How To Reduce Taxable Income For High Earners
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This article is not formal tax advice, and is only produced for informational purposes only. As there are about two hundred tax jurisdictions in the world, this article also doesn’t apply to most people.
With that being said, we do help clients with certain tax efficient investments.
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Would you like to know how to reduce taxable income for high earners? You do, of course.
You’ll be relieved to learn that there are numerous tax-reduction strategies available for high-income earners if you’re in a high tax bracket. However, you must be persistent enough to pursue them or find a reputable financial advisor who can give you advice.
High-income earners and wealthy individuals may find it challenging to keep up with the most recent tax planning techniques due to the frequent changes in tax laws and growing complexity.
It can be difficult to stay on top of the latest tax regulations. For instance, since 2017 there have been two significant revisions to tax law!
The tax code underwent its biggest revision in a generation with the passage of the Tax Cuts and Jobs Act of 2017. The income tax rates for many individual tax brackets were slightly reduced by new tax legislation.
The standard deduction was raised for both single filers and joint filers, but the tax changes are only temporary. High-income earners will find it more difficult to find enough deductions starting in 2022 thanks to an increased standard deduction of $12,950 for single filers and $25,900 for joint filers.
Additional tax legislation, such as the 2019 Taxpayer Certainty and Disaster Tax Relief Act and the new SECURE Act, were passed in December.
Both tax laws made significant changes to the tax system. Then, how can you benefit from these new tax laws, and what tax-saving options are still available to high-income earners?
The Basics of Taxes and New Tax Laws
You must comprehend the fundamentals of taxes, beginning with tax brackets, before we can discuss tax reduction strategies.
Your federal tax bracket, which should not be confused with adjusted gross income, is the proportion of tax that you owe the IRS on each tier of your taxable income. A person’s total gross income less any above-the-line deductions that the IRS permits is generally referred to as their adjusted gross income (AGI).
Contrarily, adjusted gross income (AGI) is equal to AGI minus personal exemptions and itemized deductions (also referred to as below the line deductions).
Overview of Tax Regulations for High-Income Individuals
An overview of the tax regulations for high-income earners should come first. For the purposes of this article, we define a high-income earner as someone who falls within the top three tax brackets.
This means that you are a high-income earner if your gross income is greater than $170,050 for single filers and $340,100 for married couples filing jointly.
Several provisions in the SECURE Act, which was passed into law at the end of 2019, pertain to high-income earners. They consist of:
- RMDs from retirement plan accounts must now be taken at age 72 (although if you turned 70 1/2 in 2019, you must start taking distributions in 2020).
- lowering the eligibility age for Traditional IRA contributions.
- the $19,500 annual contribution cap for 401(k) and 103(b) accounts as well as the $13,500 annual contribution cap for SIMPLE IRAs. For both Traditional and Roth IRAs, the annual contribution cap remains at $6,000.
- The Social Security wage base will now be $142,800.
- The Roth IRA income cap being raised. Contributions now end when modified adjusted gross income reaches $125,000 and $140,000. (If you and your spouse file jointly, the amount ranges from $98 to $208).
- Increasing the maximum deduction for long-term care premiums to $5,640 per person for those 71 and older and to $4,520 for those between 61 and 70. Utilizing Schedule 1 of the 1040 form, self-employed earners may deduct 100% of their premium payments.
The last type of deduction is a tax deduction, which lowers a taxpayer’s tax obligation by lowering his adjusted gross income and, potentially, taxable income. You have a greater chance of reducing your tax obligation the more deductions you can find.
The two key categories of tax deductions are above-the-line deductions and below-the-line deductions. Your adjusted gross income is indicated by the “line” (AGI).
After learning the fundamentals of taxes, the new Secure Act, and tax deductions, let’s discuss above-the-line and below-the-line deductions.
Above-the-Line Deductions 2022
Regardless of whether you choose to itemize or take the standard deduction, above-the-line deductions are permitted and lower a taxpayer’s adjusted gross income.
Above-the-line deductions are crucial because lowering your AGI might make you eligible for more tax breaks or credits. The following above-the-line deductions are options for high-income earners to consider:
- Health savings account contributions: HSAs are triple tax-advantaged accounts, meaning that your contributions are tax deductible, your money grows tax-free, and you can withdraw money tax-free for qualified medical expenses if you’re under 65 and for any reason if you’re over 65. For 2022, the individual and family contribution caps are $3,650 and $7,300, respectively. You may add an additional $1,000 if you are 55 years of age or older.
