Tax Returns: An Athlete’s 3 Biggest Misses | Josh McAlister
An athlete’s tax return necessitates specialized expertise and a thorough understanding of their industry, business, and cash flow. Without this unique knowledge, grave mistakes can be made when filing an athlete’s tax returns. Too often, these mistakes equate to tens of thousands of dollars of over overpaid taxes, and missed tax-free investment opportunities.
For the past 12 years, we have reviewed and prepared 15,000 federal and state tax returns for professional athletes. The 3 biggest tax strategies for professional athletes that are missed by clients are the following:
Duty Days Calculation
Individual (Solo) 401k Contribution
Back-Door Roth IRA Strategy
Duty Days Calculation
Problem:
The IRS and State Revenue Departments require a return to be filed in every state where an athlete plays, as well as their resident state. Most athletes receive their multiple W2s from their organization in January/February and automatically send these documents over to their tax preparer. After all, why would you do anything different, and why would you even ask the question, “are these documents accurate?”
The problem is that these documents are likely prepared incorrectly. The two most obvious examples we have seen are:
Major League baseball does not consider spring training days when preparing the W2
Teams use the home state of the team as a ‘catch all’ for unallocated wages, as in games played in TX, WA, or FL where there is 0% state income tax.
Solution:
The "Duty Days" approach allocates a player's income based on the number of days that a player performs services in a specific state. The tax preparer essentially ‘recalculates’ the correct W2 based on the physical location where the player was throughout the year, and reports income based off that calculation. To provide a tangible explanation, let us assume the following assumptions:
Player plays for the New York Yankees
Total correct # of days in a major league baseball season is 225, including off days and spring training
Incorrect number of games is 190
Player played 82 games at home in the state of New York (8.82% Income Tax Rate)
$5,000,000 salary
The player would correctly calculate taxes to the state of New York based on physical time spent in New York. The accurate calculation would be to allocate 36.5% of their total income to calculate taxes due to New York.
However, as stated above, the Yankees likely do not include the time spent in spring training (roughly 35 days) in their total days’ calculation. Thus, in the above scenario, the Yankees would generate a W2 allocating 43.2% of the player’s income to the state of New York. As Florida has a 0% state income tax, this miscalculation equates to an estimated $30,000 of overpayment to the state of New York! A simple yet powerful tool to put real dollars back into athlete’s pockets.
Individual 401k Contribution
Problem:
Sometimes referred to as a solo 401k – this retirement account is almost never taken advantage of. Athletes are paid in both W2 wages (salary from the team) and in 1099 income (endorsement deals, trading card signings, appearances, etc.).
Most athletes have an employer sponsored 401(k) plan for their W2 wages – but rarely do they have a retirement plan in place for their 1099 income. This equates to large tax dollars lost – and in some cases $22,800 of overpaid taxes in the current year. Below walks through the details for that savings number.
Solution:
Depending on your tax bracket, you can save paying 40% to 50% in taxes on a portion of your self-employment income (1099 income) or you can maximize the opportunity to grow your money tax free.
What is an Individual 401(k) plan?
Simply put, an individual 401(k) is a retirement account designed for the self-employed, or business owners with no full-time employees. An Individual 401(k) plan offers many of the same benefits of a traditional 401(k) with a few distinct differences. This is the retirement account to setup for an athlete’s 1099 income. See below for a brief overview on the rules of an Individual 401(k) plan:
As the employee, you can contribute up to $19,500 in 2020 and 2021, or 100% of compensation, whichever is less. Keep in mind, employee 401(k) limits apply by person, rather than by plan. That means if you are also participating in a 401(k) from the team, the limit applies to contributions across all plans, not each individual plan.
As the employer, you can make an additional profit-sharing contribution of up to 25% of your compensation or net self-employment income, which is your net profit less half your self-employment tax and the plan contributions you made for yourself. The limit on compensation that can be used to factor your contribution is $285,000 in 2020 and $290,000 in 2021.
If an athlete earned $285,000 off the field in 2020, they would be eligible to make a full $57,000 Individual 401(k) contribution for calendar year 2020. This is a deduction for their 2020 tax return, and assuming a 40% tax rate – this equates to $22,800 in tax savings.
Back Door Roth IRA
Problem:
We do not fundamentally understand the impact of our tax bill over a long period of time.
Solution:
The last commonly missed tax strategy is not one that reduces current year taxes, but rather removes taxes from being paid in the future. The Roth IRA is the golden goose of retirement plans. You never pay taxes again on funds contributed to a Roth, converted to a Roth, or investment gains within a Roth. A tax advantage vehicle that is this good – train and grow this horse like the thoroughbred it is!
To put the advantages of tax-free investment growth into perspective – if a 23-year-old made a full $6,000 Roth IRA contribution in 2020 – by age 70, assuming a modest 6% annual investment return, that Roth IRA balance is now worth $92,795.
Compare that to a traditional IRA or pre-tax 401(k) – the same $6,000 is only worth $70,525, assuming a 24% tax bracket.
Tax free growth is worth it – about $22,000 worth it.
The Catch.
There is a phase out income level to contribute to a Roth IRA. The beginning phase out limits are below, based on tax filing classification:
$124,000 if you are single or head of household.
$196,000 if you are married filing jointly.
If your income is greater than the above amounts – there is a strategy commonly executed by the wealthy to access the tax-free benefits of a Roth IRA.
Since the income limits on Roth conversions were removed in 2010, higher-income individuals who are not eligible to make a Roth IRA contribution have been able to make an indirect “backdoor Roth contribution” instead, by simply contributing to a non-deductible IRA (which can always be done regardless of income) and converting it shortly thereafter to a Roth IRA, and thus the tax-free growth is obtained.
Avoiding the IRA Aggregation Rule Through 401(k) Plans
The IRA aggregation rule combines all IRA accounts to determine the tax purposes of a distribution or conversion. This creates a significant challenge for those who wish to do the backdoor Roth strategy, but have other existing IRA accounts already in place (e.g., from prior years’ deductible IRA contributions, or rollovers from prior 401(k) and other employer retirement plans). Because the standard rule for IRA distributions (and Roth conversions) is that any after-tax contributions come out along with any pre-tax assets (whether from contributions or growth) on a pro-rata basis, when all the accounts are aggregated together, it becomes impossible to just convert the non-deductible IRA.
However, any employer retirement plans – e.g., from a 401(k), profit-sharing plan, etc. – are not included in the aggregation rule. However, a SIMPLE IRA or SEP IRA, both of which are still fundamentally just an “IRA”, are included.
The fact that employer retirement plans are separated out from the IRA aggregation rule means first and foremost that if assets stay within a 401(k) or other employer plan, they can avoid confounding the backdoor Roth strategy.
Free Resource:
Conclusion:
The athlete’s tax situation is unique – and there is specific expertise that is required to appropriately handle your business affairs. Our team of CPAs have the experience and knowledge necessary to handle your individual situation, and have been through multiple successful audits and reviews where we have implemented these strategies above.
Partner with those who know your situation and have the expertise and knowledge to provide the advice you deserve.
