Tax season is never fun for anyone, and paying a big chunk of your income to the IRS can be a painful experience. The good news is, there are lots of ways that you can legally reduce the amount of taxes you owe so you don't pay more than the minimum required, including:
- Maxing out your 401(k)
- Maxing out your IRA
- Contributing to an HSA
- Keeping receipts and documents that can help you save
- Making the right choice on itemizing or claiming the standard deduction
- Bundling deductions
- Claiming all your dependents
- Claiming all your credits
- Claiming all your deductions
- Getting professional tax help if you need it
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1. Max out your 401(k)
If you have a workplace 401(k), you should be contributing as much as possible -- and ideally maxing out your contribution. That's because your taxable income is reduced by the amount you contribute.
The maximum 401(k) contribution for 2019 is $19,500, while those over the age of 50 can make an additional catch-up contribution of up to $6,000. The tax savings you get from this contribution depends upon your tax bracket. If your income would've been taxed at 22%, you'd save 22% times the amount you contribute because you wouldn't pay the 22% tax on the money that goes into your 401(k).
So if you contributed $19,000 and were in the 22% tax bracket, you'd save $4,180 on your federal taxes. A $6,000 catch-up contribution would also result in additional tax savings of $1,320.
Contributing money to a 401(k) helps you save for your future, since you can invest this money to use during retirement. In many cases, your employer will match a portion of your contributions, which means you essentially get free money in addition to saving on taxes.
2. Max out your IRA
Unfortunately, not everyone has a 401(k) at work. But anyone can open an IRA with any brokerage firm or other financial institution, including some banks and credit unions. You can invest your money in almost anything you want once it's in your IRA, and the money will ideally help you build a hefty nest egg for retirement.
For 2019, the maximum deductible contribution to an IRA is $6,000. Those over 50 can also make deductible catch-up contributions of up to $1,000. You can again figure out your savings by multiplying the amount you've contributed to your IRA by the tax rate you'd have paid on the income if you hadn't been able to deduct it.
If neither you nor your spouse is covered by a workplace retirement plan, you can claim the full deduction for IRA contributions up to the annual contribution limit. If your income isn't too high, you can also make deductible contributions to an IRA, even if you or your spouse do have a retirement plan at work. But once your income exceeds a certain threshold, the deduction starts phasing out. For 2019:
- You can qualify for the full tax deduction for IRA contributions -- even if you're covered by a plan at work -- if you have an income of $103,000 jointly if you file as married or $64,000 if you file as single.
- If you're not covered by a plan at work but your spouse is, you can qualify for the full deduction if your income doesn't exceed $193,000.
3. Contribute to an HSA
In addition to 401(k) and IRA accounts, there's yet another account you could potentially contribute to in order to reduce your tax bill: a health savings account (HSA). An HSA is an account where you can make pre-tax contributions in order to help cover healthcare costs if you have a high-deductible plan.
In 2019:
- Single individuals are eligible to contribute to an HSA if they have a qualifying health plan with a deductible of at least $1,350 and a maximum out-of-pocket limit of $6,750.
- Contributions are allowed for a family plan with a deductible of at least $2,700 and a maximum out-of-pocket spending limit of $13,500.
The maximum contributions are $3,500 for individuals and $7,000 for families. A $1,000 catch-up contribution is also allowed for those who are 55 or older. Savings, again, are calculated based on the tax rate on the income on which you'd have paid taxes if you hadn't claimed the deduction.
HSA contributions are very valuable. You can withdraw money at any time and won't pay taxes on withdrawals as long as you take out the money to pay for healthcare. If you take out the money for reasons other than covering health costs, you'll face a 20% tax penalty. You also have the option to withdraw money in an HSA without penalty for any purpose after you turn 65 but will pay ordinary taxes on it unless you use it for care.
You can also choose to leave the money invested and let it grow. Because you can take a tax deduction when you contribute to your HSA and you can withdraw funds without paying taxes, HSAs provide tax benefits that are even better than for a 401(k) or IRA because both of those accounts require you to pay taxes on withdrawn funds. And tax benefits are also better than for a Roth IRA because, while a Roth allows tax-free withdrawals, you can't contribute with pre-tax dollars.