- Deductible Traditional IRA contributions: Depending on whether you have access to a group retirement plan or not, you may be able to deduct your Traditional IRA contributions up to a certain income level. There is no upper income limit if you and your spouse are not eligible for a group health plan. If only one spouse of a married couple has access to a group retirement plan, the MAGI cap for contributions is $204,000 to $214,000 for that couple. If both partners are eligible for a group plan, the MAGI range for the deduction is $109,000 to $129,000. The MAGI ranges from $68,000 to $78,000 for a single filer who has access to a group retirement plan.
- Qualified retirement plan contributions: In order to entice qualified candidates, many employers offer qualified retirement savings plans like 401(K), 403(b), and 457 plans. This is one of the simplest ways for high earners to lower their taxes if your employer provides one of these plans. Your paycheck will be directly affected by reductions, and your tax return won’t even reflect them. Net of any pre-tax contributions to retirement plans, the income reported on IRS form 1040.
- Qualified charitable distributions: A qualified charitable distribution (QCD) is a payment made directly to a qualified charity from an individual’s IRA who is 70 12 years of age or older. Simply put, the IRS permits you to use your IRA to make tax-free payments to organizations like your church or favorite charity. If you have a charitable streak, a QCD could help you avoid paying thousands of dollars in taxes.
Below-the-Line Deductions 2022
After determining your AGI, below-the-line deductions—also referred to as standard deductions or itemized deductions—are determined.
Sadly, not all below-the-line deductions will result in a reduction in your taxable income. Estimates indicate that nearly 90% of taxpayers will ultimately choose the standard deduction over itemized deductions.
The standard deduction in 2022 is $12,950 for single people, $25,900 for married couples filing jointly, and higher for blind people and people over 65.
For high-income earners, itemizing deductions is much more difficult than in previous years. There is a good chance that itemizing your deductions will further lower your tax if you plan ahead. Several tactics for lowering taxes include:
- Charitable Contributions: You can minimize your income tax and increase your charitable giving by utilizing a variety of strategies. To maximize tax deductions, high-income earners should think about donating low-cost basis stock, making a donation to a donor-advised fund, or bundling future charitable contributions into one year.
- Mortgage Interest Costs: If you are currently renting an apartment or have a sizable balance on your credit cards, you might think about buying a home or refinancing with cash out to benefit from the tax deduction for mortgage interest. Tax deductions for the financed principal of up to $750,000 may be available in 2022.
- Medical Costs. Keep an accounting of your medical costs. Even though you might be in good health, you might be able to deduct some of your medical costs if you have a larger family or a special medical need. In 2022, you may deduct medical costs that are more than 7.5% of your AGI as an itemized expense.
How To Reduce Taxable Income For High Earners: Overview
Change the Character of Your Income
Modifying the nature of your income is one way to lessen your tax burden. Here are some of the ways it can help you lower your tax bill if you’re not sure why you should.
Convert Your traditional, SEP, or SIMPLE IRA to a Roth
If you are over 59 1/2 and satisfy the five-year rule, you can convert your traditional, SIMPLE, SEP, or SEP IRA to a Roth IRA and receive tax-free distributions. They will not raise your modified adjusted gross income (MAGI), which is used to determine the 3.8% Medicare surtax, as they are not regarded as investment income.
Restructure Your Business Entity
If you are a business owner and are currently an LLC, S-Corp, or sole proprietor, you may want to consider changing your business entity. Compared to other business structures, a C-Corp has lower top-level taxes.
However, pass-through entities now have access to a new 20% business income deduction. If you run a sole proprietorship, you might also be able to pay your kids directly if you hire them without deducting any withholding or matching payroll taxes.
To decide whether reorganizing your business is worthwhile, you should consult an accountant.
Invest in Tax-Exempt Bonds
You are not required to calculate your federal income tax or Medicare surtax on any interest you earn. Additionally, state income taxes are not applied to the interest paid on municipal bonds that were bought in the state where you currently reside.
Invest in Exchange-Traded Funds (ETFs) and Tax-Efficient Index Mutual Funds.
Think about investing in exchange-traded funds and mutual funds that track indexes. These funds are passively managed, making them potentially more tax-efficient than actively managed funds. The taxation of your income after retirement can be effectively diversified through these investments.
Invest in Your Health Savings Account
If you are eligible for a Health Savings Account, you have the choice of investing the money there rather than using it for medical costs. Earnings increase tax-free, and contributions are tax-free. Additionally, distributions made in the future are tax-free if you use them to cover eligible medical costs.
Changing the character of your income has the overall advantage of lowering your MAGI for each tax year and, in some cases, enabling you to benefit from a lower tax bracket.
