By Jo Constantz
These days, a six-figure salary often doesn’t go as far as expected after taxes and adjusting for the cost of living.
Thanks to the flexibility of remote and hybrid work, high-earners have been moving to lower-tax states such as Florida from expensive cities in New York and California. No matter where you live, though, tax experts say that people who earn more than $100,000 should be generally focused on lowering taxable income.
Limiting tax exposure takes long-term planning, according to Jordan Gilberti, senior lead financial planner at Facet. People with high incomes should constantly review their options amid life changes, like having kids, buying a home or getting a big raise.
“High-income earners often focus on their taxes today and fail to see how they need to start planning for their taxes tomorrow,” Gilberti said. “Tax planning isn’t just about filing your taxes every April.”
That said, here are some of the biggest mistakes high-earners make:
1. Not maxing out retirement accounts
Many high-earning individuals don’t take full advantage of retirement plans, according to Jamie Lima, founder and president of Woodson Wealth Management. Not doing so means missing out on tax-deferred growth and matching contributions from employers, Lima said.
In 2023, employees can contribute up to $22,500 to a 401(k) and $6,500 to an IRA. The limits for workers over 50 are even higher: $30,000 for a 401(k) and $7,500 for an IRA. Households with combined finances should consider maxing out contributions to both retirement plans, according to Jeremy Bohne, principal and founder of Paceline Wealth Management.
That said, if you’re part of the Great Resignation and changed jobs in the last year, make sure that your contributions under both plans don’t exceed the annual limit.
2. Skipping HSAs and 529s
Savings accounts for health expenses and college costs might be overlooked.
Like retirement accounts, contributing to a health savings account (HSA) or 529 plan for a child’s higher education can bring tax breaks. HSAs allow you to set aside money for health-care costs, like doctors appointments and medications. The HSA contribution limit this year is $3,850 for individuals and $7,750 for family coverage.
A health savings account might seem unappealing with a relatively low contribution limit, but those accounts have triple-tax benefits, according to Justin Pritchard, a financial planner with Approach Financial Planning. Money goes into the account before taxes, grows tax-deferred and can come out tax-free when used for qualified medical expenses, he said.
Money put into 529 plans is tax deductible in some states, and can be used to pay expenses such as tuition, books, computers and room and board. Contributions can range up to $85,000 per beneficiary in a single year.
3. Neglecting to take deductions and credits
High-income workers may qualify for a range of tax credits and deductions, like those for charitable donations.
“If you consistently give to charities and your income was higher than normal, consider donating what you might have normally done over several years in a single year when you’re in a higher tax bracket,” said Paceline’s Bohne. “Bunching contributions is an effective strategy for maximizing the tax benefit you’ll receive.”
Another tax break that’s often overlooked is the home-office deduction. While employees aren’t eligible for the deduction, business owners and freelancers who regularly use part of their home as their primary place of business often underestimate what they can claim.
People wrongly assume this deduction is solely for expenses occurring in a home office, like the cost of a new desk, according to Bohne. It’s actually taking a proportionate amount of costs related to the entire home, like mortgage interest, insurance and repairs, Bohne said.
4. Failing to keep records
Keeping accurate records to prove the legitimacy of filing for deductions and tax breaks is key.
“This helps to ensure that you can claim all eligible deductions and avoid any potential audits or penalties,” Lima said.
5. Ignoring phase-outs
When income tops $100,000, taxpayers should keep track of when they become ineligible for deductions or tax breaks because they make too much money, according to Jeff McDermott, founder of Create Wealth Financial Planning. For example, eligibility this year for Roth IRA contributions end over a modified adjusted gross income, or “MAGI,” range of $138,000 to $153,000 for single filers.
“If you wind up making an ineligible contribution, fixing it can be an administrative hassle, and not fixing it in a timely manner can lead to IRS tax penalties for as long as the ineligible contribution remains in the account,” McDermott said.
Someone making more than $100,000 would also generally not be eligible to take deductions on student loan interest, since that’s a tax break that phases out for those exceeding a MAGI of $85,000.
6. Misreporting backdoor Roth IRAs
A “backdoor IRA” is a strategy used by high-earners whose income exceeds the limit to contribute directly to a Roth IRA. Instead, they convert a traditional IRA to a Roth IRA, which means paying tax on the conversion but then afterwards getting to take qualified withdrawals tax-free. But the rules are complicated, so take it slow, said Approach Financial’s Pritchard.
Mistakes are common with backdoor IRAs, according to Facet’s Gilberti. In many cases, filers either don’t report the IRA contribution and the conversion all together, or they report the conversion from the IRA to the Roth IRA as taxable, which means they pay double the taxes on their money, he said.
7. Not understanding how bonuses are taxed
An annual bonus makes up a significant portion of many high-income earners compensation. But there are two different ways bonuses can be taxed, so it’s important to know which method your company uses.
Some companies tax bonuses separately from their regular pay, which means they only withhold 22% in federal taxes, according to Gilberti. But high-income earners may be in a higher tax bracket and need to know how their bonuses are taxed and adjust their withholdings accordingly.
Otherwise, they could face an unpleasant surprise when they file their tax returns, he said.
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