Tax reduction strategies are an integral component of financial planning, even more so for high-income individuals. These individuals fall in high-income groups and are subject to higher tax rates, resulting in a substantial tax burden. Effective tax planning allows you to identify legitimate strategies and deductions to minimize your tax liability and retain a more significant portion of your income. Moreover, high-income individuals have complex investment portfolios, including stocks, bonds, real estate, collectibles, hedge funds, private equity, and other assets. Tax planning can allow you to align your individual strategies to optimize tax benefits and maximize your investment gains.
A financial advisor can help high-income individuals adopt the right tax reduction strategies that match their financial objectives. This article discusses some top tax strategies for high-income earners that can potentially help them generate more profits.
Why is tax planning important for high-income individuals?
Tax avoidance strategies are critical for high-income earners for a diverse set of reasons, as discussed below:
1. It helps you stay up to date with changing tax laws
Tax strategies for high-income earners have become crucial due to the frequent changes and growing complexity of tax laws in the country. Over the past few years, there have been three major tax legislations, including the Tax Cuts and Jobs Act of 2017, additional legislation in 2019, and the anticipated SECURE Act 2.0. Staying on top of the latest tax strategies can be overwhelming. The recent and anticipated changes have made it more challenging for high-income earners to optimize their tax positions. The Tax Cuts and Jobs Act of 2017 brought significant alterations to the tax code, including small reductions in income tax rates for various brackets and an increase in the standard deduction. For high-income earners, the higher standard deduction in 2023 ($13,850 for individuals and $27,700 for joint filers) poses a challenge, as it reduces the likelihood of finding enough deductions to itemize.
In addition to the Tax Cuts and Jobs Act, subsequent legislations, such as the SECURE Act and the Taxpayer Certainty and Disaster Tax Relief Act of 2019, further modified the tax code. Most recently, the SECURE Act 2.0, which is expected to become law soon, has introduced transformative changes that will impact high-income earners. Understanding the implications of these legislative changes and their potential long-term effects requires comprehensive tax planning, as it can affect several areas, such as retirement planning, estate planning, and more. Proactive tax planning can help high-income individuals navigate the evolving tax landscape and capitalize on new opportunities.
2. It helps to preserve wealth
Tax deductions for high-income earners are important if you want to preserve your wealth. The investment returns you earn are only one side of the coin. If you flip the coin over, you will realize that tax cuts can take away a significant portion of your capital gains and dividends. Tax planning helps you retain your profits and grow your wealth exponentially. The more money you preserve, the more you have to cover your present and future needs. Minimized taxes enable you to allocate more resources towards investments and savings, which protects your financial interests in the long run. It also helps you cover your philanthropic interests and endeavors.
3. It aids in estate and succession planning
High-income individuals typically have substantial estates and assets. Transferring these to your next of kin can be a complex process. Tax is one of the major threats to a large estate, and the burden of it can fall onto your spouse, children, grandchildren, and other loved ones who inherit your estate. Effective ways to reduce taxable income for high earners, such as tax lifetime gift exemptions, life insurance payouts, Roth accounts, tax deductions, and others, can help minimize estate taxes, gift taxes, and other transfer taxes, ensuring a smooth transition of wealth from one generation to another.
4. It ensures compliance with tax laws
As a high-income individual, you may be subjected to more tax scrutiny by tax authorities, making it essential for you to plan your tax payments well. High-income individuals may also have a more complex earning arrangement, including domestic and international investment returns, sole proprietorship, partnerships, real estate yields, and more. Multiple sources of income increase the likelihood of errors and omissions. In some cases, intentional tax avoidance can also lead to further complications, all of which can trigger tax authorities. In addition, the general perception of the world may be biased towards high-income individuals as the potential for tax evasion tends to be higher among high-income earners. High-income individuals may be more likely to be chosen for a tax audit. Any potential red flags, whether due to a genuine error or deliberate move, can lead to far-reaching consequences. Tax planning strategies for high-income earners can eliminate such a situation by ensuring tax compliance and adherence to the prevailing tax laws at all times.
How to reduce taxable income for high earners
As tricky as tax planning may seem for high-net-worth individuals, you can streamline and align your taxes to your objectives. Here are some tax reduction strategies that can help:
1. Use tax-advantaged accounts
Tax-advantaged accounts can be tax shelters for high-income earners and help you lower your tax liabilities to a great extent. Accounts such as a Health Savings Account (HSA), Individual Retirement Account (IRA), 401(k), 529 education planning account, etc., can all help you cater to unique goals and save tax.
Here are some tax-advantaged accounts you can consider:
The money you contribute to an HSA is tax-deductible. This means that the amount you contribute is deducted from your taxable income, reducing your overall tax liability for the year the contribution was made. Any earnings generated from the account are also tax-free. Lastly, funds from your HSA used to pay for qualified medical expenses, such as doctor’s appointments, prescription drugs, or hospital bills, are tax-free. Here are the 2023 contribution and out-of-pocket limits for HSA and high-deductible health plans:
|HSA contribution limit (employer + employee)||
Self-only: $3,850 |
|HSA catch-up contributions (age 55 or older)||$1,000|
|HDHP minimum deductibles||
Self-only: $1,500 |
|HDHP maximum out-of-pocket amounts (deductibles, co-payments, and other amounts, excluding premiums)||
Self-only: $7,500 |
In 2023, you can contribute $6,500 to an IRA if you are under the age of 50 and $7,500 for those aged 50 or older. Roth IRA withdrawals are tax-free in retirement, but there are no tax benefits on your contributions. Traditional IRA contributions are tax-deductible in the year you make them, but the withdrawals are taxed in retirement. You can decide on a strategy that suits your tax needs.
