There are several different knowledge domains of financial planning. These include areas like investments, estate planning, retirement planning, risk management (i.e., insurance needs), and tax planning.
Though it’s difficult to say that one of these areas is more important than the rest, it’s not so inappropriate to say that taxes remain relevant throughout the entire financial planning process. Almost every movement of money involves a tax consequence.
As you can imagine, planning for the reduction of your tax bill in any given year can prove to be quite difficult. While we always advise collaborating with your financial planner or tax expert, here are some effective methods to minimize your total tax burden in any given year.
Employer-Sponsored Retirement Plan
Employers frequently offer retirement plans to their employees, a practice that benefits both parties. The plans usually provide the company with tax deductions while simultaneously encouraging their employees to save for their own retirement with salary deferrals.
There is a plethora of different plan types that may be available to you (e.g., 401(k), 403(b), 457(b), Thrift Savings Plan). Without getting too caught up in the specifics of each plan, it is important to remember that they all have two primary commonalities:
- They offer a means to decrease your current year’s tax liability.
- They encourage folks to save for retirement.
A 401(k) is probably the most well-known type of plan, so we’ll focus on that one. Most plans will operate similarly.
Example
Let’s say your annual income is $100,000, and you decide to defer 10% of your salary to your company 401(k). Come January of the following year, when you receive your W-2 from your employer, it will show your reported wages for the previous year as only $90,000 because you elected to defer the 10% into your 401(k).
This is advantageous from a tax standpoint because reporting lower income translates to paying fewer taxes for that year.
To quantify the savings in this example, let’s also assume you are in the 24% marginal tax bracket. The 10% salary deferral to your company 401(k) will reduce your tax liability by $2,400 for the year in which it was made. In summary, by utilizing your employer retirement plan, not only are you prudently saving for your retirement, but you are also reaping immediate and tangible tax benefits through deductions.
The IRS places maximum contribution limits for these accounts each year as the tax advantages are too strong to allow unlimited contributions. The amount changes annually as it is indexed to keep up with inflation.
For 2023, the maximum contribution is $22,500. If you are 50 years old or older by the end of the year, you are allowed an additional $7,500 catch-up contribution.1
Deductible IRA Contributions
Another common way people reduce their taxable income is by making a deductible contribution to an individual retirement arrangement (IRA). As the name indicates, these accounts are also designed for retirement savings and should likely be earmarked for long-term investing. Similar to a 401(k) plan, any money you put into this account will reduce the income you report on your federal tax return by the same amount.
Example
Let’s say your annual income is $100,000, and you make a $5,000 deductible IRA contribution. This $5,000 contribution will be deducted from your total income, leaving you to report only $95,000 on your taxes. As mentioned earlier, less (legally) reported income translates to lower taxes.
It is important to note that not all taxpayers are eligible2 to make a deductible IRA contribution. Whether or not you are eligible depends upon your adjusted gross income (AGI), your participation in a workplace retirement plan, and having earned income.3
The SECURE Act of 2019 removed the age limits imposed on these types of accounts, so people of all ages are now allowed to contribute. However, this legislation also added an important caveat: You must have what the IRS refers to as “earned income” to contribute.
Unfortunately, these savings vehicles also have maximum contribution limits each year (adjusted each year for inflation). For 2023, individuals can contribute $6,500. If you are 50 years old or older by the end of the year, you can contribute an extra $1,000 as a catch-up contribution.
Contributions to a Health Savings Account (HSA)
An HSA is another tax-advantaged account. It differs from a 401(k) and IRA because it’s used specifically for medical expenses (i.e., dental, prescription drugs, vision, long-term care premiums, etc.). In order to establish an HSA, you must be enrolled in a high-deductible health plan (HDHP), which is a health insurance plan with low premiums but a high deductible. We often refer to HSAs as offering a triple tax advantage.
- Any contributions reduce your adjusted gross income.
- Investment earnings in the account grow tax-deferred.
- The distributions (if used for qualified medical expenses4) come out on a tax-free basis.
The HSA is arguably the most tax-efficient savings/investment account you can find (if it is used appropriately).
It is commonly recommended that individuals contribute to their HSA through payroll deduction (assuming the plan is qualified and offered through their employer). If contributions are made in this manner, it can save you another 7.65% in Federal Insurance Contributions Act (FICA) taxes. However, if you contribute to your HSA with funds that have already been taxed (i.e., funds in your checking account), you will not avoid paying FICA.
Lastly, it is crucial to remember that an HSA is intended to be used for medical expenses. If used for any other expenses, the distributions will be taxable as ordinary income, and a 20% penalty will apply. This rule becomes a bit more friendly once you reach the age of 65.5
If you haven’t guessed by now, these accounts also have annual contribution limits. For 2023, the single plan maximum contribution is $3,850; the family plan maximum contribution is $7,750. If you are 55 years old or older by the end of the year, you (and your spouse, if applicable) are allowed an additional $1,000 catch-up contribution.
Charitable Deductions
For those who are charitably inclined, you’ll benefit from knowing that your philanthropic endeavors, while serving the primary purpose of benefiting your selected charity, can simultaneously result in a nice tax break for your personal situation.
Gifts of cash, securities, and other forms of property to qualified charities can be deducted from your income (up to a certain percentage of your AGI, depending on the type of property). You should consider that not all charities are eligible for this tax benefit6 and confirm that your prospective charity qualifies before making any donations.7
It’s essential to note that this benefit is only available to those who itemize their deductions.
