Tag Archives: Solo401(k)

2021 YEAR-END TAX PLANNING

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. 

IRAs and HSAs

Good news on regular traditional IRA contributions, Roth IRA contributions, and HSA contributions: they don’t have to be part of an end-of-2021 tax two-minute drill. The deadline for funding an HSA, a traditional IRA, and a Roth IRA for 2021 is April 18, 2022. 

Solo 401(k)

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

Follow me on Twitter: @SeanMoneyandTax

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 for Individuals

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).

Self-employed retirement plans have their own sets of deadlines that should be considered.

Conclusion

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

Follow me on Twitter: @SeanMoneyandTax

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 Business Income Deduction Update

For those interested in tax planning for the FI community, some interesting news came from the Senate this week. Senator Ron Wyden, a Democrat and the Chairman of the Senate Finance Committee, released a proposal to modify the Section 199A qualified business income (“QBI”) deduction.

My view is that this is very good news, for reasons I will discuss below.

QBI Deduction

The Section 199A QBI deduction provides small business owners a deduction of up to 20 percent of their “qualified business income.” Usually, this is income from self-employment (reported on Schedule C) or income from a partnership or S corporation (reported on Form K-1). The deduction is subject to a host of limitations which tend to kick in hard for upper income taxpayers. 

I’ve written plenty on the Section 199A QBI deduction. My introductory post is here, and a more advanced post is here. 

The QBI deduction is good for the financial independence community. It lowers the federal income tax burden on those with small businesses and side hustles. 

Expiration

But there is one lurking issue with the QBI deduction: will it last? There are two reasons to worry that it will not. First, it was enacted by Republicans in late 2017 in a polarized political environment. While that means Washington Republicans generally support the deduction, it also means Washington Democrats may have no particular political reason to support it. Second, the deduction has an expiration date: December 31, 2025: The deduction is not available in tax years beginning after that date. 

While there are few things more permanent than a temporary tax deduction, obviously it is worrisome that if nothing else happens, we only have four and a half more years of the tax deduction. 

Wyden Proposal

Senator Wyden introduced a proposal to modify the Section 199A QBI deduction. The legislative language is available here and a summary of the legislation from Senator Wyden’s staff is available here.

I am still reviewing the language, so at this point (July 21, 2021) I only have a basic understanding of it. Please take the below as a preliminary analysis subject to change. 

The bill keeps the QBI deduction, but appears to eliminate it entirely (as related to qualified business income itself) if taxable income reported on the tax return is $500,000 or more. Between $400K and $500K of taxable income, the QBI deduction is phased out. It appears single taxpayers do very well with this provision, as the limits apply per tax return, and are not doubled for married filing joint taxpayers. 

The Wyden proposal eliminates the ability for married filing separately taxpayers and estates and trusts to claim the QBI deduction. 

The bill also eliminates the concept of a “specified service trade or business.” This simplifies the QBI deduction and will help many self-employed professionals qualify for the deduction where under current law they would not. 

See the example of Jackie I posted here. Without a deduction for Solo 401(k) contributions Jackie did not qualify for any QBI deduction at all because he was a single lawyer with a taxable income over $215K. If the Wyden proposal is enacted as written, Jackie could have up to $400K in taxable income and claim a full QBI deduction. Single moderate to high income professionals appear, at first glance, to be the big winners if the Wyden proposal is enacted. Some married professionals will also benefit from this provision. 

Section 199A Dividends

The proposed bill appears to keep the 20 percent deduction for “Section 199A dividends” which are dividends paid by real estate investment trusts (“REITs”) and mutual funds and ETFs which own REITs. It appears, however, that a taxpayer’s ability to deduct Section 199A dividends would phase out between $400K and $500K of taxable income. Under current law there is no taxable income limit on the ability to deduct 20 percent of Section 199A dividends. 

Expiration 

The Wyden proposal does not eliminate the expiration date, December 31, 2025. To my mind, that is not too surprising. Eliminating the expiration date would increase the “cost” of the Wyden proposal and thus, under Congressional budgeting procedures, likely require cutting spending or raising other taxes. 

The Good News

To my mind, the Wyden proposal is good news for those fond of the QBI deduction. Instead of eliminating the QBI deduction, we now have a powerful Washington Democrat embracing large parts of the deduction, and expanding its availability for some taxpayers. If this were to pass (and that is very speculative), then both Republicans and Democrats would have passed a version of the QBI deduction. At that point, it is unlikely that either party would want to be responsible for the deduction dying in full in 2026. 

This legislative proposal is simply a first step: stay tuned for further developments. But for the FI community, I see a powerful Washington Democrat embracing a large portion of the QBI deduction to be a positive development. 

