How to Pay Less in Federal Income Tax

The federal income tax system is a pay-as-you-go system, requiring you to pay tax as you earn income throughout the year. Tax planning involves strategically using the U.S. tax code to lower your taxable income, which is the portion of your gross income subject to taxation.

By making informed financial decisions about spending, saving, and investing, you can influence the final amount of tax you owe. This can lead to a lower tax bill or a larger refund when you file.

Reducing Taxable Income with Deductions

A tax deduction is an expense that the Internal Revenue Service (IRS) allows you to subtract from your adjusted gross income (AGI), which reduces the amount of your income that is subject to tax. The value of a deduction depends on your marginal tax rate. For example, a $1,000 deduction saves $220 for someone in the 22% tax bracket.

When filing, you must choose between taking the standard deduction or itemizing your deductions. The standard deduction is a fixed dollar amount based on your filing status, age, and other factors, while itemizing involves totaling all your individual deductible expenses. You should choose whichever method results in a larger deduction. For the 2025 tax year, you should itemize only if your total deductible expenses exceed the standard deduction amount for your filing status.

Common Itemized Deductions

Itemizing deductions on Schedule A of Form 1040 may benefit homeowners, those with high medical bills, or people who make large charitable donations. Common itemized deductions include:

• State and local taxes (SALT), including income, sales, and property taxes. This deduction is capped at $10,000 per household annually through the 2025 tax year.
• Mortgage interest on a primary and second home. The deduction is limited to interest on up to $750,000 of mortgage debt, a limit set to revert to $1 million after 2025. Your lender provides Form 1098 showing the interest paid.
• Charitable contributions to qualified organizations. You can deduct cash contributions up to 60% of your AGI. For non-cash donations, you can deduct their fair market value.
• Medical and dental expenses that exceed 7.5% of your AGI. Qualifying expenses include payments to doctors, hospitals, prescription drugs, and certain insurance premiums.

Above-the-Line Deductions

Certain deductions, called “above-the-line” deductions, are available even if you do not itemize. These are subtracted from your gross income to calculate your AGI. One of the most common is for contributions to a traditional Individual Retirement Arrangement (IRA). Depending on your income and workplace retirement plan access, you may be able to deduct your full contribution.

Another deduction is for student loan interest, allowing you to deduct up to $2,500 of interest paid. This deduction has income limitations. Contributions to a Health Savings Account (HSA) are also deductible. For 2025, you can deduct up to $4,300 for self-only coverage and $8,550 for family coverage.

Claiming Tax Credits to Lower Your Bill

A tax credit is a dollar-for-dollar reduction of the income tax you owe, making it more impactful than a deduction. A nonrefundable credit can reduce your tax liability to zero, while a refundable credit can be paid out as a refund even if you owe no tax.

Child and Dependent Credits

The Child Tax Credit helps families with the costs of raising qualifying children under age 17. A portion of this credit may be refundable depending on your income. A smaller, nonrefundable credit is also available for other dependents.

Education Credits

For higher education costs, the American Opportunity Tax Credit (AOTC) is available for the first four years of postsecondary schooling and is partially refundable. The Lifetime Learning Credit (LLC) is nonrefundable and can be used for undergraduate, graduate, and professional courses.

Earned Income Tax Credit

The Earned Income Tax Credit (EITC) is a refundable credit for low- to moderate-income working individuals, particularly those with children. The credit amount depends on income and the number of qualifying children.

Home Energy Credits

Homeowners can claim credits for energy-efficient upgrades. The Residential Clean Energy Credit is for new systems like solar panels, while the Energy Efficient Home Improvement Credit covers items like new windows or insulation. To claim the improvement credit for property placed in service in 2025, you must get a Product Identification Number from the manufacturer for your tax return.

Using Tax-Advantaged Savings and Investment Accounts

Using tax-advantaged accounts allows your investments to grow with significant tax benefits, encouraging savings for goals like retirement or healthcare.

Workplace Retirement Plans

With a traditional 401(k) or 403(b), pre-tax contributions lower your current taxable income. For 2025, you can contribute up to $23,500. Those age 50 and over can make an additional $7,500 catch-up contribution. A provision for 2025 allows a higher catch-up of up to $11,250 for those aged 60 to 63. The money grows tax-deferred.

Individual Retirement Arrangements (IRAs)

A Traditional IRA may allow for tax-deductible contributions, with investments growing tax-deferred until retirement withdrawals. A Roth IRA is funded with after-tax dollars, meaning no upfront deduction, but investments grow tax-free, and qualified withdrawals in retirement are also tax-free.

Health Savings Accounts (HSAs)

An HSA, for those with a high-deductible health plan (HDHP), offers a triple-tax advantage. Contributions are tax-deductible, the funds grow tax-free, and withdrawals for qualified medical expenses are tax-free.

529 Education Savings Plans

While 529 plan contributions are not federally deductible, the money grows tax-deferred. Withdrawals are tax-free at the federal level if used for qualified education expenses like tuition and fees. Many states also offer a tax deduction or credit for contributions.

Managing Investment and Income Timing

Managing when you sell assets and receive income can influence your annual tax burden. This involves making deliberate decisions to take advantage of favorable tax rules.

A key strategy involves managing capital gains. Assets held for more than one year qualify for lower long-term capital gains tax rates. Holding appreciated assets for at least a year and a day before selling can result in substantial tax savings, as short-term gains are taxed at your higher ordinary income rate.

Tax-loss harvesting is a technique to offset investment gains by selling investments that have decreased in value. These realized losses can offset capital gains. If your losses exceed your gains, you can deduct up to $3,000 of the excess against your ordinary income annually. Be aware of the “wash sale” rule, which disallows the loss if you buy a substantially identical security within 30 days of the sale.

Adjusting your tax withholding is a direct way to manage your tax payments. The amount withheld from your paycheck is based on your Form W-4. If you get a large refund, you are overpaying during the year, while owing a large amount can lead to penalties. The IRS offers a Tax Withholding Estimator tool on its website to help you determine the correct amount. You can then submit a new Form W-4 to your employer to make adjustments.