Yes, You Can Minimize Your Personal Taxes
Every year, people like you pay too much in taxes. In most cases, the reason is lack of knowledge. There are many opportunities to decrease your tax liability and minimize your personal taxes, but if you don’t know they exist, how can you use them to your advantage?
The place to start is by understanding which opportunities are available to you. Do your earnings come from an employer? Self-employment? Both? Is there something you love doing which could be turned into a side hustle, or even a full-time business? The choices you make affect the tax saving opportunities available to you.
Tax Saving Opportunities For Employees
As an employee, your employer might offer you the opportunity to contribute pre-tax dollars into a Flexible Spending Account (FSA), Health Savings Account (HSA), or 401(k) account. By doing so, you reduce the taxable income reported on your W-2, which translates into a lower Adjusted Gross Income (AGI). Your AGI is the starting point for calculating your taxes. The lower your AGI, the less taxes you must pay.
By contributing to an FSA, you get to use pre-tax dollars to pay certain medical and dental expenses not covered by your insurance. Expenses included are:
- Deductibles
- Co-pays
- Prescriptions
- Over-the-counter medications prescribed by your doctor
- Certain medical equipment
You get to contribute up to $2,850 per employer in 2022 but there’s a catch. You have to use at least $2,250 no later than 2 1/2 months after the end of the year, but you are allowed to carry up to $570 over into the next year.
If you have a high-deductible, Marketplace health plan, you might prefer to contribute to an HSA plan, if your employer offers you the option. Because these plans mean higher out-of-pocket expenses, you’re allowed to set aside more pre-tax dollars. For 2022, you can contribute up to $3,650 for individual, and $7,300 for families. You even get to contribute an extra $1,000 if you’re 55 or older.
Unlike an FSA, HSA’s have no provision requiring you to use the funds by a certain date, or risk losing part of your contributions. Instead, any funds remaining at the end of the year can be rolled over indefinitely. However, you can only choose this option if you have a high-deductible health plan.
Maximize Your Retirement, Minimize Your Taxes
Whether you’re an employee, business owner, or self-employed, maximizing contributions to your retirement account can not only lower your taxes in the current year, but help you provide for your own future. As an employee, the most common, elective option is a 401(k) plan.
Essentially, you contribute part of your salary to the plan. Like an FSA or HSA, the dollars are pre-tax, and the taxable income reported on your W-2 excludes your contributions. Though contributing to a 401(k) plan doesn’t protect you from paying taxes indefinitely, it can postpone your liability until after you’ve retired, and taxable income is lower.
Not only are you saving for your own future, but you can defer taxes on up to $20,500 for a 401(k) plan, or $14,000 for a SIMPLE 401(k) plan. If you are over 50, you’re also allowed to make catch-up contributions, and defer an additional $6,500 to a 401(k) plan, or $3,000 to a SIMPLE 401(k) plan, but only if your employer’s plan allows catch-up contributions. Be aware these limits might be adjusted by the terms of the plan.
It’s important to understand the rules concerning excess contributions, especially if you contribute to plans with more than one employer. HKMP can review your contributions in case you need to take a distribution by the April 15th deadline, This can potentially minimize your personal taxes and/or avoid being double taxed.
Retirement Plan Options for the Self-Employed
According to this recent article, there are several options for self-employed individuals. The most common are:
- Traditional IRA
- Solo 401(k), aka one-participant 401(k)
- SEP IRA
If you’re just starting your business, a Traditional IRA offers a couple of advantages;
- Simple to set up
- You can roll an employer’s 401(k) into it
- Can be set up easily with an online brokerage
However, if your self-employment income is growing quickly, you might want to choose another option since your contributions are limited to $6,000, or $7,000 if you’re 50 or older.
Tax Advantages for Higher Limit Plans
If your business is established, and enjoys higher earnings, a solo 401(k) might be a better option because it’s higher limits allow you defer more otherwise taxable income. You’re eligible if you’re self-employed, or a business owner with no employees other than a spouse. You can contribute to the plan:
- As an employee, up to $20,500, plus $6,000 catch-up contributions, if applicable, or 100% of your salary, whichever is less
- For an employer, up to 25% of compensation except:
- A sole proprietor or single owner LLC, up to 25% of net self-employment income
- Net self-employment income for purposes of this calculation is net profit less half your self-employment tax, and the plan contributions you made for yourself.
If you are also contributing to an employer’s 401(k) plan, be aware your contribution limits apply to all plans in which you participate. Make sure you review your contributions to all plans as you may be double-taxed on any excess contributions.
Keep it Simple With a SEP IRA
As a business owner, or self-employed individual with either no, or a few employees, you can choose a SEP IRA. Some advantages of a SEP IRA versus a solo 401(k) are:
- No IRS reporting requirements
- Allows you to make contributions for your employees
- You can deduct the lesser of your contributions or 25% of net self-employment earnings, or compensation subject to certain limitations discussed below
- Can be opened with an online broker like you would a traditional IRA
Possible disadvantages include:
- No catch up contributions
- You must contribute an equal percentage of salary for each eligible employee including yourself
Both a solo 401(k) and a SEP IRA are subject to the same compensation limits used to calculate your contribution. For 2022, the limit is $305,000.
Let HKMP help you make an informed decision, so you choose the plan which best fits your needs, both now, and as your business continues to grow. Allowing you to minimize your personal taxes and use that money elsewhere.