Earning a higher income is both a blessing in the economic sense and a curse when talking about taxes. Essentially in the current environment making more money means paying additional taxes. This is especially true starting in 2013 with two new taxes for high wage earners. Unfortunately when Warren Buffet complained that the rich were not taxed enough he was not talking about you and others in the 28-35% tax brackets. Unlike many of these “rich people” your W-2 reports all you income and there is little flexibility. With that said, let’s start with the positive ways to tax plan for next year and then discuss the new taxes.
Five Tax Saving Strategies
1. Max out your 401(K) or 403(b) Plan (Maximum amount to defer is $17,500 or $23,000 if over 50)
Example: If you are in the 33% tax bracket and max out $17,500 then you have saved over $5,500 in taxes.
2. Cafeteria Plans (i.e. Flexible Health Accounts, Child Care Expenses, etc)
These plans will reduce your taxable income by what you contribute however most plans have the use it or lose it caveat. In 2014, the Internal Revenue Service (IRS) have announced updated guidance permitting carryover of up to $500 of unused health flexible spending account (FSA) balances at the end of a plan year.
Example: If you are in the 33% tax bracket and max out $2,500 in the FSA then you have saved almost a $1,000 and you have paid medical expenses pretax. Remember, the regular medical deduction is now 10% of Adjusted Gross Income (AGI) so that is a lot of medical bills.
3. Health Savings Account (if deductible is over $2,500 for family or $1,250 for individual coverage)
The Health Savings Account (HSA) is an option for individuals or families with high deductible health insurance plans. The HSA functions much like the FSA when getting reimbursed for medical expenses but can be used for long-term family planning. Unlike the FSA, this plan is not “use it or lose it” and can be invested much like a 401(k). The maximum contributions are $6,550 for family and $3,300 for individual with the ability to contribute an extra $1,000 if over 55 years old.
Example: If you are in the 33% tax bracket and max out $6,550 in the HSA then you have saved almost $2,200.
4. Sell stocks that are trading at a loss
Review currently held security or investment positions trading below your cost before the end of the year. This situation is called an unrealized loss however these unrealized losses are not tax deductible. To use the loss for tax purposes, the position must be sold, creating a realized loss. The federal tax code says that capital losses can be used to offset capital gains. If losses exceed gains, the taxpayer can take a $3,000 loss against other income. Any excess loss can be carried forward into future tax years.
5. Give more to Charity (Taxpayers who itemize deductions)
Example: If you are in the 33% tax bracket, every dollar you give to charity will reduce your taxable income by $.33. So if you give $10,000 to charity then you will decrease your taxable income by $3,300.
There are also other options such as investing in tax-free municipal bonds, life insurance options, and investment portfolio shifting however I encourage you to understand that these may save money in tax but they don’t necessarily make economic sense in every situation. For example, by investing in a municipal bond at 1% to avoid tax and missing out on an index fund earning 10% does not make sense when looking at the opportunity cost.
New 2014 Tax Increases for High Income Earners
1. Most income tax brackets are retained however tax rates go from 35% to 39.6% for individuals earning more than $400,000 ($450,000 for joint filers, $425,000 for heads of household) (2013 and forward);
2. The Personal Exemption Phaseout (PEP) is now reinstated at threshold levels of $300,000 for joint filers and surviving spouses; $275,000 for heads of household; $250,000 for single filers; and $150,000 for married taxpayers filing separately
3. Capital gain & dividend rate increase for high earners beginning in tax year 2013. Top rate rises from 15% to 20%
4. New taxes include: 3.8% Medicare Tax on Net Investment Income and an Additional 0.9% Medicare Tax on Wages/Self-Employment Income for Taxpayers with modified adjusted gross income (MAGI) over $200,000 who file individually or $250,000 for married couples filing jointly ($125,000 if married and filing separately)