Income Shifting: An Easy Way to Lower Tax Bills
Although 2023 had been a great year financially for mortgage broker Yossi Berger, next year was probably going to be horrible. The many deals he’d lined up in the frenetic end of 2022 had pushed his expected total 2023 self-employment income to $400,000, even after about $50,000 in overhead expenses. But he hadn’t tied up any new deals in 2023. With an empty pipeline, his year of plenty would likely lead into a year of lack, with income not even covering his overhead.
Besides davening, what can he do now to help prepare for a very lean year?
When Two Halves are Better than One Whole
Rav Mordechai Gifter ZT”L noted that Rabi Akiva, after overhearing his wife, Rochel, say she’d be glad if he stayed in yeshivah another twelve years, didn’t even walk in to say hello “veil tzvei muhl tzvelef is nit vi ein muhl fir un tzvantzig”—learning Torah in two spans of 12 years isn’t as powerful as one 24-year span of total immersion.
When it comes to taxes, however, the opposite is true. One year of $400,000 in taxable income gets taxed much more severely than the combined tax bite taken out of two years of $200,000. With a bit of planning, Yossi can try and spread out that $400,000, dividing it into two to save money.
Push Income Out
By pushing some 2023 income out into 2024, Yossi may save tens of thousands in taxes. He’s a self-employed broker dependent on periodic deal payouts instead of a steady salary. Therefore, he might be able to push off a good chunk of his projected 2023 income by simply asking the title company to hold off on wiring his cut until January 2024. For others, asking a trusted client or boss to send a payment or projected bonus a quarter, month, week, or even day later can shift income into a new tax year in which expected annual income and tax rates may be lower.
Pull Expenses Forward
Similarly, Yossi may be able to prepay a lot of his 2024 business expenses to lower 2023’s taxable income. The technicalities need to be cleared with an accountant, but things like office lease payments, supplies, and health insurance may be pulled forward.
If he can push $100,000 of his expected Q4 2023 income into Q1 of 2024 while prepaying $50,000 of expected 2024 expenses early in Q4 of 2023, Yossi is well on his way to splitting a whopper year into two more modest ones. The tax savings can make the headache worth it.
Charity Donor-Advised Funds
Depending on his ma’aser plans, Yossi can also lower this year’s taxable income by overfunding his tzedakah account in advance. I’ve written about donor-advised funds before, but in short, you can get a large tax donation immediately while spreading the actual payments to charities over months or even years. There are many donor-advised funds available, enabling you to donate money now to sit and grow. Whenever the account owner is ready to make a donation, they advise the DAF via a call, website, or check about which tzedakah they would like to send a payment to. DAFs are an excellent tool to lower taxable income quickly.
If Yossi can shift $100,000 of projected 2023 income forward to 2024 and $100,000 of projected 2024 expenses and charity back to 2023, he may already be at peak tax efficiency for his situation. If not, he can get further into the weeds using pre-tax retirement accounts. He can deposit $6,000 for him and $6,000 for his wife into pre-tax traditional IRA accounts. (It’s $7,000 per year per IRA for those over age 50.) And since he’s self-employed, Yossi can even fund a SEP IRA, which allows for as much as $61,000 in pretax contributions.
But Mind the 10% Penalty
There’s a problem, though. It’s definitely possible to shift income from this year forward using IRAs, but then what? Even if Yossi’s marginal tax rate is lower in 2024, if he gets hit with an IRA’s 10% early-withdrawal penalty, using it to shift income probably won’t lower his tax bill. So, it depends. If he’s over age 59.5, there is no early withdrawal penalty, and there are also penalty exceptions for large medical bills, higher-education expenses (beis medrash and seminary costs may qualify), and, within limits, having a baby ($5,000) or buying a home for the first time ($10,000).
Similarly, using 401(k)s to lower taxable income is not a simple way to shift income from year to year. Most corporate 401(k) plans do not allow withdrawals pre-retirement, and even if money can come out, you need to deal with the aforementioned early-withdrawal penalty. As a self-employed person, Yossi can open a solo 401(k) to shelter a lot of money, but he may not be able to access it penalty-free. If so, it probably won’t serve its intended purpose for short-term tax-efficient usage. One caveat may be using the loan feature attached to many 401(k)s for limited access in a tax-free fashion.
The Sooner the Better
With some help from his accountant, Yossi may be able to lower his tax bill significantly, keeping more money in his pocket for the lean years. Ideally, this tax planning would have been taking place, in a well-designed approach, throughout the year, as it’s a lot more likely to be fruitful when planned over time rather than in a rush at year’s end. But it’s better late than never.