Tax Planning Considerations When Getting a Raise

If your efforts last year led to a raise or possible bonus that you'll receive this year, congratulations! You've earned it.

Depending on their dollar amounts, you may now be in a situation where you'll have to make some income tax decisions. Here are a few basic tax planning tips to consider.

Did your tax bracket change?

Your federal—and some states'—tax rate is determined by the amount of your taxable income. If you're like most taxpayers, the bulk of your income comes from your salary. Bonuses are included in your salary for the year in which they're received. To determine your ordinary tax rate, take a look at published IRS tax brackets.

For the sake of comparison, let's focus on the 37% bracket for married couples filing jointly. In 2022, the 37% bracket begins at $647,850 of earned income. For 2023, it begins at $693,750 of earned income. Because tax brackets are indexed for inflation and 2022 saw record-high inflation levels, we're now seeing an almost $46,000 increase in the bottom threshold of the tax bracket.

Because of these higher-indexed brackets, it could be possible to receive both a bonus and a salary increase for 2023 and not move into the next-highest tax bracket—even if you were at the top of the bracket in 2022. For example, let's say your salary was $650,000 in 2022 and you received a 5% raise for 2023 and a 2022 bonus of $10,000. In this example, you were in the 37% tax bracket for 2022. However, your estimated salary for 2023 under this scenario comes to $692,500, which is below the threshold for the 37% bracket. In this case, you actually drop from the 37% bracket into the 35% bracket.

Moving into a higher tax bracket

What if you move into a higher bracket instead of a lower one? How can you manage a potential increase in your overall tax liability?

Your first step is to complete a 2023 tax projection. This will give you an idea of the tax liability you can expect. If you work with a tax professional, they should be able to complete this for you. If you prepare your own tax return, check your tax software to see if it includes a projection feature.

Once your projection is complete, you'll have an estimate of your current-year liability. You can then compare your tax withholdings to see whether you'll have a balance due with your return.

What if your tax projection shows a balance due?

If you're in a position to receive a refund, you most likely won't need to make any changes. But what if your projection shows a balance due when you file your current-year return? Fortunately, you have a few options to manage this anticipated liability so you can ultimately avoid paying interest or underpayment penalties.

If your expected balance due is less than $1,000, you won't incur any underpayment penalties. You'll simply pay the balance due. If it's more than $1,000, it might require some changes on your part to avoid penalties and interest. These can be avoided by meeting an estimated payment safe harbor. You can avoid penalties and interest, regardless of the size of the balance due, if either of these scenarios applies to you:

• You paid in 110% of your prior-year tax liability in the current year.
• You paid in 90% of your current-year tax liability.

You're required to use the 110% of prior-year method if your adjusted gross income is $150,000 or more. You can pay estimated taxes during the year through quarterly estimated tax payments, withholdings or a combination of the two.

If you choose to increase your taxes paid through extra payroll withholding, you'll need to complete a new Form W-4 and submit it to your payroll department. Your tax professional should also be able to help you with this. When you change your withholding, be sure to review the amount being withheld per paycheck and project it for the year. This will give you the total tax withheld to be compared against your estimated tax liability.

Quarterly estimated taxes are paid in through federal Form 1040-ES. Once you determine your tax shortfall, divide the liability by four and pay the amount in using the corresponding quarterly estimated tax payment form.

Ways to reduce your tax liability

Now that you have a higher income, you may be able to reduce your tax liability. If you participate in your employer's qualified retirement plan, you might consider increasing your salary deferrals to the plan to reduce your taxable income. For 2023, the maximum amount you can defer to a 401(k) plan has increased to $22,500. If you're 50 or older, you can make additional catch-up contributions up to $7,500—for a total deferral of $30,000 per year.

Another option to reduce your tax liability would be to use some of your extra cash to increase charitable contributions. This will add to your itemized deductions and reduce your taxable income. However, make sure you can actually use the deduction. If you use the standard deduction in lieu of itemizing, the extra contributions may not have an effect on your taxable income, which won't help to reduce your tax liability.

The bottom line

Take time to celebrate your hard work that earned you a bonus and raise for this year—but also don't forget to be proactive about your new tax situation. Get an idea of how your tax liability has changed so you can determine whether you need to take steps to reduce it. And don't forget to talk about it with a trusted tax professional.