4. Keep receipts and documents that could help you save
You can claim many different tax deductions and tax credits (we'll go over those in more detail later). But you need to have documentation in case you're audited. And in some cases, you need to be able to show that your deductions exceed a certain percentage of your income.
For example, to claim a deduction for medical expenses in 2019, your care costs would need to equal at least 10% of your income. So you'd need your receipts to show that you incurred the requisite level of medical expenditures.
At the very least, be sure to save:
- Receipts for medical care
- Receipts for charitable contributions
- Proof of property tax payments and other local tax payments
- Receipts for business expenses
- Receipts for tuition and educational expenditures
If there's any doubt about whether you might be able to deduct an expenditure, keep the receipt. If you don't end up claiming the deduction, you can always toss it out at the end of the year.
You also need to keep any tax forms or paperwork you're sent by companies you do business with. For example, your mortgage lender will probably send you a statement showing interest paid on your loan during the year, and your student loan lender will send you an interest statement, as well.
Keep these papers with your receipts and other tax forms. When you go to file your taxes, your tax professional will want to see the forms, or the software program you're using will ask for the information they contain.
5. Make the right choice on itemizing or claiming the standard deduction
When you file taxes, you have two choices: You can either claim a standard deduction that's the same for everyone with the same tax filing status or you can itemize and claim deductions for specific spending you do, such as taking a deduction for paying state taxes and mortgage interest.
For 2019, the standard deduction is $12,200 for singles or those filing as "married filing separately"; $24,400 if you file as married filing jointly; $18,350 if you file as head of household. If the value of your itemized deductions doesn't exceed the value of the standard deduction, claim the standard deduction. If the value of your itemized deductions adds up to more than the standard deduction, itemize.
Making the wrong choice on which deductions to claim could cost you. If your itemized deductions add up to $15,000 as a single person and you claim the standard deduction instead, you'd lose out on a $2,800 in 2019. If you have an extra $2,800 taxed at 22%, you'd pay an extra $616 in taxes.
As all the above examples show, tax deductions substantially reduce the taxes you pay by reducing your taxable income. In some cases, taking deductions could even help you to go down to a lower tax bracket. For example, for singles in 2019, the 22% tax bracket starts at $39,476 in income. If you make $40,000, you'll land in the 22% tax bracket and pay 22% tax on your last $524 in income. But if you can take a $1,000 deduction, your taxable income will be just $38,476. You'll be in the 12% tax bracket and won't pay 22% tax on any of your income at all.
You'll notice that the savings from dropping down to a lower tax bracket isn't as big as it seems. That's because you only pay the higher tax rate on marginal dollars or additional dollars you earn once you get pushed into a higher bracket. If you move up into the 22% tax bracket because you make $39,478, your entire income doesn't suddenly get taxed at 22%. You only pay the higher tax rate on the $2 that pushed you into the 22% tax bracket.
Still, there are times when dropping your taxable income even by a small amount can make a big difference. If you lose your IRA deduction because you make more than the income limit for deductible contributions, dropping your income by a few thousand dollars could open up the door to taking this deduction again.
6. Consider bundling deductions
When you claim the standard deduction, you miss out on deductions for things like charitable donations or property taxes. If you want to claim a tax break for these activities, you can try to bundle deductions.
For example, say you give $10,000 a year to charity, and this is the only deduction you can claim. If you're a single person, you wouldn't want to claim this deduction because it's below the standard deduction. But what if you saved all of your 2019 donations in a bank account, then gave $20,000 to charity in 2020? Now you can take a $20,000 deduction.
By bundling your contributions, every other year you could get a deduction that's greater than the standard deduction. You'd be able to get the tax break you deserve for your generosity rather than missing out on this tax savings.
7. Claim all your dependents
Most people know their children usually count as dependents, as long as they meet qualifying-child requirements such as receiving more than half their financial support from you. But other people can also qualify if they meet the qualifying-relative requirement -- even if they aren't blood relatives. A qualifying relative could be an aging parent, a roommate who you support, your son's girlfriend who lives with you and who's freeloading off your family, or anyone else who meets IRS requirements.
