Do you want to reduce your taxes? Of course you do.
If you’re in a high tax bracket, you’ll be happy to know that there are dozens of tax reduction strategies for high-income earners. But, you have to be diligent enough to pursue them or contact a great financial advisor who can guide you.
Tax laws change frequently and increasing complexity can make it hard for high-income earners to stay on top of the latest tax strategies with a free cheat sheet to guide you. For example, there have been two major overhauls of tax legislation since 2017!
Note: How you manage taxes in retirement can make a huge impact on maintaining your lifestyle in retirement. For those interested, we are holding a powerful webinar on how tax planning changes through 4 stages of retirement. It's an online workshop designed for individuals age 50 plus on how to pay less taxes in retirement. It's free and you can register here.
The Tax Cuts and Jobs Act of 2017 was the largest overhaul of the tax code in a generation. New tax legislation made small reductions to income tax rates for many individual tax brackets.
But the tax changes are only temporary and increased the standard deduction for individual and joint filers alike. In 2020, a higher standard deduction of $12,400 for individuals and $24,800 for joint filers makes it harder for high-income earners to find enough deductions to itemize going forward.
In December of 2019, additional tax legislation was passed including the new SECURE Act and Taxpayer Certainty and Disaster Tax Relief Act of 2019.
Both pieces of tax legislation drastically changed tax laws. So, how can you take advantage of these new tax laws and what tax reduction strategies still exist for high-income earners?
Keep reading to learn more.
Tax Basics and New Tax Legislation
Before we get into the tax reduction strategies, it’s important that you understand the basics of taxes, starting with tax brackets.
Your federal tax bracket is the percentage of tax that you owe the IRS on each tier of your taxable income; not to be confused with adjusted gross income. Generally speaking, adjusted gross income (AGI) is an individual's total gross income minus above the line deductions allowed by the IRS.
Conversely, taxable income is adjusted gross income minus allowances for personal exemptions and itemized deductions, also known as below the line deductions.
Once you know your taxable income, you can use the chart below to determine your federal tax bracket. High-income earners should always know how the next dollar of earned income will be taxed.
Starting in 2020, federal tax rates fall into the following categories depending upon your taxable income.
Tax rates on capital gains and dividends
The tax rates themselves stay the same for 2020, but the income thresholds went up slightly.
The SECURE Act
The SECURE Act was part of the December 2019 tax package and it includes several provisions that affect your retirement planning and tax planning strategies. The SECURE ACT includes several key changes that affect tax reduction strategies for high-income earners.
The age for RMDs was raised to 72 from 70-½, although if you turned 70-½ in 2019, you still need to start RMDs in 2020.
There is no longer an age limit for contributions to a Traditional IRA.
Annual contribution limits have increased to $19,500 for 401(k)/403(b) plans and $13,500 for SIMPLE IRAs; Traditional and Roth IRA limits remain at $6,000. Catch-up contributions also increased to $6,500 for 401(k)/403(b) plans and $3,000 for SIMPLE IRAs, with Traditional and Roth IRA catch-up contributions staying at $1,000.
The income ceiling for Roth IRAs went up. Contributions phase out at $124,000 - $139,000 modified adjusted gross income (MAGI) for singles and $196,000 - $206,000 for married couples filing jointly. The phaseout zone for deducting traditional IRA contributions for an uncovered spouse also increased to $196,000-$206,000.
The Social Security wage base also increased by nearly $5,000 to $137,700.
The limits on deducting long-term care premiums also increased to $5,430 per person for those ages 71 or over and $4,350 for those ages 61 to 70. Self-employed people can write off 100% of their premiums on Schedule 1 of the 1040.
Lastly, a tax deduction is a deduction that reduces a tax payer’s tax liability by reducing his adjusted gross income and potentially, taxable income. The more deductions you can find, the higher your potential for lowering your tax bill.
Tax deductions can be broken down into two important categories: above the line deductions and below the line deductions. The “line” is a reference to your adjusted gross income (AGI).
Now that you have a basic understanding of tax brackets, the new Secure Act, and tax deductions, let’s talk about above the line and below the line deductions.
Above the Line Deductions for 2020
Above the line deductions reduce a taxpayer's adjusted gross income and are allowed regardless of whether you itemize or take the standard deduction. Above the line deductions are important because reducing your AGI may help you qualify for additional deductions or credits on your return. High-income earners may consider the following above the line deductions:
Health savings account contributions. HSAs are triple tax-advantaged accounts: Contributions are tax-deductible, the money grows tax-free, and withdrawals are tax-free for qualified medical expenses for those under age 65, and for any purpose if you are age 65 or over. The contribution limits for 2020 are $3,550 for individuals and $7,100 for families. If you are age 55 or over, you can contribute an extra $1,000.
Deductible Traditional IRA contributions. Contributions to Traditional IRAs are deductible with different income thresholds based on if you have access to a group retirement plan or not. If you and your spouse do not have access to a group plan then there is no income limit for taking the deduction. The MAGI limit to deduct contributions for a married couple with just one spouse having access to a group retirement plan is $196,000 - $206,000. If both spouses have access to a group plan then the MAGI limit for the deduction is $104,000 - $124,000. For a single filer who has access to a group retirement plan, the MAGI limit is $65,000 - $75,000.
