Legal Ways to Reduce Taxes
Last Updated: March 17, 2021
Just how big of an expense are taxes? On average, you can be expected to spend 25-35 percent of your salary on taxes each year. That means 3-4 months of each year (or 13 years of your life) goes towards paying off your tax obligation. Unfortunately, as long as you’re earning, you’ll have to pay taxes. The best strategy would be to find opportunities to pay less taxes. If you can’t do that, you should aim to defer them. The second option should be considered, especially if you expect to shift to a lower tax bracket in the future.
Effective Ways to Legally Reduce Your Taxes
- Start your own business. Becoming a small business owner is the most common way to reduce taxes. Despite potentially increasing your income, a small business owner has access to a number of tax advantages. You are allowed to deduct many of your business expenses from your earned income, which decreases your tax burden. These include large, important expenses like health insurance premiums. If your business is based in your home, you may deduct home-related expenses as well using a home office deduction. You may apply for the annual portion of your utilities and the internet used for business purposes.
- Max out retirement accounts. Have you met the contribution limits on your traditional or Roth IRAs, 401k or other retirement accounts? If not, you should start building those up. Maximizing retirement accounts is the most common option for people who choose not to open their own business.
- Generate passive income. The idea of passive income is to use your assets, and not your time, to generate income. Let’s look at a common example: owning a rental property. Rental properties are desirable because they are a gateway to real estate investing. As a landlord, the following deductions can lower taxes:
- The annual mortgage interest paid
- Repairs to the property, provided they are necessary, ordinary, and reasonable in cost
- Travel costs related to running and maintaining the property
- Home office costs (that meet the minimum criteria)
- Depreciation of the rental properties, which can be written off over a preset amount of time.
It is possible to invest in a rental property, even if you’re paying a mortgage. Often, this is done with a home equity loan or line of credit. This is a convenient, low-cost method of funding investment properties. Even better, the income earned from the investment property may be used to pay the primary mortgage. You’ll earn money from your investments and receive tax benefits.
The term for this is called debt recycling. The concept is that taking your non-deductible mortgage debt and converting it to tax-deductible (investment) debt. The income earned can then be used to eliminate your home loan faster. As long as your investments keep growing in value, you can pay off your mortgage and put money towards wealth building.
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- Investing in municipal bonds. Some financial investments come with tax-free benefits. You won’t pay federal taxes on most municipal bonds. Municipal bonds or bond funds that originate in the same state you live in are tax-free as well. The only drawback is that they may receive a lower yield than other bonds or bond funds.
- Long-term capital gains. A key tool for increasing your long-term wealth is investing. Stocks, bond and real estate investing come with favorable advantages for long-term capital gains. Any investment held longer than a year then sold at a profit may realize a lower capital gain tax rate. This may be a 0% rate for someone in the 10% and 15% brackets. In comparison, selling an investment in less than a year can result in higher rates. A financial strategy using long-term capital gains can improve your financial health and tax liabilities.
- Health Savings Accounts (HSAs). HSAs are financial accounts used with high deductible health plans, and they can reduce your taxes. They’re funded with pre-tax dollars. Neither earnings nor withdrawals are taxed.
- Get credit from the IRS. The IRS can offer dollar-for-dollar tax credits, which can reduce your taxable income. There is the earned income credit, which lets taxpayers with low incomes decrease their taxes. You may also benefit from the American Opportunity Tax Credit. It provides a maximum credit of $2,500 each year for eligible students. Middle and low-income taxpayers can also look to the saver’s credit, which can help with saving for retirement. Parents can look into the Child and Dependent Care Credit, which can counter against childcare expenses.
You’re not going to avoid paying taxes, but you may be able to lower them. Whatever strategy you employ, remember that taxes can be a serious, complicated topic. It’s best that you work with a licensed tax professional.