The yearly pain is once again upon you…yes, ‘taxing’ times are here again when you have to handle the unpleasant task of preparing your tax returns. If you don’t want a sizeable amount of your hard-earned money to go into Uncle Sam’s coffers, it becomes critical to review those investments that will lower your taxes.
The good news is there are ways to reduce your tax bill. For this, you will need to know what is included in taxable income, what qualifies as deductions on your tax return and what are the tax credits you can use to reduce your tax liability.
Taxable income
The IRS taxes income from nearly every source, be it wages, business income, investment income, gains from the sale of property owned by you, and the like. Although you may be tempted to earn an extra dollar and pay a portion of it in taxes to reduce taxable income, it may prove counterproductive. The key lies in the timing, that is, when to make your income taxable. This may sometimes reduce your overall tax liability.
Tax strategies to pay less tax
#1 Maximizing contributions to retirement accounts
You can enjoy significant tax breaks for your investment income by investing in tax-deferred retirement accounts, 401(k)s and IRAs. Whatever account you choose – traditional or Roth IRA – money will grow tax-free in that account. What’s more, each time you sell an investment in the account, you will be able to reinvest the entire sale proceeds, rather than paying a portion of proceeds in taxes.
#2 Utilizing health savings account
The good news is your contributions to the health savings account are deductible on your taxes and you don’t pay any taxes when you take distributions for qualified medical expenses. Additionally, since the contributions to the health savings account are deductible, the money grows tax-free in your account.
#3 Reducing tax through educational savings
By saving your money in a 529 plan for future higher education expenses for your children, you can reduce the taxes on your investment. However, you will not be able to deduct these contributions from your federal taxes, you may qualify to receive a state income tax break. What’s more, the money grows tax-free in the account and can be drawn tax-free for higher education expenses.
#4 Opting for tax-friendly investments
You may consider going in for partially tax-free bonds, depending upon which tax bracket you come into. The interests from bonds like municipal bond and the US savings bond do not attract federal income taxes and state income tax, respectively. However, as compared to corporate bonds, these bonds may not have that high a stated rate, but you can benefit if you calculate exactly how much you will save in taxes.
#5 Holding stocks for more than one year
Your gains in day trading of stocks will be taxed at the same tax rates as your ordinary income that may reach upto 39.6%. However, if you hold your stocks for more than one year, these are taxed according to long-term capital gains that have lower maximum rates of 20 percent.
#6 Paying estimated tax
In the event of significant gains from investing, you may like to make estimated tax payments during the year. However, your withholding for the year needs to be within $1,000 of the owed tax to avoid interest and underpayment penalties. Of this $1,000, at least 90 percent should be what you owe for the current year and at least 100 percent of what you owed for the previous year.
Act in a timely manner
You don’t need to wait until the tax season rolls around or the tax deadline closes in, it is best to plan out your portfolio much before. This becomes more pressing if your tax situation is a complex one. You can approach tax experts, who will help you out by reviewing your income, investments, and portfolio to find ways to reduce your tax liability.
Conclusion
Inaction on your part for reducing your tax liability can prove a setback to your financial health. By year-end money-saving moves and meticulous tax calculations etc., you not only get to pay a lower tax bill but may even take home a small refund after the tax season.
