During the 2016 presidential debates, Hillary Clinton accused then candidate Donald J. Trump of not paying income taxes.
Trump’s response? “That’s because I’m smart!”
Regardless of how you feel about President Trump not paying income taxes, you’d probably like to pay fewer taxes on your own income.
There are plenty of ways to reduce your income taxes if you know the code – the Internal Revenue Code (IRC), that is. It would be impossible to cover everything in the IRC in one blog post, so let’s just touch on a few things that many of us can take advantage of.
While paying zero income taxes is not a realistic goal for most people, we can likely pay a lot less in taxes by knowing the tax code and taking as many deductions as possible.
Quick income tax lesson
First, it helps if you know the rationale of the Internal Revenue Service’s tax policies. In a nutshell, any U.S. taxpayer will pay taxes on income only once.
Phase 1: Earned income from your job
- You earn $1,000 Gross Income
- You pay $ 150 income tax
- You keep $ 850 net income
Phase 2: Unearned income from investments
- You invest $850
- You get $2,000
- You gain $1,150
In the example above, when you cash out your investment, you would pay tax only on the gain of $1,150 – not the full $2,000 that you withdrew. Make sense? Okay, let’s move on.
Worth knowing: For taxation purposes, income is categorized as either earned (such as from an employer) or unearned (such as from an investment). Earned income and unearned income are usually taxed at separate rates, so it’s important to understand the difference.
Ways to help reduce your taxes
If you want to reduce the amount of money you pay in income taxes you have two key options:
- Bring in less income
- Take advantage of legally allowable tax deductions.
Since most people don’t want to reduce their income, let’s focus on option 2. The more deductions you can find for your situation, the less you will pay in income taxes.
Common tax deductions
Donations to charity
Many charitable contributions can be deducted from your taxable income. Some states will double your deduction or give you a direct credit for donations.
Key: Generally, the organization(s) need to be registered as 501(c)(3) non-profits in order for your donations to count, so your homework before writing a check.
If you work for a company that offers a retirement plan, chances are you can reduce your taxable income by putting money into your retirement account via payroll deduction.
Simple example: if you earn $40,000 a year and put $500 a month ($6,000 a year) away for retirement, your taxable income would be $34,000 ($40,000 – $6,000).
If you don’t have a retirement plan at your job, you may be able to deduct up to $5,500 a year if you put it into an IRA. For those of us age 50 and over, the deductible amount is $6,500, thanks to a “catch up” provision.
Health savings accounts
Contributions to qualified health savings accounts (HSA) are deductible in much the same way as retirement plan contributions. That means if you have money taken out of your pay and put into a HSA, your taxable income may be reduced by the amount you put away for health expenses.
Mortgage interest and property taxes
These deductions can make a big difference, and are already known by most homeowners. If you have a mortgage on your home, the interest you pay each year, and some of the other expenses like property taxes and mortgage insurance, can probably be deducted.
Medical insurance premiums and expenses
This one gets a little tricky. Generally speaking, healthcare expenses can only be deducted if the sum total exceeds 7.5% of your AGI. Still, it can pay to keep diligent records because some states give tax breaks for the money you spend on medical related expenses.
Education savings or expenses
Whether you put money into an education savings account for future years or pay for higher education expenses this year, there are many ways to reduce your overall tax bill by knowing what deductions exist and taking advantage of them.
Since your tax rate and overall tax amount is based on your Adjusted Gross Income (total income minus deductions), the bigger your deductions are, the less you’ll pay in income taxes.
Because President Trump hasn’t made his tax returns public, we don’t know for sure how – or if – he was able to reduce his income tax bill to zero. However, it’s presumable he has taken advantage of the deduction opportunities mentioned above, plus some the rest of us aren’t wealthy enough to concern ourselves with. While paying zero income taxes is not a realistic goal for most people, we can likely pay a lot less in taxes by knowing the tax code and taking as many deductions as possible.
Important: This post is intended to be educational only and should not be relied upon as tax advice. Everyone’s tax situation is unique and you should consult an expert tax preparer if you are unsure how the items above relate to you.