The more you earn, the more critical it becomes to limit your tax liability. High-income earners can reduce their tax liability by taking advantage of reduction tactics, such as contributing to retirement accounts and implementing tax planning strategies. These strategies help you preserve wealth, keep more in your pocket, and pay less tax.
Are You a High-Income Earner?
A high-income earner for the 2023 tax year earns more than $578,125 for single taxpayers and $693,750 a year if they are married and filing a joint tax return.
For 2022 and 2023, the tax rate for high-income earners is 37%. The 2022 thresholds are $539,901 and $647,851.
5 Above-the-Line Tax Reduction Tactics
An above-the-line tax deduction is an expense you can subtract from your gross income to reduce the Adjusted Gross Income (AGI), lowering your overall tax burden. Above-the-line deductions are defined under federal law in the Internal Revenue Code, Section 62.
Examples include contributions to certain retirement accounts, business expenses, and healthcare expenses. These types of deductions are allowed regardless of whether you use the standard deduction or itemize your deductions on Schedule A of the tax return.
1. Deductible Contributions to a Traditional IRA
Federal law allows you to deduct your contributions to your Traditional Individual Retirement Account (IRA) from your taxable income, provided you meet specific conditions.
Tax deductions for traditional IRAs are unavailable to individual taxpayers or married couples if their Modified Adjusted Gross Income (MAGI) exceeds the annual limit or if you or your spouse contribute to a workplace-managed retirement plan.
The IRS website provides tables determining your eligibility for traditional IRA tax deductions, depending on whether you are covered by a workplace retirement plan or not covered by one.
Example 1: If you are a single taxpayer covered by a 401(k) plan with a MAGI of $73,000 or less, you are eligible for a full deduction on contributions of up to the yearly contribution limit of $6,500 or $7,500 if you are 50 or older. (The limits are $68,000, $6,000 and $7,000 for 2022).
Example 2: If you and your spouse are filing jointly and neither have a workplace retirement plan, there is no applicable MAGI limit, allowing you to make a full deduction on Traditional IRA contributions up to the yearly contribution limit.
2. Deductible Contributions to an HSA
The Health Savings Account (HSA) is a tax-advantaged account that allows taxpayers to set money aside for medical expenses. Contributions to your HSA may also be tax-deductible. IRS Publication 969 explains the rules regarding tax deductions on HSAs and other health plans. Although the latest revision to Publication 969 was published in 2021, it is the most up-to-date version and still applies.
To qualify for HSA deductible contributions, you must be covered under a High Deductible Health Plan (HDHP), not have any other health coverage (including Medicare), and not be claimed as a dependent on another person’s tax returns.
If you qualify, any contributions you or your employer make to your HSA are tax deductible even if you don’t itemize. The 2022 yearly contribution limits are $3,650 for self-only HDHP coverage and $7,300 for family HDHP coverage. Individuals aged 55 or older can contribute an additional $1,000 to their contribution limits. The contribution limits are $3,850 & $7,750, and $1,000 extra for those 55 and older for 2023.
Example: If you are a single taxpayer aged 59, have self-only HDHP coverage, and do not have Medicare or any other health insurance coverage, 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 charitable organization that can be deducted above-the-line. These transfers are 100% tax-free and can be used to reduce your annual Required Minimum Distributions (RMDs).
To qualify for a QCD, you must be aged 70½ or older, and your retirement account may not be an ongoing SEP or SIMPLE IRA.
You must file an IRS Form 1099-R for the corresponding calendar year to report a QCD. You must also report QCDs on your tax returns (Form 1040) at the “IRA distributions” line. If the full amount was a QCD, the IRS recommends entering “0” followed by “QCD” on the “Taxable amount” field.
Example: If your annual RMD is $15,000 and $15,000 and you make a QCD worth $15,000, the donation has satisfied your RMD for the year, causing your annual taxable RMD income to fall to $0.
4. Workplace Retirement Plan Contributions
Contributions to workplace-managed retirement plans such as the 401(k), 403(b), and 457(b) plans are tax deductible. Individuals on 401(k), 403(b), and 457(b) plans do not need to report contributions to claim tax deductions because they are automatic.
These contributions are made pre-tax, so they are not included in your taxable income. For 2023, contribution limits to 401(k), 403(b), and most 457 plans have been raised to $22 from $20,500 for 2022.
Example: If your income in 2022 was $62,000 and you contributed $6,000 to your 401(k) plan, your employer reports $56,000 as taxable income on the Form W-2.
5. Sole Proprietorship Business Expenses
If you work as a freelancer, an independent contractor, or a self-employed person in a sole proprietorship, most categories of expenses related to operating your business are tax-deductible.
Tax-deductible expenses include almost every item listed in a Schedule C form: rent, power, water, utilities, meals, equipment, supplies, vehicular expenses, insurance, contract labor, and employee salaries. If your business is operated from a home office, you may also qualify for a home office tax deduction.
