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 to help ward them off. Here are six ways to protect your 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 does 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 a state or local entity for a set number of interest payments over a predetermined period. Once the bond reaches its maturity date, the full amount of the original investment is repaid to the buyer.
Municipal bonds are exempt from federal taxes, and may be tax exempt at the state and local level as well, depending on where you live. Tax-free interest payments are what make municipal bonds attractive to investors.
Municipal bonds historically have lower default rates than their corporate bond counterparts (for investment grade securities, the default rate is 0.1% for municipal bonds versus 2.28% for corporate). However, municipals typically pay lower interest rates. Because of the tax benefits, bondholders must understand their tax equivalent yield. The higher your tax bracket, the higher your tax equivalent yield.
2. Shoot for Long-Term Capital Gains
An investor holding an asset for longer than one year enjoys a preferential tax rate of 0%, 15%, or 20% on the capital gain, depending on your income level. If the asset is held for less than a year before selling, the capital gain is taxed at ordinary income rates. Understanding long-term versus short-term capital gains rates is important to growing wealth. A married couple filing jointly would pay 0% on their long-term capital gains if their income falls below $78,750.
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.
The Setting Every Community Up for Retirement Enhancement (SECURE) Act was enacted on Dec. 20, 2019. The SECURE Act allows employers to offer annuities as investment options within 401(k) plans. Also, if you are a small business owner, the Act gives tax incentives to employers to set up automatic enrollment in retirement plans for its workers, or they can join multiple employer plans and offer retirement options to their employees.
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.
Under the SECURE Act, 401(k) or IRA account holders had to withdraw required minimum distributions (RMD) in the year they turned age 70.5. The SECURE Act increases that age to 72, which may have tax implications, depending on the tax bracket the account holder belongs to in the year they withdraw. The bill also eliminates the maximum age for traditional IRA contributions, which was previously capped at 70.5 years old.
5. Use a Health Savings Account (HSA)
Employees with a high-deductible health insurance plan can also use an HSA to reduce taxes. 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, such as the Earned Income Tax Credit. For 2019, a low-income taxpayer with no children may receive up to $529 in credits. Other taxpayers with three or more children may be eligible for up to $6,557 in credits. 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; individuals 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 is important to pay all that is 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.