Tax Offset Guide

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People say death and taxes are the only things we can be certain of in life. Let me be so bold as to add another. People trying to find a way to lower their tax bill is another thing that we can be certain will happen year after year.

Taxes come each year, but we don't have to face them with dread (or procrastinate on doing them). Instead, let's strive to make this the year that you confidently do your taxes and confidently save on your tax bill.

There are a lot of ways for you to reduce your tax bill. An accountant or CPA will help you figure out the nitty-gritty details of saving for your specific scenario. But let's dive into a broad overview of what you can do yourself to can reduce your tax bill this year.

Tax Deductions vs. Tax Credits

People earning money have to pay tax on it. But the government knows that there are certain costs that people need a break on in order to afford them. Enter tax deductions.

Tax deductions reduce the overall total amount of money you will be taxed on.

“A tax offset or deduction reduces the value of what is being taxed and therefore reduces your overall tax burden. Common deductions include certain retirement plan contributions, capital losses from selling investments at a loss, and interest on student loans,” says CPA and CFP Megan Brinsfield.

Tax credits, on the other hand, reduce the total amount of tax you owe. Meaning, they reduce the actual amount of money you will pay to the government. Utilizing both deductions and credits will get you to your lowest tax bill.

A common tax credit people claim is the Child Tax Credit. This is a credit the government offers parents, since kids are expensive. This year, parents can deduct up to $2,000 per child from their taxes. This deduction is limited to individuals earning $200,000 or less and $400,000 if married and filing jointly. Up to $1,400 per child is refundable, meaning the government will pay you back via a tax refund.

Investments That Reduce Your Tax Bill

First things first, let's determine how much money you'll be paying tax on. You don't necessarily have to pay tax on all of your income.

“The most common way that a W-2 employee can reduce their tax burden is through making contributions to retirement plans. Many employers offer a 401(k) or similar plan that would allow contributions up to $19,000 annually,” says Brinsfield.

Your contributions to pre-tax retirement accounts such as a 401(k), 403(b), or traditional IRA are not taxed in the year you contribute. So if you make $50,000 a year and contribute $5,000 to your 401(k), the IRS actually counts your income as $45,000 and taxes you on that amount.

For 2019, the maximum you can contribute to your 401(k) or 403(b) is $19,000. This is up to $500 from last year, which is a good thing for investors. For both traditional and Roth IRAs, the limit is $6,000, up to $500.

If you fully fund your 401(k) and your traditional IRA, that's $25,000 you can deduct from your taxes. Roth contributions, however, are counted as taxable income. But you don't pay tax on the back end, when you withdraw the money from your account in retirement.

Brinsfield notes that investment losses might mean a deduction as well.

“For people who maintain investments in a taxable brokerage account, selling investments at a loss can generate a deduction up to $3,000 per year to offset other income,” says Brinsfield.

Personal Tax Deductions

In the first year of actually implementing the Tax Cuts and Jobs Act (passed in 2017), there are new tax laws this year.

For example, the personal exemption tax deductions have been totally eliminated. In 2017, the personal exemption deduction was $4,050. This year, that number is $0.

Losing this deduction could be hard on many families in particular. That's why it's good to know where else you can cut to make up for some losses in the new tax code.

“For workers who are paying off student loans, there is a deduction for student loan interest up to $2,500,” says Brinsfield. Many new college grads, parents, and even grandparents carry student loans in the U.S., so chopping $2,500 off in interest paid is helpful.

If you itemize for your taxes, you can deduct things like your charitable contributions, as well as your state and local taxes. Say you gave $5,000 to charity last year. You can deduct that from your taxable income if you have the receipts.

And if you work from a part of your home, measure the space and take a deduction for that as well.

These are common deductions, and they can go a long way toward lowering your overall tax bill.

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Short-Term vs. Long-Term Tax Offsets

When you're trying to lower your tax bill via credits and deductions, it's always wise to try to think both long term and short term.

Say, for example, you're making $60,000 a year. You expect your income tax rate to stay the same in retirement due to your income from a rental property and withdrawing from your investments. It may be a good idea to contribute to a Roth IRA rather than a traditional IRA.

With a Roth, you pay tax upfront, so it's tax-free when you withdraw the money. Roth IRAs also have much more flexible laws around them. For example, you don't have to take the money out at any point. (With a traditional IRA, you must start taking withdrawals at age 70½.) So if you're living off your rental income and withdrawing from other investments, you can let your Roth continue to grow as long as you'd like.

“I advise clients to think of reducing taxes over their lifetimes rather than focusing too heavily on a given year,” says Brinsfield.

It's often advantageous for early-career workers to contribute to a Roth IRA while their tax rate is comparatively low. This results in a higher tax burden for that particular year but reduces the taxes that person will pay over the course of their lives. Another example is strategically recognizing more income during working years for folks that plan to retire in a higher-tax state than where they are currently living.

Thinking about your taxes from a multiple-year-long perspective instead of just a this-year perspective can help you open the right accounts and look for the right deductions and credits as you need them.

Larry Ludwig

Larry Ludwig was the founder and editor in chief of Investor Junkie. He graduated from Clemson University with a bachelor of science in computers and a minor in business. Back in the ’90s, I helped create some of the first financial websites for firms like Chase, T. Rowe Price, and ING Bank, and later went on to work for Nomura Securities. He’s had a passion for investing since he was 20 years old and has owned multiple businesses for over 20 years. He currently resides in Long Island, New York, with his wife and three children.

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