How Do High Income Earners Reduce Taxes?

As an individual’s income grows, the strategies for managing tax obligations become more intricate. Navigating the tax code requires a proactive and informed approach to legally minimize the amount of income tax owed. Successfully implementing these methods depends on careful, long-term planning, as many involve specific rules and timelines that must be followed precisely. The guidance of a qualified tax professional is often part of developing and executing a sound tax plan.

Maximizing Tax-Advantaged Retirement Accounts

A primary strategy for reducing taxable income is to maximize contributions to tax-advantaged retirement accounts. These accounts allow investments to grow either tax-deferred or tax-free, meaning the funds are not subject to annual income or capital gains taxes as they appreciate. For many of these accounts, the immediate effect is a reduction in the current year’s adjusted gross income (AGI).

The most accessible option is an employer-sponsored plan, such as a 401(k) or 403(b). High-income earners should aim to contribute the maximum amount allowed by the IRS each year. For 2025, this limit is $23,500 for individuals under age 50. Those aged 50 and over can make additional “catch-up” contributions of $7,500, while a special provision allows those aged 60 through 63 to make a larger catch-up contribution of $11,250.

Some 401(k) plans permit after-tax contributions beyond the standard pre-tax limit, up to a total combined limit of $70,000 in 2025. This enables a “Mega Backdoor Roth” conversion, where after-tax contributions are moved into a Roth 401(k) or Roth IRA. This allows future investment growth and qualified withdrawals to be completely tax-free, but the employer’s plan must specifically allow for both after-tax contributions and in-plan conversions.

Direct contributions to a Roth IRA are restricted for high-income earners, with eligibility phasing out for single filers with a modified adjusted gross income (MAGI) between $150,000 and $165,000 in 2025. To bypass these limits, many use the “Backdoor Roth IRA” strategy. This involves making a non-deductible contribution to a Traditional IRA, which has no income limitations, and then promptly converting those funds to a Roth IRA. This process must be handled carefully to avoid complications under the “pro-rata rule” if other pre-tax IRA assets exist.

For self-employed individuals, a Simplified Employee Pension (SEP) IRA allows a business owner to contribute up to 25% of their compensation, not to exceed $70,000 for 2025. A Solo 401(k) is another option for business owners with no employees other than a spouse. This plan allows the owner to contribute as both the “employee” and the “employer,” potentially reaching the same overall limit as a SEP IRA.

Strategic Investment and Portfolio Management

Managing a taxable investment portfolio with tax efficiency can yield substantial savings by minimizing the drag from capital gains and investment income. These strategies apply to assets held in standard brokerage accounts where gains and income are taxed annually.

Tax-loss harvesting involves selling investments that have decreased in value to realize a capital loss. These losses can offset capital gains from profitable investments, reducing the total tax owed. If capital losses exceed gains, up to $3,000 of the excess can offset ordinary income, with any remaining losses carried forward to future years. When using this strategy, investors must avoid the “wash-sale rule,” which disallows a loss if the same or a “substantially identical” security is purchased within 30 days before or after the sale.

Asset location involves placing different types of assets in the most appropriate accounts. The principle is to hold tax-inefficient assets, like corporate bonds that generate regular taxable income, inside tax-advantaged retirement accounts. Conversely, tax-efficient assets, such as growth stocks held for the long term, are better suited for taxable brokerage accounts. This placement shields the highly taxed income from annual taxation.

The tax code incentivizes holding assets for more than one year. Short-term capital gains from assets held one year or less are taxed at ordinary income rates. In contrast, long-term capital gains are taxed at preferential rates of 0%, 15%, or 20%, depending on taxable income. For most high-income earners, the rate is 15% or 20%, a significant savings compared to their marginal income tax rate.

Investing in Qualified Small Business Stock (QSBS) allows for a potential 100% exclusion from federal capital gains tax on the sale of stock in a qualifying C corporation. To be eligible, the stock must have been acquired at its original issuance and held for more than five years. The business must also have had gross assets of $50 million or less when the stock was issued.

