This post may contain affiliate links. Which means we may earn a commission if you decide to make a purchase through our links. Please read our disclosure for more info.
Tax reduction planning is the analysis and arrangement of a person's financial situation to maximize tax breaks, minimize tax liabilities and avoid any trouble with the law. To do this efficiently you should know about some key concepts before making your next money move.
Here are six key tax reduction planning and tax reduction strategies to know before you make your next money move.
In this article
1. Start Investing in Municipal Bonds
Municipal bonds are a great option for investors who live in high tax brackets because they offer the opportunity to earn interest income that is exempt from federal taxes.
The U.S. municipal bond market, which consists of state and local government obligations, has grown significantly during the past decade as issuers have tapped into this source of capital to fund infrastructure projects across America's cities and towns.
Municipal bonds are the best of both worlds. They offer lower interest rates than corporate stocks, but because they're backed by taxes rather than debt in a company's financials, investors may also be able to get more out of it at tax time. The higher your income bracket is and the better suited you might need for these investments as well!
2. Pursue Long-term Capital Gains
Investing is a great way to grow your wealth. You can invest in stocks, mutual funds, bonds and real estate for favorable tax treatment if the investment has been held long-term.
The capital gains tax rates can be confusing for investors. When an investor holds a long-term asset, they get preferential treatment with 0%, 15%, or 20%. However, if the investment is held less than one year before it's sold then you have to pay taxes at your ordinary-income rate which could cost more money in higher brackets! It really pays off to understand how these different types of investments are taxed and that there may be opportunities where short-term assets become better choices depending on what type of bracket someone falls into.
An understanding of taxation based on length of ownership plays a significant role in growing wealth as well as determining whether an investor will want equity returns versus debt return from their portfolio holdings.
3. Start a Business
A side business allows many tax reduction strategies which in turn reduce the amount of taxes that you owe. In order to qualify for these special benefits, self-employed people must meet certain conditions such as providing health insurance coverage and paying estimated quarterly income taxes when due.
By strictly following Internal Revenue Service (IRS) guidelines, a business owner may deduct part of their home expenses with the home office deduction. The portion of utilities and Internet used in the business may also be deducted from income if there is proof that they were being conducted on behalf of making a profit by conducting three out five years worth of profitable transactions within those last five years according to Publication 535 published for taxpayers interested in determining whether or not they are operating as an active participant running a legitimate enterprise.
4. Max Out Retirement Accounts and Employee Benefits
In both 2020 and 2021, employees can contribute up to $19,500 into their 401(k) or 403(b). Those 50 years of age or older are allowed an additional contribution of $6,500. For example: if you're a 40-year-old earning 100K per annum in 2020-2021 who contributes only 19.5% (or under), your taxable income will be reduced from the original statement by nearly 20%.
For some people, it is worth having a retirement account at work. But for those who don't have one and are in need of financial assistance, they can get up to a $6k tax break by contributing the max amount ($7k if 50+) into an IRA every year from 2020-2021. There are also special benefits depending on your income level too!
In addition to retirement plan contributions, many employers offer a variety of fringe plans that afford employees the opportunity to exclude from their income benefits received under these programs. Benefits offered by some companies include flexible spending accounts for healthcare and education expenses, transportation cost reimbursements if your job requires you to travel often or over long distances, group-term life insurance up to $50k per person as well as deferred compensation arrangements specifically designed for senior managers and executives.
5. Use a Health Savings Account
Employees with a high-deductible health insurance plan can use an HSA to reduce taxes. As with a 401(k), money is contributed into the account before tax and grows without penalty or taxation owed on earnings.
An extra benefit of using this type of healthcare savings account for qualified medical expenses: withdrawals aren't taxed either!
6. Claim Tax Credits
The IRS offers many tax credits to reduce taxes, including the Earned Income Tax Credit. With three or more qualifying children for 2020, a low-income taxpayer could claim up to $6,660 in credits; with two it's $5,920 and so on.
The American Opportunity Tax Credit offers a maximum of $2,500 per year for eligible students. The Lifetime Learning credit allows up to 20% off your tax bill if you spent more than 10 thousand dollars on education last year.
You're probably not saving enough money for retirement, but don't worry! With just a few hours of research and some attention to your tax situation, you could be enclosing hundreds or even thousands in savings.
It's important that all legal taxes owed are paid – nobody wants the IRS on their case- but there is no need to pay more than what one owes legally. A couple of hours spent at irs.gov and researching reputable financial information sites can save you money that might have been overlooked otherwise.