Mastering Tax Strategies: Your Guide to Legally Reducing Tax Burden

Everyone living or working in the United States must pay taxes, as is the case in any other country. But, it can be a significant source of stress for many. However, with the right tax planning, you can reduce your tax burden or possibly get a bigger refund when tax season ends. Many people miss out on valuable tax benefits simply because they’re not aware of them, leading to higher tax payments than necessary. This blog will clarify, how to avoid paying taxes with proper tax planning.

In this blog, we will explore simple and legal ways to lower your taxes using methods that the experts use. Whether you’re just starting out, a seasoned earner, or a high business earner, you’ll find valuable tips to help you keep more of your money. Continue reading to discover how you can easily implement these tax planning strategies into your financial life and enjoy the benefits of reduced taxes.

What Is Taxable Income?

Taxable income is the amount of your income that is subject to taxes in a given year. It is calculated by taking your adjusted gross income (AGI), which includes your total earnings from various sources, and subtracting any deductions you’re eligible for. This income includes money earned from jobs, investments, and other sources.

Types of Taxable Income

Taxable income includes both earned income (like wages and salaries) and unearned income. Unearned income consists of:

• Canceled debts
• Certain government benefits, such as unemployment and disability payments,
• Strike benefits
• Lottery winnings
• Profits from selling assets that have increased in value
• Dividends and interest from investments

Deductions from Income

You can reduce your taxable income by claiming deductions. The IRS allows you to choose between a standard deduction or itemized deductions. If you go for itemized deductions, these can include:

• Mortgage interest
• Medical expenses that exceed 7.5% of your AGI
• Other specific expenses

How do Businesses Calculate Taxable Income?

Businesses calculate their taxable income differently than individuals. They start with their total revenue, subtract business expenses to determine business income, and then subtract any allowable deductions to find their taxable income.

Understanding Sources of Taxable Income

Taxable income includes any money you earn during the tax year. It mainly comes from what you earn at your job, but there are other sources as well.

Employee Compensation

The most typical form of taxable income is what you earn from your job, such as salaries, wages, tips, bonuses, and fees. This income is usually detailed on a W-2 form that your employer provides. This form also shows deductions like income tax, Social Security, Medicare, and contributions to plans like a 401(k).

Specific Situations Requiring Tax Reporting

• Childcare Providers: If you provide childcare, either in your own home or elsewhere, you must report the money you earn from this as taxable income.
• Fringe Benefits: If you receive certain perks from your role as a director, partner, or employee, you need to report the value of these benefits as taxable income. The IRS provides a detailed list of taxable benefits and exemptions on its website.

Income From Business and Investments

• Rental Income: Money received from renting out property must be reported. You can also declare expenses related to managing these properties, which might reduce the amount of tax you owe.

Income From Partnerships and S Corporations

• Partnerships: Although partnerships themselves aren’t taxed, the income, deductions, and losses they generate are passed on to the partners. Partners must report these on their tax returns, even if they don’t directly apply.
• S Corporations: Similar to partnerships, S corporations pass earnings, losses, and deductions directly to shareholders, who must report them on their personal tax returns.

Other Taxable Income Sources

• Bartering: If you exchange services with someone else, the value of the services received is taxable. For example, if you fix someone’s electrical system and they fix your plumbing in return, the value of the plumbing service you receive must be reported as income.
• Digital Currencies: Any income from the sale, exchange, or investment in digital currencies, like Bitcoin, is taxable.
• Royalties: Income from royalties, whether from intellectual property like copyrights or from natural resources like oil, must be reported as taxable income.

Now that we have an understanding of the sources of this taxable income let’s get to know the various ways to reduce taxable income.

Effective Tax Strategies to Reduce Taxable Income

Lowering taxable income is a key focus in financial planning for individuals and business owners. The Tax Cuts and Jobs Act (TCJA) has increased standard deductions, offering savings to many, despite removing certain itemized deductions and personal exemptions.

Retirement Savings Options

• Employer-Sponsored Retirement Plans: Contributing to employer-sponsored plans like 401(k)s or 403(b)s is a direct way to reduce taxable income. Contributions are made before taxes through paycheck deferrals, which means they lower your taxable income for that year. The maximum contribution is $22,500 in 2023 and $23,000 in 2024, with an additional $7,500 allowed for those aged 50 and older as catch-up contributions.
• Individual Retirement Accounts (IRAs): Contributing to a traditional IRA allows you to deduct the contribution from your tax return, reducing your tax liability. In 2023, the limit is $6,500, increasing to $7,000 in 2024, with a $1,000 catch-up contribution for those 50 and older. These contributions are made with after-tax dollars. The deductibility of IRA contributions can vary for those with access to an employer-sponsored plan, based on IRS rules.

