How to Pay Less Taxes Legally – Updated for 2021

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Tax time is coming up, and if you’re like most Americans, you’re dreading seeing just how much you’ll owe Uncle Sam for the year. However, here’s the truth. The tax code is not a series of punishments. The tax code is a series of incentives. Today, I am going to share with you how to pay less taxes legally. The rich pay less taxes; I want you to know how to too. 

While there likely isn’t much more you can do to alter your fate for last year, there are many ways you can reduce the amount you owe the IRS this year!

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How do Taxes Work?

Before we jump into the top tax-saving strategies, I want to cover how taxes work. There are many types of taxes, such as:

  • Federal Income Tax
  • State & Local Income Tax
  • FICA & Payroll Tax
  • Capital Gains Tax
  • Property Tax
  • Sales Tax
  • Much more!

For today, I will focus on federal income taxes and capital gains taxes. Why? Because these are the taxes you have the most control over. It’s very hard to reduce your property taxes unless you plan to move, and you can’t control sales taxes. Learning how to pay less taxes legally is primarily about learning how to mitigate federal income taxes and capital gains taxes.

Federal Income Taxes

As you may be aware, the federal government sets a series of tax brackets based on your income level. 

For 2021, the tax brackets are as follows:

Single-Filers with Taxable Income Up To:Married Couples (Filing Jointly) with Taxable Income Up To:Tax Rate
Up to $9,950$0 to $19,90010%
$9,951 to $40,525$19,901 to $81,05012%
$40,526 to $86,375$81,051 to $172,75022%
$86,376 to $164,925$172,751 to $329,85024%
$164,926 to $209,425$329,851 to $418,85032%
$209,426 to $523,600$418,851 to $628,30035%
$523,601 or more$628,301 or more37%
Source: Internal Revenue Service

However, it can be confusing how these federal income tax brackets work in practice. Let’s assume you’re a single-filer making $90,000 per year. You may look at the table and think you pay 24% on all of your income. However, that is not the case. You pay 24% on the income from $86,375 to $90,000 (as of 2021). You’d pay 22% on the income from $40,525 to $86,375 and so on. So, in essence, your effective tax rate is a bit lower than 24%. While this is a nuance, it is important to help you gain an understanding of how taxes work. 

If you are a regular employee, typically, federal income taxes are withheld from your paycheck throughout the year and then reconciled with the actual amount you owe at tax time.

Capital Gains Taxes

Capital gains taxes are another common type of tax. These taxes are levied when you profit from the sale of an asset. Capital gains could be profits on stocks or profit on the sale of your house. While there are other types of capital gains, these are the most common. 

There are two types of capital gains, short-term and long-term. Short-term capital gains are taxed at your ordinary income rate (as outlined above), while long-term capital gains get special tax treatment. Long-term capital gains are those on any asset held for more than a year. The long-term capital gains rates as of 2021 are as follows:

Single-Filers with Taxable Income Up To:Married Couples (Filing Jointly) with Taxable Income Up To:Tax Rate
$0 to $40,000$0 to $80,0000%
$40,001 to $441,450$80,001 to $496,60015%
$441,451 or more$496,601 or more20%
Source: Internal Revenue Service

As an example of how these taxes work, let’s say you bought ten shares of stock for $10 each. Five years from now, assume you sell these ten shares for $20 each. In total, your capital gain is $100 ($200 – $100). If you’re in the 15% capital gains tax bracket, you’ll pay $15 of taxes on these gains. 

While there are many kinds of taxes with literally thousands of nuances, federal income taxes and capital gains taxes are the ones to focus on for purposes of exploring ways to lower your tax bill. 

How the Rich Pay Less Taxes

Before jumping into specific tips to reduce your tax bill, I want to talk about the tax code. I mentioned above that the tax code is a series of incentives. Let me explain.

The government wants people to do certain things because it believes those things are good for individuals and society. Let’s take a simple example. If you contribute to a 401(k) at work, you will receive a tax break. Why is this? Because the government wants to incentivize people to save for retirement. 

