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How to Pay Less Tax Legally and Boost Your Savings

April 2014

Everyone who pays income taxes would like to pay as little as legally possible. Most of us would also like to save more. In 2014, why not use some of the tax deductions and credits that you qualify for to help lower your tax bill? Then use the money you’ve freed up to maximize your savings. The IRS and tax experts note that many people who qualify for the deductions and credits identified in this report fail to take them. Here are some strategies that may work for you in 2014. Be sure to consult your tax advisor about those which look promising for you.

Set Your Tax Withholding Right—Not Too High.

Okay, doing this alone does not actually save on taxes. It does, however, prevent you from giving the government an interest-free loan for a year. Did you know that the average tax refund in 2012 was $2803 according to the IRS and is running at about $2700 for tax year 2013? That’s over $225 a month that the average taxpayer could have put automatically into a tax-advantaged retirement or health savings plan. Taking advantage of this option would also lower taxable income by the amount you placed in the tax-advantaged savings plan ($225 a month lowers taxable income by $2700). So keep this in mind as you consider the tax savings options that follow. Then use this IRS Withholding Calculator to refigure your withholding. You can submit a new W-4 to adjust your withholding at any time during the year. Your goal is to get just a small return or owe just a small amount, not to give the government a multi-thousand dollar loan interest free!

Strategies for Paying Less Tax

  • Set your tax withholding right
  • Establish or contribute more to a tax-advantaged retirement savings plan
  • Take advantage of education tax credits and deductions
  • Take advantage of "cafeteria" savings plans
  • Determine if you qualify for a childcare or dependent care credit

Establish or Contribute More to a Tax-Advantaged Retirement Savings Plan

The benefit of tax-advantaged savings plans like the following is that the amount you contribute annually to the fund lowers your taxable income by the same amount and thus saves on taxes.

  • 401K plan. Saving for your retirement in a 401K in which an employer provides matching funds not only reduces taxable income but grows your savings faster because of the employer match. Your nest egg grows tax free. You pay income tax later on distributions.
  • Traditional IRA. Subject to overall contribution limits, you can have a traditional IRA (Individual Retirement Arrangement or Account) in addition to a 401K. Its principal also grows tax-free; then you pay taxes later on distributions from the fund.

Take Advantage of Education Tax Credits and Deductions

If you are a college student or the parent of college students you may be able to take advantage of several education tax credits and deductions. A tax credit directly reduces the amount of tax you have to pay. A deduction reduces the amount of income subject to tax and therefore usually reduces the taxes you pay. You can read more about these education benefits at Tax Benefits for Education on the IRS website.

  • American Opportunity Credit. If your annual modified adjusted gross income is less than $80,000 ($160,000 married, joint return), you may claim a tax credit of up to $2500 annually for up to four years for qualified expenses for a student enrolled at least half-time in post secondary education. This tax credit has been extended through 2017.
  • Lifelong Learning Credit. You may claim up to $2000 annually for qualified expenses for a student enrolled in an eligible post-secondary institution. There is no limit to the number of years you can claim it. However, you can’t claim American Opportunity Credit and Lifelong Learning Credit for the same student in the same year. This credit may be used for graduate school, take one course, or taking courses but not pursuing a degree or credential.
  • Tuition and Fee Deduction. If you qualify, you can deduct up to $4000 in a tax year for qualifying tuition and fees for post-secondary education. Since this is an adjustment to income, you can take the deduction even if you don’t itemize deductions on Schedule A. The qualifications are given in the IRS resource at the head of this section.
  • Student Loan Interest Deduction. If your annual modified adjusted gross income is less than $75,000 ($150,000 married, joint return), you may be eligible to deduct the interest you paid on a qualified education loan. Even if your parents paid the interest on your loan, you may be able to deduct this as the loan holder.
  • Education Required for Business. If you are self-employed you may deduct qualifying work-related education directly from your business income, typically on Schedule C. If you are employed and you pay for education required by your employer or by law to enhance or maintain skills for your present job, you may claim qualified expenses that exceed 2% of your adjusted gross income on Schedule A.

What about education savings plans, such as state-sponsored 529 plans and Coverdell Education Savings Accounts? The contributions are not tax-deductible but if the principal and income are used for education expenses the disbursement is tax-free.

