Legal ways to keep more of your money.
One of the trickiest things about investing in retirement accounts is that by the time you know how much you could’ve contributed for a tax break, it’s too late (e.g., you can only make 401(k) contributions through Dec. 31).
But there are a few accounts in the tax-advantaged investing world that allow contributions right up until the tax deadline, making them incredible options for last-minute savings.
After all, I prefer deductions that come from investing over deductions for spending: Why would I spend $100 to save $32 when I could invest (read: keep) $100 to save $32?
Reminder: I’m not a licensed tax professional. Please consult your CPA and do your own research before making big money moves.
Learn more about our sponsor, TaxAct: https://www.taxact.com/moneywithkatie
Transcripts can be found at podcast.moneywithkatie.com.
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Katie: If you're afraid that you may be facing a tax bill this April—and you'd be in good company—you may be eligible to try one or more of these easy ways to hang onto more of your money, and lower your tax bill in the process. Welcome back to The Money with Katie Show, Rich Girls and Boys. I'm your host, Katie Gatti Tassin, and a little disclaimer before we begin today. I'm not a licensed tax professional. This is not tax advice. Please consult your friendly neighborhood CPA and do your own research, but feel free to use this episode as an informational starting point about what options you may have to lower your tax liability for 2022.
Let's address the massive social services-sized elephant in the room before we jump into this. I believe paying your taxes is just part of being a good citizen. Your tax dollars ideally fund things like infrastructure and public schools and public transportation, and in every other high-income nation on earth, healthcare and childcare—shade…still beating the drum in the US—but I also believe that as long as the Internal Revenue Code is a zillion-page document full of jargon and loopholes exploited by the likes of Bezos and Gates and hedge fund managers the world over, it is fully within the rights of the metaphoric plebe to play the game in an informed way.
So a few years ago, I owed around $40,000 to the IRS. I feel like I'm living in the movie Groundhog Day right now; I'm having a similar situation this year. But back then, my business had taken off and I knew (checks notes) basically nothing about paying quarterly taxes. So when the final bill came due, Uncle Sam was all, “Hey, you remember me?” And in a desperate attempt to triage some of the bleeding, I used a few different methods for lowering my tax liability.
Depending on how you earn and your access to retirement accounts and certain healthcare plans, it's possible that all three, or frankly, none, of these options will be viable for you. But they all have one thing in common. They're all legal ways to hold onto more of your own money instead of forking it over. We won't be getting into the dicey territory of write-offs for business owners like, “Yeah, Joe, I swear the G-Wagon was for work.” Instead, we'll be focusing on three different—and not as widely known as they should be—pre-tax investment vehicles that allow contributions made this year, in 2023, to be characterized as though they were made last year, in 2022.
Of course, the obvious requirement is that you have to have the cash sitting around available to invest. If you're in a pinch because you owe the IRS money and you closely resemble the meme of Patrick holding out $3, this is not going to be viable. But if you've got cash or impending income, hey, at your disposal, this is for you. And finally, before we dive in, a major thing to note right off the bat when you are contributing to these tax vehicles, they're going to ask you which contribution year you are electing. And if you're trying to ease your 2022 tax burden for the bill you're gonna pay this April, be sure to select 2022, because if you choose 2023, it'll apply the contribution to next season's tax bill. We'll be right back after a message from the sponsors of today's episode.
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Katie: All right, up first, the most popular kid in school: the Traditional IRA. So if you and your spouse, if that applies, are not covered by employer-sponsored retirement plans at work (read, this is typically your trusty steed of a 401(k) or 403(b), in most cases), you can each contribute up to $6,000 to your very own traditional IRAs. We'll link a handy-dandy table from our boiz at the IRS with a breakdown of how contribution limits change for different scenarios, like if one spouse is covered by an employer-sponsored retirement plan. We also have a blog post this week about the topic, which we will link in the show notes. But that's up to $12,000 that you can wipe right off the top of your taxable income, if both partners contribute the full amount to their respective traditional IRAs. A minor note there: These are intended to be individual retirement accounts, so there's no such thing as a joint IRA. For example, if you and your spouse are in the 24% marginal tax bracket after your other deductions and you both contribute the maximum allowed, that's a joint tax savings of around $2,880, or $12,000 x 24%. This means if you owe the IRS, say, $1,500, this one move would wipe out that tax liability and probably generate a refund, too.
So when this won't work, to reiterate: This only works to the fullest extent if you are not covered by retirement plans at work. Unfortunately, we are not allowed to double-dip over a certain income threshold. Again, we're gonna link some scenarios in the show notes. This also won't work if you've already contributed the maximum $6,000 to your Roth IRA for 2022, though, if you've only contributed, say, $3,000, the other $3,000 would still be fair game.
