Not everyone should be seeking to minimize taxes. In fact, a lot of people should take advantage of these historically low tax rates to reduce taxes in the future! Roth IRA’s and Roth conversions won’t lower your tax bill. In fact, Roth conversions mean higher taxes now in exchange for a tax-free future.
But those in higher tax brackets, including business owners and self-employed individuals should consider these five tax-saving ideas.
1. Maximize the triple-tax advantage of Health Savings Accounts.
Did you know Health Savings Accounts (HSA’s) are the most tax-friendly accounts out there? It’s true—HSA’s have a triple-tax advantage:
- Contributions are tax deductible.
- Earnings grow tax-free.
- Withdrawals can be tax-free.
A Traditional IRA taxes you on withdrawals. Roth IRAs grow tax-free but don’t give you a tax deduction. HSA’s give you all three benefits!
Sure, HSAs have requirements, the biggest being you need an HSA-eligible high-deductible health plan. Also, withdrawals from HSAs are tax-free only for qualified medical expenses. But the best way to use an HSA is not for your near-term medical expenses.
For those with high current cash flow, consider an HSA as a retirement savings vehicle. Certain HSAs allow you to invest your account in mutual funds, providing tax-free growth potential.
If you have good cash flow, why take money out of an account that is growing tax-free to pay for a visit to the doctor? Instead, you can pay for current medical expenses out-of-pocket and earmark your HSA for retirement health expenses.
2. Uncover lesser-known charitable giving strategies.
Donating to charity has always been a great way to give joyfully while reducing your taxes. While you can always give more (the CARES Act allows you to deduct up to 100% of your Adjusted Gross Income), consider these two strategies:
Use RMDs as charitable donations
Although required minimum distributions (for those over 70) have been suspended this year, charitable-inclined retirees can save on taxes by simply changing which account their donations come from.
Say you have a $50,000 RMD next year. If you have the RMD sent directly to the charity as a Qualified Charitable Distribution, it won’t hit your taxes as income. If you are in the 24% tax bracket, that’s a savings of $12,000!
Open a Donor Advised Fund
A Donor Advised Fund (DAF) makes charitable giving simple. Think of it like a charitable investment. When you donate to your DAF, you get an immediate tax deduction. The funds can be invested and continue to grow tax-free. When you are ready, you can recommend grants to charities.
Of course, you can give directly to your favorite charities. So, who should consider a DAF? If you are expecting a year with higher-than-normal taxable income (i.e. sale of an asset, inheriting a large Traditional IRA), you can utilize a DAF to make a large charitable contribution and get your immediate tax deduction. You’ll have time to research your charitable options and make grants to your favorite charities when you’re ready.
3. Diversify using municipal bonds
Take a look at your recent tax returns. On your Form 1040, line 2b, there is a box for taxable interest. This includes interest from bonds like US government bonds and corporate bonds. Interest from these bonds is taxed as ordinary income. This creates what’s known as a tax drag, as the amount of bond interest can be somewhat lost to the income taxes owed.
However, interest from municipal bonds is not subject to federal income tax. These are bonds issued by state and local municipalities.
Take an example of an investor in the 35% federal income tax bracket. Let’s say he has the option of investing in a corporate bond mutual fund with a 4% yield, or a tax-free municipal bond fund with a 3% yield. Which is better?
Corporate bond annual income: $25,000
Federal income tax owed: $8,750 ($25,000 x 35%)
After-tax return: $16,250
Municipal bond annual income: $18,750
Federal income tax owed: $0
After-tax return: $18,750
Since the municipal bond is tax-free, it has a higher after-tax return!
4. Use the right type of retirement plan.
If you are a business owner, do you know the types of retirement plans available to you? If you are trying to turbo charge your retirement savings (while paying less taxes today), consider these two types of retirement plans:
Also known as a Solo 401(k), this allows a sole proprietor the potential to defer up to $57,000 in 2020. Most people can only save $19,500 in their 401(k)’s. So, what’s different about yours? As a business owner, you can save both as an employee and as the employer, giving you a higher ceiling.
Be careful—if you have employees, you’ll have to include them in your 401(k) since ERISA rules will govern the plan. This will limit the amount the business can put in your own account, but it can still be a good way to save some money.
Defined Benefit Plan
If you are a high-income-earning business owner with no employees, a defined benefit plan can drastically increase the amount you defer to retirement and save in taxes. Often, business owners are saving over $100,000 or more annually!
Who should consider a defined benefit plan? Independent contractors, consultants, or medical professionals who own a small practice.
You can even pair a defined benefit plan with an Individual 401(k)!
5. Harvest losses in your taxable investment accounts.
When you sell an asset that has increased in value, you often pay a capital gains tax on the increase. What if you sell an asset that has decreased in value? You have a capital loss. A capital loss can be used to offset any similar gains.
This act of selling assets at a loss can be done intentionally to help you save money on taxes. Since investment accounts are liquid and the assets in them are easy to buy and sell, this is a great place to do this.
This is called “tax loss harvesting” and can be done in a taxable investment account (not retirement accounts).
Be careful—selling a security at a loss and then buying the same (or equivalent) security within 30 days will trigger a “wash-sale rule.”
Sound complex? It can be! But tax loss harvesting is an automatic service that Stewardship Financial offers to clients through our partnership with Betterment. Our technology will actively look for opportunities to harvest a loss and avoid the wash-sale rule by buying a suitable replacement security.
An advisor with tax savings in mind.
Yes, the advisors at Stewardship Financial help you plan ways to grow your wealth. But as you can see, tax savings for high income earners is just as important.
These tax-saving tips are simple, but not necessarily straightforward. It can be easy to get tripped up by rules, deadlines, and limits. Let us help you put a plan in place to succeed!