Tax Planning Strategies To Lower Your Tax Bill

If you've earned income in a year, you'll probably be expected to pay tax on it. Smart tax planning can help you save money by reducing the amount of tax you owe. The first step is to understand how tax brackets work. Then, based on your income and tax bracket, consider different tax planning strategies such as taking deductions, investing in tax-deferred accounts or even claiming losses to offset capital gains.

How Tax Brackets Work

Your income tax rate primarily depends on two factors—your income and filing status. Income tax is a progressive tax, which means the tax rate increases as your income increases. Income limits for tax rates also change depending on where you're a single filer, married filing jointly or married filing separately or a head of household filer.

2022 Tax Brackets For Single Filers

For single filers in 2022, every dollar of taxable income between 0 and $10,275 is taxed at a 10% rate.
Every dollar between $10,275 and $41,775 is taxed at 12%, and so on. Here is what the tax liability looks like:

2022 Tax Brackets For Married Filing Jointly

Taxpayers who are married and filing joint returns have different income brackets for tax rates. Here's what their tax liability looks like:

Why Do You Need Tax Planning Strategies?

Once you've figured out what portion of your income is taxable and what tax bracket you fall into, you will get a pretty good estimate of how much you owe in taxes for the year. Not paying taxes is not an option as IRS imposes strict penalties for tax evasion. However, there are legal ways to reduce your tax bill by employing strategies that can reduce your taxable income or even defer taxes to paid at a later date.

Strategies For Taxable Income Over $85k Married, $42k Single

Taxpayers can find ways to drain income from the top tax brackets in order to lower their tax bill. Here are some ways to shift income to a lower bracket:

Asset Location

Asset location or rearranging your investments to reduce taxable income is a good strategy to reduce taxable income. You want investments that generate interest income to be held inside retirement accounts, and investments that generate capital gains and qualified dividends to be held outside of retirement accounts.

Deductible Retirement Plan Contributions

For high-income earners, deductible contributions to retirement plans makes great sense if you fall in the 32% or 35% tax bracket. Why? Most likely when you retire and begin taking withdrawals, your tax bracket will be lower, in the 12% to 24% range. If you can deduct money today at 35%, and pay tax later at 12%, that results in big savings.

Maximize Retirement Plan Contributions

Each year the IRS announces the new contribution limits for 401(k)s, IRAs, and other retirement plans. Be sure to adjust your payroll contributions to put the maximum amount into your plans. In 2022 and 2023, for example, the 401(k) contribution limit is $20,500 and $22,500, respectively.

Tax-Loss Harvesting

When you sell your investments for a profit, you are liable to pay capital gains tax on that profit. One way to minimize that liability is to deliberately sell other investments for a loss, using a strategy called tax-loss harvesting.

If your capital loss exceeds your capital gain, individuals can claim a capital loss deduction up to $3,000 ($1,500 for married filing jointly). If your net capital loss is greater than $3,000, you can carryover that loss to offset capital gains in future years as well.

Strategies For Taxable Income Below $85k Married, $42k Single

Falling in the lower tax brackets based on your income can change the way you approach tax planning. Here's are some strategies that married filers with less than $85,000, and individual filers with less than $42,000 in income can adopt.

Use low-income years to fund tax-free Roth accounts

Perhaps you should not contribute to a deductible retirement account. Instead, fund a Roth IRA, or make Roth contributions to your 401(k) plan. In years where your taxable income will be low, Roth IRA or Roth 401(k) contributions make sense.

For example, a real estate agent routinely made annual tax-deductible contributions to her 401(k) plan. At the end of a slow year, she looked at her tax situation and realized she would be in a low tax bracket that year. It made no sense for her to make a deductible contribution in order to save 10% in taxes now, only to make withdrawals 10 years from now, and pay tax at a projected 12% rate then. So she contributed to a Roth IRA instead of making deductible contributions to her 401(k) plan.

Take IRA Withdrawals

For those age 59½ or older, you might consider taking IRA withdrawals during low-income years, even if you are not required to. Here's why this can work. After adding up itemized deductions, such as mortgage interest and health care expenses, some retirees have more deductions than income. In years where this occurs, this can be a great opportunity to withdraw funds from retirement accounts and pay tax at only the 12% or 22% rate.

Instead, many retirees follow conventional wisdom and let tax-deferred accounts grow until they are forced to take required minimum distributions (RMDs) for the year in which you turn age 72 (70 ½ if you reach 70 ½ before January 1, 2020). If you wait until age 72, the RMD may be large enough that the extra income then shifts you into a different tax bracket.

By taking withdrawals in years where taxable income is low, you can potentially avoid paying an extra 10% to 15% tax on withdrawals later down the road.

Full or Partial Roth IRA Conversion

Consider converting your IRA account, or a portion of it, to a Roth IRA to maximize your tax savings in a year when your taxable income is low. Roth IRAs are funded with after-tax money and offers tax-free withdrawals if certain conditions are met. Traditional IRAs are funded with pre-tax money but the withdrawals are taxable.

Since your IRA funds are pre-tax, they will be taxed at ordinary income tax rates during the Roth conversion. If you time it right for a year that you have less than usual taxable income, you may be able to save some tax dollars.

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