Everyone who earns a lot of money needs to know their share of tax-saving strategies for high-income earners. High income sounds like a dream, but only until tax season comes around. Your taxable income gets a great cut when you earn a lot of money, which is why you need to work on your tax planning strategies.
But what are some good tax strategies for high income that will help you reduce your tax bill? Are there any good ways to lower your tax burden on your adjusted gross income? Well, we are about to see on that matter.
Note: A great tax saving strategy for self-employed high income earners is to record and track all of your business expenses. In fact, Bonsai Tax can help. Our tax receipt scanner app will scan your credit card/ bank statements to discover tax write-offs and maximize your savings. Users typically save $5,600 from their tax bill. Try a 7-day free trial today.
Why Do High-Income Earners Pay More In Taxes?
Many people may think that low-income earners would be the ones to lose more money when they have to pay taxes. However, it's the high-income earners that are most affected by this, mainly because of the progressive tax system.
The progressive tax system ensures that people are charged based on the taxable income they earn. The higher your income is, the higher your tax burden will be. This is a result of them entering a higher tax bracket.
Who Are High Earners?
High earners are those who receive income between $250,000 and $500,000+ per year. Very often, they are referred to as HENRYs (High Earner, Not Rich Yet), as they haven't yet invested enough to be seen as rich. Most of the money is often spent on education, consumer needs, and housing.
How Much Do High-Income Earners Spend on Taxes?
High-income earners are spread across multiple brackets, the tax rate being different based on their status (i.e., single filer, joint filer, head of household). The more you make, the more you will be taxed for it. The total income will determine how much you will have to pay in income taxes.
For example, a single taxpayer earning up to $9,950 will pay around 10% of their taxable income. However, if that single person earns more than $523,600 that year, they will pay taxes of 37%. These brackets change more or less every year, but for the 2020-2021 tax year, these are the values for federal income tax.
How to Reduce Your Taxes As a High-Income Earner
You may be earning a lot of money, but this does not mean that you must give all of it away to the tax system. Here are some tax reduction strategies that you'll want to keep in mind.
Get Your Allowable Tax Deduction
You may have a big investment income, but this doesn't mean you aren't spending a lot on your way to raising your business. As a likely business owner, you'll probably spend a lot on resources, employees, transportation, and many more.
This is why you need to find out what tax deductions for high income earners or credit you are allowed to claim. As long as they are necessary for building your business, you will be spared of those taxes. This way, you will get more of your adjusted gross income.
Hire Your Kids
Among strategies for business-owning high-income earners, hiring your kid is also something that you might want to consider. If they are of legal working age and share an interest in your business, or have the free time to do a bit of administrative work, then you may consider adding them to your payroll.
The advantage here is that you will not be required to pay tax for Social Security and Medicare for what your child earns. The condition is that the child needs to be under 18 years of age. This way, the tax burden will go to the child under the "Kiddie Tax," and you won't have to deal with such high tax rates anymore.
Donate to Charity
Philanthropists love charity for a variety of reasons - and it's not only because of the "helping" part or improving their public image. They love it because it offers them tax benefits as well.
If you donate to charity, you won't have to deal with capital gains taxes. With the receipt you get upon donating, you should be able to get tax deductions for your taxable income. Read more about a Goodwill tax deduction here.
Get a Health Savings Account (HSA)
A health savings account is essential for every person since you never know when you may have a medical need. It covers expenses of medical nature that a health insurance company may not cover for you.
For instance, things such as a broken bone or a serious urgent condition may be treated under insurance. However, things such as a dental appointment or a visit to the eye doctor may not be.
With that in mind, aside from the medical benefit, a health savings account also offers you tax benefits. All the money you place there will not be subjected to federal income taxes (or any sort of tax), and you won't be taxed for withdrawing money from there. The only condition is that it needs to be used for legitimate medical expenses.
A high-earning investor can reduce or even remove their capital gains tax by adding the pretax fund into this account. This way, your health will be covered without you having to worry about being taxed.
Invest In Junior's Education
You're almost rich now - so obviously, you probably want to get your kid through college. You are probably already setting money aside for this. Your child may be a baby at this point, but they'll eventually grow old - and you don't want them to drown in student loans in the future. Not if you can help them.
That being said, saving for your kid's education will not only put your mind at rest, but it will also help your taxes to lay low. Registered education savings accounts feature tax-deferred growth, allowing you to add funds and grow interest without being taxed for it. When the money is eventually withdrawn from the account, it will also be at a low "kiddie" rate.
Open a 401(k) Retirement Account
As an investor, you can make contributions to a 401(k) retirement account. Not only will you be saving for when you are old and grey, but you will also be able to lower your taxable income. It works pretty much in the same way as a health savings account.
Any capital gains or investment income that you shift towards your retirement account will be tax-free. The only time you may be taxed for it is when you withdraw the money, which will also depend on a variety of aspects.
For instance, if you withdraw from the 401(k) before you reach retirement age, then you will be taxed for it. On that note, if the withdrawal occurs after you passed retirement age, then the tax rate will be lower or zero. It depends mostly on your age and your adjusted gross income throughout your working days.
