As the year reaches its halfway point, it’s a good time to take proactive steps to optimize your tax situation. Planning ahead for your taxes can help you save money and reduce stress at tax filing time. Here are some midyear tax tips to consider.
If you are a W-2 employee:
– Review your income tax withholding to make sure you are having the Goldilocks amount of tax withheld from your pay…not too small, not too big, just the right amount! The IRS has an online calculator to help you calculate how much tax you should have withheld and how to fill out your W-4 https://www.irs.gov/individuals/tax-withholding-estimator
–Review your other payroll withholdings – including retirement contributions, Health Savings Account (HSA) contributions, medical Flexible Spending Arrangement (FSA) and dependent care benefit FSA withholdings. With some types of withholdings, such as retirement contribution withholding, you are able to change the amount being withheld at any time during the year. Other types, such as FSA withholdings can only be changed during the year if you have a qualifying life event. For your FSA withholdings, you will want to have a plan for how you are going to use up the amount you are setting aside from your pay as you typically have to use it up within an allotted time frame.
If you have dependent children:
–Keep track of your childcare receipts, including summer camps, and before and after school care, which may qualify you for the federal dependent care tax credit. This credit is a 20% credit on up to $3,000 of childcare expenses for 1 child (maximum $600 credit), and on up to $6,000 of childcare expenses for 2 or more children (maximum $1,200 credit). Some states also offer a state-level dependent care tax credit.
–If you or a dependent are incurring secondary education expenses, keep track of all of your expense payments so you can be sure to take advantage of any tax incentives you are due when you file your tax return. Depending on your income level, you may qualify for the federal American Opportunity Tax Credit or the federal Lifetime Learning Tax Credit. If you are using amounts from a 529 College Savings plan to pay your expenses, you will want to keep a record of your expenses paid to support that any distributions from the 529 plan were used for qualified expenses and therefore should be tax-free.
If are retired:
–Consider whether you need to adjust your tax withholding or make any quarterly estimated tax payments for the year. For some types of retirement income, such as Social Security benefits, there will not be any tax withheld unless you specifically request there to be. Other types of income, such as payouts from a brokerage account, do not have the option for tax to be withheld at all. You may want to do a tax projection to determine whether you should increase any tax being withheld or make quarterly estimated tax payments so you don’t have surprises at tax filing time.
–If you are over age 70 1/2, have a traditional IRA, and are charitably inclined, you could consider whether you want to make a qualified charitable distribution (QCD) from your IRA. A QCD allows you to transfer money directly from your IRA to the charities of your choice, with no tax consequences to you. If you have reached required minimum distribution age and don’t need all of your IRA distribution, this can be a great way to shelter some of the distribution from tax.
–Consider the effect of your income level on your Medicare premium costs. If your income for the year will be unusually high due to a one time transaction, such as the sale of real estate or other investments, or a large pension payout, be aware that this may increase your Medicare premium amount due to the IRMAA adjustment (Income-Related Monthly Adjustment Amount). Medicare premiums are based on your modified adjusted gross income level. As you reach higher levels of income, the premium cost goes up. Here is a link to a page that lists the MAGI levels and premium costs for 2023. Potentially being hit with the IRMAA adjustment can provide additional incentive to try to find additional tax deductions and ways to reduce your income in years when you have large income events.
If you have medical expenses:
–If you purchase your health insurance through a state health insurance marketplace and are receiving advance premium tax credits to offset your health insurance cost, consider whether your income for the year is on track with what you estimated for your income when you originally applied for health insurance for the year. If your income is trending higher, be aware that you may end up paying some or all of your advance premium tax credit back when you pay your taxes. If this applies to you, you may have more incentive to try to lower your income for the year as it will 1) lower your tax liability and 2) lower the premium tax credit you need to pay back.
–A question I often get from clients is whether they should be tracking their medical expenses. On your federal tax return, you typically only get a benefit for a medical expense deduction if you meet the following criteria:
- You itemize your deductions for the year and
- Your total out of pocket medical expenses for the year exceed 7.5% of your adjusted gross income.
Example A: Tom and Raquel file married filing jointly and have enough mortgage interest and state tax expense that it is beneficial for them to itemize their deductions. Their adjusted gross income for the year is $150,000. 7.5% of their AGI is $11,250 ($150,000 x 7.5%) They paid medical expenses out of pocket of $10,000. They would not get any deduction for their medical expenses because their medical expenses of $10,000 are less than 7.5% of their AGI, $11,250.
Example B: The facts are the same except their medical expenses total $17,000. They would get to deduct medical expenses $5,750 of their medical expenses ($17,000 – $11,250).
In my experience, most people are not able to deduct their medical expenses because they do not get over the thresholds listed above. However, if you know the year will be a high expense year for you, start tracking your expenses now as it is much easier to track as you incur expenses then after the fact.
-Health Savings Account contributions – if you’ve switched health insurance during the year, make sure your HSA contributions for the year are still appropriate. If you or your spouse are no longer covered by a high deductible HSA eligible health plan and you’ve been contributing to an HSA, you may need to recalculate how much you are able to contribute to your HSA. IRS Publication 969 Health Savings Accounts provides details on how to calculate your maximum allowed HSA contribution for the year.
