Tax Planning Strategies For High Net Worth Individuals
Despite how the media headlines make it look, the tax rate for high income earners is usually higher than for average earners. While there are some exceptions, notably billionaires like Elon Musk and Donald Trump, the more you make the higher percentage of taxes you pay. The reason why some ultra-wealthy Americans are able to lower their tax burden so substantially has to do with their tax planning strategies.
While it may come as a shock, the billionaires you see in the headlines for substantially lowering their tax burdens are doing so completely legally through expert tax planning strategies. The Internal Revenue Service (IRS) will never hold legal tax minimization strategies against any taxpayer regardless of what they earn. So, if the richest people in America can do it, then any ordinary high net worth individual can as well.
The IRS differentiates between different types of income for tax purposes. For instance, income earned on a paycheck is subject to different tax regulations than income earned from investments. And being self-employed or a business owner means you’re taxed differently than if you’re externally employed.
Taking these things into consideration can help high income earners understand why they are taxed so much and subsequently start reducing their tax burdens through the use of skillful tax planning strategies. Furthermore, the right tax planning strategies and some guidance from experts in the field can go a long way in savings year after year.
Tax Planning Strategies for Wealthy Small Business Owners
Many of America’s millionaires are small-business owners. In terms of tax planning strategies, owning a small business can save you a lot of money if you play your cards right. One massive way small business owners can reduce their taxes is through retirement plans. Employer contributions to their employees’ retirement plans are tax-deductible.
Another option is to utilize small business health care plans. Setting up health reimbursement arrangements, health savings accounts (HSAs), and Section 125 plans can lower your tax burden as well. All pre-tax contributions to HSAs reduce the company’s taxable income.
It is also legal for small business owners to put their children or other family members on their payroll. This tax planning strategy offers significant benefits for sheltering income, such as paying a lower marginal tax rate or eliminating the tax on their children’s income through the company. Hiring a spouse is another way small business owners can reduce their taxes, as spouses do not have to pay the FUTA tax. However, one important thing to be aware of in this tax planning strategy is that all earnings of family members must arise from legitimate business purposes.
Convert to a Roth IRA
A Roth IRA is a retirement savings account that is completely tax-free. As such, it can help you protect your income from taxes, even if you are a high income earner. A Roth IRA is different from a traditional IRA in that you contribute money you’ve already paid taxes on. The benefit of this is that you won’t pay taxes again when you withdraw.
Having a Roth IRA is among the most helpful of the tax planning strategies out there, as any income earned in your Roth IRA account will not be taxed. Furthermore, you can transfer money from a traditional IRA or even a 401k into a Roth IRA and the benefits will be the same.
When you switch money over to a Roth IRA also makes a difference. Converting in a year where you’re in a lower tax bracket, if that happens, is the best time to do it. This tax planning strategy is meant for those with a high net worth who won’t have a problem waiting until they are older to make mandatory withdrawals.
Invest in Municipal Bonds
Tax planning strategies involving municipal bonds are great to utilize as well. Municipal bonds are usually exempt from federal taxes, so while they might not be the most exciting, they are a smart investment, including for individuals with a high net worth. One of the things that makes them less exciting is their low long-term growth compared to equities. However, earning three percent from a municipal bond comes out to around the same as earning six percent from an equity-based investment after taxes.
Another big advantage to investing in municipal bonds tax planning strategy is they are stable even when equities might be down for the year. In other words, if you were planning on optimizing your investment portfolio through the use of bonds, you’d be wise to include tax-exempt municipal bonds. Furthermore, interest from municipal bonds is also tax-exempt in certain states. That means, if you live in one of those states, your tax savings increase even further. The bottom line is tax planning strategies that include investments in municipal bonds are a good idea.
Invest in Companies that Pay Qualified Dividends
Most high income earners know that taxes on capital gains are lower than standard income taxes. For this reason, affluent individuals tend to invest, as that income won’t be subject to as much taxation. Depending on where you invest and with the right tax planning strategies, your tax savings can increase even more. Yet this is just the beginning of this highly utilized tax planning strategy.
Investing in companies that specifically pay qualified dividends is one of the best tax planning strategies. As you’ll be taxed the same amount on ordinary dividends as regular income, it’s vital to choose a qualifying company to invest in to take advantage of these tax benefits. The IRS determines the qualifying companies, both US and international. The highest tax rate you’ll ever have to pay for qualified dividends is 20 percent.
Helping you achieve your evolving financial objectives
Max Out Your 401k and HSA Contributions
Your 401k contributions can be deducted from your taxes, decreasing your taxable income for the year. As far as tax planning strategies go, this is one you’ll definitely want to take advantage of. The more you contribute, the more you can deduct, making it most lucrative to contribute the maximum possible. For investors with a high net worth, reducing your yearly taxable income is highly advantageous.
Along the same line of thought involving tax planning strategies, you should also contribute the maximum amount to your HSA. On top of that, once you’re 55, the maximum increases, which is good to note. HSA growth is not taxed and can be withdrawn at any time to be used for medical expenses. Unlike a Flexible Spending Account, you don’t have to spend the money within the year or lose it.
