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4 Effective Strategies To Protect Your Income From Taxes

With tax season right around the corner, everyone is starting to think of tax planning strategies that can help protect their income from the IRS. Thanks to the tax law passed in 2017, as well as some new regulations passed in the wake of the pandemic, there are plenty of deductions you can take advantage of to retain your earnings in 2021. Here are 4 effective tax planning strategies to explore before you prepare your return to the IRS. 

Hold on to your gains

Capital gains tax can — and should — be reduced as much as possible. Capital gains tax is the tax you pay on capital gains depending on how long you held the asset before selling it. Capital gains are classified as either short or long-term, with different rates, accordingly. 

Short-term gains tax is the same rate that you would pay on your ordinary income. Depending on your federal tax bracket, that can be up to 37% in 2021. Long-term capital gains tax applies to assets that have been held for more than one year. The tax rate is according to graduated thresholds for taxable income: 0%, 15%, or 20%. Most taxpayers who report long-term capital gains don’t pay more than 15%. 

Ideally, as these rates show, you should hang on to any capital gains for at least a year. 

Invest in a retirement account

A traditional IRA, a Roth IRA, or a 401K are all great options for saving your money from the IRS and banking it for retirement. A 401K is a popular options since the IRS doesn’t tax any earnings you divert from your paycheck directly into your 401K. In 2021, you are permitted to funnel up to $19,500 per year into your 401K account (note that in 2022, this amount increases to $20,500). 

A traditional IRA is an individual retirement account in which you can invest money pre-tax and grow the investment tax-deferred. When it comes time to retire, you’ll pay income tax on withdrawals from your traditional IRA. 

In comparison, a Roth IRA allows you to grow your money tax free. You’ll pay taxes on your investment upfront, but when it comes time to withdraw your funds, there are no taxes on your earnings. This is a good solution for those who are able to let funds in the Roth IRA grow uninterrupted until retirement. 

You may be able to deduct contributions to your traditional IRA, depending on your circumstances. For 2021, you are ineligible to deduct your contributions if: 

  • you’re covered by a retirement plan at work; 
  • you’re married and filing jointly; 
  • your modified adjusted gross income was $125,000 or more.

Create an FSA

An FSA, or flexible spending account, is a type of savings account with specific tax benefits. Accountholders can contribute a portion of regular earnings to their FSA; likewise, employers can contribute to their employees’ FSAs. When you open an FSA, you’re permitted to add up to $2,750 to it tax-free. In 2022, this amount increases to $2,805. 

Note that an FSA is not designed to hold your funds indefinitely. “You’ll have to use the money during the calendar year for medical and dental expenses, but you might also be able to use it for related everyday items such as bandages, pregnancy test kits, breast pumps and acupuncture for yourself and your qualified dependents,” wrote Nerdwallet.

Give back via charitable trusts

Charitable Remainder Trusts (CRTs) or Charitable Lead Trusts (CLTs) are two vehicles worth exploring for high-income individuals. Giving back is a powerful way to lower your tax liability by giving money to nonprofit organizations. The amount you can deduct is up to 60% of your adjusted gross income, making this an attractive way to protect your wealth. 

A Charitable Remainder Trust is a tax-advantaged account that allows you to put off income taxes, thereby growing your money faster with the magic of compounding — similar to a more flexible IRA. It distributes income to a designated trust beneficiary (e.g., you and your family) at least annually for a specified period and, when that period is over, donates the remainder — everything that hasn’t been distributed yet — to your chosen charity. 

It’s important to note that CRTs only work for deferring taxes on future capital gains. If you didn’t plan for high earnings in advance, consider a Charitable Lead Trust. A CLT or CLAT offers many of the same tax benefits of the CRT but works specifically for already-realized gains. 

Alternately, investors can give back through the Opportunity Zone program.  An opportunity zone is a geographic area designated by the IRS and used as an economic development tool to invest in distressed parts of the US. The IRS is incentivizing entrepreneurs to reinvest money, in return offering a way to defer capital gains tax. 

By investing the money you earn from selling your stake in a Qualified Opportunity Fund (QOF), it’s possible to avoid paying capital gains tax until you sell or exchange your QOF investment or until Dec 31, 2026, whichever is earlier. 

Holding an investment in a QOF comes with additional tax benefits

  • If the investor holds the QOF investment for at least 5 years, the basis of the QOF investment increases by 10% of the deferred gain.
  • If the investor holds the QOF investment for at least 7 years, the basis of the QOF investment increases to 15% of the deferred gain.
  • If the investor holds the investment in the QOF for at least 10 years, the investor is eligible to elect to adjust the basis of the QOF investment to its fair market value on the date that the QOF investment is sold or exchanged.

Next Steps

Check out our Case Study on reducing ordinary income tax with a CLAT to follow up with our content. Try our innovative calculator here, or schedule a call to meet our team and share your experience!

About Valur

We have built a platform to give everyone access to the tax planning tools of the ultra-rich like Mark Zuckerberg (Facebook founder), Phil Knight (Nike founder) and others. Valur makes it simple and seamless for our customers to utilize the tax advantaged structures that are otherwise expensive and inaccessible to build their wealth more efficiently. From picking the best strategy to taking care of all the setup and ongoing overhead, we make take care of it and make it easy.