Tax day is officially behind us and hopefully you have taken advantage of any opportunity to lower your tax bill. Each year when you send your W2 or 1099 over to your tax accountant, he or she enters the information into tax planning software to come up with a number. That number is the TOTAL TAX that you and your family owe for the year, which is based on your TAXABLE INCOME, not gross income.
The natural question you should be asking here is – How can I reduce my taxable income so I can pay less taxes?
Here are 3 ways you can do that.
1. Save Toward Retirement
If you’ve ever spoken to an accountant or financial advisor they’ve most likely told you that saving for retirement is a smart financial move. Not only will you be socking money away for the biggest expense in your life – retirement and healthcare – but you’ll also be reducing your taxable income.
Those who can contribute to an employer sponsored retirement plan, such as a 401k or 403b, can make pretax contributions up to $19,500 for 2020, and if you are over 50 years old that increases to $26,000.
If you do not have the opportunity to contribute to an employer sponsored plan then make sure you are contributing to your Traditional or Roth IRA. I’ve discussed the differences here, but for the sake of this post, we’ll focus on the Traditional IRA since it reduces taxable income. For 2020, the maximum contribution limit is $6,000, or $7,000 if you are over 50 years old.
Saving for retirement will be the biggest opportunity to reduce taxable income. Do not miss out.
2. Flexible Savings Account (FSA) and Health Savings Account (HSA)
If your employer gives you the opportunity to contribute to a Flexible Savings Account you should take advantage. It provides a way to reduce your taxable income by setting aside a portion of your paycheck to pay for medical expenses or childcare costs, depending on the type of FSA. The 2020 contribution limit is $2,750.
The downside to a FSA is that it is a use-it-or-lose-it type of account. You need to make sure that whatever you contribute for the year is used by year end for qualified expenses or the amount will be forfeited. There are some exceptions, but most times its best to focus on using it so as not to risk forfeiture.
A Health Savings Account (HSA) is similar in that it allows an individual to reduce their taxable income from their paycheck to pay for healthcare costs. This DOES NOT need to be drained by the end of each year and can be rolled over indefinitely. There is a stipulation (of course) and that is you must have a high-deductible health insurance plan in order to contribute, which for 2020 is considered to be $1,400 for an individual or $2,800 for a family. Contribution limits for 2020 are $3,550 for individuals and $7,100 for families.
3. Business Deductions
I’m sure people have told you before that you should start your own business or side hustle. It’s a great way to increase your income doing something you enjoy. Well, there’s another reason. All income you generate from a side hustle is entered onto Schedule C of your tax return. You can then take business deductions against this income on Schedule C, before it swings over to your Form 1040 (Individual Tax Return) to produce your Total Tax owed for the year.
If you use part of your home for your business you may be able to deduct some rent/mortgage interest and utilities. Part of your car payment could also be a deduction. Cell phone bill? Yup, that’s possible as well. You also now get to set aside additional dollars from your Schedule C income for retirement, which again, is a reduction in taxable income.
These deductions are best discussed with your tax accountant, but the takeaway here is that there is ample opportunity to reduce your taxable income from a side hustle.
At the end of the day, having a higher tax liability because you make more money is part of the game, but if you can use some of the above ways to reduce that expense, why wouldn’t you?
Have a question? Shoot me an email I’m here to help!
Fun Fact: Honey does not spoil. You could conceivably eat 3,000 year old honey.
Disclaimer: This is meant to be general information and is in no way a recommendation for any investment product.