Disclaimer: This information is meant for educational purposes only; I am not a tax or financial advisor. For tax and financial advice, please consult a licensed advisor.
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 work towards reducing your taxable income.
#1 Invest in a Retirement Account
The best and most widely known way to potentially reduce your taxable income is by contributing to a retirement account. The most common retirement accounts are Traditional IRAs, 401k’s, or Roth IRAs. Personally, I’d use a Roth IRA because your investments can 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 deducted from your taxable income.
The maximum amount you can contribute to a Roth IRA is $6,000 per year.
Benefits of Investing in a Retirement Account
- Unlike a 401k provided by your employer, an IRA belongs to you. You are in control of how much you put in and the account isn’t affected if you switch jobs.
- You can contribute post-tax dollars into the account and the money grows tax free until you’re eligible to take it out at 59 1/2. The money remains non-taxed even after taking it out of your account.
- IRAs are typically easy to set up and do not conflict with your employer’s 401k (if provided). In addition, there is no age limit to open an IRA and you can choose automated investments if you wish.
#2 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. (Again, for exact information, consult a financial or tax advisor).
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 potentially written off to reduce your taxable income.
An LLC allows you to reduce your personal liability as a solopreneur.
#3 Contribute to a Health Savings Account
A Health Savings Account (HSA) 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.
Benefits of Contributing to a Health Savings Account
- If you do qualify for an HSA account, the money you contribute to it reduces your taxable income.
- The money you contribute grows tax-free within an HSA account. The money remains tax-free unless you use the contributions for expenses other than medical (20% penalty).
- If you don’t use the HSA funds, you can move them into tax-free stocks or funds and let them grow.
#4 Use Tax Deductions or Credits
There are many ways you can deduct expenses from your taxable income. A tax deduction lowers your taxable income, which may lower the amount you owe in taxes. Here are some standard tax deductions to reduce your taxable income. (For more information, please consult a licensed financial and/or tax advisor and continue to do your own research).
- 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 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)
#5 Pass-Through Deduction
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.
From my experience, one thing to remember with Pass-Through Deductions is that you can use this deduction on your personal taxes, not your business taxes. (Disclaimer: Consult a licensed tax advisor and continue to do your own research).
#6 FICA Tax
Another way to potentially 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 potentially 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. (Disclaimer: Consult a licensed tax advisor and continue to do your own research).
You can potentially 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.
#7 Capital Gains
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
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.
Long-Term Capital 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 has the potential to be significantly lower.
#8 Invest in Real Estate
In my opinion, 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