In the past, I’ve written about tax savings strategies for business owners and the wide variety of methods they can utilize to minimize their tax burdens. This time around we’re focusing specifically on W-2 employees that earn high incomes. Bottomline: W-2 employees have far fewer and less creative ways to save on taxes. The silver lining is these strategies are much more straightforward, and they are effective. So let’s jump right in:
There are a handful of cases where a traditional retirement plan like a 401(k) doesn’t make perfect sense, but for the vast majority of high earners, they are a no brainer. They allow you to put away money for retirement, most often with a match from your employer, and you get to defer income from your taxes. This will let you pay less taxes, today, while you’re in a high tax bracket, and then withdraw that money in retirement while you have a presumably lower tax bracket. In 2024, you can contribute up to $23,000 to your 401(k) and then your employer’s match can exceed that amount.
You also can choose to use a Roth 401(k)’s. They can be great for many reasons, but in your highest income earning years it may make sense to defer this tax till later and reduce your taxable income today. Especially if you think you will be in a much lower tax bracket in the future. On the other hand, in low income earning years, Roth can be great for locking in that lower tax rate.
I am not saying put every dollar away for retirement, but oftentimes it makes sense for highly compensated employees to max it out when they also can contribute elsewhere.
Despite what I said in the introduction, this is the strategy that most deviates from the “these are all very straightforward methods for saving on taxes” through-line.
The Mega-Backdoor Roth is a great strategy, particularly beneficial for high-income earners. Here's how it works:
Note that not all employer-sponsored retirement plans allow for the Mega-Backdoor Roth, so you'll need to check if your plan permits it. Also, the process can be quite complex and involve many moving parts, so it's highly advisable to work closely with a financial planner or tax professional before implementing it.
Despite this complexity, the Mega-Backdoor Roth is a fantastic way for high-income individuals to save a substantial amount of tax-free dollars for their future.
After you’ve maxed out your employer sponsored retirement plans, it starts to make sense to look into individual retirement accounts like a Roth IRA. If you’re like most high earners, your immediate reaction might be, “I can’t use Roth, I make too much money.” This is true… but fortunately there is something called the backdoor Roth IRA that allows anyone to contribute. You simply put money into an IRA (you don’t deduct it), then you convert to Roth. It’s that simple, but make sure you do not have other pre-tax money inside a Traditional IRA, SEP IRA, Simple, etc. If you do, it will trigger the pro-rata rule and a portion will become taxable. Read more about this here. You are able to contribute $7,000 per year per spouse, in 2024.
The reason why the backdoor Roth is so great is that you most likely already have only post-tax dollars left. And with those remaining dollars, they can go into Roth or a taxable account. Putting high appreciating assets into your Roth and never paying tax on them again is a huge advantage versus a taxable account.
Depending on your healthcare plan, you will have either an HSA (Health Savings Account) or an FSA (Flexible Spending Account). HSAs offer significant tax advantages, so let's start with them:
HSAs are among the most tax-advantaged accounts available. For high-income earners, not utilizing them today and allowing them to grow can have a significant impact. Remember to keep your receipts in case you need to withdraw funds before retirement. In 2024, you can contribute up to $8,300 for a family. This is increasing to $8,300 in 2024.
If you don't have an HSA, an FSA can also help lower your taxable income. However, it has limitations:
Another pre-tax option is a Dependent Care FSA, which allows you to save pre-tax money for qualified childcare expenses:
Dependent Care FSA:
In summary, HSAs offer excellent tax benefits, while FSAs, though valuable, have more restrictions. Additionally, the Dependent Care FSA is an option for saving on childcare expenses.
This offers an effortless method for reducing your taxable income (if you itemize), especially if you have surplus funds and a charitable inclination. You can utilize donor-advised funds, charitable remainder trusts, and similar options to achieve this tax reduction. Additionally, you have the option to donate highly appreciated securities, effectively sidestepping capital gains taxes while still benefiting from a deduction. To make the most of this strategy, donate before selling the assets; otherwise, you'll be liable for capital gains tax.
On a related note, some individuals choose to consolidate their charitable donations every other year to enhance their itemized deductions - this is called bunching. For example, if you earn $500,000 annually and aim to donate 5% of your income per year, that amounts to $25,000. This falls below the $27,700 threshold, so without additional deductions, you'd likely opt for the standard deduction. However, even with additional deductions, you might only slightly exceed the standard deduction. In this scenario, not bunching donations results in a total deduction of $55,400 over two years. Alternatively, you can choose to consolidate all donations every other year:
Year 1: Opt for the standard deduction, amounting to $27,700.
Year 2: Donate the full $50,000, resulting in a $50,000 deduction.
Total deductions over two years: $77,700.
This method provides an additional $22,300 in deductions.
If you are in the 37% tax bracket, plus state taxes, this could translate to over $10,000 in tax savings. Strategic planning like this is critical to proactive tax management.
