In the next three months, I’m going to get an email or call about a surprise tax bill. That person will be completely surprised that they have to come up with a lot of cash to pay an unexpected tax bill. Sometimes that’s because of a combination of unusual or one-time items. With the passing of the Tax Cuts and Jobs Act of 2017, we got a lot of these calls last year.
Here are three things you can do now to make sure you avoid a surprise tax bill.
1. Figure out what changed in 2020
Most tax preparers and tax software provide a Two-Year Tax Comparison page at the beginning of your tax return. Go dig it out. Think about each item. Did something change between this year and the prior year? Did you cash in shares of appreciated stock? Change jobs? Receive severance and a signing bonus? Receive a larger than normal bonus from work? Get married, divorced, have children? All of these items can affect the amount of tax due.
Once you’ve determined the difference, estimate how much it will increase or decrease your taxable income. Then multiply that number by your marginal income tax rate (usually listed at the end of the Two-Year Comparison). For example, if your taxable income from your last tax return was $180,000 and you estimate that your income went up by $10,000, your tax bill may increase by about $2,400 ($10,000 x 24% marginal tax bracket).
While there isn’t much you can do about this higher amount now that the tax year is over, you can get set aside cash now to be ready for that larger tax bill payment when you file your taxes.
2. Fund an IRA
Once the tax year is over, your options are limited. However, anyone with earned income can still fund an IRA. For 2020, the contribution limit is up to $6,000 or $7,000 if you turned age 50 anytime in 2020 or are older.
If you are single and not covered by a retirement plan, your contribution is fully deductible. If you are married filing jointly and your income is less than $196,000 (joint filer), your contribution is fully deductible.
If you are covered by a retirement plan at work and your income is less than $65,000 (single filer) or $104,000 (joint filer), your contribution is fully deductible. Above these amounts, contributions are not deductible.
If you were self-employed last year, another option is to fund a SEP-IRA. A SEP is easy to set up, can be opened and funded up until you file your tax return, and has higher income limits. Contributions are limited to the lessor of 25% of the employee’s compensation or $57,000 (2020).
3. Update your payroll withholding now
For workers, this is the perfect time of year to adjust your payroll withholding. The new calendar year has barely started and you can affect the amount of tax withholding for nearly the full tax year. To make the adjustment, complete IRS Form W-4: https://www.irs.gov/pub/irs-pdf/fw4.pdf.
Use the worksheets attached to the form to figure out the right number of exemptions to claim (different than claiming exemptions on your tax return), sign and submit it to your employer. The Commonwealth of Massachusetts Form M-4 is located here: https://www.mass.gov/lists/dor-withholding-tax-forms.
If you are self-employed or do not receive a paycheck, this is a good time of year to evaluate and adjust your quarterly estimated tax payments.
These tax tips should help you get the new year off to a great start.
As always, please consult a tax professional for specific advice concerning your particular tax situation.
Have more tax planning questions? Give us a call. We’re here to help.
Lyman H. Jackson
Financial Planning Solutions, LLC (FPS) is a Registered Investment Advisor. FPS provides this blog for informational and educational purposes only. Nothing in this blog should be considered investment, tax, or legal advice. FPS only renders personalized advice to each client after entering into an advisory relationship. Information herein includes opinions and forward-looking statements that may not come to pass. Information is derived from sources believed to be reliable. Information is at a point in time and subject to change without notice. Such information may not be independently verified by FPS. Please see important disclosures link at the bottom of this page.
 Source: https://www.irs.gov/retirement-plans/ira-deduction-limits as of 12/28/2020.
 Please note that there are special requirements to fund and deduct IRA contributions. See irs.gov for more info.