Ask any wealthy person what it takes to build a fortune, and you’re bound to hear a similar refrain: It’s not about how much you make. It’s about how much you keep.
As you get older and start earning more, it becomes increasingly vital to protect your wealth from the tax collector. This post explores what you can do to lower your tax bill and keep more of your hard-earned income.
How to reduce your taxable income
- Earn less money
- Use a financial planning tool
- Maximize your retirement accounts
- Check for local tax credits
- Consider working as an independent contractor
- Donate to charity
- Sell bad stocks
- Move to a tax-friendly state
- Sell your car
- Purchase real estate
- Invest in municipal bonds
1. Earn less money
The more money you make, the more you’ll have to pay in taxes. That’s just the way it goes. Top earners know this all too well.
That said, if you have any control over your income, you may be able to limit what you bring in strategically to stay within lower tax brackets.
For example, if your adjusted gross income (AGI) is somewhere between $40,126 and $85,525, you’ll pay a tax rate of 22%. If you exceed that threshold, you’ll move up to the 24% bracket.
So, as you get to the end of the tax year, you may want to consider scaling back if you’re in that ballpark if it makes sense.
2. Use a financial planning tool
Use a tool like Personal Capital to centralize tax planning and maximize tax efficiency. You’ll become much more organized, and the software will be able to help you identify possible tax advantages you may not know about.
There are a variety of personal financial planning tools on the market, so check out the various options.
Of course, if you’d rather talk to a human, you might want to enlist the services of a CPA who can help you figure out how to navigate tax law effectively and make decisions that work for your specific situation.
- Is Personal Capital Safe to Use?
- Basic Financial Planning for Beginners
- 21 Best Personal Finance Software (Free & Paid) for 2021
- How to Make a Financial Plan
3. Maximize your retirement accounts
One of the best things you can do to reduce the amount you pay in taxes is to maximize your retirement savings.
When you invest in a brokerage account, you have to pay taxes on all dividends and capital gain that you make during the year. This can add up to a substantial amount if you’re actively investing and moving stocks around.
Investing in a brokerage account is perfectly fine; there just aren’t any tax advantages. If you want to reduce your tax obligations, you need to leverage specific tax-friendly retirement accounts.
Here are a few examples to consider.
Check with your employer to see if they offer a 401(k) retirement plan. Not all employers do, but it’s one of the best opportunities to stash money away for retirement.
By opening a 401(k) plan, you can put up to $19,500 away for either tax-deferred or tax-free growth, depending on whether you open a traditional 401(k) or a Roth plan.
As an added bonus, employers often make 410(k) matches. So, there’s a chance your employer will match at least a portion of what you contribute to your 401k. This can help you stash away even more money for retirement while reducing the amount you have to report as taxable income.
A 401(k) account typically allows full access to a broad range of investment opportunities like stocks, bonds, mutual funds, and index funds.
Individual retirement account (IRA)
Not every company offers a 401(k). But that doesn’t mean you’re completely out of luck.
If you can’t contribute to a 401(k), you should look into opening an individual retirement account (IRA). With a traditional IRA, you can put up to $6,000 away for tax-deferred growth each year.
Alternatively, you could put $6,000 into a Roth IRA. While this won’t give you immediate tax advantages, it will enable you to enjoy tax-free growth on those funds.
Just like a 401(k), an IRA lets you diversify your holdings among many different types of investments.
- Roth vs. Traditional IRAs
- How Much Should I Have in My 401K
- Stocks vs. Bonds
- Index Funds for Beginners
- Roth 401k Might Make You Richer
Solo 401(k) and SEP IRA
If you work for yourself, you’re going to have to get creative about how you put money aside for tax savings. You won’t be eligible for a 401(k), and an IRA will limit you.
Instead, look into a solo 401(k), which lets you contribute up to a whopping $58,000 for the 2021 tax year. You might also want to consider a simplified employee pension (SEP) IRA, which can enable you to invest up to $58,000 for 2021.
Of course, in order to maximize these contribution limits, you need to be pulling in a lot of income.
Either way, each account has different advantages. If the name of the game is paying as little tax as you can, both accounts can be a lucrative tax strategy.
If you have a high-deductible healthcare plan that exceeds $1,350 for an individual or $2,700 for a family, you can put up to $3,600 aside into a health savings account (HSA) for the 2021 tax year (and up to $7,200 if you’re married).
Simply put, your HSA funds can be used to pay for expenses related to health insurance like prescriptions, medical supplies, and doctor’s appointments. It’s worth noting that, in most instances, you can’t use your HSA to pay for insurance premiums.
