Taxes are our largest ongoing liability. As a result, it behooves us to optimize our taxes as much as possible.
The good thing about having multiple income streams is the financial security it provides. The bad thing about having multiple sources of income is that taxes are a little more cumbersome to file.
My main income sources come from stock dividends, bond income, real estate rental income, occasional 1099 income, venture debt income, private equity income, and real estate crowdfunding income.
Before I had a family, my old goal was to shield as much income from taxes as legally possible and keep my Adjusted Gross Income to no greater than $200,000 a year. After ~$200,000 per person, the Alternative Minimum Tax used to really start to kick in as deductions were also phased out.
Thanks to lifestyle inflation and the need to support a family, I’ve decided to shoot for and limit our household income up to $350,000. The marriage penalty tax has all but disappeared after the Tax Cuts and Jobs Act was passed in 2017. Therefore, it’s OK to earn more money now. Besides, after $200,000 per person and $350,000 for a family of up to four, I’ve noticed there is no incremental increase in happiness.
The majority of actions to reduce your taxes must take place during the calendar year unless you’re filing as a business entity on a fiscal year. So if you want to pay less taxes, it’s worth setting aside some time during the holidays and wrestle this beast to the ground.
Being able to give your time and money away to worthy causes is one of the best benefits of being financially independent. No longer will you always feel conflicted about whether you should save and invest your next dollar versus helping someone in need. You just tend to give more because you can.
Just keep in mind there are guidelines you have to meet in order to claim deductions on charitable donations. Here are several things to keep in mind:
- You’ll need to itemize deductions and file Form 1040.
- The charity organization must be qualified with the IRS and be actively tax exempt. This excludes political candidates and organizations, as well as individuals.
- Used items such as housewares and clothing must be in good condition or better for them to be deductible.
- Donated vehicles can be deducted at fair market value if you meet certain requirements. For example, the charity must sell your car well below market price to a person in need, or the organization must make major repairs to increase the car’s value. Alternatively, you could qualify if the charity will use the car for purposes such as delivering meals to needy individuals.
- If the total of your non-cash contributions is greater than $500, you’ll need to file Form 8283.
- You’ll need a written record of all cash donations with the date, amount, and charity name. So keep your cell phone bills for text donations and any relevant bank statements.
- If you donate $250 or more in property or cash, you’ll need a statement from the charitable organization detailing your gift and if any services or goods were given to you in exchange.
- And if you receive goods or services for a donation, you can’t deduct your entire contribution. The value of what you received must be less than your donation, and you can only deduct the difference.
- If you are volunteering and performing services for a charity using your car, you can deduct mileage.
- Travel expenses can be deducted if you go on a trip with a qualified charitable organization and you’re “on duty in a genuine and substantial sense throughout the trip” per the IRS.
- Donations of property are generally deducted at fair market value based on what they would sell for on the open market.
- You can avoid capital gains on appreciated stocks held over a year if you donate them to a charitable organization. The amount you can deduct is determined by the stock’s fair market value on the contribution date.
Giving Percentage Rates By Income
Here are some interesting statistics on average charitable contributions based on income for individuals claiming itemized deductions.
It is great to see the sub-$20,000 group give away such a high percentage of their income. I remember when I was working minimum wage service jobs, those who also worked in minimum wage service jobs tended to tip the best.
At lower income levels, it’s all about giving and helping each other survive.
Here’s another giving by income chart from the National Center For Charitable Statistics. It’s interesting to see the income groups that give the least earns between $200,000 – $1,000,000.
Perhaps the main reason is due to the higher taxes paid through regular W-2 income. After all, paying taxes is a form of charity since your tax dollars get redistributed to help others.
I’ve written a lot in the past about how households making $300,000 and $500,000 a year in expensive cities are just living regular middle-class lifestyles. Part of the reason why is because a huge percentage of their income is going towards taxes.
Once you get over $1 million a year in income, a greater percentage of income tends to come from investments, which are taxed at a lower rate.
Capitalize Losses On Bad Investments
If you own securities or property that have been declining and you’re below your cost basis, consider liquidating before year end if you don’t anticipate a recovery.
