Reducing Taxes the Right Way: The Permissible Dozen
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Every year, the IRS offers taxpayers a polite warning in the form of what it calls the “Dirty Dozen.” It effectively announces that it knows of about at least 12 of the latest tax-related “scams” (the word used by the IRS) it has observed in the past year, many of which become more popular during filing season. The IRS does not conversely offer taxpayers a guide to the 12 easiest ways to reduce their federal income taxes – legitimately, of course. We therefore introduce “the permissible dozen.”
1. Retirement accounts
Retirement plans have long been an excellent way to reduce and defer taxes. Certain plans, such as traditional 401k plans and some individual retirement accounts, afford a deduction for amounts contributed into the plan. While taxes are ultimately paid when funds are withdrawn, individuals benefit from deferring those taxes and may even pay a lower rate if tax rates decline in the future or if participants fall into a lower tax bracket in retirement. Roth 401k plans and Roth IRAs, in contrast, do not offer current deductions but can offer the ability to escape taxation on all future gains and income.
There is a wide range of other retirement structures that offer similar benefits. They include nondeductible IRAs, simplified employee pension individual retirement accounts, savings incentive match plans for employees, and nonqualified deferred compensation accounts.
2. Medical accounts
Other types of accounts also offer substantial tax advantages. Flexible spending accounts can be used to fund eligible medical and other expenses with pre-tax dollars, while health savings accounts (HSA) can be even more impactful in funding medical expenses while reducing taxes. The three main tax benefits of an HSA are that contributions are made on a pre-tax basis, earnings are tax-free, and distributions (if they are used to pay for qualified medical expenses) are also tax-free.