tax planning

Leveraging the Tax Code to Minimize Your Tax Liabilities

As we head toward March, one of most dreaded times of the year approaches: tax season. Right now is the time when you’re inundated with tax documents, including a W-2 from your employer, 1099s from your side gigs, 1099-MISC statements from your online brokers, 1099-Rs for retirement income and more.

There isn’t much you can do now to reduce your 2021 tax obligations outside of contributing more to tax-deferred retirement accounts. That’s why the beginning of the year is the perfect time to adopt new strategies to minimize your tax obligations for 2022.

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All too often, your focus is on the rearview mirror – what you’ve already done and what you’ll have to pay. Instead, when you shift your focus to a proactive stance, you’ll reap the rewards throughout this year and into 2023, when you’ll file your taxes for this year.

As an enrolled agent – a professional who has earned the privilege of representing taxpayers before the Internal Revenue Service (IRS) – and a financial adviser, there are three strategies that I’ll share with you that have the potential to reduce your taxes in coming years. Of course, every situation is different and you may have other factors that cause your taxes to increase even if you adopt these and other tax mitigation suggestions.

Strategy #1: Maximize your tax-deferred retirement contributions

One of the most effective ways to reduce your tax liabilities is to increase your contributions to tax-deferred retirement vehicles, such as company-sponsored 401(k) or 403(b) accounts, government-sponsored Thrift Savings Plans (TSPs) or individual retirement accounts (IRAs). If you’re like many people, you’ve got room to increase your contributions before you hit the maximum allowable contribution.

If you’re in a 401(k) or 403(b) account, that limit is $20,500 for 2022. If you have a SIMPLE account, the limit is $14,000, while the limit for a SEP IRA is $61,000. If you are turning 50 in 2022 or are already older than 50, you can sock away more due to catch-up contributions, which are $6,500 for 401(k)s and 403(b)s and $3,000 for SIMPLE IRAs. There are no catch-up contributions allowed for SEP IRAs, because contributions can only be made by employers not employees.

For traditional tax-deductible IRAs, which are accounts that you establish for yourself, contribution limits are $6,000 a year with $1,000 extra allowed for catch-up contributions for those turning 50 and older in 2022.

Approaching your tax-deductible retirement plan contributions for the entire year in a strategic manner allows you to maximize your contributions while minimizing the impact on your budget. Here’s an example illustrated in Figure 1: Let’s say you want to increase your 401(k)contribution by 50%. If you can divide that over 26 pay periods, those additional contributions will be spread over a longer period of time, meaning that each contribution will be smaller than if you decided to take this action in the summer or in the fall, when you’d have fewer weeks remaining in the year.

Figure 1: Impact of a 50% increase in 401(k) contribution at different times of the year

Initial contribution Additional contribution Total new contribution 26 Pay Periods 13 Pay Periods 7 Pay Periods
$5,000 $2,500 $7,500 $96.15 $192.31 $357.14
$7,500 $3,750 $11,250 $144.23 $288.46 $535.71
$10,000 $5,000 $15,000 $192.30 $384.62 $714.29
$12,500 $6,250 $18,750 $240.38 $480.77 $892.86

You can see how starting early in the year offers a considerable advantage. In this case, increasing your contribution by $2,500 a year would only take additional payroll deductions of $96.15, assuming you’re paid every other week. Even if you wanted to increase your contributions by $5,000, you’d be left with a manageable deduction of $192.30 a week. However, the longer you wait, the higher the hill that you’ll have to climb in terms of the amount you have to contribute per pay period.

The more you contribute, the larger your tax savings, since 401(k), traditional IRAs, SEPs and SIMPLE IRA contributions are made with pre-tax dollars. Think of this strategy as a win-win, because not only do you save money on your taxes today, you’re also building a nest egg for tomorrow, when it’s time for you to retire. Of course, you will have to pay taxes on your contributions when you take money out in retirement.

