Reduce Your Taxes
We all desire to pay no more in taxes than we need to. So what can we do to pay less in taxes? In this post I want to cover 6 completely legal and most common ways to lower your taxes, so you can keep more money in your pocket rather than in the pocket of Uncle Sam.
1 - Retirement Account Contribution
Number one way to reduce your taxes is to contribute to your retirement accounts. This is by far the most common and easiest way to reduce your taxable income. When you contribute money into a traditional 401(k) and IRA accounts, what it does is it reduces your overall taxable income. Which in turn reduces the federal tax that you owe.
For example, let’s say you make a gross $100K a year. If you don’t contribute anything to your retirement account, you will owe federal taxes against that full $100K. This comes out to about $18,000 in federal taxes for a single filer. But if you were to let’s say contribute $20,000 into your retirement account, your taxable income is reduced to $80,000. Now you only owe about $13,000 in federal taxes vs. the $18,000. A $5K in savings because you decided to contribute to your retirement account.
And that’s not the best part. By contributing into your retirement accounts, your money is also growing tax free until your retirement. A double win in my books. If you aren’t taking advantage of contributing into your retirement accounts, you are missing out. The max contribution limit for 401(k) in 2022 is $20,500 and the IRA is $6,000. If you have the ability, max out these accounts so you can not only reduce your taxes, but save for retirement as well.
2 - Health Savings Account
A second way you can reduce your taxes is by opening up a Health Savings Account. Also known as HSA. Now there are few key benefits to this I want to highlight.
One is that, when you contribute money into an HSA, similar to a retirement account, your taxable income is reduced by that amount. The contribution limit for 2022 is $3,650 for self-only coverage and $7,300 for family plans. This means, when as a family, you contribute $7,300 into an HSA, you don’t pay taxes on that amount.
And it gets even better. The money within HSA, if invested, which I highly recommend you do, will not only grow tax free, but you can withdraw tax free for any qualified medical expenses. But wait, there’s more. There is no time cap to HSA. Which means, you can hold onto your medical receipts from 10 years ago, and if you want to withdraw tax free money today or 10 years from now, you can.
Now a caveat here is that you do need to have a high-deductible health insurance plan to be eligible to open one of these accounts. So make sure you check on that. If you are eligible, don’t miss out on this amazing account that will not only reduce your taxes, but increase your net worth as well.
3 - Flexible Spending Account
Number three way to reduce taxes is through HSA’s not so good looking younger brother, the FSA - the Flexible Spending Account. If you don’t have a high-deductible health insurance plan, you can still pay for medical expenses with tax-free dollars if your employer offers flexible spending accounts.
Most often, you enroll as part of your employer’s benefits package. Once you enroll, the FSA amount is deducted from your payroll automatically into a separate account. Which can then be used to pay for expenses running from insurance copays to over-the-counter medication.
One downside of a FSA compared to an HSA is that they have an expiration date. If you don’t spend all the money within the FSA within a specific year, the amount is forfeited. Many employers also offer FSAs for both health care and dependent care.
Dependent care could be used not only for your kids’ preschool or afterschool expenses, they can also be used for eldercare as well if you are caring for your aging parents. This is especially beneficial for us as the Sandwich Generation. Check with your employer on the details, but this is another low hanging fruit that you want to take advantage of to reduce your taxable income. For us, given we have two young kids, the FSA literally saved us thousands of dollars in taxes the past 10 years. Don’t leave money on the table.
4 - Side Hustle
If you have a side gig or a side business, you are eligible for a lot of tax deductions. You definitely shouldn’t start a side gig just for the tax savings, but they can be a great side benefit to getting your passion project up and running.
A few of the business deductions available include office supplies, shipping, advertising, website fees, professional publications and even a percentage of your home internet charge. When I was working full time and running my website on the side, I was able to deduct all the educational books I purchased because they were all contributing to improving my side-business.
To be honest, I would have purchased those books regardless since I love reading, but having a website that I was running was a great way to get a tax write off on these expenses. There’s a lot of nuances to deducting business related expenses so you want to work with an accountant on this, but the IRS rules are in favor of helping entrepreneurs get their businesses up and running. So if you’ve been thinking about starting a side gig, don’t wait, Mr IRS is also rooting for you.
5 - Sell Your Losers
Number five way to reduce your taxable income is to sell your losers. If the market took a dip this year and you have losses in your taxable investment account, cut them loose before the year-end and use the losses to offset capital-gains income. If your overall losses exceed your gains, you can deduct up to $3,000 from your other taxable income.
And even better, the losses that exceed that amount can be carried forward for future years. One caveat is that once you sell and you buy back the same stock within 30 days, your deduction will be withdrawn by the IRS. So you want to be very careful when using this strategy.
6 - Charitable Contribution
Number six way to reduce your taxable income is to contribute to charity. Most charitable contributions are tax deductible and they don’t even have to be cash. If you’ve ever donated clothes or household items because you were cleaning out your garage, you can deduct them against your income. Make sure you get a receipt though.
If you regularly donate items to Goodwill or the Salvation Army, this is an easy way to reduce taxes while at the same time getting rid of items you don’t use anymore. In addition, any donation you make to your church or your favorite nonprofit are also tax deductible. Similarly, make sure you get a receipt.
There is a hack that I’ve used if I don’t have a specific non-profit I want to donate money to yet, but I still want to take advantage of the deductions that come from charitable contributions. It’s donating money to a Donor-Advised fund. Donor-advised funds work like a mini foundation that allows you to contribute money like any other investment accounts and you get to take the tax deduction the year you contribute money.
