Blog: 6 Strategies to Reduce Your Taxes
To significantly reduce your taxes now and in the future, you need to plan ahead. There are several strategies you can adopt to lower your tax bill. When I was studying for the Certified Financial Planner™ certification, I was amazed at the volumes of strategies we are allowed to take to reduce our tax bill. Most of them involved setting up trusts, but unfortunately, they only make sense for those who have several million dollars tucked away. We middle-class folks need to take advantage of what’s available to us, so we too can be good American citizens and pay taxes, but not more than we need to.
Below, we discuss 6 strategies to help you reduce your taxes:
1. Max out your 401(k), if possible
If you are in the 32% tax bracket and you contribute the maximum for 2020 ($19,500 or $26,000 for taxpayers 50 and over) towards a pre-tax 401(k), your federal taxes can be lowered by around $6,000. If this is not possible, you should at least contribute the maximum amount that will be matched by your employer if they offer an employer matching program.
For small business owners, lower your tax bill by saving through either a SEP IRA, SIMPLE IRA, or an individual 401(k). If you are a consultant who makes $100,000 a year, you might be able to save up to $19,500 in a SEP IRA, $20,000 in a SIMPLE IRA, and $58,000 in an individual 401(k); this will reduce your income tax bill in the process.
For small business owners who generate a significantly high income, you can create your own pension plan. We have clients who are dentists, and they are setting aside $70,000 to $100,000 a year towards a pension plan – lowering their tax bill by up to $40,000 a year! They couldn’t believe it when they first heard about it, but it’s true.
2. Consider switching future contributions to a Roth 401(k)
Depending on which tax bracket you are in, and whether you can absorb a slight reduction in your take-home pay, consider switching all your future contributions from pre-tax to a Roth 401(k), if it’s an available option. This way, you will be able to pay taxes while your tax bracket is low, and thus avoid paying higher taxes when tax rates go back up. It is important to consult a Certified Financial Planner™ to know if this is advantageous for you.
3. Maximize Roth IRA contributions
Roth IRAs are taxed up front. If you are eligible, the tax savings could be immense. While your Roth IRA contributions don’t lower your tax bill today, the money you withdraw when you retire, including earnings, will be tax-free. You can contribute up to $6000 per tax year to an IRA for 2021 (or $7,000 for people 50 and older).
Roth IRAs also gives us flexibility. We can withdraw our contributions without penalty in case we decide to use it elsewhere (like house down payment, help pay for your child’s tuition).
If you are no longer eligible for a Roth IRA, you can consider backdoor Roth contributions. Thank Congress for leaving this loophole open. This can be a key strategy in retirement planning.
4. Contribute to a Health Savings Account (HSA)
Health Savings Account, or HSAs, are perhaps the most underutilized tax-advantaged way to grow our money. It’s even better than a Roth IRA. Like a Roth, earnings are tax-free, but HSAs are also tax-deductible. So you save on taxes now and in the future. You get the most out of a Health Savings Account if you don’t touch your contribution, and just let it grow by investing in stock and bond funds. Your HSA earnings are tax-free if you use it for qualified medical expenses in the future.
An HSA may be suitable if you are:
- In a position to have a high-deductible health insurance plan (no kids, healthy, have adequate cash savings);
- Looking for the most tax-efficient way to grow your money.
Not all high-deductible health plans are HSA-eligible. It has to have HSA in its name. The IRS allows you to make HSA contributions until the tax deadline and apply these as deductions to the current tax year.
5. Take Advantage of Tax Credits
There are many tax credits available. Each year the IRS releases the tax credits and deductions available to filers. It’s important that you take advantage of every tax credit that you are entitled to. Tax credits reduce the amount of tax that you owe, not just your taxable income. Americans use tax credits to save billions of dollars on their taxes every year.
Some of the popular tax credits are:
- The Earned Income Tax Credit (EITC): you can claim between $538 to $6,660 in 2020 It ranges from $543 to $6,728 for 2021.
- The Child Tax Credit: Up to $2,000 per child aged 16 or younger and $500 for a non-child dependent in 2020 and up to $3,600 per child in 2021.
- The Child and Dependent Care Credit: you can claim up to $3,000 for daycare and similar costs for a child under 13 and up to $6,000 of expenses for two or more dependents. In 2021, it’s up to 50% of $8,000 of expenses for one dependent or $16,000 for two or more dependents.
- The American Opportunity Tax Credit (AOTC): In the first four years of higher education you can claim the first $2,000 that you spent on things such as tuition, books, equipment, and school fees. Plus up to 25% of the next $2,000 for a total credit of $2,500. This doesn’t include living expenses or transportation.
6. Donate to Charity
You can take advantage of a charitable tax deduction through a standard donation or itemization. A provision in the CARES Act allows everyone to benefit from charitable giving this year. You can claim up to $300 in donations for the standard deduction. These donations must have been made in cash to 501(c)(3) charitable organizations. Cash donations include those made by credit card, check, or debit card.
You can also choose to itemize your donations instead. For this option, you can deduct your cash contributions and the fair value of the donated property, and out-of-pocket expenses paid to do volunteer work. If you want to see how you can calculate the fair market value of the donated property, look at IRS Publication 561. Donations are only deductible if they are made to approved charitable organizations. For example, if you donated money via a GoFundMe page then you probably cannot deduct that donation. The IRS’s online “Tax Exempt Organization Search” tool will tell you if the organization you want to donate to is approved for charitable donations.
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