Listen to me discuss year-end tax planning with Brad and Jonathan on the ChooseFI podcast. The episode is available on all major podcast players, YouTube, and on the ChooseFI website (https://www.choosefi.com/year-end-tax-planning-2021-ep-351/).
During the conversation we referenced this blog post.
As always, the discussion is general and educational in nature and does not constitute tax, investment, legal, or financial advice with respect to any particular individual or taxpayer. Please consult your own advisors regarding your own unique situation. Sean Mullaney and ChooseFI Publishing are currently under contract to publish a book authored by Sean Mullaney.
FI Tax Guy can be your financial advisor! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters.Please also refer to the Disclaimer & Warning section found here.
It’s time to think about year-end tax planning. Year-end is a great time to get tax planning ducks in a row and take advantage of opportunities. This is particularly true for those in the financial independence community. FI principles often increase one’s tax planning opportunities.
Remember, this post is for educational purposes only. None of it is advice directed towards any particular taxpayer.
Backdoor Roth IRA Deadline 2021
As of now (December 7, 2021), the legal deadlines around Backdoor Roth IRAs have not changed: the nondeductible 2021 traditional IRA contribution must happen by April 18, 2022 and there is no legal deadline for the second step, the Roth conversion. However, from a planning perspective, the practical deadline to have both steps of a 2021 Backdoor Roth IRA completed is December 31, 2021.
This is because of proposed legislation that eliminates the ability to convert nondeductible amounts in a traditional IRA effective January 1, 2022. As of December 7th, the proposed legislation has passed the House of Representatives but faces a very certain future in the Senate. Considering the risk that the Backdoor Roth elimination proposal is enacted, taxpayers planning on completing a 2021 Backdoor Roth IRA should act to ensure that the second step of the Backdoor Roth IRA (the Roth conversion) is completed before December 31st.
Taxpayers on the Roth IRA MAGI Limit Borderline
In years prior to 2021, taxpayers unsure of whether their income would allow them to make a regular Roth IRA contribution could simply wait until tax return season to make the determination. At that point, they could either make the regular Roth IRA contribution for the prior year (if they qualified) or execute what I call a Split-Year Backdoor Roth IRA.
With the proposed legislation looming, waiting is not a good option. The good news is that taxpayers executing a Backdoor Roth IRA during a year they actually qualify for a regular annual Roth IRA contribution suffer no material adverse tax consequences. Of course, in order for this to be true there must be zero balance, or at most a very small balance, in all traditional IRAs, SEP IRAs, and SIMPLE IRAs as of December 31, 2021.
December 31st and Backdoor Roth IRAs
December 31st is a crucial date for those doing the Roth conversion step of a Backdoor Roth IRA during the year. It is the deadline to move any balances in traditional IRAs, SEP IRAs, and SIMPLE IRAs to workplace plans in order to ensure that the Roth conversion step of any Backdoor Roth IRA executed during the year is tax-efficient.
This December 31st deadline applies regardless of the proposed legislation discussed above.
The self-employed should consider this one. Deadlines vary, but as a general rule, those eligible for a Solo 401(k) usually benefit from establishing one prior to year-end. The big takeaway should be this: if you are self-employed, your deadline to seriously consider a Solo 401(k) for 2021 is ASAP! Usually, such considerations benefit from professional assistance.
Something to look forward to in 2022: my upcoming Solo 401(k) book!
Charitable Contributions
For those itemizing deductions in 2021 and either not itemizing in 2022 or in a lower marginal tax rate in 2022 than in 2021, it can be advantageous to accelerate charitable contributions late in the year. It can be as simple as a direct donation to a qualifying charity by December 31st. Or it could involve contributing to a donor advised fund by December 31st.
A great donor advised fund planning technique is transferring appreciated securities (stocks, bonds, mutual funds, or ETFs) to a donor advised fund. Many donor advised fund providers accept securities. The tax benefits of making such a transfer usually include (a) eliminating the built-in capital gain from federal income taxation and (b) if you itemize, getting to take a current year deduction for the fair market value of the appreciated securities transferred to the donor advised fund.
The elimination of the lurking capital gain makes appreciated securities a better asset to give to a donor advised fund than cash (from a tax perspective). Transfers of appreciated securities to 501(c)(3) charities can also have the same benefits.
The 2021 deadline for this sort of planning is December 31, 2021, though taxpayers may need to act much sooner to ensure the transfer occurs on time. This is particularly true if the securities are transferred from one financial institution to a donor advised fund at another financial institution. In these cases, the transfer may have to occur no later than mid-November, though deadlines will vary.
Early Retirement Tax Planning
For those in early retirement, the fourth quarter of the year is the time to do tax planning. Failing to do so can leave a great opportunity on the table.
Prior to taking Social Security, many early retirees have artificially low taxable income. Their only taxable income usually consists of interest, dividends, and capital gains. In today’s low-yield environment, without additional planning, early retirees’ taxable income can be very low (perhaps even below the standard deduction).
Artificially low income gives early retirees runway to fill up lower tax brackets (think the 10 percent and 12 percent federal income tax brackets) with taxable income. Why pay more tax? The reason is simple: choose to pay tax when it is taxed at a low rate rather than defer it to a future when it might be taxable at a higher rate.
