How to Pay Less in Taxes (Part 2)
Money Girl helps you understand how tax deductions work, plus smart strategies to reduce your taxes.
Laura Adams, MBA
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How to Pay Less in Taxes (Part 2)
One of the best ways to save money is to understand how to pay less in taxes. This is the second episode in a 2-part series about legal strategies to lower your tax bill.
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In Part 1 I covered tax credits and reviewed 5 common ones that you might qualify for. Today, we’ll cover how tax deductions work and who can use them. Plus, you’ll learn 4 additional strategies to reduce your taxes.
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What Is a Tax Deduction?
A tax deduction is an amount you can subtract from your taxable income, which reduces the amount of tax you have to pay. For example, if your taxable income is $40,000 and you’re eligible to claim $5,000 in deductions, then you’re only taxed on $35,000.
There are loads of tax deductions, such as charitable donations, medical expenses, mortgage interest, property taxes, and student loan interest.
Many Americans are too lazy to itemize deductions and end up overpaying taxes every year.
What Are Itemized Deductions?
Some tax deductions require you to itemize your tax return and some don’t. So let’s make sure you understand how to itemize.
When you file your tax return you can choose between listing out specific deductions or claiming the standard deduction. You should always choose the method that gives you the largest deduction and saves you the most money.
If you add up your allowable deductions and they total more than the standard deduction, be sure to itemize. However, you must keep records, such as receipts and invoices, to substantiate your itemized deductions. Unfortunately, many Americans are too lazy to do this and end up overpaying taxes every year.
Don’t be one of them!
The best way to make sure that you never miss an itemized tax deduction is to review Schedule A of Form 1040opens PDF file . You’ll see the entire list that you can claim for the tax year. There’s also an instruction sheet for Schedule A, which gives you details about each of the deductions.
What Are Adjustment to Income Deductions?
I mentioned that some deductions don’t require you to itemize on Schedule A. These are called adjustments to income because they adjust or reduce your gross taxable income directly on the main tax form.
Here are some examples of adjustment deductions:
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Contributions to a Heath Savings Account (HSA)
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Self-employed health insurance
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Contributions to retirement plans
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Student loan interest
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Alimony payments
Claiming these deductions means that you don’t have to complete Schedule A; however, some of them do require you to fill out another IRS form or worksheet. Don’t let tax paperwork keep you from saving money. Take the time each year to maintain records and complete forms that will help you cut your tax bill.
4 Strategies to Pay Less in Taxes
In addition to using tax credits and deductions to pay less in taxes, here are 4 additional tips to keep more of your hard-earned money:
Tax Tip #1: Adjust Your Withholding
If you look forward to celebrating a big tax refund each year, it may actually be hurting your finances. Consider this: When you file a tax return, you’re really just settling up with the government.
If you didn’t pay enough during the previous year through payroll deductions or quarterly estimated payments (if you’re self-employed), then you have to pay the difference on tax day. But if you overpaid during the previous year, you get a tax refund for the excess. So a tax refund is simply an indication that you handed over way too much money to the government.
I don’t know about you, but I’d rather use my own money instead of giving it to Uncle Sam as an interest-free loan. You should have kept that money and put it to work earning a nice return in a savings or retirement account.
By receiving a higher paycheck—instead of waiting over a year to get a tax refund—you have more control of your money every month. To increase your net pay, complete Form W-4opens PDF file and submit it to your employer any time during the year. If you need help, ask your employer or use the Withholding Calculator at irs.gov.
Tax Tip #2: Contribute to a Retirement Account
You know that you should be saving for retirement. Plus, the fact that retirement contributions lower your tax bill is an added bonus!
No matter if you use a retirement plan at work, an account for the self-employed, or a traditional IRA, the money you put in is never taxed until you make withdrawals in the future.
See also: How Much Money Do You Need to Retire?
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Tax Tip #3: Contribute to a Health Spending Account
Health spending accounts allow you to pay for certain medical expenses with tax-free money. Two of the most popular are Flexible Spending Accounts (FSAs) and Health Savings Accounts (HSAs).
An FSA can be set up by an employer for workers who elect to set aside a portion of their earnings to pay for qualified medical expenses on a pre-tax basis. These have a “use it or lose it” rule because you typically forfeit funds not used by the end of the plan year.
On the other hand, an HSA can be used by anyone who has a qualifying high-deductible health plan, even if you’re self-employed, unemployed, or retired. Your contributions aren’t taxed, as long as you spend them on qualified medical expenses. Plus, they roll over and accumulate year to year if you don’t spend them. Â
If you’re eligible for either one of these tax-advantaged accounts, be sure to take advantage of the opportunity to spend pre-tax money. For complete information, take a look at IRS Publication 969opens PDF file .
Tax Tip #4: Hire a Professional
In many cases, spending a little money on a tax professional is the best way to save. Their job is to stay up-to-date on tax laws that are always changing. So he or she may find additional tax credits or deductions, help you stay organized, and strategize on whether you should speed up or postpose certain expenses.
See also: Tips for Choosing a Tax Pro
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And one final quick and dirty tip is that the IRS ends up with millions of dollars that it tries to refund to taxpayers, but can’t reach them. If you moved last year, complete Form 8822 to change your address and make sure that your money follows you to your new home.
From tax credits to health spending accounts, there are many ways to reduce your taxes.
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About the Author
Laura Adams received an MBA from the University of Florida. She’s an award-winning personal finance author, speaker, and consumer advocate who is a frequent, trusted source for the national media. Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers is her newest title. Laura’s previous book, Debt-Free Blueprint: How to Get Out of Debt and Build a Financial Life You Love, was an Amazon #1 New Release. Do you have a money question? Call the Money Girl listener line at 302-364-0308. Your question could be featured on the show.