We are more than a month into the new year, and that means tax season is now in full swing. Many people wait until the end of the year to try to minimize their tax bill, but why wait? If you take a proactive approach and start working on lowering your annual tax bill at the beginning of the year, you won’t be scrambling come December.
One of the easiest ways to reduce your tax bill is by reducing your taxable income since that is what your tax is based on. There are a number of ways to reduce taxable income. Some of the most effective are by giving wisely, maximizing retirement accounts and contributing to a health savings account.
Give Wisely to Charities
According to National Philanthropic Trust, in 2015 Americans gave $373.25 billion to charity. Though most people make charitable donations because they want to give back to the community, there are also tax benefits for generosity.
When itemizing deductions, all charitable giving can be included, whether cash, goods or securities. Because of this, the more you give the lower your taxable income and final tax bill will be. You need to make sure to maintain records of your giving through receipts from the charity, canceled checks or credit card statements. If the IRS ever audits you, you will need the records to back up the deductions you took.
While all charitable giving can help reduce your tax bill, there is another added benefit for those donating appreciated securities. If you’ve owned it more than one year, you can deduct the full fair market value of the security on the date of the gift. In doing this, you don’t have to pay capital gains on the appreciation and neither does the charity. (For related reading, see: Deducting Your Donations.)
Not all charities accept donations of securities, but that shouldn’t limit your giving. You can open a donor advised fund that will sell the securities and leave you with cash to donate as you wish. That way you still get the full tax benefit of donating the securities (without having to pay capital gains tax), while having cash to give to any charity you want. One caveat: it isn’t a good idea to donate securities that have experienced losses. It is better to sell the securities yourself, claim the loss on your taxes, then donate the proceeds.
Max Out Retirement Savings
Probably your greatest opportunity to lower your taxable income comes from tax-deferred retirement accounts. If your employer offers a 401(k), you can contribute up to $18,000 in 2017. Those over 50 are allowed catch-up contributions of an additional $6,000. That is $24,000 less income that you will have to pay taxes on this year.
Not everyone has the opportunity to contribute to a 401(k) because they are employer-dependent. However, everyone with an income can contribute to an IRA. In fact, you might not even have to have an income. If you are married and your spouse has an income you are eligible to contribute to an IRA as well. IRA contribution limits for 2017 are $5,500 per person, with an additional $1,000 permitted for those over 50.
If you take advantage of both kinds of retirement accounts, you can reduce your taxable income by $23,500 or $30,500 if you are over 50. That means your tax bill is reduced by $6,580 or $8,540 if you’re in the 28% tax bracket.
The catch is that traditional IRA accounts have a contribution limit based on income. This means that if you make over a certain amount of money, your deduction is phased out. For a single filer with a traditional IRA, the income threshold is $62,000 to $72,000. For married filers, it starts at $99,000 to $119,000 if you both have an employer-sponsored plan or $186,000 to $196,000 if one spouse does not have an employer sponsored plan. (For related reading, see: IRA Contributions: Deductions and Tax Credits.)
Fund a Health Savings Account
One of the most tax-advantaged savings vehicles that the government has made available to the American people is the health savings account (HSA). Contributions to HSAs are not taxable, and they grow tax-free too. The only downside is that they are only available to people with high-deductible health plans.
The 2017 contribution limits for HSAs are $3,400 for an individual or $6,750 for a family. You can also make a $1,000 catch-up contribution if you are over 55. HSAs roll over from year to year, so you don’t have a deadline for using the funds. You can even invest the funds and build up your HSA to use during retirement. All funds must be used for qualified medical expenses or face penalties. (For related reading, see: How to Use Your HSA for Retirement.)
Are you interested in utilizing these tax-reduction methods but don’t feel that you have the knowledge to implement them? An experienced financial professional can help you set up an IRA or donor advised fund or help you determine if you are eligible for an HSA.