“Lowering Your Taxable Income” [Post 24]

When I first started working in the vicinity of accountants, I didn’t understand the concept of “lowering your taxable income.” Why would anyone want to make less money on purpose?

Unsurprisingly, I just didn’t have all the details to comprehend what it actually meant.

“Lowering your taxable income” isn’t about earning less compensation, it’s about reducing how much of your income is subject to taxation.

Some of the most common ways to reduce taxes in the current tax year are by contributing to tax-advantaged accounts such as traditional IRAs, traditional 401ks, and Health Savings Accounts (HSA).

By contributing to these accounts, you lower how much of your salary is taxed by the IRS (internal revenue service).

Let’s look at some scenarios calculating federal tax owed (we will ignore state and FICA taxes for simplicity):

Jake is a 22-year-old single person and makes $70,000/year. The IRS allows a standard deduction of $13,850 in 2023 so his taxable income is $56,150. Using the chart above, this means he will pay the following in federal taxes:

• 22% x $11,425 = $2,513.50 ($70,000 salary - $13,850 deduction - $44,725)

• 12% x $33,725 = $4,047.00 ($44,725 - $11, 000)

• 10% x $11,000 = $1,100.00

Totaling $7,660.50 in federal tax.

Now let’s look at how he could lower his taxable income for 2023.

If Jake makes $70,000/year but contributes $20,000 to a Traditional 401k account and $3,000 to an HSA and takes the standard deduction of $13,850… He will lower his taxable income to a point where we won’t pay any tax at the 22% tax bracket as previously shown.

• 22% x $0

• 12% x $22,150 = $2,658 ($70,000 salary - $13,850 deduction - $20,000 401k - $3,000 HSA - $11,000)

• 10% x $11,000 = $1,100

Totaling $3,758 in federal tax.

By taking advantage of tax-deductible opportunities, Jake’s tax liability was $3,902.50 less for the current year.

These tax-deductible actions are one way to “lower your taxable income.” It’s not that you need to earn less money, it’s that the IRS views your income as exempt from taxation in the current tax year.

*Granted, this is likely only advantageous from a tax standpoint if he is in a lower tax bracket when distributing from the 401k and uses the Health Savings Account for eligible expenses – but for most people this will likely be the case as income tends to decrease in retirement. It is also worth noting that many people early in their careers may be better off contributing to a Roth 401k or Roth IRA account which is not tax deductible instead of a Traditional 401k or IRA account. It is important to consult with a knowledgeable professional before making certain financial decisions as personal circumstances can play a large role in what is most suitable from person to person.

The commentary of this blog reflects only the personal opinions of the creator and not those of KEB Wealth Advisors. The contents of this blog is intended as informational-only and should not be regarded as investment advice or recommendations. No material on this website should be taken as tax, legal or investment advice. Individuals should seek the guidance of a licensed professional prior to taking any action based upon the content of this blog. All investments in securities involve the risk of loss. Past performance is no guarantee of future results. The creator cannot guarantee any information provided has not been outdated or otherwise rendered incorrect by new research, legislation, or other changes.