You pay a lot of money in taxes — probably more than you realize. Few people know just how much they pay in taxes each year. Most people remember whether they received a refund or owed money on their return. But when you file your tax return, all you’re doing is settling up with tax authorities over the amount of taxes you paid during the year versus the total tax you owe based on your income and deductions.
Some people feel lucky when they get an income tax refund, but all such a refund really indicates is that you overpaid your income taxes during the year. You should have had this money in your own account all along. If you’re consistently getting big income tax refunds, you need to pay less tax throughout the year.
To find out the total income taxes you pay, you need to get out your federal and state income tax returns. On each of those returns is a line that shows the total tax you owed for the year: This is Line 63 on the most recent federal 1040 returns. If you add up the totals from your federal and state income tax returns, you’ll probably see one of your largest expenses.
The goal of this article is to help you legally and permanently reduce your total taxes. Understanding the tax system is the key to reducing your tax burden — if you don’t, you’ll surely pay more taxes than necessary. Your tax ignorance can lead to mistakes, which can be costly if the IRS and state government catch your underpayment errors. With the proliferation of computerized information and data tracking, discovering mistakes has never been easier.
What is Taxable Income?
Taxable income is the amount of income on which you actually pay income taxes. (In the sections that follow, I explain strategies for reducing your taxable income.) The following reasons explain why you don’t pay taxes on your total income:
Not all income is taxable. For example, you pay federal tax on the interest you earn on a bank savings account but not on the interest you earn from municipal bonds. Some income, such as from stock dividends and long-term capital gains, is taxed at lower rates.
You get to subtract deductions from your income. Some deductions are available just for being a living, breathing human being. In 2018, single people get an automatic $12,000 standard deduction, and married couples filing jointly get $24,000. (People over age 65 and those who are blind get a slightly higher deduction.) Other expenses, such as mortgage interest and property taxes, are deductible (subject to limitations) if these so-called itemized deductions exceed the standard deductions. When you contribute to qualified retirement plans, you also effectively get a deduction.
How To Reduce Taxable Income
You’re supposed to pay taxes on the income you earn from work. Countless illegal methods can reduce your taxable employment income — for example, not reporting it — but if you use them, you can very well end up paying a heap of penalties and extra interest charges on top of the taxes you owe. And you may even get tossed in jail.
Because I don’t want you to serve jail time or lose even more money by paying unnecessary penalties and interest, this section focuses on the best legal ways to reduce your income taxes on your earnings from work.
1. Contributing to retirement plans
A retirement plan is one of the few relatively painless and authorized ways to reduce your taxable employment income. Besides reducing your taxes, retirement plans help you build up a nest egg so you don’t have to work for the rest of your life.
You can exclude money from your taxable income by tucking it away in employer-based retirement plans, such as 401(k) or 403(b) accounts, or self-employed retirement plans, such as SEP-IRAs. If your combined federal and state marginal tax rate is, say, 33 percent and you contribute $1,000 to one of these plans, you reduce your federal and state taxes by $330. Do you like the sound of that? How about this: Contribute another $1,000, and your taxes drop another $330 (as long as you’re still in the same marginal tax rate). And when your money is inside a retirement account, it can compound and grow without taxation.
Many people miss this great opportunity to reduce their taxes because they spend all (or too much) of their current employment income and, therefore, have nothing (or little) left to put into a retirement account. If you’re in this predicament, you first need to reduce your spending before you can contribute money to a retirement plan.
If your employer doesn’t offer the option of saving money through a retirement plan, lobby the benefits and human resources departments. If they resist, you may want to add this to your list of reasons for considering another employer. Many employers offer this valuable benefit, but some don’t. Some company decision-makers either don’t understand the value of these accounts or feel that they’re too costly to set up and administer.
If your employer doesn’t offer a retirement savings plan, individual retirement account (IRA) contributions may or may not be tax-deductible, depending on your circumstances. You should first maximize contributions to the previously mentioned tax-deductible accounts.
Married couples filing jointly with adjusted gross incomes (AGIs) of less than $63,000 and single taxpayers with an AGI of less than $31,500 can earn a tax credit (claimed on Form 8880) for retirement account contributions. Unlike a deduction, a tax credit directly reduces your tax bill by the amount of the credit. The credit is not available to those under the age of 18, full-time students, or people who are claimed as dependents on someone else’s tax return.
2. Shifting some income
Income shifting, which has nothing to do with money laundering, is a more esoteric tax-reduction technique that’s an option only to those who can control when they receive their income.
For example, suppose your employer tells you in late December that you’re eligible for a bonus. You’re offered the option to receive your bonus in either December or January. If you’re pretty certain that you’ll be in a higher tax bracket next year, you should choose to receive your bonus in December.
Or, suppose you run your own business and you think that you’ll be in a lower tax bracket next year. Perhaps you plan to take time off to be with a newborn or take an extended trip. You can send out some invoices later in the year so your customers won’t pay you until January, which falls in the next tax year.
