Let's look at some ways your approach to income and taxes can be keeping you down.
1. You consistently get a refund
If you get a refund at the end of the year, it may feel good to get that sudden chunk of money, but you are really cheating yourself. You are having too much tax withheld. You can fill out a new W-4 form with your employer to have less tax taken out so you will have more cash on hand each month.
2. You don't have a retirement account
If you have an employer-sponsored retirement plan such as a 401(k) or 403(b) plan, you can reduce your taxable income by the amount you put into the plan. You can contribute up to $19,500 in 2020 plus $6,500 more if you are age 50 or older.
If you don’t have an employer-sponsored retirement plan, you can save money on taxes by putting money into a traditional Individual Retirement Account (IRA). The annual contribution limit is $6,000, but you can contribute an additional $1,000 if you are age 50 or older. Because you aren’t participating in an employer plan, you can fully deduct your IRA contribution, so you do not pay taxes on the amount you put into an IRA until you withdraw it during retirement.
That's for a traditional IRA. A Roth IRA is the opposite. You pay taxes now but not later when you take the money out. A Roth IRA can save you money later if you think you will be in a higher tax bracket. Withdrawals from your Roth IRA are federal income tax free if you have had a Roth account for five tax years and are either age 59 ½ or older, disabled, die or take up to $10,000 for a first-time home purchase (lifetime limit).
3. You don't invest
Investing your money wisely can reduce your taxes dramatically. If you buy municipal bonds, for example, the income from these bonds is tax-free (but may impact the taxation of your Social Security benefits and may be subject to Alternative Minimum Tax). Also, capital gains from investments are taxed at a lower rate than regular income. Using a good tax strategy can create income from investing that actually saves you money on taxes.
And remember, depending on the investment, if you don't take any money out of your investments at all, your profits accrue without you paying taxes on them. You will not pay tax until you take the money out.
4. You don't use tax credits
Several tax credits are available to taxpayers.
The earned income credit of as much as $6,920 helps people in lower tax brackets. Your credit amount depends on your income.
You can benefit from laws that were intentionally created to help you save on taxes.
You may also be eligible for a “Saver’s Credit.” (The official name from the IRS is “Retirement Savings Contribution Credit.) The credit covers contributions to an employer-sponsored retirement plan or IRA. This allows taxpayers to deduct a percentage of their retirement savings from their taxes. The amount you can take off depends on your adjusted gross income (AGI).
Here is how it breaks down.
In 2020, the IRS allows a credit of 50% of the retirement investment amount for:
- A couple filing as “married filing jointly” that makes no more than $39,000.
- A person filing as “head of household” who makes no more than $29,250.
- Those who file as single, married filing separately, or as a widow/widower and make no more than $19,500.
The IRS allows a credit of 20% of the retirement investment amount for:
- A couple filing as “married filing jointly” that makes between $39,001 and $42,500.
- A person filing as “head of household” who makes between $29,251 and $31,875.
- Those who file as single, married filing separately, or as a widow/widower and make between $19,501 and $21,250.
The IRS allows a credit of 10% of the retirement investment amount for:
- A couple filing as “married filing jointly” that makes between $42,501 and $65,000.
- A person filing as “head of household” who makes between $31,876 and $48,750.
- Those who file as single, married filing separately, or as a widow/widower and make between $21,251 and $32,500.
No Savers Credit is allowed for:
- A couple filing as “married filing jointly” that makes more than $65,000.
- A person filing as “head of household” who makes more than $48,750.
- Those who file as single, married filing separately, or as a widow/widower and make more than $32,500.
You can also use the American opportunity credit, which cuts up to $2,500 for qualified students, and the child and dependent care credit that reimburses money you pay to a care provider.
The laws regarding credits change frequently, so ask an accountant which ones are available in any given year.
5. You don't use a medical flex care plan
This plan allows you to set aside money to use for medical bills. The money you put in the plan is not taxed by the federal government for income tax purposes or Social Security/Medicare tax purposes. Be sure and check the rules of your plan. Depending on your health care plan and medical spending account, the plan may have a "use it or lose it" rule that expires at the end of the year or only allows you to roll over a certain amount to the next year.
6. You don't deduct heavy medical expenses
In 2020, if your medical costs exceed 7.5% of your income, you can deduct them. You have to itemize to take this deduction. It can save you quite a bit on taxes during a year when you have high medical bills.
7. You don't take deductions for your home
If you own your home, the interest you pay on your mortgage is tax deductible. The same applies to a second home, as long as you don't rent it out. You can no longer deduct interest paid on a home equity line unless the loan is used for home improvements.
If you just bought your home, you can deduct "points" you had to pay the bank to get the loan. If you paid this fee for refinancing, you can deduct that.
You can get energy credits for expenses to make your home more energy efficient. Check to see which improvements qualify.
You can deduct your state property taxes from your tax bill. This can result in significant savings. Beginning in 2020, your federal income tax deduction for state and local taxes, including income tax and property tax has been capped at $10,000 per year.
8. You have a hobby instead of a business
If you have a hobby, you might find ways to make it a business. If you can make sales, you can deduct the cost of supplies, materials, transportation, and the cost of the space to conduct your business. You may be cheating yourself out of deductions by pursuing a hobby that could be a commercial enterprise. Even if you operate it on a small scale, the deductions can be significant.
9. You have high credit card debt
The interest on credit cards is not tax-deductible. It can be wise to get a consolidation loan at a lower rate than your cards currently have. This will reduce the amount you pay each month and leave more money in your pocket.