Find out what it takes to be part of the "44%" who don't pay taxes.
You've probably heard about the famed 44% of Americans who pay no income taxes at all. How do you join this club? Here are several ways you can avoid paying federal taxes.
Have Little or No Income
One easy way to pay no income tax is to have little or no taxable income. About half of the Americans who pay no income tax do so because their incomes are too low. As a result of the Tax Cuts and Jobs Act, which took effect in 2018, single taxpayers receive a standard deduction of $12,950, and married taxpayers filing jointly receive a $25,900 standard deduction (2022), subject to annual adjustments. Personal and dependent exemptions were eliminated. If your income is below these levels, you won't have to pay any income tax.
Have Children
Lower-income working families with dependent children can avoid paying income taxes because they're given special tax breaks: the child tax credit, the earned income tax credit (EITC), or the child and dependent care credit. For example, a family of four (two spouses and two children over six) with an income of $30,000 would receive $3,000 tax credits for each child and a $5,980 earned income tax credit (2021). When combined with their standard deduction, they end up with no income subject to income tax. Indeed, because the child tax credit and EITC are refundable, they get money back from the IRS.
Families like these account for one-seventh of those who pay no taxes.
Be Retired
More than one-fifth of those who pay no income taxes are retirees with relatively modest incomes, although not living in poverty, who benefit from tax breaks for seniors. The most significant exemption among these is the tax exemption for most Social Security benefits.
Have Lots of Itemized Deductions
Taxpayers with high incomes can avoid paying income taxes by having lots of itemized deductions. Unfortunately, as a result of the Tax Cuts and Jobs Act, itemized deductions are harder to come by than in the past. They only include deductions for:
- health expenses over 7.5% of adjusted gross income (AGI)
- charitable contributions
- up to $10,000 in state and local taxes
- home mortgage interest (subject to home loan limits)
- casualty and theft losses due to a federally declared disaster, and
- gambling losses (up to gambling winnings).
As a result of these changes, only about 11% of taxpayers will be able to itemize instead of taking the standard deduction. Still, higher-income taxpayers who make substantial charitable contributions and/or have large uninsured health expenses can still avoid paying income taxes.
Be Super-Rich
Finally, it is quite easy to pay no income taxes if you're extremely rich. In our tax system, money is only subject to income tax when it is earned or when an asset is sold at a profit. You don't have to pay income taxes on the appreciation of assets like real estate or stocks until you sell them. Moreover, there is no tax on consumption or on borrowed money. So, the simple strategy of the super-rich is to buy assets like real estate and stocks and hold on to them, and to borrow against them when needed to finance their lifestyles. They don't have to pay any taxes at all on their borrowed income. Some politicians have proposed imposing a tax on assets owned by the wealthy, but so far, it hasn't happened.
The rich also avoid paying taxes by earning substantial interest income from tax-free municipal bonds. They also sock money away in individual retirement accounts where it grows tax-free. There aren't that many rich people, so the number of super-wealthy taxpayers who actually take advantage of these strategies is quite small.
Now, some of the above methods are either impractical or out of reach for some people, but let's look at a real-life example of reducing taxable income in practice:
An Example of Reducing Taxable Income
With some planning, it isn’t impossible to file a 1040 that shows zero tax liability. Here's how the husband and wife in a fairly standard family situation created a zero-dollar tax bill:
The Smiths: Married Couple, 40 Years Old With Two Kids
Mr. and Mrs. Smith are both 40 years old and they have two kids in elementary school. Together, the Smiths earn $103,250 per year from their full-time jobs.
The Smiths put a strong emphasis on retirement savings by contributing the maximum to their 401ks ($19,500 each) and traditional IRAs ($6,000 each). In total, they contribute $51,000 to their retirement accounts.
Since the Smiths have two children in elementary school, they have to pay for after-school care during the school year and some child care during the summer months. The total child care costs amount to $5,000 per year. The Smiths contribute $5,000 to their childcare flexible spending account provided by Mrs. Smith’s employer, and this amount is taken out of her paycheck pre-tax.
Similarly, Mrs. Smith contributes $2,750 per year to her healthcare flexible spending account, which is also deducted from her paycheck pre-tax. With the family’s typical medical and dental expenses, they are certain to use the $2,750 each year.
After taking these deductions from their gross income, their $104,300 combined salaries are reduced to an adjusted gross income of $45,550. A married couple with two children will owe $2,056 income tax on $45,550 of adjusted gross income. The Smiths can take the child tax credit of $4,000 ($2,000 per kid). $2,056 of the credit is a non-refundable credit that offsets the income tax liability and they are also allowed to take $1,944 as a refundable credit.
Their tax credits totaling $2,056 completely offset the tax liability they would otherwise have on their $45,550 adjusted gross income. The Smiths will owe zero tax and receive a refundable tax credit. Even though the Smiths enjoy a six-figure gross income, they still manage to bring their federal income tax bill down to zero by taking advantage of several tax credits and deductions.
Mr. and Mrs. Smith’s Tax Bill: $0, and a total tax refund of $1,944
Taxpayers at different stages of life can manage to reduce their tax burden significantly. And it's very possible to reduce your tax bill to zero despite earning a six-figure salary.
Taxpayers can reach a zero-dollar tax bill and/or reduce their taxes through these tactics:
- Contribute significant amounts to retirement savings plans
- Participate in employer-sponsored savings accounts for child care and healthcare
- Pay attention to tax credits like the child tax credit and the retirement savings contributions credit
- Make sure you’re investing in a tax-efficient manner
- Tax-loss harvest investments - Tax-loss harvesting is a portfolio management technique where you sell an investment at a loss to offset gains you’ve realized. Tax-loss harvesting reduces your overall tax burden by reducing your net capital gain. This strategy is particularly beneficial for offsetting short-term capital gains, which are taxed at the federal income tax rate and at a higher rate than long-term capital gains. This is a tricky tactic that should be discussed with your financial advisor up front.
Careful tax planning can slash your tax bill to almost nothing even if you have a fairly high income. I wanted to show you that it can be done with practical planning and optimizing. But any changes you'd make to a financial portfolio should be discussed with a financial professional. Reducing your tax burden is a great goal, but you also want to avoid getting on the IRS's radar in pursuing that.
If you have any questions about tax matters – or if you're finding yourself in hot water because of issues related to taxes, please don't hesitate to reach out to me or any of my Tax Problem Solver Team, and we can help you with whatever's going on. Contact me by one of the methods below in the blue box, or email me at Larry@TaxProblemSolver.com and we can review your specific issues and solve them. You can also click here to book a free consultation.
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