How to reduce tax as an employee is to implement tax planning strategies at the start of every income tax year. Effective tax planning is the secret to taking advantage of every deduction, rebate and benefit that will reduce your tax bill.
Once you understand the concept of the tax year and how to conduct basic tax planning you will minimize your tax liability. Tax planning is not complex but you need to start it early. Once most of the tax year is over it’s too late to implement strategies to reduce tax as an employee.
Consult an experienced tax accountant to discover every deduction, rebate and benefit you can claim to reduce tax as an employee. As every person’s tax position is different, only a tax accountant can design an effective tax plan for your unique circumstances.
The Tax Year
A tax year is the 12-month calendar year that covers a tax return.
The tax year varies from country to country.
In the USA, Canada and many other countries the tax year for individuals runs from 1 January to 31 December.
Tax returns in the U.S. are usually due on 15 April of the following year covering the calendar year period.
In the UK the tax year runs from 6 April to the following 5 April.
In the Australia the tax year runs from 1 July to the following 30 June.
All income earned and expenses incurred during the tax year are included in your tax return to calculate your tax liability. Therefore, planning the timing of your income and expenses is critical to reduce tax as an employee.
How to Reduce Tax as an Employee
Here are the most important items for effective tax planning to reduce your taxable income as an employee.
Claim Deductible Expenses
Employees are entitled to claim tax deductions for expenses directly related to earning taxable income. To claim a work-related deduction, individuals must have a purchase receipt dated in the current tax year. The employee must have spent the money themselves and not received any reimbursement from the employer business.
Donations to Charity
Donations to qualified charitable organizations may be claimable as a tax deduction.
The gift must be money consideration and must truly be a voluntary transfer of funds where the donor receives no material benefit or advantage. Always obtain and file a receipt.
Defer Income
One simple strategy is to defer some of your income into the next tax year. This strategy reduces the amount of income and tax in the current year. However, tax is payable on the deferred income in the next tax year. This is a useful strategy if your current year income is high and you know the next year’s income is going to be lower.
Example
You are not going to work the whole next year because you are taking time off work to attend university or travel Europe. Ask your employer to defer your last month’s salary or wages to the next tax year. In the current tax year, you earn 11 months’ salary and the last month’s salary payment is moved to the next tax year.
Effectively, you would be smoothing out your income over two years to pay lower taxes across both years.
Sell Investments at the Right Time to Reduce Taxes
When an asset, such as an investment property or stocks, is sold effects the amount of tax liability. Ensure the time of the sale takes best advantage of capital gains tax concessions. In many tax jurisdictions, the longer the asset is held the less the capital gains tax. Buying and selling assets in less than one year usually attracts the highest tax rate. Talk to your tax accountant before you sell your investments to ensure you are not generating a burdensome tax liability.
Pre-pay Expenses
Another trick to reduce tax is to pay deductible expenses up to 12 months in advance. Effectively, you are paying next year’s expenses in the current tax year to reduce your current year tax liability. Ask your tax accountant if you can use this allowance in your tax jurisdiction.
Example
Prepay next year’s interest on an investment property loan this tax year. This will reduce your taxable income and tax liability in the current tax year. Next year you will have no tax deduction for interest and will pay more tax. However, to overcome this issue you can continue to prepay the next year’s loan interest every year.
Mortgage Offset Account
Some countries allow home loan mortgage offset accounts.
Home owners deposit money into the offset bank account and earn interest on their savings. The bank offsets their non-deductible interest on the home loan with the interest on the normal taxable earnings of the offset account.
Effectively, individuals pay interest on the home loan minus the amount of interest in the offset savings account. This reduces the individual’s taxable income.
Salary Sacrifice to Your Retirement Fund
Most employers will offer sacrificing a portion of your salary to boost your retirement savings account. The tax on your retirement contribution will be less than the tax you would pay on the salary income. This mostly suits individuals with a medium to higher salary in the higher income tax brackets.