You see, the government wants you to use the tax code in legal ways to reduce your tax bill. By following strategies that reduce your tax bill, you’re doing the things the government wants you to do. That’s why you can (and should) seek legal ways to reduce your tax bill.

Let’s take another example. If you invest in a rental property, you will receive a tax benefit called depreciation. The government says you can reduce your taxable income because of wear and tear on a property. For many investors, believe it or not, income from a rental property is largely tax-free. But that’s unfair, then the rich people who invest in rental property get tax benefits that make them richer, right? Wrong. In the government’s eyes, those who are investing in rental property are creating affordable housing for the less wealthy, and the government is compensating them for doing something for the greater good. 

Whether you believe this is right or wrong, this is how the tax code works. The government incentivizes business and investment. Why? Because the government thinks businesses and investments support the greater good. Businesses employee people. Investments benefit the economy. 

If you are interested in learning more about the different types of income and their respective tax treatment, I urge you to read the book Cash Flow Quadrant by Robert Kiyosaki.

The wealthy know how to pay less taxes legally because they are using the incentive structure the government has created, mainly through having businesses and investing. 

Today, I am going to share with you how to pay less taxes legally – using many of the same ways that the wealthy do.  

Let’s first start with ways to reduce federal income taxes. When it comes to lowering federal income taxes, the name of the game is reducing your taxable income. How do I reduce my taxable income, you ask? Let’s find out!

1) Max Out Retirement Accounts

Retirement Accounts

This first tip is perhaps the most accessible for most people. The government wants to incentivize individuals to save for retirement, so they have created several programs with tax advantages in exchange for retirement savings. The two most common are the 401(k) and the individual retirement account. 

There is a traditional version of these plans and a Roth version of these plans (though not all 401(k)s offer a Roth version). The traditional 401(k)/IRA allows you to contribute pre-tax money to grow tax-deferred until retirement. With the Roth version, you pay taxes today (at your current tax rate), but then you never pay any taxes on the growth of your investments in the future. 

Here’s how this works. Assume your income is $100,000, and you expect your tax rate to be lower in retirement. You’d likely want to use a traditional 401(k) or IRA and pay the taxes in retirement (at the lower tax rate). For purposes of this example, assume you contribute $15,000 to your 401(k). Guess what:  that $15,000 is no longer treated as taxable income this year. Instead, it gets subtracted from your income, and you will pay fewer taxes in the current tax year. 

When you pay taxes, various deductions reduce the amount of tax you pay. So, in this example, instead of being taxed on $100,000, you’d be taxed on $100,000 less $15,000. In other words, you’d pay tax today on $85,000 instead of $100,000. If you want to avoid paying taxes on your salary, this is one of the best ways to do it!

While the government will catch up with you in the future (i.e., you have to pay tax when you withdraw funds in retirement), you save on taxes today, and your money grows on a pre-tax basis for a long time horizon. Growing your money on a tax-deferred basis equates to more money in your pocket over the long-run. 

There are cases where it makes sense to bite the bullet and pay taxes today rather than in retirement. If you expect your tax rate to be higher in retirement than it is today, you’ll likely want to use a Roth account, pay taxes today, and then let your earnings grow tax-free in perpetuity. 

If you’re not quite sure which is right for you, check out these ASF guides on the Roth vs. Traditional IRA and the Roth vs. Traditional 401(k). For now, though, just remember that if you contribute funds on a pre-tax basis to a traditional 401(k) or IRA, you’ll reduce your taxable income this year and reduce what you owe Uncle Sam today.

2) Fund an FSA or HSA

This next tip is also great for employees. Many companies offer flexible spending accounts (FSA) or health savings accounts (HSA) for employees. Both of these account types allow you to use pre-tax money for medical needs. 

Let’s start with the FSA. For 2021, you can contribute up to $2,750 to a flexible spending account on a pre-tax basis. Let’s say you go to a doctor and spend $100. You can use money from your FSA to pay for the doctor’s visit. In other words, you can use pre-tax money to pay the doctor instead of post-tax money where the government has already taken their slice. The biggest downside is that any unused FSA funds are lost at year-end. In other words, use an FSA, but don’t overfund it. 

