Top 9 tax strategies for high income earners in the United States
Have a high income?
A high-income individual is a person who earns more than $578,125 for single taxpayers and $693,750 per year if married filing jointly.
Note: For 2022 and 2023, the high-income tax rate is 37%. The thresholds for 2022 are $539,901 and $647,851.
5 legal strategies for tax relief in the U.S.
An above-tax deduction is an expense you can subtract from your gross income to reduce your adjusted gross income (AGI) and lower your overall tax burden. Deductions above the tax base are defined in federal law in Section 62 of the Internal Revenue Code.
Examples include contributions to certain retirement accounts, business expenses, and health care expenses. These types of deductions are allowed whether you use the standard deduction or itemize your deductions on Schedule A of your tax return.
1. Deductible contributions to a traditional IRA account
U.S. federal law allows you to deduct contributions to your traditional individual retirement account (IRA) from your taxable income if you meet certain conditions.
Traditional IRA tax deductions are not available to individual taxpayers or married couples if your modified adjusted gross income (MAGI) exceeds the annual limit or if you or your spouse contributes to a workplace-directed retirement plan.
It is important to note that the IRS website provides tables that determine your eligibility for traditional IRA tax benefits depending on whether or not you are covered by a workplace managed retirement plan.
Example 1: If you are a single taxpayer covered by a 401(k) plan with MAGI of $73,000 or less, you are eligible for a full deduction up to the annual contribution limit of $6,500 or $7,500 if you are age 50 or older (the limits are $68,000, $6,000, and $7,000 for 2022).
Example 2: If you and your spouse file jointly and neither of you has a workplace retirement plan, there is no applicable MAGI limit, which allows you to deduct Traditional IRA contributions up to the annual contribution limit in full.
2. HSA Deductible Contributions
A Health Savings Account (HSA) is a tax-advantaged account that allows taxpayers to set aside money for medical expenses. Contributions to an HSA are also tax deductible. IRS Publication 969 explains the rules regarding tax benefits for HSAs and other health plans. Although the latest revision of Publication 969 was issued in 2021, it is the most current version and still applies.
To qualify for the HSA contribution deduction, you must be covered by a high-deductible health plan (HDHP), have no other health insurance (including Medicare), and not be claimed as a dependent on other people’s tax returns.
If you qualify, contributions you or your employer make to an HSA are tax-deductible, even if you don’t itemize them. The annual contribution limits for 2022 are $3,650 for individual HDHP coverage and $7,300 for family HDHP coverage. Individuals age 55 and older may contribute an additional $1,000 toward their contribution limit. The contribution limits are $3,850 and $7,750, and an additional $1,000 for individuals age 55 and older for 2023.
Example: If you are a single taxpayer age 59, have HDHP coverage for yourself only, and do not have Medicare or other health insurance, contributions up to $4,650 are tax deductible.
3. Qualified charitable distributions
Qualified Charitable Distributions (QCDs) are transfers of funds from your IRA to a qualified charity that are deductible above the tax line. These transfers are 100% tax-free and can be used to reduce your annual required minimum distributions (RMD).
To take advantage of a QCD, you must be age 70½ or older and your retirement account cannot be a current SEP or SIMPLE IRA.
To report a QCD, you must file IRS Form 1099-R for the applicable calendar year. You must also report QCDs on your tax return (Form 1040) on the “IRA Distribution” line. If the total amount was a QCD, the IRS recommends that you enter “0” followed by “QCD” in the “Taxable Amount” box.
Example: If your annual RMD is $15,000 and you make a QCD of $15,000, the gift satisfied your RMD for the year, reducing your annual taxable income to $0.
4. Contributions to workplace retirement plans
Contributions to workplace retirement plans, such as 401(k), 403(b) and 457(b) plans, are tax-deductible. Members of 401(k), 403(b), and 457(b) plans do not have to itemize their contributions to claim tax benefits because they are automatic.
These contributions are made pre-tax, so they are not included in taxable income. For 2023, the contribution limits to 401(k), 403(b), and most 457 plans are increased from $20,500 in 2022 to $22.
5. Business expenses of a self-employed person
If you are self-employed, an independent contractor, or self-employed in a sole proprietorship, most categories of expenses related to the operation of your business are tax deductible.
Deductible expenses include almost every item listed on a Schedule C form: rent, electricity, water, utilities, meals, equipment, supplies, vehicle expenses, insurance, contract labor, and employee wages. If your business operates from a home office, you are also entitled to a home office tax deduction.
