No one likes paying taxes, but what if there were a way to reduce the taxes you owe each year? Luckily, several tax-free income breaks can help lower your tax bill. Here are 11 of the best ways to beat the taxman.
Break 1: accumulation and withdrawals of tax-free incomes using Roth IRAs Roth IRAs (tax-free money after the age of 591/2) with two significant rewards:
Reward 1. Tax-free withdrawals
With qualified withdrawals from Roth IRAs, as opposed to traditional IRA withdrawals, earnings are federal income tax-free and usually state-tax-free.
What qualifies as a qualified withdrawal?
There are withdrawals that one takes once these conditions have been met:
- You have had at least 1 Roth IRA open for over five years.
- You have reached age 59 1/2, are disabled, or are deceased.
After your death, your heirs can take tax-free qualified Roth IRA withdrawals with proper planning.
Reward 2: Avoidance of required minimum distribution (RMD) rules
As opposed to the traditional IRA, you aren’t weighed down by the proprietor’s obligation to begin taking RMDs once you hit age 72. Traditional IRA owners have a 50% penalty that does not apply to Roth IRA owners.
For that reason, you can leave a Roth account untouched for as long as you live. This key feature is what makes the Roth so desirable because it allows one’s heirs to make Roth withdrawals tax free. The Roth IRA, which you ought to establish, maintain, and leave to your heirs, provided you don’t need it to cover your own retirement living expenses.
There are two ways to get money into a Roth IRA.
Procedure 1: making contributions annually to Roth
If you’re planning to pay the same or higher standard tax rates when you retire, contributing money to a Roth IRA each year makes sense. Contributions you can take out as qualified withdrawals are exempt from future higher federal tax rates, making Roth IRA contributions an intelligent move.The Roth contributions that you make cannot offer you any tax deductions.
So, if you hope to enjoy lower taxation rates during retirement (seeing that is not likely), then making deductible traditional IRA contributions (assuming your income is low enough to permit deductible contributions) may be a better plan. The current deductions could be worth more to you than tax-free withdrawals later.
The maximum amount you can contribute to a Roth IRA for a given tax year is the lessor of your earned income for that year or the annual contribution limit for that year. Earned income means wage and salary (including bonuses), self-employment income, and alimony received under a divorce decree made before 2019.
For the first tax year beginning on or after January 1, 2022, in which you contribute to a Roth IRA, the total contribution limit is $6,000 (or $7,000 if you’re over 50 as of December 31, 2022). This assumes you’re unaffected by the AGI-based phaseout rule explained below.
For the 2022 tax year, the Roth IRA annual contributions are phased out between modified adjusted gross income (MAGI) amounts of $129,000 and $144,000 for unmarried people. For married joint filers, the phaseout range is between joint MAGI amounts of $204,000 and $214,000.
Value points: Your ability to create annual Roth contributions are not affected by age.
- You can continue with annual contributions if your earned income is substantial enough to back them up
- and your contribution privilege is not affected by the phaseout rule.
Procedure 2: Do a Roth conversion
A few years ago, a $100,000 income restriction made it challenging for individuals with MAGI over $100,000 even to be considered for Roth conversions. That restriction is now gone. Now even billionaires are eligible for Roth conversions.That makes a big difference because conversion contributions are the only easy way to obtain large amounts of money directly into a Roth IRA. To ensure it’s worthwhile, remember the federal income tax hit that will come with your conversion. There may be a state income tax hit as well.
Break 2: social security benefits which are Tax-free
We all know that Social Security is something we pay into while working. We may not know that there are ways to take advantage of Social Security benefits to minimize our taxes. Here are two strategies for doing just that.
Many taxpayers whose earnings fall under the upper limit of governmental taxation, such as between 50 and 85 percent of their Social Security benefits, are eligible for a more significant percentage of their benefits tax-exempt.
- For unmarried status: If your provisional income is less than $25,000, 100 percent of your benefits are tax-free. With provisional income between $25,000 and $34,000, you may be taxed on up to 50 percent of your benefits. If your provisional income is more than $34,000, you may be taxed on up to 85 percent of your benefits.
- For married joint filers: If you are a joint filer with a combined income below $32,000, your benefits are entirely tax free. With a joint income between $32,000 and $44,000, up to 50% of your benefits are taxed. With a combined income between $44,000 or more, up to 85% of your benefits will be taxed.
