Reducing Your Taxable Income: The Fundamentals

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Reducing Your Taxable Income: The Fundamentals

Everyone’s situation is different, and experts caution against making tax considerations the predominant factor in your financial decision-making process. That said, there are a number of strategies and some basic information that you should be familiar with as you formulate a tax plan with your advisors.

Your investments

First, regarding your investments, recognize that there are many sound assets that will increase your wealth over the long haul, but which produce little or no current income. Raw land or rental real estate that barely breaks even on a cash flow basis both can offer significant long-term appreciation in value. The same is true of buy-and-hold growth stocks whose value you expect to increase over time, but which pay scant or no dividends. The same is true of good old US savings bonds. You can defer federal income taxes on your earnings (except for Series HH bonds) if you wait until the bond reaches final maturity or you cash it in. Moreover, savings bonds are state and local income tax-free. Better yet, municipal bond interest is free from federal tax, and in most cases, free from tax in the state in which they are issued.

With any investment, it’s also usually wise to plan your eventual sale more than a year after your purchase, so that any gain is considered a long-term capital gain. As such, it will be taxed at a lower rate than will a short-term capital gain, which is taxed at your ordinary income rate.

Learn about deductions and credits

Another tax-planning approach is to reduce the part of your income that is subject to tax by taking full advantage of the many tax deductions and tax credits available to both businesses and individuals. Some of these are very narrowly focused, while others apply to a much broader group of taxpayers. Consulting with a tax-planning professional is the best way to learn which deductions and credits are available to you. The self-employed or small business owner, for example, may be able to take advantage of deductions for business meals and entertainment, automobile expenses, and business travel, among many others. Also, there is a new 20% deduction for pass-through business income. But there are always special rules that apply to these types of deductions, so again, the services of a tax professional can be invaluable.

For the moment, keep in mind the difference between a tax "credit" and a tax "deduction": A tax deduction reduces the amount of taxable income you have. A credit reduces the actual tax you owe, within limits, usually dollar for dollar (e.g., a one-dollar tax credit reduces your tax bill by one dollar). Sometimes, tax credits are refundable, which means you can get a check from the government if you owe no tax at all. Clearly, tax credits are more valuable than deductions.

Itemized deductions

The most common itemized deductions are mortgage interest, charitable contributions and state and local taxes. You should always take the higher of your standard deduction or your itemized deduction. For 2024, the standard deduction is $29,200 for married couples filing a joint return; $14,600 for singles; and $21,900 for head-of-household taxpayers. As of 2024, the mortgage interest deduction is limited to interest on acquisition indebtedness up to $750,000 (though grandfathering rules apply); and the state and local tax deduction, together with the property tax deduction, are limited to $10,000 ($5,000 for married taxpayers filing separately).

Nearly two out of three taxpayers, however, take the standard deduction—available to all—rather than itemizing. In other words, they find that the standard deduction is larger than the total of all itemized deductions they would be able to take; given the large increases in the standard deductions in 2018, this option may become attractive to even more filers. Thus, the standard deduction saves most people more on taxes.

Adjustments to income

You can also reduce your adjusted gross income through various adjustments to income. Adjustments are really a special class of deductions that you take on Schedule 1 of your Form 1040. They are traditionally called "above the line" deductions, and they reduce your adjusted gross income whether you choose to use the standard deduction or itemize your deductions.