30:["$","$L31",null,{"category":"$32","relatedArticles":[{"id":"cG9zdDoyMTk3NjI=","databaseId":219762,"postId":219762,"author":{"node":{"id":"dXNlcjo5Mw==","databaseId":93,"userId":93,"avatar":{"url":"https://secure.gravatar.com/avatar/04483497dbd73f712b504e401c9c7d22?s=96&d=mm&r=g","size":96,"__typename":"Avatar"},"description":"Mark Henricks has reported on personal finance, investing, retirement, \r\nentrepreneurship and other topics for more than 30 years. His freelance \r\nbyline has appeared on CNBC.com and in The Wall Street Journal, The New York Times, The Washington Post, Kiplinger’s Personal Finance and other leading publications. Mark has written books including, “Not Just A Living: The Complete Guide to Creating a Business That Gives You A Life.” His favorite reporting is the kind that helps ordinary people increase their personal wealth and life satisfaction. A graduate of the University of Texas journalism program, he lives in Austin, Texas. In his spare time he enjoys reading, volunteering, performing in an acoustic music duo, whitewater kayaking, wilderness backpacking and competing in triathlons.","additionalMeta":{"expertise":null,"__typename":"User_Additionalmeta"},"email":null,"firstName":"William","fullName":"Mark Henricks","lastName":"Henricks","name":"Mark Henricks","postCount":{"pageInfo":{"offsetPagination":{"total":766,"__typename":"OffsetPaginationPageInfo"},"__typename":"UserToPostConnectionPageInfo"},"__typename":"UserToPostConnection"},"slug":"mhenricks","__typename":"User"},"__typename":"NodeWithAuthorToUserConnectionEdge"},"categories":{"nodes":[{"id":"dGVybToxMzY=","children":{"nodes":[{"name":"Other","slug":"other-taxes","__typename":"Category"},{"name":"Tax Credits & Deductions","slug":"tax-credits-deductions","__typename":"Category"},{"name":"Tax Filing","slug":"tax-filing","__typename":"Category"},{"name":"Tax Planning","slug":"tax-planning","__typename":"Category"},{"name":"Tax Policy","slug":"tax-policy","__typename":"Category"}],"__typename":"CategoryToCategoryConnection"},"databaseId":136,"categoryId":136,"link":"https://smartasset.com/taxes/articles","name":"Taxes","postCount":{"pageInfo":{"offsetPagination":{"total":244,"__typename":"OffsetPaginationPageInfo"},"__typename":"CategoryToPostConnectionPageInfo"},"__typename":"CategoryToPostConnection"},"slug":"taxes","ancestors":null,"parent":null,"__typename":"Category"}],"__typename":"PostToCategoryConnection"},"content":"$33","date":"2023-11-16T07:22:13","excerpt":"

Imagine your child is getting married and you want to help pay for their wedding. You’ve been saving for years and now have $30,000 set aside for their big day, which you plan to hand over in the form of a check. However, before you pass along that much cash, it’s important to understand the […]

