By Dr. Jim Dahle, WCI FounderMore income is almost always a good thing, but not all income is created equal. Inadequate financial literacy often leads to paying too much tax on the income you do have. In this post, we'll examine 13 ways to reduce the tax bill on the income you have.
13 Ways to Reduce Your Taxes
Most of the time when people talk about reducing their tax bill, they're talking about gaining tax deductions and credits. That's not what this article is about. This article is about shifting income from one type (that is more heavily taxed) to another type (that is less heavily taxed).
#1 File as an S Corporation
When you file taxes as a corporation and take the S election, you can split your income between salary and distributions. Both are taxed at ordinary income tax rates, but both are NOT subject to employment taxes. Only salary is. Lower earners (less than the 2023 Social Security Wage Limit of $160,200) can save up to 15.3% on their taxes (slightly less actually, because half of that is deductible to the business). Higher earners can only save 2.9% on Medicare taxes (again, slightly less as the employer half of payroll taxes is deductible), plus potentially another 0.9% in PPACA tax, for a total of 3.8%. But imagine someone who earns $400,000 and files as an S Corp with a salary of $200,000? They save $200,000 * 3.8% = $7,600 per year in taxes, without decreasing any Social Security or Medicare benefits.
In this situation, you are changing highly taxed employee income to slightly less highly taxed S Corp distributions.
#2 Max Out Retirement Accounts
Making contributions to tax-deferred retirement accounts is a tax reduction technique well known to financially literate investors. Not only does it allow you to defer taxes for decades, but there is usually an arbitrage between the tax rate at which you contribute and the tax rate at which you withdraw the money. Plus, it grows in a tax-protected and asset-protected way between contribution and withdrawal.
In this situation, you are changing highly taxed income now for less highly taxed income later.
More information here:
Tax Saving Strategies for High-Income Earners
#3 Seek Out Passive Income
Passive income is great, even if it is not all that easy to get. Getting some generally requires some capital, some upfront work, some skill, and perhaps even some luck. Sometimes, it's all of the above. However, passive income allows you to make money while you sleep, and it eventually allows you to return from vacation richer than you were when you left. I highly recommend it. But did you also know it is taxed less than earned income? While the exact amount of tax varies by type of passive income, passive income is never subject to payroll taxes. It is also eligible to be reduced by passive losses, which are not too hard to get with depreciable equity real estate investments. That depreciation is recaptured at sale but only at a maximum of 25%, significantly less than many of us are paying in income tax.
In this situation, you are changing highly taxed earned income into less highly taxed passive income.
#4 Earn Tax-Free Interest
Did you know that you can earn interest on your cash and bonds that is not subject to income tax? Municipal money market funds and municipal bond funds pay interest that is tax-free on a federal level. You can even get funds that are income tax-free for many states. It only takes a few clicks to move your money from one money market fund (or savings account) to a tax-free money market fund or from a taxable bond fund into a tax-free bond fund.
In this situation, you are changing taxable interest into tax-free interest. Yes, you generally get less total interest, but after tax, high earners come out ahead.
#5 Ensure Dividends Are Qualified
John D. Rockefeller once said, “Do you know the only thing that gives me pleasure? It's to see my dividends coming in.” Dividends from investments might be the most passive of passive income out there. However, some dividends are ordinary dividends, taxable at your ordinary income tax rate. Other dividends are “qualified” with the IRS and so are taxed at the lower qualified dividend tax rates ranging from 0%-20%. Ideally, you'll make sure as large a percentage of your dividends are qualified as possible. As a general rule, stock dividends are qualified, but only if you own the shares for at least 60 days around the ex-div date. Make sure you do.
In this situation, you are changing ordinary dividends into qualified dividends.
More information here:
The 60-Day Qualified Dividend Rule
#6 Wait One Year Before Selling
If you own a stock or mutual fund for at least one year before you sell it for a gain, you pay capital gains taxes at the lower long-term capital gains rates (0%-20%) rather than the higher ordinary income tax rates.
In this situation, you are changing short-term capital gains into long-term capital gains.
#7 Tax-Loss Harvest
Tax-loss harvesting allows you to “capture” a tax loss on an investment that has gone down temporarily without changing your overall asset allocation. That loss can then be used against ordinary income up to $3,000 per year and against an unlimited amount of capital gains each year.
