Even though the pull of living in the Golden State is strong, it boasts some of the highest tax rates in the country, from sales tax, property tax, income tax and other local taxes.
This can leave Californians torn between leaving the state or sucking it up to stay and enjoy everything CA has to offer.
But, there is another way.
Knowing how to pay less taxes in California could be exactly what you need…
Many California business owners, both small and large, struggle to find solutions on how to save taxes in California.
Even though California’s income tax rates are between 1% and 13.30%, depending on your tax bracket, a tax break can help to reduce this tax burden.
Here are 8 ways on how to save on taxes in California right now:
Earn immediate tax deductions from your medical plan
Defer payment of taxes
Claim a work-from-home office tax deduction
Analyze whether you qualify for self-employment taxes
Deduct taxes through unreimbursed military travel expenses
Create a college savings account through a 529 savings plan
Invest in an IRA account
Let’s look at each of these ways on how to reduce California state income tax and see if they apply to you:
High-deductible medical plans, which the IRS defines as any plan with a deductible of at least $1,400 for an individual or $2,800 for a family, may be suitable for people who wish to reduce their taxes by contributing to a health savings account.
Taxes on these accounts are deferred and provide an immediate deduction.
These savings can be withdrawn tax-free, as long as they are used for qualified medical expenses, such as:
Routine doctors’ visits
Dental and vision care
N.B: You can roll over any balance left at the end of the year in the same way as a retirement account.
Taxes are inevitable, especially federal income tax. Eventually, everything that is owed to the federal government will be paid.
While that is true, in certain circumstances it might be better to make that payment later.
This is known as a “tax deferral,” which refers to instances where you, as a taxpayer, may opt to delay payment of taxes to some period in the future.
The deferred payment is like taking out a government loan without paying any interest—the government lends you the money without charging interest.
There are two ways you can do this:
In the end, the net taxes paid will remain static, but you will not pay income taxes on the portion of your pay in the year that you defer it.
Ultimately, it is often advantageous to pay taxes in the future, because you may find yourself in a lower tax bracket at the time the deferred compensation is paid, such as when you retire.
One incredibly effective way to save yourself from unnecessary taxes is to leverage your at-home status.
As a home office worker, you may claim a tax deduction if you fall within this category and work from home—and this applies to both homeowners and renters.
For utility fees, rent, or mortgage payments, you can claim one-fifth of the space taken up by that makeshift office.
A primary requirement of this position is that you do not need to be employed by anyone else. Therefore, you do not need to worry about that tax return if your boss handles it for you.
It’s also mandatory that you use that space regularly or exclusively for your business if you are running your own enterprise in order to apply the related tax savings.
It is possible, for example, that you have turned an extra storage room, bedroom, or even your kitchen counter into an office. Keep this in mind next time you decide to venture out and start your own business from the comfort of your own living room.
While we are on the topic of work-from-home offices, why not take full advantage of the multitude of ways you can earn valuable tax deductions as a self-employed business?
In addition to the home office deduction, you may qualify for further deductions based on your status as a freelancer.
Tax deductions are available for business trips when filing California self-employment taxes, for example.
So, if you go somewhere on business, take full advantage of the possibility that the expenses that serve that purpose may be deducted, saving you quite a bit of money in the process.
Not only do these deductions apply to travel, they also apply to a myriad of other aspects of your self-employment, such as:
Maintenance on your car (assuming you use it for business purposes)
And even insurance
In addition, you may also be in a situation where you decide to combine a vacation with a business trip to reduce the overall costs. You will be able to deduct the percentage that you spent doing business, as part of your self-employment tax deduction.
If you’re a member of the military reserve—such as the Navy, National Guard, or Peace Corps—it’s not uncommon for you to have to travel hundreds, if not thousands, of miles from your home, requiring you to stay overnight in most cases.
The good news is that you can easily deduct those taxes in the event that you were not reimbursed for other travel expenses. For example:
Moreover, if you are an active member of the navy, air force, or army, you may still have to deal with tax liability. In such an instance, you may deduct tax costs related to your movement from one station to another, which should save your wallet from unnecessary payments.
One tax to be wary of is capital gains tax, which applies to the profit that you, as an investor, will make whenever an investment is sold.
According to the IRS, the tax rate on most net capital gain is no higher than 15% for most individuals. Still, 15% is nothing to scoff at and should be minimized, if possible.
One key method of mitigating the capital gains tax is by moving your stocks with the biggest capital gains tax into a donor fund, as donor funds are tax exempt. These funds are also deductible by individuals that attempt to itemize them.
By leveraging stocks, your tax bill will benefit significantly, especially by the time your tax filings are due.
Before we delve into the benefits of a college savings account, let’s first define what is known as a “529 savings plan.”
According to the SEC, a 529 plan is a tax-advantaged savings plan which is used to encourage saving for future education costs.
In other words, it is an investment account that provides tax benefits, particularly if used to pay for certain “qualified” educational expenses for a specified, designated beneficiary.
Some qualified expenses related to education, under a 529 plan, include:
Room and board expenses
Books for college classes
Computer expenses (repair, damage, etc.)
To prove to the IRS that withdrawals from your 529 plan are eligible, qualified educational expenses, all you have to do is provide documentation. This can be in the form of receipts, checks, and other documented forms of payment.
One note to those looking to take advantage of this strategy, be sure to evaluate whether certain “gift” tax liabilities apply. Specifically, should any of your contributions or gifts toward the beneficiary of the educational investment exceed $15,000, then you may have to pay an additional fee.
Now, let’s shift gears from the younger generation looking to attend college to the older generation looking to transition into retirement.
