How to Use Tax Laws to Your Advantage
March 23, 2021
Taxes play an important role in financial planning, yet many people have only a basic knowledge of our tax system. There is a major difference between simply filing your taxes and legally reducing your tax obligations through planning. Tax laws are frequently changing, so it is important to stay up to date with current laws so you can use them to your advantage.
Let’s start with your gross income. This is all your income from taxable sources, before subtracting any adjustments, deductions, or exemptions. Once you determine your gross income, the next step is to subtract any adjustments. These are special items that lower your taxable income and allow some taxpayers to qualify for certain deductions. Notable adjustments are student loan interest, eligible IRA contributions, and health savings account contributions.
When you subtract your adjustments from your gross income, this determines your adjusted gross income or AGI. Adjusted gross income is used to determine your taxable income and your eligibility for certain tax benefits that can help lower your taxes. Your AGI is then reduced by deductions (standard or itemized) and exemptions (personal and dependent).
Deductions from your AGI can take two different forms. You will either take the standard deduction or itemized deductions. The standard deduction is a fixed amount that depends on your tax filing status (shown below). If you have qualifying expenses that exceed the standard deduction, you will take itemized deductions, including state and local taxes, mortgage interest paid, charitable donations, and more.
|Filing Status||Standard Deduction|
|Single / Married Filing Separately||$12,400|
|Married Filing Jointly||$24,800|
|Head of Household||$18,650|
After subtracting your adjustments and deductions from your gross income, you get your taxable income which is applied to the current federal income tax brackets (shown below). As an example of how the tax brackets work, let’s say you are married and filing jointly with a taxable income of $150,000. In this scenario, the first $19,750 will be taxed at a rate of 10%. Your income between $19,751 and $80,250 will be taxed at 12%. And finally, your income between $80,251 and $150,000 will be taxed at 22%.
|Single / Married Filing Separately||Married Filing Jointly||Head of Household||Marginal Tax Rate|
|Up to $9,875||Up to $19,750||Up to $14,100||10%|
|$9,876 – $40,125||$19,751 – $80,250||$14,101 – $53,700||12%|
|$40,126 – $85,525||$80,251 – $171,050||$53,701 – $85,500||22%|
|$85,526 – $163,300||$171,051 – $326,600||$85,501 – $163,300||24%|
|$163,301 – $207,350||$326,601 – $414,700||$163,301 – $207,350||32%|
|$207,351 – $518,400||$414,701 – $622,050||$207,351 – $518,400||35%|
|$518,401 or more||$622,051 or more||$518,401 or more||37%|
How to Save on Taxes
Now that you have the basics, let’s review some strategies for reducing your taxes. While there are many ways to save on taxes, we have boiled it down to three primary categories: tax deferral, tax deductions, and taxes on investments. Each of these strategies can reduce your taxable income and lower your tax bill.
1. Take advantage of tax-deferral
Tax-deferral is a great way to lower your taxable income. The simplest way to do this is to contribute to a 401(k) or a traditional IRA. When contributing to your 401(k), you can contribute a maximum of $19,500 if you are under 50 and $26,000 if you are 50 or older. The contribution limits for IRAs are $6,000 if you are under 50 and $7,000 if you are over 50. Making contributions to these accounts will also help you save for retirement.
You can also utilize flexible spending and health savings accounts to lower your taxable income. Flexible spending accounts are offered by employers to allow employees to set aside pre-tax dollars for qualified dependent or health care expenses. Health savings accounts are for those with high-deductible health insurance plans. Contribution limits to health savings accounts are $3,600 for an individual, $7,200 for a family, and an extra $1,000 if you are 55 or older.
2. Maximize tax deductions
Another way to lower your taxable income is to itemize your deductions. These are expenses like state and local income taxes1, mortgage interest paid2, medical expenses, and charitable donations. To itemize deductions, these expenses must be higher than the standard deduction amounts in the chart above. If your itemized expenses are too low, consider increasing your charitable donations to maximize your deductions. Also, remember to maintain records of your qualifying expenses.
If you don’t have enough deductions to itemize each year, consider itemizing one year and taking the standard deduction the next. You may need to consolidate some of your itemized expenses into one tax year, like making two years of charitable donations in one year or making an extra mortgage payment in December.
1Up to $10,000
2Loans up to $750,000 or $1,000,000 depending on date of loan
3. Invest for tax efficiency
This may come as a surprise, but investments can also be used to reduce your taxes. One way to accomplish this is to invest in exchange-traded funds (ETFs) instead of mutual funds. Mutual funds distribute capital gains annually to shareholders, without the shareholder selling shares in the fund. This creates taxable income for the shareholder. With ETFs, most taxable gains are only realized upon selling your shares.
Another way to use investments to reduce taxable income is with capital losses. When securities are sold for less than their purchase price, you can use those losses to lower your taxes. If you are married and filing jointly, the cap is set at $3,000, while it is $1,500 for individuals. Your capital losses must exceed your capital gains for the year, and any losses above the limit can be carried over to future years.
Lastly, you can also allocate your investments in different types of accounts, according to how they are taxed. By allocating more tax-efficient investments like stocks, index mutual funds, ETFs, and municipal bonds in taxable accounts and allocating less tax-efficient investments like actively managed mutual funds, REITs, and taxable bonds in tax-deferred accounts, you can better manage the taxes on your investment income.
Trinity Wealth Management
Taxes are an important part of financial planning. Developing a strategy to lower your tax liability can help you achieve your financial goals and objectives. Contact our office today if you would like to learn more about how we can develop a tax strategy for you. Our team of fiduciary advisors will help you develop a plan to keep more of your money.
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