\n","featuredImage":{"id":"cG9zdDoyMTk3OTI=","databaseId":219792,"altText":"","date":"2023-11-14T14:52:01","fileSize":57940,"mimeType":"image/jpeg","modified":"2023-11-14T14:52:01","sourceUrl":"https://smartasset.com/wp-content/uploads/sites/2/2023/11/wedding-event-and-father-with-bride-at-chapel-for-celebration-faith-and-marriage-ceremony.jpg_s1024x1024wisk20cXhTIW1JB9Cl7ZfbhyGdtDguGh6kdODiqtRAO-caJRw4.jpg","__typename":"MediaItem"},"modified":{"datetime":"2023-11-16","readable":"November 16, 2023"},"multipleBylinesByRole":{"editedBy":{"id":"dXNlcjoxMjA=","databaseId":120,"userId":120,"avatar":{"url":"https://secure.gravatar.com/avatar/9be66d92947dd5b190bf90987b5e85f2?s=96&d=mm&r=g","size":96,"__typename":"Avatar"},"description":"Patrick Villanova is an editor for SmartAsset, producing comprehensive personal finance content to help consumers make better decisions with their money. His particular areas of focus include retirement, financial planning and investing. Patrick studied English at the University of New Hampshire and currently holds the Certified Educator in Personal Finance (CEPF) designation. \r\n\r\nPrior to joining SmartAsset, Patrick was a senior writer at MagnifyMoney, where he covered investing. His career began in journalism and included 11+ years at The Jersey Journal, where he covered sports and news as an editor. His work has appeared on Yahoo Finance, MSN, NJ.com, and The Star-Ledger. He lives in Portland, Oregon.","additionalMeta":{"expertise":"Retirement Planning, Social Security, Estate Planning, Taxes","__typename":"User_Additionalmeta"},"email":null,"firstName":"Patrick","fullName":"Patrick Villanova, CEPF®","lastName":"Villanova, CEPF®","name":"Patrick Villanova, CEPF®","postCount":{"pageInfo":{"offsetPagination":{"total":308,"__typename":"OffsetPaginationPageInfo"},"__typename":"UserToPostConnectionPageInfo"},"__typename":"UserToPostConnection"},"slug":"pvillanova","__typename":"User"},"reviewedBy":null,"writtenBy":{"id":"dXNlcjo5Mw==","databaseId":93,"userId":93,"avatar":{"url":"https://secure.gravatar.com/avatar/04483497dbd73f712b504e401c9c7d22?s=96&d=mm&r=g","size":96,"__typename":"Avatar"},"description":"Mark Henricks has reported on personal finance, investing, retirement, \r\nentrepreneurship and other topics for more than 30 years. 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In his spare time he enjoys reading, volunteering, performing in an acoustic music duo, whitewater kayaking, wilderness backpacking and competing in triathlons.","additionalMeta":{"expertise":null,"__typename":"User_Additionalmeta"},"email":null,"firstName":"William","fullName":"Mark Henricks","lastName":"Henricks","name":"Mark Henricks","postCount":{"pageInfo":{"offsetPagination":{"total":766,"__typename":"OffsetPaginationPageInfo"},"__typename":"UserToPostConnectionPageInfo"},"__typename":"UserToPostConnection"},"slug":"mhenricks","__typename":"User"},"factCheckedBy":{"id":"dXNlcjoxNjc=","databaseId":167,"userId":167,"avatar":{"url":"https://secure.gravatar.com/avatar/ddd04b792d5bd154ea791bf3a9ec0edb?s=96&d=mm&r=g","size":96,"__typename":"Avatar"},"description":"Jaclyn is Director of Economic Analysis at SmartAsset. With a bachelor of arts in economics from The College of New Jersey, she evaluates data for trends that affect your financial life. 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In his spare time he enjoys reading, volunteering, performing in an acoustic music duo, whitewater kayaking, wilderness backpacking and competing in triathlons.","additionalMeta":"$35","email":null,"firstName":"William","fullName":"Mark Henricks","lastName":"Henricks","name":"Mark Henricks","postCount":"$36","slug":"mark-henricks","__typename":"User"},"editedBy":{"id":"dXNlcjoxMjA=","databaseId":120,"userId":120,"avatar":"$39","description":"Patrick Villanova is an editor for SmartAsset, producing comprehensive personal finance content to help consumers make better decisions with their money. His particular areas of focus include retirement, financial planning and investing. Patrick studied English at the University of New Hampshire and currently holds the Certified Educator in Personal Finance (CEPF) designation. \r\n\r\nPrior to joining SmartAsset, Patrick was a senior writer at MagnifyMoney, where he covered investing. 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","

However, before you pass along that much cash, it’s important to understand the potential tax implications of making a $30,000 gift. A gift that size could require you to pay the federal gift tax, which can reach up to 40%. The good news is you may avoid paying gift taxes altogether, but there are reporting requirements and other limitations to keep in mind. Consult a financial advisor to minimize your gift tax obligations.

","

Federal Gift Tax at a Glance

","

The federal gift tax applies when you transfer money or property to someone else without receiving something of equal value in return. Gift tax rates range from 18% to 40% based on the size of the gift.

","

However, not all gifts trigger this federal tax. The IRS allows you to give away up to $17,000 ($34,000 for married couples) per year to each individual without owing any taxes on the gift. This is called the annual exclusion, and in 2024 it will increase to $18,000 per person.

