As the title of this article insists, there are basically three different places where your money can go to in the form of taxes: the government (IRS), yourself, or a charity (through charitable contributions). If you are an upstanding citizen and love to pay taxes, then this article is probably not for you. However, if you are like most Americans and want to know how to save every penny you can in taxes (not necessarily a bystander), then you're in the right place. This article will walk you through some of the best and most popular tax saving strategies out there.
For starters, there are four different income sources (i.e. ways you can make money): ordinary income (i.e. salary, wages, bonuses, etc.), portfolio income (i.e. interest and dividends), passive income (i.e. rent collected from renting out your house or condo), and capital income (i.e. when you sell stocks). These terms will be used throughout the article, so it is important to be familiar with them. The #1 income source that a taxpayer wants to/should reduce (through tax deductions) is ordinary income because it has the biggest impact on how much you pay (or get back) in taxes. Another term to be familiar with is “deductions to arrive at AGI” (i.e. adjustments aka things you can deduct right on the face of the tax return aka what you want to maximize/focus your attention on). Also be familiar with “deductions from AGI” (i.e. itemized deductions aka things that can be hard to benefit from through taxes). Lastly, AGI stands for Adjusted Gross Income (gross income minus adjustments) and taxable income (AGI minus itemized or standard deduction minus exemptions) is what you end up multiplying by a percentage provided by the IRS to get your gross tax liability. Not too important to understand, but good background knowledge to have in general. The focus of this article will be how to minimize that taxable income amount through many different strategies.
Tax Saving Strategy #1: Deductible/Traditional Individual Retirement Account (IRA)
Arguably one of the easiest ways to save money on taxes. This is an adjustment that can get deducted right on the face of the tax return. You can deduct up to $5,500, but must qualify in order to get the deduction. You don’t qualify if you a) are in another qualified plan (i.e. another retirement plan such as a 401(k)) AND b) have an AGI greater than $61,000 (for single filing status). In other words, you can still qualify if you meet only one of these conditions (i.e. you make over $61,000, but don’t have another retirement plan or vice versa). Great way to save money on taxes and a great investment strategy as well. The money in the traditional IRA account grows tax-deferred, but the withdrawals are taxable.
What makes this deduction even better is that you have until April 15 of the following year to make your contribution and claim the tax deduction for the current year (i.e. you don't have to make a contribution to the deductible IRA by December 31, 2015 to claim the deduction for the 2015 tax year; instead you have until April 15, 2016). You can also qualify for the saver's credit by making contributions to your retirement accounts if your AGI is below a certain level.
Tax Saving Strategy #2: Health Savings Account (HSA)
Triple tax benefits. Easy way to save money. You can deduct up to $3,350 (for single filing status) right on the face of the tax return. Even more if you are married or have a family (as it applies with almost all tax benefits). The only catch is that you have to have a “high-deductible health plan” which basically means your annual deductible on your medical insurance has to be a pretty high amount (at least $1,300). Other benefits of an HSA include the fact that the money in the account grows tax-free AND the withdrawals are nontaxable making it one of very few, if not the only investment account, to offer triple tax benefits (a tax deduction, tax-free income accumulation, and nontaxable withdrawals). Just make sure the withdrawals go to qualified medical expenses. Similar to the deductible IRA, you have until April 15 of the following year to make your contributions.
Tax Saving Strategy #3: Student Loan Interest
For all those with student loans, this is a huge tax benefit that can be deducted right on the face of the tax return. Up to $2,500 in interest that you can deduct! However, the amount you can deduct will be reduced if your AGI is $65,000 or above (for single filing status). Absolutely should take advantage of this deduction.
Tax Saving Strategy #4: Net Capital Loss Deduction (Stocks)
The stock market is not the most stable thing in the world. Things happen, people lose out on money, so it’s only right to provide some type of benefit. Up to $3,000 that you can deduct right on the face of the tax return. The remaining losses can offset/reduce other capital income gains or can be carried forward to future years for an unlimited amount of time (up to how much you actually lost). Huge tax benefit. Stocks aren’t so bad after all. And this benefit doesn’t only apply to stocks, it applies to all capital losses (i.e. bonds, mutual funds, etc.).