Before the passage of tax reform in December 2017, you could claim a personal exemption for dependents. A personal exemption directly reduced your taxable income. The personal exemption in 2017 was valued at $4,050, so you could reduce your taxable income by $4,050 by claiming a dependent.
The Tax Cuts and Jobs Act eliminated your ability to take personal exemptions. But this doesn't mean having a dependent doesn't still provide tax benefits. By claiming a dependent child, you could become eligible for a child tax credit worth up to $2,000. You could also become eligible for the Credit for Other Dependents, which is valued at up to $500 for dependents not eligible for the child tax credit.
Dependents could also make it easier for you to qualify for the Earned Income Tax Credit and open the door to claiming other credits for paying certain expenses -- such as the American Opportunity Tax Credit if you cover a dependent's tuition costs.
There's a simple online tool you can use to determine if someone is a dependent. If you're providing support for a relative or for someone who lives with you, use this tool to determine if they qualify. If they do, claim them so you can get any credits they entitle you to receive.
8. Claim all the credits you can
Tax credits provide a dollar-for-dollar reduction in your tax bill. They're much more valuable than tax deductions. As our examples have shown, if you take a $1,000 deduction and are in the 22% tax bracket, your deduction would reduce your tax bill by up to $220. But if you take a $1,000 credit, the credit reduces your tax bill by a full $1,000. If you previously owed $5,000 in taxes, you would owe just $4,000 in taxes after claiming a $1,000 credit.
Some credits are fully or partially refundable. If a credit is refundable, you can claim it even if your tax bill is zero. If you owe no taxes and are able to claim a $1,400 refundable tax credit, the IRS will actually send you back a check for $1,400.
A non-refundable tax credit, on the other hand, allows you to reduce your taxable income to zero, but not below. So if you had a $2,000 non-refundable credit but your tax bill was only $1,000, you could reduce your tax bill to zero but wouldn't get $1,000 back.
You can get details here on nine tax credits you should know about, including:
- The child tax credit
- The credit for other dependents
- The child and dependent care credit
- The earned income tax credit
- The saver's credit
- The American Opportunity Tax Credit
- The Lifetime Learning Credit
- The federal adoption tax credits
- The plug-in electrical vehicle credit
9. Claim all the deductions you're eligible for
You also need to claim all the deductions you're eligible for. The deductions you can claim will depend upon your income, as well as whether you itemize.
This 2019 guide to tax deductions can provide you with complete details about some of the most popular deductions you may decide to claim, including:
- Deductions for retirement plan contributions
- Deductions for HSA contributions
- Deductions for contributions to flexible spending accounts (FSAs)
- Deductions for dependent care FSAs
- Deductions for student loan interest
- Deductions for investment loss
- The deduction for mortgage interest
- A deduction for charitable contributions
- A deduction for qualifying medical expenses
- A deduction for either state income tax or state sales tax
10. Get professional tax help if you need it
As you can see, there are tons of different ways you can reduce your taxes -- but some of them can be quite confusing. After all, it can be difficult to figure out whether someone counts as a dependent, or whether you're better off claiming the standard deduction or itemizing. If you aren't sure that you're getting all the tax breaks you're entitled to, it's a smart move to get help.
In some cases, you're entitled to free assistance. If your income is low, if you have trouble with the English language, if you're a senior, or if you're disabled, you may be able to get free tax help from volunteers. The IRS provides a website where you can find this free assistance from organizations including the Volunteer Income Tax Assistance (VITA) or the Tax Counseling for the Elderly Program.
You can also usually get help for your personal tax return from an accountant for less than $200. It's worth spending this money to make sure you're getting all the tax savings you're entitled to -- especially if you've had big life changes, such as buying a house or having a baby. Once you get help from a professional, you can learn what you need to do in order to file on your own using tax software programs in the future, unless your tax situation is very complicated.
Smart money moves help you reduce the taxes you owe
No one likes to pay more than necessary in taxes. By taking any or all of these steps, you can often save hundreds or even thousands of dollars in federal taxes. You can also help ensure a more secure future for yourself by investing in accounts that will provide for you in retirement or cover costs of healthcare or child care. You'll be richly rewarded for your tax-saving efforts and may be able to put your money to much better use than giving it to the IRS.
