We know of few things in our life that will happen with certainty. Paying taxes, unfortunately, is a safe bet and is considered by most to be a certain activity. What is uncertain, however, is the total tax liability you’ll pay.
Like a well-diversified portfolio, there are several ways to minimize the risk of high taxation - chief among them; information and awareness. Knowing the rules of the game and the options available to you will provide a return well worth your invested time.
This article, for example, is expected to take roughly 8 minutes to read. Let’s assume that this information helps to save you an additional $150 in taxes in 2023. Well, that’s the equivalent of $1,125 per hour. Best yet, it’s $1,125 per hour TAX-FREE – oh, the irony!
“But Jeff,” you may say, “I already know most of the noteworthy tax considerations as I just went through an end-of-year tax planning analysis with my financial planner.” In response, I’d first commend you for hiring such an astute financial planner. Next, I’d point out that there are constant changes proposed and enacted by the IRS every year. For starters, the IRS provides tax inflation modifications on an annual basis. These changes typically apply to tax brackets and various adjustments, but can also apply to tax credits and deferral opportunities (i.e., 401k/IRA contributions). Herein lies the opportunity of developing your strategy early.
The most effective tax planning strategies are proactive in their application, not reactive. Awareness of the upcoming changes, and their impact on you and your family, can make a world of difference in your financial success. This article particularly focuses on the strategic opportunities available to families with at least one employed individual.
Considerations for Employed Taxpayers
Employees have unique tax planning strategies compared to those who have retired. Examples are found in 401k eligibility, company-sponsored Health Savings Accounts (HSAs) and Flexible Savings Accounts (FSAs), and the ability to contribute to retirement accounts such as IRAs and Roth IRAs. Each of these examples are explained in more detail below. It goes without saying that each employee's circumstance is unique. Family size, pre-tax benefits relative to a household's current tax brackets, and future legislation changes all have an impact on the unique strategy you develop.
The maximum contribution limit for 401ks has increased from $20,500 (2022) to $22,500 (2023), allowing for an additional $2,000 in contributions throughout the year. This limit applies to all participants up to the age of 49, whereas participants 50 and older can take advantage of a catch-up contribution.
The catch-up contribution of $6,500 (2022) was increased to $7,500 in 2023, allowing participants 50 and older to defer a maximum of $30,000 into their 401k ($22,500 + $7,500). Regardless of age, these contribution limits apply to both pre-tax and Roth 401ks. Note, however, that contribution limits apply to pre-tax and Roth 401ks on an aggregate basis.
401k Tax Planning Insights
You can elect a specific contribution to your pre-tax, and a separate contribution to your Roth 401k. This can be advantageous if your taxable household income, net of deductions, partially falls in a high(er) tax bracket. For example, you may find that $6,000 of your household taxable income falls in the 32% marginal tax bracket, whereas the rest is taxed at 24% or less. With the ability to choose between pre-tax and Roth 401k contributions, you may find it advantageous to contribute no less than $6,000 to a pre-tax 401k, whereas the remainder of your contribution goes to a Roth 401k. The outcome? You’ve effectively removed taxable income exposed to the 32% tax bracket
Health Savings Account (“HSA”) Contributions
HSA contributions have increased at both individual and family levels. Individual and family qualifications are based on participating in a high-deductible HSA-eligible medical plan. The individual limit applies when the plan only covers one person, whereas the family limit applies to enrolled plans that cover more than one person.
- Individual HSA contribution limits have increased from $3,650 (2022) to $3,850 in 2023.
- Family HSA contribution limits have increased from $7,300 (2022) to $7,750 in 2023.
HSA Tax Planning Insights
HSA contributions are one of the most tax-advantaged savings vehicles available to taxpayers. Similar to pre-tax 401k or Traditional IRA contributions, HSA contributions provide a pre-tax deferral of income. For example, a $5,000 HSA contribution allows you to deduct the equivalent from your taxable income. If you are in the 24% bracket, this equates to $1,200 in federal tax savings. These contributions are even more beneficial if you find yourself in the higher tax brackets of 32%, 35%, or 37%.
HSA contributions can also grow tax-free (indefinitely) and can be accessed tax-free for future qualified medical expenses ranging from copayments, plan deductibles, dental and vision expenses, and even Medicare premiums.
Suppose an immediate tax deduction and tax-free growth aren’t enough to excite you. In that case, HSA contributions via payroll deductions have an added tax bonus - the contribution comes from your paycheck before the Social Security tax (6.2%) and Medicare tax (1.45%) is applied.
Flexible Spending Accounts (“FSA”) Limits
Unlike HSAs, FSA contributions are not dependent on who is covered by the medical plan. As a result, both individual and family coverages receive the same upper limit thresholds. The individual/family FSA limits have increased from $2,850 (2022) to $3,050 in 2023.
