Nothing’s worse than getting a huge tax bill come tax season. You’ve spent the entire year giving part of your paycheck to the IRS… and now you have to pay more?! It seems so unfair.
And if you’re working toward FIRE, it can really mess up your plans. Instead of using those precious dollars to chip away at your goals, you’re stuck handing over money to the IRS.
Lack of tax planning has caused us to shell out up to $4,000 come tax time! Learn from our mistakes.
Thankfully there are (ridiculously) simple tips you can use to reduce your taxable income—and slash your tax bill in the process. Depending on your situation, these tips could reduce your bill down to $0.
The simplest way to reduce your taxable income is to max out your retirement plans.
If you have a 401(k), 403(b), 457 plan, or a federal Thrift Savings Plan (TSP), you can contribute up to $19,500 in 2020. If you’re at least 50, your contribution limit is $27,000.
In addition to the retirement plans listed, some organizations offer access to 457 plans. A 457 plan is a type of deferred compensation plan. They are offered by state or local governments and some nonprofit employers. Money contributed to 457 plans is pre-tax! It’s yet another tax-advantaged employee retirement plan.
You can also contribute to a traditional IRA if you don’t have an employer-sponsored plan or you’d like to save more than the $19,500 limit. For 2020, the maximum contribution limit for traditional IRAs is $6,000 or $7,000 if you’re 50 or older.
On top of reducing your taxable income, contributing to these accounts may also qualify you for special tax deductions (which we’ll talk about more below).
A quick note on Roth IRAs: While a Roth IRA has many tax benefits, reducing your taxable income isn’t one of them. You reap the rewards of this account when you start making tax-free withdrawals. Don’t get me wrong, I love ROTH IRAs! They are great for tax diversification. However, the traditional IRA will alleviate the tax burden now. It’s a sure thing.
We hope, but we don’t know for sure if the ROTH IRA tax benefits will remain the same in the future. Tax laws can change.
Did you know your health savings account isn’t just for medical expenses? It doubles as a supercharged investment account that has some astonishing tax benefits. Unlike your retirement plan, this account is 100% tax-free. You make before-tax contributions, your earnings grow tax-free, and you make tax-free withdrawals (a triple whammy of benefits!).
Before age 65, you can only use an HSA for qualified medical expenses. But after that, you can use it for anything—from everyday living expenses to a trip to the Maldives.
But there’s one caveat. You don’t qualify for an HSA unless you have a high deductible healthcare plan. If you’re unsure if your plan qualifies, take five minutes to call your healthcare provider.
For 2020, you can contribute up to $3,550 to an HSA if you have an individual plan and $7,100 if you have a family plan. If you’re at least age 55, you can save an additional $1,000.
You have two options when you file your taxes: take the standard deduction or take the itemized deduction. The standard deduction is quick, easy, and doesn’t require you to keep up with any receipts for the year. The itemized deduction is more tedious and requires you to add up your deductible expenses line by line.
The IRS estimates that 90% of taxpayers will take the standard deduction in 2019 and 2020. That’s because these limits are nearly double what they were in previous years due to the Tax Cuts and Jobs Act.
If it made sense for you to itemize in the past, that may not be the case this year. Run the numbers both ways to see which deduction saves you the most money.
For example, if you’re married, filing jointly, and your itemized deductions are less than $25,800, you’d save more money by taking the standard deduction. If you’re single, you should take the standard deduction if your itemized deductions are less than $12,400.
Once you max out your retirement plans and HSA, you can reduce your income even more by claiming certain credits and deductions.
A tax credit lowers your tax bill dollar for dollar. Some credits are refundable (meaning you get a check for the remaining amount), but most are nonrefundable. Tax deductions lower your taxable income dollar for dollar.
Here is a list of popular deductions and credits broken up by category.
If you saved for retirement…
If you own a home…
There were changes to the tax benefits for homeownership under the Tax Cuts and Jobs Act. Since the standard deduction was increased significantly, the tax benefits for homeownership may not be as tax-reducing as it once was.
If you have kids…
Ready to see us put these tips into action? Here’s an example…
Clarice and Kent are in their 30s, married, and have one five-year-old child. They make a combined annual income of $100,000.
They each max out their employer-sponsored retirement plans ($19,500), traditional IRAs ($6,000), and their family HSA ($7,100). This means their taxable income is $41,900.
After they take the standard deduction, which is available to every taxpayer, their taxable income is reduced to $17,100. Based on the 2020 tax brackets, their federal income tax bill is $2,052.
But wait… they qualify for two tax credits.
With a little bit of planning, it’s totally possible to reduce your taxable income and slash your tax bill for the year. While you may not get it down to $0 every time, every little bit you save helps you work toward your FIRE goals. Just remember to maximize your tax-deferred savings plans, then go after any tax credits and deductions you qualify for.
Reducing our taxable income was the first thing we did on the FIRE journey. We focused our efforts here before looking at cutting or reducing expenses.
Have you used any of these tips to reduce your taxable income? Share your experience in the comments below.
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Maria @ Handful of Thoughts | 2nd Jan 20
Wow there are so many ways to reduce your taxable income. In Canada our system is slightly different but it is still possible to decrease your tax burden. We made the mistake of not paying attention to this one year and got hit with a huge tax bill. That is one mistake we will not be making again that’s for sure.
Claire Masters | 19th May 21
It was really interesting to learn that 90% of people would opt for the standard tax deductions. My husband has recently been laid off so we are looking for ways on how we can save money on taxes. I’ve heard that there is a way to have my taxes lowered by reduction planning so I’m going to research tomorrow on which services I can hire to help me with this.
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