etc.

The logic behind this legislation was that most people will be in their highest tax bracket during their working years and in a lower tax bracket during their retirement years. So it would be to their advantage to defer tax on some of their income and their portfolio earnings until after they retire. So, for many, if not most, people, this story will have a relatively happy ending.

Example: You invest $1,000 in a brokerage account. Over the course of your working years, it grows to a total value of $4,000.

You retire and cash out your retirement account. You now owe tax on the entire $4,000. During your working years, you earned a sizable salary and were consistently in the 22% tax bracket or above. Now that you are retired and living off your retirement earnings and Social Security, you are in the 10% tax bracket. So you pay less than half as much tax on the $4,000 as you would have during your working years.

Qualified Plans vs. Individual Retirement Accounts

ERISA defines two types of tax-deferred accounts, although they both offer the same type of tax advantage. The difference between them is who is responsible for establishing them and how much can be contributed to them.

Qualified plans are implemented by employers and have a relatively high contribution limit. Contribution limits are increased for inflation every year or so. For 2025, the limit for taxpayers under 50 is $23,500. This limit applies to all Qualified plans you participated in within the year.

The term “Qualified plan” may sound a bit vague, but this is the technical term for several types of plans you have undoubtedly heard of. The most familiar is probably the 401(k) plan made available by large private-sector employers. There are similar plans offered by state employers, such as 401(a) and 403(b).

Example: You worked one job early in 2025 and deferred $20,000 of wages to the Qualified plan offered by that employer. Later in the year, you get another job that offers a different qualified plan. Any deferral you make to the second plan beyond $3,500 will be considered an excess contribution and will incur penalties.

Deferrals to Qualified plans are taken out of your paycheck, so people don’t always think of them as “contributions”. And you don’t get to take a tax deduction on them, because the amount of the deferral is left out of the taxable income as reported by your employer. However, while the paperwork is slightly different, the result is the same as if you had included the amount in your taxable income and then deducted it.

Individual Retirement Plans (IRAs) are implemented by the individual taxpayer. IRAs have a much lower contribution limit than Qualified plans. For 2025, the limit for taxpayers under 50 is $7,000. This limit applies to the sum of contributions to all IRAs owned by an individual. Contributions to Qualified plans are subject to a separate limit and so are not considered towards the limit on contributions to IRAs.

Example: You have already maxed out your deferrals to the Qualified plans offered by the employers you worked for during 2025. You may still open an IRA and contribute the maximum of $7,000. Opening a second IRA will not allow you to circumvent this limit on IRA contributions. The limit applies to the total amount of contributions to all your IRAs.

When you contribute to an IRA, you are generally allowed to deduct the amount of your contribution from your taxable income. From a tax perspective, this has the same effect as excluding a deferral from your paycheck.

Another thing Qualified plans and IRAs have in common is that you cannot contribute more than your earned income for the year. So, if you only earned $20,000 during the year, you cannot contribute more than $20,000 to your qualified plan even if the limit is $23,500. Similarly, if you only earned $6,000 during the year, you cannot contribute more than $6,000 to your IRA, even if the limit is $7,000. This earned income contribution limit cannot be circumvented by non-earned income. So, if you win the lottery or make a lot of gains in the stock market, this does not increase your ability to contribute to a Qualified plan or IRA.

For IRAs, but not for Qualified plans, the limits can be combined for married couples. Both spouses can contribute to their respective IRAs up to the limit of their combined earned income. If a couple’s combined earned income is at least $14,000, they can each contribute $7,000. This is true even if only one spouse had earned income.

Required Minimum Distributions

Tax-deferred accounts can generally be inherited and have the same status for heirs as they had for the original owners. Meanwhile, the amount of money in the account continues to grow, and no tax is being paid on it. To reduce the amount of time that money can be rolled forward like this tax-free, the government requires that you begin distributing the money to yourself (and paying tax on it) when you reach a certain age.

