Tax saving ideas for high earners

Here are some standard (and slightly crazy) long term ideas to maximize your tax deferred and tax free savings strategy in 2013. Most can be applied even if you have a high adjusted gross income (AGI).

Tax savings methods are very important for high income households income (either single or married). With one or both people making greater than $100k income (w2) your biggest expense is likely tax. Typically working for a company with good pre-tax benefits such as retirement (e.g. 401k) and health benefits (e.g. flexible spending accounts) can help ease the tax burden. However tax breaks that are generally discussed for average earners in personal finance often do not apply if you have a higher AGI. Here is an small sample list of things you might think would apply to you, but did not in 2012:
(The AGI amounts quoted here are for married filing jointly – check links for your situation)

Obviously this isn’t an exhaustive deduction list. The idea is just to show that you need a different tax strategy to standard advice. This blog entry gives several tax savings ideas for high earners in 2013.

These tax saving ideas listed below are not right for everyone in every situation – you must (must!) consult a tax professional before acting on these items. However it is a good starting point for further research. Some of these ideas are a little off the wall, but are the presumption is that people reading this can handle money. Presumably you already have some significant savings and investments tucked away because you already earn $$. You should be able to do your own due diligence on whether it will work for you. Please bear in mind – these are ideas for more research and we are not tax professionals and don’t offer tax advice!

Each idea is structured as follows:
Idea : Description of the idea
AGI: The 2013 AGI range relevant for this idea (if not supplied then the idea can be used with any AGI)
Financial peer approval rating: What everyone will think of you when you explain it to them
Likelihood: How likely is it that you should implement this ? (low/medium/high)
Complexity: How difficult is it to execute on ? (low/medium/high)
Payoff: What is the potential financial risk/return? (low/medium/high)

Let’s get started:

Open traditional IRA and roll to ROTH IRA

Financial peer approval rating: High (most people will think this is a good idea)
AGI: Only need to do this idea if AGI > $127k (single) or AGI > $188k (married filing together)
Likelihood: High
Complexity: Medium
Payoff: High

A ROTH IRA pays no taxes on gains and no tax when you take out distributions at retirement (i.e. no tax ever once you have funded it – which is a pretty good deal). Before 2010 there were AGI restrictions on converting from a traditional IRA to ROTH IRA – so no-one earning over $100k could convert to a ROTH IRA. However this income limitation to convert from a traditional to a ROTH IRA was removed in 2010.

There are rules on age and phase out provisions which should be reviewed for your individual situation. Calculations for phase out provisions are too detailed to review here. Please review the ROTH IRA contribution limits based on income restrictions and phase out provisions.

Very Basic Example: This is the maximum contribution possible for a married couple under 50 years old, married filing jointly with AGI > $188k:
(this example assumes you haven’t done this already for 2012)

For 2012 (up until April 2013) you can contribute $5000 after tax to a traditional IRA.
For 2013 (after 1st Jan 2013) you can contribute $5,500 after tax to the same traditional IRA*.

If you are married, you can do this for both spouses.
Husband : 2012: $5000, 2013: $5500 = $10500 in husband’s Traditional IRA
Wife : 2012: $5000, 2013: $5500 = $10500 in wife’s Traditional IRA

Then rollover each spouse’s traditional IRA into a ROTH IRA.

Total results: after tax contributions of $21000, across to 2 ROTH IRA accounts.

* If you already have an IRA it is more complex because the IRS considers all your IRAs the same account. In short you need tax advice and you need to read the rules in detail (the above is just a simple example).

However for a high earner can be one of the only option retirement savings outside of a 401k. This blog post gives a more detailed overview (comments at the end of the article are worth reading).

This is definitely worth looking at to see if a ROTH IRA makes sense for you – it probably does if you are starting out with 20 or 30 years to go to retirement – because the tax savings can be huge.

Contribute max to 401k

Financial peer approval rating: High (most people will think this is a good idea)
Likelihood: High
Complexity: Low
Payoff: Medium

401k – up to $17,500 in 2013. Try and get the maximum employer match. This really is about as close to free money as you can get.
Example: Assuming your tax status is single, for 2012 your federal tax bracket is 28%, state tax is 6.45% (assume high tax state like NY), medicare 1.45%, social security 4.2% – gives approx 40% tax (its an estimate not a detailed calculation – whatever your % rate is will be different).
Then assume your employer matches up to 3% of your salary in contributions and you earn 150k salary (w2) – this is 4500k in matched contributions. You contribute the maximum of $17.5k in 2013. Your total 401k contributions are therefore 22k.
To compare with pre tax earnings: in order to save after tax 22k, you would need to earn payroll w2 of about pre tax 36.7k. This is more than twice your actual $17.5k pre tax contribution!
In this example employer contributions also give you an instant ($22k-$17.5k/$17.5k) = 25% head start (before you’ve even started investing!).

