Top 9 Strategies on How to Reduce Taxable Income
November 29, 2023
Taxes are obligatory for most U.S. citizens and permanent residents. Unfortunately, taxes can also take a huge chunk of a taxpayer’s hard-earned money; thus, it’s worth taking the time to dive deeper into how to reduce taxable income.
One of the easiest ways to figure out how to manage your taxes and balance your monthly budget is by using your pay stubs to review your gross and net income and the amount that’s regularly withheld for your taxes.
Another effective way to reduce the taxable percentage of your income is to learn the different legal and feasible ways to reduce taxable earnings.
- 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.
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.
Qualified medical expenses such as dental expenses, prescriptions, hospitality facility fees, home care, and healthcare costs, coupled with implementing addiction programs and addressing learning disabilities, are not taxed.
At the same time, your health savings account (HSA) earnings and withdrawals are tax-free. Take note that there is a limit to how much you can contribute to your HSA accounts, and these limitations are often determined by your health insurance plan policy.
#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.
#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 these funds 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.
Pay stubs come in handy for comparing your monthly income with your home office expenses and ultimately having 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. Charitable donations are usually itemized in your W-2 form, and 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 and furniture and other properties in over 15 years.
All net losses incurred from depreciation expenses are then reported on Schedule E of Form 1040.
Now that you know the different strategies on how to reduce taxable income, 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.