","

However, gifts that exceed this annual exclusion aren’t necessarily taxed either. Instead, they reduce the amount of money or property you can give away tax-free over the course of your lifetime. This lifetime limit is known as the basic exclusion amount or lifetime exemption and it’s adjusted each year for inflation.

","

The gift tax only applies when you exhaust your lifetime exemption. In 2023, a person can give away up to $12.92 million over the course of their lifetime without triggering the gift tax (this will increase to $13.61 million in 2024). For example, if someone were to give away $13 million, they would pay gift taxes on only $80,000. And if you need additional help planning for major gifts, consider matching with a financial advisor.

","

How the Gift Tax Could Affect a $30,000 Wedding Gift

","

","

If you want to give a child $30,000 to help pay for a wedding, there are a few different ways it could be structured.

","

As a gift solely from you to your child, a $30,000 wedding gift would avoid most tax liability on its own. The gift only exceeds the $17,000 annual exclusion for 2023 by $13,000, so that’s all that could potentially be taxable if you’re single.

","

If this is your first time exceeding the annual exclusion, there’s more good news. In that case, the $13,000 excess would simply reduce your $12.92 million lifetime exclusion by that amount. You would not actually have to pay any gift tax unless you exceed your remaining lifetime exclusion, though you still have to fill out Form 709.

","

Alternatively, you could gift both your child and their future spouse $15,000 each and avoid the annual exclusion threshold (remember, you can gift up to the annual exclusion amount per year per person).

","

To make sure you structure your gifts in your best interest, talk it over with a financial advisor.

","

How to Avoid Gift Tax on a $30,000 Wedding Gift

","

But what if you’re quite wealthy and you’ve already exceeded your lifetime limit? If it looks like you’re going to owe taxes on your $30,000 wedding present, there are a few more ways you could potentially avoid them:

","

Gift-splitting with spouse: If you’re married, you and your spouse could consent to split the gift on your tax returns. This would let you each make $17,000 in gifts (in 2023) without exceeding the annual exclusion. This way, you could give your child up to $34,000 tax-free.

","

Pay expenses directly: Another way to get around the gift tax is to pay wedding vendors directly rather than gifting the cash to your child.

","

Spread gifts over multiple years: You could also give up to the annual exclusion per year over multiple years and avoid triggering the gift tax.

","

Limits and Risks of Avoiding the Gift Tax

","

","

While there are a number of ways you can legally avoid paying the gift tax, there are still requirements and risks to consider. Some of those include:

","

Proper reporting: Gift amounts over $17,000 must be reported to the IRS on Form 709 to track lifetime exclusion. Failing to file Form 709 can lead to penalties.

","

Mutual consent: Gift-splitting requires that both spouses consent and file Form 709. Failing to demonstrate mutual consent can also lead to IRS penalties. Additional considerations may come into play when gift-splitting if you live in one of the nine community property states.

","

State gift tax: Two states – Connecticut and Minnesota – impose state gift taxes. This could lead to tax even if federal gift tax is avoided.

","

Lifetime limits will decrease in 2026. The Tax Cuts and Jobs Act (TCJA) doubled the lifetime gift and estate tax exemption limit in 2018 for individual filers. But starting in 2016, that generous cap will revert to pre-2018 levels (adjusted for inflation). Keep in mind that a financial advisor can help you navigate and interpret tax law changes.

","

Bottom Line

","

Most people can avoid having to pay federal gift tax when contributing $30,000 to a child’s wedding. This is because of the generous lifetime exclusion amount gifts. However, you’ll still need to properly report gifts over the annual exclusion amount on your tax return. For 2023, this amount is $17,000. In 2024, the exclusion amount goes up to $18,000. For taxpayers whose gifts may exceed the lifetime $12.92 million tax-free exclusion amount, gift-splitting and other strategies may provide a way to fund a wedding without incurring a tax.

","

Tax Planning Tips

","$4a","

As tax season approaches, SmartAsset’s Federal Income Tax Calculator can tell you how much you may owe in federal, state and local income taxes next time you file.

