How to lower taxes is one of the most common financial planning concerns among individuals and business owners. The increased standard deductions under the Tax Cuts and Jobs Act (TCJA) provided tax savings for many (even though the TCJA did eliminate many other itemized deductions and the personal exemption). Taxable income can be reduced further with a few strategic steps.

Key Takeaways

  • The simplest way to reduce taxable income is to maximize retirement savings.
  • Both health spending accounts and flexible spending accounts help reduce tax bills during the years in which contributions are made.
  • A lengthy list of deductions remains available to lower taxable income for full- or part-time self-employed taxpayers.

Save Toward Retirement

The simplest way to reduce taxable income is to maximize retirement savings.

Those whose company offers an employer-sponsored plan, such as a 401(k) or 403(b), can make pretax contributions up to a maximum of $19,500 in 2021 (also $19,500 in 2020). Those 50 and older can make catch-up contributions of $6,500 in 2021 (also $6,500 for 2020) above that limit. Because contributions are made pretax through paycheck deferrals, the money saved in an employer-sponsored retirement account is a simple and direct way to lower a tax bill.

For those without 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 2021 tax year is $6,000 (same as for 2020), with a catch-up provision of an additional $1,000 for those 50 and older, and those contributions reduce their taxes.

Taxpayers (or their spouses) who have employer-sponsored retirement plans may also be able to deduct some or all of their traditional IRA contribution from taxable income. Depending on their income, the IRS has detailed rules about whether—and how much—they can deduct.

In December 2019, the Setting Every Community Up for Retirement Enhancement (SECURE) Act was signed into law. For 2019 and years prior, taxpayers over the age of 70½ could not contribute to a traditional IRA. As of 2020, the age limit no longer applies. Taxpayers beyond the age of 70½ can contribute a maximum of $7,000 per year and receive the full tax benefit.

Consider Flexible Spending Plans

Some employers offer flexible spending plans that allow money to be socked away pretax for expenses such as medical expenses.

A flexible spending account (FSA) provides a way to reduce taxable income by setting aside a portion of earnings in a separate account managed by an employer. An employee can contribute up to $2,750 during the 2021 plan year (unchanged from 2020).

Under the use-or-lose provision, participating employees often must incur eligible expenses by the end of the plan year or forfeit unspent amounts. Under a special rule, employers may offer participating employees more time through either a carryover option or a grace period (2.5 months).

Under the carryover option, an employee can carry over up to $550 of unused funds to the following plan year. Under the grace period option, an employee has until 2.5 months after the end of the plan year to incur eligible expenses. Employers can offer either option, but not both, or none at all.

The IRS has released new guidance that allows employers more flexibility for benefit plans for 2020 and 2021 as part of the Consolidated Appropriations Act. Employers can allow employees to carry over all unused funds from 2020 to 2021 and from 2021 to 2022—or they can extend the grace period from 2.5 months to 12 months—either way, all unused funds can be carried over and used throughout the entire year.

A health savings account (HSA) is similar to an FSA in that it allows pretax contributions to be used for healthcare costs later. HSAs are only available to employees with high deductible health insurance plans, and contributions for 2020 and 2021 can be made up to $3,600 for individuals and $7,200 for families. Unlike FSA balances, HSA contributions can be rolled over if unused in the year in which they were saved.

Both HSAs and FSAs provide for a reduction in tax bills during the years in which contributions are made.

Take Business Deductions

A lengthy list of deductions remains available to lower taxable income for full- or part-time self-employed taxpayers.

A home office deduction, for instance, is calculated using either a simplified or regular method to reduce taxable income if a portion of a home is used as dedicated office space. The self-employed can also deduct a portion of their self-employment tax and the cost of health insurance, among other expenses, to lower taxable income.

Business owners or those with professional, deductible expenses can make upcoming necessary purchases or expenditures by the end of the tax year. This can make a large difference for those buying a major item for which the purchase price can be put on business expenses.

A 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 taxable income through pre-tax contributions and allow for higher limits on contributions each year.

The SIMPLE IRA allows contributions of up to $13,500 in 2021 (unchanged from 2020), plus an extra $3,000 for those older than 50. The Solo 401(k) allows contributions of up to $19,500 tax-free for 2021, also unchanged from 2020. The SEP IRA allows tax-deductible contributions of up to 25% of compensation, up to $58,000 (up by $1,000 from 2020).

The SECURE Act has implications for small business owners. The Act encourages business owners to set up retirement plans for employees by providing tax incentives if they collaborate with other small businesses to offer Multiple Employer Plans or MEPs.

The SECURE Act also allows more part-timers to save through employer-sponsored retirement plans, starting in 2021. To do so, workers will need to put in at least 500 hours a year for three consecutive years to be eligible.

The Bottom Line

Tax reform eliminated many itemized deductions for most taxpayers, but there are still ways for taxpayers to both save for the future and trim their current tax bill. To learn more about deductions and tax savings, consult a tax expert.