In this situation, you are turning ordinary income and long-term capital gains into tax-free income.
#8 Do Asset Location
If you must invest in a taxable account, preferentially place your most tax-efficient asset classes into it. By placing your least tax-efficient assets into retirement accounts, you are reducing your tax bill.
In this situation, you are turning ordinary income into tax-free income. While you may also be turning tax-free income into qualified dividend income, the overall effect will be positive.
#9 Use Depreciation to Offset Rents
Equity real estate generates both depreciation and rents. For a few years and with an appropriate amount of leverage, the depreciation will more than cover the rents.
In this situation, you are turning ordinary income into tax-free income.
More information here:
Real Estate K-1s — Here’s What My Depreciation Really Looks Like
#10 Use Qualified Charitable Distributions
Over age 70 1/2 and have a favorite charity? Use Qualified Charitable Distributions (QCDs) to give to the charity instead of giving cash or appreciated shares. This reduces current (starting at age 73) and future Required Minimum Distributions (RMD) and does not require itemizing to get a deduction for the charitable contribution. For most people, this is far better than taking the RMD, paying the taxes on it, and then turning around and giving it to charity and trying to get a deduction for the gift. QCDs are clearly the most tax-efficient way for the elderly to give to charity.
In this situation, you are eliminating ordinary income (RMDs) while still giving the same amount to charity, essentially using pre-tax dollars for your gifting.
#11 Borrow Instead of Sell
Selling assets can subject you to capital gains taxes, depreciation recapture taxes, and even ordinary income taxes. Sometimes it is better to borrow against a home, car, investment portfolio, or cash-value life insurance policy than to sell it. You simply have to weigh the tax costs against the interest costs of borrowing.
In this situation, you are turning taxable income into interest-charging loans.
#12 Sell Least Appreciated Shares First
Sell your least appreciated shares first, so that most of the money from the sale is untaxed basis rather than taxable gains. Anything that doesn't get sold during your lifetime will be eligible for a step up in basis for your heirs, and nobody will ever pay those long-term capital gains.
In this situation, you are turning long-term capital gains into tax-free “income.”
#13 1031 Exchanges
Unlike with securities, you can do a tax-free exchange from one real estate property to another. If you exchange into a more valuable property, you will have additional basis to depreciate.
In this situation, you are deferring long-term capital gains and depreciation recapture taxes, which may be avoided completely thanks to the step up in basis at death.
There's nothing wrong with more income, even more taxable income. However, a smart investor minimizes the tax hit by structuring income in the most tax-efficient way possible. I have personally used the first nine of these techniques, and it wouldn't surprise me if I've used all 13 of them by the end of my life.
If you need help with tax preparation or you’re looking for tips on the best tax strategies, hire a WCI-vetted professional to help you figure it out.
What do you think? Which of these techniques have you used? Are there any other ways to lower your tax bill? Comment below!
Great blog post, already a favorite thanks. For me:
1. N/A – I’m W2 exclusively
2. Essential – maxing two 401ks, two HSAs, two Backdoor roths, 2 mega back door roth 401k in plan conversions, and superfunding (a bit late) 529s for both children ($140K each currently, shooting for $200K each at least). 529s are the toughest because of uncertain needs and inflexible time horizon (imagine retirement was a four year window!)
3. This year will be the first chance to have more money than our retirement accounts allow adding. Passive income is an appealing idea but I have no time (any I do have is best used to preserve W2 earning) and only ever see people getting lucky making this work. Seems really hard to decide how to accomplish #3
4. Definitely need to figure this out. Going from no tax concerns index funds all the way, to having to figure out where to start here is quite hard (asset allocation needs a rethink too)
5. Hasn’t been relevant with retirement account tax protected index fund investing. Perhaps will matter in future?
6. Hasn’t mattered so far – only ever buy and hold and inside retirement accounts
7. Despite a near 7-figure income and multi-million net worth, have never been able to do this. Have seen the tiny window between RSU vests and RSU sales has led to almost $3K loss. Even then this is not a harvest opportunity really – just an actual loss that can at least offset taxes. If you don’t go outside retirement accounts, it doesn’t seem relevant?
8. I find this topic exceptionally hard. There’s so much emphasis on how easy and important it is to follow your financial plan’s asset allocation. Not so easy to actually decide what the allocation should be! I have close to 100% index fund equities with maybe 20% international. Tiny amounts in ibonds, single stock, and Bitcoin.
