In our last post we discussed how your tax bracket & rates are progressive and based on taxable income. Your taxable income places you within a certain tax bracket with a tax for income within that bracket. When you lower your taxable income you are also lowering your tax liability. That’s why we want to lower our taxable income (not your income).
Let’s clear up one thing first. This post is targeted primarily at those who are employees vs self employed or business owners. There are different opportunities to lower your taxable income for those that are self employed or business owners. I won’t be going over those but some of what we cover may apply.
So what is taxable income? Taxable income is any earned or unearned income minus any deductions or exemptions available for current tax year. Your earned income is the wages you receive from your job. Unearned income includes child support, some cancelled debts, or lottery winnings.
Pre-tax contributions
Retirement Contributions
A great strategy for lowering your taxable income (and preparing for retirement) is to maximize your retirement savings. If you have an employer sponsored 401K or 403b you can contribute up to $19,500, the limit for 2020. This contribution is considered pre-tax and lowers your taxable income. Note: you do pay taxes when you withdraw this money in retirement but it grows tax free.
If you do not have access to any of these employer-sponsored you should also consider contributing to a traditional IRA. The max contribution for an IRA is $6,000 for 2020 or $7,000 if 50 or older. You can contribute both to a Employee sponsored retirement plan and traditional IRA but take note of any changes to contribution limits because of this. See this IRS link for more details for contribution and deduction limit effects .
Another way of lowering taxable income is to contribute to a health savings account (HSA). These contributions are also considered pre tax and will lower your taxable income. Note that to contribute to an HSA you must have a high-deductible health plan. What you withdraw from this account is tax free as long as it is used for any eligible medical expenses . An HSA is owned by you and funds roll over. For 2020 HSA limits are $3,550 for the individual and $7,000 for family.
If you do not have a high deductible health plan it may not be the best plan for you. Another option that you can make pretax contributions to is a flexible savings account (FSA). An FSA is normally used for medical expenses but there are also FSAs for dependent care (If you care for a child or elderly family member) or limited FSA (specific to vision or dental). Unlike the HSA the FSA is employer managed and funds normally do not roll-over to the next year if unused unless the employer has the $500 carry over option for the account. If you don’t use it you’ll lose it. The limit for an FSA is $2,750 for 2020
Tax deductions
Finally a simple or complex way (depending on how you do it) to lower your taxable income is through tax deductions. A tax deduction is an expense that lowers your taxable income therefore your tax liability also.
The Simple Option: The Tax Cut and Job Act raised the standard deduction while at the same time lowering or taking away some itemized deductions. You have the option of taking the standard deduction or itemized. Most people will fall into the category of taking the standard deductions. It’s simple! All you have to do is to opt for the standard deduction when filing taxes. Note if you are 65 and older or legally blind you receive an additional deduction.
| Tax Filing Status | 2019 Standard Deduction | 2020 Standard Deduction |
| Married Filing Jointly | $24,400 | $24,800 |
| Head of Household | $18,350 | $18,650 |
| Single | $12,200 | $12,400 |
| Married Filing Separately | $12,200 | $12,400 |
DATA SOURCE: IRS.
The Possibly Complex Option: An itemized deduction. This is where you track all of your deductible expenses throughout the year and itemize those expenses to lower your taxable income. This can be more involved but there are apps and software that can make this a little easier. If your itemized deductions are more than standard deduction it makes more sense to file taxes with itemized deductions.
So here’s your start on lowering your taxable income. This does not even take into consideration credits which would lower the actual amount of taxes you owe. We will have to get into that in another post.
How are you planning on lowering your taxable income in 2020?
