Running the Numbers

Richard Connor

THE HOLIDAY SEASON is upon us. Our thoughts—or mine at least—turn to family, friends, wine, decorations, gifts, wine, food, fun and wine. But before I ring in the new year, I have a few financial questions I need to resolve.

Our 2022 income hasn’t been what I expected. I earn consulting income in two ways. I’m a part-time employee of a small engineering consulting firm. In this role, I’m an hourly employee with no benefits. I get a paycheck with federal, state and Social Security payroll taxes withheld. At the end of the year, I receive a W-2 tax form from my employer. This year, the work I expected hasn’t materialized and, to date, I’ve earned just $850.

I also own a small business—a sole proprietor LLC. I use this for direct consulting to several small businesses. I invoice customers and receive a check based on an hourly rate and how much time I put in. At the end of the year, I’m sent a 1099-NEC form by the companies I’ve worked for. The primary project I expected to support this year seems to have been delayed until 2023, so I’ve earned a mere $280.

As you can see, it hasn’t been a lucrative year for my consulting. That’s okay. We don’t count on me collecting a specific amount of earned income. Anything I make is nice, but it isn’t necessary. The previous two years were better, but not greatly so. The pandemic limited both my consulting opportunities and my willingness to travel.

To handle the variations in the income collected by my wife and me, I developed a spreadsheet that tracks our income, tax withholding and expected tax bills. I update it as things change. I found this necessary because, as a business owner, I’m required to pay quarterly estimated taxes to the federal and state government. You can be penalized if you don’t make timely and adequate estimated payments. You’re also responsible for self-employment taxes, which are a hefty 15.3%. My spreadsheet helps me stay on top of any required estimated tax payments.

I also use the spreadsheet to keep tabs on our current year’s tax withholding. I receive a traditional pension, from which both federal and state taxes are withheld. I also have taxes withheld from any retirement plan distributions. In 2022, I was overly conservative in my withholding. We stand to get a fairly sizable tax refund from both the federal and state government. Although it’s nice to get a big check, I don’t like making an interest-free loan to Washington, D.C., and New Jersey. I’ll likely dial back our withholding for 2023.

In addition, I use my spreadsheet to decide how much, if any, of my self-employment income I want to contribute to my solo 401(k). I started this in 2017, and it has been a great addition to our retirement portfolio. You can generally save your “net earnings from self-employment less one-half of your self-employment tax.” In the past, this has produced a nice tax savings. This year, I can make a tax-deductible contribution of some $258 out of the $280 that I earned—not a lot, but every little bit helps.

The final and biggest question that my spreadsheet helps answer: Should I do a Roth conversion? In an earlier article, I wrote about my plan to assess annually whether to convert. Since then, we’ve moved from Pennsylvania to New Jersey. Pennsylvania doesn’t tax retirement income, but New Jersey may, depending on your total income.

Even with my minimal consulting income this year, I calculate that our marginal New Jersey state income-tax rate will be 6.37%. Figure in our 24% marginal federal rate, and my spreadsheet shows that any Roth conversion would be subject to a combined federal and state tax rate of above 30%.

There are multiple reasons to do a Roth conversion, such as reducing future required minimum distributions or to leave a tax-free inheritance. This year’s market losses also make it an attractive time to convert. But barring a significant tax code change, I don’t think our future federal marginal tax rate will exceed our current 24% bracket.

My wife will begin collecting her Social Security benefits in 2023. This income will replace the IRA withdrawals we’d otherwise make. Social Security is tax-advantaged at the federal level—at most 85% of the amount is taxed—and it isn’t taxed at all in New Jersey. This means there’s a real chance we can lower the state tax on future IRA withdrawals and perhaps avoid it entirely. The upshot: I’ve concluded that a Roth conversion this year doesn’t make sense, given our likely 2022 tax rate and the chance that we’ll be taxed less heavily in future years. But I’ll check again in 2023.

Richard Connor is a semi-retired aerospace engineer with a keen interest in finance. He enjoys a wide variety of other interests, including chasing grandkids, space, sports, travel, winemaking and reading. Follow Rick on Twitter @RConnor609 and check out his earlier articles.

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