A Little-Known Way to Cut Your Income Tax

The federal tax code is impossibly complex. Usually this means you end up paying more taxes than you're legally required to. Sometimes, however, the intricacies of the tax code offer up a tasty bit of free money, if you know what to do.

A special situation that can help cut your income tax by thousands of dollars

If you sell your house at a profit, the first $250,000 in capital gains is exempt from federal income tax if you've lived in the house at least two of the past five years. If you file a joint return with your spouse the exemption is doubled. So far, this is a widely known and widely used tax break. However, this can be just the beginning for an even sweeter deal.

Many employees are eligible to defer a portion of their income taxes by contributing to a 401(k) or 403(b) retirement plan. However, most of us cannot afford to contribute the full amount allowed by the tax code ($15,500 for 2008, unless you're over 50 years old in which case it is $20,500).

If you are in the above situation, you can use some of your tax-free capital gains to reduce your current taxable income, cutting your income tax bill by thousands of dollars.

Move money from one pocket to the other and cut your income tax liability

Let's look at John Smith, who just sold his primary residence for a tidy profit of $100,000. For this example we'll assume Mr. Smith uses $50,000 of the proceeds as a down-payment on his next house and expects to need $30,000 in the foreseeable future for other expenses.

Mr. Smith invests the $30,000 he expects to use, perhaps in a money market account or some other safe investment. The remaining $20,000 he splits evenly between his savings account, a 12-month CD and a 24-month CD.

Mr. Smith now notifies his employer's payroll office to increase his 401(k) contributions such that by the end of the year he will have contributed the full amount allowed.

Since our Mr. Smith would only have been able to sock away say $5,500 this year, the increased contribution reduces his taxable income by $10,000. Assuming a marginal tax rate of 33.3% counting federal, state and local taxes this cuts his tax bill by $3,330.

This does have something of an unintended consequence for our friend. Mr. Smith will now have $6,670 less coming into his checking account this year which he can't afford. To make up the shortfall, Mr. Smith gradually transfers the $6,670 he put in his savings account into his checking account.

Next year Mr. Smith repeats the process and transfers the money from the 12-month CD to his checking once it matures. A year later he repeats the process yet again, and uses the now-matured 24-month CD to cover his checking account short-fall.

The bottom line

As a result of this maneuver, Mr. Smith has increased his 401(k) contribution total by $30,000 over 3 years. This was financed by $20,000 out of the tax-free capital gains on his old house. "Wait a minute! Where did the 'missing' $10,000 come from?" you ask.

The answer is simple. It was financed by Mr. Smith's reduction in taxes over the three year period. When Mr. Smith retires and withdraws the money he will of course owe taxes on the full $30,000.

Meanwhile, he effectively received an interest-free loan from the government. This "loan" does not "come due" until Mr. Smith retires. Over the years or decades until then, the money should grow significantly. As any financial planner will tell you, if you can defer taxes on your investments, that is almost always the best thing to do.

If your situation is similar to that of our friend Mr. Smith, talk with your tax adviser and see if you can't use the same maneuver to cut your tax bill. Who knows, maybe you too can be the beneficiary of this aspect of our convoluted tax code.