Navigating the complex landscape of taxes as a self-employed professional can be overwhelming, but implementing effective tax strategies can help you shift from paying an excess of taxes to retaining more of your income. In this article, we’ll explore some key tax strategies that will help you keep more of your hard-earned money.
Choosing the Right Business Structure
Selecting the appropriate business structure is foundational to optimizing your tax situation. Sole proprietorship, partnership, limited liability company (LLC), S corporation, and C corporation each have distinct tax implications.
For many self-employed professionals, an LLC offers a balance of liability protection and tax flexibility. It combines a corporation’s limited liability aspects with a sole proprietorship’s simplicity, allowing for pass-through taxation while safeguarding personal assets.
On the other hand, an S-Corp can be advantageous for self-employed individuals aiming to minimize self-employment taxes. By structuring income into a reasonable salary and distributions, S-Corp owners can potentially save on taxes. Furthermore, the flexibility in offering fringe benefits, which can include health and life insurance, retirement plan contributions, and other perks makes an S-Corp structure a strategic choice for tax optimization and fostering business growth.
Itemized Deductions vs Standard Deductions
Understanding the differences between itemized deductions and standard deductions is crucial for self-employed professionals. While the standard deduction provides a fixed reduction in taxable income, itemized deductions can potentially yield greater tax savings if you have significant qualifying expenses. Common deductible items include business-related travel, home office expenses, and professional development costs. Carefully tracking and documenting these expenses can contribute to substantial savings during tax season.
Maximizing Retirement Accounts
Taking advantage of various retirement accounts can reduce taxable income and secure a financial future. Contributions to Individual Retirement Accounts (IRA) and Simplified Employee Pension (SEP) IRAs are tax-deductible, providing an immediate benefit. Solo 401(k) plans, designed for self-employed individuals, allow for higher contribution limits, enabling professionals to save more for retirement while minimizing their tax liability.
Understanding Constructive Receipt
The tax concept of constructive receipt states that income is taxable when it’s made available to you, even if you haven’t physically received it. Self-employed professionals can optimize tax planning by strategically timing invoices and income recognition. For instance, deferring income to a later tax year can help minimize current tax liability. Keep in mind that effectively leveraging this flexibility requires maintaining precise records and compliance with tax regulations.
Investing in Real Estate and Rentals
Incorporating real estate rental properties into an overall tax strategy offers diverse opportunities for tax benefits and savings. Property owners can capitalize on depreciation deductions, enabling them to deduct a portion of the property’s cost annually. This deduction can substantially lower taxable income, effectively reducing the overall tax liability.
Health Insurance Plans and Premiums
Health insurance premiums for self-employed professionals are generally deductible, reducing taxable income. Alternatively, S-Corp owners can generate significant tax savings by establishing a group health insurance plan, allowing the S-Corp to cover premiums through payroll. The utilization of Flexible Spending Accounts (FSAs) and Health Savings Accounts (HSAs) provides additional avenues for entrepreneurs to reduce taxable income, offering tax-free contributions, growth, and withdrawals for qualified medical expenses.
In response to soaring inflation, the IRS has released higher tax brackets and standard deductions for tax year 2023 and subsequent returns filed in 2024. This means that more taxpayers’ earnings will remain in lower tax brackets, which should reduce their income taxes.
Higher Tax Brackets for 2023
Tax brackets are the income ranges used to determine how much American’s owe in federal income tax. The IRS adjusts these brackets to reflect the impact of inflation on workers’ earnings with the aim of preventing inflation from pushing individuals into a higher tax bracket and potentially subjecting them to higher tax rates. The IRS is essentially trying to alleviate some of the financial strain caused by inflation.
Here Are the Newly Released Tax Brackets for Year 2023
The change in tax brackets means more taxpayers’ earnings will stay in lower tax brackets next year, which should reduce their income taxes.
Married filing jointly:
10% – $0 to $22,000
12% – $22,001 to $89,450
22% – $89,451 to $190,750
24% – $190,751 to $364,200
32% – $364,201 to $462,500
35% – $462,501 to $693,750
37% – Over $693,750
Single filers:
10% – $0 to $11,000
12% – $11,001 to $44,725
22% – $44,726 to $95,375
24% – $95,376 to $182,100
32% – $182,101 to $231,250
35% – $231,251 to 578,125
37% – Over $578,125
Standard Deductions
In an effort to acknowledge the recent rise of living costs and provide taxpayers with a bit of financial relief, the IRS has also increased the standard deductions for 2023. The standard deduction is a fixed amount that taxpayers can subtract from their taxable income tax.
