How to lower taxes is one of the most common financial planning concerns among individuals and business owners. The increased standard deductions under the Tax Cuts and Jobs Act (TCJA) provided tax savings for many (even though the TCJA did eliminate many other itemized deductions and personal exemptions). Taxable income can be reduced further with a few strategic steps, which we outline below.
Key Takeaways
- An effective way to reduce taxable income is to contribute to a retirement account through an employer-sponsored plan or an individual retirement account.
- Both health spending accounts and flexible spending accounts help reduce taxable income during the years in which contributions are made.
- A lengthy list of deductions remains available to lower taxable income for full- or part-time self-employed taxpayers.
- Saving for retirement can help lower your taxable income.
- Some employers offer flexible spending plans, so ask your employer about them.
Save for Retirement
One of the most straightforward ways to reduce taxable income is to maximize retirement savings. Although there are many types of retirement savings accounts to choose from, below are two of the most common that can help reduce taxable income in the tax year in which a contribution is made.
Employer-Sponsored Plans
Those whose company offers an employer-sponsored plan, such as a 401(k) or 403(b), can make pretax contributions up to a maximum of $22,500 in 2023 ($23,000 in 2024). Those 50 and older can make catch-up contributions of $7,500 in 2023 and 2024 above the regular pretax contribution limit.
Because contributions are made pretax through paycheck deferrals, the money saved in an employer-sponsored retirement account directly lowers taxable income. In other words, the contributions reduce an employee's income for that tax year before income taxes are applied.
Individual Retirement Accounts (IRAs)
Individuals can also save by contributing to a traditional individual retirement account (IRA). The annual contribution amount to an IRA for the 2023 tax year is $6,500 ($7,000 in 2024). The catch-up provision allows an additional $1,000 to be contributed by those 50 and older in both 2023 and 2024.
Traditional IRA contributions can be deducted from a person's tax return, reducing the taxes owed in the tax year of the contribution. However, unlike contributions to an employer-sponsored plan, IRA contributions are made with after-tax dollars, meaning the money has already had income taxes taken out.
Taxpayers (or their spouses) who have employer-sponsored retirement plans may also be able to deduct some or all of their traditional IRA contributions from taxable income. The IRS has detailed rules about whether—and how much—they can deduct depending on their income.
The maximum age for contributions changed because of new laws. For 2019 and years prior, taxpayers over the age of 70½ could not contribute to a traditional IRA. As of 2020, the age limit no longer applies. Taxpayers beyond the age of 70½ can contribute the maximum per year and receive the full tax benefit.
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Consider Flexible Spending Plans
Some employers offer flexible spending plans that allow money to be socked away pretax for expenses such as medical expenses.
A flexible spending account (FSA) provides a way to reduce taxable income by setting aside a portion of earnings in a separate account managed by an employer. An employee can contribute up to $3,050 in 2023 ($3,200 in 2024).
Under the use-or-lose provision, participating employees have to incur eligible expenses by the end of the plan year or forfeit unspent amounts. Under a special rule, employers may offer participating employees more time through either a carryover option or a grace period.
Under the carryover option, an employee can carry over up to $610 of unused funds to the following plan year in 2023 ($640 in 2024). Under the grace period option, an employee has until 2.5 months after the end of the plan year to use the remaining money, but none can be carried over. Employers can offer either option, but not both, or none at all.
Health Savings Account (HSA)
A health savings account (HSA) is similar to an FSA in that it allows pretax contributions to be used for healthcare costs later. HSAs are only available to employees with high-deductible health insurance plans.
Minimum Annual Deductible
According to the Internal Revenue Service (IRS), for 2023, a "high deductible health plan" has a minimum annual deductible of $1,500 ($1,600 in 2024) for self-only coverage or $3,000 ($3,200 in 2024) for family coverage.
- Annual Contribution Limit: The 2023 annual contribution limit is $3,850 ($4,150 in 2024) for individuals and $7,750 ($8,300 in 2024) for families.
- Maximum Annual Out-of-Pocket Expenses: Under a high-deductible plan, 2023 annual out-of-pocket expenses, which include deductibles, and co-payments (not premiums), cannot exceed $7,500 ($8,050 in 2024) for self-only coverage and $15,000 ($16,100 in 2024) for family coverage. HSA contributions can be rolled over if unused in the year they were saved.
Both HSAs and FSAs provide for a reduction in tax bills during the years in which contributions are made.
Take Business Deductions
A lengthy list of deductions remains available to lower taxable income for full- or part-time self-employed taxpayers.
Home Office Deduction
A home office deduction, for instance, is calculated using either a simplified or regular method to reduce taxable income if a portion of a home is used as dedicated office space. The self-employed can also deduct a portion of their self-employment tax and the cost of health insurance, among other expenses, to lower taxable income.
Business Expenses
Business owners or those with professional, deductible expenses can make upcoming necessary purchases or expenditures by the end of the tax year. This can make a significant difference for those buying a substantial item for which the purchase price can be put on business expenses.
Retirement Savings Plans
A variety of retirement savings plans exist for the self-employed, including an individual 401(k) and a simplified employee pension (SEP) IRA. Both options provide an opportunity to lower taxable income through pre-tax contributions and allow for higher limits on contributions each year.
The SIMPLE IRA allows contributions of up to $15,500 in 2023 ($16,000 in 2024), plus an additional $3,500 for those age 50 and older in both 2023 and 2024. The Solo 401(k) allows contributions of up to $22,500 tax-free in 2023 ($23,000 in 2024). The SEP-IRA allows tax-deductible contributions of up to 25% of compensation, up to $66,000 in 2023 ($69,000 in 2024).
The SECURE Act
The SECURE Act has implications for small business owners. The Act encourages business owners to set up retirement plans for employees by providing tax incentives if they collaborate with other small businesses to offer Multiple Employer Plans (MEPs).
The SECURE Act also allows more part-timers to save through employer-sponsored retirement plans. To do so, workers will need to put in at least 500 hours a year for three consecutive years to be eligible.
How Can I Reduce My Taxable Income Legally?
Reducing taxable income legally can be achieved in many ways. For example, you could
- Fund or increase your funding into retirement accounts (e.g., employer-sponsored 401(k) plans and Individual Retirement Accounts)
- Contribute to flexible spending plans and health savings accounts
- Take available business deductions, such as home office expenses, supplies, and advertising.
Does Lowering Taxable Income Increase Your Refund?
Lowering taxable income will often reduce what you owe in taxes. This reduction could result in a refund or simply reduce what you owe.
Can You Still Claim Personal Allowances on Your W-4?
The IRS no longer uses withholding allowances on Form W-4. This change was "meant to increase transparency, simplicity, and accuracy of the form." Tax allowances reduce the amount of money withheld for taxes from a person's pay. The more allowances that a worker claimed, the less amount of money was withheld. For instance, an allowance of 0 resulted in the most taxes withheld from pay.
The Bottom Line
Tax reform eliminated many itemized deductions for most taxpayers, but there are still ways to save for the future and trim their current tax bill. To learn more about deductions and tax savings, consult a tax expert.
