If you want to save on taxes, you’re not alone. The average American pays thousands of dollars in taxes each year. Income, payroll, and capital gains taxes can easily send a quarter or more of your annual earnings to the government. There’s lots of advice out there on how to save on taxes, but a lot of it requires you to take potentially drastic action, like buying a house or starting a business.
Many of those commonly proposed tactics are simply unrealistic for the average American employee. That doesn’t mean you have to radically change your life to keep more of your paycheck. If you don’t have the time or the money to commit to overly complicated tax avoidance plans, try these 8 practical tax reduction strategies instead!
In this post:
1. Reduce Your Tax Withholding
If you are a salaried worker, your employer automatically withholds a portion of your paycheck to cover your taxes for that pay period. It’s convenient and lets you pretty much forget about your taxes until you need to file.
Most people set their withholding allowance when they start a job and then forget about it. If you’ve been getting a tax refund all along (which you probably have), you’ve been withholding too much.
To avoid penalties, you only need to pay the lesser of the following:
- 100% of the previous year’s tax liability
- 90% of the current year’s tax liability
If you withhold more than that, you’re just giving the government an interest-free loan. You might enjoy getting that lump sum every year, but it’s not a bonus. It’s been yours all along, and you could’ve been using that money to invest or pay down debt the whole year.
If you’re trying to cut your taxes because you want to boost your cash flow, reducing your withholding is a great way to do it. You’ll see an immediate increase in your paycheck.
⚠️ Just be careful not to reduce it below the thresholds above.
2. Use the Best Filing Status Available to You
Your filing status may seem pretty straightforward, but it plays a significant role in calculating your annual tax bill. It has a direct impact on:
- The size of your standard deduction
- Your eligibility for tax credits and deductions
- The width of your progressive tax brackets
If you’re not married, filing as head-of-household is far superior to filing as single. To qualify as head of household, you have to be unmarried, pay for more than half of your household’s expenses, and claim a qualifying child or dependent.
If you qualify, your standard deduction will increase by $6,250, you’ll have wider tax brackets at the lower rates (which reduces your effective tax rate), and you’ll be able to access some unique tax credits.
Married couples can choose to file jointly or separately. Filing jointly will usually give you more valuable tax credits. If one spouse earns much more than the other, there is a chance that you might want to file separately. If you can’t immediately tell which choice makes the most sense, run your return both ways or consult a tax professional.
3. Contribute to Tax-Advantaged Accounts
Of all the tools that help you cut your taxes, tax-advantaged accounts might provide the most bang for your buck and require the least amount of effort.
Here’s what happens when you invest in deductible tax-advantaged accounts like traditional Individual Retirement Accounts (IRAs), traditional 401(k)s, and Health Savings Accounts (HSAs):
- Your contributions lower your tax bill for the year.
- The annual tax savings increase the pool of cash you have to invest with, which grows larger with compound interest.
- Taxes on the investment income within the account are deferred until you take distributions (and can even be tax-free for HSAs).
Contributions to these accounts are considered “above the line” deductions. They’re separate from itemized deductions (those come later) and reduce your Adjusted Gross Income (AGI).
Reducing your AGI is one of the most efficient ways to cut your taxes because the American income tax system is progressive. That means that the last dollar you earn will fall into a higher tax bracket than the first dollar.
👉 For example:
As a single filer in 2020, your first $9,875 of ordinary income is taxed at 10%, while everything you make over $85,526 is taxed at 24%.
When you lower your AGI, it always starts with your “last” dollar, saving you from paying taxes on it at your highest marginal tax rate.
Your AGI also plays a big role in calculating a lot of other important numbers in your tax return. For example, many tax credits and deductions are only available to those with a low enough AGI, so anything you can do to reduce it is valuable.
Accounts like Roth IRAs and Roth 401(ks) won’t give you an above the line tax deduction, but your distributions are guaranteed to be tax-free in retirement.
4. Use Other Above the Line Deductions
Contributions to retirement accounts aren’t the only way to reduce your AGI and cut your taxes. There are a few other deductions that you might get to take advantage of, such as:
- Student Loan Interest: If you’re still paying off your student loans, take a deduction for the interest on the outstanding balance.
- Alimony: If you’re paying alimony to an ex-spouse and your divorce agreement was made before 2018, you can deduct that expense from your AGI.
- Penalty on Early Withdrawals: If you have to take a distribution from your retirement before age 59 1/2, you’ll probably have to pay a 10% penalty on it. That can be costly, but you can minimize the damage by claiming a deduction for the penalty.
Unlike retirement contributions, which you should actively try to maximize, these deductions are a form of damage control. They subsidize undesirable expenses, like student loans, divorces, or unavoidable emergencies. You won’t seek them out, but they can reduce the impact of adverse events.
☝️ Consult a tax professional to see if you qualify!
5. Reach the Threshold for Itemized Deductions
The standard deduction has increased dramatically since the Tax Cuts and Job Act (TCJA) came into effect in 2018, roughly doubling from the 2017 amount.