It is massively important to always contribute the minimum 401k amount to get your maximum employer match (whatever it is), because the instant return on investment is huge. This also gives you the option of extracting 401k money if needed (see next idea).

Extract some employer matched 401k money to pay down some of your mortgage

Financial peer approval rating: terrible, people will think you are crazy
Likelihood: Low
Complexity: High
Payoff: High (if used strategically for long term debt)

The following assumes that you already have built up some retirement funds using the traditional portfolio model (you remember the one that didn’t work in 2008). The following advice would probably be best applied to a maximum 25% of your overall 401k retirement pot.

Example: You have contributed the maximum amount to your 401k over the last 10 years (average $15k a year). That is 10 x $15,000 = $150,000. Your employer has matched up to $5000 every year. That is 10 x $5000 = $50,000 in employer matching. Your total 401k contributions are therefore $200k. You think the market has had a good run in the last 3 years and it could be time to reallocate or lock in some gains. So you sell some funds to the “stable value” fund (cash); extract the $50k from 401k; pay the federal tax (e.g. 28% to 35%), state tax (variable) and 10% early withdrawal fee; then use the lump sum (approx $25k) to pay down the mortgage. This will accelerate your mortgage, but still leave you with 75% invested in the 401k.
NOTE: Some 401k plans will not let you pull employer contributions from the plan, so you’ll have to have contributed enough to do this.

Obviously this depends on which tax bracket you are in – if you were planning time off (e.g. unpaid leave, or a child) then this could be an even better strategy. This idea will meet with huge resistance from most people – the obvious argument being that you’d be missing out on (guaranteed??) compounded returns of 7% for 30 years (yada yada) or you are bankrupting your future (etc). This conveniently ignores the flat returns (and considerable stress) of the last decade.

A counter point to that is that in the example you would have restored the balance to more than $200k again inside 3 years : $150k + ($5k employer match x 3) + ($15k contributions x 3) = $210k. You have no guarantee that the market performance would be up in 3 years time, plus you have “hedged” by locking in some gains at whatever you mortgage rate is for the next 30 years.

It is also interesting that if you never got an employer match and never extracted the money then you would likely be in the same 401k balance = $15k contributions x 10 = $150k. If you look at employer matches as “gravy” then it becomes easier to extract and spend them to pay down your own debt.

The traditional retirement advice for an average earner is obviously not to do this. But the assumption is here that you can handle your money and you already have plenty tucked away through a good job and savings. It is an option if you do it tactically as “asset allocation” because you wanted to go to cash with some of your 401k.

Use 401k money to invest in your company stock and hedge it with a standard taxable brokerage account

Financial peer approval rating: terrible, people will think you are crazy
Likelihood: Medium
Complexity: High
Payoff: High (with controlled risk)

Buy your employers stock in your 401k. Some employers will offer a purchase discount (sometimes up to 15%), and some employers provide discounted stock as a matching contribution (not cash contributions). Your employer has an obvious incentive to offer you their stock at a discount. The advantage of buying stock significantly below market value, is offset by your diversification risk – you already rely on your employer for your salary and bonus. Interesting this potential volatility can be used to your advantage – your employer’s stock is likely one of the only investment options in your 401k that is volatile enough to make a significant move each year (maybe 25% or more).

There is also downside risk here, but what if you can mitigate that risk by using options ?

You could hedge the entire stock position with put options in a standard taxable brokerage account. Hedging just means taking the opposite position in a stock to limit your maximum risk. You can add a position that would risk a maximum of say 10% per year, and still leave some upside available.

Hedge the stock position with put options in a taxable account – using strategies on this site, or try Radioactive Trading) or Random Walk Trading.

Rollover your ex-employers 401k into a Roth IRA (and pay lots of tax – please read)

Financial peer approval rating: nuts, people will think you are crazy
Likelihood: Medium
Complexity: High
Payoff: Very High (potentially)

If you have an old employers 401k still available, that can be rolled into a traditional IRA – this is the standard solution. No tax is paid to roll over to a traditional IRA.
However you can roll a 401k into a traditional IRA, then roll into a ROTH IRA and pay all the tax on the full 401k amount now!
This means you have a huge tax bill this year, but you would ultimately have a retirement ROTH IRA that would pay no taxes on any gains and no taxes on extracting money at retirement! (i.e. no more taxes ever).
You can also rollover smaller amounts (e.g. $10k) each year and pay smaller taxes each year.

