Every year, the federal government collects approximately $1.4 trillion in individual income taxes. This accounts for more than half of its total revenue.
No one likes filing taxes but there is no way around it. Fortunately, there are ways to impact how much you owe the government. People are always looking for ways of reducing taxes, or their “tax liability,” but the key is to do so within the limits of the law.
This article covers those and makes recommendations on how to implement strategies to lower your tax liability. Keep reading to find out how you can get the most out of your return.
In this article
What Is Tax Liability?
Every year, individuals pay taxes or have “tax liability,” of various types. These include property and vehicle taxes, as well as local, state, and federal taxes. Most often when people talk about “tax liability, they are referring to the amount of money they owe the federal Internal Revenue Service (IRS) in a given year.
Tax liability is the amount of your income that is subject to taxation by either (or both) federal and state governments. It is based mainly on your income, including capital gains. This amount determines which tax bracket you fall into and the percentage you pay on that income.
Your tax liability also can be impacted by any tax debt you owe from previous years. Note that tax liability is distinct from the amount you owe when filing tax returns, which can be offset by employer withholdings. For instance, if your tax liability is $15,000 for the year and $13,500 has already been withheld, then you only owe $1,500.
Tax liability is also calculated by applying deductions, exclusions, and exceptions to your gross income. It is the total amount you owe the federal government based on all these variables.
Ways to Reduce Your Tax Liability
There are several methods for reducing taxes you owe in any given year. Here are the main ones to consider.
Know Your Deductions
Identifying and filing all deductions for which you are eligible is the first step in reducing your tax liability. In all likelihood, you are eligible for at least a few.
Charitable donations are deductible, including cash and physical gifts. These can be anything from donations to religious institutions or nonprofits, as well as giving clothes, cars, or other items to organizations. You must provide details of your donation and can deduct up to 60 percent of your adjusted gross income.
For couples filing jointly, you can deduct up to $10,000 for property taxes and state income or sales taxes (the amount is $5,000 if filing separately). The interest you pay on your mortgage is also tax deductible. If you have student loans, you can write off up to $2,500 of your taxable income.
If you are self-employed, there are many different types of deductions you can claim. You can write off expenses like home office space, equipment (including computers), cell phone bills, credit card fees, and travel if they are associated with your work. The key is being able to demonstrate that a certain percentage of this usage is essential to your business or position.
There are many other tax deductions available for specific individuals, programs, and circumstances. For instance, school teachers can deduct up to $300 they spend on classroom supplies every year. Contributions and withdrawals to employer-based health savings and flex spending accounts are tax-deductible as well.
Know Your Tax Credits
Tax deductions reduce your taxable income. As stated, these can only go so far, especially if you do not hit the “standard deduction” threshold.
Tax credits, on the other hand, reduce the amount of taxes you owe. These also are for a specified amount, based on the credit source, versus a percentage (as with deductions).
For instance, say you are in the 24 percent income tax bracket. A deduction of $10,000 only gets you $2,400 in tax relief (considering no other variables come into play). But a $10,000 tax credit equals a $10,000 total reduction in what you have to pay.
There are many different tax credits for which you might qualify. The most common ones include the Earned Income Tax Credit, which is a credit based on income, marital status, and number of child dependents.
The Child and Dependent Care Credit helps families who pay for childcare for dependents under age 13, for the parents to work. If you adopt a child, you are eligible for a credit of up to $14,890 (although this amount incrementally decreases at certain income intervals).
Other options include the American Opportunity Tax Credit (historically called the Hope Credit). This is for families paying for higher education. The Lifetime Learning Tax Credit allows you to deduct 20 percent of the first $10,000 you pay in tuition, regardless of your age or income status.
Many other tax credits apply to specific circumstances. For instance, installing solar panels on your primary residence can get you 30 percent back on the cost of the system and installation.
Avoid Capital Gains Taxes
Capital gains are money you make from investment interest or the sale of a property that has appreciated. The federal government taxes these amounts at various rates.
One way to keep these in check is to make sure you include all reinvested dividends. This raises the cost basis, reducing your capital gains difference (and the taxes you pay on it).
Also, individuals can exempt up to $250,000 of their house’s appreciation from these taxes, when selling it. Married couples get double that ($500,000). You can only claim this exemption once every two tax years.
A final way to avoid paying capital gains taxes is by using stocks as gifts to charities. Most nonprofits and charitable organizations, as well as a qualified tax accountant, can advise you on how to carry out this transaction to optimize your tax benefits.
Contribute to Retirement
Another easy and effective way to reduce your tax liability is to contribute a good portion of your income toward retirement savings. There are several different investment vehicles for doing so.
You can deduct contributions to traditional IRAs. (Roth IRAs are not tax deductible––the idea is that you are paying taxes on the contributions now rather than down the road, when you withdraw them.)
Also, the IRS does not tax any amount you contribute directly to 401(k) retirement plans. These are common through employers, although individuals can open their own 401(k) themselves.
There are some limits to these. Currently, the total amount you can deduct is $20,500 for most employees, and $27,000 if you are 50 years old or above.
Contribute to College Savings Funds
Another type of savings that is tax deductible is contributions to 529 plans. These are designed to help pay the costs of college, technical, or trade-school education.
This includes mainly tuition and books, but some plans allow for other expenses. Also, some 529s let parents use funds to pay for private high school costs before college.
These savings mechanisms are run by states, and so the rules vary among plans. One thing they all have in common is that contributions to them are not deductible on your federal taxes (and therefore will not lower your tax bill).
However, since they are state-run plans, you can deduct contributions from your state return. Also, earnings are never subject to taxation, including when you withdraw them. So, they are not an immediate way to lower your taxes, but can be a valuable tool for doing so in the future.
Often, people are seeking ways to reduce their debt liability because they are unable to pay what is owed. Fortunately, there are options for such circumstances.
The IRS will collect from you detailed financial information, to decide. This includes bank statements and proof of monthly expenses.
“Currently not collectible status” does not mean that the debt goes away. It does mean that the IRS has determined that your circumstances are such that you are unable to pay the money owed at this time and temporarily halts any efforts at collecting the debt from you. Another major advantage to this option is that it begins to cut into the 10-year statute of limitations under which the IRS can make collections from an individual.
Learn More Strategies for Reducing Taxes
Now that you understand different ways of reducing taxes, you can implement strategies that optimize your return. With a little bit of diligence and effort, you can have the peace of mind that you are getting the most out of your tax filing.
We hope you found this information on reducing your tax liability helpful. If so, be sure to check out some of our other financial posts, as well as those on health, travel, business, education, and many other topics.