The tax code is complicated.
A complicated tax code means filing taxes can be a headache, or for some of us a migraine.
The one good thing about the complicated tax code is that it creates opportunities to pay less in taxes. Legal opportunities.
In fact, the government has intentionally built in these opportunities because it creates incentives for good behavior. This includes saving for retirement, building a medical emergency fund, and donating to nonprofits.
Due to the content of this post, before we get started I want to give a quick disclosure. I am not a tax accountant or a certified financial planner. This post shouldn’t be taken as advice for your specific situation, and you should always consult your CPA and financial advisor on your specific financial situation. You can also read our full disclosure here.
With that out of the way, I first want to share why my wife and I personally care about saving money on taxes, other than the obvious benefit of having less money going out the door.
Why I Love Lowering My Taxable Income
One unique reason I get so excited about talking about taxes is the fact that my family is one of the over one million student loan borrowers who have made at least one qualifying payment towards Public Service Loan Forgiveness (PSLF).
I go into more detail about our situation in my post I can afford to pay off my student loans, but I won’t: here’s why. In general, though, anyone pursuing PSLF has an incentive to lower their Adjusted Gross Income, or AGI, as much as possible. The lower your AGI, the less you pay towards your student loans. The less you pay towards your student loans, the more you benefit from having your loans forgiven.
Even if you aren’t trying to maximize Public Service Loan Forgiveness there are still good reason to take advantage of opportunities to save money on taxes. There are millions of people who are paying for qualified medical expenses like doctors’ bills or prescriptions who could be using pre-tax money, but instead are paying after taxes.
It’s also worth noting that there are some situations, such as qualified medical expenses, where you truly can use pre-tax income or investment gains, but in many cases you are deferring taxes. For example, if you put $10,000 into a 401(k) retirement account today, you don’t get taxed on that income today. But you will eventually get taxed on that income when you withdraw it. Whether the tax rate is higher or lower today or when you withdraw the money is unknown.
Let’s go over some of the examples where you can save money on taxes this year, either through deferring taxes or through truly paying for expenses with pre-tax income. Well start with the more straightforward options and move to some that are a bit more obscure or complicated.
Contribute to Employer Retirement Accounts
Employer retirement accounts include the 401(k), 403(b), and the solo 401(k).
The difference between a 401(k) retirement account and a 403(b) retirement account is simply type of employer. A 401(k) is used by for-profit companies and a 403(b) is used by nonprofits and government organizations. They are very comparable. Self-employed people aren’t left in the cold, as they also have a comparable option in the solo 401(k).
The IRS sets employee contribution limits for 401(k)s, and the limit for 2020 is $19,500. Those 50 and older can contribute up to an additional $6,500.
The money you deposit in your 401(k), 403(b), or solo 401(k) is pre-tax. That means each dollar you contribute lowers your taxable income by a dollar.
Once you reach the age of 59 1/2 you can start withdrawing from a 401(k) without an early withdrawal penalty. For tax purposes your withdrawals will be treated as ordinary income. If you withdraw prior to the age of 59 1/2 you will have to pay income taxes on the withdrawal and pay a 10% early withdrawal fee. There are some exceptions to the penalty if you retire at age 55 or later.
Contribute to a 457 Plan
If you are eligible to contribute to a 457 plan you have even more options available to you. This is a tax advantaged deferred-compensation retirement plan available to governmental and some nongovernmental employees.
The Contribution limit for a 457 plan is $19,500 in 2020. Those 50 and older can contribute up to an additional $6,500. The big benefit of a 457 plan is that you can contribute to both a 457 plan and a 403(b) or 401(k) plan.
If you are working towards PSLF, and have access to both a 403(b) and 457 plan, for example, you could contribute $19,500 towards a 403(b) and $19,500 towards a 457 plan for a total of $39,000. And that’s all before any additional opportunities.
Contribute to a Standard IRA
Another opportunity to defer taxes is through an Individual Retirement Account, or IRA. With an IRA you have the option of contributing to a Roth or a Standard IRA, depending on your income.
You contribute to a Roth IRA with after-tax dollars, meaning it won’t save you any money today. On the flip side, though, you could save a lot of money down the road because you can take out any money – including gains – tax-free.