9. Have no real estate. Maybe I should as per #3 and #8
10. Need to look into more efficient ways to do charity. Usually just donate direct or direct with employer match
11. I didn’t quite get this one. Any chance of an example?
12. Makes sense but not with everything in retirement accounts. In future, maybe it will.
13. Have no real estate investments
11. Imagine an 85 year old in failing health who needs some additional money. Two choices- borrow against the house or sell some taxable assets with low basis. The first will cost interest, the second taxes. The interest cost may be less than the tax cost to the point where borrowing makes sense.
Ah thanks. I got confused by
“ In this situation, you are turning long-term capital gains into tax-free “income.””
But now I see you’re saying that instead of choosing the capital gain triggering cash out of assets (with tax repercussions), instead consider using the asset to secure a loan and eat the interest charges in preference to those sale taxes.
Hi Dr. Dahle,
Excellent post as always and really appreciate the great articles that you provide with valuable insights. The one thing I have employed first hand in reducing my tax burden is owning my own business as it offers much more flexibility with deductions and potential eligibility for tax credits (e.g., R&D credits). Some other strategies include deferring revenue and accelerated business expenses at year-end if your business is using cash accounting.
-Harvey
For sure there are many deductions available only to businesses. But which ones are available is highly specific to the type of business. Few docs who are independent contractors are getting any sort of R&D credits.
My #14. Minimize toward zero any investments in a taxable account that generate income at all, if you don’t need to spend money from the taxable account.
There are enough really good large-cap companies that don’t pay dividends at all to make your own ETF:
https://seekingalpha.com/article/4688408?gt=066fcda3dfffe30f
Some new buffered ETFs seem to also be a way to defer LTCG with no income payouts until you need them – which could be never:
https://seekingalpha.com/article/4709609?gt=e200674ed5e0c8be
I am using both techniques to make a taxable account I don’t need to spend a tax efficient vehicle for the next generation.
That’s a lot of hassle to build your own ETF. You have to really hate taxes considering you can get a growth stock ETF with a yield under 1% with much, much less hassle.
WCI,
It wasn’t really a hassle, but when you do the math with the perspective of your retirement expenses, the savings are multiplied.
For instance, on the relative low end saving 1% per million $ taxable account saves the person with a $100k retirement income need around 3% in a roughly 22% tax bracket if that income is coming from TIRA.
Now let’s multiply taxes by 10. A $10m taxable account is generating roughly $100k in taxable income. Let’s say your expenses in retirement are $250k. To pay the $100k extra taxable income, again from your TIRA account at about a 40% rate you would need an extra $167k withdrawal.
In the end something like VUG is perfectly fine for most people. In fact, in the long run, I think it “wins” against real estate of any kind in a taxable account, based on total return, especially when most people don’t need to spend the taxable account at all if they have been maximizing TIRA investments all their working years.
Kind of a weird way to calculate it. Why not use some of the income to pay the tax on the income instead of an additional IRA withdrawal? $100K in dividends. Pay $22K in taxes. Leaves you $78K to spend, give, or reinvest. No need to mess with the IRA.
WCI,
That would be the traditional thinking – spend the income you created in the taxable account since you are paying taxes on it anyway. I am trying to get you to see for most higher net worth individuals or couples above age 70, the way to lower the long-term taxes on your retirement income is to not generate income above your budget. This usually means spending down the TIRA to a level for which RMDs will be reasonable to your income need once you get to RMD age.
This thread is about “lowering your tax bill on income.” What easier way to do that than not generating income you don’t intent to spend in the first place.
I don’t disagree that would lower your taxes, although it feels like letting the tax tail wag the investment dog. I just think your calculation of the tax bill on any such income using a tax-deferred withdrawal is not the right way to do it. If you had income from a taxable account you had to pay taxes on, you’d use the income from the taxable account to pay it.
Yes, that is the proper way to think about it, but what I am doing is comparing a taxable account with no income, which would be the perfect case if you don’t need that income, to what happens when you have income you don’t need to spend.
Let me try and explain it a different way. I will simplify the example by assuming a couple has worked “just the right amount” to be able to save all money in tax-advantaged accounts, retired early, and has spent down the TIRA to a reasonable amount such that growth = spending + inflation for the foreseeable future from RMDS possibly all the way to late 80’s. In other words the couple is able to live off an “RMD withdrawal” which tracks their spending curve..
