Year End Tax Planning: Critical Steps for High Income Individuals

High income taxpayers face elevated tax complexity due to limitations, phaseouts, and exposure to additional surtaxes. Year end is the final opportunity to proactively manage taxable income. This guide outlines the essential steps that must be completed before December thirty one to secure legal tax reductions and avoid unexpected penalties.

Insight provided by Han S Kim, CPA, EA, MST.

1. Establish Your Tax Baseline and Bracket Exposure

Effective planning requires an accurate projection of your total tax picture. Understanding your marginal tax bracket is fundamental because it dictates the value of every dollar of deduction or deferred income.

• Step 1: Estimate Total Income: Compile a robust projection of all income sources: wages, bonuses, interest, dividends, rental income, capital gains, and passthrough income from business entities.

• Step 2: Apply Deductions: Project your allowable deductions, including standard or itemized deductions, adjustments for retirement contributions, and Health Savings Account (HSA) contributions.

• Step 3: Identify Marginal Tax Rate: Determine the federal marginal tax bracket where the last dollar of your income falls. High income individuals must also confirm exposure to additional layers: Net Investment Income Tax (NIIT) and Additional Medicare Tax. Crossing these thresholds significantly raises the effective tax rate.

2. Maximize Retirement and Health Savings Contributions

Retirement and health savings accounts provide some of the most reliable reductions in Adjusted Gross Income (AGI), which is critical for dodging high-income phaseouts.

• Employee Deferrals (401k/403b): Contributions to these plans must be made via payroll deduction before year end. If you are age fifty or older, confirm that eligible catch up contributions are included.

• IRA Contributions and the Backdoor Roth:

  • Deductibility: The ability to deduct a Traditional IRA contribution phases out based on your income and whether you or your spouse participate in a workplace retirement plan.

  • Backdoor Roth Strategy: For those whose income exceeds the direct Roth contribution limit, the backdoor strategy involves making a nondeductible Traditional IRA contribution and immediately converting it to a Roth.

    • Warning (Pro Rata Rule): This strategy fails if you have existing pretax (deductible) balances in any Traditional, SEP, or SIMPLE IRAs. The Pro Rata Rule treats all your non-Roth IRAs as one pool, making a portion of the conversion taxable. Poor execution here creates an unnecessary tax liability. To avoid this, pre-tax IRA balances must generally be rolled into a current employer's 401(k) plan first.

• Health Savings Accounts (HSAs): If enrolled in a qualifying High Deductible Health Plan (HDHP), maximize your HSA contribution. HSAs offer a triple tax benefit: a current year deduction, tax deferred growth, and tax free withdrawals for qualified medical expenses.

3. Review Capital Gains and Losses Strategically

Capital gains and losses are finalized on the transaction date, making year end the definitive deadline for control. Strategic tax loss harvesting can reduce taxable gains.

• Tax Loss Harvesting: Sell investments trading at a loss to offset realized capital gains. This reduces the current year's tax liability.

• Wash Sale Rule: This is a high-risk area. A loss is disallowed if you buy the same or a substantially identical security within 30 days before or 30 days after the sale date.

  • Consequence: The disallowed loss is added to the basis of the new shares (deferring the loss), but if the replacement is bought in a non-taxable account (like an IRA), the loss is permanently forfeited.

• Realizing Gains: If your income is unusually low this year, consider realizing long term capital gains to utilize lower preferential tax rates, or even the 0% capital gain bracket, before your income rises again next year. This requires precise projection to avoid pushing into a higher ordinary income bracket.

4. Evaluate Itemized Deductions and Charitable Timing

For high income individuals, itemizing deductions requires careful management, particularly with the limitation on State and Local Taxes (SALT).

• State and Local Tax (SALT) Planning: The federal deduction for state and local taxes is capped. If you are already at the maximum cap, accelerating or delaying estimated state tax payments may have no effect on your federal tax liability. Analysis is necessary to confirm if timing payments offers any benefit.

• Charitable Giving:

  • Donor Advised Funds (DAFs): A DAF allows you to claim a large current year deduction upon funding, while retaining the right to distribute the funds to charities over time. This is highly effective when maximizing deductions in an unusually high income year.

  • Non-Cash Contributions: Large gifts of non-cash property (e.g., appreciated stock, real estate) require a qualified appraisal to substantiate the fair market value. Missing or inadequate documentation leads to the disallowance of the deduction.

• Alternative Minimum Tax (AMT) Exposure: High-income triggers like exercising Incentive Stock Options (ISOs), combined with large state tax payments, can trigger the AMT. You must project your liability under both regular tax and AMT to ensure year end actions do not create a larger overall tax burden.

5. Mitigate Surtax Risk and Confirm Estimated Payments

The most common penalty exposure for high income filers is the failure to properly account for and pay the additional investment and self-employment related taxes.

• Net Investment Income Tax (NIIT): This tax has a rate of 3.8% and applies to investment income (e.g., dividends, capital gains) when Modified Adjusted Gross Income (MAGI) exceeds $250,000 (Married Filing Jointly) or $200,000 (Single/Head of Household).

• Additional Medicare Tax: This tax has a rate of 0.9% and applies to wages and self employment income when those earnings exceed $250,000 (Married Filing Jointly) or $200,000 (Single/Head of Household).

• Projections are Mandatory: These taxes apply when your Modified Adjusted Gross Income (MAGI) exceeds the specified thresholds. You must project your MAGI to determine if additional estimated tax payments or increased withholding are required to avoid the federal underpayment penalty.

• Cash Flow Alignment: Tax strategies must align with your liquidity. Avoid over-contributing to accounts or accelerating payments if it creates a cash shortfall for mandatory January estimated payments or other critical expenses.

Year end planning provides the control necessary to manage tax liabilities legally. This level of complexity shows the critical advantage of working with a credentialed expert like Han S Kim, CPA, EA, MST, who ensures accuracy and strategic execution.