How To Reduce Taxable Income For High Earners: 13 Ways
1. Maximize Your Contributions to Deductible Tax-Deferred Accounts
These consist of “qualified” retirement accounts like IRAs, 401(K)s, SEPs, and others that are comparable.
Although the laws governing the maximum contributions are, to put it mildly, inconsistent, the general idea is that you can deduct the amount of your contribution from your taxable income and let the assets grow tax-free until you withdraw them.
The amount of the deductible varies, with a low of $6,000 per person and a high of about $27,000. You are also eligible to make an additional contribution of about $40,500 per person if you run your own business.
The defined benefit plan falls under a different category of these types of accounts. This plan is entirely funded by employers, but if you own a business, it might be a useful tool to lower taxes.
The maximum contribution that is tax deductible would range from $139,000 to $317,000, depending on your age.
2. Use Roth IRA Conversions
One of the most illogical tax strategies for high-income earners on this list is converting a portion of the funds in your retirement account to a Roth. But tax advantages might be substantial.
It’s true that the conversion results in taxation (withdrawals from IRAs, for example, are taxable), but there may be ways to significantly lower your lifetime tax burden.
A Roth account has tax-free growth potential and tax-free withdrawals. Any funds you transfer to a Roth will therefore be free of taxes in the future.
You could convert money now and pay less tax when you withdraw it for living expenses in the future if you manage your Roth conversions each year to avoid moving into a higher tax bracket.
The amount you convert annually will vary depending on the anticipated total income for that year, but over time you can accumulate sizable tax-free wealth for your future needs and/or the needs of your heirs.
Keep in mind that you will eventually need to make minimum withdrawals from your IRA. Those RMDs increase over time. Over time, putting money into a Roth will lower your lifetime taxes.
3. Make a Health Savings Account Contribution
HSAs (Health Savings Accounts) provide three types of tax shelters:
- You may deduct your donations from your taxes.
- The money in the account grows without paying taxes.
- Withdrawals are tax-free as long as they are made before the age of 65 for qualified medical expenses or after the age of 65 for any reason. A high earner who has access to other cash flow sources to cover medical costs may find this recent change to be very beneficial.
Investing the funds in the account is the trick. Because they plan to use the funds for medical expenses, the majority of people simply open an HSA at a bank and leave the money in a money market account.
However, you can create a sizeable source of tax-free income if you make the maximum contribution each year, invest aggressively, and keep the money in the account until you are 65.
There are contribution restrictions, but if you get started as soon as possible, this is a very beneficial tactic.
4. Superfund an Insurance Policy with a Cash Value
Permanent life insurance that includes investment features is known as cash value life insurance. The tax laws give you significant tax savings in subsequent years, assuming you have a solid insurance carrier and a good policy construction.
The majority of cash-value insurance contracts charge a premium high enough to cover the “cost” of the insurance and start to accumulate some cash value.
However, if you superfund it—contribute more than is required—you can accumulate a sizeable cash value that can increase tax-free.
Many of these policies provide beneficial investment options, allowing you to regulate the rate of growth. Withdrawals can be planned so that they are tax-free when you need the money. To avoid being subject to a tax, some planning is required, but the rewards may be well worth the effort.
5. Donate Qualified Charitable Contributions
A distribution from an IRA made directly to a qualified charity qualifies as a qualified charitable contribution. This deduction enables you to immediately lower your adjusted gross income, but you must be older than the RMD age to use it.
High earners should take note of this, as 86% of wealthy households continued or increased their giving levels during the challenging COVID pandemic period, according to a study by IUPUI.
Numerous studies have demonstrated that charitable donations become more significant as income rises. If you’re going to donate, this may be one of the most advantageous tax structures.
6. Donate Highly Appreciated Stock to Charity
High-income earners’ tax-saving strategies don’t always have to be difficult to implement. Giving stock directly to a charity is another efficient and easy method.
If you own stocks or any other investments that have seen a significant increase in value over time, you may be subject to a sizable capital gains tax. If you donate the stock to the organization and let it sell the stock, you can completely avoid paying those taxes.
You’ll get the biggest tax break possible for your donation and the charity will receive 100% of the proceeds without paying any taxes on the sale.
7. Donate to a Donor-Advised Fund
To donate a sizeable sum of money, use a donor-advised fund, which is a little more sophisticated and adaptable.
The main distinction is that although you are entitled to a tax deduction for the year you make the donation, you are not required to distribute the full amount to charity in that year.
8. Make Use of a Charitable Lead Trust or a Charitable Remainder Trust
A charitable trust might be very beneficial to you even though it is a little more complicated. In that you donate assets to receive a charitable deduction and select the charities you want to support, both of these trusts are comparable to a donor-advised fund.
