Tax-Free Income: 10 Ways to Avoid Paying Taxes

October 20, 2011 | Posted By: Manny Davis | Categorized in: Tax Advice & Tips, Finance


Although you cannot avoid having taxes taken out of your paycheck, there are some forms of income for which you can receive a 0% tax rate. Certain inheritances, rebates, fringe benefits and even airline miles that you've earned cannot be touched by the IRS making them tax-free. Here is a list of ways through which you can avoid paying taxes on certain types of income:

1. Sell Your Home

If you have lived in a house for at least two of the past five years (and it is your primary residence), you can exclude $250,000 in capital gains if you are single and up to $500,000 on a joint return when you sell your home.

If you know what you are doing, you can potentially become a house-flipper. This entails purchasing a home that needs some TLC and attention one at a time fixing it up and living in it for two years out of the last five years prior to the sale of the home. When you sell, you can make a profit if the house has increased in value since you purchased it, and you can keep up to $250,000 (or $500,000 if filing a joint return) in capital gains without paying taxes on that income.

Keep in mind that you are only allowed to exclude from capital gains tax one house during the two year period before you sell. Furthermore, be sure to note your basis because if you purchase a home for $300,000 and you put $20,000 into it then your basis is $320,000.

2. See if your Employer Provides Tax-Free Commuter Benefits

This is one of eight fringe benefits (statutory employee benefits) that your employer can provide to you as tax-free income - meaning that the benefit is excluded from gross income. Each tax-free commuter benefit falls into one of four categories: riding in commuter highway vehicles between your home and work, transit passes, qualified parking, and qualified bicycle commuting expenses.

You can take up to $120 a month for both transit passes and highway vehicle transportation combined, $230 tax-free each month for qualified parking, and up to $20 multiplied by the total number of months for which you bike to work to be used toward such expenses as the purchase of, storage for and repairs to a bicycle.

Remember that the eligibility of these benefits is based off of the commute between your residence and your place of work. For more information and details, see this IRS.gov link.

3. Make Use of a Health Savings Account

If you have a high-deductible health insurance policy, you can set up a health savings account (HSA). To qualify for this benefit in 2011, the minimum health insurance deductible is $1,200 for an individual and $2,400 for a family. You can deposit up to $3,050 per year if you have a self-only policy, up to $6,150 if you have a family policy, and an additional $1,000 per year if you are over 55 years of age. You have the option to use the money toward medical expenses at any time and the account will stay with you even if you change jobs.

There are many tax benefits that come with having an HSA, including:

  1. The contributions that you make into an HSA are tax-deductible even if you do not itemize on your tax return.
  2. In some cases, employer contributions to an HSA may be excluded from gross income.
  3. The money in a health savings account will grow tax-free, as any interest or gains in assets in the account are not taxable.
  4. The principal that you've deposited, in addition to any earnings, can be withdrawn tax-free for qualified medical expenses.

You can find more information about the tax-benefits of health savings accounts on the IRS Website.

4. Use Credit Cards to Your Advantage

When you use cash-back credit cards, the money that you get back is generally tax-free because the rebate is considered to be a reduction in the purchase price of an item. This means that if you purchase a car for $20,000 and receive 1% back in cash, then the car's cost basis is $19,800, which becomes important later when calculating your gain or loss if you sell the car.

Additionally, if you travel frequently, an airline rewards card may be a good option for you. Many people earn airline miles for tax-deductible business trips and then use their free miles for personal vacations.

5. Start a Small Side Business

If you have a full-time job, starting a small side business - with the intention of making a profit - can help you deduct expenses that you would not normally be able to. Expenses such as your home office, telephone/cell phone bills, travel costs, continuing education courses and qualifying supplies can be used to reduce the amount of income that you must claim at tax time. Be aware that using this method does require significant knowledge of the tax code.

Also, even if you legitimately write off various home-based business expenses to offset your income, if it fails to make a profit for three of the past five years, the IRS may classify your business as a hobby, meaning that your expenses are subject to the 2% miscellaneous expenses rule. It is generally a red flag to the IRS if your business does not make a profit two years in a row.

6. Have a Garage Sale or Tag Sale

Most of us have belongings that we no longer need or use, stuff that we consider to be junk, which might be of great use to someone else. Tag sales and garage sales are great not only because you get to clean out your attic or unload your garage, but also because, usually, the proceeds from these sales are either not taxable or excluded from income.

There are, however, some exceptions. If you sell an item for less than you paid for it, then you are selling it at a loss, which means that the income is not taxable because there is no gain. On the other hand, if you have a garage sale and sell that old Mickey Mantle baseball card for much more than you paid for it, you will need to pay taxes on the gain.

7. Invest in Municipal Bonds

"Munis," or municipal bonds, are bonds issued by various cities, counties, school districts, redevelopment agencies and other governmental entities. Many of these bonds earn interest that is exempt from Federal taxes and sometimes even State (in which they are issued, typically) as well as local taxes. Bonds issued for certain purposes are occasionally subject to the Alternative Minimum Tax (AMT) so if you are purchasing a bond, be sure to check with your financial advisor to be sure that the interest is tax-free.

Many argue that even though municipal bonds are tax-free, since they have relatively low interest rates, you might be better off investing in taxable bonds instead. It is best to speak to your financial advisor if you are considering purchasing bonds to determine the best option for your unique financial situation.

8. Rent Your Home for Fewer than 15 Days

If you rent out property that you use as a home for at least part of the year to someone for fewer than 15 days, you are not required to report the rent that you received as income. The IRS states: "If you use the dwelling unit as a home and you rent it fewer than 15 days during the year, that period is not treated as rental activity. Do not include any of the rent in your income and do not deduct any of the rental expenses." In other words, the rent or payment that you receive is tax-free.

Consequently, you cannot deduct any rental expenses that you incurred as a result of renting out your house, apartment, condo, mobile home, boat or vacation home. You can find more information about the tax implications of renting your home here.

9. Insure Your Life

If you currently pay for life insurance, check to see if your company offers it. IRS section 79 allows an income exclusion for group-term life insurance coverage of $50,000 or less carried directly or indirectly by your employer. Companies generally do not mind offering this benefit since the cost or premiums are usually deductible expenses. Any money paid to your beneficiary as a result of your death generally will not be taxed.

Additionally, if the life insurance policy has a cash reserve, the cash value is typically tax-free as well. Overall, the key is that you are essentially getting tax free income since if you were to purchase the same type of life insurance yourself you would pay for it with after-tax dollars. You can learn more about the details on the IRS Website.

10. Educate Yourself

Going to school will not only earn you an education, but it may also earn you some tax-free income as well. Your employer can pay up to $5,250 per year in educational assistance toward either undergraduate or graduate courses on your behalf. The money paid by the company for educational assistance is tax-deductible, and the educational assistance received by you is tax-free. There are exceptions for highly paid employees, so be sure to read about the details here.

Another option is to set up a 529 college savings plan, in which the earnings are not subject to Federal taxes - and sometimes even State taxes as well - as long as the funds are used toward eligible higher education expenses (with a few exceptions). Moreover, there are no income limitations to participate in this plan, and depending on the state in which you reside, you may be eligible for an income tax break for the money that you put into the account.

This guest post was provided by Manny Davis. His website contains a frequently updated tax tips blog that provides tax news, tax changes and tax saving advice, as well as detailed guides to IRS tax solutions to help taxpayers resolve various tax-related problems.






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