Many high income W2 employees feel stuck when it comes to paying taxes. Business owners have more opportunities to reduce their taxable income, but what about W2 employees? There are options for you too!
1. Qualified Retirement Plan Contributions
This is the simplest tax savings strategy. Many employers offer qualified retirement plans such as a 401(k) or 403(b). If you are in your highest income earning years and think you’ll be in a lower tax bracket in the future, then you should likely contribute to your retirement plan on a pre-tax basis. Contributions are made directly through your paycheck and don’t count as taxable income if made on a pre-tax basis. Additional catch-up contributions are allowed in 401ks, 403bs and IRAs beginning at age 50.
2. Health Savings Account (HSA) Contributions
HSAs are triple tax-advantaged accounts. Contributions are tax-deductible, the money grows tax-free, and withdrawals are tax-free for qualified medical expenses for those under age 65. After the age of 65, withdrawals can be used for any purpose. Nonqualified withdrawals (i.e. withdrawals that aren’t used for qualified medical expenses) are taxed at normal income tax rates but are not subject to any penalty. If you are age 55 or over, you can contribute an additional amount to your HSA.
3. Tax Loss Harvesting
The principle behind tax-loss harvesting is simple: take lemons and make lemonade. Tax-loss harvesting works like this:
1) When you have an investment at a loss, you sell that position.
2) Use that loss to reduce your taxable capital gains or offset up to $3,000 of ordinary income.
3) Reinvest the money from the sale in a different security that meets a similar goal.
We tax-loss harvest for our clients year around to take advantage of market downturns and to reduce taxes. This strategy is huge because you can build a bank of losses to use to offset an unlimited amount of capital gains.
4. A Deferred Compensation Plan
These plans allow you to reduce your salary and defer your compensation to future years. All contributions and earnings are tax-deferred.
You can contribute to this plan in addition to your retirement plan such as a 401(k). There are different types of plans that are either qualified deferred compensation plans or nonqualified deferred compensation plans.
5. 529 Plans for College Expenses
529 plans are a great way to save for college if you have kids or a loved one that you’d like to help with education expenses. They can now also be used to pay for up to $10,000/year of private tuition in some states at K-12 schools which is awesome.
Your contributions are made with after-tax dollars but all investments grow tax-free and it can be distributed tax-free for qualified college expenses.
Each state has different benefits for 529 plans, so make sure you look into your state’s specific plan to see what deductions or credits it allows.
In Indiana, you get a 20% tax credit up to $7,500. For example, if you contribute $7,500, you get $1,500 back on your state taxes. If you have multiple 529 plans for multiple children, the maximum credit you can receive for all 529 contributions is $1,500 in 2023.
6. Tax Deferred Annuity
A tax deferred annuity is when you pay an insurance company money, let it accumulate and grow at the insurer, and then the insurance company pays you back later. Think of it like a privately funded pension plan. Once you fund the annuity, your principal begins to grow on a tax deferred basis. When you take the money out in the future, you will pay tax on it then.
It is important to note that annuities due tend to have high fees and that your money is illiquid. We don’t typically recommend them for most people. However, they can be used as a tool to defer paying taxes on earnings over a long-period of time if you think you will be in a lower tax bracket in the future.
There are also many different types of annuities such as variable, fixed, immediate and deferred. It’s very important to work with an independent financial planner if you’d like to learn more about an annuity for your specific situation, not an annuity sales person that receives commission when selling you an annuity.
7. Charitable Giving
If you are charitably inclined, there are great ways to give tax-efficiently. Itemizers can generally deduct 20-60% of their adjusted gross income for charitable donation, depending on the type of contribution and the charity or organization you are donating to.
There are different ways to save on taxes when giving. People give tax efficiently by gifting appreciated securities to avoid capital gain taxes, bunching charitable giving into fewer years and/or using a donor-advised fund (DAF).
A DAF is a philanthropic vehicle that allows individuals, families, or organizations to make charitable contributions, receive an immediate tax deduction, and then recommend grants from the fund over time.
