Do you earn a lot of money? Great. But with big money can come big taxes. Fortunately, there are many ways high earners can reduce the taxes on their income.
Here are five tax-saving tips that are easy to apply.
Tip #1: Establish retirement accounts
One of the best ways for high earners to save on taxes is to establish and fund retirement accounts. You can deduct the amount you contribute to a tax-qualified retirement account from your income taxes (except for Roth IR As and Roth 401(k)s). Moreover, you do not pay taxes on investment earnings from retirement accounts until you withdraw the funds (but early withdrawals before age 59 1/2 are subject to a 10% penalty).
If you’re an employee, you should fully fund the retirement accounts offered by your employer.
If you’re self-employed, you need to establish your retirement accounts yourself. There are several different types of retirement accounts available to the self-employed, including:
- Anyone can set-up a traditional IRA. For 2019, you can contribute up to $6,000 and deduct the full amount if you and your spouse have no other workplace retirement plan.
- An individual 401(k) is ideal for most freelancers because it allows you to contribute a lot. For 2019, you can contribute 20 percent of your net profit from self-employment, plus an elective deferral contribution of up to $19,000. The maximum contribution for 2019 is $56,000.
- The Simplified Employee Pension (SEP) IRA allows you to contribute up to 20 percent of your net profit from self-employment every year, up to a maximum of $54,000 for in 2019.
Tax-free retirement accounts
Instead of establishing a regular IRA or 401(k), you can open a Roth IRAs or Roth 401(k). With these accounts, you get no deduction for your contributions. But you don’t have to pay any tax on withdrawals you make after age 59 1/2.
If you are age 50 or over you can make additional tax-deductible catch-up contributions to these accounts. For IRAs, you can put in an additional $1,000. For 401(k)s, you can put in an additional $6,000.
It’s easy to establish a retirement plan with a bank, mutual fund, or other financial institution. With these types of accounts, you don’t have to make contributions every year, and your contributions can vary from year to year. You can invest your money in almost anything (stocks, bonds, notes, mutual funds).
Tip #2: Time year-end income and expenses
If you’re self-employed, you likely use the calendar year as your tax year and are a cash basis taxpayer. Cash basis means you count money as income only in the year you receive it. Essentially, you deduct an expense in the year you pay it. This exercise enables you to do some clever tax planning at the end of the year. To minimize your taxes for the year, you should defer income and speed up paying deductible expenses.
You can defer income by refraining from billing clients until the following year. However, you can’t avoid having taxable income by simply not cashing a check until the following year.
Under a legal doctrine called constructive receipt, you must count as income any money or property made available without restriction during the year. So a check counts as income when you receive it, not when you cash it.
You can increase your deductible expenses for the year by buying stuff for your business before the end of the year. Although, you don’t have to pay cash for it by December 31 to get a deduction. You use your credit card and deduct the full amount.
Tip #3: Establish a donor advised fund
If you’re charitably inclined, charitable contributions can provide outstanding tax benefits. You may take an itemized deduction for contributions of money or property to a tax-qualified charity. You can deduct up to 60 percent of your adjusted gross income each year for gifts of money.
One of the best ways for high earners to make charitable contributions is to establish a donor advised fund. A donor advised fund is like a charitable investment account. It allows you to take current and future year contributions and deduct them all in the current year.
It is easy to establish a donor advised fund with a brokerage firm, bank, or another fund sponsor. You can put in as much money or property as you want when you open the fund. Fund sponsors typically require minimum initial contributions of at least $5,000, although many start at $25,000.
You may deduct all the money you put in your fund that year. But you don’t have to actually donate all the money to charity that year. You are the trustee of the fund and may invest and donate the funds however you want, over as many years as you want.
Donor advised funds allow you to bunch your charitable contribution deduction into a single year, thereby taking as large a deduction as possible that year.
For example, if you want to give $10,000 per year to charity over the next ten years, you can establish a donor advised fund in 2019 and put in $100,000. You then take a $100,000 charitable contribution for 2019. But you don’t have to donate all the money in your fund in 2019. You can keep the money in the fund and contribute it when you want.
Tip #4: Donate stock to charity
Gifts of stock and other securities are a particularly good way for the wealthy to give to charity and take a hefty deduction. Gifts of securities include not only publicly traded stocks like Apple or Amazon, but gifts of mutual funds, Treasury bills and notes, corporate and municipal bonds, and stock in non-publicly held companies. You can deduct up to 30 percent of your adjusted gross income each year for gifts of stock.
It’s extremely easy to give stocks and other securities that are marketable—that is, sold to the public on stock exchanges or over-the-counter markets. The amount you deduct is what the stock or other security sold for on the exchange on the day of the donation.
The tax rules favor donors who donate long-term stock (stock they have owned for more than one year) that has appreciated in value. Basically, the donor never has to pay capital gains on the appreciated stock. This can be a tremendous tax benefit and a great incentive for donors to give stock to charity.
Here’s how it works: If you own a stock for more than one year that has gone up in value, you can donate the stock to a nonprofit, get a deduction equal to the fair market value of the stock at the time of the transfer (its increased value), and never pay capital gains tax on the appreciated value of the stock.
Ari owns 1,000 shares of Evergreen stock, which traded on the New York Stock Exchange. He paid $1,000 for the shares back in 2010 and they are worth $10,000 today. He gives the stock to his favorite nonprofit, the Red Cross, and deducts its $10,000 fair market value as a charitable contribution. Ari need not pay the 15 percent capital gains tax on the $9,000 gain.
Tip #5: Establish a health savings account
If you’re self-employed and pay for your own health insurance, you should seriously consider a health savings account. A health savings account (HSA) is like a medical IRA. If you get sick, it will help you pay your medical expenses. If you never get sick, it has wonderful tax benefits.
You establish an HSA account with a bank or other financial institution. You must also obtain a high-deductible health insurance plan. Such plans have lower premiums than those with lower deductibles.
HSAs are great for your taxes in four ways:
- First, you may deduct your annual HSA contributions from your income taxes each year (up to the annual dollar limits listed below).
- The income the money in your HSA earns is tax-free.
- If you make withdrawals to pay for health expenses, they are tax-free as well (but you must pay taxes and penalties on withdrawals for nonmedical expenses).
- Once you reach age 65 or become disabled, you can withdraw your HSA funds for any reason without penalty. If you use the money for nonmedical expenses, you will only have to pay regular income tax on the withdrawals.
The money you put in your HSA belongs to you forever. There is no minimum amount you must contribute each year; you may contribute nothing if you wish. If you have individual coverage, the maximum you may contribute to your HSA for 2019 is $3,500. For those that have family coverage, the maximum you may contribute is $7,000. Persons over 50 can add $1,000 to their annual HSA contribution.