Your Largest Bill

We spend a lot of time watching our budgets. We buy the store-brand cookies instead of name-brand at the grocery store, we wait until the end of the season to refresh our wardrobe to ensure the best deals, and we share passwords for streaming services to save on our monthly expenses. All of these are great strategies to save a few bucks throughout the year, and it adds up. However, there’s a much larger bill, which we all pay that we easily forget about until April 15th of every year.

For most people, their income tax bill is their largest expense of the year, yet it receives very little attention on how to minimize it. Nobody would suggest cheating the government out of their money, but there’s also no reason to pay more than you have to.

At a very simple level, your tax bill is based on your income minus your deductions, and then that income is applied to the tax brackets. Most people take the standard deductions ($12,550 single; $25,100 married filing jointly) and move on thinking there isn’t anything else they can do. This isn’t true though. You are legally allowed to reduce your income first, and then take your standard deduction.

One of the easiest ways to lower your income is to contribute to your retirement plan. Pre-tax contributions are currently fully deductible at any level of income. Tax rules allow participants of 401(k) and 403(b) plans to defer $19,500 per year for a combined $39,000 reduction in taxable income. If your household income is over $172,750 you are in the 24% tax bracket (you only keep 76 cents of every dollar you earn over this amount). At this income level, if you and your partner both max out your 401(k) plan, you would save $9,360 in taxes, not to mention you have $39,000 in retirement accounts that will grow tax deferred until you retire. Oh, and then you still get to take the standard deduction.

If you find yourself in a lower tax bracket, you may also want to consider a Traditional IRA. The contribution limits on an IRA are $6,000 per year and $7,000 if your over 50 under current IRS rules. These contributions are fully deductible if your income is under $66,000 for single filers and under $105,000 for married joint filers. An added perk to IRA’s is that they do not need to be funded until the tax filing deadline, conventionally April 15. This means if you are unsure where your income will end up at year end, you can wait to fund it until after you’ve received all your tax documents.

Perhaps you are lucky enough to have more income than you need, have already maxed out your retirement plan, and are still facing a high tax bill. Some employers will offer a deferred compensation plan to their highly compensated employees. As the name suggests, an employee can ask their income to be deferred into a separate account and not be paid to them until after they have separated from service. Then, usually upon retirement, the income is typically paid out in installments for a set period of years. This can be beneficial not only in lowering taxes today, but for funding an early retirement which will allow a person to receive income until they may begin accessing retirement accounts and social security.

Lastly, a word on refunds. It’s nice to receive a lump sum from the government after a year of hard work. This is your money though and was all along. A tax refund means you gave an interest free loan to the government all year. Most banks won’t lend you money for free, so why would we lend the government money for free? If you are getting a large refund, consider lowering your withholding and increasing your savings. You may be able to increase your retirement plan contribution, in turn lowering your taxable income even further!

Obviously, everyone has a unique situation. There are different types of retirement plans your employer may offer with different rules. I could write a whole other post on tax efficient investing and tax-loss harvesting. Working with a CERTIFIED FINANCIAL PLANNERTM or CPA can help you find strategies to lower your taxable income. Some may be complex and others you can start doing right now. Let’s not neglect your biggest bill of the year. Happy Investing.