","

Photo credit: ©iStock.com/PeopleImages, ©iStock.com/designer491, ©iStock.com/shapecharge

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Imagine you have $50,000 to give to your daughter and her husband for a down payment on their new home. The question is, will you owe gift taxes because of your generous gesture? Despite popular framing, the federal gift and estate taxes only apply to very wealthy households. Unless you have approximately $13 million to […]

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Patrick studied English at the University of New Hampshire and currently holds the Certified Educator in Personal Finance (CEPF) designation. \r\n\r\nPrior to joining SmartAsset, Patrick was a senior writer at MagnifyMoney, where he covered investing. His career began in journalism and included 11+ years at The Jersey Journal, where he covered sports and news as an editor. His work has appeared on Yahoo Finance, MSN, NJ.com, and The Star-Ledger. 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Imagine you have $50,000 to give to your daughter and her husband for a down payment on their new home. The question is, will you owe gift taxes because of your generous gesture?

","

Despite popular framing, the federal gift and estate taxes only apply to very wealthy households. Unless you have approximately $13 million to give away over your lifetime, these taxes likely won’t apply to you.

","

A financial advisor can help you navigate and plan for gift and estate taxes. Find an advisor today.

","

To be very clear, these are the rules for federal taxation. Every state also has its own tax laws and every tax profile is different, so make sure to speak with a financial or tax professional before making any plans for your own assets. However, there are two main issues to consider within this scenario: the mortgage process and potential gift tax implications.

","

Down Payments and Gifts

","

","

With the mortgage and lender process, you want to ensure that you fill out all forms and requirements correctly. It is extremely unlikely that you can complicate the title to this property, but you can certainly complicate or invalidate the loan by making a mistake.

","

When your daughter applies for her mortgage, the lender will go through her finances in detail. They want to know what assets she has, where they came from, what income she has and any other information related to how she will repay this debt. The down payment is intended as an indicator of this financial stability, so receiving it from a third party can raise concerns.

","

Many lenders have rules around who can provide the money for a down payment. It’s common for them to reject a mortgage with a gifted down payment unless that money comes from someone with a longstanding relationship to the borrower. Among other issues, this is intended to prevent fraud and money laundering. Since the borrower is your daughter, that shouldn’t be a problem.

","

If you are giving the money directly to your daughter you will typically either need to “season” the money or provide a gift letter. Seasoning the money means transferring it more than 60 days in advance, again as an indicator of legitimacy against fraudulent transfers. A gift letter is a document signed by both the giver and the recipient confirming that this is a unilateral transfer with no right to repayment.

","

The specific format of the gift letter will vary based on lender and jurisdiction, so consult an attorney about this document. A financial advisor can also potentially help you through this process.

","

You may also make this transfer through the loan process, making the down payment on your daughter’s behalf rather than transferring the money to her. The lender will require you and your daughter to disclose this during the loan application process. In and of itself, your gift will typically not be a problem, but failing to specify the difference between borrower and payer will almost always complicate (if not invalidate) the loan.

","

Gift Tax Exclusions and Exemption Limits

","

","

Beyond the rules that surround making a gift of this sort, your main consideration here is the gift tax.

","

This is a tax that the IRS places on unilateral transfers. If you give someone money or assets without expecting fair-value compensation in return, you have given them a gift. If you give them enough money, eventually you (the gift giver) must pay taxes on the transfer. Gift tax rates range from 18% to 40% based on the size of the gift.

","

However, the gift tax only applies to very few households due to a pair of important tax provisions: an annual exclusion and a lifetime exemption limit. And if you have additional questions about either, consider speaking with a financial advisor.

","

Annual Exclusion

","

The first is the gift tax’s annual exclusion. This is the amount of money you can give to someone each year regardless of gifts in past or future years. In 2023, the annual exclusion is set at $17,000 for individuals and $34,000 for married couples who file their taxes jointly. In 2024, those limits will increase to $18,000 for individuals and $36,000 for married couples.

","

The annual exclusion applies on a per-recipient basis. So, for example, say that you had four children. You could give each of them $17,000 in 2023 without triggering any gift taxes.

