As the year rounds out, tax planning is likely top-of-mind. However, as a high-income earner, remember that tax planning is not only done at the end of the year. In fact, the more money you make, the more important it is to regularly evaluate your tax plan throughout the entire year.
In addition to itemizing and taking your usual deductions, there are several ways to reduce your taxable income and maximize your tax benefits. As you work with your TrueNorth Wealth fee-only financial planning advisor to create a tax planning strategy, consider these four ways to reduce your taxable income.
1. Max Out Contributions to Retirement Accounts
All pre-tax contributions to a 401(k) or other traditional retirement account are tax-deductible, meaning you will not pay taxes on these contributions in the year you contribute. Thus, maxing out these contributions will lower your taxable income for that year. The maximum contribution for a 401(k) in 2020 is $19,500, and if you are over the age of 50, you are also eligible to contribute an extra $6,000 a year in “catch-up” contributions.
However, money contributed to these accounts will be taxed upon withdrawal, so this strategy is most effective if you are confident that your effective tax rate (average rate) in retirement will be lower than your current highest marginal rate (top rate). In our experience, this is true for almost all retirees, with low and ultra-high earners as the typical exceptions.
2. Roth Contributions and Conversions
Making Roth contributions can also be an effective tax strategy, even though those contributions are not tax-deductible in the year you contribute them. Roth funds will grow tax-free and can be withdrawn tax-free after age 59 ½, thus lowering your taxes in the long-term.
However, as a high-income earner, it is likely that you are above the income limitation for contributing to a Roth IRA. This is where a Backdoor Roth conversion comes into play. Put simply, a Backdoor Roth allows high-income earners to contribute to a Roth IRA. Ordinary Roth conversions, where tax is realized on pre-tax assets in order to move to a Roth IRA or 401(k), should also be considered in years where income is abnormally low.
Roth conversions can be a complicated process and may or may not be beneficial in your specific circumstance. Consult with your financial planner to discuss whether a Roth conversion can help you reduce taxable income and increase your future wealth.
3. Max out HSA contributions
Unfortunately, many high earners either do not know how to use their HSA effectively or do not contribute to an HSA at all. If you are eligible for a Health Savings Account, maxing out your yearly contributions provides a current year income tax deduction and an additional avenue to save for medical expenses in retirement.
An HSA is tax-advantaged in three ways: contributions are tax-deductible, your money grows tax-free, and withdrawals are tax-free if used for medical expenses under the age of 65. Over the age of 65, withdrawals are penalty-free for any use. To get the very most from your HSA, we often recommend using an HSA as a long-term investment (retirement) account rather than spending it on current health expenses, assuming normal cash flow is sufficient to pay for medical expenses. Regardless of how you use it, though, maxing out contributions will lower your taxable income this year, providing an opportunity to decrease tax burdens.
4. Charitable Contributions
It is well known that deducting your charitable contributions can reduce taxable income. However, there are even more ways that charitable giving can provide tax relief.
We often encourage high-earners in particularly high-income years to contribute to a donor-advised fund. Donor-advised funds allow you to get a charitable contribution deduction in the current year when you don’t know who you’d like to donate to yet. It can also be used if you want to spread out the donation over multiple years but want the deduction all in the current year.
Another strategy, called “charitable bunching” is to stack multiple years of charitable donations into a single year, taking advantage of more deductions one year and the recently increased standard deduction in the next. Both these strategies take intentional planning, so work closely with your financial advisor as you include charitable donations in your tax planning.
As you create a tax plan for this year and the years to come, keep in mind these four strategies to lower your taxable income. Most importantly, work with a financial advisor that you trust. Many of these strategies are complex, and working with a professional will ensure that you create an efficient tax plan catered to your specific needs and circumstance. TrueNorth Wealth offers some of the leading financial planning services in Salt Lake City and the surrounding areas, and we’re always happy to help! Contact us at your earliest convenience.