10 Proven Strategies for Reducing Taxable Income | INVESTEDMOM
Would you believe me if I told you that the average American pays over $532,910 in income taxes throughout their life? That’s a pretty hefty chunk of change. And that's just income tax - it doesn't even account for other taxes like property, sales, or social security taxes.
It's no wonder that tax season becomes a time of stress and number-crunching as we hope to salvage as much of our income as possible. Many of us feel like we're overpaying, practically gifting Uncle Sam a shiny new car each tax year.
The problem is, even though we sense we're shelling out more than we should, we often find ourselves paralyzed, unsure of what steps to take to minimize this financial burden.
If you're nodding your head in agreement, this guide is for you. I’ve compiled 10 proven strategies to lower your taxable income - and they’re all perfectly legal. These are practical steps that can help you navigate the labyrinth that is the American tax system.
So, are you ready to put more of your hard-earned cash back where it belongs - in your pocket?
Know Your Tax Bracket
What's a Tax Bracket?
Imagine a ladder where each rung represents a different income level. The higher you climb, the more you owe in taxes. That's what a tax bracket is. A tiered system where your tax rate rises as your income increases.
Different types of income, like capital gains or self-employment income, might be taxed differently. Understanding how each dollar you earn will be taxed can help you plan better.
Why Should I Care?
Knowing your tax bracket isn't just trivial information. You can make smarter decisions about your money, avoiding costly mistakes like cashing out investments that may bump you into a higher tax bracket.
Knowing your bracket is the cornerstone for effective tax planning. For example, you might decide to defer additional adjusted gross income to the next year if you're near the edge of moving into a higher tax bracket. Think of it as the difference between driving through a storm without a map versus having a GPS to navigate around the worst parts. One way is doable, but the other is far more efficient and stress-free.
So, let's dive in and discover how to reduce your taxable income.
Max Out Those Retirement Accounts
401(k)s and IRAs
A retirement account, like a 401(k) and traditional IRA contributions, isn't just a dusty financial tool for your grandparents. Retirement accounts are vibrant treasure chests that anyone can utilize as part of their tax reduction strategies. Not only are they vehicles for compound interest, letting your money grow exponentially over time, but they often come with employer matches. If your company matches your contributions, that's free money and definite tax savings. Think of it as a BOGO deal on financial security where you're getting twice the benefit for the same initial investment.
Why It's a Win-Win
Think of retirement accounts as a double-edged sword that cuts away both present and future worries. You're not only saving for a more secure retirement but also reducing your current adjusted gross income taxes. Many retirement accounts offer a selection of investment options. In addition to tax benefits, you can also see growth through capital gains, dividends, and interest.
Get Friendly with Itemized Deductions
Itemized deductions are like your personal cheat sheet for paying less to Uncle Sam. Think of them as special hacks in the video game of taxes that can make the whole ordeal a little less painful.
An itemized deduction is an expense you can knock off your adjusted gross income before figuring out how much you owe. Instead of stressing over how much you have to pay, you focus on all the ways you can actually reduce the amount of taxable income.
Let's talk about some of these tricks.
Mortgage Interest
Think of this as the "rent" you pay for borrowing to buy your home. This is not just an obligation but an opportunity. When you itemize your mortgage interest, you essentially get a 'rebate' on a portion of what you've paid. It's like a loyalty program for homeowners; the more you pay, the more you can claim as tax-deductible.
Qualified Medical Expenses
Life's unpredictable, and sometimes, those curveballs require medical attention. The high cost of healthcare can be an enormous burden, but itemizing these qualified medical expenses is like having a financial first-aid kit. You might not be able to avoid getting sick, but you can alleviate some of the financial pain.
Charitable Donations
Giving to a charitable organization is more than just a moral win; it's a financial win, too. Your altruism pays off in the form of reduced taxable income. Consider it the universe's way of saying 'thank you' for contributing to the greater good.
Health Savings Account
If you're looking for a good way to save money and reduce your tax liability simultaneously, then you might want to consider a Health Savings Account (HSA). Think of an HSA as a secret stash of money, specifically earmarked for medical expenses, but with the added bonus of being tax-free when used for eligible healthcare costs.
Contributions to your HSA are tax-deductible, meaning they directly reduce your taxable income for the year. You can use the money in the Health Savings Account for a wide range of medical and dental expenses, from prescriptions and doctor visits to dental care and eyeglasses. Even better, any money in the HSA that you don't use during the year isn't lost. It rolls over to the next tax year, continuing to grow tax-free.
Tax Credits Aren't Just for Big Corporations
Credits vs. Deductions
While deductions lower your taxable income, tax credits directly reduce your tax bill. It’s like having a gift card to a store as opposed to a sale; the first decreases what you owe, while the second provides a credit.
Popular Credits
Big corporations aren’t the only ones who receive the golden tickets of tax credits.
Tax credits, like the Child Tax Credit and the Earned Income Tax Credit, are real game-changers designed for everyday taxpayers like you and me. While you're searching for every possible tax deduction to reduce your tax bill, don't overlook these valuable credits.
