9 Simple Ways People Pay Less Taxes
Taxes can be a nuisance—and many people would prefer to pay as little tax as possible. While it’s not likely you can entirely avoid paying taxes, there are ways to use the tax code to your advantage, and a number of simple steps you can take that may lower your tax liability.
Because the tax code can be dense, and the rules are ever-changing, however, many people aren’t fully aware of all the legally allowed deductions (which lower your taxable income) and tax credits (which directly reduce your tax bill) they may be entitled to.
Read on to learn some tips and tricks for lowering your taxable income without running afoul of the IRS.
1. Choosing the Right Filing Status
If you’re married, you have a choice to file jointly or separately.
In many cases, a married couple will come out ahead by filing jointly. Typically, this will give them a lower tax rate, and also make them eligible for certain tax breaks, such as the earned income credit, the American Opportunity Credit, and the Lifetime Learning Credit for education expenses.
But there are certain circumstances where couples may be better off filing separately.
Some examples include: when both spouses are high-income earners and earn the same, when one spouse has high medical bills, and if your income determines your student loan payments.
Preparing returns both ways can help you assess the pros and cons of filing jointly or separately.
2. Maxing Out Your Retirement Account
Generally, the lower your income, the lower your taxes. However, you don’t have to actually earn less money to lower your tax bill.
Instead, you can reduce your gross income (which is your income before taxes are taken out) by making contributions to a 401(k) retirement plan, a 403(b) retirement plan, a 457 plan, or an IRA.
The more you contribute to a pre-tax retirement account, the more you can reduce your adjusted gross income (AGI), which is the baseline for calculating your taxable income. It’s important to keep in mind, however, that there are annual limitations to how much you can put aside into retirement, which depend on your income and your age.
Even if you don’t have access to a retirement plan at work, you may still be able to open and contribute to an IRA. And, you can do this even after the end of the year.
While the tax year ends on December 31st, you may still be able to contribute to your IRA or open up a Roth IRA (if you meet the eligibility requirements) until mid April.
3. Adding up Your Health Care Costs
Health care expenses are typically only deductible once they exceed 7.5% of your AGI (and only for those who itemize their deductions). But with today’s high cost of medical care and, in some cases, insurance companies passing more costs onto consumers, you might be surprised how much you’re actually spending on health care.
In addition to the obvious expenses, like copays and coinsurance, it’s key to also consider things like dental care, Rx medications, prescription eyeglasses, and even the mileage to and from all medical appointments.
4. Saving for Private School and College
If you have children who may attend college in the future, or who attend or will attend private school, it can pay off to open a 529 savings plan.
Even if your children are young, it’s never too early to start setting aside money for their education. In fact, because of the long-term compounding power of investing, starting early could help make college a lot more affordable.
A 529 savings plan is a type of investment account designed to help parents invest in private schools or colleges in a tax-advantaged way. While you won’t typically get a federal tax deduction for the money you put into a 529, many states offer a state tax deduction for these contributions.
The big tax advantage is that no matter how much your investments grow between now and when you need the money, you won’t pay taxes on those gains, and any withdrawals you take out to pay for qualified education expenses will be tax-free.
5. Putting Estimated Tax Payments on Your Calendar
While this move won’t technically lower your taxes, it could help you avoid a higher than necessary tax bill at the end of the year.
That’s because Income tax in the United States works on a pay-as-you-go system. If you are a salaried employee, the federal government typically collects income taxes throughout the year via payroll taxes.
If you’re self-employed, however, it’s up to you to pay as you go. You can do this by paying the IRS taxes in quarterly installments throughout the year.
If you don’t pay enough, or if you miss a quarterly payment due date, you may have to pay a penalty to the IRS. The penalty amount depends on how late you paid and how much you underpaid.
The deadlines for quarterly estimated taxes are typically in mid-April, mid-July, mid-September, and mid-January.
6. Saving Your Donation Receipts
You may be able to claim a deduction for donating to charities that are recognized by the IRS. So it’s a good idea to always get a receipt whenever you give, whether it’s cash, clothing and household items, or your old car.
If your total charitable contributions and other itemized deductions – including medical expenses, mortgage interest, and state and local taxes – are greater than your available standard deduction, you may wind up with a lower tax bill.
Even if you don’t itemize and simply claim the standard deduction, you may still be able to deduct up to $300 in cash donations (and possibly more if you’re married and filing jointly). This is due to the Coronavirus Aid, Relief, and Economic Security (CARES) Act, however, and may not continue past 2021.
7. Adding to Your HSA
If you have a high deductible health plan, you may be eligible for or already have a health savings account (HSA), where you can set aside funds for medical expenses.
HSA contributions are made with pre-tax dollars, so any money you put into an HSA is income the IRS will not be able to tax. And, you typically can add money until mid-April to deduct those contributions on the prior year’s taxes.
That’s important to know because HSA savings can be used for more than medical expenses. If you don’t end up needing the money to pay for healthcare, you can simply leave it in your HSA until retirement, at which point you can withdraw money from an HSA for any reason.
Some HSAs allow you to invest your funds, and in that case, the interest, dividends, and capital gains from an HSA are also nontaxable.
8. Making Student Loan Payments
You may be able to lower your tax bill by deducting up to $2,500 of student loan interest paid per year, even if you don’t itemize your deductions.
There are certain income requirements that must be met, however. The deduction is phased out when an individual’s income reaches certain thresholds.
Even so, it’s worth plugging in the numbers to see if you qualify.
9. Selling Off Poorly Performing Investments
If you have investments in your portfolio that have been down for quite some time and aren’t likely to recover, selling them at a loss might benefit you tax-wise.
The reason: You can use these losses to offset capital gains, which are profits earned from selling an investment for more than you purchased it for. If you profited from an investment that you held for one year or less, those gains can be highly taxed by the IRS.
This strategy, known as tax-loss harvesting, needs to be done within the tax year that you owe, and can help a taxpayer who has made money from investments avoid a large, unexpected tax bill.
The Takeaway
The key to saving on taxes is to get to know the tax code and make sure you’re taking advantage of all the deductions and credits you’re entitled to.
It can also be helpful to look at tax planning as a year-round activity. If you gradually make tax-friendly financial decisions like saving for retirement, college, and healthcare throughout the year, you could easily reduce your tax burden and score a sizable refund at the end of the year.
Now, what to do with that sweet tax refund? Consider putting it in a place where it can earn a competitive interest rate, such as SoFi Money®.
Disclosures:
SoFi Money®
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