How Can You Reduce Your Tax Rate Without Risking An Audit?

While many working Americans spend February and March excited at the prospect of receiving a tax refund that can be used to pay off holiday expenses or help fund a vacation, those who tend to owe on April 15 usually feel differently. If you find yourself paying a seemingly higher tax bill year after year, you may wonder whether there's anything you can do—short of reducing your income and marginal tax rate—to put more of this money back into your pocket. However, using some deductions may not put much of a dent in a hefty tax bill. Read on for some strategic tax planning ideas for structuring your income and assets to help decrease the amount of federal and state taxes you pay each year. 

Capitalize on your capital losses

If you're an avid investor but have had a few stalwart funds lose value this year, you may be able to sell and then repurchase these funds at a lower price through a process known as tax loss harvesting. This process involves the sale of funds at a loss and the repurchase of the same (or similar funds) before the price has been given a chance to rise again.

By doing this, you've turned a paper loss into a "real" loss for tax purposes, but still own approximately the same number of shares you held previously. Once this stock or fund rises in value again, you'll be in the same position you would have been had you never sold and repurchased the stock—however, you'll also have a taxable loss you can use to offset gains and minimize (or eliminate) capital gains taxes owed.

For those expecting to owe capital gains taxes on investments withdrawn during the calendar year, creating some tax losses before year-end can help you lower your tax rate and keep more of your money in the market (rather than in the IRS's coffers). 

Fund a relative or friend's 529 account

If you'd like to use your charity dollars closer to home while still receiving an economic benefit, you might want to consider investing in a 529 college savings account to benefit a relative or close friend's child. While not all states offer tax incentives for contributing to a 529, many do—and you may find that this charitable act nets you a much more generous deduction than you'd achieve by simply adding the amount to those you've already itemized. Those who don't itemize deductions can also benefit from 529 contributions in many states. 

For example, Alabama and Michigan permit taxpayers to deduct up to $5,000 in contributions ($10,000 if married) from state taxable income—giving you a dollar-for-dollar deduction for funds contributed to a 529. Indiana provides a 20 percent tax credit for funds contributed (up to $5,000, for a maximum of $1,000 in credit), while New Mexico permits a deduction of all contributions, no matter the amount.     

Front-load next year's contributions

If you regularly make tax-deductible contributions to certain organizations (like your church or a charity close to your heart) you may want to make two years' worth of donations in the same calendar year to enjoy a dual deduction. For example, if you normally make a $5,000 cash donation to your church each year, making this year's contribution on December 30 and next year's on December 31 will allow you to deduct $10,000 on your next income tax return.

This is an especially handy strategy if you're planning to retire, go part-time, or otherwise reduce your income during the next year. While you won't be able to double-dip by claiming the deduction again, the temporary reduction in your taxable income can save enough in taxes to allow you to increase future donations if desired.