Losses on property held for personal use can’t be deducted however, only investment property losses can be written off. And you’ll also need to look at the net of your capital losses and gains, because if your gains are higher than your losses, you’ll owe money on the difference.
Under the tax code, an individual may deduct up to $25,000 of real estate losses per year as long as your adjusted gross income is $100,000 or less and if you “actively participate” in managing the property. The deduction phases out as an individual’s income approaches $150,000. Individuals whose adjusted gross income exceeds $150,000 are not eligible for this deduction. This income threshold hasn’t changed for a while.
Note that you cannot deduct rental losses to your active income (e.g. day job income). Rental losses can only be deducted from passive income. You report your rental income and deductible expenses on IRS Schedule E. The IRS reports that roughly half of the filed Schedule E forms show losses.
Unfortunately for stock investment losses, you’re still only allowed to deduct $3,000 a year in capital loss deductions. I’ve had losses of $50,000 or more before that will take over a decade to deduct! At least you can carry over unused losses into the next year and so on. $3,000 isn’t a huge tax break for the year if you qualify, but every bit helps when you’re on a mission to pay fewer taxes.
Deferring Income And Itemized Deductions
It’s good practice to anticipate and prepare for changes to your income in the upcoming year. If your income is likely to go down next year, you’ll want to take as many deductions in the current year as possible and vice versa.
Individual Tax Moves
You can make additional contributions to your 401k before year-end if you haven’t already maxed it out.
You can make current year IRA and Roth IRA contributions until April 15 the following year. You can wait to see what your modified AGI will be and then contribute accordingly.
You can also accelerate your charitable contributions to the current year. One way to give is to strategically use your credit card when making a donation because deductions are based on the date your card is charged, not the date you actually pay off your credit card bill. In other words, you can make a donation via credit card on December 30, 2019, and not have to pay it off until January 2020.
If you’re not subject to AMT, you can also consider paying property tax installments and state taxes in the current year that aren’t due until next year. Accelerating these payments may help you benefit every other year and lower your tax burden for the current taxable year.
You can also try asking your employer if they can pay your year-end bonus in the following year if you want to defer income. Back when I was working in finance we had the option to defer our entire year-end bonus until some later date by 1 – 3 years.
Finally, you can consider reinvesting some proceeds into Opportunity Zones, which may end up being tax-free if you hold for the required period of time.
Business Tax Moves
A business which is cash-based, not accrual-based, can defer taxable income to the following year by sending December invoices at the very end of the month. The reason this can work is the business won’t receive payment for those invoices until January or later, and the business’ taxable income isn’t captured until the date the cash comes in.
Companies and sole proprietors can also reduce taxable income in the current year by charging business related expenses in 4Q that they’d normally take in Q1 of the following year. If you expect your business to grow rapidly in the following year, then wait until the following year to load up on capital expenditure.
If you’re having a great business year, simply wait until the new year to cash your November and December checks in January. Although, there’s always a risk the vendor might disappear or go bust before you can cash your check. Make sure you know what the time limit is for cashing in a check as well.
If your business needs a vehicle and also is having a great year, consider buying a 6,000+ SUV or truck by 12/31. Let’s say you buy a $70,000 Range Rover Sport and use it 100 percent for business. Tax law allows you to deduct $70,000 (or a lesser amount if you would like – in this case, you use Section 179 expensing).
If the Gross Vehicle Weight is 6,000 pounds or less, your first-year write-off is limited to $10,000 ($18,000 with bonus depreciation as limited by the luxury auto limits). You can learn more about the tax rules for writing off a vehicle here.
Finally, a great private business strategy to hire a close friend or relative who is in a lower tax bracket than your business tax bracket. For example, you could hire your high school son for $3,000 to redesign your website. His $3,000 in earnings is tax free. Meanwhile, you reduce your taxable income by $3,000 and hopefully get a slick new website while teaching your son about work.
Review Your Flex Spending Account (FSA)
Make sure you don’t lose any money in your flex spending account if you haven’t yet spent as much as you anticipated this year. Check with your employer if your plan is eligible for a rollover of unused funds until March 15 of the following year.