HSAs, on the other hand, have certain benefits relative to FSAs. You can contribute funds that do not expire and roll them over indefinitely. Think of HSAs like a bank account. When you have any qualifying medical expense, you can use pre-tax money from your HSA to cover it. 

When you turn 65, if there is money left over in your HSA, you can spend it on anything (even if it’s not medical related). Spending on non-medical expenses (after age 65) is taxed at your then-current tax rate. In other words, if you have money left over at 65, it’s just like having a traditional IRA! You have funds that grow tax-deferred until retirement! In 2021, the contribution limit for HSAs is $3,600 for individuals and $7,200 for families. 

Let’s just say you are an individual in the 24% tax bracket and contribute $3,600 to an HSA. How much will you have saved on taxes? $864!

 Both the FSA and HSA can be great options to use pre-tax money for qualifying expenses!

3) Make Charitable Donations

Charitable Giving

This next tip allows you to do some good for others while simultaneously saving on taxes. When you give to charitable organizations, the IRS allows you to deduct your donation from your taxable income. Remember when I mentioned incentives? The government is trying to incentivize philanthropic donations. 

So, does gifting money always reduce your taxable income? The answer is a bit more complicated, and we need to dive into the tax code a bit further to explain this. When you file your federal tax return, you have two choices. You can take the standard deduction, or you can itemize. 

In 2021, the standard deduction is $12,550 and $25,100 for joint filters. Here’s how this works in practice. Assume you have $60,000 per year of income. If you take the standard deduction, you get to subtract $12,550 (as an individual) from $60,000 to come up with your taxable income. So, you’d pay taxes on $47,450 (your taxable income).

However, if you don’t want to take the standard deduction, you have the option to itemize. Let’s take this same example again but with an itemized tax return.

Income:  $60,000

            Less:

                        State and Local Tax Deduction:  $10,000

                        Mortgage Interest:  $5,000

                        Charitable Donations:  $250

Taxable Income:  $44,750

As you can see, sometimes you may come up with more deductions than the standard deduction, and that’s why we chose to itemize in this example. It was possible to decrease your taxable income further – and that’s the name of the game when it comes to reducing your taxes.

So, why am I making a big to-do of the standard deduction vs. an itemized deduction? Because it used to be that you could not reduce your taxable income with charitable donations if you took the standard deduction. 

However, as a one-time exemption in 2020, those who take the standard deduction were allowed to take up to $300 as a deduction to their taxable income for charitable giving. In other words, for the 2020 tax year only, if you gave to charity and took the standard deduction, you could deduct up to $300 of charitable contributions. 

If you itemize, typically, you can deduct 100% of your giving (with some exceptions). 

4) Own Your Primary Residence & Pay Your January Mortgage Payment in December

This next tip is about homeownership. There are many arguments against buying a house, but there are also reasons to consider doing so. One of the benefits of homeownership is that you can use mortgage interest to reduce taxable income.

Let’s say, for example, you pay $15,000 per year of mortgage interest (a lot in today’s low-rate environment, but stick with me). In this case, you would be able to reduce your taxable income by $15,000 (if you itemize). This can help cut your tax bill.

But there’s a problem. In 2020, mortgage interest rates hit historic lows, so if you ended up refinancing, you might not have that much mortgage interest. Because of this, it is more likely that you are taking the standard deduction. With the standard deduction, you won’t benefit from the mortgage interest deduction. Said differently, you must itemize your taxes to benefit from the mortgage interest tax savings. 

Don’t buy a house for the tax savings – buy a home because it makes sense to buy for other reasons. 

However, if you already own your home and itemize on your taxes, I’ve got a little trick to save on taxes this year. If you itemize, your goal is to maximize the number of deductions you take. 

