With the end of the year fast approaching, Tax Season may be the last thing on your mind. Yet in many ways, the final months of 2022 may be your last chance to reduce this year’s tax liability. To avoid overpaying Uncle Sam and preserve more of your hard-earned income, consider the following end-of-year tax planning tips for small business owners in 2022.
To minimize your tax liability, consider these end-of-year tax planning tips for 2022:
Tip #1: Identify Changes to Your Tax Situation
In 2022, the standard deduction is $12,950 for single filers and $25,900 for married taxpayers filing jointly. The standard rule of thumb is if you can deduct more than the standard deduction amount in eligible expenses from your taxable income, you should itemize. Otherwise, it’s generally easier and more valuable to take the standard deduction.
If your income and circumstances have been relatively stable since last year, you likely know already if you plan to itemize or take the standard deduction this year. However, if you’re on the fence, there are end-of-year tax planning strategies you can utilize to reduce your taxable burden.
For instance, consider pre-paying certain deductible expenses—for example, charitable donations or out-of-pocket medical expenses—this year so that itemizing makes more sense.
Let’s say you plan to donate $5,000 to charity each year for the next several years. If you have extra cash on hand this year, you may want to consider donating $10,000 or more to your charity of choice so you can itemize your deductible expenses. Then, next year, you can skip your regular donation and take the standard deduction.
The same is true for out-of-pocket medical expenses. If you know you have certain expenses looming for 2023, you can pay them this year to make the most of the associated tax benefit.
Tip #2: Harvest Capital Losses
Capital gains taxes can eat away at your investment returns over time—specifically in non-qualified investment accounts. Fortunately, the IRS allows investors to offset realized capital gains with realized losses from other investments.
That means you can realize profits on your top-performing investments while selling poor performers to reduce this year’s tax bill. If you have substantial losses, you may be able to completely offset your gains and potentially reduce your taxable income. And in years like 2022 when markets have struggled, you may have more losses than you think.
Keep in mind if you work with a financial advisor, you may not need to initiate this strategy on your own. Most fiduciary financial planners proactively take advantage of tax-loss harvesting to help clients with end-of-year tax planning.
Tip #3: Review Your Charitable Giving Plan
Currently, taxpayers who itemize deductions can give up to 60% of their Adjusted Gross Income (AGI) to public charities, including donor-advised funds, and deduct the amount donated on this year’s tax return.
You can also deduct up to 30% of your AGI for donations of non-cash assets. In addition, you can carry over charitable contributions that exceed these limits in up to five subsequent tax years.
When it comes to end-of-year tax planning, donor-advised funds (DAFs) can provide opportunities to meaningfully reduce your tax liability relative to other giving strategies. For example, if you plan to donate $10,000 each year to your favorite charitable organization, it may be more beneficial to take the standard deduction when you file your taxes.
On the other hand, you can front-load a donation of $50,000 to a donor-advised fund and request that the DAF distribute funds to your chosen charity each year for five years. In year one, you can receive a more favorable tax break by itemizing on your tax return. Meanwhile, you’ll still be meeting your charitable goals each year via the DAF. This strategy can be particularly beneficial in above-average income years.
And better yet, you can donate non-cash assets like highly appreciated stock to a DAF and avoid paying the capital gains tax. This strategy can also help you diversify your investment portfolio without triggering an unpleasant tax bill. Plus, you can take an immediate deduction for the full value of the donation (subject to IRS limits).
Tip #4: Look for Opportunities to Reduce Income
Maxing out your qualified investment account contributions is indeed important for meeting your future financial goals like retirement. However, this can also be a valuable end-of-year tax planning strategy.
First, be sure to check the contribution limits on your employer-sponsored or self-employed retirement plans for 2022. You can also contribute up to $6,000 to an individual retirement account in 2022 (or $7,000 if you’re age 50 or over).
In addition, individuals with qualifying high deductible health plans are eligible to contribute to a health savings account (HSA). An HSA can be a great way to save and grow your money on a tax-advantaged basis.