This is known as a Required Minimum Distribution (RMD). The rules of RMDs are complex. They generally must be taken starting in the year in which you turn 73. The administrator of your Qualified plan or brokerage for your IRA should contact you before the year is over and tell you the least amount you must withdraw to avoid a penalty.

What Is a Depreciation Schedule and Why Does Your Accountant Keep Insisting You Need One?

Preface: “The value of an idea lies in the using of it.” — Thomas Edison

What Is a Depreciation Schedule and Why Does Your Accountant Keep Insisting You Need One?

If you own a business, farm, or rental property, you probably know that you can take a significant business deduction for something called “depreciation.” You likely realize that depreciation is your recovery of the cost of business assets and that it can take a number of years to fully recover such costs. In other words, the tax code lets you deduct the cost of assets placed in service in your business, farm, or rental property, but it doesn’t always let you deduct the entire amount in a single year.

So far, so good. You may have also heard of a “depreciation schedule,” and this may have sounded a bit confusing. Have no fear, it is not really that complicated. A depreciation schedule is simply a list of your business assets that helps to explain what depreciation has already been taken on each asset and how much depreciation remains to be taken on each one.

Each line in a depreciation schedule should include five data points:

    • A description of the asset.
    • The date the asset was placed in service.
    • The cost basis, including all sales tax, fees, and other transaction costs.
    • A useful life. The IRS issues guidelines on lifetimes of depreciable assets. Your accountant should be able to determine for you the useful life of a new asset. If you are hiring a new accountant, the new accountant needs to know what life the old accountant used.
    • A method, which is to say, how much is being recovered each year over the useful life of the asset. In some cases, the entire cost may be recovered in the first year under section 179. For real estate and amortized costs, straight-line depreciation must be used, which is to say the same amount is recovered each year over the life of the asset. In most other cases, some form of accelerated depreciation is used. As with the useful life, any accountant should be able to determine this for you for any new asset, but a new accountant needs to know what method the old accountant used.

EXAMPLE: Say you spent $15,000 on an improvement to your rental property in June of this year. This bit of new information becomes a new line your depreciation schedule that says:

Renovation – July 1st, $15,000

Your accountant will know that improvements have a 15-year life and are taken using a straight line method. The amount of remaining depreciation to be recovered will then be decreased in the schedule by $1,000 each year until it reaches zero 15 years from now.

If you have a business, or multiple businesses, with a large number of assets placed in service in different years using different lifetimes and methods, this can get a little involved. But in principle, each line in the schedule is just a record of how deprecation has been taken on a particular asset.

Why Is My Accountant Asking Me for a Depreciation Schedule?

If you are starting a new business, your accountant should create a new depreciation schedule for that business and update it annually. If you are hiring a new accountant to handle an existing business, that accountant should ask you for the depreciation schedule prepared by the previous accountant. Business clients sometimes feel awkward about this kind of request, either because they are not sure what they are being asked for or because they don’t want to have to tell their old accountant they are planning to switch accountants.

There is no reason to feel at a loss. It is entirely normal for businesses to change accountants in the course of their business life. Accountants are entirely used to this. If you paid an accountant in a prior year to prepare your tax returns and you had depreciable property, then the accountant should have prepared a depreciation schedule to be able to correctly figure the depreciation in a way acceptable to the IRS. All documents prepared by the accountant, including the depreciation schedule, are then yours since you paid for them, and you are entirely within your rights to ask for copies.

The schedule tells the new accountant how much depreciation is left to be recovered in future years. You are entitled to recover the entire amount over the life of the asset, but at the same time, you do not want to invite problems by continuing to depreciate after the entire cost has already been recovered. This can be especially tricky if accelerated depreciation, bonus depreciation, or section 179 depreciation have been taken in prior years.

Having a depreciation schedule is also very important in the event that you sell any business assets. This is because the amount of depreciation taken in prior years must sometimes be added back (“recaptured”) when computing your gain on the sale.