Your adjusted gross income (AGI) from page 1 of Form 1040, plus half your Social Security benefits and any non-taxable interest income (typically from municipal bonds), are considered provisional income.
AGI is the sum of your taxable income items reduced by the sum of your so-called above-the-line deductions for things such as tax-deductible contributions to a traditional IRA, self-employed retirement plan contributions, self-employed health insurance premiums, the deductible portion of self-employment tax, and alimony payments made under a pre-2019 divorce settlement.
At least 15% of your Social Security income may be exempt from federal income tax and could be 100% exempt, depending on your provisional income. Some states exempt part or all of your Social Security income from state income tax. For example, Colorado exempts the first $24,000 from state income tax.
Break 3: Tax-free social security benefits along with tax-free IRA withdrawals
As you just read, between 50 percent and 100 percent of a person’s Social Security benefits can be tax-free for folks with modest incomes. If you are a part of that category, you might have some otherwise taxable withdrawals from your traditional IRA.
The good news is that your withdrawals from the IRA can be sheltered from your federal income tax with your standard deduction.The standard deduction amounts for 2022 are $12,950 (single), $19,400 (head of household), and $25,900 (married, filing jointly). If you’re 65 or over as of the end of the year, your standard deduction is a little bit more. The point is, a sizable or maybe all of your Social Security benefits could be free from federal taxes. Likewise, withdrawals from your traditional IRA. Excellent!
Break 4: gains from home sales that are tax-free
One of the biggest tax-saving deals ever allows a single seller of a principal residence to exclude (that is, not pay any income taxes on) up to $250,000 of gain, and a married joint-filing couple can exclude up to $500,000 of gain. After the massive surge in housing prices, which is not over yet, this break can be more valuable than ever. Naturally, there are some limits. You must pass the four tests to qualify for it.
- Ownership test: You must have owned the property for at least two years in the five years ending on the sale date.
- Use test: You have lived on the property for at least two years during the same five-year period. Periods of ownership and use need not coincide.
- Joint-filer test: To eligible for the $500,000 joint-filer exclusion, at least one spouse must pass the ownership test, and both must pass the use test.
- Previous sale test: You generally have to wait at least two years before taking advantage of the gain exclusion deal again if you excluded a gain from a prior principal residence sale. If a married joint-filer, the $500,00 exclusion is available only if neither you nor your spouse claimed the exclusion privilege for a previous sale within two years of the later sale.
Suppose you do not qualify for the maximum $250,000/$500,000 gain exclusion. In that case, you may still be eligible for the prorated (reduced) exclusion if you had to sell your home for job-related or health reasons.
For instance, say that you are a married joint-filing taxpayer. You and your spouse had your residence as your principal home for one year before moving for work-related reasons. You qualify for a prorated exclusion of $250,000 (half of the $500,000 maximum allowance for a joint-filing couple, based on passing the ownership and use tests for only one year, as opposed to two years).
Break 5: capital gains and dividends which are tax-free
When you occupy the sweet spot—the part of income in which long-term gains and qualified dividends are taxed at 0 percent—You can have a decent amount of income and still be within the 0% bracket for long-term gains and dividends.
- Say you are a married joint-filer with two dependent children in 2022. You claim the standard deduction of $25,900. Your adjusted gross income could be up to $109,250. This is the upper limit of the 0 percent income tax bracket for joint filers in 2022. ($109,250 – $25,900 = $83,350 of taxable income, which is the top limit of a 0 percent tax bracket for joint filers in 2022.)
- As a divorced individual, you file a W-2 as a head of household. You have two dependent children and claim the standard deduction of $19,400 in 2022. Your AGI could be up to $75,200 (including dividends and long-term gains). ($75,200 – $19,400 =$55,800 of taxable income, which is the top of the 0 percent capital gains bracket for heads of households in 2022.)
- Say that you are unmarried and have no children. You claim the standard deduction of $12,950 in 2022. If your AGI is $54,625, including long term capital gains and dividends and still be within the 0% bracket ($54,625-$12,950=$41,675.)
If you itemize deductions, your AGI (including long-term gains and dividends) could be even more significant, and you would still be within the 0% bracket for those gains and dividends.
Break 6: Tax-free capital gains sheltered with capital losses
Have you sustained capital losses this year related to stocks and mutual fund investments in a taxable brokerage firm account? If you had, you’re certainly not alone. The stock market has been out of control.
