How To Give Yourself A Tax Cut

When it comes to taxes, the good news is that we all have until May 17th to file and pay our federal income taxes. (Your state income tax deadline may be a different story.) Parents can also qualify for the higher child tax credit. The bad news is there isn’t much you can really do to reduce your 2020 taxes. However, there are steps you can take to reduce your taxes in 2021 and beyond (short of having more children):

1) Increase pre-tax contributions to your employer's retirement plan and/or a traditional IRA.

If your employer offers a pre-tax retirement plan like a 401(k) or 403(b), you can contribute up to $19,500 for 2021 and an additional $6,500 if you turn age 50 or older this year. (If you also have a 457 plan, you can contribute that same amount to that plan too.) If you don't have a retirement plan at work, you can contribute up to $6,000 to a traditional IRA (plus another $1k if you turn age 50 or older this year) and deduct the contributions from your taxable income. If your employer has a plan, you can still contribute to a traditional IRA, but how much you can deduct depends on your income. (Also note that the deadline to contribute to an IRA for 2020 has also been extended to May 17th.) 

Whether you're contributing to a pre-tax 401(k) or taking a deduction on an IRA, you're not paying tax on that money now, but you still have to pay taxes on it when you eventually use the money. So how is that a benefit? The obvious one is that since most people need less income in retirement, you may end up retiring in a lower tax bracket.

But even if you don't, there's still a good chance that you'll end up paying a lower average rate on that money. That's because not all of your income gets taxed at your tax bracket. For example, let's say you have a joint taxable income of $100k. That puts you in the 22% tax bracket. But the first $19,750 is only taxed at 10%, the next bucket of income up to $80,250 is only taxed at 12%, and so only the $19,750 above that $80,250 is taxed at the 22% rate. According to this calculator, your overall average rate would actually be 13.5% for 2021.

When you contribute pre-tax money to these accounts, it "comes off the top" so in this case, it would have all been taxed at that 22% tax rate. However, when you withdraw that money, some of it may not get taxed at all because of deductions and credits, and a lot of it may end up getting taxed at those lower brackets. So if you retire with the same taxable income, you'll still probably end up paying a lower average tax rate on those 401(k) withdrawals. Of course, you could also end up paying a higher tax rate in retirement if your income is higher or if rates go up. This brings us to...

2) Contribute more to a Roth retirement account.

Your employer may offer you a Roth option in your retirement plan or you may be able to contribute to a Roth IRA. (If your income is too high to contribute directly to a Roth IRA, you can always try the "backdoor" method.) The contribution limits are the same as the traditional accounts, but the Roth accounts won't reduce your taxes now. The advantage is that as long as you have the account for at least 5 years and are over age 59 1/2, all the earnings are tax-free so it doesn't matter how high your future tax rate is. (Having tax-free income can also help you qualify for health insurance subsidies if you retire before qualifying for Medicare at age 65.)

3) Contribute more to an HSA (health savings account).

If you have a high-deductible health care plan, you may be eligible to contribute up to $3,600 for individual coverage or $7,200 for family coverage to an HSA. You can also save an additional $1,000 if you’re age 55 or older. These basically combine the best of both worlds because the contributions are pre-tax, and you can withdraw the money tax-free for qualified health care expenses. Once you turn age 65, you can also withdraw the money penalty-free for non-medical expenses, but it will be taxable.