","

Lifetime Exemption

","

The lifetime gift and estate tax exemption is the amount of money you can give away over the course of your life – or at your death – without triggering either gift or estate taxes. For gifts that exceed the annual exclusion, the difference is applied to your lifetime exemption. If you give someone a gift over that year’s annual exclusion and have exhausted your lifetime exemption, you’ll owe gift taxes on the amount of money that exceeds that year’s exclusion.

","

In 2023, the lifetime gift and estate tax exemption is $12.92 million for individuals, which means married couples have a combined exemption limit of $25.84 million. In 2024, the exemption will increase to $13.61 million for individuals and $27.22 million for married couples. If an individual has already gifted $12.92 million over the exclusion limits by 2023, they will be able to gift another $690,000 in 2024 (not including the annual exclusion amount).

","

Unlike the annual exclusion, the lifetime exemption does not reset. While you can gift up to the annual exclusion each year, any remainder permanently reduces your lifetime cap. The lifetime exemption is on a per-donor basis, meaning that it applies collectively to all gifts you have given. For example, say that in 2023 you give $20,000 to each of your four children. Each gift exceeds the exclusion by $3,000. Collectively, they would lower your lifetime gift and estate tax exemption by $12,000.

","

Gift Taxes And Down Payments

","

When it comes to your daughter’s down payment, the tax issues are this: Are you married? And how much have you given away throughout your life? Let’s assume you’re single for simplicity’s sake.

","

First, if you give her the down payment money in 2023, the first $17,000 of the gift will automatically be free of any potential tax liability. However, since the gift exceeds the annual exclusion by $33,000, that remainder will lower your lifetime exemption.

","

So, for example, if you have never given anyone a taxable gift, you will pay no gift tax and your annual exclusion will be reduced to $12.887 million ($12.92 million minus $33,000). If you have already exhausted your lifetime exemption, you would have to pay taxes on the $33,000.

","

However, there would still be ways to manage this potential tax liability. If you could wait until 2024 to give your daughter the money, your lifetime exemption would go up to $13.61 million. You can apply the remainder to the newly raised cap and will owe no taxes on the excess gift. But if you need additional help managing your tax liability, consider working with a financial advisor.

","

Bottom Line

","

Unless you have gifted more than $12.92 million over your lifetime, you can almost certainly give a $50,000 down payment to your daughter or other family member and not owe gift taxes in 2023. Just be careful to do the paperwork right, otherwise, it could complicate the loan.

","

Gift Tax Tips

","$5d","

Photo credit: ©iStock.com/gradyreese, ©iStock.com/payphoto, ©iStock.com/designer491

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While you can’t avoid taxes, the IRS allows you to lower your tax burden by combining tax deductions and credits. Here are nine common tax-saving strategies to protect your wealth. A financial advisor can help optimize your investment portfolio to lower your taxes. Aim For Long-Term Capital Gains Long-term capital gains are profits from the […]

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While you can’t avoid taxes, the IRS allows you to lower your tax burden by combining tax deductions and credits. Here are nine common tax-saving strategies to protect your wealth.

","

A financial advisor can help optimize your investment portfolio to lower your taxes.

","

Aim For Long-Term Capital Gains

","

Long-term capital gains are profits from the sale of assets held for more than one year. The tax rates on long-term capital gains are typically lower than those on short-term gains, providing an opportunity for tax efficiency. For example, a single filer making $95,000 in 2024 will pay a 15% long-term capital gains rate. On the other hand, their tax rate for standard income and short-term capital gains is 22%.

","

To qualify for long-term capital gains treatment, you must hold an asset for more than one year before selling it. In addition, your income level determines your capital gains tax rates. As a result, it’s advisable to sell investments to realize gains in years when your overall income is lower, potentially resulting in a lower tax rate.

","

Tax-loss harvesting can also help reduce your tax bill. Specifically, the U.S. tax code lets capital losses offset capital gains. This means you can deduct up to $3,000 of capital losses in excess of capital gains. So, if you sell assets for less than you bought them, the loss can lower your taxable income, and possibly lower your overall tax rate.

","

Max Out Retirement Accounts

","

Contributing pre-tax dollars to retirement accounts can reduce taxable income while building a nest egg for the future. Popular retirement accounts serving this purpose include 401(k)s and traditional IRAs.

