Easy Guide on How to Pay Less Taxes and How to Reduce Your Taxable Income
One thing we know for sure is that in this life we have to pay taxes. There is no way out of it. Unless of course, you want to get in the IRS blacklist.
We all know the feeling of dread every April 15 when Uncle Sam demands his share of our hard-earned money.
But what if I tell you there are a few simple ways to reduce your taxable income? Therefore reducing your tax liability?
Yes, that is right amigos, you can reduce the amount of taxes you owe with these simple easy steps!
From a very young age, I have been very conscious and aware of saving money.
There were a few years during my early career when I went crazy with spending.
I am talking about really bad spending habits.
I went shopping with my best friend and coworker every day.
Talking about peer pressure.
Truly, I cringe every time I think back on those days.
I was going out shopping mostly every day with my friend during lunch hours and sometimes after work too.
But thank goodness I eventually came to my senses.
After having my AHA moment, I decided I was going to save money big time.
I put myself on a budget and started keeping track of my expenses.
As a result, I created an excel spreadsheet where I could track my monthly income and expenses.
I logged every single penny that came in and everything that went out.
Also, I automated my savings by contributing to my employer’s 401(k).
I also changed my W-4 withholdings and started monthly contributions to an IRA.
Money out of sight, money out of mind.
How to Reduce Your Taxable Income
Retirement Savings Plan 401(k), 403(b)
This type of account is an employer sponsor savings plan.
Yor 401k contributions directly reduce your taxable income and the taxes you owe.
For more in-depth information about 401k read my Complete Retirement Guide to 401k For Beginners
A 401k account is also known as 403(b) in the public sector such as hospitals, universities and government agencies.
The maximum limit contribution for 2019 was $19,000.
If you are age 50+ you were allowed to contribute an extra $6,000.
The IRS just announced the contribution limit increase for 2020.
The Contribution Limits for 401(k), and 403(b) Plans in 2020 is as Follows
- $19,500 (an increase of $500 from the $19,000 limit in 2019)
- $6,500 – The catch-up contribution limit for ages 50 and over (an increase of $500 from the $6,000 limit in 2019)
The cool thing about 401(k) is that the money you contribute is taken out of your paycheck before taxes are deducted.
Also, you get to lower your taxable income by the money amount of your contributions…say whaaat?!!
For example, if you max out your 401k contribution, you will be able to reduce your taxable income by $19,500 (in 2020).
But wait… if you are age 50 or more you have even greater savings.
You will be able to reduce your taxable income by $26,000 (in 2020).
Age | Max Contribution | Savings 32% tax bracket | Savings 24% tax bracket | Savings 22% tax bracket | Savings 12% tax bracket |
---|---|---|---|---|---|
49 and below | $19,500 | $6,200 | $4,680 | $4,290 | $2,340 |
50 and above | $26,000 | $8,320 | $6,240 | $5,720 | $3,120 |
Just by making the maximum contribution to a 401k you will be able to reduce your taxes AND save money at the same time.
Individual Retirement Accounts (IRA)
An IRA is a tax-deferred retirement savings account.
Your money grows tax-deferred.
And you don’t pay taxes until you take the money out.
The IRA contribution limit for 2020 is $6,000, the same as in the year 2019 People 50 years of age or older have the option of a catch-up contribution up to $1,000(extra).
Therefore contributing a maximum of $7,000.
Pro-Tip:
Setup the IRA account to automatically deduct the money out of your checking account every month, biweekly, or weekly, whichever way works best for you. Just set it and forget it.
If you contribute annually $6,000 to a Traditional IRA you get to lower your taxable income also well as your AGI (adjusted gross income) by that amount.
It is worth mentioning that the tax deduction does not apply to Roth IRA.
In my Guide to Traditional IRA, you will find more in-depth information, benefits, and advantages of this type of IRA account.
Contributing to an IRA is a win-win situation.
You save money towards your retirement and you get to lower your tax bill.
If you are confused with the lingo and terminology, go take a look at my ultimate guide to investment terms definition.
For example, if you max out your IRA contribution, you will be able to reduce your taxable income by $6,000.
If you are age 50 or more you have even greater savings.
You will be able to reduce your taxable income by $7,000.
Age | Max Contribution | Savings 32% tax bracket | Savings 24% tax bracket | Savings 22% tax bracket | Savings 12% tax bracket |
---|---|---|---|---|---|
49 and below | $6,000 | $1,920 | $1,440 | $1,320 | $720 |
50 and above | $7,000 | $2,240 | $1,680 | $1,540 | $840 |
How to Pay Fewer Taxes and Save Money at the Same Time.
Health Savings Account (HSA)
A Health Savings Account (HSA) for short, is a savings account that allows you to set money aside for medical expenses on a pre-tax basis.
