Strategies for High-Income Earners to Minimize Taxes

 

As tax filing season arrives, a lot of “high income earners” in the Bay Area are starting to think of more ways to shelter taxes. I put the words high income earners in quotations, because it is fair to say that most bay area high income earners aren’t categorized correctly. A low to mid six digit salary is at most an average middle class in San Francisco. From this moment on, I will refer to them as HIE for short. HIEs often find themselves facing a significant challenge – minimizing taxes while maximizing wealth. As your income rises, so does your tax liability. In this article we will cover how to optimize your financial situation and help you keep more of your hard-earned money. 

Let’s start by utilizing your retirement accounts to their fullest potential. You should really try to max out your pre-tax contributions. Some companies offer either a 401 (k) or a 403 (b), there are others that offer both 403 (b) and 457 (b). For 2024, the max amount you can contribute is $23,000 if you’re under 50 years of age. If you are over 50 years of age, you can add a catch-up amount of $7,500 on top of the $23,000. For example, if you are 50 years old and you have a 403 (b) and a 457 (b) available to you through work, then you can effectively save a total of $61,000 pre-tax. By doing this, you are lowering your taxable income by -$61,000. Some employers even match your pre-tax contributions up to a certain amount, which is basically free money added to your retirement plan. In that sense, you are saving on taxes and making even more money for your retirement. If you work at multiple jobs that offer pre-tax retirement accounts, make sure you do not over contribute. For example, you work at Company A and Company B, and they both offer a pre tax 401 (k) plan. You can only contribute a total of $23,000 (if you’re under 50) to both Company A and Company B’s 401 (k) plans. You have to be diligent in calculating these contributions, because these two companies will not be checking these limits for you. If you over contribute, you will have to pay a 6% penalty fee for each year that the excess amount remains in your account. 

If you have children, contribute to a 529 educational savings plan. A 529 plan is similar to a Roth IRA in the sense that the money you put in is after-tax money, but investments in the 529 grow tax free. Many states offer additional tax incentives to encourage residents to contribute to 529 plans. This can include state income tax deductions or credits for contributions to the plan. California’s ScholarShare 529 unfortunately doesn’t offer this tax deduction, but other state’s 529 plans do. It's essential to check the specific rules and incentives offered by different 529s from different states and to make sure which one will work best for your situation. 529 plans are not tied to a specific state, allowing you to choose a plan from any state that suits your needs. This means you can select a plan with favorable investment options and fees, regardless of your state of residence. 529 plans have a flexible beneficiary designation. If the original beneficiary does not use all the funds for education, you can change the beneficiary to another qualifying family member (beneficiary’s blood-related or adopted family/relative) without incurring taxes or penalties.

If you have a high deductible health plan, you can contribute pre-tax to a health savings account (HSA). You can sign up for your own HSA plan with Fidelity, etc. The maximum contribution limit for 2024 is $4,150 for individuals or $8,300 for a family plan. You can only contribute the entire $4,150 if you are enrolled in a HDHP the entire year. Otherwise, your contribution needs to be pro-rated appropriately. Caveat, if your health plan is from your employer, you have to check whether you have this type of option. Because most employer HSA and FSA plans do not roll-over. This means that if you do not use the amount you have put in for the year, then you lose that money. This is not the case at all for HSA plans that you sign up for yourself outside of work. Make sure you understand the difference.

Next, create a diversified portfolio of investments. This not only helps with tax efficiency, but also mitigates your risk. Different investment vehicles are taxed at different rates. For Example, place tax-inefficient investments like bonds, partnerships and REITs in tax-advantaged accounts like your 401 (k) or Roth IRA retirement accounts. Then, place tax-efficient investments like your low cost index ETFs or stocks in your taxable accounts. Qualified dividends from those are taxed as capital gains which is cheaper in comparison to earned income tax. It is important to note, that you should hold these investments for at least a year in order to qualify in paying only capital gains when you sell them. If you buy and sell these investments in less than a year, then they will be taxed as earned income.

Since we are already talking about investments, let’s cover tax-loss harvesting. Tax-loss harvesting can offset your taxable income by up to $3,000 maximum annually. If you are holding some investments that you are wanting to sell and they are currently at a loss, you can claim up to $3,000 of that loss. If that loss is greater than $3,000, you can roll over the remainder to the subsequent years.

Utilize all the available tax deductions if you can. For example: Deductions for charitable contributions, mortgage interest, and business expenses (if you have a business such as a rental property).Keep detailed records and receipts, and work with a tax professional to ensure you're maximizing your deductions within legal boundaries.

Don’t forget estate planning. I covered estate planning a few articles ago and hopefully you have had a chance to read it. Estate planning is not only a critical component of wealth management, but it can also play a significant role in minimizing your taxes. Look into strategies such as gifting (max amount per individual changes yearly), establishing trusts, and leveraging exemptions to pass on assets with minimal tax consequences. A well-thought-out estate plan can protect your wealth for future generations. Make sure to find a well-qualified estate-planning attorney to help you navigate this area.

Last but certainly not the very least, explore tax credits that may be available to you based on your specific circumstances. Credits can significantly reduce your tax liability, and high-income earners may qualify for credits related to education, energy-efficient home improvements, Electric vehicles, and more. Be proactive in identifying and claiming all eligible credits. Qualified home improvements in 2023 can save you up to $3,200. You can read more about the home improvement tax credit here. EV (Electric vehicles) tax credit can save you up to $7,500 as stated here. You can learn more about education tax credits here.

Remember, the tax landscape is dynamic, with laws and regulations subject to change. You need to make it a habit to regularly review and adjust your strategies to align with any new developments. Stay informed by reading blogs like these, but also do your own research. It is important that you consult with highly qualified financial professionals that can help you develop and implement a tailored tax strategy that aligns with your financial picture.

That is all for now. 

See you on the next one!

-Pam

As a reminder, I created this blog to share information and to increase everyone's financial literacy. This serves as my notebook that I willingly share publicly to help others increase their curiosity and knowledge in wealth building and money management. I am not an official financial advisor, lawyer, or accountant. You will not find legal advice in this blog. Read the full terms and conditions here.