Fortunately, capital losses aren’t all bad. Suppose you’re current-year net capital loss and capital loss carryover into the current year. In that case, you can use it to shelter capital gains and up to $3,000 of other income (from salary, self-employment income, interest, and so on).
You can carry any excess net capital loss from the preceding year to shelter gains and other income going into 2023 and beyond.
Break 7: Treatment for inherited assets can be tax-free
If you inherit a capital gain asset, such as stock or mutual fund shares, or real estate, the federal-income-tax basis of the investment is stepped-up to its fair market value. The date of your benefactor’s death will decide (or six months after that date if the estate executor so chooses).
So, if you sell the inherited asset, you won’t owe any federal capital gains tax except to the extent that the fair market value as of your benefactor’s death exceeds the ending basis.
Break 8: Real estate exchanges can be -Tax-free under section 1031
Section 1031 property trade postpones taxes is not tax-free. However, while there, you may wish to learn how we can get it to be tax-free.Section 1031 of the Internal Revenue Code allows you to delay paying federal income taxes on appreciated real properties with a like-kind exchange. Because Section 1031 exchanges have been around for so long, they’re a significant factor in why many real estate investors have become rich.
If you pass away while owning real property that you acquired in a Section 1031 exchange, the tax basis of the property is stepped up to the fair market value as explained above. Consequently, owing to this information, the 1031 deferred gain will be tax-free.
Your heirs can sell inherited property and only owe capital gains tax on the appreciation after the date you pass. Amazing!
Break 9: small business stock gains can be tax-free
Qualified small business corporations (QSBCs) are a particular category of a corporation in which the stock can qualify for federal income-tax-free treatment if sold for a gain.
As long as the current tax regulations remain on the books, QSBC stocks that are owned after September 27, 2010, and are retained for five years or more before being sold are eligible for a 100 percent gain exclusion, which equates to a wholly federal income tax-free treatment if you hold the shares.
Break 10: Tax-Free Withdrawals from Section 529 College Savings Plans
Section 529 college savings accounts also let you take advantage of a tax-free gain.
529 contributions account lets contributors make bigger contributions to their college savings programs. A state income tax break may apply to the account based on the beneficiary’s age.
Contributions to a 529 account also protect your taxable estate (if you worry about that) because the contributions are treated as gifts to the account beneficiary. Contributions in 2022 are eligible for the $16,000 annual federal gift tax exclusion. Contributions up to that amount won’t reduce your unified federal gift and estate tax exemption.
Unified exemption for 2022 will be $12.06 million, or $24.12 million for a married couple. If giving makes you feel generous, you can make a larger lump sum contribution and spread it over five years for gift tax purposes. This situation allows you to start the beneficiary’s college fund while benefiting from five years’ worth of annual gift tax exclusions.
Break 11: Withdrawals from Coverdell Education Savings Accounts (CESAs) can also be Tax-Free
You can contribute up to $2,000 annually to a Coverdell Education Savings Account (CESA) for a beneficiary, typically your child or grandchild. A CESA is a private account for set up by you to function exclusively as an education savings account for that designated beneficiary.
The IRS allows CESAs to accumulate federal income tax free. Then withdrawals are tax-free and may be taken on behalf of the beneficiary’ s education expenses, tuition fees, books, supplies, and room and board. You may contribute up to $2,000 per beneficiary to a CESA account if the account is set up in several names.
If you have the right to make CESA contributions is phased out between MAGI of $95,000 and $110,000, or between $190,000 and $220,000, if you are a married joint-filer.
Infrequently, this restriction can be circumvented by nominating a trustworthy individual who is free from this restriction. For instance, you could give contribution dollars to another trustworthy adult (maybe a brother or sister or parent), who would open the CESA and make the contribution on your behalf.
If your responsible party is someone other than yourself, you may lose whatever control you have over the account. Be mindful of that.
You have heard the phrase tax-free. Here, you learned about 11 different tax-free sources of income.
- Roth IRAs
- Social Security benefits up to the taxable limit
- Tax-free IRA withdrawals (on top of tax-free Social Security)
- Deductions for home sales up to $250,000 ($500,000 if married, filing jointly)
- Tax-free capital gains and dividends when you profited the most
- Capital gains sheltered with capital losses
- An inherited step up.
- Real estate exchanges under section 1031 held until death
- Qualified business tax gains
- Section 529 college savings plans
- Coverdell education savings accounts