The increase (along with the simultaneous removal of many previously legal deductions) made it much more difficult to make itemizing worthwhile. The number of taxpayers to pull it off decreased from roughly 46 million to just 16 million.
Itemizing is still possible and potentially lucrative if you can substantially exceed the standard deduction. Here are four deductions that are commonly used by successful itemizers:
- Medical expenses over 7.5% of your AGI
- Mortgage interest on the first $750,000 to $1,000,000 of principal
- State and local income taxes (or state sales taxes)
- Charitable contributions up to $10,000
You shouldn’t try to rack up medical expenses or mortgage interest in the hopes that you’ll qualify for a tax deduction, but if you already have a large mortgage balance and perhaps a dependent parent in a nursing home, itemizing can still work out in your favor.
💡 If you find yourself falling just short of the threshold to itemize, one great way to put yourself over the edge is to double up on your charitable expenses. For example, you could donate $6,000 in one year instead of $3,000 over two years.
6. Take Advantage of Tax Credits
Qualifying for tax credits requires a bit more foresight than most deductions, and many people fail to use them effectively. If you’re eligible and you plan carefully they can save you a lot of money.
Check these tax credits and see if you qualify:
- Retirement Savings Contribution Credit: Previously called the Saver’s Credit, it’ll reward you even further for putting money into your retirement accounts.
- Earned Income Tax Credit: This credit only requires you to earn ordinary income, though the income limits are on the low end.
- Child and Dependent Care Tax Credit: You can take a tax credit for a percentage of the expenses you pay to have someone care for your child or dependent so that you can go to work.
Tax deductions are applied at the beginning of your tax calculation process. They simultaneously lower your marginal tax rate and the amount it’s applied to, both of which indirectly reduce your tax bill.
But tax credits are applied at the end of your tax calculation process. They directly reduce your tax bill, dollar for dollar.
👉 Here’s an example:
Let’s say you make $65,000 and fall comfortably into a 25% marginal tax bracket. A $1,000 tax deduction would save you $250 in taxes (25% of $1,000), but a tax credit of the same amount would reduce your tax bill by $1,000, putting it all back in your pocket directly.
7. Tax-Friendly Investments can Minimize Your Tax Drag
If you’re a diligent saver, you may eventually have more cash than you can fit into your tax-advantaged accounts. At that point, your investments will start to add to your tax bill.
When you buy paper assets (like funds, stocks, or bonds) through a regular brokerage account, you’ll owe tax on the income it produces each year in the form of interest, dividends, and capital gains (even if you don’t sell your asset).
These costs are your asset’s “tax drag” and can take a surprisingly hefty toll on your returns.
To cut your taxes on these assets, put your most tax-inefficient investments, like the following, into your tax-advantaged accounts:
- Real estate investment trusts (REITs)
- High-turnover active funds
- High-yield corporate bonds
Investments like these produce a lot of taxable income as they grow. Something more stable, like a low-cost index fund, does not and would be better in a taxable account.
8. Use tax-loss harvesting
For the particularly active or ambitious, tax-loss harvesting can be another way to increase the efficiency of your investments and cut your taxes. Here’s how it works.
Even in a well-designed portfolio, you’re going to have periods with negative returns with some assets operating at a loss. If you sell those assets and lock in your capital losses, you can offset them against any capital gains you might have in the same year. If you use the proceeds to immediately purchase a replacement asset, you can maintain the integrity of your portfolio and avoid missing out on any time in the market.
There are a few important limitations to keep in mind:
- You can only harvest losses in taxable accounts, not retirement accounts like an IRA or 401(k).
- Losses are first applied to capital gains of the same variety (long-term vs. short-term), then to the opposite, then to ordinary income up to $3,000.
- You must buy a “significantly different” asset to replace what you sold OR wait 30 days before repurchasing it to avoid a wash-sale, which would disallow your deduction.
With those restrictions in mind, here’s an example of effective tax-loss harvesting:
Imagine you buy two funds at the beginning of the year. Fund A performs well, earning you $10,000 in short-term capital gains by the end of the year, but Fund B loses $12,000 over the same period. You decide to harvest those losses and sell both funds.
Your $12,000 loss in Fund B completely offsets the $10,000 of short-term capital gains from Fund A. Assuming you’re in a 25% marginal tax bracket, that would save you $2,500.
If you have no other capital gains, you can then apply the remaining $2,000 in losses to your ordinary income, saving you a further $500. And to avoid a wash sale, you decide to purchase Fund Q a couple of days later, which is significantly different from Fund B.
Consult a Tax Professional.
When you execute them properly, these practical strategies can help you pay significantly less in taxes each year. However, the regulations and implications that surround them can be tough to figure out on your own. If you make a mistake you could face significant penalties.
When in doubt, consider working with a tax professional to avoid making any mistakes. Interview a few Certified Public Accountants (CPAs) to find one that can help you formulate an effective tax strategy and stay within the rules.