In 2023, you can contribute $22,500 to a 401(k) if you are under 50 and $30,000 for those aged 50 or older. Roth 401(k) withdrawals are tax-free in retirement, but your contributions are not tax-deductible. Traditional 401(k) contributions are tax-deductible in the year you make them, but you pay tax on your distributions later. You can select a variant that suits your tax needs.
d. 529 education savings plan
Contributions to a 529 plan are made with after-tax dollars and are not tax-deductible. However, the earnings on the investments within the plan grow tax-free. The withdrawals made for qualified education expenses are also tax-free. While not all states, many states offer tax benefits for contributions made to 529 plans, such as deductions or credits on state income taxes. It is essential to check the specific rules and regulations of your state to know more.
In addition to using the above-mentioned accounts, it is also important to optimize the timing of your withdrawals to maximize tax benefits. For instance, early withdrawals can lead to penalties and taxes. If you time your distributions well, you can eliminate these easily.
Further, you can also invest in tax-efficient Exchange-Traded Funds (ETFs) and index mutual funds, tax-exempt bonds, cash-value life insurance, and other similar tax-friendly investment options.
2. Aim for long-term capital gains
The tax treatment of capital gains depends on the holding period of the asset. Short-term capital gains tax applies to profits earned from assets held for one year or less. These are treated as ordinary income, and the tax rate is levied based on your tax bracket. Long-term capital gains tax applies to profits earned from assets held for more than one year. These are charged at specific tax rates of 0%, 15%, or 20%.
Long-term capital gains tax rates in 2023 based on filing status and taxable income
|Single||Up to $44,625||$44,626 to $492,300||More than $492,300|
|Married filing jointly||Up to $89,250||$89,251 to $553,850||More than $553,850|
|Married filing separately||Up to $44,625||$44,626 to $276,900||More than $276,900|
|Head of household||Up to $59,750||$59,751 to $523,050||More than $523,050|
- Short-term capital gains tax:
These can differ based on your overall income for the year and range between 10%, 12%, 22%, 24%, 32%, 35% and 37%.
3. Go beyond standard deductions and exemptions
Itemizing deductions has become more challenging for high-income earners. The increase in the standard deduction has made it less likely for individuals to find enough deductible expenses to exceed the standard deduction threshold. However, by implementing proactive tax planning strategies, you can still optimize your itemized deductions to lower your taxable income potentially.
Instead of renting a home, purchasing a home or considering a cash-out refinance can offer opportunities for deducting mortgage interest. Homeownership can provide several tax advantages for high-income earners who currently rent or carry significant consumer credit card debt. In 2023, up to $750,000 in principal financing may be tax-deductible, making it a viable option for lowering your taxable income. High-income earners should also explore tax-saving techniques, such as donating appreciated low-cost basis stocks, contributing to donor-advised funds, or strategically timing charitable donations to maximize tax deductions. Additionally, you can use your medical expenses to save on taxes. In 2023, medical expenses that exceed 7.5% of the Adjusted Gross Income (AGI) may be deducted as an itemized expense. This makes tracking medical expenses essential for high-income earners.
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4. Use tax loss harvesting
Your investment losses can be used to offset your investment gains and potentially lower your tax cut. This is known as tax loss harvesting and is one of the best tax strategies for high-income earners with multiple investments. While seeing losses on your portfolio can be disheartening, you can use them to save money. Consider a scenario where you buy shares worth $50,000, but they are currently worth only $30,000. On the other hand, one of your real estate investments has generated a capital gain of $30,000. In this case, you have two options. The first is to let your shares be. The market may recoup, and your losses can be turned into profits. However, you would owe tax on your real estate investment profit. The second option is to sell your shares and realize a loss of $20,000. You can then use this loss to offset the gain of $30,000 from the property. In this case, your taxable profit will be reduced by $20,000. You could then reinvest the proceeds into a different investment and maintain your portfolio’s desired asset allocation.
Tax loss harvesting is an excellent tax reduction strategy. However, it is essential to understand how this applies to you and the situation you are in. A financial advisor can help you make the right decision.
5. Claim real estate exemptions
Another great way to lower your taxable income is to use the Section 121 exclusion. Also known as the primary residence exclusion or the home sale exclusion, this exemption allows you to deduct a certain amount of capital gains from the sale of the main home from your taxable income. In 2023, you can exclude up to $250,000 of capital gains from the sale of your main home if you file a single tax return. For married couples filing a joint return, the exclusion amount increases to $500,000. However, to qualify for this tax exemption, you should have owned the home for at least two years within the five-year period leading up to the sale, also known as the ownership test. Additionally, you should have used the home as your primary residence for at least two years during the same five-year period, known as the use test. The ownership and use tests do not have to be in the same two years and can be met during different two-year periods as long as both tests are within the overall five-year period preceding the sale of the home. But if you have already excluded capital gains from the sale of another home within the two-year period preceding the sale of your current home, you may not be eligible for the Section 121 exclusion.
Another thing to note is that this section does not apply to the sale of investment properties or second homes and can only be used in the case of the primary residence.
There are several ways to reduce taxable income for high earners. You can use all of the strategies mentioned above or employ the ones that you see fit in a combination based on your financial needs and future goals. In addition, it is crucial to stay updated with the changing tax laws and understand how they impact you individually. Review the relevant Internal Revenue Service (IRS) guidelines to ensure eligibility and compliance, proactively plan your taxes, ensure timely tax payments to avoid penalties, and more.
It is also advisable to consult with a financial advisor or tax professional to discuss different strategies and your financial goals at length. Use the free advisor match service to search for suitable professionals near you. Answer a few questions about your financial needs, and the matching tool will connect you with 1-3 advisors who can best fulfill your financial requirements.
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