Careful tax planning matters when you have a higher net worth. By implementing tax strategies for high-income earners, you can preserve more of your earnings and wealth over time. That can help you leave behind a larger financial legacy for your loved ones through your estate plan.
The Tax Cuts and Jobs Act (TCJA) that came into force in 2018 created opportunities for tax savings for millions of Americans, including those in higher tax brackets. If you're interested in high net worth tax planning, here are some of the most important things to consider.
Investment Tax Planning
Your investments can generate current income and long-term wealth but it's important to consider the tax implications. Selling investments at a profit can trigger capital gains tax.
Long-term capital gains tax applies to investments held for longer than one year; short-term capital gains tax applies to those held less than one year. The TCJA aligned the long-term capital gains rates of 0%, 15% and 20% with maximum taxable income levels. Short-term capital gains tax is always the same as ordinary income tax rates.
The previous law applied the 0% rate to the two lowest tax brackets, while the 15% rate fell on the middle four and the 20% rate was reserved for taxpayers in the highest tax bracket.
If you're in a higher tax bracket, you stand to pay more in short-term capital gains tax when you sell investments. For example, a single filer making $523,601 or more would land in the 37% tax bracket for 2021.
The takeaway? Before selling off investments in your portfolio, consider how large the tax bite may be.
Tax-loss harvesting, which involves selling off losing investments to offset capital gains, can help you reduce your tax bill.
Estate and Gift Tax Planning
Trump's tax plan instituted changes to the estate and gift taxes that directly affect high net worth individuals. Specifically, the act doubled the gift, estate, and generation-skipping transfer tax exemptions. In 2021, for example, the estate tax exemption is $11.7 million per person. The annual exclusion limit for the gift tax is $15,000 per person for 2021, while the tax rate for all three remains unchanged at 40%.
Higher lifetime exemption limits mean you have more opportunity to leave behind wealth for future generations while minimizing taxation in your lifetime. To fully leverage the tax changes while they're in place, it's important to consider whether your current estate plan is structured to allow you to take advantage of the higher estate tax limit, while ensuring that you're not passing on more (or less) of your wealth to your spouse, children, or grandchildren than you intend to during your lifetime. You should also be coordinating your federal estate tax strategies with any tax implications that may be triggered at the state level.
Without additional tax law updates, the current tax rules are set to expire on Dec. 31, 2025.
Tax Planning for Charitable Giving
Charitable giving can be one of the most attractive tax shelters for high income earners who want to do good while getting a tax break. Under the TCJA, the IRS allows you to deduct cash contributions to eligible charities, with the deduction maxing out at 60% of adjusted gross income (AGI). The act also repealed the Pease limitations, which capped the amount of charitable deductions available to high-income taxpayers.
The higher limits on deductions are a boon for high net worth taxpayers who itemize on Schedule A. It's possible to make sizable tax-free transfers of wealth, for example, by putting some of your assets into a charitable lead annuity trust. If you're over age 70 1/2, you can avoid paying income tax on up to $100,000 in charitable donations made annually from a traditional IRA, for an added tax benefit.
Setting up a donor-advised fund can also yield an upfront tax deduction.
Deducting Pass-Through Entity Income
One final tax issue for high net worth individuals to consider is the potential impact of the 20% deduction on business income for pass-through entities. If you operate a business that's taxed as a pass-through entity, you may be able to deduct 20% of your qualified business income right off the top, with certain limitations. If you're a high income earner who owns a business, you may want to explore the advantages of forming a limited liability company to take advantage of this deduction.
If your business operates as a C Corporation, you won't be able to take advantage of the deduction, but the TCJA reduced the corporate tax rate to 21% from 35%, offering another potential avenue for tax savings.
Tax Strategies to Avoid
When implementing tax strategies for high earners, it's important to ensure you're pursuing only legal and ethical methods. There is, after all, a difference between tax minimization and outright tax avoidance, which can lead to IRS penalties and, in the worst-case scenario, criminal charges.
For example, knowingly underreporting income is a form of tax evasion, as is claiming excessive or bogus tax deductions. Consulting a trusted tax professional can help you create a strategy for minimizing your tax liability and preserving wealth while staying on the right side of the IRS.