Tax planning should be a year-round endeavor, and not relegated to tax return filing and perhaps year-end planning.
While everyone thinks (or worries) about taxes when they are due, many participate in some form of year-end tax planning. Few, however participate in what we like to call “year-beginning tax planning.” We believe a more prudent approach is to create and execute a tax plan early in the year and pay attention to planning opportunities throughout the year with a final review during year-end tax planning season.
In terms of year-beginning tax planning, there are a myriad of low effort tax strategies to consider, such as:
Delay Required Minimum Distributions
At the end of December, the SECURE 2.0 Act was signed into law, as part of the $1.7 trillion omnibus spending bill. As we wrote about earlier this year, the act brought many updates to the U.S. retirement system, including increasing the age for required minimum distributions (RMD). For those turning 72 after December 31, 2022, the RMD age has increased from 72 to 73. In 2033, this will be further increased to 75. If you turn 72 in 2023, you no longer have to take your initial RMD by April 1, 2024. Rather, your first RMD will be due for your 73rd year, by April 1, 2025. Your 2025 RMD will also be required that same year, so careful tax bracket management is recommended.
Increase Retirement Contributions
Separate from the SECURE 2.0 Act, retirement plan limits received an inflation adjustment increase this year as well. In 2023, individuals can now contribute up to $22,500 annually (up from $20,500 in 2022) to 401(k), 403(k), most 457 plans and Thrift Savings Plans. Those who are 50 or older can contribute an additional $7,500 (up from $6,500 in 2022) in catchup contributions.
The SIMPLE IRA contribution limit increased to $15,500 (up from $14,000 in 2022) with an additional $3,500 (up from $3,000 in 2022) available in catchup contributions for taxpayers age 50 and over. Traditional and Roth IRAs also received an increase to $6,500 (up from $6,000 in 2022), but catchup contributions to these IRAs remains at $1,000.
Simplified Employee Pension (SEP) IRA contribution limits have increased from $61,000 in 2022 to $66,000 in 2023. Defined benefit plans also got a significant jump, from $245,000 in 2022 to $265,000 in 2023. SEPs and defined benefit plans are great retirement vehicles for small businesses and the self-employed, and often allow much greater tax deferral than Traditional and Roth IRAs or 401(k)s.
With these new higher retirement limits, it is a great idea to max out contributions if you can. Adjusting to higher contributions earlier in the year will make the cash flow hit less noticeable over the course of the year, as the higher limit will be spread out. If you are 50 or older, it is also a great idea to max out your catchup contributions in 2023. Taking full advantage of the higher retirement limits this year will put you in a stronger financial position when you decide to retire later in life.
Consider a Roth Conversion
While often considered at year-end, it may be appropriate to consider whether or not to convert your Traditional IRA or 401(k) to a Roth IRA early this year… especially when the market is down. There are many implications to converting that should be considered, which we earlier covered in depth. One added reason to convert to a Roth IRA is when the stock market is down and your portfolio is suffering from a depressed value. Converting when your plan’s value is lower than expected will allow you to convert a greater amount than you would normally be able to for the same cost. After paying the appropriate tax costs to make the account an after-tax Roth IRA, it will be able to grow tax-free. Of course, you may also benefit from some of the attributes of Roth accounts, such as no required minimum distributions and tax-free distributions after the age of 59½. Ultimately, this might not be the year you decide to convert to a Roth IRA, but it is good to keep it in mind and discuss it with your tax adviser if the benefits seem favorable.
Adjust 2023 Withholding
Irrespective of your level of income, it is never pleasant to have a large tax balance due (tax and/or underpayment penalties and interest) with the filing of your federal and state tax return. When major life events occur, such as a one-time increase in investment income, harvesting of gains from the sale of investments, getting married or divorced, or retiring or changing jobs, you may want to revise your Form W-4 to ensure the amount withheld is sufficient and accurate enough for your specific circumstances. If you have not reviewed your withholding recently, you should consider a 2023 tax projection. We often perform tax modeling and planning on a quarterly basis for our clients.
