Select’s editorial team works independently to review financial products and write articles we think our readers will find useful. We earn a commission from affiliate partners on many offers, but not all offers on Select are from affiliate partners.
For each dollar you earn from your employer, you must pay a certain amount in taxes based on your level of income and where you live . However, there are many ways you can lower that overall income to minimize your tax bill — without taking a pay cut.
1. Enroll in an employee stock purchasing program
If you work for a publicly traded company, you may be eligible to enroll in an Employee Stock Purchase Plan (ESPP). By enrolling in your ESPP, you will divert after-tax dollars from your paycheck with the intent of purchasing shares of your company, and in many cases, you will be offered a discount (typically around 15%) on the stock price that is only available to employees.
You can choose how much after-tax dollars you want to contribute to your ESPP, which usually ranges between 1% to 10%. Keep in mind, however, the 2022 maximum contribution limit is $25,000 total per year.
The tax advantage of enrolling in an ESPP comes into play when you decide to sell your shares. While employees can choose to sell their shares immediately after purchase or at a later date, they’re rewarded for holding onto their shares for at least one year from the purchase date. Selling immediately means you pay ordinary income tax, while selling later means you pay a lower long-term capital gains tax — therefore reducing your tax burden.
While it can be a good idea to take advantage of purchasing your employer’s stock at a discount, while also benefitting from holding your shares over the long term, make sure 1) you have enough cash to contribute and 2) the investment fits into your overall financial plan. Certain financial goals, such as paying off high-interest debt, saving up an emergency fund and contributing to an IRA or 401(k) — and meeting any employer match — should first be met before participating in a stock plan.
2. Contribute to a 401(k) or traditional IRA
One of the easiest, and potentially most beneficial ways to reduce your taxable income, is to contribute to a pre-tax retirement account such as an employer-sponsored 401(k) or traditional IRA. With either of these tax-advantaged investment accounts, money from your paycheck (in the case of a 401(k)) or bank account (in the case of a traditional IRA) goes in before getting taxed.
With pre-tax contributions, you are also essentially taking out less from your disposable income now, which is better for your immediate cash flow. Your money grows tax-deferred, however, and later in retirement you will have to pay income tax on the funds you withdraw.
In 2022, the contribution limit for a 401(k) is $20,500, with an additional $6,500 available for those 50 and older. The annual contribution limit for IRAs is $6,000 (between traditional and Roth IRA accounts), with an additional $1,000 available for those 50 and older.
With a traditional IRA, your contributions may also be tax-deductible, depending on your income, tax filing status and whether or not you have a retirement plan through your employer.
“Many people are eligible to deduct their traditional IRA contributions, which can help reduce their tax liability,” says Corbin Blackwell, a CFP at Betterment, a robo-advisor offering traditional, Roth and SEP IRAs. “Not all IRA contributions are tax deductible, however, so be sure to work with your tax preparer to understand your situation.”
Basically, you cannot make a deduction if you (or your spouse, if married) have a retirement plan at work and your income is $78,000 or more as a single filer/head of household, $129,000 or more as married filing jointly/qualifying widow(er) or $10,000 or more as married filing separately. If you (and your spouse, if married) do not have a retirement plan at work, you can make a full deduction up to the amount of your contribution limit.