Filing taxes and reducing your taxable income.

[Editor’s Note: This is an independent post written by Jack. This post contains affiliate links. Please read our disclosure for more info.]

Tax Software:

Firstly, if you haven’t tried filing your own taxes I recommend you take the plunge! Most tax situations just aren’t that complicated and can quickly be done with the aid of very affordable tax software (in fact if your tax situation is simple enough most softwares are even free to use). I’ve e-filed for about 6 years now. I’ll admit that doing so costs me some time, but saved me A LOT of money. You can argue that paying an accountant doesn’t cost that much in the grand scheme of things, and I would agree with you; however, by paying someone to do it you’re missing out on a VERY valuable educational opportunity.

I learned a lot my first year filing using TaxAct and continue to learn more each year that I file. TurboTax is by far the most popular tax software around, and it’s arguably more user friendly than TaxAct, but I continue to use TaxAct because it has been consistently cheaper for MY tax situation. The last two years I’ve actually input all of my information into both softwares to compare the two (see the image below), and TaxAct continues to be cheaper for me. Regardless TurboTax, TaxAct, and tax software in general is informative, offering explanations and examples as you progress through inputting your information; however, if you’re feeling any hesistancies, don’t be afraid to consult forums (such as Bogleheads), books (such as Taxes Made Simple by Mike Piper), or a tax professional.

***ACTIVE MILITARY personnel can file their taxes for FREE through H&R block.

Reducing Taxable Income:

Many financial hobbyists out there are big advocates of filing your taxes via paper forms at least once (completely free minus postage) because of how instructional the experience can be. Honestly I haven’t done that yet, but in preparation for writing this post I did go through a line-by-line analysis of the digital copies of my tax forms from 2017 and 2018. The chart below compares my income, deductions, credits, and taxes for each year (click here to make a copy of this spreadsheet for your own use):

You may have noticed that I earned a higher income in 2018 versus 2017 (technically my social security and medicare wages were pretty close, though), but I paid significantly LESS in taxes . Federal Tax Reform contributed a bit to the difference (notice my marginal tax rate decreased from 15% to 12% as a result), but we also took some additional steps to reduce our taxable income this year:

  • What WE did in 2018:
    • Contributed 28k to 529 accounts. This reduced my state taxable income to only $3308, meaning I only owed $14 to south carolina.
    • Tax-Loss Harvested about 22k of losses in our taxable investing account during the last (brief) bear market. This not only allows us to deduct 3k of our ordinary income this year, but we can also carry those losses forward, allowing us to deduct 3k of our ordinary income for the next 5ish years.
  • What we will do in 2019:
    • Contribute to a Health Savings Account (HSA).
    • Ensure dividend income is “qualified” by holding the share(s) at least 60 days within the 120 dividend distribution window.
    • Don’t realize any capital gains (sell investment shares in a taxable account with a net gain). We were taking steps to merge our finances by consolidating our investment accounts, and I just didn’t think about the consequence of liquidating my taxable account to put it in a joint account at the time. I should’ve just held onto that taxable account for later in life, donated the shares to charity, etc.
    • Continue Tax-Loss Harvest if the market takes a downturn and use our carryover losses to deduct 3k of our ordinary income.
  • Other deductions/credits I’ve used in the past:
    • Deductions: State/local taxes, mortage/student loan Interest, PMI, charitable donations, flexible spending account contributed to a flexible spending account (FSA),
    • Credits: Education Credits, Foreign Tax Credits
    • Don’t be afraid to consult google or the library about all of the possible deductions/credits available to you. Taxes Made Simple has a few great chapters on many common credits/deductions that would apply to the average filer at some point.

Terminology:

  • Social Security Wages: employEE and employeER pay 6.2% EACH
    • Caps at $128,400 of wages earned.
  • Medicare Wages: employEE and employER pay 1.45% EACH
    • No cap. Increases to 2.35% EACH for wages earned beyond $200,000 ($250,000 filing jointly).
  • Adjusted Gross Income (AGI): includes additional income not reported on your W2 and “above the line deductions”.
  • Taxable Income: AGI minus allowances for exemptions and “below the line (standard or itemized) deductions”.
  • Taxable Interest: usually earned via money held in bank accounts (checking, savings, CDs, etc.).
  • Tax-Exempt Interest: interest earned that is exempt from federal and/or state taxes, usually from tax-exempt or municipal bonds.
  • Ordinary Dividends: dividends taxed as “ordinary income, because they were paid out on investments in a taxable account and did not meet requirements to “qualify” for the capital gains tax rate.
  • Qualified Dividends: dividends taxed under capital gain rates, because they were paid out on investments in a taxable account and met the requirements to “qualify” for the capital gains tax rate.
  • Capital Gains: gains “realized” from selling investment shares in a taxable account that are worth more than originally purchased.
    • Long-Term Capital Gains (LTCG) are those held for a year or longer and are taxed at the capital gains tax rate.
    • Short-Term Capital Gains (STCG) are those held for less than a year are taxed as ordinary income.
  • Capital Losses: losses “realized” from selling investment shares in a taxable account that are worth less than originally purchased.
    • Can be used to offset realized capital gains and UP TO $3,000/year of ordinary income (an “above the line deduction”).
  • Standard Deduction: the amount each filer is entitled to deduct from your taxable income by default. It’s essentially an automatic “tax break”.
    • The large majority of filers will fall under this category, particularly after the recent tax reform which raised the standard deduction ($12000 for single filers, $24,000 for married filing jointly filers).
  • Itemized Deduction: if the total of your “below the line deductions” exceeds that of the standard deduction, then filers can opt to use their total itemized deduction in lieu of the standard deduction.
    • Examples include mortage interest, student loan interest, private morgage insurance (PMI), etc.
  • Foreign Tax Credit: a credit issued for taxes paid on foreign investments in a taxable account.
  • Marginal Tax Rate: the percentage of taxes you would pay on your last/next dollar earned. What most people consider their “tax bracket“.
  • Effective Tax Rate: your income tax(es) divided by your taxable income. Most people use this as a reference for year-to-year comparison.
  • Actual Tax Rate: this is not an “actual thing” like the other terms listed above. We do however find this calculation useful and determine it by simply dividing our taxes by our total income.

What tax software do you use (if any and why)? What percentage of your income are you paying in taxes? What steps, if any, do you plan on taking next year to reduce your taxable income? Comment below!

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