In 2022, as the world emerged from the COVID-19 pandemic, new economic uncertainties and challenges — spurred by soaring inflation rates, global conflicts and political discord — began to take shape.
Here is a summary of the most impactful tax planning opportunities to consider before year-end.
Review investments held outside of tax-deferred vehicles (like an individual retirement account (IRA) or 401(k)) to determine if there are opportunities to minimize taxes. For example, if you have already realized significant capital gains before year-end, consider harvesting losses from investments that have decreased in value. Any realized losses can help offset the capital gains and reduce your tax burden.
From a tax standpoint, you should generally hold investments that have increased in value for more than one year before selling so you can take advantage of preferential capital gains rates. For 2022, the long-term capital gain and qualified dividend rates remain unchanged at 0%, 15% and 20%, based on statutory income brackets and adjusted for inflation.
- Pay attention to the holding periods of appreciated investments. Investments held for fewer than 12 months generate short-term capital gains, which are taxed at higher ordinary income rates.
- Consider gifting appreciated investments to relatives in a lower income tax bracket (such as children or grandchildren), who may pay substantially less or no tax on the long-term capital gains when the shares are later sold.
- Avoid buying back any stock harvested for losses within 30 days before or after the sale. Under wash sale rules, this type of loss is disallowed and becomes part of the basis of the newly acquired stock, which defeats the purpose of harvesting the stock loss.
RETIREMENT PLAN CONTRIBUTIONS
The contributions and earnings of a traditional employer-sponsored retirement plan are generally not subject to tax until you begin receiving distributions from the retirement plan. The maximum contribution to a 401(k) plan is $20,500 in 2022 (up from $19,500 in 2021). Employees aged 50 or older can make an additional catch-up contribution of up to $6,500 (unchanged from 2021).
In addition, you should consider contributing up to $6,000 to an IRA. Whether this contribution is deductible depends on your income level and whether you or your spouse already actively participate in an employer-sponsored retirement plan. Alternatively, you could contribute to a Roth IRA. Contributions to a Roth IRA are not tax-deductible, but you will not be taxed on their withdrawal. You may also withdraw earnings in the account tax-free after you’ve had the Roth IRA for at least five tax years and reached age 59½. In 2022, the Roth IRA contribution phases out as your adjusted gross income (AGI) exceeds $129,000 to $144,000 for unmarried filers, $204,000 to $214,000 for joint filers, and less than $10,000 for married persons filing separately.
- If your income exceeds the Roth contribution thresholds, you may want to consider making a “backdoor” Roth conversion. This involves converting a contribution from a traditional IRA into a Roth IRA. There are no income restrictions for this type of conversion. However, the conversion is considered a taxable event and will generate taxable income.
- Since the stock market fell substantially in value in 2022 from its 2021 highs, you may want to consider doing a Roth conversion now because the tax cost of converting is substantially less than what it would be in an up market.
- You may want to spread the conversion over several years to avoid entering a higher tax bracket.
- Make sure you take your required minimum distributions (RMDs) from your tax-deferred accounts when necessary. The penalties for non-compliance can be as much as 50% of the amount that should have been withdrawn.
NET INVESTMENT INCOME TAX
Individuals whose income is above certain thresholds are subject to an additional 3.8% net investment income tax (NIIT) on their net investment income. Net investment income includes interest, dividends, capital gains, rental income (unless derived from ordinary business activities) and passive activities, less deductions properly allocated to net investment income.
- Consider electing installment sale treatment on the sales of certain appreciated property so gains are spread out over several years. Doing so may reduce the current year’s net investment income and income thresholds, which would minimize or eliminate the 3.8% tax for the current and future tax years.
- Consider selling stocks that are underwater in your investment portfolio to offset capital gains recognized earlier in the year that would otherwise be subject to the NIIT.
- Consider materially participating in a passive business to potentially convert otherwise passive income into non-passive income that is not subject to the NIIT.
- Consider switching investments in your taxable portfolio to tax-exempt investments because tax-exempt investments are not subject to the NIIT. You should also consider state taxation of such investments.
SMALL BUSINESS OWNERS
Depending on whether you will be in a higher tax bracket in 2023 relative to 2022, you may want to either accelerate/delay income recognition or accelerate/defer expense recognition in 2022. This guide includes strategies to consider for minimizing your business-related taxes.
- Deferring income: Taxpayers under the cash method can defer income by billing and collecting revenue after year-end. Accrual-method taxpayers can delay shipping products or performing services after year-end.