The IRS also allows sole proprietors to deduct miles driven with personal vehicles used for business purposes using the Self-Employed Mileage Deduction Rules. For 2023, the deductible mileage rate is $0.655 per mile, up 3 cents from the 2022 mid-year increase.
Example: If you operate a business as a sole proprietorship and work in a dedicated office within your home, you will complete Form 8829 to itemize your home office expenses and calculate your tax deductions. You can then claim the deduction on Schedule C, line 30.
4 Tax reduction tactics below the line
Deductions below the line are itemized deductions that are subtracted from taxable income, allowing you to reduce the tax you owe after calculating your adjusted gross income (AGI).
While below-the-line tax reduction tactics can help you reduce your taxable income in the same way as above-the-line tactics, itemizing deductions can increase your risk of tax audit. Consider taking out tax audit defense insurance.
1. Charitable contributions
If you itemize deductions and have made charitable contributions to specific organizations, you can claim tax deductions for your donations as an itemized deduction on Schedule A. Contributions made from a donor advised fund (DAF) are also tax-deductible.
Eligible organizations are defined by federal law in Section 170(c) of the Internal Revenue Code. Common examples are churches, synagogues, religious organizations, veterans’ organizations, nonprofit volunteer fire companies, and U.S.-based foundations, corporations, and funds.
You can claim deductions for non-monetary donations, such as donations of appreciated stock. These gifts are valued at fair market value.
Under IRS rules on deductions for charitable gifts, you can only deduct up to 60% of your annual income for charitable gifts. Depending on the organization to which you donate and the type of contribution you make, your deduction may be limited to a lower percentage. For more information, see the IRS’s deductible status code table.
2. Tax deduction for mortgage interest
The mortgage interest deduction allows you to deduct the interest you pay on your mortgage loan from your taxable income.
The mortgage interest deduction is only available to taxpayers who elect the items rather than the standard deduction. In 2022, the standard deduction amounts are $12,950 for individuals, $25,900 for married couples, and $19,400 for unmarried heads of household.
The maximum principal for which you can deduct interest is $750,000 for individuals and $375,000 for married couples filing separately.
If you took out a mortgage loan before December 16, 2017, the maximum mortgage debt is increased to $1 million for individuals and $500,000 for married couples filing separately.
Debt is considered protected if the loan is prior to October 14, 1987 and no limits apply.
If you qualify for tax deductions for mortgage interest but do not qualify for a full tax deduction, you may qualify for a partial deduction. Part II of IRS Publication 936 contains complete details on determining your deductible interest limits.
3. SALT deductions
SALT stands for state and local taxes. Federal law allows certain taxpayers to deduct the taxes they pay to their state and local governments from their federal income taxes.
To qualify for SALT deductions, you must itemize your federal tax deductions. You can apply for the SALT deduction by filing IRS Form A. Eligible deductions include property taxes and income or sales taxes (but not both) paid during the year.
After passage of the Tax Cuts and Jobs Act, SALT deductions are limited to $10,000 per year through 2025 or $5,000 for married couples filing separately.
4. Deductions for medical and dental expenses
Individuals who itemize deductions can claim tax deductions if they paid certain medical or dental expenses for themselves, their spouse, or their dependents. Under IRS Topic 502, only medical expenses that exceed 7.5% of the taxpayer’s GNI are deductible.
Eligible expenses include the diagnosis, treatment, prevention, mitigation and cure of diseases, as well as any medical procedure that affects “any structure or function of the body.” A complete list of eligible types of medical expenses and providers can be found in IRS Publication 502.
Are traditional tax planning tactics not enough?
If standard tax planning methods are not sufficient, consider alternative tax management strategies, such as taxable income and tax deferral strategies. Utilizing these plans can help you achieve additional tax savings.
Income deferral strategies
Income deferral, also known as accelerated deductions, is a long-term strategy that includes methods and measures designed to minimize your tax liability in the current year.
They work by “accelerating” expenses or costs to obtain tax deductions now rather than next year.
1. Unrecognized deferred compensation contributions
Nonqualified deferred compensation deferral plans (NQDCs) are qualified retirement plans that allow certain categories of taxpayers (e.g., high-income workers) to defer more of their compensation than the IRS allows in a typical qualified retirement plan.
NQDCs operate as agreements between employers and employees in which the employer provides the employee with additional compensation and bonuses. Instead of receiving these benefits immediately, they are deferred to a later date.
Typical plans defer receipt of these benefits for 5-10 years into the future or until the employee retires. Deferring payment of this additional compensation also defers the tax due for that later date.
