Today’s discussion of tax strategies for high-income professionals demands an important disclaimer: Do not let the tax tail wag the dog.
In other words, the fact that some action or “investment” can lower your taxes doesn’t mean you should do it. Some of the strategies suggested by today’s guest author are among my favorites; others I generally advise against and would not personally consider.
For example, I think tax loss harvesting is great, and I’ve been using a donor advised fund as part of our charitable giving strategy for nearly 10 years. On the other hand, I have no use for whole life insurance (and its high fees and modest returns) and tools like captive insurance and conservation easements are often associated with sketchy numbers and questionable characters.
Before reading the following discussion that includes some complex strategies, be sure you’ve got the basics of tax-reduction down by reading my Top 10+ Ways to Lower Your Taxes in which I elaborate on why you may want to avoid some of the more advanced strategies you’ll be reading more about below.
Paulina Szuszkiewics, the author of today’s guest post is a tax reduction adviser at Ratio CPA. While I may not be a fan of every strategy she outlines, I think it’s important for you to be exposed to ideas from a variety of people, and your specific needs and your appetite for risk may be different than mine.
High income comes with high income taxes – this is obvious. What is less obvious is that there is a wide range of tax saving strategies that can help high income earners and high net worth individuals lower their tax bill, at times drastically. This applies to business owners, W-2 wage earners, self-employed individuals, and those receiving a K-1.
A quick Google search on “tax planning” will give you a list of obvious suspects: qualified retirement accounts, contributions to a health savings account (HSA) for medical expenses, starting a 529 plan for education-related expenses, or tweaking Form W-4 to adjust withholdings.
Some tax professionals will also suggest starting a business, hiring a spouse, or contributing to a SEP IRA. While these tax reduction strategies are certainly useful and cannot be overlooked, they just do not put a big enough dent in a high earner’s tax burden.
High income earners may qualify for more powerful tax strategies, outlined below.
Qualify for Investment Tax Credits
While a high income earner will not qualify for many common credits, such as the child tax credit or the earned income tax credit, they can get massive tax benefits in the form of Investment Tax Credits (ITC).
One way to receive Investment Tax Credits is by participating in green energy projects, such as solar energy projects. These projects are not on the residential level (you are not installing solar panels on your own roof!) but on a commercial level. The beneficiary of electricity provided by solar panels can be a non-profit, such as a school or place of worship.
High income earners can fund solar panels for the non-profit (or other business), and in return receive ITC, a depreciation bonus, as well as residual passive income from the sale of electricity over dozens of years.
This is a huge win-win for the investor, the beneficiary of the electricity, and the environment.
If you max out your allowable ITC for any given year, it can be carried forward for 20 years, or carried back up to 3 years. This means you can invest in green energy projects and lower last year’s taxes!
Tax Strategies for Accredited Investors
An accredited investor is an individual who either owns assets valued at over a million dollars (excluding a primary residence), or has earned $300,ooo a year in the last two consecutive years if married, $200,000 if single.
Accredited investors can participate in various tax reduction strategies and purchases unavailable to those in a lower tax bracket. One of these strategies is syndicated conservation easement – though this strategy has its pros and cons and those interested should consult a qualified and experienced tax strategist.
If carried out correctly, a strategy like conservation easement can lead to a high charitable donation deduction, which decreases federal income tax (and, at times, state income tax).
The market has been kind to many real estate investors, but selling an appreciated property can lead to high capital gains tax liability. However, you will not have to pay tax on the sale of an appreciated property if you do a so-called 1031 exchange (Section 1031 is a provision of the tax code).
A 1031 exchange allows real estate investors a tax deferral on gains from the sale of an investment property if they “roll” the proceeds directly over into a similar property within 180 days. The provision was established in 1921 to promote economic activity.
Charitable Donation Deductions Using a Donor Advised Fund
Many high earners make donations to charities – but do not always receive a full tax advantage for doing so (because of the standard deduction). A good CPA firm will help you become much more tax efficient by setting up a Donor Advised Fund (DAF). [PoF: These are very easy to set up on your own. I recommend CharityVest (lowest fees) or Fidelity Charitable and use both.]
