6 Tax Tips For High Income Investors

By in Advanced Investing, Investing, Reader Question, Taxes, Tips | 8 comments

Investment Strategies For High Income Earners

Jon, from MoneySmartGuides asks; 

“What investment strategy should a couple use if they are in a high tax bracket and want to minimize taxes on their investments?”

Who doesn’t want to (legally) reduce taxes?

I had the good fortune of being brought up by someone who was supremely focused on tax reduction. From the time I was a teen, my dad recommended tax reduction strategies. I pride myself on keeping abreast of the legal methods for reducing taxes by investing. In fact, I just wrote about how I started out investing the maximum amount allowable by law in tax advantaged vehicles in “Why You Must Start Investing Now” at Good Financial Cents.

Best Investment Strategies To Reduce Taxable Income

tax tips high income investors

1. Contribute the maximum amount allowable by law to your retirement accounts.

That includes a 401(k), 403(b), SEP-IRA, traditional IRA, Roth IRA.

Although you won’t be able to contribute to all of those accounts the more you can contribute to tax advantaged accounts, the better. To find out the details about various types of retirement accounts, the IRS website is quite helpful (yes, the government is good for something).

With most workplace retirement accounts, you are killing two birds with one stone.

Benefit 1: Your contribution into these accounts reduces your taxable income (except the Roth IRA).

Benefit 2: The money in the account is not subject to tax until it is withdrawn (except the Roth IRA). The result is that you have lowered your federal taxable income with the expectation that upon withdrawal, you will be in a lower tax bracket.

With a Roth IRA, the initial contribution is not deducted from your income, but the money invested within the Roth IRA grows tax free. And the best part of this investment vehicle is that when you withdraw the money at any point after age 59 1/2, the withdrawals are also tax free.

2. If possible, set up a Health Savings Account (HSA).

This is an account for individuals with a high deductible health plan (HDHP).

The account has  tax four benefits.

Benefit 1: The money contributed is tax deductible.

Benefit 2: While in the account, the money grows tax free.

Benefit 3: Withdrawals for qualified medical expenses are also tax free.

Benefit 4: The unused contributions can stay in the account and grow tax deferred.

I contribute the maximum allowable by law to this type of account for the tax benefits. Unused prior year’s contributions can roll over indefinitely. Although there is a penalty if ineligible funds are withdrawn (in addition to a tax obligation) before age 65. In the case of death, disability, or participant reaches age 65 and older, funds can be withdrawn without penalty. And there are investment choices in these accounts as well.

3. I Bonds protect your income from state and local taxes.

If you live in a state with high taxes (and even if you don’t), I bonds are a great investment for the cash portion of your investment portfolio.

Benefit 1: For tax planning purposes, there are no state or local taxes due on the interest payments.

Benefit 2: These investments protect your cash from the ravages of inflation as their interest rate is tied to the inflation rate.

4. Place investments in appropriate accounts to reduce tax liability.

Tax efficient investing is the way to invest so that your financial assets incur the lowest amount of taxes. The rule of thumb is to place financial assets with the largest annual interest and dividend liability in tax advantaged accounts. Low dividend and capital gain assets such as stocks are usually better placed in a taxable investment brokerage account.

Place these investments in retirement (tax advantaged) accounts:

The premise for asset location is that the investments with the highest tax burden should be placed in the retirement accounts. In general, place assets with high annual  taxable income and dividends in tax advantaged accounts.

Place bonds, bond funds, REITS, high dividend paying assets and funds in retirement accounts. Additionally, diversified funds with both bonds and stocks, such as target date retirement funds should also be placed in retirement accounts.

Place these investments in taxable investment brokerage accounts:

Individual stocks and stock funds belong in taxable accounts. In general, these funds have smaller dividend and capital gain payments than bond-type investments. Stock investment capital gains and losses can be managed to minimize taxes owed.

Of course, if you own tax free municipal bonds, those should be in a taxable account due to their tax efficiency.

The above mentioned I bonds and any other savings bonds should also be in taxable funds due to their preferred state and local tax treatment.

5. Consider buying municipal bonds or municipal bond funds from your state.

If you are in a high tax bracket, consider investing in a municipal (muni) bond or fund from your state. These are great because the dividends from muni investments are usually tax free for both state and local tax.

In order to figure out whether these types of investments make sense for you, there is a very simple formula to calculate the tax equivalent yield. This formula standardizes the return on municipal bonds so they may be compared with an equivalent taxable bond.

Tax Equivalent Yield = Tax Free Municipal Bond Yield/1-Tax Rate

For example, if you are in the 41% tax bracket (Federal + State + Local), use the tax equivalent yield to compare a 5 year corporate bond with a yield of  1.91% and a 5 year municipal bond with a yield of 1.23%.

The Tax Equivalent Yield =1.23/(1-.41)=2.08%

Thus, when you compare the taxable yield of 1.91% with the 2.08% tax equivalent yield of the muni, you are better off investing in the municipal bond.

 6. Tax loss harvesting.

This is a strategy to reduce taxes when selling investments. The investor attempts to sell stocks with losses to offset the capital gains from selling stocks which have  advanced in price.

It’s not a good idea to let taxes drive your decision whether to sell a holding or not. But, consider selling stocks that didn’t meet your expectations and match those losses with the gains from winning investments.

Although tax loss harvesting doesn’t eliminate the loss, it does cut down your overall tax bill by using the loss to minimize capital gains taxes.

If you are lucky enough to be in a high tax bracket, invest in a tax smart way. You worked hard for your money, so why not use all legal methods to keep as much of that money as possible?

Readers, have I missed any tax strategies for high income investors?

    8 Comments

  1. This is a great list Barb! Thanks for answering my question. All of these are easy to implement, even for the non-high income earner. And many times, these make sense for all investors. The more you can shelter from taxes, the more you can keep for yourself!

    Jon @ Money Smart Guides

    March 17, 2014

  2. @Jon, I really appreciated the question. I’ve been focused on keeping taxes low for decades and hope your question will prompt others to maintain a “tax reduction” focus.

    Barbara Friedberg

    March 17, 2014

  3. If you invest in real estate it often makes sense to set up a LLC instead of adding the rent to your personal income, especially if you are in the higher tax bracket.

  4. @Pauline-Thanks for the information. LLC’s will protect you from some potential legal pitfalls as well.

    Barbara Friedberg

    March 18, 2014

  5. i tend to put my higher growth stock in my Roth IRA because if its value rises you won’t pay any tax on it. If you bought something at $20 that appreciates to $200 a share even if you’re at 15% capital gains you’re better off in a Roth and pay no taxes. Having slow growth stocks in a taxable makes more sense.

    Charles@gettingarichlife

    March 19, 2014

  6. @Charles, That’s a good strategy, as long as you are correct, and the high growth stock appreciates. The problem occurs if the stock tanks, you sell, and can’t benefit from the capital loss on your taxes. (But I hope that doesn’t happen to you 🙂 ).

    Barbara Friedberg

    March 19, 2014

  7. Good list that covered a lot. It’s funny that I still have an HSA even though I no longer have an HDHP. While I can no longer contribute to the HSA, I can still use it to pay co-pays and prescriptions.

    Bryce @ Save and Conquer

    March 19, 2014

  8. @Bryce-They are amazing retirement vehicles. Your comment shows how useful they are even if you can no longer contribute. If you invest the funds in a stock and/or bond fund, your money can grow tax free until you withdraw it for medical expenses.

    Barbara Friedberg

    March 19, 2014

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