Can’t You Just Compute Your Own Depreciation Schedule from Last Year’s Numbers?

In some simple cases, it may be possible to reconstruct a missing depreciation schedule from the previous year or several years’ worth of returns. This will still require asking you, the business owner, many questions about the descriptions of the assets and their purchase dates. The tax forms themselves only contain the annual totals or are broken down only by useful life or type of depreciation (MACRS, section 179, or bonus).

It might help to compare a depreciation schedule to a prison roster. When a group of prisoners is transferred from one prison to another, the new warden needs to be told how long a sentence each prisoner is serving, when he began serving that sentence, and other important information, such as whether the prisoner has had his sentence reduced for good behavior, etc.

Remember the States

Many state laws governing depreciation differ from federal law. So, as you can imagine, depreciation taken on state tax returns may not be the same as depreciation taken on your federal return. So it is a very good idea to keep a state depreciation schedule in addition to a federal one. Even if the numbers are the same in some cases, keeping separate federal and state schedules makes this explicit.

Do I Owe Tax If I Sold My House, Car, or Household Items?

Preface: “The hardest thing to understand in the world is the income tax.” – Albert Einstein

Do I Owe Tax If I Sold My House, Car, or Household Items?

If you sold your home, vehicle, furniture, or maybe household items at a garage sale or on eBay, you may be wondering if any of the money you received is taxable.

The short answer is: probably not.

Please read on if you would like to sharpen your understanding of taxable gains and learn when some of the money from sales like this may be subject to tax.

Disclaimer 

The IRS treats personal-use property very differently than property used in business or for investment. In this brief article we are speaking only of personal-use property. If you purchase items for resale, keep inventory, etc., much of the following does not apply.

Understanding Basis

An important concept to understand in all computation of taxable gains is basis. Basis begins with what you originally paid for the item, including taxes and fees you paid in addition to the sticker price. Some later modifications can change the basis, but that is rarely the case for cars and smaller household items.

If you sold property for more than its basis, then you have a gain. Only the gain on a sale is taxed, not the recovery of the basis.

For example, if you paid $8 for something and sold it for $10, your gain is $2.

Once you understand this, it should be clear that you will not owe tax on most things you sell for less than you originally paid. Most personal-use property loses value through time and use and is rarely sold at a gain.

Excluding Gain on Sale of Your Home

Besides certain collector’s items, the only kind of personal-use property that is commonly sold at a gain is a home. And yet, you probably do not owe tax on the sale of your home either, as long as certain conditions are met.

The Taxpayer Relief Act of 1997 exempted from taxation the capital gains on the sale of a personal residence up to $500,000 for married couples filing jointly and up to $250,000 for everyone else. These amounts have not been adjusted for inflation.

Any amount of gain above these thresholds is taxable.

For example, a married couple that buys a house for $400,000 and sells it three years later for $950,000 will have a taxable gain of only $50,000, not $550,000. If the sale is for $900,000 or less, they will not owe any tax.

There are several requirements to check for to see if you qualify for this exclusion. Most of these requirements do not apply to most homeowners. The two most important ones are:

    • The ownership requirement. You must have owned the home for at least 24 months (2 years) out of the last 5 years leading up to the date of sale. For married couples filing jointly, it is enough that one spouse meets the ownership requirement to get the full exclusion amount.
    • The Residence Requirement. You must have used the home as your residence for at least 24 months of the previous 5 years. The 24 months of residence can fall anywhere within the 5-year period, and it doesn’t have to be a single block of time. All that is required is a total of 24 months (730 days) of residence during the 5-year period. Unlike the ownership requirement, each spouse must meet the residence requirement individually for a married couple filing jointly to get the full exclusion.

If you meet these requirements and your gain is below the threshold, not only do you not owe tax on the sale of your home, you don’t even have to report it.

