Year-End Tax Planning: Maximizing Your Net Worth | Erik Averill
You have worked hard for your money, which is why it never feels good when you see how much you lose to taxes. With a few year-end tax planning strategies, you can set yourself up for a much better outcome at tax time.
Unfortunately, most people neglect ongoing individual tax planning, which results in paying more in taxes than they should.
If you’re in the highest tax bracket, you’re losing between 40% to 50% of your income to taxes, contingent on state residency. In lower tax brackets, you’re losing out on the opportunity to build future tax-free investment growth and income.
Our family office model provides wealth management and tax planning for many high-earning professional athletes and business owners – but these strategies are worth looking into for anyone who wants to maximize their after-tax income and net worth.
Our End of Year Tax Planning Tips
When it comes to paying less tax and increasing your net worth, it pays to have a tax planning strategy. Below we’ve included some of our best tax planning ideas to help you start the planning process.
Start thinking about these strategies now, so you can take action before the end of the calendar year to save yourself from paying more in taxes than you need to.
Defer your income
If you think that you will be in the same or lower tax bracket in the following year, defer your income to next year to avoid paying taxes on it this year.
This is difficult for full-time employees, but it might be possible to get your bonus paid to you in the following year. If you’re self-employed, a freelancer, or a consultant, you have a bit more flexibility and can delay invoicing clients until late December to ensure that payments are only received next year.
Likewise, athletes who are negotiating a signing bonus can look into the possibility of splitting the payments over the course of a few years.
Regardless of your employment status, you can postpone receiving some of your income by claiming capital gains in the following year, thereby reducing your income tax liability.
Donate to charity
The charitable contribution tax deduction allows you to donate to charity at a lower net cost while reducing your tax bill. Most taxpayers can’t deduct their charitable contributions, but there is a special deduction for cash gifts to a charity of up to $300 for individuals and up to $600 for married couples who file jointly. The special rules apply to 2021 tax filings, but at the time of writing this article, have not yet been extended to 2022.
You can boost the effectiveness of your donation by donating appreciated stock or property instead of cash. If you’ve owned the asset for longer than a year, you get an additional benefit - you’re allowed to deduct the property’s market value on the date of the donation and avoid paying capital gains tax on any accumulated appreciation.
Just ensure that you have a receipt for any donation you make, regardless of the amount.
Contribute the maximum to retirement accounts
Tax-deferred retirement accounts are one of the best investments possible since they can compound over time free of taxes. 401(k) plans are best because employers often match any individual contributions.
Most large employers will offer 401(k) plans, although some may have stipulations before you can start contributing. NFL players preparing for retirement, for example, can only start contributing after they’ve played two seasons.
If you can, maximize your 401(k) contribution — in 2022 that’s $20,500 if you’re under 50 and $27,000 if you’re 50 or older.
Convert money from a traditional IRA to a Roth IRA
Roth IRAs provide huge tax advantages, including tax-free growth and tax-free withdrawals in retirement, and don’t have required minimum distributions. Withdrawals from traditional IRAs, on the other hand, are taxed in retirement and have required minimum distributions.
To get the benefits of a Roth IRA, you’ll have to convert money from traditional accounts to Roth accounts. Keep in mind that you’ll have to pay taxes on the amount you convert, so this move only makes sense if:
You have the cash on hand to pay the conversion taxes
It doesn’t move you into a higher tax bracket
Your existing IRA account has suffered recent losses
You’re currently in a lower tax bracket than you usually are
You have more itemized deductions that you usually do
Your earnings are too high to contribute to a Roth IRA, but you’re expecting a high tax rate in retirement
Offset gains with tax-loss harvesting
Tax-loss harvesting refers to the process of selling securities at a loss to offset capital gains taxes. If you have stocks or taxable investments that have lost value during the year, you can sell them and deduct up to $3000 in losses against your personal income.
Note: if you’re claiming losses on stocks, be aware of the wash sale rule. This prohibits you from buying the same stock, or a substantially identical one, within 30 days of selling and claiming a tax reduction.
Check your flexible spending accounts
Flexible spending accounts let employees pay part of their wages into a special account that can be used for childcare or healthcare expenses. If you have a remaining balance at the end of the year, ask your employer to carry it over to next year’s plan. Usually, this amount can be no more than $550, but the rules have been loosened because of the pandemic. There’s a chance you might be able to carry over the full remaining balance, but not every employer allows it.
