This post is the last in our five-part series about taking charge of your finances in 2010. Each article in the series has been about a pillar of personal finance—setting goals, saving, investing, and being properly insured. Today’s topic is about the how to legally cut your tax bill.
If you’re like many people who work for an employer, you may not know exactly how much you pay in taxes each year. Of course you know that taxes are deducted from your paychecks and that you may be eligible for a refund at tax time. But do you realize that taxes are probably your largest expense? Because they take such a huge bite out of your income, it’s smart to reduce them in every way possible. Now, I’m not suggesting that you do anything illegal to avoid paying taxes. But even the IRS encourages people not to pay more in taxes than the law requires.
How to Reduce Your Taxes
So how do you actually reduce taxes without skirting the law? Here are the five best ways:
Strategy #1: Adjust Your Withholding
Many people have too much federal tax withheld from their paychecks. You’re in that boat if you receive a large tax refund each year. I know it seems counterintuitive, but receiving a tax refund never helps your finances. Consider this: When you file a tax return, you’re really just settling up with the government. If you didn’t pay enough during the year through payroll deductions to cover your tax bill, then you have to pay the difference on tax day. Or if you overpaid your tax bill, you get a tax refund for the excess.
So receiving a tax refund is simply an indication that you handed over way too much money to the government. Instead, you should have received that money and put it to work earning a nice return in a retirement or savings account. Receiving a higher paycheck now, rather than getting a tax refund in the future, doesn’t actually lower your tax bill, but it does give you an instant pay raise so you can control more of your hard-earned money. You adjust your withholding by completing Form W-4 and submitting it to your employer any time during the year. The W-4 can be confusing, so get some help with it by using the Withholding Calculator at irs.gov.
Tax credits are one of the most powerful ways to lower your taxes because they reduce your actual tax bill dollar for dollar.
Strategy #2: Take Tax Credits
Tax credits are one of the most powerful ways to lower your taxes because they reduce your actual tax bill dollar for dollar. It’s like going to the grocery store with a $3 coupon. If your total bill is $75, using the coupon means you only pay $72. Well, tax credits slash the amount of tax you owe in the same way. See if you’re eligible for any of these ten tax credits:
Child Tax Credit
Child and Dependent Care Credit
Earned Income Credit
Credit for the Elderly or the Disabled
Retirement Savings Contribution Credit
American Opportunity Tax Credit
Lifetime Learning Credit
Nonbusiness Energy Property Credit
Residential Energy Efficient Property Credit
Strategy #3: Take Tax Deductions
A tax deduction is an amount that the IRS allows you to subtract from your taxable income, such as charitable contributions, student loan interest, and certain IRA contributions. When you reduce your taxable income, you also lower your tax liability. For example, if your taxable income is $40,000—but you’re eligible to claim $10,000 in allowable deductions—then you only have to pay taxes on $30,000. The best way to see every allowable deduction is to review Schedule A of Form 1040, because that’s where you claim itemized deductions. There’s also an instruction sheet for Schedule A, which gives you details about each of the deductions.
Strategy #4: Contribute to Tax-Deferred Retirement Accounts
Retirement accounts, like traditional IRAs, workplace 401(k)s, and Keoghs (which are for the self-employed) are great ways to lower your tax bill. That’s because you don’t pay tax on the money you contribute to them until you withdraw it in the future. That doesn’t eliminate the tax, but you defer it for many years.
Strategy #5: Use Health Spending Accounts
There are several programs created to help offset the growing cost of health care:
Health Savings Accounts (HSA)
Flexible Spending Arrangements (FSA)
Health Reimbursement Arrangements (HRA)
They allow you to pay for certain medical expenses with tax-free money and can be combined with a high-deductible health plan in some cases. If you’re eligible for one of those tax-favored accounts, don’t miss the opportunity to save taxes by spending pre-tax money on qualified health care or child care expenses. Take a look at IRS Publication 969 for complete information.
Before I go I want to remind you that each year the IRS ends up with millions of dollars that it tries to refund taxpayers. If you moved recently it’s a good idea to complete an address change form—that’s IRS Form 8822 to make sure your money follows you. Or better yet, set a tax refund up for direct deposit into a special account, like your heath savings account, retirement account, or a bank savings account. You can even split it up between multiple accounts by completing IRS Form 8888.
Money Girl Audiobook & Contact Info
Thanks to everyone who’s downloaded my newest audiobook, Money Girl’s 10 Steps to a Debt Free Life. Get your copy today at Audible.com, Amazon.com, or in the iTunes store. It’s a great way to support the podcast and to get on the road to a better financial future. You can always send your e-mail comments or questions to me at email@example.com.
IRA Contributions: Deductions And Tax Credits
Money Girl Podcast #151: What is the Expanded First-Time Homebuyer Tax Credit?
Money Girl Podcast #153: How to Lower Your Taxes with Energy Efficient Improvements
Money Girl Podcast #84: Get to Know Health Savings Accounts
Money Girl Podcast #154: The New Roth IRA Rules for 2010
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