Today, I'll cover the basics of this topic, as delving into it would result in a lengthy post. I have a pair of podcasts that cover this in detail.
Real estate stands out as a highly advantageous asset class from a tax perspective. Strategies like bonus depreciation, cost segregation studies, and 1031 exchanges offer substantial tax deference and reductions when utilized.
If your spouse holds Real Estate Professional Status (REPS) or if you take advantage of the short-term rental loophole, you can use the resulting losses to offset other active income. This may sound appealing, but it's important to note that meeting all the necessary criteria can be challenging. There are specific tests to satisfy in these cases, and I recommend consulting with a tax professional for guidance if you're considering this route.
Another good option is Qualified Opportunity Zone investing. This can make sense if you have a large capital gain from your equity compensation or some other investment. If you do, you could consider putting some from the sale into an opportunity zone investment which will defer taxes until 2026, and then the growth will be tax free if you hold it for 10 years. But remember, just any opportunity zone won’t work, you still need to make sure it’s a good investment. Learn more about this on one of my recent podcast episodes.
There are going to be years that your income will eventually be lower prior to retirement. In these years, it can make sense to move your pre-tax dollars (401(k), Traditional IRA, etc…) to Roth. You’ll incur a tax hit in that year, but those assets will continue to grow tax free, and will ultimately be withdrawn tax free. Ideally, timing this when the market is down, can yield even greater benefits, as the tax hit you’ll incur during the year of the conversion will be even less.
Many high-income earners receive equity compensation in various forms, such as RSUs, ISOs, NSOs, or ESPP plans. Effective tax management is essential in handling these. Here's a brief overview of each:
While this overview is high-level, I have more detailed resources available for each type of equity compensation. By strategically planning and managing your equity compensation, you can effectively minimize your tax liability.
These two concepts are closely related. Asset location primarily involves:
Effective management of asset location can result in substantial tax savings throughout your lifetime. It's crucial to avoid a significant tax burden in your taxable account.
Additionally, tax loss harvesting offers a strategy to sell investments at a loss and then transition to a similar asset. This enables you to utilize that loss to offset gains elsewhere when they occur. If you have no gains to offset, you can deduct up to $3,000 from your income, and any remaining losses can be carried forward to offset future gains in the next tax year.
Deferred compensation plans are distinct from your regular income and provide a means to receive additional payment without immediate taxation. Instead, taxes are deferred until a later date. The downside is that if the company fails, you may not receive anything.
In certain scenarios, incorporating a deferred compensation plan into your financial strategy can be a smart move, particularly when you have a substantial income.
529 plans provide an excellent method for saving for college expenses, but it's important to note that the benefits can vary significantly from state to state. For instance, in Indiana, you can receive a 20% tax credit, up to $5,000. However, a state like California offers no such deduction. So, if you contribute $5,000, you can expect a $1,000 reduction in your tax bill. Like other tax advantaged accounts, the investments within the plan grow tax-free, and qualified college expenses can be withdrawn tax-free.
Before committing to a 529 plan, it's crucial to research your specific state's plan and the deductions or credits it offers. If you reside in a state with no state income tax, the benefits may be less pronounced, but a 529 plan can still be a valuable tool for saving for educational costs.
This section will be the lightest considering that estate planning is unique to each individual and their goals. I’d recommend working with a financial professional and an estate planning attorney to maximize your opportunities here.
There are too many considerations to begin to list all of them, but beyond the basics, there are a multitude of estate planning strategies that you should be aware of.
First, understanding that the estate tax exemption’s current thresholds are set to sunset, in 2026, to effectively half of what they currently are - down from $12.92 million at time of writing. You may want to utilize some of the following to move money out of your estate to get underneath the exemption threshold.
Annual Gifting: You can gift money to family members each year up to the reporting limit, effectively reducing your taxable estate without using your lifetime gift tax exclusion.
Lending Money: You may consider lending money to family members at the required interest rates, which can be an effective strategy to transfer wealth while maintaining control over the principal amount.
Education and Healthcare Expenses: Covering college or healthcare expenses for family members can be a tax-efficient way to provide financial assistance while reducing your taxable estate.
These strategies can help high-net-worth individuals manage their estates, minimize estate taxes, and ensure a smooth transfer of wealth to the next generation. Consulting with an estate planning professional is essential to determine the best strategies for your specific financial situation and goals. And, like I said, there are many, many other considerations in estate planning, as we didn’t even touch on trusts, here.
This post is not comprehensive, but it is a great resource in beginning to understand many of the tax saving options available to you. Tax planning is challenging, but absolutely necessary if you care about lowering your lifetime effective taxes. Explore as many of them as possible and, again, work with a professional to see which of these or combination of these can best assist you in keeping your money yours.
Disclaimer: This is just for informational purposes. None of this should be seen as tax advice. Work with your financial planner and tax professional to evaluate which strategies would be the best for your situation.
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