Reducing Taxable Income

by Nancy

No reasonable person would prefer to make less money than more money. However, when the income tax bill comes due it can make one question, would they would be in better shape with less income? Fortunately, though, there are several effective ways to reduce taxable income without actually taking a pay cut.

To start, let’s answer the question, “what is taxable income“? In simple terms, taxable income is the amount of income that a person earns in a given year that is subject to being taxed. It is calculated by totaling a person’s income from all sources, then deducting tax-exempt income and tax deductions.

For most people, taxable income includes wages, salaries, qualified retirement plan distributions, and business income for those who are self-employed. Reducing taxable income, whether by electing tax-free income, deducting allowable expenses, or diverting savings into tax-advantaged vehicles, is a perfectly legitimate, legal way to reduce your tax bill. Let’s take a look at some of the most common and effective ways of reducing taxable income.

1. Retirement savings

Retirement savings are a major influencer of taxable income for people who are already retired, as well as those who are still saving for retirement.

For those saving for retirement, the tax treatment of retirement account contributions is important to understand. Contributions to traditional individual retirement accounts and 401k’s are tax-deductible in the year the contributions are made. This makes them a useful tool for those who need to reduce taxable income now. Keep in mind, however, that distributions from these types of accounts are taxable.

For those who may not need to minimize income now but anticipate a need to do so in retirement, Roth IRAs may be attractive. Roth IRA contributions are not tax-deductible, but earnings accrue on a tax-deferred basis, and distributions after age 59 ½ are completely tax-free. There is also no required minimum distribution at any age.

2. 401k

Reducing your taxable income with a 401(k) contribution is incredibly easy and effective. Simply enroll in your employer-sponsored 401(k) plan and tell the administrator what percentage of your pay you would like to contribute. Your employer will simply deduct this amount from your paycheck and contribute it to your 401(k) per your allocation instructions.

It couldn’t be easier: your contribution will be automatically invested, the reduced income figure will be reflected on your Form W-2 at the year’s end, and you will report a lower income than you otherwise would while also saving for retirement. It’s a win-win.

3. IRA

In a similar way as 401(k) contributions, contributions to an individual retirement account are an effective way to reduce taxable income. Money contributed to a traditional account reduces taxable income up to a limit set by the IRS. This limit is currently $5,500; or $6,500 for investors over age 50.

At the end of the year, you will receive Form 5498, which is to be filed with your tax return as evidence of the contribution. Note that contributions to a traditional account are the only ones that reduce taxable income. Contributions to a Roth accounts are not tax-deductible.

4. Health tax break

We all hope to avoid major medical expenses, but in the event that you don’t, you may be entitled to some tax relief. Currently, the IRS allows for the deduction of medical expenses that exceed 10% of a taxpayer’s adjusted gross income. Among other things, allowable expenses include treatment, preventative care, surgeries, vision care, and dental care.

Health insurance is quite expensive, but buying coverage could reduce your taxable income. Health insurance premiums go toward the health tax break for medical expenses that exceed 10% of AGI, and by buying health insurance you also avoid the IRS tax penalty for not carrying coverage.

5. Getting a Raise

A reduction of taxable income due to a pay raise is unlikely, but the increase in taxable income may be less consequential than you think.

For example, assume that you earn $37,000 and are in the 15% tax bracket. Your take-home pay would be $31,774. A pay raise to $40,000 would put you into the 25% bracket, which on the surface may look as if your take-home pay would be $30,000 – a reduction.

The 25% tax, however, would apply only to amounts in excess of $37,590. Your actual take-home pay after grossing $40,000 would be $34,262, which would still result in getting a raise in take-home pay.

6. Pre-tax dollar spend

In addition to the deduction of medical expenses, flexible spending accounts (FSAs) are another health-related way to reduce taxable income.

FSAs reduce taxable income in a similar way as 401(k) contributions, as your employer takes a specified amount of your pay and places it in a separate account. FSA dollars may be used to pay for qualified medical expenses that you would otherwise pay out of pocket. The funds are not taxed unless used for unauthorized purposes. In order to take full advantage of your FSA dollars, though, you must complete your pre-tax dollar spend them before the end of the year.

7. Pay back loans

Paying off outstanding debt is a good rule in general, but doing so can also reduce your taxable income. Certain types of interest such as mortgage interest, student loan interest, and interest for some business loans, can be deducted from taxable income.

Don’t take this as a recommendation to take on new debt in order to save money on taxes, however; even with tax savings, interest is still an expense that comes out of your pocket. If you already have loans and need to reduce your taxable income, though, pay back loans now to do so.