5 Ways to Reduce Your Taxable Income in 2020
Since it’s tax time, I thought I would write a little more about taxes today.
I’m not sure how you feel about taxes, but as I look at how much I paid in taxes over the course of the last year, I can’t help but look for ways to reduce my overall tax burden.
With that in mind, here are 5 ways you can reduce your taxable income in 2020. This will allow you to keep more of your money in your own pocket, helping you progress towards financial independence.
Disclaimer: Please remember that I am not a tax professional. This blog post is for informational and entertainment purposes only. Please consult a certified public accountant, financial advisor, or other professional before making decisions regarding your taxes.
Contribute to your 401(k)
The first thing that I would recommend you do to reduce your taxable income is contribute to your employer sponsored retirement plan. Based on the type of business of your employer, this could come in the form of a 401(k), 403(b), 457(b), or Thrift Savings Plan (TSP) .
Contributions to employer sponsored retirement plans are an excellent way to reduce your taxable income because they are made with pre-tax dollars. While technically these contributions are not a tax deduction on the 1040 tax form, they mathematically function in the same way as other above the line tax deductions. This is because any amount you contribute reduces your taxable wages on your W-2. As a simple illustration of how this works, if you make $60,000 at your job over the course of the year, and contribute $10,000 to your 401(k), your taxable wage is technically reduced to $50,000, which thereby reduces your taxable income.
As I mentioned in my post FI Step by Step: Step 7, Maximize Your Employment Benefits, if your employer offers to match some of your contributions, I would STRONGLY recommend you contribute at least up to this amount. Not only do you get a 100% instant return on this money, but the amount you contribute reduces your taxable income. And if you are in a stronger financial position, I would recommend you contribute the full possible amount, which is $19,500 for 2020 ($26,000 if over age 50).
It is important to be aware that while contributing to an employer sponsored retirement plan reduces your tax bill today, you will owe taxes on the distributions that you collect in retirement. But for many, especially those in their peak earning years, there is a good chance you will pay a lower percentage in taxes during retirement than you are now. So it makes more sense to save on your tax bill today.
Also be aware that many employer sponsored retirement plans also have the option to make Roth contributions. This means you pay taxes now, but won’t owe taxes when receiving distributions. While this won’t reduce your tax bill today, it will eliminate any taxes on the money you withdraw from the account in retirement. If you believe you will be in a higher tax bracket in retirement, this could be a better option. However, most in the FI community would argue to save all you can on taxes today since we can’t predict future tax rates or strategies that you may be able employ to reduce taxes in retirement.
These are just some of the basics of these plans. If you would like to learn more about the specifics, I would recommend you check out my post Top Ten Terms You Should Know About Retirement Plans & Accounts, Part 3. And if you are self-employed and don’t have an employer sponsored retirement plan, then I would consider contributing to a Solo 401(k) or a SEP IRA.
Contribute to a Traditional IRA
Another excellent way to reduce your taxable income is to contribute to an IRA. While there are many different types of IRA, the two most common types are a traditional IRA and Roth IRA.
Contributions made to a traditional IRA can reduce your taxable income now, so long as you meet certain criteria, but you will owe taxes on the distributions in retirement. Conversely, contributions to a Roth IRA are made with post-tax dollars, but you won’ have to pay taxes on the distributions in retirement.
If you want to learn more about these two types of retirement accounts and which one might be better for your situation, you can check out my same FI Top Ten post for the details on these as well.
Since we are talking about reducing your taxable income in 2020, we will focus on traditional IRAs.
Contributions to a traditional IRA are an excellent way to reduce your taxable income because they are what is commonly referred to as an “above the line deduction.” An above the line deduction is technically an adjustment to your gross income (aptly named your adjusted gross income or AGI), which is the baseline dollar amount that determines how much you owe in taxes. Above the line deductions are great because you can take advantage of them without having to itemize your deductions.
In 2020, the IRA contribution limit is $6,000 per individual, and $7,000 if you are over age 50. You can check out all the rules on who is eligible to take this deduction at the IRS website. But the basic idea is that if you or your spouse DO NOT have an employer sponsored retirement plan, you can take the full deduction regardless of your income. If you or your spouse DO have an employer sponsored retirement plan, your ability to take the deduction is limited by your income.
Contribute to a Health Savings Account (HSA)
A Health Savings Account (HSA) is another great option to reduce your taxable income. Contributions to an HSA are also considered above the line deductions. In order to contribute to an HSA, you must be enrolled in a high deductible health plan. Check out my posts on why HSA‘s are the ultimate retirement account here and here.
The awesome thing about an HSA is that it is the only triple tax advantaged account. This means you can deduct the amount you contribute on your tax bill today AND the money grows tax free AND you don’t have to pay taxes on the distributions (so long as they are for approved medical expenses).
In 2020 the maximum HSA contributions limits are $3,550 for individuals and $7,100 for families.
Give Money to a Church or Charity
Charitable contributions are also tax deductible. However, this is what would be considered a below the line deduction, which means it comes after the line on form 1040 for calculating your AGI. More importantly, this means that you would have to choose to itemize your deductions, rather than take the standard deduction, in order to deduct charitable contributions.
