Tag Archives: Tax Deductions

2022 Year-End Tax Planning

Below are the main tax planning items for the year 2022 as I see them. Of course, this is educational information for the reader, and not tax advice directed toward any particular individual. 

The first two tax loss harvesting items are particularly unique to 2022 vis-a-vis recent years. 

Tax Loss Harvesting

2022 has given us plenty of lemons. For some Americans, it’s time to make some lemonade through tax loss harvesting. The deadline to do this and obtain a benefit on one’s 2022 tax return is December 31, 2022. 

Tax Loss Harvesting and Bonds

There is a tax loss harvesting opportunity in 2022 that has not existed in recent years to the scope and scale it exists today: tax loss harvesting with bonds and bond funds. In a recent post I went into that opportunity in detail and how it might create both a great tax loss harvesting opportunity and a great tax basketing opportunity. 

Tax Loss Harvesting Crypto

Many cryptocurrencies have declined in value. This can create a tax loss harvesting opportunity, regardless of whether the taxpayer wants to remain invested in crypto. To harvest the loss if one wants to get out of crypto, it’s easy: just sell the asset. For those wanting to stay in crypto, it’s not that much harder: sell the crypto (by December 31, 2022 if wanting the loss on their 2022 tax return) and they rebuy the crypto shortly thereafter. Crypto is not a “security” for wash sale purposes, and thus, repurchases of crypto are not subject to the wash sale rule, regardless of when they occur. 

Solo 401(k) Establishment

Quick Update 12/23/2022: My initial reading of SECURE 2.0 is that it does not change any 2022 Solo 401(k) deadlines. The one deadline it appears to change is effective starting for plan years beginning in 2023.

For Schedule C solopreneurs looking to make a 2022 employee contribution to a Solo 401(k), the Solo 401(k) must be established by December 31, 2022. This is NOT the sort of thing you want to try to do on December 30th. Almost certainly those trying to establish a Solo 401(k) will want to act well before the end of December, as it takes time to get the Solo 401(k) established prior to year-end. 

The deadline to establish a Solo 401(k) for an employer contribution is the tax return filing deadline. For individuals, this is April 18, 2023, but can be extended to October 15, 2023. For S corporations, this is March 15, 2023, but can be extended to September 15, 2023. 

Solo 401(k) Funding for Schedule C Solopreneurs

Employee elective deferral contributions (traditional and/or Roth) must meet one of two standards. Either (i) they must be made by December 31st or (ii) they are elected by December 31st and made by the tax return filing deadline, including any filed extensions. 

Employer contributions must be made by the tax return filing deadline, including any filed extensions. 

Roth Conversions 

Taxpayers with lower income (relative to the rest of their lives) may want to consider taxable conversions of traditional retirement accounts to Roth accounts. The deadline to get the Roth conversion on one’s 2022 tax return is December 31st, though it is not wise to wait until the last minute.

For the self-employed, there may be a unique opportunity to use Roth conversions to optimize the qualified business income deduction. 

Tax Gain Harvesting

For those finding themselves in the 12% or lower federal marginal income tax bracket and with an asset in a taxable account with a built-in gain, tax gain harvesting prior to December 31, 2022 may be a good tax tactic to increase basis without incurring additional federal income tax. Remember, though, the gain itself increases one’s taxable income, making it harder to stay within the 12% or lower marginal income tax bracket. 

HSA Funding Deadline

The deadline to fund an HSA for 2022 is April 18, 2023. Those who have not maximized their HSA through payroll deductions during the year may want to look into establishing payroll withholding for their HSA so as to take advantage of the payroll tax break available when HSAs are funded through payroll. 

The deadline for those age 55 and older to fund a Baby HSA for 2022 is April 18, 2023. 

Roth IRA Contribution Deadline

The deadline for funding a Roth IRA for 2022 is April 18, 2023. 

