When you take your first job out of college chances are that you will be starting in an entry level position. Add to that student loans on top of every day living expenses and its likely that what you save each month is pretty slim. However, as you progress in your career, your business takes off, or you climb the corporate ladder, your income is likely to grow as well. While this is almost certainly a positive change it also means that you are likely to start getting more attention from Uncle Sam. The more money you make, the more interested the IRS becomes, and the likelihood that you will owe taxes at the end of year instead of getting a return steadily rises. As they say, the only things certain in life are death and taxes. Although it is unlikely that you will ever be able to completely avoid taxes there are some ways to reduce the amount that you owe at the end of the year. Each option involves reducing your taxable income either by paying yourself or giving to others.
Retirement Plan Contributions
Perhaps the biggest opportunity that most people have to reduce their taxable income is through an employer sponsored retirement plan such as a 401(k) or 403(b). As we have discussed at length in this blog, retirement plan contributions are often made pre-tax. This means that your paycheck (and therefore your income) is reduced by the amount of your contribution. Your contributions and any investment gains that come from them are not taxed until you withdraw them in retirement. For the tax year 2023, the 401(k) contribution limit for individuals under 50 is $22,500 ($30,000 for ages 50+). In some circumstances, this may mean the difference between one tax bracket vs. another!
But what if you don’t have access to an employer retirement plan or work as a sole proprietor? There are options for you to contribute to your retirement with an even greater potential for tax reduction! Small business owners (or really anyone who receives a 1099 and can claim to work for themselves) can start solo retirement plans such as a SEP IRA or a Solo 401(k). Both plan types have the potential for the individual to contribute as much as $66,000 a year depending on their business income.
Now you might be thinking to yourself, “that’s great and all Alex, but I don’t make near enough money to make contributions like that. What is there for me?” Well, if you don’t have access to any of the plans that I have already mention or have a spouse that doesn’t have a job outside of the home there is an option for you as well. A Traditional IRA works much the same way as a 401(k) or SEP IRA from a tax standpoint. However, anyone can open an IRA and contribute up to the max of $6,500. These contributions are pre-tax and work to reduce your taxable income as well. Whatever option you choose, retirement plan contributions are a great way to invest for your future, defer taxes until retirement when you will likely be in a lower tax bracket, and reduce your current taxable income.
529’s and HSA’s
Health Savings Accounts (HSA) and 529 College Savings Plans are great ways to both reduce your taxable income while accomplishing other important financial goals. If you have a high deductible health insurance plan (HDHP) then you also have the ability to contribute to an HSA. This type of account is meant to be a way for you to save money in order to cover your health insurance deductible and out of pocket costs. It accomplishes this by allowing you to make tax-deductible contributions that become tax-free if used for qualified medical expenses. For 2023, families are allowed to contribute up to $7,750 to an HSA.
Up to this point every option that I have shared with you results in a reduction of your income for Federal taxes purposes. But what about state income taxes? In some states, such as my home state of Michigan, you are allowed to deduct up to $10,000 of 529 college savings plan contributions from your income annually. The catch is that you often need to utilize the state-sponsored 529 plan provider in order to receive that state tax deduction. 529 plans operate in much the same way as an HSA but with a different goal in mind. Contributions are state tax deductible (up to $10,000) and become tax free if used for qualified educational expenses.
If it is in your heart to support a specific cause or give to a certain charity, just know that tax deduction could be an additional perk. As a general rule, you are allowed to deduct up to 60% of your adjusted gross income (AGI) for charitable donations (some limitations apply based on donation method and type of donation). The catch here is that the deduction only applies if you itemize your deductions instead of taking the standard tax deduction. This differs from the other options that I mentioned as each of those methods of tax deduction are “above the line” deductions or in other words come before the standard deduction. Generally speaking, the only time that it makes sense to itemize your deductions as opposed to taking the standard deduction is when it would result in a lower taxable income. For single filers the standard deduction is $13,850 and $27,700 for married couples filing jointly. If your itemized deductions, including charitable contributions, exceed that amount then this could be an option for you.
Retirement plan contributions, 529 and HSA contributions, and charitable donations are all great ways to decrease the amount you pay to the government and increase the amount that you put towards things that really matter to you. For more information, make sure to reach out to your financial advisor and your tax accountant.
Thanks again for checking out this week’s blog post! This week’s song of the week is a new one that I think is pretty cool. Enjoy!
Investing involves risks including possible loss of principal. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Content in this material is for general information only and not intended to provide specific advice or recommendations, or a substitute for specific individualized tax or legal advice.