Many high-earning taxpayers know how to save money on taxes by benefiting from the tax deductions and credits that are available to them. Wealthy taxpayers also tend to hire professionals who know the tax code, said Mark Steber, chief tax officer at national tax preparation service Jackson Hewitt. They know how to maximize tax breaks and avoid mistakes.
With changes happening in the White House and to the tax code, it's important you stay aware of developments that could impact your taxes. The new tax code, including your personal tax bracket, will impact the money you earn in 2018. Although you're filing taxes this year in 2018, you're reporting income you earned in 2017, before the new tax code took effect. For now, it's business as usual, but expect filing taxes next year to be different.
To minimize your tax bill as high-income taxpayers do, click through to find out how you can follow their lead.
1. Don’t Look for the Cheapest Tax Preparer
The rich don't look for the lowest cost provider when preparing their tax returns each year, said Stephan M. Brown, a tax attorney and partner at NewPoint Law. "A minor oversight or lack of understanding can lead to a missed deduction or improper tax position that can far outweigh the cost of tax preparation."
Even if someone else prepares your tax return for you, you're responsible for the information on that return. A tax error can cause big headaches, so it's important to choose a qualified tax preparer, such as an enrolled agent, certified public accountant or tax attorney. The IRS has a searchable directory of federal tax return preparers that have the proper credentials and are registered with the IRS.
2. Think About Taxes All Year Long
"Wealthy people tend to think about taxes all the time," said Mark Steber, chief tax officer at Jackson Hewitt Tax Service. "It's not just an April event." They take steps throughout the year to lower their taxable income and increase the number of tax breaks they're eligible to receive.
And they stay organized throughout the year by filing receipts and keeping track of transactions and life events that could affect their tax return. Tax planning throughout the year enables smart taxpayers to owe less to the IRS. Taxpayers who wait until April 15 to think about taxes miss a lot of opportunities to reduce their tax liability, added Brown.
3. Don’t Understate Your Income
Although wealthy taxpayers pay a higher income tax rate — up to 39.6 percent — they don't forget to include certain income on their return to lower their tax bill or get a bigger refund, Brown said. Instead, they focus on submitting a correct tax return to prevent any accuracy penalties from being assessed and to avoid audits, he said.
Taxpayers who substantially understate their income have to pay an accuracy penalty of 20 percent of the underpayment, according to the IRS.
4. Shelter Income Legally
The rich might avoid understating income to stay out of trouble with the IRS, but that doesn't mean they don't look for opportunities to lower their taxable income. One of the key ways to shelter income legally is to contribute the maximum allowed to a workplace retirement account such as a 401k, said David Du Val, vice president of customer advocacy at TaxAudit.com.
Contributions to such accounts typically come out of your paycheck before taxes — which lowers your taxable income — and the money in the account grows tax-deferred. "The consequences of missing out on tax-advantaged accounts can mean thousands of dollars over a lifetime," Du Val said. And when your employer offers a workplace retirement plan, you can participate regardless of your income level.
5. Avoid Capital Gains by Trading Within Retirement Accounts
People in higher tax brackets contribute to retirement accounts to reduce taxable income, but they also use them to eliminate taxes on capital gains by trading within their accounts, said David Hryck, a tax attorney and partner at Reed Smith law firm in New York City.
Typically, if you sell an asset that has increased in value, you have to pay taxes on the gain. It's a short-term gain and taxed at your regular income tax rate if you held the asset less than a year. It's a long-term gain and taxed at a rate up to 20 percent if you held the asset more than a year.
"If you are going to be buying and selling stocks during the course of the year, you should be conducting those moves within your IRA,"Hryck said. That's because money in an individual retirement account and 401k grows tax-deferred, so you don't pay tax on any gains until you take the money out.
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6. Don’t Tap Retirement Savings Early
When you take money out of a retirement plan before age 59½, you typically have to pay a 10 percent early withdrawal penalty and income taxes on the amount you withdraw.
