How can I reduce my income taxes?

Irrespective of your political affiliation, almost everyone I know asks this question. They want to know how to legally reduce their taxes. There are many directions this could go to be honest and there are people way smarter than me who do this for a living. But as always, I want to help everyone understand at a basic level how to think about this. The purpose of this article is really to give a basic framework and some common methods of minimizing taxes. In my article on the basics of income taxes, I introduced a few basic concepts to everyone and I will reference a few of those in this article. Again, this article is fairly US-centric so my apologies to my non-US readers. One final note: I know some folks feel a bit of an ethical or moral quandary when thinking about tax planning. I want to make two things clear – one, everything I talk about here is perfectly legal. Two – none of these are tax loopholes but simply ways the government incentivizes different activities and types of income. None of what I discuss here is anything fancy like stashing your money in some tax havens which I know a lot of folks feel squeamish about. Having said all this, if you feel strongly about not wanting to pursue any of this due to moral/ethical reasons, I totally understand and respect that. Personal finance is personal after all.

Legal tax planning fundamentals

I promise to keep this simple. So if you remember nothing else, just remember this section. At the highest level, legal tax planning exists at four levels:

1. Shift Gross Income to more tax advantaged income sources
2. Reduce the Adjusted Gross Income (AGI) by taking advantage of the above-the-line adjustments. 
3. Reduce the Taxable Income (TI) by taking advantage of some of the below-the-line adjustments. 
4. Geographic Tax arbitrage

Shifting gross income to tax advantaged sources

Believe it or not, this is where most of the wealthy folks do their tax planning. But you don’t have to be Bill Gates to take advantage of some of these. 

• Wages/salaries/tips – For a lot of people, the majority of their gross income is wages, salaries or tips accompanied by a W2. If the majority of your income is in W2 earnings, you don’t have a lot of tax moves to make. The US tax system really taxes W2 earners the most. If you are a high income W2 earner and that’s where the majority of your income comes from, you are pretty much screwed! You will pay the highest taxes – period.  BUT, what if you are expecting in a specific year to earn a ton of non W2 income and you and your spouse have been talking about wanting to take a break from your jobs? This is probably a great year to consider doing it in a way that could reduce your taxes. Ultimately, if you are looking to become financially independent, you are trying to move away from this kind of income anyway.
• Interest income – Interest income earned through savings accounts, money market accounts, CDs or bonds are normally taxable at normal income tax rates. So no tax planning can be done with these.  But there are some exceptions. The most popular one are municipal bonds – interest from these bonds are tax exempt – meaning you don’t pay taxes on them. More often than not, including muni bonds in your portfolio is a good tax advantaged move. Of course, you still need to ensure you evaluate risk here because muni-bonds are not risk free. 
• Dividends – now things start to get a bit more interesting. Dividends paid by regular publicly listed companies (when you own their stocks or a fund/ETF) if you held the stock for 60 days before they paid the dividend and for 60 days after are called qualified dividends. Now, qualified dividends don’t get taxed at ordinary income taxes but at capital gains taxes. I will explain the capital gains taxes structure in a bit but the maximum tax anyone will pay is 20% (23.5% for people above a certain income) and for most people it will be 15% or if you are smart, it can be 0%. Now, not all dividends are qualified. Dividends from REITs for eg. are taxed at ordinary income tax rates. Dividends from stocks held for less than the 120 days are also not qualified dividends (so if you thought you were being smart by buying a high dividend paying stock just before they issued the dividend and sold it right after then you are paying ordinary income taxes on those, think again!.). 
• Capital gains and losses – this is where tax planning starts to get really fancy. Before we get into that let me briefly explain what are capital gains and losses and how they are taxed. Capital gains or losses are profits (or losses) you make upon the sale of a capital asset. A capital asset can be a stock or a bond, a piece of real estate, a business, or any tangible asset. When you make a profit (when you buy for $X and sell for $X+$Y), you pay capital gains taxes on the profit ($Y) only. Similarly, when you make a loss, you get to offset your income with those losses. The IRS distinguishes between long term and short term capital gains. If you bought and sold an asset in less than 1 year, it is considered a short term gain and will be taxed at ordinary income taxes. But if you held it for more than 1 year, then it is taxed at long term capital gains taxes. Below is the tax structure for long term capital gains in 2021:

The above $ numbers are based on your AGI (Adjusted Gross Income). So if you are married, filing jointly and your overall AGI is less than $501,600, then you only pay 15% taxes on the capital gains. Now, if you have figured out a way to keep your AGI below $80,800 then you will pay NO TAXES on your capital gains! I have read about some early retired couples who make all of their income each year on capital gains only by selling a bit of their portfolio and keeping it below the first bracket and hence pay no taxes! Folks also take advantage of capital losses to offset gains to reduce income.  

