High Rates and a Hot Market Make Tax Returns Trickier

(Bloomberg) — Americans who enjoyed capital gains from a rallying stock market or interest from high-yield savings accounts in 2023 may have a few surprises waiting for them in their tax bill.

That’s emerging as one of the major themes of this year’s tax filing season. But there are even more considerations taxpayers should be aware of ahead of the April 15 deadline. This includes a new and free way to file federal taxes, if you’re eligible, and higher interest rates the Internal Revenue Service will charge for underpayment.

Related: High-Yield Savings Accounts Slam Americans With Larger Tax Bills

“I always refer to this time of year as the time when all the skeletons come out of the closet — all of the things that went wrong that you find out about now during tax season,” said Tim Steffen, director of advanced planning for Baird Wealth Management.

Below are some of the top issues to be aware of — and some wrinkles to consider for next year, according to a Bloomberg survey of tax experts, financial advisers and CPAs.

A New (and Free) Way to File 

Related: Capital Gains Hikes at Center of Biden’s Second-Term Tax Agenda

The IRS is piloting a new Direct File tool this tax season. The free online portal guides taxpayers with relatively simple federal returns on how to file a Form 1040 and then submit it directly to the IRS. Filers with more than $1,500 in interest income can’t use the service, and the only deductions that can be claimed — on top of the standard deduction — are educator expenses and student loan interest.

A small test pilot, which was rolled out in February to government employees, led to a full-scale launch of the service on March 12 for eligible taxpayers in 12 states. The program will be evaluated after the filing season to determine its future.

Higher Interest Income for Many

Interest rates on high-yield savings accounts, certificates of deposit and the like made good money for savers in 2023. The rub? Unlike long-term gains on stocks, which may be taxed at 0%, 15% or 20%, interest income is taxed at ordinary income rates, which go as high as 37%.

Interest rates were so low for so long that the bill on this year’s gain may come as a shock to filers, especially if they don’t have an adviser monitoring their income on a regular basis. 

If you have capital losses from losing investments, you can use them to offset up to $3,000 in ordinary income per year. But “in a bull market such as we’ve had, most people are using their losses to offset their capital gains,” said Alvina Lo, chief wealth strategist at Wilmington Trust.

If you held CDs in a tax-deferred account like an IRA, however, you don’t have to pay income taxes on that interest this year. You’ll pay income tax on the money in that account when you withdraw it later in life.

Read more: High-Yield Savings Accounts Slam Americans With Larger Tax Bills

The Need to Re-Do Roths 

Bigger gains can also mean you may need to “undo” some or all of your Roth IRA contributions. 

How much you are able to contribute to an after-tax Roth IRA depends on your adjusted gross income. So if your income winds up being higher than anticipated — because of large amounts of interest income, for example — you may need to withdraw contributions you made. 

“We hear about this a lot — people who early last year made a Roth IRA contribution without realizing that their income would be too high,” said Steffen of Baird Wealth Management. “With gig workers, you really don’t know what your income will be for the year. And big capital gains can disallow you from contributing to a Roth.” 

Avoiding a penalty is pretty simple, though. Just take the money out of the Roth, along with any earnings on it, before you file your return. Savers can also do what’s called a “recharacterization” and move the entire amount into a traditional IRA. 

Read more: How to Make the Most of Retirement Savings in 2024

Higher Rates Charged by the IRS 

Higher interest rates may also mean higher interest to be paid on certain amounts owed to the IRS. The rate the IRS applies to things like substantial underpayments in estimated quarterly payments is now 8%, up from 3% a few years ago. The rate is set quarterly at three percentage points above the rate on short-term Treasuries.

There are so-called “safe harbor” provisions that protect taxpayers from penalties. For instance, joint filers with an adjusted gross income of more than $150,000 can be exempt from fees if they paid at least 110% of the equivalent amount of taxes owed on the prior year’s return. 

Conversely, if a taxpayer overpays their tax bill, the IRS says it will pay back out the same rate in interest. 

Future shocks in 2024

Balances in many retiree accounts likely grew in 2023— which is great, but means the minimum amount the IRS says retirees must withdraw from tax-deferred accounts in 2024 to avoid penalties may go up. Those withdrawals are taxed at ordinary income rates.

Here’s how that works. The IRS requires retirees with money in 401(k)s and IRAs to take “required minimum distributions,” or RMDs, in their early 70s. The amount is determined by taking the account balance at the end of the prior year and dividing it by a number found in IRS tables of life expectancies by age.

After a nearly 28% gain for the S&P 500 in 2021, the nearly 20% drop the following year meant that minimum RMDs for stock-heavy retirees were comparatively low in 2023. But the reverse is likely true for 2023, and retirees may have to take out more money this year.

In addition, anyone who was a non-spousal beneficiary of an inherited IRA in recent years may need to plan for more taxable income. It used to be that many beneficiaries could stretch out the taxable withdrawals they had to take from accounts over their lifetime.

That would lessen the risk of being bumped up into a higher tax bracket by withdrawals. But rules now require, in most cases, that accounts must be emptied within 10 years.

Proposed rules from the IRS also require that a minimum amount be taken from the accounts annually to avoid a penalty. The IRS has waived penalties for missed distributions the last few years because of confusion about how the regulation applies, said  Steffen. “But we expect them to [come into effect] eventually.”

Baird is advising affected clients to expect to have to take a required distribution in 2024, but to feel free to wait until later in the year to see if the IRS again waives the penalty, he said.

To contact the author of this story:

Suzanne Woolley in New York at [email protected]