This story originally appeared on SmartAsset.com.
Taxes can take a big bite out of your income, especially if you’re in a higher income tax bracket. And even with careful planning, it’s possible that you could still be hit with an unexpected tax bill. The good news is, there are things you can do to keep more of your hard-earned dollars in your pocket instead of handing them over to the IRS. If you’re interested in how to avoid paying taxes legally, or at the very least minimize your tax liability each year, these tips and strategies can help.
How to Avoid Paying Taxes With Tax Deductions
Deductions can be a taxpayer’s best friend since they enable you to reduce your taxable income for the year. In simple terms, it’s an amount you deduct from your income.
When filing taxes, it’s important first to determine whether you want to claim the standard deduction or itemize deductions. The standard deduction is a flat dollar amount that you can deduct from your income. Your individual standard deduction is based on your filing status. Here are the standard deduction amounts for 2020 and 2021:
2020 Standard Deduction
- $12,400 for single filers or married couples filing separately
- $24,800 for married couples filing jointly
- $18,650 for head of household
2021 Standard Deduction
- $12,550 for single filers or married couples filing separately
- $25,100 for married couples filing jointly
- $18,800 for head of household
If you choose the standard deduction, you wouldn’t be able to itemize. Itemizing deductions means listing out individual expenses that you want to deduct from your taxable income. Generally, it makes sense to itemize if doing so would yield a larger tax benefit versus claiming the standard deduction.
The IRS allows you itemize and deduct a lengthy list of expenses, including:
- State and local tax payments
- Mortgage interest
- Charitable deductions
- Investment losses
- Qualified business or side hustle expenses
- Qualified medical expenses
- Gambling losses
The amount you can deduct depends on the deduction itself. With the mortgage interest deduction, for example, you can deduct interest expenses on up to $750,000 of mortgage debt if you purchased your home after Dec. 15, 2017. If you bought your home before then, the old deduction limit of up to $1 million still applies.
Additionally, you may have options for how to avoid paying taxes at the state level if your state offers additional deductions. For instance, some states allow you to deduct contributions to a 529 college savings account.
Reduce Taxes With Above-the-Line Deductions
There are some tax deductions you can claim even if you don’t itemize. These are called above-the-line deductions and they’re subtracted from your income before your adjusted gross income is calculated.
Examples of above-the-line deductions you might be able to claim include:
- Educator expenses
- Health savings account contributions
- Moving expenses if you’re an active-duty military member
- Half of your self-employment tax
- Self-employed retirement plan contributions
- Health insurance premiums you pay out of pocket if you’re self-employed
- Savings account and certificate of deposit account early withdrawal penalties
- Traditional IRA contributions
- Traditional 401(k) contributions
- Student loan interest
- Tuition and fees
- Alimony payments
You don’t need to itemize to claim above-the-line deductions. But it’s important to note that if you do decide to itemize, the amount of above-the-line deductions you take can affect any below the line or itemized deductions you might be eligible for.
When itemizing or taking above-the-line deductions, the IRS can impose thresholds on how much you can deduct. There can also be income limits for who can claim a particular deduction. The higher your income, the more your deduction amount may be reduced until it’s phased out eventually.
For example, say you’re covered by a retirement plan at work but you also contribute money to a traditional IRA. If you’re single or file head of household and have a modified adjusted gross income of $65,000 or less, you can deduct your entire contribution up to the annual contribution limit. But you can only take a partial deduction if your modified AGI is more than $65,000 and less than $75,000. Once you reach $75,000 you wouldn’t be able to deduct any part of your traditional IRA contribution.
Reduce Taxes Using Credits
Credits can also help to lower your tax bill but they work differently from deductions. Instead of reducing your taxable income, credits reduce your tax liability dollar for dollar. So if you owe $2,000 in taxes and you receive a credit worth $500, your net tax liability would be $1,500. Similar to deductions, there are a variety of tax credits you may be able to claim, based on your filing status and income. Some of the most popular tax credits include:
- Child tax credit
- Credit for other dependents
- Child and dependent care credit
- Earned income tax credit
- Retirement contribution savings credit
- American opportunity tax credit
- Lifetime learning credit
Again, just like with deductions the IRS imposes limits on how much credit you can claim and who can claim them. For example, the earned income tax credit is designed for people who have earned income for the year that’s below certain thresholds. A single filer with no children could be eligible for the credit for the 2020 tax year if their adjusted gross income doesn’t exceed $15,820. The maximum credit they’d be able to claim would be $538.
It’s possible to claim both tax credits and deductions on your tax return but generally, you can’t claim for the same expenses. For example, you can’t take a tuition and fees deduction in the same tax year that you claim the American opportunity tax credit or the lifetime learning credit. The IRS requires you to pick one or the other, so it’s important to do the math to figure out which one will yield the biggest tax break.
How to Pay Less In Taxes Each Year
Understanding the difference between standard, itemized and above-the-line deductions as well as tax credits is a first step in cutting your tax bill. Beyond that, you can consider whether any of these actionable strategies fit into your tax plan:
- Contribute to your employer’s 401(k) and max out your plan if possible
- Open and contribute to a traditional IRA and/or health savings account (HSA)
- Deduct your mortgage interest and student loan interest
- Make charitable donations for a tax deduction
- Harvest capital losses in your investment portfolio
- Start a side hustle or business and claim deductible expenses
When claiming any sort of tax break, it’s important to keep a paper trail documenting your expenses. Some of this is made easier for you. If you pay mortgage interest, for example, you should receive a Form 1098 – Mortgage Interest Statement from your lender at the end of the year. You should also receive statements from your 401(k), IRA or HSA showing how much you contributed for the year.
In the case of charitable donations or business expenses, you’ll need to keep accurate records yourself. When making donations, for instance, you should get something in writing showing when the donation was made, how much was donated if you gave cash to charity and the name and address of the organization. If you’re donating items, you’d want to keep an itemized list of what was donated and their value.
Keeping a paper trail can help ensure that you’re reporting deductible expenses accurately. And it can also help prove your deduction claims if your tax return is selected for an audit.
The Bottom Line
There’s no magic formula for how to keep more of your hard-earned money. Instead, it comes down to proper planning to make sure that you’re taking advantage of every available tax break. One of those is using tax credits; another one is claiming all the above-the-line tax deductions you’re entitled to. Talking to a tax professional can help you pinpoint opportunities for saving on taxes that you may have otherwise overlooked.
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