Think of all the millionaires and billionaires who probably earn a sizable chunk (if not all) of their income through capital gains or long term dividends. The maximum tax they pay is 20% which is a far cry from the really high income W2 earners who might be paying the 37% ordinary income tax! Now as of 2021, for most folks who earn an AGI above $200,000 for single and $250,000 for married couples will pay a 3.8% surtax on capital gains on top of this making the highest capital gains rate at 23.8%. 

Note: Selling your personal residence for a profit of upto $250,000 for single filers and $500,000 for married filing jointly, does not incur any capital gains taxes, as long as you meet the eligibility test laid out by the IRS. 

• Other Income – This is what really separates the wealthy and smart from the average W2 earners. This includes rental income (or losses), business income (or losses), royalties etc. There are perfectly legal ways to earn money but still show losses in rental property or businesses. That is because the IRS wants to incentivize this type of income in general. Robert Kiyosaki in his book ‘Rich dad, Poor Dad’ talks about this extensively and says this is the kind of income rich people tend to have mostly. If you own a business or rental property, you have a lot of scope for taking advantage of adjustments here. This is where you get to deduct all sorts of business expenses and you can legally offset these expenses against any profits your business makes. You can see the list of expenses here in Schedule C under Part II: Expenses if you have a sole proprietorship business; or if you have rental properties or a partnership or S corp business, here in Schedule E. 

Reducing AGI with above-the-line adjustments

I talked about the different above-the-line adjustments in the article on the basics of income taxes. From a tax planning perspective, there is limited scope here if you are a W2 wage earner. The most obvious and common ones here are IRA (Individual Retirement Account) deductions or Self employed and qualified retirement plans, and finally the Health Savings Account contributions. Below are the maximum contribution limits in 2021 per person: 

• IRA –  $6000 and $7000 if you are age 50 and older (there are income limitations to take advantage of this)
• 401(k)s, 403(b)s and most 457 plans – $19,500 and additional $6500 if you are age 50 and older
• HSAs – $3600 for individuals and $7200 for families (who have a qualifying High Deductible Health Plan)

If you are a high income W2 earner, it would be a no-brainer to take advantage of the above and should be the basic tax planning everyone should consider. 

Reduce the taxable income with below-the-line adjustments

If you are taking the standard deduction, there is nothing to be done here and zero tax planning involved. As I mentioned, with the 2017 Tax cuts and Jobs Act, the majority of the folks are taking the standard deduction. However, from a pure tax planning perspective, some folks are considering taking advantage of the itemized deductions by increasing their charitable contributions. There are a few folks who are ‘bunching’ charitable contributions they would make over 2-4 years all in one year to take advantage of the itemization in a specific year and not make them in the subsequent years. Of course, this applies only if you are someone who makes a fair amount of charitable contributions. 

Note on tax Credits: Tax credits directly reduce your taxes paid dollar for dollar but I generally don’t view them as tax planning. They are more items in the tax code you can take advantage of for your specific situation. For eg, you get the child tax credits. But last I checked, I don’t know of too many people who planned to have children just for the sake of tax benefits :). You have other tax credits here like the Earned Income Tax Credit and Savers credit which are really targeted for people with extremely low AGI and again, I don’t really see them as tax planning tools. 

Geographic tax arbitrage

First off, this has nothing to do with hiding your money in tax havens and while I am aware of those tactics, I don’t know anything about them and not referring to them here. This is something more basic than that but a significant lifestyle/life event changing approach but can have probably one of the most significant impacts to your taxes. You can pursue this at 2 levels:

1. Move to a low/no state income tax state in the US – If you live in one of the 41 states in the US that has state income taxes, you could consider moving to the one of the 9 states where there are no state income taxes or simply to a state that has much lower taxes than the state you currently live in. There are a few states that are extremely tax friendly for retirees and wont tax things like social security income. So if not right away, it may be a consideration for you in retirement. You can imagine people in retirement don’t just move to Florida for the weather but also their great tax advantages.  
2. Move to a low cost country – I have heard of people who get even more creative by moving to a different low cost country and take advantage of the foreign earned income exclusion to reduce their taxable income. Again, the idea is not to move to a low tax country necessarily but to a low cost country where your expenses are low and hence, need much lesser income to live. 

Concluding thoughts

Tax planning is a bit of a labyrinth and can be confusing to all. My hope is this article helped provide a framework on how to think about this. Appropriate levels of tax planning can help protect your wealth from the taxman and allow it to grow. I am pretty certain I have not covered everything in this article but think of it as a start to get your juices flowing. As always please consult with your CPA or tax professional to get advice for your specific situation. 

Thank you for reading and I wish you success in your financial journey!

Disclaimer: I am not a financial advisor and all the information in my articles are from my personal experience and are for informational and educational purposes only. Please consult with a financial advisor or CPA for professional advice.