What are the best ways to reduce taxable income?


How to reduce taxes is one of the most common financial planning concerns among individuals and business owners. Increasing the standard deductions under the Tax Cuts and Jobs Act (TCJA) provided tax savings for many (although the TCJA eliminated many other itemized deductions and the personal exemption). Taxable income can be further reduced with a few strategic steps.

Key takeaways

  • An effective way to reduce taxable income is to contribute to a retirement account through an employer-sponsored plan or an individual retirement account (IRA).
  • Both health spending accounts and flexible spending accounts help reduce taxable income during contribution years.
  • A long list of deductions to reduce taxable income remains available for self-employed full or part-time taxpayers.

Save for retirement

One of the easiest ways to reduce taxable income is to maximize retirement savings. Although there are many types of retirement savings accounts to choose from, here are two of the most common that can help reduce taxable income in the tax year in which you make a contribution.

Employer sponsored plan

Those whose business offers an employer-sponsored plan, such as a 401 (k) or 403 (b), can make pre-tax contributions up to a maximum of $ 19,500 in 2021 (also $ 19,500 in 2020). Those age 50 and older can make recovery contributions of $ 6,500 in 2021 (also $ 6,500 for 2020) above that limit.

Because contributions are made before taxes through paycheck deferrals, money saved in an employer-sponsored retirement account directly reduces taxable income. In other words, contributions reduce an employee’s income for that tax year before income taxes are applied.

Individual Retirement Account (IRA)

People can also save by contributing to a traditional individual retirement account (IRA). The annual contribution amount to an IRA for fiscal year 2021 is $ 6,000 (same as for 2020), with an additional $ 1,000 recovery provision allowed for those age 50 and older.

Traditional IRA contributions can be deducted from an individual’s tax return, reducing the taxes owed in the tax year of the contribution. However, unlike contributions to an employer-sponsored plan, IRA contributions are made with after-tax dollars, which means that income taxes have already been removed from the money.

Taxpayers (or their spouses) who have employer-sponsored retirement plans can also deduct some or all of their traditional IRA contribution from taxable income. The IRS has detailed rules about whether (and how much) they can deduct based on your income.

In December 2019, the Configuration of All Communities for the Improvement of Retirement Act (SECURE) was enacted. For 2019 and prior years, taxpayers age 70½ and older couldn’t contribute to a traditional IRA. As of 2020, the age limit no longer applies. Taxpayers over the age of 70½ can contribute a maximum of $ 7,000 per year and receive the full tax benefit.

Consider flexible spending plans

Some employers offer flexible spending plans that allow you to save money before taxes for expenses like medical expenses.

A Flexible Spending Account (FSA) provides a way to reduce taxable income by setting aside a portion of earnings in a separate account managed by an employer. An employee can contribute up to $ 2,750 during the 2021 plan year (unchanged from 2020).

Depending on the use or loss provision, participating employees must often incur eligible expenses at the end of the plan year or lose unspent amounts. Under a special rule, employers can offer participating employees more time through a carry-over option or a grace period (2.5 months).

With the rollover option, an employee can roll over up to $ 550 of unused funds to the next plan year. Under the grace period option, an employee has up to 2.5 months after the end of the plan year to incur eligible expenses. Employers can offer either option, but not both or neither.

The IRS has released new guidance allowing employers more flexibility for 2020 and 2021 benefit plans as part of the Consolidated Appropriations Act. Employers can allow employees to roll over all unused funds from 2020 to 2021 and 2021 to 2022, or they can extend the grace period from 2.5 months to 12 months, either way, all unused funds can be transfer and use throughout the year. .

Health Savings Account (HSA)

A health savings account (HSA) is similar to an FSA in that it allows pre-tax contributions to be used later for health care costs. HSAs are only available to employees with high deductible health insurance plans.

Minimum annual deductible

According to the Internal Revenue Service (IRS), for 2021 and 2022, a high deductible health plan has a minimum annual deductible of $ 1,400 for individual coverage or $ 2,800 for family coverage.

Annual contribution limit

The annual contribution limit for 2021 is $ 3,600 for individuals and $ 7,200 for families. However, by 2022 The contribution limit is $ 3,650 for individuals and $ 7,300 for families.

Maximum annual out-of-pocket expenses

Also, under a high deductible plan, annual out-of-pocket expenses, which include deductibles, copays, but not premiums, do not exceed $ 7,000 for individual coverage or $ 14,000 for family coverage for 2021, but for 2022, do not exceed $ 7,050 for individual coverage or $ 14,100 for family coverage.

Unlike FSA balances, HSA contributions can be rolled over if they were not used in the year they were saved.

Both HSAs and FSAs provide for a reduction in tax bills during the years contributions are made.

Take business deductions

A long list of deductions to reduce taxable income remains available for self-employed full or part-time taxpayers.

Deduction from the Ministry of the Interior

A home office deduction, for example, is calculated using a simplified or regular method to reduce taxable income if part of a home is used as dedicated office space. The self-employed can also deduct a portion of their self-employment tax and the cost of health insurance, among other expenses, to reduce taxable income.

Business expenses

Business owners or those with deductible professional expenses can make the next necessary purchases or expenses by the end of the fiscal year. This can make a significant difference for those who purchase a major item whose purchase price can be included in business expenses.

Retirement savings plans

There are a variety of retirement savings plans for the self-employed, including an individual 401 (k) account and a Simplified Employee Pension (SEP) IRA. Both options provide the opportunity to reduce taxable income through pre-tax contributions and allow higher limits on contributions each year.

The SIMPLE IRA allows contributions of up to $ 13,500 in 2021 (unchanged from 2020), plus an additional $ 3,000 for those age 50 and older. The Solo 401 (k) allows contributions of up to $ 19,500 tax-free for 2021, also unchanged from 2020. The SEP IRA allows tax deductible contributions of up to 25% of compensation, up to $ 58,000 (up to $ 1,000 as of 2020).

The SAFE law

The SECURE Act has implications for small business owners. The Act encourages business owners to establish retirement plans for employees by providing tax incentives if they collaborate with other small businesses to offer multiple employer or MEP plans.

The SECURE Act also allows more part-time workers to save through employer-sponsored retirement plans, beginning in 2021. To do so, workers must put in at least 500 hours per year for three consecutive years to be eligible.

The bottom line

Tax reform eliminated many itemized deductions for most taxpayers, but there are still ways to save for the future and cut your current tax bill. To learn more about tax deductions and savings, consult a tax expert.

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Mark Holland

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