7 strategies to maximize tax-free income

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Despite the best efforts of some politicians, there are still widely available ways for individuals to earn federal income tax free. This is the second in our two-part series on the subject.

For those in the sweet spot, the federal tax rate on long-term capital gains and eligible dividends is still 0%. The startling truth is that you can have a pretty healthy income and still be in the 0% range for long term earnings and dividends, depending on your taxable income. For example:

  • Suppose you are a married spouse filer with two dependent children in 2022. You are claiming the standard deduction of $ 25,900. You could have up to $ 109,250 in Adjusted Gross Income (AGI), including long-term earnings and dividends, and stay in the 0% range. ($ 109,250 – $ 25,900 = $ 83,350 in taxable income, which is the top of the 0% bracket for joint filers in 2022.)

  • Suppose you are divorced with two dependent children and you register as the head of the family. You claim the standard $ 19,400 deduction in 2022. You could have up to $ 75,200 from AGI, including long-term earnings and dividends, and stay in the 0% range. ($ 75,200 – $ 19,400 = $ 55,800 in taxable income, which is the top of the 0% bracket for heads of household in 2022.)

  • Say you are single with no children. You claim the standard deduction of $ 12,950 in 2022. You could have up to $ 54,625 from AGI, including long-term earnings and dividends, and still be in the 0% range ($ 54,625 – $ 12,950 = $ 41,675 of taxable income, which is the top of the 0% Tranche for single filers in 2022.)

The AGI is equal to the sum of your taxable income items less the sum of the deductions said above the line for things like deductible contributions to a traditional IRA; up to $ 300 in cash contributions to IRS-approved charities if you do not itemize or $ 600 if you are a married spouse filer; contributions to the pension scheme for the self-employed, premiums for health insurance for the self-employed; the deductible part of the self-employment tax; alimony payments made under a pre-2019 divorce agreement; up to $ 250 in eligible reimbursable expenses for educators; plus up to an additional $ 250 if your spouse is also an educator incurring qualifying expenses and you are filing jointly.

If you itemize the deductions, your AGI, including long-term earnings and dividends, could be even higher, and you would still be in the 0% range for those earnings and dividends.

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Capital gains sheltered from capital losses are tax-free

When you incur capital losses during the year and / or you have a capital loss carryforward from a previous year, you can shelter capital gains from the current year until up to the capital losses for the current year plus any capital losses carried forward into that year. If you still have a net capital loss after this fiscal year, you can use it to shelter up to $ 3,000 in income from other sources (salary, self-employment income, income from interest, whatever), or up to $ 1,500 if you use the separate tax return. status.

Coverdell Education Savings Accounts (CESA) Tax-Free Withdrawals

You can contribute up to $ 2,000 per year to a Coverdell Education Savings Account (CESA) opened for a beneficiary (usually your child or grandchild) who has not yet turned 18. A CESA is an account opened by a “responsible person”, which means that you, to function exclusively as an education savings vehicle for the beneficiary of the designated account.

CESA income may accumulate free of federal income tax. Then, tax-free withdrawals can be made to pay for the beneficiary’s tuition, fees, books, supplies, and accommodation and meals. If you have more than one beneficiary in mind, you can contribute up to $ 2,000 per year to separate CESA established for each.

Here’s the only catch: your right to make CESA dues is being phased out between a modified adjusted gross income (MAGI) of $ 95,000 and $ 110,000 or between $ 190,000 and $ 220,000 if you are a married spouse filer. . This restriction can often be circumvented by enlisting someone who is unaffected. For example, you can donate the contribution dollars to another trusted adult (perhaps a sibling or parent) who can open the CESA as a “responsible person” and make the contribution on behalf of your recipient. However, when the “responsible person” is other than yourself, you lose all control over the account. Keep that in mind.

Tax-Free Withdrawals from Section 529 Education Savings Plans

Section 529 education savings plan accounts also allow earnings to accumulate without any federal income tax. The main selling point is that 529 accounts allow people who can afford to make larger contributions to get their education savings programs started quickly. Then, when the beneficiary of the account (usually your child or grandchild) reaches college age, tax-free withdrawals can be made to cover higher education expenses. State tax breaks are also often available.

Contributions to a 529 account will also reduce your taxable wealth (if that worries you), as contributions are treated as gifts to the account beneficiary. Contributions in 2022 are eligible for the annual federal exclusion of donation tax of $ 16,000. Contributions up to this amount will not decrease your unified federal gift and inheritance tax exemption. Assuming there are no changes in tax law, the unified exemption for 2022 will be $ 12.06 million or effectively $ 24.12 million for a married couple. If you’re feeling more generous, you can make a larger lump sum contribution and spread it over five years for gift tax purposes. This allows you to immediately benefit from five years of annual gift tax exclusions while starting the fund at the recipient’s university.

Example: If you are not married, you can make a 2022 lump sum contribution up to $ 80,000 (5 x $ 16,000) to a Section 529 account opened for a child, grandchild or any other person you wish. to help. If you are married, you and your spouse can together contribute up to $ 160,000 (2 x $ 80,000). Lump-sum contributions up to these amounts will not decrease your unified federal gift and estate tax exemption by $ 12.06 million. If you want to help several children or grandchildren, you can run the 529 account contribution exercise for each of them.

Non-taxable small business equity gains

Qualified Small Businesses (QSBCs) are a special class of companies, the shares of which are potentially eligible for exclusion of earnings disruptions. Assuming no changes are made to tax laws, QSBC shares issued after 9/27/10 will continue to be eligible for a juicy 100% earning exclusion, which equates to free federal treatment. tax, if you hold the shares for more than five years. before selling. Consult your tax advisor if you are considering an equity investment in a small business that may be eligible for the QSBC Earnings Exclusion Agreement.

Tax exemption for valued inherited capital gains

If you inherit a capital gains asset like stocks or real estate, the asset’s tax base is increased to its full market value from the date of your benefactor’s death or six months after. this date if the executor chooses. So, if you sell the inherited asset, you won’t owe any federal capital gains tax except on appreciation that occurs after the magic date. This super-taxpayer result is thanks to section 1014 (a) of our beloved Internal Revenue Code. The Biden tax plan included a proposal to dramatically reduce base disruption, but that idea appears to have been scrapped until further notice.

Real Estate Exchanges Tax Free Under Section 1031

Section 1031 of our beloved Internal Revenue Code allows you to defer the federal income tax bill for unloading valued real estate by arranging a Section 1031 exchange, AKA a similar exchange. This time-honored maneuver is one of the main reasons some real estate investors have gotten rich over the years because it keeps Uncle Sam out of their pockets. A proposal in Biden’s tax plan would have significantly limited your ability to defer taxes with a Section 1031 swap. But this proposed tax increase is apparently not on the table until further notice. .

Here is the big tax saving bonus. If you die while you still own real estate that you acquired in an exchange under section 1031, the tax base of the property is increased as explained immediately above. So your heirs can sell the inherited property and owe federal capital gains tax only on appreciation that occurs after the magic date, if any. Wow!

For more details on Section 1031 trades, see my previous column here.

The bottom line

While income and earnings are generally taxable, there are a number of ways you can collect federal income and earnings tax-free, as I explained in this column and in its previous companion. So, don’t passively assume that you will owe taxes just because you won out of a transaction. Check with your tax advisor before pulling the trigger for large transactions, because sometimes, with good planning in advance, you can get more money tax-free.


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