The two main levers in this regard are Roth conversions and tax gain harvesting. Roth conversions move amounts in traditional retirement accounts to Roth accounts via a taxable conversion. The idea is to pay tax at a very low tax rate while taxable income is artificially low, rather than leaving the money in deferred accounts to be taxed later in retirement at a higher rate under the required minimum distribution (“RMD”) rules.
Tax gain harvesting is selling appreciated assets when one is in the 10 percent or 12 percent marginal tax bracket so as to incur a zero percent long term capital gains federal tax rate on the capital gain.
Early retirees can do some of both. In terms of a tiebreaker, if everything else is equal, I prefer Roth conversions to tax gain harvesting, for two primary reasons. First, traditional retirement accounts are subject to ordinary income tax rates in the future, which are likely to be higher than preferred capital gains tax rates. Second, large taxable capital gains in taxable accounts can be washed away through the step-up in basis at death. The step-up in basis at death doesn’t exist for traditional retirement accounts.
One time to favor tax gain harvesting over Roth conversions is when the traditional retirement accounts have the early retiree’s desired investment assets but the taxable brokerage account has positions that the early retiree does not like anymore (for example, a concentrated position in a single stock). Why not take advantage of tax gain harvesting to reallocate into preferred investments in a tax-efficient way?
Long story short: during the fourth quarter, early retirees should consider their taxable income for the year and consider year-end Roth conversions and/or tax gain harvesting. Planning in this regard should be executed no later than December 31st, and likely earlier to ensure proper execution.
Roth Conversions, Tax Gain Harvesting, and Tax Loss Harvesting
Early retired or not, the deadline for 2021 Roth conversions, tax gain harvesting, and tax loss harvesting is December 31, 2021. Taxpayers should always consider timely implementation: these are not tactics best implemented on December 30th!
For some who find their income dipped significantly in 2021 (perhaps due to a job loss), 2021 might be the year to convert some amounts in traditional retirement accounts to Roth retirement accounts. Some who are self-employed might want to consider end-of-year Roth conversions to maximize their qualified business income deduction.
Stimulus and Child Tax Credit Planning
Taxpayers who did not receive their full 2021 stimulus may want to look into ways to reduce their 2021 adjusted gross income so as to qualify for additional stimulus funds. I wrote in detail about one such opportunity in an earlier blog post. Lowering adjusted gross income can also qualify taxpayers for additional child tax credits.
There are many factors you and your advisor should consider in tax planning. This opportunity may be one of them. For example, taxpayers considering a Roth conversion at the end of the 2021 might want to hold off in order to qualify for additional stimulus and/or child tax credits.
Accelerate Payments
The self-employed and other small business owners may want to review business expenses and pay off expenses before January 1st, especially if they anticipate their marginal tax rate will decrease in 2022. Depending on structure and accounting method, doing so may not only reduce income taxes, it could also reduce self-employment taxes.
State Tax Planning
For my fellow Californians, the big one here is property taxes. It may be advantageous to pay billed (but not yet due) property taxes in late 2021. This allows taxpayers to deduct the amount on their 2021 California income tax return. In California, the standard deduction ($4,601 for single taxpayers, $9,202 for married filing joint taxpayers) is much lower than the federal standard deduction, so consideration should be given to accelerating itemized deductions in California, regardless of whether the taxpayer itemizes for federal income tax purposes.
Required Minimum Distributions (“RMDs”)
They’re back!!! RMDs are back for 2021. The deadline to withdraw a required minimum distribution for 2021 is December 31, 2021. Failure to do so can result in a 50 percent penalty.
Required minimum distributions apply to most retirement accounts (Roth IRAs are an exception). They apply once the taxpayer turns 72. Also, many inherited retirement accounts (including Roth IRAs) are subject to RMDs, regardless of the beneficiary’s age.
Planning for Traditional Retirement Accounts Inherited in 2020 and 2021
Those inheriting traditional retirement accounts in 2020 or later often need to do some tax planning. The end of the year is a good time to do that planning. Many traditional retirement account beneficiaries will need to empty the retirement account in 10 years (instead of being on an RMD schedule), and thus will need to plan out distributions over the 10 year time frame to manage taxes rate on the distributions.
2021 Federal Estimated Taxes
For those with small business income, side hustle income, significant investment income, and other income that is not subject to tax withholding, the deadline for 2021 4th quarter estimated tax payments to the IRS is January 18, 2022. Such individuals should also consider making timely estimated tax payments to cover any state income taxes.
Review & Update Beneficiary Designation Forms
Beneficiary designation forms control the disposition of financial assets (such as retirement accounts and brokerage accounts) upon death. Year-end is a great time to make sure the relevant institutions have up-to-date forms on file. While beneficiary designations should be updated anytime there is a significant life event (such as a marriage or a death of a loved one), year-end is a great time to ensure that has happened.
2022 and Beyond Tax Planning
The best tax planning is long term planning that considers the entire financial picture. There’s always the temptation to maximize deductions on the current year tax return. But the best planning considers your current financial situation and your future plans and strives to reduce total lifetime taxes. 2022 is as good a time as any to do long-term planning.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters.Please also refer to the Disclaimer & Warning section found here.
Tax deductions can be a confusing topic considering the many types of tax deductions and the terminology for them. Below I explain the different types of tax deductions you can claim on your tax return. You may be taking several of these types without even knowing it.
Types of Individual Tax Deductions
Exclusions
Many things we think of tax deductions are not treated as tax deductions on a tax return. Instead, they are excluded from taxable income. An exclusion from taxable income has the exact same effect as a tax deduction.