3. Purchasing real estate
When you buy a home, you can claim two big ongoing expenses of home ownership as deductions on Schedule A: your property taxes and the interest on your mortgage. You’re allowed to claim mortgage interest deductions for a primary residence (where you actually live) and on a second home for mortgage debt totaling up to $750,000, which is down from the previous limit of $1 million (and a home equity loan of up to $100,000). You may be grandfathered under the higher $1 million limit for mortgages taken out before December 16, 2017 or who had a home under contract by that date and closed on that purchase by April 1, 2018.
Under prior tax law, there was no limit on property tax deductions on Form 1040 Schedule A. Effective 2018, property taxes (combined with state and local income tax payments) are limited to a maximum $10,000 annual deduction.
To buy real estate, you need to first collect a down payment, which requires maintaining a lid on your spending. You can read our best tips on saving for a down payment.
4. Trading consumer debt for mortgage debt
When you own real estate, you haven’t borrowed the maximum, and you’ve run up high-interest consumer debt, you may be able to trade one debt for another. You may be able to save on interest charges by refinancing your mortgage or taking out a home equity loan and pulling out extra cash to pay off your credit card, auto loan, or other costly credit lines. You can usually borrow at a lower interest rate for a mortgage and get a tax deduction as a bonus, which lowers the effective borrowing cost further. Consumer debt, such as that on auto loans and credit cards, isn’t tax-deductible.
This strategy involves some danger. Borrowing against the equity in your home can be an addictive habit. I’ve seen cases where people run up significant consumer debt three or four times and then refinance their home the same number of times over the years to bail themselves out.
An appreciating home creates the illusion that excess spending isn’t really costing you. But debt is debt, and all borrowed money ultimately has to be repaid (unless you file bankruptcy). In the long run, you wind up with greater mortgage debt, and paying it off takes a bigger bite out of your monthly income. Refinancing and establishing home equity lines cost you more in terms of loan application fees and other charges (points, appraisals, credit reports, and so on).
At a minimum, the continued expansion of your mortgage debt handicaps your ability to work toward other financial goals. In the worst case, easy access to borrowing encourages bad spending habits that can lead to bankruptcy or foreclosure on your debt-ridden home.
5. Contributing to charities
You can deduct contributions to charities if you itemize your deductions on Form 1040, Schedule A. Consider the following possibilities:
- Most people know that when they write a check for $50 to their favorite church or college, they can deduct it. Note: Make sure that you get a receipt for contributions of $250 or more.
- Many taxpayers overlook the fact that you can deduct expenses for work you do with charitable organizations. For example, when you go to a soup kitchen to help prepare and serve meals, you can deduct some of your transportation costs. Keep track of your driving mileage and other commuting expenses.
- You can deduct the fair market value (which can be determined by looking at the price of similar merchandise in thrift stores) of donations of clothing, household appliances, furniture, and other goods to charities. (Some charities will drive to your home to pick up the stuff.) Find out whether organizations such as the Salvation Army, Goodwill, or others are interested in your donation. Just make sure that you keep some documentation — write up an itemized list and get it signed by the charity. Take pictures of your more valuable donations.
- You can even donate securities and other investments to charity. In fact, donating an appreciated investment gives you a tax deduction for the full market value of the investment and eliminates your need to pay tax on the (unrealized) profit.
6. Remembering auto registration fees and state insurance
If you don’t currently itemize, you may be surprised to discover that your state income taxes can be itemized. When you pay a fee to the state to register and license your car, you can itemize a portion of the expenditure as a deduction (on Schedule A, Line 7, “Personal Property Taxes”). The IRS allows you to deduct the part of the fee that relates to the value of your car. The state organization that collects the fee should be able to tell you what portion of the fee is deductible. (Some states detail on the invoice what portion of the fee is tax-deductible.) Due to changes from the 2017 tax bill that took effect in 2018, there’s a $10,000 annual federal income tax deduction limit on state and local taxes combined with property tax payments on your home.
Several states have state disability insurance funds. If you pay into these funds (check your W-2), you can deduct your payments as state and local income taxes on Line 5 of Schedule A. You may also claim a deduction on this line for payments you make into your state’s unemployment compensation fund.
7. Deducting self-employment expenses
When you’re self-employed, you can deduct a multitude of expenses from your income before calculating the tax you owe. If you buy a computer or office furniture, you can deduct those expenses. (Sometimes they need to be gradually deducted, or depreciated, over time.) Salaries for your employees, office supplies, rent or mortgage interest for your office space, and phone/communications expenses are also generally deductible.
Many self-employed folks don’t take all the deductions they’re eligible for. In some cases, people simply aren’t aware of the wonderful world of deductions. Others are worried that large deductions will increase the risk of an audit. Spend some time finding out more about tax deductions; you’ll be convinced that taking full advantage of your eligible deductions makes sense and saves you money.
