As Founding Father Benjamin Franklin once said, "Nothing is certain except death and taxes". And, due to progressive taxation, the more you earn, the higher your federal taxes are. While no one likes to pay taxes, there are strategies to reduce it, such as hiring a personal tax accountant.
Meanwhile, let's discuss how to reduce taxable income for high earners so that you can maximize savings and financial success.
Taxable income is calculated by subtracting adjustments, deductions, and exemptions from a taxpayer's gross income. Taxpayers with the same taxable income can be subject to different tax brackets depending on their filing status.
For example, if a person earns $50,000 a year and the tax bracket is 10%, the first $9,875 of their income is taxed at 10% (or $987.50), with the remaining $40,125 being taxed at the higher rate. This same formula is applied for any given tax bracket and income amount.
This year's tax rate for high-income earners remains unchanged from last year at 37%.
According to the Internal Revenue Service (IRS), you are considered a high-income earner even if you do not make over $400,000 or $500,000. A high-income earner reports at least $200,000 in Total Positive Income (TPI) on their tax return, so it is possible to be classified as a high-income earner without being aware.
TPI is the sum of all positive amounts for different income sources, including wages, salaries, self-employment income, capital gains, and investment income. However, it does not include tax-exempt income, such as Social Security benefits or municipal bond interest.
Calculating tax inflation adjustments for the tax year 2023 is important to remain compliant with IRS regulations and don't experience bracket creep, wherein taxes can increase despite stagnant or reduced real income. Based on the Consumer Price Index (CPI), these adjustments ensure your tax reflects real income growth.
When it comes to tax deductions, you'll come across the term adjusted gross income (AGI), which is the total amount of an individual's or family's income for a particular tax year before deductions have been made.
It is calculated by subtracting any adjustments to income from gross income. Adjustments can include certain items such as alimony payments, self-employment taxes, qualified business expenses, and student loan interest. AGI is often used as a starting point to determine tax liabilities and eligibility for certain tax deductions and credits.
Effective tax planning for high-income individuals is rarely achieved with a single strategy. Most high-income earners combine multiple approaches to their AGI to reap the greatest benefits. This may include strategies that produce an instant tax reduction and those that minimize taxable income over time.
Some of the most well-known tactics to reduce tax liability include the following, which we'll explain in more detail:
- Above-the-Line tax reduction tactics;
- Below-the-Line tax reduction tactics;
- Income deferral strategies;
- Tax deferral strategies;
- Change the character of your income.
1. Above-the-Line Tax Reduction Tactics
An above-the-line tax deduction is an income tax deduction listed directly on the front page of a taxpayer's Form 1040. These deductions reduce an individual's Adjusted Gross Income (AGI) and are available to all taxpayers regardless of whether or not they itemize their deductions. Common above-the-line deductions include contributions to a Traditional IRA, alimony payments, and student loan interest.
High-income earners should be mindful of all possible above-the-line deductions when filing their returns, as this may reduce their Adjusted Gross Income (AGI) and open up the potential for additional deductions or credits.
Contribute to a Traditional IRA
If you are under 50 and contribute to a pre-tax IRA in 2023, you can take advantage of the $6,500 contribution limit. If you are 50 years or older, the contribution limit is $7,500. The amount you can deduct for your traditional IRA contributions when filing taxes will depend on your and/or your spouse's adjusted gross income and filing status.
Should either of you have an employer-sponsored retirement plan, your income level will affect the deductible amount of your IRA contributions (See: Qualified Retirement Plan Contributions).
Increase Health Savings Account Contributions
Making voluntary contributions to your Health Savings Account (HSA) can be tax-deductible or pre-tax if your employer takes the money out as a payroll deduction. Any leftover funds in your HSA carry over to the next year, and rollover contributions do not reduce your overall contribution limit for the given year.
To be eligible to contribute to an HSA, you must have an approved health plan. Additionally, you cannot be enrolled in Medicare or claimed as a dependent on someone else's tax return. In 2023, people with an eligible high-deductible health plan can contribute up to $3,850 to an HSA. Family contributions are capped at $7,750.
Contribute to a Qualified Retirement Plan
If your employer offers an eligible, qualified retirement saving plan, like a 401(K), 403(b), or 457 plan, it could be a great way for you to reduce your taxes. The money taken from your paycheck to contribute to these plans is tax-exempt, so your income, as reported on your IRS 1040 form, will not consider your contributions. This means you won't pay taxes on the money you've set aside before filing your tax return.
In 2023, 401(k) plan contributions by an employee and their employer may not be more than $66,000, though employees who are 50 or older may benefit from catch-up contributions that increase the limit to $73,500. Please note total contributions must not exceed 100% of the employee's annual compensation.
Make Qualified Charitable Distributions
Individual Retirement Accounts (IRAs) require individuals to begin taking RMDs at age 73, regardless of whether they need or want the funds. This increases taxable income and may result in potentially losing eligibility for certain tax deductions and credits, such as personal exemption and itemized deductions. Furthermore, it can trigger higher taxes on Social Security income.
