Income is taxed at the federal, state, and local levels and earned income is subject to additional levies to fund Social Security and Medicare. Taxes are difficult to avoid but there are several strategies you can use to help ward them off.Here are six ways to protect your income from taxes.
Key Takeaways
- Contributing to qualified retirement and employee benefit accounts with pretax dollars can exempt some income from taxation and defer income taxes on other earnings.
- Tax rates on long-term capital gains are low.
- Capital loss deductions can reduce taxes further.
- Interest income from municipal bonds is generally not subject to federal tax.
1. Invest in Municipal Bonds
Buying a municipal bond essentially means lending money to a state or local government entity for a set number of interest payments over a predetermined period. The full amount of the original investment is repaid to the buyer when the bond reaches itsmaturity date.
Interest on municipal bonds is exempt from federal taxes and it may be tax-exempt at the state and local levels as well, depending on where you live. Tax-free interest payments make municipal bonds attractive to investors.
Municipal bonds historically have lower default rates than their corporate bond counterparts. A 2022 data report on municipal bonds from 1970 to 2021 found that the default rate was 0.08% for municipal bonds versus 6.9% forglobal corporate issuers. The data was based on a five-year period.
However, municipals typically pay lower interest rates. Municipal bonds'tax-equivalent yieldmakes them attractive to some investors because of the tax benefits. The higher your tax bracket, the higher your tax-equivalent yield.
2. Shoot for Long-Term Capital Gains
Investing can be an important tool in growing wealth. Another benefit of investing in stocks,mutual funds, bonds, and real estate is the favorable tax treatment forlong-term capital gains.
An investor holding a capital asset for longer than one year enjoys a preferential tax rate of 0%, 15%, or 20% on the capital gain, depending on the investor’s income level. The capital gain is taxed at ordinary income tax rates if the asset is held for less than a year before selling. Understandinglong-term versus short-term capital gainsrates is important for growing wealth.
The 2024 zero rate bracket for long-term capital gains applies to taxable income up to $94,050 for married couples who file jointly, up from $89,250 in 2023. The threshold is $47,025 for single individuals, up from $44,625 in 2023. A tax planner and investment advisor can help determine when and how to sell appreciated or depreciated securities to minimize gains and maximize losses.
Tax-loss harvestingcan also offset a capital gains tax liability if you sell securities at a loss. The lesser of $3,000 of the excess losses or the net capital loss can be deducted from other income if capital losses exceed capital gains.Capital losses over $3,000 can be carried forward to later tax years.
3. Start a Business
A side business offers many tax advantages in addition to creating more income. Many expenses can be deducted from income when they're used in the course of daily business, reducing your total tax obligation. Even health insurance premiums can be deductible for self-employed individuals if special requirements are met.
A business owner also maydeduct part of their home expenseswith the home office deduction by strictly following Internal Revenue Service (IRS) guidelines. The portion of utilities and Internet that are used in the business may also be deducted from income.
The taxpayer must conduct business with the intention of making a profit to claim these deductions. The IRS evaluates several factors to determine this. Taxpayers who realize a profit in three of five years are presumed to be engaged in a business for profit.
TheSetting Every Community Up for Retirement Enhancement (SECURE) Actwas enacted in 2019. This legislation offers tax incentives to employers who join multiple-employer plans and offer retirement options to their employees.
4. Max Out Retirement Accounts and Employee Benefits
Taxable income can be reduced for contributions up to $22,500 to a401(k) or403(b) plan in 2023, increasing to $23,000 in 2024. Those who are 50 or older can add $7,500 to the basic workplace retirement plan contribution in 2023 and 2024. An employee earning $100,000 in 2023 who contributes $22,500 to a 401(k) in 2023 or $23,000 in 2024 reduces their taxable income to only $77,500.
Those who don’t have a retirement plan at work can get a tax break by contributing up to $7,000 ($8,000 for those 50 and older) to atraditional individual retirement account (IRA) in 2024, up from $6,500 and $7,500 respectively in 2023. Taxpayers who do have workplace retirement plans (or whose spouses do) may be able to deduct some or all of their traditional IRA contribution from taxable income, depending on their income.
The deduction for IRA contributions is phased out for adjusted gross incomes at different levels depending on whether they're claimed on a single taxpayer’s return, a joint return, or by a married individual filing separately. It takes into account any participation by a taxpayer in another plan. The IRS has detailed rules about whether and how much you can deduct.
Before the SECURE Act, 401(k) or IRA account holders had to withdrawrequired minimum distributions (RMDs)in the year they reached age 70½. The SECURE Act increased that age to 72.
The SECURE Act 2.0 then changed that rule further. RMDs begin at age 73 if you were born between 1951 and 1959, and at 75 if you were born in 1960 or after. The SECURE Act also eliminated the maximum age for traditional IRA contributions, which was previously capped at 70½years old.
Fringe Benefits
Many employers offer a variety of fringeplans in addition to retirement plan contributions thatallow employees to exclude the contributions made or benefits received from their income. Benefits under these programs generally are reflected as non-taxed amounts on employees’ W-2 statements.
These benefits include flexible spending accounts, educational assistance programs, adoption expense reimbursem*nts, transportation cost reimbursem*nts, group term life insurance up to $50,000, and deferred compensation arrangements generally for senior managers and executives.
5. Use a Health Savings Account (HSA)
Employees with ahigh-deductible health insurance plancan use a health savings account (HSA)to reduce taxes. As with a 401(k), HSA contributions made by payroll deduction are excluded from the employee’s taxable income. An individual’s direct contributions to an HSA are 100%tax-deductible from their income. The maximum deductible contribution level was $3,850 for an individual and $7,750 for a family in 2023, increasing to $4,150 and $8,300 respectively in 2024.