If you are looking to lower your taxable income this year, though, you will want to take a look at a Standard IRA. Contributions go into a Standard IRA pre-tax, resulting in lower taxable income.
The contribution limit for both a Roth and Standard IRA is $6,000, or $7,000 for those 50 and older. Roth IRA contributions may be limited based on your income and filing status.
Contribute to a Health Savings Account (HSA)
Health Savings Accounts, or HSAs, are a great opportunity to shield income from taxes. These are unique in the sense that unlike the retirement accounts we’ve talked about so far HSAs can be a way to avoid taxes on income altogether, not simply deferring taxes to a later date.
The “triple tax advantage” of HSAs include:
- Contribute funds tax-free
- Withdraw funds tax-free when used for a qualified medical expense
- Invest funds after reaching a certain balance (i.e. $1k or $2k); investment gains are not taxed when withdrawn for qualified medical expenses
For 2020 the IRS has set the contribution limit for HSAs to $3,550 for an individual or $7,100 for a family. For those over the age of 55 there is an opportunity to contribute an additional $1,000. You must have a High-Deductible Health Plan (HDHP) to be eligible to make contributions.
Your HSA stays with you. There is no “use it or lose it,” and it doesn’t matter if you switch to a different health plan.
For a more thorough overview check out our 2020 Guide to Health Savings Accounts.
Realize Investment Losses
I don’t want to jinx us, but it’s been a little difficult to realize investment losses over the past five to ten years. The stock market returned nearly 30% on average in 2019.
Don’t get me wrong: not having investments to sell at a loss is a good problem to have.
But if you did own stock that lost value, one option to lower your taxable income is to sell the shares at a loss and offset gains. You can also carry forward these losses to future years. If your losses are greater than your gains by more than $3,000, the losses in excess of $3,000 can be carried to future tax years.
Contribute to a 529 Plan
A 529 plan is operated by a state or educational institution that offers tax advantages when used for college savings. There is quite a variety of 529 plans as each state typically offers their own plan, but you don’t have to go with your state’s plan. (Simple enough? Kidding.)
I won’t get into the pros and cons of each state’s plan and which is better for who, but let’s talk about them at a high level. Contributions are not deductible, but earnings are not subject to federal tax (and typically not state taxes either) when used for qualified education expenses of the designated beneficiary. These expenses include things like tuition, fees, books, and room & board.
Like Health Savings Accounts, 529 plans give you the opportunity to not pay taxes on a portion of your income. They aren’t as advantageous as HSAs because contributions to a 529 plan are not pre-tax, but the investment gains are.
I personally think most people would be better off focusing on other financial goals other than contributing to a 529 plan. I go into more detail in my post Before You Contribute to a 529 Plan – Read This
Make Charitable Contributions
Charitable contributions can lower your taxable income when you itemize your deductions. But the 2017 tax law nearly doubled the standard deduction to $24,000 for a couple and $12,000 for a single tax filer. This increased to $24,400 and $12,200, respectively, in 2019. Because of these changes the Tax Foundation estimates that less than 14% of taxpayers will itemize their deductions in 2019.
If you hit the jackpot on a slot machine or have a high income and want to find ways to lower your taxable income specifically on this year’s tax return, you can consider a donor-advised fund.
Essentially someone can make a contribution in one year, get the tax benefit in that year through itemizing their deductions, and in turn make grants from the fund at any point in the future, to as many organization as they want.
If you take this route you definitely want to get your tax accountant and lawyer involved.
I’m sure I’m only scratching the surface with this list, but for a majority of individuals these options are what will be used to lower taxable income. A good tax accountant can help you navigate the inevitable complexities of tax strategy, but even contributing to a tax-deferred retirement account like a 401(k) or 403(b) is a good first step.
I will end this post by reminding you to discuss your personal financial situation with your accountant and financial advisor to see how these options could potentially fit in your current plan.
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Another reason I like the HSA is that there are no convoluted income requirements that can come with IRA’s. As long as you have a qualifying HDHP, you can max out an HSA no matter what your income is.