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January 12, 2012

Tax Planning for Life Events - High Income


Smart tax ideas are up for grabs - can you find the money?


During tax season we reckon with multiple facets of the massive, quirky, and complex US tax code. While most tax activity involves cash flowing passively from us to the government, some of it requires action on our part to reverse the flow back to us. For perspective on these tax management activities, let’s think of the US tax code as a board game.

That’s right, Hasmo presents America’s family night sensation, “Find the Money.” What a thrill as you roll the dice and advance your game token around the IRS labyrinth! Take the trail to a charitable contributions deduction and collect $350! Climb the hill to the energy-saving home improvements credit and get $500! Miss the ramp to foreign taxes paid, and – no dough for you, Charlie!

The truth is there are smart ideas you can employ to find more money. Otherwise, the IRS keeps it. It’s their game.

Life events, their taxes (and strategies to deal with them)

While the tax management strategies that work for you will reflect your specific financial life, here are some general life-tax events to consider. Perhaps these will stir your spirits to “Find the Money” on your game board.

● High Income.  Professional success leads to the reward of high income – but also higher income taxes.

● Highly Appreciated Assets.  If you sell an appreciated asset like stock, art or real estate (remember when we could do that?), you’ll face capital gains taxes.

● Inheritance.  If you inherit a brokerage account or real estate, you’ll reckon with capital gains. If you’re the beneficiary of an IRA, you’ll have income taxes.

● Retirement.  In retirement you’ll need sustainable income that may come from a variety of sources like Social Security, retirement accounts, brokerage assets, or a company pension. These generate income and capital gains taxes.

● Death.  Since death and taxes are still a certainty, they come together with the estate tax – in 2012, for personal estates worth over $5.12 million.


High Income


If you’ve achieved the goal of professional success and the income that comes with it, you face a problem you might have relished when you were on the way up and eating ramen noodles – higher income taxes. Such high income can exceed the level of current living expenses, so it’s smart to look for ways to channel extra cash away from current income taxes. You’ll pay taxes on the money and its growth eventually, but hopefully at a lower rate.

To postpone some of your income, look to one of several deferred compensation plans. The traditional non-qualified deferred comp plan for executives allows your employer to sock away a portion of your income, invest it on your behalf, and pay it to you in the future. A deferred comp plan eases your present income tax burden and entices you to remain with your firm for the payout.

Perhaps the most common way to defer compensation is to make pre-tax contributions to a qualified retirement plan, such as adding part of each paycheck to your company 401(k). For 2012, you may contribute up to $17,000 plus a $5,500 catch-up amount if you’re 50 or older.

If you’re part of the senior management team at your company, your 401(k) options improve. Your company may use safe harbor provisions combined with tiered profit-sharing contributions to maximize the benefits to key employees. For safe harbor provisions, the company makes special contributions to non-key employee accounts that are immediately vested to satisfy top-heavy discrimination tests. The tiered profit-sharing feature allows up to 90% of the employer contribution to be allocated to key employees. These strategies also allow key employees to maximize their own income deferrals.

If you’re self-employed and are the only employee of your company (like a consultant, real estate professional, or doctor), you have the most attractive options. You might consider a SEP-IRA for its simplicity and contribution level (the greater of 25% of comp or $50k). To stash away the most income for retirement though, a defined benefit plan lets you as employer contribute up to $200k of business income on your own behalf. You may also combine a defined benefit plan with a 401(k) for up to $200k of employer contributions and employee deferrals.

If you work for a company who provides them, another smart way to take some of your income at a lower tax rate is with incentive stock options, a favorite of many company executives. In this way, you may use half of your income to purchase company stock to be sold later at lower capital gains tax rates. The stock needs to grow in value for ISOs to work properly; but the results can be rewarding.

These are some of the ways to play the tax game and keep more of your money if you’re blessed with the problem of having a high income. For help with other taxable life events like retirement, selling assets, and death taxes, please visit our blog in the coming weeks.

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