How to Reduce Taxable Income

Everyone wants to pay less taxes, but who wants to make less money? It seems almost counter-intuitive, but to reduce your tax liability sometimes it is wise to reduce your income. The income we are speaking of is taxablincome. Reducing this income will reduce your federal tax liability. There are three main ways to reduce your tax liability: premium-only plans, dependent care flexible spending accounts and defined-contribution retirement plans.

Most times employees already pay towards these expenses with after-tax dollars, so you are reducing your taxes on money already spent. Best of all, you can contribute to these employer-sponsored plans free of federal,state, medicare, and social security taxes. You direct your employer to withhold pay from your salary before taxes are calculated. Therefore, it is effectively like the IRS is helping to pay for these expenses. Consider you have a marginal tax rate of 25% and you contribute $2,500 in pretax income each year to these sponsored plans that we mentioned, then you have already saved yourself $625 in money you don’t pay in taxes to the IRS.

Let’s look at each of these employer-sponsored plans in a little more detail.

Premium-Only Plan

Most larger employers offer this type of plan which allows employees to withhold a portion of their pretax salary to pay their premium contributions for employer-provided health benefits. These typically include medical, dental, vision, and some sort of disability insurance. Any amounts withheld are not reported to the IRS as taxable income. For example, say you have $50 a month withheld (unlikely in today’s climate of rising premiums, but for example’s sake) that would total $600 annually. If your effective marginal tax rate is 25%, then you would be saving $150 in money that you don’t have to send to the government in taxes.

Dependent Care Flexible Spending Account

A flexible spending account (FSA) is popular because it allows employees to fund qualified medical expenses with a pretax salary contribution. This allows people who know they will have un-reimbursed medical expenses in the upcoming year to pay for them without paying taxes on the money they will spend.

Examples of common expenses that are qualified expenses for FSAs are deductibles, office co-payments, over the counter drugs, prescriptions, orthodontics, eyeglasses, etc. Again, if you withhold $50 under this type of plan and have a 25% effective marginal tax rate, you would reduce your costs by the same amount.

The drawback of FSAs is the “use it or lose it” rule. Any unspent money in the account at the end of the year is forfeited and not returned to the employee. The IRS does allow for employers to grant a grace period that typically runs until March 15th.

Defined-Contribution Plan

A defined-contribution plan is an IRS-approved plan for retirement that is sponsored by an employer in which the employee makes pretax contributions that in turn lower their tax liability. The most common form of this plan is a 401(k). Also many times employers will match a percentage of contributions, e.g. 5%, so the employee essentially gets “free money”.

Make it your goal to contribute to these types of plans when offered and your tax liability will go down, down, down.

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