The most common exclusion is the exclusion for employer provided benefits, including health insurance, retirement plan contributions, and health savings accounts contributions. Here is an example:
Example: Mark has a salary of $100,000. He contributes ten percent ($10,000) of his salary to his employer’s 401(k) plan. His W-2 for the year will report wages of $90,000, not $100,000, and he will enter $90,000 as wages on his Form 1040. The $10,000 Mark contributed to his 401(k) is excluded from his gross income. This exclusion has the same income tax effect as a deduction.
Exclusions are a great form of deduction in that they are generally unlimited on your tax return, though they may have their own limitations. For example, in 2021 the most an employee under age 50 can exclude for contributions to a 401(k), 403(b), or a 457 is $19,500.
For those at least 70 1/2 years old, the qualified charitable distribution (“QCD”), which I wrote about here, can be a great tax planning technique.
Exclusions also reduce adjusted gross income (“AGI”). Items that reduce AGI are great because AGI (or modified AGI, “MAGI”) is usually the measuring stick for whether a taxpayer qualifies for many tax benefits (such as eligibility for making a deductible contribution to an IRA or making a contribution to a Roth IRA). Lowering AGI is an important tax planning objective, since lower AGI opens the door to several tax benefits.
Business Deductions
Business deductions include trade or business deductions generated from self-employment and investments in partnerships and rental property. On a Form 1040, these deductions are reported on Schedule C or Schedule E. Business deductions include salaries, rent, depreciation (deducting the cost of a business asset over a useful life), and other ordinary and necessary expenses.
Business deductions are generally great tax deductions because they are subject to relatively few limitations on your tax return. That said, limitations such as the passive activity loss rules and the at-risk limitations can limit a taxpayer’s ability to claim some business losses. Further, business deductions reduce not only income tax but also self-employment income, and thus, self-employment tax.
Business deductions are also valuable because they reduce AGI.
“For AGI” or “Above the Line” Deductions
On your Form 1040 you deduct certain expenses from your gross income to determine your AGI. Prior to tax returns filed for 2018 and later, these deductions were at the bottom of page 1 of the Form 1040. Starting with tax returns for 2018, these deductions are presented on Schedule 1 which accompanies Form 1040.
Examples of these deductions include one-half of self-employment tax paid by self-employed individuals, deductible contributions to IRAs, and contributions to certain self-employed retirement plans.
Capital losses, generally up to $3,000 on any one tax return, can be deducted for computing AGI. Capital losses in excess of $3,000 are carried over to future tax years to be deducted against capital gains and against up to $3,000 per year of ordinary income.
Health Savings Accounts (“HSAs”) are their own special breed. If contributions to an HSA are made through workplace payroll withholding, they are excluded from taxable income. If contributions to an HSA are made through another means (such as a check or wire transfer to the HSA), the contributions are for AGI deductions reported on Schedule 1. Which is better? From an income tax perspective, there is no difference. But from a payroll tax perspective, using payroll withholding is the clear winner. Amounts contributed to an HSA through payroll withholding are not subject to the FICA tax, creating another HSA tax win!
Standard Deduction or Itemized Deductions
Tax reform changed the landscape of itemized deductions. As a result of the tax reform bill enacted in December 2017, far fewer taxpayers will claim itemized deductions, and will instead claim the standard deduction.
The most common itemized deductions are state and local taxes (income, property, and in some cases, sales taxes), charitable contributions, and mortgage interest.
Taxpayers generally itemize if the sum total of itemized deductions (reported on Schedule A) exceed the standard deduction. Tax reform did two things to increase the chance that the standard deduction will exceed a taxpayer’s itemized deductions. First, the amount of the standard deduction increased. It went from $6,350 for single taxpayers in 2017 to $12,000 for single taxpayers in 2018. For married filing joint taxpayers, the standard deduction went from $12,700 in 2017 to $24,000 in 2018.
The standard deduction for 2021 is $12,550 (single) and $25,100 (MFJ) for most taxpayers.
In addition, several itemized deductions were significantly reduced. For example, starting in 2018 there is a deduction cap of $10,000 per tax return ($5,000 for married filing separate tax returns) for state and local taxes. This hits married taxpayers particularly hard and increases the chance that if you are married filing joint you will claim the standard deduction, since you will need over $15,100 in other itemized deductions to itemize (using the 2021 numbers).
In addition, miscellaneous deductions, such as unreimbursed employee expenses and tax return preparation fees, were eliminated as part of tax reform.
Thus, many taxpayers will find that they will often claim the standard deduction. As discussed below, there will be planning opportunities for taxpayers to essentially push many itemized deductions (such as charitable contributions) into one particular tax year, itemize for that year, and then claim the standard deduction for the next several years.
Neither the standard deduction nor itemized deductions reduce AGI.
Special Deductions
In a relatively new development in tax law, there are now deductions that apply only after AGI has been determined and separate and apart from the standard deduction or itemized deductions.
QBI Deduction
Tax reform created an entirely new tax deduction: the qualified business income deduction (also known as the QBI deduction or the Section 199A deduction). I have written about the QBI deduction here and here. Subject to certain limitations, taxpayers can claim, as a deduction, 20 percent of qualified business income, which is generally income from domestic business activities (not wage income), income from publicly-traded partnerships, and qualified REIT (real estate investment trust) dividends.
The QBI deduction does not reduce AGI.