In 2020, the standard deduction is $12,200 for individuals and $24,400 if you are married filing jointly. So your charitable contributions combined with other below the line deductions would need to add up to more than these amounts for it to make sense to itemize your deductions. But if this is the case for you, it is definitely worth it. For our family, this is our single biggest tax deduction and it makes a huge difference.
Contribute to a 529 plan
Do you have kids? Are they planning to go to college? If so, then you’ve probably thought about how you can help them pay for higher education.
One of the best ways for parents to save for college for their kids is through 529 plans. Although contributions to 529 plans won’t reduce your federal income tax bill, it may reduce your state income tax bill. So 529 plan contributions can still help to reduce your overall tax burden.
Each state runs their own plans, and some are better than others, so do your research. And not every state gives you a tax break for contributions, but many do. Check out this awesome list compiled on nerdwallet.com to see if your state offers a tax benefit for in state contributors. If so, then it probably makes the most sense to contribute to your state’s own 529 plan. However, if not, another state may have a better plan that is more appealing to you.
Putting it All Together
I like to use examples to reinforce the concepts I’m writing about. So let’s pretend we have a high income earner and see how much she would owe in federal income tax without taking advantage of any of these ways to reduce taxable income. Then we will calculate how much it would lower her tax bill to use these strategies. For simplicity, we won’t consider state income tax or any 529 plan contributions since that is more variable throughout the country.
Let’s assume she is 45 years old, married filing jointly, has two kids, and earns $100,000 per year at her job.
First, let’s calculate how much she would owe In federal income tax without taking advantage of any of the aforementioned methods to reduce taxable income. We will assume she doesn’t have any above the line deductions, so her AGI is $100,000. We will also assume she chooses to take the standard deduction, which is $24,400 in 2020 since she is married filing jointly. This reduces her taxable income to $75,600. Remember that we have a progressive taxation system, as is demonstrated in the following figure from Nerdwallet.
Using these values for 2020, her federal income tax bill would be calculated as follows:
- The first $19,750 of income she makes is taxed at 10%, so 0.10 x $19,750 = $1,975.00
- The next $55,850 of income (which is $75,600-$19,750) is taxed at 12%, so 0.12 x $55,850 = $6,702.00
- Adding these numbers together, $1,975 + $6,702 = $8,677
Her total federal income tax bill would be $8,677.
Now let’s assume she is a super saver and takes advantage of these strategies to reduce her taxable income. She contributes the maximum amount to her 401(k), which is $19,500 in 2020. She also contributes the maximum amount to a traditional IRA, which is $6,000 in 2020. Her family is enrolled in a high deductible health plan, which allows them to have an HSA. She contributes the maximum amount to their HSA, which is $7,100 in 2020. She also contributes $5,000 in tithes to her church and other charities. This may seem like a lot of saving, but it still leaves their family with $62,400 to live on, which is about the median American income.
Let’s see what effect this has on her federal income tax bill.
- The $19,500 401(k) contribution reduces her taxable wages to $80,500.
- She can take the above the line deduction for the $6,000 traditional IRA contribution because even though she has an employer sponsored retirement plan, her income is below the $104,000 limit where this deduction starts to phase out per the IRS. This reduces her taxable income to $74,500.
- She can also take the above the line deduction for the $7,100 HSA contribution, further reducing her taxable income to $67,400.
- Although she has been generous by donating $5,000 to her church and charities, this amount (even combined with her other below the line deductions) is less than $24,400 standard deduction. So she decides to take the standard deduction of $24,400, reducing her taxable income to $43,000.
Here is how her federal income tax would be calculated in 2020 based on her reduced taxable income of $43,000:
- The first $19,750 of income she makes is taxed at 10%, so 0.10 x $19,750 = $1,975.00
- The next $23,250 of income (which is $43,000-$19,750) is taxed at 12%, so 0.12 x $23,350 = $2,790.00
- Adding these numbers together, $1,975 + $2,790 = $4,765
Her total federal income tax bill is reduced to from $8,677 to $4,765. Even though she makes $100,000 from her job in both scenarios, taking these deductions has nearly cut her federal income tax bill in half! Plus, I think it is also important to point out that she didn’t spend this money on frivolous things. It has been invested to save for her future and retirement. So from my standpoint it is a win-win situation. She is moving towards financial independence AND reducing her tax bill at the same time!
Conclusion
That’s all I have for today. Hopefully as you are filing your taxes this year it will inspire you to consider doing one or more of the above things to reduce your taxable income in 2020. Here are some take home points to consider:
- For most of us, taxes are our single biggest expense. So it should make sense to you to spend some time considering what you can do to reduce this expense and keep a little more of your hard earned money.
- All of the ways I have discussed to reduce your taxable income don’t just decrease your tax bill. You are allocating this money for things that should be extremely important to you: your retirement, your healthcare, a worthy cause, and your kids college. That should be all the more incentive to make these a part of your financial plan.
- You don’t have to be the super saver in the example we discussed today. Start small and incorporate these strategies into your personal finances slowly over time.
Thanks for reading. I hope you are doing well in your progress towards reaching FI. If you have any questions or comments that might help other readers, please list them below. In the meantime, keeping working towards Freedom Through FI!
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