W2 employees have fewer tax planning options out there, however, that does not mean they have none. Here are 12 of the best tax planning moves to consider as a high-income W2 employee.
1. Max Out Your Pre-Tax 401(k)
Retirement accounts are great. They allow you to put away a ton of money for retirement, oftentimes with a match. You also have the choice between Roth (post-tax) and Traditional (pre-tax). 401(k)’s allow you to do up $22,500 of your own contributions a year, then you can go above that with your employer match.
Roth 401(k)’s can be great for many reasons, but in your highest income earning years it may make sense to defer this tax till later and reduce your taxable income today. Especially if you think you will be in a much lower tax bracket in the future.
I am not saying put every dollar away for retirement, but oftentimes it makes sense for highly compensated employees to max it out when they also can contribute elsewhere.
2. Use a Mega-Backdoor Roth
The Mega-Backdoor Roth is a great tool for high income earners. You can still max out your pre-tax 401(k) then contribute to an after-tax 401(k). The IRS rules allow you to contribute up to $66,000 a year but everything beyond the $22,500 is non tax-deductible.
To do the Mega-Backdoor Roth (not all plans allow it) you put money into the after-tax 401(k), then roll it into either a Roth IRA or Roth 401(k). This can get complicated with many moving parts so work with your financial planner before doing it. But this is an awesome way to get a ton of tax-free dollars put away for the future.
3. Individual Retirement Accounts
Once you have utilized your employer-sponsored retirement accounts to the right amount, it starts to make sense to look into individual retirement accounts like a Roth IRA. However, you may be thinking “Well I can’t do that, my income is too high.” True… but there is something called the backdoor Roth IRA that allows anyone to utilize. You simply put money into an IRA (you don’t deduct it), then you convert to Roth. It’s that simple, but make sure you do not have other pre-tax money inside a Traditional IRA, Sep Ira, Simple, etc. If you do it will trigger the pro-rata rule and a portion will become taxable. You are able to contribute $6,500 a year per spouse.
You may be thinking “Why would I want to pay tax today vs get the deferral when my income is so high?” Well, that is a good question. You most likely have already maxed out the other pre-tax options and now have post-tax dollars left. They can go here or to a taxable account. Never paying tax again is a great advantage you get with the backdoor Roth.
4. Utilize Other Pre-tax Options
Depending on what healthcare plan you have, you will either have an HSA or an FSA. HSA’s are way better tax-wise, so let’s start there.
- Reduce taxable income
- Can be invested and grow tax-free
- Can be used tax-free on future health care costs or long-term care insurance premiums in the future
This is the most tax-advantaged account out there. For high-income earners, not using it today and letting it grow can be so impactful. But keep those receipts just in case you ever need to pull funds out pre-retirement. You can contribute up to $7,750 for a family in 2023.
If you do not have an HSA, using an FSA can be great too as it will lower your taxable income. It just cannot be invested and utilized down the line. It is typically a use-it-or-lose-it benefit this year (with a small amount potentially being able to be rolled over). You can contribute up to $3,050 in 2023.
Another pre-tax option is a dependent care FSA. This allows you to pre-tax save money for qualified childcare expenses you have. You can funnel $5,000 a year which is still impactful.
5. Donate To Charity
This is a really easy way to lower your taxable income if you have extra funds and are charitably inclined. You have donor advise funds, charitable remainder trusts, etc. that can be used to lower your taxable income. You also can donate highly appreciated securities to avoid capital gains taxes and still get a deduction. To maximize this, donate before you sell. If you don’t, you will have to pay the capital gains tax on it and just get the income deduction.
On this same note, some consider bunching charitable donations every other year to increase itemized deductions. Let’s say you make $500k and want to donate 5% a year. That is $25k. This is under $27,700 so you would take the standard deduction if you do not have a ton more. But even if you do have some more, you may barely be over the standard deduction anyways. If you do not bunch them in this example, you could you total deductions over 2 years = $55,400. Or you could bunch it all every other year.
- Year 1 = Standard and get $27,700
- Year 2 = Donate all $50k and get $50k deduction
- Total deductions = $77,700
That is $22,300 more in deductions by doing the same thing If you are in the 37% bracket + state. That could be over $10,000 in tax savings just by being strategic around what you do and how you do it. This is what proactive tax planning looks like.
6. Invest In Real Estate
Real estate is a very tax-advantaged asset class. With bonus depreciation, cost segregation studies, 1031 exchanges, etc. you can reap a ton of rewards by utilizing this asset class.