FI Tax Guy can be your financial advisor! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

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. 

S Corporations for Beginning Solopreneurs

Last month the blog discussed the beginning of the self-employment journey. Specifically, it discussed how one pays taxes when they become self-employed. This post goes further. It explores a potentially powerful tax planning for self-employed solopreneurs, the S corporation. 

None of the below is tax advice for any particular taxpayer. Note that if you are considering an S corporation, you are generally well advised to work with a tax professional before and during the process of implementing an S corporation. 

The S Corporation Concept

Generally speaking, a corporation is subject to federal income tax at a 21 percent rate. For example, if Acme Incorporated has $100,000 of taxable income for the year, it owes the IRS $21,000 of federal income tax. Further, the shareholders are subject to taxes on the receipt of dividends from the corporation. If Acme Incorporated pays its after tax profit of $79,000 to its shareholders, generally its shareholders must include the receipt of the dividend in taxable income (though the dividend may qualify for the favorable qualified dividend income rates). 

Based on both the corporation and the shareholders having to pay tax on the same income, it is said that many corporations (so-called “C corporations”) are subject to double tax. 

For smaller businesses, this can be very problematic. The tax rules recognize this, and thus, for certain small business entities, allow an “S corporation” election (meaning that the corporation is taxed under the rules of Subchapter S of the Internal Revenue Code).

S corporations are generally subject to only one level of tax, as all of the tax items of the S corporation (taxable income, gain, loss, credits, etc.) are reported and taxed on the shareholder(s) individual tax returns. The S corporation itself usually does not pay federal income tax. 

Most states replicate this treatment to a large extent. For example, in my home state of California, S corporation income is reported on the shareholders’ tax returns, but the S corporation itself is subject to a 1.5% income tax (with a minimum annual tax due of $800 regardless of income). 

The Self-Employment Tax Savings and Reasonable Compensation

There is another wrinkle to S corporations which can make them advantageous to solopreneurs. The S corporation must pay owner-employees reasonable compensation as W-2 salary. However, the rules generally allow the owner-employee to take some of the earnings of the S corporation as a dividend. This has the rather interesting effect of, in many cases, reducing the overall payroll tax liability of the solopreneur. 

Here’s a quick example of how that could work:

Aurora works as a private detective. After business expenses, she has a net income of $110,000. The payroll taxes she pays will depend on whether the business is organized as a sole proprietorship or an S corporation. 

If she is operating as a sole proprietorship, she will pay $15,543 in self-employment taxes, as computed on Schedule SE (roughly, 14.13% of her profits are due in self-employment taxes). 

Things are different if the business is organized as an S corporation. Assume, just for the sake of this example, that the S corporation pays Aurora $55,000 in W-2 compensation and this is reasonable. The FICA tax she and the S corporation together pay is 15.3% of that amount, $8,415. 

In this example, Aurora saves over $7,000 in payroll taxes by electing to operate out of an S corporation.

Of course, compensation must be reasonable. S corporation owner-employees who pay themselves very small W-2 salaries can have dividend payments recharacterized as W-2 salary, prompting disputes with the IRS and state taxing agencies and the collection of back payroll taxes.

Solopreneur Requirements for an S Corporation

Below I discuss, very broadly, the general requirements to establish and maintain an S corporation for a solopreneur who does not employ other people. Those items with a single asterisk can (but does not have to) apply to a Schedule C sole proprietorship (for example, for solopreneurs a limited liability company can be either a Schedule C sole proprietorship or an S corporation). The item with a double asterisk also applies to a sole proprietorship, but perhaps to a somewhat lesser extent. 

Entity Formation*

To have an S corporation, one must operate out of a legal entity. Generally, the legal entity can be a corporation or a limited liability company (an “LLC”). Corporations and LLCs are creatures of state law. Each state has its own formation and regulation procedures, requirements, and fees. Often it is wise to consult with legal counsel when forming a legal entity.

Under the federal income tax rules, an S corporation generally must have 100 or fewer shareholders and only a single class of stock outstanding. 

Tax Election

Electing S corporation status requires the filing of a Form 2553 with the IRS with the signatures of all the shareholders. In community property states, usually one’s spouse is considered a shareholder. Taxpayers omitting a spouse’s signature where the S corporation stock is community property can fix the omission under the procedure available under Revenue Procedure 2004-35. 

Entity Maintenance*

Legal entities have requirements for maintenance. These vary by state, and can include annual fees, annual shareholders’ meetings, and meetings of a Board of Directors. Consultations with legal counsel can be helpful in this regard. 

Separate Books, Records, and Bank Accounts**

A legal entity should have its own bank account to collect revenue and pay expenses. Most solopreneurs operating out of either a sole proprietorship or an S corporation are well advised to hire a (very likely virtual) bookkeeper to track revenues and expenses. 