In fact, these accounts offer triple tax savings. Contributions, capital gains, and withdrawals are all tax-free if you use your funds for eligible healthcare expenses. And like qualified retirement accounts, you can deduct your contributions from your taxable income in most cases to reduce your overall tax liability.
Tip #5: Take Advantage of Lower Income Years with a Roth Conversion
The IRS allows individuals to convert a traditional IRA to a Roth IRA via a Roth conversion. A Roth IRA conversion shifts your tax liability to the present. As a result, you avoid paying taxes on withdrawals in the future. In addition, Roth IRAs don’t require minimum distributions.
With a Roth conversion, you pay taxes on the amount you convert at your current ordinary income tax rate. That’s why it can be a particularly powerful end-of-year tax planning strategy in tax years when your income is below average.
At the same time, a down market can be an opportune time to take advantage of a Roth conversion. Since account values typically decline in a negative market environment, so does the amount on which you pay taxes when converting to a Roth. Plus, there’s greater potential for future appreciation and withdrawals that tax-free.
After you convert your traditional IRA to a Roth, any withdrawals you make in retirement will be tax-free if you’re over age 59 ½ and satisfy the five-year rule. And since Roth IRAs don’t have RMDs, you can leave your funds to grow tax-free until you need them.
While Roth conversions can be beneficial for many, they don’t make sense for everyone. Be sure to consult with a trusted financial advisor or tax expert before leveraging this strategy.
Tip #6: Strategically Transfer Wealth
If you expect to leave significant wealth to your heirs, proper estate planning is key. Fortunately, there are end-of-year tax planning strategies you can leverage to help minimize your estate’s potential tax burden.
In many cases, gifting is one of the simplest ways to efficiently transfer wealth while reducing your estate. Each year, the annual gift-tax exclusion allows you to gift a certain amount (up to $16,000 in 2022) to as many people as you like without incurring the federal gift tax. Moreover, spouses can combine the annual exclusion to double the amount they can gift tax-free.
Indeed, cash gifts are most common. However, you can also use the annual exclusion to transfer personal property or contribute to a 529 college savings plan. Alternatively, the IRS allows you to pay educational and medical expenses on behalf of someone else without incurring federal taxes if you pay the institution directly.
Trusts can also help you transfer wealth strategically while reducing your family’s taxable burden. However, trusts are varied and complex. It’s important to consult your financial planner or estate planning attorney to determine if a trust may be an appropriate end-of-year tax planning strategy.
Tip #7: Donate Your Required Minimum Distribution (RMD)
To keep people from using retirement accounts to avoid paying taxes, the IRS requires individuals to begin taking minimum distributions from certain qualified accounts once they reach a certain age. As of 2020, required minimum distributions (RMDs) kick in at age 72.
You can withdraw more than your RMD amount in any given year—but be prepared for the potential tax consequences. On the other hand, the IRS imposes a penalty of up to 50% if you fail to take your full RMD before the deadline.
Both scenarios can be costly. Fortunately, careful end-of-year tax planning can help you manage your RMDs to avoid high taxes and other penalties.
For example, if you don’t need the extra income, you can donate your RMD to charity—a tax planning strategy called a qualified charitable distribution (QCD). A QCD allows IRA owners to transfer up to $100,000 directly to charity each year.
QCDs can satisfy all or part of your RMD each year, depending on your income needs. You can also donate more than your RMD amount up to the $100,000 limit. And since QCDs are non-taxable, they don’t increase your taxable income like RMDs do.
It’s important to note that the IRS considers the first dollars out of an IRA to be your RMD until you meet your requirement. If you take advantage of this tax planning strategy, be sure to make the QCD before making any other withdrawals from your account.
For More End-of-Year Tax Planning Tips, Consult a Trusted Financial Advisor
While this isn’t an exhaustive list of end-of-year tax planning strategies for small business owners, these tips can help you determine if there are opportunities to reduce your taxable burden in 2022. At the same time, a trusted financial advisor or tax expert can help you identify which strategies are right for you within the context of your overall financial plan.
Oak Capital Advisors specializes in the financial and tax planning needs of small business owners. If we can help you identify strategies to reduce your overall tax liability, please start by requesting your complimentary Financial Independence Roadmap™.