How to Avoid Paying so Much in Taxes
The way you reduce taxable income is all about deductions. The more legitimate deductions you take, the more you can drop your Adjusted Gross Income (AGI.) Your AGI is how the IRS determines your tax liability. In 2017, the Tax Cuts and Jobs Act increased the standard deductions from $6,350 to $12,000 for single filers. Head of household filers saw standard deductions rise from $9,350 to $18,000. Married couples filing jointly saw an increase of $12,700 to $24,000.
The Tax Cuts and Jobs Act also made changes to long-standing personal deductions. The law restricts the amount of deductible interest on a home mortgage from $1,000,000 to $750,000. The deduction for state and local taxes was capped at $10,000. For states with higher tax rates, these changes make homeownership less affordable.
The new law also changed the tax brackets.
Tax Brackets Before
Tax Brackets After
The new tax law cuts corporate taxes permanently – the flat rate is now 21%. The tax rate for individuals will expire in 2025.
Tax reform has long been needed. The complicated filing process is complex and confusing. The rationale behind raising the standard deduction was to simplify the process. The thinking was most taxpayers could forego itemizing their deductions. High-income earners would rely on their tax accountants.
The incoming administration has made it clear they intend to make changes. The biggest impact will land on wealthier people.
But many deductions have stood the test of time, no matter which party holds the White House. If you want to reduce your taxable income, these strategies work for everyone.
Tips to Reduce Taxable Income
Some of the best ways to reduce your taxes now come from planning for the future. The list below helps individuals, and some small businesses save on their taxes.
1. Retirement Accounts
A traditional 401k and IRA are pre-tax accounts. Your contributions are deducted from your taxable income. The maximum annual contribution for a 401k is $19,500 – a bit out of reach for some. But any contribution you make to your account is reduces your taxable income.
The IRA has a lower contribution rate, $6000 a year. The same rules apply, all contributions are deducted from your income. Both accounts grow tax-free until you withdraw your money. Then you pay taxes on the withdrawal at your current tax bracket.
A Roth 401k or IRA will not reduce your tax liabilities. They are after-tax accounts – your contributions are not deductible when you make them. But when you withdraw money, it’s tax-free.
2. Private Mortgage Insurance Deduction returns in 2020
In 2017, the Tax Cuts and Jobs Act ended the deduction on private mortgage insurance. For homeowners with less than 20% equity, losing the deduction stung. At the end of 2019, the deduction was reinstated. It’s was even retroactive for 2018 and 2019 returns.
There are some issues to overcome. To take the PMI deduction, you need to itemize your return. Depending on your other deductions, this might not be worth the trouble. With the standard deduction ranging from $12,000 to $24,000 – you have a lot to cover.
But itemizing can reduce your tax liability. If your mortgage interest is higher than the standard deduction, that’s a strong indicator. You can also deduct real estate taxes, and tax on personal property – like an RV, boat, or car. You pay personal property tax whenever you register them.
If you want to deduct payments for state and local taxes, you can’t take a deduction for sales taxes. Itemize your charitable donations too. Make sure you have the receipts to back the deductions up.
Just a tip: When it comes to PMI, you only have to carry it until you have 20% equity. In this world of recurring autopay, you could be making payments you don’t have to make. Check your equity.
3. Write Off Education Costs
There are 2 tax credits for education. The first benefits undergrads and their parents. The second is for adult lifelong learning.
The American Opportunity Credit incents undergraduate education. Parents or students can claim it for four years. If the student is a dependent, his or her parents will file for the credit. If not, the student can claim it themselves.
Filers can claim 100% of the first $2000 spent on tuition, fees, and books. Then you can claim 25% of the next $2000. The maximum credit is $2500 per year. Be aware the expenses cannot include the cost of living or transportation.
Eligibility is determined by the filer’s Adjusted Gross Income. Single filers making less than $80,000 or married couples filing jointly at $160,000 qualify. If you made between $80k and $90K you can claim a reduced credit. Same for married couples making between $160k and $180K.
If you make more than that, you can’t claim the credit. But if you have no income, you can still receive a partial credit when attending school.
The Lifetime Learning Credit has a broader scope. There is no limit on the number of years you can claim it. The credit covers undergrad studies, graduate programs, and vocational training. You can apply the credit for non-degree courses, like tech certifications.
The tax credit is 20% of the first $10,000 paid for tuition and fees, capped at $2000 total. It covers books and supplies as well, but not living expenses and transportation. You cannot apply for Lifetime Learning credit while receiving the American Opportunity Credit. But students pursuing a graduate degree can use this credit to move forward during the next tax year.
If you make less than $59,000 a year, you’re eligible to claim the credit. For married couples filing jointly, it doubles to $118,000. You can get a reduced credit if your income falls within $10k or $20k respectively. People making more than $69,000 of $138,000 cannot claim the credit.