","

You can lower your taxable income every year through contributions to traditional retirement accounts. Specifically, you can contribute $7,000 to an IRA in 2024 or $8,000 if you’re over age 50. Likewise, you can contribute $23,000 to your 401(k) in 2024 or $30,500 if you’re over age 50.

","

Taking advantage of one or both of these accounts can reduce your taxable income by tens of thousands of dollars. If your employer provides a 401(k) and you open an IRA, you could lower your taxable income by $30,000 if you’re under age 50.

","

In addition, 401(k)s and IRAs offer tax-deferred growth. This way, you won’t have a tax burden every year for how much your accounts accumulate. Instead, you’ll pay income taxes when you withdraw the money.

","

Invest in Municipal Bonds

","

State and local governments issue municipal bonds to fund public projects, such as schools and infrastructure. Investors buy these bonds and then receive the principal with interest over time from the government. In essence, municipal bond investors give municipalities a loan and profit from the interest payments. Fortunately, most municipal bond interest is exempt from federal income taxes, giving you a federal tax-free income stream. The downside is that municipal bond interest rates may be lower than other investments.

","

Fund a Health Savings Account

","

Health Savings Accounts (HSAs) are tax-advantaged accounts linked to high-deductible health plans. If your employer offers a health insurance plan with a high deductible (or you have your own high-deductible plan), you can contribute to an HSA and draw from the account to pay for medical expenses.

","

Your HSA contributions are made pre-tax, just like your 401(k). Your funds also grow on a tax-deferred basis, and your employer might even match a portion of your deposits. Withdrawals are tax-free if you use the funds to pay for medical care and other qualified expenses.

","

Like IRA and 401(k) contributions, your HSA has an annual limit. Specifically, individuals can contribute $3,850, and families can contribute $7,750 in 2023. The numbers for 2024 are $4,150 for individuals and $8,300 for families.

","

Claim Tax Credits

","

","

Tax credits directly reduce your tax liability, providing a dollar-for-dollar reduction in the amount of taxes you owe. You may qualify for the following:

","

Child Tax Credit: Families with qualifying children may be eligible for the Child Tax Credit. You’ll get up to a $2,000 credit for each dependent you have under age 17.
Child and Dependent Care Credit: If you pay for the care of a dependent adult or a child aged 13 or under, you can claim this credit. You can receive up to 20% to 35% of your care expenses, maxing out at $3,000 for one dependent and $6,000 for two or more.
Earned Income Tax Credit (EITC): The EITC lightens the tax burden of lower-income families. The more children you have, the higher the benefit. For example, qualifying families with three or more children in 2024 will receive $7,830, while qualifying families with one child will receive $4,213.

","

Contribute to a 529 Plan

","

A 529 plan is a tax-advantaged savings plan for future education costs. It’s like a 401(k) in that earnings are tax-deferred, but it pays for school instead of retirement. Contributions to a 529 plan are not tax-deductible on the federal level, but the earnings grow tax-free if used for qualified education expenses. Plus, contributions may be tax-deductible in some states.

","

Donate to Charity

","

Giving to a 501(c)(3) registered charity can also reduce your taxes. Both money and items count for this deduction. Specifically, you can deduct between 20% and 60% of your adjustable gross income in charitable donations, depending on your circumstances. Remember, itemizing your deductions is necessary to claim this tax advantage.

","

Look for State and Local Tax Breaks

","

Beyond federal taxes, explore tax breaks offered by your state and local governments. For example, more than 30 states offer pass-through entity tax benefits for small business owners. In addition, New York City residents receive an exemption for parking taxes, and New Jersey dwellers can deduct medical costs above 2% of their adjustable gross income.

","

Some states also have a 0% income tax rate. If you live in Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, or Wyoming, you won’t pay any state income taxes. Likewise, New Hampshire doesn’t tax earned income – but it does tax interest and dividends (though that is currently being phased out).

","

Make Your Home Energy Efficient

","

Investing in energy-efficient improvements for your home can result in tax credits and long-term cost savings. The Inflation Reduction Act of 2022 provides up to a $3,200 tax break through 2032 for heat pumps, energy-efficient windows and doors, and insulation improvements. Additionally, the Residential Clean Energy Credit provides a tax benefit equal to 30% of the cost of solar panels, wind and geothermal energy, and fuel cells/battery storage.

