The current taxpayer system in the US is set up so that as your income increases, the percentage in tax that you pay on that income increases. The percentage of tax owed on the final dollar of your income each year is called your marginal tax rate.
A common phrase used to describe when these percentages change is the term “tax brackets. The IRS changes these brackets occasionally, and each year publishes the new brackets on its website.
Since each additional dollar is taxed at a higher marginal rate, it is important to take advantage of every opportunity to reduce your taxable income as much as is legally allowed. Fortunately, the tax code provides many opportunities for taxpayers to do just that.
Read on to discover five easy ways to reduce your taxable income.
Max out annual retirement savings
Most employers offer a retirement savings plan to their employees commonly by way of a 401(k) plan. When I ask someone how much they are contributing to their retirement plan, I often hear the answer “Oh, I’m contributing the max”.
Upon further review, we learn that they are contributing just enough to receive the company match.
This may mean only a 3-6% contribution of their salary. This may not be the max! Individuals can contribute up to $20,500 annually with an additional $6,500 allowed for those over the age of 50!
Employers also may contribute funds, while other plans allow for post tax or “Roth” contributions. In fact, the overall limit on contributions to a 401(k) in 2022 is $61,000 and $67,500 for participants over the age of 50.
Each pre-tax dollar contributed to your 401(k) reduces your taxable income this year, then grows tax-deferred until you take it out of the plan, potentially in a year when your marginal tax rate is lower. This may provide substantial tax savings when done over 20 years!
Utilize a Health Savings Account
An HSA is an account used in conjunction with a high deductible medical plan that allows you to save for either medical expenses or even save for retirement.
To be eligible to contribute to an HSA, you must be covered under a High Deductible Health Plan (HDHP). In 2022, the deductible must be at least $1,400 for an individual, or $2,800 for a family plan. The maximum annual contribution limits are $3,650 for an individual and $7,300 for family coverage for individuals under 55. For those over 55, the IRS adds $1,000 to these limits.
An HSA is one of the only ways to benefit from “triple tax” savings benefits. The triple tax benefit should be a significant incentive for people to implement an HSA strategy.
- Your contributions are pre-tax, so it reduces your taxable income.
- HSAs allow you to invest the funds, and this growth is not taxed.
- If you withdraw the funds to use on eligible medical expenses, the withdrawals are not taxed.
HSA funds can also be rolled over each year if you do not use them. If you do not use the funds for medical expenses, at age 65 you can roll the funds into a retirement savings account and simply use the money for retirement income.
Contribute to a Donor Advised Fund
A donor advised fund is a simple, flexible, and tax-efficient way to give to your favorite charities. While donor advised funds have been around since the 1930s, they have only recently grown in popularity and are now philanthropy’s fastest growing vehicles.
There are many ways you can donate to a DAF. The most common is simply through a cash contribution via a bank account. These types of donations are eligible for a deduction of up to 60 percent of your adjusted gross income!
In addition to the cash donations, another option is to donate appreciated securities directly. Rather than liquidating the securities and being subject to long-term capital gains tax, you can simply donate the securities, avoid the capital gains tax, and deduct the eligible donation value up to 30% of your adjusted gross income.
One advantage of a DAF is that you can contribute in a year in which your income is high, and then let the assets grow tax-free until you designate a charitable organization to receive the funds.
Start a business
There are many tax advantages available to small businesses owners that are not available to traditional employees receiving a salary from a company.
Many expenses for a home-based business may qualify for a deduction. The portion of utilities such as gas, electricity, and phones that are used for business can be deducted. Through 2022, meals while traveling on business or entertaining a client may qualify as a 100% deductible expense.
As a self-employed individual, you are eligible to take advantage of an entire universe of retirement savings plans. Some of the more common plans include:
- Solo 401(k) – similar to a 401(k) in the workplace, but with additional flexibility
- SEP IRA – very popular plan and easy to set up. Limits are lower than the solo 401(k) plan
- Defined Benefit – this plan can supercharge retirement savings for a high-earning small business owner. There is no limit on the contribution amount, rather you determine an income amount to receive in retirement, then an actuary determines how much funding is needed to achieve this income. I’ve seen annual contributions over $300,000 with that amount reducing taxable income by the same figure.
Prepay Taxes through a Roth Conversion
Many of the tips discussed in this article are ways to defer taxes. While this is a huge benefit over time, eventually the IRS wants to get paid. They are going to force you to pay taxes on withdrawals in retirement accounts through annual required minimum distributions (RMDs).
If you’ve been funding retirement plans for 30 years, these RMDs can be really big numbers. RMDs over $100,000 are not unusual. RMDs are also taxed as ordinary income. That can be a painful tax bill to swallow, especially if it forces you into a higher marginal tax bracket.
One way to help reduce these RMDs and provide tax flexibility is to convert dollars into Roth IRAs now and over several years. Once dollars are in a Roth IRA they aren’t just tax-deferred…they are tax-free! The investments grow tax-free, and the withdrawals are not taxed, provided certain rules are met.
The downside of a Roth conversion is that it forces you to pay tax on the amount you convert, in the year it’s converted. It’s important to coordinate the timing of these conversions in years where your income is lower, while you have funds available to pay the additional taxes that will be owed due to the conversion.
I strongly recommend working with a tax professional or a financial advisor to coordinate a Roth conversion strategy, as tax projections and investment returns can drastically change the appropriate amount of conversion from year to year.