People don't get used to the large amount of federal income tax that is withheld from each paycheck. The IRS will withhold more income tax for every dollar you earn.
Personal Capital's senior tax specialist, I am often asked the question: Can you reduce your taxable income so that you have $0 in tax bills?
Even if your income is very high, careful tax planning can significantly reduce your tax burden. Here's how.
Personal Capital's dedicated team of advisors can help create a tax-efficient investment and financial plan. Register for our financial tools and schedule an appointment to meet with an advisor.
What is the Average American Tax Bill?
The IRS received more than $4.1 trillion in taxes during the fiscal year 2021. It processed more than 261,000,000 tax returns and issued more $1.1 trillion in refunds.
The IRS has historically collected most tax from California, New York and Texas. These states also had the highest total refunds.
The highest income earners borne the majority of the tax burden. The IRS released the most recent federal income tax data in 2018. It found that the top 50 percent paid 97.1 percent of individual income taxes. While the bottom 50 percent only paid 2.9 percent, this is according to IRS.
Are you an investor? Our free guide, 5 Tax Hacks Every Investor Must Know, teaches you how to reduce your capital gains tax, make losers winners by tax-loss harvesting and maximize after-tax returns.
The State of the Tax Code
The tax code can be complicated. The basic structure is quite simple. As your income rises, your tax rate will increase. Complexity is caused by the many types of income and credits that are available to taxpayers who plan well.
These deductions and credits that are phased out with income increases add another layer of complexity. There are many reasons that the tax system is so complicated. These include individuals who take advantage loopholes in code, which leads to the creation of additional rules, and government-driven initiatives or incentives. The sweeping changes to the tax code that were made by President Donald Trump's 2017 Tax Reform and Jobs Act only make matters more complicated.
How Average Americans Can Lower Their Taxable Income and How to Avoid Taxes
Let's get down to the important question: Does the average American have to pay no taxes? Some taxpayers could pay no tax, even if they have more than $100,000 in investment income. It doesn't matter what your income is or how much you have, it's prudent to use any tax credits and deductions that you are eligible for.
John: John is a 23-year-old recent college graduate
John is a 23-year old who wants to keep his taxes at zero. John recently finished college and has just started full-time employment with a starting salary of $30,000. John was able to live comfortably while attending college and is now ready to continue the college student lifestyle for another few years. He was fortunate to have studied finance at college, and is familiar with compounding investment returns. He is aware that his investments made in his twenties can grow for decades, which will help him secure a comfortable retirement.
John lives with roommates who share the rent and utilities. John is able to comfortably live on $1,300 per monthly, which comes out of his $2,500 monthly salary. John contributes $1,000 each month to his employer's retirement plan. This amounts to $200 per paycheck, which is enough to pay for Social Security and Medicare tax withholding.
23 year old single person, no children |
|
---|---|
Annual Salary | $30,000 |
Contributions to 401k | -$12,000 |
Adjusted Gross Income | $18,000 |
Standard Deduction | -$12,950 |
Taxable income | $5,050 |
Federal Taxes | $545 |
Retirement Savings Contributions Credit | -$545 |
Total 2022 Tax Bill |
$0 |
After subtracting the $12,000 John contributed to his 401k in the year, what began as a $30,000 salary will become $18,000 in adjusted gross income for tax purposes. An individual taxpayer without dependents will owe $545 for $18,000 in income tax year 2022. John has the right to the Retirement Savings Credit because he funds his 401k account through the year. John's retirement savings contributions credit will be $545. This credit will reduce John's tax bill to zero.
The Retirement Savings Contributions credit, also known as Saver's Credit offers taxpayers a credit up to 10%, 20%, or 50% on contributions to retirement savings accounts like a 401k, IRA, or IRA.
These are the AGI (Adjusted Gross Income) limits that you can claim the Saver's Credit to file your taxes for 2022.
2022 Savings Credit
Credit Rate |
Married Filing jointly |
Head of Household |
All Other Filers* |
---|---|---|---|
Contribution: 50% | AGI no more than $41,000 | AGI no more than $30,000. | AGI no more than $20,000. |
20% of your contribution | $41,001- $44,000 | $30,751 – $33,000 | $20,501 – $22,000 |
10% of your contribution | $44,001 – $68,000 | $33,001 – $51,000 | $22,001 – $34,000 |
Contribution 0% | More than $68,000 | More than $51,000 | More than $34,000 |
*Single, married filing separate, or qualifying widow(er).
The credit amount is limited to the total tax due by the taxpayer. John is eligible for a maximum of $1,000 in the Saver’s Credit. The Saver's Credit can only be used for $545 because John's tax bill is $545 without the Saver's Credit. The Saver's Credit, unlike other credits such as the Earned income Credit or the Additional Child Tax Credit, is not refundable if it exceeds the taxpayer's tax liability.