For homes, consider also that certain long-term improvements such as additional structures, etc. may increase the basis beyond its original purchase price.

Dealing with Loss

If you sold property for less than its basis, then you have a loss.

One major difference between personal-use property and business or investment property is that a loss from the sale of personal-use property cannot be deducted.

If you sell stock in a number of companies and lose money on some and gain money on others, you can net your losses against your gains. If you sell several rental properties, some at a loss and some at a gain, you can net your losses against your gains. But if you sell a lot of personal effects at a yard-sale or online, some at a loss and some at a gain, then you owe tax on the gains and you cannot use the losses to offset them.

However, this is rarely an issue since it is so seldom that personal-use property is ever sold at a gain.

Gifts and Inheritances

If you sold property that you received as a gift or inheritance, you might be worried that your basis is zero, so you owe tax on the entire amount of the sale. Not so.

When you receive property as a gift, you also receive the basis in the gift that the person who gave it to you would have had.

For example, if your uncle gives you a car that he paid $50,000 for and you sell it for $5,000, you have a $45,000 non-deductible loss, not a $5,000 taxable gain.

The treatment of inherited property is even more favorable to the recipient. The basis of inherited property is “stepped up” to its fair market value on the date of death. So the gain to you when you sell inherited property will be limited to the amount it has appreciated in value since it was left to you.

For instance, say you inherit a collector’s item that your relative paid $5 for back in the day. If, on the date of your relative’s death, the item in question is worth $1,000 on the open market, then that $1,000 is the item’s stepped-up basis to you. If you sell it for $1,001, then your taxable gain is $1, not $996.

Keep good records, know the law, don’t be afraid, and don’t pay more tax than you have to.

How to Respond to a Tax Notice

Preface: “Don’t Panic.” – Douglas Adams, The Hitchhiker’s Guide to the Galaxy

How to Respond to a Tax Notice

There is never a reason to panic if you receive a tax notice in the mail from the IRS or from a state or local tax authority. Wisdom, caution, and deliberation are all warranted, but never panic.

First, never respond to an unsolicited phone call, email, or electronic communication from the IRS or other tax authorities. All communications from tax authorities are initiated by mail, as in the slow kind that comes on paper in an envelope to your home address. Communications initiated electronically that claim to be from tax authorities should be marked as spam. Preferably, they should be referred to law enforcement.

Second, not every written communication you receive from a tax authority necessarily means you’re “in trouble” or that anything bad will happen. The tax authority often informs you of slight modifications to your tax filing. This modification may even be in your favor. Other times, they may ask you for an additional document or an explanation of a particular line item. This missing bit of information may be something very straightforward. You will likely never hear anything more about it once you provide them with what they are asking for.

The Collections Process

If you are being contacted about a balance you may owe, you always have the choice of either paying the balance or disputing it. If you decide to dispute it, you always have a window to respond before any tax, penalties, or interest are assessed. The time window to respond before the issue escalates will be stated clearly on the notice, as well as the steps to be taken if you wish to enter a dispute. A first notice of adjustment usually has a 30-day window.

In this situation, time is of the essence. Whatever you decide to do, do it within the time window provided. You always want to stay caught up in the process.

Hiring a Tax Professional

You may respond to the IRS on your own. It may be far more straightforward than you expect and you will surely learn something. Hiring someone else to do it for you is not legally required.  If you decide to refer the case to a tax professional, do so calmly and relaxedly, but do it immediately. The more time elapses from the date on the tax notice to the date a professional first sees it, the more you undermine that professional’s ability to help you.

While hiring a professional can provide many benefits, the process is more cumbersome. Remember that the tax professional is a mediator between you and the tax authority. The IRS and several states require you to sign a Power-of-Attorney authorizing the professional to discuss your tax issues with them. You will still need to sign the appeals and other tax documents necessary to resolve the dispute. If any tax or penalties are owed, they are owed by you and not by the professional.