The IRS also allows sole proprietors to deduct miles driven using 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 midyear increase.
Example: If you operate a business in 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 report the deduction on line 30 of the Schedule C form.
4 Below-the-Line Tax Reduction Tactics
Below-the-line deductions are itemized expenses subtracted from taxable income, allowing you to reduce the taxes you owe after calculating your Adjusted Gross Income (AGI).
Although below-the-line tax reduction tactics can help you reduce your taxable income in much the same way as above-the-line equivalents, itemizing deductions may increase tax audit risk. Consider tax audit defense insurance.
1. Charitable Contributions
If you itemize your deductions and have made charitable contributions to specific organizations, you can claim tax deductions on your donations as a Schedule A itemized deduction. 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 include churches, synagogues, religious organizations, veteran organizations, nonprofit volunteer fire companies, and U.S.-based trusts, corporations, and funds.
You may claim deductions for non-cash donations, such as donating appreciated stock. These donations are evaluated according to their fair market value.
According to IRS rules regarding charitable contribution deductions, you may only deduct up to 60% of your AGI in charitable donations. Depending on the organization you donate to and the type of contribution made, the deduction may be limited to a lower percentage. Refer to the IRS Deductibility Status Codes table for more information.
Example: When contributing to a public charity, you may only deduct up to 60% of your AGI for cash donations and 50% for non-cash donations such as appreciated stock. If your AGI for the year is $42,000, a $20,000 cash donation to a public charity would be fully tax-deductible, as it falls under the 60% limit of $25,200.
2. Mortgage Interest Tax Deductions
The home mortgage interest deduction allows you to deduct the interest you pay on your mortgage from your taxable income.
Mortgage interest deductions are only available to taxpayers who itemize instead of taking the standard deduction. The standard deduction amounts in 2022 are $12,950 for individuals, $25,900 for married couples, and $19,400 for unmarried heads of households.
- The maximum principle you can deduct interest for is $750,000 for individuals and $375,000 for married couples filing separately.
- If you took out the home loan before December 16, 2017, the maximum mortgage debt increases to $1 million for individuals and $500,000 for those married but filing separately.
- The debt is considered grandfathered if the loan is before October 14, 1987, and no limits apply.
If you are eligible for mortgage interest tax deductions but don’t meet the conditions for full tax deductions, you may be eligible for a partial deduction. Part II of IRS Publication 936 contains the full details to determine the limits on your deductible interest.
Example: An individual taxpayer has taken out a home mortgage in 2018 worth $600,000. In this instance, the taxpayer is eligible for a mortgage interest deduction.
3. SALT Deductions
SALT stands for State and Local Taxes. Federal legislation permits specific taxpayers to deduct qualifying taxes paid to their local and state governments from their federal income taxes.
To be eligible for SALT deductions, you must itemize your federal tax deductions. You may claim a SALT deduction by filing an IRS Form Schedule A. Qualifying deductions include property taxes and either income taxes or sales taxes (but not both) paid during the year.
Since the passage of the Tax Cuts and Jobs Act, SALT deductions are capped at $10,000 annually through 2025, or $5,000 for married couples filing separately.
Example: A taxpayer living in California reports paying $22,000 in annual property taxes and $12,000 in state income taxes, totaling $35,000 in SALT. As the number exceeds the cap, this taxpayer can only claim deductions on the first $10,000.
4. Medical and Dental Expense Deductions
Individuals who itemize their deductions may claim tax deductions if they paid for specific dental or medical expenses for themselves, their spouse, or their dependents. According to IRS Topic 502, only the medical expenses that exceed 7.5% of the taxpayer’s AGI are tax-deductible.
Eligible expenses include diagnosis, treatment, disease prevention, mitigation, cures, and any medical operations affecting “any structure or function of the body.” You can find a complete list of qualified medical expense types and service providers in IRS Publication 502.
Example: If your AGI for the year is $42,000, all expenses over the first $3,150 are tax-deductible. If you incur $9,200 in medical bills this year, $6,050 are deductible.
Traditional Tax Planning Tactics Not Cutting It?
If typical tax planning methods aren’t enough, consider alternative tax management strategies, such as taxable income and tax deferral strategies. Taking advantage of these plans can help you make additional tax savings.
Income Deferral Strategies
Income deferral, also known as accelerating deductions, is a long-term strategy comprising methods and measures intended to minimize your tax liability during the current year.
They function by “accelerating” spending or expenses to obtain tax deductions now instead of next year.
1. Nonqualified Deferred Compensation Contributions
Nonqualified deferred compensation (NQDC) plans are specialized retirement plans allowing specific categories of taxpayers (e.g., high-earning employees) to defer a higher portion of their compensation than the IRS allows in a standard qualified retirement plan.
