People commonly wait until taxes are almost due to think about ways to lower their taxes, but the best time to focus on your upcoming tax return is at the end of the calendar year.
While certain moves can be made up until Tax Day (typically April 15th plus maybe a day or two), many effective tax mitigation strategies must be employed before Auld Lang Syne is sung as the calendar turns to January 1st.
A lot can be done to lower taxes. Below, I’ll share more than ten ways you can lower your taxes. Most can be used by everyone including W-2 employees, a couple of them are specific to business owners, and some I don’t necessarily recommend, but are worth mentioning for the sake of being thorough.
Which will you employ before the clock strikes midnight on New Year’s Eve?
Top 10 Ways to Lower Your Taxes
#1: Max Out ALL Tax-Deferred Contributions Available
This may sound obvious, but if you’re not already contributing to the maximum allowed by the IRS in the various accounts that let you deduct tax-deferred contributions, this is where you need to start.
Now, it might make sense to make Roth contributions in some instances. It’s not always about making your taxes as low as possible, but about optimizing your tax situation. I’ve detailed my thought process behind making traditional versus Roth contributions. In general, the more money you make, the more it makes sense to defer the tax, but there is some nuance to that decision.
You might be able to invest in a 401(k) or 403(b). You may also have a 457(b) option; the governmental variety is a better 457, but it often makes sense to invest in a non-governmental 457(b) when it’s offered.
Maybe a SIMPLE IRA is what your employer offers. Or you’re self-employed and have started a SEP-IRA. Put as much money as you can in them, and if you’re using a SEP-IRA, ask yourself why you’re not using an individual 401(k) instead.
Finally, don’t forget to max out a Health Savings Account (HSA) if you have one available. It’s a “triple tax free” account when used to cover health care expenses.
#2: Maximize Itemized Deductions
Something in the neighborhood of 90% of taxpayers do not itemize deductions, taking the standard deduction instead. In 2021, it will take $25,100 in itemized deductions to match the standard deduction for those married filing jointly.
If you’re single, the standard deduction is half that, at $12,550 in 2021. Oddly, both married and single filers are limited to the “SALT limitation” that only allows you to deduct a total of $10,000 in combined State And Local Taxes — think state, county, and city income taxes plus property taxes.
Assuming you have at least $10,000 in SALT (as most high-earners do) and $10,000 in mortgage interest, you only need about another $5,000 in itemized deductions to eclipse the standard deduction if married, and you’re well above it if filing single.
There are some miscellaneous deductions if you have high medical bills or other rare events, but for most of us, the remainder of our itemized deductions will come from charitable giving.
There are a few ways to increase how much you deduct in the form of charitable giving.
You can clean house. Go through your closets, garage, and storage areas to decide what you’re willing to part with. Donate anything of value and assign it a resale value, taking a deduction for the grand total.
You can also donate cash directly to charity. Normally, you can deduct cash donations equaling half of your adjusted gross income (AGI) but in 2020, you can deduct 100% when giving cash.
Third, and this is my favorite method, start a donor advised fund. You can donate appreciated assets, take the deduction in the tax year you part with the asset(s) and make grants from the fund over the remainder of your life, if you wish.
Using a donor advised fund is especially smart if you normally donate just enough to exceed the standard deduction. Instead, make five years’ of donations at once and much more of your donated dollars will result in a tax deduction for you.
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#3: Tax Loss Harvest
Do you have stocks, mutual funds, or ETFs with losses?
You can lower your taxes by selling the losers, and ideally replacing them with something similar but not identical. The capital loss will be applied against any realized capital gains first and then will allow you to deduct up to $3,000 against ordinary income every year.
If you take more losses than you can deduct, the unused capital losses will be carried forward to be used on future tax returns.
It’s a clever strategy, and if done right, can save most taxpayers a minimum of $1,000 to $1,500 a year, and potentially tens of thousands of dollars in capital gains taxes.
For important details, including avoiding wash sales and step-by-step instructions, refer to the following articles.
