That is right. I said it. There are really only four ways to cut your taxes. When you look at all the things out there, they break down into four different areas. So, let’s take a look at each area and the pluses and minuses.
- Spend a Dollar to Cut Your Taxes by 15 Cents. This is how most deductions work. And, actually depending on your marginal tax rate (the tax rate you pay on your last dollar earned) you’ll spend a dollar to cut your taxes by 10 cents, 15 cents, 25 cents, 28 cents, 33 cents or 35 cents. Does it seem like a good idea to spend a dollar to save cents? If cutting your taxes is the only reason for the transaction then you’re making yourself poor while you are saving taxes. If someone told you, “If you give me a dollar, I’ll give you 15 cents”, would you take that deal? Most of us wouldn’t. However, if you already want to spend the money for another reason such as, “I always wanted to own a house” or “I want to give money to charity” then the tax cut may (depending on whether you itemize) make the house more affordable or the gift to charity a little less expensive. The bottom line is, in this case especially, don’t let the tax tail wag the dog.
- Spend a Dollar to Cut Your Taxes by a Dollar. Now we’re into the realm of tax credits. Tax credits reduce your taxes dollar for dollar…with one caveat. Often times not all your money spent for an expense that is eligible for a credit will receive a credit. For example we’ll look at the American Opportunity Credit. The American Opportunity Credit provides a dollar for dollar credit for the first $2,000 spent on qualified education expenses. Then the credit is reduced to 25% of the next $2,000 in education expenses. After that there is no credit for education expenses. So, if the total qualified education expenses are $2,000 you will get a dollar for dollar reduction in your tax bill (I know, it is tough to do a year’s worth of school on $2,000, but a 529 plan combined with out-of-pocket expenses could make this happen). There are other credits out there and quite possibly you could plan your expenditures to maximize (hopefully to 100%) the amount the expense reduces your tax bill.
- “Account” for a Dollar to Cut Your Taxes by 15 Cents. Just like the situation above the actual cents saved depends on your marginal tax rate. What I’m talking about here is “non-cash” expenses that you can deduct on your taxes. “Non-cash” expenses are accounting procedures such as depreciation and depletion to document the wearing-out of assets. Now, this only works for assets that are used for business purposes so for most taxpayers I’m talking about rental property…most likely Rental Real Estate. For example if you own a house that you rent out you can deduct a percentage of the value of the house (not including land…it doesn’t wear out) each year. Specifically, you can depreciate the house over 27.5 years. If the house is worth $275,000 you can deduct $10,000 each year that you offer the house for rent (In actuality, the rules are a little more complex than this and you may not be able to deduct all of your deprecation in a given year depending on your income and the total loss on the property). Getting a tax deduction for a dollar you never actually spent is not a bad deal. There is one other warning though. If at some point in the future you sell the house you may owe taxes on the depreciation you took or should have taken. There are ways to avoid that tax as well too.
- Save a Dollar to Cut Your Taxes by 15 Cents. In my mind, this is the best option and like example 1 your savings are determined by your marginal tax rate. In essence, you save a dollar for your future and the government will pay you back for saving. How do you do this? For most military members the best way to cut your taxes through savings is by using the Thrift Savings Plan (TSP). Every dollar you put into TSP reduces your taxable income and therefore reduces your taxes. There also are a lot of other good reasons (like the expense ratio) to invest in TSP. Once you’ve maxed out your TSP you can consider putting money into a Traditional IRA for you or your spouse, assuming you meet the requirements to deduct the IRA. Other options might include 529 plan contributions, which are not deductible against Federal Income Taxes, but in many states can be deducted against State Income Taxes.
Now, in all honesty, there is at least one other way to reduce your taxes and that involves managing your income using techniques such as tax efficient investing…but we’ll cover that another day.
To wrap it all up, everyone wants to reduce their taxes and there are 4 major ways to do it. Some make more sense than others, so make sure you think through all your options before you make a tax planning decision.
Curt Sheldon, EA is a Fee-Only Financial Planner and Enrolled Agent based in Northern Virginia. He can be contacted at (703)542-4000, (800)928-1820 or Curt@CLSheldon.com
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The information contained in this blog is for general financial education and should not be construed as individual financial advice. Please consult your own financial, tax or legal advisor prior to applying any principles discussed here to your own financial situation.