We may be roughly three months past Tax Day, but it's never too early to begin thinking about ways to reduce your taxable liability to Uncle Sam.
According to the 2015 Internal Revenue Service Data Book, which covers tax collection data between Oct. 1, 2014 and Sept. 30, 2015, the IRS collected $3.3 trillion in taxes in 2015, of which just shy of $1.8 trillion came from individual taxpayers. Although roughly 4 in 5 tax filers are due refunds, and $348 billion in refunds were issued by the IRS in 2015, this leaves a lot of room for improvement.
You see, getting a refund from the government isn't necessarily a good thing. While a tax refund can be viewed as a way to force savings among Americans who lack proper plans to save, it also means you've overpaid on your taxes, and have essentially given the government an interest-free loan with your hard-earned money. Realistically, your goal each year should be to minimize the amount of tax you have to pay to the IRS.
Seven ways to (legally) earn tax-free income
The best possible scenario would be to simply not pay any taxes at all. With this best case in mind, let's look at seven ways you can legally earn or receive tax-free income.
1. Contribute to a Roth IRA
The smartest way to earn tax-free income is simply by opening up and contributing to a Roth IRA.
The Roth is a retirement account that allows the money you contribute to grow completely free of taxation so long as you make no unqualified withdrawals. There are no age contribution limitations with a Roth, so if you're 75 and you want to keep adding, you're free to do so. There are also no minimum required distributions, allowing you complete flexibility in how you withdraw your money during retirement. Perhaps best of all, since Roth IRA distributions don't count toward your annual income, it could reduce your chances of paying tax on Social Security benefits, or premiums surcharges for Medicare Part B and Part D, in retirement.
2. Sell your home
According to the IRS, if you sell your home for a profit, you may be entitled to receive the entirety of the profit without paying a cent in tax, assuming certain criteria are met.
First, there are the numbers. If the capital gain is $250,000 or less for individual filers, or $500,000 or less for joint-filers, it meets the capital gains threshold for tax exemption. Secondly, you have to have lived in the home as your primary residence for at least two years prior to the sale within a five-year period. This is a pretty lenient rule, since most individuals or families will likely be in their home for two years prior to selling. If you meet both the ownership and use test over the five-year period, and you make less than $250,000 individually or $500,000 jointly from the sale, the capital gain is yours to keep.
3. Invest in municipal bonds
One of the most tried-and-true methods for earning tax-free income is to invest in municipal bonds.
Municipal bonds, or munis for short, are debt obligations issued by cities, counties, states, or other government entities that help fund capital projects like building highways, rail systems, or schools. The purchaser of the bond receives income that's completely free of federal taxation. However, you will need to do a little nosing around, because not all muni bonds are tax-free at the state level, although most are. The general rule to follow is to purchase a muni bond in the state you reside. Most states forgo collecting tax on the interest earned from a muni bond if you reside in that state.
4. Hold your stocks for the long-term
As a general rule, holding stocks for the long-term, defined as at least one year and one day, will net a lower capital gains tax rate. Long-term capital gains taxes are what allow the wealthiest Americans to hang onto their money, forking over 20% in long-term capital gains taxes instead of paying the ordinary income tax rate of 39.6% associated with the highest ordinary income tax bracket.
However, Americans in the two lowest-earning ordinary income tax brackets -- 10% and 15% -- get a special surprise if they hold their investments over the long-term. That surprise is a capital gains tax rate of 0%! Based on the 2016 federal tax tables, this means single filers could earn up to $37,650, and joint-filers up to $75,300 without having to pay a dime on their long-term capital gains.
5. Contribute to a Health Savings Account
Just as you would save for retirement, a Health Savings Account, or HSA, is in place to help certain people better cope with their medical expenses.
An HSA does have a few specifics you'll need to meet in order to qualify. For example, you need to be enrolled in a high-deductible health plan with an out-of-pocket maximum of at least $6,550 for individuals or $13,100 for joint filers in 2016. You also can't be enrolled in Medicare, and you can't be claimed as a dependent on anyone else's tax return.
However, if you do qualify to contribute to an HSA, you'll be able to use the money in the account to pay for qualifying medical expenses. Whereas money distributed from an HSA in retirement is taxable, just as it would be with any tax-deferred account, money spent specifically on qualifying medical expenses escapes this tax. Most notably, an HSA can provide this tax-free benefit at any age -- not just after you retire.
6. Receive a gift
Another interesting way to receive money tax-free is to accept it as a gift. According to the IRS, in 2014, 2015, and 2016, taxpayers were allowed to give away up to $14,000 per year to as many people as they liked. A gift over this amount would trigger a tax with the IRS. Historically, the annual gift tax exclusion tends to increase about every three to four years.
The gift tax can come in especially handy for wealthy individuals and couples looking to pass along some of their income to their children, grandchildren, or other family members. With no limit on the number of people they can gift to, wealthy individuals can transfer a good chunk of their wealth to their family members over their lifetime free of taxation.
7. Rent your home
Finally, if you want tax-free income, consider renting out your home. As long as you rent your home out for 14 days or less, the income you receive is completely tax-free. Best of all, the days your home was rented out won't count against or prorate your mortgage interest deduction and property taxes, which can help lower your taxable income. Additionally, there's no limit to how much you can charge, so earn as much as you can in those 14 days! And, as one final bonus, vacation homes can qualify, too.
Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.
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