You can legitimately reduce the tax you owe by planning ahead.
By keeping an eye on the tax consequences for your every day financial decisions, you can lower your tax bill. For example, lower taxable income means you pay lower income taxes. You can lower your taxable income by contributing to a tax-deferred retirement account. Your contribution reduces the income that’s reported to the IRS and as a result, the current tax you owe. Any earnings in the account are also tax deferred.
Of course, when you take money out of the account after you retire, you’ll owe tax on the full amount of your withdrawal. But you may be paying at a lower tax rate when you take money out than you were when you put it in. In some sense it’s a gamble, but thanks to the power of compounding, it’s possible to come out significantly ahead, even if tax rates have increased.
Or, if you want to avoid mandatory taxable withdrawals from your retirement savings, you might put your retirement money in a tax-free Roth IRA. While you’ll contribute after-tax income, your withdrawals will be completely free of federal income tax provided your account has been open at least five years and you’re at least 59½. Similar tax savings are available with a Coverdell education savings account (ESA) or a 529 college savings plan.
Investment decisions have tax consequences, although minimizing taxes should be only part of your overall investment strategy. The investment risk you’re willing to take, the return you can reasonably expect, and the impact of the transaction on your portfolio diversification are all at least as important as the tax implications.
Here’s what you need to know:
So, as you make investment decisions, you may want to postpone sales when feasible to qualify for the long-term gain rate and sell some assets with capital losses at the end of the tax year to offset some gains.
If you sell an investment that has lost value to offset your capital gains, but plan to buy it back because you think it has future promise, you need to be careful to avoid the wash sale rule. In brief, the rule says that a potential offset is disallowed if a substantially identical investment is sold and then repurchased, or purchased and then sold, within 30 days.
If your employer offers a flexible spending account (FSA) as an optional employee benefit, it's a tax-saving opportunity you probably don't want to pass up. An FSA lets you set aside pretax income to pay for uncovered healthcare expenses, including copays, deductibles, prescription drugs, and many over-the-counter medications that meet the IRS standards for treating or preventing disease or illness.
An FSA usually works on a calendar year. To participate you contribute, through payroll deductions, as much as you think you'll spend during the year, up to the maximum of $2,750. If you and your spouse are both eligible to participate, each of you can contribute up the $2,750 limit.
There is one risk: If you don't use the money during the year for eligible expenses, you may forfeit it. Employers, however, may offer either a two-and-a-half month grace period into the following year or allow you to access up to $500 of any unspent money in that year, removing some of the pressure of using up your balance.
You are entitled to deduct gifts you make to qualified charitable, religious, and educational organizations. The way you make the gift can have tax consequences. For example, you’re likely to save on taxes by giving assets you own directly to the organization you want to benefit rather than selling the assets and making a cash gift.
The tax consequences of gifts you give to individuals, such as children and grandchildren, can be reduced as well by making those gifts in certain ways. Among the examples are creating trusts and avoiding the generation-skipping tax. Working with experienced legal and tax advisers as you make your plans is always wise and sometimes essential.Previous: Attracting Employees Next: Tax Brackets and Statuses