Tax and Other Planning for High 2014 Earnings

[CoolChange]

I had some good fortune last year which is very likely to put me in the the top 2% - 3% of wage earners in the USA for 2014. Now, I am hoping to mine the collective knowledge and experience here with regard to planning for my anticipated minor windfall.

Here is a list of the things that I have already done or am planning to do. I would sincerely appreciate any pointers towards other things I should be doing, or at least considering, this year and down the road with regard to my personal finances:

• Realized as much of my 2014 compensation in 2013 as I could
• Maxed 401(k) and HSA contributions
• Defer as much of my 2014 compensation to 2015 as I can (This does seem risky to me; but, I think I am comfortable with those risks.)
• Really, really plan to buy an umbrella liability policy this year

I realize this is a very nice problem to have; but, I still want to avoid looking back on this year at some point and realizing that I missed something obvious.

Some personal details which might be relevant:

• Late 40's
• Single, no dependents
• No home ownership, cheap rent
• Almost 6% state income tax
• 2015 outlook and beyond
  • Earnings will likely drop back below $200k if I continue to suffer from my OMY syndrome
  • Earnings will likely drop $100k if I pull the ER ripcord early in the year.
• My planned yearly expenses in ER are less than $60k / year for the lifestyle I think I want.
• Some kind of ESR (likely consulting in some form) may be in my future prior to full ER, mostly as a treatment for my OMY syndrome

Being in the right place at the right time was definitely the major contributor to this good fortune as I believe is the case with most people who find themselves in this, or a better, position. I personally know a lot of smarter, harder w*rking people than myself who just missed this particular opportunity. On the other side of that coin, I have also seen many people I consider useless dolts do much better financially than I have. But, that may say more about me than them.

 

[MichaelB]

I realize this is a very nice problem to have; but, I still want to avoid looking back on this year at some point and realizing that I missed something obvious.

Congratulations! It is a pleasant situation to encounter, especially when it is the result of good fortune combined with hard work. I'm sure you will get lots of constructive feedback, so just a couple of questions. Have you set a savings target for this income? That might help. Also, can you push healthcare expenses into 2015? The deduction level for medical is >10% of income, so unlike other deductions, you may more value by waiting, if that is an option.

 

[Alan]

I would also pay the max contribution to a tIRA. It will be after tax money but the gains are tax deferred.

 

[CoolChange]

Congratulations! It is a pleasant situation to encounter, especially when it is the result of good fortune combined with hard work. I'm sure you will get lots of constructive feedback, so just a couple of questions. Have you set a savings target for this income? That might help. Also, can you push healthcare expenses into 2015? The deduction level for medical is >10% of income, so unlike other deductions, you may more value by waiting, if that is an option.

Thank you for the kind words and quick response.

I don't really have a savings target or budget in the traditional sense. Rather, I am one of those who finds is somewhat painful to spend money. This is very annoying to many around me; but, it is a personality quirk which has definitely contributed to my FI goal. My expenses have not increased significantly with my wages, net worth, etc.

Luckily, I do not anticipate any major healthcare expenses in the foreseeable future. I generally spend less than $1,000 / year on healthcare, most of that is my part of employer's HSA health insurance plan.

 

[daylatedollarshort]

This is my favorite article on legally avoiding income taxes -

ROI: How to Avoid Paying Income Taxes - WSJ.com

 

[CoolChange]

Traditional IRA Contribution

I would also pay the max contribution to a tIRA. It will be after tax money but the gains are tax deferred.

This is something that I actually had not considered which I may pursue.

For some reason, I thought I was not eligible to make any IRA contributions; but, a very quick glance at the IRS web site seems to indicate this is not the case. I may also make a 2013 contribution.

Thank you.

 

[CoolChange]

This is my favorite article on legally avoiding income taxes -

ROI: How to Avoid Paying Income Taxes - WSJ.com

This is an interesting article and hopefully useful to others; but, the vast majority of suggestions are not applicable to my current situation:

• I am not self employed and do not have time or energy to incorporate any kind of moonlighting into my life this year. Many of these kinds of suggestions will likely be useful if I ever head down the ESR path.
• I am not currently a home owner; although, I am starting to consider the option.

Thank you.

 

[Sesq]

I found this to be an interesting perspective.

Contrarian Tax Planning: Increasing Income To Take Advantage Of The AMT - Forbes

 

[LOL!]

Basically spending money away before the tax man cometh is the standard method:

1. Get married
2. Adopt or have kids
3. Give it all away to charity
4. Buy huge house with huge interest loan and huge property taxes
5. Get really sick since health care expenses can be deductible if you have a lot of them
6. Find a financial advisor who charges more than an arm and a leg since their fees above 2% of AGI can become deductible
7. Move to a state with even higher state income taxes
8. Be sure to lose lots of money on investments, because those losses will eventually be used to offset income
9. Get old fast since older people benefit from higher personal exemptions

10. You could think about bunching deductions into every other tax year and bunching income into those years with high deductions.

I see that already 30% of my paycheck is tax-free because of some of the things you are doing:
401(k)
HSA
health insurance
dental insurance
vision insurance

Of course, sometimes it is just cheaper to pay the taxes.

