Top 9 Strategies on How to Reduce Taxable Income

Knowing how to reduce taxable income can help you save as much of your earnings as possible while fulfilling your obligations toward the IRS.

While taxes are obligatory for most U.S. citizens and permanent residents, they can reduce your gross income by a significant percentage. Fortunately, there are many different strategies you can use to legally lower taxable income. They range from making contributions to your HSA and Flexible Spending Accounts to taking capital losses and donating to charity.

We will explore these and many other tactics to help you choose the best way to reduce your taxable income, so let’s get started!

Key Takeaways

• Some of the most common and effective ways to reduce taxable income include contributing to HSAs and retirement account plans, investing in long-term capital gains, and setting up college funds.
• A business or individual’s taxable income is determined by their tax bracket, filing status, number of dependents, if any, and their source of income.

What Is Taxable Income, and How Does It Work?

Taxable income is the amount of your income that the IRS takes into account when calculating how much you must pay in taxes.

This doesn’t include everything you make in a year. Therefore, it differs from your gross income, which includes both taxable and nontaxable income, like salaries, bonuses, investment returns, business profits, rent, stock options, and so on.

Before the IRS starts calculating your taxes, it makes some adjustments to your gross income (e.g., subtracting IRA contributions or student loan payments) to get your adjusted gross income (AGI). At this point, they apply standard deductions or itemized deductions to determine your taxable income.

This final number is the one used to put you in a specific tax bracket and apply relevant rates to calculate your federal tax liability for that year.

9 Ways to Reduce Taxable Income

Before we discuss the nine secrets to reducing your taxable income, it is crucial to note that there are key factors to consider when choosing a method to regulate the amount of taxes you owe.

These factors include:

• Tax bracket. Your tax bracket is a reflection of how much income you make. Some methods to reduce taxable income are better suited for low-income households, while others are better for taxpayers who earn more. If you are unsure about your tax bracket, check the net income amount on your pay stub, then find the income range on the IRS tax bracket where your net pay belongs.

• Dependents. The government offers leeway to parents that allows them to minimize their taxes. This is especially true for parents with dependents enrolled in college or university.

• Source of income. Reducing taxable income differs between employees, individual taxpayers, and business owners.

Keep in mind the factors listed above so you can choose the most suitable way to reduce taxable income out of the following methods:

#1. Contribute to a Health Savings Account

One of the most effective secrets on how to save tax on salary is to open a high-deductible health insurance plan.

Withdrawing from a health savings account (HSA) to pay for the following qualified medical expenses isn’t taxed:

• Dental expenses
• Prescriptions
• Hospitality facility fees
• Home care
• Healthcare costs associated with implementing addiction programs and addressing learning disabilities.

At the same time, your HSA earnings and withdrawals are tax-free. Still, there are limitations to how much you can contribute to your HSA accounts, and these are set by the IRS.

#2. Invest in Long-Term Capital Gains

Long-term capital gains are acquired from assets that are held for at least a year or more before they are sold. Examples of capital gains are stocks, bonds, real estate, jewelry, and precious metals.

The tax rates for long-term capital gains are 0%, 15%, and 20%. After the Tax Cuts and Jobs Act (TCJA) was passed, distinct tax brackets were created for long-term capital gains.

Consequently, the IRS uses the designated tax brackets for long-term capital gains to check your taxable earnings and filing status and determine the tax rates to impose on your capital gains. While this won’t reduce the amount of taxable income itself, it’s a great way to reduce your tax liability on those gains.

#3. Contribute to a 401(k) or IRA

Another easy way to reduce your taxable income involves using retirement account contributions.

It is also a known way to reduce taxable income for high earners because it helps reduce taxable income, especially when your 401(k), traditional or SEP IRA, HSA, or FSA (flexible spending account) are maxed out.

By the time you reach retirement, you can withdraw funds from your Roth 401(k) and Roth IRAs tax-free. If you are contributing to a 401(k) account, you can find your 401(k) contributions under the pre-tax deductions column in your pay stubs.

