Tax Strategies for High Income Earners
No one wants to pay more in taxes than they legally have to. After all, income tax is typically the largest expense for most people.
With this in mind, the government offers tax deductions and credits to ease this financial burden.
But the system seems to favor those who fall in a certain income range.
Why?
For the most part, most tax incentives are phased out for higher income individuals.
In some situations, higher income means adjusted gross income (or AGI) of $186,000 for IRA contributions or $315,000 for the new business income deduction for partnerships.
In both scenarios, taxpayers earning above these thresholds don’t qualify for the respective tax benefits.
There are millions of Americans who earn higher than these amounts but still fall in the middle class or who have a lot of expenses to cover.
It just does not seem fair.
Which is why tax planning exits.
Tax planning involves the analysis of a financial position from a tax perspective.
The purpose of tax planning is to achieve tax efficiency. Tax efficiency ensures that you pay the least possible tax in a given situation.
This practice is available to all taxpayers, whether your annual earnings are $40,000, $400,000 or $4,000,000.
But since tax brackets cause higher income individuals to pay a higher percentage tax rate, tax planning becomes even more difficult.
However, there are tax strategies for high income earners. This is where forethought, strategy and a little creativity comes into play.
The Current Tax System
The current tax system taxes individuals based on brackets.
How tax brackets work is the higher your income, the more you pay in taxes.
The government implements a credit and deduction system designed to limit the amount of taxes you pay.
As stated before, the system is not necessarily designed for individuals who make over 6 figures.
And while that covers the vast majority of Americans, there are still a large number of taxpayers who can’t benefit.
Yet, the top 1% of taxpayers pay roughly 40% of federal income taxes. The system does not seem to treat these individuals the same.
The effects of this tax disparity are people committing tax evasion.
Tax evasion is the illegal underpayment of tax. By no means should you commit tax evasion. Those found guilty are imprisoned for up to 5 years.
The solution is tax strategies for high income earners. There are a number of legal ways to minimize tax.
Maybe you own a business or inherited a family fortune or simply make a high salary. There are a few tax strategies for high income earners that will help you save thousands or more on your taxes.
Retirement Accounts
There’s no doubt that everyone should be retirement planning.
Besides the fact you want a comfortable retirement, investing in certain types of retirement accounts is one the best tax strategies for high income earners.
401(k) Plans
If you work for a company that has 401(K)s, take advantage of it!
For the tax year 2018, individuals can contribute up to $18,500 to their 401(K).
401(K) contributions consist of pre-tax dollars. It is deducted from your paycheck and deposited into your 401(K) account.
Your taxable income is lowered, therefore, less tax is due. You would only pay tax once funds are withdrawn which should be no earlier than age 59 ½. Any time before then, you would incur a 10% penalty tax which would defeat the purpose.
401(K) plans are especially great if you expect your tax rate to be lower at retirement. In most cases, people are in a lower tax bracket at retirement and save substantially when it’s time to withdraw funds.
If you work for a nonprofit or government agency, a comparable plan is the 403(b) plan.
Solo 401(k)
Solo 401(k)s are good if you are self-employed with no employees. They have the same tax treatment as a 401(k)s and allow you to contribute the same annual amount.
Individual Retirement Accounts (IRAs)
Back Door Roth IRAs
Traditional IRAs do not offer any tax-deductible benefits for those with a Modified Adjusted Gross Income (MAGI) of more than $72,000 and earnings are only tax-deferred.
However, Roth IRAs allow you to contribute after-tax dollars while earnings and withdrawals are tax-free.
There’s a catch.
If you have a MAGI of more than $120,000, you are not able to contribute to a Roth IRA. Unless, you convert your non-deductible contribution from your traditional IRA, aka backdoor Roth IRA.
The back door Roth IRA happens in 2 steps:
- Open a traditional IRA account. Because you surpass the income limits for a tax-deductible contribution, all of your contributions will be after tax and non-deductible.
- Convert your traditional IRA to a Roth. There are no income limits on conversions.
Keep in mind, if you happen to have other pre-tax IRAs, the IRS will impose a tax on those accounts at conversion.
Also, starting in 2018, conversions to Roth IRAs are permanent so make sure this strategy fits your situation.
Simple IRA
If you are self-employed and have employees, consider setting up a SIMPLE IRA. They are less costly for your business with a slightly lower contribution limit of $12,500 annually.
