High W2 Income Tax Planning. Earning a high W2 income is both a blessing in the economic sense and a curse when talking taxes. 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 living in the 28-35% tax brackets. Unlike many of these “rich people” your W2 reports all your income and there is little flexibility. With that said, let’s start with the positive ways to conduct high W2 income tax planning for next year and then discuss the new taxes.
High W2 Income Tax Planning – Five Tax Saving Strategies
1. Max out your 401(K) or 403(b) Plan
The maximum amount you can put in an 401(k) 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
Cafeteria plans can include flexible health accounts and child care expenses. 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) 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 by paying 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
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. However it can also be used for long-term family wealth planning. Unlike the FSA, this plan is not “use it or lose it” and can be invested much like a 401(k). The tax deductible portion is $2,500 for family or $1,250 for individual coverage. 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 your current 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 help high W2 income tax planning, these investments need to be deductible. In other words, the position must be sold so a realized loss is created.
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. If the loss is over $3,000 then the excess loss can be carried forward into future tax years.
5. Give more to Charity
In order for charity giving to have an effect on high W2 income tax planning, the tax payer must be eligible to take itemized deductions.
Example: If you are in the 33% tax bracket, every dollar you give to charity will reduce your taxable income by 33 cents. So if you give $10,000 to charity then your taxable income will decrease by $3,300.
There are also other high W2 income tax planning 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 may not necessarily make economic sense. 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.