Throughout the process, continue to provide your tax professional with every additional communication you receive from the tax authority every step of the way until the issue is resolved. Please do not leave any tax notice until you return from your vacation or file it with other tax documents you plan to bring in when the next tax filing season rolls around.

For every deadline missed, the amount of paperwork that must be filed increases, as do the financial and legal stakes. At some point, additional penalties and interest may be assessed. At some point, even if the dispute is ongoing and you expect to have the entire amount refunded to you, you may have to pay the outstanding balance to avoid a lien. At some point, you may exhaust the tax authority’s internal appeals process and have no option but to go to tax court to continue your dispute. Going to tax court will require an attorney. The point is that none of these things happen overnight, and usually, nothing gets that far.

The Investment Energy Credit for Businesses

Preface:  “One of the most exciting opportunities created by renewable energy technologies like solar is the ability to help the world’s poorest develop faster – but more sustainably too.” – Ed Davey

The Investment Energy Credit for Businesses

Section 48 of the Internal Revenue Code provides a tax credit for businesses that invest in properties that conserve or produce certain types of energy. The credit is generally worth 30% of the cost of the property if conditions are met. Bonus credits can increase the total value of the credit even more.

There is also a Production Tax Credit under Section 45 that can be claimed for the production of clean electricity on a per kilowatt-hour basis, but we will only address the Investment Tax Credit here. You cannot take the Investment Tax Credit and the Production Tax Credit on the same property.

Types of energy property that can be used to claim the credit include: geothermal, fuel cell, microturbine, small wind, biogas, microgrid controllers, energy storage, solar illumination, combined heat and power systems, waste energy recovery, and clean hydrogen production.

This credit is only available for depreciable property for which original use begins with the taxpayer.

The credit can be taken by individuals if they are sole proprietors or if they are partners or shareholders in pass-through entities that pass through part of the credit to them. Like all business credits, it is non-refundable, and any unused portion can be carried forward for up to 20 years.

The credit is claimed on Form 3468 parts I & VI. Part I reports the facility where the property has been installed, and Part VI claims the Energy Credit.

The 1MW Exception

A separate claim must be filed for each facility for which the credit is claimed. If the facility produces more than 1 megawatt of alternating current or equivalent, you must file an application with the Department of Energy confirming that you agree to meet prevailing wage and apprenticeship requirements. Once the facility is in service, you must notify the DOE and confirm that the requirements were met. Failure to make these notifications will result in the credit being only 6% instead of 30%. 

To put this limit in perspective, consider that 1 megawatt is enough electricity to power about 600 homes.

Domestic Content Bonus Credit and Energy Community Bonus Credit

The Domestic Content Bonus Credit adds an additional 10% to the credit if you attach a signed declaration that all steel, iron, or manufactured products that are a part of the facility were produced in the United States.

The Energy Community Bonus Credit adds an additional 10% to the credit if the facility is located in either:

  • A brownfield site; or
  • The site of a coal mine closed after 1999 or a coal-fired power plant closed after 2009; or
  • A statistical area with at least the national average of unemployment and at least 0.17% direct employment in or at least 25% local tax revenue related to coal, oil, or natural gas

The Domestic Content Bonus Credit and Energy Community Bonus Credit are not mutually exclusive. However, these two types of bonus credit are each worth only 2% instead of 10% unless the energy project has either:

  • Maximum net output of less than 1 megawatt; or
  • Its construction began before January 29, 2023; or
  • It meets the prevailing wage and apprenticeship requirements

Low-Income Communities Bonus Credit

For solar and wind facilities, the credit may also be increased:

  • An additional 10% if installed on Indian land; or
  • An additional 10% if installed in a low-income community; or
  • An additional 20% if part of a qualified low-income residential building; or
  • An  additional 20% if part of a qualified low-income economic benefit project

You must apply and be approved to receive any kind of Low-Income Communities Bonus Credit.