8. Private Family Foundation
A private family foundation is a charitable organization that is controlled and funded by a single family. Making donations through the foundation grants you tax deductions while giving you more control over the donated funds vs using a donor advised fund.
Giving to a private foundation may:
· Reduce your taxable income each year a contribution is made.
· Avoid capital gain taxes on any highly appreciated securities that are donated.
· Reduce or eliminate potential estate taxes.
· Allow tax-advantaged growth of assets contributed.
· Create a lasting charitable legacy.
Generally, an initial funding of at least $500k would be needed for a private foundation to make sense.
9. Managing Your Equity Compensation
Many high-income earners receive equity compensation as part of their comp package. The different types of equity comp include restricted stock units (RSU’s), incentive stock options (ISOs), nonqualified stock options (NQSO’s) or employee stock purchase plan (ESPP).
Managing your equity compensation correctly is key to avoiding surprise tax bills or paying more taxes than needed. Different types of equity comp have different tax rules, so it’s important that you have a plan in place to manage your tax liability.
Here are examples for the most common types of equity comp.
RSU’s
When RSUs are granted, they do not trigger immediate tax. This is because you don’t receive any actual shares at that time. RSUs vest over a specified period, and at each vesting date, a portion of the RSUs is converted into actual company stock. When RSU’s vest, they are taxed as ordinary income.
After they vest, you can choose if you want to sell them or hold on to them. You do not receive any additional tax benefit if you decide to continue to hold them. If you hold them for less than 1 year, you will be taxed at short-term capital gain rates. If you hold them for longer than 1 year, you will be taxed at long-term capital gain rates.
ISO’s
ISO’s are given to employees to promote the company’s long-term success. There are special tax advantages to ISOs compared to NQSO’s, but they do come with specific eligibility and holding period requirements.
When a company grants ISO’s to an employee, there are no immediate tax consequences (unless you trigger AMT). However, there may be limitations on the number of shares you can purchase and the exercise price.
The tax implications of ISO’s begin when the employee chooses to exercise the options by purchasing the company's stock at the exercise price. The difference between the exercise price and the fair market value of the stock on the exercise date is not considered ordinary income for tax purposes. This is a significant advantage of ISO’s.
To take full advantage of the favorable tax treatment, the employee must meet two primary holding period requirements:
1) The employee must hold the ISO shares for at least one year from the exercise date.
2) The employee must hold the ISO shares for at least two years from the grant date.
NQSO’s
Unlike ISO’s, NQSO’s don’t offer any special tax advantages. There are no taxes when the company grants the NQSO’s. When you choose to exercise the NQSOs, you are taxed based on the difference between exercise and market price at your ordinary income rate. If you choose to sell your NQSO’s after exercise, your gain will be taxed at short-term or long-term capital gain rate, depending on if you held them for less than a year.
Think of NQSO’s as an annual bonus program with a formula attached to it.
ESPP
Employee stock purchase plans allow employees of a company to purchase shares of the company's stock at a discounted price. The purpose of an ESPP is to provide employees with the opportunity to become shareholders in the company they work for, fostering a sense of ownership and alignment of interests between employees and shareholders.
You decide if you want to participate during their open enrollment period. If you do contribute, you will contribute a portion of your salary to the ESPP on an after-tax basis. Contributions are accumulated over a specific period, often referred to as the “accumulation period”, which is typically 6 months. After the accumulation period, company stock will be purchased at a discounted price. The stock is purchased at the lower of the fair market value at the beginning or end of the accumulation period. This discounted price allows employees to acquire shares at a lower cost than current market value. The discount is typically capped at 15%.
After the purchase is complete, you will be taxed on the gain you received from the discount at your ordinary income tax rate. Later on, if you choose to sell your shares, your proceeds will be subject to short term or long term capital gain rates, depending on your timeframe.