You can also elect to contribute up to $2850 into a flexible savings account for the following year. This contribution is pre-tax, so you’ll be lowering your taxable income as long as you repay yourself for out-of-pocket healthcare expenses like deductibles, co-insurance, and common items you would find at a pharmacy.
Now that we’re covered some tax planning ideas, let’s take a more comprehensive look at the year-end tax planning strategies you can leverage to pay less tax.
Year-End Tax Planning Strategies
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.
Checklist of What Should Be Accomplished By Year-End
Prepare year-end tax projection
Open an Individual 401(k) by December 31st
Designate as a Roth or Traditional
Determine IRA Strategy and open appropriate accounts
Roth IRA
Traditional IRA
Back-door Roth IRA Strategy
Not All Money Is Created Equal
While everyone with a job receives some form of income, this revenue is classified differently depending on whether or not you are employed or self-employed. This creates a number of opportunities for maximizing tax deferral depending on your income classification.
W2 Wages: Employee
Professional baseball players are treated as employees by their respective teams. Therefore, your earnings are considered wages (W-2).
This classification as an employee limits the amount of money you can contribute to tax-advantaged retirement plans such as an IRA ($6,000 limit in 2022) or MLB Vanguard 401K Plan ($20,500 limit in 2022), regardless of how big your salary is. This results in the majority of your income being taxed in the year that you earn it.
For instance, after you receive your pay stub (which has been paid in tax), you may choose to use those after-tax dollars to invest; but the growth on those investments will continue to be taxed.
For instance, each time you earn interest or dividends from your investments, you will be taxed on that earned amount in that given year. Or if you choose to withdraw this money from the investment down the line, you will owe taxes on any gains you’ve earned over time.
1099 Income: Self-Employed
Another form of income professional athletes earn is Off-the-field income (NIL deals like endorsements, card deals, appearances, equipment deals, etc.) which are classified as self-employment income (1099 income).
For those earning 1099 income, there is an opportunity to set up additional tax-advantaged retirement plans that offer the following benefits depending on your tax bracket:
Accumulate a significant amount of cash you can use to help provide financial security during retirement.
Benefit from an immediate tax break if contributions to a retirement plan are pre-tax. If contributions are post-tax (Roth), there’s no immediate tax break, but you will benefit from tax-free growth on your investments (see note 4 below).
Tax-deferred growth — meaning you don’t pay taxes each year on capital gains, dividends, and other distributions. This allows your money to compound more quickly than it would if it were taxed yearly. You will pay taxes upon distribution after age 59 ½.
Tax-free growth – if your tax rate is low, your contribution to a Roth designated account will grow tax-free and future distributions after age 59 ½ are tax-free as well.
The timing of contributions and eligibility are unique to each athlete throughout their career. It is essential to evaluate each plan on an annual basis with your CPA or Certified Financial Planner (CFP®) professional in order to maximize tax deferral while earnings are at their peak.
Tax rates, cash flow, and eligibility should all be considered together to determine which plan is appropriate and when.
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.
The Basics
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Eligibility rules |
No income or age restrictions but must earn 1099 income |
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Contribution limit |
Total of up to $58,000 in 2021 and $61,000 in 2022, with an additional $6,500 catch-up contribution if 50 or older. |
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Taxes on contribution |
Individual 401(k): Contributions are made pre-tax, reducing taxable income for the year. Roth 401(k): Contributions are made with after-tax dollars. |
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Taxes on qualified distribution in retirement |
Individual 401(k): Qualified distributions are taxed as income. Roth 401(k): Qualified distributions are tax-free. |
Deadline
If you want to make a contribution for the current year, you must establish the plan by Dec. 31. You can make the contribution once you have calculated your net business income for the year, but no later than your tax filing deadline including extensions.
However, as a business owner, you can open a plan after the end of the calendar year, and still make employer profit-sharing contributions. The SECURE Act gives solopreneurs until the business tax deadline, April 15th, to sign up for a Solo 401(k) and start saving for retirement.
If you sign up by December 31, you can contribute both employee and employer portions. If you open the account past December 31, you can only contribute the employer portion.
