Saving for retirement isn't just a smart move for the long run. It can also cut your taxes right now.
But just because you can reduce your currenttax bill doesn't mean it's always the right move. For many workers a smarter option -- and one made possible by more and more employers -- is a retirement plan that completely eliminatesyour tax bill down the road.
Make Way for the Roth 401(k)
401(k) plans have been staple benefits from employers for decades. Your retirement plan at work lets you have money taken straight out of your paycheck, and in some cases, your employer matches those funds with extra money of its own.
In a regular 401(k), the money you set aside reduces your taxable income for the year, potentially saving you hundreds or even thousands of dollars in current-year taxes. But a relatively new type of retirement plan -- called the Roth 401(k) -- can be an even better idea for some workers.
Based on the Roth IRA, these retirement plans don't give you the same up-front tax break. But unlike regular retirement plans, you don't have to pay a cent in tax when you pull money out of a Roth 401(k) to spend after you retire.
Is the Tax Trade-Off Worth It to You?
Currently only a very small number of workers who have access to Roth 401(k)s at work have taken advantage of them. In part, that's because you lose your current-year tax savings when you contribute to a Roth 401(k). (Apparently, the idea of paying taxes today on money that will be locked up for decades in a retirement account doesn't sit well with many workers.)
But that only tells half the story. For many workers -- especially those who are early in their careers -- you can expect your income to go up over time, as well as your corresponding tax rates. Giving up on a deduction now essentially lets you preserve it until a time when it might be worth a whole lot more.
Take a simple example: Many taxpayers currently pay taxes in the 15% bracket. For them, putting aside $2,000 in a traditional 401(k) gives them a $300 boost to their tax refund. But by the time they retire, they could well be in the 25% or higher tax bracket. When they withdraw that money in the future, they'll pay far more in taxes -- not just on the original $2,000
they invested, but on any gains they earned between now and then.
With a Roth 401(k), you give up that $300 refund now. But in exchange, you never have to worry about whether higher tax rates will end up costing you more later -- because you'll never have to pay any taxes on that money ever again. All the growth on that money is tax-free even when you use it in retirement. In the long run, that can add up to big tax savings.
If that's a trade-off you're willing to consider, it can make a big difference in how much after-tax money you have when you really need it.
Get in touch with your HR department to find out whether your employer offers a Roth 401(k) plan. Depending on your personal financial situation, switching from a regular 401(k) to a Roth could make you a lot richer in your golden years.
This isn't really a tax deduction, but it is an important subtraction that can save you a bundle. And this is the break former IRS Commissioner Fred Goldberg told Kiplinger's that a lot of taxpayers miss.
If, like most investors, you have mutual-fund dividends automatically invested in extra shares, remember that each reinvestment increases your "tax basis" in the fund. That, in turn, reduces the taxable capital gain (or increases the tax-saving loss) when you redeem shares.
Forgetting to include the reinvested dividends in your basis results in double taxation of the dividends -- once when they are paid out and immediately reinvested in more shares and later when they're included in the proceeds of the sale. Don't make that costly mistake. If you’re not sure what your basis is, ask the fund for help.
Although all taxpayers have a shot at this write-off, it makes sense primarily for those who live in states that don't impose an income tax. You must choose between deducting state and local income taxes or state and local sales taxes. For most citizens of income-tax states, the income tax is a bigger burden than the sales tax, so the income-tax deduction is a better deal.
The IRS has tables that show how much residents of various states can deduct, based on their income and state and local sales tax rates. But the tables aren't the last word. If you purchased a vehicle, boat or airplane, you get to add the sales tax you paid to the amount shown in the IRS table for your state.
The same goes for any homebuilding materials you purchased. These add-on items are easy to overlook, but big-ticket items could make the sales-tax deduction a better deal even if you live in a state with an income tax. The IRS has a calculator on its Web site to help you figure the deduction.
It's hard to overlook the big charitable gifts you made during the year, by check or payroll deduction (check your December pay stub).
But the little things add up, too, and you can write off out-of-pocket costs incurred while doing work for a charity. For example, ingredients for casseroles you prepare for a nonprofit organization's soup kitchen and stamps you buy for your school's fundraising mailing count as charitable contributions. Keep your receipts; if your contribution totals more than $250, you'll need an acknowledgement from the charity documenting the services you provided.
If you drove your car for charity in 2011, remember to deduct 14 cents per mile plus parking and tolls paid in your philanthropic journeys.