Separate Federal Income Tax Return

S corporations must file an annual income tax return with the federal government, the Form 1120-S. Included in this Form is a Form K-1. Form K-1 reports to both the shareholders and the IRS the ordinary income and other tax results of the S corporation for the year that must be reported on the income tax returns of the shareholders.

Generally speaking, the Form 1120-S is due March 15th, but can be extended to September 15th. 

Separate State Income Tax Return

In most states, S corporations have to file income tax returns. There can be entity level taxes on S corporations (such as California’s 1.5% income tax, $800 minimum tax) and in most states the shareholders will need to report the S corporation’s income on their own state income tax return. 

Running W-2 Payroll/Reasonable Compensation

S corporations must pay their employees, including solopreneur owners, reasonable compensation. This requires running W-2 payroll, including federal and state payroll tax withholding and remittance. There are payroll processors that specialize in providing payroll services for small S corporations. 

As discussed above, W-2 compensation must be reasonable. 

Forms W-2, W-3, 940, and 941

There are both quarterly and annual payroll tax returns that must be filed to report salaries paid and payroll taxes withheld and remitted. The Form 941 is filed for each quarter and is generally due one month after the end of the quarter. 

Forms W-2, W-3, and 940 are filed on an annual basis and generally due January 31st.

Tracking Distributions and S Corporation Stock Basis

Shareholders must track their “basis” in their S corporation stock. Generally speaking, dividends from an S corporation are not taxable to the shareholder. However, they reduce the shareholder’s basis in their S corporation stock. If the shareholder receives a distribution at a time he or she does not have basis in their S corporation stock, it triggers a taxable gain to the shareholder.

Basis should generally be tracked as part of the tax return preparation process. However, basis should also be tracked during the year prior to the shareholder taking significant dividends from the S corporation. 

Increased Professional Fees

Operating out of an S corporation generally increases the professional fees a solopreneur pays. This absolutely can be worth it, but in many cases there needs to be professional assistance regarding reasonable compensation, tax filings, legal maintenance, and payroll processing. 

Tax Planning

In a world without two of my favorite tax topics, the qualified business income deduction and the Solo 401(k), the analysis was usually somewhat straightforward. Estimate business income and run it through the filters of income and self-employment tax if reported on a Schedule C versus income and payroll tax if reported through an S corporation. This yielded an estimate of the overall tax savings obtained using an S corporation structure. 

To make the “S corporation or Schedule C” decision, the taxpayer would then, for the most part, compare the estimated annual tax savings versus the additional administrative burden and costs associated with the S corporation. 

Today, we live in a world with the qualified business income deduction and the Solo 401(k). These planning opportunities make the “S corporation or Schedule C” question more nuanced. At a minimum, solopreneurs should work with their tax advisors to model out what the income tax, self-employment tax, qualified business income deduction, and retirement plan results look like at their anticipated business income level and desired retirement plan contribution level to determine whether the S corporation or the Schedule C route is better. 

Operating through an LLC

One option available to solopreneurs is operating out of an LLC as the sole owner. LLCs provide a legal entity out of which to conduct business. Properly operated, an LLC can provide a solopreneur with liability protection and reputational advantages. One great feature of LLCs is their tax flexibility. They default to disregarded status, meaning that for a solopreneur, the default option is that the taxable income of the LLC is simply reported on their Schedule C. However, using the Form 2553, a solopreneur can elect to have the LLC treated as an S corporation.

Those looking to work through an LLC should consider hiring legal counsel regarding the establishment and maintenance of their legal entity. 

Conclusion

Operating out of an S corporation is a significant additional operational commitment. There are instances where it can make a great deal of sense for a solopreneur. Those considering using an S corporation should understand the administrative commitment involved and should work with advisors as appropriate to ensure they make an informed decision. 

FI Tax Guy can be your financial advisor! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

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.

Sean Discusses Tax Planning on the ChooseFI Podcast

I was honored to discuss using tax returns as a springboard to tax planning on a recent episode of the ChooseFI podcast. Click here for the episode website.

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

Follow me on Twitter: @SeanMoneyandTax

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. 

Paying Taxes When You’re Self-Employed

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):

QuarterDate Estimated Tax Payment is Due
First QuarterApril 15, Year 1
Second QuarterJune 15, Year 1
Third QuarterSeptember 15, Year 1
Fourth QuarterJanuary 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

Follow me on Twitter: @SeanMoneyandTax

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. 

Sean on the How to Money Podcast

I recently discussed tax planning, financial independence, and entrepreneurship on the How to Money podcast. Please click the below link to listen. https://www.howtomoney.com/smart-tax-planning-moves-with-sean-mullaney/

FI Tax Guy can be your financial planner Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

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. 

