According to the Tax Foundation, the average American pays over $14,000 in income taxes yearly. While you can't escape paying taxes in the US, there are several legal ways to reduce your tax burden.
In this article, we'll explore some legal strategies you can consider to optimize your tax situation, as well as how our best tax relief services can help you create a comprehensive plan tailored to your specific financial needs.
Maximize Tax Deductions and Credits
Whether you hire a professional or use online tax software, understanding available tax benefits is crucial. Deductions are eligible expenses that reduce your taxable income, while credits are government incentives that directly lower your tax bill. Knowing how to leverage both can lead to significant savings on your annual taxes.
There are two kinds of deductions to consider:
Above-The-Line Deductions: These deductions lower your adjusted gross income, even if you’re not itemizing. Expenses such as alimony payments, retirement plan contributions, health savings account contributions, student loan interest, and teacher classroom expenses are always deductible.
Below-The-Line Deductions: These deductions are only available if you itemize your deductions (by adding up all deductible expenses for the year). Expenses like state income or sales tax, property tax, mortgage interest, and certain medical or dental expenses can be included.
There are also two different kinds of credits available, including:
Refundable Credits: These credits are given in full, even if they are returned as a tax refund. Credits like the earned-income tax credit and child tax credit may be refundable.
Non-refundable Tax Credits: These only reduce your taxes owed to $0, with no additional refund for excess amounts. Examples include the saver's credit, lifetime learning credit, adoption credit, and foreign income tax credit.
Contribute to Tax-Advantaged Accounts
Several types of investment accounts can simultaneously lower your tax bill and boost your savings. Here are some key examples:
Retirement Accounts
These include workplace options like 401(k)s, 457s, and 403(b)s, as well as Individual Retirement Accounts (IRAs). Traditional versions offer immediate tax benefits, while Roth options provide tax-free growth and withdrawals in retirement. Maximizing contributions to these accounts can significantly reduce your annual taxable income.
College Savings Accounts
If you’re saving for college, a qualified tuition program (QTP), also referred to as a section 529 plan, may help lower state taxes in some states. Plus, the earnings in the account grow tax-free, and withdrawals used for educational expenses are also tax-free.
Other Tax-Advantaged Accounts
These include Health Savings Accounts (HSAs), Flexible Spending Accounts (FSAs), and business retirement accounts, which allow you to contribute pre-tax funds and lower your taxable income.
Consider Adjusting Your Withholding
If you end up with a tax bill each year, you might not be withholding enough from your paycheck. This is especially common for high-income families with both spouses working. Your tax withholding is typically calculated based on your income alone, so you may need to adjust how much you withhold each paycheck to avoid a large tax bill at the end of the year.
You can adjust your withholding by sending a new W-4 form to your company’s Human Resources department. Your paycheck will be slightly smaller, but you won’t be hit with a surprise tax bill later.
Take Advantage of Tax-Loss Harvesting
If you have investments in a taxable brokerage account, you can use a strategy called tax-loss harvesting to potentially lower your tax bill. This approach involves selling investments that have dropped in value since you bought them. You then use that money to buy similar investments that fit your financial plan. By doing this, you can offset any investment gains you've made or even reduce your regular income tax.
“This process captures tax losses in down markets, which accumulate indefinitely,” said Chris Wilbratte, financial planner and founder of Echelon Financial. “Then in later years, when you sell stock for a gain, you can offset your gains with the tax losses that you have accumulated.”
You can deduct those losses against your taxable income when you sell an investment at a loss, depending on your financial situation. There's a capital loss deduction limit of $3,000 per year, but you can carry over any additional loss to future tax years for more deductions.
Tax-loss harvesting only applies to taxable investment accounts, not retirement accounts or other tax-advantaged accounts, which already offer tax benefits. Remember that you can't immediately repurchase the same or very similar investment you sold. If you do, the IRS won't allow the deduction. This rule, known as the "wash-sale" rule, helps prevent abuse of the tax-loss harvesting strategy.
Leverage Retirement Accounts for Tax Savings
Retirement accounts are highly effective tax savings and investing vehicles. You can lower your taxable income while investing toward your financial future. Here are a few retirement accounts and how they help you save on taxes:
401k (or 457, 403b)
Employer-sponsored retirement accounts, such as a 401k, 457, or 403b account, allow you to automatically contribute toward retirement directly from your paycheck. You can set aside a portion of your income into a workplace retirement account, which is deducted from your taxable income. Some companies also offer “matching funds”—meaning they will put in extra money toward your retirement up to a certain percentage of your salary—matching your contributions.
Individual Retirement Account (IRA)
Outside of work, you can open an individual retirement account (IRA) and invest up to $7,000 annually. This can lower your taxable income and allow you to pick your own investment with your chosen broker. These accounts are easy to set up and don’t usually incur monthly fees.
Roth IRA
If you aren’t worried about saving on taxes right now but want to pay fewer taxes in retirement, a Roth IRA may be a good retirement account to consider. This account is similar to a traditional IRA, but you contribute after-tax dollars instead of lowering your taxable income. However, when you enter retirement and start withdrawing funds, you won’t have to pay any income taxes.
