While Uncle Sam would like nothing more than to pocket more of your money, “he” does offer a number of ways for you to decrease your taxable income which means more money in YOUR pocket. The U.S. Government provides numerous opportunities for taxpayers to reduce their tax bill – you just need to understand what is available. Read on for a high-level overview of some of the tax-advantaged vehicles that you can take advantage of to reduce your tax bill.
Retirement savings plans are full of acronyms: 401(k), 403(b), 457, IRA, SEP IRA and the list could go on. Although all of these plans have different names, they all basically provide the same benefit: the ability to save money for retirement on a before-tax basis. For example, if you would like to save $5,000 over the course of a year, you have two choices: 1.) You can put it in a tax-deferred account or 2.) You can put it in a taxable savings or investment account.
From the example below you can see that by contributing to any of the tax-deferred retirement savings plans mentioned above, you can end up with more money in your pocket today (due to the tax savings). The other added bonus is that you have will have more money available for future growth since the account is not taxed until you withdraw funds after age 59 ½ (if you withdraw funds prior to age 59 1/2, you will have to pay a 10% penalty on top of ordinary income taxes).
|Sample Pay Stub||Scenario 1||Scenario 2|
|Gross Income:||$ 4,166.67||$ 4,166.67|
|Contribution to retirement savings plan||$ 416.67||$ –|
|Taxable Income:||$ 3,750.00||$ 4,166.67|
|Taxes (assuming flat 25% tax rate)||$ 937.50||$ 1,041.67|
|After tax savings||$ –||$ 416.67|
|Net Income||$ 2,812.50||$ 2,708.33|
Your employer might also offer other tax-advantaged benefits such as a flexible spending account (FSA). A FSA allows employees to pay for certain qualifying expenses with pre-tax dollars. Qualifying expenses can include either medical expenses or dependent care expenses or both. If you have specific out of pocket medical expenses that occur every year, then a health-care FSA is a great way to save money on those expenses.
Likewise, if you have to pay for dependent care expenses (day care, nursery school, day camp, before/after school programs), then utilizing a dependent care FSA is a great benefit to utilize so that more money ends up in your pocket (the care provider / camp, etc. must have a tax-ID number). It’s important to note that flexible spending accounts operate on a use it or lose it basis therefore it’s critical to accurately predict your expenses for the coming year.
There are restrictions on how much you can contribute to flexible spending accounts as well, with health-care FSA contributions being capped at $2,500 per year in 2014 and dependent care FSA contributions being capped at $5,000 for the year. If you incur $2,500 of out of pocket medical costs in 2014 and contributed that amount into a FSA account, you’ve effectively saved $625 based on a 25% tax bracket.
So, if you would like to reduce the amount of money that you are sending to Uncle Sam, check with your employer to see if they offer a retirement savings plan and flexible spending accounts. If your employer doesn’t offer a retirement savings plan, you can always take advantage of before-tax retirement savings by opening up an individual retirement account (IRA).
About the Author
Kelly Stanley, CFP®, MBA is a Financial Planner with Beverly Financial Group and is an Investment Advisor Representative offering securities and advisory services through Cetera Advisors LLC, member FINRA/SIPC. Cetera is under separate ownership from any other named entity.
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