How to Reduce Your 2019 Tax Bill (for High-Earning Working Individuals)
Russell W. Hall, CFP®
“I am proud to be paying taxes in the United States. The only thing is—I could be just as proud for half the money.” —Arthur Godfrey
There are any number of jokes about the IRS greedily going after all of your income. One of my favorite songs by The Beatles is “Taxman,” which wryly tells those who die to “declare the pennies on your eyes.”
There are also several famous quotes about not giving the government more than what you’re required to pay, and that’s where this article will focus. We emphasize strategies to reduce federal taxes for high-earning working individuals, but many of these ideas can help even if you don’t consider yourself to be in that category. If your 2018 taxes were worse than you expected, here are some ideas to try for this year.
1. Save to a Retirement Plan
This step is the most obvious place to start because every dollar in tax-deductible contributions to a retirement plan can help lower your tax bill. If you work for a company that offers a 401(k) or similar retirement plan, contribute the maximum amount allowed. In 2019, that number is $19,000 if you’re under 50. You can contribute an extra “catch-up” amount of $6,000 if you’re over 50 (for a total of $25,000).
What if you are not covered by a retirement plan or are self-employed? Here are a few options (ordered by least contribution amount to highest):
IRA: The humble individual retirement account still works for a lot of people, and if neither you nor your spouse has other retirement plan options, you can contribute $6,000 ($7,000 if over 50) per person no matter how much income you have. That amount may not be a big reduction for your tax bill, but if you’re a W-2 employee of a company that doesn’t have a retirement plan, an IRA could be your only option.
Side note on whether to contribute to a Roth IRA/401(k) instead: It’s really a tax decision. Since you don’t get a deduction for Roth contributions, they won’t help with your taxes today. Ideally, you want to contribute or convert to a Roth when your tax rate is low and you expect it to be higher in retirement. Contribute to deductible accounts like an IRA or 401(k) when your current income is high and you expect retirement income to be the same or even a bit lower. The tax break is worth more to you.
One potential strategy involving Roth accounts for high earners is the “backdoor Roth.” If you’re maxing out your 401(k) and don’t have an IRA account already, you can make a non-deductible IRA contribution and then in the same year convert those funds to a Roth IRA. Unfortunately, this won’t help with taxes today, but it will be useful for future tax planning.
SEP-IRA and SIMPLE IRA: If you own a business, these retirement plans are usually the first place to start.
SEP-IRA contributions can be made by only the employer, not by employee salary deferrals, and are limited to 25% of compensation, with a $56,000 maximum in 2019. If you’re self-employed, the contribution is based on your net profit reduced by self-employment tax, so it works out to be 20% of that net income number.
Note that if you have other employees besides yourself, you may have to make contributions for them as well. Anyone over 21 who has worked for you in three of the last five years and received at least $600 in compensation must be covered by the plan. You also must contribute the same percentage of salary to everyone.
For those reasons, the SIMPLE IRA is sometimes more attractive for small business owners. These plans allow for employees to contribute via salary deferrals, up to $13,000 (plus a $3,000 catch-up if over 50). The employer must match those contributions up to 3% of compensation, or they can make non-elective contributions of 2% to each employee instead. Part-time employees who haven’t been paid $5,000 in two previous years and the current year can be excluded.
The positive aspect of both SEP-IRAs and SIMPLE IRAs is that they are easy to set up and maintain, with limited filing requirements. The biggest downside is the limited contribution amounts, especially for the SIMPLE IRA.
Individual (Solo) 401(k): If you are a sole proprietor or own a business with your spouse, this plan can be a great way to put a lot into a retirement account and save taxes. Just like a standard 401(k), you as an employee can contribute $19,000 from your salary ($25,000 if over 50). However, you also wear the employer hat with this plan, so just like a SEP-IRA, you can effectively contribute 20% of the net income from your business. Also like the SEP-IRA, you are limited to a total contribution of $56,000 in 2019.
We see the individual 401(k) working for many high-earning small business owners, as long as they don’t have W-2 employees. Adding a full-time W-2 employee to the mix basically switches the individual 401(k) to a regular 401(k) plan, with all the filing and testing requirements that go along with that.
The bottom line on all of these options is that if it’s possible for you to save to a retirement plan, contributing the maximum allowed amount will help you save on taxes.