8. Enlisting Education Tax Breaks
The government offers several tax reduction opportunities for those with educational expenses. Knowing that you don’t want to read the dreadful tax code, here’s a summary of key provisions you should know about for yourself and your kids if you have them:
- Student loan interest deduction: You may take up to a $2,500 deduction for student loan interest that you pay on IRS Form 1040 for college costs as long as your modified adjusted gross income (AGI) is less than or equal to $65,000 for single taxpayers and $135,000 for married couples filing jointly. (Note: Your deduction is phased out if your AGI is between $65,000 and $80,000 for single taxpayers and between $135,000 and $165,000 for married couples filing jointly.)
- Tax-free investment earnings in special accounts: Money invested in section 529 plans is sheltered from taxation and is not taxed upon withdrawal as long as the money is used to pay for eligible education expenses. Subject to eligibility requirements, 529 plans allow you to sock away $200,000+. Please be aware, however, that funding such accounts may harm your potential financial aid.
- Tax credits: The American Opportunity (AO) credit and Lifetime Learning (LL) credit provide tax relief to low- and moderate-income earners facing education costs. The AO credit may be up to $2,500 per student per year of undergraduate education, while the LL credit may be up to $2,000 per taxpayer. Each student may take only one of these credits per tax year, and they are subject to income limitations. And in a year in which a credit is taken, you may not withdraw money from a 529 plan nor take a tax deduction for your college expenses.
How To Reduce Investment Income Taxes
The distributions and profits on investments that you hold outside of tax-sheltered retirement accounts are exposed to taxation when you receive them. Interest, dividends, and capital gains (profits from the sale of an investment at a price that’s higher than the purchase price) are all taxed.
1. Investing in tax-free money-market funds and bonds
When you’re in a high enough tax bracket, you may find that you come out ahead with tax-free investments. Tax-free investments pay investment income, which is exempt from federal tax, state tax, or both.
Tax-free investments normally yield less than comparable investments that produce taxable income. But because of the difference in taxes, the earnings from tax-free investments can end up being greater than what you’re left with from taxable investments.
Tax-free money-market funds can be a better alternative to bank savings accounts (where interest is subject to taxation). Likewise, tax-free bonds are intended to be longer-term investments that pay tax-free interest, so they may be a better investment option for you than bank certificates of deposit, Treasury bills and bonds, and other investments that produce taxable income.
2. Selecting other tax-friendly investments
Too often, when selecting investments, people mistakenly focus on past rates of return. Everyone knows that the past is no guarantee of the future. But choosing an investment with a reportedly high rate of return without considering tax consequences is an even worse mistake. What you get to keep — after taxes — is what matters in the long run.
For example, when comparing two similar funds, most people prefer a fund that averages returns of 14 percent per year to one that earns 12 percent per year. But what if the 14-percent-per-year fund, because of greater taxable distributions, causes you to pay a lot more in taxes? What if, after factoring in taxes, the 14-percent-per-year fund nets just 9 percent, while the 12-percent-per-year fund nets an effective 10-percent return? In such a case, you’d be unwise to choose a fund solely on the basis of the higher (pre-tax) reported rate of return.
I call investments that appreciate in value and don’t distribute much in the way of highly taxed income tax-friendly. (Some in the investment business use the term tax-efficient.)
Real estate is one of the few areas with privileged status in the tax code. In addition to deductions allowed for mortgage interest and property taxes, you can depreciate rental property to reduce your taxable income. Depreciation is a special tax deduction allowed for the gradual wear and tear on rental real estate. When you sell investment real estate, you may be eligible to conduct a tax-free exchange into a replacement rental property.
3. Making your profits long term
When you buy growth investments such as stocks and real estate, you should do so for the long term — ideally ten or more years. The tax system rewards your patience with lower tax rates on your profits.
When you’re able to hold on to an investment (outside of a retirement account) such as a stock, bond, or mutual fund for more than one year, you get a tax break if you sell that investment at a profit. Specifically, your profit is taxed under the lower capital gains tax rate schedule. High income earners pay 20 percent of your long-term capital gains’ profit in federal taxes. (The same lower tax rate applies to stock dividends.)
Most moderate and upper income taxpayers face a long-term capital gains’ tax rate of 15 percent. Finally, for those in the lowest tax brackets, the long-term capital gains tax rate is 0 percent.
High-income taxpayers (with total taxable income above $200,000 for singles; $250,000 for marrieds filing jointly) are subject to a 3.8-percent-higher tax on their investment income (for example, interest, dividends, and capital gains) to help pay for Obamacare. This produces a top long-term capital gains rate of nearly 24 percent.
There are all sorts of ways to prepare your tax return. Which approach makes sense for you depends on the complexity of your situation and your knowledge of taxes.
Regardless of which approach you use, you should be taking financial steps during the year to reduce your taxes. By the time you actually file your return in the following year, it’s often too late for you to take advantage of many tax-reduction strategies.