Tax avoidance strategies aren’t solely for the rich — plenty of tax deductions and credits are available for middle- and low-income taxpayers, too. You might be able to take advantage of the best tax loopholes to lower your tax bill.
What is a tax loophole? Tax loopholes are simply legal ways to use the tax code to save yourself money. Different loopholes exist for different levels of income.
Whether your income level is low, high or in the middle, this guide to the best tax loopholes can help you save money.
Tax Loopholes for Low-Income Earners
Some tax loopholes come in the form of tax credits designed specifically for lower-income taxpayers. Two types of credits are available:
- Refundable credits: Enable taxpayers to receive refunds even when they have zero tax liability
- Nonrefundable credits: Enable taxpayers to reduce their tax liability but does not increase their refunds
Low-income earners are eligible for both types, including the following three credits.
1. American Opportunity Tax Credit
The American opportunity tax credit is an educational tax benefit that replaces and expands on the Hope credit. It applies to the first four years of college educational expenses and provides a tax break for expenses including tuition, books and other supplies. The credit is worth up to $2,500 per eligible student, and its most attractive feature might be the fact that you’re refunded 40% of your total credit — $1,000 maximum — that exceeds your tax liability. In other words, if your tax bill is $1,000 but you earn $2,000 in refundable tax credits, you’re entitled to a refund of $400 — 40% of the $1,000 that exceeds your tax liability.
Calculating the credit can be complicated, but the IRS provides instructions both online and on the forms you’ll use to file your taxes. Essentially, you can claim 100% of the first $2,000 and 25% of the next $2,000 you spend for each eligible student as a credit, which adds up to the maximum credit of $2,500.
To claim the full amount of the American opportunity tax credit, you must have a modified adjusted gross income of $80,000 or less, or $160,000 or less if you’re married and filing jointly. The allowable amount of the credit falls as your MAGI rises. Once you top $90,000 — or $180,000 if you’re married and filing jointly — you’re no longer eligible for the credit.
2. Saver’s Tax Credit
The saver’s credit — formally known as the retirement savings contributions credit — is designed to help lower-income families contribute to retirement plans. If you qualify, this credit essentially pays you to put money in your retirement account. You can write off the first $2,000 of contributions — $4,000 for married couples filing jointly — you make to a qualified retirement plan, such as a 401(k) or a traditional or Roth individual retirement account.
Whether you can claim the credit depends on your income and filing status. To qualify, you must not be a full-time student or be claimed as a dependent on someone else’s tax return. You must also be at least 18 years old.
The adjusted gross income limits for claiming the saver’s credit are as follows:
- Married and filing jointly: $64,000 for 2019
- Filing as head of household: $48,000 for 2019
- Other filers: $32,000 for 2019
The amount of your credit will be 10%, 20% or 50% of your contribution, depending on your AGI. For example, if you’re married and filing jointly in tax year 2019, you can claim the 50% credit if your AGI is $38,500 or less. An AGI of $38,501 to $41,500 entitles you to a 20% credit, and an AGI of $41,501 to $64,000 nets you a 10% credit.
3. Earned Income Tax Credit
The earned income tax credit was designed specifically to assist low- to moderate-income families. Even single taxpayers can benefit from the credit, however. Income and the number of children in your household determine the amount of the credit.
For tax year 2019, the income limit ranges from $15,570 if you’re single and have no children to $55,952 if you’re married and filing jointly and have three or more qualifying children.
The maximum amount of earned income tax credit is:
- $6,557 for three or more qualifying children
- $5,828 for two qualifying children
- $3,526 for one qualifying child
- $529 for no qualifying children
You must qualify for the credit by having business income or income from a job. When you’re claiming a qualifying child, they must be younger than 19 years old unless they’re enrolled as a full-time student, in which case the age limit rises to 24.
Keep Reading: The Complete Guide to Filling Out Your W-4 Form
Tax Loopholes for the Middle Class
In general, income tax loopholes for individuals in this category are harder to come by, as phase-out rules make them ineligible for a number of credits and deductions. Many credits are designed to help out lower-income taxpayers or pertain specifically to high earners; however, some credits and deductions are still available to middle-income earners. Check out these tax breaks that might help if you fall into this category.
