Paying taxes is necessary -- after all, our government needs funding to provide things we need, such as schools, roads, courts, and so on. Still, there's no need to pay more in taxes than you have to. Here are 15 ways that you can lower your taxes in the coming year and beyond.
- Contribute to an IRA and/or 401(k). Traditional (not Roth) IRAs and 401(k)s receive pre-tax contributions. So if you have taxable income of $75,000 and you contribute $5,000, you get to subtract that from your taxable income and avoid paying taxes on it now (you will ultimately be taxed on it upon withdrawal in retirement, when your tax rate may be lower). If you're in the 25% tax bracket and contribute $10,000 to these accounts, you'll cut your tax bill by $2,500!
- Contribute to an HSA or FSA. Contributions to Health Savings Accounts (HSAs) and Flexible Spending Accounts (FSAs) are made with pre-tax money, too, so that's another way to shrink your taxable income. Note that you need to have a qualifying high-deductible health insurance plan to be able to take advantage of HSAs. They can be well worth it, though, as they let savings accumulate and grow over time, not taxing withdrawals for qualifying medical expenses. After age 65, you can withdraw money from an HSA for any purpose, paying ordinary income tax rates on withdrawals. Any unused amounts can be rolled over from year to year, unlike FSA money, which is mainly use-it-or-lose-it from year to year. (Still, even that can be very helpful.) Contribution limits for Health FSAs are $2,550 for 2016 and $2,600 for 2017. For HSAs, contribution limits for individuals are $3,350 for 2016 and $3,400 for 2017. For families, they're $6,750 for both years. Those 55 or older can chip in an additional $1,000.
- Be careful with the timing of your mutual fund investments. If you're planning on investing in a mutual fund close to the end of the year, beware. Funds typically distribute dividends in December, and their shares fall in value by the amount of the distribution. That's fair for longtime shareholders, but if you buy just before the distribution, you'll be hit with a tax bill for an investment you've held for very little time. Ask the fund company when the distribution is happening and buy after that – you'll avoid the tax and will get a lower price, to boot.
- Harvest investment losses to offset gains. If you're bracing to fork over significant capital-gains taxes because of having sold some winning stocks, you might be able to shrink that tax bill -- if you're sitting on some losing stocks. If so, you might sell some of those to generate an official loss that can be used to offset your gains. If you're sitting on $10,000 of long-term capital gains, facing a 15% tax hit on them that will cost you $1,500, you could wipe out half of that if you have $5,000 in losses. Gained $6,000 and lost $13,000? Your gain is now zero, you can use $3,000 of your loss to offset your income, and you can carry over $4,000 of losses to use next year. You might even buy back the losing stocks, if you still believe in them – just wait at least 31 days to do so, to avoid having a "wash sale."
- Be a long-term investor. Speaking of holding periods, remember, that while most people currently face a 15% long-term capital gains tax rate, short-term gains are taxed at ordinary income tax rates, which are often 25% or 28% and can approach 40% for very high earners. Don't base stock-selling decisions solely on tax concerns, but if you're thinking of selling a winning stock, think about whether holding it for at least a year and a day, to qualify for the lower tax rate, makes sense.
- Take the Earned Income Tax Credit (EITC). If you earn relatively little, you may be able to take advantage of the EITC, a very powerful but underused tax credit potentially worth thousands of dollars to those who qualify.
- Buy a house. If you're trying to decide whether to rent or buy a home, remember that mortgage interest is deductible -- as are property taxes. And in the early years of a mortgage, much of your monthly payments is made up of interest. That shouldn't be your only reason for buying instead of renting, but if you decide to buy, it will help lower your taxes.
- Be smart when selling your house. If you'll be selling your home, learn about the home sale exclusion first. If you meet the requirements, you can avoid paying taxes on up to $250,000 of your gain on the sale of your primary residence (and up to $500,000 if you're married and file your taxes jointly).
- Have kids. Don't base your family planning on taxes, but if you're planning to have children, or more children, know that you'll enjoy some tax breaks. For example, the Child Tax Credit offers $1,000 for every eligible child you have under the age of 17 (as of the end of the tax year), while the Child and Dependent Care Credit is worth up to $3,000 for a single child or qualifying dependent or $6,000 for two or more, and is tied to expenses you incur for the care of children or dependents that lets you work or seek work.
- Donate to charity. If it's worth it for you to itemize deductions, then being extra generous with charitable contributions can get you bigger deductions and a smaller tax bill. Just follow the rules and have documentation of donations. Remember that donating household items and clothing can also qualify, as long as you have receipts from qualifying organizations and are deducting the fair market value of what you donate, not their original costs.
- Make most of hefty medical expenses. Just as with charitable contributions, medical expenses can often be deducted, so if you have the bad luck to have spent a lot on healthcare, you may be able to enjoy a little benefit by deducting many of those expenses. Better still, plan ahead and... bundle your deductions.
- Bundle deductions. If you have trouble accumulating sufficient deductions to make itemizing worthwhile, consider bundling. That's when you try to concentrate deductions in every other year, so that you're able to itemize in one year and take the standard deduction in the next. For example, you might make annual charitable contributions in January and December of one year, and might pay deductible taxes that are due in January in December instead. If you have upcoming major medical expenses (such as a hip replacement, cataract surgery, or orthodontia), you might move them up or push them back as needed, if that's reasonable.
- Make the most of deductions and credits. There are gobs of deductions and credits available to taxpayers. Of particular interest are above-the-line deductions (i.e. those that don't require itemizing) and tax credits, as they can significantly shrink your taxable income. Above-the-line deductions exist for expenses such as alimony payments, self-employment taxes, IRA contributions, school supplies, student-loan interest paid, and more. Tax credits shrink your taxable income on a dollar-for-dollar basis and they're available for all kinds of things, such as education expenses, energy-efficient home improvements, the adoption of children, the care of children and dependents, and much more.
- Make the most of being self-employed. If you use a part of your home for a home office, you may be able to deduct expenses related to it (such as mortgage interest, utilities, and insurance). If you use one of your home's seven rooms as an office, for example, you might be able to deduct a seventh of the qualifying expenses. There's a simpler option available now, too, offering a $5 deduction per square foot of your home office, up to 300 square feet, for a maximum $1,500 deduction. Self-employed people have many other deductions they can take, too -- so do look into them if you work for yourself. For example, while self-employed folks may not have access to workplace-sponsored 401(k)s, they can often contribute to SEP IRAs, which sport higher contribution limits than regular IRAs.
- Hire a tax pro. Finally, one of the best ways to pay lower taxes next year is to hire a good tax professional to strategize with you and perhaps prepare your return. Pros know the tax code far more than you do, and they know many tax-reducing strategies, too. Don't just hire anyone or go to a random tax-preparer, though -- ask for references from friends or look for "Enrolled Agent," a tax pro licensed by the IRS who is authorized to represent you before the IRS if need be. You might find one through the National Association of Enrolled Agents website.
There are many more tax tips you might learn about and take action on. A little Googling will likely turn up more money-saving ideas -- but you can save a lot just from the suggestions here.
Longtime Fool specialist Selena Maranjian, whom you can follow on Twitter, owns no shares of any company mentioned in this article. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.