Life is unpredictable, but as the saying goes, you can always count on death and taxes. Taxes are a necessity for maintaining a stable society. That said, there's no reason to pay more than your fair share. And while there's no arguing that our tax system is confusing and onerous, there are a handful of simple things that almost anyone can do to cut their taxes, allowing them to save more money for retirement and help pay some regular expenses at the same time.
Let's look at three things you can probably benefit from doing today.
1. Finally open that 401(k) at work
If you aren't putting money away with your employer-sponsored 401(k), then you're missing out on a big opportunity for free money. The first is the tax benefit: Your contributions are tax-deductible, dollar for dollar. In other words, if you put $5,000 into a 401(k), you reduce your federal taxable income by $5,000. Furthermore, you can contribute up to $17,500 to a 401(k) in 2014 -- and another $5,500 in "catch-up" contributions if you're over 50 -- so it's wise to contribute as much as you can.
And there are two more reasons to contribute to a 401(k):
- You won't pay any taxes on your contributions or gains until you take a distribution in retirement. Then it's treated like regular income.
- Second, your employer probably matches at least some portion of your contributions. That's free money -- don't leave it on the table! Also, don't let concerns about changing or losing your job keep you from contributing. All of your contributions belong to you, and you can move them to a rollover account with most online brokers if you do leave the company.
If you are your own boss, then you can set up your own 401(k) and get the same benefits. Check out the Fool's Broker Center to find one that offers a 401(k) for the self-employed. Furthermore, because you are self-employed, you can "match" your $17,500 in salary contributions up to a certain percentage of your total income. However, only the first $17,500 (plus any catch-up contribution if you're over 50) is tax-deductible income.
2. Individual retirement accounts
In addition to contributions through your employer, you can contribute up to $5,500 per year (or $6,500 if you're aged 50 or older) to a traditional IRA. Restrictions could limit how much you can deduct, but most people can deduct contributions up to $5,500 from their taxable income. As with a 401(k), the money grows tax-free until you take distributions in retirement. Check out the IRS website to find out how much you can deduct from your taxes by contributing.
Roth IRAs deserve some consideration, too. You can contribute the same amount each year, but you cannot deduct contributions from your taxable income. However, the money in your Roth not only grows tax-free, but is also not taxed when you take distributions, meaning you spend less on taxes in retirement. If you have a 401(k) through your employer, contributing to a Roth IRA outside of work might be smart: It will give you options in retirement, along with a tool to reduce taxes during your post-work life.
Roth IRAs have another benefit as well. Traditional IRAs begin required minimum distributions at age 70-1/2, meaning that at that age, you have to begin withdrawing a certain amount each year. Meanwhile, distributions are never required from a Roth. If you've effectively saved and invested over your retirement, this will prevent you from having to take distributions in years when you don't need the extra cash, allowing you to let your investments continue growing tax-free.
3. Flexible spending arrangements
Another benefit that's probably available through your employer, FSAs are a great way to set aside money (currently up to $2,500 per year) for medical expenses and to reduce your taxable income by the amount you contribute, just like your 401(k) contributions. And it gets even better.
You select the amount you want to contribute in open enrollment each year, and the funds are available to you the first day of the plan year, but you pay this back through payroll deductions. This can be especially handy if you know you will have covered medical expenses early in the year. In short, you save on taxes and improve your ability to pay for medical expenses at the same time.
If an FSA is available through your employer, contribute at least enough to cover your prescription medication costs and doctor co-pays and deductibles each year.
A little tax planning can save you a lot of money
These three tools alone are worth $25,500 per year in taxable-income reduction. Even if you can't max out all of these options, or might not need to max out the FSA, it's worth contributing as much as you can. Not only will you reduce your taxes today, but you'll also begin a long-term process of building your wealth and investing in your future.
And that's every bit as valuable as cutting your tax bill today.