Athlete Taxes: Safe Harbor Strategy

Every dollar matters.

Unfortunately, many of us do not maximize every dollar available to us, usually due to a lack of knowledge or planning.

In this article, we aim to arm you with a strategy that maximizes your dollars – all through managing the timing of your tax payments. This strategy matters for players who have significant income increases – such as moving from the minors to the majors or from league minimum money to arbitration money.  

We will walk through a scenario below, showing you an opportunity how you can have your tax payment make you money. Sounds great, and it is great - if executed appropriately.

But first – let’s review the three ways we pay taxes:

1. Paycheck Withholdings
   This is how most people pay their taxes. The IRS and state departments of revenue require taxpayers to withhold specific amounts of taxes due from their paycheck. Failure to withhold the proper amount will trigger tax penalties and interest payments for you – something you want to avoid.
   To avoid penalties and interest, you must withhold the smaller of 90% of your expected tax for the year or 110% of your prior year’s taxes.
2. Quarterly Estimated Tax Payments
   This method is required when taxes are not withheld on income earned. For example, players earn endorsement $ as 1099 income. Taxes are not withheld on 1099 income – and the IRS requires the taxpayer to estimate their taxes due and pay those amounts quarterly.
   Like withholding your taxes, failure to make the appropriate quarterly estimated payments will require the taxpayer to pay tax penalties and interest. Not fun.
3. Tax Payments Upon Filing a Tax Return
   Taxes are due upon filing your tax return if you did not withhold enough money through paychecks or pay enough quarterly estimated payments.

We will walk you through a scenario below on appropriately making money through planning a tax payment due on filing your tax return while avoiding tax penalties and interest.

The Opportunity

Typically, most athletes pay their taxes through their paycheck withholdings (explained in #1 above). By doing so – the athlete misses an opportunity to earn potentially tens of thousands of dollars by being a bank to the government. This opportunity is called “The Estimated Tax Safe Harbor Rule.”

To show how the athlete can be a bank to the government, let’s walk through a scenario of an athlete whose salary was $570,000 in the prior year and whose salary is $3,500,000 in the current year.

This athlete will be able to invest a portion of his current year’s tax payment and if he earned even 2% on that savings then it could amount to an extra $23,000. Again, sounds great and is great - if executed appropriately. If not executed appropriately, tax penalties and interest can be enforced.

IRS definition of “The Estimated Tax Safe Harbor Rule”:

To avoid an estimated tax penalty, individuals with adjusted gross income (AGI) of more than $150,000 ($75,000 if you are married filing a separate return) must pay the smaller of either:

90% of your expected tax for the current year

OR

110% of the tax shown on your prior-year return

The IRS’ definition sounds complicated – but it’s not.

An athlete who has a considerable increase in income in the current year must only withhold 110% of last year’s tax payment through their paychecks to avoid tax penalties and interest.

Remember our scenario – an athlete made $570,000 last year and is making $3,500,000 this year. To calculate The Estimated Tax Safe Harbor Rule Opportunity for this athlete, we utilize a 3-step process:

1) Calculate what amount of tax is required to be withheld through paychecks to AVOID tax penalties & interest:

In our scenario, the athlete had a tax payment last year of $228,000. To avoid penalties and interest on their current year’s taxes, the athlete must withhold a minimum of $251,000, or 110%, of last year’s tax payment.

2) Calculate the current year’s projected tax payment:

The above is a simplified version of something called a tax projection – and is an annual requirement to maximize every dollar in tax minimization for an athlete.

However, in our simplified scenario, let us assume that the taxpayer will owe a projected $1.4 million for their current year’s taxes.

The projected payment above for the current year taxes of $1.4 million shows why you would prefer to withhold 110% of last year’s tax ($251,000) as opposed to 90% of the current year’s projected tax ($1.4M * 90% = $1.26M) – I would prefer to only have $251,000 withheld from my paychecks as opposed to $1.26M!

3) Calculate what amount of your projected tax payment you can invest and earn money with:

In step #1, we calculated the athlete’s required withholding to avoid tax penalties and interest: $251,000, denoted with [B].

In step #2, we calculated the athlete’s projected tax payment for the current year: $1,400,000, denoted with [C]. This will be paid by Tax Day on the following year.

In our example, since we are instead opting to only withhold 110% of the prior year’s return ($251,000), that means there is a difference ([C] – [B]) of $1,149,000. While this difference will still be due by Tax Day next year, we can now put those dollars to work through investing in the meantime.

By planning to pay $1,149,000 on Tax Day next year, the athlete can invest that money throughout the year or ‘become the bank’ to the government. Assuming a 2% rate of investment return[1], the athlete just made $23,000 through proactive tax planning.

Here is a red flag that may shock you – if you received a refund when filing your tax return, that is evidence that appropriate tax planning is not being done for you. You are potentially missing out on the above opportunity.

Conclusion:

Every dollar does matter. Real dollars are missed without the proper expertise and financial team, most commonly through a lack of tax planning.

Partner with a team that works in your best interest and maximizes every dollar of your hard-earned money.

______________________________

[1] "The information included herein this entire article is educational and general in nature, and does not represent a guarantee. This article does not take in the reader's personal financial circumstances; therefore, it is not intended to be a substitute for individualized financial, legal, or tax advice. Investment returns are not guaranteed, and the investment percentage return included in the article is only an example for illustrative purposes. All investing assumes a level of risk and this is not a financial recommendation. Please consult your financial professional before making any investment decisions.