6 Tax Moves You Need to Make Right Now
With tax day thankfully behind us for another year, the last thing you probably want to think about right now is… taxes! But this is the ideal time to plan ahead for a less "taxing" April 15th next year. Here are the best moves to make right now. (See also: The 10 Worst Tax Moves You Can Make)
1. Estimate Your Taxes
If you're like most taxpayers, you probably got a refund this year. That may have felt like a nice bonus, and it's okay if you treat it as forced savings that may not have happened otherwise. However, getting money back means you overpaid your taxes. And with the average refund weighing in at over $2,800, that's a hefty overpayment.
While you have to pay your taxes, you do not have to overpay. To estimate what you'll really owe in federal taxes this year, grab a copy of the return you just filed and pencil in what your numbers are likely to look like this year. Or just visit the IRS Withholding Calculator, and run some numbers that way.
Next, look at how much federal tax currently is being withheld on your paychecks, multiply it by the number of checks you'll receive this year, and compare it to your estimates. If you're on a path to overpay again this year, contact your employer's HR department and ask to have less withheld from your paycheck. Or, if you're self-employed, lower your quarterly estimated payments accordingly.
Now do the same thing with your state taxes, although your state probably doesn't have an online calculator. So, print a form from your state's Department of Revenue or Secretary of State's office website and run the numbers manually.
2. Increase Your Retirement Savings
If you got a big refund this year and plan to follow the advice we just discussed, put some or all of your new monthly surplus into a tax-advantaged retirement savings plan, such as a 401(k) or IRA. That'll strengthen your future financial security and may also reduce your tax bill.
At more and more workplaces, employees have a choice between participating in a traditional 401(k) or a Roth 401(k) — or a traditional or Roth 403(b) if you work for a tax-exempt organization such as a school, charity, or government organization. The main difference between a traditional and a Roth retirement plan is how taxes are treated. With a traditional plan, every dollar you contribute reduces your taxable income. You get the tax break now, and then pay taxes on your contributions and earnings when you withdraw the money in retirement.
With a Roth, your contributions do not reduce your taxable income, but when you withdraw money from the account in your later years you can do so tax-free.
In general, the decision comes down to a comparison between your tax rate today and an educated guess about your tax rate when you retire. When you're in the early years of your career, chances are your salary isn't very high, so your tax rate isn't very high. You may be better off with a Roth. But if you're on the higher end of the earnings spectrum, you may be better off with a traditional 401(k). If that's you, increasing your contributions this year will lower your tax bill.
In 2014, you are eligible to contribute $17,500. Those age 50 and older can contribute another $5,500.
If you don't have access to a 401(k), the same advice applies to investing in a traditional or Roth individual retirement account (IRA), although the contribution limits are much lower — $5,500, and another $1,000 if you are 50 or older.
3. Save for Your Health Care
There are two primary ways to save on taxes when saving for health care costs.
Open a Health Savings Account
An increasingly popular way to pay for health care is to pair a high-deductible health insurance plan with a health savings account (HSA). The high deductible gets you a relatively low insurance premium. You then you cover the deductible and other out-of-pocket health care expenses by making tax-deductible contributions to an HSA. For individuals, a health insurance plan with a deductible of $1,250 qualifies you for an HSA. For families, the deductible must be at least $2,500. Individuals can then make tax-deductible contributions into an HSA of up $3,300; families can contribute $6,550. One great benefit of an HSA is the ability to roll over unused funds from one year to the next.
Participate in a Flexible Spending Account
If you don't qualify for a health savings account, your employer may offer a flexible spending account (FSA) for out-of-pocket health care costs. This one is a little trickier and not as advantageous as an HSA. Like an HSA, contributions into an FSA reduce your taxable income, but the maximum you can contribute is $2,500 per year, and your employer can only allow you to roll over $500 of unused funds from one year to the next. That means you have to be careful in estimating how much you may spend on health care costs for the coming year.
4. Buy a House
Of course, there are other considerations than taxes when buying a house (like making sure you can actually afford to buy a house!), but you may be surprised to find that owning doesn't cost much more, if at all, than renting. That's because you can deduct mortgage interest and property taxes. Print a copy of Schedule A from the IRS, add up your qualifying itemized deductions, and see if it comes to more than your standard deduction ($6,100 for individuals, $12,200 for married couples filing jointly). If so, plug those numbers into the estimates you ran earlier in figuring this year's tax bill and see how home ownership may impact your cash flow.
5. Shore Up Your Emergency Fund
Paying taxes can be painful enough. Paying tax penalties is even worse. And yet, the IRS took in $5.7 billion in penalties from people who withdrew money from their IRA or 401(k) before age 59½. Some of the early withdrawals can be chalked up to lack of knowledge about better alternatives, such as rolling over your balance penalty- and tax-free into an IRA when leaving your employer. Some of it is due to a lack of other savings. To avoid treating retirement savings as an emergency fund, build a real emergency fund by stocking a savings account (online banks typically pay the best interest) with three to six months' worth of essential living expenses.
6. Save for College
Finally, if you have a college-bound child, saving through a 529 plan may reduce your taxes. Every state offers such a plan. While there are no federal income tax deductions available for contributions, some states offer state tax benefits to residents who use their state's plan. Of those, some allow you to take deduction, which lowers your taxable income. Even better, some provide a tax credit, which lowers your tax bill dollar for dollar. Find out what your state offers by searching on the name of your state and "529 plan" or visit www.savingforcollege.com.
What steps have you taken to make the tax laws work in your favor?