The following is a guest post from Gary Dek from Gajizmo. If you are interested in guest posting at Club Thrifty, please see our guest posting guidelines.
If you are like every other American, you’re constantly trying to find new and legal tax strategies to lower your liabilities to the government. Some tax deductions and credits only work for individuals who itemize their taxes while others can work even for people who use the 1040EZ return. One of the easiest ways to pay lower taxes is to choose the right tax form. If you do not have a lot of deductions, the EZ may actually give you a better refund, but if you are eligible for a lot of tax credits and deductions, it is usually best to itemize your return on the 1040 long form. Here are a number of ways you can pay less taxes every year regardless of whether the IRS changes its rules and regulations.
A Quick Explanation of Tax Exemptions, Deductions and Credits
Tax exemptions and deductions are deducted from your annual gross income (AGI) and you pay taxes on the adjusted (reduced) gross income. The amount of the standard exemption varies from year to year, but it is deducted for you, your spouse and any eligible dependents. Tax credits are added to the amount of taxes you paid, so if you paid $10,000 in withholding tax, and you received $5,000 in tax credits, you will be credited with payment of $15,000 in taxes. If you already paid more taxes than you owe, the credit will be added to your tax refund.
However, as great as a tax refund sounds, I always prefer owing the government money at the end of the year than them refunding my own money back to me, assuming I don’t have penalties or interest payments levied against me. Why do I prefer it this way? Because I can use the capital throughout the year to invest, get a return, and then effectively increase my cash flow. For example, if I owe $10,000 at the end of the year in taxes to the U.S. government and throughout the year, I’ve invested that money and received 5% yields on safe investments, or 16% which the S&P returned last year, I will have made an extra $500, or $1,600 from the stock market. I can still pay the government their $10,000 share, but the net proceeds will now only be $9,500, or $8,400 from my bank account. Again, the important relationship between time and money – cash now is worth more than cash later.
Choose The Right Filing Status
The right filing status can make a difference in the amount of taxes you pay, especially if you file your return on a short form. If you are single, filing as the single head of a household can significantly reduce the amount of your tax liability. Check with a tax professional to find out which filing statuses you may qualify for and which to choose to get the biggest tax break, but generally speaking, most single individuals can claim at least 2 exemptions on their W-4 form. Additionally, most people can opt for a couple of different filing statuses, like married filing separately or married filing jointly, so choose the one that saves you the most money.
Do Not Pay Off Student Loans Early
While it is advisable to pay off high interest debt as quickly as possible, the interest from student loans is tax deductible and is probably amongst the lowest interest rate debt you have. When deciding to pay off student loan debt versus credit card debt, always pick credit card debt since the interest rate on student loans is likely less than 10%, while credit card debt is probably in the high teens, at least. Carrying student loans can lower your tax burden, especially if the interest payments are significant. You cannot deduct all the interest you pay and may not be eligible for this deduction if you are in a higher tax bracket, but if you do qualify for the deduction, you can save money on taxes. Just remember, paying no interest is always your best bet, so don’t feel the need to keep a high balance of student loan debt and keep your cash parked in a checking account with no interest accruing just for the sake of having a tax deduction. Research and consider other short-term investment options.
Buy or Refinance a Home
If you have a mortgage, your mortgage interest is tax deductible. In the first few years, most of the payments made on a mortgage go toward interest so the deduction can be sizable. Even better, property tax payments are also deductible, and if you paid points to your mortgage broker or lender when buying or refinancing the house and getting a loan, those fees can be deducted for the year in which the house was bought. The greater your tax liability, the greater the benefits of owning your own (mortgaged) home. These are some of the considerations and factors to keep in mind when you ask yourself “should I pay off my mortgage early?”
Open or Fund A Retirement Account
Contributions to regular IRAs and 401(k)s are tax deductible, with a maximum deduction of $5,000 for people 49 and under and $6,000 for people over age 50. You must have earned income for the year in which you take the deduction and it does not apply to Roth accounts. Earned income includes salaries, commissions, alimony, tips, bonuses or income from self-employment. A spouse’s income counts as earned income for couples that are legally married.
In addition to IRA accounts, fully fund your 401K. The more you contribute, the more you can reduce your AGI and the amount of income used to calculate your taxes. Furthermore, your 401K grows tax-deferred until you withdraw the funds during retirement, when you will likely be in a lower tax bracket.
Tax-Deductible Charitable Donations
If you donate money or goods to a non-profit organization or tithe to your church, you can usually deduct the amount from your income. The non-profit must prove they have 501(c)(3) tax status and you must have a receipt for the donation. There may be a maximum deduction for charitable expenditures so it is a good idea to discuss this type of deduction with a tax expert. Other deductions may include car mileage on your personal vehicle for charitable work like a Meals on Wheels program or transportation for shut-ins.
Medical and dental expenses for you and your dependents are tax deductible if they exceed 7.5% of your adjusted gross income. It may be possible to include medical expenses which were paid for a parent, even if the parent is not an eligible dependent on your tax return. Eye glasses, false teeth and expenses not covered by insurance are deductible and transportation to and from medical appointments can be included in this deduction. Medical insurance costs that are paid from your after tax income are deductible.
Go Back To School
Got a yen to learn about accounting, auto shop, Chinese pottery, Renaissance art, real estate, or aerospace? Taking a college class may make you eligible for the Lifetime Learning Credit. This credit is available even if the class is not related to your current career. If your income is above the level for the credit, you can deduct tuition and fees for continuing education classes at a college whether or not the expenses are work-related.
Energy Tax Credit
If you need to buy a new major appliance (refrigerator, washer, dryer, water heater) you may be eligible for the energy tax credit if you choose an energy-efficient model. Other qualified items include HVAC systems, thermal insulated replacement windows and home insulation. Buying a new car? Some hybrid models also qualify for this tax credit. There is a cap on the credit and you only get a percentage of the total expenditure back, but saving money on energy and taxes? Why not go green.
Earned Income Credit
Families whose income falls below levels set by the government may qualify for the earned income credit. In order to claim the credit, the tax filer must choose the head of household filing status and have an eligible dependent. The amount of income that qualifies for this credit depends on family size and income requirements are subject to change every year.
Have Your Tax Return Done By A Professional
Tax law is complex and changes every year, making it difficult to keep up with allowable deductions and new tax credits. One of the best ways to save money on your income tax is to have your return prepared by a professional who is knowledgeable about the tax code. It may cost you some money, but in most cases an accountant or trained tax preparer can save you more on taxes than the amount you pay them for preparing your return. Not only that, most professionals will help you explain deductions and credits claimed on returns if you should be audited by the IRS.
IRS and Online Resources
The IRS website offers free help to people who prefer to prepare their own returns. TurboTax online is another great resource if are into DIY – my experience with them has always been great and they walk you through your return, step-by-step, asking if you qualify for certain deductions to ensure you get the most money back.
(Editor’s Note: Club Thrifty also highly recommends using H&R Block At Home for DIY tax preparation. Please note that Club Thrifty may receive a small referral fee if you choose to purchase either the TurboTax or H&R Block tax prep programs after clicking the links provided.)
Gary Dek is a personal finance blogger who focuses on investing, saving, credit/debt, real estate, career and education advice, and insurance at Gajizmo.com. Gary has worked at an internet company on their M&A team, as well as two private equity firms in California.