If you’re a high-income earner, you have a number of unique tax considerations that can impact your annual burden by hundreds-of-thousands or even millions of dollars. As a trusted Los Angeles CPA firm that deals largely with high-income clients, we see a lot of common mistakes and oversights from affluent individuals preparing their taxes. By employing just a few basic tax strategies for high-income earners, you can save a fortune when April 15th rolls around.
Structure a Business–Even if You’re Not a Traditional Entrepreneur
If you’re already a business owner, this point may be moot. However, if you’re still operating as a sole proprietor or high-income employee with no formalized business structure in place, you may be missing out on some major tax benefits. If you set up an LLC to manage your personal investments and assets, you can start writing off any applicable business expenses—potentially saving thousands of dollars a year on your tax burden.
In addition to expense write-offs, there are deductions (some fairly new) that all business owners should be aware of. For example, the section 199A deduction (introduced in 2018) allows you to deduct as much as 20% of your small business or rental real estate profit.
Note that eligible expenses and deductions vary depending on the type of business you establish. We recommend working with a reputable CPA company if you plan to pursue this route, as the specific tax requirements and eligible deductions can get complicated.
Invest Money in a Health Savings Account
Even if you have excellent health insurance, a health savings account can offer numerous benefits for high-income earners. It allows you to set aside money for medical expenses while also reducing your tax burden. All contributions that you make are tax-deductible. As of 2020, you can contribute up to $3,500 per year as an individual or up to $7,100 on behalf of your family. If you’re over 55, you can contribute an additional $1,000.
Even if you don’t have a health savings account, be sure to keep close track of any major medical expenses. As of 2020, medical expenses exceeding more than 10% of your adjusted gross income can be deducted as an itemized expense.
Be Generous With Charitable Donations
Charitable donations can make a big difference for organizations and causes you care about. It’s also one of the easiest ways to reduce your tax burden as a high-income earner. What many people don’t realize is just how much you can deduct—up to 60 percent of your gross adjusted income. Just make sure you have the receipts to back up those charitable donations.
Consider a Defined-Benefit Plan
If you own your own business, a defined benefit plan can save you a lot of money at tax time while also helping you to contribute toward your retirement. It works like a pension, and it gives you the opportunity to set aside tens of thousands of tax-deferred dollars separate from your 401(k). Another benefit is that it reduces your total taxable income. So if you earn too much to qualify for the qualified business income deduction (which caps at $157,500), you can set aside a defined benefit plan to reduce your taxable income and qualify for the QBI.
Note that defined-benefit plans aren’t right for every high-income individual. Depending on your retirement goals, and if your income threshold already qualifies you for the QBI, you may only need an IRA or 401(k) to achieve the maximum tax benefit.
Opt for a SEP-IRA
Speaking of retirement benefits, a Simplified Employee Pension IRA (or SEP-IRA) may be an excellent option for certain business owners. This type of plan is designed to make it easier and more cost-effective for employers of small businesses to offer retirement savings options for their employees. If you’re self-employed, you can also contribute up to 25% of your earnings or $57,000 (whichever is less) to your own SEP-IRA as of 2020, thus reducing your taxable income.
Deduct Mortgage Interest Expenses
We can’t talk about tax strategies for high-income earners without mentioning real estate. Now may be an excellent time to purchase a home or opt for a cash-out refinance. In 2020, you can deduct the mortgage interest paid on as much as $750,000 of a home’s principal. Just note that when you take this and other itemized deductions, you forgo the standard tax deduction (which usually isn’t an issue for high-income earners).
Look Into Cash Value Life Insurance Options
Cash value life insurance has higher investment limits than standard life insurance plans. High-income earners favor these types of accounts not only because of the higher caps but also because the cash value can be withdrawn similar to a savings account.
In addition, all accumulated cash value remains tax-free and you never have to pay taxes if you borrow against the policy. And because your beneficiaries don’t have to pay taxes on the death benefits, the tax advantages continue even after you’re gone.
Manage Your Stocks and Bonds Like a Pro
Stocks, bonds, mutual funds, and other tradable assets can be beneficial for anyone trying to limit their tax burden. Tax-exempt bonds, for instance, are exempted from both Medicare surtax and federal income tax, and most capital gains are taxed at rates far below standard income.
You must be very strategic, though, in how you manage these assets. The timing at which you buy and sell shares can significantly impact your tax burden. Unless you have a background in finance, this will require some assistance from a knowledgeable financial planner.
For example, short-term investments are taxed at a higher rate than long-term investments, and long-term annual dividend payments have less of a tax burden than short-term distributions. If you precisely time the selling of an unprofitable asset, you can recoup some of the loss by deducting up to $3,000 against your income. This is part of a strategy known as tax-loss harvesting.
Get Yourself a CPA
This last point ties back to everything we’ve covered so far. Tax laws are complicated and ever-changing. We could go on and on with effective tax strategies for high-income earners, but the most important thing we can recommend is to get in touch with a certified public accountant (CPA) with a background in tax law.
CPAs are the most aggressively educated and vetted tax experts, adept at managing the complexities of a high-income tax return. Whether you need help with tax-loss harvesting, establishing an LLC, or just maximizing your deductions over the course of the year, a CPA is the best partner you can have at your side.
If you’re looking for a knowledgeable CPA to help you, contact the experts at Lalea & Black. We work with high-income earners and would be happy to help you minimize your burden at tax time and throughout the year.