Maximize Use of the Annual Gift Tax Exclusion
While everyone should be thinking about ways to maximize their retirement funds, another area you should be thinking about early in 2023 is minimizing your estate and gift tax. For 2023, the annual gift tax exclusion has increased to $17,000 (from $16,000 in 2022). This means you are able to gift $17,000 ($34,000 if married filing jointly) to each donee without affecting your estate and lifetime gift tax unified credit. While the estate and gift tax unified credit is currently $12,920,000 for gifts made, it is currently scheduled to be reduced to an inflation-adjusted $6,800,000 in 2026, so any reductions in the unified credit could be much more meaningful in the near future.
As the annual exclusion amount does not carry over to the following year, keeping this exclusion in mind as you plan out 2023 can help you make smart and impactful gifts throughout the year.
Take Advantage of the Historically High Unified Credit
As we just mentioned, it is likely that the unified credit is near its historical peak, with the current credit scheduled to sunset in 2026 and revert to an inflation-adjusted $6.8 million. The IRS previously released regulations stating that, to the extent a higher basic exclusion amount was allowable as a credit in computing gift tax during the decedent’s life, the sum of these credits used during life may be used as a credit in computing the decedent’s estate tax. Therefore, if a taxpayer utilized the entire $12.92 million credit for 2023 gifts, and the decedent dies in 2026 after the credit is reduced to $6.8 million (adjusted for inflation), the entire gift of $12.92 million would still be excluded at the taxpayer’s death in 2026 or beyond. As a result, it may make sense to fully utilize the current credit over the next few years and remove as many assets from your estate as possible while the unified credit remains high.
Utilize 529 Plans
While the annual gift tax exclusion is beneficial for gifting in the current year, you might want to think beyond this year or even the next few years. If your children or grandchildren are likely to consider college in their future, contributing to a 529 qualified tuition plan is a great way to be prepared for the associated expenses that come along with it. These plans can be used to cover the cost of tuition, room and board, and other qualified higher education expenses at accredited schools in the United States. Even before the child reaches college age, they can also use tax-free distributions to fund up to $10,000 of eligible expenses at elementary and secondary schools.
In addition, over 30 states offer a tax deduction or tax credit for contributions for a 529 plan. While generally, a donor can only contribute the annual exclusion amount ($17,000 in 2023) to a child’s 529 account before having to worry about reducing their lifetime exclusion, a special rule exists where an election can be made to treat a contribution to a 529 plan as having been made over a five-year period. Therefore, for 2023, a married couple can make a $170,000 contribution to a 529 plan without incurring any gift tax liability or utilizing any of their lifetime exclusion, since the annual gift exclusion for 2023 is $17,000 per donor and the contribution can be split with the donor’s spouse.
Plan for Any Change in Tax Rates
As we look ahead to the remainder of the year, consider whether your 2023 tax rates could be potentially higher or lower than last year. For many taxpayers with relatively flat income, they will see a decrease in their tax rates due to steeper than usual inflation adjustments to the tax brackets in 2023. For 2022, the top individual tax rate of 37 percent applied to joint filers with taxable income greater than $628,301 and single filers with taxable income greater than $523,601. However, for 2023, these thresholds jumped to $693,750 for joint filers and $578,125 for single filers. Similar changes were in effect for the lower brackets as well.
Additionally, if 2023 is looking like it could be a great year and you received a promotion or substantial bump in income, you might want to consider accelerating your deductions this year. You may wish to accelerate your medical deductions, interest payments or charitable contributions, or maximize pre-tax retirement contributions. Planning ahead and making the most of your itemized deductions this year could allow you to reduce your tax liability significantly more than if you took the standard deduction.
On the other hand, you might not have had a significant increase in income this year. It might be wise to defer those itemized deductions if you can and save them for 2024. This will allow for more flexibility in the event you do receive a significant bump in income that year, as you will have itemized deductions lined up to reduce your total income.