The standard deduction is increasing for tax year 2023 to $27,700 for married couples filing jointly (up from $25,900 in 2022). Single filers can claim $13,850 (up from $12,950 in 2022).
Additional Deductions
Among the other deductions that will increase in 2024 are the foreign earned income exclusion, which rises from $120,000 to $126,500. This is a tax benefit that allows eligible U.S. citizens working abroad to exclude a certain amount of their foreign earned income from their U.S. federal income tax in order to prevent double taxation. Additionally, the annual exclusion for gifts will increase from $17,000 to $18,000.
Benefits to Taxpayers
These adjustments help to ensure that workers’ wages, which may have risen to keep up with inflation, are not eroded by higher tax rates. This means that individuals will not be penalized for earning more money to combat rising living costs. In fact, the changes can help stimulate the economy by putting more money in the hands of consumers.
Furthermore, the increased standard deductions provide financial relief by lowering the overall tax burden on taxpayers. This extra money can be used to offset the rising costs of everyday expenses, such as housing, transportation, and groceries.
Americans are no strangers to seeking out ways to legally minimize their tax burdens. Fortunately, there are several financial tools available that can help taxpayers slash their tax liability. In this article, we explore how these tools help you optimize your tax planning and maximize tax savings.
Pre-Tax Contributions to Retirement Plans
One of the most effective ways to reduce taxable income while securing your financial future at the same time is through pre-tax contributions to retirement plans. Traditional Individual Retirement Accounts (IRAs) and employer-sponsored 401(k)s allow taxpayers to contribute a portion of their income before it’s adjusted for taxes. Subsequently, your taxable income decreases, which lowers your immediate tax liability. Furthermore, you can defer taxes on these contributions until you withdraw the funds during retirement, allowing your investments to grow tax-deferred over the years.
Roth IRAs for Tax-Free Growth
Roth IRA contributions are made with after-tax dollars, meaning they do not reduce your taxable income in the year they are made. However, the growth and withdrawals from a Roth IRA are generally tax-free during retirement. This is different from a traditional IRA, which offers upfront tax benefits. Choosing between the two depends on individual circumstances and your current and projected future tax brackets.
Health Savings Accounts (HSAs)
HSAs are a tax-advantaged savings option for individuals with high-deductible health insurance plans. Contributions to HSAs are tax-deductible, and qualified medical expenses can be withdrawn tax-free. They also have no “use-it-or-lose-it” rule, meaning the funds can roll over from year to year. This makes an HSA an excellent long-term savings and tax-reduction tool. Additionally, after age 65, if the funds are used for non-medical expenses, they can be treated similarly to a traditional IRA, subject to regular income tax but without any penalty.
Tax Credits
Tax credits provide a dollar-for-dollar minimization in tax liability, making them a highly valuable tool for taxpayers. Some common tax credits include the Earned Income Tax Credit (EITC), Child Tax Credit, and education-related credits like the Lifetime Learning Credit and the American Opportunity Credit. Qualification and the amount of tax credits differ based on aspects such as income, family size, and educational expenses. Taking advantage of these credits can substantially shrink your tax bill or even result in a refund.
Charitable Contributions
Contributions to eligible charities can be itemized deductions, reducing taxable income. In order to claim the deduction, make sure the charity qualifies under the IRS guidelines, and keep detailed records of your donations. You can also donate appreciated assets, such as stocks or real estate to avoid capital gains and reap additional tax advantages.
Flexible Spending Accounts
Through an employer-sponsored FSA, employees can set aside pre-tax dollars for qualified medical expenses and dependent care expenses. This reduces taxable income and therefor reduces tax liability. Note that it’s important to plan FSA contributions thoughtfully. Unlike an HSA account, any unused funds remaining in an FSA by the end of the year may be forfeited.
The IRS makes tax adjustments every year but because of high inflation, the adjustments for the 2023 tax year are more significant, including changes to standard deduction amounts and tax brackets. Read on for an understanding of the most significant changes in order to plan your finances through 2023.