2. Donate to Charity
First, a caveat—we always say you shouldn’t donate to charity just to get a tax break. Donating a dollar may save you 40 cents in taxes, but that means you still have 60 cents less than you did before the donation. That said, if you already have charitable intentions, making donations can definitely save you taxes.
There are three main ways to give. You can gift cash (write a check, donate online, etc.), you can donate investments, or you can make noncash contributions.
Cash: The advantage of cash is that you can give an exact amount, and it might be a little easier to keep track of what you donated. Also, some smaller charities may only be able to accept cash donations.
Investments: Donating investments may be more advantageous because you can gift securities with unrealized long-term capital gains. A long-term capital gain is an increase in value from what you paid for an investment (your cost basis) that you bought more than one year ago and what it’s worth currently. It’s almost two tax breaks in one because you get the charitable deduction now and avoid a future taxable gain whenever you sell that investment.
Noncash gifts: Of course, you can also give noncash items to charity, like used clothing and other household items. When you do that, be aware that you need to use a reasonable fair market value when you claim the write-off. That value should be a fair price of what a buyer would pay for that item now in its current condition, not the price you originally paid. If you’re claiming over $500 of noncash contributions, you need to file a separate form with the IRS (Form 8283). Even if you’re giving less than that amount, you need to keep good records and get a receipt from the organization.
For any charitable contributions, you want to make sure that you’re actually getting the tax benefit. By this, we mean that if you are no longer itemizing your deductions because of the recent tax law changes and are now using the standard deduction, the donations probably aren’t helping you.
To get around that, you may want to bunch your charitable donations into every other year. In other words, make two years’ worth of donations in one year to allow you to itemize deductions, and then don’t contribute in the second year to claim the standard deduction. As with anything we’ve discussed here, be sure to check with your tax preparer to see if this makes sense for your situation.
For investments held in a non-retirement account (taxable account, like community property, joint, individual, or trust), consider using tax-free money markets and bonds/bond funds. Depending on your tax bracket, doing so can help put more after-tax money in your pocket.
Tax-free bonds are also called tax-exempt, and they come in different flavors. The most tax efficient are often municipal bonds from your city or state government since those are usually tax-free at both the state and federal level. In a high-income-tax state like California, this could save you $0.45 in combined taxes on every $1.00 of income.
Municipal bonds have also historically been safe investments, although you are taking on a certain level of risk if you are totally concentrated in one area. Many years ago, we were concerned enough with our state’s finances to swap out of the California tax-free bond fund we were using. Michigan and Illinois have also made the headlines in recent years with issues that could affect their ability to repay their bond obligations.
An alternative is to invest in a national tax-free bond fund, where the income is subject to state tax but not to federal tax. These funds are very diversified in their holdings across the United States and thus are less subject to the headline risk that could affect state-specific municipal bond funds or individual bonds.
Another caveat (there are always caveats anytime you are discussing taxes)—for certain federal tax calculations, tax-free bonds won’t help you. For instance, if you’re paying the alternative minimum tax (AMT), the income from municipal bonds is added back, and you don’t get the benefit.
4. Other Possible Strategies
There are other ways that you might be able to save on taxes, and we wanted to highlight two that are not as generic but might help you.
Child tax credit: If you are caring for minor children under 17, you can claim a credit of up to $2,000 per child. That amount now phases out at higher levels ($400,000 for joint filers and $200,000 for single filers), so more taxpayers have been able to take advantage of it. And tax credits are better than deductions because a credit reduces your tax bill dollar for dollar. Another tax law change is that you may now be eligible to claim a $500 credit if you are providing support for a non-child dependent (an elderly parent, for instance).
Health savings accounts: We could—and probably will—write an entire article on health savings accounts (HSAs), but in a nutshell, they are tax-free medical savings accounts. HSAs are paired with high-deductible medical insurance plans and allow you to save pre-tax dollars that will never be taxed if used for medical expenses. In essence, they are triple-tax-free, which can be very useful for high-income individuals. If you are already making maximum contributions to your 401(k) or IRA, an HSA may be another good way to save on taxes.
We hope these tips are helpful. Again, we’ll say that you should talk to your tax preparer before implementing any new strategy and make sure that it will work for you. Our Fullerton financial advisory firm is also happy to talk through your situation, so if you have additional questions, schedule a 15-minute discovery call with a fee-only financial advisor.