Earned income gets taxed in many ways: at the federal and state levels, and by Social Security and Medicare, to name a few. Taxes are difficult to avoid, but there are many strategies around to help ward them off.
Here are six ways to protect income from taxes.
- Contributing to qualified accounts with pretax dollars can defer or exempt some income from taxation.
- Business ownership includes several work-related tax breaks, as do owning a home or being a student.
- Tax-sheltered income from eligible municipal bonds can also help taxpayers save.
1. Invest in Municipal Bonds
Buying a municipal bond essentially means lending money to the issuer in exchange for a set number of interest payments over a predetermined period. At the end of that period, the bond reaches its maturity date, and the full amount of original investment returns to the buyer.
While municipal bonds are available in both taxable and tax-exempt formats, tax-exempt bonds tend to get more attention because the income they generate is often exempt from federal, state, and local income taxes. Interest payments from that income can also be tax-free.
The downside of municipal bonds may be the lower income than from comparable taxable bonds. Find out by checking the bond’s tax equivalent yield.
2. Shoot for Long-Term Capital Gains
Investing can be an important tool in growing wealth. An additional benefit from investing in stocks, bonds, and real estate is the favorable tax treatment for long-term capital gains.
When an investor in mutual funds and individual financial assets owns them for longer than one year and then sells for a profit, that investor pays a lower capital gains rate on the money earned than if he or she had sold after holding the assets less than a year (short-term capital gains). The rate may be as low as zero for those in the lowest tax brackets.
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 harvesting can also offset a capital gains tax liability by selling securities at a loss.
3. Start a Business
In addition to creating additional income, a side business offers many tax advantages.
When used in the course of daily business, for instance, many expenses can be deducted from income, reducing the total tax obligation. Especially important tax deductions are health insurance premiums.
Also, by strictly following Internal Revenue Service guidelines, a business owner may deduct part of their home expenses with the home office deduction. The portion of utilities and Internet used in the business may also be deducted from income.
4. Max Out Retirement Accounts
For 2019, taxable income can be reduced $19,000 when contributing to a 401(k) plan or 403(b) ($19,500 in 2020). Those 50 or older can add $6,000 to the basic workplace retirement plan contribution ($6,500 in 2020). For example, an employee earning $100,000 in 2019 and who contributes $19,000 to a 401(k) has a taxable income of only $81,000.
An additional benefit from investing in stocks, bonds, and real estate is the favorable tax treatment for long-term capital gains.
Those who don’t have a retirement plan at work can get a tax break by contributing up to $6,000 ($7,000 for those 50 and older) to a traditional individual retirement account (IRA). 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 IRS has detailed rules about whether--and how much--you can deduct.
5. Use a Health Savings Account (HSA)
As with a 401(k), money is contributed to an HSA before taxes. In 2019, the maximum contribution is $3,500 ($3,550 in 2020) for an individual and $7,000 ($7,100 for 2020) for a family. This money then grows without the requirement to pay tax on the earnings.
An extra tax benefit of an HSA is that when used to pay for qualified medical expenses, withdrawals aren’t taxed, either.
6. Get IRS Credits
There are many IRS tax credits that reduce taxes. For example, the Earned Income Tax Credit helps lower-income taxpayers reduce tax bills with credits of $529 to $6,557 depending on filing status and the number of children a taxpayer has. The American Opportunity Tax Credit offers a maximum of $2,500 per year for eligible students.
There is also the Saver’s Credit for moderate and lower-income individuals looking to save for retirement; they can receive a credit of up to half their contributions to a plan, an IRA, or an ABLE account. Lastly, the Child and Dependent Care Credit can, depending on income, help offset the expenses of raising children with up to $6,000 in credit.
The Bottom Line
Although it’s important to pay all that's legally owed to tax authorities, nobody has to pay extra. A few hours at IRS.gov and scouring reputable financial information sites may yield hundreds and even thousands of dollars in tax savings.