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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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I’m single with no children. My only close relative is unlikely to need an inheritance from me (I’ve discussed it with her), so most of my estate will go to charities. Since the charities won’t be required to pay tax on my traditional IRA, I realized that it doesn’t make much sense to continue to convert the account to a Roth.
Making assumptions and doing the math is always the best way to make long term tax decisions, so my hat is off to you for doing that. Personally, though, I might take a guaranteed hit now versus a future risk. My reasoning is that I expect the funds to continue to grow, and after the roth conversion that will be tax-free, so there’s an upside there, and I expect the tax rates to also increase, although I don’t know when, and so that also inclines me to take the hit sooner rather than later. So I might convert enough that I at least get to the top of my current tax bracket, rather than hoping for a drop in brackets or rates in future years.
Richard, when doing future tax projections, one should also consider any potential IRRMA ‘tax’ impact also.as well as the taxability of SS – a potential large impact when transitioning through the lightly taxed range for SS until you hit the full 85% taxability as each dollar of other income can increase SS taxability by as much as another 50 to 85% until taxability is maxed out. The 22% bracket times 1.85 actually contains an effective 40.7% bracket within its range for some You comment however that you expect to be in the 24% bracket in the future, so I expect your SS will be fully taxed(85%) or close to it? Can be complicated – there are some YTube videos that cover the topic for those not well versed in.
Good luck in your crystal balling. On top of that, you can’t control what Congress will do in the future, so I periodically reevaluate and just hope my decisions reasonably workout. You meniton inheritance considerations – one of mine too. When the Secure Act changed inherited IRA rules I had to update my recently redone Will and beneficiary breakdown of who gets what – Roth, IRA or non IRA money. And keep track of capital gain step up money too – to preserve or cash out if you have the ability to choose.
Lots to think about, but instead of puzzles as other seniors do…..
Yes – all of this!
“The complexity of the variables involved in a decumulation strategy — life expectancy, expected portfolio returns, estimating retirement spending needs (especially health care) over a 30-year span, and the impact of inflation — makes three-dimensional chess look like a game of Go Fish by comparison. Nobel Laureate William Sharpe“
He went on to say that all the constantly moving variables make decumulation the nastiest, hardest problem in fanance.
Portfolio management isn’t what we need – it’s an emerging new personal finance service called Advice-Only financial planning. Maybe that’s something to check out, Richard.
When interest rates went from 0% to 4% in a short time, I had a lot of income I was definitely not expecting. I had to take some money from a Roth IRA and have 99% withheld for taxes to get caught up.
Richard, are you sure you can have a marginal federal tax rate of 24% and 8.97% state marginal rate at the same time?
Dick, thanks for checking. You are correct – I found a typo in my spreadsheet. The correct value for state marginal rate is 6.37%. I would be happy to hit the 8.97% marginal rate (over $500k total income)!
Made that fix to the story!
Thanks Jonathan.
Thanks Richard. Your article is a good real life example of how to do this.
It is that time of year again, indeed past it for me. By this time I’m usually long done with assessing our year, and considering whether to make a Roth conversion, and/or whether to harvest some capital gains.
This year has been a weird one though. Traveling for most of it, overseas for most of that, then selling the house and putting everything in storage, and now nomadic. These financial things that would normally be top of mind (IOW, that I would geek out on) just haven’t been.
In a few days we’ll stop in one place for 10 days sitting two cats, the longest we’ll have been in one spot since hitting the road. That’ll be time to do some homework.