Taxpayers can claim the QBI deduction regardless of whether they elect itemized deductions or the standard deduction.
Special Deduction for Charitable Contributions
For the 2021 tax year, taxpayers who do not claim itemized deductions are eligible for a special deduction for charitable contributions. The deduction is limited to $300 for single filers and $600 for MFJ filers.
As discussed by Jeffrey Levine, this deduction, like the QBI deduction, neither reduces AGI nor is an itemized deduction.
The statutory language for this new deduction is found at Section 170(p). I believe that there is a very good chance that this deduction is extended to years beyond 2021, though as of now, it is only applicable to the 2021 tax year.
Planning
Tax deductions provide a great opportunity for impactful tax planning. Here are some examples.
Timing
If your marginal income tax rate is the same every year, then you generally want to accelerate deductions. Thus, if you have a sole proprietorship and are a cash basis taxpayer, you are generally better off paying rent due on January 1, 2022 on December 31, 2021 instead of January 1, 2022 since the deduction saves the same amount of tax regardless of which tax year you pay it, but you’ll get the cash tax benefit sooner – on your 2021 income tax return instead of on your 2022 income tax return.
But there can be situations where you anticipate that your marginal tax rate will be greater next year than this year. In those cases, it makes sense to delay deductions. For example, perhaps you would make a large charitable contribution next year instead of before the end of the current year. Or, in the above example, you would pay the rent on January 1, 2022 to ensure the deduction is in 2022 instead of 2021.
Bunching
For some taxpayers, it may make sense to bunch deductions to maximize the total benefit of itemizing deductions versus claiming the standard deduction over several years. My favorite example of this is the donor advised fund. I’m not alone in my fondness of the donor advised fund. It allows you to contribute to a fund in one year, claim a charitable deduction for the entire amount of the contribution, and then donate from that fund to charities in subsequent years. The big advantage is that you get an enhanced upfront deduction in the first year and then claim the standard deduction in several subsequent years. This strategy only works if the amount of the deduction for the contribution to the donor advised fund is sufficient such that your itemized deductions in the year of the contribution exceed the standard deduction by a healthy amount.
Deadlines, Deadlines, Deadlines!!!
Different deductions have different deadlines. Many deductions have December 31st deadlines, so it is important to make the contribution by year-end. For charitable contributions, it is best to make the contribution online with a credit or debit card before January 1st if you are running really late, though if you place the contribution in a U.S. Postal Service mailbox prior to January 1st that counts as prior to the near year (though it makes it harder to prove you beat the deadline if you drop it in the mailbox on December 31st).
For employee contributions to a 401(k), the deadline is December 31st. Thus, if you are reading this on December 5th and you want to significantly increase your 401(k) contribution for 2021, you ought to get in touch with your payroll administrator and increase your contribution rate for your last paycheck ASAP.
By contrast, the deadline for a 2021 contribution to a deductible IRA or a non-payroll 2021 contribution to a HSA is April 15, 2022 (the date tax returns are due).
Tax deductions present several important tax planning considerations. These considerations should include the taxpayer’s current marginal tax rate and future marginal tax rate. They should also include consideration of maximizing the combination of itemized deductions and the standard deduction over multiple taxable years.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
As always, the discussion is general and educational in nature and does not constitute tax, investment, legal, or financial advice with respect to any particular individual or taxpayer. Please consult your own advisors regarding your own unique situation.
FI Tax Guy can be your financial advisor! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters.Please also refer to the Disclaimer & Warning section found here.
Thinking of shifting to self-employment? If you’re thinking about starting a business and being your own boss, one of the things you need to do is figure out how to pay taxes. The transition from W-2 work to self-employment significantly alters the tax landscape.
Below I discuss the taxes self-employed solopreneurs are subject to and how to pay them. As always, the below is for educational purposes only and is not tax advice for any particular taxpayer.
Taxes Paid by the Self-Employed
Federal Income Tax
The first tax is the exact same tax you paid as a W-2 worker: federal income tax. The determination of how much of your income is subject to this tax is a bit different. As a W-2 employee, you received a Form W-2, and, generally speaking, Box 1 of Form W-2 told you how much of your income was subject to federal income taxes.
As a self-employed individual, you now need to track the income and expenses of your business. Solopreneurs should strongly consider practices such as having a separate bank account for the business and hiring a bookkeeper, possibly a virtual one.
Income and expenses of the solopreneur’s business are reported annually on a Schedule C filed with Form 1040 every year. The amount of income computed on Schedule C is taxable on Form 1040.
Federal Self-Employment Tax
Congratulations on the transition to self-employment! You just signed up for a new tax: the federal self-employment tax. It’s actually (roughly speaking) the same FICA tax you paid as a W-2 employee, but now you pay it yourself (instead of through employer W-2 withholding), and you pay both halves of it.
Here is an example of federal self-employment tax:
Leslie reports self-employment income of $80,000 on her Schedule C. Leslie has no W-2 income. Her self-employment tax is $11,304, computed as 14.13 percent of $80,000.
One’s self-employment tax will not always be approximately 14.13 percent of self-employment income. That said, in many cases 14.13 percent will be the approximate percentage. Self-employment tax is computed and reported annually on Schedule SE. Schedule SE is filed with the annual Form 1040.
To account for the fact that the self-employed pay both halves of the payroll tax (the employee side and the employer side), they receive an income tax deduction (from adjusted gross income) on Schedule 1, line 14 for the “employer” half of the payroll tax.