In principle, if you were eligible for both the Domestic Content and Energy Community Bonus Credits and qualified for either the low-income residential building or qualified low-income economic benefit project part of the Low-Income Communities Bonus Credit, you could recoup 70% of your costs as a tax credit.

The Clean Vehicle Credit and You

Preface: “For by Him were all things created, that are in heaven, and that are in earth, visible and invisible, whether they be thrones, or dominions, or principalities, or powers: all things were created by Him, and for Him” -Colossians 1:16

The Clean Vehicle Credit and You

The Inflation Reduction Act of 2022 may or may not have reduced inflation, but it did introduce a streamlined clean vehicle credit for qualifying clean energy vehicles placed in service from April 18, 2023, through to 2032. Since this new version of the credit is slightly less complicated than it was in prior years, and since it will be in effect for the better part of another decade, it’s worth taking a few minutes to understand it.

The Clean Vehicle Credit includes three different types of credit: one for new clean vehicles, another for previously owned clean vehicles, and yet another for “qualified commercial clean vehicles.” Let’s look first at the credit for new vehicles.

Credit for New Clean Vehicles 

To take the credit for a new clean vehicle, the vehicle must:

      • Have at least four wheels.
      • Be EITHER an electric vehicle (EV) with a battery capacity of at least 7 kilowatt hours capable of being recharged from an external source of electricity OR a fuel cell vehicle (FCV). Note that hybrids that are not plug-in will not qualify.
      • Have been manufactured primarily for use on public streets, roads, and highways.
      • Be placed in service by you in 2023 or later.
      • Be for your own use or for lease to others, not for resale.
      • Be used primarily in the United States.
      • Have undergone final assembly in North America.
      • Meet either mineral or battery component requirements, or both.
      • Have a gross vehicle weight rating (GVWR) of less than 14,000 lbs.
      • Have a manufacturer-suggested retail price (MSRP) of less than $55,000 ($80,000 for vans, SUVs, and pickup trucks).
      • EVs (but not FCVs) must be manufactured by an IRS-designated “qualified manufacturer.” An updated list can be found here.

The value of the credit for a new vehicle is:

      • $3,750 if it meets the critical minerals requirement, and
      • $3,750 if it meets the battery components requirement,

for a total of $7,500 if it meets both. Don’t worry, you don’t need to start studying up on minerals and battery components. Sellers of qualifying vehicles should be licensed dealers who are required to provide you with information you will need to claim the credit, including the credit value of the vehicle. This information will be linked to the car’s vehicle identification number (VIN). You will include the VIN on your tax return, and if it matches, the IRS should allow you the credit.

The credit is non-refundable, meaning the amount of the credit you can take is limited to your tax liability in the year you take it. An unused amount of the credit cannot be carried forward or back.

The credit is also limited by your income. If your modified adjusted gross income (MAGI) is over the limit, you are not eligible for any credit. There is no phase-out. Rather, the credit completely disappears if you earn even one dollar over the limit. For this purpose, MAGI is your adjusted gross income plus any excluded foreign income.

The one saving grace is that you can choose to use your MAGI from either the year you take delivery of the vehicle or the year before. As long as one of them is below the threshold, you can take the credit.

The most recent MAGI limits provided by the IRS for the Clean Vehicle Credit are as follows:

      • $300,000 for married couples filing jointly or a surviving spouse
      • $225,000 for heads of households
      • $150,000 for all other filers

These numbers are likely to be adjusted for inflation.

If you receive any Clean Vehicle Credit through a passthrough entity such as a partnership, S-corporation, or trust, then the income limit applies to your MAGI, not the entity’s.

A new vehicle that was used partly for business and partly for personal use must be prorated so that part of the credit is a business credit and part is personal credit.