- Tax Loss Harvesting with Vanguard: A Step by Step Guide
- Tax Loss Harvesting with Fidelity: A Step by Step Guide
- Top 5 Tax Loss Harvesting Tips
#4: Understand the Sec 199A QBI Deduction
In 2020, I should be able to deduct 20% of my “qualified business income,” a complex calculation that varies depending on the type of business one has and how much taxable income one will be reporting.
That deduction, which in my case should be about $64,000 in 2020, will save me about $18,000 in state and local income taxes.
If you are an independent contractor or any kind of small business owner, it’s imperative that you understand how this deduction applies to your situation specifically. If not, you could make a costly mistake.
One error that I often see is the assumption that forming an S Corporation or simply filing as an S Corp will help save on taxes. In some cases, this is true, but if your taxable income is under the QBI deduction phaseout range (the start of the 32% income tax bracket — $329,851 and up in 2021), you’re probably better off without the S Corp.
Why? With the S Corp, you can avoid paying the 2.9% on the portion of income that you take as a distribution, but you’ll be limiting your much more valuable 20% QBI deduction, which will be based on the lower of either 20% of the distribution or 50% of the W-2 wage you pay yourself. This concept is explained more completely by The Tax Adviser.
Yes, it’s complicated, which is why I use an amazing spreadsheet to figure out what’s optimal for my business. More on that later.
For additional hints and tips, see 10 Things You Should Know About the 20% QBI Deduction (Section 199A).
#5: Qualified Opportunity Zone Investments
If you’ve realized significant capital gains by selling an asset for well above what you paid for it, you can postpone the tax due for years and have a portion of it forgiven by making an investment in one (or more) of thousands of qualified opportunity zones (QOZ) throughout the United States.
If you invest the gains within 180 days of realizing them into a QOZ investment, usually a real estate investment, your capital gains taxes due will be deferred until the end of 2026.
Second, your capital gains tax due will be reduced by 10% if you hold onto the QOZ investment for at least five years and 15% if you hold on for at least seven years.
Finally, the new investment you made in the QOZ will not incur capital gains if held at least ten years. You will have paid 85% of the original tax due, but you won’t owe additional taxes for the gains that arise from the QOZ investment.
You can find individual projects to invest in or you can invest in a fund that will hold a variety of opportunity zone investments.
Bonus: If your realized gains came from a real estate transaction, you have another option, the 1031 exchange. It’s another way of deferring the capital gains tax due, perhaps indefinitely, if you hold the next investment (or the one after that or the one after that, etc…) until death.
#6: Bonus Depreciation
Depreciation is another option for real estate investors. The Tax Cuts and Jobs Act temporarily brought back bonus depreciation. This benefit is scheduled to be phased out by 20% per year from the years 2023 to 2026. After that, you’ll still be able to depreciate your properties at a rate of a few percent per year.
For tax years 2018 through 2022, real estate investors have been able to have a cost segregation study done on their properties to determine which elements of the building(s) are “dedicated, decorative, or removable.” 100% of the tally can be fully depreciated and deducted in the year the investment is made.
Based on examples I’m familiar with, roughly 20% to 25% of the building’s purchase price may qualify for the full 100% bonus depreciation. If you’re putting 20% to 25% down on the property, that means that the value of your entire investment amount can qualify.
Normally, for high-income earners, depreciation can only be used to offset things like rental and other passive gains (and not dividend income from stocks) but if you or a spouse spend enough time on real estate as a business, the passive losses from depreciation can be used to offset active earned income.
Achieving real estate professional status (REPS) by virtue of spending at least 750 hours on your real estate business and not spending a greater amount of time on a different profession is a great way to take advantage of depreciation.
You don’t need to obtain a real estate license to do so, and a common strategy for married couples is to have one spouse obtain REPS while the other has a high-paying job. This is what our friends at Semi-Retired MD have done.
