Is it possible to not have to pay any taxes? Do the rich pay a lower percentage of taxes than the average American? Can you as an average-earning American figure out how to reduce taxes in 2020?
The short answer to all these questions is, yes. However, there’s a lot more that plays into this than a simple, “yes”.
The truth is that the only reason the rich can avoid taxes is simply that they understand tax laws. They take the time to study them and set themselves and their income up in a way in which they don’t have to pay as much in taxes.
Are the rich able to do this only because they’re rich? The answer to that is a resounding, “no”.The average American can also find a way to reduce their taxes. The rich do it legally, and so can the average American.
The key is to learn how. In this article, we’ll be going over strategies you can utilize to minimize the taxes you owe on your income.
With this being said, keep in mind that the information given here is general. You should consult a trusted, licensed CPA or tax advisor for your individual tax information. Your results can vary depending on several factors relating to your lifestyle. Use the information here to get started on minimizing your taxes, but again, keep in mind that results vary depending on your situation.
Just like the rich can use the knowledge they have to minimize their taxes, you too can have the knowledge to minimize your taxes according to your lifestyle.
The key to paying fewer taxes, other than learning the laws, is to make your income look as low as possible, without actually reducing your income. In America, we have tax brackets. Your income puts you in a specific tax bracket.
The tax brackets go as follows:
How do tax brackets work? Very simple, the taxes you owe/pay are based on your earned income. This means that, for example, if you are single and you make $40,125 annually, you would be in the 12% tax bracket. This is considered your marginal tax rate.
This means you pay federal income taxes of 12% of your annual earned income at the end of the tax year. More details on tax brackets are available in a separate article.
Your marginal tax rate is based on your earned income. Oddly enough, there are three types of income for tax purposes. They are, earned income, passive income, and portfolio income.
In this article, we’ll be focusing on earned income.
#1. Long-Term Capital Gains
Keeping your investments for longer than a year before realizing your profit is a great option for those who want to avoid large amounts of taxation on their investments.
When you realize a capital gain, it simply means you sold the investment and actualized its gain into monetary value. If you don’t sell the investment, even though it made profits, it is referred to as an unrealized profit or a profit on paper.
The reason why it’s a great option to take long-term capital gains is that they are not taxed at your standard marginal tax rate. Short-term capital gains are the profits you have when you sell an investment before 1 year and 1 day. They are taxed as regular income. Long-term capital gains are only taxed at:
- 0% for $0 to $40,000 income
- 15% for $40,001 to $441,450 income
- 20% for $441,451 or more income
There are specific strategies one can utilize to avoid that 20% tax rate on large amounts of long-term capital gains. This is more specific to those who have large profits in retirement after several years of investing but we won’t be going over those here.
Taking long-term capital gains is a method that any smart investor can take to avoid large taxes on what they make from investments. As said before, if you were to sell your investment before 1 year and 1 day of buying them, then your capital gains would be taxed as regular earned income rather than portfolio income.
#2. Standard Deduction
Standard deductions are simply cuts you can make in your taxable income to make it look like a smaller portion of income. Most people take a standard deduction when filing their taxes but there are few that don’t.
Some people make itemized deductions but this is generally the lesser of the two options because itemized deductions tend to be lower than the standard deduction.
People don’t usually familiarize themselves with either of these options. Sometimes, you’ll have people who don’t take either of these deductions and end up paying more taxes than necessary, simply because they aren’t educated on these common deductions.
The standard deductions are as follows for the 2020 year:
- For single taxpayers or married individuals filing separately, the standard deduction is: $12,400
- For married couples filing jointly, the standard deduction is: $24,800
- For heads of households, the standard deduction is: $18,650
A simple example using the information above can be:
A single person who earns $40,000 a year can take the standard deduction and show the IRS that they only earn $27,600. Thus, making only $27,600 taxable income, instead of the entire $40,000.
Taking a standard deduction can save you a large amount of money every time you file your taxes. All you have to do first is know they exist!
#3. Max Out Retirement Accounts
Retirement accounts are another huge advantage you can take to minimize your taxable income. Depending on your situation, there are a number of options you can choose.
Keep in mind that you can take advantage of these but some are only under certain circumstances.
- Traditional IRA – IRA stands for Independent Retirement Account. This account is one in which you can contribute pre-tax dollars to invest for retirement. You can contribute a max of $6,000 (for the year 2020). By making contributions to your Traditional IRA, you minimize your taxable income by $6,000 annually, thus owing less on taxes.
- Traditional 401k – A traditional 401k is offered by your employer. It is a retirement account on which you can contribute an annual maximum of $19,500 (for the year 2020). Just like a traditional IRA, you contribute pre-tax dollars to this account. Reducing your taxable income as a result.
- Solo 401k – This is a 401k qualified retirement plan for self-employed people. They may not have any employees other than the business owner and their spouse. A solo 401k also has a maximum annual contribution limit of $19,500 (for the year 2020), just like a traditional 401k.
