6 Strategies to Protect Income From Taxes

Income is taxed at the federal, state, and local levels and earned income is subject to additional levies to fund Social Security and Medicare. Taxes are difficult to avoid but there are several strategies you can use to help ward them off. Here are a few you might want to consider.  

1. Invest in Municipal Bonds

Governments need money to fund their obligations to their citizens, such as maintaining safe roadways and public schools. They raise this money in part by selling securities: municipal bonds or "munis."

The advantage here? Assuming you hold the bond until maturity, you don’t have to pay federal taxes on the interest—or state and local taxes either if you live in the locality where the bond was issued. Tax-free interest payments make municipal bonds attractive to investors.

That said, don’t assume that a bond isn’t taxable just because it’s a muni. There are some exceptions to munis’ tax-free status. A “de minimis” tax can apply if you purchased the bond(s) at a discount of more than 0.25%. Interest and gains derived from the discounted amount are taxed, and they’re taxed as regular income, not at kinder, long-term capital gains rates, no matter how long you hold the bonds. 

Overall, municipal bonds historically have lower default rates than their corporate bond counterparts. A 2022 data report on municipal bonds from 1970 to 2022 found that the default rate was 0.08% for municipal bonds versus 6.9% for global corporate issuers. The data was based on a five-year period.

Municipals typically pay lower interest rates. Municipal bonds' tax-equivalent yield makes them attractive to some investors because of the tax benefits. The higher your tax bracket, the higher your tax-equivalent yield.

2. Shoot for Long-Term Capital Gains

Investing can be an important tool in growing wealth. Another benefit of investing in stocks, mutual funds, bonds, and real estate is the favorable tax treatment for long-term capital gains.

An investor holding a capital asset for longer than one year enjoys a preferential tax rate of 0%, 15%, or 20% on the capital gain, depending on the investor’s income level. The capital gain is taxed at ordinary income tax rates if the asset is held for less than a year before selling. Understanding long-term versus short-term capital gains rates is important for growing wealth.

The 2024 zero rate bracket for long-term capital gains applies to taxable income up to $94,050 for married couples who file jointly, up from $89,250 in 2023. The threshold is $47,025 for single individuals, up from $44,625 in 2023. A tax planner and investment advisor can help determine when and how to sell appreciated or depreciated securities to maximize gains and minimize losses.

Tax-loss harvesting can also offset a capital gains tax liability if you sell securities at a loss. The lesser of $3,000 of the excess losses or the net capital loss can be deducted from other income if capital losses exceed capital gains. Capital losses over $3,000 can be carried forward to later tax years. 

3. Start a Business

A side business offers many tax advantages in addition to creating more income. Many expenses can be deducted from income when they're used in the course of daily business, reducing your total tax obligation. Even health insurance premiums can be deductible for self-employed individuals if special requirements are met.

A business owner also may deduct part of their home expenses with the home office deduction by strictly following Internal Revenue Service (IRS) guidelines. The portion of utilities and Internet that are used in the business may also be deducted from income.

The taxpayer must conduct business with the intention of making a profit to claim these deductions. The IRS evaluates several factors to determine this. Taxpayers who realize a profit in three of five years are presumed to be engaged in a business for profit.

The Setting Every Community Up for Retirement Enhancement (SECURE) Act was enacted in 2019. This legislation offers tax incentives to employers who join multiple-employer plans and offer retirement options to their employees.

4. Max Out Retirement Accounts and Employee Benefits

Taxable income can be reduced for contributions up to $22,500 to a 401(k)  or 403(b) plan in 2023, increasing to $23,000 in 2024. Those who are 50 or older can add $7,500 to the basic workplace retirement plan contribution in 2023 and 2024. An employee earning $100,000 in 2023 who contributes $22,500 to a 401(k) in 2023 or $23,000 in 2024 reduces their taxable income to only $77,500.

Those who don’t have a retirement plan at work can get a tax break by contributing up to $7,000 ($8,000 for those 50 and older) to a traditional individual retirement account (IRA) in 2024, up from $6,500 and $7,500 respectively in 2023. Taxpayers who do have workplace retirement plans (or whose spouses do) may be able to deduct some or all of their traditional IRA contribution from taxable income, depending on their income.

