Taxes. It's perhaps the most dreaded five-letter word in the English language next to "audit," and the scourge of all working Americans.
Between 1955 and 2015, the U.S. tax code grew from just two documents totaling 1.4 million words into an impressive manifesto spanning over 10 million words. As the Tax Foundation pointed out last year, this 10 million-word figure doesn't even include the legal tax cases that allow Americans to make sense of the U.S. tax code.
Despite its complexity, tax time can also bring joy to many Americans. About 80% of all federal taxpayers receives refunds in a given year. This refund can help fund emergency accounts, kick-start a retirement fund, or be used to pay down debt.
But high-income earners, specifically millionaires, aren't typically so lucky. Millionaires almost always owe tax to the federal government, assuming their earned income stays consistent or grows from one year to the next. Millionaires can't do a whole lot to impact their earned income with regard to their federal taxes, but there are still a number of tax planning strategies that can be employed to improve their financial outlook each year.
Here are seven tax planning tips millionaires should take into consideration.
1. Think long-term
One of the smartest tax moves millionaires can make is to think long-term to minimize what they'll owe come tax time.
For example, most interest and short-term stock gains are taxed at the ordinary income tax rate. Individuals earning in excess of $415,050, and couples with more than $466,950 in adjusted gross income are lumped into the highest ordinary income tax bracket, 39.6%. Thus, interest earned on a bank CD or the capital gain on a stock held for 365 days or less could be taxed quite heavily. Furthermore, individuals and couples earning more than $200,000 and $250,000, respectively, could be subject to the 3.8% net investment income tax (NIIT) and 0.9% Medicare surtax.
On the other hand, long-term capital gains taxes for the highest-income earners are just 20%, plus the aforementioned NIIT. Paying 20% on capital gains for investments held for 366 days or longer is a lot more favorable than 39.6%. Reasonably low long-term capital gains have allowed millionaires the ability to retain a sizable chunk of their wealth.
2. Contribute to tax-advantaged retirement vehicles
Secondly, millionaires should strongly consider maximizing their contributions to tax-advantaged retirement tools like employer-sponsored 401(k)s or Traditional IRAs.
Chances are that millionaires are going to be saving and investing regardless of whether they're using tax-advantaged retirement tools or not. However, utilizing a 401(k) and/or Traditional IRA can provide upfront tax benefits. According to the Tax Policy Center, the top 20% of income earners receive about 80% of the tax write-offs for retirement saving compared to just 7% for the bottom 60% of income earners.
Contributions to a 401(k) and Traditional IRA are made with before-tax dollars, meaning that you'll owe ordinary income tax when you begin making withdrawals during retirement (i.e., between age 59-1/2 and 70-1/2). However, contributions also reduce your tax liability since it's money that's taken out before taxes. Maxing out a 401(k) with an $18,000 contribution limit for those aged 49 and under, or $24,000 for those aged 50 and up, and/or a Traditional IRA with limits of $5,500 or $6,500 based on those same age ranges, could certainly lower your current-year liability. As an added bonus, as noted above, investment gains can grow on a tax-deferred basis for years, if not decades.
3. Use investment losses to your advantage
Another smart option for millionaires to consider is harvesting investment losses.
At some point, all investors will make bad trades and lose money. But for millionaires this bad choice can be quite helpful. Selling investments at a loss may not be what you had in mind when you originally purchased an asset, but tax-loss selling can help reduce your current-year capital gains tax liability, or possibly provide a carryover to future years if the loss is large enough. Selling a loser could be what pushes a high-income earner into a lower tax bracket, or for a millionaire it could help lower what you'll owe in federal taxes for the current or upcoming year.
4. Consider municipal bonds
The vast majority of interest income is taxed at the ordinary income tax rate, which isn't good news for millionaires looking for steady interest-based income. However, a solution exists: municipal bonds.
Municipal bonds are debt securities issued by a state, county, or city that are often used to fund large projects, such as building a new bridge or highway restoration. The beauty of municipal bonds is that they're exempt from federal taxation -- and, if you purchase a municipal bond from the same state you live in, there's a really good chance it'll be exempt from state taxation, too.
Municipal bonds are obviously subject to the risk of a city or state declaring bankruptcy, but history has shown this to be a rarity, making muni bonds a keen investment opportunity for risk-averse millionaires.
5. Give to charity
Millionaires also have access to considerably larger deductions than the lower- and middle-income classes when it comes to charitable contributions. The charitable tax deduction is based on an individual's or couple's peak ordinary income tax bracket. Thus, millionaires effectively receive a deduction of $0.396 for every $1 they donate to charity since the peak marginal tax rate is 39.6%. Comparatively, low- and middle-income Americans are liable to receive just $0.10, $0.15, or $0.25 on every $1 they donate.
One thing to keep in mind is that you'll want to ensure that your donation is both documented and headed to an eligible charity. If the charity isn't a federally recognized nonprofit organization, or you have no documentation to back up your donation, it won't help reduce your tax liability.
6. Buy health insurance
Health insurance may not be something that immediately springs to mind when you're thinking about tax planning, but being covered has two big benefits for millionaires.
To begin with, having health insurance is mandated in the United States via the Affordable Care Act's individual mandate. If you don't buy health insurance, you could face a penalty known as the Shared Responsibility Payment, or SRP. In 2016, the SRP is the greater of $695 or 2.5% of modified adjusted gross income (capped at the annual cost of a bronze plan in your state). In other words, having no health insurance will probably result in an SRP of $2,500 or higher for top-income earners.
Secondly, medical bills are the leading cause of bankruptcy in the United States. Having health insurance could provide the financial protection you need in case an unexpected and costly illness or accident arises.
7. Where you live matters
Finally, millionaires should take into consideration that where they decide to live could greatly impact their finances.
For instance, seven states have no state income tax. These include: Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. Living in these could save millionaires a low-single digit percentage of their income that, over time, could be substantial.
Other factors millionaires should consider include local sales tax rates, property tax rates, whether or not an estate tax exists, and how each state handles the taxation of retirement income and Social Security benefits. These factors differ on a state-by-state basis, and taking the time to understand how one state differs from another should remove any state-based tax surprises.