It often seems like there’s a tax for everything we do. We pay sales taxes every time we pump gas, buy groceries, or fill a prescription. We also pay yearly property taxes on our homes and cars. But nothing compares to the federal tax that is withheld from our paychecks.
The more money you make, the more the government takes. On top of the 15.3% Social Security and Medicare taxes, we also have to pay between 10% to 37% in federal income tax. That’s a huge chunk of change that could go towards a rainy day fund or paying off debt.
While you cannot escape taxation, there are things you can do to lessen the burden. Proper tax planning allows you to significantly reduce your tax bill and boost your tax refund. Here’s a quick guide to get you started.
1. Maximize your retirement contributions
One of the best ways to reduce your taxable income is to contribute to a retirement account. 401(k) and IRA contributions are tax-deductible and will help you reduce your federal tax bill. The earlier you start saving for your retirement, the more money you also save.
If you work for a company that offers a retirement savings plan such as a traditional 401(k) or 403(b), you may contribute up to $19,500 for tax year 2021. Individuals 50 and older may also make catch-up contributions of up to $6,500 on top of the existing limit.
If your employer doesn’t offer a sponsored plan, you may contribute up to $6,000 (for tax year 2021) to a traditional individual retirement account (IRA), and $1,000 in catch-up contributions for those 50 and older.
The rules for claiming a deduction on retirement contributions depend on your income and your IRA plan, among other factors. Please consult a tax expert to clarify your tax situation.
2. Itemize your deductions
The 2017 Tax Cuts and Jobs Act doubled the standard deduction, simplifying the tax process for millions of taxpayers. For tax year 2021, the standard deduction is $12,550 for Single filers, $18,800 for Heads of Households, and $25,100 for Married Filing Jointly.
While claiming a standard deduction is definitely easier and more convenient, you might save more money if you itemize your deductions. Expenses you can claim a deduction on include state and local income and sales taxes, personal property taxes, losses from Federally declared disasters, uninsured medical and dental expenses, and contributions to qualified charities.
3. Take advantage of self-employment tax deductions
Whether you call yourself a freelancer, an independent contractor, or self-employed, you shouldn’t forget to take advantage of the tax deductions available to you. You can use your side hustle to lower your tax bill even if you have a full-time job.
You may take a business deduction on business-related marketing, rent, startup costs, insurance, training and education, subscriptions, vehicle use, travel, meals, supplies and equipment, and home office expenses. You may also claim your personal health or dental insurance as an expense.
Just make sure you have the receipts to back up your claims. If you can’t show proof or establish a paper trail for your self-employment business expenses, the IRS may deny your claim.
4. Know your tax credits
While tax deductions are one of the most popular ways to reduce a taxpayer’s final tax bill, not everyone is familiar with tax credits. For instance, according to the IRS, 1 in 5 eligible Americans fail to claim the Earned Income Tax Credit.
You need to know all the tax benefits available to you to minimize your tax liability and maximize your refund. Here are some of the tax credits you need to know.
Earned Income Tax Credit
The Earned Income Tax Credit (EITC) is a tax break for low to moderate-income individuals and families. The amount of your tax credit depends on a few factors, including if you have a qualifying child or dependent and your disability status.
To qualify for the EITC, you must:
- Show proof of income from an employer or self-employment
- Have a valid Social Security number
- Be a U.S. citizen or resident alien
- Have investment income below $3,650 in the tax year you claim the credit
- File a tax return as Single, Married Filing Jointly, Head of Household, or Qualifying Widow or Widower
It’s important to note that you must file a tax return to receive the EITC, even if no tax is owed.
Child and Dependent Care Credit
If you have dependents under the age of 12 or are not mentally or physically able to care for themselves, you can claim the Child and Dependent Care Credit (CDCC). The tax credit covers a percentage of your out-of-pocket expenses for the care of qualifying children or dependents while you work or look for work.
The 2021 American Rescue Plan Act increased the benefits of the CDCC and expanded it to cover more families. The act increases the maximum percentage eligible for the credit and makes it fully refundable. For tax year 2021, you may qualify for a tax credit of up to 50% of qualifying expenses for one qualifying dependent and up to $16,000 for two or more qualifying dependents.
American Opportunity Credit and Lifetime Learning Credit
With the cost of higher education rising every year, the federal government has introduced tax credits to help lighten the load for taxpayers.
The American Opportunity Tax Credit (AOTC) covers 100% of the first $2,000 of qualified education expenses for each eligible student and 25% of the next $2,000. The maximum annual credit is $2,500 per eligible student.
The Lifetime Learning Credit (LLC) helps offset the cost of continuing education for taxpayers enrolled in an eligible educational institution to improve their job skills. The credit covers up to $2,000 of qualified education expenses.
Since the IRS only allows one tax reduction per student per year, you cannot combine the AOTC with the LLC. You can have 40% of your remaining AOTC credit refunded to you, while the LLC is non-refundable.
5. Talk to a tax expert
Filing a federal tax return is already complicated enough without having to think about tax deductions and credits. If you’re serious about reducing your taxable income and maximizing your tax refunds, it pays to contact a reputable tax service.
For over 25 years, the tax experts at TFX have helped countless American taxpayers prepare and file their tax returns on time and accurately. You can trust our team to know the ins and outs of the U.S. tax system, including all the strategies you can use to get your tax bill down to zero.