High earners tend to pay a higher percentage of taxes than average earners. That’s the way it’s been for a long time. But, does it necessarily mean that you must resign yourself to a high tax burden?
The short answer is no. At Cook Martin Poulson, we spend a lot of time talking about 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?
We like this question because it makes sense. 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 make the complex US tax code work for you.
Here are some of our favorite tax reduction strategies for high earners.
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 in the year you contribute. Instead, you’ll pay taxes when you decide to take money out of your account.
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 2019, the maximum 401(k) contribution is $19,000 and the maximum 403(b) contribution is the same. The limits for 2020 will increase to $19,500. Keep in mind that if you’re over the age of 50, you may contribute an additional $6,000 in “catch-up” contributions this year, too.
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.)
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.
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.
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.
Set Up a Donor-Advised Fund
You probably already know that donating money to charity offers the opportunity for a tax deduction. 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 the donation this year and take the full tax deduction. Then, going forward, you can decide how much money to donate per year and where to donate it.
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 only contribute if you’ve selected a high-deductible insurance plan. For 2019, the maximum contributions are:
- $3,500 for individuals
- $7,000 for families
You may contribute an additional $1,000 if you are 55 or older. The contributions for 2020 will increase to $3,550 and $7,100 respectively. 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.
When you’re in a high income bracket, it’s important to find ways to reduce taxable income every year. The strategies we’ve outlined here will help you minimize your taxes in 2019 and beyond.
Need help determining the best tax reduction strategies? Contact Cook Martin Poulson today!