Split-Year Backdoor Roth IRAs

Can I contribute to a Roth IRA? Can I do a Backdoor Roth IRA? These are two questions I often hear as a tax-focused financial planner.

Perhaps you find yourself preparing your 2020 tax return in early April 2021. You have not contributed anything to a traditional IRA or a Roth IRA yet for 2020. Do you have time to perhaps do a Roth IRA or a Backdoor Roth IRA? The answer is, “Absolutely!” if you have the right facts in place. Let’s discuss a comprehensive example:

Example 1: Jack is single, 35 years old, participates in a 401(k) at work, and has self-prepared his 2020 tax return but not yet filed it. It is April 9, 2021, and his tax-return software indicates that he does not qualify for a Roth IRA, as his modified adjusted gross income for 2020 is $150,000. Jack has no traditional IRAs, SEP IRAs, or SIMPLE IRAs. Jack just learned about the existence of the Backdoor Roth IRA. 

What can Jack do? Can he do a Backdoor Roth IRA for 2020? The answer is, Yes! 

First, Jack should, by April 15, 2021, make a traditional, non-deductible IRA contribution of $6,000. When he does this, he should designate the contribution as being for 2020. With his soon-to-be-filed 2020 federal income tax return, he should file a Form 8606 which will report the $6,000 traditional, non-deductible IRA contribution. Easy enough. 

Assuming Jack contributed to his 2020 traditional, non-deductible IRA in April 2021, in May of 2021 Jack should convert the entire balance in his traditional IRA to a Roth IRA. Third, he should ensure he has no balance in traditional IRAs/SEP IRAs/SIMPLE IRAs as of December 31, 2021. 

Jack can also do a Backdoor Roth IRA for 2021, which may be advisable if (a) his modified adjusted gross income exceeds the Roth IRA contribution thresholds and (b) he will have no balance in traditional IRAs/SEP IRAs/SIMPLE IRAs as of December 31, 2021. 

Assume Jack makes a traditional, non-deductible contribution to an IRA for 2021 on June 1, 2021, and on July 2, 2021, he converts the amounts in the traditional IRA to a Roth IRA. Further assume (a) the amounts converted in May and July were $6,001 and $6,002, respectively, and (b) Jack has no balance in traditional IRAs/SEP IRAs/SIMPLE IRAs as of December 31, 2021. 

When Jack files his 2021 tax return, Page 1 of his Form 8606 should look like this:

Page 1 of the Form 8606 reflects the total basis in traditional IRAs (without considering the Roth conversions). Note that I had to use the 2019 version of the Form 8606, as the 2021 version has not yet been released. Please adjust all dates in your mind’s eye accordingly.

Page 2 (reporting the 2021 Roth IRA conversions) of the Form 8606 should look like this:

The gross amount of the Roth IRA conversions are taxable, but Jack gets to recover his $12,000 of traditional IRA basis.

Post Tax Return Filing Split-Year Backdoor Roth IRA

Example 2: Jim is single, 35 years old, participates in a 401(k) at work, and has self-prepared his 2020 tax return and filed it on March 15, 2021. Jim’s modified adjusted gross income for 2020 is $150,000. Jim has no traditional IRAs, SEP IRAs, or SIMPLE IRAs. It is April 9, 2021 and Jim just learned about the existence of the Backdoor Roth IRA. 

Can Jim still do a Backdoor Roth IRA for 2020? Absolutely!

First, Jim should, by April 15, 2021, make a traditional, non-deductible IRA contribution of $6,000. When he does this, he should designate the contribution as being for 2020. So far, everything is the same as Example 1.

But here is where things change. Jim should also, by April 15, 2021, file a standalone Form 8606 with the IRS and be sure to sign the form on page 2. The Form 8606 will report the contribution to the traditional, non-deductible IRA. Jim will have to paper file the Form 8606 and mail it to the IRS Service Center that he would mail his Form 1040 to (if he were to paper file his Form 1040). 

Jim could then convert the traditional IRA to a Roth IRA to successfully complete the Backdoor Roth IRA. He should also ensure he had no balance in a traditional IRA, SEP IRA, or SIMPLE IRA on December 31, 2021. 

Advanced Split-Year Backdoor Roth IRA

Example 3: Jill is married to Joe, 35 years old, participates in a 401(k) at work, and has self-prepared their 2020 tax return but not yet filed it. Jill and Joe’s modified adjusted gross income for 2020 is $250,000. Jill has a traditional IRA with a balance of $100,000 (and no previous non-deductible contributions). It is April 9, 2021 and Jill just learned about the existence of the Backdoor Roth IRA. 