However, if you're 70½ or older, you can contribute up to $100,000 annually ($200,000 for couples) to Qualified Charitable Distributions (QCDs) from your IRAs. This includes traditional, inherited, inactive SEP, and inactive SIMPLE IRAs. A QCD minimizes future required minimum distributions and reduces the balance in your IRA while avoiding additional taxes.
2. Below-the-Line Tax Reduction Tactics
Below-the-line deductions, also called itemized deductions, further reduce your taxable income once you've calculated your adjusted gross income. These types of deductions are not included in the standard deduction and must be claimed individually.
The most common below-the-line tax deductions are certain out-of-pocket medical expenses, deductions for contributions to traditional and Roth Individual Retirement Accounts (IRAs), unreimbursed employee business expenses, student loan interest, and alimony payments.
Deduct Mortgage Interest Expenses
Using itemized deductions, homeowners with mortgages can deduct mortgage interest paid on up to $750,000 of their loan principal. To qualify for the home interest deduction (HMID), your mortgage must be secured by a qualified home, meaning the home must be used as your principal residence or second home, and should be in the United States.
Your property can be a house, co-op, apartment, condo, mobile home, houseboat, or similar property with basic living accommodations comprising sleeping, cooking, and bathroom facilities. Additionally, the loan should be used for buying your interest in the property or half of your ex-spouse in the case of a divorce.
In 2023, the standard deduction is $13,850 for single taxpayers and $27,700 for married couples filing jointly.
Deduct Qualified Medical Expenses
You may be able to deduct certain medical or dental expenses incurred by yourself, your spouse, or dependents if they exceed 7.5% of your AGI. Qualifying expenses include diagnostic services, treatments, disease prevention measures, and medical operations. You can review a detailed list of medical expenses types and service providers in IRS Publication 502.
If your adjusted gross income (AGI) is $45,000 and you have $5,475 of medical expenses, you should multiply your AGI by 0.075 (7.5%) to find the amount eligible for itemized deduction. In this case, only expenses exceeding $3,375 can be included.
Therefore, your total medical expense deduction would be $2,100 ($5,475 minus $3,375). This amount should be included on your Schedule A, Itemized Deductions.
Make Charitable Contributions
You can claim tax deductions for charitable donations to organizations defined as tax-deductible by Section 170(c) of the Internal Revenue Code. These include churches, synagogues, nonprofit volunteer fire companies, trusts, corporations, and funds based in the US. Simply list the donation as an itemized deduction on Schedule A.
Donations of non-cash items, like appreciated stock, must be valued at their fair market value. Note that the IRS limits these donations to no more than 60% of your Adjusted Gross Income (AGI). Certain donations or organizations may have a lower limitation - check the IRS Deductibility Status Codes for additional details.
3. Income Deferral Strategies
Income deferral is a method of delaying the recognition of income until a subsequent tax year. This strategy reduces taxes paid in the current year by pushing the income into a future tax period when the tax rate might be lower.
High-income tax earners are particularly keen to use income deferral as they are more likely to be affected by higher marginal tax rates and could benefit from strategies that help reduce their tax burden.
Ask Your Employer to Defer Income Until 2023
Deferring your income until the next year decreases your taxable income immediately. As an employee, this could mean asking your employer for a deferment of your year-end bonus. Remember to weigh any current tax savings against taxes you'll pay in the future if you find yourself in a higher tax bracket, as deferring income only works if your taxable income will be lower next year.
You can defer a maximum of $22,500 in 2023 for all of your plans except for 457(b)s, including pre-tax and Roth contributions. Even if a plan you are participating in has lower limits on contributions, you are still limited to the total allowed by the tax law, which is not affected by the number of plans you are in or who sponsors them.
Delay or Accelerate IRA Withdrawals Upon Retirement
Depending on your tax bracket, you may find it beneficial to accelerate or delay taking your IRA distributions until later. For instance, you could benefit from converting your traditional IRA savings to a Roth IRA if you think you will be in a higher tax bracket.
On the other hand, if you need to lower your taxable income for the current year, you could delay your IRA distributions. Utilizing either of these tax planning strategies for high-income earners could even out your tax brackets over the long run, ultimately decreasing the tax you pay in retirement.
Consider Non-Qualified Deferred Compensation Contributions
Nonqualified deferred compensation (NQDC) plans are specialized retirement options for high earners, enabling them to delay taxation on a greater portion of their income than IRS limits in standard qualified retirement plans. Employers and employees agree that extra income is deferred until 5-10 years or until the employee's retirement.
NQDCs are generally employed by those who have maximized their certified retirement programs. One example of an NQDC plan is the 409A, devised by the Internal Revenue Code Section 409A, introduced for nonprofit and governmental organizations. These plans are alternatives to the 457(b) and 457(f) financial arrangements.
4. Tax Deferral Strategies
Tax-deferred investment vehicles differ from tax-exempt ones, such as with a Roth IRA or HSA account, as those invested in the former will still face tax consequences upon distribution of the assets. Nevertheless, high-income earners may invest in these vehicles to defer taxes. Additionally, these accounts will compound accelerated, as any earnings remain untouched by taxation.