Generally, you can only deduct mortgage or student-loan interest if you are legally required to repay the debt. But if parents pay back a child's student loan, the IRS treats it as though the money was given to the child, who then paid the debt.
So, a child who's not claimed as a dependent can qualify to deduct up to $2,500 of student-loan interest paid by Mom and Dad. And he or she doesn't have to itemize to use this money-saver.
Mom and Dad can't claim the interest deduction even though they actually foot the bill since they are not liable for the debt.
If you're among the millions of unemployed Americans who were looking for a job in 2011, we hope you kept track of your job-search expenses ... or can reconstruct them.
If you're looking for a position in the same line of work, you can deduct job-hunting costs as miscellaneous expenses if you itemize. Such expenses can be written off only to the extent that your total miscellaneous expenses exceed 2% of your adjusted gross income.
Deductible job-search costs include, but aren’t limited to:
• Food, lodging and transportation if your search takes you away from home overnight.
• Cab fares.
• Employment agency fees.
• Costs of printing resumes, business cards, postage, and advertising.
Job-hunting expenses incurred while looking for your first job don't qualify.
As we just mentioned, job-hunting expenses incurred while looking for your first job are not deductible. But, moving expenses to get to that position are. And you get this write-off even if you don't itemize. (Moving for a job that isn't your first? Don't worry -- you can qualify for this deduction, too.)
To qualify for the deduction, your first job must be at least 50 miles away from your old home. If you were employed before, the new job must be at least 50 miles farther from your old home than your old job location was. If you qualify, you can deduct the cost of getting yourself and your household goods to the new area.
If you drove your own car, your mileage write-off depends on when during 2011 you moved. For moves from Jan. 1 through the end of June, the standard mileage rate is 19 cents a mile; for moves during the second half of the year, a 23.5 cents a mile rate applies. In either case, boost your deduction by any amount you paid for parking and tolls.
Members of the National Guard or military reserve may tap a deduction for travel expenses to drills or meetings. To qualify, you must travel more than 100 miles from home and be away from home overnight.
If you qualify, you can deduct the cost of lodging and half the cost of your meals, plus an allowance for driving your own car to get to and from drills. For qualifying trips during January through June, 2011, the standard mileage rate is 51 cents a mile; for driving during the second half of the year, the rate is 55.5 cents a mile. In any event, add parking fees and tolls. And you don't have to itemize to get this deduction.
Folks who continue to run their own businesses after qualifying for Medicare can deduct the premiums they pay for Medicare Part B and Medicare Part D, and the cost of supplemental Medicare (medigap) policies. This deduction is available whether or not you itemize and is not subject the 7.5% of AGI test that applies to itemized medical expenses.
One caveat: You can't claim this deduction if you are eligible to be covered under an employer-subsidized health plan offered by your employer (if you have a job as well as your business) or your spouse's employer.
A credit is so much better than a deduction; it reduces your tax bill dollar for dollar. So missing one is even more painful than missing a deduction that simply reduces the amount of income that's subject to tax.
You can qualify for a tax credit worth between 20% and 35% of what you pay for child care while you work. But if your boss offers a child care reimbursement account -- which allows you to pay for the child care with pre-tax dollars -- that might be a better deal. If you qualify for a 20% credit but are in the 25% tax bracket, for example, the reimbursement plan is the way to go. (In any case, only expenses for the care of children under age 13 count.)
You can't double dip. Expenses paid through a plan can't also be used to generate the tax credit. But get this: Although only $5,000 in expenses can be paid through a tax-favored reimbursement account, up to $6,000 for the care of two or more children can qualify for the credit. So, if you run the maximum through a plan at work but spend even more for work-related child care, you can claim the credit on as much as $1,000 of additional expenses. That would cut your tax bill by at least $200.
This sounds complicated, but it can save you a lot of money if you inherited an IRA from someone whose estate was big enough to be subject to the federal estate tax. Basically, you get an income-tax deduction for the amount of estate tax paid on the IRA assets you received. Let's say you inherited a $100,000 IRA, and the fact that the money was included in your benefactor's estate added $45,000 to the estate-tax bill.
You get to deduct that $45,000 on your tax returns as you withdraw the money from the IRA. If you withdraw $50,000 in one year, for example, you get to claim a $22,500 itemized deduction on Schedule A. That would save you $6,300 in the 28% bracket.