Some Roth accounts are financed by after-tax dollars, wherein you can pay your contributions in cash after taxes. The advantage of this is that you are not charged any additional taxes on your Roth account balance come retirement.

#4. Set Up a College Savings Fund

Here’s how to save income tax for parents with dependents in college: set up a 529 plan to generate a college savings fund. A 529 plan is an investment account designed to save funds for future educational expenses. Your 529 plan earnings grow tax-free in the long run.

While 529 plan contributions are not federally tax-deductible, you may be eligible for state income tax deductions if you are located in a tax-parity state.

Alternatively, you can take advantage of the American Opportunity Tax Credit (AOTC). The AOTC is a tax credit for qualified educational expenses.

These qualified educational expenses, which include books, school supplies, and other equipment required in the eligible student’s course, are paid for during the first four years of college.

The AOTC provides up to $2,500 worth of credit annually per student. The said amount is then deducted from your federal taxes, and if the credit exceeds the taxes you owe, you can refund up to $1,000.

#5. Take Capital Losses

At first glance, capital losses are not a good sign for your investments. However, capital losses can prove useful when you want to reduce your taxable earnings.

Capital losses occur when investments or securities are sold for less than the original purchase price. You can report your capital losses on your tax returns as a form of tax deduction.

You can also use Form 8949 and Schedule D on your tax return to deduct losing stocks from your taxes.

#6. Claim Business Deductions

If you are self-employed or have freelancing work, you can claim business deductions to save on income tax.

Business expenses in the form of home internet costs used for business and freelancing purposes, advertising, business trips, shipping, and home office supplies qualify as tax deductions that you can use as a self-employed taxpayer.

There are also other types of tax deductions, aside from business deductions, that you can take advantage of to reduce your federal tax amounts. Better yet, keep copies of your pay stubs, especially if you’re a freelancer.

Self-generated pay stubs (even though freelancers don’t receive them from clients) can come in handy for comparing your monthly income with your home office expenses. They can help you have a comprehensive record that lets you itemize more costs that qualify for a tax deduction.

#7. Exclude Fringe Benefits

Some employers offer additional fringe benefits to their employees on top of health insurance and retirement account plans. You can maximize these benefits to reduce your taxable income.

These fringe benefits include group-term life insurance, educational assistance programs, adoption expense reimbursements, and transportation coverage.

All expenses and coverage that fall under any of the enumerated fringe benefits above are typically reported as non-taxed values or amounts on an employee’s W-2 form, Wage, and Tax Statement.

#8. Donate to Charity

Donating to charity is an acceptable way to reduce taxable income. The key is to make donations to qualifying charitable organizations.

Qualifying charitable organizations are volunteer, tax-exempt groups that focus on performing philanthropic activities for religious, scientific, academic, charitable, and public safety purposes.

Charitable donations need not be in cash. Food, clothing, and property, such as vehicles and equipment, are acceptable charitable gifts that you can itemize and include in your tax write-offs.

For charitable donations, taxpayers can subtract 20% to 60% of adjusted gross earnings in the 2023-2024 tax year.

Make sure to check your tax documents, specifically your Form W-2 and Form 1040. Charitable donations can be reported on your Form W-2, but you can only deduct them if you itemize deductions on Form 1040. You can take note of the said value to ensure you calculate your adjusted gross income and taxable income accurately.

#9. Use Depreciation Deduction

More specifically, use the so-called Modified Accelerated Cost Recovery System (MACRS). The system is a known method to reduce taxable income with real estate.

The MACRS depreciation method entails devaluing structural improvements and residential properties for rent in 27.5 years, farm buildings in 20 years, office furniture in 7 years, automobiles, office machinery, and computers in 5 years, etc.

All net losses incurred from depreciation expenses are then reported on Schedule E of Form 1040.

Payroll & Tax Withholding Strategies

Optimally managing your payroll, employing the right tax withholding strategies, and leveraging common tax write-offs allows you to maximize your take-home pay.