A DAF allows donors to make a larger charitable contribution, receive an immediate tax deduction, and then recommend grants to charities from the fund over time. Donors can contribute to the fund as frequently as they like and recommend grants whenever it makes sense for them.
You can make a charitable contribution to a DAF in the form of cash, appreciated stocks, mutual funds, real estate, or artwork, and immediately receive the maximum tax deduction for the year. Additionally, your contributions in a DAF can be invested and grow tax-free.
Lowering Business Income
Business owners have a lot more legroom when it comes to tax deductions and lowering taxable income. They can make various tax-deductible purchases (vehicles, home office, mileage, software subscriptions, equipment, salaries, employee retreats, and expense legal or accounting advice). A business owner can also hire a spouse to double retirement savings or hire a child under the age of 18 for both tax-free income and business deductions.
The above can, in some circumstances, also apply to individuals receiving a 1099.
In addition, if your profitable business activities come with a lot of liability that typical insurance policies do not cover (most insurance policies do not cover political unrest, war, “acts of god”, pandemic risk, acts of terrorism, loss of a key employee, etc.), you can set your mind at ease, save on taxes AND additionally insure your business by setting up your own insurance company (called a micro-captive, captive insurance, or Section 831(b)).
Premiums paid to a captive insurance company are federal tax free. If you use the funds inside your captive to pay for a claim, there is no tax to be paid at all. If the funds are withdrawn from the captive after a number of years, you will pay the long-term capital gains rate on the funds, and not your ordinary income tax rate.
Captive insurance companies have their risks if implemented incorrectly – you should always consult a tax planning professional before implementing this strategy.
Rental Real Estate Investments While Obtaining Real Estate Professional Status
Investing in real estate is just that – an investment. Some investors make a LOT of money buying, renting, and selling properties – and some lose quite a lot as well. This is because an ROI from an investment is never guaranteed – no matter what anyone tells you.
Rental income (unless you achieve professional real estate status) is considered passive income. If you have more expenses than revenue – this is called a passive loss. Many rental properties have passive losses as a result of depreciation, maintenance, property management fees, real estate taxes, insurance, and other operating costs.
With various business or self-employment income types, you can deduct losses on your annual income tax return. With passive losses this may not be possible – as passive losses can usually only be offset by passive gains (i.e. if your rental property becomes profitable, your passive losses will offset your passive gains, but usually NOT your active (ordinary) income, like from a W-2 job, a business, or a 1099).
Unless you have a passive gain OR sell the property, your passive losses will be carried forward indefinitely – with no benefit to you.
There are exceptions to the above, but those with full-time jobs in a higher tax bracket often do not meet the requirements.
You may be able to deduct passive losses against your ordinary income if you obtain real estate professional status. This is not easy to do – as you must spend at least 750 hours annually in the real estate business, and more than half of your working hours must be dedicated to real estate. You must also fulfill a series of other requirements. This is almost impossible if you have a full-time job.
You should do a lot of due diligence on a company promising to slash your taxes in half through a rental property investment (especially if the aforementioned company wants you to set up a convoluted legal entity structure or employ complicated measures or loopholes).
So… what can you do if you are eager to invest in rental real estate or already own a property?
- View your purchase as an investment – and not a tax reduction strategy
- Understand that your rental property may not be profitable – and you may not see any of the passive income you strived to obtain with the investment.
- There ARE various ways to increase your passive losses to help offset passive gains (such as doing a cost segregation study), or defer capital gains from the sale of your property (e.g., 1031 exchanges described above).
Whole Life insurance as a Retirement and Tax Reduction Tool
Money in a 401(K), or equivalent (like a traditional IRA or SEP IRA), is not tax-free – just tax-deferred. This means you will pay taxes on 401(K) retirement funds – as you take distributions upon retirement. [PoF: Not necessarily]
What will your federal and state tax rates be when you retire in 10, 20, or 30 years? No one can know that – but most experts expect tax rates to go up.