For high income earners, perhaps these tax planning strategies seem minuscule. Yet year after year, they add up quite a bit, consistently lowering your taxable income, sometimes at both the federal and state level.
Switch Over to a Roth 401k
High income earners would be wise to consider using a Roth 401k over its traditional counterpart as a tax planning strategy. Contributing to a traditional 401k lowers current taxable income. However, when they withdraw the money, they will have to pay taxes on it. This method is favored by people who believe taxes will be lower when they withdraw after they retire.
Investing in a Roth IRA can be much more beneficial as a tax planning strategy for those with a high net worth. For one, a Roth 401k does not exclude those with exceptionally high incomes, unlike a Roth IRA. Additionally, the maximum contribution limit is higher. While your current taxable income won’t decrease, you will have more control over the amount of taxable income you’ll realize in your retirement years. As you’ll already have paid taxes on your contributions to a Roth 401k, your contributions and growth can be withdrawn tax-free during retirement.
Another benefit of this tax planning strategy is that many high income earners end up in a higher tax bracket or with more taxable income in their portfolio when they retire. The ability to invest in a Roth 401k and then withdraw all contributions and earnings later in life will be a blessing in this case.
Invest in Your Children’s Education
If you have children (or grandchildren), investing in their education is a worthwhile venture, not only for your kids’ well-being but also as a tax planning strategy. A 529 plan is an education savings investment account with a couple of tax advantages. Anything you contribute to a designated beneficiary’s 529 plan grows tax-free and remained untaxed so long as it is spent on qualifying educational expenses. These include college as well as private K-12 schools.
As of 2022, each individual can donate $16,000 annually to a beneficiary’s 529 plan. Aside from their growth being non-taxable, contributions to 529 plans are deductible on most state taxes. As far as tax planning strategies go, this one is a no-brainer for wealthy individuals with children.
Donate Valuable Items
Among the widely underused tax planning strategies is donating valuable items to nonprofits. These can include real estate, airline miles, vehicles, clothing, furniture, and anything else that is valuable to the nonprofit in question. Some people donate their old wedding dresses. Others donate furniture they no longer want. All you have to do is find a nonprofit that collects the valuable item you want to donate.
When you donate a valuable item to a nonprofit, you get a free tax deduction for the amount of the item you donated. Considering that you already bought and used the item, or they were airline miles that you weren’t going to use anyway, it’s a great way to reduce your taxes (and donate to charity at the same time). This is among the tax planning strategies all high net worth individuals should take advantage of if they have valuable items they can part with.
Invest-Borrow-Die Strategy
Invest-Borrow-Die is one of the tax planning strategies often used by families with millions or even billions of dollars. Using this tax planning strategy, a family can realize unlimited investment gains without capital gains thus never having to pay income taxes on that wealth. This is how it works.
You either start a business or purchase investments and never sell the holdings. However, you can still use the generated wealth from your investments by borrowing against them. This will yield a tax deduction from the interest paid on what you borrowed. At the same time, any deductions you’re able to make have the potential of offsetting gains in other areas of our investment portfolio. Then, when you eventually die, the value of your appreciated assets will be adjusted for your heirs. Your heirs can then sell without owing capital gains taxes. While this is among the more complicated tax planning strategies, it’s worth looking into if your net worth is sizable.
Problematic Tax Planning Strategies to Avoid
While many tax planning strategies are completely legal for affluent individuals to employ, other tax planning strategies lie in a gray area of legality. Those are the tax planning strategies to watch out for and avoid. They can lead to dire consequences, such as hefty fines or even time in jail.
The most famed shady tax planning strategy is establishing offshore accounts and trusts for your assets. Bank accounts in Switzerland can sound fancy for the wealthy elite, but they are an illegal way to avert paying income taxes and can easily lead to prosecution. Since 9/11, there are strict limits on the amount of money a person can put in an offshore account. The reasons for placing assets offshore also have to be in congruence with the law. Thus, this is not a recommended tax planning strategy for most. If you choose to utilize this tax planning strategy, make sure you’re double and triple-checking the legality of the transaction from more than one tax professional.
High income earners may have also considered conducting transactions between family and close friends as a tax planning strategy to avoid paying taxes. For instance, someone might consider selling appreciated property to a sibling for a fraction of its market value to avoid the taxes on the gain. However, the IRS does not look kindly on this behavior. All transactions must be conducted as what’s referred to as a “non-arm’s-length” transaction, meaning all transactions should be conducted as if they were with a total stranger. Any tax planning strategies conducted at “arm’s length” could lead to prosecution.
Conclusion
Recently, based on proposals by President Joe Biden, it’s likely that taxes for high net worth individuals will be increasing. This means high income earners will be on the lookout for tax planning strategies to take the edge off some of those increases. Expert guidance from tax professionals can help the wealthy make better investment choices to minimize taxes within the long arm of the law. Without these kinds of tax planning strategies, taxes for high income earners should easily sky-rocket.
Get in touch with one of Arrowroot Family Office’s experienced tax professionals to plan a tax planning strategy specifically designed for you.
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