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Death and taxes may be two certainties few people look forward to, but there's another, rosier certainty -- that many ways to shrink your tax bill exist, and most of us can take advantage of at least a few, to lop hundreds, if not thousands, off our tax bills each year.
Here's a look at 18 key ways that you may be able to reduce your taxes. See how many you can act on, now or soon, to keep more of your money in your pocket.
Image source: Getty Images.
First up, be organized. Don't just deal with your taxes once a year, in April. Instead, dedicate a folder or box to tax-related documents, and fill it all year long -- with receipts for deductible expenses, 1099 forms and other IRS forms that arrive in the mail, trade confirmations and end-of-year statements from bank and investment accounts that you may need to refer to, and so on. That way, when it's time to start preparing your tax return -- or to hand off needed information to a paid preparer -- everything will already be in one place.
Keep your tax-related records for a while, too. It's smart to keep copies of your returns, at least for a minimum of three years and, to be more conservative, up to seven. You'll likely be free from any chance of a tax audit by then.
As you know, a tax deduction shrinks your tax bill by shrinking your taxable income. If, for example, you earn $70,000 and take a $5,000 deduction, your taxable income will shrink by $5,000, letting you avoid being taxed on that $5,000. If you're in a 24% tax bracket, that could save you $1,200.
It's a little more complicated than that, though. You can choose to itemize and claim all your various deductions, or you can just take the "standard deduction" available to all taxpayers. That deduction has been roughly doubled in recent years, making it the smart (and easy!) move for most taxpayers.
Filing Status |
Standard Deduction for 2020 Tax Year |
---|---|
Single |
$12,400 |
Head of household |
$18,650 |
Married filing jointly |
$24,800 |
Married filing separately |
$12,400 |
Data source: Internal Revenue Service.
Here are a few things you need to know about deductions:
It's important to make the most of not just tax deductions, but also tax credits. Credits, after all, are far more valuable than deductions. Remember how a $5,000 deduction might shrink your tax bill by 24% or $1,200? A $5,000 credit can shrink it by $5,000.
The most powerful tax credits are "refundable" ones, meaning that you get their full value even if they shrink your tax bill to less than zero. For example, imagine that you're on track to owe $4,000 in taxes but you then apply a $5,000 tax credit. If it's an ordinary credit, it will wipe out all of the $4,000 you owe, and will stop there. A refundable credit, though, will wipe out the $4,000 and then still give you that last $1,000 of value -- via a tax refund.
There are lots of tax credits available, relating to expenses for education, the adoption of a child, dependent care, energy-efficient home improvements, and more.
As mentioned earlier, you can take a tax deduction for donations to qualifying charitable organizations -- and that includes donations made in the form of cash, stocks, goods, and even miles driven.
There are a bunch of rules regarding charitable donations you need to know about, though, such as:
Image source: Getty Images.
Tax breaks are available to you if you contribute to retirement accounts such as IRAs and 401(k)s, but it depends on whether you contribute to a "traditional" or "Roth" version of the account. Contributions to Roth accounts give you no upfront deduction, but if you play by the rules, when you withdraw from the account in retirement, that money will be yours tax-free.
With traditional IRAs and 401(k)s, you can generally deduct the amount of your contribution from your taxable income. So if your taxable income is $65,000 and you sock away $5,000, that drops your taxable income to $60,000, letting you avoid taxation on that $5,000. (You do get taxed on it later, when you withdraw it.)
For the 2020 tax year, you can contribute up to $6,000 to an IRA (or a total of up to $6,000 can be divided among multiple accounts), plus an extra $1,000 for those 50 and older. With 401(k) accounts, in 2020 you can sock away up to $19,500, plus $6,500 for those 50 and older.
Note that it's actually not too late to make a 2019 contribution to your IRA(s) -- that deadline is April 15, 2020.
Not only can contributions to retirement accounts give you tax breaks -- they can also help you set yourself up for a more comfortable retirement. The table below shows how much you might amass saving various sums annually and earning an average annual gain of 8%:
Growing at 8% For: |
$5,000 Invested Annually |
$10,000 Invested Annually |
$15,000 Invested Annually |
---|---|---|---|
10 years |
$78,227 |
$156,455 |
$234,682 |
15 years |
$146,621 |
$293,243 |
$439,864 |
20 years |
$247,115 |
$494,229 |
$741,344 |
25 years |
$394,772 |
$789,544 |
$1.2 million |
30 years |
$611,729 |
$1.2 million |
$1.8 million |
Many employers will let you set up a Flexible Spending Account (FSA), which lets you sock away funds for qualifying healthcare expenses on a pre-tax basis, shrinking your tax bill. For example, you might contribute the maximum (for 2020) of $2,750 to your FSA and then spend it on, say, prescription drugs, braces for your kid, therapist visits, and some doctor visits. That $2,750 will not show up as taxable income, meaning that if you're in the 24% tax bracket, you'll avoid paying $660 in taxes on it.
There's a little catch, though -- that's use-it-or-lose-it money. If you don't use those funds during the year, they go up in smoke. (Some employers give workers an extra grace period until March 15 in which to spend the money.)
There are also Dependent Care FSAs, which help people pay for dependent-care expenses with pre-tax money, and those have a $5,000 annual contribution limit for most folks.
Even better than a Flexible Spending Account is the Health Savings Account (HSA), which also lets you pay for qualifying healthcare expenses with pre-tax money. For starters, it sports a higher contribution limit -- for 2020 it's $3,550 for individuals and $7,100 for families, with those 55 and older able to contribute an additional $1,000. The money in your account can stay and grow over years, too, and if there's any left once you turn 65, you can spend it on anything, though withdrawals for anything other than qualifying healthcare expenses will count as ordinary income.
