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For each dollar you earn from your employer, you must pay a certain amount in taxes based on your level of income and where you live. However, there are many ways you can lower that overall income to minimize your tax bill — without taking a pay cut.
From diverting income to retirement accounts, to using your student loan interest to your advantage, to selling off some of your 'loser' stocks, Select details below five common ways to reduce your taxable income starting today.
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1. Enroll in an employee stock purchasing program
If you work for a publicly traded company, you may be eligible to enroll in an Employee Stock Purchase Plan (ESPP). By enrolling in your ESPP, you will divert after-tax dollars from your paycheck with the intent of purchasing shares of your company, and in many cases, you will be offered a discount (typically around 15%) on the stock price that is only available to employees.
You can choose how much after-tax dollars you want to contribute to your ESPP, which usually ranges between 1% to 10%. Keep in mind, however, the 2022 maximum contribution limit is $25,000 total per year.
The tax advantage of enrolling in an ESPP comes into play when you decide to sell your shares. While employees can choose to sell their shares immediately after purchase or at a later date, they're rewarded for holding onto their shares for at least one year from the purchase date. Selling immediately means you pay ordinary income tax, while selling later means you pay a lower long-term capital gains tax — therefore reducing your tax burden.
While it can be a good idea to take advantage of purchasing your employer's stock at a discount, while also benefitting from holding your shares over the long term, make sure 1) you have enough cash to contribute and 2) the investment fits into your overall financial plan. Certain financial goals, such as paying off high-interest debt, saving up an emergency fund and contributing to an IRA or 401(k) — and meeting any employer match — should first be met before participating in a stock plan.
2. Contribute to a 401(k) or traditional IRA
One of the easiest, and potentially most beneficial ways to reduce your taxable income, is to contribute to a pre-tax retirement account such as an employer-sponsored 401(k) or traditional IRA. With either of these tax-advantaged investment accounts, money from your paycheck (in the case of a 401(k)) or bank account (in the case of a traditional IRA) goes in before getting taxed.
With pre-tax contributions, you are also essentially taking out less from your disposable income now, which is better for your immediate cash flow. Your money grows tax-deferred, however, and later in retirement you will have to pay income tax on the funds you withdraw.
In 2022, the contribution limit for a 401(k) is $20,500, with an additional $6,500 available for those 50 and older. The annual contribution limit for IRAs is $6,000 (between traditional and Roth IRA accounts), with an additional $1,000 available for those 50 and older.
With a traditional IRA, your contributions may also be tax-deductible, depending on your income, tax filing status and whether or not you have a retirement plan through your employer.
"Many people are eligible to deduct their traditional IRA contributions, which can help reduce their tax liability," says Corbin Blackwell, a CFP at Betterment, a robo-advisor offering traditional, Roth and SEP IRAs. "Not all IRA contributions are tax deductible, however, so be sure to work with your tax preparer to understand your situation."
Basically, you cannot make a deduction if you (or your spouse, if married) have a retirement plan at work and your income is $78,000 or more as a single filer/head of household, $129,000 or more as married filing jointly/qualifying widow(er) or $10,000 or more as married filing separately. If you (and your spouse, if married) do not have a retirement plan at work, you can make a full deduction up to the amount of your contribution limit.
3. Contribute to a Health Savings Account
A Health Savings Account (HSA) is a medical savings account designed for taxpayers with a high-deductible health plan (HDHP) to save for upcoming health care expenses.
This account is known by some as the 'triple tax advantage' as funds go in tax-free (or tax-deductible if you opened your own account), can grow tax-free by investing the balance and be withdrawn tax-free at any time if used for qualifying medical expenses — things like deductibles, copays and coinsurance. These three tax advantages each help reduce your tax burden. Plus, your HSA balance, if not entirely used, will roll over from year to year.
Some employers offer an HSA benefit to their employees, while others may need to open their own HSA away from their place of employment. If your employer does sponsor an HSA plan, see if it contributes a set amount or matches employee contributions. Keep in mind, however, that any employer contributions count toward the IRS' maximum annual limits.
The limits of pre-tax funds contributed to an HSA for 2022 are $3,650 for a single person and $7,300 for a family, plus an additional $1,000 if you're 55 or older.
4. Deduct the student loan interest you've paid
While student loans can be a burden, the interest you've paid can be a simple deduction on your taxable income. For 2022, if your modified adjusted gross income (MAGI) is less than $70,000, or $145,000 filing jointly, you can deduct up to $2,500. If you earn above that to certain cut-offs, you can deduct a pro-rated amount. The cut-offs for claiming a deduction are above $85,000 for single taxpayers and above $175,000 for joint filers.
If you have federal student loans, payments have been frozen and all interest has stopped accruing for the past roughly two years. However, federal student loan repayment is anticipated to resume May 1. So, if you pay student loan interest this year and you meet the income and tax filing qualifications, you will be able to deduct them against your taxable income come 2023.
5. Sell your losing stocks
It's normal to have stocks in your portfolio that may not be performing well. The good news is that a popular investment strategy called tax-loss harvesting can help you use a market downturn to your advantage.
Tax-loss harvesting essentially means using your investment losses to offset the taxes you would pay on other investment gains, otherwise lowering your taxable income.
Amanda Gutierrez, a CFP and financial planning consultant at eMoney Advisor, suggests investors look into tax-loss harvesting: "Investors can sell losing stocks and realize capital losses, which can be used to offset capital gains," she tells Select. "For those who have no capital gains, those losses can offset up to $3,000 of ordinary income. Any excess losses can carry over to future years and be used to lower taxes."
While you can certainly implement tax-loss harvesting on your own, it's easy to do through robo-advisor services like Betterment, Wealthfront or Charles Schwab, which each automatically look for opportunities to harvest losses regularly, reducing investors' tax exposure throughout the year.
Robo-advisors provide a simple way to get started investing, but we suggest talking to your financial advisor about what they recommend as the best tax-harvest strategy for you.
And, come tax time when you've harvested investing losses, use tax software like TurboTax or H&R Block to make it easier to correctly input and claim those losses on your taxes, which will hopefully reduce your overall tax bill.
The common theme here for reducing your taxable income is to invest your money. Investing can significantly defer and even reduce your tax liability in some cases. And by investing, you're allowing your money to grow and compound over time.