Backdoor Roth IRA

There’s no law saying “the deadline for the Backdoor Roth IRA is DATE X.” However, the deadline to make a nondeductible traditional IRA contribution for the 2022 tax year is April 18, 2023. Those doing the Backdoor Roth IRA for 2022 and doing the Roth conversion step in 2023 may want to consider the unique tax filing when that happens (what I refer to as a “Split-Year Backdoor Roth IRA”). 

Anyone who has already completed a Backdoor Roth IRA for 2022 should consider New Year’s Eve. December 31st is the deadline to be “clean” for 2022. Anyone who has done the Roth conversion step of a Backdoor Roth IRA during 2022 will want to consider (to the extent possible and desirable)  “cleaning up” all traditional IRAs, SEP IRAs, and SIMPLE IRAs as of December 31, 2022. 

Charitable Contributions

The deadline to make charitable contributions that can potentially be deducted on one’s 2022 tax return is December 31, 2022. Planning in this regard could include contributions to donor advised funds. If one is considering establishing a donor advised fund to get a deduction in 2022, I recommend moving well before December 31st, since it takes time for financial institutions to process donations and establish donor advised funds. 

RMDs from Your Own Retirement Account

The deadline to take any required minimum distributions from one’s own retirement account is December 31, 2022. Remember, the rules can get a bit confusing. Generally, IRAs can be aggregated for RMD purposes, but 401(k)s cannot. 

RMDs from Inherited Accounts

The deadline to take any RMDs from inherited retirement accounts is December 31st. For some beneficiaries of retirement accounts inherited during 2020 and 2021, the IRS has waived 2022 RMDs. That said, all beneficiaries of inherited retirement accounts may want to consider affirmatively taking distributions (in addition to RMDs, if any) before the end of 2022 to put the income into a lower tax year, if 2022 happens to be a lower taxable income year vis-a-vis future tax years. 

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

Follow me on Twitter at @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, investment, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, investment, and tax matters. Please also refer to the Disclaimer & Warning section found here.

The Special Tax Loss Harvesting Opportunity for 2022

There is a tax loss harvesting opportunity in 2022 that has not existed in recent years to the scope and scale it exists today: tax loss harvesting with bonds and bond funds. In most recent years, many bonds and bond funds have not had significant built-in-losses. 2022 is different: now there are plenty of bonds and bond funds in taxable accounts with significant built-in-losses. 

Tax Basketing for Bonds and Bond Funds

Bonds tend to be tax inefficient, for two reasons. First, they generate ordinary income, which is taxed at the taxpayer’s highest marginal tax rate. Second, they tend to have higher yields than equity investments. Thus, a dollar of a bond fund often produces more taxable income than a dollar of an equity fund, if they are both owned inside a taxable account.

As a result, holding bonds and bond funds in traditional retirement accounts is often logical from a tax basketing (or tax location) perspective. If they produce ordinary income anyways, why not hold them in a traditional retirement account (IRA, 401(k), etc.) where the owner can defer the timing of the ordinary income taxable event (through later Roth conversions and/or distributions)? 

Tax Basketing for Stocks and Equity Funds

Bonds also don’t suffer from the “transmutation” problem equities have. Stocks and equity funds, in most cases, pay “qualified dividend income” which qualifies for the lower long term capital gains tax rates (including the 0% long term capital gains tax rate). Holding them in a traditional retirement account transmutes that preferred income into ordinary income, subject to the taxpayer’s marginal ordinary tax rate. 

Now, as a practical matter, most Americans have most of their non-real estate financial wealth in traditional retirement accounts. Having some equities in traditional retirement accounts should not in any way cause despair. But, on the margins, it can be beneficial to review the overall portfolio to see if there can be some tax efficiency gains made by some tax rebasketing of assets. 

Rebasketing and Tax Loss Harvesting

The deadline for tax loss harvesting for 2022 is December 31, 2022. 

To my mind, some of the best 2022 tax loss harvesting will be selling bonds and bond funds at a loss in taxable accounts. Why is that? Because this sort of tax loss harvesting enjoys the main benefits of tax loss harvesting and it can achieve a great tax basketing result. 

