Whether it's the start of a new year, or the April filing deadline, there's usually something that can be done to reduce a tax bill. When it comes to taxes, having a plan can help maximize savings on a return.
Let's face it; no one likes paying income taxes. We all understand they pay for essential services, so we feel good about paying our fair share. But that's where it stops; the thought of paying too much money is not a pleasant one. That's where a good plan comes into play.
When it comes to paying income taxes, it's a good idea to map out a plan. Doing so should help reduce the amount owed each year. Creating a plan and sticking to it, will prevent a scramble for last minute tax savings tips later on.
In this article, we're going to try to legally shelter income from taxes. We're going to do that by listing some of the biggest tax-savings programs available today. The tips we're going to talk about range from retirement savings strategies through medical expenses and college savings plans.
Employee supplemental retirement plans are an extremely effective way to reduce income taxes. The three most common plans include the 403(b), 401(k) and 457(b). More progressive employers will offer choices of Roth 403(b) and Roth 401(k) accounts too.
There are two big benefits associated with these plans:
If an employer doesn't offer a retirement plan, it may be possible to contribute to a Roth or Traditional IRA. With a Roth IRA, after-tax contributions are made to an account that provides tax-free income in retirement. With a Traditional IRA, individuals may qualify to place money in an account and claim a tax deduction on their income tax return.
This website maintains up-to-date information on Traditional IRA contributions as well as funding a Roth. Anyone not sure which type of account to fund should take a look at our article: Investing in Retirement Accounts.
Individuals that have self-employment income may be able to increase their retirement contributions by opening a Keogh account. The contribution limits on a Keogh are high. In 2020 the limit is $57,000 or 100% of eligible compensation, whichever is less. The maximum deductible contribution is limited to 25% of compensation. In 2021 the limit increases to $58,000.
For individuals with self-employment income, the Keogh offers another great way to save on income taxes today.
Here's a tip for anyone that's been lucky in the stock market and is feeling charitable. If a stock has grown in value, and it's been held for at least one year, then donating the stock to charity is a win-win situation.
With this type of donation, it's possible to avoid paying taxes on the stock's appreciation in value. Even better, it's possible to deduct the full value of the stock on an income tax return as a charitable donation. Larger charities should be familiar with this type of transaction, and they're often more than happy to help complete the required paperwork.
This rule holds true as long as the stock has been held for at least a year, and the contribution deduction does not exceed 30% of adjusted gross income.
A tax credit is more valuable than a tax deduction. For example, to someone in the 28% tax bracket, a deductible expense of $100 is worth $28. On the other hand, a $100 tax credit adds $100 to their refund check.
There are many different tax credits, but here is a list of the most common:
To find out more information on this topic, check out our article: Tax Credits.
If an employer offers flexible healthcare spending accounts, then pretax dollars can be used to pay for medical premiums as well as out-of-pocket healthcare costs. Examples of out of pocket costs include copayments and deductibles as well as coinsurance amounts. It's also possible to deduct some childcare costs in addition to expenses related to prescription medications.
The only downside of these flexible accounts is the "use it or lose it" provision. That means money not used during the year is forfeited. Anyone considering funding one of these accounts should run through some health care cost calculations to make sure the account is not over-funded.
Parents that want to send their children off to college one day should consider saving for college as part of a comprehensive tax planning strategy. Investing in a state sponsored 529 plan makes a lot of sense, since many states allow parents to deduct all or a large part of a contribution on a state income tax return.
In addition, the earnings on 529 plans grow on a tax-deferred basis. If the money is eventually used to pay for higher education expenses, those earnings may also be free of federal and state income taxes.
If the thought of saving for college and saving on income taxes sounds good, then so should contributing to a Coverdell ESA. There are no limits on the number of separate Coverdell accounts that can be established for a beneficiary, but the total of all contributions to a beneficiary cannot exceed $2,000 in a single tax year.
While the contributions to a Coverdell ESA are not tax deductible, the beneficiary does not owe taxes on the distributions as long as they are less than their qualified education expenses.
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