A reader wrote me recently: "I have discovered only three ways to cut my taxes: reduce income, give more to charity and incur major medical expenses. Is there anything else I can do?"
The reader has the right idea: Anything that reduces your income or maximizes your credits and deductions will lower your tax bill.
And now is the perfect time of year to make some moves that can help you shrink your tax liability for 2009 -- and make key decisions about your employee benefits that can cut your taxes for 2010. Here are 10 ways to lower your taxes:
Boost your 401k contributions: Any money you contribute to a 401k lowers your taxable income. You can contribute up to $16,500 to a 401k in 2009 (plus an extra $5,500 if you're 50 or older). You still have a few months to boost your regular contributions, or you can add any year-end bonus you receive to help max out your contributions before 2009 is over.
Make the most of your flexible spending account: Contributions to a flexible spending account avoid income tax and Social Security tax, which can save you 35% or more compared with spending after-tax money. Most employers require you to use your FSA money by Dec. 31 or by March 15 of the following year, so make sure you're on track to spend the money in your account before the deadline (otherwise it disappears). See "25 ways to spend your flex account" for more information.
You'll be making key decisions about next year's FSA account over the next few months, and you may want to boost your contributions if your employer is increasing your out-of-pocket health care costs for next year -- as many of them are.
The maximum-contribution limits vary by employer, but many let you set aside $3,000 a year in pretax money for a health care flexible spending account and up to $5,000 in a dependent-care FSA. Note that Congress is now considering a bill to cap the FSA deduction at $2,500 and limit the expenses to insulin prescription drugs.
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You're considered a first-time homebuyer if you (and your spouse, if you're married) haven't owned a home in the past three years. The credit begins to phase out if your modified adjusted gross income tops $75,000 (or $150,000 if married filing jointly), and it disappears if your income exceeds $95,000 if you're single (or $170,000 if married filing jointly).
A special rule lets you receive the money quickly: After you close on the house, you can claim the credit for the 2009 purchase on an amended 2008 tax return. But unlike the 2008 version of the tax break, you don't have to pay back the credit, as long as you live in your home for at least three years. See "Take advantage of these stimulus breaks soon" for more information.
In addition, the Worker, Homeownership and Business Assistance Act of 2009 provides a credit up to $6,500 to those who have had a principal residence for five consecutive years out of the last eight and who purchase a new principal residence. The house itself can be old; it just has to be a new principal residence. The measure limits the credit to those with incomes between $125,000 and $145,000 ($225,000 and $245,000 for joint filers) and denies any credit for houses costing more than $800,000. The new law also denies any credit to someone less than 18 years old.
Buy a car: The stimulus plan includes a tax break for new-car buyers. If you buy a new car between Feb. 17 and Dec. 31, you can deduct state and local sales taxes and excise taxes paid on up to $49,500 of the cost of the car. If you live in a state that doesn't have a sales tax, you still get a tax break if your state imposes a flat fee on the purchase of vehicles or a fee based on the price you pay.
The tax break applies to new (not used) cars, light trucks, motor homes and motorcycles. To qualify, your modified adjusted gross income must be less than $135,000 if you're single, or $260,000 if married filing jointly (the deduction starts to phase out if you earn more than $125,000 if single, or $250,000 if married filing jointly).
Sell losing investments: Capital losses are used first to offset capital gains, and then up to $3,000 of the net loss can be deducted against income, such as your salary. Any excess loss is carried forward to future years. (See "Got long-term capital gains and losses? Lucky you.")
Maximize your tax credits and deductions: Tax credits can lower your tax bill dollar for dollar. If you contribute to a 401k, IRA or other retirement-savings plan, you may qualify for the retirement savers' tax credit, which can trim your tax bill by up to $1,000 per person. Unfortunately, to get the maximum 50% credit, your adjusted gross income can’t be more than $16,500. If you then subtract a $3,650 personal exemption and a $5,700 standard deduction, your taxable income is capped at $7,150. The maximum tax on that is $715, not the $1,000 promised by Congress. On a joint return, the numbers limit the credit to $1,430, rather than the promised $2,000.