Leveraging Business Ownership and Real Estate

Individuals who own a business or invest in real estate have access to specific tax strategies that can lower their overall tax burden. These opportunities are built into the tax code to encourage entrepreneurship and property investment.

The Qualified Business Income (QBI) deduction allows owners of pass-through entities, such as sole proprietorships and S corporations, to deduct up to 20% of their qualified business income. For 2025, this deduction is available in full to taxpayers whose taxable income is below $197,300 for single filers or $394,600 for joint filers. For those with income above these thresholds, the deduction may be limited based on the amount of W-2 wages paid by the business and the basis of its property.

Real estate investors can utilize depreciation, a non-cash deduction that allows them to write off the cost of a property over time. While a residential rental property structure is depreciated over 27.5 years, a cost segregation study can accelerate these deductions. This study identifies property components like fixtures and landscaping that can be depreciated over shorter periods of 5, 7, or 15 years.

These shorter-lived assets are also eligible for bonus depreciation, which for 2025 is set at a 40% rate. By segregating costs and applying bonus depreciation, an investor can take a much larger deduction in the first year of owning a property. This significantly reduces taxable income and improves cash flow.

A Section 1031 exchange allows an investor to sell an investment property and defer paying capital gains tax on the profit, provided the proceeds are used to purchase a “like-kind” property. The rules are time-sensitive, as the investor must identify potential replacement properties within 45 days of the sale. The investor then has a total of 180 days from the initial sale date to close on the purchase of a new property.

Advanced Charitable Giving Techniques

For philanthropically inclined individuals, several strategies can make charitable contributions more tax-efficient, providing a larger donation to the charity and a more significant tax advantage for the donor.

Donating appreciated securities, such as stocks held for more than one year, provides a dual tax benefit. The donor can typically take a charitable deduction for the full fair market value of the asset at the time of the donation. They also avoid paying the long-term capital gains tax that would have been due if they had sold the asset and then donated the cash.

Donor-Advised Funds (DAFs) are charitable giving accounts where an individual can make an irrevocable contribution of cash or other assets and receive an immediate tax deduction. The assets in the fund can then be invested and grow tax-free. The donor can then recommend grants from the fund to qualified charities over time.

A Qualified Charitable Distribution (QCD) is a tool for individuals age 70½ or older. This rule allows a person to donate up to $108,000 in 2025 directly from a Traditional IRA to a qualified charity. The amount of the QCD is not included in the taxpayer’s gross income for the year, which can lower their AGI. A QCD can also be used to satisfy the taxpayer’s Required Minimum Distribution (RMD), which begins at age 73.

Utilizing Other Tax-Favored Accounts and Deductions

Several other accounts and techniques can provide tax advantages while addressing specific financial goals like saving for healthcare or education.

A Health Savings Account (HSA) offers a triple tax advantage for those enrolled in a high-deductible health plan (HDHP). Contributions are tax-deductible, the funds grow tax-free, and withdrawals are tax-free when used for qualified medical expenses. For 2025, contribution limits are $4,300 for an individual and $8,550 for a family, with a $1,000 catch-up for those age 55 and older. An HSA can also function as a supplemental retirement vehicle if funds are left to grow.

For education savings, 529 plans allow money to grow tax-deferred, and withdrawals are federally tax-free when used for qualified education expenses. These expenses include college costs and up to $10,000 per year for K-12 tuition. Many states also offer a state income tax deduction or credit for contributions.

A practical timing strategy is “bunching” deductions, which became more common after the standard deduction was increased and a $10,000 cap was placed on the state and local tax (SALT) deduction. Bunching involves consolidating multiple years of itemizable expenses, like charitable gifts, into a single tax year. This pushes itemized deductions for that year above the standard deduction, allowing for a larger overall deduction. In the following year or two, the taxpayer would claim the standard deduction, maximizing their tax savings over the multi-year period.