It is always nice to earn more, but with higher income comes increased tax liability. Thankfully, there are some ways that high-income individuals can reduce their tax liability. Below are five personal tax strategies that all high-income individuals should be aware of.
The first personal tax strategy for high-income individuals involves maximizing the effectiveness of income tax deductions.
Often there are limited options to reduce income taxes, so making sure you are taking full advantage of tax deductions is a good place to start. The key is to be thoughtful about how you are taking deductions, so they have the greatest impact. The 2017 Tax Cuts and Jobs Act increased the standard deduction significantly while at the same time limiting the itemized deduction for state and local taxes to only $10,000. The effect of these changes for many people who traditionally itemized deductions is that their deductions are now only slightly greater, and sometimes may even be less, than the standard deduction amount.
Under the current law, the only way for a lot of people to benefit from itemized deductions is if they can bunch them into one year. For example, if you know that you are going to have significant medical expenses in a given year, then you should consider scheduling any other planned medical procedures in that year in order to maximize the deduction. Bunching charitable gifts is another option for those who are charitably inclined. The goal of bunching itemized deductions is to have one year in which these deductions significantly exceed the standard deduction, then simply take advantage of the current increased standard deduction for other years. Taking advantage of this in a year that you anticipate having higher income than normal such as due to the sale of a business can have an even greater impact.
The following is an example of how this works. Assume that a married couple who file a joint return typically only have these deductions for state and local taxes (limited to $10,000) and an annual charitable contribution of $10,000. The standard deduction for married taxpayers filing jointly in 2023 is $27,700 (with an additional $1,500 deduction for each spouse over 65). Based on this scenario, the couple would be better off taking the standard deduction, but that means they don’t get any tax benefit for their charitable contributions. This couple could use a bunching strategy to give two or more years work of charitable contributions in one year in order to get their itemized deductions over the standard deduction amount.
A great way to potentially take advantage of a bunching strategy for charitable contributions is through the use of a donor advised fund or DAF. Contributions to a DAF are generally tax deductible in the year the contribution is made. However, the donor has the ability to distribute the funds to the donor’s selected charities over a number of years.
The second personal tax strategy for high-income individuals involves minimizing capital gains.
One of the benefits of owning appreciating property is that you do not have to recognize a gain on the appreciation until you decide to sell the asset. Although the decision to sell an asset is not generally driven by the tax implications, this flexibility may allow you to time the sale to minimize the tax. For instance, if tax rates are anticipated to increase in the next year, then you may consider going ahead and selling an asset at the current more favorable rate.
Another way to minimize capital gains is by harvesting capital losses. Capital gains can be offset by capital losses, so each year it is important to review the performance of your portfolio and consider selling securities that have depreciated in value in order to offset any recognized capital gains for the year. An important distinction with regards to capital gains is whether the asset has been held for over one year. Assets that have been held for more than one year are taxed at more preferable, long-term capital gains rates, while assets held for one year or less are taxed at the higher, ordinary income tax rate. Because of this, offsetting capital gains with capital losses can be even more important when the gains are short-term and subject to ordinary income tax rates.
For certain appreciated assets, an installment sale can be a good strategy to spread the tax recognition over multiple years. It should be noted that this strategy is not available for marketable securities such as exchange traded stock. In considering an installment sale it is important to understand that you will be taxed at whatever rate is in effect in the year you receive the proceeds of the sale. For example, if you enter into an installment sale under which you will be paid in equal installments over a four-year period and the capital gains rate increases significantly in the second year then you may end up paying more in taxes than if you had recognized it all in the first year at a lower rate.
The third personal tax strategy for high-income individuals involves charitable giving.
As previously mentioned, the strategies for reducing income tax are somewhat limited. Charitable deductions are often the single most effective way to reduce income taxes. Bunching charitable deductions was mentioned earlier, but there are other ways to maximize the tax benefits of a charitable deduction.
When making a charitable contribution, it is important to consider what assets should be given. For example, giving $10,000 of cash to a charity generally results in the same deduction as giving $10,000 in appreciated stock. However, if you give appreciated stock then you avoid having to recognize capital gains tax on the appreciation. You are essentially giving away the built-in game that you would have otherwise had to recognize at some point in the future.
Another option for high-income individuals who are over age 72 and are taking required minimum distributions (RMDs) from their retirement account is to treat a portion of their RMDs as a qualified charitable distribution (QCD). For individuals over age 72 up to $100,000 of their RMD can be treated as a QCD each year. RMDs are taxed as ordinary income, but any amount treated as a QCD is excluded from income which allows you to reduce your taxable income each year by up to $100,000.
