Tax tips for employees: find your hidden savings potential

When discussing tax-saving strategies, business owners appear to have the upper hand. W-2 employees gaze with envy upon the vast menu of deductions and credits available to the self-employed.

But envy not! Employees with W-2 wage statements can harness powerful techniques to reduce their taxable income and keep more of their hard-earned money.

Let’s delve into some tax-saving strategies specifically tailored for employees. Keep in mind that this is general information not tailored to your specific situation. Please consult with your financial planner and tax professional before putting any of these into action.

Max out your 401(k)

A 401(K) with an employee match is a cheat-code for the W-2 employee. The IRS allows annual contributions of up to $22,500 (more if you are over age 50), and many employers match a portion of those contributions. We generally recommend that W-2 employees contribute at least up to their employer match, as the match is the closest thing you can get to “free money.”

Traditional 401(k) contributions are tax-deferred, meaning that you defer the taxes on contributions and earnings in the account until you withdraw the funds in retirement. With a Roth 401(k), contributions are made with after-tax money, but growth and income within the account are tax free forever, as are withdrawals in retirement.

Because 401(k)s were set up to incentivize retirement saving, there are strict limits on withdrawing funds from these accounts which should be considered.

Look into the Mega-Backdoor Roth

For high income earners, the Mega-Backdoor Roth presents an excellent opportunity.

Once you have maximized contributions to your pre-tax 401(k), you can contribute up to an additional $43,500 to an after-tax 401(k) and then convert these after-tax dollars to a Roth IRA (if your plan allows it). From then on, all growth and income produced by these assets will be tax free (so long as you follow the withdrawal rules). Roths are also exempt from required minimum distributions in retirement, allowing the money to keep compounding, and not even your heirs will pay tax on qualified withdrawals.

Use IRAs (Roth and Traditional)

In 2023, W-2 earners can contribute up to $6500 ($7500 if age 50+) to IRAs, either Traditional or Roth.

Traditional IRAs reduce taxable income in the year of your contribution and grow tax free. The catch is that distributions are taxed as income when withdrawn, there are strict limits on when you can start making those distributions without penalty, and after a certain age, the IRS forces you to start withdrawing from the account.

Roth IRAs do not reduce taxable income in the year of contribution, but grow tax free and are not subject to required minimum distributions.

Single earners making $73k or less and married earners filing jointly earning less than $116k can contribute up to $6500 per spouse to a traditional IRA and receive a full deduction, with the deduction phasing out for those earning higher incomes.

Single earners making $138k or less and married earners filing jointly earning less than $218k can contribute up to $6500 each to a Roth IRA ($7500 if older than 50), while higher-earning individuals are able to contribute less.

Keep in mind that, if only one spouse in a married couple works, the working spouse can make contributions on behalf of the non-working spouse.

Consider a Roth Conversion

If you make too much money to contribute to a Roth IRA, you can still fund a Roth, just in a roundabout way. The first step would be to make a non-deductible contribution to a traditional IRA, then convert that money to a Roth IRA. In doing this, you still pay taxes on the contribution in the year earned, but once the money is in the Roth IRA, you will pay no taxes on future growth or earnings and not be subject to future required minimum distributions. Never paying taxes on this pool of capital again is a strong argument against simply investing these funds in a standard brokerage account.

Use a 529 for educational expenses

College is expensive, and parents need every advantage as they save for it. 529 plans provide tax-free investment growth and withdrawals for qualified education expenses. The SECURE Act made these accounts even more attractive, as up to $35k per beneficiary can now be rolled over to a Roth IRA once the 529 has existed for 15 years. 529s are restrictive, however, so make sure you understand all the nuances before deciding to save this way.

Consider an HSA or FSA

For those with a High Deductible Health Insurance Plan, Health Savings Accounts, or HSAs can be a great tax savings tool. These accounts can be used to help pay for current medical expenses, as well as a “supplementary” retirement plan, similar to a 401(k) or IRA.

