5 Reasons Your Tax Bill May Be Higher Than Normal This Year

April 15th marks the deadline for filing federal tax returns for the 2023 tax year. Many taxpayers are noticing a higher tax bill than normal this year, and there are several reasons why.

The year 2023 saw above-average interest rates, a robust stock market, and significant layoffs in the technology sector. These economic changes may have led to unexpected income or capital gains for many, thereby increasing their tax liabilities.

While every taxpayer’s situation is different, certain trends from 2023 likely contributed to the steeper tax bills many of us face this tax season. In this blog post, we’ll examine some of these key factors and offer strategies to help manage your tax burden more effectively in the future.

#1: Higher Yields on Cash Savings Might Mean a Higher Tax Bill

Interest rates in 2023 were notably higher than in previous years, leading to higher yields on cash savings accounts, certificates of deposit (CDs), and money market funds. For instance, some savings accounts that paid a mere 0.50% annual percentage yield in 2022 paid upwards of 4% in 2023, according to data from NerdWallet. 

While higher yields were a welcome change for savers who had seen minimal returns on these accounts in the past, this jump meant that the interest they earned from these sources, which the IRS considers taxable income, was also higher. For taxpayers with significant cash reserves, this increase may have pushed them into a higher tax bracket, resulting in a higher tax bill. 

The Federal Reserve has hinted at lowering rates as soon as this year, which might mean yields on savings accounts have peaked for the time being. Nevertheless, the following strategies can help you capitalize on higher yields without significantly increasing your tax burden: 

• Leverage Tax-Deferred Accounts. Consider moving extra cash into tax-deferred accounts such as Individual Retirement Accounts (IRAs) or 401(k)s when possible. Contributing to a traditional IRA or 401(k) can result in an immediate tax deduction. Plus, funds in these accounts can grow tax-free until withdrawal, helping to minimize your current taxable income.
• Consider Tax-Exempt Investments. If you tend to hold a significant amount of cash, consider investing some of your savings in tax-exempt securities like municipal bonds. The interest from these bonds is generally exempt from federal income tax and, in some cases, state and local taxes, allowing you to earn income without it increasing your overall tax lability.

#2: Capital Gains Resulting from Investment Activities  

The S&P 500 advanced more than 24% in 2023, encouraging many investors to lock in gains by selling profitable investments. While this approach often contributes to a successful investment strategy, realizing capital gains outside of a qualified investment account such as an IRA or 401(k) typically results in capital gains taxes.

For those who sold stocks, bonds, real estate, or other assets at a profit in 2023, these gains may have led to a higher tax bill than normal. This is especially true if you realized gains on investments you held for less than a year, as short-term capital gains count as ordinary income for tax purposes. 

Mutual fund investors may have also had taxable gains in 2023, even if you didn’t sell your shares. The portfolio managers in charge of these funds may have realized gains on successful investments, resulting in a capital gains distribution. These distributions typically occur annually and can come as a surprise to investors who aren’t prepared for them. 

Fortunately, there are strategies that can help mitigate the tax impact of capital gains and potentially enhance the overall efficiency of your investment portfolio. Examples include: 

• Hold Investments Longer. By holding investments for more than a year, gains qualify as long-term capital gains, which are taxed at a lower rate than short-term gains. This approach not only allows for potential appreciation but also minimizes the tax hit when you do decide to sell.
• Tax-Loss Harvesting. This strategy involves selling other investments at a loss to offset the taxes due on gains. However, it’s important to carefully manage the timing of these sales to maximize the tax benefits and avoid violating the IRS’s wash-sale rule. 

#3: Under-Withholding Taxes from Cash Bonuses and RSUs

If you received a cash bonus or had restricted stock units (RSUs) that vested in 2023, you may not have withheld enough taxes from these income sources to cover your entire tax obligation. Typically, employers withhold taxes from bonuses and vesting RSUs at a flat rate, which might be lower than your actual tax rate, especially if the additional income pushes you into a higher tax bracket. 

For the 2023 tax year, the IRS withholding rate is a flat 22% of supplemental income unless your compensation exceeds $1 million. In this case, the withholding rate is 37%.