In order to participate in an HSA plan, you need to have a High Deductible Health Plan (HDHP).
The maximum amount you can contribute to an HSA in the year 2020 is $3,550 for self-only coverage and up to $7,100 for family coverage.
The contributions to an HSA plan are not included in your taxable income for federal tax purposes.
Also, the earnings in the account grow tax-free, and if used for qualified medical expenses the distribution is also free of taxes.
For example, if you contribute the maximum to your HSA, you will be able to reduce your taxable income by $3,550 for coverage for yourself only (in 2020) or by $7,100 (in 2020) for health coverage for the entire family.
Coverage | Savings 32% tax bracket | Savings 24% tax bracket | Savings 22% tax bracket | Savings 12% tax bracket |
---|---|---|---|---|
Self $3,550 | $1,136 | $852 | $781 | $426 |
Family $7,100 | $2,772 | $1,704 | $1562 | $852 |
Flexible Spending Account (FSA)
A flexible spending account or FSA for short is a healthcare savings account offered by employers as part of the benefits package.
This is not to be confused with an HSA. Not all employers offer HSA.
An FSA allows an employee to use pre-tax dollars from your paycheck, to pay for eligible and qualify health care expenses for you, your spouse and your dependents.
This works on a calendar year. From January 1 to December 31.
There is a limit as to how much money you can contribute to an FSA.
For the year 2019, the IRS set the maximum limit to $2,750. An increase of $50 from the $2,700 in 2019.
If by the end of the calendar year (December 31) you have a balance left over, you can only carryover over to the new year up to $500.
For example, if you elected to contribute for the year $2,700, but only used $2,500, you can carry over the remaining $200 for the following year.
However, on the other hand, for example, you elected to contribute for the year $2,700 but only used $2,000, you will only be able to carry over $500, but you will lose the remaining $200.
2020 Max Contribution | Savings 32% tax bracket | Savings 24% tax bracket | Savings 22% tax bracket | Savings 12% tax bracket |
---|---|---|---|---|
$2,750 | $880 | $660 | $605 | $330 |
Transit Benefits (TransitChek)
Transportation benefits are also known as commuter benefits. Most employers offer this benefit to their employees.
You set aside pre-tax income to cover transportation costs.
This benefit allows you to save real money on something you already pay for: Your commute to work.
The IRS monthly maximum amounts are (up to $270/month for transit and up to $270/month for qualified parking).
You can use Transitchek for subway, bus, train, ferry, car, or vanpool.
By using Commuter Benefits you save double.
The amount set aside for transit + parking is pre-tax and also reduces your taxable income
For example, if your commute is driving to the train station and taking the train and you elected to have $150/month for the train and $200/month for parking.
Yearly that comes up to $1,800 for train and $2,400 for parking, for a total of $4,200 Year.
Commuter Benefit Contributions | Savings 32% tax bracket | Savings 24% tax bracket | Savings 22% tax bracket | Savings 12% tax bracket |
---|---|---|---|---|
Train $1,800 | $576 | $432 | $396 | $216 |
Parking $2,400 | $768 | $576 | $528 | $288 |
Total | $1,344 | $1,008 | $924 | $504 |
How to Pay Less Taxes and Save More Money by Contributing to Retirement Accounts
Let me give you an example of a single person (Jane Doe) with no dependents. Shet makes $51,000 annually. In the table below you will be able to see how much money Jane Doe can potentially save for retirement each year.
Jane Doe | No Contribution | Small Contribution | Moderate Contribution | Maximum Contribution |
---|---|---|---|---|
Gross Salary | $51,000 | $51,000 | $51,000 | $51,000 |
401k Contribution | $0 | 1,000 | $10,000 | $19,500 |
IRA Contribution | $0 | 500 | $3,000 | $6,000 |
HSA Contribution | $0 | 250 | $1,750 | $3,500 |
Commuter Benefit | $0 | $250 | $900 | $1,800 |
Taxable Income | $51,000 | $49,000 | $35,350 | $20,200 |
Tax Bracket | 22% | 12% | 12% | 10% |
Federal Tax Paid | $4,462 | $4,222 | $2,584 | $800 |
These tax savings in the examples above are per person.
If you are married, you and your spouse can both contribute and double your tax savings.
Remember the goal here is to reduce the amount of taxes you OWE.
How to Reduce or Pay Less Taxes in 2020
The best strategy to pay less taxes and maximize your tax savings in 2020 are:
- Make contributions to your 401k. At least the matching point if possible.
- Open an IRA and make contributions.
- Participate in the HSA or FSA plans.
- Make use of the commuter benefits if your employer offers it.
Which of these strategies are you planning to implement to reduce your taxable income and pay less taxes this year?
Have you already been using any of these ideas and have reduced the amount of taxes you owe?
Please share in the comments section below. I will love to hear from you and if you have any questions ask away!