Tax savings strategies for high income earners (+ examples)

Tax savings strategies for high income earners (+ examples)

If you're here, you are most certainly not looking for a leisurely read to pass the time — a thrilling poolside page-turner, tax saving strategies are not. Instead, you’re likely here for one of two reasons.

1. You’ve recently been on the receiving end of a substantial tax hit from your favorite uncle, the one and only Uncle Sam. (Don’t beat yourself up too much. It’s more common than you think; it happens to the best of us.) While you appreciate parts of your relationship with the particular uncle — family is family — the tax side isn't your favorite and you'd like to find a way to limit the significance of the tax side on that relationship. 

2. You've been in the same place as the folks that fall in reason one or you’re planning ahead for what you believe is an impending tax monster … one you’d rather avoid, if at all possible. Either way, planning ahead is a great thing. No one likes surprises, especially those of the tax liability persuasion, as they often run the risk of sucking cash out of your bank accounts!

Whichever category you fall in, you’re in the right place. In this article, you’re going to learn the most common tax savings strategies you can potentially lean on as a high-income earner looking to minimize their liability going forward, potentially as part of a larger financial plan.

However, before you discover what those are, we need to address a particular elephant in the room.

You’re right, U.S. tax laws are confusing

I’ll be honest, this isn’t one of my favorite topics. Although I’d wager my reasons for this are quite similar to yours First of all, let’s just say it out loud — no one enjoys paying taxes. There is no part of paying taxes that is fun. 

Second, trying to make heads or tails of what the tax laws are, even when it’s your profession, isn't exactly straightforward! Tax law is complicated. For example, the United States Tax Code is approximately 6,800 pages long, which makes Bonfire of the Vanities look like The Hungry, Hungry Caterpillar.

🔑 Free resource: Financial planning template for individuals and families

As you can imagine, with 6,800+ pages of tax code, there is quite a bit of nuance when it comes to answering your income tax questions. So, before we move forward, keep in mind that what of the strategies that follow (if any) will make the most sense for you is highly dependent on your individual circumstance. 

To the best of my ability, I will talk through how certain variables and circumstances can influence the strategies I discuss below. Ultimately, however, you need to speak with a tax professional (I know a few folks!) who can help you map a tax savings strategy that works best for your unique situation.

In fact, I would caution you that any content you read on this topic that doesn’t come with this type of caveat should be strictly scrutinized. Your personal tax savings strategy should be just that: personal. 

Let’s empower you to have the right tax savings conversations

Now, even though I cannot tell you what your precise tax savings strategy should be without ever having a conversation with you, there is still a lot you will walk away with from this article. 

The more educated you are before you enter into a conversation about your financial future with a professional, whether that’s with us or someone else, the better off you’ll be. That one-to-one conversation you’re about to have with a professional can mean the difference between a tax surprise next year or a high-five when you see the savings successes of your plan.

To best prepare you for this conversation, let’s start by talking about what questions you should be prepared to answer. That’s why I’m here sharing this information with you today. To empower you with a base-line understanding of the types of topics you should be covering with someone to alleviate some of the challenges you can all too easily experience with our dear old Uncle Sam.

For example, “Where does your income come from?”

This is the first question you’ll be asked, and you may feel inclined to answer, “Well, from my hard work!” 

Of that I have no doubt, but this is not quite what this question is targeting. When you think about your income sources, here’s what we’re really asking with this question. Are you self-employed? Do you work for someone else? Do you have any passive income streams, in addition to any direct employment income you’re earning? 

In addition to the questions you need to be prepared to answer (to the best of your ability), you’ll learn about the most common tax strategies that may be available to you, based on a general knowledge of your circumstances. 

So, where does your income come from?

Why does this even matter? Let’s assume that you own a car (income), and that car needs to be repaired (tax bite). Now, let’s say that car is a Chevy (self-employed). Can you buy parts from the Ford dealership (employee) to repair your car? 

Sure you can, but it will probably come out like a car from the Johnny Cash song: "One Piece at a Time." You've got to use the right parts in the right place. 

For instance, if you’re self-employed, then you have the potential to deduct expenses incurred in operating your business whereas if you are employed you don't have that option.

Self-employed income

Self-employed income is income that is earned from your own trade or business, i.e. goods you sell or services you provide to others. Odds are you already know this, but here’s why it matters. 

When you have a business and are self-employed, you have different options available to you to help with the tax burden:

• Business expenses are one of the most common ways people reduce their taxable income when they are self employed. In order to take full advantage of this, you must keep detailed records for all of your business-related expenses.
  
  
• Home office space is probably more familiar to people now than it was before 2020. The key here is that the space must be dedicated to work. Think of a spare room vs. a kitchen table.
  