State Income Tax
Most states have an income tax, and the self-employed must pay it too, no different than when one is a W-2 employee.
Local Taxes
Localities have various taxes solopreneurs may be subject to. First, there may be a general business tax which is often either a flat annual fee or a small percentage of revenue. Especially with the latter, there may be an exemption amount (usually, a revenue threshold) below which the solopreneur does not owe the tax. It is usually important to register with your locality to be able to claim any exemption from these taxes.
Second, localities sometimes impose a separate sales tax on particular industries or goods.
It is best to look into these taxes upfront. Localities know that sometimes small businesses miss these taxes and are usually willing to work with those who apply for relief for any missed filings or payments.
Paying Taxes
Now that we’ve discussed the broad categories of taxes the self-employed are subject to, the next step is to determine how and when to pay those taxes.
Federal Income Tax and Self-Employment Tax
This is one stop shopping. The federal tax rules require the self-employed to pay estimated taxes in quarterly payments (referred to as estimated tax payments). The dates they are due for each quarter of the year are as follows (assume the estimated tax payments account for Year 1):
Quarter
Date Estimated Tax Payment is Due
First Quarter
April 15, Year 1
Second Quarter
June 15, Year 1
Third Quarter
September 15, Year 1
Fourth Quarter
January 15, Year 2
Note that if a payment due date occurs on a weekend or federal holiday, generally the due date is moved to the next day that is not a weekend and/or a federal holiday.
Generally speaking, the estimated tax payment must include both the estimated income tax due and the estimated self-employment tax due. Further, it must account for all taxable income (interest, dividends, capital gains, etc.), not just self-employment income.
Failure to pay in sufficient amounts on time can lead to an underpayment penalty computed on Form 2210. Usually, the amount required to avoid an underpayment penalty is the lesser of (i) 90 percent of the current year tax due (paid in timely, equal payments) or (ii) 110 percent of the previous year tax due (paid in timely, equal payments). These two standards are often referred to as safe harbors.
Note that if previous year adjusted gross income was less than $150,000, the 110 percent safe harbor drops to 100 percent.
For those with growing incomes, the 110 percent safe harbor often works best. Those who have filed your Year 1 tax return by April 15, Year 2 (or at least have it just about ready to go) can take the total tax due number from the Form 1040, multiply it by 1.1, and divide it by 4 to get the amount of the required quarterly estimated tax payment to be good to go. Here is an example:
Josh is self-employed and filed his Year 1 tax return on April 1, Year 2. His business is growing. His total federal tax for Year 1 (including income tax and self-employment tax) was $45,000. Josh believes that his self-employment income could significantly increase in Year 2, so he has decided to rely upon the 110 percent safe harbor to pay his estimated tax. He multiplies $45,000 by 1.1 and then divides that product ($49,500) by 4 to get his quarterly estimated tax payment of $12,375). He makes four $12,375 payments to the IRS no later than April 15, Year 2, June 15, Year 2, September 15, Year 2, and January 15, Year 3.
The nice thing about this strategy is that Josh is now protected against the underpayment penalty even if he wins the lottery during Year 2. He simply makes those estimated payments and then, with his Year 2 Form 1040, he pays the IRS the balance due, which could be quite large. But regardless of the balance due, Josh’s underpayment penalty is $0.
Taxpayers who might be subject to the underpayment penalty can request relief from it on the Form 2210 and/or “annualize” their income on Form 2210 to prove that the majority of their income came from later in the year (and thus estimated taxes paid later in year are sufficient for the current year’s estimated tax). Using the 110 percent safe harbor generally eliminates the need to look to mitigation tactics.
Paying the IRS
Solopreneurs can mail estimated taxes to the IRS with a Form 1040-ES. Alternatively, solopreneurs can use the IRS DirectPay system and pay electronically at this IRS website.
State Income Taxes
States with income taxes also generally require periodic or quarterly estimated tax payments. Many follow some or all of the IRS rules. My home state of California has its own timing rules for estimated tax payments. It generally requires taxpayers to pay 30 percent of their estimated income tax liability during the first quarter (April 15th due date), the next 40 percent of their estimated income tax liability during the second quarter (June 15th) and the remaining 30 percent after the end of the fourth quarter (the following January 15th).
States, like the IRS, generally have website portals where solopreneurs can make estimated tax payments.
The Transition Year
Transitions from W-2 work to solopreneurship presents many challenges and opportunities. One potential opportunity is the need to pay less or possibly no estimated taxes for the year of the transition. This can be true for several reasons.
It may be that based on the W-2 withholding collected prior to leaving full time employment, the new solopreneur had enough withheld to cover the tax on their annual income. W-2 withholding generally assumes a full year of employment, but if one leaves full time employment and experiences start-up expenses and lower self-employment income as they build a business, it may be the case that they need to make little or no estimated tax payments in that first year.
Another source of tax payments is spousal W-2 withholding. If filing jointly with a spouse, the spouse’s W-2 withholding combined with the new solopreneur’s partial year W-2 withholding might be enough to cover the estimated taxes for the transition year.
EINs and Forms 1099
In most cases, it makes sense for sole proprietors to obtain an employer identification number (“EIN”) from the IRS for their sole proprietorship. This EIN is used on the business’s Schedule C. Further, this number is used (instead of a Social Security number) to file any required Forms 1099s paid with respect to the business. Forms 1099 (such as the Form 1099-NEC) are required for cash payments of $600 or more during the year to individuals in the course of business.
