Income is taxed at the federal, state, and municipal levels, and earned income is subject to extra levies to pay, among other things, Social Security and Medicare. Taxes are tough to avoid, but there are several techniques available to assist. Here are six strategies to keep your money tax-free.
- Contributing pretax cash to qualifying retirement and employee benefit accounts may exclude certain income from taxation and delay income taxes on other gains.
- Long-term capital gains are taxed at a low rate.
- Capital loss deductions may further lower taxes.
- Municipal bond interest income is normally exempt from federal taxation.
1. Invest in Municipal Bonds
Purchasing a municipal bond entails providing money to a state or local governmental organization in exchange for a specific number of interest payments over a given period of time. When the bond matures, the buyer receives the entire amount of the initial investment.
Municipal bond interest is tax-free at the federal level and may be tax-free at the state and local levels as well, depending on where you reside. Municipal bonds are appealing to investors due to their tax-free interest payments.
Municipal bonds have typically had lower default rates than corporate debts. According to a research of municipal bonds from 1970 to 2019, the default rate for investment-grade municipal bonds was 0.1% against 2.25% for global corporate issuers.
Municipalities, on the other hand, often pay lower interest rates. Municipal bonds’ tax-equivalent return is appealing to certain investors because of the tax advantages. Your tax-equivalent yield increases as your tax bracket rises.
2. Shoot for Long-Term Capital Gains
Investing may be a useful technique for increasing wealth. The advantageous tax treatment for long-term capital gains is another advantage of investing in stocks, mutual funds, bonds, and real estate.
If an investor holds a capital asset for more than a year, the capital gain is taxed at a preferential rate of 0%, 15%, or 20%, depending on the investor’s income level. The capital gain is taxed at regular income rates if the asset is held for less than a year before being sold. Understanding long-term vs short-term capital gains rates is critical for wealth accumulation.
In 2021, a married couple filing jointly would pay no tax on long-term capital gains if their taxable income was less than $80,800, and a single person would pay no tax if their taxable income was less than $40,400.
The zero-rate bracket for long-term capital gains applies to taxable income of up to $83,350 for married couples and $41,675 for single persons in 2022. A tax counselor and an investing advisor may advise you on when and how to sell appreciated or depreciated assets in order to limit profits and maximize losses.
Tax-loss harvesting may also be used to reduce capital gains taxes by selling assets at a loss. If capital losses outnumber capital profits, the smaller of $3,000 or the net capital loss might be deducted from other income. Capital losses of more than $3,000 may be carried over to subsequent tax years.
3. Start a Business
Aside from earning extra money, a side company has several tax benefits.
Many costs may be deducted from income when spent in the course of everyday business, lowering the overall tax requirement. Health insurance premiums, which are accessible provided certain conditions are satisfied, are particularly essential tax deductions for self-employed persons.
A company owner may also deduct a portion of their home expenditures using the home office deduction if they properly follow Internal Revenue Service (IRS) requirements. Income might also be reduced by the amount spent on utilities and internet for the company. To claim these deductions, the taxpayer must run a profitable company. The IRS considers a variety of variables, which are detailed in Publication 535. Taxpayers who have made a profit in three of the past five years are deemed to be involved in a profit-making enterprise.
In 2019, the Setting Every Community Up for Retirement Enhancement (SECURE) Act was passed. The SECURE Act provides tax breaks to firms that participate in multiple-employer plans and provide retirement alternatives to their workers.
4. Max out Retirement Accounts and Employee Benefits
Contributions to a 401(k) or 403(b) plan may lower taxable income up to $20,500 in 2022 (up from $19,500 in 2021). Those aged 50 and over may increase their standard employer retirement plan contribution by $6,500. For example, if an employee earns $100,000 in 2021 and pays $19,500 to a 401(k), their taxable income is reduced to $80,500.