Strategy #2: Invest in stocks with qualified versus ordinary dividends

Qualified dividends are taxed at more favorable capital gains tax rates, in contrast to ordinary or nonqualified dividends, which are taxed at ordinary income tax rates. Capital gains tax rates are 0%, 10%, 15% or 20%, in contrast to ordinary income rates, which can be as high as 37%.

Generally, if you hold dividend-paying stocks in taxable accounts – not retirement accounts – you’ll pay taxes at the qualified dividend rate, as long as you hold shares in the company that issues those dividends for more than 60 days during the 121-day period that starts before the day that a company’s dividend is recorded, which is also known as the ex-dividend date.

While this definition may seem complicated, there is method to the IRS’ madness – the intention of Congress was to reward long-term shareholders with a lower qualified dividend rate. This is why you must hold stock for a period of time to receive the preferential dividend rate.

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The definition of an ordinary dividend, in contrast to a qualified dividend, is a dividend from certain types of stocks, such as real estate investment trusts (REITs) and master limited partnerships (MLPs). In practice, those stocks may have dividends that are taxed at lower effective rates, but there are many different factors that play into this distinction that are beyond the scope of this article.

In addition, money market funds and dividends paid by employee stock option plans are also ordinary dividends. Fortunately, you don’t have to do the math or know which is which as those will be automatically categorized on your tax statement by type.

To get around these issues and minimize your tax liabilities, it can make sense to hold qualified dividends in taxable accounts and stocks and other instruments with ordinary dividends in tax-deferred accounts, like qualified retirement plans, or in non-taxable accounts, like Roth IRAs.

Strategy #3: Consider investment-only variable annuities

Frequently overshadowed by other types of annuities, investment-only variable annuities offer an option to save money on a tax-deferred basis beyond other tax-deferred vehicles, such as 401(k)s or traditional IRAs. Unlike many other types of variable annuities, which have gotten a bad rap because of their high fees and complexity, investment-only variable annuities are fairly straightforward, provide a wide variety of investment options and carry reasonable fees.

An advantage of investment-only variable annuities, especially compared to 401(k) funds, is the wide variety of investment options available. These can be used to diversify retirement assets, as many 401(k) plans offer limited options in a few asset classes. You can use an investment-only variable annuity to invest in alternative investments or in asset classes that might not be offered within your company-sponsored retirement plan.

Investment-only annuities aren’t suitable for everyone. If you haven’t maxed out your company-sponsored retirement accounts, there’s not much sense in investing in this type of vehicle. However, if you have maxed out your company-sponsored retirement accounts and are looking for another place to stash savings that you can use to get a tax deduction, it might be worthwhile considering an investment-only annuity.

Like other types of annuities, investment-only annuities don’t offer liquidity. In other words, if you’re likely to need the money you’ve saved before you turn 59½, you shouldn’t invest in this type of annuity, because you’ll have to pay a penalty of 10% if you take the money out early.

In addition, contract language for annuities is quite complex and some of the provisions can be difficult to understand. Fees vary widely, so be sure to investigate all your options before committing to one of these products.

Securities and advisory services offered through Registered Representatives of Cetera Advisor Networks LLC (doing insurance business in CA as CFGAN Insurance Agency LLC), Member FINRA / SIPC, a broker/dealer and Registered Investment Advisor. Cetera is under separate ownership from any other named entity. Investment advisory services may also be offered through HBW Advisory Services LLC. LHD Insurance & Financial Services, HBW Insurance & Financial Services, Inc. dba HBW Partners and HBW Advisory Services LLC are separate entities, which do not offer legal or tax advice. CA Insurance license: 0C63007
This article is designed to provide accurate and authoritative information on the subjects covered. It is not, however, intended to provide specific legal, tax or other professional advice. For specific professional assistance, the services of an appropriate professional should be sought.
All investing involves risk, including the possible loss of principal. There is no assurance that any investment strategy will be successful.
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401k Tax Rules on Withdrawals and Contributions

Employer-sponsored retirement plans like a 401(k) are a common way for workers to save for retirement. A little more than half of employees participate in a retirement plan at work, according to the Bureau of Labor Statistics. So it’s important for participants to understand how 401(k) taxes work. With a traditional 401(k) plan, employees can […]

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Should You Worry about Tax Increases? Maybe Not!

