There’s perhaps no expense more frustrating to business owners than income taxes – the amount of money you pay to the IRS. I receive more calls from business owners asking me how to minimize their tax bill than anything else. Therefore, I want to go over 20 different strategies, or ways, to reduce taxable income for the business owner.
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Lately, I’ve been writing a lot about personal finances for business owners. In particular, I’ve been talking about cash flow. Thus far, I’ve written many blogs about the income portion of cash flow. I’ve talked about how to pay yourself from your business, how to determine how much to pay yourself, how to hire your spouse, how to hire your children, etc. Now, it’s time to start shifting to the expense section of cash flow. I’ll start by giving you, a business owner, 20 ways to reduce your taxable income.
First, contributing to your traditional IRAs and 401(k)s can reduce your taxable income. In fact, your qualifying contributions are deducted from your Adjusted Gross Income.
As of 2019, you can put $19,000 per person into your 401(k) or $25,000 per person if you’re over the age of 50. That means that if you’re married, you can contribute a combined total of $38,000 or $50,000 depending on your ages. If you make $100,000 in income but contribute $38,000 or $50,000 to your 401(k), your taxable income drops from $100,000 to $62,000 or $50,000 respectively.
For IRAs in 2019, you can contribute up to $6,000 per person if you’re under the age of 50 or $7,000 per person if you’re over the age of 50. Thus, if you’re married, you can contribute a combined total of $12,000 or $14,000 depending on your ages. If you make $100,000 in income but contribute $12,000 or $14,000 to your pre-tax IRA, your taxable income drops from $100,000 to $88,000 or $86,000. Combine that with your maximum 401(k) contributions, and you’re lowering your taxable income by $50,000 or $36,000!
Not only do your contributions reduce your present tax bill, but they also help you save for your future. If you combine these pre-tax retirement account contributions with other investment strategies, you can solidify your income for life. Be sure to consult your CFP and tax advisor.
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The second thing you can do to reduce your taxable income is a strategy called tax loss harvesting. Basically, you’re trying to sell floundering, non-qualified investments at a loss to offset any gains you’ve had. By doing this, you could remove all of your gains from your investments and further reduce your taxable income up to $3,000 per year.
From October to December of 2018, the U.S. stock market and most of the markets around the world experienced a major fall. In that time period, many people were selling their positions at a loss. In other words, they may have bought a position that was trading at $20 a price point. However, it fell to $18. Thus, people sold at a loss of $2 and invested the money into a similar asset class, hoping their investments would rebound.
If done correctly, those investors could wipe out all the gains they had during the rest of the year. Additionally, they could generate $3,000 in losses that would wipe $3,000 off of their AGI on their tax returns. That may seem like a lot of work. However, let’s say you’re at a 50% tax bracket. If you lower your AGI by $3,000, that’s a $1,500 tax savings!
If you do not know how to do this or do not have the software capabilities, this is where you would hire a qualified CFP®.
When the Tax Cuts and Jobs Act passed in 2017, the federal standard tax deduction almost doubled in size. In 2017, the standard deduction for married filing jointly was $12,700, but in 2018, it increased to $24,000. In 2019, the deduction became $24,400. Thus, unless you have more tax-deductible expenses than that, it doesn’t do you any good to itemize your taxes.
This is where a strategy called tax bunching comes into play. Let’s say that you give $15,000 to charity annually. If you “bunch” that donation with your mortgage interest expenses, your property taxes, your sales taxes, and other deductible expenses, then you might be able to itemize your taxes. You might have more than $24,400 in taxable deductions.
Yet, what if you “bunched” two years worth of donations and expenses into one year? What if you gave $15,000 to charity throughout the year and gave another $15,000 to charity in December as your contribution for the next year? Then, property tax payments are usually due in February. What if you paid your 2019 tax payment in February, but you pre-paid your 2020 property tax in December of 2019? By “bunching” two years worth of payments into one year, you can maximize your Schedule A deductions and greatly exceed the standard deduction. Thus, one year, you would itemize your taxes, and the next year you would claim the standard tax deduction.
