After finishing up and filing our family's 2019 taxes two weeks ago, I've turned my attention to planning for 2020 taxes.
I like to run these planning calculations 2-4 times (~ March-April, Aug-Sep, and November) throughout each tax year for the following reasons:
- Utilize/leverage the tax codes and loopholes as a path to building wealth.
- Avoid tax penalties through underpayments (i.e. making sure I'm withholding sufficient amounts of federal and state income tax from my paychecks throughout the year).
- Prevent surprises at 2020 tax return filing time by needing to pay large amounts of taxes due.
- Prevent large over-payment of taxes, essentially providing the government with an interest-free loan until getting a tax refund almost a year later.
Overall Approach to Tax Planning
The approach I take towards tax planning is a spreadsheet that I've developed/tweaked over the past 8 years or so.
Essentially, it is an abbreviated, less formal version of the same calculations performed in preparing a 1040 federal return and a state tax return.
Step # 1 - Predict Federal and State Income Tax Withholding for Entire Year
The first step I perform in this process is to extrapolate the total amount of federal and state income taxes that WILL be withheld by end-of-year 2020 from my paychecks (we don't pay estimated taxes). This calculation assumes no changes made to exemptions or additional tax withholding amounts.
This calculation is fairly simple: YTD taxes withheld + (# of remaining paychecks x tax withheld per paycheck). All of this information is accessible on my most recent pay statement.
Step # 2 - Compare to Prior Year Federal and State Income Taxes Owed
The next step is this workflow involves comparing the state and federal tax predictions from step # 1 to the total state and federal taxes owed the prior year's (2019 in this case) tax returns. In our family's case (since we moved in 2019 from CO to NC in September of 2019), we paid state taxes to two states. As such, I compared my predicted NC taxes to be paid in 2020 to the sum of taxes owed to both NC + CO to be on the safe side.
The idea here is to ensure that I will at-least pay as much taxes in 2020 as I owed in 2019 in order to avoid tax underpayment penalties at the time that I file our 2020 taxes in early 2021. In my case, the calculations showed that we would be paying a sufficient amount of both state and federal taxes throughout 2020 with our current withholding structure. However, if changes are needed, you would just need to go to your company's W4 administrator and either 1) alter the number of exemptions/allowances and/or 2) request additional tax withholding to be taken above what your exemption calculations dictate. My personal preference is to specify additional tax withholding directly because it allows more precise control of the amount of tax withdrawn.
Step # 3 - Predict/Calculate Total 2020 Year-End Taxable Income
Having convinced myself that I wouldn't be in a tax underpayment penalty situation, I then proceeded to predict what my taxable income will likely be in 2020.
This simplified 1040 calculation is described below:
- Add up our family's income.
- + W2 income.
- + Self employed income for my wife and I.
- + State tax refund received in 2020 for 2019 tax year return.
- + Taxable interest income (assume same as 2019).
- + Ordinary dividend income (assume same as 2019).
- + Capital gains (assume same as 2019).
- Subtract out deductions.
- - FSA contributions (none for me this year since we are doing high deductible plan).
- - HSA contributions.
- - Limited purpose FSA contributions.
- - Dependent care FSA contributions.
- Dental, vision, health insurance premiums.
- - Deductible portion of self-employment tax (predicted using online calculator).
- - Qualified business income deduction.
- - Student loan interest paid.
- - Standard deduction.
- - Tax-deferred self-employed or employee 401k contributions.
Step # 4 - Predict Federal and State Taxes Owed for 2020
Once my taxable income is predicted, I then proceed to estimate what my state and federal taxes owed will be for 2020.
- Federal taxes owed:
- + Calculate federal tax by Googling 2020 tax brackets.
- + Self employment taxes (predicted using online calculator).
- - Child tax credit.
- - Foreign tax credit.
- - Child care credit.
- - Personal exemptions (have not applied since 2018 due to tax law reform).
- State taxes owed:
- Generally, I estimate state taxes owed by using my federal taxable income predicted and multiplying it by the recommended fixed state tax income rate.
- For North Carolina, this value is 5.25%.
Step # 5 - Use Excel Solver Function to Run What-If Analyses to Determine Action(s) to Take, If Needed
Now that everything has been tallied up, the fun part (at least for me) starts! It's time to use the tax codes to my benefit.
For me, this usually involves trying to reduce my taxable income to accomplish the following goals:
- The first goal is to look at the tax brackets and determine if it's at all possible to reduce taxable income to the point where you get into the the next lower tax bracket.
- For our family, this usually involves seeing if it's possible to move from a 20-30% tax bracket to the 12-15% tax bracket.
- For 2020, this goal seemed too aggressive (meaning it would require an unrealistic or impossible reduction in taxable income to accomplish).
- The second goal is to try to reduce my total state federal tax predicted to be owed for the year to approximately the levels that are already being withheld from my regular paychecks.
- This was the goal I opted to go after for the remainder of 2020.
Having figured out that my goal would be to reduce my taxable income/taxes owed to the levels being withheld from my regular paychecks using 4 allowances and $0 additional taxes, it's next time to determine what levers can be manipulated to reduce taxable income. The main levers I use are the following:
- Increase contributions to FSAs and HSAs.
- This was not possible for me this year since we are already contributing maximums allowed.
- Increase contributions to tax-deferred 401ks (self-employed + my job's 401k).
- This was the best route for me to take for the rest of the year to lower my taxable income.
- I increased my 401k contributions nearly 3x in order to reach the maximum allowed by IRS regulations for 2020. In addition, we will start contributing more to the my wife's self-employed 401k now that we have maxed out contributions to both of our Roth IRAs and an equivalent amount in taxable mutual fund investment accounts.