The benefit is optimal when you are older and close to retirement age as the contributions reduce the overall tax liability. The money is only locked away in your retirement account until you retire from work.
There are restrictions as to how much can contributed to your retirement account in a tax year. Please consult your employer and tax accountant.
Contribute to Your Spouses Retirement Fund
Most employers will offer sacrificing a portion of your salary to boost your spouse’s retirement savings account. The tax on your retirement contribution will be less than the tax you would pay on the salary income. This mostly suits individuals with a medium to higher salary in the higher income tax brackets.
There are restrictions as to how much can contributed to your spouse’s retirement account in a tax year. Please consult your employer and tax accountant.
Salary Sacrifice to Other Expenses
Some employers may offer salary sacrificing part of your salary to pay for private expenses such as motor vehicles, private health insurance and childcare. The payments are taken from your pre-tax salary to reduce your overall tax liability. However, the employer may be exposed to fringe benefits tax for providing this service.
Talk to your employer to find out if they can provide this service to lower your tax liability.
Self-Education Expenses
Some tax jurisdictions allow employees to claim a tax deduction for education expenses. The education course must be provided from a technical college, university or professional association. The education course must relate to the employee’s current employment and maintain or improve the skills or knowledge required for the employee’s current role.
Investment Property Deductions
Property investors can claim a capital works deduction and a plant and equipment depreciation deduction for their investment properties. Many other expenses relating to leasing the property are allowed as tax deductions. An investor can claim advertising costs, council rates & taxes, water charges, homeowner association fees, gardening, pest inspection, building insurance, repairs and property management fees.
These deductions reduce the investment income from the properties.
The capital works deduction applies to items of a fixed nature that form part of a property’s structure and includes renovations. The plant and equipment deduction relates to eligible items within the property, such as carpet, curtains, blinds, air conditioners, clothes dryers and dishwashers.
Consult your tax accountant to prepare a depreciation schedule to maximize your claim for capital works allowance and depreciation.
The Best Books on Property Investment
Negative Gearing Investment Property
When an investment property’s tax-deductible expenses are higher than the property’s income, the property is negatively geared.
Many tax jurisdictions allow employees to offset net rental losses from investment properties against salary taxable income. The result is an overall reduction in tax liability.
Caution: You should never purchase an investment property for the sole purpose to reduce tax. In some cases, it is acceptable for an investment property to make small loses particularly in the first few years. The property may make income loses but make capital gains.
However, the investor must have sufficient other sources of income to fund the losses until the property becomes profitable and produces a positive cashflow.
Health Insurance
Some tax jurisdictions allow employees to claim a tax deduction for private health insurance expenses.
Funeral Insurance
Some tax jurisdictions allow employees to claim a tax deduction for funeral insurance expenses. Prepaying for funerals allow individuals specify what they want while paying at today’s prices.
Invest in Managed Funds or Stocks with Franking Credits
In some tax jurisdictions, companies distribute fully franked dividends where the taxpayer can claim a credit for tax against their taxable income.
Franking credits are a kind of tax credit that allows companies to pass on the tax paid at company level to stockholders. The company pays the tax on the dividends before distribution to stockholders.
Effectively, franking credits can reduce the income tax paid on dividends or potentially you may receive as a tax refund.
Talk to your tax accountant to find out if this tax planning strategy can help reduce your tax liability.
Home Office Expenses
Many employees now work from home full-time or part-time. You may claim a portion of the cost of your home as a tax deduction. Other expenses such as computer, printer, desk, internet & phone costs may be claimed as deductible expenses against your income.
Conclusion
The secret to reduce tax as an employee is to start planning your tax return at the beginning of every income tax year. Commence tax reduction strategies early in the tax year to be as effective as possible. Always consult an experienced tax accountant every year to discover every allowable deduction, rebate and benefit you can claim to reduce tax as an employee.