Under-withholding taxes can lead to an unexpected tax liability and overall higher tax bill when you file your tax return. However, the following strategies can help you avoid surprises and potential penalties: 

• Adjust Withholding on Regular Paychecks. If you anticipate receiving bonuses or large equity grants, consider adjusting the withholding on your regular salary to cover the shortfall. You can do this by filing a new W-4 form with your employer.
• Make Estimated Tax Payments. For those with significant non-wage income, making quarterly estimated tax payments can help manage the tax impact. Estimated tax payments allow you to spread out the tax burden, avoiding a large lump-sum payment at tax time.

Implementing these strategies can provide a more balanced approach to managing your tax obligations throughout the year. 

If you’re a Googler or Meta employee with RSUs, you can find more information about withholding taxes here: Managing GSU Withholding Tax: A Guide for Googlers; Managing RSU Withholding Tax: A Guide for Meta Employees. 

#4: Phasing Out of the Child Tax Credit Leading to a Higher Tax Bill

The Child Tax Credit is designed to provide financial relief to families with children, offering a potentially significant tax break. However, this credit begins to phase out for households with higher income levels. 

For the 2023 tax year, the phaseout of this credit begins for single filers with modified adjusted gross income (MAGI) above $200,000 and joint filers with MAGI above $400,000. Households with incomes that exceed these thresholds may be eligible for a partial credit. 

If your taxable income increased in 2023, you may not have qualified for the Child Tax Credit. This may have resulted in a significantly higher tax bill compared to previous tax years when you were eligible to claim this credit.  

If you expect your household income to exceed these thresholds moving forward, there are strategies you can implement to help mitigate the additional tax burden. These include: 

• Income Spreading. If possible, consider strategies to spread income across multiple years to avoid hitting the phase-out threshold in a single year. This could involve deferring bonuses or managing the timing of capital gains and losses.
• Maximize Other Deductions and Credits. Be sure to explore other tax deductions and credits available for families, such as the Dependent Care Credit, Education Credits, or increased contributions to tax-advantaged accounts like 529 plans for educational expenses. 

By planning ahead and making use of other available tax benefits, you can manage the impact of losing the Child Tax Credit as your income grows.

#5: Tax Implications of Exercising Stock Options After a Layoff  

Many companies in the tech sector underwent significant layoffs in 2023, which meant many tech professionals lost their jobs unexpectedly. This may have forced some employees to make quick decisions regarding their vested or unvested stock options. 

Typically, there are set time frames (often 90 days post-termination) within which terminated employees must exercise their options, or they forfeit them. This condensed decision-making period can lead to exercising a large number of options within a single tax year, potentially increasing taxable income and leading to a higher tax bill.

If you lost your job unexpectedly in 2023, the temporary reduction in income may have offset any additional taxes you incurred due to exercising stock options. However, if you find yourself needing to exercise stock options within a limited timeframe, you may be able to mitigate the associated tax burden by employing the following strategies:

• Strategic Exercise of Options. If possible, consider staggering the exercise over the allowable period to manage the tax impact. Review the specific terms of your stock option plan and consult with an experienced advisor like Simplicity Wealth Management to optimize the timing based on your tax situation and market conditions.
• Capital Gains Management. If you exercise and then sell your stock options for a profit, you’re also subject to capital gains tax. To minimize taxes, consider holding the shares for at least a year post-exercise to qualify for the lower long-term capital gains rate. You may also be able to use tax-loss harvesting to offset gains and lower your overall tax bill. 

Simplicity Wealth Management is here to help. 

The 2023 tax year presented a unique set of challenges that may have led to a higher tax bill for many individuals. However, by understanding the implications of your financial decisions throughout the year and implementing effective tax management strategies, you can potentially reduce your tax liability and avoid surprises come next tax season.  

For those working in the technology sector, where compensation packages often include bonuses, equity grants, and stock options, proactive tax planning is especially critical. A financial advisor with expertise in equity compensation and tax implications can provide invaluable guidance. Simplicity Wealth Management is a fee-only financial advisor specializing in the financial planning needs of tech professionals with equity compensation. We can help you develop a comprehensive plan that aligns with your unique financial circumstances and goals, enabling you to make the most of your financial resources while minimizing taxes. Schedule a call today to get started.