#7: Incur Business Expenses (Own a Business)
As a business owner, you owe taxes on the business profits rather than the total revenue. Those earning on a 1099 (or K-1 in the case of a partnership) will tell you that they have quite a few more tax deductions than they might have had in a previous life as a W-2 employee.
If you happen to be reading this towards the end of the calendar year, there may be some expenses that you could incur now or a few weeks from now. Spend that money in this calendar year, and you’ll have lower profits to report, and thus lower taxes to pay on your upcoming tax return.
Note that this benefit isn’t really a way to run a more profitable business. People who don’t seem to understand profit and loss statements tend to throw around “it’s a write-off for them” as if it costs a business nothing to spend money on certain things.
I could buy a new $1,000 laptop tomorrow for Physician on FIRE and fully depreciate it immediately, lowering my taxes by about $300, assuming a combined federal and state marginal income tax rate of 30%. The net result would be a business that’s $700 less profitable this year. The “write off” isn’t a magic way to create money where none existed.
Still, if you have upcoming expenditures, you’ll see the tax benefit of December purchases 12 months sooner than expenses you postpone until January.
#8: Invest with Tax-Efficiency In Mind
When it comes to tax savings, it’s not just what you own, but where you own it. Intelligent asset location matters.
A tax-advantaged account is any account that doesn’t tax earnings. Your IRA, 401(k), 403(b), 457(b), HAS, etc… Roth accounts have the added bonus of tax-free withdrawals (as does the HSA when used for eligible healthcare expenses).
These accounts are the ideal place for investments that would normally spin off taxable income in the form of distributions or dividends. Debt-based real estate investments that pay interest, REITS, and high-interest stocks fit the bill. Investments that you anticipate could generate sky-high returns are ideally held in a Roth account.
Your “taxable accounts” are any investments you hold outside of tax-advantaged accounts, including in a regular (non-qualified) taxable brokerage account and any other investment like real estate, private equity, etc… when made outside of a tax-advantaged account.
Stocks and funds with no or low dividends make sense in taxable accounts, as do real estate investments on the equity side that often pass through the depreciation benefits to investors. It is possible to invest tax-efficiently in a “taxable account” if you do it right.
I always thought that international funds were most tax-efficient in taxable accounts due to the foreign income tax credit, but my analysis of the funds I own has challenged that view. The foreign tax credit is more or less nullified by the tax-inefficiency created by a mix of ordinary and qualified dividends.
#9: Upstream Gifting
This one is complex and is best accomplished with the use of a trust or trusts. It’s a sneaky (and potentially risky) way of increasing the cost basis of highly-appreciated investments.
Essentially, you give some assets with a low cost basis that have increased significantly in value to an irrevocable trust that lists an elderly family member or trusted family friend as the beneficiary.
When the beneficiary passes away, you inherit the assets of the trust, and those assets undergo a step up in cost basis to the current market value.
Upstream gifting for this purpose seems like a loophole that ought to be closed, and if the step up in cost basis upon death is written out of the tax code (as proposed), it will be.
Nevertheless, this is a tax-lowering maneuver that I’ve seen discussed in the Millionaire Money Mentors group, and it may be of interest to some high net worth individuals.
#10: Conservation Easement / Captive Insurance / Oil and Gas Partnerships
I bundle these last few together, and I’m sure there are a few more tax plays, like many forms of cash-value life insurance, that could be lumped in with them.
The benefits of these setups are usually touted the loudest by those who profit the most from placing people in them. That doesn’t mean that they’re inherently bad, but it can be hard to find objective information about the usefulness of these tax-reduction schemes.
The White Coat Investor gave an informative overview of conservation easements. Basically, you (and co-investors) purchase some wilderness land at what presumably are fair market rates, donate the land to a conservation group, and take a deduction for the assessed value of the land.
For this to work out in your favor, the assessed value has to be at least double to triple the actual purchase price, and it’s often far higher. This can only be true if you found the deal of the lifetime in an exceedingly inefficient market or if the assessor is prescribing a highly-inflated value to the property.