Flexible Spending Plans

Employers may offer Flexible Spending Accounts (FSAs), where employees can set aside pre-tax money for eligible medical expenses. The contribution limit is $3,050 in 2023 and $3,200 in 2024. However, FSAs have a use-or-lose rule, although employers can offer a carryover of up to $610 in 2023 ($640 in 2024) or a grace period extension.

Health Savings Accounts (HSAs)

HSAs are available to those with high-deductible health plans, allowing pre-tax contributions for future healthcare costs. The 2023 contribution limits are $3,850 for individuals and $7,750 for families, increasing in 2024 to $4,150 and $8,300, respectively. The maximum out-of-pocket expenses for 2023 are $7,500 for individual coverage and $15,000 for family coverage.

Business Deductions

For self-employed or small business owners, numerous deductions are available to reduce taxable income:

• Home Office Deduction: You can claim a portion of your home used regularly for business as a deduction, using either a simplified or regular method.
• Retirement Plans for the Self-Employed: Self-employed individuals can significantly reduce taxable income through retirement plans like Solo 401(k)s, SEP IRAs, and SIMPLE IRAs. These plans allow for pre-tax contributions and have high contribution limits.

The SECURE Act

The SECURE Act offers benefits for small business owners setting up retirement plans, providing tax incentives to encourage the setup of Multiple Employer Plans (MEPs), and expanding eligibility for part-time workers who meet certain criteria.

Education Savings Plans (529s)

Education Savings Plans, or 529 plans, are an excellent way to save for future educational expenses while also reducing taxable income. Contributions to these plans are not federally tax-deductible, but earnings grow tax-free, and withdrawals for qualified education expenses are also tax-free. These plans are flexible and can be used for a wide range of educational costs, from kindergarten through graduate school, and now they can also be used for apprenticeships and to repay student loans under certain conditions.

Tax-Saving Investments

Tax savings with smart investment choices can lower your tax liability, allowing you to retain more of your hard-earned money. Read this in detail to learn how:

Capital Gains and Losses

Capital gains occur when you sell an investment or asset for more than what you paid for it. Conversely, capital losses happen when you sell something for less than its purchase price. The IRS taxes capital gains but allows you to use capital losses to offset gains.

• Short-term capital gains (on assets held for one year or less) are taxed at your ordinary income tax rate.
• Long-term capital gains (on assets held for more than one year) benefit from lower tax rates, which are 0%, 15%, or 20% depending on your income level.

If your capital losses exceed your gains, you can use the loss to offset up to $3,000 ($1,500 if married filing separately) of other income per year. If you have more losses than that, you can carry them forward to future years.

Tax-Advantaged Accounts

Tax-advantaged accounts are special types of accounts that offer tax benefits, either by deferring taxes until a later date or by allowing tax-free growth. Examples include:

• Retirement Accounts (IRA, 401(k), Roth IRA, etc.): Contributions to traditional IRAs and 401(k)s may reduce your taxable income in the year you make them, and the investments grow tax-deferred. Withdrawals are taxed as regular income in retirement. Roth IRAs and Roth 401(k)s are funded with after-tax money, meaning withdrawals in retirement are tax-free, as long as certain conditions are met.
• Health Savings Accounts (HSAs) and Flexible Spending Accounts (FSAs): HSAs are available to those with high-deductible health plans. Contributions are made pre-tax, and withdrawals for qualified medical expenses are tax-free. FSAs also allow for pre-tax contributions to cover medical expenses but typically use-it-or-lose-it rules apply.

Real Estate Investments

Investing in real estate can also provide tax advantages:

• Depreciation: This is a non-cash deduction that can offset income from rental properties, reflecting the property’s decrease in value due to wear and tear.
• 1031 Exchange: This provision allows you to defer paying capital gains taxes on an investment property when it is sold, as long as another similar property is purchased with the profit gained by the sale.
• Mortgage Interest Deductions: Interest paid on a mortgage for investment properties can often be deducted, lowering your taxable income.

Municipal Bonds

Municipal bonds, or “munis,” are issued by local, state, or federal governments to finance public projects. The interest income from most municipal bonds is exempt from federal income tax and sometimes from state and local taxes, especially if you live in the state where the bond is issued.

• General Obligation Bonds: These are secured by the issuing government’s credit and taxing power.
• Revenue Bonds: These are secured by the revenue from a specific project or source, like highway tolls or lease fees.

Investing in municipal bonds can be a good strategy for those in higher tax brackets seeking steady, tax-free income.

