Income is taxed at the federal, state, and local levels, and earned income is subject to additional levies to fund 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 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 governmental 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.
Interest on municipal bonds is exempt from federal taxes and 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 study of municipal bonds from 1970 to 2019 found that the default rate was 0.1% for investment-grade municipal bonds versus 2.25% for global corporate issuers.
However, municipals typically pay lower interest rates. Because of the tax benefits, municipal bonds' tax-equivalent yield makes them attractive to some investors. 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. An additional benefit of investing in stocks, mutual funds, bonds, and real estate is the favorable tax treatment for long-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. 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 for growing wealth.
For 2023, the zero rate bracket for long-term capital gains applies to taxable income up to $89,250 for married couples filing jointly (increased from $83,350 in 2022) and $44,625 for single individuals (increased from $41,675 in 2022). 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. If capital losses exceed capital gains, the lesser of $3,000 of the excess losses or the net capital loss can be deducted from other income. Capital losses in excess of $3,000 can be carried forward to later tax years.
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, many expenses can be deducted from income, reducing the total tax obligation. Especially important tax deductions for self-employed individuals are health insurance premiums which are available if special requirements are met.
Also, by strictly following Internal Revenue Service (IRS) 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.
In order to claim these deductions, the taxpayer must conduct business to make a profit. The IRS evaluates a number of factors, outlined in Publication 535. Taxpayers who realize a profit in three of the last five years are presumed to be engaged in a business for profit.
The Setting Every Community Up for Retirement Enhancement (SECURE) Act was enacted in 2019. The SECURE Act 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
In 2023, taxable income can be reduced for contributions up to $22,500 to a 401(k) or 403(b) plan (up from $20,500 in 2022). Those 50 or older can add $7,500 to the basic workplace retirement plan contribution (up from $6,500 in 2022). For example, an employee earning $100,000 in 2023 who contributes $22,500 to a 401(k) 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 $6,500 ($7,500 for those 50 and older) to a traditional individual retirement account (IRA) in 2023 (up from $6,000 and $7,000, respectively, in 2022). 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, higher in 2023 than in 2022, depending on whether claimed on a single taxpayer’s return, joint return, or married individual filing separately, as well as taking 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 withdraw required minimum distributions (RMDs) in the year they turned age 70½. The SECURE Act increased that age to 72. The SECURE Act 2.0 changed that rule further. It now begins at 73 if you were born between 1951 and 1959 and at 75 if you were born in 1960 or after. This may have tax implications, depending on the tax bracket the account holder belongs to in the year they withdraw. The SECURE Act also eliminated the maximum age for traditional IRA contributions, which was previously capped at 70½ years old.
In addition to retirement plan contributions, many employers offer a variety of fringe plans that allow 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 reimbursements, transportation cost reimbursements, group-term life insurance up to $50,000, and generally for senior managers and executives, deferred compensation arrangements.
5. Use a Health Savings Account (HSA)
Employees with a high-deductible health insurance plan can use a health savings account (HSA) to reduce taxes. As with a 401(k), HSA contributions (which may be matched by the employer) 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.
For 2023, the maximum deductible contribution level is $3,850 for an individual and $7,750 for a family (up from $3,650 and $7,300, respectively, in 2022). These funds can then grow 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. Claim Tax Credits
There are many IRS tax credits that reduce taxes, such as the Earned Income Tax Credit. For the tax year 2023, 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. These numbers are up from $6,935 for three or more kids, $6,164 with two, $3,733 with one, and $560, in 2022.
The American Opportunity Tax Credit offers a maximum of $2,500 per year for eligible students for the first four years of higher education and the Lifetime Learning Credit allows a maximum of 20% credit for up to $10,000 of qualified expenses or $2,000 per return.
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.
The Child and Dependent Care Credit can, depending on income, help offset qualified expenses for the care of children and disabled dependents.
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, meaning the money you contribute to them comes before your income is taxed, thereby reducing your overall income that is taxed, which 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 will have to pay in taxes.
What Does the IRS Allow You to Deduct?
The IRS allows you to deduct quite a few items. These include home-office costs, vehicle costs, cell phone costs, self-employed retirement plan contributions, self-employed health insurance premiums, and more.
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 on the IRS website (IRS.gov) and scouring reputable financial information sites may yield hundreds, maybe even thousands, of dollars in tax savings.