Another thing you can do to lower your tax bill is to purchase or keep your health insurance. I realize that the Affordable Care Act’s mandate was repealed in 2019. I get that. You no longer owe a fee on your federal taxes if you do not have health insurance. However, many states are potentially going to uphold the penalty for not having insurance the Obamacare mandate enforced. If you’re in a state that requires you to carry insurance and you don’t have the proper coverage, you can still have tax penalties imposed on you. Therefore, you need to check and make sure your health insurance coverage is up-to-date.
While we’re talking about health insurance, let’s talk about the HSA, a Health Savings Account. I love this investment vehicle. In fact, it’s the first place I tell my clients to place their money. Why? Well, it’s the only account that I’m aware of, to date, that you can make a deposit and get a tax reduction. Additionally, if you use the money for qualified purposes, the money comes out tax-free. I don’t know of any other accounts like that. Sure, 529 plans may provide tax benefits on a state-by-state basis, but for a federal tax reduction, the HSA is the best place to put your money.
A family can deposit $7,100 as long as you meet eligibility requirements for the HSA. Individuals can contribute up to $3,550 into their HSA accounts. Any contributions you make are a great way to reduce your taxable income. For example, if you contribute the maximum $7,100 to your family’s HSA and you’re in a 50% tax bracket, you can reduce your tax liabilities by $3,550. That’s a nice return on your investment into a tax-free account! It also benefits your life long-term.
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Perhaps you own a business or work for a business large enough to offer Flexible Spending Accounts or FSAs. Similar to HSAs, Flexible Spending Accounts are savings accounts which allow you to make pre-tax contributions and use the money for out-of-pocket medical expenses. Although the contributions you make to an FSA are not tax deductible, they reduce your taxable income because your contributions are made with pre-tax dollars.
In 2019, employees can defer up to $2,700 of their salaries into their Flexible Spending Accounts. Therefore, if your annual salary is $100,000 and you choose to contribute the maximum $2,700 into your FSA, your taxable income becomes $97,300. However, if you don’t spend all of the money within the calendar year, you risk forfeiting the money. That’s why I prefer an HSA, but FSAs can also be a way for you to reduce your taxable income.
Along with obtaining health insurance and opening an HSA or an FSA, keeping track of your yearly medical expenses could save you tax money. In 2019, if you have more deductions than the standard deduction ($12,200 for individuals or $24,400 for married filing jointly), then you are eligible to deduct your medical costs as long as they exceed 10% of your adjusted gross income.
Some years, you may not spend that much money on medical expenses. Yet, in other years you may incur significant, unanticipated medical bills. This is why keeping good records and keeping a budget is so important. If you use a good accounting app or software, the program will even isolate your medical expenses for you. If you keep track of the expenses and work with a good financial planner and accountant, you may be able to deduct those expenditures from your taxable income at the end of the year.
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While you’re tracking your medical expenses, be sure to track your income and other expenses throughout the year. If you’re using a good accounting app or software and you’re working with a good tax professional, you can monitor your budget and catch things as they happen. Maybe your income doubles. Talk to your planner immediately to see if you need to adjust and/or increase your taxable expenses to offset that gain. What if your revenue decreases? Again, you want to contact your planner immediately and adjust and/or lower your taxable expenses to offset that loss.
Why don’t you go to your CPA in May or June, after the craziness of tax season is over, and ask him or her to review your taxes from the previous year? How could you have reduced your taxes last year? Can you implement strategies this year to reduce your taxes before the end of the year? Do you have any unexpected expenses this year that you didn’t have last year? How will those expenses affect your taxable income? By keeping your budget up-to-date throughout the year and by reviewing last year’s budget, you can adjust your tax planning strategies quickly enough to reduce your taxable income by the end of the year.
So you’re keeping a budget, and you’re monitoring your income and expenses. You and your tax professional may decide that you need to change your income. Maybe you need to make adjustments to how you’re getting paid from your business. Instead of taking an owner’s draw, maybe you need to pay yourself W-2 income so that you’re paying taxes through your business weekly, monthly, or quarterly.