Each of these investment options offers unique tax advantages and can be a valuable part of your overall investment strategy. It’s important to assess your financial situation and possibly consult with a financial advisor to choose the best options for your needs.

Maximizing Tax Advantages Through Charitable Contributions

Charitable giving is not only a noble endeavor but also recognized and encouraged through various tax incentives by the U.S. tax code. On average, U.S. individuals and families contribute over $1 billion daily to charitable causes.

Tax Strategies for Charitable Contributions

• Donating Long-Term Appreciated Assets: When you donate assets like stocks, bonds, or real estate that have increased in value, you avoid capital gains taxes and can deduct the full market value of the donation. This deduction can be up to 30% of your adjusted gross income.
• Bunching Multi-Year Donations: To surpass the standard deduction threshold set by the 2017 tax reform, you can combine several years’ worth of donations into one year. This strategy allows you to itemize deductions that year and take standard deductions in other years. Tools like a Charitable Giving Tax Saving Strategies Calculator can help estimate the benefits.
• Estate Planning: Including charitable gifts in your estate plan, such as naming charities in your will or as beneficiaries of your insurance or retirement plans, can reduce or eliminate estate taxes for your heirs. This ensures your legacy continues through ongoing charitable support.
• Donor-Advised Funds: Contributing to a donor-advised fund allows for an immediate tax deduction. These funds enable you to recommend how donations are distributed over time to various charities and allow for the tax-free growth of funds. Donor-advised funds can offer greater tax advantages than private foundations, including benefits on income, capital gains, and estate taxes.

Reducing Taxes Through Charitable Giving

• Income Tax Reduction Strategies: Charitable donations to 501(c)(3) organizations are deductible, reducing your taxable income. Maximizing this deduction might involve “bunching” contributions or combining gifts of cash and appreciated assets to increase benefits during high-income years.
• Capital Gains Tax Reduction: Donating assets that have appreciated in value, such as stocks or real estate, allows you to deduct their full market value and avoid paying capital gains taxes, which can be up to 20%. This is effective for both publicly and non-publicly traded assets.
• Estate Tax Reduction: The federal estate tax applies to the transfer of property at death. When structured correctly, charitable gifts can remove assets from your estate, potentially reducing the estate tax burden. Unlimited charitable deductions are allowed for bequests to charities, making this an effective strategy for estate planning. This includes using charitable trusts and strategically selecting assets to leave to various beneficiaries to minimize taxes.

Tax Planning for Small Business Owners

Tax season is key for small business owners because it helps them save money and grow their businesses. Here are six simple tax strategies to manage taxes effectively.

Select the Appropriate Business Structure

The structure of your business affects how much tax you pay and your personal liability.

Choosing the right structure is essential, as it influences legal risks and financial obligations, impacting overall profitability.

• Sole Proprietorships: This structure reports income and losses on personal tax returns, simplifying the process but increasing personal liability.
• Partnerships: These entities pass profits and losses directly to partners, who then report them on personal tax returns.
• LLCs: Limited Liability Companies offer flexibility, allowing taxation as a sole proprietorship, partnership, or corporation, impacting your filings and tax benefits.

Take Advantage of Tax Deductions

Reducing taxable income means you pay less tax. Maximizing deductions ensures that you only pay taxes on net income, increasing cash flow, which is vital for the financial health of any small business. Key deductions include:

• Home office expenses
• Costs for internet and phone services
• Travel and entertainment for business
• Educational expenses for professional development
• Fees for professional services

Leverage Tax Credits

Directly lowering your tax due can significantly improve your bottom line. Utilizing tax credits can directly decrease the amount of tax you owe, providing substantial financial relief and freeing up resources for reinvestment in your business. Tax credits reduce your tax bill more directly than deductions:

• Work Opportunity Tax Credit: For hiring individuals from certain groups facing employment barriers.
• Small Employer Health Insurance Credit: If you provide health insurance to employees.
• Clean Energy Credits: For engaging in environmentally sustainable practices.

Adjust Income Timing

Smoothing out income can lead to tax savings, depending on rate fluctuations. Managing when you recognize business income can help you take advantage of lower tax rates and align better with business cycles, optimizing your tax situation each year.

• Defer Income: Consider postponing income into the next year if you expect a lower tax rate.
• Accelerate Income: Recognize income earlier if you anticipate a tax rate increase or wish to capitalize on current deductions.

Contribute to Retirement Plans

Lower your current taxable income while saving for the future. Contributing to retirement plans reduces current taxable income and provides long-term benefits, aiding in personal financial security and business stability.

• Contributions to plans like 401(k)s are deductible and reduce your personal taxable income.
• Employer contributions are exempt from payroll taxes.
• Setting up new qualified plans might qualify you for additional tax credits.