Other Types of Tax Saving Retirement Accounts
There are other types of self-employed retirement accounts that allow you to make higher tax-deferred contributions. As much as $60,000 if you are over the age of 50. And $54,000 for those younger than 50.
Health Savings Accounts
Do you qualify for a Health Savings Account (HSA)? If so, you definitely want to max out your contribution limit.
HSAs are a way to save pre-tax income into a specific account and withdraw the funds for medical purposes. By putting pre-tax money aside, you lower your taxable income and pay less in taxes. Then when funds are withdrawn from the HSA, they are tax-free.
HSAs can be used towards any medically related expenses such as prescriptions, eyeglasses, medical supplies and more.
Another way to take tax advantage of HSAs is by allowing the funds in your account to grow over time and then using those funds for non-health expenses.
But how?
The key is using your own (after-tax) money on medical expenses for a period of time. If you find that you need additional funds (for even non-health purchases like a home or car repair), you can utilize the funds in your HSA.
Distributions would be made TAX FREE. As if they were used on health-related expenses.
The catch is the healthcare related expenses you’ve been paying out of pocket have to be greater than or equal to your HSA distribution. So you would need to keep up with your receipts to validate your distribution.
Section 199A Deduction
New for the 2018 tax year, self-employed individuals are able to take a business deduction equal to 20% of business income.
The qualified business income deduction or section 199A deduction allows sole proprietors, partnerships, and S corporations to reduce their taxable income with certain limitations.
However, if you are filing a joint return with taxable income under $315,000 (from a trade or business), you qualify.
Your section 199A deduction can be as much as $63,000!
Donate Stock
Your charitable donations are not limited to cash only. Many wealthy individuals find it advantageous to donate stock. here’s why.
When stock of appreciated value is donated, the owner does not pay any capital gains tax. In fact, they are able to deduct the full market value, aka the appreciated value, not the price you paid.
This strategy works best for stocks that have increased in value since you bought them.
If you donate stocks that have decreased in value since purchase, you would only be able to deduct the lower market value.
Hire Your Kids
Somehow, your kids will always find a way in your pockets. Instead of just giving it to them, why not hire them to work for you.
With the new tax plan, the first $12,000 will be tax-free for your employee-child because of the new standard deduction.
Their wage will also serve as a business tax deduction for you, lowering your taxable income.
There are a few things to keep in mind with this method.
First, make sure the wage you pay them is reasonable. Excessive compensation may trigger an IRS audit.
Secondly, be mindful of your child’s age. The IRS may consider a child under age 8 incapable of performing duties necessary for a business.
Give a Financial Gift to Your Spouse/Kids/Beneficiaries
The IRS currently allows taxpayers to give monetary gifts (to anyone) up to $14,000 without triggering any tax on the part of the giver.
This will reduce estate taxes and put money in the hands of your beneficiaries throughout your lifetime.
Factors to Consider When Tax Planning
Paying Tax Later is Better Than Paying Tax Now
This is known as tax deferral or deferring tax.
If tax can be deferred for a later time, that’s better for you as the taxpayer.
But how when you potentially might end up paying the same amount later?
Well, the tax you deferred could potentially be invested until it’s time to pay or you might end up being in a lower tax bracket later.
Furthermore, situations change and you could find more tax incentives are available or may incur some losses to offset any income later.
Either way, deferring tax provides you with flexibility. If and when legally possible, you should always defer your taxes.
Don’t Spend a Dollar to Save 30 Cents in Taxes
This rule is usually geared towards business owners but can really apply to anyone.
Near the end of the year, taxpayers try their best trying to find ways to reduce their taxable income by spending more.
“Maybe I should donate $10,000” or “Maybe I should buy a $2,000 laptop for my business”
Spending money haphazardly to reduce your taxable income is NOT tax planning. In fact, it makes little to no sense.
A strategy like this only makes sense if you purchase items you were always planning on purchasing, irregardless of your tax plan.
What’s Next?
For the most part, everyone pays tax.
Whether you work full time or part time and at any level, the IRS expects you to pay taxes.
It’s unlikely they’ll inform you that you overpaid or missed out on applicable tax incentives, which is why tax planning is so important for everybody.
Especially for higher income individuals, who have more to pay than anyone else.
But tax strategies for high income earners do exist! Implement some of these tax strategies you can save big on tax day!
If you feel that some of these tax strategies are hard to wrap your head around and would prefer the advice of a professional, contact us today! Our licensed tax professionals are here to help!