How to protect your income from taxes
Everyone who earns any income wants to keep as much of it to themselves as possible. While income taxes may be unavoidable, there are plenty of ways to protect your income from being overly taxed, especially if you are in the high-income bracket. The answer to the question of how to protect your income from taxes lies in understanding the basics of taxation, the SECURE Act, and several options that taxpayers have available to them. You can, of course, hire one of the top tax debt relief companies to make the whole process easier and more straightforward. Either way, knowing what your options are is never a bad thing. In this article, we will walk you through everything you need to know to protect your income from taxation.
The basics of taxation
You pay your income taxes based on federal tax brackets. Your federal tax bracket represents the percentage of your taxable income that you owe to the IRS. The taxable income itself is calculated by taking your adjusted gross income and applying itemized deductions and personal exemptions (below-the-line deductions). Adjusted gross income is your total gross income minus the above-the-line deductions (IRA contributions, retirement plan contributions, charitable distributions, etc.)
The tax brackets themselves work through “tiers”. Your income gets taxed depending on the tax bracket. For example, the first $0 to $10,275 of your taxable income has a 10% tax associated with it. Everything above $10,275 goes into the next bracket (12% tax), up to $41,775. Any income above $41,775 will be taxed at a much higher tax rate, starting at 22%.
The 2022 federal tax brackets are as follows:
- 10% tax rate – $0 – $10,275
- 12% tax rate – $10,275 – $41,775
- 22% tax rate – $41,775 – $89,075
- 24% tax rate – $89,075 – $170,050
- 32% tax rate – $170,050 – $215,950
- 35$ tax rate – $215,950 – $539,900
- 37% tax rate – Above $539,900
Married couples filing jointly
- 10% tax rate – $0 – $20,550
- 12% tax rate – $20,550 – $83,550
- 22% tax rate – $83,550 – $178,150
- 24% tax rate – $178,150 – $340,100
- 32% tax rate – $340,100 – $431,900
- 35$ tax rate – $431,900 – $647,850
- 37% tax rate – Above $647,850
How is your income taxed?
Here’s how the brackets work in practice. Let’s say that your taxable income for the year is $300,000. By looking at the brackets, you would think that you will need to pay 35% in taxes, which amounts to $105,000! But the tax system does not work as simple as that. What is actually happening is that your income is taxed through these tax bracket tiers. This means that the first $10,275 is taxed under the 10% tax rate, whereas the next $31,500 is taxed under the 12% tax rate, and so on. In this specific scenario, your federal income tax amount would be closer to $75,000 than $105,000.
Additionally, these are “just” federal taxes. You will most likely need to deal with both the state and local taxes as well. As well as understand all the three tax types. Do note that some states do not have an income tax. This is something that you might want to consider when you want to protect your income from taxes.
Another thing taxpayers need to understand is The SECURE Act. The acronym stands for “Setting Every Community Up for Retirement Enhancement“. The act brought several changes with it that affected the usual strategies for protecting your taxable income. Here are some of the highlights:
- No more age limit for contributing to a traditional IRA
- Increased Social Security wage base to $147,000 for the year 2022. This has the effect of taxpayers paying more for their social security.
- The minimum age for RMDs (Required Minimum Distributions) was raised to 72.
- Increased limits on deducting long-term care premiums
- The increased income ceiling for Roth IRAs, maxing out at $144,000 modified adjusted gross income.
It is in your best interest to familiarize yourself with the changes and how they affect your taxable income. Some of the best tax relief strategies involve utilizing the information found in the SECURE act. Speaking of which, it is now time to speak about what you can do to protect your income from taxes.
How to protect your income from taxes?
Here are some of the top strategies and tax deductions that you can utilize to protect your income from taxation:
- Municipal bonds
- Long-term capital gains
- Starting a business
- Health savings account (HSA)
- Tax credits
- Qualified charitable distributions
- Charitable contributions
- Qualified retirement plan contributions
- Medical expenses
- Mortgage interest expenses
- Income deferral/Acceleration
Universally, the goal is to have some of your income be exempt from taxation, potentially lowering the tax bracket it falls into. Most of these strategies and deductions are ways to make your income either exempt from the federal tax or make it being taxed less.
Investing in municipal bonds essentially means that you are lending your money to your local government (or your state). You will get a predetermined number of interest payments over a period of time. Once your bonds reach their “maturity dates”, the entirety of your original investment will be repaid to you.
The key takeaway here is that the interest on municipal bonds is completely federal tax-free. Furthermore, your state may also exempt this money from taxation as well. Some states offer their municipal bonds with terms that are attractive to investors, boosting their economy in the process.
The main issue with municipal bonds is that they have a much lower interest rate than corporate bonds. However, together with the tax benefits, they may end up being more lucrative for some high-income earners. Basically, the higher your tax bracket is, the higher the “tax-equivalent yield” municipal bonds offer.
Long-term capital gains
Almost every high-income taxpayer looks to invest their money to grow their wealth. Capital gains are heavily taxed, though, and it might be a good idea to consider long-term capital gains instead.
