So, let’s kick off this blog with some bad news. There are very few changes you can make after year-end to positively impact your tax situation. Why? Because many deductions and tax planning strategies have to be implemented during the tax year (or at least by December 31). The best time to get things in order is, at a minimum, weeks in advance. The good news? We can show you what to do to make the next tax season as painless as possible. Let’s dive into some of those year-end planning strategies now.
Cash-basis or accrual-basis strategies. Use timing to your advantage.
If you’re a business owner, understanding the difference between cash and accrual-basis accounting–and which one your business uses for tax purposes–is critical. There are important distinctions between the two as well as different tax implications.
Cash-basis is when your business is taxed on income when cash is received (regardless of when it ‘s earned) and your business gets deductions when cash is paid (regardless of when it’s accrued). If this is you, you can:
- Defer taxes for the current tax year by waiting to send your December/Q4 invoices until the first part of January. This way your customers won’t pay you until the following tax year. This will push that income taxability to the following tax year.
- Accelerate paying business expenses i.e. pay them by December 31, instead of waiting until the next year. If you’re planning a large equipment purchase, it might make sense to make a decision on which brand/model etc. to buy by early December so you can make the purchase by December 31 (and, therefore, get the deduction in the current tax year).
Accrual-basis accounting is when your business is taxed on income when it is earned (regardless of when cash is received) and your business gets deductions when the expense is accrued (regardless of when it is paid). If this is you, you can:
- Determine year-end bonuses shortly after the new year and pay them out in the following tax year. Then you can include the deduction in the current tax year since it was for work performed in that year.
- On the income side, you could ensure any new contracts kick-off on January 1 instead of December 15. This will push your income (or at least a portion of it) into the following tax year. Even if you were paid a deposit on December 15, you wouldn’t count it in the current tax year because work wouldn’t start January 1.
Adjust your estimated tax payments.
As a self-employed business owner, you might not have a W-2 job where you’re able to adjust tax withholdings up or down. Instead, the IRS will expect you to make estimated tax payments each quarter. The rule is, in general, you must pay at least 90% of your current tax bill or 100% of the tax shown on your prior tax return–whichever is less. If you don’t meet these thresholds, the IRS will assess an “underpayment of estimated tax” penalty.
Example: Your prior year 2021 tax return showed total federal taxes of $7,500. Your current year 2022 tax return shows a federal tax liability of $9,200. Using the above, you would need to have paid at least $7,500 timely during the 2022 estimate periods to avoid the underpayment penalty. As you can see, this is the prior year amount; it is the lesser of the two thresholds.
Lots of accountants will use the “100% of tax shown on your prior tax return” rule. This means they’ll take your prior tax return’s tax liability, divide it by 4, and advise you to send that amount to the government each quarter. But, what if your business takes off this year and you make twice as much as the prior year? You’ll get slammed with a huge bill at tax time. Or, what if your business slows down? Now you’ve paid the government way too much and will have to wait months to get the money back. The best thing you can do is to monitor your business’s activity during the year basing it on what’s actually happening (instead of using the prior year as a model). Then send in your tax estimates based on the current year. The goal is to try to pay in nearly exactly what you owe–no more, no less–so your tax return is filed with the right information. No huge unexpected bill, no huge overpayment.
The Revel difference: At Revel, most of our monthly clients have quarterly tax planning sessions as part of their accounting package. In these sessions, we look at a mock tax return and see if their tax payments (factoring in payroll withholdings + estimates) should be adjusted based on those results. This way, there won’t be any surprises at tax time! If you aren’t a monthly client, we offer these sessions as one-off meetings too! You can find more information here.
Check your W-4 to ensure your W-2 withholdings are correct.
Create a mock tax return to check if your withholdings are accurate. To do this, get your earnings-to-date from your most recent pay stub and extrapolate out the wages and tax information based on the number of pay periods you have left in the year. You’ll also want to estimate any other taxable income, deductions, or credits which might impact overall tax. From this, you can see how much overage or underage you might have when you file your tax return. Based on that, you can fill out an updated W-4.
Example: You have one W-2 job and no other income. There are no substantial deductions or credits to take into account. Let’s say through October 31, you have taxable wages of $75,000; federal income tax withheld of $6,500, and state income tax withheld of $2,000. Your October 31 paystub shows gross income of $3,000; federal income tax withheld of $400; and state income tax withheld of $75. If you get paid twice a month, that means you have 4 pay periods left in 2022. Assuming you’re paid the same amount, you could take your October 31 paystubs amount and multiply it by 4 to get the amount to add to your year-to-date pay stub. That would look something like this:
Gross wages of $75,000 at October 31 + $12,000 from remaining 4 pay periods = $87,000 gross wages for the year
Federal income taxes of $6,500 at October 31 + $1,600 from remaining 4 pay periods = $8,100 in federal income taxes for the year PLUS
State income taxes of $2,000 at October 31 + $300 from remaining 4 pay periods for the year
= $2,300 in state income taxes withheld for the year
From this information, you’ll be able to see if you are projected to over or under then adjust accordingly.
Ensure you have a correct, up-to-date W-4 form (the form informing the payroll system on how much to withhold from your paychecks in relation to your marital status and/or if you have dependents). This is vital in terms of ensuring you’re paying the correct amount of income tax. If your circumstances have changed since you first filled out/last updated the form with your employer, update it as soon as possible. If it’s not correct, it could be part of the reason why your income taxes are being over/under-withheld.
Check your W-2 withholdings at least once per year. You’ll notice if your employer is withholding too much or too little in income taxes and can adjust accordingly.
If you have a W-2 job AND a side hustle or small business, it might complicate the tax process. Since your side hustle and/or small business don’t have employer tax withholdings, you can pay in the applicable taxes by either:
- Increasing your W-2 job’s withholdings (to essentially help cover your side hustle/small business’s portion of your overall tax liability)
- Sending in estimated tax payments (see the prior section for more on this!)
- Doing a combination of both
Increase your retirement contributions
If your employer offers a retirement plan such as a 401(k), you can increase your employee deferrals each pay period to decrease your overall taxable wages. Each dollar you put towards retirement can defer upwards of 40 cents in tax, depending on your tax bracket. Note that with this strategy, you are likely deferring taxes, not wiping them out forever.
You will owe taxes on those retirement contributions once you distribute them during your retirement years.
Example: You have a salary of $100,000 per year and you decide to contribute 10% of your salary towards your company’s 401(k) plan. Instead of paying income tax on all $100,000 of your salary this year, you’ll only pay income taxes on $90,000, since $10,000 was contributed towards retirement.
Note: You’ll still have applicable FICA taxes (Medicare and Social Security) of 7.65% – these do not get deferred.
Recognizing a capital loss: using an investment loss to your advantage.
Note: Please consult with your financial advisor before you do this.
If you have a portfolio of investments, this is a very popular strategy. You can sell underperforming stock by year-end to deliberately recognize it as a capital loss and then offset any capital gains you have for the year with that loss. Or, if you have an excess, you can take $3,000 per year to put against your ordinary income (anything above $3,000 will have to be carried forward for future years).
It’s important to note you can’t sell an investment and repurchase the same (or substantially similar) investment within 30 days. If you do, the loss will be disallowed. This is referred to as the “wash-sale rule.” Again, please consult with your financial advisor if you want to ensure you don’t fall into this trap before you make year-end sales at a loss strictly for tax purposes.
The Revel difference
Getting ahead of the tax year and making the IRS rules work for you is sort of our jam. We know how complex it can get and we love breaking it down to work to your advantage. If you want expert advice on how to get a handle of your tax return, or just some more detail on specific sections in this blog, you can get in touch here.