And this highlights where tax planning can get a little bit tricky, because it's possible you'd rather use your allowable $6,000 per year IRA bucket to get Roth exposure instead of lessen your tax burden. So you may decide it's worthwhile to take the tax hit and contribute to Roth instead. Fortunately, if you are covered by a plan at work and you are not eligible to consider a Traditional IRA contribution that's tax-deductible, you can still contribute up to $6,000 to a Roth IRA, with some income limitations. We're gonna link a little video about how to get around those. It won't lower your tax bill, but it's still a good idea, because it creates more tax-sheltered investments that you can tap into in the future without paying taxes on the gains.
So you can open a Traditional or Roth IRA at pretty much all major brokerage firms. I prefer roboadvisors for ease of use (think Betterment, M1 Finance, et cetera). But if you choose to take the DIY route, remember to invest the cash you contribute. I know way too many smart people who opened an IRA, funded it, and then never invested the cash, so it just sat there for years, uninvested. It's a very easy mistake to make. Don't make it. We have an episode about indices to consider when you're building a diversified portfolio that we will also link in the show notes. Got all that? Okay, moving on.
Okay, the SEP IRA. Where are my side hustle honeys at? Or I suppose, my fully self-employed honeys? I don't know. If you have self-employment income, aka 1099 income at all, you are an eligible honey. The SEP IRA is a great tool for deferring income. I used this tool during Taxgate a few years ago to ratchet down my big bill, but a few things to note up front. Number one: If you have full-time employees, the rules are gonna be a little bit different. You have to contribute to their SEP IRAs too. So if that's your situation, you probably have a business CPA who can guide this choice. But if you're just a solopreneur or a side hustler, this is probably a fairly uncomplicated option for you. You can contribute to a SEP IRA even if you're also covered by, say, a 401(k) at work, since they are accounts associated with two different sources of income.
The TL;DR on the SEP IRA is that you can contribute up to 25% of your net business income, up to a whopping $61,000 per year—yeah—for 2022. A tax pro that I befriended taught me a cool trick that can help make this calculation a little bit easier, since you are allowed to deduct your self-employment taxes as well. And it can get a little bit complicated when you're trying to do the back-of-the-napkin math.
Sidebar: The 15.3% self-employment tax is composed of the 12.4% Social Security tax owed on up to $160,200 of your net earnings, and a 2.9% Medicare tax owed on the entirety of your earnings. So in order to figure out what you can contribute to your SEP IRA after accounting for your self-employment tax deduction, the tax pro told me that the easiest way to do this is to simply multiply your income after your write-offs number. So if you earned $15,000 and you're writing off $3,000 of expenses, it's $12,000. Multiply that number by 20% rather than 25%. So you'd multiply $12,000 by 20%. You can contribute around $2,400 to your SEP IRA. Again, that's gonna give you a nice round ballpark figure. It won't be precise, exactly. If you wanna get a really precise number, you can always go to a CPA, but that should give you kind of a general ballpark. And for some with a lot of side hustle or self-employment income, this deduction will be pretty significant.
Okay, when this won't work. This won't work if A), none of your income came from self-employment or side hustle-type 1099 sources; or B), you've already contributed the maximum to a Solo/Individual 401(k). For the uninitiated, a Solo 401(k) is just a 401(k) you can open for yourself and use as a self-employed person. For example, if I had a Solo 401(k) in 2022 and I already contributed 20% of my net business income to it as employer contributions, I can't then double dip and contribute 20% more to a SEP IRA too, because remember, I'm using 20% instead of 25% to account for the self-employment tax deduction, per my friend's weird trick. He is the head of tax at a major brokerage firm, so I'm inclined to trust him.
Now, if you didn't fully fund your Solo 401(k)—for example, maybe you only contributed 5%—you could finish funding the Solo 401(k) with employer contributions in 2023 for the 2022 tax year. That's totally fair game too—no SEP IRA required. The reason the SEP IRA is a more viable option for retroactive tax avoidance is that you can't open a Solo 401(k) in 2023 and fund it for 2022. The Solo 401(k) has to be opened by December 31, 2022 to be eligible for 2022 contributions.
So if you're listening to this in February '23 and you don't have one yet, that ship has sailed for 2022. Tiny violin problems, I know, but that's why the SEP IRA is so baller, because you could have started a business in 2022, made absolutely no moves to invest in pre-tax self-employment vehicles, and then decide on April 13, 2023 that you wanna open and fund one for 2022. You can generally open SEP IRAs at all major brokerage firms without much fuss. Roboadvisors typically offer them as well. But again, remember if you DIY it, invest the money that you contribute.