Invest in Qualified Retirement Plans
Tax shelters for high-income earners 401(k), 403(b), or 457 plans are an effective retirement-saving method through deferring investment income. According to the SECURE Act, the maximum amount of money you can defer in qualified retirement plans in 2023 is $22,500.
If you are 50 or over, you can contribute an extra $7,500 to your retirement account for 2023. This is known as a catch-up contribution. The advantage of using these accounts is that the earnings are not subject to tax until you take a distribution from the account at age 59 ½ or later. You will not need to pay dividends, interest, or capital gains taxes until you withdraw the funds.
Open a 529 Plan for Education
529 plans have two options – savings and prepaid tuition – and both are afforded the same federal income tax treatment. Contributions to the plans gain tax deferment, meaning annual earnings are not subject to income taxes. Withdrawals used for the beneficiary's qualified educational expenses are exempt from federal income tax. This provides a great opportunity to amass funds for college.
Qualified educational expenses for savings plans include tuition, fees, room and board, computers, and books for college, plus K-12 tuition payments up to $10,000 annually. For prepaid tuition plans, the qualified educational expenses typically include tuition and college fees at participating schools.
Take Out Cash-value Life Insurance
Cash-value life insurance tax deferral is a feature of whole life insurance policies that allows policyholders to build savings in their policies. These savings accumulate on a tax-deferred basis, meaning no taxes are paid until the money is withdrawn from the policy.
This provides a tax-advantaged way to build up cash savings that can be used for various needs, such as retirement income, college tuition, or unexpected medical expenses. The cash value also serves as extra protection in case of death, as it pays out as part of the death benefit.
The tax deferral caps for cash-value life insurance policies are set annually and adjusted for inflation; for single life policies, the cap is currently at $101,100, and for joint life policies, it is $202,200. If you exceed these caps when you withdraw or surrender the policy, you will be subject to income taxes on the excess amount.
5. Change the Character of Your Income
Other tax strategies for high-income individuals include adjusting the assets in your portfolio to reduce income tax. Revising your business structure is also an effective tax reduction option if you are a business owner.
Convert Traditional, SEP, or SIMPLE IRA to a Roth
Converting a traditional, SEP, or SIMPLE IRA to a Roth IRA reduces taxes by allowing you to pay taxes on the contribution now rather than when you withdraw during retirement. This can result in significant savings, as you may presently be in a lower tax bracket versus when they will be required to withdraw from their retirement accounts.
Furthermore, Roth IRAs offer tax-free growth on any gains, whereas traditional, SEP and SIMPLE IRAs are taxed at withdrawal time. Also, Roth IRAs have no required minimum distribution (RMDs) rules which means you never have to withdraw money, which is a huge advantage over traditional, SEP, and SIMPLE IRAs.
Buy Tax-exempt Bonds
Tax-exempt bonds are a type of municipal bond that state and local governments issue. They are exempt from federal, state, and in some cases, local taxes. Their tax benefits make them attractive to bondholders because instead of paying taxes on their bond interest income, they can reinvest it for higher returns.
Municipal bonds are very secure, and the interest payments are typically reliable since they are backed by the issuer's "full faith and credit." As a result, investors can often get higher yields on tax-exempt bonds than on most other types of investments.
Municipal bonds generally have a lower yield than other taxable bonds, but they can be quite beneficial in terms of tax savings. Calculating the bond's tax-equivalent yield would be wise to determine if investing in them is a good option for you.
Invest in Tax-Efficient Index Mutual Funds and EFTS
To maximize your long-term investment returns, it's essential to consider the tax implications of how your investments are structured. Investing in tax-efficient index mutual funds and exchange-traded funds (ETFs) is one way for high-income earners to diversify the taxable income they receive in retirement.
These funds are specifically designed to minimize taxes on your investments from year-to-year. Index funds and ETFs can provide greater tax efficiency compared to actively managed funds. With proper planning, you can reduce your taxes on your investments, leaving you with more money to enjoy your retirement.
Restructure Your Business Entity
Restructuring your business can help reduce taxes in two primary ways: reducing taxable income within a tax year and limiting taxes on accumulated assets.
- Reducing Taxable Income: Your business may pay more expenses upfront to reduce taxable earnings by taking advantage of tax deductions. Other restructuring strategies might include moving into higher tax brackets, selling capital investments, or making charitable donations;
- Limiting Taxes on Accumulated Assets: Your business can transfer ownership of real estate assets from an individual to a corporation, or you can transfer ownership of depreciated assets from a corporation to an LLC, which allows for the benefits of lower corporate tax rates. Additionally, restructuring can take advantage of capital gains tax deferral strategies.
Most high-income earners implement long-term tax reduction strategies to take advantage of deductions and tax credits by carefully timing income and expenses. We have outlined various methods here, but you should consult us about tax codes and possibilities for the best results.
With 25 years of experience, our Chicago CPA firm has worked nationwide, providing special tax planning strategies for high-income earners. Contact us today to reduce your taxable income.
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