In addition, traditional retirement plans have contribution limits, income limits, and a minimum distribution age, i.e. how old you have to be before you can start taking money out without incurring penalties, or at what age you are forced to start taking distributions – whether you need to or not.
A *whole life insurance policy can circumvent all these limitations, though your contributions (premiums) are made with post-tax dollars.
Though purchasing a whole life insurance policy to supplement retirement is definitely not for everyone, the strategy can offer:
- Tax preferred cash accumulation(your funds grow tax free)
- No contribution limit, regardless of taxable income
- Baseline, guaranteed cash accumulation
- Potential (not guaranteed!) *dividends that add to your cash accumulation
- Ability to take tax-preferred withdrawalsin retirement
- A custom policy to meet your needs
- An income tax free death benefit(if eligible!!)
- You can also add bells and whistles to your policy, such as a disability waiver, a long-term care rider, or even a term life insurance policy
Those interested must keep in mind that *dividends are not guaranteed and that whole life insurance plans are medically underwritten – thus, are not available to all applicants. It’s also important to see complete policy illustrations before making any decisions!
Move to a State with No Income Taxes – or a Tax-Advantaged US Territory
Nothing lowers taxable income like a 0% income tax rate. There are currently a few states with no income taxes: Wyoming, Washington, Texas, Tennessee, South Dakota, Nevada, Florida, and Alaska.
Want no state tax burden? Simply move to one of the above!
You do have to become a bona fide resident of a 0% income tax state in order reap the benefits – meaning transferring your mail, driver’s license, voting registration, and primary residence to the state in question. You also have to spend at least 183 days out of the year residing in said state.
Certain US territories, such as Puerto Rico, offer even bigger incentives to business owners and high net worth individuals who move offshore – again, under the condition that they prove they are, by definition, residents of the territory.
Benefits might include receiving a 100% tax exemption from income taxes on all dividends and interest, tax exemptions on capital gains stemming from the sale or exchange of securities that appreciated in value, or reduced corporate taxes and exemptions from property taxes, municipal taxes, and taxes on dividend distributions for income generated and property used in exempt operations.
Strategic Tax Loss Harvesting
If your capital investments did well this year, you may be forced to pay short or long-term capital gains taxes. One strategy for reducing capital gains is to sell other investments at a loss and use those capital losses to balance the gains for tax purposes. If you make a capital gain of $10 and a capital loss of $10, the net effect is zero – and no taxes are owed.
However, utilizing capital losses is the least beneficial of all the options in this article. Using capital losses literally means you have to lose money on one stock in order to avoid paying income taxes on another. This method is often referred to as loss harvesting, where you sell shares at a loss on purpose to balance the gains on profitable sales.
Don’t DIY: Find the Right Tax Advisor to Help Lower Your Taxable Income
Perhaps most importantly: find a tax advisor who specializes in tax planning.
Just like not all physicians specialize in neurosurgery, not all accounting or financial planning firms specialize in lowering tax burden using tax planning strategies.
Although googling instead of working with a professional may seem to be hassle-free, remember that there is a lot of misinformation online.
Never pursue a strategy meant to lower your taxable income unless you’ve spoken with an experienced, licensed tax professional. Otherwise, you are risking incorrect implementation, an IRS audit, as well as potential penalties and interest.
[PoF: While I agree with using a tax professional to complete tax returns and implement complex strategies, I’m of the opinion that simple strategies like charitable giving and tax loss harvesting can be undertaken by the individual taxpayer. I’ve provided lots of resources on this blog to help guide you.]
In summary, high income earners can rely on advanced tax reduction strategies such as Investment Tax Credits, strategies for accredited investors (such as conservation easement), 1031 exchanges, whole life insurance policies, obtaining professional real estate status, and loss harvesting, among others, to lower tax liability.
Most importantly, it’s unwise to go down the tax planning route alone – you need a qualified, licensed, and experienced tax reduction strategist to guide you along the way.