When it comes to the income tax formula, there are two broad deductions available for taxpayers to choose from: the standard deduction and the itemized deduction.
The standard deduction is offered to all taxpayers and should usually be taken if its value is higher than the value of your itemized deductions (this is the case for most people). The standard deduction amount for 2023 is $13,850 for those filing single and $27,700 for those married filing jointly.
The itemized deduction is comprised of several different deduction items (e.g., state and local income taxes paid,8 mortgage interest paid, medical expenses in excess of 7.5% of your AGI, charitable giving/donations). If your itemized deductions for the year are higher than your standard (and you elect to itemize), only then will you benefit from your charitable giving (from a tax standpoint, of course!).
For many folks, compiling a list of itemized deductions substantial enough to surpass the standard deduction can be challenging. This is where you can utilize a strategy called deduction clustering, which involves clustering your deductions all into one year.
Example
Let’s say you give $5,000 on an annual basis to your local church. Let’s also say your medical expenses are nominal, your mortgage interest is $10,000 annually, and your state and local taxes paid cap out at $10,000. The value of your itemized deduction for that year would be $25,000. If your filing status is married filing jointly, this itemized deduction doesn’t sound as attractive as your $27,700 standard deduction. Simply put, this form of charitable giving does not allow you to take advantage of (deduct) your donations.
However, if instead, you set aside your $5,000 on an annual basis for four years, you suddenly have $20,000 to give to your church in the fourth year (along with your $10,000 of mortgage interest and $10,000 in state and local taxes). Your itemized deduction now sits at $40,000, which we can all agree sounds much more attractive than the $27,700 standard deduction. By clustering your deductions for certain years, you are able to take better advantage of the deductions that go into itemizing.
Deductions for Self-Employed Individuals
It is true that self-employed individuals have access to some of the same tax-saving vehicles as your rank-and-file W-2 employees. However, there are notable distinctions when contrasting the available provisions for self-employed individuals and those accessible to regular employees. Below, we will discuss some tax-saving strategies specifically available for people who are self-employed.
Half of SECA Taxes
A slight drawback of being self-employed is that you must pay Self-Employment Contributions Act (SECA) taxes. This tax levy ensures that self-employed people pay into the FICA tax system. The rate for SECA taxes is 15.3%, which is further broken down into 12.4% for Social Security tax and 2.9% for Medicare. This aggregate percentage (15.3%) applies to whatever your business reports as net income (i.e., gross profits-expenses).
However, there is a tax advantage available here that you should ensure is being taken advantage of. Half of your SECA tax payment is deductible against your income.
Example
Let’s say you are self-employed, and your business reports $100,000 of net income for the year. You will pay SECA taxes of $14,129.55 based on your reported income from the business. Now that we have this information, we can explain the tax benefit. You are able to deduct half of the SECA taxes paid against your income. So, you will be able to list $7,064.78 as an “above-the-line deduction” on your federal tax return. As a recurring theme, the less income reported, the less taxes paid.
Retirement Plans for Self-Employed Individuals
As mentioned earlier, self-employed individuals will likely not have access to the same attractive retirement plans that W-2 employees do. However, there are other options available that can serve as great substitutes. These include tax-advantaged plans like SEP IRAs, SIMPLE IRAs, and solo 401(k)s. All of these plans offer tax benefits that would otherwise not be available to self-employed individuals.
What takes precedence in this situation is choosing the most appropriate plan for your business. This is why we recommend consulting with a financial planner or tax professional to determine which of these plans might best suit your specific situation.
Self-Employed Health Insurance Premiums
A great provision of the U.S. tax code allows self-employed people to deduct the cost of their health insurance premiums. This same provision is not necessarily available to employees, so it is important to take advantage of it if you fall in that first category.
When you receive health insurance through work as an employee, you’re likely part of a group plan. Group health insurance plans tend to be cheaper than policies for self-employed individuals. Although you would likely agree that it is not desirable to have higher healthcare premiums, it does make this deduction more attractive.
An important caveat here is that you are only able to claim a deduction equal to or less than your reported business income in any given year. If your business reported a loss, then you are not able to deduct any health insurance premiums.
Example
Let’s say your business reported income of $10,000 for the year, and your annual healthcare premiums were $15,000. You will only be able to deduct $10,000 for that year, even though the total expense was $15,000.
Additionally, let’s say your business reported a loss of $10,000 for the year, and your annual healthcare premiums were $15,000. You will not be able to deduct any of the premiums for that year.
Closing
The preceding strategies have a proven track record when it comes to saving tax dollars for the current tax year. However, in the realm of tax planning, it’s essential to plan for more than just the present. Some strategies to save on this year’s return could end up costing you money over the long term. Accordingly, tax planning should always be viewed through a long-term lens.
As always, we strongly encourage you to work with a financial or tax planning professional (i.e., CFP®, CPA, EA) to help guide your long-term decisions regarding these complex tax strategies. Happy tax planning!
2 For more information on eligibility, we encourage you to speak with your financial planner and/or tax advisor.
3 Earned Income | Internal Revenue Service (irs.gov)
4 Qualified Medical Expenses | 2022 Publication 502 (irs.gov)
5 Health Savings Account Rules (HSA Rules)
6 Exemption Requirements – 501(c)(3) Organizations | Internal Revenue Service (irs.gov)
7 Search for Tax Exempt Organizations | Internal Revenue Service (irs.gov)
8 Up to $10,000