One of the reasons people tap their retirement accounts before retirement is to cover unexpected expenses, Du Val said. The wealthy don't do this because they have built rainy day funds to cover emergencies.
You don't have to be rich to have an emergency fund, though. You just have to get in the habit of regularly setting aside money into a savings account — preferably, a high-interest savings or money market account.
7. Itemize Deductions
Almost all taxpayers who earn more than $200,000 choose to claim itemized deductions rather than the standard deduction on their tax return, according to the Tax Foundation. Itemizing requires filling out an additional form, the Schedule A. So why do people bother? Because itemizing reduces their income more than the standard tax deduction.
The standard deduction for 2017 federal tax returns is $6,350 for singles and $12,700 for married couples filing jointly. But you might get a higher deduction by itemizing if you paid things like mortgage interest, real estate and personal property taxes, state and local income taxes, or sales taxes and other deductible expenses. Figure your taxes both ways to determine if you're better off itemizing deductions or not.
8. Take Advantage of the Benefits of Homeownership
Homeownership brings a host of tax breaks, and smart taxpayers take advantage of them — but you'll need to itemize to do so. "Once you buy a home and have a mortgage, you have mortgage interest and property taxes that you can deduct," Steber said.
You can deduct these expenses associated with owning a home:
- Property tax
- Mortgage interest on a primary and secondary home, and up to $100,000 in home equity debt
- Points you paid when you got a mortgage
Even with current mortgage rates as low as they are, these deductions can save you money.
9. Take Tax Breaks for Charitable Donations
Itemizing your tax return allows you to deduct charitable contributions, and wealthy individuals take the opportunity to write off their generosity, Du Val said. About 60 percent of charitable contributions deducted on federal tax returns are claimed by taxpayers earning more than $200,000 per year, according to the Tax Foundation. You don't have to be a major donor to an organization, though, to take advantage of this tax break.
Any contribution of cash or property to a qualified organization can be deductible. Keep track of your giving throughout the year. You'll need receipts documenting your cash contributions for amounts of $250 or more. Plus, you have to file Form 8283 for noncash contributions worth $500 or more.
10. Deduct State and Local Income Taxes
You can deduct state and local taxes withheld from your paycheck or estimated tax payments you made to a state or local government if you itemize your tax return. Deducting these taxes will lower the amount of income the federal government considers taxable and, as a result, lower your tax bill — or boost your refund.
The wealthy take advantage of this deduction much more so than average- or lower-income taxpayers. According to the Tax Foundation, taxpayers with incomes over $200,000 claimed 55 percent of the state and local taxes.
11. Take the Sales Tax Deduction If Your State Doesn’t Impose an Income Tax
When you itemize, you have the choice of writing off the amount you paid in state and local income taxes or state and local sales taxes. Smart taxpayers know to take advantage of the state sales tax deduction if they live in a state that doesn't impose an income tax.
Sometimes taxpayers who live in a state with an income tax still come out ahead by claiming the sales tax deduction if they made large purchases throughout the year. The IRS has a sales tax deduction calculator to help you figure out how much you might be able to deduct.
12. Keep Track of All Your Medical Expenses
Wealthy taxpayers — especially older adults who have more medical expenses — take advantage of tax breaks for out-of-pocket medical costs if they can, Du Val said.
When you itemize, you can deduct unreimbursed medical and dental expenses that exceed 10 percent of your adjusted gross income. You might also be able to deduct 17 cents per mile when using your car to drive to and from medical appointments.
13. Sell Your Losing Stocks
You don't want to cash out your retirement account when the market is down — or any time before age 59½ — because you'll pay a 10 percent early withdrawal penalty. But wealthy individuals who own stocks outside of retirement accounts know that they can take advantage of losing stocks at tax time, Steber said. "There's a tax break there for that," he said.
When you sell stocks, bonds or other assets that have declined in value since you bought them, they're considered a capital loss. And when your losses exceed your capital gains, you can use up to $3,000 in losses to offset your income.