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4. Mortgage Interest Deduction
For middle-income taxpayers, your best chance of scoring a big tax break is with your home. When you buy a home, you can claim the mortgage interest deduction, which allows you to deduct the interest portion of your mortgage payment but not the principal. In other words, you can’t write off your entire monthly payment, but you can deduct the interest payments you’ve made all year with a qualifying mortgage.
The deduction can be a big tax saver in cases where it makes sense to itemize deductions. When the amount of your mortgage interest deduction exceeds your standard deduction, you’ll save more money if you itemize.
For tax year 2019, the standard deduction amounts are:
- $12,200 for single filers or married filing separately
- $18,350 for head of household
- $24,400 for married filing jointly and qualifying widows and widowers
Individuals age 65 and older and blind individuals qualify for an additional standard deduction:
- $1,650 for single or head of household filing status
- $1,300 for married taxpayers and qualifying widows and widowers
The IRS publishes extensive information on what a qualifying home is and who can claim the mortgage interest deduction. However, most standard mortgages qualify, as long as the loan is for your primary residence and you are the homeowner.
5. Lifetime Learning Credit
The lifetime learning credit is an educational tax credit that’s similar to the American opportunity tax credit. However, when you claim one of these two credits, you cannot claim the other for the same student. Unlike the refundable American opportunity tax credit, the lifetime learning credit is nonrefundable. You can claim the lifetime learning credit for an unlimited number of tax years, whereas the American opportunity tax credit has a four-year maximum.
The lifetime learning credit lets you claim up to 20% of the first $10,000 in qualifying expenses — up to $2,000 per tax return — to help offset the educational costs of a qualifying student. The credit comes with relatively high modified adjusted gross income caps: $133,999 if you’re married and filing jointly or $66,999 if you’re filing as single, head of household or qualifying widower. The lifetime learning credit gradually phases out for single filers with a MAGI of $57,000 or more and taxpayers who are married and filing jointly with a MAGI of $114,000 or more. You can’t claim the credit if you’re married and filing separately.
The tax credit is available regardless of your age, as long as it goes toward a qualifying educational expense. Acceptable expenses include tuition, student activity fees, course-related books, supplies and equipment.
6. Child Tax Credit
The child tax credit is for taxpayers with qualifying children, and they can claim this on top of the earned income credit and credit for child and dependent care expenses. The child tax credit can be worth up to $2,000 per child living in your household, and it’s partially refundable. It allows you to get back up to $1,400 even if you don’t owe tax before claiming the refund — as long as your family income is at least $2,500.
To qualify, you must claim the child as a dependent on your taxes, and the child must have a Social Security number by the date on your tax return, be age 16 or younger at the end of the year and be currently living with you for at least half the year.
A $500 nonrefundable credit can be applied to eligible dependents who can’t be claimed for the child tax credit.
You might qualify for the full child tax or other dependent credit if your modified adjusted gross income is less than the following amounts:
- $200,000 for single filing status
- $400,000 for married filing jointly
Both credits begin to phase out at a MAGI of $200,000 — or $400,000 for taxpayers who are married and filing jointly.
7. Retirement Savings Accounts
Although taxpayers of all income levels are eligible to contribute to retirement savings accounts, the tax benefits are typically more accessible to middle-income earners. Low-income taxpayers often can’t afford to contribute the maximum amount to retirement accounts, and high-income earners are ineligible for tax breaks on certain accounts.
However, the benefits can be huge for those who can afford to contribute to retirement savings accounts. Contributions to employer-sponsored 401(k) plans and individual retirement accounts are eligible for tax deductions that can reduce your total taxable income.
For example, if you contribute $5,000 to your company 401(k) plan, the amount of your taxable income drops by $5,000. If you’re in the 25% tax bracket, it amounts to savings of $1,250 in federal tax.
Retirement accounts offer more than just an immediate tax benefit: As long as you keep the money in the account, it grows tax-deferred. For a regular brokerage account, you would owe taxes annually on dividends and capital gains payouts, but if you have a retirement account, you pay taxes only when you make a withdrawal from the account.