Example: $100k 401k with ex-employer – rollover to traditional IRA, then rollover to ROTH IRA. This would be paying 33% federal tax, and 7% state tax – to keep the calculations simple. That is $40k in taxes this year. However if 100k grows at 7% for 30 years, then you could have about $761k at retirement. It is very likely that tax rates will have risen significantly by then – but lets make some optimistic assumptions – keep the tax rates the same and assume you’d be in a (lower) 25% federal tax bracket and the (same) 7% state tax. That would give a tax bill of about 32% on 761k in a tax deferred account (401k), or about $244k.
Do you want to spend $40k now, to save on $244k in tax in 30 years ? That depends on the inflation rate, but this quick example shows the cost/benefit – whether it can be worth doing.

The other big disadvantage of a traditional IRA is that you are forced to start extracting money at age 70.5. With a ROTH IRA you dont have to do that.

The basic idea behind the trade off is tax now, verus tax tomorrow – you decide if it makes sense. It definitely makes sense to try it with some of your retirement funds. You can then have both tax deferred distributions (traditional IRAs/401k) versus tax free distributions (ROTH IRA). This hedges your bets somewhat, but the ROTH IRA discussion is definitely worth investigating (and it has only been an option for high earners since 2010).

This technique needs professional tax advice, but a good starting point to converting to ROTH IRAs is explained in Ed Slott’s books Retirement Savings Time Bomb Defused and Stay Rich for Life.

Health Savings Account (HSA)

Financial peer approval rating: people will be interested – dont think this is that well known
Likelihood: Medium
Complexity: Medium
Payoff: High

The Health Savings Account can be only be used for health spending and operates similar to a Health Flexible Spending Account (FSA). You can contribute up to $3250 in pre-tax money in 2013 (if you are married filing jointly). There are a few key differences to an FSA :
– Never expires: no annual “use it, or lose it”. You can rollover balances every year.
– Invest it: you can buy investment funds (similar to 401k)
– Keep it: you can move it with you when you move employers (is it your money, like a 401k)

An HSA is an estimate for future medical expenses, but can be useful for long term family planning. One large wealth risk is a long term risk that you may get hit with a big medical bill in your lifetime, and this can help keep the money invested (401k style) so that it keeps up with inflation. Must maintain a minimum cash balance of $1000, but the rest can be invested in typical 401k options. This can be rolled over year to year, so you dont have to contribute every year. HSA can be used for general medical doctors co-pays, prescriptions (etc), but also for some big ticket “non essential” medical items (such as laser eye surgery).

You typically need to be enrolled in the high deductible health plan from your employer to qualify for an HSA. Not all employers will offer an HSA plan.

Stop getting paid on a W2

Financial peer approval rating: high – people will be jealous
Likelihood: Medium
Complexity: Medium
Payoff: High
Become a non-managing partner at your company and be paid on a K-1 instead of W-2. Your K-1 income is paid gross (before tax). You are then typically liable to pay the IRS in estimated quarterly taxes. The major advantage here is that you can invest the K-1 money tax free straightaway. This will likely not work for larger companies, but for smaller firms where non managing partners already exist, find out the promotional criteria for becoming one. K-1 income isn’t subject to some taxes including the Social Security Tax (and therefore doesn’t contribute towards your social security eligibility) so there are downsides here that should also be discussed with a tax and retirement planning professional.

Pay your mortgage payments this year to get tax credit, but don’t pay until next year using your credit card

Financial peer approval rating: unknown, people haven’t heard of this method
Likelihood: Medium
Complexity: Medium
Payoff: High (if used strategically for long term debt)

Get a cheap loan to pay your mortgage payments today on your credit card, to get the mortgage tax deduction for this year. But don’t pay out for mortgage payment money until a year or more later. Then invest that mortgage payment money for a year or more while you wait.

This can save you hundred of dollars by pre-paying early on your mortgage. You also have a big cash float to invest (money that was going to mortgage payments) in the mean time.
Check out Float My Mortgage

Shameless plug / disclaimer: Float My Mortgage is another Freedom 2020 LLC company.

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