Also valuable -- and often overlooked -- is the dependent-care tax credit, if you pay someone to care for your child while you work. Keep in mind that even summer day camp counts if your child is younger than 13 and you or your spouse work.
And tax deductions are valuable, too, which lower your taxable income and in turn reduce your tax bill.
Pay college bills: The stimulus also improved the tax breaks for paying college bills. The new American Opportunity credit replaces the Hope credit for 2009 and 2010. It increases the size of the maximum credit from $1,800 to $2,500. The income limits to qualify have increased, too -- from $80,000 to $90,000 if you're single and from $160,000 to $180,000 if you're married filing jointly.
You can claim the American Opportunity credit in the first four years of college (not just the first two years, as was the case with the Hope credit).
Money you use to pay for college from a 529 or Coverdell education-savings account (both of which can already be used tax-free for college bills) doesn't count toward the American Opportunity credit. You need to pay at least $4,000 in tuition, fees and course materials, such as textbooks, from a source other than a 529 or Coverdell to qualify for the full credit.
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Give to a charity: You can write off charitable contributions if you itemize your deductions. But people often scramble in late December to decide which organizations to support. Now is a good time to start thinking about who should benefit from your largesse.
When tallying up your charitable contributions for the year, don't forget to count gifts of cash as well as appreciated stock and noncash donations. You can also include out-of-pocket costs to help a charity, such as 14 cents a mile in transportation costs to do charitable work or the cost of ingredients for a casserole you make for a nonprofit's soup kitchen.
For more, see "Give and grow rich with charitable deductions."
Max out tax breaks for the self-employed: If you're self-employed or have just a little freelance income, be sure to make the most of the tax breaks.
You'll be able to deduct the cost of equipment you use in your business, such as a computer, printer, fax machine and copier, as well as a dedicated phone line, office supplies, business travel and advertising. You may even be able to deduct a portion of your rent or mortgage, homeowners insurance and utilities if you have a qualified home office.
You can also make tax-deductible contributions to a retirement plan for the self-employed, such as a simplified employee pension or a solo 401k, and can deduct your health insurance premiums if you aren't eligible for health insurance from an employer or your spouse's employer. (You can't deduct more than the net income of your business.) For more information about what you can deduct and what forms you need to file, see "Tax toolkit for the self-employed."
Keep track of medical expenses: As you mentioned, incurring big medical expenses can result in a lower tax bill. But it can be tough to get much of a break for medical costs.
You qualify for the tax break only if you itemize your deductions, and you can write off expenses only if they exceed 7.5% of your adjusted gross income.
That means if you're earning $50,000 per year, you can deduct out-of-pocket medical expenses beyond $3,750. If you have $5,000 of qualified costs, you're left with a deduction of just $1,250. But even that partial deduction can make a difference. If you're in the 25% bracket, a $1,250 deduction can lower your tax bill by $313.Keep the receipts of money spent on medical bills in your tax file throughout the year because you could end up with a surprisingly large deduction if you have a medical emergency or a major expense that isn't covered by insurance, such as fertility treatments, orthodontia, laser eye surgery or any experimental medical procedures that your insurer won't cover.
Updated Nov. 24, 2009
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it seems that Obama is trying to help the middle class but unfortunately for our situation, not one of the tax breaks would apply to us. the rules are too exclusive for the most part. one of us never owned a home but because we sold our old one this year and i bought the new one, we don't qualify. the cash for clunkers would have worked too but you need to be continously insured to qualify. so far, we've lost $8000 and another $4500 because we don't qualify. that money would have helped us quite a bit especially since one of us is unemployed. what do we do now? really disappointed but hopeful. it also seems like the more programs Obama proposes and signs into the law the worse the economy is getting. i'm not against Obama because i really believe that he is trying to help but it looks like this is not working out for our country. if i had to vote all over again for him, i would still cast my ballot for him because with mccain in power, it would have been worse. look at what happened with mr. bush. i know that i'm going off on a tangent but here's another thought: as americans, we should all band together and try to work out our differences not trying to rip each other off or down each other every chance we get. we need to talk to each other, respect each other and try to find a solution together not destroy ourselves, our economy our planet our future. i know, corny but my opinion.