If you are a business owner:
–Make sure you are tracking all business expenses, including mileage, meals, and home office use. Keep track of expenses now will make your life much easier at tax time.
–If you believe your business will be in a loss position for the year, be sure you are keeping the appropriate records to support that you are treating the activity as a business and not a personal hobby. If the IRS examines your tax return and determines your activity is a hobby, your deductions and losses related to that activity would be limited. Claiming business losses for several years can invite additional scrutiny from the IRS. The IRS provides a list of some criteria to consider when determining whether it is appropriate to report an activity as a business or a hobby https://www.irs.gov/newsroom/people-should-know-if-their-pastime-is-a-hobby-or-a-business
–Now is a great time to implement a retirement plan for your business if you haven’t already. Depending on how much you want to save and whether you have employees, options available could be a SEP IRA, Simple IRA, or a solo 401(k). If your business is very profitable, it could also make sense to consider a cash balance plan, which is a type of retirement plan that can allow you to set aside large amounts of money.
-Consider whether hiring a family member could reap tax benefits. Hiring your child under the age of 18 can be a great tax strategy if your business files taxes as a sole proprietorship/single member LLC reporting on your personal income tax return, as you do not have to pay Social Security, Medicare, or federal unemployment tax on their wages. Depending on how much you pay them, they may also be able to avoid income tax on the wages. There are also scenarios where hiring your spouse can be beneficial.
–Be sure you are setting enough money aside for taxes. Oftentimes, a business owner’s quarterly estimated tax payments are based on their prior year tax liability. You can typically pay in 100% of your prior year tax (110% if the taxable income on your personal tax return is over $150,000) and not be subject to any underpayment of estimated tax penalty. This is great because it is a known amount. However, if business is currently booming, making quarterly payments based on the prior year tax will keep you from being penalized, but you will still need to have money aside to pay your tax bill when you file your annual income tax return.
Example: Arianna’s sandwich shop was not profitable in 2022. She had a small amount of other income for the year, putting her federal tax liability at $1,000. She expects business to take off in 2023; she is projecting that her taxable income will be $216,000 and her federal tax will be $20,000. She calculates her 2023 quarterly estimated tax payments as $1,000 (prior year tax) x 110% or $1,100 for the year. She makes a payment of $275 ($1,100 divided by 4) each quarter in 2023. When she files her 2023 tax return, her taxes turned out as she expected; she owes $18,900 with her tax filing; this is her tax amount of $20,000 minus the $1,100 she paid in via estimated payments. Even though she has a balance due with the return, she does not have to pay any underpayment of estimated tax penalty because she paid in the IRS safe harbor amount via quarterly estimated tax payments.
If you own rental properties:
–Track the hours you spend on your real estate activities. Keeping a log of your time spent on real estate activities may give you more flexibility at tax time to claim certain real estate related tax benefits. You may be able to claim a deduction called the qualified business income deduction on your net rental income. The IRS has provided a safe harbor test for this deduction that is based on the number of house you spend on real estate. Being able to substantiate your hours is also critically important if you want to claim the real estate professional election for your real estate activities.
-If you are making repairs or improvements to your property during the year, consider what tax benefit you will receive from the repair or improvement. Depending on what you are doing to your property and the type of property you own, you may be able to deduct the amount paid fully in the year paid, capitalize as an improvement but take accelerated depreciation, or you may need to capitalize and take depreciation expense over the life of the property. These treatments can have vastly different tax effects.
-If you are renting to family members, be aware of the personal use rules. You must rent at fair market value and the property must be used as the family member’s main home for it to qualify as an arms length rental in the IRS. Failure to meet these criteria may result in some or all of the property’s expenses being disallowed for deduction on your tax return (but you still have to report the rental income as taxable income…it’s a raw deal!) Note that in some circumstances the IRS may accept a slightly discounted rental rate to family in exchange for them doing work on the property, the expectation that they will take better care of the property then an unrelated third party, etc.
Other midyear tax planning considerations:
–If you are selling property -review the taxable gain or loss from the sale and impact on your tax position for the year. Do not make the mistake of waiting until it is tax time to understand the tax implications of a property sale.
–Gifting – if you want to make gifts to family and friends, the 2023 annual gift exemption amount is $17,000. This means you can gift up to $17,000 during 2023 to an individual without any tax reporting obligations. If you gift over $17,000 to any one individual, you will need to file a Form 709 Gift Tax Return. Even if you meet the threshold to file a gift tax return, you will not owe gift tax until you use up what is called your lifetime exemption, which is currently $12,920,000 per person. This means you would not owe gift tax until you have gifted over $12,920,000 during your lifetime. If this applies to you, then let’s be friends!! Remember that making payments directly to an educational institution or medical facility on behalf of another do not count towards your annual gift exemption amount.
-If you file taxes in a state that imposes an income tax, consider whether your state offers special income tax incentives. Each state offers it’s own variety of tax deductions and credits. Common benefits include exclusion from state income tax of some or all retirement income, additional deductions or credits for contributing to specific charitable organizations or state charitable funds, as well as additional credits and deductions for older people, children, and those in lower income tax brackets.
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