high income earners disproportionately fee the burden of taxes in our progressive system. While paying taxes is a civic duty we all must participate in, there are also legal ways to reduce your taxable burden through proper planning and utilization of credits, deductions, and more. This article will explore tax minimization strategies tailored towards high earners to put more money back in your pocket.
In this article we'll Cover:
Max Out Retirement Accounts
One of the best ways for high earners to reduce your taxable income is to contribute to tax-advantaged retirement plans like 401(k)s and IRAs. The money you put into these accounts can directly reduce your taxable income for the year.
401(k) plans offered through your employer allow you to contribute up to $20,500 in 2023. Those over 50 can also make an extra "catch-up" contribution of $6,500. Always contribute at least enough to get your full employer 401(k) match if one is offered. The money grows tax-deferred and you pay income taxes only when you make withdrawals.
Self-employed? Consider a Solo 401(k) or SEP IRA. Solo 401(k)s allow up to $61,000 in contributions in 2023, including a $6,500 catch-up for those over 50. SEP IRAs offer a contribution limit of up to 25% of your net income or $61,000, whichever is less. Take advantage for tax-deferred growth and income tax upon withdrawal.
Utilize Health Savings Accounts (HSAs)
If you are enrolled in a high deductible health insurance plan, you can open and contribute pre-tax dollars to a health savings account (HSA). In 2023, you can contribute up to $3,850 for individuals and $7,750 for families. HSA funds can be invested and grow tax-free similar to IRA accounts.
HSAs provide triple tax advantages
Contributions are pre-tax,
Funds grow tax-free, and
Withdrawals made for qualified medical expenses are tax-free.
After age 65, non-medical withdrawals simply get taxed as ordinary income without penalty. This makes HSAs one of the most tax-advantaged accounts available.
Invest in Real Estate
Investing in income generating real estate can provide beneficial tax deductions that reduce your taxable income. All operating expenses, mortgage interest, property taxes, maintenance costs, and depreciation can be deducted against rental property income.
Investment properties allow you to claim depreciation as a deduction, representing the property's gradual wear and tear over time. While it seems like the property value is decreasing, in reality, real estate often appreciates. This deduction helps investors lower taxable income while simultaneously generating cash flow.
Harvest Tax Losses
Tax loss harvesting involves strategically selling securities at a loss to offset capital gains and income. For example, if you realized $10,000 in capital gains this year but also incurred $10,000 in losses from selling securities, your net capital gain would be zero - eliminating that tax liability.
Pro Tip - Up to $3,000 in excess losses can even be deducted against ordinary income, with remaining losses carrying forward.
Moreover, individuals within the zero capital gains tax bracket can explore portfolio opportunities without relying on a capital loss offset. If you hold unrealized capital gains, selling the investment and repurchasing it can elevate your basis without increasing your tax liability. You can impliment this strategy until you hit the 0% capital gains limit.
Choose Qualified Dividends Over Ordinary
The long term capital gains tax rate maxes out at 20% for high income earners. Meanwhile, ordinary investment income gets taxed as high at 37% at the Federal level, plus applicable state taxes. That's why stocks and funds that pay qualified dividends are advantageous. Qualified dividends also fall under the favorable long term capital gains rates if certain holding period rules are met. Prioritizing investments that pay dividends can save quite a bit come tax time.
Donor Advised Funds (DAF)
A donor-advised fund (DAF) serves as a powerful tool for individuals looking to optimize their charitable giving while minimizing tax liabilities. It operates as a charitable investment account, allowing donors to contribute assets, receive immediate tax benefits, and then recommend grants to their chosen charities over time.
One of the primary advantages of a DAF is the immediate tax deduction upon contribution. When you donate assets like cash, stocks, or real estate to a DAF, you receive an immediate tax deduction for the fair market value of the assets donated. This deduction can be particularly beneficial for high-income earners seeking to reduce their taxable income in a given year.
Another key benefit is the flexibility and control offered by DAFs. Once the assets are contributed to the fund, donors can advise on the distribution of funds to eligible charities at their own pace. This flexibility allows for strategic giving, whether it's a one-time significant contribution or regular donations over time.
Additionally, DAFs offer the opportunity for donors to potentially grow their charitable contributions. By investing the assets within the DAF, donors have the potential to grow their initial donation over time, allowing for more substantial charitable grants in the future.
Moreover, using a DAF can simplify the administrative burden of charitable giving. Rather than managing multiple donations to various charities, donors can consolidate their giving into one account, streamlining the process and reducing paperwork.