The IRS has an internet portal here for taxpayers to apply online for EINs.
Tax Planning
The transition from W-2 employment to self-employment can provide several tax planning challenges and opportunities. Here is a brief overview of several challenges and opportunities.
Qualified Business Income Deduction
The Section 199A qualified business income deduction is a relatively new deduction for small businesses, including solopreneurs. I have previously blogged about this deduction here and here.
Roth Conversions for the Self-Employed
The transition to self-employment may present Roth conversion opportunities, for two reasons. First, as a business starts up, the soloprenuer’s taxable income might be very low, and thus a start up year might be a great time to execute a Roth conversion (i.e., moving amounts from traditional IRAs/401(k)s etc. to Roth accounts) and enjoy a low marginal federal income tax rate on the converted amount.
Second, there are instances where Roth conversions by the self-employed can benefit from the Section 199A qualified business income deduction. I blogged about that opportunity here.
S Corporations
Many solopreneurs will have the opportunity to operate out of what is referred to as an “S corporation” for U.S. federal tax purposes. There are several advantages to operating out of an S corporation, but there are also some disadvantages.
Next month’s blog post discusses S corporations and some of the planning considerations involved.
Solo 401(k)s
Solopreneurs are responsible for their own workplace retirement account. The Solo 401(k) is a great opportunity for many solopreneurs to stash significant amounts into tax-advantaged retirement accounts.
As I announced in March, I’m currently working on a book about Solo 401(k)s, which is tentatively set to be published in early 2022.
Hiring Professionals
To my mind, the shift from W-2 employment to self-employment often signals the need to hire a tax return preparer, and possibly a (virtual) bookkeeper as well. Self-employment significantly increases the complexity of one’s tax return and thus it is often wise for the self-employed to hire a tax return preparer and a bookkeeper.
Conclusion
The shift to self-employment is both exciting and challenging. Yes, the self-employed have a more complicated tax picture. But with some intentional planning, managing and ultimately optimizing the tax picture is very much possible.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
Qualified charitable distributions (“QCDs”) are an exciting tax planning opportunity, particularly for the FI community. Below I describe what a qualified charitable distribution is and how members of the FI community should think about them when tax planning.
Of course, this post is educational in nature. Nothing in this blog post is tax advice for any particular taxpayer. Please consult your own tax advisor regarding your unique circumstances.
Qualified Charitable Distributions
QCDs are transfers from a traditional IRA directly to a charity. Up to $100K annually, they are (a) not included in the taxpayer’s taxable income, (b) not deductible as charitable contributions, and (c) qualify as “required minimum distributions” (“RMDs”) (to the lesser of the taxpayer’s required minimum distribution or the actual distribution to the charity). Here is an example:
Example 1: Jack and Jill are 75 years old and file their tax return married filing joint. Jack has a RMD from his traditional IRA of $40,000 in 2021. Jack directs his traditional IRA institution to transfer $40,000 during 2021 to a section 501(c)(3) charity. Jack and Jill recognize no taxable income on the transfer, and Jack does not have to take his 2021 RMD (the $40K QCD having covered it). Further, Jack and Jill receive no charitable contribution deduction for the transfer.
Considering that Jack & Jill (both age 75) enjoy a standard deduction of $27,800 in 2021, they get both the standard deduction and a $40K deduction for the charitable contribution from the traditional IRA (since they do not have to include the $40K in their taxable income). This is the best of both worlds. Further, excluding the $40K from “adjusted gross income” (“AGI”) is actually better than taking the $40K as an itemized deduction, since many tests for tax benefits are keyed off of AGI instead of taxable income.
Important QCD Considerations
Take QCDs Early
Generally speaking, it is best that QCDs come out of the traditional IRA early in the year. Why? Because under the tax rules, RMDs come out of a traditional IRA first. So it is usually optimal to take the QCD early in the year so it can fulfill all or part of the required minimum distribution for the year. Then you can do Roth conversion planning (if desired), so long as the full RMD has already been withdrawn (either or both through a QCD and a regular distribution) from the traditional IRA first.
No Trinkets
I don’t care how much you love your PBS tote bag: do not accept any gift or token of appreciation from the charity. The receipt of anything (other than satisfaction) from the charity blows the QCD treatment. So be sure not to accept anything from the charity in exchange for your QCD.
QCDs Available Only from Traditional IRAs
In order to take advantage of QCD treatment, the account must be a traditional IRA. 401(k)s and other workplace plans do not qualify for QCDs. Further, SIMPLE IRAs and SEP IRAs do not qualify for QCD treatment.
As a practical matter, this is not much of an issue. If you want to do a QCD out of a 401(k) or other tax advantaged account, generally all you need to do is rollover the account to a traditional IRA.
QCD Age Requirement
In order to take advantage of the QCD opportunity, the traditional IRA owner must be aged 70 ½ or older.
Inherited IRAs
QCDs are available to the beneficiary of an inherited IRA so long as the beneficiary is age 70 ½ or older.
QCDs For Those Age 70 ½ and Older
If you are aged 70 ½ or older and charitably inclined, the QCD often is the go-to technique for charitable giving. In most cases, it makes sense to make your charitable contributions directly from your traditional IRA, up to $100,000 per year. QCDs help shield RMDs from taxation and help keep AGI low.