If your spouse has Real estate professional status (REPS) or you take advantage of the short-term rental loophole, you can actually use these losses to offset other active income. Sounds great, right? Well… it is but it is not easy to pass all the tests. Here are a couple resources to go into what those tests are. Definitely need to work with your tax professional if you want to consider this route.
Another good option is Qualified Opportunity Zone investing. This can make sense if you have a large capital gain from your equity comp or some other investment. If you do, you could consider putting some from the sale into an opportunity zone investment which will defer taxes till 2026 and then the growth will be tax-free if you hold for 10 years. But remember, any opportunity zone won’t work, you still need to make sure it is a good investment
7. Roth Conversions
There are times when you will have lower incomes years. This could be when you move to one income, retire early, start a business, etc. This is a great time to move pre-tax to post-tax assets by doing Roth conversions and paying tax at a lower rate than you would in the future. Tax planning is all about paying taxes at lower periods of time. Another good time to consider this is when the market drops and your portfolio is lower.
8. Manage Your Equity Compensation
Many high-income earners get equity compensation. Whether it is RSU’s, ISO’s, NSO’s, or ESPP plan, you can plan well and manage your tax liability. Here’s a quick overview of each:
- RSU’s = When RSU’s vest, they are taxed as ordinary income. Holding beyond that does not give you a tax benefit. But… if you are going to hold on, then you are taxed at short-term capital gains rates if you hold for less than 1 year, and long-term capital gains rates if greater than 1 year.
- NSO’s = When you exercise, you are taxed based on the difference between exercise and market price. This will be taxed at your income rate. Then if you hold on you are taxed at either short-term or long-term capital gains based on the timeframe you hold for.
- ISO’s = When you exercise, you have no tax unless you trigger AMT. This stands for alternative minimum tax and if triggered results in 26% or 28% added tax (most comes back as a credit in the future). Then have short-term or long-term capital gains based on time frame.
- ESPP – With an ESPP plan, you choose to buy company shares at a discount, the best plans have a 15% discount and a look-back provision. This is where it compares the fair market value of the stock at the beginning of the offering period and purchase date, then uses the lower value to calculate your purchase price. You are taxed right then around the gain you received from the look back and discount. Then, if you hold, based on timeframe (this one is more complex and needs a post on its own) you can get either short-term or long-term capital gains rates.
For this post, I had to go high level but do have resources out on each type of equity comp. You can be strategic and plan this and minimize taxes.
9. Asset Location And Tax Loss Harvest
These two can go hand in hand. Asset location is all about:
- The most tax-advantaged assets in your taxable account
- The highest appreciating assets in your tax-free accounts
- Lowest appreciating assets in tax-deferred accounts
Managing this well can lead to tons of tax savings over your lifetime. You do not want a huge tax drag in your taxable account.
Going off that, tax loss harvesting is a way to sell investments at a loss and move to a similar asset. This allows you to bank that loss and use it to offset gains elsewhere when you have them. If you have none, $3,000 can be used to offset income then the rest carries forward to the next year.
10. Non-Qualified Deferred Comp Plan
Deferred comp plans are separate from your regular income and are a way to be paid more but not actually receive it or be taxed on it until a later date.
Adding a deferred comp plan could be a great move in the right situation when you have a ton of income.
11. Utilize a 529 Plan For College Expenses
529 plans are a great way to save for college. But… some states have a way better plan and benefits than others. In Indiana, you get a 20% tax credit up to $5,000. So if you put in $5,000, you get $1,000 back on taxes. That is a pretty great benefit. Then investments grow tax-free and it can be used tax-free on qualified college expenses.
Make sure you look into your state’s specific plan and what deductions or credits is allowed before making a decision. If you live in a state with no state income tax, they definitely have less of a benefit, but still can be useful!
12. Do Estate Planning
Besides the basics, there are tons of estate planning strategies the wealthy can consider. You may want to utilize tools to get some money out of your estate if you will be over the estate tax exemption.
You also can gift money yearly to family under the reporting limit, lend money at the required rates, pay for college or health care expenses, etc. to help more and not use the lifetime limit.
Disclaimer: This is just for informational purposes. None of this should be seen as tax advice. Work with your financial planner and tax professional to evaluate which strategies would be the best for your situation.Investment advice offered through Stratos Wealth Advisors, LLC, a Registered Investment Advisor. Stratos Wealth Advisors, LLC and Flagship Financial Advisors are separate entities. Please remember that past performance is no guarantee of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Flagship Financial Advisors, or any non-investment related content, made reference to directly or indirectly in this commentary will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from Flagship Financial Advisors.