Along those same lines, deferring income or incurring expenses at the end of the calendar year may also help reduce your tax bill. For example, I know a contractor who could have finished a project the week after Christmas and collected payment in full for the job. However, by delaying the completion of the project until the first week in January, he didn’t receive payment until the following year. Thus, he was able to defer some of his income to the next year. Other clients of mine pay business bills a little bit early to reduce their taxable income. For instance, in December, you can go ahead and pay bills that are coming due in early January.
Although this strategy seems like a no-brainer, it’s not. To lower your taxable income, you need to deduct any and every business expense to which you’re entitled. You can’t do this if you just drop off your information to your CPA in February, March, or April. That’s being reactive rather than proactive about your tax bill. That means that you’ve missed possible deductions you could have taken.
Remember, you are not a tax expert. Your tax advisor is. The Internal Revenue Code can be one of the greatest wealth-building tools available to you, but most likely, you don’t know or understand the code. Your tax advisor should. If you start working with your tax advisor early in the year, he or she can help you maximize your tax-deductible business expenses.
Maybe you can claim some travel expenses as business expenses if you combine a personal vacation with business travel. Perhaps there are more home office deductions you can take than you realized. Whatever the deductions are, be sure you work with an expert who knows the law and the Internal Revenue Code. Yes, you want to claim every business deduction possible, but you also want to do so legally.
RELATED READING: 49 Possible Tax Deductions for Business Owners
In #4, I mentioned 529 Plans. As of 2019, there are some states in the U.S. that allow you to make contributions to a 529 plan and get a tax deduction at the state and/or local level. However, your contributions to the plan are not deductible at the federal level. Nonetheless, a 529 plan is a state-sponsored education savings plan. You can deposit money into the account, let the money grow tax-free, and then withdraw money tax-free IF you use it for qualified K-12 or higher education expenses.
Unfortunately, if you have money left over in the account, you will owe a 10% excise tax on any money you withdraw for non-qualified expenses, and you will owe ordinary income taxes on those withdrawals. However, if you live in particular states, you can deduct your 529 contributions from your state or local income taxes.
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Next, you can go out and invest in yourself. One of the things you can do is take advantage of the Lifetime Learning Credit of $2,000 per tax return. Notice the word “credit” there. Technically, this isn’t a tax deduction. It’s a tax credit. Thus, if you owed $10,000 in taxes and you got a $2,000 credit, you would reduce your tax bill from $10,000 to $8,000. If the $2,000 was a deduction (instead of a credit), if your tax bill was $10,000, and if you were in a 20% tax bracket, you would only reduce your tax bill by $400. Therefore, a credit is HUGE.
If you’re looking strategically at your professional life and your taxes then, you may want to take advantage of the Lifetime Learning Credit. Go back to school. Earn another degree. Take courses to improve your job skills. Invest in yourself. If your business is down or it’s annuitized where you’re not having to make any strategic moves, it may be time to invest in your education and reap tax advantages at the same time.
RELATED READING: Tax Tip: Check Out College Tax Benefits
Speaking of a tax credit, you can also receive a $2,000 tax credit for each qualifying dependent child under the age of 17. Prior to the 2017 Tax Cuts and Jobs Act, the credit was $1,000, but the available credit doubled in 2018 and will remain until 2025. So… although this is drastic, you could have a baby!
Maybe you’re planning for your future, and your business is doing well. Perhaps it’s time to add a baby to your family. Obviously, you don’t want to have a baby just to get a tax credit. That would be ridiculous. However, having a baby or having children can reduce your tax liabilities.
You can reduce your taxable income and your tax liabilities by giving some money to charity. Most of us here in the Bible Belt of East Tennessee have heard the rule that you give 10% to your church. That’s the rule of the Old Testament in the Bible, but you can always do more than that, especially if you’re trying to itemize your taxes beyond the standard $24,400 deduction.
Of course, you can give cash to charities. Yet, did you know that you can give assets to charity, too? You can contribute appreciated stocks to charity instead of selling them and paying capital gains taxes on them. Donating property, land, or natural resources can also benefit charities and reduce your taxable income, too.
