Marginal tax rate: How can I lower my taxes?

Understanding the concept of the marginal and average tax rate is beneficial to single individuals as well as to couples.

Individuals can benefit especially from tax-year optimization. Making a decision about a sale of mutual fund investments or taking a lump sum from your pension plan this or next year can make a difference in how much taxes you pay.

Wise planning for narrowing the percentage difference between a couple's marginal and average tax rate will result in a reduction of the total tax paid by a couple because less income is taxed at the higher income earners marginal tax rate as income is shifted to the spouse with the lower marginal tax rate. This will reduce the couple's average tax rate.

How can I lower my taxes?

Income from investments...

The income you earn from investments is added to your income from all other sources. As a result, each additional dollar of investment income is taxed at the highest rate applicable to your total income.

If for example you know that you make high income this year and your income is expected to drop next year, it very well makes sense to defer the sale of your investments to the year when your marginal tax rate will be lower.

Pension plan and other payments...

The same can be said about taking money out of your pension plan (401K, IRA, etc.). Taking a lump sum out of your pension plan can easily move you to higher tax bracket; therefore, if you have the option to take your lump sum later in a year when your total annual income is lower, it may impact your tax liability significantly and positively.

Income from reinvestments...

Another example is the taxation of income from reinvestments. If a couple (filing separately) has investments in the name of the higher-income-earning spouse, then the investment income is likely to be taxed at a higher rate than it really needs to be. So called Income on Income tax strategy can be used to reduce the tax rate which is used to tax income from reinvestments.

If you earn income and transfer it to your spouse, you as the transferring spouse will have to tax it. If this income generates some income while it is in your spouse's hands, the attribution rules assign this income to the transferring spouse for taxation purposes. The transferring spouse has to pay taxes in this income. However, the good news is that this income becomes the capital of the spouse receiving it and can be reinvested in the receiving spouse’s name. The income earned on this reinvested income (that is the Income on Income) is not attributed back to the transferring spouse. The spouse being in the lower tax bracket will tax this income.

This strategy is a very effective method of transferring capital from a spouse in a high marginal tax bracket to a spouse in a lower marginal tax bracket. This strategy brings more benefit for wealthier individuals who can afford to transfer tens of thousands of dollars, but regardless how much you make, generally if both you and your spouse work, and there is excess income that is being invested, this income should be invested in the hands of the individual in the lower tax bracket.

Income splitting between spouses...

If one of the spouses makes little money and the other one is a high earner, then it makes sense to distribute their income more evenly between them. For example, the higher income earner should receive tax deductions. If you own your own business, you can pay your spouse a salary for work that he or she performs (must be reasonable and documented though).

Spousal loans...

Spousal loans work in a way that the higher-income-earning spouse lends a sum of money to the lower-income spouse. You can for example loan your spouse money to start his or her business. The loan agreement has to be written. It is best if it is notarized.

The lower-income spouse agrees to pay interest at the prescribed rate. This rate must not be excessive to not raise a red flag with IRS, be reasonable. The lower-income spouse then invests the borrowed funds at a rate greater than the borrowing rate which makes this strategy as tax effective as possible.

This strategy is very nice because if the borrowing interest rate is low enough, it avoids the attribution rules being applied. And, most importantly, the excess yield from the assets over the amount of interest charged will then effectively be transferred to the lower-income spouse without triggering the attribution rules. (Remember, the Income on Income strategy does trigger attribution rules.)

Salary to your spouse...

In case you own your own business, you can pay your spouse a salary for the work he or she performs. Again, this must be well documented and reasonable. The wage or salary that you pay to your spouse must correspond with prevailing market rates.

How do I calculate taxes?

Once you know what taxation scheme you apply, you will need to calculate your effective tax rate and the amount of your taxes. Our interactive federal tax calculator might help you.

Do you have any more tips on how to lower my taxes?

Yes, of course. First, you might be interested in visiting our taxes discussion forum where you can find many tax tips. You can also ask questions. Then, you might be interested in the following articles:

Expenses: section 179 tax deduction for your computer
10 tips last-minute checklist for error-free tax return
Capital gains tax rates
Alternative Minimum Tax

And, the following resources might be able to help you as well: