The slower days of summer are a great time to revisit your New Year’s resolutions and set new goals for the second half of the year. Taxes are a subject many of us may prefer to avoid, but you can turn that aversion into an advantage by taking stock of the current year’s tax situation while there is still time to minimize your 2023 tax bill.
Marie McGrath, a CPA and senior tax manager at Leelyn Smith, recommends framing tax planning around your current year income trajectory. “Whether you are having a good, average, or bad year in terms of taxable income can determine the best tax-savings strategies to implement,” Marie said.
Below, we build on Marie’s insight and detail actions to consider taking to help avoid unwelcome surprises when filing your taxes next year.
Tax strategies for an above-average income year.
When your taxable income rises, there are several ways to neutralize that increase:
1. Maximize 401(k) and traditional IRA contributions: The amount of pre-tax dollars you contribute to your employer-sponsored retirement savings plan or a traditional IRA lowers your adjusted gross income (AGI). For example, if your salary increased this year, boosting your pre-tax retirement payroll contribution by the same amount can help offset any additional tax you would have owed. An added bonus is a larger retirement nest egg that grows tax-free until you begin withdrawals. Individuals can contribute up to $22,500 annually to their 401(k) or similar qualified retirement plan, with an additional $7,500 catch-up provision for those 50 and older. IRA contribution limits are $6,500 with a $1,000 catch-up provision.
2. Use charitable looping: Instead of donating the same, lesser amount to charity every year, consider putting your extra income to work by investing a larger amount in a donor-advised fund. This will provide a larger, current year tax deduction and allow you to distribute the funds to your favorite charities over time. This allows you to take the standard tax deduction—which is currently very generous—in most years and itemize your taxes in the year you make the larger contribution to your donor-advised fund. If your investment portfolio has done exceedingly well, you can also donate appreciated stock to a donor-advised fund and owe no taxes on that appreciation.
3. Realize capital losses: Conversely, if you are sitting on investment losses, selling some of those positions provides a bank of taxable losses that can be used to offset capital gains. If your losses exceed your gains, you can offset up to $3,000 in ordinary income annually. Any unused losses for the current tax year can be carried forward to help manage future year investment gains and income.
4. Leverage additional tax savings vehicles: If your income bump still leaves you with more than enough to meet everyday expenses, consider contributions to a health savings account (HSA) or a family member’s 529 education savings plan. For those covered under a high-deductible health plan in 2023, individuals can contribute up to $3,850 ($4,850 for taxpayers 55 or older) to an HSA, which also lowers your AGI. For family coverage, the HSA contribution limit in 2023 is $7,750. Depending on your state of residence for tax purposes, contributions to a state-sponsored 529 plan can lower your taxable state income. In Illinois, for example, individuals can deduct up to $10,000 and married couples up to $20,000 from their state income taxes.
Tax strategies for a below-average income year.
If your income has declined, you can turn a potentially anxious situation into a productive one by considering these actions:
1. Create a “backdoor” Roth IRA: While contributions to a Roth IRA are not tax deductible, they grow tax-free, allowing you to make withdrawals without an additional tax bill. But the ability to contribute to a Roth outside of a work 401(k) is restricted once your AGI hits a certain level (you can check the limits here). In years of declining income, you may qualify for a lower tax bracket, making it more advantageous to contribute to a Roth and pay the lower tax.
A backdoor Roth IRA is created by contributing to a traditional IRA but not taking the tax deduction. You can then immediately convert the IRA to a Roth to enjoy long-term, tax-free compounding. This strategy works especially well for high-income earners who qualify and younger investors who have a long investment horizon. There is a catch to this strategy if you have an existing traditional or SEP IRA, so talk to your tax advisor before pursuing this option.
As part of the Secure Act legislation passed in 2020, up to $35,000 of unused funds in a 529 education savings plan can be rolled into a Roth IRA.
2. Sell highly appreciated investments: In a corollary to the capital losses strategy above, the best time to sell investments with high embedded capital gains is when you have losses in other parts of your tax return that can offset those gains.
Evergreen tax savings strategies.
Whether experiencing a good, bad, or flat income year, taking a closer look at your tax situation mid-year can make a difference later on.
1. Adjust your withholdings: Most taxpayers are happy to receive a refund when filing their returns, and the tax preparation industry devotes millions in advertising the idea of maximizing your refund. But a tax refund really is the result of a short-term, interest-free loan to the U.S. government.
Refunds arise from withholding too much from your primary income sources, usually your paycheck. If you have been receiving a state or federal refund, adjusting your withholdings by filling out a new W-4 form or your state’s equivalent can bring your tax withholding more in line with what you will actually owe. If your income has gone up this year, factor the projected increase into your withholding calculations.
2. Use gifts to lower your taxable estate: If you think you will have more in your estate than you and your spouse require to cover your needs, you may want to consider adopting an annual giving approach. In 2023, the federal estate tax generally only applies to assets over $12.92 million. However, in Illinois, estates over $4 million are subject to tax. Currently, both you and your spouse can give $17,000 per year per person. Therefore, if you are married and your adult child is married, you can give $68,000 per year to the couple without triggering the need to file a gift tax return.
Start next year’s tax conversation now.
Given the many variables that go into calculating taxable income, determining the optimal tax strategy can be complicated. That is why we suggest discussing your current tax situation with your Leelyn Smith advisor. They can also help you consider the best tax strategies to manage your specific circumstances and answer any tax questions that should be addressed before April 15, 2024—while you still have plenty of time to take action.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.
We suggest that you discuss your specific tax issues with a qualified tax advisor.