What if you’re looking to sell your business? Did you know that you can donate your sellable business to a charity? Done correctly, you can reduce your taxable income, and the charity can sell the business tax-free. With the proceeds earned, the charity can create a Charitable Remainder Trust through which you receive income for the rest of your life. If you don’t want to give your entire business to charity, though, you can give cash contributions to charities before or after your business sells to reduce tax liabilities you might owe upon the sale of your business.
RELATED READING: Achieving Charitable Desires While Increasing Your Net Gain
Now may be a good time to buy a house! Buying or owning a house could reduce your taxable income because the money you pay on mortgage loan interest and on your property taxes is deductible to a certain point. As of 2019, you can deduct any mortgage interest you pay on up to $750,000 of qualified residencial loans. So if you buy a million dollar house, only the interest on the first $750,000 of the loan is tax deductible.
The interest you pay on a Home Equity Line of Credit could also be tax deductible IF you use the funds to purchase a house, build a house, or improve a house. However, if you’ve already maxed out the qualifying $750,000 loan interest maximum through a residential home loan, then HELOC interest would be a moot point.
Additionally, you can deduct up to $10,000 of your State and Local Taxes (SALT) from your income taxes. Therefore, all or portions of your home’s property taxes may be deductible up to the SALT deduction limitations. However, unless your “bunched” tax-deductible expenses exceed the standard deduction of $24,400 for married couples filing jointly, then your mortgage interest and property tax payments may make no difference.
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You may be able to reduce your actual property taxes. That’s a tax saving, too, especially if your property taxes exceed or take up the majority of the $10,000 of SALT deductions you can claim.
Even though property values are rising, many home values throughout the United States still haven’t recovered from the 2007 to 2009 economic meltdown. Your home may be worth $350,000, but you’re paying property taxes on it as if it’s worth $450,000. It’s time to call your county property assessor. You may need to have your property reassessed, and by doing so, you might be able to lower your property taxes. In effect, this could potentially lower your income taxes because it frees up part of your SALT deductions.
Talking about your house, another thing you can do to reduce your taxable income is to make your house more energy-efficient. Maybe instead of installing central heating and air, you could put in a geothermal heat pump. Perhaps you can install solar water heaters or solar water panels. Through a Congressional budget deal that was signed into law in 2018, you can now claim Energy Tax Credits through 2021 for up to 30% of the costs of installation for solar water heaters, solar panels, geothermal heat pumps, wind turbines, and fuel cells depending on the year you make these home improvements. So maybe it’s time to make some energy-efficient home improvements.
Maybe you decide to take energy efficiency to other areas of your life. As of 2010, the federal government and several states offer incentives, including tax credits, to those who buy electric vehicles. You can receive a tax credit between $2,500 and $7,500 per electric vehicle purchased depending on the size of the vehicle and its battery capacity. With that tax credit, you can offset your income taxes.
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Number 19 may seem drastic, but moving to a different state could significantly lower your tax burden. Now, I’m not talking about your state of mind here. I’m talking about moving to a different physical state within the United States. You see, federal income tax affects you no matter where you live in the U.S. However, states and counties assess their own income, property, license, sales, inheritance, estate, and excise taxes.
Maybe you live in a state with high income and/or sales tax levies. As of 2018, New York ranked as the leader in combined sales and income state taxes with Connecticut, New Jersey, Illinois, and California close on its heels. Yet, there are other states in the union with lower tax burdens. In fact, seven states – Wyoming, Washington, Texas, South Dakota, Nevada, Florida, and Alaska – have no personal income tax requirements. If you’re in a type of business that’s not state-specific, then you could potentially transfer your domicile or your state of residence to reduce your State and Local Tax (SALT) burden.
A donor-advised fund is like a charitable investment account, for the sole purpose of supporting charitable organizations you care about. When you contribute cash or other assets to a donor-advised fund at a public charity, you could be eligible to take an immediate tax deduction. Then those funds can be invested for tax-free growth and you can recommend grants to virtually any IRS-qualified public charity.
So there are 20 ways to reduce taxable income. I’m sure there are 15, 20, or even 30 more. This is where a good tax advisor can help you. A good tax planner can look at your life and your goals and figure out the best tax reduction strategies for you. If you don’t have a good tax planner, reach out. We should be able to recommend a GREAT one.