Tax savings opportunities for realized income and salary • Learn with Valur

It’s tax season, so our inbox is flooded daily with a common question: Valur talks a lot about reducing the taxes on capital gains, but is there any way to do the same for ordinary income, like salary, a bonus, or 1099 earnings? In fact, some of the best tax breaks out there apply to ordinary income just as well as capital gains. In this article, we’ll identify the broad categories of tax savings available for ordinary income; in future posts, we’ll explore the specific highest-value strategies that can increase your take-home income by 40% or more.

In particular, here, we’ll discuss three key tax savings opportunities for realized income and salary that can help you reduce the taxes:

Tax credits
Deductions
Depreciation

Let’s start with the basics.

What are tax credits?

A tax credit is a dollar-for-dollar reduction in the amount of taxes you owe. For example, say you have $100,000 of income and owe $25,000 in taxes. If you then received a $5,000 tax credit, your tax liability would be reduced to $20,000, and you would take home that extra $5,000.

Importantly, tax credits are different from deductions, a concept more people are familiar with. Deductions reduce the amount of income that is subject to taxes. Tax credits directly reduce the amount of taxes you owe and in a sense are similar to a gift card or store credit you can use to reduce your tax bill.

Tax credits show up throughout the tax code. In fact, you’ve probably taken one at some point whether you know it or not. Some of the more well known credits include the child tax credit (which you receive for providing for a child) and the electric vehicle tax credit (which you get for buying a qualifying EV), but these opportunities abound; maybe you installed energy-efficient windows in your home or took the lifetime learning credit while you were in college.

What each of these credits demonstrates is that the government typically offers tax credits to incentivize certain behaviors or investments. Today, credits are deployed as tax savings opportunities for realized income and salary in areas of pollution control, energy conservation, green technology, and other areas that support environmentally conscious economic development

Over the last few years tax credits have become an increasingly popular tax mitigation tool due to increasing incentives tied to renewable energy incentives. In particular, the solar infrastructure credits in the 2022 Inflation Reduction Act are a particularly attractive opportunity to reduce your income tax. Read more about the IRA’s investment tax credits.

What are tax deductions?

A deduction is another way to reduce taxable income, this time by reducing the income that is subject to taxation, thereby indirectly reducing the amount of taxes you owe. Contrast this with tax credits, which directly reduce the amount of taxes you have to pay.

Like tax credits, deductions are very common in the code. The most common is probably the deduction for charitable donations; by donating to a qualified charity, you can reduce your taxable income and thus your taxes. Other well known deductions include the mortgage interest deduction and the student loan interest deduction.

Two common approaches to using charitable donations to reduce your taxes are:

Donating to Donor Advised Funds (DAF): For every dollar you donate to a DAF you are able to lower your taxable income by a proportionate amount (in most cases). From a Donor Advised Fund you are able to control the investment of the assets, choose when to donate the money to charity and choose the charity(s) which receive the money but you cannot receive those proceeds.
Setting up a Charitable Lead Annuity Trust (CLAT): For every dollar you donate to a CLAT you also are able to lower your taxable income by a proportionate amount (in most cases). In addition, you are also able to control the investment of the assets, choose the charity(s) which receive money from the trust annually and you receive what’s left in the trust after the trust expires.
Donating appreciated stock. This isn’t so much an approach as a clever trick that you can stack onto the strategies we’ve described above. If you donate appreciated assets such as stocks or mutual funds, you can take a deduction for the full market value of the asset while avoiding any capital gains taxes you would have otherwise paid on the appreciation, supercharging your tax savings.

What is depreciation?

Depreciation is the amount of value that a physical asset loses over time. When you drive your new car off the lot and its value drops immediately, or when a piece of machinery becomes less valuable due to wear and tear, that’s depreciation. From a tax standpoint, depreciation is relevant because you may be able to take a deduction for some or all of the amount of the value an asset loses over time, reducing your taxable income and saving money on your taxes.

Depreciation arises less often for wage earners than other deductions and tax credits, for the simple reason that this is typically not a deduction that you are allowed to take against wage income. Instead, depreciation usually arises if you have a business or own a rental property; business owners are allowed to deduct the depreciation on their business’s assets, like office furniture, electronics, and vehicles, and landlords may deduct the depreciation on the property they rent out.

Depreciation deductions are also available to investors; if you invest in real estate, oil and gas projects, or renewable energy infrastructure, the wear and tear on the physical assets underlying your investment may be deductible, often up to 100%. Here, again, the 2022 Inflation Reduction Act has changed the game, offering significant additional depreciation benefits to many Main Street investors.

How much are these tax savings worth?

All of this is well and good in theory, but how does each type of tax benefit affect the bill you’ll pay in April?

Take Alfredo and Kim, who live in California, earned $1,100,000 in salary and company stock this year, and expect to pay $550,000 in federal and state taxes (or a 50% effective tax rate). Imagine that they have the option to take a $100,000 write of in the form of a tax credit, a charitable deduction, or depreciation. How would the potential tax savings compare?

Tax Credits: Alfredo and Kim would be able to apply their $100,000 tax credit directly to the federal taxes they would otherwise owe. As a result, instead of owing $550,000 to the federal government, they would have to pay only $450,000. In other words, the tax credit applies directly to their tax bill, reducing it by $100,000.

Deductions: If their tax benefit took the form of a $100,000 charitable deduction instead, Alfredo and Kim could use their deduction to reduce their taxable income. Accordingly, instead of being taxed on $1,100,000 of income, their tax would be calculated on an income of $1,000,000 flat. Assuming their effective rate stays at 50%, that would mean that they would owe $500,000, for a reduction of $50,000.

Depreciation: Depreciation works just like any other deduction, reducing the family’s taxable income by $100,000 and, as a result, taking $50,000 off of their bill. With that said, one nuance to consider is that depreciation is usually spread out over time. For example, if you expect your physical asset to fully depreciate over 5 years, you don’t typically get to write off 100% of the value in the first year; instead, you would receive one-fifth of the deduction each year. (This is, of course, an oversimplification. The depreciation rules vary depending on the type of asset and where you live.)

Conclusion

The key takeaway is that there are several tax savings opportunities for realized income and salary. The most significant savings come from tax credits, which directly reduce the tax owed by the amount of the credit. Deductions and depreciation reduce taxable income and therefore lower the tax owed, although the savings are less substantial. It’s important, of course, to understand the specific rules and limitations of each type of tax benefit, as well as the long-term effects, in order to make the best decision for your financial situation. With the right planning and strategy, you too can take advantage of these tax savings and keep more of your hard-earned money.

About Valur

We built a platform to give everyone access to the tax and wealth building tools of the ultra-rich like Mark Zuckerberg and Phil Knight. We make it simple and seamless for our customers to take advantage of these hard to access tax advantaged structures so you can build your wealth more efficiently at less than half the cos of competitors. From picking the best strategy to taking care of all the setup and ongoing overhead, we make it easy and have helped create more than $500m in wealth for our customers.