Management consultants, particularly those in the early phases of their careers, face some unique tax complexities and tax planning opportunities as a result of their career path. Visor works with many of these consultants and has even given on-site tax seminars at several consulting firms.
This article attempts to summarize some of the major tax areas that consultants should be aware of about their taxes. Our aim is to help consultants to avoid filing mistakes and to optimize their finances proactively.
You May Need to File Returns in Multiple States
Management consultants travel frequently. They are often sent to work in different states for weeks or months at a time.
All that travel means the consultant might need to file tax returns in each state they worked. That’s because each state will claim a portion of your income as being earned in that state.
Your timesheet will help determine the days spent in each state, and your employer will actually withhold state taxes accordingly. A consultant might see two or more states shown in the state portion of their Form W-2, Wage and Tax Statement. See box 15 in the bottom left of the example Form W-2, below.
Graphic: Example Form W-2 showing tax withholding in multiple states
A common mistake is management consultants accidentally paying double state tax. This happens because a consultant might not realize they need to take a credit in their home state for taxes paid to other states.
Figuring out how much income to report in each state can get a little tricky. That’s because each state has its own rules for calculating how much income of a non-resident is taxed within the state.
To get a sense of these state-level issues, see our article about filing tax returns in multiple states.
You Could Be Taxed on Your MBA Tuition Loan Forgiveness
Sometimes an employer will pay for the full cost of a consultant’s MBA tuition. The employer often sets this up as a loan that must be repaid if the employee stops working for the firm, but the loan is forgiven in installments if the consultant continues working for a specific period of time. For instance, if they covered $120,000 of total tuition payments, then $60,000 might be forgiven after one year of work post MBA and the other $60,000 forgiven after your second year of work.
What is often misunderstood though is that loan forgiveness of $60,000 will show up on your Form W-2 each year as a taxable fringe benefit. This likely results in a significant tax bill to you, even though you didn’t actually receive the $60,000 in cash (it was used to pay your tuition a few years earlier).
What can be done?
The one thing that can be done is to claim the MBA tuition expenses as a deduction in the tax year that the expenses were paid. This deduction is available for the year 2017. If someone forgot to claim a deduction for their MBA tuition, they can revise their previously filed tax returns as far back as 2014. Going forward, the deduction for MBA tuition will be temporarily unavailable for the years 2018 through 2025.
Let’s illustrate this with an example. Sarah, a graduate from the class of 2017, started her MBA program in 2015. She had $30,000 of tuition expenses in tax year 2015, $60,000 in 2016, and $30,000 in 2017, for a total of $120,000 of tuition covered by her firm, McKinsey. One year after returning to work, McKinsey will forgive $60,000 of those tuition payment, meaning Sarah will see an extra $60,000 reported on her 2018 Form W-2. The same will happen on her 2019 Form W-2.
Sarah didn’t realize that she would face the tax impact, and she never claimed the tuition expenses on her tax return. For 2017 taxes, which need to be filed by April 17, 2018, she can deduct the $30,000 paid in this year. She can also do the same by amending the tax returns for 2015 and 2016. The tax savings that result from taking the deduction can help her cover the cost of the high tax bill that Sarah will face in 2018 and 2019.
Don’t forget, the IRS carefully analyzes this deduction, so we highly advise working with a tax advisor to make sure your return is in good shape. Visor specializes in handling these cases.
Retirement Saving Optimization
Like many employees, many management consultants have not given a lot of thought to their retirement savings. Often, they elect to contribute a portion of their wages to a traditional 401(k) on their first day of work, and don’t think about it again other than to increase or to decrease the contribution amount from time to time.
Many consultants are unaware that there is a second version of the 401(k), known as the Roth 401(k), that requires after-tax contributions today in exchange for avoiding any tax obligation when funds are withdrawn in retirement. The traditional 401(k) works the opposite, shielding income from tax today and deferring tax until retirement.
For consultants in the earlier stages of their career, opting to pay tax now via the Roth 401(k) might be the better choice, if they believe they will be in a higher tax bracket in retirement. Management consultants typically have good career prospects are good. We wouldn’t be surprised at all if consultants accumulate significant assets over time and work in some part-time or board of director capacity during retirement.
For further detail, see our article on how to choose between a Traditional and Roth 401(k).
Beyond choosing between the two types of 401(k), we often have consultant clients interested in finding ways to put more into retirement savings. That is because the 401(k) employee contributions are limited to a maximum of $18,500 in 2018. Consultants may want to set aside as much as possible for retirement while younger knowing that the investments will compound over the years.
For those clients interested in boosting their savings, we point them to what is known as a backdoor Roth IRA contribution. This allows people to save another $5,500 per year. The backdoor strategy is helpful because it avoids some income limitations that would normally prevent most consultants from making a direct contribution. If this might be of interest, read more about the backdoor Roth IRA.
Another common misconception among consultants is the tax treatment of bonus payments.
For tax purposes, bonuses are treated like any other form of wage compensation. That means, whether you earned $100,000 in salary and $50,000 in a bonus or $150,000 all in salary will not affect your total tax liability.
However, the bonus payment is subject to unique withholding requirements set by the IRS, often resulting in either a significant over- or under-withholding. The implication of this is that, when it is time to file your taxes, you might be surprised by a large tax refund or a large balance due. Neither of these outcomes are ideal – one is an interest free loan to the government and the other could result in an underpayment penalty.
What can you do about it? There are a few possible solutions, including adjust your withholding selection applied to your regular wages over the course of the remainder of the year.
Tax Move Takeaways
- Multiple State Income Tax Filings: Each state has its own set of rules and too often consultants will double pay state income taxes without ever knowing. Be very careful if using a do-it-yourself online solution and, if using an accountant, make sure he/she is familiar with the tax code of the relevant states. Visor solves this problem for our management consultant clients as a national firm that does not charge anything extra for each state income tax filing.
- MBA Employer Sponsorship: Having your MBA paid for by your employer is great, but there is often a large future tax bill associated with it when you return to work. Deducting the tuition expenses in the tax years when you were a student is a great way to offset the costs if eligible. Visor can help determine your eligibility, and even go back and amend past year’s tax returns if you did not take advantage of the deduction at the time.
- Retirement Saving Optimization: Particularly in the early stages of your career, consider making contributions to a Roth 401(k) on an after-tax basis, rather than using a pre-tax Traditional 401(k). And after reaching the $18,500 limit for the 401(k), consult a tax advisor if interested in contributing another $5,500 to an IRA, as the backdoor Roth IRA contribution strategy might be beneficial to you.
- Bonus Payments: Bonuses have special withholding rates, but are subject to standard tax rates. If you are not proactive, than you might be overwithheld, meaning you will not get that money back for potentially months until you file that year’s tax return. You may want to adjust the withholding on your standard paycheck to increase your cash flow in the meantime to recapture those funds sooner, and a tax advisor can help you with this.
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