Especially for high-income earners, there is good reason to be motivated to try to find ways to reduce the amount of taxes you have to pay on your income. Unfortunately, the federal government doesn’t make it easy to pay less tax on W-2 income. Most people will find that there aren’t many ways to dramatically alter their tax obligation on W-2 income. But there are a handful of strategies you can consider taking advantage of, and the savings may be substantial if there is a strategy that makes sense in your situation.
Charitable Contributions
As you probably know, donating cash or items to charity can result in a tax deduction. The primary hurdle is that you only benefit from donations once the amount exceeds your standard deduction (along with your other itemized deductions, such as your mortgage interest and real estate taxes on your home). Here are some ways to maximize the tax benefit of charitable contributions:
- If your itemized deductions aren’t usually high enough to exceed your standard deduction before adding donations, you may want to “bunch” your donations together in one tax year rather than donating a little each year, so that you can surpass your standard deduction and maximize your tax benefit.
- You can donate assets such as stock, real estate, or cryptocurrency that has appreciated in value. If you sell an item and then donate the cash, you have to pay capital gains tax on the appreciation of the asset. But if you instead donate an appreciated asset, then you don’t have to pay any capital gains on the appreciation, but you still get to deduct the full current fair market value of the item.
- If you don’t yet know how you want to distribute your contributions, you can use a Donor-Advised Fund (DAF) to make donations now to get the tax benefit in the current tax year, but delay distributing the funds to specific charities until a later date.
- You can create a Charitable Remainder Trust (CRT) to allow you to donate income-generating assets to the trust, but continue to receive income from those assets during your lifetime. So you get an immediate tax deduction for the value of the donated assets, but you can continue to receive income that the assets generate. The trust would then donate the assets to a charity after your death (or after a specified term).
- Charitable Gift Annuities (CGA) allow you to make a sizable donation to a charity, which then provides you with a set amount of lifetime fixed income. Your original donation is partially deductible, and a portion of the income you receive may also be tax-free.
- For taxpayers aged 70½ or older, Qualified Charitable Distributions (QCDs) provide a tax-efficient way to give to charity directly from an IRA. Individuals can make charitable distributions directly from their IRA accounts up to $100,000 per year without counting the distribution as taxable income, while still satisfying their minimum distribution requirements.
Also be aware that your maximum deduction may be capped at a maximum of 20%-60% of your income, depending on the type of donation and the type of charitable organization that you are donating to.
Retirement Plan Contributions
Contributing to a 401(k) plan is a straight forward way to reduce your taxable income. A 401(k) plan may be a traditional plan, which shelters your contribution amount from income tax. Contributions to a Roth-designated 401(k) account aren’t tax deductible, but the advantage of a Roth-designated account is the withdrawals are tax-free. You may also qualify to make a tax deductible contribution to a Traditional IRA account if your income is below the income limit for the current year.
Depending on job, your employer may also other similar retirement plans, such as 403(b), 457, SEP, and others that provide similar tax advantages.
HSA Contributions
If you’re covered by a high-deductible health insurance plan (HDHP), you can contribute to a Health Savings Account (HSA). Unlike retirement accounts, an HSA is a “triple tax-advantaged account”. Contributions are made with pre-tax dollars, your investments grow tax-free, and withdrawals used for qualified medical expenses are tax-free.
There is no requirement that you spend the money in the account each year, so you can let it remain invested for as many years as you would like. If you save your medical receipts, someday in the future you can withdraw money from the account and the withdrawal is tax-free if you can document that your withdrawal is to reimburse yourself for past medical expenses going back any number of years.
Real Estate
Real estate investing is one of the few ways you can substantially reduce your taxes, potentially all the way down to paying $0 tax. But there are some substantial hurdles to be aware of, and the tax savings is often less than people initially expect.
Rental real estate may generate negative taxable income, even when it is profitable, thanks to depreciation. The amount of depreciation you can take in one year can be dramatically accelerated by doing a cost segregation study, which allocates a portion of the property to fast depreciation methods, which are also eligible for bonus depreciation. But be aware that the amount of tax savings from doing a cost segregation study may be less than what you may expect. See our article on cost segregation studies, and the tax savings estimation calculator on that page to estimate your potential tax savings.
The biggest hurdle to using real estate to reduce your taxes is that by default, real estate tax losses can’t offset your W-2 income and are instead suspended and carried forward to offset future passive income. But there are some exceptions. Two of the biggest ones are the short-term rental loophole, and real estate professional status. But both of these strategies also require that you “materially participate” in the rentals, so you can’t just buy a short-term rental and get a property manager to deal with it and still get the tax benefit. But if you, or your spouse, are willing to put in the time and investment to take advantage of these real estate strategies, the potential tax savings can be huge in some circumstances.
Side Businesses
If you’re considering operating a side business, that can be a way to generate a current year tax deduction, while also creating future income. A business may generate a sizable tax loss, especially in the first few years of operations. The tax loss is deductible against your other income as long as you materially participate in the business. So it can’t merely be a passive investment if you want to deduct the loss against your W-2 income.
Expenses incurred while setting up a new business aren’t deductible until the tax year that the business begins operating, so be aware that it won’t create a tax benefit until that point. And also be aware that losses from an unprofitable business that may be classified as a hobby or leisure activity may be disallowed, with particular additional scrutiny if a business hasn’t generated a taxable profit for three years in a row.
When you have a business, there are numerous strategies you can use to maximize your deductions related to the business, including hiring your kids, a home office deduction, or the Augusta Rule (renting out your own home for a business purpose).
Oil & Gas Investments
Certain types of oil and gas investments are tax advantaged investments because they are uniquely classified as a non-passive activity for tax purposes, even when you are just passively investing money into it. That means this type of investment can use depreciation and other deductions to generate a tax loss that can offset your other taxable income. The downside is that these types of investments are typically risky, and you can easily lose more money than you saved in taxes if the investment doesn’t pan out.
Tax Credits
Along with those significant tax savings strategies, there are also numerous tax credits you may be eligible for that may help to at least somewhat reduce your tax bill. Some of the more significant ones you may be eligible for include:
- If you have children or dependents (including a disabled parent who you support) and you pay for someone to provide care for them, you may qualify for the Child and Dependent Care Credit (CDCC). To be an eligible expense, the care must be provided during times when both spouses are working.
- If you’re paying for yourself or a dependent to attend college, the American Opportunity Tax Credit (AOTC) and Lifetime Learning Credit (LLC) may be available. Both of these do phase out for high income earners above the income limit.
- If you made upgrades to your home that increased its energy efficiency, you may be eligible for the Energy Efficient Home Improvement Credit. There is no income limit for this credit.
- If you installed solar panels on your home, you may be eligible for the Residential Clean Energy Credit.
- If you buy an electric vehicle, you may qualify for the Electric Vehicle (EV) Tax Credit. The current version of this credit does phase out above certain income limits.
These are just a handful of some of the more common tax credits, but there are many others. Your tax software, or tax professional, will usually ask questions to find out if you qualify for tax credits that may be applicable to your situation.
Summary
Your options to reduce your income taxes on W-2 income can pretty much be summarized by saying most of the available strategies will reduce your taxes at small or moderate amount. The exceptions that can generate a large benefit include charitable contributions, which can produce a large deduction, but requires that you to make a large donation. Or real estate investing, which can also generate a large deduction, but requires a significant investment of both time and money.
While there may easy ways to instantly and dramatically reduce your taxes on W-2 income without any drawbacks, it’s valuable to be aware of what your options are so you can maximize the potential tax savings that are available to you for your situation.