A long-term capital gain is when an investor holds their capital asset for a period that is longer than one year. This sort of capital gain enjoys preferential tax treatment and is vital when it comes to protecting your income from taxation. Depending on your income level, you may not even need to pay any tax on long-term capital gain at all! There are three brackets, 0%, 15%, and 20% when it comes to long-term capital gains taxation. In 2022, the 0% bracket applies to taxable income that is not over $41,675 for single filers and $41,675 for joint filers.
How to protect your income from taxes – Starting a business
Starting a business of your own can be a great way to protect your income from taxes. The main reason is the fact that some of your expenses can be deducted from your taxable income if they are used for business purposes. The most notable example is health insurance.
Furthermore, the IRS offers guidelines on how a business owner can deduct some of their own home expenses by having a home office. To qualify for these deductions, the business itself must make a profit, and there are other factors that influence it. Starting a business that makes a profit, any profit at all can be a great way to boost your tax refund amount without many drawbacks. But it can be a bit complicated to set up and it requires quite a lot of knowledge. In most cases, you will want to reach out to a tax relief company and get some advice.
Health savings account (HSA)
The contributions to your HSA have three main advantages when it comes to taxes. First, all the contributions are completely tax-deductible. Second, the money that is invested grows without any tax liability. And third, any withdrawals are absolutely tax-free for any qualified medical expenses you might have. And if you are over 65, the withdrawals are tax-free for any purpose whatsoever.
All of this sounds amazing but there is a limit to the contributions that you can make. These limits change by year, and in 2022 the maximum amount of contributions to your HSA is $3,650 for single filers and $7,300 for families. And if you happen to be older than 55, you can contribute an extra thousand. Needless to say, high-income earners should max out their HSA contributions each year.
So far we’ve talked about strategies for high-income earners. If you are looking for how to protect your income from taxes on a low to medium income, tax credits are one of the solutions.
Every taxpayer has access to numerous IRS tax credits. There’s the American Opportunity Tax Credit, the Earned Income Tax Credit, the Saver’s Credit, etc. Depending on your income and circumstances, you will be able to take advantage of one or more of these tax credits. However, there is a limit to how much money you can deduct with these credits.
These tax credits are influenced by how many “qualifying” children a taxpayer has. In 2022, a low-income taxpayer could claim tax credits up to $560 if without any children, $3,733 with one child, $6,164 with two, and $6,935 with three or more children. Then there’s the “American Rescue Plan” which provides great tax breaks to low-to-moderate income individuals and families. Up until this plan, the minimum age to claim some of these tax credits was 25. Today, you can claim these credits starting from age 19 and there is no upper age limit (which used to be 65).
Qualified charitable distributions
There are two ways that you can protect your income from taxes via donating to charity: Qualified charitable distributions and charitable contributions (more on them soon).
Qualified charitable distributions come from your IRA and are paid directly to qualified charities. The “catch” is that you need to be older than 70 and a half. These distributions basically allow you to pay any charitable organizations without any taxes. By donating to charities in this manner, you can potentially save thousands of dollars in taxes! However, the charity you are distributing to needs to qualify first.
The other way of reducing the tax on your income is by making charitable contributions. The specifics are quite convoluted, though, but this is one of the best methods of reducing your taxable amount. Some of the most common contributions include stacking charitable donations within a single year, donating your low-cost basis stock, and similar.
Most of the time, you will want to have professionals assisting you with your charitable contributions. That said, you will also want to avoid IRS tax relief scams. Taxes are a very complicated subject, after all, and you will want to ensure that you are working with a reliable and trustworthy tax relief company.
How to protect your income from taxes – Qualified retirement plan contributions
One of the best ways to reduce the income tax for high-income taxpayers is through qualified retirement plan contributions. Many companies these days offer such savings plans to their employees, fully knowing the benefits that they bring. The main benefit of these plans is the fact that all the reductions do not even appear on your tax return. They occur directly on your paycheck instead.
You can make an itemized deduction for any medical expenses that are over 7.5% of your adjusted gross income. That is why you may want to keep track of your and your family’s medical expenses at all times. Do note that this percentage is for the year 2022, and is liable to change in the future years. You may want to keep an eye on it as years go by.
Mortgage interest expenses
Mortgage interest expenses are tax-deductible. For the year 2022, the amount that can be deducted is up to $750,000. You may also consider cash-out refinances and take the most advantage out of the mortgage system.
Deferring/accelerating your taxable compensation might not be applicable to every situation but it has the potential to compound your investments and savings at a much faster rate. To get the most benefits, you will want to consider the following options:
- Non-qualified deferred compensation contributions
- Having your employer defer your income until the following year
- Accelerate IRA withdrawals upon retirement
- Qualified retirement plans
- Cash-value life insurance
High-income earners usually combine several of these strategies to protect their income. But you should take care when utilizing them, as they might not be ideal for your particular situation. The best choice is to consult tax professionals and create a plan according to your circumstances. Hiring a tax relief company to help you learn how to protect your income from taxes is usually the easiest option. You can find all the best companies simply by exploring the Consumer Opinion Guide.