There’s been no shortage of handwringing about the prospect of tax increases over the course of the past year. Worried about potential tax changes, some business owners pushed ahead with sales or other liquidity events, while investors raced to book gains in 2021.

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However, as 2022 progresses, the tax legislation spurring those actions faces a highly uncertain future. And for business owners and investors who were facing increases, the most recent drafts of the Build Back Better Act suggest several future planning options to mitigate the pain.

First, Put Matters into Perspective

Let’s start big picture. Tax considerations are important, but they are often secondary to business and investment planning. Focusing on business operations and growth can drive valuation increases that more than pay for future tax hikes given the right investment timeline. This same logic applies to investment assets, as investors weigh expected value appreciation against the potential for tax increases. Attempting to complete sales before tax changes take effect could result in lower tax rates, but might also come at an economic cost.

Fortunately, financial projections and tax modeling can bring clarity to an uncertain future.

The Build Back Better Plan Has Evolved

It’s worth noting that the most recent legislative proposals are a significant retreat from the earlier push to raise capital gains taxes for the highest earners to a combined 43.4%. Instead, the version of the Build Back Better Act most recently under consideration in Congress would add a surtax to push up rates on all income — not just capital gains — for taxpayers only over specified income thresholds.

That surtax would be:

  • 5% on income over $10 million.
  • An additional 3% on income north of $25 million.
  • For trusts and estates, significantly lower thresholds of $200,000 (for a 5% surtax) and $500,000 (for an additional 3% surtax) would apply.

Those income thresholds would narrow the scope of tax increases as compared to an actual increase in capital gain rates. They also serve as the key to tax-planning opportunities.

Let’s also remember that the proposed tax increase on capital gains through the surtax is just that — a proposal, subject to congressional negotiations. Last fall it appeared that there was momentum for tax legislation on Capitol Hill, as the House passed a version of the BBBA and the Senate began its deliberations. However, that progress stalled, and the likelihood of significant tax increases is diminishing.

Opportunities for Business Owners

That said, tax increases do matter, and if you’re already planning to transition out of your business or investments, tax planning could minimize your liability.

One tactic business owners might consider is an installment sale. Stretching out the payment of purchase price over an agreed-upon number of years could help sellers keep their annual income recognition from the sale below the threshold that would trigger the surtax.

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Installment sales aren’t for everyone. They have the notable drawback of sellers assuming economic risk for the unpaid portion of promissory notes until the final payments are received. An interest charge may also apply to the deferred tax liability, depending on the amount of deferred gain.

A similar but potentially less risky option would be to sell businesses in phases, with each sale of a stake treated as a stand-alone liquidity event.

Sellers might also explore selling stock under the qualified small business stock gain exclusion. Those rules uniquely allow for the permanent exclusion of taxable gain, though the eligibility requirements are strict. The Build Back Better Act included proposals to reduce the maximum benefit of the gain exclusion. However, a gain exclusion of any type is always beneficial and would provide amplified benefits to taxpayers above the surcharge thresholds.

The potential for tax changes could also prompt business owners to revisit their plans around gifting or succession, both potential avenues to divest from the business in a tax-efficient manner. Tax changes involving gifting and estate planning were removed from the Build Back Better Act during the legislative process, but business owners should continue to watch that area closely.

The Bottom Line

There’s little we can be certain about with upcoming tax changes. But it’s a safe bet that taxes won’t go down anytime soon, and business owners are right to pay attention. Yet, setting out to eschew growth to escape a future of higher taxes may be counterproductive. It’s often better to focus on making your business as successful as possible, and then when it comes time to sell, figure out the most tax-advantageous way to do it.

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