When you put money into an HSA, you can offset your tax liability. And best of all, if you keep the money there until age 65, the account automatically turns into an IRA—meaning you don’t have to worry about using the money solely for qualified medical expenses forever.
4. Check for local tax credits
Make sure to check for any local or state-wide tax credits you may be able to apply to further reduce the amount you pay in taxes.
The state of Florida, for example, has the Homestead Act, which gives a tax credit to homeowners who live in the state year-round.
Do some research and check with your tax advisor to determine if you’re eligible for any specific tax break. That way, you won’t wind up paying more than you should.
5. Consider working as an independent contractor
Take a close look at how your employer classifies you, and see if there is an opportunity to potentially switch to a 1099 basis as an independent contractor. You could potentially save a lot of money in taxes this way.
By becoming an independent contractor, you can form your own LLC and open a solo 401(k). This requires some work, but you may be able to save a lot of money in taxes.
In addition, you’ll expand what you can legally write off in tax credits. Plane tickets for work-related travel, dinner with clients, office supplies, new computers, professional development courses, home office expenses—all of these will be fair game to write off and reduce your tax burden.
Before moving forward with this tactic, you need to crunch the numbers to make sure it’s worthwhile. The last thing you want is to lose your benefits and have to pay both the employee and employer’s share of payroll taxes if the revenue isn’t there to justify the move.
6. Donate to charity
By choosing to itemize your taxes, which we’ll explain in a bit, you can further reduce your tax bill.
For example, if you’re filing as an individual in 2021, you can claim up to $12,550 in charitable contributions to qualified organizations. Married couples filing jointly, on the other hand, can claim up to $25,100 in contributions.
When exercising this option, just make sure that the organizations to which you donate meet IRS tax-exemption qualifications. Check the IRS Tax Exempt Organization Search tool to make sure you’re funneling money into the right areas. Otherwise, you could be in for a rude awakening come tax time.
Of course, you shouldn’t just donate for tax purposes. This should be done in the spirit of giving and goodwill. However, by doing so, you can save yourself some money.
If this sounds appealing to you, open your checkbook and start donating to maximize the amount you save on taxes. It’s the best of both worlds: You’ll save money while basking in the warm glow of charitable giving at the same time.
7. Sell bad stocks
Take a look at your investment portfolio and highlight some stocks that are dragging down your portfolio. Chances are there are at least a few investments that aren’t moving and won’t be moving any time soon.
By ditching these underperforming stocks, you can potentially write them off and claim them as a loss on your tax return, further lowering what you pay in taxes.
Of course, before you do this, you should seriously consider whether the stock is just underperforming now or whether it’s truly a dud that’s not going to rebound. Look at its historical price and its dividend yield to see if it’s worth getting rid of.
Ditching stocks isn’t the best strategy for long-term investors. But, in some situations, it can potentially have benefits.
If you decide to sell stocks and claim a loss, just keep the wash sale rule in mind.
In short, a wash sale occurs when you ditch a security, take a loss, and then buy back that security or a similar one within 30 days of the sale. If you violate the wash rule, the IRS may penalize you.
The wash sale rule was designed to discourage investors from selling securities and claiming losses.
8. Move to a tax-friendly state
Many states have harsh income tax rules in place that tax residents according to their annual net income.
State income taxes can be frustrating, as they require taxpayers to pay extra in addition to federal taxes. States like California and New York are notorious for having high taxes.
Here’s the kicker: Not all states have income taxes. This is a big reason people move to states like Florida, Nevada, South Dakota, and Texas.
When you move to a state with no income tax, you stop paying taxes the moment you become a resident of that state. This means you’ll look at your paycheck one day and notice a bump in pay just for switching locations. It’s a very empowering feeling.
Of course, moving to a state without an income tax is not always ideal, especially if you find nothing else about that state appealing. So, it’s a good idea to have a strong reason for wanting to move apart from just saving money.
Keep in mind that you’ll still most likely have to pay property taxes and other local taxes. When it boils down to it, taxes will follow you wherever you go.
9. Sell your car
In addition to income taxes, some states (like Connecticut, Virginia, and Rhode Island) also charge periodic car taxes.
If you live in one of these states, consider ditching your car and using a rideshare service to get around instead. You could also ride a bicycle. You’ll still pay taxes on the sale of your car, but at least you’ll break the cycle of paying property taxes on your vehicle each year.
As an added bonus, you’ll save thousands of dollars per year on gasoline, insurance, maintenance, and car payments. If you can get around without your own car, this could be one of the best financial decisions you ever make.
