If you live in the U.S, you might have already asked yourself what are the best ways to reduce taxes. Even more if you’re a high income earner citizen. The more you earn, the more invested you’re likely to be in making sure that money doesn’t go to the federal government. In fact, most of the world’s billionaires pay a fraction of their total net worth in taxes. But is there a way to legally not pay taxes? And if so, how to reduce your taxable income to reduce them?
Lucky you, we have some key answers. You don’t need to be a billionaire — or a tax expert — to protect your income from the IRS. The wealthiest are obligated to pay a federal rate of 37% on their taxable income, which is steep, but still less than the 39.6% rate pre-TCJA. This high rate provides high earners more incentive to protect their hard-earned income by reducing their tax liability.
So stop asking yourself why you pay so much taxes, and let’s dive into some easy ways to reduce your taxable income and keep more money in your bank account!
5 Ideas on How to Reduce Taxable Income
1. Use charitable trusts and other deductions
The IRS permits high-income individuals to lower their tax responsibility by giving money away 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.
There are a few ways to reduce taxable income. One effective option is to set up tax planning process, either with a Charitable Remainder Trust or Charitable Lead Trust. 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. When set up at the right time, a CLAT offers many of the same tax benefits as the CRT but works specifically for already-realized gains.
2. Hold assets for at least a year
Probably, now you’re wondering how holding your assets for A YEAR could help you in any way lower your taxable income. Well, income isn’t always in the form of a paycheck; sometimes your taxable earnings are the result of selling your stake in a company, cashing out a crypto asset, or realizing the full value of some other asset. If this is the case, timing is everything.
Enter: capital gains tax. Capital gains, including gains on crypto, are classified as either short or long-term and taxed at different rates accordingly. Simply put, the tax you pay on capital gains depends on how long you held the asset before selling it.
Short-term gains tax is the same rate that you would pay on your ordinary income. Remember, for high earners that can be as much as 37%. However, 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, you should try to hold out for at least a year to receive that long-term capital gains rate, rather than the much higher rate of up to 37%. Consider reinvesting in equities to reduce taxable income when receiving high earnings, could help you avoid short-term capital gains.
3. Invest in municipal bonds
Municipal bonds are a great way to reduce your taxable income and pay less in taxes. Through these you lend money to a state or local government and earn interest over a predetermined period. Municipal bonds are exempt from federal taxes and some state and local taxes, depending on where you live. Once the bond reaches its maturity date, you receive the full amount of the original investment.
This strategy carries a low-level of risk in comparison to other reinvestment options. “A study of municipal bonds from 1970 to 2019 found that the default rate was 0.1% for investment-grade municipal bonds versus 2.25% for global corporate issuers,” wrote Investopedia.
The drawback to investing in municipal bonds is that they typically pay lower interest rates. But, because municipal bonds have tax-equivalent yield, the higher your tax bracket the better you fare.
4. Set up a Donor-Advised Fund
A donor-advised fund is a private fund administered by a third party and created for the purpose of managing charitable donations. It’s a good way to take deductions while bringing good to the world. Donor-advised fund holders receive a federal income tax deduction of up to 60% of adjusted gross income for cash contributions, as well as up to 30% of adjusted gross income for the appreciated securities they donate.
There are several third-party sponsors from which to choose, including:
- Community foundations and faith-based entities
- National donor-advised fund organizations, which are often charitable arms of for-profit financial services institutions
- Public foundations
The biggest advantage of the donor-advised fund is that you receive an immediate tax benefit. However, it’s worth noting that your contribution is irrevocable; your assets cannot be returned to you no matter the reason. Do your homework before deciding to lower your tax liability with this option.
5. Plan for the future
Play the long-game: invest in retirement funds, HSAs, and other vehicles that can protect your wealth from taxes in the long-run.
“In most cases here, you’re trading a current tax benefit in the form of lower taxable income now for a future benefit of tax-free income later. Despite being in a high tax bracket currently, you could be in an even HIGHER tax bracket in the future…even if you have lower income,” wrote one wealth management firm.
There are few options you can consider now to protect your income from taxes later. Explore contributing to a Roth IRA, a health savings account (HSA), or a Roth or traditional 401K. HSAs, for instance, offer tax-deductible contributions, tax-free earnings, and future tax-free withdrawals for qualified medical expenses.
Next Steps
Follow up with the CLATs series with our comprehensive guide about CLATs. Try our innovative tax-saving calculator to evaluate your potential return on investment, or schedule a call with our team for a free consultation!
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 take care of it and make it easy.