4. Fund FSA Dependent Care
A flexible savings account sets aside pre-tax contributions for medical expenses. Your employer diverts money from your paycheck and anything you don’t use, you lose. Either way, try to
An FSA Dependent Care account can be used to pay for childcare expenses. Some plans include eldercare expenses too. If your employer has a plan it’s worth checking out. You can reduce your tax liability by up to $5000. For children under 14, the fund will pay for daycare, before and after school care. Preschool is also included and even some day camps.
Like other FSA accounts, you lose any money you don’t spend. But dependent care is easier to estimate. Look at the monthly cost of your childcare and multiply it by 12. That will give you the minimum amount you need. Then sign up and your employer will start diverting the pre-tax dollars toward it.
(A Health Savings Account is different than an FSA. It’s funded with pre-tax dollars and there’s no use it or lose it clause. It’s only available to people who have a high deductible healthcare plan. If that’s you – you can write off every contribution you make to the account. You can claim $3550 individually or $7100 for families. There are some exceptions, for example, military members who use Tri-care cannot open up an HSA.)
5. Earned Income Tax Credit (EITC)
The EITC gives people of low and moderate-income a tax credit. The maximum refund is as high as $6,557 in 2020. The amount either reduces your taxable income or increases your refund.
Eligibility for EITC is based on income and family size. Income eligibility is $15,570 for single taxpayers with no children. Married families with 3 or more children can earn up to $55,952. There are special eligibility requirements for military members, clergy, and taxpayers with disabilities.
To claim the credit, you may not have investment income over $3,650. Married couples cannot claim the EITC if they are filing separately. Even if you make too little income to file, you may be able to get an EITC refund check.
The IRS has an EITC Qualification Assistant to help determine eligibility.
How Do High-Income Earners Reduce Taxes?
A high-income earner is anyone who falls in the top three tax brackets. These are the rates for 2020. The columns show the Tax Bracket, Income Level, and Tax Owed.
According to the Tax Foundation, the tax rate actually paid in the 37% bracket is 26.8%. How do they pay 10% less than the imposed tax rate? Deductions.
High income earners will max out their 40ks. They hire accountants and tax attorneys to reduce their taxable income. They also know how to get tax-free cash when they need it.
Here are some of the methods – all legal – that they use.
1. Start a Donor Advised Fund
A donor-advised fund is a charitable fund that allows you to choose how and when you make donations. Charitable donations without a fund are deductible too. But you have to itemize your return and it’s a one time write off.
Donor-advised funds are managed by a non-profit sponsor. The sponsor is responsible for managing the money and other assets contributed to the fund. Besides cash contribution, assets can include stock, artwork, or even real estate. Many financial services firms offer non-profit programs, like Vanguard Charitable.
Donors tell the fund sponsor the non-profits they want to support. Though the assets are the legal property of the fund, donors decide when to release them.
Donate stock directly to the fund, you eliminate capital gains taxes. You also reduce your income tax and avoid the Medicare surtax for high-income earners. Another huge tax advantage is donating real estate directly to the fund where the estate tax does not apply.
Joining a donor-advised fund is helpful in a year where your income jumps. The large tax write off (which can carry several years) reduces your AGI and tax liability.
2. Invest, Invest, Invest
When you can afford to invest, you’re likely to pay less taxes than you do if you rely on a paycheck. Investments are taxed through capital gains. While the highest individual tax rate is 37%, the highest long-term capital gains rate is 20%.
The true beauty of buying stocks is they aren’t taxed until the assets are sold. High-income earners increase their net worth by buying and holding their assets. When they decide to sell, they apply strategies to reduce their capital gains tax liability.
Many wealthy investors put their assets into trusts for their heirs. They convert as much of their income as possible into capital gains and hold them until death. Applying a tax benefit called the “stepped-up basis”, heirs gain a lifetime of assets without tax. It’s a way for families to retain wealth and most can avoid the estate tax.
3. Life insurance Loans
Loans are not considered taxable income. You increase your cash flow tax-free when you borrow money. One way wealthy earners do that is by borrowing against their life insurance.
Here’s how it’s done. You buy a life insurance policy with a large cash payout. Once you’re past any waiting periods, you take a loan against the policy.
Most banks let policy owners borrow up to 90% of the value of the policy. If the payout is $750,000, you can borrow $675,000 against it. That $675,000 is yours to use – no capital gains, no tax. Put it in an investment account, buy real estate. You earn a sizable return while the loan is paid back.
Another way high-income earners increase their cash flow without increasing their tax liability.
Reduce Your Taxable Income
There are lots of ways to reduce the amount you pay in taxes – rich or not so rich. The most important rule is to follow IRS requirements for the deductions you take. Keep records of what you’re doing and don’t try to cheat the IRS.
The penalty for illegally “reducing your taxes” will cost you more than what you could have paid.
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