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How to Reduce Taxable Income
When you earn a high income, you tend to pay a higher percentage of taxes than average earners. This is fundamentally a good place to be in. High taxes means you are financially independent and earning a bigger income!
But no one likes paying taxes and you’re probably wondering how to reduce taxable income.
There are a few different ways you can reduce your taxable income. Below we look at 6 common ways you can reduce your taxable income. Who knows – you might even end up getting a tax refund in the end.
Are There Legal Ways to Low Your Taxable Income?
You have to pay income tax on all of the income you make in a tax year.
However, there are some ways to decrease the amount of your income that is taxable. These are called tax deductibles. These deductions are there to incentivize good civil behaviour, like paying for healthcare, donating to charity, and saving for retirement.
If you are self-employed, then your business deductions also reduce your taxable income. Your business is taxed on its profit, not its gross income.
Do not try to reduce your taxable income by making up deductions or expenses. This is tax fraud and is illegal. If you are unsure, contact a tax specialist and get sound financial advice.
6 Ways to Lower Your Taxable Income
Tax reform eliminated some of the complicated, itemized deductions that taxpayers could use in the past. But there are still ways to save for the future and trim your current tax bill.
Save for Retirement
Retirement savings are tax-deductible. This means every dollar you put into a retirement account reduces your taxable income.
For you to reap this tax benefit, the retirement account has to be recognized as such by law. Employer-based retirement accounts, such as 401(k) and 403(b), will reduce your taxable income. If you are self-employed or earn money from a side-hustle, you can also contribute up to 20% of your net self-employment income to a Simplified Employee Pension to reduce your taxable income. On top of both of these options, you can also contribute to an Individual Retirement Account (IRA) to reduce your taxable income.
To maximize your tax benefit, you should max out your retirement contributions.
The tax benefit of saving for retirement is two-fold. Firstly, every dollar you put into your retirement account is not taxed until you withdraw the money from your account. Your retirement contributions are pre-tax contributions, hence why they decrease your taxable income. This means your tax burden is reduced each year you contribute. Then, if you wait until you have retired to withdraw your money from your retirement account, you will be in a lower income bracket and will be taxed at a much lower rate.
It is important to note that Roth IRAs and Roth 401(k)s will not reduce your taxable income. Your Roth contributions are post-tax contributions. In other words, the money you put into your Roth account has already been taxed. This means it will not be taxed when you withdraw the money from your account. Investing in a Roth account still spreads your tax burden, but will not reduce your taxable income.
Buy tax-exempt bonds
Tax-exempt bonds might not be the most glamorous investment, but is a good way to reduce your taxable income. The income and even the interest payments from tax-exempt bonds are exempt from tax. This means when your bond matures, your original investment is returned without being taxed.
Utilize Flexible Spending Plans
Your employer’s answer to how to reduce taxable income might be to offer a flexible spending plan. A flexible spending account is an account managed by your employer. You set aside a portion of your pre-tax earnings and your employer uses it to pay for things such as medical expenses on your behalf.
Utilizing a flexible spending plan decreases your taxable income and provides a reduction in tax bills during the year in which the contribution is made.
A flexible spending plan could be a use-or-lose model or offer a carry-over option. On the use-or-lose model, you have to spend the money you contributed this tax year or forfeit the unspent amounts. In a carry-over model, you can carry over up to $500 of unused funds to the following tax year.
Use Business Deductions
If you are self-employed, you can reduce your taxable income by claiming all of the business deductions available to you. You can claim business deductions on full- or part-time self-employed income.
For example, you claim business deductions for the cost of running your home office, the cost of your health insurance, and a portion of your self-employment tax.
If you have big deductible purchases, make them by the end of the tax year to reduce your taxable income and spread your tax burden across tax years.
Give to Charity
If you claim it properly, making charitable contributions will reduce your taxable income.
For cash contributions, make sure you have proof of your donation. If you donate $250 or more, you’ll also need an acknowledgement from the charity.
If you have a share that you have owned for more than one year, you can also donate the security to a charity. You can deduct the full value of the security and you won’t have to pay taxes on capital gains. A donor-advised fund is another way to donate securities and gain a tax benefit from it.
Pay Your Property Tax Early
If you pay your property tax early it will reduce your taxable income for the current tax year. Property tax is one of the more complicated ways of reducing taxable income. Before paying your property tax early, talk to your tax preparer to determine whether you’re vulnerable to the alternative minimum tax.
Defer Some Income Until Next Year
If you have had a series of incomes this tax year that you think won’t apply to you next year, you can try to defer some of your income to the next tax year. If you defer some of your income, you will only pay tax on them next year. This is worth it if you think it will help you fall into a lower tax bracket next year.
Some ways of deferring income are to ask for your year-end bonus to be paid the following year or send bills to clients late in the tax year.
- Why Was No Federal Income Tax Withheld From My Paycheck?
- Why Do I Owe Taxes?
- Why Do I Owe State Taxes?
- Are You Exempt from Federal Withholding?
- How to File Taxes With No Income
- Can You File Taxes Without a W2?
- H1B Taxes: Everything You Need to Know
- Are Financial Aid and Student Loans Taxable Income?
As you can see, there are actually a few ways to reduce your taxable income. You can pay less tax by making investments in tax-deductible or tax-exempt funds, like retirement funds and municipal bonds. By spending this money, you are reducing the part of your income that is taxable by the government.
The other way to reduce your taxable income is by spreading your income over multiple tax years. This means that you will be in a lower tax bracket for both years, and theoretically pay less tax.
Tax law can be complex. When in doubt, hire a professional for advice.