You’ll have to get creative about getting from place to place. But you’ll be better off financially.
10. Purchase real estate
Owning a rental property is a great way to receive a steady cash flow. It also comes with some great tax benefits.
As a rental property owner, you can deduct property taxes, loan interest, insurance premiums, and even depreciation. You can also deduct the cost of maintenance, repairs, and utilities, among other things.
By deducting these expenses, you can drastically reduce what you pay in taxes, putting more money back into your pocket at the end of the year.
There are also advanced real estate strategies you can use to further reduce your tax load. For example, you can try a 1031 exchange by trading your property for one of equal or lesser value. By doing so, you can potentially defer capital gains taxes on the sale of your property for life!
Unfortunately, you can’t write off these tax deductions on your personal home. You have to own an investment property that generates income to claim them.
11. Invest in municipal bonds
Municipal bonds are securities issued by local governments. It’s basically a debt instrument you buy to make a loan to your local town.
The interest you generate from municipal bonds is usually free from federal tax and state taxes. However, you’ll still have to pay taxes on any capital gains distributions from municipal bonds.
Case study: Paying less taxes
There’s a lot to take in here. It may help to put things in perspective.
Meet Jose, a married person who earns $85,000 per year working in advertising—a decent salary that puts him in the 22% tax bracket. His spouse does not work.
Jose is one savvy saver and knows that if he makes a few adjustments, he can lower his taxable income enough to sneak into the 12% tax bracket for considerable savings.
To accomplish this, Jose takes a few simple measures.
First, Jose lives in a state that doesn’t have an income tax, which immediately saves him money every paycheck.
Jose also maxes out his IRA every year for $6,000 in savings. He also donates $2,000 per year to his local church. Since he has a high-deductible health insurance plan, Jose then puts $3,600 into his HSA account. And that’s it!
Jose could probably be even more aggressive by looking into things like claiming a home office expense and other deductions. However, by claiming the above-mentioned deductions, Jose is able to reduce his total taxable income to just $73,400—and that’s before the standard deduction.
This means he’s able to easily fit into the lower 12% tax bracket, saving a lot of money.
Saving money on taxes doesn’t have to be complicated. By taking just a few key steps, it’s possible to reduce what you owe and save a lot of money in the process.
Frequently Asked Questions
Should I claim the standard or itemized deduction?
As a taxpayer, you get the option to choose whether you take the standard or itemized deduction.
To figure that out, add up your expenses, and if they exceed the standard deduction of $12,550 (single) or $25,100 (joint), then it probably makes sense to claim the itemized deduction. Just make sure all your expenses are qualified and that you save receipts.
If you own a house and have a mortgage, you will likely want to take the itemized deduction so you can write off mortgage interest.
What are tax credits?
A tax credit is a special incentive that enables taxpayers to reduce what they have to pay to the government. The more tax credits you claim, the less you’ll pay overall when tax season rolls around.
For example, there are tax credits for childcare and education. Small business owners can also claim additional tax credits.
Is it ethical to reduce your taxes?
There is nothing wrong with trying to reduce your tax burden.
It doesn’t make you a bad citizen. As long as you pay the taxes you legally owe to the government, you’re doing your part to keep the country operating.
The trick is to pay the bare minimum in taxes. Nobody wants to pay any more in taxes than they owe, and you shouldn’t, either.
What are qualified business expenses?
Qualified business expenses are specific tax write-offs that business owners and self-employed independent contractors can claim on their tax return to reduce what they have to pay. For example, an airplane ticket to a conference or new work computer would each count as qualified business expenses.
Should I work with a qualified tax professional?
Most likely, yes. Let’s face it: The tax code is complicated. Instead of doing your own taxes, consider working with a professional who can help identify tax savings and help reduce overall tax liability.
A tax professional can help reduce your reported earned income, maximize pre-tax dollars, maximize retirement savings, and help you claim a better tax refund.
The Bottom Line
At the end of the day, you should never feel bad about your federal income taxes. By getting a little creative and using the above-mentioned strategies, you can reduce the amount of taxes you owe the government.
As the famous idiom tells us, nothing is certain in life but death and taxes. No matter what you do, you’re going to have to settle up with Uncle Sam sooner or later. That’s just the way it is.
The good news is that by taking a proactive stance on your taxes and developing a strategy that helps you offset your obligations, it becomes much easier to keep more of your hard-earned money in your pocket.
Here’s to lowering your tax bill as much as you can—and paying the government exactly what you owe each year and not a penny more.