Understanding the tax credits and deductions that you're eligible for and calculating them correctly can mean the difference between owing the Internal Revenue Service (IRS) money at tax time or receiving a welcome refund. You can minimize your tax liability by increasing retirement contributions, taking part in employer-sponsored plans, profiting from losses, and donating to charities.
Key Takeaways
- The key to minimizing your tax liability is reducing the amount of your gross income that's subject to taxation.
- Increasing your retirement contributions can reduce your gross taxable income.
- Putting pre-tax dollars into an employer-sponsored retirement plan like a 401(k) is another easy way to reduce your taxable income for the year.
- You may be able to use the loss to offset other income if you sell an investment that's losing its value.
- Donating to charity can decrease your annual tax bill if you itemize your deductions.
Increase Your Retirement Contributions
The income tax you pay each year is based on your gross income, which is the total amount of money you earn from all sources before accounting for any tax credits or deductions. One of the easiest ways to reduce that figure is by contributing to an employer-sponsored retirement plan or a traditional individual retirement account (IRA).
The age restriction for contributing to a traditional IRA was lifted following the passage of the Setting Every Community Up for Retirement Enhancement Act (SECURE) of 2019. You weren't able to contribute after age 70½ before the passage of the SECURE Act. Taxpayers can now contribute to IRA accounts indefinitely.
Individuals were required to take required minimum distributions (RMDs) from their 401(k) and traditional IRA accounts at the age of 72 under the SECURE Act. That was raised from age 70½ for those who reached that age on or before Dec. 31, 2019.
The age for RMDs increased again when the SECURE Act 2.0 was passed in December 2022. Anyone who turned 73 on or after Jan. 1, 2023 had to begin taking these withdrawals from their accounts by April 1 of the following year.
Employer plans such as a 401(k) or a 403(b) allow you to contribute pre-tax dollars to your account up to a certain maximum. The maximum amount you could contribute was $22,500 for 2023, increasing to $23,000 in 2024. Anyone over the age of 50 can kick in an additional $7,500 as a catch-up contribution in 2023 and 2024.
The change to taking distributions from your retirement account can impact your taxes when you start withdrawing funds, depending on your tax bracket.
Contribute to Traditional Plans
Contributions to traditional 401(k) or 403(b) plans are made through regular paycheck withholdings and offer a direct dollar-for-dollar reduction to total taxable income. Other versions of these plans, the Roth 401(k) or Roth 403(b), don't provide any upfront tax benefit but they do allow tax-free withdrawals later on.
You might consider a traditional IRA instead if an employer-sponsored plan isn't available to you. You can make contributions with pre-tax dollars, resulting in a direct reduction to your taxable income in the year you make them and ultimately to your total tax liability.
Your contributions couldn't exceed $6,500 in 2023 but this increases to $7,000 total in 2024, with an additional $1,000 allowed for those who are age 50 and above. There's also the option of a Roth IRA without any immediate tax benefit.
Profit From Investment Losses
Selling off investments that have declined in value since you purchased them can also help you reduce your tax liability for the year. This strategy is often referred to as tax-loss harvesting. These investment losses can be written off against your investment gains or other income up to a certain limit each year. The Internal Revenue Service (IRS) sets this limit to $3,000 or $1,500 if you're married and filing separately as of January 2024.
Any losses that you can't take advantage of in the current year can be carried forward to future years, reducing your taxes then. Conversely, it can be beneficial to delay selling an appreciated asset and avoid being taxed on your gain, especially in a year when your taxable income is already high.
It's often a good idea and well worth the money to consult a CPA or other knowledgeable tax pro for more information about these and other strategies for reducing your tax bill,
Donate to Charity
Making contributions to qualified charitable organizations can also reduce your taxes but only if you itemize deductions on your tax return and don't take the standard deduction. Contributions can be in the form of cash or goods, such as used household items, but any donation that has a value exceeding $250 requires a receipt.
You can take a deduction of up to 60% of your adjusted gross income (AGI) for qualifying cash donations if you itemize as long as your contributions are made to qualified charities.
What Is a Tax Liability?
A tax liability is the total amount of money you owe to a government. The most common types are sales taxes paid to businesses and governments, property taxes, local taxes, state taxes, and federal taxes.
The most commonly talked about tax liability is owed to the IRS each year. Your tax liability is the amount of money you owe after any tax credits, deductions, exceptions, and exclusions are accounted for and subtracted from your gross income.
What Steps Can I Take to Reduce My Tax Liability?
Your tax liability is a tax bill. You may owe taxes to the IRS if you earn income but there are certain steps you can take to minimize the amount of tax you owe on your earnings at the end of the year. This includes saving money for retirement, taking part in employer-sponsored retirement plans, and using tax-loss harvesting as a strategy. You can also use the deduction for charitable donations to lower your tax bill if you itemize your deductions.
How Can a Business Minimize Its Annual Tax Bill?
Running a business comes with a tax liability but this bill can also be reduced with proper planning. Businesses can cut their tax bills by knowing and taking the right deductions, including travel expenses and wages. Applying tax credits to reduce the year's tax bill can also help.
Other steps that businesses can take include investing in equipment and personnel and making purchases of equipment, raw materials, and other important assets for the business at the right time. Company owners may want to consider talking to a tax professional to weigh their options.
The Bottom Line
There's a very good chance that you'll have to pay taxes if you have a source of income. Any money earned from an employer will certainly incur a tax bill. But no one wants to pay more taxes to the government than they have to, especially when economic times are tough.
There are a few ways you can reduce that tax bill. But if you feel that you're still going to end up owing a great deal and if you can afford to, you may want to consider increasing the amount of taxes that are withheld from each of your paychecks by your employer.
