Part of our build your own financial plan series
Tax planning: 10 ways to keep more of what you earn in 2020
A little tax planning now can go a long way toward helping you keep more of your money next year.
To get started, use our tax planning worksheet (PDF) to think through potential savings from tax credits and deductions. (And log the savings.)
Of course, every person’s situation is different and tax rules and laws can change in the blink of an eye. So it’s always good to consult a tax professional.
Change in filing deadline: The federal government extended the deadline to file and pay federal income taxes from April 15 to July 15, 2020. State tax deadlines may vary, so check with your state’s Department of Revenue.
Here are a few things to consider doing in 2020 to help put a (bigger) smile on your face when you do your tax return in 2021.
1. Increase contributions to retirement accounts.
Any 401(k) or 403(b) contributions taken from your paycheck on a pre-tax basis reduce your taxable income. Dollar for dollar.
For example, if you make $50,000 and have $100 taken out of 26 paychecks in 2020, that’s $2,600. So your adjusted gross income (AGI) is $47,400. That may save around $312 in taxes for a married couple, depending on your tax bracket.
More about retirement accounts
Things to remember about your 401(k) or 403(b) plan:
- You’ll pay taxes on that pre-tax money someday (darn) … when you withdraw funds in retirement.
- The max you can contribute to most 401(k) or 403(b) plans increased to $19,500 in 2020.1 (Some have a lower limit, so check into your plan’s details.)
- If you’re self-employed or have a business, your version of a 401(k) is a SEP or Simple IRA.
- If you’re 72 or older, you don’t have to take a required minimum distribution (RMD) from your IRAs in 2020. This is a change based on the CARES Act, passed in March 2020. If you don’t need the money this year, it’s a way a lower your taxable income.
What’s the difference between a deduction and a credit?
A tax deduction reduces the amount of income your taxes are based on.
For example, if your taxable income is $50,000, a $2,000 deduction reduces it to $48,000. So, you pay taxes on a $48,000 income instead of $50,000. Your actual “savings” is a fraction of the $2,000 deduction.
A tax credit reduces the total amount of income tax you owe.
If you owe $10,000 in federal income tax, a $2,000 credit reduces the amount you owe to $8,000. With a credit, your actual savings is $2,000.
Contributions to a traditional IRA are also made on a pre-tax basis (for those eligible to deduct their contribution) and therefore lower your AGI, similar to 401(k) contributions. Whether you can take a tax deduction depends on how much you make and if you have access to a retirement plan at work. In 2019, the max you can contribute to an IRA increased to $6,000.1 Learn more about IRAs.
About catch-up contributions: If you’re age 50 or older, still working and your plan allows, you can contribute an additional $6,000 to a 401(k) or 403(b) plan, or $1,000 to an IRA beyond the standard limits.1 It’s another way to lower your AGI.
You have until July 15, 2020 to make 2019 contributions to your IRA. (Normally, the deadline is April 15.)
If you’re wondering about a Roth IRA, it’s a different animal. With a Roth, you pay taxes now, but enjoy tax-free withdrawals later.* Take this quiz (PDF) to help you decide if a Roth IRA could be right for you.
2. Take advantage of a Flexible Spending Account (FSA).
If an FSA is available through your employer, every dollar you put in for dependent care expenses and/or medical expenses lowers your taxable income. The money comes out of your paycheck on a pre-tax basis. Then you submit expenses for reimbursement as they occur.
There’s a max you can set-aside in 2020, of course—$5,000 for dependent care, and $2,750 for health care. If you have enough qualified expenses for both, you could reduce your taxable income by $7,500. This could save you $900 in federal taxes.
If an FSA is not available to you, consider looking at the Dependent and Child Care Tax Credit instead. (Some restrictions apply, so consult your tax professional.)
Tip: Why lower your taxable income? Less income. Lower taxes. And that can mean more money in your pocket.
More scoop about FSAs
So when you elect benefits at your employer, consider whether an FSA makes sense for you. Plan carefully how much you put into an FSA. What you don’t use, you’ll likely lose, as it generally doesn’t carry over to the next year. And look at what is and isn’t eligible for reimbursement. You might be surprised by what’s on the list.
“People say they can’t take money out of their paychecks for an FSA. But it’s for expenses they expect to have anyway,” says Brandy Lamp, a senior financial consultant for Principal®. “Setting aside money from each paycheck spreads out the costs. And because it lowers your taxable income, it’s designed for saving money.”
3. Contribute to your Health Savings Accounts (HSAs).
This is another one tied to your employee benefits at work. If a high deductible health plan (HDHP) is offered and you choose it for your medical coverage, you can contribute to an HSA to save for out-of-pocket medical expenses not covered by your plan. There are lots of rules around HSAs, so visit the IRS website to learn more.