83b Election
If you have equity compensation, you may also be eligible for an 83(b) election. This election allows you to elect to recognize the income associated with the stock at its fair market value at the time of grant rather than when it vests. This election can be particularly advantageous in certain situations and save you a lot of money in taxes if done appropriately.
10. Roth Conversions
Did you know you can convert your tax-deferred assets (401k and IRA) to a Roth IRA? Those dollars then can continue to grow tax-free and you are able to take tax-free distributions later on in retirement. You are also able to avoid taking required minimum distributions beginning at age 73 when you convert to Roth dollars. You will need to pay tax on the conversion at the time it's completed.
Roth conversions are great to do in low-income years. We are always looking for Roth conversion opportunities for our clients. Some of our favorite times to do Roth conversions are when clients have started a business, if they retire early or if they have a low-income year for any other reason.
11. Use a Mega-Backdoor Roth
The Mega-Backdoor Roth is a great strategy for high income earners. If you have access to an after-tax 401(k) that allows mega-backdoor Roth contributions, then IRS will allow you to contribute up to $66,000 in 2023! Here’s how it works:
1) You maximize your regular contributions to your 401(k) plan.
2) Then make after-tax contributions to your after-tax 401(k). This does include your max contribution from your pre-tax 401(k).
3) Trigger a Roth conversion for the after-tax contributions in your after-tax 401(k). This means you will convert the after-tax contributions to a Roth account within your employer plan.
4) Once the after-tax contributions are in the Roth account within your employer plan, you can roll over these funds into a Roth IRA.
This can get complicated quickly, so be sure to work with an advisor to ensure you are doing this correctly.
12. Asset Location & Tax Diversification
Asset location is the unsung hero of tax planning and can often save a ton of dollars in taxes if your assets are simply in the right location. A financial plan will help you put your investments in the right account type.
There are 3 different type of accounts you can put your investments in, and they all have different tax treatments.
1. Taxable accounts - these are brokerage accounts that are taxed when you earn dividends or interest or you realize capital gains by selling investments that went up in value. The most tax advantaged assets are best to put in taxable accounts.
2. Tax-deferred accounts - these are 401(k)s, 403(b)s and IRAs that allow payment of taxes to be delayed until later when the money is taken out. The distributions are taxed as ordinary income. The lowest appreciating assets are best in tax-deferred accounts.
3. Tax-free accounts - these are Roth IRAs, Roth 401(k)s and Roth 403(b). Contributions are made with after-tax dollars, meaning you pay taxes going in, but the dollars grow tax-free and are distributed tax-free. The highest appreciating assets are best in tax-free accounts.
Contributing to all three different account types is important because it allows you to have more control over your tax bracket in retirement or when you need to access your funds.
13. Start a Business
Maybe you have a dream to own your own business. Or maybe you have a side hustle that brings you income, but you don't technically have a business set up. While it's not necessarily easy to run a business, it is easier than ever to start a business. If you currently have a dream to start a business or have a side hustle and want to save more on taxes, consider these 10 Steps When Starting a Business.
There are many tax advantages for business owners. One of the best and simplest advantages is the 401(k) retirement contribution limit. As a business owner, you can contribute as both an employer and an employee, which means you are eligible to contribute up to $66,000 in 2023. If your spouse is also an owner of the company, you can each save that amount. This means you are able to defer a maximum of $132,000 of income.
14. Permanent Insurance
If you expect to be in a high tax bracket in the future as well, you can consider purchasing permanent life insurance with cash value. Instead of drawing income from investments that are fully or partially taxed during retirement, you can help keep your tax bracket down by integrating distributions from cash value life insurance into the mix. At retirement, you can take tax-free loans or withdrawals from the cash value to supplement your retirement income, thus helping to minimize their taxes.
There are a ton of different types of insurance products including whole life, variable and universal. Be sure to work with an independent financial planner (not a salesperson that makes commission) to identify the right product for you.
15. Real Estate
Real estate investment properties help reduce taxable income because you can deduct:
· Operating expenses
· Mortgage interest
· Depreciation
· Owners expenses