One such way is to try to boost the amount of mortgage interest you pay this year. Let’s say you’ve paid your mortgage payment for January through December. You have 12 months of mortgage interest. However, if you pay your upcoming January’s mortgage payment in December, you’ll be able to claim the interest from that payment in the current tax year. In other words, you’ve managed to claim 13 months of interest on your taxes in one year.

However, the downside to this strategy is that next year, you’ll have to do the same thing, and you’ll only get 12 months of interest (February – January). Still, the time value of money principles states that you should take the extra benefit today rather than later.

It’s a small timing trick, but it is one to explore nonetheless for some current-year tax savings.  

If you’ve been following along so far, you may be wondering, how much can I reduce my taxable income? Like most things in life:  it depends. However, if you itemize and take many different deductions, the answer is that it is quite possible to reduce your taxable income by tens of thousands of dollars.

These next couple of tips on how to pay less taxes legally are unique to individual situations (and less easily accessible for everyone). 

5) Contribute to a 529 Plan

529 Plan

If you have kids, a 529 plan is worth exploring as a means to contribute to their college education. Unfortunately, the tax benefits of the 529 program aren’t immediately realized (at the federal level); however, funds in a 529 plan will grow tax-free. In other words, if you’re saving for your child’s education anyway, you’ll do better with a 529 plan than a taxable investment account. 

In addition to the federal tax benefits, many states offer tax deductions or credits for 529 plan contributions. However, every state varies, so this one will require a bit more homework based on your situation. 

6) Track Your Medical Expenses

This next tip is a little tougher to use, but you should know about it nonetheless. If your total medical expenses exceed 7.5% of your taxable income, you can deduct some of your medical expenses to reduce your taxable income. So, if you have a taxable income of $50,000 and medical expenses of $5,000, you can deduct the amount above 7.5% of your taxable income. In other words, you can deduct $1,250 ($5,000 – ($50,000*0.75)). 

While it is unlikely this deduction be available to you unless you have substantial medical bills, it’s worth tracking just in case. 

7) Offset Capital Gains

Most of the tips I’ve mentioned above revolve around reducing your taxable income for the sake of federal income taxes. However, it is also essential to understand how to minimize taxes on your investments. 

As mentioned above, when you have an asset that goes up in value that you then sell, you’ll pay capital gains tax on the investment. 

However, there are ways to reduce the tax you pay on capital gains. One such approach is through something called tax-loss harvesting.

Let’s say you have two stocks:  stock A and stock B. Also, assume you’re in the 15% capital gains tax bracket. 

Stock A:  Purchased for $500; sold for $1,000

Stock B:  Purchased for $1,000; currently worth $500

If you sell stock A, you’ll have a capital gain of $500. At a tax rate of 15%, you’d owe Uncle Sam $75. However, if you want to reduce your tax bill, you could choose to sell stock B at a loss. If you sell stocks A and B, your capital gain will be $0 ($500 gain on stock A and $500 loss on stock B). Therefore, you will pay no capital gains tax.

While you shouldn’t sell losers just to offset capital gains, it can make sense to sell investments at a loss if you need to rebalance your portfolio or no longer believe in the investment. Doing so can help reduce your tax burden and align your portfolio to your longer-term goals. 

8) Invest in Real Estate

House with Dollar Sign

When you invest in real estate, you receive special tax benefits called depreciation. In other words, you can reduce your taxable income using an expense that exists only in principle, not in real cash. 

Let’s say you buy a residential property for $100,000 with the intent to rent it out. The depreciation period of the property would be 27.5 years. So, you’d take $100,000 divided by 27.5. Each year, you’d get to claim a deduction on the income produced by the property of $3,636. 

Let’s assume the property produces $4,000 per year of cash. To figure out how much tax you’d owe the government, you’d subtract $3,636 from $4,000. The remaining amount becomes your taxable income. In other words, of the $4,000 in cash that would go into your pocket, you’d only pay tax on $364. If your tax rate is 24%, you will pay $87 on $4,000 of income. Effective tax rate? Just about 2%. 

If this seems unfair, just remember the government is trying to incentivize investors to create affordable housing. Real estate is powerful in that it allows you to put cash into your pocket today at low effective tax rates.