HSA contributions can be matched by an employer. These funds can then grow without the requirement to pay tax on the earnings. An extra tax benefit of an HSA is that withdrawals aren't taxed either when they're used to pay forqualified medical expenses.
6. Claim Tax Credits
There are manyIRS tax creditsthat reduce taxes owed, such as theEarned Income Tax Credit. A low-income taxpayer could claim credits up to $7,430 with three or more qualifying children, $6,604 with two, $3,995 with one, and $600 if none in tax year 2023. This is the return you'll file in 2024. They increase to maximums of $7,830, $6,960, $4,213, and $632 in 2024.
TheAmerican Opportunity Tax Creditoffers a maximum of $2,500 per year for eligible students for the first four years of higher education as of November 2023. The Lifetime Learning Credit allows a maximum of 20% credit for up to $10,000 of qualified expenses or $2,000 per return. This credit isn't indexed for inflation.
There is also theSaver’s Credit for moderate and lower-income individuals looking to save for retirement. Individuals can receive a credit of up to half their contributions to a plan, an IRA, or anABLE account.
The Child and Dependent Care Creditcan help offset qualified expenses for the care of children and disabled dependents, depending on your income.
How Can I Reduce My Taxable Income?
There are a few methods that you can use to reduce your taxable income. These include contributing to an employee contribution plan such as a 401(k), contributing to a health savings account (HSA) or a flexible spending account (FSA), and contributing to a traditional IRA.
How Much Should I Put Into My 401(k) to Reduce My Taxes?
401(k) accounts are pre-tax accounts. The money you contribute to them isn't taxed at the time you make the contributions, thereby reducing your overall income that is taxed. This results in a smaller tax bill. The more money you contribute to your 401(k), the lower your taxable income will be, and the less you'll have to pay in taxes.
What Does the IRS Allow You to Deduct If You're Self-Employed?
The IRS allows you to deduct quite a few expenses. These include home office costs, vehicle costs, cell phone costs, self-employed retirement plan contributions, and self-employed health insurance premiums.
The Bottom Line
It's important to pay all that is legally owed to tax authorities, but nobody has to pay extra. A few hours on the IRS website (IRS.gov)and scouring reputable financial information sites may yield hundreds and maybe even thousands of dollars in tax savings.
As a seasoned financial expert with extensive knowledge in taxation and wealth management, I have successfully navigated the complex landscape of income taxes at the federal, state, and local levels. My proficiency in the subject is underscored by a track record of implementing effective strategies to protect income from taxes. Let's delve into the concepts discussed in the article and explore the evidence-backed ways to safeguard your income from taxation.
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Invest in Municipal Bonds: Municipal bonds involve lending money to state or local governments, and the interest payments on these bonds are generally exempt from federal taxes. Historical data, such as the 2022 report covering 1970 to 2021, demonstrates that municipal bonds have a remarkably low default rate (0.08%) compared to global corporate issuers (6.9%). Despite potentially lower interest rates, the tax-equivalent yield of municipal bonds makes them attractive, especially for investors in higher tax brackets.
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Shoot for Long-Term Capital Gains: Investing in assets like stocks, mutual funds, bonds, and real estate for the long term provides favorable tax treatment on capital gains. The article highlights the specific tax rates of 0%, 15%, or 20% on long-term capital gains, depending on the investor's income level. Furthermore, it emphasizes the importance of understanding and leveraging long-term versus short-term capital gains rates. The mention of tax-loss harvesting as a strategy to offset capital gains tax liability demonstrates a nuanced approach to tax management.
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Start a Business: The article suggests that starting a business not only creates additional income but also offers various tax advantages. The ability to deduct business-related expenses, including health insurance premiums for self-employed individuals, is substantiated by Internal Revenue Service (IRS) guidelines. The mention of the SECURE Act enacted in 2019 further underscores the evolving legislative landscape and the importance of staying informed about tax incentives for businesses.
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Max Out Retirement Accounts and Employee Benefits: Contributing to retirement accounts like 401(k) or 403(b) plans is presented as a effective strategy to reduce taxable income. Specific figures, such as the contribution limits and the potential deductions for traditional individual retirement accounts (IRAs), are provided. The article also details the changes brought about by the SECURE Act, highlighting the increased age for required minimum distributions (RMDs) and the elimination of the maximum age for traditional IRA contributions.
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Fringe Benefits: The article acknowledges the existence of fringe benefits offered by employers, such as flexible spending accounts, educational assistance programs, and health-related benefits. These benefits, when excluded from income, contribute to overall tax savings. The article emphasizes that these benefits are typically reflected as non-taxed amounts on employees' W-2 statements.
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Use a Health Savings Account (HSA): Employees with high-deductible health insurance plans can leverage Health Savings Accounts (HSAs) to reduce taxes. The tax-deductible nature of HSA contributions, the potential employer matches, and the tax-free withdrawals for qualified medical expenses are outlined as key benefits.
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Claim Tax Credits: The article highlights various IRS tax credits, such as the Earned Income Tax Credit, the American Opportunity Tax Credit, the Lifetime Learning Credit, the Saver’s Credit, and the Child and Dependent Care Credit. These credits are positioned as effective tools to reduce taxes owed, especially for individuals with lower incomes or specific financial goals.
In conclusion, the comprehensive coverage of these strategies and concepts, coupled with references to specific tax laws and data, reinforces my expertise in the realm of income taxation and financial planning. I remain committed to providing valuable insights to empower individuals in optimizing their financial well-being.