Bonds create ordinary income and are generally higher yielding than equities, which often produce tax favored qualified dividend income. Thus, from a tax basketing or tax location perspective, it can often make sense to hold bonds and bond funds in a traditional retirement account and hold equities in a taxable account. Today, many investors can do some tax loss harvesting and strategically reconfigure their portfolios to make them much more tax efficient. Here is an example of how this could play out.

Jorge is 30 years old. He currently owns a diversified equity fund (Fund A) inside his workplace traditional 401(k) plan worth $80,000. It has a 2% annual dividend yield, most of which is qualified dividend income (though of course it is tax deferred inside the 401(k) and will later be subject to ordinary income tax when withdrawn or Roth converted). Separately, he owns a diversified bond fund (Fund B) inside his taxable brokerage account. It is worth $20,000, and Jorge has a $24,000 tax basis in the fund. The bond fund has a 3% annual interest yield ($600), all of which is ordinary income. Jorge wants to have an 80% / 20% equity to bond allocation. 

Here’s Jorge’s portfolio today:

AssetAmountAnnual Taxable Income
401(k) Fund A (Equity)$80,000None
Taxable Fund B (Bond)$20,000$600
Total$100,000$600

Jorge, could, in theory, execute two transactions to both tax loss harvest and become more tax efficient from a tax basketing perspective. First, Jorge could exchange his $20K of Fund B for $20K of an equity fund inside his brokerage account with a dividend yield similar to Fund A. Second, inside his 401(k), he could exchange $20K worth of his Fund A holding for a bond fund with an income yield similar to Fund B. If Jorge’s new fund inside the 401(k) is not substantially identical to Fund B, he can claim most, if not all, of the $4,000 loss, though the prior month’s Fund B dividend might slightly reduce the loss under the wash sale rule.

Here’s Jorge’s portfolio after these two transactions:

AssetAmountAnnual Taxable Income
401(k) Fund A (Equity)$60,000None
401(k) Bond Fund$20,000None
Taxable Equity Fund$20,000$400
Total$100,000$400

Jorge may obtain two tax benefits from these transactions. First, assuming he successfully navigates the wash sale rule, he may be able to deduct up to $3,000 against ordinary income by triggering the capital loss on the Fund B sale. 

Second, regardless of whether he successfully navigated the wash sale rule, he has just made his portfolio more tax efficient. It used to be that he reported $600 of ordinary income (from Fund B) on his tax return. Now that sort of interest income is hidden inside the 401(k). If he now receives approximately $400 a year in qualified dividend income from the new equity fund inside the taxable brokerage account, he has (i) reduced his annual taxable income by $200 (and growing through compounding) and (ii) now has mostly qualified dividend income from the taxable account instead of ordinary income, lowering his federal tax rate on his portfolio income. He has done all that without disturbing his overall asset allocation. 

Getting the tax basketing of his investments better without changing his investment allocation is likely to be worth it even if loses the tax loss due to the wash sale rule. He would want to review the options available to him inside his 401(k) to see if there is an acceptable (to him) bond fund that is not “substantially identical” to Fund B so as to avoid the wash sale rule being triggered by the investment in a bond fund inside the 401(k). 

Conclusion

Declines in the stock and bond market are some of the lemons of 2022. But, there’s a chance to make some lemonade. When it comes to bonds held in taxable accounts, there may be an opportunity to obtain two benefits: tax loss harvesting and better tax basketing. 

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

Follow me on Twitter at @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, investment, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

Three Ways the Solo 401(k) Supports Financial Independence

Financial independence encourages thinking about one’s financial future in a different way. You were told to “build a career and retire at age 65.” Financial independence says you should write your own financial script. The system, your parents, and a large employer should not be the authors of your financial future.

Guess what goes perfectly well with a financial independence mentality? The Solo 401(k)! The Solo 401(k) helps you control today’s tax burden and helps you plan for your retirement your way. 

Here are three ways the Solo 401(k) can support the financial independence journey. 

Choice and Low Fees

One advantage of working for yourself is you gain control over your workplace retirement account. Solopreneurs themselves determine where their Solo 401(k) is established and the investment options available to them. They determine contribution levels and whether or not to contribute to a Roth account.

