Chapter 3: Manage Your Taxes

Properly managing your taxes can greatly reduce the amount of money you pay both now and in the future.

Pay the Right Amount
You know you are paying the right amount of taxes if you neither get a large tax refund the end of the year, nor owe money to the IRS (or your state). While a refund may seem positive, it is really not making the most of your income during the year. For example, a $2,000 refund translates into $166 that you don’t have in your pocket every month. On the other hand, if you owe and can’t pay the entire sum, you’ll have to pay interest and possibly penalties, thus increasing your tax liability.

Max Out Your Retirement Options
As previously stated, IRAs, defined contribution plans, and other retirement plans offer tax-advantaged savings. If possible, contribute the maximum allowable amount into your 401(k) or 403(b). Since you make contributions with pre-tax dollars, your taxable income and possibly your marginal tax rate will be lowered. The marginal tax rate is the tax rate paid on the last dollar of your income. Tax rates are graduated – they are lower for the first income dollars than for later income dollars. Therefore, you may be able to lower your marginal tax rate by contributing to a tax-deferred plan, and pay less in taxes. The investment grows on a tax-deferred basis, so when you retire and take the money out, the earnings will be taxed on your new (and in most cases, lower), tax rate.

With a traditional IRA, if you do not have a tax-deferred plan through your employer, in addition to the tax-free compounding you also get an immediate tax deduction, saving you even more money by lowering your tax burden. Contributions to a Roth IRA are made with after-tax dollars. Earnings accumulate tax-deferred and may be withdrawn tax-free if the withdrawal occurs more than five years after you first contributed to it, and you are at least 59 ½.

Take Advantage of Employee Benefits
If you are an employee, your company may offer some benefits that can reduce your taxable income and therefore your tax liability (the amount you owe):

• Flexible Spending Accounts (FSAs). There are two types of FSAs. One is the medical FSA, where you set aside money to pay items such as health insurance co-payments, uninsured treatments, or over-the-counter medications. The other is the dependent care account, where you can set aside work-related child or dependent care expenses. For both, the money usually is taken out through regular, equal payroll deductions on a pretax basis.

• Transportation plans. These plans allow you to use pretax dollars (and reduce your taxable income) to pay for public transit, vanpooling, or parking.
  

Use All Your Deductions and Credits
A tax deduction is an expense that you can subtract from your gross income, resulting in a lower taxable income. Common examples of tax deductions are:

• An exemption amount for you, your spouse, each child, and any other qualified dependents, and certain disabilities
• Mortgage interest paid on your primary residence
• Equity loan or line of credit interest
• Charitable contributions to eligible organizations
• Certain business expenses
• Union and professional dues
• Some medical expenses
• The cost of tax advice, software, and books
• Depreciation of business assets
• Some work uniforms and clothing
• Moving expenses, in some cases
• Some educational expenses
• Qualified capital losses
  

A tax credit is a dollar-for-dollar reduction in what you would owe for taxes. For example, if you qualify for a tax credit of $1000, you would be able to subtract that amount from your total tax liability. Common examples of tax credits are:

• Earned income credit. This credit reduces the tax burden on lower-income taxpayers.

• Education-related credits. The Hope credit can be used for the expenses that you incur in the first two years of college. The lifetime learning credit applies to tuition costs for undergraduates, graduates, and those improving job skills through a training program.

• Child-related credits. These include credit for child and dependent care expenses, the child tax credit, and the adoption credit.