Financial Planning for Executives: Advanced Income Tax Strategies for Highly Compensated Workers
As an executive, a key element to your financial planning is income tax planning. The end goal is for you to keep as much of your hard-earned money as possible, which can be challenging when you fall into a tax bracket that reflects your high compensation. Many of the tax strategies that are commonly found online work well for people with moderate incomes, but you may find that it’s time to amp up your game.
Strategies That Take Place Through Your Employer
There are two different categories of tax planning you can pursue – strategies that fall within your employer and strategies that fall outside. Most of your employer-focused tax strategies will be centered on your benefits and compensation.
Defined Contribution Plans
If your employer offers a defined contribution plan – either a 401(k), 403(b), or 457 plans – your contributions to that plan lower your taxable income. If you’re able, it’s wise to max out your contributions. If you are under 50, then your limit in 2018 is $18,500. If you’re over 50, then you get to contribute an additional $6,000 each year up to a limit of $24,500. Keep in mind that some employers only match your contributions if you continue contributing throughout the full year – so don’t max out your contributions too early, or you’ll leave money on the table. If there's any doubt, contact your HR / payroll / benefits department and they can tell you how the match is administered.
Nonqualified Deferred Compensation
If your employer offers a NQDC plan, it might be wise to take advantage. Deferring a portion of your income now for a set period reduces your current taxable income. At a specified time in the future, you’ll then receive this deferred amount as income. Most of the time, this can be deferred until retirement when you’re not receiving any income, so it will then be taxed at a lower tax bracket. This should be coordinated with other plans that will pay out income at retirement so you can manage the tax brackets in which you find yourself.
One client I worked with had the unfortunate case of electing all of his payouts before I started working with him. It resulted in him receiving all of his deferred compensation and stock plan payouts in the year after he retired. This collective income was higher than any income he had received over his entire career. Planning these income elections carefully cannot be overstated. Every plan is different, so check your options within your own specific plan.
Strategies That Take Place Outside Your Employer
If you feel limited when it comes to the tax strategies you can take advantage of at work, you can look outside of your employee benefits to mitigate the impact of taxes on your income.
Donor-Advised Charitable Contributions
Donor-advised funds (DAF) are investment accounts that are specifically for charitable donations. They are helpful in two ways:
- If you have a year(s) of high income and want to reduce your income through charitable giving, then you can make lump contributions to this account.
- A DAF allows you to donate to charity but with some great benefits. You can split the contribution between multiple charities with the DAF administrator doing all the work of sending funds. If you make a contribution in 2018, it doesn't have to be distributed to a charity that year - there is no timeline. You can get a charitable deduction in the current year, but invest the contribution and distribute it at a much later date.
A client of mine has been using this strategy effectively for the last 10 years. Due to a fortunate series of events, they came into a sum of money. They made a one-time donation of $500,000 to a DAF, received a sizable charitable deduction that was able to be carried over to future years and have invested the money inside the DAF. They have been giving to various charities throughout this time, but have also seen the account grow to over $800,000. Everyone wins!
An additional feature that makes a DAF attractive is that it doesn't have to be extra income that can be donated - appreciated securities can as well. Without having to sell these securities and realize the tax implications, these securities can be transferred to the DAF generating a charitable deduction, and then sold inside the DAF incurring no gains, and then distributed to the charities.
Managing Inherited Real Estate
Boomers could potentially inherit up to $27 trillion over the next several decades – and some of this could come in the form of real estate. Beneficiaries who inherit real estate are taxed on a stepped-up basis, meaning their tax basis in the property is the fair market value on the date of the deceased owner's death. This helps them to avoid capital gains tax on a property they didn’t own as it was appreciating.
Inherited real estate is a strange commodity. For many, it doesn't fit into their long-term goals so it's easier to sell it quickly, minimize the tax impact, and use the cash to further personal goals.
For others, they may change their financial goals upon receiving this real estate. They may start a rental business to generate more income, but find themselves paying taxes on that income at a high rate given where their current income already finds them. A way around this is to put the real estate into it's own company, and set up a retirement plan for that company. As an employee, you can max out a 401(k), and as a new business owner, you can max out a self-employed retirement plan. This will allow you to double up on your retirement contributions due to incorporating the rental income you receive.
There are many avenues to go down with real estate, and maximizing it's use for tax purposes, so make sure to consult with your financial advisor and accountant before moving forward with any of them.
Tax-Deferred Variable Annuity / Tax Location
At times, it makes sense for you to invest in a tax-deferred variable annuity to – you guessed it – defer your tax liability. One example I often use is the case of Mr. Smith (name has been changed). Mr. Smith had over $20,000,000 in investments. His portfolio was diversified, and had a notable bond that generated taxable income each year. His W2 income already had placed him in the highest tax bracket available – and this bond was being taxed at around 40%. Ouch!
By putting a large amount of his bond into an annuity, we were able to defer taxes on the income. He didn’t need to spend that money later on, and was concerned about how the taxes on it were going to impact his ability to leave money to his heirs. Investing in the tax-deferred variable annuity helped him to hold on to a larger portion of those funds while still finding a way to invest it wisely.
But not everyone has $20,000,000. But this strategy can also be used by those who have a pension, stock plans, deferred contribution savings plans, and taxable accounts. It's a process called "tax location" and is an important investing strategy in managing the taxes generated by investments. Every circumstance is unique, but I do use this strategy with many of my clients.
Don’t Go It Alone
With most things regarding financial planning, my advice is to speak with a financial professional before making any decisions. However, in this case it’s especially important that you speak with both your financial planner and tax professional to ensure you’re maximizing your tax strategy. There are many options available to you that can help to reduce your total taxable income, or minimize the impact that taxes have on future investment gains.