How to (very legally!) Minimize Your Tax Bill

Filing our taxes can be an arduous process that we often try to get through as quickly as possible. But before we hit submit or give our accountants the final okay, we want to make sure we are minimizing our tax bill (or maximizing our tax return).

Why? First and foremost, that means we’ll have more money in our pockets to allocate towards our goals. And second, if we don’t, we’re paying more taxes than we need to.

Here are some ways to minimize your tax bill or increase your tax refund. If it’s too late to utilize some of these strategies, you can plan ahead to maximize them next year.

Max out your IRA.

Many of us don’t realize that we actually have until the filing deadline, April 15th, to max out our IRAs for the previous year. You have until April 15, 2021 to max out your 2020 IRA contributions. Yay! There’s still time.

Contributions to a Traditional IRA (where the money goes in pre-tax) can reduce your taxable income. Contributions to a Roth IRA won’t give you a deduction, but you may qualify for the Saver’s Credit (more on this below).

The contribution limit for an IRA in 2020 and 2021 is $6,000 - or $7,000 if you are over 50 years old.

What exactly is a tax deduction?

We pay taxes on our taxable income, not our total income. A tax deduction decreases our taxable income. For example, a $1K tax deduction reduces our taxable income by $1K. Instead of being taxed on $65K, we’re now taxed on $64K.

If your effective tax rate is 30%, then a $1K tax deduction saves you $300 ($1K x 30%). This will either result in you paying $300 less in taxes or receiving $300 more in your tax return.

Max out your HSA.

Pre-tax contributions to a Health Savings Account (HSA) can also reduce your taxable income (which means less in taxes or a higher tax return). The contribution deadline is also the tax filing deadline - April 15th.

There are some other great benefits to having an HSA as well, like tax-free investment growth.

Contribute to an employer sponsored FSA.

For those who have a Flexible Spending Account (FSA) available through work, you can contribute to reduce your taxable income because contributions are pulled from pre-tax dollars.

You can use these accounts to reimburse us or pay for qualified medical expenses. There are also Dependent Care FSAs you can use for child or other dependent care expenses.

The caveat is that there usually is a 'use-it-or-lose-it' component to it. Some plans allow you to roll over up to $550 of our FSA spending to the next year and / or have an extended deadline, but otherwise, any amount that goes unused disappears.

Due to pandemic, the IRS is offering more leniency on both the carryover limit and deadline to use funds. Since these are employer plans, it’s important to look into the details of your specific plan.

Know and use your tax deductions.

This one is juicy! Depending on your financial situation, some of these tax deductions may reduce your taxable income (see the definition of a tax deduction above).

There are hundreds of options for deductions. Here are some of the common ones:

Charitable contributions. Keep track of all the charitable contributions you make throughout the year.
Student loan interest. Interest paid on student loans is tax deductible.
Charity and medical miles. Miles driven to volunteer and for medical purposes can be tax deductible. Medical miles only qualify if your medical expenses were over 10% of your adjusted gross income. Charity miles qualify for $0.14 per mile.
State sales tax. Using this calculator you can find out how much your state and local tax you can deduct.
Mortgage interest. A deduction on interest on any loan(s) you took out to purchase, build, or improve your home residence on loans of up to $750K.

What’s adjusted gross income?

Let’s start with our gross income. Our gross income is the total amount we earned through our salary, interest, rental income, business profit, and any other wages. It’s the total of what we earned in a given year before we paid for taxes and other expenses.

To calculate our adjusted gross income (AGI), we take our gross income and adjust it for certain deductions. Our AGI is what we’ll use when filing our taxes and will determine if we qualify for certain deductions and credits.

If you received a COVID stimulus payment in 2020, you do not have to claim that as taxable income.

Be strategic with timing

To maximize deductions in one year, you can plan to make deductible purchases before year-end. For example, you can pay January’s mortgage payment before December 31st to deduct more mortgage interest.

If you haven’t spent the funds in your child or dependent care FSA (max of $5,000), you can prepay expenses where possible. You can contribute to more charitable organizations or even make purchases for your business if you’re self-employed or have a side hustle.

When it comes to certain expenses, specifically business related expenses, there’s a popular belief that expenses that are tax deductible are free. That’s sadly not the case. If I wasn’t going to buy a new printer for my home office anyway, I won’t be saving money if I buy one to reduce my taxable income. It can be helpful to think about these expenses as items we get on sale (or for a discount in the same amount as our tax rate).

Understand potential tax credits.

Tax credits are especially exciting because rather than giving us a discount on the things we were purchasing or spending on anyway (deductions), these are dollar-for-dollar reductions to our tax bill (or additions to our tax refund).

A $200 tax credit means either $200 less in taxes I’m going to pay or an additional $200 in a tax refund.

There are many options for credits. Here are some of the common ones:

Earned Income Tax Credit. Between $529 and $6,557 depending on income, number of children and marital status. See income limits here.
Child Tax Credit. This could get you up to $2,000 per child under 17 and $500 for a non-child dependent. The higher your income, the less you’ll qualify for. You may qualify if your AGI is less than $200,000 ($400,000 for married filing jointly).
Child and Dependent Care Credit. 20-35% of dependent care expenses up to $3,000. Goes up to a maximum of $6,000 for two dependents or more. This credit decreases as you earn more income, and it will reduce your tax bill but won’t contribute to a refund.
Adoption Credit. For the 2020 tax year, this covers up to $14,300 in adoption costs per child.
The American Opportunity Credit. Up to $2,500 per student enrolled in a four-year college for tuition, books, and other qualified expenses.
Lifetime Learning Credit. Up to $2,000 per person for tuition, books, and other qualified expenses for an undergraduate, graduate, and non-degree courses.
Energy Saving Home Improvements. Up to 30% of the cost of the energy saving home improvements like solar panels.
Credit for Electric Vehicles. Up to $7,500 for purchasing a new electric vehicle.
Savers Credit. Up to $1,000 credit for contributions to retirement accounts for joint filers with income under $65,000, head of households with income under $48,750, and single filers with income under $32,500.

Make sure you’re choosing the most beneficial filing status.

Choosing your filing status can affect how much you pay in taxes and what kind of return you get. If you’re married, your choice is to file jointly or separately (married, filing separately).

There are many factors to consider, including income, deductions, and tax credits. The simplest way to decide whether to file a joint return or separately is by preparing your taxes both ways and choosing the filing status that generates the most favorable outcome.

If you’re single and have a dependent (like a child or parent), you can choose to file as Head of Household, which often comes with tax benefits.