Contributions to a Roth IRA don’t qualify for a tax deduction at the time you make the deposit. Instead, you withdraw your earnings and contributions tax-free once you’re 59 1/2 years old. Roth IRA contributions come from post-tax income — you pay taxes on your income now, but not in the future. You don’t get the immediate tax break for Roth IRAs like you do for pretax accounts like traditional IRAs and 401(k) plans.
Tax Loopholes for the Rich
High-income taxpayers face both challenges and benefits when it comes to tax loopholes. On one hand, having a high income makes taxpayers ineligible for a lot of tax breaks — or at least reduces their benefits. On the other hand, many tax breaks are more beneficial for the wealthy and amplify their savings because they pay a high tax rate. Examine these benefits that might apply to you if you’re a high earner.
8. Capital Gains Tax
Although the capital gains tax loophole is available to taxpayers of all income levels, it benefits high-income earners — or filers in the 25% or higher tax bracket — the most. The reason comes down to the progressive structure of the tax system.
The special tax rate on capital gains is beneficial to high-income earners because the tax on long-term capital gains and dividend income for most taxpayers is 15% to 20%, depending on their income level. Exceptions include the higher 25% tax rate on unrecaptured Section 1250 gains, which is a type of depreciation-recapture income realized on the sale of depreciable real estate, and the 28% tax rate on the sale of collectibles or small-business stock.
Meanwhile, the tax rate on a high earner’s ordinary income can be as high as 37% for the 2019 tax year. This disparity in rates can translate to great tax savings.
For example, say you’re in the highest tax bracket and about to receive a $100,000 windfall. When this money is taxed as ordinary income, you’ll owe as much as $37,000 in federal income tax, or $100,000 times the highest rate of 37%. But if this income comes in the form of a capital gain, you’d pay only $23,800 in federal income tax, or $100,000 times the 20% capital gains tax rate plus the 3.8% net investment income tax for high earners — which amounts to a savings of $13,200.
9. High-Income Mortgage Interest Deduction
The mortgage interest deduction for middle-income earners can benefit high-income earners even more at tax time. Statistically, higher-income earners are more likely to itemize deductions rather than take the standard deduction. Additionally, higher-income filers tend to have larger mortgage payments, which increases the potential amount of their mortgage interest deductions.
For example, you generally need a high income to get a mortgage for $1 million. If you’re paying interest on a mortgage that large, you’ll have more interest to deduct than a taxpayer who pays interest on a $350,000 mortgage.
But there’s a limit to this loophole. The IRS only allows mortgage deductions on up to $750,000 in loans to buy or repair a home. Therefore, the super wealthy with multimillion-dollar homes won’t benefit any more than high-income taxpayers with a mortgage of $750,000.
In addition to the mortgage interest deduction, you can deduct the interest you pay on a home equity loan used to build, buy or substantially improve the primary or second home you’re borrowing against. The only caveats are that the home equity loan and first mortgage cannot total more than $750,000, and the total loan amounts cannot exceed the cost of the home.
There’s more good news: You can deduct up to $10,000 of property tax — or $5,000 if you’re married and filing separately.
10. Carried Interest Loophole
The carried interest loophole basically applies to high-income taxpayers only. Venture capitalists, hedge fund managers and partners in private equity firms are eligible for special tax treatment based solely on their occupations.
The carried interest loophole is a variation on the capital gains tax benefit. Paid compensation in these professions is considered a distribution of investment fund profits, which is called carried interest. Because this income is regarded as an investment profit rather than a salary or wage, it’s taxed at the long-term capital gains rate instead of the regular income tax rate — which can be significant for those in high-income tax brackets.
For example, a $1 million salary would be subject to the 37% tax rate plus a 3.8% net investment income tax, which would come out to $408,000. When salary is considered carried interest, however, that same $1 million would be subject to only the top 20% capital gains rate plus a 3.8% net investment income tax, which would come out to $238,000.
Find Your Loopholes
Regardless of your income level, plenty of tax loopholes exist that you can use. From educational credits to savings on retirement contributions, there are likely deductions or savings that are relevant to you. Use this list as a starting point and see how much you can save.
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About the Author
Barri Segal has 20+ years of experience in the publishing and advertising industries, writing and editing for all styles, genres, mediums, and audiences. She has been writing on personal finance topics for 12 years and gains great satisfaction from making a difference in consumers’ lives.