The best income is the kind you get to keep. In most cases, you take on the IRS as a partner every time you walk into work — but the government keeps its hands off the money you earn if it comes from the right sources.
If you’re looking to add a new income stream, make it one that’s out of the tax man’s reach.
The following is a look at several ways to lower your taxable income. Some of the tips involve creating income sources that are exempt from taxes. Others involve reducing the taxable amount of ordinary income you earn at work.
All, however, result in the same outcome: You keep more of your money.
Move to a State That Doesn’t Tax Income
If you move to one of the eight states that don’t levy income taxes, you can increase your tax-exempt income without getting a raise or launching a side hustle. They are:
- South Dakota
There’s no dodging the IRS, but avoiding states with high taxes certainly can help lessen the burden come April. At 13.3%, California has the highest rate in America, according to Intuit Turbotax. It’s 11% in Hawaii and 10.75% in New Jersey. Five other states and Washington, D.C., are above 8.5%.
Offset High State Taxes With Treasury Securities
If you do live in a state with prohibitively high income taxes, you should consider investing in income-generating Treasury securities such as notes, bills and bonds. When you buy them, you’re loaning the government money, and the interest the government pays you in exchange is exempt from state and local taxation. They’re still taxed at the federal level, and the tradeoff for their extremely low risk is that they pay lower rates than other fixed-income securities. But in high-tax states, they can go a long way in reducing your taxable income.
Buy Municipal Bonds
The federal government exempts municipal bonds from the income tax it levies on most other kinds of bonds — and this exemption applies even if you buy bonds through a fund or ETF.
While muni bonds aren’t exempt from state and local taxes, most states don’t tax income from their own bonds; so, if you buy them from your home state, the income they generate could be completely tax-free.
The tradeoff is that muni bonds typically have lower yields. They tend to attract higher-income investors whose larger tax obligations would negate the higher yields paid by taxable alternatives like corporate bonds. If you collect Social Security, keep in mind that muni bond income does count toward the portion of your taxable benefits.
Invest in a Permanent Life Insurance Policy
Most people probably know the government doesn’t tax life insurance payouts to beneficiaries. But what’s less known is that policyholders don’t have to wait until they die; they can borrow from a permanent life insurance policy tax-free.
There are a few caveats. The loan can’t exceed the amount you’ve paid in premiums; and, if your policy lapses or you surrender your policy, the loan amount will be taxed as income. But if not, you can borrow from your policy without forking over a dime to your state or the IRS.
Harvest Capital Losses
Loss harvesting can be a smart way to lower your taxable income while sprucing up your portfolio. It involves selling underperforming assets at the end of the year to lock in capital losses, which reduces your capital gains and, therefore, your taxable income. You can use this strategy to offset up to $3,000. You can then take the money from the sale and reinvest it in a more suitable security.
Open a Roth IRA
Unlike 401(k)s, Roth IRAs grow your money on an after-tax basis, which makes them one of the easiest ways to build tax-exempt income for the future. Six months after you turn 59, you can start making withdrawals on your Roth account completely tax-free. You also can keep contributing to them for life, there are no required minimum distributions and your heirs won’t have to pay taxes on your Roth IRA if you leave it to them as an inheritance. None of that is true with 401(k) accounts.
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