There are things you need to know this tax season if your life changed last year.
As Americans begin the annual slog of filing with the Internal Revenue Service, people who tried new things in 2022 may find the task particularly tricky. It was a year when the Great Resignation was still in full swing, and there was continued migration from high-cost cities to the Sun Belt. The market plunge for stocks and bonds is also something many will grapple with as the April 18 tax deadline approaches.
“This year is going to be different,” said Elliot Pepper, a financial planner and director of tax at Northbrook Financial in Baltimore. “Over the past two years, we’ve had either a combination of extended due dates, stimulus payments and other tax credits that obscured a traditional tax return.”
Here are the upsides to consider and pitfalls to avoid for some common life changes.
Whether you quit your job or were laid off, your new employment status will likely mean extra work this tax season. But you could also be in for a higher refund.
Pepper of Northbrook Financial has worked with many clients who switch jobs and receive some good news around tax time: unexpectedly large refunds. That’s because old and new employers often don’t communicate about how much they are withholding in taxes for Social Security and Medicare. New employers often withhold too much, which ultimately needs to be repaid to the staff member.
“I’ve had clients who might be used to getting a hundred dollars’ refund or owing a hundred dollars,” said Pepper. “And then in a year of change they get a $3,000 IRS refund, which is a nice surprise.”
Downside: Interest-free loans
Big refunds are nice, but they also come with an opportunity cost. Large refunds are effectively interest-free loans you’ve given to the government, according to Pepper. The better strategy is to get your withholding amounts right when you switch jobs and put any spare cash into a high-yield savings account.
Recent data from the US Postal Service shows that Americans have been on the move to cheaper zip codes. But complications await those who may have been more focused on relocation logistics than their tax obligations, said Alvina Lo, chief wealth strategist at Wilmington Trust in New York City.
Upside: New investment options
A number of Lo’s clients have been moving to lower-cost states, in part to reduce their tax burdens. But moving states can also present a new investment landscape. For instance, some clients moving from New York to lower-tax states have long invested in triple-tax exempt municipal bonds. (They are exempt from federal, state and New York City tax on their interest, if purchased by residents.)
“When you’re moving to Florida, guess what? That doesn’t matter anymore,” Lo said, noting that other investments with higher yields may become more attractive in lower-tax states.
Downside: New tax obligations
Not everyone is relocating to lower-tax jurisdictions, of course. And those who move to destinations with higher taxes should remember that obligations can crop up in unexpected places.
Lo remembers having this surprise herself when she moved from Massachusetts to New York City. She was used to being taxed at the federal and state levels, but not at the city level, as happens in New York. She ended up with a bigger bill than she expected because of city obligations when it came to tax time.
Whether they stem from inflationary pressures or a desire to pursue a passion, side hustles are more popular than ever. They can also be more lucrative than expected. But as financial advisers point out, side hustles can get tricky from a tax perspective very quickly.
Upside: Retirement savings
A successful small business provides a great way to save for retirement, according to Dan Herron, a financial adviser at Elemental Wealth Advisors in San Luis Obispo, California.
The IRS allows entrepreneurs to set up Simplified Employee Pension (SEP) plans for themselves and their staff. Such plans do not have startup or operating costs like retirement plans at larger companies. Employees using SEPs are allowed to contribute up to 25% of their pay or $66,000 in 2023, whichever figure is smaller.
This means that someone already contributing the maximum amount to their retirement accounts at their main job also has the opportunity to contribute even more to a tax-favored retirement account through their side hustle.
Downside: 1099 trouble
Side hustlers are likely familiar with the 1099 form, which they receive from clients who paid them $600 or more a year in nonemployee compensation.
Taxes aren’t deducted from payments on 1099 forms. This means sidle hustlers need to keep track of how much they bring in, and how much they will eventually owe in taxes. Because the accounting can be time-consuming, Pepper of Northbrook Financial recommends taking 30% of revenue from a side hustle and putting it in a high-yield savings account. That way, when it comes time to pay taxes, there will be more than enough in the bank to prevent cash-flow issues.
Last year, the S&P 500 Index posted its worst annual performance since 2008. Tough as it may have been on portfolios, losses presented a unique tax benefit for investors.
Upside: Tax-loss harvesting
Savvy investors who sold poor-performing stocks before the end of 2022 can use those losses to offset capital gains from the sale of better-performing assets. As per IRS rules, these latter assets can include stocks and bonds, but also a home or business.
There is a limit: Investors can only deduct up to $3,000 against their taxable income each year. But losses beyond $3,000 can be carried forward every year until death to offset gains in future years.
Downside: You may be too late
Pepper of Northbrook Financial had some tough news for a financial-planning client who came to him recently excited about tax-loss harvesting. The client hadn’t done it before the end of 2022, so he was too late for the current filing year.
If you are in the same boat, Pepper says this can be an important reminder to check in on your tax-loss harvesting opportunities from time to time throughout the year. As a very general rule for do-it-yourself investors, he recommends tax-loss harvesting twice a year. Doing it too much runs the risk of skewing an investor’s asset allocation. And some roboadvisers will do it automatically, taking out both the guesswork and potential to forget.