John can maintain his zero tax bill even if he receives a raise. He can increase his contributions by the amount he gets a raise. His adjusted gross income will still be $18,000 and he will continue to get the Retirement Savings Contributions Credit.
John's tax bill $0
The Smiths: Married Couple, 40 years old with Two Children
Our second example is the Smith family, which pays no federal income tax. Both Mr. and Mrs. Smith have been married for 40 years and have two children in elementary school. The Smiths make $103,250 a year together from their full-time jobs.
The Smiths place a strong emphasis upon retirement savings, contributing maximum to both their 401ks (each $120,500) and traditional IRAs (each $6,000) . They contributed $53,000 to their retirement accounts.
The Smiths have two elementary school-aged children, so they must pay for after-school care during school year and child care in the summer. The annual child care expenses amount to $5,000. The Smiths contribute $5,000 to Mrs. Smith's childcare flexible spending account, which is deducted from her salary before taxes.
Similar to Mrs. Smith, she contributes $2750 annually to her healthcare flexible spending account. This is also taken from her paycheck before tax. The family will likely use $2,750 annually for their typical dental and medical expenses.
Married Couple, 40 years old, 2 Children | |
---|---|
Annual Salary | $104,300 |
Contributions to 401k (x2) | -$41,000 |
Traditional IRA Contributions (x2) | -$12,000 |
Healthcare Flexible Spending Account | -$2,750 |
Flexible spending account for child care | -$5,000 |
Adjusted Gross Income (AGI) | $43,550 |
Standard Deduction | -$25,900 |
Taxable income | $17,650 |
Federal Taxes | $2,056 |
Childcare Tax Credit | -$2,056 |
Refundable child credit | -$1,944 |
Total 2022 Refund |
-$1,944 |
These deductions are taken from their combined gross income to reduce their $104,300 salaries to an adjusted gross of $43,550. On $43,550 of adjusted income, a married couple will owe $2056 income tax. The Smiths are eligible to claim the $4,000 child tax credit ($2,000 per child). The credit, which is non-refundable and offsets income tax liability, amounts to $2,056. They can also take $1,944 as an refundable credit.
The tax credits of $2,056 offset their tax liability on $43,550 in adjusted gross income. The Smiths will pay no tax and receive a tax credit that can be refunded. The Smiths have a six-figure income but still manage to reduce their federal income tax bill by using a variety of tax credits and deductions.
Mr. Mr. and Mrs. Smith's Tax Bill: $0 and total tax refund of $1.944
The Jacksons: Married Couple 55 Years Old, Empty Nesters
We will use the Jackson family as our third example to show how ordinary households can avoid federal income tax. The Jacksons have an annual salary of $113,750.
The Jacksons raised two amazing children, and now they are looking forward to retiring in five years. Both of the Jackson children are now graduates from college and no longer depend on their 55-year old parents. They are proud to have paid off their 30-year-old mortgage on the house that they purchased when they got married.
The Jacksons now have more income after the children are out of the house and the house is paid off. They want to turbocharge their retirement savings to make more disposable income since Mr. and Mrs. Jackson are approaching retirement.
Married Couple, 55 Years Old, No Dependents |
|
---|---|
Annual Salary | $113,750 |
Contributions to 401k (x2) | -$54,000 |
Traditional IRA Contributions (x2) | -$14,000 |
Capital Loss Carryforward | -$3,000 |
Contribution to the Health Savings Account | -$8,300 |
Adjusted Gross Income (AGI) | $34,450 |
Standard Deduction | -$25,900 |
Taxable income | $8,550 |
Federal Taxes | -$1,145 |
Retirement Savings and Contribution Credit | -$1,145 |
Total 2021 Tax Bill |
$0 |
The Jacksons have good news because the IRS rules allow taxpayers 50 years old and older to make "catch-up" contributions to their 401k plans or IRAs. A person 50 years old or older can make an additional $6500 catch-up contribution to their 401k and an additional $1,000 contribution to their IRA by 2022.
The law allows taxpayers 50 years old and older to contribute $27,000 annually to a 401k or $7,000 to an IRA. These catch-up contributions are also available to spouses 50 years and older. The Jacksons contributed $66,000 to their traditional IRAs and 401ks for 2021, including catch-up contributions.
More Information: Retirement Planning
Although Mr. and Mrs. Jackson are not currently experiencing any serious health issues, they wish to make sure they have sufficient savings to cover their healthcare costs in retirement. His employer offers Mr. Jackson a maximum contribution of $8,300 to the Health Savings Account.
A Health Savings Account (or HSA) is a account that allows families to contribute up to $7,300. The catch-up provisions allow taxpayers over 55 to make an additional $1,000 contribution, bringing the total contribution to $8,300. HSA contributions are retained in the account year-after-year if not used (in contrast to flexible spending accounts, whose balances are usually forfeited at year's end).
