Lowering your tax bill is always a joy. For most taxpayers, it's fairly easy to trim down your tax liability without breaking the rules (and therefore inviting some truly nasty penalties down the road). The simplest way to manage this feat is to reduce your taxable income. That doesn't mean asking your boss for a pay cut – rather, the idea is to make part of your income exempt from taxation. This strategy really shines when it can drop you into a lower tax bracket, because not only will you pay less in taxes, but you'll also reduce your tax rate for part of your income.
How tax brackets work
You've probably seen those tax charts with the income ranges on one side and a series of percentages – 10%, 15%, 25%, etc. – on the other side. Many people jump to the conclusion that having an income in a particular range means all of their income is taxed at that bracket's rate. Actually, tax brackets are "marginal," rather than absolute. That means only the part of your income within each range is taxed at the corresponding tax rate.
Take a look at this 2017 tax bracket report to get an idea of what that means. If your filing status is single, and you made $50,000 in 2017, then the first $9,325 of your income would be taxed at a 10% rate (in other words, you'd owe $932.50 in taxes on that chunk of income). Your income between $9,325 and $37,950 would be taxed at a 15% rate, and the rest of your income for the year would be taxed at a 25% rate.
In this example, the income that the IRS hits the hardest is the bit above $37,950. But if you could turn all your income above $37,950 into nontaxable income, then the IRS would keep its hands off everything in the 25% tax bracket, and your top tax rate for the year would be 15% – a much nicer number. So if you wanted to drop into a lower tax bracket, your goal for 2017 would be to get at least $12,050 (that's $50,000 minus $37,950) of your income declared off-limits for tax purposes.
How to make your income nontaxable
The IRS actually provides quite a few ways to transform taxable income into nontaxable income. They're called "deductions." Yes, that's what a deduction really is – a way to flag a piece of income as nontaxable. It's how the federal government rewards you for spending money in ways that it deems beneficial to society. The trick to maximizing your deductions is planning them out in advance so that you can be sure to reach your goal ($12,050 in this example).
Consider the following options:
- Contributing to a retirement account. If your employer offers you a 401(k) account, then use it – the contributions will typically come out of pre-tax income, so they automagically lower your taxable income without any extra work required on your part. No 401(k) available? No problem. Practically any bank or brokerage firm will happily set up an individual retirement account (IRA) for you, often with low or no fees. Any contributions you make to an IRA are fully deductible (as long as your income falls below a certain threshold ). Note that if you're trying to reduce your taxable income now, you'll want a traditional IRA, not a Roth IRA, which is funded with after-tax money. For 2017, you can contribute up to $18,000 into a 401(k) or up to $5,500 into an IRA. If you're aged 50 or older, the maximums go up to $24,000 and $6,500, respectively.
- Contributing to an HSA. If you have a high-deductible health insurance plan, then you may qualify to open an HSA, and any contributions you make to said HSA are deductible. For that matter, distributions from the HSA (when used to pay for medical expenses) are also tax-free. HSAs are definitely a taxpayer's friend. For 2017, the annual contribution limit for HSAs is $3,400 if you're on an individual health insurance plan or $6,750 if you're on a family plan.
- Pay (the right kind of) interest. The interest you pay on certain kinds of debt is deductible. This includes mortgage interest, student loan interest, interest on debt used to purchase investments, and interest on business debt. There is one catch, though: You can only claim interest deductions if you itemize, rather than taking the standard deduction (excepting student loan interest -- you don't have to itemize to take that one). Retirement account and HSA contributions, on the other hand, can be deducted regardless of you itemize. If you have a lot of itemized deductions to claim, it's probably worth your while to do so.
- Pay your taxes. The state and local taxes that you pay, including real estate taxes, qualify as an itemized deduction. This can help push you into the "itemizing makes sense" category if you're close but not quite there. Note that you can deduct either state income tax or state sales tax, but not both; usually, it makes more sense to deduct the state income tax, but if your state has low or no income tax, then deducting your sales tax is the way to go.
- Donate to charity. Charitable contributions of up to 50% of your adjusted gross income are also deductible if you itemize. The contributions must go to a qualified charity, and both cash and property donations can be deducted (property is generally deducted at the fair market value). This is a great way to do well by doing good. If you're approaching the end of the year and you don't have quite enough itemized deductions to make itemizing worthwhile, then consider clearing out the attic and making a big donation.
If the year's already over and you didn't quite manage to drop into a lower tax bracket, then you have one last chance: IRA contributions made up until the deadline for the previous year's tax return can count as deductions for the previous year (usually April 15, unless that date falls on a weekend). This will only work if you're eligible to deduct IRA contributions and you haven't already maxed them out for the year, but if you meet those requirements it's a perfect last-minute save for your tax bill.
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