Strategic Ways to Lower Your Annual Tax Bill

Tax planning involves making legal choices throughout the year, not just during tax season. The process is about systematically using the provisions within the tax code to your advantage. This requires a forward-looking approach to your finances, considering how different decisions might affect your tax liability.

Maximizing Tax Deductions

A tax deduction is an expense the IRS allows you to subtract from your adjusted gross income (AGI), which lowers your taxable income. The primary decision is whether to take the standard deduction, a fixed amount that changes annually, or to itemize by adding up all eligible expenses. If your total itemized deductions are greater than the standard deduction, itemizing will result in a lower tax bill.

A common itemized deduction is for state and local taxes (SALT). This allows you to deduct either state and local income taxes or sales taxes, along with property taxes on your primary residence. This deduction is capped at $10,000 per household annually.

Homeowners can deduct interest paid on home acquisition debt, which is money borrowed to buy, build, or improve a main or second home. The deduction is limited to the interest on up to $750,000 of mortgage debt. This is a valuable deduction, particularly in the early years of a mortgage when interest payments are higher.

Charitable contributions to qualified organizations are deductible. You can deduct cash contributions and the fair market value of non-cash items like clothing or household goods. The deduction for cash gifts is limited to 60% of your AGI, with different limits applying to non-cash donations. You must maintain records, such as bank statements or written acknowledgments from the charity, to substantiate your donations.

The deduction for medical expenses is subject to a high threshold, as you can only deduct qualifying medical expenses that exceed 7.5% of your AGI. Qualifying expenses include payments to doctors, hospitals, prescription drugs, and health insurance premiums paid with after-tax dollars. Because of the AGI limitation, this deduction is most beneficial for taxpayers who have very high medical costs in a given year.

Claiming Valuable Tax Credits

A tax credit offers a more direct benefit than a deduction. While a deduction reduces your taxable income, a credit reduces your actual tax liability on a dollar-for-dollar basis. For example, a $1,000 tax credit will lower your final tax bill by the full $1,000.

Credits are categorized as either nonrefundable or refundable. A nonrefundable credit can reduce your tax liability to zero, but you will not receive any of it back as a refund if the credit is larger than your tax bill. In contrast, a refundable credit is paid out to you even if it exceeds your total tax liability, potentially resulting in a cash payment from the government.

The Child Tax Credit is a benefit for taxpayers with qualifying children. To be eligible, the child must be under the age of 17 at the end of the tax year, be your dependent, and meet several other criteria. The credit amount is subject to income phase-outs, which reduces its value for higher-income taxpayers.

Two tax credits are available for higher education. The American Opportunity Tax Credit (AOTC) is for qualified expenses for the first four years of higher education. The Lifetime Learning Credit (LLC) is for undergraduate, graduate, and professional degree courses, including those taken to acquire job skills. The AOTC is partially refundable, while the LLC is nonrefundable, and each has its own set of income limitations and rules.

Energy credits provide incentives for home efficiency improvements and for purchasing a clean vehicle. The Energy Efficient Home Improvement Credit allows homeowners to claim a credit for a percentage of the cost of improvements like new windows, doors, or insulation. The Clean Vehicle Credit offers a credit for the purchase of a qualifying new or used electric vehicle, subject to limitations based on the vehicle’s price, battery capacity, and the buyer’s income.

Contributing to Tax-Advantaged Accounts

Contributing to tax-advantaged accounts helps you save for the future and reduce your current tax burden. Accounts that allow for pre-tax contributions directly lower your taxable income for the year.

Traditional 401(k)s and Traditional IRAs allow you to contribute pre-tax money. This means that every dollar you contribute reduces your taxable income by a dollar. The money grows tax-deferred, and you pay taxes on withdrawals in retirement. This is in contrast to Roth accounts, where contributions are made with after-tax dollars, and qualified withdrawals in retirement are tax-free.

A Health Savings Account (HSA), for those in a high-deductible health plan (HDHP), offers a triple-tax advantage. Contributions are tax-deductible, the funds grow tax-free, and withdrawals for qualified medical expenses are also tax-free.

Flexible Spending Accounts (FSAs) also use pre-tax dollars for certain expenses. Health FSAs can be used for medical costs not covered by insurance, while Dependent Care FSAs can be used for expenses related to the care of a child or other qualifying dependent. FSAs have a “use-it-or-lose-it” rule, requiring you to spend the funds by the end of the plan year, though some plans offer a grace period or limited carryover.

Implementing Investment Tax Strategies

For taxable investment accounts outside of retirement plans, certain strategies can reduce tax liability. These techniques focus on the timing of sales and offsetting gains and losses.

Tax-loss harvesting involves selling investments that have decreased in value to realize a capital loss. This loss can then be used to offset capital gains from selling other investments at a profit. If your capital losses exceed your capital gains, you can use up to $3,000 of the excess loss to offset your ordinary income each year, with any remaining losses carried forward to future years.

When tax-loss harvesting, be aware of the “wash sale” rule. This IRS regulation prevents you from claiming a loss on the sale of a security if you buy the same or a “substantially identical” security within 30 days before or after the sale. This rule is in place to stop investors from selling a security solely to claim a tax loss and then immediately buying it back.

The timing of your investment sales can affect your tax bill. A long-term gain, from an asset held for more than one year, is taxed at preferential rates that are lower than ordinary income tax rates. Short-term gains on assets held for one year or less are taxed at your regular, higher income tax rate. Holding appreciated assets for more than a year before selling can lower the tax you owe on the profit.