5 Strategies For Lowering Next Year's Taxes

By Amy Fontinelle | April 01, 2010 AAA

You've finished your tax return and you're not exactly thrilled with the number on line 60 of form 1040: your total tax due. If that's the case, there's no better time than right now to start planning to reduce next year's tax bill. Here are several ways to accomplish that goal.

IN PICTURES: 9 Ways To Use A Tax Refund

Contribute More to Your Retirement Accounts
Have you maxed out your 401(k) or 403(b) contributions? If not, increasing your contributions to your work-sponsored retirement plan is a great way to reduce your tax bill. If you're self-employed, look into increasing your contributions to your SEP, SIMPLE or Keogh plan; if you qualify to contribute to a traditional IRA, these contributions can also lower your tax bill. Keep in mind, however, that it's only a temporary reduction. You'll ultimately pay taxes when you withdraw that money in retirement and, since no one can predict future tax rates, it's a gamble whether this strategy will leave you with a higher or lower tax bill in the long run.

Take Full Advantage of Your Flexible Spending Account
A flexible spending account (technically called a "flexible spending arrangement") is a type of account offered by some employers that allows employees to pay for qualified medical expenses with pre-tax dollars that are deducted from their salaries, typically each pay period. You pay neither federal taxes nor employment taxes (Social Security and Medicare) on FSA contributions. The catch is that you have to decide how much to contribute for the year ahead of time, and you have to spend the entire amount before the end of the year or you forfeit it.

To determine if you should be contributing more to your flexible spending account, estimate what you spent last year on items that you could have purchased with a flexible spending account, like contact lenses, contact lens solution, prescription medication, over-the-counter medication and orthodontic treatment. These are just a few of the many expenses that can usually be paid for out of an FSA. For a complete list, see IRS publication 502.

Then think about which of these expenses you are likely to incur in the future and whether you would be likely to come out ahead by contributing more to your FSA. IRS publication 969 has more information on flexible spending arrangements. (This benefit could give you a return this year that puts many other investments to shame. Read Healthcare FSAs Increase Your Personal Savings to learn more.)

Buy a House
If you enter into a legally binding home purchase contract by April 30, 2010, close by June 30, 2010, and meet certain other requirements, you could be eligible for the first-time homebuyer $8,000 tax credit or the long-time homebuyer $6,500 tax credit.

You'll also be able to start deducting items such as your mortgage interest and property taxes. You can also probably deduct any points you pay when you take out your mortgage.

Furthermore, if these tax-deductible expenses of owning real estate mean that it makes sense for you to start itemizing instead of taking the standard deduction, you'll be able to start taking advantage of other itemized deductions that can lower your tax bill. These include the state income tax or state sales tax you pay, personal property taxes (like motor vehicle registration fees) and charitable donations. (For more on this topic, read The Mortgage Interest Tax Deduction.)

Donate More
If you're itemizing your deductions, your charitable contributions are tax deductible as long as you meet certain IRS guidelines (for example, political contributions do not qualify). Who would you rather have decide how your money gets spent: you or the politicians? Only you can make sure that your money goes to your own favorite causes.

Be aware that there are limits on how much you can donate to charity and take a tax deduction for in 2009. Cash contributions exceeding 30% of taxpayers' adjusted gross incomes were subject to limits. But unless you're quite wealthy, you probably won't have to worry about the limits. See IRS publications 78 and 526 for more information on deducting charitable contributions. (Being generous has never been more [financially] rewarding! Read Give To Charity; Slash Your Tax Payment to learn why.)

Time Your Expensive Medical and Dental Procedures
If you itemize your deductions, you can only itemize the portion of your medical and dental expenses that exceeds 7.5% of your income, a threshold that healthy people (thankfully) find difficult to meet. For example, if your taxable income is $40,000, 7.5% of that amount is $3,000. If you spend $3,001 on medical expenses, you can only deduct $1 on your tax return - and that's only if you itemize.

If you know you will be needing an expensive medical procedure (one that you can plan for in advance, of course), try to have everything related to that procedure taken care of in the same year (instead of, for example, doing part of it in December 2010 and part in January 2011). This strategy will make it more likely that you can deduct part of your expenses. If you had to pay $7,000 in medical expenses in a single year and had a taxable income of $40,000, you would be able to deduct $4,000 ($7,000 minus $3,000). If you split that $7,000 medical bill over two years, you'd have to meet the 7.5% threshold twice, and you'd only get to deduct $1,000 over two years.

Make sure to consult IRS Publication 502 to see what kinds of medical and dental expenses you can deduct. Also, the IRS cautions that "You cannot deduct qualified medical expenses as an itemized deduction on Schedule A (Form 1040) that are equal to the distribution you receive from the FSA." In other words, the IRS doesn't allow double dipping. (For more ideas on dealing with expensive medical procedures, see Steering Clear Of Medical Debt.)

Bottom Line
The tax code provides many perfectly legal ways to reduce your tax bill - are you taking advantage of all the ones you're eligible for? (For even more tax-saving ideas, check out 10 Most Overlooked Tax Deductions.)

Catch up on this week's top financial news in Water Cooler Finance: Auto Hope, Bubbling Oil And Obamanomics.

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