This is the first year I used a CPA to file my taxes. It is one of the many things I decided to outsource to allow extra time for me to focus on growing The Physician Philosopher and Money Meets Medicine podcast. When my CPA came back with the taxes owed, I figured we would owe between $5,000 and $10,000. So, when I saw that the tax bill was essentially $20,000, I set out to figure where I had missed on estimating my tax bill – and what tax deductions for high earners I could take advantage of in 2020.
After discussing some of the math and basic principles behind taxes, I’ll lay out 6 ways that you can save money on your taxes. If you stick around til the end, you’ll even learn about a pretty smart hack for paying Uncle Sam.
Looking at the Math
Our tax liability came in right around $100,000 for the year. We already paid just north of $80,000 in taxes throughout the year. Yet, when I looked at our taxable income it was around $20,000 higher than what I anticipated.
After looking through my taxes and doing the math, I sent my CPA an email with the tax deductions I expected to get. This included our itemized deductions – which we will discuss more below – and $68,000 in pre-tax contributions towards retirement.
As it turns out, where the math went wrong during the year is that my wife’s W2 was coded for giving Roth contributions towards her retirement accounts. Thinking I had surely changed this for 2019, I went over to Prudential, which services Kristen’s governmental 457 and 401K. Sure enough. We made a mistake. We put the money into the wrong box and most of it was being contributed via a Roth mechanism.
There goes $20,000 in pre-tax savings and explains the difference in our taxable income. It cost us $8,000 in taxes this year. This accidental miscue is what led to this post.
Before we get to the tax deductions for high earners, we should be a little more specific on which sort of tax we are talking about here.
Marginal versus Effective Tax Rate
While your effective tax rate is pretty simple math (Total Tax Paid / Taxable Income), your marginal tax rate is how much the last dollar you made gets taxed.
To figure this out you can use tax software, or simply ask your accountant to increase your income by $100 and see how much more tax you would have paid. If they say $30 – then your marginal tax rate is 30%.
Once you know this number, any charitable giving you provide will save you that percentage on your taxes. So, if you give $10,000 in our hypothetical example, you would save $3,000 in taxes. Not only does giving money to others in need feel good, but it’s also a great tax break for high income earners.
Our marginal tax rate for 2019 was 35% just from the federal side. If we add in the NC state tax (5.25%) and some self-employment taxes, our marginal rate easily sails over 40%. So, for every dollar that we place into the tax-advantaged space, we saved 40 cents on the dollar. In other words, for every $10,000 tax deduction we can find, that will save us $4,000 in taxes paid.
This is a huge tax savings that is also allowing us to accomplish our financial goals.
In addition to this, if you are in an Income-Driven Repayment program for your student loans, the contributions above will decrease your monthly payment as well, which is dependent on your Adjusted Gross Income.
Alright, now that you’ve got the basics. Here are the 5 tax deductions for high earners plus a 6th tax hack at the end of the post.
1. Retirement Contributions
One of the best ways that you can lower your taxable income is through pre-tax retirement contributions. For example, in 2020, we plan to deduct all of the following from our taxable income:
- My 403B ($19,500)
- My non-governmental 457 ($12,000)
- Our Health Savings Account ($7,000)
- Kristen’s governmental 457 ($19,500)
- Kristen’s 401K ($19,500)
- School pension ($3,000)
In total this is going to decrease $80,500 from our taxable income. Doing the math on our marginal tax rate, this saved us $32,000 in taxes paid in 2019 alone.
While we will also contribute $12,000 into a backdoor Roth IRA and an additional $6,000 into a taxable account – this money is not-tax deductible.
2. Charitable Giving
Of all the itemized tax deductions for high earners, charitable giving is the one you have the most control over. It’s not like the pre-determined interest rate on your home or the capped SALT deductions mentioned below. You can determine for yourself how much you plan to give.
This was another missed opportunity when looking back on last year’s taxes for 2019. My family aims to give at least 10% of our taxable income each year to charity. We undershot this goal by a little bit this year. How much you should give is a highly personal question, but I suggest you set a goal each year and then try to achieve it.
With each dollar that you put towards charity, you will shave money that gets taxed on the back-end. For many high-income earners, this ends up being substantial given the progress tax-bracket system we have in place.
3. Mortgage Interest
Your mortgage interest is also deductible up to $1,000,000 if married filing jointly ($500,000 if married filing separately). For my family, this was significant in 2019. Our interest rate was 4.75%, which amounted to ~$22,000 in tax deduction this year.