 

[LOL!]

I would also pay the max contribution to a tIRA. It will be after tax money but the gains are tax deferred.

I would not do this unless the money could be converted to Roth IRA within a [-]month[/-] day of the contribution. This is called a "back door Roth IRA".

If you don't do the conversion, this IRA will come to poison other things. In particular, gains would be taxed as ordinary income instead of at favorable long-term cap gains tax rates.

 

[Alan]

I would not do this unless the money could be converted to Roth IRA within a [-]month[/-] day of the contribution. This is called a "back door Roth IRA".

If you don't do the conversion, this IRA will come to poison other things. In particular, gains would be taxed as ordinary income instead of at favorable long-term cap gains tax rates.

I agree, he should also immediately convert his tIRA contributions to a ROTH since his contribution is with after tax $ anyway. He hadn't listed any type of IRA contribution in his list of things to do which is why I suggested it.

 

[Shawn]

If you make charitable contributions, consider a Donor Advised Fund (DAF). They are relatively easy to set up at Fidelity, Vanguard, and other financial institutions. You can make a large contribution this year to the DAF and then dole out the funds to your favorite charities in subsequent years. You get the full tax deduction this year (within limits) while your income and presumably marginal tax rate are higher.

 

[Ready]

Basically spending money away before the tax man cometh is the standard method:

1. Get married
2. Adopt or have kids
3. Give it all away to charity
4. Buy huge house with huge interest loan and huge property taxes
5. Get really sick since health care expenses can be deductible if you have a lot of them
6. Find a financial advisor who charges more than an arm and a leg since their fees above 2% of AGI can become deductible
7. Move to a state with even higher state income taxes
8. Be sure to lose lots of money on investments, because those losses will eventually be used to offset income
9. Get old fast since older people benefit from higher personal exemptions

10. You could think about bunching deductions into every other tax year and bunching income into those years with high deductions.

Just curious, but did you require some time to come up with this list, or was it just stored in your head and you were just waiting for someone to ask the question?

 

[LOL!]

It's stored in the first few pages of Form 1040 and on Schedule A, so it is pretty easy to regurgitate it every time someone asks how to save on taxes.

 

[CoolChange]

Short-term Capital Losses

Basically spending money away before the tax man cometh is the standard method:
...
7. Move to a state with even higher state income taxes
8. Be sure to lose lots of money on investments, because those losses will eventually be used to offset income
...
Of course, sometimes it is just cheaper to pay the taxes.

I will admit to considering a move to a no income tax state. FL, TX and NM would be reasonable locations for me to base myself for the next few years. But, as has been discussed in many other threads, there are many considerations beyond the tax bite.

On the purely financial side: Are there any considerations with locking in short-term capital losses by swapping sector ETF's after a large correction? My brief research on this makes me think that these losses can be used in much the same way as long-term losses, including carrying them forward for use in future years. But, I rarely hear anyone discuss locking in short-term capital losses; the discussion always seems to focus on harvesting the long-term losses.

Again, just trying to avoid anything obvious.

 

[aim-high]

If at all possible convert from being an employee to contract work through an LLC you own. You'll have a lot more flexibility that way - SEP-IRA, Personal 401K, and other options.

 

[Animorph]

I will admit to considering a move to a no income tax state. FL, TX and NM would be reasonable locations for me to base myself for the next few years. But, as has been discussed in many other threads, there are many considerations beyond the tax bite.

On the purely financial side: Are there any considerations with locking in short-term capital losses by swapping sector ETF's after a large correction? My brief research on this makes me think that these losses can be used in much the same way as long-term losses, including carrying them forward for use in future years. But, I rarely hear anyone discuss locking in short-term capital losses; the discussion always seems to focus on harvesting the long-term losses.

Again, just trying to avoid anything obvious.

Short term losses are no worse than long term losses, and can be better. However, they may offset long term gains if you don't have any short term gains to offset. So short term losses may not be worth any more than long term losses. Same wash sale rules. Having the short term loss allows you to take some short term gains, which can be useful.

 

[2B]

If you make charitable contributions, consider a Donor Advised Fund (DAF). They are relatively easy to set up at Fidelity, Vanguard, and other financial institutions. You can make a large contribution this year to the DAF and then dole out the funds to your favorite charities in subsequent years. You get the full tax deduction this year (within limits) while your income and presumably marginal tax rate are higher.

I just set one up with Fidelity Charitable. It was easy to do and have just made our first donation to a charity we routinely give to. They allow smaller contributions and individual donations than Vanguard.

I am bunching deductions for this year in anticipation of ending my OMY. I will receive a significant amount of taxable income in the year I retire.

 

[CoolChange]

Thank you for the commentary and suggestions.

If at all possible convert from being an employee to contract work through an LLC you own. You'll have a lot more flexibility that way - SEP-IRA, Personal 401K, and other options.

This may be an option at some point but will not be for this year. I actually started down this path a few years ago but never got very far.

Short term losses are no worse than long term losses, and can be better. However, they may offset long term gains if you don't have any short term gains to offset. So short term losses may not be worth any more than long term losses. Same wash sale rules. Having the short term loss allows you to take some short term gains, which can be useful.

