Welcome to tax projection season!
I bet many are thinking, “this isn’t relevant to me”, but I don’t think that is true. I think everybody can benefit from a tax projection, whether it is to set expectations for what is coming, or to spur you into taking an action prior to year-end that will help your finances.
A projection may not be a necessity when it comes to your finances (although for some it is), but I would label it as a “nice to have” for the vast majority. Either way, I think this can be valuable information.
Here are some ways a projection can help you plan for what is coming.
Accelerate Income or Expenses
This is very relevant to business owners who have more control over their income and expenses, but can also be applied in certain aspects for those who are employees.
For business owners, the planning becomes relevant when you have lumpy income, meaning some years of high income and some years of low income, depending on the timing of your expenses and your income.
Generally, you have less control over when you receive money, unless that is getting negotiated upfront. You do have more control over your expenses, especially when it comes to investing in the business. I’ll leave you with two examples for my business to give you an idea of how you can have some control:
Accelerating income: tax season is coming up! The question becomes, will it be more beneficial for me to receive income in 2021 or 2022? If I am having a low income year in 2021, I could consider asking for advanced payment of tax services prior to year-end from my clients. I could give a discount to incentivize my clients; this way, I am receiving income in 2021 during a low income year and thus a lower tax rate than I expect in the future.
Accelerating expenses: suppose it is the opposite and I had an unusually high income year in 2021. I want to get my taxes lower by investing in the business with legitimate business upgrades. I could revamp my WFH setup with a new mic, camera, laptop, etc. and assume all those expenses this year to lower my income (and thus, my taxes), which will benefit me over the next few years.
Now, you can see how a business owner may have some control over the timing of their net income, which employees typically do not have. But, there are a couple ways that employees can accelerate income or postpone income. Note, these are also available to business owners in addition to what was mentioned above.
Capital gain / loss harvesting: This is a strategy in which you have investments in taxable accounts. Your investments will either make money or lose money… and nothing will be taxed until you sell these investments at a gain or loss. Once this sale happens, the IRS deems this as “realized” gains or losses and that is when taxes are due. So, you can implement strategies to change the timing of your taxation by either selling or not selling your investments. Of course, this is subject to the whims of the market and you don’t always have losers when you want to realize a loss, or winners when you want to recognize some extra income.
Retirement account contributions / conversions: you can impact your income by either contributing to pre-tax retirement accounts or post-tax (Roth) retirement accounts. You can also convert some of your pretax holdings to Roth holdings, which again accelerates income in a low income year (and thus a lower tax rate on that conversion).
Estimated Tax Payments
Estimated tax payments are again more relevant to business owners, as there is no withholding on the income you receive throughout the year. The IRS created a “pay as you go system” - this is implemented in the form of four quarterly payments throughout the year, which the IRS expects you to pay based on how much money you’ve made through each quarter.
This can also be relevant to non business owners who have high investment income, a side hustle, or other income that isn’t subject to withholding.
A tax projection will help you understand how much you need to pay each quarter in order to avoid penalties or interest throughout the year. There are a few strategies to avoid these penalties and interest, and a good tax projection will help you to decide which strategy to use that is most beneficial for you.
Charitable giving is not a zero sum game. So yes, if you give to charity, your tax bill may be lower (it depends, of course). But, the tax savings you receive will never outweigh, or be equal to, the amount you gave to charity.
Charitable giving should be done because it is important to you and is part of your values, not solely for the tax benefits.
Doing a projection will help you to understand if charitable giving will benefit you, and by how much. This again can allow you to accelerate “expenses” via charitable gifts by giving more in a year with high income (for a deduction on a higher tax rate) and less during low income years.
Expected Refund or Tax Due
Of course, the other side of a tax projection isn’t all about planning - but just curiously knowing what is coming. This helps you to either 1. plan what to do with the extra money you’ll receive or 2. come up with a plan on how to pay your tax due.
Knowing this number in advance gives you time to prepare and decide when to file your tax return. If you have tax due, you can probably take your time filing a return since there is no benefit to filing early. You can delay your payment until April to make sure you have the money available and do not need to go on a payment plan with the IRS, although that is always an option.
If you expect a big refund, typically this leads to wanting to get your return filed ASAP, so the IRS can begin the process of issuing that refund sooner rather than later.
Once you get that refund, it may be worthwhile to look back and understand how your savings goal went in the last year, and maybe use this extra money as some “catch-up” savings to help your future self. The cool thing is you can use some of this money to make late contributions for the prior year into your IRA, Roth IRA, SEP, SIMPLE, Solo 401(k) or HSA - depending on what is available to you. Just make sure this is all accurately reported on the correct tax return.
Expected Student Loan Payment
Hopefully you haven’t forgotten about your loans since they’ve been paused for almost two years… but those that have public student loans will have payments coming due again starting in February, 2022.
In regards to an income driven repayment plan, it is still murky what will happen when payments resume, but the likely scenario is that your payments will be the same as they were before the payment freeze, until you recertify your income. The income recertification is based on a recent tax return, so coming up with a projection will also help you to get an idea for how much you can expect to pay monthly on an income driven repayment plan.
This can help you to be strategic as well. If your payments will go up substantially based on your next filed tax return, it may make sense to try to delay filing that tax return until after you’ve recertified your income, so your income will be based on the last tax return that is presumably lower.
Being proactive with your taxes, as opposed to reactive, can save you thousands of dollars in taxes throughout your lifetime. Things are constantly changing - new presidents, different relief payments and stimulus measures, new and expanded tax credits, etc. But one thing that has shown to be constant is that these relief measures are income based. If there is some government support, history shows it will go to individuals with lower income first.
It is important to understand your income, and how you can have some control over it in these situations, so you can plan around how these changes affect you personally.
Beyond just planning around your tax bill, there are other situations that will change your taxes that would be helpful to understand. Just about every financial decision, and many non-financial decisions, will have an impact on your taxes. Some examples include; how will buying a house change my taxes? How will getting married and starting a family impact taxes? What if I choose to move closer to family, and a new state?
Knowing how to navigate these changes and how these decisions affect your wallet are an important consideration to the whole decision making process. They certainly should not be the only factor, but in my opinion should always be part of the conversation.