Standard Deduction
The standard tax deduction, which is based on filing status, is a fixed amount that the IRS allows taxpayers to deduct from their taxable income, thus reducing their tax liability. It is adjusted each year for inflation. Most taxpayers already take the standard deduction rather than itemizing their deductions, and with the inflation adjustments for 2023, even more taxpayers may move into claiming the standard deduction.
For single taxpayers and married couples filing separately, the standard deduction increased from $12,950 in 2022 to $13,850 in 2023. For married taxpayers filing jointly, the standard deduction increased from $25,900 in 2022 to $27,700 in 2023. For those filing head of household, the standard deduction increased from $19,400 in 2022 to $20,800 in 2023.
Additionally, taxpayers who are blind or at least age 65 can claim a further standard deduction of $1,500 per person (an increase of $1,400 from tax year 2022) or $1,850 if they are unmarried and not a surviving spouse.
Tax Bracket Thresholds
Because of inflation, the federal income tax brackets for both ordinary income and capital gains increased by roughly 7% for tax year 2023. For example, the top tax rate of 37% applies to individual single taxpayers with incomes greater than $578,125 ($693,750 for married couples filing jointly, which is up from $647,850 in 2022), and the lowest tax rate of 10% applies to individual single payers with incomes of $11,000 or less ($22,000 for married couples filing jointly, which is up from 20,550 in 2022).
Retirement Plan Contribution Limits
The IRS has also increased contribution limits for several retirement plans in 2023. For 401(k), 403(b), and most 457 plans, the contribution limit will increase to $20,500 in 2023 (up from $19,500 in 2022). For catch-up contributions for taxpayers age 50 and older, the limit will increase from $6,500 in 2022 to $7,500 in 2023. Traditional and Roth IRA accounts will also see an increase in contribution limits from $6,000 in 2022 to $7,000 in 2023 (the catch-up contribution limits for taxpayers age 50 and older will not change).
Gift Tax Exclusion
In 2023, the annual exclusion for gifts increases by $1,000, from $16,000 in 2022 to $17,000 in 2023. This means that taxpayers can now give up to $17,000 to each recipient without having to pay gift tax.
Earned Income Tax Credit
The maximum EITC amount for qualifying taxpayers who have three or more qualifying children was $6,935 for tax year 2022. In 2023, this amount increases to $7,430 for qualifying taxpayers.
Alternative Minimum Tax
This tax for high-income earners is imposed on taxpayers who make a certain income. In addition to their income tax, the AMT ensures that they pay their fair share in taxes even when taking many deductions. The AMT exemption amount increases from $75,900 for tax year 2022 to $81,300 for tax year 2023. The AMT for joint filers is $126,500.
Health Flexible Savings Account
For tax year 2023, the dollar limitation for employee salary reductions for contributions to health flexible spending arrangements increases to $3,050. For cafeteria plans that approve of the carryover of unused amounts, the maximum carryover amount will be $610.
A key approach to minimizing taxes, especially as you near retirement, is to implement tax planning strategies that can help you save money and maximize your retirement savings. Here are some tax-efficient strategies to consider.
Contribute to Tax Advantage Retirement Accounts
When you contribute to a retirement account such as a 401(k), IRA, and Roth IRA, you can lower your taxable income in the year you make the contribution. With a traditional 401(k), you defer income taxes on contributions and earnings, which means you won’t pay taxes on them until you withdraw the funds in retirement. With a Roth IRA, your contributions are made after taxes and your earnings may be withdrawn tax-free in retirement.
Utilize Catch-Up Contributions
Workers over the age of 50 are eligible for an additional tax break when they make catch-up contributions to retirement accounts. In 2023 individuals can contribute an additional $1,000 to an IRA (up to $7,500 in total). For 401(k) plans, individuals can contribute an additional $7,500 for a total tax-deductible contribution of as much as $30,000. Catch-up contributions help to save more for retirement and reduce taxable income.
Consider a Health Savings Account
A Health Savings Account (HSA) is a tax-advantaged savings account that can be used to pay for qualified medical expenses. If you have a high-deductible health plan, you may be able to contribute to an HSA. The contributions are tax-deductible, the earnings grow tax-free, and you can withdraw the funds tax-free in retirement to pay for qualified medical expenses.
