How can I reduce my taxable income?
One of the excuses I had for not contributing more to my retirement was the thought that I couldn’t afford it. In fact, 47% of Americans feel the same way I felt. In all honesty, I just didn’t want to reduce the amount of my direct deposited check. I was comfortable seeing a certain amount and I didn’t want to lower it. I had bills to pay, money to spend and money to save.
Yup, I thought that the money I was saving in my savings account earning a measly 1% in interest was better saved there! Oh to be young and naive.
I just didn’t know any better. I didn’t understand that the money I contributed to my retirement plan was not only being invested but I was also saving money. How you may ask? I would have been saving money by not paying taxes on that money AND as a result, my taxable income would have lower. Let’s get into this!
What is taxable income?
In simple terms, taxable income is the amount of your income on which you pay taxes also know as your post-tax income. I was surprised when I received my first paycheck at 14 to see that my back of the napkin math didn’t add up to my paycheck. I quickly learned that there were things like social security, Medicare and taxes. All of which was deducted from my earnings long before I got my paycheck. (Learn more about pre-tax vs. post-tax income and how much you really make).
Does my story sound familiar? It may feel like every dollar you earn is taxed, but due to our complicated and something called our “graduated tax” system (also known as progressive tax), not all income is taxed. Examples of income not taxed include child support payments, the money you contribute to certain types of retirement accounts and money that you put aside for childcare or medical expenses. This also includes money you put in an employer-sponsored account like a Health Savings Account or Flexible Spending Account.
Top Off Your Retirement Savings Plan
Money contributed to an employer-sponsored retirement plan, such as a traditional 401(k), isn’t included in your taxable income. In 2016, you can contribute up to $18,000 or $24,000 if you’re 50 or older, by the end of the year. If you haven’t maxed out, ask your employer if you can make an additional contribution before December 31.
If you have self-employment income from a side job, you can sock away even more. You can contribute up to 20% of your net self-employment income to a Simplified Employee Pension, up to a total contribution limit of $53,000 for 2016. (Unlike 401(k) contributions, there’s no December 31 deadline for SEP deposits. You can make 2016 deposits anytime before the due date of your tax return.)
Give to Charity
If you itemize, making charitable contributions before December 31 will reduce your taxable income. For cash contributions, hang on to your canceled check or credit-card statement as proof of your donation. If you contribute $250 or more, you’ll also need an acknowledgment from the charity. Donations made by credit card before December 31 are deductible on your 2016 tax return, even if you pay the credit-card bill in January.
Donating appreciated securities can also reduce your taxable income. When you donate appreciated securities you have owned more than one year to charity, you can deduct the full value of the securities on the date of the gift. You won’t have to pay taxes on capital gains, and the charity won’t have to pay them, either. Not all charities can accept donations of appreciated securities. If your favorite cause falls into that category, consider opening a donor-advised fund. The fund administrator will sell the securities for you and add the proceeds to your account. You can deduct the value of the securities on your 2016 tax return and decide later where you want to donate the money.
Take advantage of tax loss harvesting
If you have losing investments, selling them allows you to harvest your losses to offset taxes on investment gains or to reduce your taxable income by up to $3,000.
This strategy can be especially beneficial if your income is going to be higher than normal and you want to avoid being pushed into a higher tax bracket, or if you’re going to be selling investments that you’ll need to pay short-term capital gains on.
Keep track of your medical costs
If you incur substantial medical expenses, you may be able to take a deduction for the funds you spent.
In 2019, you can deduct unreimbursed allowable medical expenses only if they exceed 10% of your income — up from 7.5% in 2017 and 2018. You’ll need to itemize to claim this deduction — which doesn’t make sense for many tax payers due to the large standard deduction.
Still, you should keep the bills you incur throughout the year. If your costs are high enough to hit the threshold for deductibility, you want to be able to take advantage of the tax savings to offset some of your big care expenses.
Get organized.
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.
Claim all the deductions you can.
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.
Get the timing right
From a tax perspective, there’s a huge difference between doing something on Dec. 31 and doing it a day later. If you know an upcoming expense is going to be tax-deductible, think about whether you can pay for it this year rather than next year. Making January’s mortgage payment in December, for example, could give you an extra month’s worth of mortgage interest to deduct this year. Similarly, if you know you’re near the threshold for the medical-expenses deduction, moving that root canal up might make the pain more bearable if the cost suddenly becomes deductible, too.
Tweak your W-4
The W-4 is a form you give to your employer, instructing it on how much tax to withhold from each paycheck. If you got a huge tax bill this year and don’t want another surprise next year, raise your withholding so you owe less when it’s time to file your tax return. If you got a huge refund, do the opposite and reduce your withholding — otherwise, you could be needlessly living on less of your paycheck all year.
You can change your W-4 any time.
Stash money in your 401(k)
Less taxable income means less tax, and 401(k)s are a popular way to reduce tax bills. The IRS doesn’t tax what you divert directly from your paycheck into a 401(k). For 2020, you can funnel up to $19,500 per year into an account. If you’re 50 or older, you can contribute an extra $6,500 in 2020. These retirement accounts are usually sponsored by employers, although self-employed people can open their own 401(k)s. And if your employer matches some or all of your contribution, you’ll get free money to boot.
Contribute to an IRA
There are two major types of individual retirement accounts: Roth IRAsand traditional IRAs.
You may be able to deduct contributions to a traditional IRA, though how much you can deduct depends on whether you or your spouse is covered by a retirement plan at work and how much you make.
For the 2019 tax year, you may not be able to deduct your contributions if you’re covered by a retirement plan at work, you’re married and filing jointly, and your modified adjusted gross income was $123,000 or more. In 2020, that number rises to $124,000.
There are limits to how much you can put in an IRA, too:
For 2019 and 2020, the limits are $6,000 per year, or $7,000 for people 50 or older.
You have until the tax-filing deadline to fund your IRA for the previous tax year, which gives you extra time to take advantage of this strategy