Tax Planning for High-Income Years: Income Smoothing Strategies

Why income spikes cost more:

Scenario A: $80,000 in Year 1, $200,000 in Year 2 (total $280,000):

• Year 1 federal income tax (single, standard deduction): approximately $8,200
• Year 2 federal income tax: approximately $35,000
• Two-year total: $43,200

Scenario B: $140,000 in both years (total $280,000):

• Year 1 federal income tax: approximately $21,400
• Year 2 federal income tax: approximately $21,400
• Two-year total: $42,800

The difference is small in this example ($400), but the effect compounds with larger spikes and with self-employment tax (which is a flat 15.3% up to the Social Security wage base, making the marginal rate on SE income 30%+ in middle brackets). At higher spike levels ($100,000 vs. $300,000), the two-year difference can reach $5,000-$15,000.

Income smoothing strategies:

1. Maximize retirement contributions in high-income years:

• Solo 401(k) employer contribution: up to 25% of W-2 salary (S-Corp) or 20% of net SE income (sole prop), maximum $70,000 total (2025)
• Defined benefit plan: deductions of $100,000-$280,000/year depending on age and plan design
• In a high year, contribute the maximum. In a low year, contribute less or nothing.
• This shifts the deduction to the high year where it saves more per dollar.

2. Time equipment purchases (Section 179 / bonus depreciation):

• Buy equipment in the high-income year, not the low-income year
• A $50,000 equipment purchase saves $16,000 at a 32% rate (high year) vs. $11,000 at a 22% rate (low year)
• Same equipment, same cost, $5,000 more in tax savings from timing

3. Accelerate expenses into the high year:

• Prepay January rent in December (cash method only)
• Stock up on supplies before year-end
• Pay annual insurance premiums early
• Accelerate marketing spend into December

4. Defer income from the high year (cash method only):

• Delay billing for work completed in December until January
• Delay collecting receivables until January
• Do NOT delay recognizing income already received (constructive receipt doctrine applies: if the money is available to you, it’s income, even if you don’t deposit it)

5. Charitable contributions:

• Donate in the high year (itemize instead of standard deduction if total itemized deductions exceed $15,750)
• A donor-advised fund (DAF) allows a large deduction in the high year with distributions to charities over time
• Cash donations: deductible up to 60% of AGI
• Appreciated stock donations: deductible at FMV (no capital gains tax), up to 30% of AGI

6. Hire family members:

• In the high year, put a child (age 7+) or spouse on payroll for actual work performed
• The child’s standard deduction ($15,750) shelters the first $15,750 of their income from tax
• The family member’s tax rate is likely 10-12%, vs. the owner’s 32%+ marginal rate
• Sole proprietors hiring children under 18: no FICA under IRC 3121(b)(3)(A)