Tax strategies for high-income earners work to preserve your financial wealth while still ensuring you meet all of the legal guidelines in local taxes, state taxes, and federal income taxes. By working with a financial advisor with specific skills in navigating strategies for high-income individuals, it becomes possible to protect the value of your assets significantly.
Consider strategies such as income deferral and tax-advantages accounts, deferring income, utilization of tax-advantaged accounts for retirement planning, tax-efficient strategies, and charitable giving. Though the term “high earner” could be used in various contexts, it is typically a person with an annual income of $500,000 or more.
Unique Tax Challenges
A high-income earner is a person who earns significantly more than the average person. These individuals are in a higher income tax bracket, which means they face a much more significant tax burden than others. More so, they are also faced with the risk of having to pay alternative minimum tax (AMT). AMT is a separate tax system that could lead to taxpayers calculating some of their tax liability twice. This is done under ordinary income tax rules but then again under AMT. They end up paying whichever amount is higher.
Importance of Tax-Efficient Strategies
It is critical for those who earn more to create tax saving strategies early on to reduce taxable income. Having proactive tax planning will maximize after-tax wealth and minimize your tax liability. In short, if you do not act to plan for tax advantages like these now, it will lead to costly, and often times fully avoidable tax costs later.
Consider the following five specific tax strategies that may be available to you, depending on your situation.
You can get matched with a financial advisor who can offer hands-on support throughout the process of building a tax strategy to minimize your losses. Contact Invested Better to get started getting into the better tax brackets through effective tax saving strategies.
#1. Income Deferral and Tax-Advantaged Accounts
It helps to consider both income deferral and tax-advantaged accounts. The term “income deferral” can be used in several ways. One method is to defer the taxable compensation you receive until later, perhaps next year. This may help reduce your income tax exposure and reduce the risk of capital gains taxes.
Income deferral is not just something to think about now, though, but also over time. By utilizing some income deferral strategies, specifically by putting more of your money into tax-advantaged plans now, you can build wealth over time.
Deferring Income Recognition
One of the strategies for reducing taxes includes maximizing contributions to your retirement accounts. Some accounts are tax-advantaged, which means that they allow for individuals to put money into them now and pay less tax later or not pay tax later at all, depending on the type. There are several commonly used types of retirement accounts including employer-based 401(k) accounts and IRAs, which anyone can open.
It is important to speak to your financial planner about any income phase out and income restrictions based on the specific types of accounts you select to use. Those who earn more than the income limits may not be able to add as much in Traditional IRA contributions or others.
Discuss strategies like maximizing contributions to retirement accounts (401(k)s, IRAs) to reduce your taxable income in the current year.
Tax-Advantaged Accounts
While there are some income limitations on tax-advantaged accounts, you and your tax professional should consider any that you qualify for (note that income limitations change year to year). Some of the most important considerations include these:
- Traditional IRAs: Traditional IRAs are ideal for those who do not have an employer-sponsored retirement account. They allow you to contribute to your retirement account throughout the year on a tax-deferred basis if you meet the income limits.
- Roth IRAs: A Roth IRA is also ideal for individuals and allows you to invest pre-taxed money that grows tax-exempt in your retirement account over your lifetime. As long as your income is under the required AGI, you can add money into these accounts, and when retirement arrives, you don’t pay taxes on your withdrawals.
- SEP IRAs for self-employed individuals: A SEP IRA allows individuals to contribute 25% of their net earnings from self-employment to a retirement account.
- Health Savings Account (HSA) with high deductible health plans: An HSA allows you to contribute to the account throughout the year to cover your medical costs and expenses using pre-taxed dollars. This applies to any qualified medical expenses you pay through the health savings account.
Note that many tax-advantaged accounts have income limitations that may prohibit some high-wage earners from utilizing them.