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14. Use ETFs to Avoid Capital Gains
The rich use exchange-traded funds to their advantage, Hryck said. ETFs are designed to track a particular stock, bond, commodity or other index. Unlike with a mutual fund, when a security is sold within an ETF by its fund manager, it's not treated as a capital gain.
So investors typically don't have to pay any taxes when trades are made within an ETF. They only pay capital gains when they sell an ETF.
15. Include Reinvested Dividends in Your Basis
When you receive dividends from a stock or mutual fund, you have to report that income on your tax return — even if those dividends are reinvested to buy more shares, according to the IRS. Even so, smart taxpayers and tax preparers know that reinvested dividends can be added to the stock or fund's basis or the amount you originally paid for an asset.
Having a higher basis can reduce the capital gain when you sell. Don't forget to include reinvested dividends as part of your basis or you'll essentially pay taxes on them twice, according to Kiplinger.
16. Explore Retirement Tax Shelters for the Self-Employed
The number of individually owned businesses in the U.S. has grown dramatically over the past 20 years, and wealthy taxpayers earn the majority of income from such businesses, according to the Tax Foundation. Just as high-income taxpayers earning a paycheck look for ways to lower their taxable income, so do high-income small business owners.
Self-employed taxpayers can deduct contributions to IRAs, such as a SEP-IRA or solo 401k, which have higher contribution limits than traditional IRAs. With a SEP-IRA, you can contribute 20 percent of net income, up to a maximum of $54,000. A Solo 401k lets you contribute $18,000 plus 20 percent of business earnings, up to a maximum of $54,000, plus a catch-up contribution of $6,000 if you are over 50.
17. Take the Write-Off for Self-Employment Taxes
Although employees pay only half of Social Security and Medicare taxes and their employers pay the other half, self-employed workers must shoulder the entire 15.3 percent tax rate for Social Security and Medicare. But they can deduct half of what they pay when figuring their adjusted gross income on Form 1040 — so this deduction doesn't require itemizing.
18. Take the Home Office Deduction
Smart self-employed taxpayers who work out of their homes know that they can write off expenses for the business use of their homes. To qualify for the home office deduction, you must regularly use part of your home exclusively for business, and your home must be your principal place of business, according to the IRS.
The IRS allows taxpayers to determine the actual expenses — including mortgage interest, insurance and utilities — based on the percentage of their home that's used for business. Or they can use a simplified option to multiply a prescribed rate by the square footage of the office.
19. Take Insurance Write-Offs When Self-Employed
Self-employed taxpayers and small business owners can deduct the amount they paid for medical and dental insurance — and even long-term-care insurance — for themselves and their family. And they don't have to itemize to take this deduction.
They also can deduct premiums for other insurance related to their business, such as liability insurance and car insurance.
20. Claim Travel Expenses
Smart self-employed taxpayers know to keep track of vehicle expenses for business because they can get tax write-offs for them. Deductible costs include parking fees, tolls, and the standard mileage rate, or actual expenses such as gas, insurance, depreciation, and repairs.
Self-employed taxpayers and small business owners also can deduct the cost of travel by plane, train or bus to business destinations — as well as meals and lodging on business trips.
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21. Take Tax Breaks for Investment Property
Rental property can offer numerous different tax breaks and moves that can have a positive effect on your tax situation, Hryck said. One thing that smart taxpayers do is take advantage of Section 1031 of the tax code. With a 1031 exchange, taxpayers who sell rental property can avoid capital gains by rolling over the proceeds of a sale into a similar investment vehicle within 180 days, Hryck said.
22. Look for Opportunities for Tax-Free Income
The rich take advantage of opportunities to invest in assets that will generate income that escapes taxes, such as tax-free bonds, Du Val said. Treasury bills, notes and bonds are subject to federal income tax but not state and local income taxes.