Jill’s example is a bit more challenging than Jack and Jim’s previous example. Yes, it is possible that Jill could successfully complete a Backdoor Roth IRA for 2020. But it involves much more execution risk – the risk that the proper steps will not be completed in time. While taxpayers engaging in any sort of tax planning should consider engaging professional assistance, Jill is in a position where that is even more so the case. 

Here is how Jill could successfully execute a Backdoor Roth IRA for 2020. Jill should go to her workplace benefits website and download and review the “Summary Plan Description” for the 401(k) plan (sometimes initialized “SPD”). 

It may be the case that Jill’s workplace 401(k) plan will accept a roll-in of her traditional IRA. Many 401(k)s do, but many do not. Some plans will only accept roll-ins of other qualified plans (401(k)s, 403(b)s, etc.), and some plans will only accept roll-ins of qualified plans and so-called “conduit IRAs” i.e., IRAs that consist only of money that was formerly in a qualified plan. However, there are some plans that will accept roll-ins of both old qualified plans and any type of traditional IRA (though note that in all events 401(k) plans cannot accept roll-ins of amounts representing non-deductible IRA contributions).

If Jill’s workplace 401(k) plan will accept a roll-in of the $100,000 traditional IRA, then Jill could transfer (in a direct trustee-to-trustee transfer) her traditional IRA (other than the amount of any nondeductible contributions, including a $6,000 2020 contribution) to the 401(k). If she fails to do that by December 31, 2021, then any Backdoor Roth IRA would be very tax inefficient (and unavisable) – you can read more here in the “Jennifer” example. 

This is one reason I say that there is “execution risk” – perhaps Jill does the “Backdoor Roth IRA” steps but neglects the transfer of the old traditional IRA to the 401(k) until after December 31, 2021. If that happens, Jill’s Backdoor Roth IRA will now be very tax inefficient.

Some might say “couldn’t Jill start a side hustle, open a Solo 401(k) for it, and then roll the traditional IRA into the Solo 401(k)?” To my mind, that is a dangerous path. Jill’s side hustle might not rise to the level of a trade or business for tax purposes. If it does not, then it is not eligible to have a Solo 401(k). Any transfer of a traditional IRA to a plan that does not qualify as either an IRA, 401(k), 403(b), or similar plan is simply a taxable distribution subject to full income tax and a 10 percent early withdrawal penalty. Ouch!!!

Jill should not over think it. If she can easily roll her old traditional IRA into her workplace 401(k), then she should consider doing so and doing a Backdoor Roth IRA. But if she cannot, then fine, there are plenty of other ways to become financially independent and/or achieve retirement planning goals. Not having the Backdoor Roth IRA tool available is no killer to her future plans and goals. 

Note further that if Jill’s balance was in a SIMPLE IRA that was less than 2 years old, she could not roll the SIMPLE IRA into anything other than a SIMPLE IRA for the first two years of her SIMPLE IRA’s existence without incurring a 25% penalty.

FI Tax Guy can be your financial advisor! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

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. 

From Tax Returns to Tax Planning

Many colloquially refer to the Winter and early Spring as “tax season.” To my mind, that is short sighted. Yes, for most the time from late January to mid-April are when their tax return is prepared and filed. But the most impactful tax work is not tax return preparation — it’s tax planning!

Below I discuss ways to use your current tax return as a springboard to tax planning. 

Before we get started, two notes. First, there is some tax planning that can be “do it yourself” and some tax planning that is best considered and implemented with the help of a tax planning professional. When in doubt, the concept is probably the latter. Second, it is helpful to keep in mind the correct use of this blog or any other blog–as a tool to raise awareness. Blogs are not a substitute for professional advice, and are not advice for any particular person. Rather, this post and others should be viewed as a way to increase knowledge and help faciliate more informed conversations with professionals. 

Your 2020 Tax Return

Your 2020 tax return is a great springboard for tax planning. Look at the following items on your tax return to jump start your tax planning.

Schedule D Line 13 Capital Gain Distributions

Everyone should review their own tax returns for the past few years and look at this line. If there is a substantial number on this line, it should raise a red flag.

I previously discussed capital gain distributions here. Generally, they come from mutual funds and ETFs in taxable accounts. These financial securities pass gains out to the shareholders, creating capital gains income on the shareholders’ tax returns. Actively managed funds tend to have much greater capital gain distributions than passively managed index funds.

The planning opportunity is to review the accounts that are generating significant capital gain distributions. If the realized gain in such accounts is low (or if there is a realized loss in those accounts), it might be advisable to sell the holding and replace it with a fund likely to have lower capital gain distributions. Taxpayers considering this strategy should be sure to fully understand the gain or loss in the securities before selling. Financial institutions do not have to report to investors (and the IRS) basis in mutual funds purchased prior to 2012, so sometimes it can be difficult to determine the taxable built-in gain or loss on older holdings.