- 401(k): $345,000 annual limit
- Traditional IRA: No income limit in most cases
- Roth IRA: Annual income of $161,000 for single person
#2. Investing Smart for Tax Savings
Profitable investment strategies can be limited when you face uncontrolled taxation on them. Instead of simply investing and hoping for the best, create a plan that helps you invest smart, in a tax efficient way.
Tax-Efficient Investing:
Some types of investments are tax-free or tax-exempt. That includes;
- Bonds
- Life insurance
- Bond funds
- Leases
- Notes
- Mutual funds
- Trusts
Municipal bonds are one of the most straightforward options available. They offered a guaranteed return without any taxes. Tax-free is always a good option.
Tax-Managed Funds
There are some alternative options, such as tax-managed funds. The goal of these types of investments is to reduce taxable income by minimizing capital gains distributions. Some mutual funds are managed in this way to reduce your tax burden. To do this, they may avoid dividend-paying stocks or offsetting capital gains with losses. Exchange traded funds (ETFs) can often help with this.
Capital Gains Management
Capital gains are a key component of taxation since you may pay a significant amount of money when they occur. Tax laws offer various strategies to help you with this. Tax reduction strategies such as holding investments for long-term capital gains are one option. You may also benefit from tax loss harvesting, which allows you to offset some of the capital gains you have with losses. That can help a high-income earner to significantly reduce tax obligations. If you are facing significant capital gains, this strategy can be critical.
Common Pitfalls High Earners Make in Tax Planning
- Underutilizing the breadth of options in retirement planning
- Not contributing to charities soon enough during their lifetime
- Not planning for future taxation as they get older
- Not looking into a Roth Conversion over time
- Not hiring an advisor to guide decision-making
#3. Charitable Contribution Tax Benefits
Another way you may be able to reduce income taxes is through the donation to charitable organizations. However, the key for high-income earners is to donate in a tax advantaged way.
Tax-Efficient Charitable Contributions
For example, donating long-term appreciated assets could offer better value in reducing your tax liabilities. This may include assets such as real estate, stocks, and bonds, donated to a recognized charitable organization. These you do not have to pay capital gains on and you may be able to take an income tax deduction for the full fair market value of those assets.
A second route is to use donor-advised funds. A donor-advised fund is a simple and tax effective way to provide money to the charity you want to support. This could include assets or cash. When you do, you receive a tax deduction because the organization is a public charity.
Charitable Trusts
A charitable trust is another way for high-wage earners to reduce tax obligations. It allows you to provide the funds you want to the organizations you desire, as long as they are recognized charities, and then minimize tax liability. For philanthropically minded people who have nonessential assets, such as real estate or stocks, this strategy may be an ideal choice.
#4. Tax Advantages for Business Owners
As a business owner, your taxable income can seem like having to pay twice in state and local taxes as well as federal income tax. This is true if you do not have the right foundation in place to minimize taxes and may be in a higher tax bracket than you should be. Consider these strategies to reduce income tax and see improved tax benefits.
Entity Selection
Another route for high income earners to reduce the risk of paying too much in taxes is to ensure their business is set up in the proper way to mitigate those risks. Your business structure determines the type of income tax return you must file and, therefore, the type of tax costs you pay. The IRS recognizes the following business entity structures:
- Sole proprietorships
- Partnerships
- Corporations
- S corporations
- Limited Liability Companies (LLC)
In many cases, for example, the formation of an LLC is ideal for professionals because it reduces the risk of paying taxes twice. By providing the owner with the ability to file their taxes as a partnership or an S corporation, or in some cases, a sole proprietorship. This enables higher income earners to choose the most effective way to pay federal taxes at the lowest rates.
Business Expense Deductions
Business owners may reduce tax liability by applying business expenses to their earnings as tax deductions. The tax code allows businesses to significantly reduce taxable income based on the expenses they have. Expenses, including home office deductions, travel expenses, and other expenses of operating the business, reduce the amount of taxable income you pay taxes on. That lowers income tax rates.:
Retirement Plans for Business Owners
Take into consideration the opportunities to reduce your taxable income through the use of retirement plans. As a business owner, you may not have access to traditional retirement accounts, such as a 401(k). However, your tax strategy may include establishing a retirement account for yourself that minimizes your losses and is funded by the income you pay yourself.