Qualified retirement plan contributions. Many employers offer qualified retirement savings plans such as 401(K), 403(b), and 457 plans to help attract qualified employees. If your employer offers one of these plans, this is one of the easiest ways for high-income earners to reduce taxes. Reductions occur directly on your paycheck and don’t even appear on your tax return. The income stated on IRS form 1040 is net of any pre-tax retirement plan contributions.
Qualified charitable distributions. A qualified charitable distribution (QCD) is a distribution from an IRA owned by an individual age 70 ½ or over that is paid directly from the IRA to a qualified charity. In simple terms, the IRS allows you to pay organizations like your church or favorite charity tax free from your IRA. A QCD has the potential to save you thousands of dollars in taxes if you are charitably inclined.
Below the Line Deductions
Below the line deductions, also known as standard deductions or itemized deductions, are determined after calculating your AGI. Unfortunately, not all below the line deductions will lower your taxable income. According to estimates, nearly 90% of taxpayers will end up taking the standard deduction rather than itemizing deductions. In 2020, the standard deduction is $12,400 for individuals, $24,800 for married filing jointly, and higher for the blind and individuals age 65 plus.
Itemizing deductions is much harder for high-income earners than in years past. If you plan ahead, there is serious potential to reduce your tax further by itemizing your deductions. Tax reduction strategies may include:
Charitable contributions. There are many strategies to help you maximize your charitable contributions and reduce your income tax. High-income earners should consider donating low cost basis stock, contributing to a donor advised fund, or stacking future charitable donations in a single year to maximize tax deductions.
Mortgage interest expenses. If you currently rent or have a lot of consumer credit card debt, you may consider purchasing a home or doing a cash-out refinance to take advantage of deducting mortgage interest. In 2020, up to $750,000 in principal financed may be tax deductible.
Medical expenses. Keep track of your medical expenses. While you may be healthy, it’s possible that larger families or a one time medical need could allow you to deduct a portion of your medical expenses. In 2020, medical expenses that exceed 10.00% of your AGI may be deducted as an itemized expense.
Income Deferral or Acceleration.
Deferring or accelerating taxable compensation isn’t the right approach for every situation, but it may reduce your exposure to income and capital gains taxes and the 3.8% Medicare surtax on investment income.
Income deferral isn’t just about deferring income in the current year. Tax savvy individuals know that creating a long-term income deferral strategy can help you compound your savings and investments at a faster rate.
One thing to keep in mind as you consider tax reduction strategies for high-income earners is that the current tax rates are temporary and slated to expire in 2025; income you defer in 2020 may actually be taxed at a higher rate later on.
Key income strategies to consider:
Consider non-qualified deferred compensation contributions. If your employer offers a deferred compensation plan you can reduce your taxable income this year and build your post-retirement savings.
Ask your employer to defer income until 2021. Are you having a big year for commission income? If so, your taxable income may be higher this year than next year.. If you plan on receiving commissions or other types of earned income late in 2020, consider asking your employer to defer paying your income until 2021. If your taxable income is going to be lower next year, deferring your income until next year could reduce your tax burden by transferring the income to a lower tax bracket.
Delay or accelerate IRA withdrawals upon retirement. Depending upon your tax bracket, you may benefit from accelerating or delaying IRA distributions until a later date. For example, converting traditional IRA savings to a Roth IRA may be advantages if you plan to be in a higher tax bracket in the future. Conversely, you may consider delaying IRA distributions if you need to reduce your taxable income this year. Either strategy may help smooth out your tax brackets over time thereby reducing the income tax you pay in retirement.
Income Tax Deferral
Tax-deferred investment vehicles aren’t the same as tax-exempt (such as a Roth IRA or HSA accounts); at some point, there will be tax consequences associated with the distribution of the assets. However, tax-deferred accounts can be an effective tax strategy for high-income earners to reduce current year tax liabilities. Additionally, tax-deferred accounts benefit by compounding returns faster by sheltering income from current taxation.
Here are three tax-deferred investment vehicles to consider:
Qualified retirement plans. Contributing to a 401(k), 403(b) or 457 plan is one of the easiest ways to defer investment income. As noted above, the SECURE Act lets high-income earners age 50 and over save $26,000 a year in a 401(k) so you have more control over when you retire. Your earnings are sheltered from tax until withdrawal which mean won’t pay tax on dividends, interest and capital gains until you actually take a distribution from the account at age 59 ½ or later.
529 plans for education. You pay federal taxes on your contributions, but the money grows tax-free and distributions for qualifying educational expenses are not taxed. There are no annual contribution limits, but contributions above $15,000 per donor per beneficiary count against the lifetime estate and gift tax exemption. For Virginians who want to know how to reduce Virginia income tax, up to $4,000 per account per year is deductible for state income tax purposes. Money in these accounts can now be used to cover private school tuition of up to $10,000 per year.