You'll also need to have a qualifying high-deductible health insurance plan, to take advantage of HSAs. They're not ideal for everyone, as you must be able to afford to pay that high deductible if needed, but if you can, and especially if you're young and healthy, they can make a lot of sense, as their premiums are lower than plans with lower deductibles.
If you have one or more kids heading to college (or who will incur other qualifying educational expenses) in the future, you can shrink your tax bill by making contributions to a 529 plan. A notable feature of these plans is that you can contribute a lot to them. The rules and plans vary by state, but many states allow you to sock away hundreds of thousands of dollars per account. Money in the account can grow on a tax-free basis, before being spent on qualified education expenses. Some states offer their own tax breaks for contributions by residents to their state plan and some states even offer breaks for those saving in another state's plan. Read up on 529 plans, if you think they may help you.
If you face education expenses this year or in the future, look into the Coverdell Education Savings Account, too. It permits contributions of up to $2,000 per year per beneficiary and offers a wider range of investment choices than a 529 plan.
Here's a great tax-shrinking tip: You can offset some or all of your taxable capital gains with capital losses. For example, if you sold some stocks for a total gain of $5,000 this year, you'll capital gains taxes on that sum. But if you also sell some stocks that give you losses totaling $4,000, you can shrink that taxable gain to $1,000. Indeed, if your losses exceed your gains, you can also deduct up to $3,000 from your taxable income, and then even carry any remaining losses into the next year(s).
As usual, though, there are rules regarding this "tax-loss harvesting," such as that you first have to offset long-term gains with long-term losses and short-term gains with short-term losses -- and you shouldn't buy back any stock until at least 31 days have passed. Read up on the topic if you think you can profit by it.
This tax-shrinking tip is very easy: Aim for all your investment gains to be long-term ones, meaning that you held the asset for more than a year before selling it. Long-term capital gains tax rates are 0%, 15%, or 20%, with most of us probably facing the 15% one. Short-term capital gains, meanwhile, for assets held a year or less before being sold, are taxed at your ordinary income tax rate, which could top 30%, depending on your income level.
So if you're about to sell a stock after owning it for 11 months, think about hanging on a bit longer. It's not always the smart thing to do, but it can often save you some meaningful tax dollars. Overall, it's good to aim to hang on to healthy and growing companies for many years.
There are tax-shrinking tips that apply to mutual funds, too -- such as being mindful of when you sell shares of them. Funds generally distribute income to shareholders (from dividends, interest, and/or capital gains) near the end of the year, and when they do so, their shares will fall in value by the amount of the distribution -- because that portion of the shares' value has been distributed to shareholders. That's fine for those who have owned the shares for a long time, but if you bought just before the distribution, you'll end up taxed on that distribution which covers the fund's past year, even though you only owned your shares for a small portion of the year. So ask the fund company when its distribution is happening, and aim to buy shares after that.
When you set out to buy a home, if you're lucky enough to have enough cash with which to buy all of it, you may still want to buy it with a mortgage. Why? Well, in part because mortgage interest is deductible. There are some rules, though, such as:
Buying a home with a mortgage, especially in our low-interest rate environment, can free up funds that can be invested for your retirement.
When it's time to sell your home, know that you may be able to exclude up to $250,000 of your gain on it (up to $500,000 for those married and filing jointly) via the home sale exclusion rule. That can be a big deal! If you bought your home for $300,000 and sell it for $450,000, your gain of $150,000 can be entirely free of taxes -- subject to a few rules:
Image source: Getty Images.
This may seem like a minor issue, but filing your tax return with the wrong status can be costly. For example, not all single people should be using the "single" status: If you're a single parent or support a dependent such as a parent, you may be able to claim the "head of household" status, which will confer some bigger tax breaks. (Scroll up, for example, and you'll see a much bigger standard deduction.) Meanwhile, most couples will do best by filing jointly, but in some situations, separately is more advantageous. Run the numbers to see what will serve you best.
Our tax code is very complex, and it changes a little or a lot from year to year. To keep your taxes to a minimum, either keep up with changes yourself or employ a tax pro who does so, and strategize keeping the latest rules in mind.
Social Security is vital to most retirees, and there are some tax rules regarding it that you should know. For starters, your Social Security benefits may be taxed. The rules are a bit tricky, and your chances of seeing your benefits get taxed are higher if your income features significant non-Social Security sources, such as wages, self-employment income, interest, and dividend income. Depending on that income, up to 50% or up to 85% of your benefits may be taxable. One way to avoid this is to draw more from income sources such as IRAs and 401(k)s earlier in your retirement, especially if you're working, while delaying starting to collect Social Security. (That will increase your Social Security benefit checks, too.)
This tip can not only save you money, but can reduce headaches and hassles, too. If your tax situation is fairly straightforward -- such as if you (and perhaps your spouse) mainly have just salary income, without self-employment income, business income, complicated investments, and so on -- you should consider using tax-prep software to get your tax return done. It automates much of the math and will prompt you for information that can help you maximize deductions and credits.
If your tax life isn't so straightforward, or if you just want more reassurance that you're making the best tax decisions throughout the year and shrinking your bill as much as you can, seek the services of a good tax pro. It's their job to keep up with all the tax law changes and to know effective tax strategies. Ask around for strong recommendations or perhaps look for an "Enrolled Agent," a tax pro licensed by the IRS, near you. The National Association of Enrolled Agents website can help.
The more you know about taxes, the smaller your tax bill can be. Taxes may not be super exciting, but saving hundreds or thousands of dollars certainly can be.