The name of this column is Money Made Simple. Einstein is credited with saying, “Everything should be made as simple as possible, but not simpler.” There is value in reducing complex topics into understandable bits.
Our U.S. Congress hasn’t figured that out.
If I had a financial wish list for 2025, near the top would be a plea for Congress to simplify the tax code. It’s become a hairy, gnarled, convoluted behemoth. And it’s only gotten worse in the past few years with recent legislation.
Let me give you one rather tame example of the complexity.
In the mid-1970s, Congress created a new designation called “qualified accounts.” These are investment accounts that receive special tax benefits. There are many types of qualified accounts, but for the purpose of this article, only two matter: IRAs and 401(k)s. Both accounts help people save for retirement. IRAs are set up by individuals, and 401(k)s are set up by employers.
There are two ways to contribute to IRAs and 401(k)s. In the first, contributions are shielded from taxes, but those contributions and all future gains are taxed once they are distributed from the account – what’s known as a pre-tax account. In the second, contributions are fully taxed up front, but those contributions and all future gains are never taxed again – what’s known as a Roth account.
Simple enough.
But here’s where the complexity seeps in. If you have a pre-tax IRA, you can roll it into – in other words, combine it with – a separate pre-tax 401(k). It works in the opposite way too. If you have a pre-tax 401(k), you can roll it into a pre-tax IRA. That makes sense. Both account types have identical tax treatment. So why not have the ability to combine them?
Similarly, if you have a Roth 401(k), you can roll it into a Roth IRA. Again, they are treated the same from a tax perspective, so it only makes sense to allow them to be combined. But get this: if you have a Roth IRA, you absolutely cannot, under any circumstances – no matter how much good sense it makes – roll that Roth IRA into a Roth 401(k).
Why? You got me. I’m sure there’s some esoteric reason for that one glitch, but from a practical perspective it makes zero sense.
Like I said, that’s a rather benign example of the complexity in the tax code. It gets far more egregious.
Consider the following figures.
If you take money out of a pre-tax account before age 59 ½ – and don’t get me started on why the ½ exists in the tax code – there is a 10% penalty. Congress initially created a handful of key exceptions to the 10% early distribution. There are now 20. Three of those exceptions only apply to IRAs, six only apply to 401(k) plans, and 11 apply to both.
Or how about this one? Once you reach a certain age, you are required to take money out of pre-tax accounts, whether you want to or not. Congress eventually wants its tax dollars. There are now four different ages for when this kicks in, depending on when you were born. It could be 70 ½ -- there’s that ½ again – or 72 or 73 or soon-to-be 75.
And God help you if you inherit an IRA after its former owner dies. There are eight different inherited RMD rules, and to know which rules apply, it’s a confusing combination of the original account owner’s age and whether you are a “designated beneficiary,” an “eligible designated beneficiary,” or a “non-person beneficiary.”
Good luck figuring that out, as well as when and how much you need to distribute from your inherited IRA each year. It’s a mess of tangled regulations.
The tax code is needlessly complex. I would like to think at some point Congress would get the message, but that may be wishful thinking.
Simple is smart. Einstein said so.
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