Whether you recently became a high earner or have been for years, paying close attention to tax planning opportunities can have a significant impact on your ability to accumulate wealth. Broadly speaking, tax planning involves the following:
- Deferring income taxes to lower-income tax years
- Taking advantage of tax-saving vehicles available through your employer or business
- Taking advantage of all available income tax deductions and tax credits
- Structuring your investments to be tax efficient
Although the objective of tax planning is to defer, reduce, and manage your taxes, it is important to coordinate tax planning with other financial planning needs, involve tax professionals where appropriate, and be wary of aggressive tax techniques offered by individuals not familiar with your situation.
Let’s dive into three tax-saving strategies for high-income earners.
Are you looking for proactive tax planning guidance that fits into your overall financial plan? Schedule a call with Bay Point Wealth to find out how we can help.
3 Tax-Saving Opportunities For High-Income Earners
1. Structure your investments tax efficiently.
Taxes associated with your investments are driven by the types of investments you own and what account type they are owned in. Even if you own an investment appropriate for your situation, simply owning that investment in a less-preferred account type can trigger taxes that could have otherwise been avoided. These added taxes have the potential to meaningfully reduce your investment returns over time.
Owning certain types of investments in their most tax-preferred account type is a technique called “asset location.” A common example of asset location is to own or “locate” taxable bond investments in one of your tax-deferred accounts (such as a traditional IRA, SEP IRA, or a 401(k) plan) and your stock investments in a taxable account such as a brokerage account. This is because the interest payments generated by those taxable bonds will not be subject to taxation until you take a distribution from one of these accounts, thus allowing you to reinvest those interest payments without incurring taxes along the way. Meanwhile, your stocks will continue to be taxed at more favorable capital gain rates.
2. Take advantage of above-the-line income tax deductions and retirement plans.
Deductions come in the form of both above-the-line and below-the-line deductions; both, ultimately, will reduce your taxable income.
The most commonly used above-the-line deductions are contributions to your employer retirement plan (such as a 401(k) or 403(b)) or contributions to a Traditional IRA or, for business owners, a SEP or SIMPLE IRA. Not only do these savings vehicles help you meet your longer term goals but they also offer tax benefits along the way. Although these are deductions in the current year, they are technically an income tax deferral, meaning you or someone who may inherit the account will pay income taxes at some point. The goal is to pay the taxes at the lowest rate available—which is often during retirement.
For those already in retirement and over the age of 70 ½, you have the opportunity to meet your charitable giving goals by using Qualified Charitable Distributions (QCDs). QCDs reduce any taxable distribution amount from your IRA dollar-for-dollar (up to $100,000 per person, per year) as long as the donation is made payable from the IRA to a qualified charitable organization.
Flexible spending arrangements (FSAs) and health savings arrangements (HSAs) offer another method of reducing your taxable income as well as meeting cash needs for medical expenses. Both plan types may be available through your employer or business.
You can only contribute to one or the other, never both, so you will want to familiarize yourself with the differences. Similar to retirement plan contributions, you can contribute to these accounts with your pre-tax dollars up to their annual contribution limits. These dollars can then be used tax-free to the extent they are used for qualifying medical expenses. So you may never end up paying taxes on the income you defer to these plans.
3. Take advantage of below-the-line income tax deductions.
Below-the-line deductions come in two forms: the standard deduction and itemized deductions. You can select which one to use each year, and each will reduce your taxable income.
The standard deduction is straightforward; it is an amount set by the IRS each year. Itemized deductions are various expenses you incur that the IRS allows you to aggregate. If the total of these itemized expenses is larger than the standard deduction, then you are afforded the opportunity to take the higher of the two.
For most households, the interest on their home mortgage and the property taxes they pay make up the majority of their itemized deductions. However, there are planning opportunities to maximize the use of your itemized deductions, particularly if you own multiple investment real estate properties and/or are charitably inclined. This planning will ensure you are taking advantage of all available deductions and credits.
Go Beyond High-Income Tax Strategies
At Bay Point Wealth, we take a comprehensive approach to strategizing your investment, tax, and other financial decisions based on your overall financial plans and unique financial circumstances. Interested in learning more? Schedule a call today.