Another thing to note: You don't need an EIN number to open a SEP IRA. The EIN number is essentially, it's like your business or your side hustle's equivalent of a Social Security number. Though you will need one if you choose to open a Solo 401(k). So keep that in mind. The common way to get your EIN number is by establishing an LLC or otherwise incorporating your business. I established my LLC using a product called Stripe Atlas that incorporated my business in the state of Delaware, which is apparently ideal, though I'm not sure why.
Another watch-out: If you're currently someone who dabbles in the Backdoor Roth IRA strategy for earners over the Roth IRA income limit, you'll wanna weigh your priorities here before you open and contribute to a SEP IRA. Because a SEP IRA counts as a Traditional pre-tax IRA, which means it'll make executing a backdoor Roth IRA more complicated.
Sometimes people opt for Solo 401(k)s instead, for this reason. So weigh your desire to continue the Backdoor Roth IRA against your desire to lower your tax bill this year. And may the odds be ever in your favor. And if you're down for a complicated workaround, you can open both a SEP IRA and a Solo 401(k). Fund the SEP IRA for 2022, and then after you filed and tax season is over, just roll that shit over into your Solo 401(k), such that you have a $0 balance in the SEP IRA. Problem solved. We'll be right back after a message from the sponsors of today's episode.
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Katie: All right, the consolation prize for our late capitalist, privatized, for-profit healthcare hellscape is—you guessed it—it's an HSA. Crowd roars in glee. The HSA is essentially the manifestation of the IRS throwing us a bone and saying, “You know what, guys? If you get cancer in this country, you might go bankrupt. So here's a tax break.”
If you have a high deductible health plan as defined by the IRS, you may be eligible for an HSA plan. You may already have an HSA set up through your work, or you may need to open one yourself. And once you surpass a certain amount of cash in the account, typically somewhere in the $1,000 to $2,000 range, but it varies by plan, you're typically able to invest the funds inside it, something that you'll do within your HSA account portal. Word to the wise is, just go ahead and do it. The contributions and growth will be tax-free forever if you use the money for qualified medical expenses. So it's a great place to rack up hella capital gains. The contribution limits vary on HSA plans for the 2022 tax year. So if your health insurance plan just covers you solo, the limit is $3,650. And if your plan covers your whole family, it's $7,300. This is an amazing opportunity available to most people who have a high-deductible healthcare plan, regardless of how they earn or whether or not they're covered at work. So it makes it a pretty easy move. You will have to go to your HSA provider, their website, and make a direct contribution (as opposed to a payroll contribution) to contribute one big fat lump sum, which is technically suboptimal, because your direct contributions are not exempt from FICA tax the same way that the payroll contributions are. So for 2023, consider contributing through your payroll deductions as an elect for the money to be taken out of your paycheck, because then your contributions won't be subjected to FICA tax either, which is another 7.65% saved.
All right, so when this won't work. If you've already contributed the maximum to your HSA in 2022, unfortunately this retroactive move is not an option. This also won't work if you have a low-deductible plan. The HSA is one of the best tax vehicles out there, because it's effectively a second Traditional IRA that'll never be subjected to required minimum distributions. If you hang onto your HSA until you're 65, it'll basically convert to follow the same rules as a Traditional IRA, and you'll be able to make withdrawals for whatever you want, not just health expenses, without paying a penalty. You'll pay taxes on your withdrawals like you would with a Traditional IRA if you don't spend them on health-related expenses. But that's about it.
Someone who's not covered by a retirement plan at work, has side hustle income, and has a high-deductible health plan could theoretically use all three of these methods. So talk about a triple tax whammy (I hate myself) But it's worth restating: I'm not a licensed tax professional. Please consult your CPA, do your own research before making big money moves. But I hope this serves as a starting point for your pre-tax investing game this tax season if you have not made any of those big decisions yet.
And of course, shout-out to our presenting sponsor this quarter, TaxAct. I've been using TaxAct for years to file my convoluted tax returns and they are my favorite.
All right, y'all, that is all for this week. I will see you next week, same time, same place, on The Money with Katie Show. Our show is a production of Morning Brew and is produced by Henah Velez and me, Katie Gatti Tassin, with our audio engineering and sound design from Nick Torres. Our video editors are Christie Muldoon, Sebastian Vega, and Nicole Friedman. Devin Emery is our chief content officer, and additional fact checking comes from Kate Brandt.