Solopreneurs are no longer at the mercy of a large employer’s 401(k) plan, which may not have the investments they want, a Roth option, and/or low fees. 

Further, many Solo 401(k) providers offer low or no fees to establish a Solo 401(k) with their institution. For example, today neither Schwab nor Fidelity charges Solo 401(k) fees, other than the fees of the underlying investments (such as mutual fund expenses). Vanguard charges $20 per mutual fund inside a Solo 401(k) (other than the underlying fund fees), though the $20 fee can be waived if the solopreneur has enough qualifying assets invested with Vanguard. 

Tax Rate Arbitrage

The Solo 401(k) supports very significant tax deductions. For those at their peak earning years, contributions to Solo 401(k)s can benefit from high marginal tax rates. Further, in certain circumstances, traditional deductible Solo 401(k) contributions can help solopreneurs qualify for the qualified business income deduction, increasing the marginal tax rate benefit of traditional, deductible Solo 401(k) contributions. 

During early retirement, retired solopreneurs can convert traditional retirement accounts to Roth accounts. Those Roth conversions can be sheltered by the standard deduction, and then taxed at the 10 percent and 12 percent marginal federal income tax rate. This arbitrage opportunity (deduct contributions at high marginal rates, later convert the contributions and earnings to Roth accounts at lower tax rates) can supercharge the journey to financial independence. 

Reducing MAGI for PTC Qualification

Many solopreneurs have their medical insurance through an Affordable Care Act plan. These plans often have hefty annual premiums. However, there is a Premium Tax Credit (“PTC”) that can significantly reduce the cost of those premiums.

PTCs decline as modified adjusted gross income (“MAGI”) increases. Very generally speaking, from a planning perspective, as MAGI increases, PTCs decline by approximately 10 to 15 percent. Solopreneurs can reduce MAGI by contributing to a traditional deductible Solo 401(k). That decrease in MAGI can significantly increase the PTC, defraying their ACA medical insurance premiums. 

Conclusion

The Solo 401(k) can help solopreneurs achieve financial independence. Chapter 13 of my new book, Solo 401(k): The Solopreneur’s Retirement Account, goes into further detail about marrying the Solo 401(k) with one’s own FI journey. The book is available from Amazon, Barnes & Noble, and other outlets. 

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

Follow me on Twitter at @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

Baby HSA

Are you married? Age 55 or older? You might have an opportunity to open up a small health savings account and get a $1,000 annual tax deduction!

HSA Contribution Limits

Health Savings Accounts (“HSAs”) have annual contribution limits. The limits depend on two things: medical insurance coverage through a high deductible health plan (a “HDHP”) and age. Here are the 2024 HSA contribution limits (hat tip to Kay Bell).

AgeHDHP Self CoverageHDHP Family Coverage
Under Age 55$4,150$8,300
Age 55 or Older$5,150$9,300

Family HDHP Coverage

Family HDHP coverage is coverage of an insured plus either or both a spouse or a dependent(s). Coverage must be the only medical insurance coverage the person has. 

HSA Catch-Up Contributions

Those age 55 or older can contribute an extra $1,000 per person to an HSA every year. While the “normal” contribution limits ($4,150 self / $8,300 family) are indexed for inflation, the $1,000 annual catch-up contribution limit is not indexed for inflation.

Two additional notes: First, as a practical matter, at age 65 a taxpayer will no longer qualify for an HSA (and thus, the catch-up contribution). This is because at age 65 most Americans switch from a HDHP to Medicare for their medical insurance. 

Second, for IRAs and qualified plans (such as 401(k)s), the age to be eligible to make “catch-up” contributions is 50. For HSAs, the age is 55, not age 50. 

HSA Contribution Limits for Married Couples

The normal contribution limits are coordinated. Thus, the family contribution maximum for a married couple is normally $8,300, not $8,300 times two. Here’s an example of how that works: 

Example 1: Steven and Holly are married, both age 45, and covered by a family high deductible health plan for all of 2024. Thus, each has an HSA contribution limit of $8,300. However, when looking at Steven’s limit, we must look at what Holly has contributed to her HSA for 2024. If Holly contributes $8,300 to her HSA for 2024, then Steven’s HSA contribution limit is reduced by Holly’s contribution to $0. 