- 457b Plan – This plan is only offered to government employees and is very similar to the 401k with its annual contribution limits and its pre-tax contributions. The advantage of this plan is that you don’t need to wait until the age of 59.5 to make withdrawals. You can make withdrawals before that age and not get penalized for it.
- HSA Account – HSA stands for Health Savings Account. This account is one in which you can make (again) pre-tax contributions. You can contribute an annual maximum of $3,550 (for the year 2020). All withdrawals within this account are completely tax and penalty-free as long as you make withdrawals for qualified health expenses after the age of 65. One caveat is that you need to have a high-deductible health insurance plan to be able to qualify for this account.
With each of these accounts you have the opportunity of making contributions with pre-tax dollars. You have the option to contribute to more than one of these accounts per year depending on your circumstances.
When you contribute to these accounts, you reduce your total taxable income and legally save yourself a large sum of money that could’ve gone toward taxes.
Traditional IRAs are taxed on their gains when you make withdrawals, but if you take advantage of the Roth IRA Conversion Ladder you can have your pre-tax contributions completely tax free.
#4. Invest in Municipal Bonds
When you buy a bond, you are effectively lending money to an entity for a pre-determined time. The entity provides interest payments on your principal (the amount that you bought the bond for). After the maturity date of the bond is reached, the entity pays back your principal in full, assuming they didn’t default.
Bonds have a certain level of risk but are considered to be less risky than stocks. The more risky an entity, the greater the interest they will be paying on your principal, and vice versa.
If the entity you buy the bond from is not government-related, chances are that the interest payments on your principal will not be tax-free. Unless you make the investment within a tax-advantaged account. Otherwise, the bond will be prone to taxes; these bonds are usually corporate bonds.
Municipal Bonds are government bonds rather than corporate bonds. The interest payments they give are federally tax-free. However, they might be prone to state and local taxes depending on your state.
Municipal bonds tend to pay a lower interest rate on your principal because they, historically, posses a very low default rate. Their default rate is 0.1% compared to 2.28% for corporate bonds. Since they are a safer investment, they don’t usually pay as much interest as corporate bonds.
This is why you should always make sure that the tax you’re saving from municipal bonds compensates for that smaller return. As a bondholder, you should understand your tax-equivalent yield to ensure you’re getting the best deal for your bond. The higher your tax bracket, the higher your tax-equivalent yield.
A tax-equivalent yield is a pre-tax yield that a taxable bond must possess for its yield to equal that of a tax-free municipal bond. Before you invest in municipal bonds, make sure to understand your tax-equivalent yield to see if it’s worth it to invest in municipal bonds.
#5. Start Your Own Business
Starting your own business is one of the best options to legally avoid taxes. Not everyone is on board with starting a business but it is worth noting that owning one can put you in a big tax advantage.
By carefully following IRS guidelines, a business owner may be able to deduct part of their home expenses with the home-office deduction. Any utilities used for the business can also be deducted from your income.
There are a number of interesting deductions you can make when it comes to business ownership. Some of these deductions include, but are not limited to:
- Self-Employment Tax
- Vehicle Use
- Home Office
- Start-Up Costs
An individual business owner can also choose to run their business through something called an S-Corp. All the business income you make goes into the S-Corp, and all business expenses come out of the S-Corp. When you do this, the S-Corp becomes a hub of doing business. You are paid directly from the S-Corp into your own personal account.
Effectively, with an S-Corp, you become the “employee”, and the S-Corp becomes your “employer”. You get paid a base salary as an employee of the S-Corp and any money that’s leftover is paid to you in a form of a distribution.
These distributions are not subject to medicare or social security taxes. This can save you about 15.3% on taxes, according to irs.gov. The intricacies of running your business through an S-Corp are highly technical and you should consult a professional CPA to get started with this if you’re currently self-employed.
This leads me to my next point!
Make Sure To Hire A Good CPA or Tax Advisor
All the information provided here is to demonstrate that there are advantages that you can take as a taxpayer to avoid overpaying taxes. These are benefits that most people don’t take advantage of because they’re simply not aware of them. Due to their lack of knowledge, they end up paying more in taxes than they should or could at the end of the tax year.
After learning the information given here, your next move should be to consult a trusted licensed CPA or tax professional to ensure that, under your given circumstances, you are able to take all the advantages you can to legally reduce taxes.
I want to reemphasize that the CPA or tax advisory you choose should be well trusted. Make sure they have your best interest, ensure they go over all the details of how you can lower your taxes under your given circumstances.
While CPAs can be a great resource, some CPAs only care about getting the job done as quickly as possible with a client and don’t show the client all the options they have available. Sometimes they may not even know that the client has certain options available because the client doesn’t know about them and, as a result, never discusses them.
Discuss how you can take advantage of some (or all) of the tips given here. Do they apply to your individual circumstances? Can you take advantage of extra perks to reduce your taxes? If you can, take advantage of them ASAP! It will save you tremendously in the long run.
Let me know in the comments below if you think you think you can take advantage of some of these. I’d be glad to hear the options that helped you out today.