Depending on your family’s goals and objectives, a charitable trust can also provide a significant tax benefit. A charitable remainder trust (CRT) is often used as a way to sell an asset without the donor having to recognize the tax immediately. This is often used in connection with the sale of a business or concentrated position and allows the asset to be sold by the CRT, and the proceeds invested in a diversified portfolio without the donor having to immediately recognize gain on the sale. The donor or whoever the donor names as the income beneficiary generally will pay taxes on the gain as the income beneficiary receives payments under the terms of the trust. At the end of the term of the income payments, the charity receives the remainder of the trust assets.
The fourth personal tax strategy for high-income individuals is maximizing contributions to your retirement account.
If your employer offers a 401(k) or similar type of retirement plan, maximizing contributions is an easy way to reduce your income tax liability. For 2023, the amount an individual can contribute to a 401(k), 403(b), and most 457 plans is $22,500 (with an additional $7,500 allowed for individuals over 50 years of age). Business owners have even more options and may be able to contribute up to $66,000 in 2023. The benefit of making pre-tax contributions to your retirement account is that these contributions are not included in your income, and you can defer paying tax on the amount contributed until you withdraw the funds during retirement.
If you have a high deductible health insurance plan, then making contributions to a health savings account (HSA) is another great strategy for reducing income and works almost the same as a traditional retirement account. A family can contribute up to $7,750 to an HSA in 2023. Just like 401(k) contributions, HSA contributions are excluded from income, and thus reduce your taxes. In addition, HSA withdrawals are tax-free to the extent they are used to pay for qualified medical expenses. If you are in good health, and don’t need the HSA for medical expenses, you can still withdraw the funds at age 65 without penalty. The withdrawals are, however, subject to ordinary income tax the same as withdrawals from a traditional retirement account.
High-income individuals are often compensated in part with stock options, stock appreciation rights, or some other form of deferred compensation. These forms of compensation often provide a significant benefit in deferring the associated tax. There may be specific tax strategies depending on the form of deferred compensation and it is important to discuss this with your CPA to determine if there are any actions you need to take to minimize the income tax on these earnings.
The fifth personal tax strategy for high-income individuals involves minimizing potential estate tax liability.
In addition to paying more in income tax, high-income individuals often also find themselves subject to the federal estate tax, which is in addition to all of the income taxes that have already been paid. An individual’s estate is subject to what is essentially a 40% federal estate tax to the extent that it exceeds the lifetime exemption amount. For 2023 lifetime exemption is almost $13 million per person, or nearly $26 million combined for a married couple. However, the current exemption was increased as part of the 2017 Tax Cuts and Jobs Act and this increased exemption amount sunsets at the end of 2025 at which time the exemption will essentially be cut in half barring any new legislation.
Thankfully, there are a number of strategies that can significantly reduce one’s estate tax liability. One of the easiest strategies is to take advantage of the annual exclusion, which is in addition to the lifetime exemption. The annual exclusion allows you to give up to $17,000 to as many people as you would like without reducing your lifetime exemption amount. Individuals who believe they will be subject to the estate tax should consider putting an annual gifting plan in place to take advantage of the annual exclusion. As part of the plan, you should consider the most efficient way to make the gift. For example, making the gift to a life insurance trust to pay the premiums on the insurance policy may have a bigger impact than an outright gift.
Another strategy for reducing estate taxes involves using all or a portion of your lifetime exemption to make larger gifts during your life. The lifetime exemption may be used during life or at death. The amount available at death is reduced by any gifts made during your life in excess of the annual exclusion. For many families going ahead and making larger gifts during life can be a better tax strategy than waiting to use the exemption until death. Making a gift during life to take advantage of the current increased exemption is a great example of this. However, in order to take advantage of the current increased exemption you actually have to use it. For example, if you made a $13 million gift today then you would have no lifetime exemption left, but you would have gotten $13 million of assets out of your estate. If on the other hand you only made a $7 million gift then you would still have about $6 million of exemption today, but if the lifetime exemption drops to $7 million in 2026 then you would have no lifetime exemption left but would have only gotten $7 million out of your estate. Making a gift of this size is something that most people are not comfortable with, but there are strategies that can allow one spouse to give assets to a trust for the other spouse to remove the assets from the couple’s combined taxable estate while still allowing the beneficiary spouse access to the assets if needed.
In the end, there are strategies that you and your family can potentially take advantage of to receive tax savings and tax benefits. Putting tax planning strategies in place is as easy as looking at medical expenses, having a health savings account, trying to maximize tax deductions, looking at capital losses and gains, identifying tax credits, and so much more. As always, it is important to have these tax planning discussions with your advisors as well as your CPA.