Now, of course, there’s no such thing as a free lunch, so when you sell the property, the government will get their bite at the apple, but if you hold real estate for an extended time, you’ll get many years of benefit before having to face the tax burden. 

This benefit is what makes real estate so popular amongst investors. 

9) Start a Business

This next tip is likely the most prominent tool used by the wealthy. If you want to learn how to pay less taxes legally, this is the most powerful tool. 

Think about the wealthiest people you know. Are they employees or business owners? In general, the wealthy own businesses rather than work for somebody else.

Businessowners receive a tax break that allows them to use pre-tax money for expenses. 

Let’s use a straightforward example. You have a cell phone bill that costs $100 per month. If you are an employee, you have to pay this $100 with post-tax money. Said differently, maybe you had to earn $133 of pre-tax money to pay a $100 bill. 

What if, however, you own a business, and you need that cell phone to conduct your business? You could treat your $100 cell phone bill as a business expense and pay for it with pre-tax money. So, instead of needing $133 of pre-tax money to pay a $100 bill, you only need $100 of pre-tax money to pay a $100 bill.

Smart business owners pay all ordinary and necessary expenses at the business level with pre-tax money. While this may mean the amount they put into their pocket from the business is lower, they’ll have fewer expenses paid post-tax. 

Business ownership can build massive amounts of wealth, and there are many reasons for that, not the least of which is tax savings from incurring expenses at the business level.     

10) Change Your W-4 Withholding

Form W-4

This next tip is less about how much you pay in taxes and more about managing your taxes efficiently. When you started your job, you probably received a pesky form W-4, that asked you to fill in a number that would determine the tax withholding from your paycheck.

However, most people don’t make the best decisions when it comes to this form—making the wrong decision could mean A) either a big refund at tax time or B) a hefty bill at tax time.

Your goal is to choose a withholding that minimizes the amount you owe or receive to/from the government in April. 

Why? Let’s first talk about the case where you owe the government money at tax time. Having a hefty bill at tax time is an unfavorable outcome because if you didn’t plan for the expense, you might have a tough time coming up with the money.

However, most people don’t understand that a refund isn’t good either. Why? Because you’re just getting back money that is rightfully yours, which you’ve now allowed the government to hold onto for many months for free. Why let Uncle Sam have use of your money without being compensated for it?

If you find that you habitually owe at tax time or receive a big refund, adjust your withholding so that tax time is less surprising. 

11) Hire a CPA

This final tip will cost you some money, but it will save you a lot more in the long-run. While many advocate using software like TurboTax, I am not one of them.

If you use some kind of software to do your taxes, you’re going to miss potential savings or make a costly mistake. Instead, find yourself a qualified accountant who knows the rules of the tax code. They can make sure you’re receiving all tax savings available to you, and you’ll have comfort in the accuracy of your taxes. It is your accountant’s job to know how to pay less taxes legally. 

Most importantly, it is not uncommon to get a letter from the IRS claiming you owe more money. If you receive one of those letters, you’re much better off if you have a CPA that will stand by their work rather than a tax software where you are responsible for all errors or omissions. 

How to Pay Less Taxes Legally:  A Summary

Paying taxes is no fun. I get it. But if you know a little bit about how taxes work, you’ll be well-positioned to seek opportunities to save on taxes. 

Remember, the tax code is a series of incentives. By understanding these incentives, you’ll be able to use many effective, legal strategies to reduce your tax bill. 

To recap, 11 simple ways to avoid paying taxes legally include:

1) Max Out Retirement Accounts

2) Fund an FSA or HSA

3) Make Charitable Donations

4) Own Your Primary Residence & Pay Your January Mortgage Payment in December

5) Contribute to a 529 Plan

6) Track Your Medical Expenses

7) Offset Capital Gains

8) Invest in Real Estate

9) Start a Business

10) Change Your W-4 Withholding

11) Hire a CPA

So, get started using some of these tax-saving strategies today! Any tips we missed? Let us know in the post comments!

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