When you earn a high income, you are likely to pay a higher percentage of taxes than normal earners. This is a fundamentally positive situation. High taxes indicate financial independence and a higher income!
However, no one likes paying taxes, and you may be asking how to reduce taxable income.
There are several ways to reduce your taxable income. Here are typical ways to reduce your taxable income. Who knows, you might even get a tax refund at the end.
Is It Legal to Reduce Your Taxable Income?
You must pay income tax on all of your earnings within a tax year.
However, there are several strategies you can use to reduce the amount of your income that is taxable. These are known as tax deductions. These deductions are intended to encourage good citizenship behaviors such as paying for healthcare, donating to charity, and saving for retirement.
If you are self-employed, your business deductions reduce your taxable income as well. Your business is taxed based on its profit, not its gross income.
Make no attempt to reduce your taxable income by inflating deductions or costs. This is illegal tax evasion. If you are unsure, seek sound financial counsel from a tax specialist.
When You Can’t Afford to Be Wrong, Talk to a Tax Expert
How To Reduce Your Taxable Income
#1. Participate in an employee stock purchase program.
You may be qualified to participate in an Employee Stock Purchase Plan if you work for a publicly traded company (ESPP). By participating in your ESPP, you will divert after-tax cash from your paycheck with the goal of purchasing shares of your firm, and in many cases, you will be provided a discount on the stock price that is exclusively available to employees (usually around 15%).
You can contribute as much after-tax money as you like to your ESPP, which typically runs from 1% to 10%. However, keep in mind that the 2022 maximum contribution limit is $25,000 total per year.
When you decide to sell your shares, the tax benefit of subscribing to an ESPP comes into play. Employees can sell their shares immediately after purchase or at a later date, but they are rewarded if they keep them for at least one year from the purchase date. Selling immediately results in ordinary income tax; however, selling later results in a lower long-term capital gains tax, lowering your tax burden.
While it may be advantageous to purchase your employer’s stock at a discount while also benefiting from holding your shares over time, make certain that
- You have adequate cash to contribute and
- the investment fits into your overall financial strategy. Before enrolling in a stock plan, certain financial goals, such as paying off high-interest debt, saving for an emergency fund, and contributing to an IRA or 401(k) — as well as meeting any workplace match — should be accomplished.
#2. Make a 401(k) or regular IRA contribution.
Contributing to a pre-tax retirement plan, such as an employer-sponsored 401(k) or traditional IRA, is one of the simplest and potentially most beneficial strategies to reduce your taxable income. Money from your paycheck (in the case of a 401(k)) or bank account (in the case of a traditional IRA) is deposited into either of these tax-advantaged investment accounts before it is taxed.
With pre-tax contributions, you are also taking less money out of your disposable income right now, which is healthier for your immediate cash flow. However, your money grows tax-deferred, and you will have to pay income tax on the cash you remove later in retirement.
The 401(k) contribution limit is $20,500 in 2022, with an additional $6,500 available for those 50 and over. The yearly contribution limit for IRAs is $6,000 (for both regular and Roth IRA accounts), with an additional $1,000 available for people over the age of 50.
Contributions to a traditional IRA may also be tax-deductible, depending on your income, tax filing status, and whether or not you have an employer-sponsored retirement plan.
“Many consumers can deduct traditional IRA contributions, which can help reduce their tax obligation,” says Corbin Blackwell, a CFP at Betterment, a Robo-advisor that offers conventional, Roth, and SEP IRAs. “However, not all IRA contributions are tax-deductible, so speak with your tax preparer to understand your circumstances.”
If you (or your spouse, if married) have a retirement plan at work and your income is $78,000 or more as a single filer/head of household, $129,000 or more as married filing jointly/qualifying widow(er), or $10,000 or more as married filing separately, you cannot deduct it. If you (and your spouse, if married) do not have a workplace retirement plan, you can deduct the full amount of your contribution limit.
#3. Open a Health Savings Account.
A Health Savings Account (HSA) is a medical savings account created for taxpayers who have a high-deductible health plan (HDHP) to save for future medical bills.
Some refer to this account as the ‘triple tax benefit,’ because funds can be deposited tax-free (or tax-deductible if you formed your own account), invested tax-free, and withdrawn tax-free at any time if used for qualified medical expenses such as deductibles, copays, and coinsurance. These three tax breaks each contribute to a lower tax burden. Furthermore, if your HSA balance is not fully utilized, it will roll over from year to year.
Some employers provide an HSA benefit to their employees, while others may need to open their own HSA outside of the workplace. If your company offers an HSA plan, find out if it provides a specific amount or matches employee contributions. However, keep in mind that any employer contributions count toward the IRS’s maximum yearly restrictions.
Pre-tax contributions to an HSA for 2022 are limited to $3,650 for a single person and $7,300 for a family, with an additional $1,000 if you are 55 or older.
#4. Subtract the interest paid on your school loans.