Make Use of the Saver’s Credit
In order to be eligible for the saver’s credit in 2023, you must contribute to a 401(k) or IRA and earn up to $36,500 for individuals, $54,7500 for heads of household, and $73,000 for married couples. You can claim the saver’s credit on retirement account contributions of up to $2,000 ($4,000 for couples). Depending on your income, it is worth between 10% and 50% of the amount contributed (bigger credits go to lower-income savers). The saver’s credit may be claimed in addition to the tax deduction for traditional retirement account contribution.
Refrain from Triggering the Early Withdrawal Penalty
You could be subject to a 10% tax penalty if you make IRA withdrawals before age 59 ½ and 401(k) withdrawals before age 55. The penalty may be avoided for certain specific purchases such as:
Up to $10,000 for a first home purchase
College costs
Extensive health care costs
Health insurance following a layoff from your job
If a Roth IRA is at least five years old, you may be able to withdraw funds that you contributed, but not the earnings, without prompting the early withdrawal penalty.
Don’t Sleep on Required Minimum Distributions
After age 73, savers are generally required to take required minimum distributions (RMDs) from IRAs and 401(k)s, and income tax will be owed on each distribution. Should you withdraw the incorrect amount, you could be subject to a 25% penalty of the amount that should have been withdrawn. This is in addition to the income tax due. However, if you act quickly to amend the error, that penalty could drop to 10%. Your first RMD is due by April 1 of the year after you turn 73. All following distributions must be taken by Dec. 31 each year in order to avoid the penalty.
Put Off 401(k) Withdrawals if You’re Still Employed
If you are still employed in your 70s and beyond, you may be able to delay withdrawals from your 401(k) account until your retirement (provided you don’t own more than 5% of the company sponsoring the retirement plan). Just be aware that after age 75, you will still be required to take RMDs from IRAs and 401(k)s associated with previous jobs in order to avoid the 25% tax penalty.
Plan Your Withdrawals
When you start withdrawing funds from your retirement accounts, plan in a way that minimizes taxes. For instance, you can withdraw funds from taxable accounts first to avoid triggering taxes on Social Security benefits. During your 60s, you can take penalty-free withdrawals from your retirement accounts without being required to take distributions each year. You can also take advantage of tax-efficient withdrawal strategies, such as the bucket approach, which involves dividing your assets into different buckets based on when you plan to use them.
Filing taxes puts stress on small business owners, because most know that mistakes on business tax returns can affect your business’s success. Here are some common tax mistakes to avoid.
Mixing Business and Personal Expenses
Be sure not to report personal expenses on your small business’s tax return. It’s always a good idea to have separate credit cards, bank accounts, and filing folders for each. Sometimes an expense isn’t as cut-and-dry and you may have difficulty determining if it is indeed business or personal. In this case, turn to the IRS’s Publication 535 at www.irs.gov, which provides an overview of expenses that are and are not deductible.
Being Disorganized with Recordkeeping
This may seem like second nature to some business owners, but staying on top of tax documents, receipts, and copies of bank and credit card statements will go a long way toward avoiding overwhelm at tax time. While you don’t need to submit receipts or other proof of tax deductions to the IRS, you will need them on hand if the IRS decides to probe into your taxes further. If you get audited and you don’t have required documentation on hand to prove any claimed deductions, your tax bill could increase significantly.
Filing the Wrong Tax Forms
There are different types of tax forms required for different types of businesses (C corporations, S corporations, etc.), and if you have employees, you’ll need to fill out additional forms that document their payment through the year. Simply put, it can be a lot to track. A tax advisor can help you determine which forms you should be filling out.
Taking Too Many Deductions
Simply stated, taking deductions means that you get money back for certain purchases that assisted your business. Just keep in mind that too many deductions could raise a red flag for the IRS. If you’re unsure, a tax advisor can ensure that you’re adhering to deduction limitations and only claiming expenses that qualify.
Forgetting or Underestimating Your Tax Payments
Many small business owners are required to make quarterly estimated tax payments. Typically, the deadlines for these payments are the 15h of April, June, September, and January of the following year. How much you owe is based on your income. If you miss a payment, or if your payment falls short of your actual tax liability for the year, the government could saddle you with penalties, thereby increasing your tax liability. Furthermore, if the IRS suspects an intention to defraud it, the fine can be as high as 75%, and you could face criminal tax fraud charges.