Case Study: High Income Married Couple Reducing Taxes Through Smart Planning Strategies
John is and his wife Rebecca are 48 and 50 years old respectively. They both work for tech companies as engineers and John is able to earn some additional income as a consultant. With their wage income, equity compensation, and self-employment income they earn a combined $650,000 annually. Given this level of income, they both feel significant stress attempting to minimize their taxes each year. They consulted United Tax's guidance on legal ways to reduce their tax burden. We suggested the following:
Both John and Rebecca should Max out thier 401(k) plan at work with $22,500 in contributions. Additionally John should contribute an additional $7,500 catch-up for being over 50.
John fully funded a Health Savings Account with $7,750 since he has a qualifying high deductible health plan. The HSA contribution came out of the paycheck on a pre-tax basis and is able to be used for health related expenses entirely tax-free.
John also chose to contribute $6,000 to a self-employed/individual 401(k) plan on the recommendation of United Tax. He was eligible for this due to his consulting income which is considered a form of self-employement.
The couple invested year-end bonus money in a rental property to take advantage of tax deductions on expenses and depreciation. Despite projecting a $30,000 annual income from the rental property, the deductions from expenses and depreciation will turn this income into a minor net loss, thereby avoiding additional taxes.
The couple used $12,000 in tax losses from their after-tax investment portfolio. This offset $2,000 in capital gains and $3,000 in ordinary income. Additonally, they're carrying forward the remaining loss to offset future income and gains.
They asked their financial advisor to transition their portfolio towards stocks that paid qualified dividends rather than ordinary dividends. This move aligned a larger portion of their income with the long-term capital gains rate instead of their ordinary income rate.
The couple is also charitably inclined and decided to donate $25,000 to their Donor Advised Fund. A contribution of this size enabled the couple to itemize their deductions rather than take the standard deduction. When combined with their state taxes and mortgage interest, their itemized deductions totaled $42,000, granting them an extra $12,800 deduction compared to what they would have received through the standard deduction.
Implementing these seven strategies allowed John and Rebecca to reduce their taxable income by around $91,500 through retirement contributions, health savings contributions, and real estate deductions, etc. Plus their capital gains tax was brought to zero by harvesting losses and they reduced future dividend/investment income taxes by shifting to qualified dividends.
Over time, maxing out tax-advantaged accounts, investing in cash flowing real estate, tax loss harvesting, and choosing tax efficient investments can really add up. John and Rebecca noted that they feel their wealth is now growing faster than ever since they have reduced a significant amount of tax drag while applying their income to tax-efficient investment vehicles.
Frequently Asked Questions
Can I deduct my mortgage interest payments as a form of tax reduction?
ANSWER: Yes, mortgage interest on up to $750,000 of loans taken after Dec 15, 2017 can be deducted as an itemized deduction. This used to be $1 million limit but changed with the tax code overhaul.
What are some examples of qualified dividends?
ANSWER: Many blue chip stocks like Microsoft, Johnson & Johnson, Coca-Cola, Visa, and Procter & Gamble pay qualified dividends that fall under capital gains rates if held over 60 days.
When should I start contributing to retirement accounts?
ANSWER: As early as possible. Even if in a lower tax bracket now, tax-deferred growth over decades can add up substantially to set you up well for retirement. Use IRAs if no access to 401(k) at work.
Can I deduct my kid's college tuition payments?
ANSWER: Up to $4,000 in tuition payments for each eligible child can be deducted annually on your taxes as part of the Lifetime Learning Credit, subject to income limits. Consult IRS Publication 970 for specifics.
I have substantial stock losses this year. How much can I deduct against ordinary income?
ANSWER: Up to $3,000 in net capital losses can be used to offset ordinary income annually. Remaining losses carry forward to future tax years indefinitely. No time limit to use them up!
Bringing It All Together - High Income Tax Reduction Strategies
Effectively managing taxes for high-income earners necessitates meticulous planning. Leveraging legal deductions, credits, tax-deferred accounts, property depreciation, and tax loss harvesting can substantially alleviate your tax burden. At United Tax, we specialize in mapping out comprehensive long-term strategies that could potentially save you hundreds of thousands over your career.
Interested in reducing your tax liability? It all starts with a tax projection, laying the groundwork for a strategic tax plan. With United Tax's free tax projection tool, you can estimate your taxes and gain invaluable insights into minimizing your tax burden. Take a proactive and strategic approach to your planning. The tax code offers opportunities for those who diligently seek them out. Let us help you navigate these avenues and optimize your tax strategy.
