Few of us want to pay more tax than we have to. Understanding the tax credits and deductions that we're eligible for, and calculating them correctly, can mean the difference between owing more money at tax time or receiving a welcome refund. Here are three simple ways to minimize your tax liability.
- The key to minimizing your tax liability is reducing the amount of your gross income that is subject to taxes.
- Putting pre-tax dollars into a retirement plan like a 401(k) is one easy way to reduce your taxable income for the year.
- If you sell an investment that has lost value, you can use that loss to offset other income.
Increase Retirement Contributions
The income tax you pay each year is based on your gross income, and for many of us, the easiest way to reduce that figure is by contributing to an employer-sponsored retirement plan or individually held traditional IRA.
For 2020 and beyond, the age-restriction (70.5 years) for contributing to a traditional IRA has been lifted due to the passage of the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019. Now seniors can contribute to IRA accounts indefinitely.
In addition, the new law raised the age seniors must take required minimum distributions (RMDs) from their 401(k) and traditional IRA accounts. In the past, RMDs had to be taken at age 70.5, with the passage of SECURE, that age goes up to 72 years. The change to taking distributions may impact taxes, depending on a person's tax bracket when they start withdrawing funds.
Employer plans, such as a 401(k) or a 403(b), allow you to contribute pre-tax dollars to your account, up to a certain maximum. For 2020, the maximum is $19,500 (up from $19,000 for 2019). Anyone over the age of 50 can kick in an additional $6,500 as a catch-up contribution, for a total of $26,000.
Contributions to Employer-Sponsored Plans
Contributions to traditional 401(k) or 403(b) plans are made through regular paycheck withholding and offer a direct dollar-for-dollar reduction to total taxable income. (Another version of these plans, the Roth 401(k) or Roth 403(b), doesn't provide any upfront tax benefit but does allow for tax-free withdrawals later on.)
If an employer-sponsored plan isn't available to you, consider a traditional IRA instead. Your contributions will be made with pre-tax dollars, resulting in a direct reduction to your taxable income for the year and ultimately to your total tax liability. For 2020, your contributions cannot exceed $6,000, with an additional $1,000 allowed for those age 50 and above. (As with 401(k) and 403(b) plans, there is also a Roth IRA, without any immediate tax benefit.)
Profit From Investment Losses
Selling off investments that have declined in value since you purchased them can also help you reduce your tax liability for the year—a strategy often referred to as tax loss harvesting. These investment losses can be written off against your investment gains or other income up to a certain limit each year, currently $3,000. What's more, any amount you can't use this year can be carried forward to future years, reducing your taxes then, as well. Conversely, it can be beneficial to delay selling an appreciated asset and avoid being taxed on your gain, especially in a year when your taxable income is already high.
The charitable contributions you make during the year can reduce your taxes—but only if you itemize deductions.
Donate to Charity
If you itemize deductions on your tax return, as opposed to taking the standard deduction, making contributions to qualified charitable organizations can also reduce your taxes. Contributions can be in the form of cash or goods, such as used household items. However, any donation that has a value exceeding $250 requires a receipt to be a valid deduction, and donations over a certain percentage of your adjusted gross income are limited, depending on the type of organization.
For more about these and other strategies for reducing your tax bill, it's often a good idea, and well worth the money, to consult a CPA or other knowledgeable tax pro.
Mark Struthers, CFA, CFP®
Sona Financial, LLC, Minneapolis, MN
If you’re in a high-deductible health insurance plan, you can open a health savings account (HSA); contributions and distributions are tax-free when used for medical expenses. The same goes for 529 Plans, used for educational expenses. Taxes on the interest earned by Series EE savings bonds can be deferred for 30 years, or until you redeem them. You can avoid taxes on appreciated assets by gifting them to someone, within gift-tax limits. Whenever possible, hold heavily taxable assets in tax-deferred retirement accounts. Just make sure you are not passing up good investment choices or strategies just to avoid giving the IRS its due. Many clients will cut their tax bill to the detriment of sound financial planning. That’s the tax tail wagging the investment dog.