Dennis Hammer is a writer and finance nerd with six years of investing experience. He writes about personal finance for Wealthsimple. Dennis also manages his own investment portfolio and has funded several businesses in the past. Dennis holds a Bachelor's degree from the University of Connecticut.
No one likes paying taxes. We know they’re necessary for an orderly society, but it still hurts to see those deductions on your paycheck. How do you ease the pain? By paying less, of course! You can reduce your tax bill by reducing your taxable income.
What Does Taxable Income Mean?
Your taxable income is the amount of money you earned that your tax agency uses to calculate how much you owe in taxes. It’s your gross income minus any income adjustments.
What’s your gross income? It’s your income from all taxable sources. It includes wages/salary, tips, bonuses, and investment income (dividend payments, asset appreciation, and capital gains). It also includes unearned income like government pensions, disability payments, gambling winnings, and cancelled debts.
People often assume gross income refers to only their wages because their wage earnings make up the majority of their income (for most people). But this isn’t the case. Gross income includes every penny that’s taxable.
If you shovel your neighbor’s steps for $20, the taxman considers that income. It’s even income if you trade goods or services. Many people fail to report these kinds of income, but they count.
Other kinds of income are nontaxable, however. These are not part of your gross income, and therefore are not part of your taxable income. They include…
Life insurance payouts
Compensatory damages for injury
Income you contribute to retirement accounts.
If you aren’t sure if money you earned is taxable or nontaxable, speak with a tax adviser who knows your region. Different agencies define taxable and nontaxable income differently. For example, the Canada Revenue Agency does not consider lottery winnings taxable, but the Internal Revenue Service in the United States does.
Calculating How Much of Your Income is Taxable
Taxable Income = Gross Income - Income Adjustments
Like we said, gross income includes income from taxable sources. Income adjustments are deductions that reduce the size of your gross income.
Here’s an example: Mark earned $75,000 through his job and $15,000 from some consulting side work. He also owns stock that paid $2,000 in dividends. His gross income was $92,000.
Mark doesn’t pay taxes on $92,000. Since he lives in the United States, he took the standard deduction: $12,200. He also had $1,200 in business expenses and $4,000 in dependent deductions (for his two kids).
After his deductions, Mark’s taxable income is $74,600. This is the amount he’ll pay taxes on.
Reducing Taxable Income
You can’t avoid paying your taxes, but with a little planning you can reduce your total bill. Here are some essential strategies to reduce taxable income.
1. Contribute to Retirement Accounts
The best way to reduce taxable income is to contribute to retirement accounts. When you save for retirement, the tax man looks the other way. He doesn’t collect taxes on what goes into the account (up to a limit). Governments want people to save for retirement, after all.
What are retirement accounts? You can contribute to a 401(k) or 403(b) in the United States and a personal pension plan in the UK. Both are employer-sponsored, which means your boss will deduct your contributions right out of your paycheck. You can also contribute to an ISA in the UK or a Roth IRA in the United States.
The best part about these accounts is that you get to keep and grow the money by investing it in the market. Over time, the tax savings can boost your retirement fund’s growth.
2. Contribute to Flexible Spending Plans
A flexible spending plan (FSP) is an account where you can deposit pre-tax dollars for specific expenses, like dependent care or medical costs. You don’t pay taxes on the money you contribute.
These plans are managed by your employer. Your boss will deduct a predetermined amount from your paycheck and deposit it in the account. The account administrators will release the funds for eligible expenses.
The downside, unfortunately, is that you forfeit whatever you don’t spend by the end of the year (though there are some carryover provisions). For instance, if you put $2,000 into an account for daycare expenses, then decide to stay home with your child, you would lose the money.
A health savings account (HSA) is a flexible spending plan for medical costs. You fill it with pretax dollars and use this money for healthcare expenses. You lose the money if you don’t spend it during the year, but you don’t pay taxes on the income either way.
3. Deduct Business Expenses
If you’re self-employed (full or part time), you can deduct work expenses you incur. You can deduct the costs of materials and supplies. You can also deduct marketing and advertising expenses, traveling and shipping costs, and a portion of your phone and Internet bill. If you work from home, you can even take a home office deduction to reduce your taxable income.
4. Track Your Healthcare Costs
In the United States, you may be able to deduct medical costs from your gross income. This only works if the costs plus other deductions are greater than the standard deduction, but your account or tax software will walk you through that. Log all of your costs so you know which method (itemizing or taking the standard deduction) is cheaper.
5. Defer Some Income if You’ll Make Less Next Year
If you think your income will be smaller next year, it can help to defer some of this year’s income until the next tax year. You might wait a month to bill a client or ask your boss to hold your bonus until after the New Year.
6. Hire a Tax Professional or Tax Software
Taxes are complex. You’re bound to miss a deduction or credit if you try to do them on your own. Rather than slog through your taxes manually, use tax software that will walk you through the process with simple questions. Better yet, hire a professional. Both options will help you reduce your taxable income as much as possible.
7. Save Money for Children’s Education
If you have a child, you probably want to save for their future education. In the United States, contributions to a 529 plan (an education savings account) may be deductible in your state. You can’t deduct it on your federal return, but you can use these contributions to reduce your state taxable income. However, the money grows tax-free.
8. Bundle Your Deductions
U.S. taxpayers take whichever is larger—the standard deduction or an itemized list. If your deductions add up to more than the standard deduction, they don’t reduce your taxable income. It’s smarter, in some cases, to bundle your deductions every other year. So you would itemize one year and take the standard deduction the next year.
For example, let’s say you donate $500 to your church every year, but end up taking the standard deduction. It may be smarter to give $1,000 every other year if it pushes your total deductions over the standard in those years, thus forcing you to itemize.
Keep Your Money
Reducing your taxable income takes planning and effort, but it’s worth the trouble. The more money you keep in your pocket, the faster you’ll grow your nest egg and build a comfortable retirement.