How do they work? You or your employer contribute funds to the HSA (up to $7,750 per family in 2023), which can then be used to cover your out-of-pocket qualified medical costs. Contributions are tax-deductible and the money can be invested within the HSA and grow tax-free. Withdrawals are also tax-free when they are used for qualified medical expenses. All this makes HSAs “triple-tax advantaged.”

To boot, once you reach age 65, money held in the HSA can be used for any reason, but you will pay ordinary income tax on the withdrawals not used for qualified medical expenses.

For those with a high deductible insurance plan, a Flexible Spending Account (FSA) is another way to pay for medical expenses while reducing taxable income. The rules on FSAs are more stringent than HSAs, and planning around health care costs is important, as funds must typically be used within the plan year or are lost, unlike in an HSA.

Charitably inclined? Consider bunching deductions

If you donate to charity, consider bunching your donations over time.

Let's say you plan on donating $25k to charity each year. Assuming no other deductions, this would keep you under the standard deduction threshold of $27,700 for married couples in 2023, effectively nullifying any tax benefit you’d get from the donation.

Alternatively, you could donate $50k every other year. Assuming a 37% marginal tax bracket (not even factoring in state taxes here), this simple move would result in $8,251 in tax savings every other year versus no tax savings at all when donating $25k each year. Alternatively, you could look at setting up a donor-advised fund for more advanced tax planning.

Manage equity compensation

Restricted Stock Options (RSUs), Non-Qualified Stock Options (NSOs), Incentive Stock Options (ISOs), Employee Stock Purchase Plans (ESPPs) – equity compensation can be a dizzying subject, and how and when you exercise your options can have a huge impact on your tax situation. It pays to optimize it!

Large capital gain? Consider an Opportunity Zone Strategy

For those with large capital gains, investing in a Qualified Opportunity Zone (QOZ) can be a great option. The timelines are tight (individuals have 180 days from the recognition of the capital gain to reinvest in a QOZ, though if the gain comes via a pass-through entity the timeline extends), and the hold period is long (10+ years), but the tax benefits can be phenomenal.

The first benefit – tax is deferred on any gains invested in a QOZ until 2026.

The second benefit – the new investment gets a cost basis step-up in 10 years.

Again, the rules must be followed stringently and failing to do so can cause financial havoc, so consider investing alongside an institutional manager who can help you through it.

And never let the tax tail wag the investment dog! An investment that goes to zero, even with great tax benefits, is still a bad investment, so make sure you scrutinize a QOZ investment just like you would a non-tax advantaged investment.

Consider real estate

With 1031 exchange possibilities, cost segregation, and accelerated depreciation, real estate can be a tremendously tax-favored asset class. Even better – as a W-2 earner, its often easier to get approved for a loan than a self-employed business owner! If your spouse can claim Real Estate Professional Status or you can take advantage of the short-term rental loophole, you can potentially use paper (or actual) losses to offset your W-2 income. This is a complex topic rife with pitfalls, so be careful here.

For those considering 1031 exchanges, keep in mind that there are many institutionally managed 1031 exchange options available on the market, so it’s not necessary to manage investment real estate directly to execute an exchange.

Wrapping up

As a W-2 wage earner, you may not have the same breadth of tax-saving opportunities as business owners, but that doesn't mean you're without options. Stay informed about changing tax laws and seek advice from a qualified financial planner or tax professional to make the most of your tax-saving endeavors. With careful planning and strategic decisions, you can keep more of your hard-earned money!

Brent Hause is a Portfolio Manager, Financial Advisor and Partner at Fortuna Investors, an independent Registered Investment Advisor with an office in South Lake Tahoe. More information is available at http://www.fortunainvestors.com, or by calling (530) 600-2040. No part of this article should be construed as a recommendation to buy or sell securities, or as personal financial or tax advice. Please consult your financial planner and/or tax professional before implementing any financial or tax strategy.