Form 8889 Line 14c Distributions

Form 8889 is the tax return form for a FI favorite: the health savings account. Amounts other than $0 on Line 14c of Form 8889 should appear, in my opinion, only if the taxpayer is elderly or found themselves in a dire situation during the tax year. It is generally not optimal, from a tax perspective, to take distributions from an HSA to fund medical expenses when one is neither elder nor in a dire situation. 

Amounts other than $0 on Line 14c can be a learning and planning opportunity. Future routine medical expenses are usually best paid from one’s checking account (a regular taxable account), and taxpayers should save the receipt. In the future, taxpayers can reimburse themselves tax free from their HSA for that expense. In the meantime, the money has grown in the HSA and enjoyed many years of tax free compounding. 

Form 1040 Line 4b IRA Distributions Taxable Amount

Taxpayers who did a Backdoor Roth IRA and have a large amount on Line 4b of Form 1040 should review their transactions to make sure everything was correctly reported. Part of the idea behind a Backdoor Roth IRA is that, if properly executed, it should result in a very small amount of taxable income (as indicated on Line 4b). 

It may be the case that the tax return improperly reported the Backdoor Roth IRA (and thus, the taxpayer should amend their return to obtain a refund). Or, it may be the case that the taxpayer did the steps of the Backdoor Roth IRA at a time they probably should not have (because they had a significant balance in a traditional IRA, SEP IRA, or SIMPLE IRA). 

Discovering the problem can help effectively plan in the future, and if necessary take corrective action. 

For those executing Roth Conversion Ladders, a large amount on Line 4b is the equivalent of Homer Simpson’s Everything OK Alarm. Roth Conversion Ladders are intended to create a significant amount of taxable income, and Line 4b is where that income is reported on Form 1040. Note further that all Roth IRA conversions require the completion of Part II of the Form 8606. 

Schedule A Line 17 Total Deductions

Those who claimed itemized deductions in 2020 should review Line 17 of Schedule A. Is the number reported for the total itemized deductions close to the standard deduction amount (for 2021, single taxpayers have a standard deduction of $12,550 and married filing joint taxpayers have a standard deduction of $25,100)?

If so, there a tax planning opportunity. Why is that number what it is? Is it because of charitable contributions? If so, the donor advised fund might be a good opportunity. Here’s how it might work:

Example: Joe and Lisa file married filing joint. In 2020, they itemized based on $10K of state taxes, $9K of mortgage interest, and $6K of charitable contributions ($500 a month to their church). Thus, at $25,000 of itemized deductions, they were barely over the threshold to itemize. In 2021, they move a sizable amount into a donor advised fund ($25,000). They use the donor advised fund to fund their 2021, 2022, 2023, and 2024 monthly church donations. 

From a tax perspective, Joe and Lisa itemize in 2021 (claiming total deductions of $44K – the state taxes, mortgage interest, and a $25K upfront deduction for contribution to the donor advised fund). In 2022, 2023, and 2024, they would claim the standard deduction, which is (roughly speaking) almost equivalent to their 2020 itemized deductions. 

By using the donor advised fund, Joe and Lisa get essentially the same deduction in 2022 through 2024 that they would have received without the donor advised fund, and they get a tremendous one year increase in tax deductions in 2021. 

Form 8995 or Form 8995-A Line 2

Those with any amount on Line 2 of the Form 8995 or the Form 8995-A should likely consider some tax planning. This line indicates that the taxpayer has qualified trade or business income that may qualify for the new Section 199A qualified business income deduction. Taxpayers in this situation might want to consider consulting with a professional, as there are several planning opportunities available to potentially increase any otherwise limited Section 199A qualified business income deduction.

2021 Adjusted Gross Income Planning to Maximize Stimulus Payments

Taxpayers should review line 11 (adjusted gross income or “AGI”) on their Form 1040 in concert with reviewing their stimulus checks. For those taxpayers who did not receive their maximum potential stimulus payments in 2021, there can be opportunities to lower AGI so as to qualify for additional stimulus payments and/or increased child tax credits. I blogged about one planning opportunity in that regard here.

The Shift to Tax Planning

Tax planning can take many shapes and sizes. But it needs to be driven by goals, not by tactics. Bad tax planning begins something like this: “I need a Solo 401(k), how do I set it up?” N.B. Opening a Solo 401(k) when you do not qualify for one is a great way to create a tax problem for yourself. 

Good tax planning begins more like this: “I want to achieve financial independence. How do I best save for retirement in a tax advantaged way? I’ve heard a Solo 401(k) is a great option. As part of this process, we should consider it as a possible way to help me achieve my goal.”

