Using smart tax strategies will allow you to retain more of the dollars you earn, thereby increasing your ability to build wealth. Below are some practical and legal methods to reduce your tax liability by using strategic planning and other available tax saving tools.
1. Maximize Your Tax-Advantaged Accounts
Utilizing tax advantaged accounts is likely the simplest and most effective method to minimize your tax obligation. Tax advantaged accounts allow you to either reduce your taxable income or defer taxes until you retire.
Tax Advantaged Accounts:
401(k), Traditional IRA – Contributions to traditional IRAs and 401(k)s are tax deferred, therefore decreasing your taxable income for the year.
Roth IRA – Although Roth IRA contributions are not tax deductible, qualified distributions from the account are tax free.
Health Savings Account (HSA) – HSA contributions are tax deductible; withdrawals from an HSA are tax free if they are made for qualified medical expenses.
Increasing the contribution levels of these accounts will not only decrease your taxable income during the current year, but also increase your potential wealth overtime.
2. Take Advantage of Tax Deductions and Credits
Tax deductions and credits directly lower the amount of taxes you have to pay. It is important to know which tax deductions and credits you qualify for in order to maximize your potential savings.
Common Tax Deductions and Credits:
Standard or Itemized Deductions – The standard or itemized deductions that provide the greatest benefit should be chosen (e.g., mortgage interest, charitable donations).
Education Credits – Education credits such as the American Opportunity Tax Credit (AOTC) assist in offsetting education related costs.
Child Tax Credits – Child tax credits provide a direct reduction to your tax liability for families with dependent children.
Both tax deductions and credits can significantly decrease the amount of taxes you pay.
3. Invest in Tax Efficient Investment Strategies
Investment structure can affect the amount of taxes you are required to pay. Tax efficient investment strategies help you retain more of your returns by minimizing taxes on capital gains and dividends.
Examples of Tax Efficient Investing Strategies:
Tax Efficient Funds – Index funds or exchange traded funds (ETFs) that have a low turnover ratio minimize taxes on capital gains.
Tax Loss Harvesting – Tax loss harvesting offsets gains by selling investments that result in a loss, which in turn reduces your taxable income.
Long Term Investing – Holding onto your investments for over a year qualifies them for long term capital gains tax rates that are generally lower than short term capital gains tax rates.
Tax efficient investing will reduce taxes and help you grow your wealth more effectively.
4. Use Tax Deferred Growth Strategies
There are investment strategies that permit your money to grow tax deferred, which can create substantial long term advantages.
Examples of Tax Deferral Growth Strategies:
Annuities – Purchase an annuity that has tax deferred growth; you will only pay taxes upon withdrawal of the funds.
Real Estate Investments – Use tax deferred exchanges to reinvest the profit from your real estate investments without having to pay taxes.
Both of these options will enable your wealth to grow faster by delaying tax payments.
Conclusion
Reducing your tax burden legally requires a combination of strategic planning and knowledge of available tools. Individuals can substantially reduce their taxes and build wealth by utilizing tax-advantaged accounts, tax deductions and credits, tax efficient investing strategies and tax deferred growth opportunities. Effective tax planning is critical to achieving long-term financial success.
