By Dr. James M. Dahle, WCI Founder
More 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:
#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:
#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:
#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!