QCDs and the Pro-Rata Rule
If you have made previous non-deductible contributions to your traditional IRA, distributions are generally subject to the pro-rata rule (i.e., the old contributions are recovered ratably as distributions come out of the traditional IRA).
However, QCDs are not subject to the pro-rata rule! This has a positive effect on future taxable distributions from the traditional IRA. Here is an example of how this works:
Example 2: Mike is age 75. On January 1, 2021, he had a traditional IRA worth $500,000 to which he previously made $50,000 of nondeductible contributions. If Mike makes a $10,000 QCD to his favorite charity, his traditional IRA goes down in value to $490,000. However, his QCD does not take out any of his $50,000 of basis from nondeductible contributions. This has the nice effect of reducing the tax on future taxable distributions to Mike from the traditional IRA, since the QCD reduces denominator (by $10K) for determining how much basis is recovered, while the numerator ($50K) is unaffected.
QCDs for Those Under Age 70 ½
Those in the FI community considering early retirement need to strongly consider Roth conversions. The general idea is that if you can retire early with sufficient wealth to support your lifestyle, you can have several years before age 70 during which your taxable income is artificially low. During those years, you can convert old traditional retirement accounts Roth accounts while you are taxed at very low federal income tax brackets.
For the charitably inclined, the planning should account for the QCD opportunity. There is no reason to convert almost every dime to Roth accounts if you plan on giving significant sums to charity during your retirement. Why pay any federal or state income tax on amounts that you ultimately will give to charity?
If you are under the age of 70 ½ and are charitably inclined, QCDs should be part of your long term financial independence gameplan. You should leave enough in your traditional retirement accounts to support your charitable giving at age 70 ½ and beyond (up to $100K annually). These amounts can come out as tax-free QCDs at that point, so why pay any tax on these amounts in your 50s or 60s? Generally speaking, a Roth conversion strategy should account for QCDs for the charitably inclined.
Conclusion
For the charitably inclined, QCDs can be a great way to manage taxable income and qualify for tax benefits in retirement. QCDs also reduce the pressure on Roth conversion planning prior to age 72, since it provides a way to keep money in traditional accounts without having to pay tax on that money.
FI Tax Guy can be your financial advisor! Find out more by visiting mullaneyfinancial.com
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters.Please also refer to the Disclaimer & Warning section found here.
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters.Please also refer to the Disclaimer & Warning section found here.
Are you new to financial independence (FI or FIRE)? Are you steeped in financial independence, but confused about tax optimization?
If so, this is the post for you. This post works on the 80/20 principle: sure, there’s a ton of knowledge, expertise, and hacks out there, but oftentimes 80 percent of the benefit can come from 20 percent of the knowledge.
But first, a caveat: none of this is advice for your specific situation, but rather, this comprises a list of the top four moves I believe those pursuing financial independence should consider. No blog post (this one included) is a substitute for your own and your advisors analysis and judgement of your own situation.
ONE: Contribute to Your Workplace Retirement Plan Up to the Employer Match
Many, though not all, employer sponsored 401(k)s, 403(b)s, 457s offer some matching of employee contributions. The TSP (for federal government employees) does as well. For example, a 401(k) plan might provide a 25 percent matching contribution up to 6 percent of compensation. Thus, if a plan participant makes $50,000 per year, to get the full match, the employee must put 6 percent of her annual salary, $3,000 total, into the 401(k) in order to get the full employer match, which in this case would be $750 per year (computed as $50,000 times 6% contribution rate times 25% match rate).
In our example above, the employee would be foolish not to contribute up to at least the 6 percent matched contribution rate.
Your top priority in retirement planning is to contribute up to the point of your employer match in your employer retirement account! Money should be contributed there before it is placed anywhere else. An employer match is an instantaneous, guaranteed return on your investment. No one seeking financial independence can afford to pass that up.
Watch me explain the 401(k) employer match.
Here are some additional considerations.
Vesting
In many plans, the employee is not fully “vested” in the employer match, but only becomes vested after a period of time. Employee contributions are immediately vested, but employer contributions may take some time to vest (i.e., become the property of the employee).
Some plans have “cliff” vesting where the matching contribution is unvested (i.e., not the employee’s money) for three years, at which point the matching contributions (and their earnings) become “fully vested” (i.e., fully the employee’s money).
More common is a graduated vesting schedule. Sometimes it is 20% vested at 2 years and then 20% more each year after, and there are plenty of varieties of graduated vesting.
It is important to understand the vesting rules in your particular plan. That said, a waiting period to vest does not change my view. Contribute to your employer plan at least to the level of the matching contributions! First, the matching level is usually a fairly modest level. If you can’t contribute to that level you may need to re-examine all your expenses to give yourself a decent shot at financial independence and retirement.
Second, the odds are actually pretty good you will stay with that employer to partially or fully vest and capture some or all of the matching contribution benefits. With the rise of technology enabled virtual work, you might even move and keep your job. So be aware of how your plan vests, but make sure you are contributing to the level required to get the full employer match!
Timing
Many employers match pay period by pay period, instead of only once or twice a year. What that means for you is that you should be careful not to over-contribute to your 401(k) or other employer retirement plan early in the year.
Currently (as of 2021), the employee contribution limit on a 401(k) is $19,500 for those under 50 years old. An employee might have a spouse earning money or otherwise have cash sufficient such that they do not need to take a salary early in the year. Thus, they may consider contributing a very large percentage of their salary to their 401(k) early in the year until they reach the maximum of $19,500, in order to earn more time for tax-deferred growth.
