Wow! 2021 has been yet another wild and crazy year. Many people have seen their incomes jump in 2021, while others have been out of work and have seen their incomes plummet. Either way, year’s end is the time to do some proactive tax planning to help reduce your 2021 income taxes. Why pay more in taxes than is necessary?
When your income shrinks or grows, what qualifies as an allowable tax deduction may also change, along with the federal and state tax brackets this income falls into. Each year, proactive tax planning is imperative for high-income self-employed and small business owners.
Yes, there are a few ways to minimize your taxes after New Year’s Eve, but most of your tax-planning tools will be limited once we reach 2022.
What Are the Deadlines for Your 2021 Retirement Account Contributions?
When and how much you can contribute to your retirement will vary between types of plans and types of contributions. The good news for those using a Roth IRA, or traditional IRA, is these retirement accounts can be opened and funded all the way until April 15, 2022, for the tax year 2021. The bad news is you can only contribute $6,000 per year. (Those 50+ can also make a $1,000 catch-up contribution. That will likely not be enough to fund a secure retirement for anyone earning an average income or more. Rule of thumb, you should be contributing at least 10% of your income into retirement accounts, more if you are starting late or want to retire early.
Those with self-employment income (or income from a small business) should check out the SEP-IRA or Solo 401(k) plans. These valuable retirement accounts come with later contribution deadlines and higher contribution limits. The highest earners among the self-employed may also benefit by opening a Cash Balance Plan, which may allow you to defer taxes on hundreds of thousands of dollars of income per year. The larger your income, the more valuable tax deductions will be.
For SEP-IRAs, you may be able to contribute up to $58,000 for 2021. Even better, you have until October 15, 2022, to fully fund your SEP-IRA retirement account. That assumes you file your taxes on an extension. Also, SEP-IRA accounts can be opened just before you file your taxes.
Typically, I prefer to use a Solo 401(k) plan versus a SEP-IRA. It is just easier to make larger contributions, which translates to more tax savings. Individual K plans must be set up by December 31, 2021. The employee contribution should be made by year’s end, but you have until October 15, 2021, to fully fund the employer contributions to the plan. For 2021, you can contribute up to $58,000 into a Solo 401(k), but that figure jumps an additional $6,500 if you are 50 years old or older.
Cash Balance Pension Plan Contribution Deadlines: Need to be set up before year’s end. Contributions do not need to be made until you file your taxes.
Have You Had Enough Taxes Withheld from Your Paycheck?
There is nothing worse than a big surprise tax bill. Take a moment to see if you have had enough taxes withheld from your paycheck. If you are self-employed, check to make sure you have paid enough quarterly taxes throughout the year. Keep in mind, unemployment benefits are taxable, which will matter to the millions of Americans who found themselves out of work during the COVID-19 recession.
To help with this process, there is a tax withholding calculator available for free on the IRS site. This calculator is best for employees and retirees. The process is a bit more complex for the self-employed. If this is you, get help from your certified financial planner or tax preparer.
Will You Take the Standard Deduction or Itemize Your Tax Deductions In 2021?
Under the Tax Cuts and Jobs Act (TCJA), a vast majority of taxpayers will simply choose the standard deduction when filing their personal income taxes. Previously, around 30% of taxpayers filed a Schedule A to itemize tax deductions. However, under the Trump tax plan, that number has dropped to just 10% of filers.
Much of the drop in itemizing is due to the painful $10,000 State and Local Tax (SALT) Cap from the Trump tax plan. That costs people living in high-value real estate areas and/or high-tax states dearly. As a Los Angeles-based financial planner, I can tell you that it costs myself and many of my clients a ton in extra taxes. The $10,000 cap is the same, whether you are single or married—another example of the Marriage Penalty in the tax code. I am hopeful President Biden and Speaker Pelosi will eliminate the state and local cap. Until then, it may be easier for more singles to itemize their tax deductions.
For the 2021 tax year, the base standard deduction is $12,550 for single filers. The standard deduction doubles to $25,100 for married couples filing jointly.
Taking the standard deduction is one of the easiest ways to file your taxes. You will not need to save receipts to track your various tax deductions. All the same, it is worth the hassle to itemize your taxes if it saves you money!
Look at your investments in your non-retirement accounts. It may make sense to sell some winners or losers, depending on your overall tax situation for the year. You can realize up to $3,000 in short-term losses to offset up to $3,000 of regular income each year. Unused short-term losses can carry forward for future use. Tax harvesting may be tough as much of the stock market is up substantially in 2021.
Be Generous with Charitable Donations
While most people donate to charity to give back, a nice tax deduction can help you give more money if you so choose. With more and more people utilizing the standard deduction, fewer people are getting a tax deduction for their charitable giving. One prevalent strategy to get around this is bunching deductions. That essentially means donating several years’ worth of gifts in a single year, pushing you above the threshold, so you will benefit from itemizing your deductions.
If you are considering that strategy, you may want to look at using a donor-advised fund. You can make the contribution and get the tax deduction now but distribute funds to charities later. In the meantime, the money can be invested and potentially grow tax-free.
Increased 2022 Retirement Plan Contributions
Plan for your 2022 taxes at year’s end as well. If your business income was down, you might want to try and push some expenses into next year. On the flip side, if your income was up, you may want to pre-pay some bills to pull more tax deductions in 2021.
Also, looking forward, you may be able to make larger pre-tax contributions to retirement accounts in 2022. The maximum contribution to a 401(k) plan has increased to $20,500 for an employee. A total of $61,000 can be contributed when combining the employee and employer profit-sharing contributions in 2022, plus a potential $6,500 catch-up contribution for taxpayers 50 or older.
The maximum contribution to a Cash Balance Plan has also increased by $15,000 to $245,000 in 2022. Combine this with the maximum 401(k) contribution, and business owners can shelter more than $300,000 of income into pre-tax retirement accounts. In high-tax states like California, the tax savings could be more than 50%. In plain English, maximizing your contributions to a Solo 401(k) combined with a Cash Balance Pension Plan could save you more than $150,000 in taxes next year. This can be doubled for a high-income couple who work together in a business.
Review Your Qualified Business Interest Deductions In 2021
If you have a small business or self-employment income, you may be eligible for the Qualified Business Interest (QBI) deduction. This is also known as the 199A pass-through business deduction. The bottom line, it works out to a 20% deduction for the net income of many businesses that operate as pass-through entities. The QBI tax deduction is limited for those with a 2021 income of more than $164,900 (single) or $329,800 (married filing jointly).
For earners near those income thresholds, tax planning may become even more valuable. If this is you, you may be able to get your income low enough to qualify for a larger 199A tax deduction. Things like contributing to a Solo 401(k) or Cash Balance Plan are the obvious ways. Even at 2022 contribution levels, a Cash Balance Plan / 401(k) profit-sharing plan combination could potentially save a California business owner in the top tax brackets more than $1.5 million in taxes over the next decade.
It is not how much you make but how you keep it that matters. Doing a little year-end tax planning can also help make the tax-filing process just a little bit easier. Follow these seven-year-end tax-saving moves, and you should be able to avoid a big tax-time surprise. 2021 has been a terrible year in many ways, but it does not have to be a terrible year tax-wise. Make sure to do some proactive tax planning now to keep more of your hard-earned money in your proverbial pocket.