Establish and Fund a Donor-Advised Fund
One mechanism that greatly assists in tax planning and bunching deductions from year to year is a donor-advised fund (DAF). A DAF, usually set up through a broker or financial institution, is like a charitable account, where a taxpayer can make charitable contributions to the account and claim deductions for these contributions. After the account is funded, the taxpayer can then direct the DAF to make disbursements to the charities of their choice. Therefore, the taxpayer can separately control their charitable deduction and support of their favorite charities. As an example, taxpayers could double up their charitable contributions to the DAF every two years, while maintaining a similar level of support to the charities. For many taxpayers, this results in a large contribution in one year, then claiming the standard deduction in the other year, often creating a great tax benefit over the two-year period.
Harvest Your Capital Losses
In addition to bunching up your itemized deductions, you can further reduce your tax liability by harvesting your capital losses. While tax-loss harvesting is a common planning strategy in December, we believe you should review more frequently, and at least quarterly for many reasons. Here are only two such examples: First, harvesting losses at year-end can potentially increase your losses, as you are selling at year-end when many others are selling their worst-performing positions (and potentially the same positions you are selling). Second, with regular tax loss harvesting, you can remain more consistent with your desired investment allocations and overall investment strategy.
As a result, if you presently have investments that have unrealized losses, it might be a good time to consider selling them and taking advantage of the capital loss harvesting strategy for the reasons just noted. This will allow you to offset any capital gains you generate for the rest of the year, as well as up to $3,000 of your ordinary income ($1,500 if married filing separate). Any capital losses remaining can be carried forward beyond the current tax year. If you anticipate a higher tax bracket next year, it would further benefit you to sell any gains currently in your portfolio while you have a lower tax rate on your income.
Invest in Energy Efficient Property
With the passage of the Inflation Reduction Act in August 2022, a number of energy credits have been enhanced for 2023. For example, the energy efficient home improvement credit replaced the nonbusiness energy property credit for 2023. It provides a credit of 30 percent of the costs of all eligible home improvements (such as roofs, insulation, windows, doors, air conditioners, water heater, heat pumps, etc.) made during the year, up to a $1,200 annual limit―rather than a $500 lifetime maximum under prior law. In addition, the residential clean energy property credit allows a 30 percent credit for expenditures on certain solar, fuel cell, wind, geothermal and battery storage property, subject to certain kilowatt restrictions.
Plan for April
April is right around the corner, and with it the 2022 tax payment deadline. To assist in projecting your cash flow, you may wish to consider 2022 tax modeling to avoid any unnecessary surprises.
Also, you should consider making sure that you have maximized your HSA and IRA funding, as well as self-employed retirement plans such as SEP IRAs, money purchase, defined benefit and profit-sharing plans for 2022, prior to the due date of the return. This could be your last chance for last-minute tax savings to reduce your 2022 tax bill. If you need additional time to make these contributions, you may wish to consider an extension of your tax returns until October 16, 2023, which would also increase the time available to make these contributions. For money purchase and defined benefit plans, extending tax returns would only extend your ability to contribute until September 15, the minimum funding deadline.
Tax planning should be a year-round endeavor, and not relegated to tax return filing and perhaps year-end planning. The topics discussed above are quick-strike tax strategies to be thinking about as you plan your year, as they could be implemented throughout the year to save meaningful dollars―if you plan ahead. While such strategies are generally beneficial to most taxpayers, there are many factors involved, some of which may change from year to year and for each unique situation. Before considering adopting any new strategy, it is always wise to speak with your tax adviser.
For More Information
If you would like more information about this topic or your own unique situation, please contact John I. Frederick, Steven M. Packer, any of the practitioners in the Tax Accounting Group or the practitioner with whom you are regularly in contact. For information about other pertinent tax topics, please visit our publications page.
Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm's full disclaimer.