Explore Tax-Efficient Investment Strategies
There are several tax-efficient investment strategies that can help you lower your taxes now and control your taxable income in the future. Here are a few tax strategies for your investments to consider:
1. Diversify Your Accounts
Having a mix of pre-tax and post-tax investment accounts gives you greater control of your taxes while working and in retirement. You can maximize your 401(k) contributions to reduce current tax liability, while also funding a Roth IRA to enjoy tax-free withdrawals later. Plus, maintaining a taxable brokerage account provides flexibility in managing your retirement income stream.
2. Consider Putting Fixed-Income Investments in Tax-Advantaged Accounts
If you plan on investing in fixed-income investments like bonds or dividend stocks, it can save on taxes to keep them in tax-advantaged accounts. Since these income-producing investments pay out monthly or quarterly dividends, you can avoid income tax on these distributions by keeping them in IRAs, 401ks, or other tax-protected accounts.
3. Consider Municipal Bonds
Many municipal bonds are exempt from state and local taxes, and can save a bundle if you’re in a high-tax state. If you hold these bonds in your taxable brokerage account, the dividends from municipal bonds won’t be counted as income when you file state and local tax returns.
“Municipal Bonds are a great strategy right now because not only do you receive tax-free interest, but you can also benefit from appreciating bond prices because of interest rate cuts,” said Wilbratte. “Bond prices and interest rates are inversely related to one another. So, if you own a bond paying 5% and rates drop to 4%, your 5% bond will be worth more than a bond paying 4%.
4. Possibly Invest in ETFs
An exchange-traded fund (ETF) is usually passively managed, meaning there are very few trades within the fund that could cause a taxable event. Holding ETFs inside taxable accounts can be more tax-efficient than standard mutual funds.
Understand the Benefits of Filing Status and Dependents
How you choose to file your taxes and the amount of dependents you can claim can have a significant impact on your tax bill each year. Your tax filing status is typically one of the following:
Single: Unmarried with no dependents.
Head of Household: Unmarried with a dependent child.
Married Filing Jointly: Couples submitting a combined tax return.
Married Filing Separately: Spouses filing individual returns.
Qualifying Surviving Spouse: Recently widowed (within two years) with a dependent child.
Only married couples have the option to change their filing status. While filing separately can occasionally offer benefits, it's rare. Generally, married filing jointly is more advantageous. This option lets you combine incomes and deductions, claim a higher standard deduction, and often results in a lower overall tax liability.
Many parents claim their children as dependents for tax benefits until they turn 18. However, you can continue to do so beyond this age under certain circumstances. For college students under 24, if you provide more than half their support, you can still claim them as dependents and potentially deduct their educational expenses.
Even for individuals over 24, you may be able to claim them as qualifying relatives if they meet specific criteria. These include being a US citizen, receiving at least half their support from you, and being either unmarried or married but filing separately.
Plan Charitable Contributions Strategically
You can deduct charitable donations if you’re itemizing your tax return, but even if you don’t plan to itemize, there are several ways to lower your taxes through giving. Here’s how:
Donate Your Investments
If you have investments that have gained value, consider donating them directly to charitable organizations. This applies to assets like stocks, real estate, or business interests. By doing so, you'll avoid paying capital gains taxes on the appreciation. Plus, you can deduct the donation's fair market value on your current year's taxes, assuming you're itemizing deductions on Schedule A (Form 1040).
Sell at a Loss (Then Donate)
If you have any investments that are currently trading at a loss within a taxable account, you can sell those investments and donate the proceeds. This allows you to tax-loss harvest and donate at the same time.
Open a Donor Advised Fund (DAF)
If you want to donate assets that have risen in value but want some time to decide where and when you'll donate—you can open a donor-advised fund (DAF). This allows you to transfer your assets into the fund, which is sold and donated to a charity of your choice. You can deduct the donations immediately, but also take your time choosing a charitable organization.
You Can Use Flexible Spending Accounts (FSAs) and Health Savings Accounts (HSAs)
If you want to save on taxes, invest for your future, and set aside funds for upcoming medical expenses, there are two tax-advantaged accounts that allow you to do this.
Health Savings Accounts
Health Savings Accounts (HSAs) are available to individuals and families with an eligible high-deductible health plan. These accounts allow you to deduct contributions each year, and when you withdraw these funds for medical expenses, no taxes are assessed on the account's growth either. This can potentially save a huge amount in taxes over your working career.
Flexible Spending Accounts
Another health savings account that lowers your tax bill is a Flexible Spending Account (FSA). This lets you contribute money toward upcoming medical expenses for the year. However, you must use the funds contributed to your FSA by the end of the calendar year, or you risk losing access to the money.
The Role of Tax Professionals in Lowering Your Tax Bill
Navigating the complex US tax code can be daunting. If you're looking to maximize deductions, implement tax strategies, or simply avoid the headache of doing it yourself, professional help can be invaluable. When considering how to choose a tax relief service, opt for licensed professionals with recognized credentials.
A qualified CPA, Enrolled Agent, or Tax Attorney can uncover hidden credits, develop tax-saving strategies, and optimize your investments. For business owners, this expertise is particularly crucial—potentially saving you thousands and ensuring compliance. Remember, not all tax professionals offer equal expertise, so choose wisely to maximize your financial benefits and minimize stress during tax season.