Capitalize on Depreciation Deductions

Large purchases can be cost-effective when tax benefits are considered. Making the most of depreciation deductions helps manage the financial impact of large purchases, ensuring that you maximize tax savings and maintain cash flow.

• Section 179 Deduction: Allows full deduction of certain property costs up to a specified limit (approximately $1 million).
• Bonus Depreciation: This can accelerate depreciation benefits, making new asset investments more attractive.

With these strategies, small business owners can not only alleviate the stress of tax season but also enhance their operational and financial strategies.

Tax Planning Strategies for High-Income Earners

Explore a variety of approaches that combine tax deductions, credits, and savvy investment choices designed specifically to reduce your tax burden significantly. These methods are particularly effective for high earners looking to optimize their financial strategies and minimize their taxable income.

• Max Out Your Retirement Contributions: Contributing the maximum to your 401(k) or 403(b) plans is a straightforward method to reduce your taxable income since these contributions are tax-deferred. For 2024, you can contribute up to $23,000, with an additional catch-up of $7,500 if you are over 50. By deferring taxes until retirement, where you may be in a lower tax bracket, you’ll save on the amount of taxes paid.
• Roth IRA Conversions: Convert traditional IRAs or 401(k)s to Roth IRAs to pay taxes now at a lower rate and enjoy tax-free growth and withdrawals. This strategy is particularly effective if you anticipate being in a lower tax bracket temporarily or if you plan to delay withdrawals until required minimum distributions at age 73.
• Buy Municipal Bonds: Municipal bonds are a reliable investment for high-income earners due to their tax-exempt status. The interest earned is generally exempt from federal, state, and local taxes, making them an attractive option despite their typically lower yields compared to taxable bonds.
• Sell Inherited Real Estate: Selling inherited real estate promptly allows you to benefit from the stepped-up tax basis, potentially avoiding significant capital gains tax. If you sell the property shortly after inheriting, you may pay little to no taxes on the gain.
• Set Up a Donor-Advised Fund: By setting up a donor-advised fund, you can make a large charitable contribution this year, receive an immediate tax deduction, and then distribute funds to charities over time. This strategy is ideal for high earners looking to manage their taxable income more effectively across multiple years.
• Use a Health Savings Account (HSA): Contributing to an HSA is beneficial if you have a high-deductible health plan. For 2024, the contribution limits are $4,150 for individuals and $8,300 for families, with an additional $1,000 for those 55 or older. HSAs offer triple tax advantages: tax-deductible contributions, tax-free growth, and tax-free withdrawals for qualified medical expenses.
• Invest in Companies that Pay Dividends: Investing in companies that pay qualified dividends can offer tax advantages since these dividends are taxed at a lower rate compared to ordinary income. Ensure you invest in companies that meet the criteria for qualified dividends to enjoy this reduced tax rate.
• Tax Residency Planning: Consider establishing residency in a state with low or no income tax to reduce your tax liability. Be mindful of the residency rules and potential for increased costs in other areas, and work with a tax professional to navigate this complex strategy.
• Pay Your Property Taxes Early: Paying your property taxes early can be beneficial, especially if doing so allows you to stay within the IRS’s $10,000 deduction cap for state and local taxes. Some jurisdictions offer discounts for early payments, providing additional savings.
• Fund 529 Plans for Your Children: Contributing to 529 plans can reduce your estate tax liability and provide a way to save for your children’s education tax-efficiently. While contributions are not deductible at the federal level, they may be at the state level, and the growth and withdrawals are tax-free when used for qualified education expenses.
• Invest in an Opportunity Zone: Invest your capital gains in Opportunity Zones to defer and potentially reduce taxes on those gains. This investment must be held until at least December 31, 2026, or until you sell the investment, whichever comes first, to reap the tax benefits.

These strategies provide high earners with multiple avenues to manage and reduce their taxable income effectively, leveraging both investments and tax planning techniques.

Summing Up with Compliance and Essential Legal Considerations

Understanding tax laws is crucial to make sure you meet your obligations and save as much as possible. Good tax planning means making smart choices that follow these laws, giving you a clear idea of how to avoid taxes and problems associated with them.

A recent survey showed that taxpayers who used tax professionals got refunds that were $840 higher on average than those who filed on their own. With expert help, you can get similar results. If you want to improve your tax return, our team is here to assist. We offer advice and strategies to boost your tax benefits and lower your tax burden.

Our firm also offers a range of services, including CFO services, advanced tax planning, individual tax planning, succession planning services, business continuity planning, and family tax office services. As a tax planner in California (and beyond), we provide tailored solutions to meet your financial needs.