This post was originally published May 27, 2020 and extensively updated
March 08, 2021.
When you earn a high income, you tend to pay a higher percentage of taxes than average earners. There are exceptions, of course, but in general, people who earn more pay more. And, if you're a high earner, you might think you have no choice -- that you must resign yourself to bearing a high tax burden. But is that really the case?
The short answer is no. At Cook Martin Poulson, we spend a lot of time discussing and working on proactive tax planning with our clients, including those who have sizable incomes. In fact, one of the most common questions we hear is this:
What’s the best way to reduce taxable income?
The more money you make, the more complicated your taxes are going to be. So, if you have a higher income than most people, it’s important to work with a skilled accountant to figure out how to reduce the amount of income taxes you pay. In addition to taking your standard deduction and other deductions, there are many things you can do to lower the amount you pay.
Here are some of our favorite income tax reduction strategies for high earners.
Overview of Tax Rules for High Income Earners
Let's start with an overview of tax rules for high income earners. For the sake of this post, we'll consider anybody in the top three tax brackets as a high income earner. That means that if you earn more than $163,301 in gross income as a single earner and $326,601 if you're married filing jointly, you are a high income earner.
The SECURE Act, which became law at the end of 2019, includes several provisions that apply to high income earners. They include:
- The age for Required Minimum Distributions (RMDs) from retirement plan accounts was raised to 72. However, if you turned 70 1/2 in 2019, you will be required to take a disbursement in 2020.
- Eliminating the age limit for contributions to Traditional IRA accounts.
- Increasing annual contribution limits for 401(k) and 103(b) accounts to $19,500, and to $13,500 for SIMPLE IRAs. The contribution maximum for Traditional and Roth IRAs remains at $6,000 per year.
- Increasing the Social Security wage base to $142,800.
- Increasing the income ceiling for Roth IRAs. Contributions now phase out at $125,000 and $140,000 of modified adjusted gross income. ($198,000 to $208,000 if you're married filing jointly.)
- Increasing limits for long-term care premium deductions to $5,640 per person for people age 71 or over, and to $4,520 for people between the ages of 61 and 70. Self-employed earners may write off 100% of their premiums using Schedule 1 of the 1040 form.
These changes are significant because they make it possible for high income earners to make additional contributions to a retirement plan during the tax year.
Why Change the Character of Your Income?
One way to reduce your tax burden is to change the character of your income. If you're wondering why you should do so, here are some of the ways it can help you to lower your tax bill.
- Convert your SIMPLE, SEP, or traditional IRA to a Roth IRA. If you are over the age of 59 1/2 and you meet the five-year rule, Roth distributions are tax free. Because they are not considered investment income, they will not increase your modified adjusted gross income (MAGI), which is used to calculate the 3.8% Medicare surtax.
- If you own a business, restructure your business entity, particularly if you are operating as a sole proprietor, LLC, or an S-Corp. The taxes for a C-Corp are lower at the top than for other business structures. However, there's also a new 20% deduction of business income for pass-through entities. And, if you hire your children, you can pay them without withholding or matching payroll taxes if you have a sole proprietorship. You should work with an accountant to determine if restructuring your business is worthwhile.
- Invest in tax-exempt bonds. Any interest you earn is not subject to federal income tax and from Medicare surtax calculations. Also, municipal bond interest for bonds purchased in the state where you live is exempt from state income taxes, too.
- Consider investing in index mutual funds and exchange-traded funds. These funds are not actively managed and as a result, can be more tax-efficient than managed funds. These investments are a good way to diversify the taxation of your income after retirement.
- If you qualify for a Health Savings Account, you have the option of investing them instead of spending them on medical expenses. Contributions are tax-free and earnings grow tax-free, and -- if you use future distributions to pay for qualified medical expenses -- distributions are tax-free as well.
The overall benefit of changing the character of your income is that it can reduce your MAGI for each tax year and allow you to take advantage of a lower tax bracket in some cases.
6 Ways to Reduce Taxable Income as a High Earner
The good news is that with a combination of tax deductions, tax credits, and contribution strategies, you can reduce your tax bill by reducing your taxable income.
Here are 6 ways to accomplish your goal and reduce your tax bill:
1. Max Out Your Retirement Contributions
Let’s start with retirement accounts. Employer-based accounts such as 401(k) and 403(b) accounts allow you to lower your taxable income easily. That’s because every dollar you put into these accounts is not taxed until you withdraw the money from your account -- and that reduces your tax burden each year you make a contribution.
The benefit here is that if you wait until you have retired to withdraw money from your 401(k), your income will be lower because you’ll no longer be drawing a salary. The result? You’ll be in a lower tax bracket, which means that the money you withdraw will be taxed at a much lower rate than it would’ve been if you’d had to pay taxes when you earned it.