- Accelerating expenses: Cash-basis taxpayers can prepay certain expenses before year-end.
- Utilizing the home office deduction: Provided you use at least part of your home regularly and exclusively as your principal place of business or as a place to meet or deal with customers, clients or patients in the normal course of business, you can either deduct a portion of eligible expenses based on the relative square footage of the home or use a simplified method of $1,500 ($5/square foot up to 300 square feet).
- Businesses should take advantage of the favorable 100% bonus depreciation deduction available for qualified assets placed in service before December 31, 2022. Bonus depreciation applies to new and used property used in a business. Under current tax law, the percentage will decrease from 100% to 80% in 2023 and gradually taper off until it phases out completely in 2027.
- Set up or contribute to a retirement plan to reduce your taxable income. Consider the following:
- A 401(k) plan must be set up before December 31, 2022. This year the total employee and employer contributions are limited to $61,000 or the employee’s compensation, whichever is less.
- If you miss the cutoff date to set up a 401(k) plan in 2022, you may still be able to set up a simplified employee pension plan (SEP). You have until the due date of your return (including extensions) to set up a SEP. In 2022, the employer’s contribution to a SEP is limited to 25% of the employee’s compensation or $61,000, whichever is less.
- If you set up a new 401(k) or SEP, you can deduct your contributions to the plan, and you may also qualify for the retirement plans startup costs tax credit. This credit is available to employers that:
- Had 100 or fewer employees who received at least $5,000 in compensation during the year;
- Had at least one plan participant who was a non-highly compensated employee; and
- Have not had another employer-sponsored retirement plan in the past three years.
- The credit is worth 50% of the plan’s startup costs, to a maximum of $5,000.
Donations to qualified charities can now only be deducted if you itemize your deductions. The $300 ($600 for married couples filing jointly) above-the-line tax deduction for non-itemizers expired at the end of 2021.
To encourage individuals to give during the pandemic, in 2021 the charitable contribution limit was increased to 100% of AGI for cash donations to public charities. However, in 2022 the charitable contribution limit reverted to no more than 60% of your AGI for cash contributions.
For non-cash contributions to public charities, the charitable contribution limit is 50% of your AGI for donations of certain types of appreciated property and 30% of your AGI (unchanged from 2021) for donations of long-term capital gain property.
For cash or property donations (including stock donations) of $250 or more, you must obtain an acknowledgment letter from the qualified charity on or before the date you file your 2022 tax return.
- If your itemized deductions are less than the standard deduction, you will not receive a tax benefit from your charitable contributions. If you anticipate this will be the case, you may want to consider “bunching” future charitable contributions into 2022 to increase your itemized deductions so that you can benefit from the charitable donations. You may also want to consider using a donor-advised fund for this purpose. You will receive a charitable deduction when you contribute to the donor-advised fund, and you will have the flexibility to make actual grant distributions to charities at a later time.
- If you are age 70½ or older, you may also want to consider making a qualified charitable distribution (QCD) of up to $100,000 annually from your IRA directly to a qualified charity. These distributions can be used to satisfy the required minimum distribution requirement that is imposed on IRAs and are also excluded from taxable income.
- Sell depreciated stock and donate the cash proceeds to a public charity by the end of 2022. Charities are tax-exempt organizations and generally do not benefit from any inherent losses in donated stock. However, you can utilize the “built-in” loss once you sell the stock to offset any current capital gains and deduct any remaining loss against ordinary income (up to $3,000 if you file married filing joint or $1,500 for all other taxpayers). You will also receive a charitable deduction once the proceeds have been donated to a public charity.
- Donate appreciated property held longer than a year instead of donating cash so you can avoid recognizing capital gains and receive a charitable deduction for the full fair market value of the appreciated property.
Before the Tax Cut and Jobs Act of 2017 (TCJA), the mortgage interest deduction debt limit was $1 million. Today, the debt limit is $750,000. Consequently, you can deduct the interest on a mortgage up to $750,000 ($375,000 if you filed married filing separate). However, any home purchased after October 13, 1987, and before December 15, 2017 is still eligible for the original $1 million limit (or $500,000 each, if married filing separately). Likewise, interest on debt incurred prior to December 15, 2017, but refinanced later is deductible under the original mortgage limitation to the extent the new debt does not exceed the original debt outstanding at the time of the refinance.
The interest on a home equity loan is generally not deductible unless the proceeds were used to buy, build, or substantially improve a home and the debt is secured by the home.
