While you can’t avoid taxes, the IRS allows you to lower your tax burden by combining tax deductions and credits. Here are nine common tax-saving strategies to protect your wealth.
A financial advisor can help optimize your investment portfolio to lower your taxes.
Aim For Long-Term Capital Gains
Long-term capital gains are profits from the sale of assets held for more than one year. The tax rates on long-term capital gains are typically lower than those on short-term gains, providing an opportunity for tax efficiency. For example, a single filer making $95,000 in 2024 will pay a 15% long-term capital gains rate. On the other hand, their tax rate for standard income and short-term capital gains is 22%.
To qualify for long-term capital gains treatment, you must hold an asset for more than one year before selling it. In addition, your income level determines your capital gains tax rates. As a result, it’s advisable to sell investments to realize gains in years when your overall income is lower, potentially resulting in a lower tax rate.
Tax-loss harvesting can also help reduce your tax bill. Specifically, the U.S. tax code lets capital losses offset capital gains. This means you can deduct up to $3,000 of capital losses in excess of capital gains. So, if you sell assets for less than you bought them, the loss can lower your taxable income, and possibly lower your overall tax rate.
Max Out Retirement Accounts
Contributing pre-tax dollars to retirement accounts can reduce taxable income while building a nest egg for the future. Popular retirement accounts serving this purpose include 401(k)s and traditional IRAs.
You can lower your taxable income every year through contributions to traditional retirement accounts. Specifically, you can contribute $7,000 to an IRA in 2024 or $8,000 if you’re over age 50. Likewise, you can contribute $23,000 to your 401(k) in 2024 or $30,500 if you’re over age 50.
Taking advantage of one or both of these accounts can reduce your taxable income by tens of thousands of dollars. If your employer provides a 401(k) and you open an IRA, you could lower your taxable income by $30,000 if you’re under age 50.
In addition, 401(k)s and IRAs offer tax-deferred growth. This way, you won’t have a tax burden every year for how much your accounts accumulate. Instead, you’ll pay income taxes when you withdraw the money.
Invest in Municipal Bonds
State and local governments issue municipal bonds to fund public projects, such as schools and infrastructure. Investors buy these bonds and then receive the principal with interest over time from the government. In essence, municipal bond investors give municipalities a loan and profit from the interest payments. Fortunately, most municipal bond interest is exempt from federal income taxes, giving you a federal tax-free income stream. The downside is that municipal bond interest rates may be lower than other investments.
Fund a Health Savings Account
Health Savings Accounts (HSAs) are tax-advantaged accounts linked to high-deductible health plans. If your employer offers a health insurance plan with a high deductible (or you have your own high-deductible plan), you can contribute to an HSA and draw from the account to pay for medical expenses.
Your HSA contributions are made pre-tax, just like your 401(k). Your funds also grow on a tax-deferred basis, and your employer might even match a portion of your deposits. Withdrawals are tax-free if you use the funds to pay for medical care and other qualified expenses.
Like IRA and 401(k) contributions, your HSA has an annual limit. Specifically, individuals can contribute $3,850, and families can contribute $7,750 in 2023. The numbers for 2024 are $4,150 for individuals and $8,300 for families.
Claim Tax Credits
Tax credits directly reduce your tax liability, providing a dollar-for-dollar reduction in the amount of taxes you owe. You may qualify for the following:
- Child Tax Credit: Families with qualifying children may be eligible for the Child Tax Credit. You’ll get up to a $2,000 credit for each dependent you have under age 17.
- Child and Dependent Care Credit: If you pay for the care of a dependent adult or a child aged 13 or under, you can claim this credit. You can receive up to 20% to 35% of your care expenses, maxing out at $3,000 for one dependent and $6,000 for two or more.
- Earned Income Tax Credit (EITC): The EITC lightens the tax burden of lower-income families. The more children you have, the higher the benefit. For example, qualifying families with three or more children in 2024 will receive $7,830, while qualifying families with one child will receive $4,213.
Contribute to a 529 Plan
A 529 plan is a tax-advantaged savings plan for future education costs. It’s like a 401(k) in that earnings are tax-deferred, but it pays for school instead of retirement. Contributions to a 529 plan are not tax-deductible on the federal level, but the earnings grow tax-free if used for qualified education expenses. Plus, contributions may be tax-deductible in some states.
Donate to Charity
Giving to a 501(c)(3) registered charity can also reduce your taxes. Both money and items count for this deduction. Specifically, you can deduct between 20% and 60% of your adjustable gross income in charitable donations, depending on your circumstances. Remember, itemizing your deductions is necessary to claim this tax advantage.
Look for State and Local Tax Breaks
Beyond federal taxes, explore tax breaks offered by your state and local governments. For example, more than 30 states offer pass-through entity tax benefits for small business owners. In addition, New York City residents receive an exemption for parking taxes, and New Jersey dwellers can deduct medical costs above 2% of their adjustable gross income.
Some states also have a 0% income tax rate. If you live in Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, or Wyoming, you won’t pay any state income taxes. Likewise, New Hampshire doesn’t tax earned income – but it does tax interest and dividends (though that is currently being phased out).
Make Your Home Energy Efficient
Investing in energy-efficient improvements for your home can result in tax credits and long-term cost savings. The Inflation Reduction Act of 2022 provides up to a $3,200 tax break through 2032 for heat pumps, energy-efficient windows and doors, and insulation improvements. Additionally, the Residential Clean Energy Credit provides a tax benefit equal to 30% of the cost of solar panels, wind and geothermal energy, and fuel cells/battery storage.
Adopting strategic financial practices can significantly mitigate the impact of taxes on your income. Even if you take the standard deduction, you can qualify for most of the items listed above. Remember, saving for retirement provides one of the largest tax deductions available. Working with a tax professional can help ensure you’re optimizing your taxes and keeping as much of your hard-earned cash as possible.
Tips for Protecting Income from Taxes
- A financial advisor can help optimize your investments to lower your tax liability. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- A high income can incur higher tax rates. These are the most vulnerable areas where high earners are losing money on taxes.
Photo credit: ©iStock/Thicha Satapitanon, ©iStock/Liubomyr Vorona, ©iStock/pixdeluxe