Dear Carrie: When I did my taxes this year, I wound up owing a lot to the IRS. A friend at work mentioned they got a huge tax refund. How can I get a refund next year?—A Reader
Dear Reader: The end of tax season always brings a host of questions from readers. Mostly they boil down to “How can I pay less in taxes?” or “How can I get a bigger refund?” Many readers dont realize that these are two very different questions. Lets explain the difference and then talk about a few steps you can take to minimize your overall tax bill, keeping more money in your pocket.
Tax Refunds and Tax Rates
Ive discussed before why getting a big tax refund isnt the best thing, but I want to remind readers that a refund doesnt mean youre paying less in taxes. A tax refund simply means that you gave the government a zero-interest loan the prior year. The bigger your refund, the more money you lent.
In the same way, having to pay taxes when filing doesnt mean youre paying more in taxes. It just means you had less withheld than you owed during the prior year.
Whats more important is your effective tax rate, or the total amount of tax you pay divided by your taxable income. This percentage should be your main focus, not whether you got a refund or owed additional taxes.
Check Your Withholding
To make sure youre not overpaying or underpaying, check to see if you have the right amount of taxes being withheld from your income via the IRS Tax Withholding Estimator. You can also make quarterly estimated tax payments to the IRS if you dont have taxes withheld from your income.
Its important not to under-withhold by too big of a margin, as that can trigger a penalty. Be sure to account for bonuses, investment income and other income sources like rental income to ensure that you are withholding the right amount.
Recent tax-law changes increased the standard deduction ($12,400 for single taxpayers and $24,800 for married filing jointly in 2020), reducing the number of people who will itemize deductions like mortgage interest. As a result, its more important than ever to take advantage of every tax strategy, including contributing to tax-advantaged accounts when you can.
Maximize Contributions to Tax-Advantaged Savings Accounts
One surefire way to reduce your tax bill is to take advantage of tax-advantaged accounts. Tax-deductible contributions to traditional IRA, 401(k), 403(b) and 457(b) accounts can reduce your taxable income dollar for dollar.
Roth contributions dont provide a tax deduction upfront but still provide tax-deferred growth and the potential for tax-free earnings for qualified distributions after age 59 1/2.
If you have access to a Health Savings Account (HSA), you get the advantage of 100 percent deductible contributions, tax deferral and tax-free distributions for qualified health care expenses now or any time in the future. Saving and investing in an HSA can be a great tax move.
Dont forget, at the end of the calendar year, individuals 50 and older can make extra “catch-up” contributions of $1,000 to an IRA and $6,500 to 401(k)/403(b)/457(b) plans. Individuals 55 and older can make catch-up contributions to an HSA of $1,000/year.
Other tax-advantaged accounts like 529 college savings plans and flexible savings accounts can help you save on taxes while saving for other goals.
Get (Tax) Credits
Another important step is to take advantage of tax credits. Tax credits are more valuable than tax deductions because deductions only reduce the amount of your income that is subject to tax, but credits are a dollar-for-dollar offset against tax liabilities.
There are tax credits available to all types of taxpayers covering a wide range of expenses and situations. Some of these credits may not apply or may be phased out based on your filing status or income, but its worth your time to do some research. Heres a list of just a handful of important (but often overlooked!) tax credits:
- Earned Income Tax Credit: a tax break for lower-income families with children. The average amount of EITC received nationwide was about $2,500 in 2019.
- Child and Dependent Care Credit: up to $3,000 for each qualifying child or dependent, or $6,000 for two or more.
- Retirement Savers Credit: up to $2,000 in government “matching funds” in the form of a savers credit to help low earners save more in a 401(k), 529 ABLE or IRA.
- American Opportunity Credit (AOTC) and Lifetime Learning Credit (LLC): These credits help with the cost of higher education. The AOTC is up to $2,500 per eligible student, and the LLC is up to $2,000 per tax return. You can claim both AOTC and LLC creditsRead More – Source