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A lot of thought goes into trying to save on taxes, but when it boils right down to it, there are really only four different ways to do it. Pretty much every idea you’ve heard from a friend or somebody hawking an idea on TV comes down to one of the following techniques. I’ll rank them from least effect to most effect.
Spend a Dollar to Save 25 Cents (or $0.15, $0.28, $0.33, $0.39 depending on your tax bracket). These are your classic deductions. The one you hear the most about is the mortgage interest deduction. In essence, for every dollar you spend on mortgage interest you reduce your taxes by 25 cents….kind of. You also need to realize that you only reduce your taxes with itemized deductions that are more than what you would deduct with merely your standard deduction. So you may actually get less than 25 cents on the dollar. Above the line deductions, like student loan interest, tuition deduction, and alimony are 25 cents on the dollar without worrying about the standard deduction (Above the line deductions are those found on the first page of the form 1040 used to calculate Adjusted Gross Income (AGI))
Spend a Dollar to Save a Dollar. Now we are talking about Tax Credits. Some, but not all, tax credits reduce your taxes by a dollar for every dollar you spend on the “targeted” expense. One classic example is the American Opportunity Credit. If you qualify for the credit (income limits apply) you will reduce your income tax by one dollar for every dollar you spend on qualified post-secondary education expenses (up to a total of $2,000). Then for the next $2,000 in qualified expenses you will receive a 25% credit for a total of $500. You qualify for credits whether you itemize or not.
Account for a Dollar to Save 25 Cents. There are some deductions that are allowed where you don’t actually spend money. The most common example here is depreciation on a rental home. Depreciation is an accounting procedure to allow for the fact that things wear out over time. In the case of a rental house, the IRS allows you to deduct a portion of the value of the house each of 27.5 years (House Value/27.5). You may eventually end up owing taxes on the depreciation if the house holds or goes up in value, but for the current year you will at least shelter income or get to take a deduction against other income (income limits apply).
Invest a Dollar to Save 25 Cents. You may be able to keep your dollar and still get a tax deduction. If you contribute a dollar to a 401(k) plan (or 403(b) and TSP) or Deductible Traditional IRA you will reduce your tax bill by 25 cents and you’ll still have the dollar…a pretty good return on your investment.
When it is all said and done, that is pretty much it…4 ways to reduce your taxes once you earn taxable income. There are other options available to not “earn” the income but once you recognize taxable income it pretty much boils down to these 4 techniques.
As always, working with a professional Tax/Financial Planner may provide options that you haven’t thought about.
Taxes picture via Shutterstock