You can take advantage of the tax-reducing benefits of retirement accounts by contributing the maximum amount. For 2021, the maximum 401(k) contribution is $19,500 and the maximum 403(b) contribution is the same, while the maximum contribution for SIMPLE IRAs is $13,500. Keep in mind that if you’re over the age of 50, you may take advantage of catch-up contributions of up to $6,500, as well.
2. Roth IRA Conversions
Roth IRAs are tax-free retirement accounts that can help you to reduce your tax burden and save money on your taxes, even if you’re in one of the top brackets. Unlike a traditional IRA, Roth IRA contributions are made from post-tax income. That means you’ll pay taxes before you contribute, but not when you withdraw.
That might not seem like an advantage, but it is. Any income earned on the money in your Roth IRA is also tax free. You can even roll over the money in a traditional IRA or a 401(k) into a Roth IRA and reap the same benefits.
Some of the best times to do a Roth IRA conversion are when you’ve had a year with less income than the previous year, or when you’ve retired and are temporarily in a lower tax bracket. This strategy makes sense if you can wait until the age of 70 ½ to make mandatory withdrawals. We like to suggestion this option to our clients because it's easy to overlook, especially when people are focused on tax deductions as a way of reducing their taxable income.
3. Buy Municipal Bonds
Municipal bonds might not be the most glamorous investment, but we often recommend tax-exempt bonds to our high-income clients. When you buy a municipal bond, you lend money to the issuer in exchange for set interest payments over the period of the bond. At the end of the period, the bond is mature, and the original investment is returned to the buyer.
The income from tax-exempt bonds is usually exempt from all income taxes, including federal, state, and local taxes. Even the interest payments from the income may be exempt from taxes.
Of course, municipal bonds usually earn less income than other taxable bonds, but they can still be a worthwhile strategy for reducing your tax burden. You can decide whether they’re worth it by calculating the bond’s tax equivalent yield.
4. Sell Inherited Real Estate
If you’ve inherited real estate from a parent or someone else, you may not realize that you can save money on property taxes by selling the real estate quickly. Here’s why:
Let’s say your parents bought a home for $200,000 and it is now worth $900,000. If they’d sold it while they were alive, they would’ve paid capital gains on $700,000. If you hold onto the house, you’ll have a stepped-up tax basis of $900,000 and will be required to pay property taxes on that amount, thus significantly limiting your potential gain from the sale. The goal is to minimize your capital gains tax liability.
The alternative is to sell the home quickly after you inherit it, thus saving money on property taxes and maximizing your inheritance. Of course, you should also know that you can avoid capital gains tax by rolling the income from the sale into another real estate investment within 180 days.
5. Set Up a Donor-Advised Fund
You probably already know that donating money to charity offers the opportunity for a tax deduction in the year the donation is made. What you may not know is that you can get a deduction this year for several years’ worth of contributions if you set up a donor-advised fund.
A donor-advised fund is a charitable fund that you can set up that allows you to decide how and when to allocate funds to charities. You can make contributions this year and take the full tax deductions for several years on your tax return, thus reducing your tax bill. Then, going forward, you can decide how much money to donate per year and where to donate it.
We often recommend this strategy to our high-income clients, especially if they have a year with higher-than-normal income due to an inheritance or windfall. It's a good way to use charitable deductions to your advantage.
6. Use a Health Savings Account
Finally, you may choose to contribute some income to a Health Savings Account (HSA) to save on your taxes. You may contribute only if you’ve selected a high-deductible insurance plan. For 2021, the maximum contributions are:
- $3,600 for individuals
- $7,200 for families
You may contribute an additional $1,000 if you are 55 or older. HSA contribution limits are linked to inflation, even though cost increases for medical expenses typically outpace inflation every year.
You can use the money in your HSA for medical and dental expenses as well as related costs, such as over-the-counter medication and first aid supplies. If you withdraw money and use it for non-qualified expenses, then you will pay tax on your withdrawals.
You should know that the money in your HSA is yours forever, unlike money you contribute to a Flexible Spending Account, which must be spent during the tax year. For that reason, you may want to consider an HSA, you’ll need to weigh the risks of having a higher deductible against your potential savings.
When you’re in a high income bracket, it’s important to find ways to reduce taxable income every year. You should work with a qualified tax accountant to make sure that every tax credit and tax deduction you qualify for is reflected on your taxes. The additional tax reduction strategies we’ve outlined here will help you minimize your taxes in 2021 and beyond.
Need help determining the best tax reduction strategies to lower your tax bill? Contact Cook Martin Poulson today!