Contributing up to $6,000 ($7,000 for those 50 and over) to a typical individual retirement account (IRA) in 2022 and 2021 will result in a tax reduction for people who do not have a retirement plan at work. Depending on their income, taxpayers who have employment retirement plans (or whose spouses have) may be eligible to deduct part or all of their conventional IRA contributions from taxable income.
The IRA contribution deduction is phased out for different levels of adjusted gross income, higher in 2022 than in 2021, depending on whether claimed on a single taxpayer’s return, joint return, married individual filing separately, and taking into account any participation by a taxpayer in another plan. The IRS has certain guidelines governing whether and how much you may deduct.
Prior to the SECURE Act, 401(k) or IRA account participants were forced to take required minimum distributions (RMDs) in the year they reached 7012. The SECURE Act raised that age to 72, which may have tax repercussions depending on the account holder’s tax status in the year they withdraw. The law also removes the previous maximum age for regular IRA contributions, which was 712 years old.
In addition to retirement plan payments, many businesses provide a range of fringe benefits that enable workers to deduct their contributions or perks from their income. Benefits from these programs are often reported as non-taxable amounts on workers’ W-2 forms.
These benefits include flexible spending accounts, educational aid programs, adoption expenditure reimbursements, transportation cost reimbursements, group-term life insurance up to $50,000, and, in general, deferred pay plans for top managers and executives.
5. Use a Health Savings Account (HSA)
Employees who have a high-deductible health insurance plan might utilize a health savings account (HSA) to save money on taxes. As with a 401(k), payroll deduction HSA contributions (which may be matched by the employer) are excluded from the employee’s taxable income; direct donations to an HSA are 100% tax-deductible from their income.
The highest deductible contribution amount for 2021 is $3,600 for individuals and $7,200 for families. These limits will increase to $3,650 for individuals and $7,300 for families in 2022. These funds may then expand without having to pay taxes on their gains. An additional tax advantage of an HSA is that withdrawals are not taxed when used to pay for eligible medical costs.
6. Claim Tax Credits
The Earned Income Tax Credit is one of numerous IRS tax credits that lower taxes. For the tax year 2021, a low-income taxpayer might receive credits of up to $6,728 if they have three or more qualified children, $5,980 if they have two, $3,618 if they have one, and $543 if they have none.
In 2022, the credit increases to $6,935 for three or more children, $6,164 for two children, $3,733 for one, and $560 for none.
President Biden signed the American Rescue Plan on March 11, 2021, which provides hefty tax relief for low- and middle-income households. The earned-income tax credit will be increased for childless families only in 2021. The maximum credit amount for those without children has increased from $543 to $1,502.
The age group has also been broadened. People who do not have children will be allowed to claim the credit at the age of 19, rather than 25, with the exception of select full-time students (students between 19 and 24 with at least half a full-time course load are ineligible).The highest age restriction of 65 will be removed. The phaseout rate for single filers is raised to 15.3%, and the phaseout amount is increased to $11,610.
The American Opportunity Tax Credit provides a maximum of $2,500 per year for eligible students throughout their first four years of higher education, while the Lifetime Learning Credit provides a maximum 20% credit for up to $10,000 in qualifying costs or $2,000 each return.
For moderate and lower-income persons wishing to save for retirement, there is also the Saver’s Credit; individuals may obtain a credit of up to half of their contributions to a plan, an IRA, or an ABLE account.
Depending on income, the Child and Dependent Care Credit may assist cover eligible costs for the care of children and handicapped dependents.
The Child Tax Credit was also modified in President Biden’s American Rescue Plan for 2021. It will rise to $3,000 per kid in 2021 ($3,600 for children aged 5 and younger). The qualified child’s age is also raised to 17 years old (from 16).Furthermore, the credit is totally refundable. The IRS may additionally advance up to half of an eligible household’s credit between July and December 2021, using either 2020 or 2019 tax returns to assess eligibility.
The Bottom Line
Although it is essential to pay all taxes owing to the IRS, no one is required to pay more. A few hours spent on the IRS website (IRS.gov) and researching credible financial information sites might result in hundreds, if not thousands, of dollars in tax savings.
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