Interestingly enough, catch-up contributions are not coordinated. Let’s change the example to have Steven and Holly be both age 55.

Example 2: Steven and Holly are married, both age 55, and covered by a family high deductible health plan (provided by Holly’s employer) for all of 2024. Thus, each has an HSA contribution limit of $9,300. Holly maxes out her 2024 HSA ($9,300) through payroll withholding (to get the payroll tax exclusion as well as the income tax exclusion). When looking at Steven’s normal contribution limit, we must look at what Holly has contributed to her HSA for 2024. Since Holly maxed out her HSA, Steven’s normal contribution limit is $0. However, Steven’s catch-up contribution limit is still $1,000, since it is not reduced for contributions Holly made to her HSA.

Steven is eligible for what I refer to as a Baby HSA. He will need to find a financial institution which offers HSAs. He can contribute up to $1,000 to his Baby HSA for 2024. Even better, Steven and Holly will get a $1,000 tax deduction on their 2024 tax return which lowers their adjusted gross income. 

Note that Steven’s Baby HSA cannot just be simply added to Holly’s HSA. Each of them have their own limits, and an HSA is an account in the name of a single owner (the same as an IRA). Thus, Steven will need to reach out to a financial institution to establish his own HSA. 

Benefits of the Baby HSA

Yes, a $1,000 tax deduction is nice, but it is not life changing. Let’s not pooh-pooh it too quickly, however. Steven might qualify for 10 years of that $1,000 Baby HSA, which is $10,000 of tax deductions. Second, Steven and Holly get this deduction against adjusted gross income, which means that they won’t have to claim itemized deductions to obtain it. 

Third, most tax deductions require giving up money to get a tax benefit. Often we think about business deductions, charitable contributions, and home mortgage interest. It’s great to take tax deductions for those, but you are giving up the money. The deduction for a Baby HSA contribution is simply moving money from a taxable account to an HSA: it’s still your money!

Last, an HSA deduction/exclusion is better than a deduction/exclusion for a traditional 401(k) contribution. In exchange for the upfront tax benefit, the traditional 401(k) will be fully taxable when withdrawn later on. Not so with the HSA. As long as the HSA is used to pay qualified medical expenses and/or to reimburse PUQME, the money comes out tax-free. No wonder I’m so fond of HSAs!

One additional benefit for retirees is the $1,000 deducted for a Baby HSA is $1,000 more of Roth conversions that can be slotted in at a low tax rate. The HSA deduction also lowers both adjusted gross income and “modified adjusted gross income” for Premium Tax Credit purposes, making it valuable for early retiree tax planning.

One Spouse Under Age 55

What happens if one of the spouses is under age 55? Here’s an example:

Example 3: Steven (age 56) and Holly (age 52) are married and covered by a family high deductible health plan provided by Holly’s employer for all of 2024. Thus, Holly has an HSA contribution limit of $8,300. Steven has an HSA contribution limit of $9,300, computed as a $8,300 normal contribution limit plus a $1,000 catch-up contribution limit. Holly maxes out her 2024 HSA ($8,300) through payroll withholding. When looking at Steven’s normal contribution limit, we must look at what Holly has contributed to her HSA for 2024. Since Holly maxed out her HSA, Steven’s normal contribution limit is $0. However, Steven’s catch-up contribution limit is still $1,000, since it is not reduced for contributions Holly made to her HSA.

Because Steven was 55 or older during the year, he still gets to contribute $1,000 to his Baby HSA. Holly’s age and contributions are irrelevant because the catch-up contributions of one spouse are not limited by the age and contributions of the other spouse. 

Watch me discuss the Baby HSA on YouTube. Stay to the end to see me butcher some 80’s movie trivia.

