Did you know you can save money if you reduce your taxable income? You may be like me and think you can't afford to invest or take a cut from your pay. One of the excuses I had for not contributing more to my retirement was the thought that I couldn’t afford it. In fact, 47% of Americans feel the same way I felt.
In all honesty, I just didn’t want to reduce the amount of my direct deposited check. I was comfortable seeing a certain amount, and I didn’t want to lower it. I had bills to pay, money to spend, and money to save. Yup, I thought that the money I was saving in my savings account earning a measly 1% in interest was better in there! Oh, to be young and naive.
I just didn’t know any better. I didn’t understand that the money I contributed to my retirement plan was not only being invested, but I was also saving money. How, you may ask? I would have been saving money by not paying taxes on that money, AND as a result, my taxable income would have lower. So let's get into this!
What is taxable income?
Before we discuss how to reduce taxable income, you need to understand what it is. In simple terms, taxable income is the amount of your income on which you pay taxes, also known as your post-tax income. I was surprised when I received my first paycheck at 14 to see that my back of the napkin math didn’t add up to my paycheck.
I quickly learned that there were things like social security, Medicare, and taxes. All of which was deducted from my earnings long before I got my paycheck. (Learn more about pre-tax vs. post-tax income and how much you really make).
Does my story sound familiar? It may feel like every dollar you earn is taxed, but due to our complicated and something called our "graduated tax" system (also known as progressive tax), not all income is taxed.
Examples of income not taxed include child support payments, the money you contribute to certain types of retirement accounts, and money that you put aside for childcare or medical expenses.
This also includes money you put in an employer-sponsored account like a Health Savings Account or Flexible Spending Account. Income can come from various sources; your salary, interest earned on a savings account, bonuses, and even unemployment are all examples of taxable income.
Tax-deferred vs. taxable income
To incentivize people to save for retirement, the government offers a number of tax benefits, including tax-deferred savings accounts. What this means is that the amount you contribute is subtracted from your taxable income.
Simply put, if you earn $3,000 of taxable income and contribute $300 a month, you reduce your taxable income by $300! You will now only owe tax for the remaining $2,700.
Ways to save in a tax-deferred savings account
Contributing to tax-deferred accounts is how you can lower your taxable income easily. The most common way to save is with an employer-sponsored retirement account. The contributions you choose are deducted out of your paycheck before being taxed. 401Ks, 403Bs, Thrift Savings Plans and, Traditional IRAs are different types of pre-tax retirement accounts.
I want to be clear that tax-deferred accounts only postpone the payment of taxes. Eventually, you will have to pay taxes when you withdraw the funds. But what you will do, is allow your money to grow tax-deferred, and the earnings can potentially outweigh your future tax obligation.
How will my money grow in my tax-deferred account?
Ok, so you are ready to start contributing to a tax-deferred account so you can reduce your taxable income. But once you begin contributing to a tax-deferred account, don’t let your money just sit there! Start learning how investing works so you can maximize your investments earning potential.
If you partake in an employer's plan, your company probably works with some type of investment brokerage firm to house their employer-sponsored retirement plan. You get to decide which investments to buy (usually mutual funds) with your contributions.
It took me a while to realize that contributing money to my retirement plan made me an investor! I wasn’t stock picking, reading financial reports, or analyzing quarterly earnings statements, but yet I was investing. Imagine how much better you can do when you actually understand how investing works?!
How will tax-deferred contributions affect my paycheck?
Let’s take someone who is single with no dependents. Their gross pay is $50,000 a year. If they contribute nothing to their tax-deferred accounts, they would fall into the 22% tax bracket based on their income. (Which is the current tax bracket if you earn anywhere from $39,476 to $84,200).
Here in the United States, we have a progressive tax system. This simply means that portions of your income are taxed at different rates. You won’t be paying 22% on all $50,000. Using the 2021 tax rate, the first $9,950 will be taxed at 10%.
The money earned between $9,951 and $40,525 will be taxed at 12%, and the money earned between $40,526 and $86,375 will be taxed at 22%. The total amount of your taxes that need to be withheld from your paycheck for the year will be about $8,140.
But, despite the progressive tax system, because of this person's lack of contributions to tax-deferred accounts, their entire $50,000 salary is subject to tax.
How people who earn more pay less taxes
Let's look at another example below, but this time WITH tax-deferred contributions:
The total gross income is $70,000, yet their taxable income is less than the person making $50,000 in the previous example! This is how a person making more is paying less in taxes! This is Uncle Sam’s way of encouraging us to save for retirement.
Let's assume that tax rates remain the same forever (Ha!). The person who contributes less to a retirement account will pay more in taxes over the course of their lifetime than the person who made $20,000 more a year!
As you invest your contributions, the money will begin to grow at the rate of the investment you have chosen. If you invest in a mutual fund that tracks, for example, the S&P 500, your investment will grow(or fall) at the rate of the best top 500 U.S.-based businesses.
How to calculate taxable income
The easiest way to figure out how to calculate taxable income is to use a federal income tax calculator. This allows you to input your income along with contributions to see what your taxable income is. Here are a few calculators to try:
Use these calculators to see how to lower taxable income with hypothetical figures to your retirement funds. This is a great tool to figure out how to reduce taxable income for high earners also.
How to reduce taxable Income
Contributing to tax-deferred accounts like the ones listed below is how to reduce taxable income:
- Retirement plan contributions
- Health Savings Accounts
- Pension contributions
- Flexible Spending Accounts (for both health or childcare)
As your tax-deferred account contributions increase, the federal tax withholdings will decrease. (See image below). A 10% contribution to your retirement account does not equal a 10% reduction in your take-home pay, but over the course of a year, you can reduce the amount of your taxable income quite significantly.
(For simplicity, I have omitted deductions like state income tax, health insurance costs, and any other paycheck deductions in the chart above).
Some will point out the obvious: Reducing taxable income is also reducing your take-home pay. But there is one thing to consider, contributing $19,500 to your tax-deferred accounts starting now could mean that in 40 years, your investment could be worth over $315,000 if you contributed the maximum for just a single year and allowed that money to grow.
Note: The return on your investment will generate over time. Historically, the 30-year return of the S&P 500 has been roughly 12%. I’ve used 7% to be conservative.
Reduce taxable income to save more money!
So now you know how to lower taxable income! Be sure to take advantage of any employer matching. Yes, there are some employers who will match your contributions to your retirement plans. It’s free money. Not only does the government incentivize you to save so does your boss.
It took me almost a decade of having access to a retirement account before I understood the power of investing. As a result, I paid more in taxes during the course of several years and saved minimally.
While you may not be able to contribute the maximum to your retirement this year, make a promise (and take action) that you’ll start by increasing what you contribute today.