Another point: I find there is far too much focus on “I had to pay [insert perceived sizable amount here] this year in taxes” and far too little focus on lifetime taxes. To my mind, the goal should not be to pay less tax in any one year. Rather, the goal should be to legitimately reduce lifetime tax burden. Sure, there can be tax planning that does both, but the best tax planning (whether DIY or with the help of a professional) places reducing lifetime tax burden as its primary goal.

Below are just some areas where taxpayers can begin their tax planning considerations.

Retirement Planning

This is a big one. Taxpayers should understand whether they contribute to a traditional IRA and/or Roth IRA, and why or why not. This post helps explain whether taxpayers qualify to make an annual contribution to a traditional IRA and/or a Roth IRA. 

Taxpayers should consider their workplace retirement plans, which can provide several planning opportunities. 

Small Business/Self-Employment Income

For those with a small business and/or significant self-employment income, tax planning is very important. I have written several posts about just some of the tax planning available to those with small businesses. People with small businesses often benefit from professional, holistic tax and financial planning. 

Stock Options

Stock options and employer stock grants provide some good tax planning opportunities. I’ve previously written about ISOs, but all kinds of stock option programs can be an opportunity to do some tax planning, which often should be with a professional advisor. 

Conclusion

Filing timely, accurate tax returns is important. But the best way to optimize one’s tax situation is to do quality, intentional tax planning. Tax planning should prioritize goals over tactics. There is some tax planning that can be done by yourself, but many areas of tax planning strongly benefit from professional assistance.

FI Tax Guy can be your financial advisor! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

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. 

SEP IRA Versus Solo 401(k)

If you qualify for both a SEP IRA and a Solo 401(k), is there a clear winner? In the past, it was often the case that the tax benefits of a SEP IRA and a Solo 401(k) were similar, particularly if you also had access to a 401(k) plan at a full-time employer. Today the landscape has changed, and in most cases, there’s a clear winner.

This post discusses whether a SEP IRA or a Solo 401(k) is better in situations where the self-employed person qualifies for both plans.

Note that both plans have eligibility requirements. For example, under the tax rules, if you employ anyone other than your spouse for 1,000 hours or more during the year you are ineligible for a Solo 401(k). There are additional tax rules and separate (and additional) plan rules to consider to determine if you are eligible for a particular SEP IRA and/or Solo 401(k).

The Basics

Both the SEP IRA and the Solo 401(k) are self-employed retirement plans. They can be established by legal entities (in this context, often S corporations) or they can be established by individuals that have self-employed income. That self-employment income generally must come through a sole proprietorship or through a limited liability company (“LLC”) that is disregarded for tax purposes and reported on a Schedule C filed with the individual’s tax return. 

SEP IRAs

A SEP IRA allows only “employer” contributions. For this purpose, your own sole proprietorship or disregarded LLC can be your employer. 

Generally, the employer can make annual contributions of up to 25 percent of eligible W-2 compensation (from a corporation) or 20 percent of an individual’s self-employment income, limited to $66,000 of contributions in 2023.

Today, many financial institutions (including Fidelity, Schwab, and Vanguard) offer low-cost SEP IRA options.  

A SEP IRA can be established for a tax year by the deadline for filing that tax year’s tax return, including extensions. 

The administrative compliance burden of a SEP IRA is generally very manageable. 

History of the SEP IRA vs. the Solo 401(k)

Watch me discuss the history of both the SEP IRA and the Solo 401(k).

Solo 401(k)s

A Solo 401(k) (sometimes referred to as an “Individual 401(k)”) is a 401(k) plan established by a self-employed individual for their own benefit. 

The main advantage of the Solo 401(k) is that it allows annual contributions by the self-employed individual in his/her role as the “employee” and annual contributions by the self-employed individual (or S corporation) in his/her role as “employer.” 

Employee contributions are limited to the lesser of earned income or $22,500 ($30,000 if 50 or older) in 2023. Employer contributions are limited to up to 25 percent of eligible W-2 compensation (from a corporation) or 20 percent of an individual’s self-employment income, limited to $66,000 of contributions in 2023. Total employee and employer contributions are limited to $66,000 ($73,500 if age 50 or above) in 2022. 

Today, many financial institutions (including Fidelity, Schwab, and Vanguard) offer low-cost Solo 401(k) options.

The administrative compliance burden of a Solo 401(k) is generally very manageable, but note that once there are more than $250,000 in the plan and/or the plan is closed, a Form 5500-EZ must be filed.

The Clear Winner

At this point, you might be saying, “Great, both the SEP IRA and Solo 401(k) are attractive. Is there really a big difference between them? Should I care too much about which plan I establish?”

