For most young investors, tax filing consists of a single W-2 and possibly some student loan interest deductions. What many young investors aren’t doing, however, is taking advantage of workplace 401(k) contributions and IRA contributions. These are just two simple solutions to help young investors lower their taxable income while saving money to reach financial freedom (financial independence) in the future.
Besides contributing to an IRA before the April 15 tax deadline, below are a few simple tips to help with this year’s income tax.
CONTRIBUTE TO A TAX-ADVANTAGED SAVINGS PLAN
Contributing to a 401(k) or other savings plan is easily the first step for young investors when attempting to reduce their taxable income and accumulate wealth. Not only do most plans offer a match to employee contributions, but any employee contribution is paid with pre-tax dollars which means the taxable income shown on a W-2 is lower by the total contributions. Assume you are 23 years old and wish to retire at age 60. If you are earning $35,000 per year and you save just 10% of your current income in a 401k which your employer adds to with a 50% match. Your $3,500 plus your employer match of $1,750 will grow to $1 million in 37 years assuming a 7.7% annual return.
If a savings plan is not an option due to that company’s age or years of service requirement, or a company just doesn’t offer such a plan, contributions to a traditional Individual Retirement Account (IRA) or Roth IRA may be an option. Traditional IRA contributions are tax deductible whereas Roth IRA’s are not. Both grow tax-deferred but the Roth allows tax free distributions after age 59 ½.
ADJUSTING YOUR PERSONAL WITHOLDING
Are you on track to overpay or underpay your taxes? Many young investors with families often over-withhold, leaving cash in the hands of the government, earning nothing. That money could instead be used for immediate savings earning something. On the flip-side, withhold too little and you’ll be surprised with a tax bill come next April 15th. If you’re unsure about the proper level of withholding, speak to your tax advisor and then visit the human resource or payroll department to adjust the amount of income tax withheld. If your withholding is short the longer you wait to make changes, the harder it may be to reach your target by year-end.
KEEP TRACK OF DONATIONS
Most donations are made around the holidays as many charitable organizations begin asking donors to fund next year’s budgets. Big or small, all donations could add up to enough dollars to exceed the standard deduction.
For young parents, tax breaks are plentiful and usually overlooked as opposed to just taking the standard deduction. For instance, volunteer expenses, donations to schools, and mileage for charitable events are items one could itemize for a larger deduction on your taxes. Also, non-cash donations of clothing or furniture are deductible, but you must obtain a receipt and determine a fair value of the goods donated.
HARVEST INVESTMENT LOSSES
Capital gains incurred in taxable accounts will create income taxes. However, capital losses may be taken to offset capital gains. Excess net capital losses are deductible up to $3,000 per year. Be sure to meet with your advisor towards the end of the year to ensure you have a proper harvesting procedure for your taxable accounts.
OPEN A FLEXIBLE SPENDING OR HEALTH SAVINGS ACCOUNT (FSA/HSA)
Find out if your employer allows you to have an FSA through work to pay medical expenses and dependent care and other expenses. Money deducted from an employees’ pay is not subject to payroll taxes or income taxes. A plan may permit an employee to carry over up to $500 into the following year without losing the funds. Similarly, if you have a high-deductible health insurance plan through work, most plans offer HSA contributions through a qualified custodian. An HSA allows for tax-deferred growth of contributions earmarked for medical expenses.
Source: Fidelity Investments
Next time: Tax-Efficient Funds Are Better Than Annuities