Unfortunately, this strategy will cost employees matching contributions in the later pay periods during the year. In each of the later pay periods, the employee will contribute 0 percent of their salary, meaning there will be nothing for the employer to match.
Make sure you know how your employer’s plan matches and structure your employee contributions to maximize the employer match you receive.
401(k) Auto-Enrollment
Many employer retirement plans automatically enroll new employees into their 401(k) or other plan. This is to ensure employees don’t lose out on some money simply because they never filled out the paperwork.
Whenever you join a new employer, you need to learn about the plan and ensure you are contributing at the right level. There are instances where the auto-enrollment contribution percentage is less than the employer matching contribution percentage, so be sure to take action, and if necessary, change your contribution percentage.
Traditional or Roth
In many plans, the employee does not have a choice – employee contributions are “traditional” deductible contributions. Increasingly, plans are offering the Roth option where the contribution is not deductible today, but the contribution and its growth/earnings are tax-free in the future.
This post addresses the traditional versus Roth issue. But for now, it suffices to say that contributing at the level that receives the full employer match must be your top wealth building priority.
Resource
Your workplace retirement plan should have a PDF document called a “Summary Plan Description” available in your workplace benefits online portal. Reviewing that document will help you figure out the contours of your 401(k) or other workplace retirement plan.
TWO: Establish a Roth IRA
For a primer on Roth IRAs, please read my Ode to the Roth IRA. Roth IRAs, like traditional IRAs are “individual.” You establish one with a financial institution separate from your employer.
Generally speaking, a Roth IRA gives you tax-free growth, and if done correctly, money withdrawn from a Roth IRA is both tax and penalty free.
There is no better account to hold in retirement than a Roth IRA. Why not start one today (2021), when (a) federal income tax rates are at historic lows and (b) Roth IRA contributions give you an immediate emergency preparedness benefit.
Roth IRA contributions can be withdrawn tax and penalty free at any time for any reason! The Roth IRA is the only retirement account that offers unfettered, tax-free access to prior contributions. Note, however, in most cases the best Roth IRA strategy is to keep money in the Roth IRA for as long as possible (so it continues to grow tax free!).
Every working and retired American should ask themselves whether they have a Roth IRA. If they do not have one, they should ask why that is. For those who do not currently have a Roth IRA, now is as good a time as any to consider a Roth IRA contribution (if you qualify), a Backdoor Roth IRA, or a Roth conversion.
THREE: Contribute to an HSA to the Maximum Allowed If You are Offered a HDHP and the HDHP Works for You
A health savings account is a very powerful saving vehicle. You have access to it if you have a high deductible health plan. To have an HDHP through your employer, you need to determine (i) if your employer offers a HDHP and (ii) whether the HDHP is appropriate medical insurance for you.
If you do not have employer provided insurance, you may be able to obtain an HDHP in the individual marketplace.
Let’s assume your employer offers an HDHP and you determine it is appropriate for you. At that point, you need to prioritize contributing the maximum to the HSA (second only to receiving the employer match in your 401(k) or other retirement plan and establishing a Roth IRA). You receive an upfront income tax deduction for the money you contribute. If the funds in your HSA are used to pay qualified medical expenses, or are used to reimburse you for qualified medical expenses, the contributions and the earnings/growth are tax-free when paid out of the HSA. This tax-friendly combination means the HSA should be a high priority.
Here are a few additional considerations:
Payroll Taxes
The HSA has an additional benefit. Contributions made by an employee through payroll deductions are federal payroll tax deductible (unlike contributions to employer retirement plans). To get this additional benefit, you must contribute through an employer payroll deduction. Writing a check to your HSA only creates an income tax deduction.
State Income Taxes
In California and New Jersey, HSAs are treated as taxable accounts. Thus, in these states there are no state income tax deductions for contributions to an HSA. Furthermore, dividends, interest and other realized income and gains generated by HSA assets are subject to state income taxes. While detrimental, the federal income tax and payroll benefits are so powerful that even residents of these states should highly prioritize HSA contributions.
Employer Contributions
Check to see if your employer offers an employer contribution to your HSA. Many do. When the employer does, the employee leaves free money on the table if they do not enroll in the HDHP.
Reimbursements
In most cases, it is advisable to (i) pay current medical costs out of your own pocket (your checking account and other taxable accounts) and (ii) record and track these medical expenses. Leaving the money in the HSA allows it to grow tax-free!
Years later when the money has grown, you can reimburse yourself tax-free from your HSA for the previously incurred costs, as there is no time limit on reimbursements. In most cases, there should be sufficient previous medical expenses that can be reimbursed tax-free from the HSA. Note that only qualified medical expenses incurred after you are first covered by the HDHP are eligible for tax-free reimbursement.
FOUR: Save, Save, Save!!!
My last recommendation is simple: save, save, save! Are there ways to do it in a tax-efficient manner? Absolutely! But the absolute most important consideration is the act of saving and investing itself. Between retirement plans, lack of a payroll tax, and favored dividend and capital gain tax rates, saving and investing are often tax efficient without trying to be.
More Tax Optimization
Maybe you’ve got the basics down and want to do more tax optimization. Understanding that nothing on this (or any other) blog is advice tailored to your situation, here are some posts that can get your wheels turning regarding tax planning.
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
