Did you know that the average American pays 28% of their earnings in taxes every year? That’s over a quarter of your income going into taxes! Fortunately, you can do a few things to reduce your taxable income and save money each year.
Invest in a Retirement Account
The best and most widely known way to reduce your taxable income is by contributing to a retirement account. The most common retirement accounts are Traditional IRAs, 401ks, or Roth IRAs. Personally, I recommend a Roth IRA because your investments grow tax-free and aren’t taxed when you take them out.
The maximum amount you can contribute to a Roth IRA is $6,000 per year. So, when you file your taxes, $6,000 will be taken out of your taxable income. For example, say you make $80,000 per year. Since $6,000 of those earnings was contributed to your retirement account, it reduces the amount of income you made that year. As a result, you’re left with only $74,000 as your taxable income, lowering the amount you owe in taxes.
Claim Business Deductions for a Side Hustle
Any side hustle or business that produces income can be used to reduce your taxable income. For example, you can write off business-related expenses such as food, travel, advertising, or other costs from your taxable income.
Another way to claim business deductions is by creating an LLC. An LLC allows you to reduce your personal liability as a solopreneur. For example, you could be a person who creates social media content and gets paid to promote products. So, by establishing yourself as an LLC, any purchases or expenses you make for that business can be written off to reduce your taxable income.
Contribute to a Health Savings Account
A Health Savings Account is a savings account that lets you contribute money towards future medical expenses. To qualify for an HSA, you must have a high deductible, meaning the amount you pay before your insurance covers your expenses is very high.
If you do qualify for an HSA account, the money you contribute to it reduces your taxable income. In addition, the money you contribute grows tax-free within the account. The money remains tax-free unless you use the contributions for expenses other than medical (20% penalty). Lastly, if you don’t use the HSA funds, you can move them into tax-free stocks or funds and let them grow.
Use Tax Deductions or Credits
There are many ways you can deduct expenses from your taxable income. A tax deduction lowers your taxable income, lowering the amount you owe in taxes. Here are some standard tax deductions to reduce your taxable income.
- Student Loan Interest Deduction
- Deduction for State and Local Taxes
- Mortgage Interest Deduction
- IRA and 401k Contribution Deduction
- HSA Contribution Deduction
- Self-Employment Expenses Deduction
- Home Office Expense Deduction
A tax credit may be available for certain expenses encouraged by the government, thereby reducing your taxable income if you’re eligible. Here are some common tax credits to reduce your taxable income:
- Child Tax Credit
- Saver’s Credit (Depends on filing status and income)
- Residential Energy Credit (Solar Panels and Solar Water Panels)
Invest in Real Estate
I saved the best for last because I truly believe that real estate is one of the best investments you can make. If you operate, manage, and maintain your real estate properties, you can write off expenses such as:
- Property Taxes
- Property Management Fees
- Property Insurance
- Mortgage Interest
- Property Maintenance and Repairs Cost
You can also use a Pass-Through Deduction to reduce your taxable income. For example, owning a rental property as a sole proprietor, through a partnership, or as an LLC allows you to deduct up to 20% of your qualified business income (QBI) from your taxes. Your QBI consists of the money collected from rent. One thing to remember with Pass-Through Deductions is that you can use this deduction on your personal taxes, not your business taxes.
Another way to reduce your taxable income through real estate is by avoiding the FICA tax. If you own a rental property and make income on the property, the income is considered not earned. So, you can keep the money that the IRS would’ve taken out from your FICA tax since you aren’t a “payroll” employee working for a paycheck.
Lastly, you take advantage of capital gains. For example, there are two types of capital gains – Short-Term and Long-Term. Short-Term Capital Gains are when you purchase a property and sell it within a year of owning it. Unfortunately, you’re subject to taxes on the profit with these types of gains.
On the other hand, Long-Term Capital Gains are when you purchase a property and hold off on selling it for at least a year or longer. When you eventually sell the property, your tax rate will be significantly lower.
Taxes can be extremely confusing and expensive if you don’t know what you’re doing. However, by educating yourself and following these tips, you’ll be reducing your taxable income in no time.