Depending on your location, your income taxes might actually be your biggest fixed expense.
In this article, I will explain to you how you can reduce your taxable income (don’t worry this all definitely legal) through retirement plans, flexible spending accounts, health saving accounts, and maximizing deductions via making charitable contributions. I help you learn the strategies the wealthy use to keep more of their income.
Retirement Plans
The most effective tax-reducing tool that you can employ is contributing to a suitable retirement plan such as a 401k retirement plan or an Individual Retirement Account (IRA).
401K Plans
A 401K plan is an employer-sponsored qualified retirement plan, recognized by the IRS, as having certain tax benefits.
Contributions to a 401K is made using your pretax income so all contributions constitute deductibles from your taxable income.
Contributing income to a retirement plan will allow you to defer taxes on your contributions until you withdraw your retirement funds at the appropriate age of fifty-five or older. If you withdraw earlier, however, you will incur a penalty.
As of the year 2020, you are allowed to make an annual contribution to your 401K plan of up-to $19,500. If you are above the age of 50, then you may be permitted to make an additional contribution of $6,500 although it depends on your plan. Note: This $19,500 does not include any of your employer match
IRA
An Individual Retirement Account is essentially a tax-advantaged investing tool that can be obtained through an IRS approved institution such as a bank or a brokerage firm.
Similar to 401K plans, the income that you invest in an IRA is deducted from your pre-tax income, but once you withdraw the money for retirement at the age of fifty-nine and a half or older you will incur taxes. Earlier withdrawals will incur penalties as well.
As of 2020, the annual maximum individual contribution to a traditional IRA is $6,000, in a majority of cases, while individuals at or above the age of 50 may make a higher contribution at $7,000.
Flexible Spending Accounts (FSA)
An FSA is a type of tax-advantaged savings account that is provided by employers for employees to be able to meet health-related expenses, often including dental, over a year through deducting a contribution from their salary.
Its purpose is to allow you to meet health-related expenses not covered under your insurance plan without having to pay out of pocket. Many items covered in a typical FSA, although these vary, include common first-aid products, dental expenses, and prescription glasses. You cannot pay for insurance premiums or ‘healthful’ but not ‘health-related’ products such as plastic surgery or herbal medication, however.
The annual limit on an FSA contribution in the year 2020 is $2,700 according to the IRS. The money that you contribute to an FSA must be used by the end of the one-year period or it will be considered forfeited; some employers may be able to offer you a grace period of up to two and a half months after the completion of one year.
When you open an FSA account, you reduce your gross income as contributions to your FSA are made using pre-tax money which reduces your total taxable income. If you earn an annual gross income of $60,000 and devote $1,000 to your FSA, your annual gross income is reduced to $59,000, and therefore your overall tax liability is also reduced.
It is important, however, to avoid overfunding your FSA so that any unused amount is not forfeited by the end of the year.
Health Savings Account (HSA)
An HSA is similar to an FSA in the sense that both are tax-advantaged accounts whose contributions are not counted as part of your taxable income. The primary difference between the two is that an HSA is created specifically for people insured under high-deductible health plans (HDHP) who have qualified expenses far above their HDHP coverage limits.
To be eligible for an HSA, you need to already have been insured under an HDHP that has an annual out-of-pocket maximum.
The maximum contributions that you can make to an HSA are $1,400 for an individual and $2,800 for a family. Earnings received on HSA accounts are also not taxed, and unspent money rolls over to the next year which is a big advantage of HSA’s over FSA’s where unused income is forfeited.
Therefore, if you’re already covered under a high-deductible health plan, it can be very beneficial to open health savings account from a tax perspective.
However, high-deductible health plans are quite expensive and may cost you more than they save if you are an individual with high expected medical expenses. So, HSA’s are not a useful way to reduce taxable income for everyone.
Charitable Contributions Deductions
The IRS permits individuals to receive an itemized tax deduction from their gross income if they donate to a recognized charitable organization. Therefore, making contributions to a charity can be a very effective way for you to lower your overall tax liability while simultaneously accomplishing your philanthropic goals.
The IRS imposes a maximum on the tax deductibles in a year, typically it is 50 % of an individual’s adjusted gross income (AGI). It is, however, important for you to maintain proper documentation of your charitable contributions.
The vast majority of charities operating in the United States, including religious organizations and not-for-profit companies, are recognized by the IRS as being eligible for donors to receive tax deductions on their contributions.
Your contributions don’t necessarily need to be in cash either, the IRS permits non-monetary contributions such as vehicles or capital goods as well. Donating unneeded household goods is probably one of the best ways to achieve both goals.
Contributing to your favorite charity can be a great way to lower your overall tax liability while also fulfilling your altruistic goals.
The Takeaway
If you want to reduce your annual tax liability, there are a number of intelligent ways to do so. From opening or increasing contributions to retirement plans, investing in FSA’s and HSA’s, and making contributions to your local charities, you can take immediate effective steps to lower your tax liability.
