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 eligible municipal bonds is 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 level 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
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 2020, a married couple filing jointly would pay 0% on their long-term capital gains if their taxable income falls below $80,000 and, in the case of a single individual, below $40,000.
For 2021, the zero rate bracket for long-term capital gains applies to taxable income up to $80,800 for married couples and $40,400 for single individuals. 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 both 2020 and 2021, taxable income can be reduced for contributions up to $19,500 to a 401(k) or 403(b) plan. Those 50 or older can add $6,500 to the basic workplace retirement plan contribution. For example, an employee earning $100,000 in 2020 or 2021 who contributes $19,500 to a 401(k) reduces taxable income to only $80,500.
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) in 2020 and 2021. 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 is phased out for adjusted gross incomes at different levels, higher in 2021 than in 2020, depending on whether claimed by on a single taxpayer’s return, joint return, 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 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 70½ years old.
In addition to retirement plan contributions, many employers offer a variety of fringe plans that afford employees to exclude from their income contributions made or benefits received under these plans. 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 2021, the maximum deductible contribution level is $3,600 for an individual and $7,200 for a family. In 2022, those maximums rise to $3,650 for individuals and $7,300 for families. 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 2021, a low-income taxpayer could claim credits up to $6,728 with three or more qualifying children, $5,980 with two, $3,618 with one, and $543, if none.
The American Rescue Plan, signed by President Biden on March 11, 2021, includes generous tax breaks to low- and moderate-income people. For 2021 only, the size of the earned-income tax credit will increase for childless households. The maximum credit amount for childless people increases to $1,502, from $543. The age range has also been expanded. People without children will be able to claim the credit beginning at age 19, instead of 25, with the exception of certain full-time students (students between 19 and 24 with at least half a full-time course load are ineligible). The upper age limit, 65, will be eliminated. For single filers, the phaseout percentage is increased to 15.3% and phaseout amounts are increased to $11,610.
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 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 for children and disabled dependents.
President Biden's American Rescue Plan also made changes to the Child Tax Credit for 2021. In 2021, it will increase to as much as $3,000 per child ($3,600 for ages 5 and under). The age limit for qualifying children also rises to 17 (from 16). In addition, the credit is fully refundable. The IRS may also issue up to half of an eligible household’s credit as an advance disbursement between July and December 2021, using 2020 or 2019 tax returns to determine eligibility.
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, even thousands, of dollars in tax savings.