Few of us want to pay more tax. Understanding the tax credits and deductions that we're eligible for, and calculating them correctly, can mean the difference between owing more money at tax time or receiving a welcome refund. So to answer the question, there are ways you can minimize your tax liability, including increasing retirement contributions, taking part in employer-sponsored plans, profiting from losses, and donating to charities.
- The key to minimizing your tax liability is reducing the amount of your gross income that is subject to taxes.
- Consider increasing your retirement contributions.
- Putting pre-tax dollars into an employer-sponsored retirement plan like a 401(k) is one easy way to reduce your taxable income for the year.
- If you sell an investment that loses its value, you can use that loss to offset other income.
- Donating to charity can decrease your annual tax bill if you itemize your deductions.
Increase Your Retirement Contributions
The income tax you pay each year is based on your gross income, which is the total amount of money you earn from all sources before accounting for any tax credits or deductions. For many of us, the easiest way to reduce that figure is by contributing to an employer-sponsored retirement plan or traditional individual retirement account (IRA).
The age restriction for contributing to a traditional IRA was lifted following the passage of the Setting Every Community Up for Retirement Enhancement Act (SECURE) of 2019. Prior to the law, you weren't able to contribute after age 70½. Now seniors can contribute to IRA accounts indefinitely.
Under the SECURE Act, individuals were required to take required minimum distributions (RMDs) from their 401(k) and traditional IRA accounts at the age of 72. That age was raised from 70½ for those who reached that age on or before Dec. 31, 2019. The age for RMDs increased once again when the SECURE Act 2.0 was passed in December 2022. Anyone who turns 73 on or after Jan. 1, 2023, must begin taking these withdrawals from their accounts by April 1 of the following year.
Employer plans, such as a 401(k) or a 403(b), allow you to contribute pre-tax dollars to your account, up to a certain maximum. The maximum amount you can contribute is $20,500 for 2022 ($22,500 for 2023). Anyone over the age of 50 can kick in an additional $6,500 as a catch-up contribution (increasing to $7,500 for 2023).
The change to taking distributions from your retirement account may impact taxes, depending on your tax bracket, when you start withdrawing funds.
Contribute to Employer-Sponsored Plans
Contributions to traditional 401(k) or 403(b) plans are made through regular paycheck withholding and offer a direct dollar-for-dollar reduction to total taxable income. Another version of these plans, the Roth 401(k) or Roth 403(b), doesn't provide any upfront tax benefit but does allow for tax-free withdrawals later on.
If an employer-sponsored plan isn't available to you, consider a traditional IRA instead. Your contributions will be made with pre-tax dollars, resulting in a direct reduction to your taxable income for the year and ultimately to your total tax liability.
For 2022, your contributions cannot exceed $6,000 ($6,500 in 2023), with an additional $1,000 allowed for those age 50 and above. As with a 401(k) and 403(b) plans, there is also a Roth IRA, without any immediate tax benefit.
Profit From Investment Losses
Selling off investments that declined in value since you purchased them can also help you reduce your tax liability for the year. This is a strategy that is often referred to as tax-loss harvesting. These investment losses can be written off against your investment gains or other income up to a certain limit each year. The Internal Revenue Service (IRS) sets this limit to $3,000 or $1,500 if you're married filing separately.
What's more, any amount you can't use in the current year can be carried forward to future years, reducing your taxes then, as well. Conversely, it can be beneficial to delay selling an appreciated asset and avoid being taxed on your gain, especially in a year when your taxable income is already high.
For more about these and other strategies for reducing your tax bill, it's often a good idea and well worth the money, to consult a CPA or other knowledgeable tax pro.
Donate to Charity
Making contributions to qualified charitable organizations can also reduce your taxes only if you itemize deductions on your tax return and don't take the standard deduction. Contributions can be in the form of cash or goods, such as used household items. However, any donation that has a value exceeding $250 requires a receipt to be a valid deduction.
If you do itemize and take the deduction for charitable donations, you can take a deduction of up to 60% of your adjusted gross income (AGI) for qualifying cash donations as long as they are made to qualified charities.
Mark Struthers, CFA, CFP®
Sona Financial, LLC, Minneapolis, MN
If you’re in a high-deductible health insurance plan, you can open a health savings account (HSA). Contributions and distributions are tax-free when used for medical expenses. The same goes for 529 Plans used for educational expenses. Taxes on the interest earned by Series EE savings bonds can be deferred for 30 years, or until you redeem them. You can avoid taxes on appreciated assets by gifting them to someone, within gift-tax limits. Whenever possible, hold heavily taxable assets in tax-deferred retirement accounts. Just make sure you are not passing up good investment choices or strategies just to avoid giving the IRS its due. Many clients will cut their tax bills to the detriment of sound financial planning. That's the tax tail wagging the investment dog.
What Steps Can I Take to Reduce my Tax Liability?
Your tax liability is the total amount of money you owe to another entity, usually the government. Put simply, it's a tax bill. For instance, if you earn income, you may owe taxes to the IRS. But there are certain things you can do to minimize the amount of tax you owe at the end of the year. This includes saving money for retirement, taking part in employer-sponsored retirement plans, and using tax-loss harvesting as a strategy. If you itemize your deductions, you can also use the deduction for charitable donations to lower your tax bill.
What Is a Tax Liability?
Tax liability is the total amount of money you owe to a government or other entity. The most common types are sales taxes paid (to businesses and governments), property taxes, local taxes, state taxes, and federal taxes. The most commonly talked about tax liability is owed to the IRS each year. In this case, your tax liability is the amount of money you owe after any tax credits, deductions, exceptions, and exclusions are accounted for after they're subtracted from your gross income.
How Can a Business Minimize Its Annual Tax Bill?
Running a business comes with a tax liability. But this bill can be reduced with proper planning. Like individual taxpayers, businesses can cut their tax bill by knowing and taking the right deductions, including travel expenses, wages, and the standard mileage rate. Similarly, applying tax credits to reduce the year's tax bill can also help.
Other steps that businesses can take include investing in equipment and personnel and making purchases (equipment, raw materials, and other important assets for the business) at the right time.
Company owners may want to consider talking to a tax professional to weigh out their options.
The Bottom Line
If you have a source of income, there's a very good chance that you'll have to pay taxes. Any money earned from an employer will certainly incur a tax bill. But let's face it, no one wants to pay more taxes to the government than they have to—especially when times are tough. But there are a few ways you can reduce that tax bill. Taking the steps listed above can certainly minimize your tax liability. But if you feel that you're still going to end up with a big tax bill and can afford to, you may want to consider increasing the amount withheld from each paycheck by your employer.