January is a great time to start thinking about how you can reduce your tax bill for the current year. Kicking off your tax planning early in the year gives you the greatest range of options possible for shrinking your annual tax bill. Here are some ideas to get you started.
1. Track your medical expenses
Thanks to a last-minute renegotiation, the new tax reform bill did not end up repealing the medical expense deduction. That means taxpayers with high medical expenses can continue to claim a significant tax break. But in order to squeeze the best possible deal out of the IRS, you'll need to keep track of all your medical expenses for the year -- starting now.
You can simplify the tracking process by putting all your medical expenses on one credit card (pick a card with cashback or rewards points for a double financial whammy). When you prepare your tax return, you can just sit down with your credit card statements and add up all the qualifying expenses, then transfer the totals to your Schedule A. You'll still need to keep the actual receipts, though, in case the IRS checks up on you.
2. Save for retirement
Contributing to a traditional IRA or 401(k) means a potentially huge tax break for you. Of the two, 401(k) contributions produce the best tax break: first, you get the tax deduction automatically without having to claim it on your return (because the contributions come out of your pre-tax paycheck), and second, contribution limits are higher for 401(k)s than for IRAs, so you can contribute more and thereby get a bigger deduction. However, if you don't have access to a 401(k), by all means open an IRA and contribute as much as you possibly can. After all, those contributions aren't just about getting a tax break -- they're also what you'll live on after you retire.
3. Buy a house
Becoming a homeowner isn't for the faint of heart, because you'll be taking responsibility for a lot of tasks (and expenses) that renters can pass on to their landlord. Still, it's a great feeling to own your own home -- and being able to deduct thousands of dollars in mortgage interest ain't shabby, either.
Standard fixed-rate mortgages are set up so that more of your payments go toward interest on the loan during the first few years you're repaying it. As you get further into the repayment term, the percentages shift so that more of your payment goes to principal on the loan rather than interest. That means that during the first year or two you own your house, the mortgage interest you pay -- and the resulting deduction -- will be at their highest.
4. Donate to charity
One of the benefits of starting your tax planning early in the year is that you'll be able to decide right away whether or not you want to try itemizing deductions, which means you'll know whether you want to put your energy into pursuing itemized deductions. The charitable contribution deduction (along with the medical expense deduction and the mortgage interest deduction) is an itemized one, so don't bother trying to max it out unless you're going to itemize. If you do decide that itemizing deductions is the way to go, though, the charitable donation deduction can give you a substantial tax break. That's because this deduction doesn't just count for cash contributions; donating items also qualifies. So dig through your garage and attic once a month, donate the junk you find to charity, and hang onto the receipt. Making regular charitable donations throughout the year can result in a remarkably large tax deduction.
5. Qualify for tax credits
Tax credits are an even better deal than deductions, because credits are subtracted from the taxes you owe; deductions simply reduce your taxable income. Researching tax credits early in the year makes it much easier for you to qualify for the better ones, since you have the whole year to work on meeting the requirements.
One way to qualify for more tax credits is to keep your taxable income low. Certain tax deductions are subtracted from your income before calculating your adjusted gross income for the year, which means these deductions can help you to qualify for some of the best tax credits. The IRA deduction, the student loan interest deduction, and the health savings account deduction are three examples. Max out these deductions, and you'll not only reduce your tax bill, you'll open up your eligibility for yet more tax breaks.
It's also wise to review the requirements for some of the bigger tax credits to see if there's anything else you can do to qualify. For example, to qualify for the education tax credits, you have to have education expenses. In particular, scope out the Earned Income Tax Credit, the Lifetime Learning and American Opportunity education credits, the Child and Dependent Care Credit, and the Savers Credit. These are all potentially huge tax breaks that are relatively easy to qualify for.
Effective tax planning requires you to put in a little extra time and effort throughout the year to track your expenses and qualify for tax breaks, but when it comes time to fill out your tax return for the year, you will be richly rewarded for your work. And the sooner you get started with your tax planning, the more likely you'll be to save a bundle on your taxes.
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