Now a couple years into RMDs this balance is upset with a large inheritance from parents that is throwing off income of an amount that is 1/2 their budget – what do they do?
1. They do nothing and just pay the tax bill from the inheritance. This will get larger and larger every year. What else is going on is they now are being forced via RMDs to withdraw more ordinary income by the amount of the taxable account less its taxes. They are way off their “optimized” path of being able to spend all the income they generate – good problem to have most would say, but I would say “wasteful.”
— wasteful by an amount equal to the ordinary income + tax on the ordinary income involved (what I was getting to in my previous post.
2. What are a couple possible options:
a) Lower TIRA balance with a conversion, such that they can spend RMDs and taxable account income. This is an expensive option but lowers their ordinary income by an amount that offsets the income they can spend after-tax from the taxable account.
b) Remove all income from taxable account and let it grow as is with no to little tax involved. If you do this immediately on inheritance there is no cost to you. In effect send it to the next generation so they can do the same or spend it tax-free on a second home or otherwise.
Option b was my choice. Granted maybe getting to exactly zero is not really attainable in the long run, but it doesn’t change the goal.
Bottom line, from an estate planning perspective, I am spending down the assets that essentially cost me the least amount of earnings to make / save (TIRA) and or Roth if need be, and saving the most “costly” taxable funds with the hope that the step-up in basis will still be in effect when the time comes. One benefit from this is the TIRA and the taxable account both go farther, as TIRA tax is being paid in a lower retirement bracket than heirs would likely have to pay while working, and taxable account is made more “Roth-like” if it gets the step-up in basis.
Maybe I’m dense, but I still don’t understand why having more income from a taxable account has any effect whatsoever on how much must be taken out of the retirement account. The tax bill due from the taxable account income is always going to be less than the income from the taxable account. So it can always be paid from that income. No need to touch the retirement account to do that.
Now, if they truly only want to spend RMDs and just inherited a bunch of taxable assets (your situation), I suppose they could reinvest those assets in your favored tax free way and minimize taxation on them from the time of inheritance to death and thus maximize the inheritance they leave behind to heirs or charity. But they do need to be careful not to let the tax tail wag the investment dog. As I said before, the goal is not to reduce the taxes paid, but to have the most left after paying taxes. You seem to be operating under the assumption that one can have the same return using non dividend paying assets as dividend paying assets, but there is fairly decent data (see small value studies) that is not the case. I also agree with you that a Roth conversion may also be a fantastic option depending on who will eventually be spending the money.
In your personal situation I’d advise you to at least consider two other options:
# 1 Spend more money. If you work hard at it, I bet you can find something to spend on that will make your and/or yours happier.
# 2 Give those taxable assets away now while they may be able to do more good for your heirs or charity than they may later at the uncertain time when you die. Money is just a lot more useful at 20 or 40 than it is at 60 when you hopefully already have enough of it yourself. But you know your situation best. Plus you get to see them enjoy it and there’s some value in that.
The answer to your dilemma is the same reason why most with RMDs that they can’t spend, tend to want to reduce them, and goes back to the fact that paying taxes on money you don’t need to spend is “wasteful.” Think of it this way, if RMDs were not required would not the optimized approach be to spend all the taxable account income generated and supplement that with higher ordinary income from TIRA, or tax-free income from Roth? In reality maybe spending the taxable down altogether is the best result as it is the least tax efficient of the bunch.
I don’t think anyone has a “lock” on how to convert the most earnings to the most after-tax spendable dollars and each has their own goals along the way. I try to optimize what little I have earned by controlling the few things that are really in my control (the market is not one of those things.) However, the taxes paid along the way can be controlled to an extent, by not paying taxes on money you don’t spend – much the theory of the TIRA, if you neglect RMDs. I think that is the reason I have kept retirement effective tax in mid-single digits.
Plenty of chance to use QCD for tax-free distribution to your favored charities and I make use of that. I save giving taxable funds to grandkids in a Roth matching program to the extent they have earned income. No need to donate taxable money to charities after 70.5.
Spending more is always an option, but when you get to 70 you have to assess how much of that more needs to be in reserve for health care and how much can be used for “experiences” or things. Everyone tries to find a balance based on imperfect inputs.