- You may be able to deduct mortgage points, i.e., prepaid interest, in the year you acquire or build your house where the home serves as collateral for the loan. Alternatively, the points may be amortized over the life of the loan.
The deduction for medical expenses remains unchanged in 2022 and can be deducted to the extent the expenses exceed 7.5% of AGI. Eligible expenses include health insurance premiums (if not deducted elsewhere on your income tax return), long-term care insurance premiums (subject to limitations), medical and dental services, prescription drugs, certain over-the-counter drugs, the cost of equipment in or improvements to a home to accommodate a disability (to the extent they do not increase the value of a home), and personal protective equipment used to prevent the spread of COVID-19, including hand sanitizers, masks, and sanitizing wipes. Keep in mind any reimbursed medical expenses, such as those reimbursed by your insurance or employer, cannot be deducted. Medical expenses paid from a flexible spending account or health savings account are not deductible either. Finally, the IRS generally disallows expenses for cosmetic procedures.
- Like charitable contributions that can be bunched together to ensure the overall amount of itemized deductions exceeds the standard deduction in a given tax year, you may consider bunching elective medical procedures in 2022 for both services and purchases. The combined expenses need to exceed the 7.5% floor and the standard deduction.
FLEXIBLE SPENDING ACCOUNT (FSA)
Money contributed to a healthcare FSA is not subject to federal income, Social Security or Medicare taxes. For 2022, the maximum contribution increased by $100 to $2,850.
The dependent care contribution limit for 2022 is unchanged at $5,000 for single taxpayers and married couples filing jointly, and $2,500 for married individuals filing separately.
In 2021, employers were permitted to allow qualifying employees to roll over all unused funds to 2022. This provision no longer applies in 2022 and you are only permitted to carry over $570 of unused funds to 2023. Alternatively, some employers may allow their employees a grace period of 2.5 months to use their FSA funds after the end of the tax year.
HEALTH SAVINGS ACCOUNT (HSA)
Not only are your contributions to an HSA tax-deductible, but the unused contributions and investment income also grow tax-free. Withdrawals are also tax-free and penalty-free for qualified medical expenses, and penalty-free for any purpose after age 65. Moreover, there is no “use it or lose it” provision and you get to keep your HSA if you leave your job or change your health plan. This makes the HSA an often overlooked, but very important, savings vehicle.
For 2022, you can contribute up to $3,650 for individuals and $7,300 for families, while individuals age 55 or older can save an additional $1,000 per year in catch-up contributions to an HSA. These contributions can be made until April 18, 2023 and count toward the 2022 deduction.
CHILD TAX CREDITS
In 2021, parents received enhanced benefits that expanded eligibility for the child tax credit and increased the amount they could receive to up to $3,600 per child aged 17 and younger, which was also fully refundable on their tax returns. In addition, parents could also receive up to 50% of the estimated credit in the form of prepayments before they filed their 2021 tax return.
Unfortunately, many of these benefits did not carry over to 2022. In 2022, the credit amount reverted to $2,000 per child aged 16 and younger, and the tax credit is only refundable up to $1,500 per child if the parent had earned income of at least $2,500 and the credit hasn’t fully phased out. For single filers and filers filing as married filing joint, the thresholds for modified adjust gross income need to be below $200,000 or $400,000, respectively. The credit is reduced by $50 for every $1,000 that modified adjusted gross income exceeds the thresholds above. Finally, the advance payment option is no longer available in 2022, meaning taxpayers will have to file their 2022 tax returns to claim the credit.
Any discussion about year-end tax planning should include the impact of inflation. Many thresholds for applying certain tax provisions, including the income tax brackets (more on that below), are indexed for inflation. The annual adjustments to these brackets were higher than usual because inflation started to increase from its historic norms during 2021. Inflation adjustments are needed to limit the impact of paying tax at higher income tax rates on income that doesn’t have a comparable increase in purchasing power. Inflation can also diminish the value of tax credits or deductions. There is a limited number of thresholds that are not adjusted and will lose significant value in real dollars over time in an inflationary environment. These include:
- The $750,000 limit on new mortgages taken out after December 17, 2017 for determining deductible mortgage interest;
- The thresholds for applying the 3.8% net investment income tax and the 0.9% additional Medicare tax;
- The $10,000 cap on state and local tax deductions (SALT);
- The up to $500,000 exclusion of capital gains on the sale of a principal residence; and
- The annual deduction of capital losses in excess of capital gains, which is limited to $3,000.