Their distinctiveness stems from the added advantages, which might make the price of creating the trusts worthwhile.
In a mechanical sense, you create a trust that will help the charity or foundation of your choice. With a tax deduction, you donate money or assets that have appreciated to that trust.
Depending on the kind of gift you give and your AGI (adjusted gross income), the tax savings may vary, but they are still often quite large. The extra advantages apply in this situation.
In a Charitable Remainder Trust, you get an income stream from the trust for a number of years or for the rest of your life, and the charity you’ve chosen gets the remaining funds at the end of this period.
In a Charitable Lead Trust, the income stream goes to the charity of your choice, and at the end of the chosen term, the remaining funds go to your beneficiaries.
9. Contribute to a Deferred Compensation Plan
You can ask your employer to set up a deferred compensation plan to give highly compensated executives like you the chance to postpone up to $27,000 of income and save on taxes for the current year.
The benefit of tax-free growth over decades can be significant, and these accounts can be set up with investment options. The money from the account must be withdrawn over a predetermined period of years when you reach retirement.
You have the freedom to manage your income over a period of ten years or more even though withdrawals are then taxed. Your timing of income, whether you take it all in one year when your tax rate is low or spread it out over many years, can help you manage your tax liability.
10. Request a Year of Income Deferral from Your Employer
Employers occasionally agree to postpone pay for a full year. This method is straightforward and works best if you’re expecting a sizable year-end bonus.
It’s crucial to keep in mind that your income tax will depend on how much net taxable income you have in any given year as you think about high-income tax planning strategies.
If your employer is willing to “push” a bonus payment from a year when your income is already high to one when it will be lower, you might be able to lower your overall tax burden because the second year’s tax rate will be lower.
Even though you can’t do this annually, it can be very helpful in years when your income spikes.
11. Buy Municipal Bonds
Although municipal bonds may not be the most glamorous investments, we frequently advise our wealthy clients to buy tax-exempt bonds.
In exchange for predetermined interest payments over the duration of the bond, you lend money to the issuer when you purchase a municipal bond.
The bond matures at the end of the time frame, and the buyer receives their initial investment back.
Tax-exempt bond income is typically exempt from all income taxes, including those levied at the federal, state, and local levels. Taxes may not even apply to interest payments made from income.
Municipal bonds, while typically earning less income than other taxable bonds, can still be a worthwhile tax-saving strategy. You can determine their value by figuring out the bond’s tax-equivalent yield.
12. Sell Inherited Real Estate Property
You might not be aware that selling the real estate quickly can help you save money on property taxes if you inherited it from your parents or another person. The reasons are the following:
If your parents spent $200,000 on a house that they now own for $900,000, then. Capital gains of $700,000 would have been due if they had sold it while still alive.
If you decide to keep the house, your stepped-up tax basis will be $900,000 and you’ll have to pay property taxes on that sum, which will greatly reduce your potential gain from the sale. Your tax liability on capital gains should be kept to a minimum.
A faster sale of the house after you inherit it would be an alternative that would maximize your inheritance while saving money on property taxes.
Of course, you should also be aware that you can avoid paying capital gains tax by investing the proceeds from the sale in another property within 180 days (1031 exchange).
13. Early Payment of Property Taxes
The Tax Cuts and Jobs Act of 2017 mandated that the property tax deduction be capped at $10,000 per year as of the time of this writing.
The limit was attempted to be repealed in 2019, but it was unsuccessful. Therefore, the maximum amount of state and local property taxes you may write off in a single tax year is $10,000.
If you haven’t already paid your taxes to the maximum, it might be advantageous to do so. You can save money up front by paying in advance because some states and counties give discounts for doing so.
The most crucial thing to understand is that paying the tax debt is a requirement for deducting it from your federal taxes. If you are a high earner and want to know if this is a good tax strategy for you, you should speak with an accountant.
These high-income earner tax planning techniques may help you lower or postpone your taxes. The IRS would have you believe that paying taxes, or at least the amount you pay in taxes, is inevitable.
You are in charge, and with some sage advice, you ought to be able to create the ideal tax strategy for your requirements.
Unfortunately, some tax preparers might not compare these to your unique needs, and there are far too many “advisors” who are really just trying to sell you something financial.
The first group might overlook some important tax deductions you are eligible for. The second group might try to sell you something that doesn’t provide the full tax benefit they claim.
It’s also important to keep in mind that some of these high-income tax planning strategies might not apply to your particular circumstances. Others will lower your future tax liability. Some will result in an immediate tax.
Finding a completely unbiased advisor who can analyze your unique situation and goals and then determine which combinations of strategies will work best for you, your family, and your heirs is the trick.
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