If you have private student loans from servicers such as SoFi or Earnest, interest has been accruing throughout the outbreak.
While student loans can be burdensome, the interest you’ve paid on them can be deducted from your taxable income. For 2022, you can deduct up to $2,500 if your modified adjusted gross income (MAGI) is less than $70,000, or $145,000 if you file jointly. If your income exceeds specific thresholds, you can deduct a pro-rated amount. The threshold for claiming a deduction is $85,000 for single taxpayers and $175,000 for joint filers.
For the past two years, payments on federal student loans have been halted, and no interest has been accrued. However, it is expected that federal student loan repayment will start on May 1. So, if you pay student loan interest this year and meet the income and filing requirements, you will be eligible to deduct it from your taxable income in 2023.
When You Can’t Afford to Be Wrong, Talk to a Tax Expert
#5. Get rid of your losing stocks.
It is natural to have stocks in your portfolio that are underperforming. The good news is that a popular investment practice known as tax-loss harvesting can help you take advantage of a market downturn.
Tax-loss harvesting is the practice of using investment losses to offset the taxes you would otherwise pay on other investment profits, so lowering your taxable income.
According to Amanda Gutierrez, a CFP and financial planning specialist at eMoney Advisor, investors should consider tax-loss harvesting: “Investors can sell underperforming equities and experience capital losses to counterbalance capital gains,” she tells Select. “Person losses can offset up to $3,000 of ordinary income for those who have no capital gains.” Any excess losses can be carried forward to future years and used to reduce taxes.”
While you can execute tax-loss harvesting on your own, it’s much easier to do so with Robo-advisor services like Betterment, Wealthfront, or Charles Schwab, which all look for chances to harvest losses on a regular basis, decreasing investors’ tax exposure throughout the year.
Robo-advisors are an easy way to get started investing, but we recommend speaking with your financial advisor about the best tax-harvest approach for you.
When it comes time to file your taxes, use tax software like TurboTax or H&R Block to make it easy to correctly input and claim your investment losses, which should reduce your overall tax payment.
When You Can’t Afford to Be Wrong, Talk to a Tax Expert
#6. Claim Business Deductions with Your Side Hustle
Self-employed people (whether full-time or part-time) are entitled to a slew of tax breaks, and Tsoir encourages people to start side hustles so they may take advantage of them. That means that your freelance work or time spent as a ride-share driver could result in significant tax savings.
Business-related vehicle mileage, shipping, advertising, website fees, percentage of home internet charges used for business, professional publications, dues, memberships, business-related travel, office supplies, and any other expenses incurred to run your business are some of the business deductions available. If you pay your own health, dental, or long-term care insurance premiums, those may also be deductible.
“If you do it correctly, you can save a lot of money,” Tsoir explains. However, because IRS laws can be complicated, it’s recommended to consult with a professional for some advanced tax savings ideas.
#7. Make a claim for a home office deduction
Don’t be scared to claim the home office deduction if you work for yourself or have a side business.
The space must be used regularly and exclusively for business activities in order to qualify for the deduction. For example, if an extra bedroom is solely utilized as a home office and accounts for one-fifth of your apartment’s living area, you can deduct one-fifth of your rent and energy costs.
#8. Make Your Home Available for Business Meetings
The Augusta rule, sometimes known as the Augusta exemption or the 14-day rule, allows homeowners to rent out space in their homes for 14 days without reporting the income to the IRS. The hitch is that the owner’s primary place of business cannot be the home.
This can be a tax-saving strategy for business owners who do not have a home office. They can rent out a room in their home for a business conference, deduct the cost from their business taxes, and then deduct the rental fees from their personal tax return.
Tsoir warns against charging your business an extravagant amount in order to avoid taxes. Instead, the price paid by the business must be comparable to the leasing rates charged by comparable premises in your market. Keep precise records of when the meeting occurred and its purpose.
#9. Deduct Business Travel Expenses Even While on Vacation
When you combine a vacation with a business trip, you can reduce vacation costs by deducting the percentage of expenses spent on business. This could include flights and a portion of your lodging charge based on the amount of time spent on business activities. Speak with a tax specialist about how to calculate this correctly.
#10. Half of your self-employment taxes can be deducted.
To fund the Social Security and Medicare programs, the government levies a 15.3% Federal Insurance Contributions Act tax on all wages.
While businesses share the expense with their employees, self-employed persons must pay the entire sum individually. To make up for the additional cost, the government will allow you to deduct 50% of the amount spent from your income taxes. You don’t even have to itemize to take advantage of this tax break.
#9. Obtain a Higher Education Credit
The government provides valuable tax breaks to help with the cost of higher education. The American opportunity tax credit is available for the first four years of college and is worth up to $2,500 per student each year.
Because it is a credit, the amount is subtracted from any taxes you may owe the government. If it exceeds the amount of taxes owed, you may be eligible for a refund of up to $1,000.