Contribution Limits
To understand Individual 401(k) contribution rules, you want to think of yourself as two people: an employer (of yourself) and an employee (yes, also of yourself). Inclusive of both roles, the overall contribution limit in 2022 is $61,000. But do note, your contributions are subject to additional limits in each role:
As an employee, you can contribute up to $19,500 in 2021 and $20,500 in 2022, or 100% of compensation, whichever is less. Those 50 or older get to contribute an additional $6,500.
Keep in mind, employee 401(k) limits apply by person, rather than by plan. That means if you’re 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 than half your self-employment tax and the plan contributions you made for yourself. The limit on compensation that can be used to factor in your contribution is $290,000 in 2021 and $305,000 in 2022.
Comparing an Individual 401(k) versus a SEP IRA
A common mistake we see is the recommendation to open a SEP (Simplified Employee Pension) IRA for the 1099 income. For an individual with no employees, the Individual 401(k) is the superior choice for the following reasons.
Individual 401(k) Tax Advantages
The nice thing about an individual 401(k) is you get to pick your tax advantage. You can opt for the traditional 401(k), under which contributions reduce your income in the year they are made. In that case, distributions in retirement will be taxed as ordinary income.
The alternative is the Roth individual 401(k), which offers no initial tax break, but allows you to take distributions in retirement tax-free.
In general, a Roth is a better option if you expect your income to be higher in retirement. If you think your income will go down in retirement, opt for the tax break today with a traditional 401(k).
Backdoor Roth IRA
You can only contribute to a Roth IRA up to a certain income level. That limit increased for 2022. To contribute the full amount, you must make less than:
$129,000 if you’re single or head of household.
$204,000 if you’re married filing jointly.
If you’re already contributing to an employer-sponsored plan, like a 401(k), you can also contribute to a traditional IRA. But there are restrictions on what you can deduct from your taxes, based on your income. Those income ranges increased in 2022 as well.
Depending on how much money you make, you may be able to deduct more of your IRA contributions from your taxes in 2022. Get all the details of those changes on the IRS website.
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.
Note: Congress has been contemplating the elimination of the ability to do Backdoor Roth Conversions via the Build Back Better legislation. While it is possible that the legislation would be retroactive to January 1, 2022, as we get deeper into the year, it seems more likely that if the bill were to pass, it would become effective as of January 1, 2023.
To be conservative, it may make sense to wait a few more months to see what happens before proceeding with a 2022 Backdoor Roth Conversion.
Avoiding the IRA Aggregation Rule Via 401(k) And Other Employer Retirement Plans
The IRA aggregation rule combines together 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 as long as assets stay within a 401(k) or another employer plan, they can avoid confounding the backdoor Roth strategy.
Can I have more than one 401(k)?
Yes, you can have multiple 401(k) accounts. Keep in mind, employee 401(k) limits apply by person, rather than by plan. That means if you’re also participating in a 401(k) from the team, the limit applies to contributions across all plans, not each individual plan. However, employer contribution limits apply to each individual plan.
Covering your spouse under your Individual 401(k)
The IRS allows one exception to the no-employees rule on the individual 401(k): your spouse if he or she earns income from your business.
That could effectively double the amount you can contribute as a family, depending on your income. Your spouse would make elective deferrals as your employee, up to the $20,500 employee contribution limit (plus the 50-and-older catch-up provision, if applicable). As the employer, you can then make the plan’s profit-sharing contribution for your spouse, of up to 25% of compensation.
The Bottom Line
Ongoing tax planning is the key to lower taxes and maximizing your net worth. Don’t miss out on the potential to save paying 40% to 50% in taxes on a portion of your self-employment income (1099 income) or maximizing the opportunity to grow your money tax-free.
Checklist of What Should Be Accomplished By Year-End
Prepare year-end tax projection
Open an Individual 401(k) by December 31st to take advantage of both employer and employee contributions
Designate as a Roth or Traditional
Determine IRA Strategy and open appropriate accounts
Roth IRA
Traditional IRA
Back-door Roth IRA Strategy
Speak to an experienced wealth management team who can help you formulate a comprehensive tax-saving strategy.
If paying substantially less when it’s time to file your taxes sounds appealing, contact us today.