Convert Into Roth IRA
If you have a traditional IRA or a SEP, then you might want to consider converting everything into Roth IRA. The catch here is that you'll need to be aged at least 59 and a half, but once you are eligible, you should be able to get Roth distributions that are tax-free.
The advantage here is that Roth IRA is not included in the category for investment proceeds. It spares you the Medicare tax, which is regularly around 3.8% (depending on the taxable year). By switching to Roth IRA, you should be able to reduce your tax bill in the future.
Restructure Your Company
If you are the sole proprietor of a company, then you may want to consider switching the structure of the company to a C corporation. This is actually one of the best tax reduction strategies for high-income earners, as it brings you to a financial advantage.
While you won't work tax-free with a C corporation, you would still pay less as compared to a sole proprietor. High-income earners that are sole proprietors have higher tax rates as compared to C corporation owners.
Check every structure company and see what fits you best. Depending on your marital status or whether you have kids or not, one company structure might be more suitable for saving your capital gains over the other.
Trusts and Income Splitting
Among tax strategies for high-income earners, this is one that you should pay very close attention to. Provided that you structure it properly, a partnership or a family trust can help shift your investment income to someone who has a much lower tax rate.
Often, this is done either through loans or annual gift exclusions. Also, if you involve children in the matter, you must keep in mind that the kiddie tax has its limitations as well.
Most tax reduction strategies also recommend trusts to better handle your capital gains. Granted, the federal tax here will still apply, but at least you'll reduce your capital gains tax liability for state taxes.
Purchase Municipal Tax-Exempt Bonds
Good tax planning strategies for high-income earners will also recommend taking a look at municipal bonds. They might not be the most glamorous type of investment, but these tax-exempt bonds are good for the tax credits of high-income earners.
When purchasing a municipal bond, you are lending money to the one issuing the bond, in exchange for interest payment sets given throughout the bond.
Once the period ends, the bond will be considered to have matured. At that point, the original investment will be given back to the buyer, meaning you.
Income received from municipal bonds is tax-free, no matter if we are talking state tax, federal tax or local tax. Even payments in interest from said income can be tax-free.
Indeed, a municipal bond earns less interest in comparison to a taxable bond, but in terms of tax strategies for high-income earners, you can reap many benefits. Simply calculate the tax-equivalent yield of the bond, and determine whether investing in these bonds is worth it for you or not.
Sell Your Inherited Real Estate
As a high earner, there is a good chance you may have some pieces of inherited real estate here and there. You probably purchased your home from your own funds as a high-income earner, and then you inherited a home from some parent or relative.
It all sounds cool to have as many properties as possible - but the problem here is that for every property you have, you will also end up paying a lot of tax money. This becomes especially troublesome if the value of the home has increased over time. There would be fewer taxes to pay if the home was sold when the owners were still alive.
In this case, tax strategies for high-income earners advise you to sell the home as soon as you inherit it. This way, you should be able to dodge property taxes while maximizing your inheritance.
Also, if you roll the income from the sale into another real estate investment, then you should be able to dodge the tax for capital gain. The condition is that you need to do that within 380 days.
This is especially common with rental properties, where 1031 exchanges are done. This way, by investing in a new property, you should be able to defer the taxes that apply to your gain.
Invest In Companies Selling Dividends
In many circumstances, the right investments might just aid your tax planning efforts. If you ever wondered why billionaires seem to pay smaller tax rates, then the answer is usually in the dividends section.
Many high-earning individuals get their wealth from shares, as the companies are generating income from the shareholder. It is considered one of the best tax strategies mainly because these gains are taxed at a much lower rate. The longer their term, the longer the rate will be.
Go for Tax-Efficient Investments
If you want to reap tax advantages as someone with a high business income, then you might want to start making tax-efficient investments. Go for a research-based company, such as gas, oil, mining, or renewable energy.
To put it simply, these companies may "renew" the costs coming your way. This way, you may file for tax deductions on your end, a deduction that can reach the amount you invested in the first place. This should improve your net revenue in the end.
Try Opportunity Zones
The Tax Cut and Jobs Act of 2017 came with a good thing for the taxpayer - and this is called "opportunity zones." This allows you to invest your money in a special opportunity zone, setting the stage for tax deferral on your capital.
This will allow you to be on a tax-free status until December 21st, 2025, or until the opportunity zone is sold - whichever one comes earlier.
Another advantage is that if the opportunity zone brings you further earnings, the said income will not cost you a thing in taxes. This will save on money in the long run.
If high-income people would not reap tax advantages and pay the full tax rate, with no tax-loss harvesting or deductions claimed, they would not have that much money to sustain their lush daily life. High-income earners pay the highest taxes, so without the tax cuts, they would hit a bit of trouble.
This is why these tax strategies should come in handy. With the right investments, their capital can go tax-free and they can make a profit. There are multiple options for high-earning people to reduce their taxes, which is why you may want to opt for the help of a tax advisor.