One of the best things you can start with is adjusting your W-4, the Employee’s Withholding Certificate. For instance, you can accurately claim dependents or factor in anticipated deductions to change how much tax will be withheld from your paycheck.

Following that, it’s important to track your income and deductions to ensure tax compliance. You can quickly create and effortlessly manage electronic documents by using our generators.

For example, while employees aren’t required to make pay stubs, you can use our pay stub generator to track gross earnings, deductions, and withholdings. This will make it easier for you to calculate your taxable income later on.

Besides that, freelancers and gig workers can use our invoice generator to keep track of their earnings. Since they are wholly responsible for their own taxes (as they don’t have employers to withhold any) and typically have to make quarterly tax payments, detailed record-keeping is paramount year-round.

3 Common Tax Mistakes to Avoid

Here are the three most common mistakes to avoid when considering how to lower your taxes.

#1. Overlooking Deductions and Credits

Deductions can directly reduce your taxable income, while credits reduce tax liability. Some individuals who prepare their own taxes aren’t aware of these opportunities or don’t know whether they qualify, resulting in them losing out on valuable take-home pay.

Some of the most common deductions include those for student loan interest or self-employment expenses (if you’re an independent contractor). Credits, on the other hand,include the Child Tax Credit, education credits, and similar.

These are some of the best tax breaks for individuals, so not taking advantage of them can result in paying more tax than legally required. It’s recommended to do proper research, make calculations carefully, and get professional tax advice if needed.

#2. Misclassifying Freelance or Self-Employed Income

Misclassifying freelance or self-employed income can be a costly mistake, as it can lead to IRS investigations that result in severe penalties. This usually happens because independent contractors and employees calculate their taxes differently and require different documentation to file taxes.

Freelancers and gig workers receive Forms 1099-NEC or Forms 1099-MISC to help them file and pay self-employed tax in its entirety. On the other hand, traditional employees have some of their taxes withheld by employers, and they receive Form W-2.

Needless to say, wrong classification can lead to incorrect tax calculations and compliance issues for both employers and employees or self-employed professionals.

#3. Failing to Keep Proper Records

Keeping proper records is the best way to ensure you have proof of income and deductions to provide to the IRS.

For employees, critical records include Forms W-2 and specific pay stubs that help verify their accuracy. Meanwhile, freelancers and independent contractors should keep track of all their contracts, invoices, and Forms 1099.

Additional records include various receipts that can be used to claim expenses (e.g., business or medical ones), bank statements, travel and transportation, purchases, and more.

Failing to keep proper records can result in underpaying or overpaying taxes. Moreover, it can lead to penalties during audits due to the individual’s inability to provide all the relevant documentation to support their case.

Final Thoughts

Now that you know the different strategies on how to lower your taxes, the next step would be to choose a method that suits your finances, household, and the nature of your employment to make the most of these potential tax deductions.

Finally, make it a habit to keep records of your pay stubs. Your pay stubs allow you to compare your gross and net earnings with your taxes and other deductions and gauge the effectiveness of your chosen tax reduction method.

If your employer does not issue your paychecks, you can take advantage of our pay stub generator to produce your pay stubs.

How to Reduce Taxable Income FAQ

#1. What is the best investment to reduce taxable income?

The best investment to reduce taxable income depends on the individual’s goals, circumstances, and financial situation. Some of the most popular options include contributions to traditional 401(k), IRA, SEP IRA, SIMPLE IRA, Health Savings Account, and so on.

#2. How can high earners reduce their taxable income?

High earners can reduce their taxable income by maximizing pre-tax retirement contributions, charitable giving, investing in tax-exempt municipal bonds and real estate, utilizing business deductions, etc. Some of these tactics work best for those in high tax brackets due to their ability to contribute more.

#3. How to reduce taxable income with real estate?

Some of the best ways to reduce taxable income with real estate include deductions due to depreciation, operating expenses, Qualified Business Income (QBI), and passive activity loss rules. These strategies are complex, but they can significantly reduce your taxable income, so it’s critical to consult a tax professional.