The Jacksons own some investments in a brokerage account which they manage independently. Mrs. Jackson enjoys managing the individual holdings, and she "tax loss harvests” at least $3,000 annually from these taxable investments.
Continue reading: Guide to Tax-Loss Harvesting
After subtracting the 401k, IRA and health savings account contributions and the capital loss deduction, Jacksons manages to bring their earned income of $113,750 down to an adjusted gross income (or $34,450)
A married couple without additional dependents will have a $36,550 income that is subject to tax. The standard deduction takes out $1,145. To further reduce their tax bill, the Jacksons can take the Retirement Savings Contributions Credit.
Married couples can claim a credit up to 50% on up to $4,000 in retirement contributions if their adjusted gross income is greater than $34,450 The Jacksons would receive a $2,000 tax credit. The credit is only available for tax owed to the taxpayers. For the Jacksons, it is $1,145. The Jacksons claim the $1,145 Retirement Savings Contributions Credit to reduce their tax bill by reducing it to zero.
Total Tax Bill for Jackson: $0
The Millers: A 30-Something Married Couple with 3 Young Children
The Millers are a married couple in their 30s who have three children and will make approximately $150,000 between their salaries and moderate investments in 2021.
This table shows their combined gross salaries, as well as all deductions from their salaries for retirement savings, child-care, flexible spending account and health savings account. After taking out all of the deductions, their combined gross salaries of $150,000 are now $83,700. This is almost a 56% decrease.
Salaries and Deductions | Husband | Wife |
---|---|---|
Annual Salary | $69,000.00 | $81,000.00 |
Contributions to 401k | -$20,500 | -$20,500 |
Dependent Care | $0 | -$5,000 |
Health Savings Account (HSA). | -$7,300 | $0 |
Health Insurance | -$12,600 | $0 |
Dental Insurance | -$2,000 | $0 |
Vision Insurance | -$500 | $0 |
Remaining Gross Salaries |
$26,100 |
$55,500 |
This second table shows the earned income and investment income, along with a series of deductions that includes capital losses from tax loss harvesting. The Millers had three children so they were eligible for $4,714 in child non-refundable tax credits. The Millers also had $300 foreign tax withheld from their investment income. This enables them to receive a $300 foreign income credit. A $1,286 refundable tax credit was available for children.
Their qualified dividends were also exempted from tax because their taxable income was below $80,800.
They were able to eliminate their tax liabilities by using both the refundable and non-refundable Child Tax Credit. In addition, they were able receive a $1,286 refund.
2022 Taxes, 30-Something Married Couples, 3 Children | |
---|---|
W2 Salaries | $81,600 |
Interest | $500 |
Dividends ($6,500 qualified dividends) | $7,500 |
Long-term capital gains for the current year | $25,000 |
Capital loss carryover | -$50,000 |
Net capital loss | -$25,000 |
Limitation on capital loss and carried forward into the next year | $22,000 |
Current year allowed capital loss | -$3,000 |
Total Income | $58,600 |
Contribution to an IRA (x2) | -$12,000 |
Adjusted Gross Income | $46,600 |
Standard Deduction | -$25,900 |
Taxable income | $20,700 |
Federal Taxes | $5,014 |
Child Tax Credit | -$4,714 |
Foreign Income Tax Credit | -$300 |
Refundable child tax credit | -$1,286 |
Total tax credits | -$6,300 |
Total Tax Return |
-$1,286 |
Effective tax rate |
0% |
Tax on $6.500 of Qualified Dividends |
$0.00 |
How to lower your taxable income
It is possible to file a 1040 showing zero tax liability with some planning. These four examples show how taxpayers at various stages of their lives have managed to reduce their tax burden. Three households in the examples reduced their tax bills to zero, despite having six-figure incomes.
How did these taxpayers achieve a zero dollar tax bill? And how can you pay less taxes?
- Contribute substantial amounts towards retirement savings plans
- Participate in Employer Sponsored Savings Accounts for Child Care and Healthcare
- Be aware of tax credits such as the child tax credit or the retirement savings contributions credit.
- Tax-loss harvest investments
- Make sure your investments are tax-efficient. Our top tips are in our free guide 5 Tax Hacks For Investors.
Continue reading: Tax Optimization
Tax planning can reduce your tax bill by almost zero, even if you earn a lot.
Keep your finances in order
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By: Brian Wainscoat, CPA
Title: How to Reduce Taxable Income: Can the Average American Pay No Taxes?
Sourced From: www.personalcapital.com/blog/taxes-insurance/average-american-pay-no-taxes/
Published Date: Tue, 06 Sep 2022 14:30:42 +0000
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