The deduction for IRA contributions is phased out for adjusted gross incomes at different levels depending on whether they're claimed on a single taxpayer’s return, a joint return, or by a married individual filing separately. It takes into account any participation by a taxpayer in another plan. The IRS has detailed rules about whether and how much you can deduct.

Fringe Benefits

Many employers offer a variety of fringe plans in addition to retirement plan contributions that allow employees to exclude the contributions made or benefits received from their income. Benefits under these programs generally are reflected as non-taxed amounts on employees’ W-2 statements.

These benefits include flexible spending accounts, educational assistance programs, adoption expense reimbursements, transportation cost reimbursements, group term life insurance up to $50,000, and deferred compensation arrangements generally for senior managers and executives.

5. Use a Health Savings Account (HSA)

Employees with a high-deductible health insurance plan can use a health savings account (HSA) to reduce taxes. As with a 401(k), HSA contributions made by payroll deduction are excluded from the employee’s taxable income. An individual’s direct contributions to an HSA are 100% tax-deductible from their income. The maximum deductible contribution level was $3,850 for an individual and $7,750 for a family in 2023, increasing to $4,150 and $8,300 respectively in 2024.

HSA contributions can be matched by an employer. These funds can then grow without the requirement to pay tax on the earnings. An extra tax benefit of an HSA is that withdrawals aren't taxed either when they're used to pay for qualified medical expenses.

6. Claim Tax Credits

Tax credits are perhaps the greatest tax break of all. 

Let’s look at a scenario: Maybe your overall income for the year was $50,000. You spend $8,000 of that on IRS-friendly deductible expenses. You’ll pay your ordinary tax rate on $42,000, assuming that none of the money derived from long-term capital gains. Now, let’s say that you’re also eligible for one or more tax credits. They’re worth $5,000. But that $5,000 doesn’t reduce your taxable income. It comes directly off the tax you owe the IRS on that $42,000. It’s a dollar-for-dollar perk.  

There are many tax credits available, and here are two of the more commonly claimed credits:

The Child Tax Credit  

The Child Tax Credit is an important one for U.S. taxpayers with children, in that it can significantly lower your tax burden. This Child Tax Credit was worth $2,000 for each qualifying child in tax year 2022 (the return filed in 2023). To qualify for the full credit amount, you can’t earn more than $200,000 if you’re single or $400,000 if you’re married and file a joint return. You might qualify for a partial credit if you earn slightly more. 

Your child or children must be younger than age 17 as of the last day of the tax year to qualify. They must have lived with you for more than half the year and they can’t have paid for more than 50% of their own support needs. Stepchildren, siblings, and descendants can qualify, too, provided that you claim them as dependents on your tax return.

The Earned Income Tax Credit (EITC)

The Earned Income Tax Credit (EITC) can be a nice financial gift for low- to lower-middle income families. To qualify, you must have some earned income and there’s a cap on how much it can be, as well as on the amount of any unearned income you might enjoy.

A low-income taxpayer could claim credits up to $7,430 with three or more qualifying children, $6,604 with two, $3,995 with one, and $600 if none in tax year 2023. This is the return you'll file in 2024. They increase to maximums of $7,830, $6,960, $4,213, and $632 in 2024.

The maximum amount of the credit is a calculation based on your income, marital status, and the number of children you support. (It’s worth noting that you can potentially qualify with no children if your income is very low.) 

You must have a Social Security number to qualify and you must be a U.S. citizen or resident alien. You generally won’t qualify if you’re married and filing a separate tax return, but there are some limited exceptions to this rule.

Other Tax Credits

The American Opportunity Tax Credit offers a maximum of $2,500 per year for eligible students for the first four years of higher education as of January 2024. The Lifetime Learning Credit allows a maximum of 20% credit for up to $10,000 of qualified expenses or $2,000 per return. This credit isn't indexed for inflation.

There is also the Saver’s Credit for moderate and lower-income individuals looking to save for retirement. Individuals can receive a credit of up to half their contributions to a plan, an IRA, or an ABLE account.

The Bottom Line

It's important to pay all that is legally owed to tax authorities, but nobody has to pay extra. A few hours on the IRS website (IRS.gov) and scouring reputable financial information sites may yield hundreds and maybe even thousands of dollars in tax savings.

It also may be wise to check with a tax professional before you claim them on your tax return. You’ll want to be sure you qualify when all the intricate qualifying rules are applied—and then enjoy the money you saved because of your diligence.