Tax Saving Strategy #5: Medical Expenses
One of the most popular itemized deductions. Unfortunately, you can’t deduct this right on the face of the tax return, but if you have enough expenses, it can pay off tremendously. You can deduct things like prescription drugs, doctor visits (i.e. physicals), medical insurance premiums, required surgery, and disability expenses. Just add all of these expenses up, subtract whatever your insurance provider covered and subtract 10% of your AGI to get your final medical expense itemized deduction amount.
Tax Saving Strategy #6: Charitable Contributions
Another big itemized deduction. Whether it’s money, clothes, or other items, you can add these to your list of itemized deductions. The limit however is 50% of your AGI for money (cash) and 30% of your AGI for items with a total limit of 50% for ALL of your charitable contributions. Any qualified contributions that exceed the 50% or 30% limits can be carried forward for up to five years. Unfortunately, you can’t deduct services (i.e. time) you provide (i.e. mentoring kids and anything not cash or an item). Also, be sure to get a receipt for any contribution(s) you make.
Tax Saving Strategy #7: State and Local Income Taxes
Great itemized deduction. Whatever income taxes you paid to your state or local (i.e. city) government can be deducted right back. Simple enough.
One important thing to note is that federal income taxes that you paid throughout the year are fully deductible/refundable and therefore don't fall in the itemized deduction category. Instead, they are refundable credits that you can get back in full once you file your taxes.
Tax Saving Strategy #8: Property/Real Estate Taxes
Basically the same as state and local income taxes. Whatever property taxes you paid to the government can get deducted right back as an itemized deduction. And as an added bonus, you can deduct mortgage interest as well. However, you cannot deduct assessments such as street and sidewalk assessments.
With all itemized deductions combined, if they equal to more than $6,300 (i.e. the standard deduction for single filing status; higher amount if you’re married), you’ll maximize your tax savings.
Tax Saving Strategy #9: Moving Expenses
If you decide (or your company decides) to relocate you to another state, you can deduct your qualified moving expenses right on the face of the tax return. Qualified moving expenses include travel and lodging such as transportation to the new location. And we all know airplane tickets cost an arm and a leg now a days so take advantage. Meals along the way are unfortunately nondeductible.
Tax Saving Strategy #10: Self-Employed Taxes
The self-employed probably benefit the most compared to any other individual when it comes to taxes. There are countless tax benefits for the self-employed, but I will cover three in particular: one-half self-employment (FICA) tax paid, any health insurance premiums, and a retirement plan known as the Keogh plan (up to $53,000!!). Huge tax benefits right on the face of the tax return on top of all the benefits the self-employed receive. Must be nice to be self-made.
Pre-Tax Saving Strategies:
There are other popular ways to save money on taxes. Whenever you can pay something pre-tax, that saves you A LOT of money in most cases. With pre-tax money, you basically prevent that money from being taxable income, which lowers your tax bill in the end. A traditional (pre-tax) 401(k) is an excellent way to get pre-tax deductions directly from your paycheck. You can also make pre-tax HSA contributions instead of taking the deduction on the tax return. The next pre-tax saving strategy you can use is what is known as a Flexible Spending Account (FSA) where you set money aside (up to $2,550) directly from your paycheck in order to pay for qualified expenses (normally medical-related). The only catch with an FSA is that if you don't use the money within two and a half months after the end of the tax year, you lose it. Another great pre-tax strategy to use is what is known as commuter benefits which basically means that if you work for an employer that offers it, you can use pre-tax contributions to pay for transit (i.e. CTA) and parking expenses up to a certain limit set by the IRS.
Keep in mind that taxes are much more complicated than this article and there are plenty of more tax benefits out there, but this is information that you can take advantage of. Lastly, taxes are all about timing thanks to the time value of money. Either you pay the government now and get the money back later or you hold on to that money now and the government gets some (or all) of it back later. Money today is worth more than money tomorrow.
For more information on all of these strategies, IRS.gov is a great site. Or you can always contact me with any questions or concerns.
Note: All amounts in this article are reflective of the 2015 tax year. Amounts in the 2016 tax year and beyond are subject to change.