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How can I strategize my tax planning as a W-2 only earner?

tax strategy

Form W-2 is the most commonly filed tax document in the US. It’s a simple document that employees file every year. These taxes will cost you 10% to 37% of your income, depending on how much you make. But there are several ways to save on taxes that don’t immediately meet the eye.

With some careful proactive planning and perhaps a few transfers, you can reduce your tax burden.

The simplest way to reduce your current tax burden is through retirement account contributions.

Traditional IRA contributions are often tax-deductible. However, your deductions may be limited. If your spouse has their own retirement plan from work or your income is too high, your deductions may be lowered.

A traditional IRA is fully deductible up to your contribution limit. For the tax year of 2020, you can deduct up to $6,000 if you’re under 50. If you’re 50 or older, you can deduct up to $7,000.

Keep in mind that your allowable deduction will also be affected by your income and marital status.

Maxing Out Your 401(k) Through Your Employer

Maxing out your 401(k) will allow you to save money on taxes and contribute more towards your retirement. All applicable contributions are tax-deductible for the year you made them. In fact, most financial advisors would encourage you to max out your 401(k) contributions.

Employer Matching

Employer matching of 401(k) contributions means your employer will contribute a set amount to your retirement savings plan. In general, the amount they contribute is a percentage based on your annual contributions or your annual salary. There are also other arrangements that employers will try to make with employees, such as a specified dollar amount. If your employer has a matching contribution benefit, be sure to contribute up to the match amount otherwise you are losing out on free money.

As is the case with IRAs, your 401(k) contributions have limits placed on them. These limits are subject to changes year-by-year, so check with the IRS to determine your contribution limits.

Tax-loss harvesting is a method investors can use to minimize their tax burden.

It can be applied to capital gains tax and other income. It works by selling investments that have lost more value than what you paid for it, replacing them with reasonably similar investments (usually within the same industry), and then offsetting any realized investment gains with those losses. This results in lowering or eliminating your capital gains and lowering your taxable income. 

A realized capital loss is the sales price of an asset, like a stock, which is sold for is less than what you paid for it. If you sell your investment assets at a loss before the end of the tax year, you can use that loss to offset any investment gains and the loss can offset $3,000 of ordinary income on your return. So, if your assets incur a sudden drop in value and you sell them off immediately, you are tax-loss harvesting.

If you want to engage in tax-loss harvesting to drop a sub-par investment and save on taxes, be aware of the Wash-Sale Rule. The Wash-Sale Rule is an IRS regulation that prevents you from claiming a tax deduction for securities sold in a wash sale. A “wash sale” according to the IRS is when you sell a security at a loss while also buying a “similar or identical” security 30 days before or after the sale. Your spouse or company are subject to the same restrictions.

Not sure how to tax-loss harvest? Check out this great article from the White Coat Investor.

Contributions to a Flexible Spending Account (FSA) can be reimbursed for eligible healthcare expenses and lower your W-2 wages.

For 2020, the maximum contribution to an FSA is $2,750 for an individual. But you should be careful to not overfund your FSA, as it doesn’t offer you the rollover over funds from year to year as an HSA will. 

Health Savings Accounts (HSAs) are, as their name suggests, accounts used to pay for healthcare expenses.

But the HSA, introduced in 2003, is also a great investment and savings account tool for W-2 earners. Individuals, especially those with high incomes, can save a lot of money through them over the course of their careers.

HSAs are triple tax-advantaged. Meaning contributions are contributed tax-free, they grow tax-free, and come out tax-free if used for qualified medical expenses. Contributions to HSAs are limited to $3,500 for individuals and $7,000 for families (2020). And the amount you contribute to your HSA is tax-deductible up to your contribution limit without any income limitations.

Not only that, your contribution withdrawals from the account are tax-free, as long as they go towards qualified healthcare expenses.

Unlike a Flexible Spending Account (FSA), HSAs are not subject to the same “use it or lose it” rules so you can contribute year after year and not have to worry about using the contributions before 12/31.

Perhaps the greatest “hidden” benefit to an HSA is the fact that you can use it to invest, just like 401(k) and Roth IRA accounts. All while saving you money on this year’s tax bill

You can take advantage of medical reimbursement plans for tax purposes.

The Health Reimbursement Arrangement is one of the applicable plans. 

Does your employer offer a formal medical reimbursement plan? In that case, reimbursements are tax-deductible to your business and tax-free to you as the employee. These types of plans allow for the tax-free reimbursements of some medical expenses. Many of the qualifying expenses are personal health insurance expenses, co-pays, dentist, etc.

Taking advantage of your state’s 529 plan enables you to take advantage of an additional tax deduction or credit on your state tax return.

529 plans allow you to contribute a specified maximum amount per year towards you, your spouse, or dependent’s qualified education expenses. The amount of the contribution depends on your state and not all states have a deduction for your 529 plan contributions.  Qualified expenses include such expenses as tuition, books, computers, school supplies, etc. It should be noted that there is no federal deduction for your 529 plan contribution.

Your 529 plan is an investment account that grows tax-free and the growth and earnings will not be taxed on the distribution as long as the funds are used for qualified education expenses. Before contributing to a 529 plan, look into your state’s specific 529 plan and the applicable fees associated with the account. 

Boost your deductions by bunching your charitable contributions.

After the 2017 tax reform, most individuals no longer itemized their deductions because the standard deduction increased to over $24K for joint filers. That means they lost the tax benefit of deducting items such as their mortgage interest, real estate taxes, and donations to charity. However, one way to boost your itemized deduction so you can deduct more than the standard deduction is to “bunch” your charitable contributions. 

What’s “bunching” you might ask? This is when you combine the intended charitable contributions for more than one year into one yar. If, for example, you normally can’t itemize with your annual $10,000 donation to your church, you can donate $20,000 in year 1 and potentially qualify to itemize your deductions in year 1. You then forgo the annual charitable contribution in year 2. You receive the full benefit of the two years of contributions in year 1 and your charity still receives their normal contributions.

Did this article give you ideas to help lower your tax liability? Are you getting a refund every year? You are giving the IRS an interest-free loan on your money! Tweak your paycheck so you don’t have so much over withheld by submitting an updated W-4.

All you need to do is download your Form W-4 from the IRS website right now, fill the form out, and turn it into your company’s human resources or payroll team. Most of the form is very easy to fill out, as they primarily ask for basic information. 

If you are not sure if these tweaks to your W-2 situation apply to you or you are not sure how to execute them, check out our ROI page to see if you are a good fit for complementary tax analysis.