10 Tips for Lower Taxes

When it comes to doing our taxes, many of us have two main goals: minimizing what we owe to the IRS and, if we’re lucky, securing a decent refund. While these are common objectives, figuring out how to lower our tax bill isn’t always straightforward. It’s essential to remember that a tax refund is essentially getting back money you’ve already earned; you’ve essentially loaned it, interest-free, to the government. While a refund can be a welcome addition to your finances, some argue that it’s better to aim for a balanced outcome with the IRS, neither owing nor being owed a significant amount. After all, it’s your hard-earned money.

That’s where we come in. From exploring deductions to optimizing retirement plans, from leveraging tips to managing tuition expenses, there are strategies available for almost every taxpayer to find some relief come tax time. Sometimes, we just need a bit of guidance on which approach to take. Should you invest the time in itemizing your deductions, or is it more practical to take the standard deduction and hope it’s worth the effort saved?

Arguably one of the most critical tax decisions you’ll make is whether to itemize your deductions. Sure, the decision to file your taxes is paramount, but that’s typically non-negotiable. The government offers two options: take the standard deduction or itemize your deductions. The standard deduction varies depending on your filing status. For instance, in 2020, it’s $12,400 for single filers and $24,800 for married couples filing jointly.

The standard deduction might seem like the simpler choice, and for many, it is. However, it’s essential not to overlook the potential tax savings that come with itemizing deductions. This method allows you to deduct various expenses, including some medical costs and charitable donations. Perhaps the most significant deduction for many homeowners is mortgage interest. Thanks to tax reform, you can write off interest on the first $750,000 of mortgage principal for mortgages originated after December 15, 2017. For older mortgages, you can deduct interest on the first $1 million of principal and $100,000 from a home equity loan.

Forget what we just said about the benefits of itemizing. Well, not entirely, but don’t assume every little deduction is worth the hassle. Take medical expenses, for instance. You might think you can deduct all your medical bills, but it’s not that straightforward.

Here’s the deal: You can only deduct medical expenses that exceed a certain percentage of your adjusted gross income (AGI). Let’s say your AGI is $50,000, and you have $10,000 in medical expenses. You can only deduct $6,500 of those expenses because the remaining $5,000 falls below the 7.5% limit set for tax year 2020.

The key takeaway? Don’t overlook the potential complexities of deductions. You might end up increasing your tax bill instead of reducing it if you’re not careful.

Some strategies for reducing your tax burden are like magic tricks, while others are more straightforward. One simple yet effective approach is to ensure you’re paying enough taxes throughout the year, so you’re not hit with a hefty bill come tax season.

If you find yourself facing a large tax bill every April, it could mean that either you or your employer aren’t withholding enough from your income. Fortunately, there are ways to address this issue. One option is to adjust your withholding by submitting an amended W-4 form to your employer. If you have additional sources of income, such as freelance work, you might need to make estimated tax payments to cover your obligations. While this won’t reduce your overall tax liability, it can help you avoid a large lump-sum payment at tax time.

Many people overlook the potential tax benefits of contributing to a retirement plan, but it can actually be a smart move. While it might seem counterintuitive to stash money away in a retirement account, it can provide significant tax advantages.

One popular option is a 401(k) plan. You can contribute up to $19,500 annually to your 401(k) ($26,000 if you’re 50 or older), and the best part is that this income isn’t taxed. Essentially, you can subtract up to $19,500 from your taxable income by contributing to your 401(k).

However, it’s important to understand that these tax benefits come with a trade-off. Although you don’t pay taxes on your contributions now, you will be taxed on the distributions when you start withdrawing funds from your 401(k) in retirement. Additionally, it’s worth noting that not all retirement plans operate in the same way; IRAs and Roth IRAs, for example, have their own unique tax implications, and some contributions may be taxable.

While splurging on a pricey purchase might seem like an odd tax-saving strategy, it can actually be quite beneficial in certain situations. Take buying a car, for example. While it’s not advisable to make such a significant purchase solely for the purpose of tax deductions, if you need to buy a car for your business, it can be advantageous to write off the entire cost in the year of purchase.