Meanwhile, the lifelong learning credit is excellent for those who want to further their education and skills. This credit is worth up to $2,000 per year and can be used to pay for college and educational costs that will help you advance in your career.
When You Can’t Afford to Be Wrong, Talk to a Tax Expert
#10. Determine Your Eligibility for the Earned Income Tax Credit
Even if you don’t need to pay federal income taxes, the government may refund you. For the tax year 2021, the earned income tax credit is a refundable tax credit of up to $6,728.
The EITC is determined using a formula that considers income and family size. The credit’s income limits range from $21,430 for single taxpayers with no children to $57,414 for married couples filing jointly with three or more children.
#11. Deduct Private Mortgage Insurance Premiums
You probably pay private mortgage insurance if you have less than 20% equity in your property. Lenders demand this coverage to safeguard them in the event that you fail to make payments.
Taxpayers could deduct the expense of private mortgage insurance on their itemized deductions until 2017. While the Tax Cuts and Jobs Act abolished the deduction, Congress has reinstated it each year and it will be available again for the tax year 2021 files.
#12. Make Charitable Contributions
Contributions to charities made through payroll deductions, checks, cash, and donations of commodities and apparel are all tax deductible.
To take a deduction, you must normally itemize, and since the 2017 tax reform almost quadrupled the standard deduction, many people choose not to itemize. “Donations kind of faded into the background after the TCJA,” Tsoir recalls.
The Coronavirus Aid, Relief, and Economic Security Act, or CARES Act, on the other hand, permitted taxpayers who do not itemize to deduct monetary donations of up to $300. This deduction will be reinstated for the 2021 tax year, with married couples filing jointly eligible to deduct a total of $600.
#13. By donating stock, you can avoid capital gains tax.
Another strategy to prevent capital gains is to donate equities to charity.
Money transferred into a donor-advised fund is not only tax-free, but it can also be deductible by people who itemize. Depending on the firm, donor-advised funds can be established with as little as $5,000.
#14. Purchase Qualified Opportunity Funds.
Although not for everyone, qualified opportunity funds can save investors a significant amount of money in taxes, according to Ian Formigle, chief investment officer at property investing firm CrowdStreet.
“The greatest tax-advantaged vehicle available is real estate investing,” Formigle says. “If you never want to pay taxes on (money invested in real estate), there is a way to do it.”
The Tax Cuts and Jobs Act of 2017 established qualified opportunity zones to rebuild designated areas. Investors can transfer eligible gains, such as proceeds from stock sales, to a qualified opportunity fund, which invests in projects in these areas. This allows you to postpone paying capital gains tax on that money for up to ten years. Furthermore, after ten years, further gains on the investment may be tax-free.
Because these investments are complex, using a platform like CrowdStreet is one approach to avoid violating government regulations. Another alternative is to work with an investment professional. Many funds are only open to accredited investors with a certain level of income or net worth.
#15. Deductions for Military Personnel
Are you in the National Guard or the military reserves?
You can deduct unreimbursed travel expenditures such as transportation, meals, and accommodation if you go more than 100 miles from home and need to stay away overnight.
If you are an active duty service member, you can deduct any moving expenses for a permanent change of station.
#16. Don’t Forget About State and Local Tax Credits
State and local taxes can add up, so search for strategies to reduce your tax burden in those areas as well.
Despite the fact that the federal tax reform law eliminated miscellaneous deductions, several states still allow them or have a lower bar for claiming them.
In New Jersey, for example, taxpayers can deduct medical expenses that exceed 2% of their adjusted gross income. Only medical expenses that exceed 7.5% of a person’s income are deductible on federal tax forms.
Tax breaks aren’t restricted to income taxes. In New York City, for example, some rented spaces are subject to a parking tax, although residents can essentially forgo a portion of the price by requesting an exemption.
Check with your local and state taxing authorities to discover what deductions you may be eligible for, regardless of where you live.
What is considered as taxable income?
Amounts included in your income are generally taxable unless specifically exempted by legislation.
What type of income is not taxable?
The IRS considers the following items to be nontaxable: inheritances, gifts, and bequests. Cash rebates on purchases made from a store, manufacturer, or dealer.
Why is my 2023 refund so low?
One of the most common reasons your tax return may be less is that you earned more money last year than you recall. In comparison to 2020, most people worked more hours, while others may have received a pay raise or changed jobs, which may have resulted in an increase in your earnings.
When You Can’t Afford to Be Wrong, Talk to a Tax Expert
Conclusion
Investing your money is a prevalent theme for lowering your taxable income. In some circumstances, investing can greatly delay and even reduce your tax liability. Furthermore, by investing, you allow your money to grow and compound over time. For most taxpayers, tax reform eliminated many itemized deductions, but there are still ways to prepare for the future and reduce their current tax burden. Consult a tax professional to learn more about deductions and tax savings.
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