There are a variety of tools available to do this including a Solo 401(k) which operates much like a traditional 401(k) but is designed for business owners. Another option is to consider SEP IRAs, which like traditional IRA investments can help to reduce taxes.
Depending on your income level, you may be able to utilize these retirement plans as a way to either defer taxes or pay them now and not pay them when you withdraw the funds to use during retirement. Keep in mind that there are annual contribution limits, and your modified adjusted gross income (MAGI) must be below the required limitations set by the IRS each year. If your income is above this, you may not be able to use this method.
#5. Estate Planning Considerations
For high-income earners, another way to reduce taxable income is to create a tax strategy that allows them to pass on those assets to another party, such as their heir, and in doing so, keep them in a lower tax bracket.
Minimizing Estate Taxes
There are several routes you can consider to minimize estate taxes specifically, and it is often best to create a strategic plan designed specifically for your situation. Options to reduce the estate taxes may include:
- Maximize the annual gift tax exclusion you are given. In 2024, that was $18,000. That means you can provide anyone with a gift of up to $18,000 a year without any gift tax liability applied. You can use gift splitting if you are a couple to give up to $36,000 without it being considered taxable income. This helps reduce the value of your estate without using up your lifetime gift and estate tax exemption.
- Fund a 529 plan or custodial account. These accounts may be a tax strategy to leave funds behind to your child or grandchild for their education and benefit from reduced overall taxes in the process. Though the lifetime contribution limit is set by the states, most people can contribute up to $18,000 each year without paying a gift tax. That reduces your taxable income.
- Charitable giving is a viable option here, too. To reduce estate taxes, use a donor-advised fund. In this case, you receive an income tax deduction in the year that you make the donation.
- Put an estate plan in place. Estate plans create a way to reduce your tax rate, reduce capital gain on real estate investment, and help you make key decisions about how you want to leave your assets to your family. They can help reduce your estate tax liability as well.: Briefly introduce the concept of estate taxes and strategies to minimize their impact, such as gifting strategies or using trusts.
Conclusion
For anyone concerned about their taxable income being too high and putting them into a much higher tax bracket, the key is to take action. When your adjusted gross income is higher, you could end up paying higher taxes unless you employ one of these numerous tax strategies to reduce your financial obligations. High-income earners need to be proactive here. Waiting until the last minute and hoping to get help may not be possible.
Summary of Strategies
The most important and impactful way to get out of those high-income tax brackets and reduce your federal income tax bill includes using these strategies:
1. Use income deferrals and tax-advantaged account
2. Incorporate smart investing strategies to reduce taxes and reduce your tax bill
3. Use charitable contributions to maximize tax benefits
4. Apply all business tax advantages if you are a business owner
5. Establish and build an effective estate plan
These strategies can help you reduce costs in numerous ways, especially if you expect to owe capital gains, have increasing business income year after year, or hope to keep investment income growing instead of paying out in taxes.
Working with a Financial Advisor
The most effective solution for high-income earners is to create a custom-designed tax strategy based on the most recent tax laws and strategies. This is more than just taking tax-deductible savings or minimizing capital gains tax; it is rather creating a cohesive, overarching plan that brings together all of these points.
To do that, hire a qualified financial advisor with the knowledge and experience to help create a personalized tax savings plan that fits your specific situation. While you cannot always be tax-free, there are many ways that a high-income earner can lower their taxes and keep their money growing for them.
Turn to Invested Better for the guidance you need. Develop strategies to reduce your taxes with the help of a financial advisor. Use our tools now to find a financial advisor who has the knowledge and resources to help you structure a very effective tax savings plan. Contact us today to learn more.