Conclusion

The Baby HSA is a nice tax planning tactic for married individuals with a HDHP as their only medical insurance between turning age 55 and going on Medicare. While limited in scale, the Baby HSA can provide real tax benefits and later tax-free growth. Of note, some ACA plans qualify as HDHPs. This means that the Baby HSA opportunity will exist for some using ACA plans in early retirement, as well as those covered by a HDHP through an employer. 

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

Follow me on Twitter at @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

The Tax Increase in SECURE 2.0

There’s a tax increase in the new SECURE Act 2.0 legislation. Unfortunately, it falls largely on those least equipped to shoulder it.

Catch-Up Contributions

Since enacted in 2001, “catch-up” contributions have been a great feature of 401(k) plans. Currently, they allow those age 50 or older to contribute an additional $6,500 annually to their 401(k) or similar plan. Those contributions can be traditional deductible contributions, Roth contributions, or a combination of both.

The idea is that by age 50, workers have much less time to make up for deficiencies in retirement savings. Thus, the law allows those workers to make catch-up contributions to have a better chance of financial success in retirement.

Other than age (must be at least 50 years old), there are no limits on the ability to make catch-up contributions. That could be viewed as a give-away to the rich. However, it is logical to keep retirement savings rules simple, especially those designed to help older workers behind in retirement savings.

Watch me discuss SECURE 2.0’s tax increase on catch-up contributions

Catch-Up Contributions for Those Behind in Retirement Savings

For those behind in retirement savings, deducting catch-up contributions usually makes the most sense. First, many in their 50s are in their highest earning years, and thus tax deductions are their most valuable. Second, those behind in retirement savings are not likely to be in a high tax bracket in retirement. With modest or low retirement income, they are likely to pay, at most, a 10% or 12% top federal income tax rate in retirement.

Here is an example of how that works:

Sarah, single and age 55, is behind in her retirement savings, so she maxes out her annual 401(k) contribution at $27,000 ($20,500 regular employee contribution and $6,500 catch-up contribution). Sarah currently earns $130,000 a year and lives in California. Since she deducts her catch-up contributions, she saves $2,165 a year in taxes ($6,500 times 24% federal marginal tax rate and 9.3% California marginal tax rate). That $2,165 in income tax savings makes catching up on her retirement savings much more affordable for Sarah.

Sarah’s approach is quite logical. If things work out, Sarah can make up the deficit in her retirement savings. Doing so might push her up to the 12% marginal federal tax bracket and the 8% marginal California tax bracket in retirement.

For someone like Sarah who is behind in their retirement savings, the Roth option on catch-up contributions is a very bad deal!

SECURE 2.0 and Catch-Up Contributions

SECURE 2.0 disallows the tax deduction that people like Sarah rely on. It requires all catch-up contributions to be Roth contributions. For the affluent, this makes some sense. Why should someone with very substantial assets get a tax deduction when they already have a well-funded retirement?

Sadly, many Americans in their 50s and 60s do not have well-funded retirements. Removing the tax deduction for catch-up contributions increases their taxes. These are people who can least afford to shoulder a new tax. The goal should be to make it easier for those behind in retirement savings to catch-up. Taking away this tax deduction makes it more difficult to build up sufficient savings for retirement.

Fortunately, as of this writing SECURE 2.0 has only passed the House. It has not passed the Senate. Hopefully this provision will be reconsidered and will not ultimately become law.

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

Follow me on Twitter at @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

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. 

Sean on The Struggle is Real Podcast

I chatted with Justin Peters on The Struggle is Real Podcast regarding tax issues for those in their 20s to consider. You can access the episode here: https://justinleepeters.podbean.com/e/what-you-need-to-know-about-taxes-in-your-20s-e39-sean-mullaney/

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

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 Earn & Invest Podcast

Really enjoyed this year-end tax planning conversation with Doc G on the Earn & Invest podcast. Stay tuned to the end for some candid behind the scenes podcast recording.

https://www.earnandinvest.com/episodes-2/year-end-tax-moves-that-count

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

Follow me on Twitter: @SeanMoneyandTax

This post (and this podcast episode) 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.