  
• Retirement plans for self-employed individuals offer some of the best ways to move income from currently taxable to taxable later. Nuance alert! Depending on your age, marital status, income and whether or not you have employees you could be eligible to save up to $135,000 per year before taxes! That's not chump change, from a tax standpoint – it’s also a side benefit you'll be thankful for later when you get ready to retire.

🔎 Related: How to invest for retirement at age 40 (+ examples)

Employed by someone else

So, you work for someone else as a W-2 employee. Although the options above are not available to you, you still have plenty of options. The key for you is to find places to move your money that will defer current taxes to a later time or, in some cases, defer those taxes permanently.

• Employer-sponsored retirement accounts offer you the ability to defer taxes on the largest amount of income. An individual may be able to defer taxes on up to $28,000 per year by utilizing employer sponsored retirement plans.
  
  
• Health savings accounts are fantastic options if you have a high deductible health care plan. These allow you to make pre-tax contributions to lower your taxable income and pay for certain medical care costs (that you are going to have anyway) with pre-tax dollars.
  
  

Flexible spending accounts are similar to the health savings accounts but are more flexible — see what I did there? You make contributions on a pre-tax basis, but these dollars are available to use for healthcare and dependent care. When my kiddos were in daycare, we were able to pay for a good portion of their daycare using funds that were never taxed by our favorite Uncle by utilizing this exact tool!

Passive income streams

Passive income is probably my favorite kind of income. Why? Because you don't actually trade time or provide a service for this type of income. It's usually earned by some type of investment. 

Now, passive income can be a little tricky to offset or alleviate tax burden. One way to deal with this is before you actually earn the passive income:

• Investing in tax-efficient funds can help by reducing capital gains and dividend taxes, which are taxed at income rates.
  
  
• Municipal bonds are also good options, as they can provide tax-free federal income, as well as possibly at state and local levels.
  
  
• Depreciation of real estate is a great way to offset income earned from rental properties.

🔎 Related: How much does investment management cost? (+ examples)

What are the most common tax saving strategy tools?

Now that you understand how the source (or sources) of your income influence what types of tax savings strategies may be available to you, here is a quick overview of some of the other options you might consider.  
Again, I share these options with the disclaimer that you should work closely with a tax professional to develop the tax savings strategy you need for your situation. There is no one-size-fits-all approach to minimizing your tax liability — trust me, as a fellow taxpayer, I wish it weren’t the case! 

Tax-qualified savings vehicles

401(k) (employer-sponsored retirement plan)

Pros: Allows pre-tax savings which reduces your overall taxable income. 

Cons: Contributions aren't easily accessed until retirement, and withdrawals in retirement are taxable.

This isn’t for you if: you’re self-employed.

Solo 401(k) (self-employed retirement plan)

Pros: Allows pre-tax savings which reduces your overall taxable income. 

Cons: Contributions aren't easily accessed until retirement, and withdrawals in retirement are taxable.

This isn’t for you if: you’re self-employed and also have employees, hence the “solo” designation.

HSA (health savings account)

Pros: Allows for pre-tax contributions and tax-free payment of medical costs. 

Cons: Only available through an employer-sponsored program.

This isn’t for you if: you don’t have an employer who sponsors HSAs.

HSA (health savings account)

Pros: Allows for pre-tax contributions and tax-free payment of medical costs. 

Cons: Only available through an employer-sponsored program.

This isn’t for you if: you don’t have an employer who sponsors HSAs.

Deductions and credits 

Charitable donations

Of course, charitable donations and contributions are really only an option if you’re a charitable person. On top of that, the amount of tax savings you can realize from charitable donations has diminished in recent years.

According to the Tax Policy Center, the 2017 Tax Cuts and Jobs Act (TCJA) reduced the number of taxpayers claiming deductions for charitable giving by increasing standard deduction rates, along with other new deduction caps, limitations, and eliminations. It also reduced the tax savings for each dollar donated.

We encourage you to explore the above-linked resource if you'd like to learn more about the specifics of this particular piece of legislation, as well as its impact on tax savings for charitable donations.

Job-related expenses

You can also deduct job-related expenses. For example, if you invested in your own professional development or if you had to subsidize your own home office for your employment, you may have a tax savings opportunity here. 

This is your tax savings guide to a larger conversation

As you can see, there is a lot of meat on this particular bone. Hopefully this has given you some guidance on at least how to begin to approach this conversation, as well as a few of the options that may be available to you. 

Again, we encourage you to use this as a guide to begin a conversation with someone who does this for a living. There is value in a plan, and I’m excited that you've taken the first step to building one by reading through this. Now, it’s time to take the next step — schedule a one-on-one with us to dig deeper and set you on a path for a more pleasant tax season!