","

Bottom Line

","

","

Adopting strategic financial practices can significantly mitigate the impact of taxes on your income. Even if you take the standard deduction, you can qualify for most of the items listed above. Remember, saving for retirement provides one of the largest tax deductions available. Working with a tax professional can help ensure you’re optimizing your taxes and keeping as much of your hard-earned cash as possible.

","

Tips for Protecting Income from Taxes

","$76","

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Creating an S Corporation can potentially reduce self-employment taxes by allowing business owners to split their income into salary and distributions. While salary is subject to employment taxes, distributions (such as payments that are made to shareholders from a portion of company profits) can potentially be exempt from those taxes. Here’s what you need to […]

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If you are an entrepreneur, a financial advisor can work with you to create a financial plan for your needs and goals.

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How Self-Employment Taxes Work

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To understand self-employment taxes, let’s break them down to their fundamentals: they consist of 12.4% for Social Security and 2.9% for Medicare, culminating in a total tax of 15.3%. This tax can add up over time as you’re paying that every year, in some cases on top of paying business taxes in some states.

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Now, imagine you run a freelance graphic design business earning $50,000 in net income, all of it may count as your individual earnings, depending on your business formation of choice. You would pay $7,650 in self-employment taxes (15.3% of $50,000), significantly impacting your net income. It’s important to understand how you plan on setting your business up and what your long-term goals are, such as whether you plan on having employees, so you can make the right long-term tax decisions.

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How S Corporation Taxes Work

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S Corporations stand out with their distinctive tax structure, which can be a huge benefit to some. They function as pass-through entities, bypassing corporate federal income tax with corporate income, losses, deductions and credits passing through to shareholders. These ‘pass-through’ components effectively integrate into their personal tax returns, effectively sidestepping the potential double taxation that C Corporations face.

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This feature makes S Corporations attractive to many self-employed individuals. S corporations are its own formation option but you could also be taxed as an S corporation if you open a limited liability company (LLC) as well. Decisions between S and C Corporations (or how to be taxed as an LLC) can be complex, so consulting a financial advisor who can tailor advice for your situation can be incredibly beneficial.

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How S-Corp Distributions Are Taxed

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When we talk about distributions, we are referring to shareholders getting their share of the profits from an S Corporation. These distributions are taxed individually, and they are not subject to self-employment taxes, leading to potentially significant tax savings. However, there’s a catch: shareholders must receive a “reasonable compensation” which basically means you must pay yourself a reasonable salary if you work at the company. Your salary is taxed normally in your tax bracket.

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Let’s consider a business owner who earns a substantial income of $100,000. Her reasonable compensation might be $80,000, leaving $20,000 as a distribution that isn’t subject to employment taxes (though it would still be subject to regular income taxes). While this strategy could help lower your overall tax liability, you should note that it does not guarantee any tax savings, as it will depend on your specific finances.

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Reasons You May Want to Use an S Corporation

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While tax savings can be a significant benefit, it is crucial to consider other factors specific to your business and long-term goals before choosing an S Corporation. Factors like the ability to attract investors through stock issuance, the nature of your business and your earning potential play an equally important role. Consulting with a financial advisor can help in this decision-making process, evaluating upsides and risks with an S Corporation choice.

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Risks of Using an S Corp

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Choosing an S Corporation doesn’t necessarily translate into smooth sailing as it is very dependent on your situation.

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First, you should note that the potential tax savings may not always offset the administrative costs of maintaining an S Corporation, especially for smaller businesses with limited profits.

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Second, even though the S corporation itself doesn’t pay any income taxes, it still has to file a tax return, which can cost several thousand dollars to prepare.

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Third, many experts will tell you that there is a certain income you should meet before electing an S Corporation, in most circumstances, so that the benefits more than offset the costs.

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And fourth, bear in mind that this business structure requires that you pay reasonable salaries (which are subject to employment taxes), and restricts the number of shareholders to 100 U.S. citizens or residents.

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Bottom Line

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While S Corporations could help you minimize self-employment taxes by splitting income into salary and distributions, you should be aware of the requirements and potential risks before setting up this business structure.

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Tips for Tax Planning

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