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.