Tax Season’s Over, Now What?

By Ryan L. Pope, CFP®

Wealth Manager, Principal

April 16, 2024

Let’s face it: There is nothing fun about income taxes. They can be even more unpleasant when you have to cut a fat check to Uncle Sam in April because of a life or work event or change that occurred in the prior calendar year. Perhaps this situation was something you could have planned and prepared for in advance to soften the blow?

What You Can Do Now to Avoid Tax Planning Mistakes in the Future

Since you have just finished and filed this year’s return, the last thing you probably want to do is think about next year’s tax return. But the best time to prepare for next year’s tax return is early in the current calendar year, to allow you many months to make any needed adjustments.

Below are several circumstances that could have tax implications next April, but that you can start preparing for now.

Restricted Stock Units and Large Bonuses

The past decade has been led by vast expansion in many privately and publicly held companies — particularly in technology — that have seen their valuations soar in recent years. These businesses then offer handsome compensation packages, including supplemental income such as restricted stock units (RSUs) and bonuses, to key employees. While RSUs and bonuses are great retention tools and create a lot of value for employees, they can also present major income tax surprises without proper planning.

Both RSUs and bonuses are effectively supplemental income to a regular salary. Bonuses are taxed in the calendar year they are paid, while RSUs are taxed in the year they vest. Hence, these types of compensation introduce a lot of variability into taxable income from year to year. What is important to note, and where issues may arise, is that while companies do withhold income taxes from bonus payments and vested RSUs, they may under-withhold relative to the higher marginal tax bracket you may now fall under because of your higher income level.

RSUs are particularly tricky. Because vesting periods can vary widely, those RSUs that were issued in prior years and are now vesting in the current year may have fallen off your tax-planning radar. When RSUs vest, many companies may only withhold federal income taxes at a flat rate. That flat rate may be below your current marginal income tax bracket with the addition of the supplemental income. This under-withholding can be exacerbated after factoring in varying state income tax withholding requirements. The potential for a significant tax planning error further escalates if you also receive a bonus in the same year some or all of your RSUs vest.

Your Modera advisor can help you monitor important vesting dates for your RSUs so you can plan for potential income tax impacts. One simple strategy may be to increase W-2 withholdings or make regular estimated tax payments during the calendar year. Your advisor may also be able to reduce the tax burden by shifting certain income tax-triggering events from one year to another, when your RSU vesting schedule may be less onerous.

K-1 Income

Similar to the under-withholding potential pitfall of RSUs and bonuses, another income source that could catch you off guard is income attributed to partnerships on Schedule K-1. This income could be related to active business ventures, passive income from private or public investments, or even an inheritance from an estate or trust.

In any of these situations, the potential income tax consequences could be significant and complex if you are not planning for it in advance. Therefore, it important to keep your advisor in the loop on your business interests and how they are performing, as well as any other potential investments or circumstances that could result in large windfalls.

Capital Gains

You may be sitting on sizable gains from investments you have made in recent years. If you are thinking about selling some or all of your stake in appreciated assets, you will want to consider the method and timing for realizing your capital gain.

For example, in the situations above where your income may be higher in a given calendar year due to RSUs vesting, bonuses, or other factors, you may be better off delaying sales of investments for a couple of months. This delay will allow you to push your capital gains income into the following calendar year. Similarly, holding off the sale of property could also positively change the rate at which your capital gains are taxed, depending on your holding period.

You may want to consider gifting some portion of appreciated investments to charity, either through direct gifts or via a donor advised fund, where you can obtain an immediate charitable deduction for a multi-year gift.

Your advisor can help you determine which tax realization strategy will be best for your capital gain situation.

Residential Property

Speaking of capital gains, the residential real estate market has been strong in recent years. One of the great benefits of owning a home is that your principal residence can benefit from as much as a $500,000 capital gains exclusion (if married filing jointly) when you are ready to sell it.

However, to obtain this exclusion, you must have lived in that home as your principal residence for at least two of the last five years. This can create some complexities especially for part-time property, vacation homes, and rental property.

For residential property owners selling a rental house, an important tax implication to be aware of is depreciation recapture. Depreciation recapture is the gain realized by selling a depreciable capital property which must be reported as ordinary income. So, while you own the rental property, you can claim a depreciation deduction on your tax return each year, even if the property value is increasing. But when you sell that property, you will owe depreciation recapture tax.

It is important to regularly update your advisor about your property holdings and any potential changes to your primary residence or rental property statuses. We can help determine potential gains and alert and prepare you to any potential income tax ramifications if you are considering a sale.

Tax Planning is an All-Year Event

While having more income than expected is generally a high-quality problem, it can create some tax headaches. Tax season may be over now, but as the above scenarios illustrate, tax planning is a year-round event, and it is never too early to start planning for your tax return next year.

Our job at Modera Wealth Management is to help you to keep more of your income with proactive planning. To learn more about what you can do now to get ahead of potential tax pitfalls, please get in touch with your advisor.

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