4 ways to reduce taxable income and pay lower taxes.
In today’s post, we’ll be going over legal ways you can reduce your taxable income.
In all seriousness, reducing taxable income is something we all want to do, right?
And since eliminating your income is clearly not an option, we need to look at the strategies to reduce your taxable income or the income that the IRS views as taxable.
Make sure to take notes on each tip mentioned in this post.
If you choose to capitalize on these tips, you are going to save thousands of dollars or more on your taxes.
In fact, as CPAs, we’ve helped businesses and individuals save on their taxes through tax planning.
With tax planning, we go over the ins and outs of a taxpayer’s situation.
We review all sources of income and major life circumstances and come up with legal ways to save them thousands in taxes.
We recently had a tax planning client that was overpaying in taxes by $11,522 annually!
We ran the numbers and found that if she could pocket that cash she’s overpaying in taxes and invest it towards her retirement…
…she would have at least $1.6M dollars saved by the time she retires!
Granted, everyone’s circumstances are different and if you want to do things right and legal, you must work with a CPA to figure out the best strategies for you.
This post will merely plant seeds of knowledge for you and then it is up to you what you’ll do with this knowledge.
Our hope is that you work with a CPA and implement every strategy we are about to outline so you can have more cash here.
All good? Let’s get started!
Tips on How to Reduce Taxable Income
1. Open a Retirement Account
Perhaps you’ve heard of employer 401ks where employers and employees contribute to the employee’s 401k account.
The employee’s contribution is made with pre-tax dollars.
This means before you pay taxes, that contribution goes to your 401k account and actually reduces your taxable income.
But what if you own your business or your employer does not offer 401ks as a benefit?
There is another type of tax-advantaged retirement, and that is an Individual Retirement Account or Traditional IRA.
Self-employed individuals can start a SEP IRA.
Both are similar, in that, you can make contributions to these accounts with pre-tax income.
So while you are saving for retirement (something we all should be doing), you are reducing your taxable income.
However, there is a limit to the amount you can contribute to your 401k or IRA account every year.
These amounts change slightly year over year according to the new tax law so it’s important to verify this every single year so you don’t get into any trouble.
But for 2020, you can contribute up to $19,500 to your 401k. And up to $6,000 to your traditional IRA account and up to $57k for your SEP-IRA account.
There are other income and contribution limitations and guidelines that apply to opening and funding an IRA account.
So, make sure you familiarize yourself with those details.
However, reducing your taxable income by $6k, $19k, or $57k will also dramatically reduce your taxes owed.
This money also grows and compounds tax-free over the years.
Disclaimer: You will ultimately have to pay taxes once you withdraw these funds at retirement. However, most people are in a lower tax bracket at retirement and would pay fewer taxes compared to when they were actively working.
You also can’t withdraw from these accounts prematurely or prior to 59 ½ years old or you will be penalized.
So just keep this in mind.
2. Health Saving Accounts or HSAs
An HSA is a tax-advantaged medical savings account. The funds you contribute to an HSA are not subject to income taxes and actually, reduce your taxable income.
A big reason why HSAs exist is to make healthcare costs much more affordable.
So for this reason, you have to use the cash in an HSA for medical expenses.
But with the rising cost of healthcare, that shouldn’t be too hard to do, especially considering the wide array of expenses you could use your HSA for.
- prescriptions and over the counter medications
- contact lens
- physical therapy
- chiropractor visits
…and much more.
And unlike retirement accounts, when you withdraw money from your HSA and use it on a qualified expense, there aren’t any taxes imposed.
If for any reason, you don’t utilize all of the funds in your HSA, no worries, you can roll it over to the next year.
Of course, there are limitations.
HSAs are only for those individuals who have a high deductible health plan and you can only contribute up to $3,550 in 2020. $7,100 for families.
3. Municipal Bonds
This tip does not necessarily reduce your taxable income.
But if you’re an investor and looking for another way to invest your cash and diversify your portfolio while enjoying some tax-exempt earnings, consider municipal bonds.
Municipal bonds are debt securities issued by the state and local governments to fund public projects like roads, bridges, parks, and other infrastructure.
So you are basically lending money to the government to fund projects and they pay you back with interest.
These bonds are considered relatively safe and stable. Though, you should consider the risk factors of making any investment.
The tax advantage of municipal bonds is that the interest you earn on your investment is tax-free.
The average yield or return on municipal bonds is around 1.5% to 5%, depending on the bond’s maturity date.
Checkout Vanguard to see what municipal bonds are available.
4. Home Office Deduction
This next tip is for the entrepreneurs out there.
If you have your own business or side hustle and work from your home, you could possibly take the home office deduction.
What makes this write-off so great is that you get to deduct normally personal expenses as business deductions. And therefore it can help you save on taxes.
The key is having a space in your home that is regularly and exclusively used for business.
If you do have such a space, you could take deductions for your rent and utilities.
For homeowners, you can deduct a portion of your mortgage interest.
There are two ways to come up with the exact amount of the deduction.
The 1st is called the simplified method, where your total home office deduction is $5 for every square foot of office space.
So if your home office is 100 square feet, you’d get to deduct $500.
The 2nd method is the actual expense deduction.
So here, you would take your total home expenses (rent, utilities, insurance, etc.) and apply a rate to determine your deduction.
The rate is the percentage of space your home office is compared to your entire home.
So if your home office is 250 square feet and your entire home is 1,000 square feet, your home office represents 25% of your home.
And you could write off 25% of the appropriate home expenses.
There you have it! We hope you enjoyed this post and will implement some of the strategies we talked about today.
What will you do to reduce your taxable income?
Will you open a retirement account or HSA?
Or how about investing in municipal bonds or utilizing the home office deduction?