4. Review your paycheck withholdings.
Check to see if you have too much, too little, or just the right amount taken from your paycheck for federal and state taxes. This can get a little tricky and confusing.
If you have too much withheld from your paycheck, you may end up with a bigger tax refund.
- According to the IRS, the average refund tops $2,800. That’s around $233 a month. Would you rather have that money under your control, making interest in your accounts? Could you funnel the dollars toward one of the goals you’ve set?
- If you have trouble saving money throughout the year, maybe you use the extra withholdings as your savings plan and then pay down debt or fund your goals when you get your refund?
If you have too little withheld from your paycheck, you may end up owing more in taxes.
- That can be an extra “ouch” at tax time.
- Depending on the amount, Uncle Sam may charge you a penalty for underpayment. Double ouch.
Use the tax withholding calculator on the IRS site so you know where you stand, withholding-wise. It only takes a few minutes.
5. Buy a home.
If becoming a homeowner is one of your goals for 2020, you may be able to reduce your taxable income if you itemize deductions for mortgage interest and possibly a portion of the property taxes.
But due to the Tax Cuts and Jobs Act of 2018 you may take the standard deduction for your tax filing status versus itemizing deductions. Homebuying brings its own set of financial advantages and disadvantages outside of tax planning. Consult a tax professional to see if it adds any advantages when developing your tax plan.
Tip: Under tax reform, the standard deduction for each filing status increased significantly two years ago. But if your total itemized deductions are more than the standard deduction, you can still claim deductible expenses on your tax return. Calculate it both ways and do what works in your favor.
6. Make energy efficient improvements to your home.
There’s a federal tax credit for part of the cost of making qualified energy efficient home improvements. With the residential energy efficient property credit, homeowners can claim 30% of the cost of alternative energy equipment (including installation). Solar hot water heaters, solar electric equipment, wind turbines, and fuel cell property are examples of eligible equipment.
If you plan to make such improvements in 2020, hang onto your receipts. You can learn more about energy tax credits on the IRS site.
7. Consider adding money to a 529 college savings account.
A 529 plan is a tax-advantaged way to save for education-related expenses. You contribute with after-tax dollars, but earnings are tax-deferred while invested.
More than 30 states plus the District of Columbia offer state income tax deductions or credits for contributions to a 529 college savings plan. Tax benefits differ by state and how much you contribute to a 529 plan during a tax year. Learn more about Tax Benefits for Education (PDF) from the IRS.
8. Buy a car (not just any car though).
A plug-in electric vehicle, that is. The amount of this tax credit depends on the size of the vehicle and its battery capacity, up to a max of $7,500.
The credit is available until 200,000 qualified electric vehicles have been sold in the U.S. by each manufacturer. To check the status of that and learn more about tax credit amounts for specific cars, visit fueleconomy.gov’s pages about electric vehicles and plug-in hybrids.
9. Keep an eye on your investment portfolio.
If you have mutual funds and stocks, keep an eye on their performance during 2020. Selling some securities at a loss by year-end to offset capital gains may help reduce your taxes for 2020. It’s called “tax loss harvesting.”
But honestly, it’s complicated. Consult a financial professional for guidance on this tactic.
10. Have a baby.
Oh, we’re just kidding! But have you heard of the Child Tax Credit? It’s a real thing that can decrease your tax bill.
If you add to your family in 2020, it’s worth $2,000 per child under the age of 17 … subject to a few income limitations and rules, of course. (Just call the kids “little tax credits.”)
- All those acronyms related to income taxes can be a little confusing. Here’s a cheat sheet of 11 of the more common tax acronyms.
- Interested in learning about Principal’s 529 plan, Scholar’s Edge? Visit scholarsedge529.com.
- Brush up on the latest tax law changes by reading Filing your taxes in 2020: What to remember this year.
1 IRS annual limits for 2020.
* Your account must be open for 5 years and you must be over age 59½ to be eligible for qualified tax-free withdrawals.
Investing involves risk, including possible loss of principal. Asset allocation and diversification do not ensure a profit or protect against a loss.
The subject matter in this communication is educational only and provided with the understanding that Principal® is not rendering legal, accounting, or tax advice. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, or accounting obligations and requirements.
Insurance products and plan administrative services are provided by Principal Life Insurance Company. Principal Funds, Inc. is distributed by Principal Funds Distributor, Inc. Securities are offered through Principal Securities, Inc., 800-547-7754, member SIPC. Principal Funds Distributor, Principal Securities and Principal Life are members of the Principal Financial Group®, Des Moines, Iowa, 50392.