Credit for Previously Owned Clean Vehicles

To get the credit for a used vehicle, the vehicle must:

      • Have a model year at least two years earlier than the calendar year you bought the vehicle
      • Have had a sales price of less than $25,000
      • You must not have taken the credit for a previously owned clean vehicle in the last three years
      • The used vehicle must meet all the remaining requirements for new vehicles.

The value of the credit for a used vehicle is the lesser of:

      • $4,000 or
      • 30% of the purchase price of the vehicle.
      • Like the credit for new vehicles, it is non-refundable.

Like the credit for new vehicles, the used vehicle credit will not be allowed if your MAGI exceeds certain limits in either the year you take delivery of the vehicle, or the year before. The current income limits for the used vehicle credit are:

      • $150,000 for married filing jointly or a surviving spouse
      • $112,500 for heads of households
      • $75,000 for all other filers

As with the new vehicle credit, you must buy the vehicle from a licensed dealer who will provide you with a report on the value of the tax credit for the vehicle and you will need to enter the VIN on your tax return in order to get the credit.

The used vehicle credit cannot be taken as a business credit.

Qualified Commercial Clean Vehicle Credit

Businesses cannot take the credit for a used vehicle. However, businesses can take the credit for a “qualified commercial clean vehicle,” the most valuable and least restrictive type of the Clean Vehicle Credit.

Unlike the credit for individuals, it is not subject to an income limitation or to an MSRP cap, it has no mineral or battery component requirement or assembly in North America requirement.

It can also be taken for vehicles that weigh more than 14,000 lbs. In this case, if the vehicle is an EV, it must have a battery capacity of at least 15 kilowatt hours. For a qualifying heavier vehicle, the maximum credit is $40,000 instead of $7,500.

The only catch is that the vehicle must be a depreciable asset used for business or for lease.

The Qualified Commercial Clean Vehicle Credit is also more complex to calculate. It is the least of:

      • 30% of the vehicle’s cost (15% if the vehicle is a plug-in hybrid) or
      • $7,500 ($40,000 for vehicles weighing more than 14,000 lbs) or
      • The “incremental cost” of the vehicle, which is the cost of the clean vehicle over the cost of a comparable gas or diesel-powered vehicle.

While you cannot take the Qualified Commercial Clean Vehicle Credit on a car for your personal use, this credit may mean it is cheaper for you to lease a qualifying vehicle if the leasing company is able to take the credit. This option also allows you to benefit from the credit if your income is too high to allow you to take the Clean Vehicle Credit in your own name.

Transferring the Credit to the Seller

If you are buying a new or used vehicle that you intend to use for personal use and that qualifies for the Clean Vehicle Credit, you may arrange at the time of sale to sign your Clean Energy Credit over to the seller in exchange for a reduction in the sale price. This may allow you to receive the full value of the credit regardless of your tax liability. However, this does not exempt you from the income limitation. You must still apply for the credit on your tax return and include the vehicle’s VIN. If you do not qualify, for example, because your income is too high, the amount you received from the seller will then be added to your tax. In this case, you do not need to repay the seller, the IRS will consider the amount to be repaid as part of your tax liability for the year.

The option to transfer the credit to the seller must be for the entire credit amount and not just part of it. The option to transfer may be chosen for the Clean Vehicle Credit for either a new or used vehicle, but not for more than a total of two vehicles in the same year.

Transfer of the credit is optional. The buyer is not required to elect it and the seller is not required to offer it.

In Closing

The Clean Energy Credit is a potentially valuable credit available from now until 2032. If you are considering buying an EV or FCV, look into the credit before you decide to buy. Not all vehicles you think of as “clean” vehicles necessarily apply. Not all taxpayers may take the credit or your benefit from the credit may be limited.

A good place to begin researching the eligibility of particular models can be found here.

When you buy a qualifying vehicle, make sure you get a time-of-sale report from the seller that includes all the information you will need to claim the credit.

Finally, you must reduce the cost basis of a vehicle you buy by any amount of the credit you are able to claim on it.