It’s tax season again and I thought I would take a minute to discuss the main (legal) ways to reduce your tax bill and be good to your wallet as well.
The best way to reduce your taxable income (i.e. the amount of income the IRS will apply your tax rate to), is to have as many legal deductions as possible. Some require you to itemize to receive the deduction.
I do not want get into exemptions and tax credits here as it is very arcane and I’m not an accountant anyway. I just want to talk about some common and easy ways to reduce your overall taxable income that most of you can apply right away. Yes, I know it’s almost April 15th, but there’s always next year.
The three common ways to increase or create deductions are the following (there are more if you are self-employed, but I will only talk about the ones common to everyone):
- CONTRIBUTE TO RETIREMENT and/or Contribute to a 529 plan – no need to itemize to get the benefit
- Mortgage interest deduction – need to itemize to get the benefit
- Charitable giving – need to itemize to get the benefit
Number one is my favorite way to reduce your tax exposure. If you can manage it from a cash flow standpoint, contribute the maximum you can to your employer’s retirement plan (or yours if you are self-employed). The more you sock away the better it is from a tax and retirement perspective.
Mortgage interest deductions are great, but if you are not in a position to own a home for cash flow reasons or because you lack the down payment necessary, this option won’t be available to you. Owning a property that is rented out all of the year, has a different tax treatment than the mortgage of your main residence, which means buying a small place to rent out might not afford you the tax cover you want.
Charitable giving benefits everyone. You get a deduction and you’ve helped a worthy cause. The key to remember here is that not all causes you deem worthy are considered charitable to the IRS. Contributions to a political group or party are not considered a charitable deduction. Make sure the group you want to contribute to can give you a letter with their letterhead, saying you have given a donation to a group recognized by the IRS as being a charitable organization.
Also, remember, your TIME is not a deductible gift even though it is a charitable one. If you help serve meals at a food bank or some other cause where you donate your time, you cannot do a calculation that equates your time to money (like multiplying the hours you volunteer by your professional hourly rate… sorry… no go).
Some other things that help are index funds. If you have investible assets outside of your retirement or 529 funds, you can invest them in index funds, which generally, have fewer taxable events (trades) than regular mutual funds where you have to pay taxes on gains from trades within the fund (much longer story, but trust me on this).
I’m sorry to say there aren’t many ways for plain old regular people to reduce their tax bills legally, but if you max your retirement contributions and have a good mortgage, you are way ahead of the game.