Consider cash-value life insurance. This is one of the most popular tax deferral strategies for high-income earners because of higher limits that can be invested. You make contributions with after-tax dollars, but the money can grow tax-free and withdrawals up to the amount of premiums paid are not taxed.
Change the character of your income
You can adjust the assets in your portfolio to change the way your income is taxed. If you own a business, changing your business structure can be a very effective tax reduction strategy for high-income earners.
Here are some options:
Convert your traditional, SEP, or SIMPLE IRA to a Roth. After age 59-½ (if you’ve met the five-year rule), Roth distributions are generally tax-free. In addition, they aren’t considered investment income, so they won’t increase your MAGI for the 3.8% Medicare surtax. You’ll need to analyze your federal tax brackets, but Roth conversions can be a powerful tool to reduce the taxation of your future income.
Buy tax-exempt bonds. Interest income from tax-exempt bonds is excluded from Medicare surtax calculations and not subject to federal income tax. Even better, municipal bond interest on bonds purchased in your state of residence are state and federal ncome tax free.
Restructure your business entity. Incorporating your business lets you choose the tax structure that works best for you financially. A C-corp, for example, has a lower top tax rate than an S-corp or sole proprietorship. In addition, earnings from a pass-through entity may also qualify for a new deduction of up to 20% of business income. Switching to a sole proprietorship lets you hire your minor children without having to withhold or match payroll taxes. Children’s earnings are also taxed at a lower rate.
Invest Your Health Savings Account contributions. Many high-income earners either don’t use an HSA at all or they use it incorrectly. If you qualify for a Health Savings Account, consider investing your HSA contributions for the long-term instead of spending them on current medical expenses. Earnings will grow tax free and future distributions are tax free if used for a qualified medical expense.
Invest in tax-efficient index mutual funds and exchange-traded funds (ETFs). Every high-income earner should have a plan to diversify the taxation of income in retirement. For taxable accounts, a tax-efficient index mutual fund and/or ETF may help reduce the taxes you pay on your investments year-to-year. Index funds and ETFs can be more tax-efficient than actively managed funds.
Time your gains or losses
Effective tax strategies for high-income earners should include managing the timing of large gains so you aren’t subject to the Medicare surtax or pushed into the 20% capital gains bracket.
Here are some techniques to manage your gains:
Establish and contribute appreciated positions to a charitable remainder trust. Charitable remainder trusts disperse income to beneficiaries for an established period of time before the remainder is donated to charity. By contributing a long-term, appreciated asset, you avoid incurring tax on the gains and get a deduction based on the current value of the gift.
Invest in a Qualified Opportunity Fund (QOF) . These were created in the Tax Cuts and Jobs Act and allow you to defer taxes on capital gains until 2026 by investing them in a QOF within 180 days of the sale. Taxes can be reduced by holding onto the investment for at least five years.
Harvest unrealized losses on your investments. When stock markets fall, you may consider selling investments in taxable accounts that have losses. A strategy known as tax-loss harvesting allows you to sell your investments to capture your losses on paper. In 2020, the IRS allows taxpayers to deduct up to $3,000 in losses against regular income and allows you to offset losses with current and future year capital gains. Losses not used in the current year can be carried forward to subsequent years.
Bundle your 529 plan contributions
If you want to maximize your family gifting, there is a special provision for 529 plans. Under the law, an individual can give up to $75,000, or five years’ worth of gift-tax exemptions, in a single year as an initial contribution to a student’s 529 plan.
It’s worth noting that any additional gifts to that same student over the next five years will reduce your lifetime exclusion. However, the student gets the benefit of kickstarting his account and the cash has more time to compound and grow.
For Virginia tax payers who want to know how to reduce Virginia income tax, 529 plan accounts can further reduce your taxable income by $4,000 per account.
Wealth management is complicated. It takes more than finding the right tax reduction strategies for high-income earners to ensure your money is working for you in the most efficient way possible.
The right financial advisor makes all the difference.
At Covenant Wealth Advisors, we take the time to get to know you and understand your priorities and values. We’ll help you create a wealth management plan that accomplishes your goals and maximizes the assets you built over a lifetime.
We are independent Certified Financial Planners who operate on a fee-only basis; meaning we never receive commissions for product sales. Additionally, we serve as a fiduciary which means we are required by law to always put your best interests and objectives at the forefront.
We can help you find the right tax-reduction strategies to conserve your wealth and the right investments to achieve your goals. Get in touch today for a free wealth management consultation.
Mark Fonville, CFP®
Mark has over 18 years of experience helping individuals and families invest and plan for retirement. He is a CERTIFIED FINANCIAL PLANNER™ and President of Covenant Wealth Advisors, an award winning wealth management firm in Richmond and Williamsburg, VA.
Disclosure: All expressions of opinion are subject to change. This information is intended for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services. Diversification does not eliminate the risk of market loss. Investment risks include loss of principal and fluctuating value. There is no guarantee an investing strategy will be successful. Past performance is not a guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.