NQDCs function as agreements between employers and employees where the former offers the latter additional compensation and bonuses. Instead of receiving these benefits immediately, they are deferred to a later date.
Typical plans defer the reception of these benefits to 5-10 years in the future or until the employee retires. Postponing the payment of this extra compensation also defers the tax owed to that later date.
NQDC plans are primarily intended for individuals who have “maxed out” (reached the maximum limit of) their standard 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 include 457(b) and 457(f) plans, which cover non-profits and governmental organizations.
Example: A high-earner only contributes a small percentage of their annual earnings to their 401(k). For 2023, an individual with a yearly salary of $800,000 contributes only 2.8% of their annual earnings if they contribute the maximum limit of $22,500. An NQDC plan allows that person to contribute more and defer tax payments for later.
2. Converting a Traditional IRA to a Roth IRA
If you are a high-earning individual whose yearly income exceeds the annual Roth IRA contribution limits, a common workaround is converting your Traditional IRA into a Roth IRA.
The primary difference between a Traditional IRA and a Roth IRA is when you pay taxes. Traditional IRAs let you deduct contributions now and pay taxes later when you withdraw. Roth IRAs let you pay taxes on contributions now and get tax-free withdrawals.
Although converting your existing Traditional IRA funds to a Roth IRA requires you to pay income taxes on the year of conversion, doing so can make sense in specific situations, such as for individuals whose tax bracket will increase during retirement.
Consult a financial advisor or a tax professional before making this change; once the conversion is complete, it is irreversible. Since the passage of the Tax Cuts and Jobs Act, it is no longer possible to undo or recharacterize a Roth conversion.
Example: If you are filing as a married couple filing jointly with a modified AGI of $260,000, you exceed the maximum limit allowing you to contribute to your Roth IRA. Converting your Traditional IRA funds grants two benefits: the possibility to add funds to the Roth IRA now and tax-free withdrawals down the line.
Tax Deferral Strategies
Tax deferral strategies are used to delay taxes and pay them another year. Taxpayers looking to manage their income flow and potentially pay lower taxes in the future should implement this strategy.
1. Contributions to a Traditional IRA or a 401(k)
Payments made to retirement accounts such as a traditional IRA or a 401(k) are not subject to taxation until they are withdrawn.
Example: Saving up for retirement, Alex contributes $6,000 to his traditional IRA account. Since it is now in a retirement fund, he will no longer have to pay taxes on that $6,000 this fiscal year.
2. Section 1031 Exchange
A 1031 exchange is when one real estate investment property is exchanged for like-kind property, and the capital gains are deferred. Following all of the rules set by the IRS will result in the taxes being deferred to a later year, likely when you sell the new property.
Example: James sold a commercial property for $700,000 in 2022. Rather than pay taxes on the property, he reinvested the money into a like-kind property within 180 days. By reinvesting the capital, taxes on the revenue of $700,000 were deferred.
3. Deferred Annuity
A deferred annuity is when a person pays an insurance company with the promise of paying the owner back at a later date. There are no taxes on the amount deposited until it is withdrawn from the annuity.
Example: Jess invests $500,000 into a deferred annuity with her insurance provider. She wants the annuity to mature for 10 years, with an interest rate of 4.25% in years 1-3 and a minimum of 1.7% in years 4-10. At the end of her annuity, she expects to collect a lump sum of $637,443.40.
Change Your Revenue Vehicle
If you are not interested in more traditional methods, changing your revenue vehicle is an alternative strategy for reducing your tax liability.
Option 1: Incorporating Your Business
If you form a corporation and limited liability company (LLC) you may be able to take advantage of lower tax rates on business income and reduce your tax liability.
Example: Saving up for retirement, Alex contributes $6,000 to his traditional IRA account. Since it is now in a retirement fund, he will no longer have to pay taxes on that $6,000 this fiscal year.
Option 2: 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 control over the donated funds.
Example: A family sets up a private charity foundation and contributes $75,000 while following the outlined regulations in IRS 501(c)(3). Because of this, the $75,000 is an income tax deduction.
FAQs
Here are the answers to some common questions about tax strategies for high-income earners.
While tax planning and above-the-line strategies do not, below-the-line tactics and strategies that rely on itemized deductions may increase the risk of a tax audit.
Avoid higher tax brackets with tax-deferred retirement accounts, such as Traditional IRAs and 401(k) plans. Consider additional methods to reduce your taxable income, such as Section 83(b) elections.
There are several legal and efficient ways to reduce your income tax, including taking advantage of deductions and tax credits, using tax-deferred retirement accounts, and implementing income- and tax-deferral strategies.
No. Section 529 contributions are payments made to qualified tuition programs that do not reduce your AGI. Some jurisdictions may offer tax credits or deductions for 529 contributions, potentially reducing local and state tax liability.