NQDC plans are primarily intended for individuals who have “maxed out” (maxed out) their normal retirement plans. A typical example of an NQDC plan is the 409A plan, named after Internal Revenue Code Section 409A, which defines plans sponsored by for-profit organizations. Other examples are the 457(b) and 457(f) programs, which cover nonprofit organizations and governmental entities.
Example: A highly compensated individual contributes only a small percentage of his or her annual income to a 401(k) plan. By 2023, an individual with an annual salary of $800,000 contributes only 2.8% of his or her annual income if he or she contributes the maximum of $22,500. An NQDC plan allows that individual to contribute more and defer tax payments to a later date.
2. Converting a traditional IRA to a Roth IRA
If you are a high-income earner whose annual income exceeds the annual Roth IRA contribution limits, a common solution is to convert your traditional IRA to a Roth IRA.
The main difference between a traditional IRA and a Roth IRA is the tax period. Traditional IRAs allow you to deduct contributions now and pay taxes later when you withdraw them. Roth IRAs allow you to pay taxes on contributions now and take tax-free withdrawals.
Although converting funds from a traditional IRA to a Roth IRA requires paying income tax in the year of conversion, it may make sense in certain situations, such as for individuals whose tax bracket will increase in retirement.
Consult a financial advisor or tax professional before making this change; once the conversion is made, it is irreversible. After the passage of the Tax Cuts and Jobs Act, it is no longer possible to reverse or recharacterize a Roth conversion.
Example: If you file a joint return as a married couple with a $260,000 modified IRA, you exceed the maximum allowed to contribute to your Roth IRA. Converting the funds in your traditional IRA provides you with two advantages: the ability to add funds to the Roth IRA now and the ability to withdraw them tax-free later.
Tax deferral strategies
Tax deferral strategies are used to delay taxes and pay them for another year. Taxpayers who wish to manage their income stream and potentially pay less taxes in the future should implement this strategy.
1. Contributions to a traditional IRA or 401(k)
Payments made to retirement accounts, such as a traditional IRA or 401(k), are not taxed until withdrawn.
Example: Saving for retirement, Alex contributes $6,000 to his traditional IRA. Because he is now in a retirement fund, he will no longer have to pay tax on the $6,000 this tax year.
2. 1031 exchange.
A 1031 exchange is when investment property is exchanged for similar property and capital gains are deferred. If all IRS rules are followed, taxes will be deferred until a later year, most likely when you sell the new property.
Example: James sold a commercial property for $700,000 in 2022. Instead of paying taxes on the property, he reinvested the money in a similar property within 180 days. By reinvesting the capital, taxes on the $700,000 income were deferred.
3. Deferred income
A deferred annuity is when an individual pays an insurance company with the promise to pay back the money to the owner at a later date. There is no tax on the amount paid until it is withdrawn from the pension.
Example: Josh invests $500,000 in a deferred annuity with his insurance carrier. He wants the annuity to mature in 10 years, with an interest rate of 4.25% for years 1-3 and at least 1.7% for years 4-10. At the end of the annuity, he expects to receive a lump sum of $637,443.40.
Change of income vehicle
If you are not interested in the more traditional methods, changing your income vehicle is an alternative strategy to reduce your tax liability.
Option 1: Establish your company
By incorporating a corporation and a limited liability company (LLC) you can take advantage of lower tax rates on business income and reduce your tax liability.
Example: Saving for retirement, Alex contributes $6,000 to his traditional IRA. Because he is now in a retirement fund, he will no longer have to pay taxes on the $6,000 this tax year.
Option 2: Private family foundation
A private family foundation is a charitable foundation that is controlled and funded by a single family. Giving through the foundation provides you with tax deductions while giving you control over your donations.
Frequently asked questions from our readers
We have created a section of frequently asked questions, these are the most common questions that our readers do not send us. If you do not find an answer to your question, you can leave us a comment at the end of this article and we will take it into account for a future article published in IsaacPost.com.
How can I avoid a higher tax rate?
Avoid higher tax rates with tax-deferred retirement accounts such as traditional IRAs and 401(k) plans. Consider other methods of reducing taxable income, such as section 83(b) elections.
How can I legally reduce my income tax?
There are a number of legal and effective ways to reduce your income tax, such as taking advantage of tax deductions and tax credits, using tax-deferred retirement accounts, and using tax and income deferral strategies.
Do Section 529 contributions reduce AGI?
No. Section 529 contributions are contributions to qualified tuition plans that do not reduce your AGI. Some jurisdictions may provide a tax credit or deduction for 529 contributions, which could potentially reduce your state and local tax liability.
Article publidhed on January 26, 2023 by Josh Smith
Last Update January 26, 2023 by Josh Smith
