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How to Lower Your Taxable Income This Year
Why would you pay more taxes to the government when you don’t have to? There are legal ways to reduce taxable income reported to the IRS and in today’s article I’m going to share with you 6 of the best.
I’m going to show you some ways to save money on taxes. I’ll explain six investing tax loopholes that will help you reduce your tax bill so you can keep more of what you make legally.
The bottom line is if you want to pay less taxes you have to reduce your income. The best way to do this is to quit your job not make any money, and just live off food stamps. That’s just a joke right.
Seriously though if you want to pay less taxes you have to lower the income that the government views as taxable. This doesn’t mean making less money. It just means you need to switch over to certain types of income that aren’t taxable.
This is called tax-exempt income. The more tax-exempt income you have the less taxes you’ll pay. You also want to maximize all your tax deductions. The more tax deductions you take the less taxes you’ll pay.
By the way did you know that Warren Buffett pays less taxes than his secretary? Yep it’s true. It might seem unfair but tax laws are skewed way way way way in favor of investors and business owners.
Although we can’t all be like Warren Buffett, there’s a lot of ways to reduce your tax bill even if you don’t own a business or have a lot of money. Let’s get into it…
6 Ways to Reduce Taxable Income and Save More
1. Through a 401(k)
The easiest way to reduce your taxes is by putting money away into a 401(k). In general you owe taxes on everything you make. As soon as the money comes through the door. But with a 401K the IRS lets you contribute a chunk of your paycheck to that first. and then they’ll charge you taxes on whatever is left.
The end result is that you pay taxes on a much smaller amount so you can save and invest with tax-free earnings. Let me illustrate this with an example:
Let’s say your salary is $5,000 a month. You decide to save $500 of that every month into your 401K which lowers your taxable income to $4,500. Now assume your tax rate is 40%. Instead of owing $2,000 which is 40 percent of $5,000 you’ll pay only $1,800.
Now that’s $200 that you saved. That money stays with you instead of going to the government.
You’ll be able to save your money so much faster in a 401k account especially if you’re lucky enough to have an employer that offers contribution matching. This is where they’ll match all your contributions dollar for dollar.
If you have that option you should totally take advantage of that. That’s basically free money and it’s also tax-free.
Important things to know about 401(k)’s.
One thing you need to know is 401k’s were meant to help you save for retirement. So you generally can’t touch this money until you turn 59 and a half years young although there are some cool things you can do.
For example like you can take a loan out from it if you want to make a big purchase like buy your first house. You’re basically just borrowing money from your own 401k.
So there are things like that that you can do but generally this money is meant for a retirement so you can’t touch it till you retire.
Also you can only open a 401k if you work for an employer that offers one. So if you don’t have a 401k through work or you’re self-employed then the next on our list of ways to reduce taxable income is for you.
Bottom line: Take full advantage of 401(k) contributions if you have that option available to you and reduce your taxable income.
2. SEP IRA
The SEP stands for Simplified Employee Pension IRA.
The SEP IRA is the equivalent of a 401k and it’s for all you freelancers, self-employed people and business owners. It lets you put away up to 25 percent of your net business income into a tax-free investment account.
There way too many freelancers and independent contractors who don’t know about this tax loophole and it’s not even a tax loophole. It’s just something available for everyone and this is a huge mistake if you’re self-employed.
Definitely look into SEP IRA’s. I mean why pay any more taxes than you need to?
So if there’s only one thing you take away from this article it’s this: open a SEP IRA!! I can’t scream that out loud enough!
3. Health Savings Account (HSA).
This one’s my favorite and it’s one of the best ways to reduce taxable income for ordinary people. HSAs are a lot like 401ks and SEP IRAs in the sense that any contributions you make to it immediately reduces your taxable income.
However, HSAs are a little bit different because they’re supposed to help you pay for health related expenses with tax-free money. The good thing about HSA is that you don’t have to wait till you’re retired to spend it.
You can use them for all health related expenses right now. So for example you can use your HSA to pay for your contact lenses, acupuncture visits and you can even use it for massages if you get a prescription from your doctor.