Remember, tax credits and tax deductions work together to minimize what you owe. While deductions like mortgage interest or medical expenses help lower your overall taxable income, credits like the Child Tax Credit can be a lifesaver for families, essentially giving you a refund on some of the costs of raising kids. Similarly, the Earned Income Tax Credit can provide essential relief for lower-income households.
Real Estate
Why Real Estate?
When you consider investing in real estate, it's easy to envision yourself as a landlord collecting rent. But there's so much more to it. Real estate investment is like constructing a tax-saving fortress that shields you from hefty tax bills. In essence, real estate acts as a Swiss Army knife, offering you a multi-tool approach to reducing your tax liability.
Not only can you take advantage of tax-deductible expenses like mortgage interest and maintenance costs, but you can also benefit from property depreciation. These tax-deductible expenses work to lower your overall taxable income, which in turn reduces your tax liability.
Depreciation works as a silent but potent ally that allows you to write off a portion of the property's value every year, serving as another layer of armor against high taxes. Real estate investors can harness depreciation to reduce their taxable income while leaving their cash flow unaffected.
Timing is Everything with Investments
Ever heard the phrase "Timing is everything"? Well, when it comes to investments and taxes, that couldn't be truer. Getting your timing right can be the difference between keeping a good chunk of your profits or handing them over to the taxman.
Short-Term vs. Long-Term
Holding onto investments like stocks for over a year moves them from short-term to long-term investments, and you're taxed less when you sell. It's akin to letting a stew simmer—the flavors get richer, and in this case, your tax liability is reduced.
Real-World Examples
Imagine you have two pots of $10,000 each. In one scenario, you cash out after 11 months and pay high short-term capital gains. In another, you wait for 13 months and pay significantly less. The latter scenario sounds a lot better, doesn’t it?
The Art of Gifting
Gifting Basics
Gifting allows you to give money to loved ones or charities without it counting toward your adjusted gross income. You can gift up to $15,000 per individual per year without incurring taxes. So spread the wealth without spreading yourself thin!
Hire Your Teenager. Seriously.
Did you know that you can literally hire your child or spouse and use them as a tax deduction?
Hiring your teenager or spouse isn’t just a fun family affair; it’s a way to shift ordinary income into lower tax brackets and one of the best tax reduction strategies. It offers a smart way to reallocate income and take advantage of lower tax rates. You're turning your family into a tax-optimizing team, playing the game with a strategy most people overlook.
Incorporating your family members into your business allows you to effectively distribute the family income in a way that allows you to pay taxes minimally. And don't forget, if your family members are legitimately employed, their earnings could be put into tax-advantaged accounts like IRAs, setting them up for a financially stable future while further reducing the family's overall taxable income.
When to Call in the Pros
DIY Limitations
While these tips can go a long way, doing it yourself has limits. Think of it like DIY home renovation; you might be able to paint the walls and maybe lay down some tile, but eventually, you may need to call in an expert. It's not just about knowing how to swing a hammer; it's about understanding the architecture that holds your financial house together. While you can patch up small holes on your own, you'll need a pro for the larger structural issues.
Why Advisors Are Worth It
Spending on a tax advisor is an investment in your future savings. They can help you uncover opportunities that are as hidden as truffles in a dense forest. A skilled tax advisor can find tax advantages you never knew possible. Using their expertise allows you to invest in a financial strategy that could pay dividends for years to come while reducing our tax bill.
Stay Woke: Tax Laws Change
The Constant Change
Tax law is as constant as shifting sand. It’s crucial to stay updated to use the most effective strategies. You need to adapt to new tax laws to maximize your savings. If you're not keeping up, you're missing out on new opportunities and potentially setting yourself up for costly mistakes while missing out on tax-free opportunities.
Where to Stay Updated
Sources like the IRS website, financial news outlets, and reliable tax software can keep you in the loop. Consider these resources your navigational beacons in the foggy waters of tax law. But don't stop there. Subscribing to newsletters or following finance experts on social media can be great avenues for timely tips and advice. Being well-informed is your first defense in the complex game of taxes.
Conclusion
From understanding your tax bracket to the surprising tax perks of hiring your own kids, we've walked through some seriously handy tips to keep more of your hard-earned cash safe and sound in your pocket. Because let's face it, you hustle for every penny, and it's high time you got to keep more of it!
If you're ready to crank up those savings, you can find incredibly helpful tips and resources over at Invested Mom. Trust me, your future self will thank you. And hey, if you found this guide useful and want more insights on finances in general, you'll love my upcoming book, A Wealth Building Framework. It has even more tips and strategies to elevate your financial game.
Meet the Author:
Inge was born and raised in Cape Town, South Africa, and moved to Canada in 2010 looking for a better life. She always had an entrepreneurial spirit and started her first side hustle when she was 9 years old – selling fudge at school during lunch breaks.
It wasn’t until much later that she realized that saving isn’t enough to get ahead. She was always very interested in real estate, but saving up for a down payment was grueling and slow, and the demands of life kept getting in the way.
She started investing in herself and upgrading her skills while learning how to invest. She quickly became debt free and compounded her money at a staggering rate.
It wasn’t until she became a coach that she realized how significant an impact she can make in people’s lives by sharing her journey, learnings, and processes.
So here she is, advocating for everyone who is invested and wants to build their wealth, especially the mommas!