1. Retirement Contributions
Everyone talks about retirement contributions and how they can save you a ton of money come tax time. But not all retirement plans are created equal. For instance, if your retirement plan has the "Roth" designation, that means that you are paying tax on the income that you use to fund your retirement, in hopes that when you retire, you'll make tax-free withdrawals ("distributions" is the fancy term) from your retirement account. But if you just have a regular IRA, it means that your contributions today are reducing your taxable income. So let's walk through each of those examples.
You make $50,000, that means that you'll pay about $4,400 in taxes this year. But, you decide to contribute $5,000 to a Roth IRA, which will bring your new tax bill to... $4,400 (no difference). However, when you reach retirement age, you can withdraw whatever you have in your Roth IRA and not pay any taxes on it. So if your $5,000 grew to be $20,000, you can take those $20,000 without paying any taxes.
Same income situation. You make $50,000, meaning that you'd pay about $4,400 in taxes. However, this time, you decided to contribute $5,000 to your IRA. This will reduce your taxable income by those $5,000. Now, you're only being taxed on $45,000 which would bring your tax bill down to about $3,800. So just by saving $5,000 towards your retirement, you've saved an additional $600 on your taxes. However, the downside here is that when your $5,000 grows into $20,000, Uncle Sam will come knocking, looking for about 15% of your $15,000 in growth ($2,250).
2. Charitable Contributions
Charitable contributions just became a lot harder to deduct on your taxes, thanks to the boost in the standard deduction. If you have a mortgage and pay interest, you might make it over the standard deduction. But if you don't have a mortgage, or maybe the interest on your mortgage gets you to just under the standard deduction, then you may want to consider making some charitable contributions. Keep in mind that sometimes it might be beneficial to double your charitable contributions every other year, and not make any in the years in between. Let's dive in with a couple of examples:
- Income: $50,000/year
- Mortgage interest: $900/month
- Charitable contributions: $100/month
If you continue doing what you're doing, you'd end up with the standard deduction (barring any additional deductions). That means that your current deductions (mortgage interest and charitable contributions = $12,000 per year) are the same as your standard deduction. So your tax bill comes out to approximately $4,400.
This year, you decide to get smart about your taxes, and you sacrifice a little bit by doubling your monthly charitable contributions from $100 to $200. Now, your itemized deductions climb to $13,200 ($2,400 of charitable contributions and $10,800 of mortgage interest (next year, you won't make any charitable contributions). By making this simple change, you have saved yourself $200 in taxes. Admittedly, it does seem like quite a burden to change your monthly budget by $100 in order to save $200 over the course of the year, but this sort of tax planning can really add up as the amounts start to get larger.
3. Health Savings Accounts
Health savings accounts (HSAs) are a great way to reduce your taxable income. HSAs are tax advantaged in three ways (if you qualify).
- They're tax deductible, meaning that they serve to reduce your taxable income just like contributions to an IRA.
- They can be used towards qualifying medical expenses without incurring any tax.
- You can withdraw your HSA savings any time after the age of 65.
For a complete list of qualifying expenses that won't trigger a taxable distribution click here.
Individuals can contribute up to $3,450 per year or $4,450 if you're over the age of 55. If you have a family health plan, you can contribute up to $6,850 per year. There are certain restrictions in place that require you to have a high deductible health plan where your deductible is at least $1,350 per individual or $2,700 for a family. That plan's out-of-pocket maximum must be $6,650 for an individual or $13,300 for a family.
4. College Savings Plans (529 Plan)
College savings plans or 529 plans for short, are a great way to set aside funds for everyday educational expenses. Thanks to the TCJA (new 2018 tax law), 529 plans can now be used for any educational expense, not just college. This includes school books, uniforms, field trips, tutoring, etc. If you know that on average, little Johnny's private school cost $7,000/year, you can easily turn that expense into a tax deduction by first making a $7,000 contribution to his 529 plan, then by paying for the tuition from 529 account. This effectively would reduce your taxable income by $7,000 without having to change any of your spending habits.
While contributions to 529 plans aren't explicitly limited by the IRS, there is the annual gift tax that applies to gifts given in excess of $15,000. This would mean that you can contribute up to $15,000 per child, per year, without incurring a gift tax. Additionally, your spouse can contribute another $15,000 per year, per child, without incurring the gift tax either. You can also make a lump-sum contribution in the amount of $75,000 to cover a 5 year period.
Lastly, the amount that can be accumulated in a 529 plan is set by the state the plan is listed in. Therefore, overall contribution limits vary by state and can range from $235,000 up to $520,000.
Some states also offer state tax credits or deductions that can be applied to your state income tax return.
5. Replacing wage income with non-wage income
This is probably the hardest of our 7 tips. This requires that you make investments in either tax-free or tax-advantaged assets. These can include municipal bonds (tax-free) or standard stocks and bonds (tax-advantaged). Let's walk through each example:
The interest that you collect from owning municipal debt is often tax free. So if you invest $100,000 in municipal bonds that pay an interest rate (coupon) of 5%, you'll be earning $5,000 per year, none of which you'll have to pay any tax on.
Stocks and Bonds
When done correctly, investing in stocks and bonds can have a tremendous tax benefit and provide a reliable source of income. If you were to invest in an index fund that pays dividends, you could expect to earn around 2% per year (plus appreciation) and only be taxed at the long-term capital gains rate of 15% - 20%. If you were to amass $1 million in a fund that pays 2% in dividends, you would pay $3,000 - $5,000 in taxes. If you're earning $250,000 via a salary, you're paying an effective rate of approximately 23.8%. Therefore, by changing your income source from salary income to investment income, you're effectively capping your tax rate at 20% instead of potentially climbing into the highest tax bracket.
6. Harvesting investment losses
A lot of people associate harvesting losses with actually taking losses on positions that they've held for a long time, but that's not necessarily true. If you wanted to harvest a tax loss without necessarily locking in the loss, you could sell your positions with a paper loss on 12/31 and buy them back on 1/2 of the following year. This would minimize the change in the stock's price while allowing you to capture the loss for tax purposes. This could potentially save you thousands in capital gains taxes for positions in which you've actually decided to sell at a gain.
7. Knowing the ins and outs of your industry
Knowing the ins and outs of your industry (or at least having a CPA that does) could lead you to thousands in tax savings. For instance, did you know that on average, gas is taxed at around $0.50 per gallon, and of that $0.50, state and local taxes are about $0.31? And that in Florida, commercial fishermen can apply for a refund on those state and local gas taxes? Knowing the ins and outs of your industry can prove to be very lucrative when maximizing your tax refund.