Typically, you’d have to depreciate the cost of the car over several years, spreading out the deduction. However, Section 179 offers a different approach. This tax provision allows businesses, including self-employed individuals, to deduct the full cost of qualifying equipment purchases, such as vehicles, up to a certain limit. For the tax year 2020, this limit was set at $1,000,000. It’s important to familiarize yourself with the specific eligibility criteria and rules to ensure you qualify for this deduction.

Medical expense accounts aren’t the only way to squirrel away some of that sweet income into funds that Uncle Sam can’t touch. If you’re desperate to make that tax bill shrink, you might want to consider putting some of your savings into a spot that’s more specific than your bank account.

If part of your savings is going to a child’s college education (or yours, or anyone’s), you can start investing the money in a 529 plan. These plans are sponsored by either a school or state, and they offer a few benefits to make saving for college a bit easier. Now don’t think you’re just going to plop money into the account and watch your income (and tax bracket) shrivel. Contributions from 529 plans aren’t tax-free; you can’t deduct them. But any earnings they make are not taxable and usually don’t require state taxation when you use them for college expenses [source: IRS 529].

So in the long run, putting your college savings in a 529 plan might be a lot more useful than letting it sit in a savings account. The tax reform in 2017 also allows funds from a 529 plan to pay for additional education expenses. For example, tuition for private elementary schools (Grades K-to-12) now qualify too.

There are other avenues to safeguard your income from taxation, beyond medical expense accounts. If you’re looking to minimize your tax bill, consider directing some of your savings into specific investment vehicles rather than just keeping them in a standard bank account.

One option worth exploring is a 529 plan, particularly if you’re saving for a child’s college education or your own. These plans, sponsored by either educational institutions or states, offer several advantages to simplify college savings. While contributions to 529 plans aren’t tax-deductible, any earnings they generate are tax-free. Additionally, when used for qualified college expenses, these earnings typically aren’t subject to state taxation.

In the long run, allocating your college savings into a 529 plan could prove more beneficial than leaving them in a traditional savings account. Moreover, recent tax reforms have expanded the scope of eligible expenses for 529 plan funds, now including tuition for private elementary schools (Grades K-to-12).

We’ve explored how itemized deductions might not always yield substantial tax advantages, particularly concerning medical expenses. However, there’s a clever workaround to cover these costs tax-free, regardless of whether you itemize deductions.

Enter the flexible spending plan, a benefit offered by some employers. By contributing the maximum allowable amount—$2,750 in 2021—directly from your paycheck into this plan, you effectively decrease your taxable income. This translates to reduced taxes owed and potentially even a lower tax bracket.

Another avenue is a health savings account (HSA), which also offers tax benefits. While contributions to an HSA don’t directly lower your income, you can deduct them on your tax return, even without itemizing deductions. This deduction reduces your taxable income, leading to potential tax savings.

When tax time rolls around, people often fret over scenarios that are unlikely to occur. They may worry about omitting significant portions of their income or overlooking valuable tax credits like the child tax credit. While these concerns may not materialize, they’re even less likely if you opt for electronic filing.

Filing electronically offers several advantages. Tax preparation software typically guides you through the process, helping to ensure you don’t miss anything important. Moreover, electronic returns have a significantly lower error rate compared to paper returns—less than 1% versus about 20% for paper returns. By filing electronically, you not only reduce the likelihood of errors but also potentially save yourself from the hassle and expense of an audit.

Additionally, filing online can expedite your refund, delivering it to you much faster than if you were to file by mail. While this may not directly lower your taxes, it’s certainly a perk that few would turn down.

Despite all our encouragement for you to take charge of your taxes, there’s no contradiction in suggesting that you consider hiring a professional to prepare your return.

While many individuals can confidently handle their taxes, there’s no shame in seeking assistance to ensure you’re maximizing your tax breaks. It’s essential to recognize that not all tax situations are straightforward. If you have complex investments, losses, or earnings, enlisting the help of a tax professional can remove uncertainty and ensure accuracy. Similarly, major life changes like divorce or adjustments in child support may have significant implications for your taxes, and a professional can help navigate these complexities.