23. Give the Right Gifts
Gifting stocks is another savvy capital gains-related move that the rich make, Hryck said. "If you are looking at a high capital gains tax, you can pass those holdings to a family member who is in a lower tax bracket," he said. That person will be responsible for the gain, but it will be taxed at his or her lower tax rate.
The rich also avoid the capital gains tax on stocks or other appreciated assets by donating them to charity, Du Val said. They can deduct the fair market value of the assets at the time they donated them, he said.
24. Take Advantage of Tax Savings Offered by a Roth IRA
Roth IRAs are a great way to save retirement because, unlike 401ks and traditional IRAs, earnings in these accounts can be withdrawn tax-free in retirement. But single taxpayers who have a modified adjusted gross income above $133,000 — and married couples who have a MAGI of more than $196,000 — can't contribute to a Roth IRA.
But wealthy individuals can get around the income limits by converting a traditional IRA to a Roth IRA. You have to pay taxes at your federal income tax rate on any amount rolled over to a Roth IRA that wasn't a non-deductible IRA contribution.
25. Take Advantage of College Savings Benefits
Du Val pointed out that wealthy individuals can't take advantage of some valuable tax credits for qualified education expenses, such as the American Opportunity Tax Credit and the lifetime learning credit, because their income exceeds eligible limits. So they take advantage of 529 college savings plans.
A 529 plan is a tax-advantaged way to save for college. You invest in mutual funds or similar investments and can withdraw earnings tax-free for qualified education expenses. And more than half of states offer tax deductions or credits for 529 plan contributions, according to SavingforCollege.com.
26. Get Tax Credits for New Technology
The wealthy who spend money to buy electric vehicles or to install solar panels take advantage of tax credits to offset the cost of these purchases, Du Val said.
The credit for electric vehicles purchased after 2009 is worth up to $7,500. And taxpayers can claim 30 percent of the cost of Energy Star-approved solar-power systems during the year in which they are installed on their homes.
27. Don’t Ignore the Nanny Tax
Although plenty of households don't bother to pay the nanny tax, smart taxpayers know that they are required to pay employment taxes for people who work in their homes — such as a nanny, senior caregiver or housekeeper. When you pay a household employee $2,000 or more in a calendar year, you are responsible for withholding taxes from the employee and paying taxes of your own, said Kerri Swope, senior director at Care.com HomePay.
You could have to pay back taxes with penalties and interest and possibly face tax evasion charges if you don't pay, according to Care.com HomePay.
28. Take Tax Breaks for Child Care
"A lot of families have this preconceived notion that paying the 'nanny tax' is costly, which isn't necessarily the truth," Swope said. "Many families are able to take advantage of various tax breaks to chip away at a significant portion of their employment taxes."
Whether you have a nanny or send your child to day care, you can set aside up to $5,000 pretax in a flexible spending account to pay for child care expenses. Another option is the child and dependent care tax credit that can save as much as $1,050 for families with one child and $2,100 for families with two or more children.
29. Don’t Inflate Tax Deductions
The wealthy make sure they take advantage of every tax deduction they deserve, but they don't inflate deductions, Brown said. "The rich have a higher rate of being audited, so it is very important that everything is correct," he said.
The IRS is more likely to audit your return if your deductions are high compared to your income. And if you are audited, you'll need to provide records you used to prepare your return and documentation for the deductions you claimed. The length of audits can vary, and if you agree to the findings, you'll have to pay any money you might owe, according to the IRS.
30. Embrace the Benefits of Technology
Wealthy taxpayers take advantage of all the benefits that technology has to offer — from tax guidance online and tools to help calculate tax savings to electronic tax return filing, Steber said. They also scan receipts and important documents so they don't get lost and are easily accessible when it comes time to prepare tax returns.
Smart taxpayers use technology to stay organized and to stay on top of their taxes throughout the year because they "don't want to leave money on the table," Steber said.
Cameron Huddleston contributed to the reporting for this article.