1. Identify your tax credits
Tax credits can be the simplest and most efficient way of reducing your tax bill. While tax deductions decrease your taxable income, tax credits apply directly to the tax you owe on a dollar-for-dollar basis.
Example #1—Deductions: You’re married and filing jointly. Your income is $78,900. You have $28,900 worth of deductions. Your deductions reduce your taxable income to $50,000.
- $78,900 income - $28,900 tax deductions = $50,000 taxable income
For your tax bracket, the $28,900 you deducted would otherwise have been taxed at a 12% rate. Thanks to your tax deductions, you’ll save $3,468 on your tax bill.
- $28,900 deductions from taxable income x .12 tax rate = $3,468
Example #2—Credits: Your taxable income is $50,000. In the 12% tax bracket, you owe $6,000 in federal income tax. However, you have three children who are under age 17 at the end of the tax year. As a result, you claim the Child Tax Credit for all three of them. Because your $50,000 in taxable income is well below the $400,000 phase-out threshold, you typically can claim the full $2,000 Child Tax Credit for each child.
- $2,000 per child x 3 children = $6,000 total credit amount
Because the $6,000 is a credit, you can subtract it directly from the amount you owe in taxes.
- $6,000 taxes owed - $6,000 Child Tax Credit = $0.00 taxes owed
Your $6,000 in tax credits means you enjoy $6,000 in tax savings, which is substantially more than the $3,468 you saved with your $28,900 in tax deductions.
Some of the most common tax credits include:
- The Child Tax Credit
- The Child and Dependent Care Credit
- The American Opportunity Tax Credit
- The Earned Income Tax Credit
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2. Put money into a retirement account
Contributing to a retirement savings account can be an effective way to lower your taxable income and decrease your tax bill. The three most popular retirement accounts are 401(k) plans, Traditional Individual Retirement Accounts (IRAs), and Roth IRAs. The main differences between them include when your savings are taxed and how you have access to them.
Employer-sponsored 401(k) plans can be the most efficient way of saving, because many employers match a portion of their employees’ contributions to their 401(k) plans. Financial experts often recommend saving the full amount permitted by the IRS ($19,000 per year for the tax year 2019 or $25,000 per year for taxpayers age 50 and over). At the very least, experts recommend contributing the maximum amount that your employer will match. Otherwise, you’re leaving “free money” on the table.
Traditional Individual Retirement Account (and 401(k)) contributions are commonly referred to as “pre-tax” savings, because the money goes into your IRA account before it is taxed. Such contributions lower your taxable income for the tax year in which they are claimed. You have until the tax filing deadline—not just the end of the tax year—to make an IRA contribution that you can deduct from your taxable income. The investment gains earned by your IRA account will not be taxed each year, so the savings grow tax-free. You only pay taxes on your savings when you withdraw the funds in retirement. The plan with an IRA is that you’ll be in a lower tax bracket when you retire, so you’ll pay a lower tax rate on your withdrawals than you would if you paid tax on the money now.
Roth IRAs also allow the earnings on your savings to grow tax-free. The difference is that you cannot deduct your contributions from your taxable income now. You pay income tax on the funds upfront. However, unlike withdrawals from a 401(k) or traditional IRA, your Roth IRA distributions—including the investment gains you earn—are not taxed when you withdraw the money in retirement.
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3. Fund Your Health Savings Account
Another way to lower your taxable income is to fund a Health Savings Accounts (HSA). As with IRA contributions, you can fund your HSA account right up to the deadline for filing your taxes (July 15 for 2019 taxes filed in 2020) and still apply the deduction to the current tax year. That means you can lower your taxable income and reduce your tax bill well after the end of the calendar year. Medical expenses you can pay with your HSA without being taxed include: deductibles from high-deductible insurance plans, insurance co-payments, over-the-counter drugs, and long-term care insurance.
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