As a reminder, the standard deduction for married couples filing jointly is $24,000. The mortgage interest we paid this year was essentially as much as the standard deduction before any of our other deductions were even considered.
Note: With the recent 30 year low in interest rates being hit, we refinanced our house to a 3% rate on a 15-1 ARM (Adjustable Rate Mortgage). We plan to pay the house off in the next 5 to 10 years. Going forward, our mortgage interest deduction will be less and less each year.
4. SALT Deduction
This one is essentially automatic for any physician. The State and Local Tax (SALT) deduction caps at $10,000. Given that the state tax rate where we live in North Carolina is 5.25%, we hit this number pretty easily.
However, it is one more deduction that still encourages my family to itemize instead of taking the standard deduction. With our mortgage interest and SALT deduction we are well above the standard $24,000 deduction.
5. Child Tax Credit
If you earn less than $400,000 you get a child tax credit (i.e. dollar for dollar deduction on your taxes) for each child you have. The number is $2,000 per kid. For my family, that is a potential $6,000 in direct tax savings for each child if we can get our taxable income below $400,000.
In some ways, this becomes a bit of a game as our taxable income is usually right around that number. So, if I can do my math better in 2020, I can not only save on taxes through my charitable giving, but can also increase my child tax credit until I drive our taxable income down below $400,000.
6. Alternating Years
The last tax trick you might consider applying as a high-income earner is alternating the years in which you take the standard deduction and years in which you itemize.
For example, let’s say that you have paid off your mortgage. You give $25,000 to charity annually and have the $10,000 in SALT deductions. Instead of deducting $35,000 itemized each year, you could double up on your charitable giving every other year.
Doing this, you would give zero dollars to charity in one year, and then give double ($50,000) in the other years.
Alternating Standard and Itemized Deductions Case Study
If you were to itemize each year using the $10,000 SALT and $25,000 charitable giving, it would look like the following:
- First Year: Itemized Deduction of $35,000
- Second Year: Itemized Deduction of $35,000
- Third Year: Itemized Deduction of $35,000
- Fourth Year: Itemized Deduction of $35,000
Your total deduction over this time period would be $140,000.
What would it look like if we alternated each year instead by doubling up on charitble giving every other year and taking the standard deduction in the others?
It would look like the following:
- First Year: Standard deduction of $24,000
- Second Year: Itemized deduction of $60,000 ($50,000 charitable giving + $10,000 SALT)
- Third Year: Standard deduction of $24,000
- Fourth Year: Itemized Deduction of $60,000
Total tax deductions: $168,000
Using this technique, you would give the same amount to charitble causes ($25,000 per year on average). Despite the same charitable giving effort, you would save an additional $28,000 in taxable income over the same time period, becuase you are maximizing the deduction provided by the government in years 1 and 3.
If you are in my shoes with a 40% marginal tax rate, that would be $11,200 back in your pocket over those 4 years. That’s $2,800 per year. Not too bad.
You don’t have to understand everything about taxes, but you do have to understand enough to make smart personal finance decisions. We made a mistake with Kristen’s Roth contributions last year. This year we have fixed the problem.
As our mortgage interest continues to decline, we will start employing all 6 tactics mentioned above. For now, we do our best to optimize our charitable giving, SALT, and mortgage interest.
What ways do you use to minimize your tax burden? Are you using all of the tax advantages available to you? Leave a comment below.
Congrats if you are each getting away with deferring both your 457, your 403b, AND your 401ks cumulatively. In reality (legally), you are only allowed to deduct a *TOTAL* of $19,500 of pre-tax dollars each, across all of those accounts. The total retirement contributions (pre/post/company match) across all retirement accounts in 2020 is $57,000 per individual. Only $19,500 of that can be Tax Deferred.
Incorrect. Don’t take it from me. Take it from the IRS. I can contribute $19500 to my 403B and $19500 to a 457b.
My wife can contribute to her 401K and 457. That is okay as well.
What you cannot do is contribute the max to both a 401k and a 403B (or a simple IRA).
If your county bumpkin accountant let you each defer more than 19,500 (total) in retirement contributions, you should look for another accountant. If you’ve been doing this for several years, as a result for preparing your own taxes, you should rectify the errors, and file adjustments for each year, as this can set you up for a MAJOR MAJOR headache (with penalties) when you are in your 60s.
Incorrect. Don’t take it from me. Take it from the IRS. you can contribute $19500 to a 403B and $19500 to a 457b.
What you cannot do is contribute the max to both a 401k and a 403B (or a simple IRA).