Another effective method of reducing your end of the year taxes is to open an individual retirement account (IRA). As you may already know, there are two types of IRAs:
Let's look at how each of these can help you save taxes in CA:
With a traditional IRA, your taxes will be affected in the sense that when you contribute pre- or after-tax dollars, your money will grow tax-deferred.
This way, your withdrawals will be taxed as current income after the age of 59.5 years.
This type of IRA account is most advantageous for individuals who expect to find themselves in either the same tax bracket from when they started taking withdrawals, or a lower tax bracket from when they started taking withdrawals.
By contrast, the Roth IRA allows individuals to make after-tax contributions.
With this form of IRA, you have the ability to contribute after-tax dollars so that your money grows tax-free, and so that you can make tax- and penalty-free withdrawals once you exceed the age of 59.5 years.
This type of account is most advantageous for those who see themselves entering a higher tax bracket in retirement or whenever they start taking withdrawals, as compared to before they start taking withdrawals.
However, keep in mind that these factors will affect the type of deductions you can make on your taxes, particularly if made to a traditional IRA.:
How much you make
Whether or not your spouse is covered by the same retirement plan
NB: There's no guarantee that the above methods will allow you to completely dodge a California sales tax audit, but they could help make them a lot easier to manage.
Now that we have discussed how to lower taxes in California in general, it’s time to get more specific.
In this section, we will guide you through how to avoid California state income tax, specifically, and four key ways, on top of the eight listed above, that will save your wallet from exorbitant taxation:
Evaluate the Corbett Factors
Claim taxes based on whether you are a part-year resident of California
Sell your business
Decide whether or not you want to retain a home in California
Your residency will have a significant impact on how much taxes you pay in a year.
Under the circumstance that you decide to opt out of California state taxes by declaring yourself as a non-resident or, perhaps, a part-time resident, there are several factors, known as the “Corbett” factors, that you should consider.
By way of background, there are 29 residency factors that the state of California analyzes when determining whether or not an individual is a resident of the state.
Of the 29, some of the most prominent factors include:
Where you were born
Whether you are raising a family
Location of your home and/or other properties
Where you attend church
And even where you make donations
As a taxpayer, if you are seeking to reduce and/or completely evade the taxes of your home state of California, you need to be mindful that you have not already ticked several of the boxes under the Corbett factors.
Ultimately, the California government will assess the Corbett Factors holistically, in the sense that there will be some form of balancing of interests.
For example, if you argue that you’re an Arizona resident because you received your license in Arizona, despite the fact that you married, had children, and your home is currently located in California, your chances of success are likely slim.
By contrast, if the only connection tying you to the state of California is that you made a one-time donation to the Los Angeles Center for Law and Justice, then you are more likely to pass the Corbett test for residency and avoid California state taxes.
In addition to the more black-and-white analysis of whether or not you are a California resident, it may also help your case if you fall under the more gray-zone category being a part-year resident of California.
During their time as non-residents, part-year residents are taxed on:
All income earned worldwide, and
Income earned from California sources
When analyzing this situation, depending on whether you lived within or outside of the state throughout the tax year, you may be considered a part-year resident.
You will most likely qualify as a non-resident if you visit the state for:
To complete a job, transaction, or contract for a short time period.
As long as you are not in California for employment purposes, you qualify for safe harbor as a non-resident.
NB: Our California source income rule guide goes into more depth on this matter and what income sources are taxable under Californian law.
For the business owners out there, another method of how to avoid California taxes on your company, particularly if you are deciding to sell your business, is to time your transition of residency to a different state properly.
For example, your company operated in California for several years before being sold for a significant amount of money. You then decide to move out-of-state to Arizona before the sale is finalized so that you can claim Arizona state taxes on your tax returns, as opposed to California’s.
This will likely not work, because California will see that you have moved state strategically, in such a specific and short amount of time, to avoid taxes.
The solution to this problem is to move your personal residency to out-of-state several years or at least one year prior to the sale of your business.
This way, the state will not have as strong of an argument to claim that you moved out of state for tax purposes. This is because you will have been a resident of a new state for over a year by the time your company’s sale has been consummated.
For those seeking to leave California for tax-related reasons, consider whether or not it is advantageous for you to keep real estate, especially your home, in the state even after you leave.
Looking back at the Corbett factors, while the state will evaluate your residency holistically through the 29 factors, keeping a home in California is a major signal that you plan to return to California or still consider yourself a resident.
Be wary of the hidden costs of keeping a home in the state after you leave, and decide whether the costs outweigh the benefits.
Whether you are an individual or a business owner living in the state of California, there are a myriad of ways that you can save your wallet from unnecessary expenses during tax filing season and the tax system.
The best part of these strategies on how to avoid California income tax and how to pay less taxes in California is that they build upon one another.
If you qualify for one type of tax exemption based on your employment status, residency, or some other classification, you likely qualify for even more tax benefits and ease the burden from the tax laws.
So, be sure to evaluate every factor thoroughly, as you may find yourself saving much more than expected.
If you’re in any doubt whether any of these factors apply to you, speak to a Brotman Law tax professional to talk through your situation.
Yes, you can be exempt from California state deductions when it comes to withholding tax. You’ll need to complete a DE-4 or W-4 form and also confirm that you won’t owe any taxes for the current financial year, nor were you liable for any taxes in the preceding year.
Californians and non-Californians will have to pay California state income tax if they have tax liabilities for a particular tax year, no matter if they are a resident, non-resident or were only resident for a part of a tax year.
You will have to pay California taxes if you live out of state and if you have taxable sources linked to California. Examples of this include taxable income from a property in California, income from a California business and the sale of a property in California.
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IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, I must inform you that any U.S. federal tax advice contained in this website is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter contained in this website.