The answer is that in most cases, the Solo 401(k) is the much better option for a self-employed person. If you are considering a SEP IRA over a Solo 401(k) in a situation where you qualify for both, you ought to think twice about that decision.

Here are the main reasons why the Solo 401(k) is much better than the SEP IRA in most cases.

Employee Contributions

The Solo 401(k) allows employee contributions. If your self-employment income is relatively modest, this greatly increases the amount you could contribute. For example, if Jane, under age 50, has a side-hustle that earns her $10,000 in 2023 after the deduction for one-half of self-employment taxes is accounted for, her maximum Solo 401(k) contribution is $10,000, while her maximum SEP IRA contribution is only $2,000 (20% of $10,000).

Note that this assumes that Jane has contributed $12,500 or less to a workplace 401(k) or similar retirement plan. Using the 2023 limitations, $22,500 is the maximum total employee deferrals Jane can make to her 401(k) and similar plans, so Jane’s other employer retirement accounts should also be considered.

Section 199A and 80% Deductions

I have previously written about the new Section 199A qualified business income (“QBI”) deduction and its impact on self-employed retirement plans. Traditional contributions to both Solo 401(k) plans and SEP IRAs create, for many taxpayers, deductions that are only “80% deductions.” Here is an example.

After self-employment taxes, Joe, a single taxpayer, earns $120,000 from his sole-proprietorship. Joe makes a 10 percent employer contribution ($12,000) to either his Solo 401(k) or SEP IRA. In the 24 percent marginal tax bracket, he expects to save $2,880 ($12,000 times 24%) on his federal income taxes. He is surprised to learn that he only saved $2,304 on his federal income taxes. 

How is that possible? While Joe is correct that he receives a $12,000 retirement plan contribution tax deduction, he failed to consider that he lost $2,400 of his QBI deduction. A traditional Solo 401(k) contribution and a SEP IRA contribution is an 80% deduction. In Joe’s case, he received a net federal income tax deduction of only $9,600 (80 percent of $12,000). 

Why then would Joe prefer a Solo 401(k) to a SEP IRA? Because the Solo 401(k) gives him a planning option that avoid the 80% deduction issue. Instead of making traditional contributions to a Solo 401(k), Joe can make Roth employee contributions to a Solo 401(k).

Note further that Joe could possibly implement Mega Backdoor Roth IRA planning by making after-tax contributions to his Solo 401(k). Many Solo 401(k) plans do not offer this option, but some do.

The SEP IRA does not offer these options. 

Not all financial institutions offer the Roth Solo 401(k) and the after-tax Solo 401(k) contribution options. It is important to understand the features of any particular Solo 401(k) before you adopt it as your plan. 

For upper income taxpayers, the 80% deduction phenomenon may not be an issue, considering that the ability to claim the QBI deduction is reduced or eliminated above certain income thresholds. These taxpayers need not prefer the Solo 401(k) to a SEP IRA for QBI deduction reasons, but may prefer to have the increased planning ability, such as the ability to make Roth and/or after tax contributions to the Solo 401(k) that a SEP IRA does not offer. They may also prefer the Solo 401(k) for the reasons discussed below.

Backdoor Roth IRA Planning

The Backdoor Roth IRA is a great planning tool. But the Pro-Rata Rule can cause significant snags. For example, if you execute the two independent steps of a $6,500 Backdoor Roth IRA in a year when you have a separate significant traditional IRA, SEP IRA, or SIMPLE IRA at year-end, you will cause most of the Backdoor Roth IRA to be taxable. 

The SEP IRA is a significant roadblock to the ability to execute an efficient Backdoor Roth IRA. A Solo 401(k) does not cause this problem with the Backdoor Roth IRA. For this reason alone many will want to choose a Solo 401(k) instead of a SEP IRA, even if they plan on making traditional deductible contributions to the plan. 

Catch Up Contributions

If you are age 50 or older, you can make up to $7,500 (in 2022) in catch up employee contributions to a Solo 401(k).

This option does not exist for a SEP IRA. Thus, for high earning self-employed persons age 50 or older, a Solo 401(k) has an additional advantage over the SEP IRA.

Solo 401(k) Book

This post was originally published in 2019. In 2022 I published Solo 401(k): The Solopreneur’s Retirement Account, a book that goes into much more depth about Solo 401(k)s.

Conclusion

If you qualify for both, generally the Solo 401(k) is better than a SEP IRA. If you are going with a SEP IRA over a Solo 401(k), you should understand the reasons for doing so. Finally, self-employed retirement plans is an area that taxpayers usually benefit from receiving personal advice from a qualified tax advisor. 

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

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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.