February’s Savings Tip
The Basics: Tax Saving Ideas
BY Taylor Smith
Fidelity Investments
Looking for tax breaks that can fund your financial goals.
The approach of April 15 may find you searching for tax breaks that will keep more money in your pocket—rather than Uncle Sam’s coffers. Fortunately, the federal government offers many tax credits and deductions that can help you achieve your financial goals.
“Tax season is a perfect time to take advantage of retirement savings strategies that may help you reduce your taxes while also putting you on the path to achieve your goals,” says Chris McDermott, senior vice president of Investor Education, Retirement, and Financial Planning at Fidelity.
Many IRS tax rules reward you for making wise financial decisions. Here are some ways to take advantage of those provisions:
Fund your retirement. The federal government provides incentives to encourage you to contribute to a workplace retirement saving plan, like a 401(k) or 403(b). Still, millions of U.S. workers simply don’t participate, according to estimates by the Employee Benefit Research Institute.
Until you begin taking withdrawals, your workplace retirement plan shields your savings from annual taxes, leaving you in control of more of your pay, and helping you build your investment portfolio. Consider this hypothetical example: If you make $75,000 a year and contribute $7,500 to your employer’s retirement plan, you’ll pay taxes on just $67,500 in income. For some people in the 25% tax bracket, that could add up to nearly $2,000 in tax savings each year.
In 2010, the IRS allows contributions of up to $16,500 to 401(k) and 403(b) plans, and an additional $5,500 if you’re age 50 or older. Each pretax dollar you contribute up to the allowable limit lowers your taxable income, which may reduce the tax you owe come April 15. When you withdraw the money it will be taxed at ordinary income rates. Of course, by then you may be in retirement and your tax rate may have changed.
Moreover, the immediate tax savings aren’t the only reason you might want to consider maximizing your contributions. When you put money in an account that offers tax advantages, it has the potential to grow—and the longer you invest, the greater potential for growth. So, tax breaks today can have a big impact down the road.
Individual retirement accounts (IRAs) offer additional opportunities to save on taxes. With a traditional IRA you can contribute up to $5,000 in 2009 and 2010. If you are over age 50 and meet the eligibility requirements, you may take advantage of an additional $1,000 “catch up” contribution, a total of $6,000. The contribution may be tax deductible, with certain income limits.
Roth IRAs may offer another tax strategy to your portfolio. Contributions are made with after-tax dollars, so they don’t reduce your current taxable income—but withdrawals in retirement are tax free, provided you meet certain requirements. You may contribute to a Roth IRA in 2010 if your adjusted gross income is $120,000 or less (single filers) or less than $177,000 (married filing jointly). If you are concerned about being in a higher marginal tax bracket in retirement, you might want to consider a Roth IRA.
“Saving for retirement is most individuals’ primary financial goal,” said McDermott. “Thanks to the tax advantages of workplace plans and IRAs, you can take an important step toward greater retirement readiness, while saving money on taxes.”
Pursue your dreams. Few things have as big an effect on your financial situation or overall well-being as your job. A degree or professional certificate can open the door to a better career and more income. Education costs continue to rise, but there are several tax strategies to make them easier to bear.
First, look into programs that offer tax credits, which typically provide a dollar-for-dollar reduction in your tax bill. For example, if you owe $2,000 in taxes, a $2,000 tax credit will reduce what you owe to zero.
The Lifetime Learning and the American Opportunity programs offer annual tax credits of up to $2,000 and $2,500, respectively, for tuition payments. There are several eligibility requirements for these programs, including maximum income limits. To learn more, check out www.irs.gov.
If you aren’t eligible or won’t be using tax credits, the IRS also allows certain tax filers simple deductions of up to $4,000 for tuition expenses during a given year. To qualify for the full deduction, your adjusted gross income must be below $65,000 (for single filers) or $130,000 (for joint filers).
Also, if you are saving for education in the future, consider setting aside money in a 529 college savings plan. These state-sponsored savings plans provide the opportunity for tax-deferred growth, and withdrawals for qualified higher education expenses are tax free. You can open an account for anyone—a child, your spouse, even yourself. And if your beneficiary decides not to go to college or doesn’t use all the money, savings are easy to transfer to another eligible member of the original beneficiary’s family. You don’t have to invest in your own state’s plan—but you may receive a tax break on contributions if you do. You can compare 529 plans at sites such as savingforcollege.com.
“Saving in a 529 plan or taking advantage of other tax benefits for education could help families be better prepared to meet rising college expenses, and could also reduce their reliance on other funding sources, such as student loans,” said Joe Ciccariello, vice president of college planning at Fidelity. “Funding education is important—graduates have the potential to earn more income and have more options available for employment.”
Take care of your family. Some employers offer additional savings plans that allow you to use pre-tax income to cover expenses such as medical or childcare.
Health savings accounts (HSAs) have steadily gained in popularity in recent years. These accounts, which must be paired with eligible high-deductible health insurance plans, let you use pretax income to pay for qualified medical expenses, from doctor visits to medicine—meaning that HSA distributions are never taxed as long as they are used for qualified medical expenses.4 Your savings within the accounts can grow tax free—and once you reach age 65 you can withdraw funds for any reason (though distributions for nonmedical expenses will be taxed as ordinary income).
“A growing number of Americans are using HSAs to take more control of their health care spending through reduced premiums, while at the same time providing a tax advantaged way to save for health care expenses in retirement,” says Eric Stanger, director of HSA product management at Fidelity.
Employers also may include flexible spending accounts (FSAs) in their benefits packages. These accounts are similar to HSAs, but can be used to pay for a wider range of items—often including dependent care costs such as child care. For example, you can use a dependent-care FSA to pay for up to $5,000 in child care expenses in a given year, using pretax money. However, unlike HSAs, which allow account balances to roll over from year to year, money in an FSA is forfeited if you don’t spend it by the end of the calendar year.
Invest in Your Home. Homeownership has a lot of perks—including potential tax saving opportunities.
“Owning a home is the biggest investment most of us will ever make,” says McDermott. “Taking full advantage of the tax-deductibility of mortgage interest can be a great way to make that investment pay off.”
The interest you pay on your mortgage is fully deductible, as is municipal property tax. If you have a home equity loan or line of credit, you can deduct the interest paid on the first $100,000, as well as interest on additional home equity debt used for significant home improvements.
Keeping IRS rules straight is difficult even for the most experienced CPA. But that doesn’t mean you should ignore the opportunity to save a significant amount come tax time. Consult your tax advisor about the best ways to take advantage of federal tax breaks. With any luck, you can significantly reduce your tax bill—leaving you more cash for your financial future.