Strategies to Reduce Taxable Income

Most people, after they pay their tax bill in April (or May this year), don’t think about their taxes again until after the New Year. Savvy taxpayers, on the other hand, know that tax planning is a year-round event. Investing in retirement accounts, being mindful of tax credits and deductions, timing income and losses, and characterizing your income properly can yield real savings on your tax bill, translating to extra money in your pocket. Additionally, effective tax planning is one of the most impactful “controllable” factors in building wealth.

What Will the Government Tax?

Taxes are levied on your “taxable income.” Taxable income is calculated by subtracting allowable deductions from your gross income. According to the IRS, gross income includes everything from everywhere unless specifically exempted. This means things like wages, dividends, capital gains, business income, retirement distributions as well as all other income. You then calculate your adjusted gross income (AGI) by subtracting all applicable above-the-line adjustments, such as student loan interest, contributions to an HSA or retirement accounts, allowable tuition and other education fees, and certain expenses from renting your personal property. AGI is also important in calculating a variety of tax limitations and Medicare thresholds for higher-income individuals.

After AGI is calculated, credits and below-the-line deductions are applied to reduce your total tax bill. Below-the-line deductions are subtracted to determine your taxable income, the amount upon which you tax will be calculated. After all of these values are tabulated, the appropriate tax rate(s) are applied, and your tax bill is determined. Tax credits reduce the calculated tax. In the United States, we utilize a progressive tax rate system that results in a “layer cake” approach with different layers of your income being taxed in different tax brackets (rates).

Depending on your withholding and any estimates you may have paid, you will either receive a refund from the government or owe additional taxes.

If you take away one thing from this blog, let it be this: the steps below, when used properly, are the secret to effectively increasing your wealth through profitable tax planning. This is achieved by effectively managing your marginal tax bracket, considering both the current year and future tax years as part of a long-term tax planning process.

Now that we know how taxes are calculated, let us look into what you can do to decrease your bill.

Invest in Your Retirement

One of the ways to reduce your AGI is through investments in retirement accounts that are subtracted from your income (Roth accounts are an exception). So, if you have an IRA, 401(k), SEP, etc., you should fund those to a level that optimizes your marginal tax rate. Not only is this an investment in your future, but it’s money that the government won’t get its hands on next April 15th.

There are limits to the maximum annual contribution to a retirement plan. For 2021, those limits are:

Account Type	Limit	Additional Catch-up Contribution Limit	Age When Catch-Up Contributions Start
401(k)	$19,500	$6,500	50
SIMPLE 401(k)	$13,500	$3,000	50
IRA	$6,000	$1,000	50

Save for Children’s Education

In addition to saving for retirement, putting aside money for your child or grandchild’s education can be a win-win: more money for them to go to school and a decrease in taxes for you. Common savings vehicles are 529 accounts, which are tax-advantaged accounts that can be used to cover scholastic expenses throughout one’s education, from kindergarten through graduate school. Although contributions aren’t deductible, earnings in a 529 plan grow federal tax-free and won’t be taxed when the money is taken out to pay for qualifying college expenses. Additionally, up to $10,000 in tuition expenses for private, public, or religious elementary schools (per year per beneficiary), along with student loan payments and apprenticeship program costs can be withdrawn tax-free as of 2018 and 2019, respectively. Additionally, 30 states (including Ohio) offer state tax benefits on top of what’s offered federally.

Flexible Spending Account (FSA)

An FSA allows you to contribute pre-tax earnings to your account, lowering your taxable income. You can contribute up to $2,750 in 2021. Money invested in an FSA can be used to reimburse healthcare expenses. One important item to note is that an FSA is a “use it or lose it” benefit; funds not spent in a plan year are lost, although individual employer plans may offer you a grace period after the end of the plan year when you can still use the money for your benefit, or it may allow you to roll over a portion of what you’ve saved.

Health Savings Account (HSA)

HSAs are a benefit everyone should take advantage of because they are triple-tax advantaged (as good as it gets): money going into the HSA is pre-tax, earnings on the account are tax-free, and withdrawals are tax-free, provided they are spent on qualified medical expenses. Another benefit of an HSA is, unlike an FSA, money contributed to the account can roll over from one year to the next. Also, the HSA can be invested in stock funds through your HSA provider. This makes HSAs a great long-term investment to be used for medical expenses in retirement. To take full advantage of this benefit you must forgo using HSA funds for medical expenses now and pay these bills out of pocket.

A condition of implementing an HSA is having a High-Deductible Health Plan, where the deductible must be at least $1,400 for an individual or $2,800 for a family. The total annual contribution limit for an HSA in 2021 (employer + employee) is $3,600 for an individual and $7,200 for a family. People aged 55 and older can contribute an extra $1,000 as a catch-up contribution.

Charitable Giving

Contributions made to charitable causes are tax-deductible. By virtue of the Consolidated Appropriations Act signed into law December 28, 2020, individuals may deduct charitable donations made up to 100% of their AGI. What’s more, those donations don’t have to be money; clothes, food, household items, and even expenses incurred while volunteering for a qualified charity (but not the value of your time itself) can be deducted. Appreciated securities can be donated as well, both to support a worthy cause and avoid capital gains taxes; often this can be done through a Donor Advised Fund, which can be started with as little as $5,000.

