More Money, More (Tax) Problems: Tax Planning for a High-Income Year
By Brittany Brinckerhoff
You’re having a great year: perhaps you got that extra bonus payout, successfully flipped an investment property, exercised equity awards when your employer went public, or even won the lottery. That’s awesome! But your high income could mean you need to do some extra planning.
Whether your earnings came from hard work or good luck, the final few months of the year are a perfect time to review this year’s income and make sure you have a smart tax plan in place. Here are the planning steps to take.
Assess where you currently are.
First, you want to review what income you’ve received so far this year, making note of anything substantially different from last year. A recent pay stub should show your year-to-date wages, but you’ll also want to think about any other sources of income: stock awards, rental properties, investment accounts, businesses, etc. Once you know approximately where your current income is, consider the remainder of the year - do you expect to see any changes to your income over the coming months? You don’t need to know exactly what your total income will be for the year, but it’s helpful to have a realistic estimate.
Look for tax boosts that align with your goals.
Now for the fun part: you want to consider all of the possible ways you can take advantage of this extra income while working toward your goals AND minimizing income taxes.
Retirement Savings - With a few months left before the calendar turns, you have enough time to review your employee benefits and adjust your retirement plan contribution rate. Are you on track to save the maximum in your 401k or 403b? If you’ve been saving to the Roth side of the plan, are you able to switch to pre-tax contributions for the rest of the year? Do you have access to any additional retirement plans, such as a 457b, where you could get additional tax savings by setting aside even more for retirement? Does your company offer any deferred compensation plans? You typically have to enroll in deferred comp plans before you earn the income, but perhaps that can help with next year’s savings.
Health Savings Accounts (HSAs) - If your health insurance is an HSA-eligible high-deductible health plan, you should confirm whether it makes sense for you to contribute the maximum to an HSA. HSA contributions are tax-deductible, and HSA withdrawals for qualified medical expenses are tax-free, making it a uniquely powerful savings tool.
Charitable Giving - If one of your priorities is to be philanthropic, it can be advantageous to donate extra to charity in a year where you have higher income. Strategies such as bunching your gifts, gifting to a Donor Advised Fund, or gifting appreciated assets can help you make the most of your charitable gifts.
Tax Credits - Depending on your income, you may be eligible to lower your tax bill by claiming a tax credit. There are tax credits available for a variety of scenarios, such as buying an electric vehicle, paying student loan interest, adopting a child, or paying for college. Your tax advisor can help you find any other tax credits that might apply to you.
Don’t be surprised at tax time.
If you’ve exhausted all your pre-tax savings opportunities, then the final step is to make sure your income tax withholding is on track. This is important – if you haven’t withheld enough, then you might owe a large amount to the IRS at tax time AND have to pay a penalty for underwithholding.
One way to avoid underpayment penalties is to follow “safe harbor” rules. These rules spell out how much you need to withhold for the year in order to avoid penalties. Generally, if you withhold 100-110% of your previous year’s total tax obligation, then you’ll meet the “safe harbor” amount and won’t be penalized, even if you have a large tax bill.
It’s also helpful to build up your cash reserves in advance of tax filing, so you don’t have to tap into your investment accounts to cover any tax bill. Consider using a money market fund or a high-yield savings account to help you earn more interest on these extra cash reserves between now and tax day.
Working with a financial advisor and tax professional can help you be proactive with tax planning - allowing you to work towards your financial goals WHILE minimizing your tax burden. Win-win!
Reach out to us if you’d like to learn more about how we incorporate tax planning as part of our holistic financial planning process.
This material is provided as a courtesy and for educational purposes only. Please consult your investment professional, legal or tax advisor for specific information pertaining to your situation.
Hilltop Wealth Advisors does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state laws are complex and constantly changing. You should always consult your own legal or tax professional for information concerning your individual situation.