The U.S. federal income tax system is a graduated system, which means the higher your taxable income, the higher your tax rate. While it is illegal to avoid paying your legitimate taxes, it is acceptable to avoid paying any taxes you don't owe. You can apply some legitimate strategies at the end of the year to reduce your taxable income, but you might be better off implementing your tax reduction plan all year long.
The federal government wants you to save for your retirement years. To encourage such savings, they offer to defer taxes on your contributions to certain tax-advantaged retirement programs, such as your 401(k) plan at work or your traditional individual retirement account. All of the investments in these retirement accounts grow tax-deferred, and contributions to these accounts are made with pre-tax dollars. Every dollar you contribute, up to the limits established by law, reduces your taxable income on a dollar-for-dollar basis.
If you have money in savings accounts, bank certificates of deposit, U.S. treasury securities or corporate bonds, the interest you received is fully taxable at your ordinary income tax rate when you file your federal income tax return. You can reduce your taxable interest income by investing in tax-free municipal bonds instead of taxable government or corporate bonds, or bank investments. The interest rate on municipal bonds is typically lower than the rates paid by comparably-rated corporate bonds, and there is a higher risk factor than with U.S. government securities or FDIC insured bank accounts, but your taxable interest income will be reduced.
Itemize Your Deductions
You might be able to reduce your taxable income by itemizing your deductions rather than claiming the standard deduction. You can deduct your mortgage interest, your private mortgage insurance premium, real estate taxes, employee business expenses, charitable contributions, business use of your home or car, excess medical and dental expenses, qualifying educational expenses, and either your state and local sales taxes or state and local income taxes. Every dollar over the standard deduction that you can claim by itemizing reduces your taxable income on a dollar-for-dollar basis. Most people claim the standard deduction because it is much simpler to figure. The IRS recommends figuring your taxes using both methods, then filing your tax return using the method that gives you the lowest tax obligation.
The Internal Revenue Service considers almost everything you own to be a capital asset, and you have to include the gains from sales of capital assets when you file your federal income tax return. You can offset your gains with capital losses, and you can use up to $3,000 in excess capital losses to reduce other income, including your salary or wages. If you own stocks or other comparable investments that are worth less than you paid for them as the end of the year approaches, it might be worthwhile to consider selling them at a loss to reduce your tax obligation.
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.