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Finances & Money Taxes

Reader Question: Diminishing My Taxable Income

Ok, I have admitted many times before that I purposely don’t advise on taxes or investing on this site for a reason. That reason is because 1) I changed from Accounting to an IT major intentionally and 2) Taxes and Investing are both boring and scary to me. However, reader Renee has a question I think I can give some guidance on based on my on recent experience.

So as I am preparing this year’s taxes, I realize I made a little more money, although it surely didn’t feel that way. My expenses also increased, namely for daycare. I am a single mom of 2, receiving NO child support. I don’t make bad money in IT. Anyway, I realized that I paid almost 22k for daycare this past year and all the gov’t is giving me is a 1600 tax credit for daycare. This is insane. So, what I would like is some of your advice about ways to diminish my taxable income. What ideas do you have to cut down my income with before-tax deductions, yet after taxes being able to bring home a decent amount. I know I should contribute more to 401k and my HSA, but do you have any other suggestions for me to research? Uncle Sam is killing me.- By the way, I’ve been reading yor blog for a few years and you’ve done a great job.

How Renee can save on her taxes

First off, I’m going to put out there that to save on taxes, generally you need to either make less money or spend more money on things like pre-tax or tax-deferred investments, so there’s no easy way to just get rid of taxes and keep your existing quality of life, but here are some tips:

  1. Max out your 401(k) – While investments aren’t guaranteed to go up, at least put in as much as is needed to get any company match, if your company offers it. Whatever you contribute, up to the max you’re allowed, will come right out of your taxable income.
  2. Contribute to a Traditional IRA – This is something I’m lazy at doing, but you can still contribute to your 2010 Traditional IRA if you haven’t yet and reduce your taxable income. Yes, it’s spending money to save money, but again, it’s investing in your future.
  3. Contribute to a Dependent Care Flexible Savings Account (FSA) – It will just make a small dent in your $22k/year daycare bill, but if your employer offers the benefit and you can work out payment with the daycare (this is where my experience and knowledge fall short), then do it. It’s another way to reduce your taxable income.
  4. Donate to charity – I know, it’s yet another way of spending to save, especially when you’re not getting the direct benefit of the money spent, but what do you think the rich do to lower their taxable income? The Gates Foundation isn’t there just because Bill Gates is extremely generous! If you have causes you want to support, then support them dangit! And get a little bit back from the feds in return. You can also look into donating non-cash items, but make sure you understand all the related rules and restrictions.

Those are the quick tips that come to mind, and I know each of them mean that you have less money in your paycheck at the end of the day, but the reality is taxes suck and we just need to plan for them properly by hedging with pre-tax and tax-deferred options and available tax deductions.

What do my other readers have to say? I’d love your input because I’m sure your collective intelligence is far greater than mine!

About the author

Clever Dude

9 Comments

  • I think you have a slight mix-up on the IRA. A Roth IRA would not reduce her taxable income, but a traditional IRA would.

    Her best bets would probably be to max out the 401k, as you mention, and her HSA as well, since those contributions are made w/ pretax dollars.

    The FSA, if available, would probably be a little better than the dependent care credit, as it avoids the SS tax deduct, but it would depend probably on her income, and whether her employer offers it, of course.

  • As the other commenter pointed out, contributions to a Roth IRA are not tax-deductible.

    #4 doesn’t make any sense. Yes, charitable contributions are tax-deductible, but they don’t actually save money overall. If you are in the 25% tax bracket and make a charitable contribution of $100, you will get back $25 in taxes, so in the end, it still costs you $75. Of course, donating to charity is a great thing to do, but it’s not a way to save money.

  • >I paid almost 22k for daycare this past year and all the gov’t is giving me is a 1600 tax credit for daycare. This is insane.

    What? Its insane that there isn’t government provided daycare? Sheesh.

  • @Mike, well, there is gov’t provided or should i say “funded” daycare if your income qualifies. Then I recently found out that my kids can’t go to their neighborhood elementary school until they are 5 yrs old, though the school offers a 3 & 4 year old program, again, because to enter them before 5 yrs of age, your income must be below certain limits. So poor families get free schooling and families that simply feel poor because we are eating all of the taxes are forced to pay for school because the gov’t says we can. Go figure!

    @Everyone else, thanks for your comments and ideas. Happy Taxes 🙂

  • You need to max out the dependent care portion of the FSA. Then simply submit receipts to the FSA from your daycare. You will have submitted enough receipts to recoup the maximum amt. by April probably. This should create a large tax offset in your favor.

  • There isn’t anything you can do to minimize LAST years taxes in terms of allocating cash to IRAs, charities, etc. Last year is over so anything you do to change your current allocation of money will be for next years taxes. Paying for day care is expensive, which is why for some couples it makes sense for one of the two to be a stay at home parent. In your case it is impossible because you have to work.

    Here is what you should do on your taxes if you haven’t already:

    First, you should be filing as Head of Household. That will raise your standard deduction and allow you to take exemptions for yourself and all qualifying children. As long as your husband did not try to claim your children or head of household, this will help you quite a bit.

    You also qualify for the child tax credit if your children are under the age of 17, which has to be the case or you wouldn’t be sending them to day care. The child care tax credit is available as long as your children are under 13 for part of the year.

    The first two suggestions by CD are good. You should be maxing out your 401k up to the company match to get the most free money possible. Not only that, every dollar you contribute is not counted as earned income. It’s like it doesn’t exist to the IRA (until you take it out). Not only that but you might be eligible for a retirement savings contribution credit. This also applies to the traditional IRA but not the Roth IRA. (on a side note, the Roth IRA is the next best option to a company matched 401k for retirement accounts unless you’re over the max income limitations)

    The last option CD gives: Charitable contributions, is not a good way to lower your tax liability for a couple reasons. First, if you don’t have enough in itemized deductions then charitable contributions can’t be written off. If you don’t own a home and pay your mortgage every month, most people don’t have anywhere close to the required amount where it would be better to itemize. If you do have more in itemized deductions (in your case as Head of Household I doubt it) then it will increase your deductions. This only decreases your taxable income but, like another commenter pointed out, only helps depending on the tax bracket you’re in. If you are in the 25% then it saves $25 for the $100 you donated but you’re still donating $75 which could be spent on childcare.

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