Donor Advised Funds are simple to set up and allow you to pre-pay charitable gifts and take the related deduction in high income years when that deduction is more valuable (as part of your long-term tax plan). You do not even need to identify the charity that will receive the funds at the time of the transfer. The actual gift to the charity of your choice can be made years later.

Qualified Charitable Distributions (QCDs) offer a unique opportunity to obtain a tax benefit for charitable giving in a world where very few taxpayers itemize deductions. Specifically, individuals who are at least 70 ½ years old at the time of the QCD request may arrange for distributions from their IRAs to go directly to charity. These distributions satisfy an individual’s RMD obligation. The limit is $100,000 per taxpayer per year.

Since RMD income is then reduced, your AGI also lowers. This helps many taxpayers reduce their Medicare premium surcharge in addition to providing a state tax benefit for many states (like Ohio) that don’t permit itemized deductions. This means a QCD can reduce three taxes, federal, state and Medicare.

Tax Loss Harvesting

Although no one likes to see the market tumble, under the right circumstances you can take the lemons of temporarily lost value and turn them into the lemonade of a current-year tax deduction. You can “harvest” losses to offset any amount of capital gains and up to $3,000 of non-investment income. If you’ve harvested more losses than you can use in a year, the remaining losses can be carried forward and used to offset future gains. To optimize this process, keep an eye on your portfolio and trigger losses during periods of market volatility when they are still short-term, to accelerate the tax maximum benefit. To keep your portfolio in balance, the securities that are sold for tax purposes should be replaced with similar, but not substantially identical securities. If the same (or substantially identical) securities are repurchased within thirty days (before or after the loss recognition transaction) the “wash-sale” rules kick in, and the loss that you worked so hard for will be non-deductible, although you will ultimately receive the benefit through a basis adjustment.

Structure Income to Capture Tax Rate Advantages

If you own a capital asset, such as a stock or real estate, for longer than a year, under current law the capital gain from that asset will enjoy a preferential tax rate of 0%, 15%, or 20% depending on your income. If you fail to hold the asset for at least a year, the capital gain is taxed at ordinary income rates. The moral of this story is to check your holding period before selling an asset. If it is close to a year, it might pay to wait a bit longer to capture the long-term tax rates.

If you purchase a security in stages, at different prices over time, you have established several tax lots. Each lot can be specifically identified for trading. Using this strategy may help you carve out portions of your position to give you the tax result you desire.

Before selling a capital asset, be sure to adjust your basis by including any improvements or reinvested dividends. For example, if you sell a rental property, you can reduce the taxes you’ll owe by including every renovation, improvement, or other kind of investment made that increased the value of the property, that had not already been expensed or depreciated.

Additionally, converting a traditional IRA to a Roth IRA may be beneficial if you expect to be in a higher tax bracket in the future. This can be an especially prudent move for retired taxpayers before they must begin taking required minimum distributions (which will drive them into higher tax brackets in the future). It will help reduce the amount of future taxable income that will be forced on them when RMDs begin since Roth IRAs do not require an RMD. Conversions can be optimized when done during a market decline because conversion values will be depressed, and the resulting taxable income lessened. As a result, it is beneficial to plan Roth conversions well in advance, as part of a long-term tax plan, and wait for the opportunity to present itself.

Timing Income and Expenses

If you’re working from a multi-year tax plan (to optimize your marginal tax bracket each year and minimize your lifetime tax burden), you may find yourself with too much or too little income in a given year. In these situations, you should either defer or accelerate income and/or expenses as your situation permits. If you need to decrease your income, giving to a Donor Advised Fund now, to claim the deduction when you need it to reduce your income and then giving that money to the charities of your choice in the future is a good option. On the income side, if you expect to receive a year-end bonus from your employer, it would be to your advantage to see if you can receive that bonus in the new year. Also, capital gains can be accelerated or deferred at your discretion by selecting a transaction date. Therefore, if you plan to rebalance your investment portfolio at the end of the year, which would involve selling profitable assets, waiting until the next year can keep the income from that sale off of the current year’s tax bill. If the rebalancing will result in a loss, it could be advantageous to take it in the current year, subject to the limitations discussed above.

It also pays to be aware of potential tax law changes (rate increases and decreases, loss or introduction of deductions) as various political administrations go in and out of power. For example, the Biden administration has proposed a variety of tax increases that could have a negative impact on higher income taxpayers. In this case, it could make sense to accelerate income and pay tax obligations sooner, in order to do so at a lower marginal rate. Of course, the time value of your tax dollars must be considered in making this decision.

Conclusion

Everyone knows the value of putting in hard work to build wealth. Fewer people are aware of the work that should be done in creating and managing a long-term tax plan to keep your wealth away from the taxman after you’ve earned it. Identifying and acting on tax planning opportunities can save a fortune on your lifetime tax bill, allowing you to keep more of what you earn and create the financial freedom you desire for that dream retirement you are planning.

Don’t Have a Multi-Year Tax Plan? Talk To Us About Designing One for You.

Mike Hengehold, CPA/PFS MST RICP®
Mike is the Founder and President of HCM Wealth Advisors. Over the last 30 years, he’s provided financial planning guidance to a myriad of families to help them realize their financial dreams. Mike is an avid homebrewer and animal lover, and when he’s not at work you can often find him on the golf course working on his short game.