Tax-Filing Strategies for High-Income Earners

When it comes to accumulating wealth, investors often keep a sharp focus on amassing income and managing their investments. But to truly increase the value of your assets, minimizing taxes is just as important.

As the saying goes, it's not what you make but what you keep that counts. And by strategically managing your tax exposure, you can potentially keep even more of your investment returns.

In particular, tax bracket management can help you reduce taxes over time by either realizing or deferring income in a given year. Here's a look at two approaches that might make sense, depending on your estimated income for the year, as well as specific ways you might use tax bracket management to your advantage.

Say you're typically in the 35% income tax bracket but your self-employment income was lower than usual this year, dropping you into the 32% tax bracket. If you think you'll be back in a higher bracket next year, you could realize just enough extra income this year to "fill up" (reach the maximum allowed amount for) the lower bracket.

The idea is to realize as much income at the lower rate as possible, so that less income is exposed to a higher rate later on.                                                                                                                                                                                            

In particular, you could:

• Perform a Roth conversion. If you have significant tax-deferred IRA savings that will be subject to required minimum distributions (RMDs), you could convert part of those savings to a Roth IRA. You'll owe taxes on the converted amount this year, but any future growth can be withdrawn tax-free in retirement (assuming you're at least 59½ and the five year rule has been met). Plus, Roth IRAs aren't subject to RMDs, so you can leave the money invested for potential growth as long as you want. Roth conversions tend to be best for people who expect to be in a higher tax bracket in the future than they are today, which is a real possibility if you have significant retirement savings that will be subject to RMDs.
• Take a qualified distribution. If you're 59½ or older, you can take penalty-free withdrawals from your tax-deferred accounts. This income is taxed at your ordinary rate in the year of withdrawal but, again, if your income this year is lower than you expect it to be in the future, you can potentially reduce your total taxes paid over time. This solution might be preferable to a Roth conversion, if you need the money in less than five years.
• Harvest investment gains. Long-term capital gains—that is, returns on assets held longer than a year—are taxed at 0%, 15%, or 20%, depending on your income (plus, an additional 3.8% net investment income tax if you earn above a certain threshold.) For example, consider someone normally in the 20% long-term capital gains tax bracket who has fallen into the 15% bracket this year. That person could strategically sell highly appreciated assets this year to help minimize taxes owed on the gains.

If a sizable bonus, large RMDs, or significant capital gains have pushed you into a higher tax bracket, there are several strategies you can potentially use to help lower your taxable income for the year. Especially, if you're right on the cusp of two tax brackets.

For example, you might:

• Max out tax-advantaged savings. Contributing the maximum amount to your tax-deferred retirement plan or health savings account (HSA) can help reduce your taxable income for the year. For example, in 2024, you can contribute up to $23,000 to a 401(k) or similar plan, plus an additional $7,500 catch-up contribution if you're age 50 or older. For HSAs, the individual maximum is $4,150, plus an additional $1,000 for those age 55 and older. This approach is ideal if you believe you'll be in a lower tax rate in retirement.
• Make charitable donations. There are several options for those looking to offset their income by donating to charity:
  • Assuming you itemize your deductions, donating appreciated long-term investments can be especially tax-efficient because you won't owe capital gains on the assets and can take a tax deduction for the full fair-market value of the donation (up to 30% of your adjusted gross income).
  • Individuals who are subject to RMDs can elect to make a qualified charitable distribution (QCD) of up to $105,000 in 2024 from their individual retirement account (IRA) directly to charity. A QCD can satisfy part or all of your RMD for the year, helping to keep your income in check.
• Harvest investment losses. If you realize sizable capital gains this year, you can offset some of the taxes you'll owe on those gains by selling investments that have gone down in value. For example, if you have $80,000 in gains this year, you could strategically sell investments that have a combined $80,000 in losses, which would effectively cancel out the gains. And if you have losses that exceed your gains, you can use them to offset up to $3,000 in ordinary income. Any remaining losses can be carried forward to offset future income.