Tax Savings Tips

I am often asked “Is there anything that I should be doing to minimize my income taxes?” Often, the answer is a resounding YES! Following are some of the things that you can do to reduce your tax burden:

1) If your employer offers it, sign up and contribute to their 401K, 403B, etc. tax deferred retirement plan.  This is the easiest thing you can do to reduce your tax bill – it’s automatic and convenient – your employer withholds your contribution and sends it in for you. You typically have many investment choices so you can diversify adequately. The amount that you can contribute is typically higher than the limits for traditional or Roth IRAs. Your W-2 form at the end of the year will show your taxable wages reduced by the amount you contributed to the plan, and your employer’s matching contributions are also tax deferred! I really only recommend this if your employer has a matching contribution – or if you cannot contribute to a traditional IRA because of the income limitations. The downside to these plans is that they are an arrangement between your employer and a plan provider – you don’t have any choice in the matter. And to get any of your money out you typically have to “separate from service” – that is, quit, retire, or die. I do NOT recommend ever getting any sort of loan or taking a “hardship” distribution.

2) Contribute to a Traditional IRA. Notice I clearly said TRADITIONAL, and not Roth. This is because the Roth IRA contributions are NOT deductible when made. Remember the old adage “a bird in the hand is worth two in the bush?” Well, that tax deduction NOW for contributing to the traditional IRA is a certain thing and you can put the income tax savings in your hand. The future tax benefits for contributing to the Roth IRA are out there in the bushes – you may have to wait a long time to reap the benefits. Now of course there are exceptions where the Roth makes sense – but I typically only recommend the Roth for very young workers – less than about 30 years old. This is because they have so much time to invest and create a larger amount to withdraw tax free. You can open an IRA just about anywhere – banks, credit unions, savings and loans, brokerages, etc. And since it’s your money – no employer or other plan involved – you can always request an IRA distribution at any time – just remember the tax consequences!

3) Acquire Rental Property. Now it takes a lot more effort to implement income tax savings. The first two above were easy – now you have to become really proactive and seek out the next opportunities. Rental property ownership is not for everyone – trust me, I’ve had three of them in my past and am quite happy right now to have none. But for those with the tolerance and patience it can be a good strategy. You typically leverage your investment with borrowed dollars. You can claim a depreciation deduction while you own the property (see “acquiring rental property” under my FAQ tab for more about this). You also deduct all of your on-going expenses, property taxes, mortgage interest, repairs, maintenance, etc. The advantage to your income taxes is that if you do manage to show a profit, that profit is only subject to income tax and is not subject to self employment (social security) tax. This is because this activity is considered “passive”. You acquire the rental property and rent it out, but then you normally do not have to actively do anything else. You are allowed to deduct up to $25,000.00 each year of passive rental losses against your other income – unless your combined income exceeds $150,000.00 (or you are a real estate professional). The downside to this strategy is that when you sell the rental property any gains will be subject to either long or short term capital gains and any depreciation claimed will have to be recaptured (taxed) as ordinary income. But if you sell it at a loss this could be deductible as a capital loss (limited to $3,000.00 per year with the amount above this carried over to future years).

4) Start a small business (see “starting a small business” under my FAQ tab for more about this). Now you’re really getting aggressive and can deduct a lot of things that ordinary folks simply cannot. Of course you have to report all gross receipts you collect from your self employment activity, but you can also deduct those necessary and reasonable expenses. If you start a small business, be sure that you have a legitimate profit motive and that you truly expect to someday make a profit (as opposed to it just being a hobby with no real intent to make a profit). What kind of business? Well that’s totally up to you – but I’ll list here a few of the types of businesses I’ve helped prepare income tax returns for: Painter, carpenter, electrician, plumber, medical records transcriptionist, business consultant, sign maker, over the road trucker, landscaper, excavator, circle track racer, fishing guide, hunting accessory maker, and many more. Get any ideas? Consider the hunting accessory maker who sells his product from sporting goods stores all across the southeast. He makes several trips per year to sell and to provide stock for these sporting goods stores. Is is just coincidental that one of his routes passes through Myrtle Beach each year and that he needs to stay in this area while he sells his product? If you can substantiate that your expense is reasonable and necessary during the normal operation of your business you can generally deduct that expense – to the extent that is is attributable to the business. If the hunting accessory maker calls on sporting goods stores for two days while in the Myrtle Beach area, but says there four days total, then he can deduct 50% of the travel expenses while there – but all of the travel expenses to get there and back, assuming that there was not any significant personal time spent or personal benefit to the travel.

5) Start Farming – Generally everything that applies to starting a small business also applies to Farming. You will file an IRS form Schedule F for the farm as opposed to an IRS for Schedule C for a small business – but the way your income and expenses are taxed are the same. Farmers often raise cattle or vegetables, but can also raise show animals, dogs, horses, etc.

6) If you have self employment profit from a small business or a farm you now become eligible to possibly contribute to a SEP IRA or an individual 401K plan. These plans allow you to potentially contribute much more than a regular IRA.

7) If you have self employment profit from a small business or a farm and pay health insurance premiums to a health care plan that qualifies as an HSA (Health Savings Account) plan, you can open an HSA savings account and contribute money to it. You don’t get an immediate deduction for the contribution, but any money you spend from the HSA account for qualifying medical expenses is not subject to income tax! And you don’t have to spend it all every year – it rolls over.