Captive Insurance is a way for a business to self-insure in a tax-effective manner. It’s also an area that seems to straddle the line between tax avoidance and tax evasion, depending on how it’s set up.
Oil and gas partnerships have legitimate tax benefits, but no amount of tax benefit makes up for a well that runs dry. Some have done amazingly well in the oil industry, but many investors in these oil and gas partnerships have come to regret their investment.
I would also note that the demand for gas and oil is waning in the developed world as the focus shifts to renewable energy sources. I would not be shocked to see tax benefits associated with oil and gas legislated away.
Bonus #1: Retire!
While it may not be the solution you’re looking for at this point in your life, there’s no better way to drop several tax brackets than to start earning less. Want to go from a 37% marginal tax bracket this year to the 12% bracket next year? Retire early.
Depending on how your portfolio is structured and how early you retire, you may be able to engineer zero federal tax liability even with a six-figure annual spend.
If the bulk of your retirement assets are in tax-deferred accounts, you will likely generate some taxes each year, but you can probably find a way to stay in the 0% bracket for qualified dividends and long-term capital gains.
Bonus #2: Move to a Low or No Tax State
Again, moving across state lines may not be in the cards right now, but the tax arbitrage between living in a state with high income tax to one with no state income tax can be huge.
I went the opposite way once in my career, moving from South Dakota to Minnesota. That decision cost me about $30,000 per year until I retired about six years later. It adds up!
While state income taxes can, in some situations, be deductible on your federal tax return, that never really benefitted me. Prior to 2018 and the Tax Cuts and Jobs Act, I paid the alternative minimum tax (AMT) each year, so I didn’t get the state income tax deduction.
Now I no longer pay the AMT, but there is a new $10,000 limit for deductions of state, local, and property taxes combined. A few states have created workarounds for business owners, but most of us are stuck with this $10,000 deduction limit.
The tax-savvy play is to live in a place where you can get the best of both worlds. Karsten Jaske moved to Vancouver, WA from California when he retired. Now, he pays no state income tax, and he can shop a few miles away in Portland, Oregon and pay no sales tax.
You could take this concept one step further and move to a different nation with low or no income tax. Since the U.S. will tax your worldwide income regardless of where you’re living, to take full advantage of the arbitrage opportunity, you’d have to denounce your U.S. citizenship.
That last step is not something I would consider, but the Nomad Capitalist has done it, and he teaches people all about worldwide tax arbitrage opportunities.
Bonus #3: The Backdoor Roth
This move, common among high-income professionals is a way for anyone with earned income, no matter how high, to contribute to a Roth IRA.
It won’t save you much in taxes now, maybe $20 to $40 in the first year that you do it, but it can add up to hundreds of thousands of dollars if you make this maneuver annually for decades.
You can’t do this successfully if you have tax-deferred dollars in an IRA (a 401(k) is fine), and it’s not the panacea some make it out to be, but I feel this list would be incomplete without any mention of the Backdoor Roth. I do this for my wife and for me every year, and I document the process with Vanguard step by step.
Final Bonus: Run Tax Scenarios Before The Year Ends
After spending countless hours trying to come up with a spreadsheet of my own, I realized there were too many moving parts to the tax code to figure it all out in one sheet.
Thankfully, someone else spent thousands of hours coming up with a comprehensive spreadsheet that could make all the calculations I wanted to see.
Now, with this tool, I can run scenarios showing how end-of-year Roth conversions or charitable giving might affect my Section 199A QBI deduction, child tax credit, marginal tax bracket, and more. With a QBI deduction worth $18,000, a child tax credit worth $4,000 and tens of thousands in donations, it’s enlightening to see how these all interact.
If you want to optimize your tax situation, I highly recommend CPA Kathryn Hanna’s personal finance bundle. It has saved me a ton of time and money.
For simple tax situations, try running some scenarios through the free online TaxCaster from Intuit.
What are your favorite tax-saving strategies?