Don’t Forget Charitable Gifts and Expenses

Almost everyone knows that you can deduct gifts given to qualified charitable organizations. However, many people forget that if they volunteer for a charity they may deduct certain qualified expenses. If you drive to the food bank where you volunteer, for example, you can keep a written record of your mileage and deduct 14 cents per mile plus parking and any tolls. If you donate foods to the food bank or supply a meal to the senior citizens center, you can deduct the cost of those foods. Up to $250 of such miscellaneous deductions in one year don’t require acknowledgement from the recipient; just keep your receipts.

Maybe you are thinking of making a larger monetary gift. If you own stocks, mutual funds, or other securities outright (not in an IRA or 401K), consider giving the gift of appreciated securities. You can then deduct the current fair-market value (not the amount you originally paid) from your taxes. You also will not owe capital gains on the appreciated value. Talk to your investment or tax advisor about the pros and cons of this option.

Take Advantage of “Cafeteria” Savings Plans

As part of employee benefits, your employer may offer a “cafeteria” or “flex” plan that enables you to contribute up to set amounts for eligible medical and caregiving expenses.

The health-related options include Health Savings Accounts (HSAs), Flexible Spending Accounts (FSAs) and Medical Savings Accounts (MSAs). Your contributions to such plans are deducted from your income before taxes are withheld. They are too complex to explain here, but you can read all about them in IRS Publication 969.

Dependent Care Flexible Savings Accounts let you contribute up to $5000 per household annually to cover caregiving expenses for a dependent child (under age 13), a person of any age unable to provide self care, or an elderly person who lives with you. The individual must be counted a dependent on your tax return. Again, read IRS Publication 969 for full details.

There are differences in each of these types of plans; so be sure to read carefully to examine pros and cons for your situation.

Identify All Possible Medical Deductions

If you itemize deductions, you are able to deduct medical expenses not covered by insurance (or otherwise reimbursed) that exceed 10% of your adjusted gross income (7.5% for adults over age 65). The cost of such things as insurance premiums, co-pays, uncovered medical visits and treatments, prescription medicines are well known. But don’t overlook other potential deductions:

  • The cost of transportation to and from medical visits. That includes parking and the actual cost of public transport or 14 cents a mile if you drive. So keep a written mileage record and receipts. If you have to go to a distant city, travel, lodging and a portion of food costs are deductible.
  • The cost of a weight loss program if it is prescribed by a physician to treat obesity or another related chronic disease (but not the required food or a health club/gym membership).
  • Qualifying improvements to your home to accommodate your disability or that of your spouse or other dependent. Such improvements might include an entrance/exit ramp for your home, modified plumbing or bathroom fixtures and widened doorways or halls.

For particulars on these medical deductions and more, see IRS Publication 502, Medical and Dental Expenses.

Do You Qualify for a Childcare or Dependent Care Credit?

If you work (if single) or if you and your spouse both work (if married) and you pay for childcare (for children under 13) or dependent care for a disabled or elderly dependent so that you can continue to work, you may qualify for a Dependent Care Tax Credit of up to $3000 for one qualifying person or up to $6000 for two or more qualifying dependents. There are a number of qualifying terms that your situation must meet. To check out your potential eligibility for this tax credit, see IRS Publication 503, Child and Dependent Care Expenses.

If you qualify for this credit on your 2014 taxes, be sure to keep appropriate documentation and receipts all during the year.

Deductible Job- or Work-Related Expenses

Qualifying expenses in these categories may be deductible.

Back to the Goal of Saving More

As you can see from just these few strategies, there may be several ways in which you can reduce your taxable income and save on income taxes overall. One of the facts I like best about the tax-advantaged savings plans is that you can reduce your tax burden and build savings at the same time. Taking advantage other deductions and credits can lower taxes and free up money that you can also use for savings. Spending just a few hours to identify the potential tax benefits you qualify for could save you a bundle.

For More Information

IRS Withholding Calculator

Tax Benefits for Education

IRS Publication 969

IRS Publication 502, Medical and Dental Expenses

IRS Publication 503, Child and Dependent Care Expenses

IRS Publication 529, Miscellaneous Deductions

IRS Publication 521, Moving Expenses

IRS Publication 463, Travel, Entertainment, Gift and Car Expenses

Remar's Report Saving on Health Care Costs

GetReal Fifty Plus Guide Building a Nest Egg: Savings and Investment Options

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