HSAs are typically only allowed for people who have health insurance plans that have really low monthly premiums but higher out-of-pocket expenses. Having an HSA makes a lot of sense for you if you’re pretty healthy and you just want a tax-savvy way to cover your medical expenses if and when you need it.
4. Municipal Bonds or “Munis”
Now let’s talk about some ways to make tax-free income. Municipal Bonds or “Munis” in Wall Street jargon are bonds issued by local governments. Their purpose is to fund things like infrastructure, water projects and anything that the city, county or state needs to run well.
The best way to invest in Munis is through municipal bond funds. These are funds that hold hundreds and even thousands of bonds from different municipalities. This is good because it helps you diversify and spread out your credit risk.
Short-term municipal bond funds can be a relatively safe place to park your cash while earning some tax-free interest. As of the time of writing this article in March 2020, you can expect to make a yield of around 1.65%.
This doesn’t sound like much but if you factor in the tax benefits, you get a tax equivalent yield of about 2.5%. Of course this is not a recommendation to buy because it has to be appropriate for your situation.
Also know that municipal bonds do have their risk but if you want to do more research on this check out VWITX, which are bond funds run by Vanguard.
5. 1031 Exchange
We’re still looking for ways to reduce taxable income for the ordinary everyday Jane and our next tip is 1031 Exchange. If you own rental property or you want to own rental property one day, this one is for you.
Real estate tends to go up a lot in value but if you were ever to sell, you would have to pay major taxes on the gains with capital gains tax at 20%, we’re talking a big chunk of change when it comes to real estate. But thanks to 1031 Exchanges you could get away with never paying taxes on any of your real estate for the rest of your life. That sounds like fun right?
So here’s what happens with the 1031 Exchange. With a 1031 Exchange you pay zero taxes on the gains when you sell your investment property as long as you roll it over into a new property of equal or higher value.
It’s basically a tax break offered by the government to help you grow your real estate portfolio. Think about it. Normally when you sell you have to pay full capital gains on any profits you’ve made. If you want to reinvest that money into something else you’d have 20% less buying power because you had to pay your taxes .
However, if you do a 1031 Exchange you can pocket all the gains without having to pay any is on it as long as you follow a few simple rules. One of them being that you need to reinvest that money into a new property.
People do this all the time trading in a duplex for a triplex and then trading that in for a multi-family building and then trading that in later on for an apartment building and just getting bigger and bigger that way.
It’s a lot easier to grow your net worth when you don’t have to pay taxes. There’s definitely a lot of advantages to investing in real estate and the 1031 Exchange is literally one of the best things out there and what makes real estate so great for building wealth.
6. Roth IRA
Our last loophole in finding ways to reduce taxable income is through Roth IRA’s and is a great way to avoid paying taxes on your investments. How does it work to help you lower your taxable income?
Anything you buy inside of a Roth you’ll never have to worry about taxes again. Any stocks, bonds or assets you hold in your Roth IRA can grow tax-free until you retire and when you retire any income you get or withdrawals you make from your Roth are tax-free as well.
A key feature of Roth IRAs is that your contributions don’t reduce your taxable income this year but you get the tax benefits on the back end when you retire. Therefore a great combination is to have a 401k and a Roth IRA or for a self-employed folks a SEP IRA and a Roth IRA.
Maxing out your contributions to both accounts would mean you’re saving as much as possible for a retirement and not paying any more in taxes than you need to. Also this is just a passing comment.
If you are starting out investing in stocks, bonds and other paper assets, make sure you have an IRA either a Roth, SEP or traditional or you’re doing it within a 401k.
Basically make sure you’re doing it within a tax-advantaged account before you do it in a brokerage account which is fully taxable. Because otherwise you’re leaving a lot of money on the table.
As you can see there are ways to reduce taxable income and I have shared 6 of them with you. Like I said my favourite is HSA but perhaps there’s one way that’s your favourite.
So my question for you which of the best ways to reduce taxable income is your favorite investing tax loophole and why?
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