(Steve is a guest blogger from Think Save Retire.)
Here we are, a favorite time of year for the majority of tax-paying citizens of the United States! This time of year saddles some Americans with a huge IRS tax bill, but for others who remember a few easy tips, tax season can turn into just another day at the office and might even include a refund check from your friendly government.
The bottom line before we get started: Yes, the tax code is terribly complex, but a few techniques can help to keep this process simple and pain-free. The key is to know your financial situation well enough to take full advantage of what the tax code provides.
Let's get started. Below are four ways to ensure that your tax burden makes the most sense for you and your family.
When I was younger, I used to allow the government to withhold more money from my paycheck in order to maximize the refund I received every year. But eventually, I got wiser and realized that I don't want the government handling any more of my money than necessary, so I balanced my withholding very close to the breaking even point each year - meaning I keep more of my earnings throughout the year rather than letting the federal government hold onto them for me until the following April.
Remember, any extra money that the government keeps for us until refund time earns no interest or capital gains, and through the power of inflation, that refund check may not hold quite as much buying power as it would have had if that money was invested throughout the year instead. Whenever possible, resist the temptation to let the government withhold extra money from your paycheck in order to ensure a refund in April. Instead, adjust your tax withholding lower and setup automatic bank transfers to funnel that money into a savings or investment account before you have a chance to spend it.
My goal is to withhold just enough money throughout the year to stay within a couple hundred dollars either way of my legal tax burden. After all, the last thing that I want is a big surprise on tax day. When it comes to taxes, I don't like surprises!
Use the IRS Withholding Calculator to help figure out how to adjust your withholding amount.
I never truly understood what "pre-tax" meant until my late 20s, but it is a critical component to help reduce our tax burden to the government. In simple terms, "pre-tax" refers to earnings (ie: a yearly salary) before taxes have been removed. But, it gets a little more interesting than that.
The government calculates every individual's tax burden based on "taxable income", which amounts to the income we generate after legal tax deductions and retirement savings have been removed. The idea is to reduce our taxable income as much as possible by maximizing pre-tax deductions, which ultimately lowers our tax responsibility come April.
For example, let's take a situation with a base salary of $100,000 a year. Without any pre-tax deductions, our taxable income is $100,000 (minus the standard deduction). In other words, the large majority of our income remains taxable. Paying taxes on ALL (or most) of our income is a situation that we want to avoid, and we can do just that through pre-tax deductions like an employee-sponsored 401k or Health Savings Account (HSA). Both of these savings accounts reduce taxable income by subtracting the amount contributed to these accounts from your pre-tax earnings.
In 2015, individuals could contribute up to $18,000 into a 401k account (or up to $24,000 if you're over 50). Our taxable income gets reduced by the amount that we contribute. If we contributed the entire $18,000, then using our previous scenario of a $100,000 yearly salary, our income gets effectively reduced to $82,000 just from our 401k contributions. We pay taxes on $82,000, not $100,000. This can significantly reduce our yearly tax burden.
Whenever possible, focus on reducing your taxable income as much as you can by contributing to your retirement accounts. Not only will this technique reduce your tax burden, it will also better prepare you to retire in financial comfort.
In a similar fashion to the 401k tip above, another excellent way to reduce your taxable income is by claiming investment losses on your tax filing. This can turn into a valuable tool to help reduce your tax burden.
It works like this: If you sold stock at a $1,500 loss during the year, that $1,500 can be claimed as a loss on your taxes, reducing your taxable income by the amount that you lost - in this case, $1,500. Your investment losses can also offset your gains. For example, if you sold stock at a $10,000 profit as well as another stock at a $1,500 loss, only $8,500 will be taxable as income.
In some situations, it may benefit investors to sell under-performing stock at a loss to reduce taxable income, especially if that means a shift into a lower tax bracket.
Note that only $3,000 can be claimed as a loss each year. However, losses can be carried over into the following year if they exceed the $3,000 limit.
Depending on a variety of factors (like income, children, age, etc), you may be eligible for one or more tax credits and deductions. For example, if you bought a hybrid or electric car in 2015, check out the Alternative Motor Vehicle Credit or Plug-In Electric Drive Vehicle Credit.
Here are some of the more common tax credits and deductions:
The Standard Deduction is a deduction that tax filers can claim and is based on your filing status (ie: Single, Head of Household, Married Filing Jointly, etc).
Many donations to nonprofit and charitable organizations can be deducted from your tax returns. Donations must be made to IRS-approved charitable organizations, so use the EO Select Check tool provided by the IRS to search for approved entities.
For lower income earners, the Earned Income Tax Credit is a well-known option. It reduces taxable income even further and may result in a refund from the federal government.
If you have children under the age of 17 whom you claim as dependents on your tax return, they can earn you up to $1,000 each through the Child Tax Credit.
Did you install solar panels or a fuel cell power system on your home in 2015? If so, you may be eligible for the Residential Energy Efficient Property Credit.
If you use a vehicle for business, charitable, medical or moving purposes, the government will reimburse your mileage. For example, in 2015 the government provided 57.5 cents per mile for vehicles driven for business uses and 23 cents a mile for medical or moving purposes.
Believe it or not, taxpayers can also claim moving expenses incurred to take a first job if the move was more than 50 miles. The government will reimburse you 23 cents a mile.
If you have a room in your home used exclusively for work, take a look at the Home Office Deduction.
Remember, since Emancipation Day (a Washington D.C. holiday) falls on April 15th, the tax deadline to file 2015 taxes is April 18th, 2016. Residents of Maine and Massachusetts get another day due to the Patriots' Day holiday that falls on the third Monday of April.
Do you have any other techniques for reducing your tax burden? If so, comment below and let's hear 'em!
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