Thank you for confirming my understanding on this issue.

I just set one up with Fidelity Charitable. It was easy to do and have just made our first donation to a charity we routinely give to. They allow smaller contributions and individual donations than Vanguard.

I am bunching deductions for this year in anticipation of ending my OMY. I will receive a significant amount of taxable income in the year I retire.

It sounds like Fidelity Charitable is in my future; this is likely the year it will make sense.

 

[RockyMtn]

If you make charitable contributions, consider a Donor Advised Fund (DAF). They are relatively easy to set up at Fidelity, Vanguard, and other financial institutions. You can make a large contribution this year to the DAF and then dole out the funds to your favorite charities in subsequent years. You get the full tax deduction this year (within limits) while your income and presumably marginal tax rate are higher.

+1 on the DAF. I donated some appreciated ETF's in a year I had a significant stock option windfall. Helped lower the taxes significantly and avoided 23% in cap gains as well. Win win all around.

 

[Shawn]

It sounds like Fidelity Charitable is in my future; this is likely the year it will make sense.

I have a Donor Advised Fund (DAF) at Fidelity Charitable too. While it is a tad - and only a tad - more expensive than the Vanguard equivalent, Fidelity Charitable is more flexible in terms of its lower dollar requirements for fund contributions and charitable grants (just as 2B says).

I opened my account at Fidelity in 2011. With it I can "pre-fund" future charitable contributions but get the tax deduction now during my last few years of work when my income is higher. This is particularly useful since I am subject to AMT. I get a 42% tax deduction today (federal AMT plus state) instead of the lower expected tax deduction when I am retired (potentially as low as 0% if I no longer itemize).

And it gets better. It is fairly easy to contribute shares of stocks or mutual funds that have unrealized capital gains. This allows one to get the higher charitable deduction and avoid taxes on capital gains. Double win. Of course, one does not need a DAF to donate appreciated shares. But the DAF makes the process easier, since it is streamlined to do this. My recent contributions to Fidelity Charitable have been with appreciated Vanguard mutual fund shares. The process has taken only about a week to complete, probably because the two biggest fund companies are involved. The only real difficulty is the need to get a "Medallion Signature Guarantee" (I have obtained mine at a local Fidelity office, which then mails in my contribution forms for me).

I am very satisfied with the DAF concept. The investment options at Fidelity Charitable, while not extensive, are quite satisfactory (e.g., low-cost index funds are available). I have yet to make actual charitable grants using my DAF account (still writing/mailing checks from my credit union), but the process appears to be very user friendly. It could be a useful method to make charitable contributions even without the tax advantages.

 

[LOL!]

On the purely financial side: Are there any considerations with locking in short-term capital losses by swapping sector ETF's after a large correction? My brief research on this makes me think that these losses can be used in much the same way as long-term losses, including carrying them forward for use in future years. But, I rarely hear anyone discuss locking in short-term capital losses; the discussion always seems to focus on harvesting the long-term losses.

Again, just trying to avoid anything obvious.

One should always realize losses before they go long-term, so I don't know where you got the idea that folks concentrate on long-term losses. Indeed, if one realizes losses that are short-term, one should almost never have any long-term losses to realize (in a taxable account).

I always look at any position that was bought 11.5 months ago. Also I look in November and December to see if I need to sell losers for tax-loss harvesting purposes. I will buy replacement shares in something not substantially identical.

The benefits are 2-fold:
1. One avoids the loss aversion trap and emotions and sentimentality.
2. One starts every year with all positions in the black and none in the red.

So once again: book the losses before they go long-term.

 

[Dash man]

If you haven't already, you'll want to consult with an estate planning attorney to set up a living trust and identify what beneficiaries you want should something happen to you. The last thing you want is for the state to decide where your money would go.

 

[CoolChange]

One should always realize losses before they go long-term, so I don't know where you got the idea that folks concentrate on long-term losses. Indeed, if one realizes losses that are short-term, one should almost never have any long-term losses to realize (in a taxable account).

I always look at any position that was bought 11.5 months ago. Also I look in November and December to see if I need to sell losers for tax-loss harvesting purposes. I will buy replacement shares in something not substantially identical.

The benefits are 2-fold:
1. One avoids the loss aversion trap and emotions and sentimentality.
2. One starts every year with all positions in the black and none in the red.

So once again: book the losses before they go long-term.

This is what my limited research seemed to indicate as well. But, most of what I was finding was only discussing long term gains and losses. I just had not read much to support my growing inclination that I would be better off harvesting my losses ASAP.

This is the kind of thing I was seeking when I started this thread: I have no doubt paid much more in taxes than I needed to had I followed this simple practice. But, for some reason, I had thought that use of long term losses was more restricted; I have no idea where I originally got that idea.

Now, I know more. Thank you.

If you haven't already, you'll want to consult with an estate planning attorney to set up a living trust and identify what beneficiaries you want should something happen to you. The last thing you want is for the state to decide where your money would go.

This is an area of my life that I definitely need to revisit. Thanks for the reminder.