The age-old question of how to lower taxes is one of the most common financial planning concerns among individuals and business owners. Paying taxes is unavoidable, but ample opportunities exist to help achieve a lower tax bill. Although each taxpayer has a different obligation to the Internal Revenue Service (IRS) each year, the potential to reduce taxable income is available across the board with the help of a few strategic steps.
Save Toward Retirement
The simplest way to reduce your taxable income is to maximize retirement savings. If your company offers an employer-sponsored plan, such as a 401(k) or 403(b), make pretax contributions throughout the year up to a maximum of $19,000 in 2019 ($18,500 in 2018). If you are over the age of 50, make catch-up contributions of $6,000 above that limit as well for an additional opportunity to save money while reducing your taxes. Because your contributions are made on a pretax basis through paycheck deferrals, the money saved in your employer-sponsored retirement account is a simple and direct way to lower your tax bill.
If you do not have the option to save through an employer-sponsored plan, contributions to a traditional individual retirement account (IRA) may be a smart alternative. The maximum contribution to an IRA for the 2019 tax year is $6,000, with a catch-up provision of an additional $1,000 if you are over 50. Contributions to a traditional IRA lower your taxable income only if you do not have access to an employer-sponsored plan or when your total income is under a certain threshold.
A wide variety of retirement savings plans exist for the self-employed, including an individual 401(k) and a simplified employee pension (SEP) IRA. Both options provide an opportunity to lower your taxable income through pretax contributions and allow for higher limits on contributions each year.
Consider Flexible Spending Plans
Some employers offer flexible spending plans that allow for pretax savings for expenses such as medical costs and dependent care. A flexible spending plan (FSA) provides a way to reduce taxable income by setting aside a portion of your earnings in a separate account managed by your employer. An employee who chooses to participate can contribute up to $2,700 during the 2019 plan year. That’s a $50 increase over 2018.
Under the use-or-lose provision, participating employees often must incur eligible expenses by the end of the plan year or forfeit any unspent amounts. But under a special rule, employers may, if they choose, offer participating employees more time through either the carryover option or the grace period option.
Under the carryover option, an employee can carry over up to $500 of unused funds to the following plan year — for example, an employee with $500 of unspent funds at the end of 2019 would still have those funds available to use in 2020. Under the grace period option, an employee has until two and a half months after the end of the plan year to incur eligible expenses — for example, March 15, 2020, for a plan year ending on Dec. 31, 2019. Employers can offer either option, but not both, or none at all.
A health savings plan (HSA) is similar to an FSA in that it allows you to make pretax contributions that you can use for health care costs later. HSAs are only available to employees with high deductible health insurance plans, and contributions can be made up to a maximum of $3,450 for individuals and $6,900 for families. Unlike FSA balances, HSA contributions can be rolled over if you do not use them in the year in which they were saved. However, both HSAs and FSAs provide for a reduction in your tax bill during the years in which you make contributions.
Track Business Deductions
A lengthy list of deductions are available to lower taxable income if you are self-employed either full- or part-time. Use a home office deduction to reduce your taxable income if at least one-fifth of your home is utilized as dedicated office space, and you can deduct a portion of your mobile phone and Internet bills as well. In addition, expenses for advertising, marketing, travel and shipping can all be used to lower your taxable income each year.
Dave Rowan, CFP®
Rowan Financial, LLC, Bethlehem, PA
One of the best ways to lower taxable income is to change your employment status: going from staff worker to independent contractor. Choosing this path can be risky – it means giving up a steady paycheck and corporate benefits – but it opens up a host of options to save for retirement while simultaneously reducing your taxable income.
One is the SIMPLE IRA. In 2019, it allows you to contribute up to $13,000 annually in pre-tax dollars, plus an extra $3,000 if you're over 50.
Another is a Solo 401(k) plan: You're able to contribute up to $56,000 total for 2019, and the first $19,000 in earnings can be contributed tax-free; add on an extra $6,000 to both figures if you’re over 50.
Finally, the SEP IRA allows you to make tax-deductible contributions of up to 25% of your compensation, up to $56,000.