FSA Tax Planning Insights
The IRS disallows joint participation in an HSA and a general-purpose FSA plan in the same calendar year. Unfortunately, this limitation applies to all tax filers within the same household. As a result, a joint filer would be unable to deduct their HSA contributions if their spouse participates in an FSA. The FSA supersedes the HSA when qualifying for tax deductions per IRS guidelines. For example, a $100 FSA contribution would eliminate the tax deductibility of a $3,650 HSA contribution. Furthermore, the HSA contribution would be disallowed and must be rectified before tax filing.
Traditional & Roth IRA Contributions
Traditional and Roth IRA contribution limits have increased from $6,000 (2022) to $6,500 in 2023. Like 401k deferrals, Traditional and Roth IRAs allow for a catch-up contribution at a much lower $1,000. Thus, taxpayers aged 50 and older can contribute up to $7,500 in 2023.
Traditional/Roth IRA Tax planning insights
The IRS states that a person can contribute up to the annual limit, or 100% of their earned income, whichever is less. If your only earned income is from part-time work and you earn $5,000, for example, your contribution limit would be $5,000 (not $6,500).
Roth IRA Eligibility
The IRS limits eligibility for Roth IRA contributions to households with a modified adjusted gross income (“MAGI”) under a specific threshold. This threshold differs between individual and joint tax filers and has experienced a dramatic increase from 2022 to 2023 – nearly 7%.
- Individual (single and head of household) filers must have a MAGI of $138,000 or less in 2023 to be eligible for a full Roth IRA contribution, up from $129,000 in 2022.
- Married (filing jointly) filers must have a MAGI of $218,000 or less in 2023 to be eligible for a full Roth IRA contribution, up from $204,000 in 2022.
Roth IRA Eligibility Insights
The IRS MAGI limitations are not an all-or-nothing scenario. Instead, the IRS allows for reduced Roth IRA contributions up to an income threshold of $228,000 and $153,000 for married filing jointly and individual taxpayers, respectively. You can learn more about Roth IRA eligibility on the IRS website “Amount of Roth IRA Contributions That You Can Make For 2023.”
Social Security Tax
Each year the IRS sets wage limits applicable to Social Security tax. While the tax rate remains unchanged (6.2%), the amount of taxable earned income subject to the tax has increased once again. Whereas the wage limit in 2022 was $147,000, it is $160,200 in 2023. So, for example, you should expect to pay a 6.2% tax on the first $160,200 of income in 2023 (total tax of $9,932.40). This is on a pre-individual basis and does not discriminate among single or married filers.
Social Security Tax Planning Insights
Sorry, there is little you can do to reduce the impact on Social Security tax, with the exception of HSA contributions made via payroll deferrals.
Child Tax Credits
Lucid Wealth had recently conversed with a client about the 2022 Child Tax Credits, to which the client's final response was "I do love how simple the government makes these things." Needless to say, this was said with the utmost sarcasm. The American Rescue Plan of 2021 changed the tax credit eligibility age from “under age 17” to “under age 18,” in addition to increasing the credit amount itself (from $2,000 to $3,000). The American rescue plan was only applicable to 2021, however. The IRS rules in 2022 and beyond reduce the credit back to $2,000 per qualifying child, defined as children under the age of 17 as of Dec 31st for the calendar year.
Child Tax Credit PLANNING INSIGHTS
There is nothing I'd like more, as a father of two little ones, than to keep my kids as cute and innocent as long as possible. They will, however, mature into adults as quickly as a blink of an eye. From a tax planning perspective, I advise you to accept this with open arms and gratitude while subsequently planning for a reduction in tax credits. A tax credit, vs a deduction, is a dollar-for-dollar offset of liability. Thus, a $2,000 credit reduces your liability by $2,000. Another perspective here is that as soon as your child turns 17, your tax liability will increase by $2,000 all other things equal. At this time it may be a good time to review your employer's federal tax withholding to ensure you don't have any year-end surprises.
The IRS divides income into different tax rates. This is referred to as a "progressive tax system." Each subsequent portion of your income will have an increased tax rate applicable. For example, if you are a single filer who makes $37,000 in 2023, your first $11,000 will be taxed at 10%. The next portion of your income will be taxed at an increased rate; from $11,000 to $37,000, your tax rate will be 12%. As your income increases, you’ll fall into higher tax brackets and will have a higher tax rate for each portion of your income.
The tax brackets have increased for all tax filers from the 2022 levels, regardless of whether you file as single, head of household, married filing jointly, or married filing separately. The 2023 tax brackets are as follows:
Don't let tax planning leave you feeling overwhelmed. Life is already challenging enough when balancing your career development, family needs, and personal interests. Enjoy less stress and a smoother process by being fully prepared for the 2023 tax year. Please contact Lucid Wealth Planning if you have any additional questions, or if you are interested in learning more about our financial planning and investment management services.
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