On the other hand, if you’ve already run out of funds in your flex spending account but have things like medical work or fillings to do at the dentist, try to postpone them until next year if they aren’t urgent. That way you can save on taxes by allocating enough funds in next year’s FSA to cover those expenses.
If you’re planning on leaving Corporate America next year, get your physical done this year (usually free under preventative care). Also consider going to specialists to treat specific injuries. Maybe you need an MRI for a bum knee. Maybe you should finally see a pulmonologist for your asthma or COPD.
Try and get your money’s worth when it comes to healthcare. Don’t neglect physical ailments that are bothering you, for they might get worse and more difficult to fix in the future.
Consider Revising Your Withholding
Even though you probably submitted your W-4 form to your employer ages ago, you can still file a revised form to make adjustments to the remaining pay periods left in the year. If you anticipate you haven’t withheld enough taxes so far this year, you can increase your withholding to help reduce penalties and fees when you file your taxes.
Check if you’ve already paid 100% of your current tax liability this year. If so and your AGI is less than ~$150,000, you should be able to avoid being charged a penalty. But you’ll need to have paid 110% of your current tax liability in the year to avoid getting dinged if your AGI is above ~$150,000.
This safe harbor method is generally the easier option to avoid paying a penalty because the alternative is to have withheld 90% of your tax liability, which can be difficult for freelancers and independent contracts to calculate.
If you are earning both W-2 wages and 1099 income, bumping up your January 15th estimated tax payment to compensate for having underpaid in previous quarters doesn’t work. Each quarter is treated separately with estimated taxes. However, withheld taxes on paychecks are treated as if they were paid throughout the whole year.
Review Your Retirement Contributions To Date
The maximum 401k contribution limit increases to $19,500 for 2020 from $19,000 in 2019. You should max out your 401(k) if you are in the 24% marginal federal income tax bracket or higher to save on taxes.
Even though this is the season of giving, don’t forget to pay yourself first. Take a look at how much you’ve contributed to your retirement accounts so far to date, and make additional contributions to the maximum.
If you only have one retirement account and it is already maxed out, check if you’re eligible to take additional deductions by opening additional accounts. You may not qualify if you have a high AGI, but it’s always good to know what your options are, especially if your income is likely to decrease in the future.
Know The Tax Rules
We all need to spend several hours each year reviewing and understanding the latest tax rules. Given the tax code is tens of thousands of pages long, spending several hours a year is the least we can do.
Below are the 2020 federal income tax rates for individual taxpayers and married individuals filing joint returns.
Based on the latest federal income tax rates, the optimal gross adjusted income for an individual is about $163,300 and about $326,600 for married couples with up to three children. At these income levels, you’re paying at most a 24% marginal federal income tax rate. Every dollar above requires you to pay a 32% marginal income tax rate.
If you’re making more, but your lifestyle is terrible, consider cutting back on your work hours or change jobs or professions. At the very least, stop stressing about having to be the best employee possible to get that raise and promotion.
We don’t know exactly how much more or less we’ll make the next year, but we can all make an educated guess and plan accordingly.
If you want to save more on taxes, start a business or a side business. You can either incorporate as an LLC or S-Corp or simply be a Sole Proprietor (no incorporating necessary, just be a consultant and file a Schedule C and 1040.
Every business person can start a Self-Employed 401k where you can contribute up to $57,000 ($19,500 from you and ~20% of operating profits) for 2020. All your business-related expenses are tax deductible as well.
The first step is to launch your own website to legitimize your business. The next step is to obviously go try and make some income! Most expenses related to the pursuit of such income should be considered a business expense. Below is an income statement example from a sole proprietor.
Pay Your Taxes With Pride
For those of you who are paying more in taxes than the median household makes a year (~$63,000), feel proud that you are contributing a lot to society.
Taxes are used to pay for defense, healthcare, infrastructure, food and shelter assistance programs, public schools, and more. If these things are considered good, then paying taxes is absolutely a form of giving.
It’s understandable that some people want to raise taxes on others without having to pay more themselves. If you are one of them, I encourage you to start contributing more yourself before going after other people who already are.
Readers, what other tax moves do you recommend making before year-end? Disclaimer: I’m not a tax professional, so please consult one before making any tax moves.