It's almost April, and with April comes April 15th, the tax-filing deadline (outside of extensions). Getting past filing taxes is a worthwhile anticipation. For many though, they find out that their tax situation changed for the worst and then need to figure out what to do to fix it.
These are very common examples I have noticed for clients that could change, generally as their income grows or income is comprised of more tax-deferred sources for those who are retired.
Made too much money to fund a Roth IRA:
Roth IRA's which have an annual limit of $7,000 ($8,000 over 50) are great tools to build tax-free resources for retirement, yet the IRS imposes income limits on who can contribute. If you're single and have an AGI (Adjusted Gross Income) below $150,000 you can max out a Roth IRA, between $150-165k you can do a partial contribution. Married and filing jointly have a max below $236,000 and do partial between $236,000-$246k.
But you contributed and now it says you made too much?
This is where a "Recharacterization" works in your favor. You can take the contribution amount (plus any applicable growth) out of the Roth IRA and take it in cash, and pay tax on the earnings, or do a recharacterization to a traditional IRA. Make sure you work with a tax professional and also work to file a From 8606 for any "Non-Deductible Contributions" to track. You do have the ability to convert this back to a Roth IRA, but that can be saved for another time.
You could continue to do "Back-Door" Roth IRA contributions, by funding a traditional IRA and then doing a conversion (pay tax on any growth and your contribution is now tax-free). The Roth conversions need to be completed prior to December 31st each year, and also have two keys rules: Step Doctrine and the Pro-Rata treatment of other IRA's (Traditional, Rollover, SEP, etc.) that could affect taxation. If you have other IRA's it's important to talk to a financial advisor and tax professional prior to doing any Back-Door Roth contributions.
You now pay Net Investment Income Tax (NIIT):
Part of the Affordable Care Act imposed an extra tax on dividends, interest income and passive income (not earned income), known as the Net Investment Income Tax. This is a sneaky tax rate, that many don't realize they pay. Who pays it? If you're single with AGI over $200,000 or married-filing-jointly with income over $250,000 this tax is imposed on any capital gains, dividends, trust income or interest income.
What's the tax rate?
This is an additional 3.8% tax. While it may not seem like much, let's say you are at a 15% Federal capital gains tax-rate and 4% State income tax rate (like here in North Carolina). That means on any gains or qualified dividend income, you are now paying over 20% in taxes. Even savings and high-yield savings accounts that pay interest incur this tax, and that's your ordinary income rate (which may be higher than 15%) and state rates.
Adjusted Gross Income:
Adjusted Gross Income is very important to your ability and flexibility on financial items. It determines if you can fund Roth IRA's, certain deductions and tax credits, if student loan interest is deductible as well as Medicare and healthcare premiums. And many try to lower this amount. There are only a few ways to lower your AGI, such as: 401k/403b retirement plan contributions, SEP IRA contributions, business expenses for self-employed, student loan interest, alimony payments*, healthcare plan contributions (Flex Savings Accounts and Health Savings Accounts). One common misconception is that giving money away will lower your AGI. In fact, it will not, but it will lower your taxable income.
So if you noticed some changes to your taxes this year, it may be a great time to reach out to an advisor and assess your options to find the best solutions for you and your goals. Please do not hesitate to reach out if I can help.
*Student loan interest has income limits for deductibility, for single a MAGI under $95,000 and married filing-jointly under $195,000.
**Alimony payments following a divorce after 2019 are no longer tax-deductible.