6 Last-Minute Ways to Reduce Your Tax Liability
The clock is ticking! Here are 6 last-minute ways to lower your tax bill this year.
It’s everyone’s favorite time — tax season! This can be a stressful period, particularly for people who don’t have W-2 jobs that require withholding of incomes taxes on their wages. This includes people who are self-employed or have lucrative side hustles. If you’re trying to retire early, this probably means you.
If you don’t have your income taxes withheld throughout the year, you may be left having to come up with a lot of cash quickly in order to pay your bill when you submit your return.
Now, once the end of the year is passed, there’s only so much that can be done to lower your tax liability — there’s a lot more you can do within the tax year than between January 1 and the filing deadline. But, there are things you can do to reduce your tax liability — even at the last minute.
How to reduce tax liability
People make a big deal out of taxes. After all, universities offer advanced degrees in the subject, so it must be complicated, right?
But, the basics are actually quite simple. The only way to reduce your tax liability is to lower your net income. And, since net income equals gross income minus deductible expenses, only two ways to lower tax liability:
- Making less money (no thanks), or
- Find more deductions
Strategies for reducing tax liability at the last minute
Once the year is over, you’ve pretty much made the income you’re going to make and spent the money (on deductible expenses) that you’re going to spend.
But there are still some things you can do before the tax-filing deadline. So, if you’re trying to find ways to reduce your tax liability before the deadline, be sure to consider these:
1. Home office deduction
2020 was a year unlike any other. With COVID, just about everybody was working at home for at least part of the year. If you fall into that category, you can qualify for certain home office deductions!
Start by measuring the part of your residence that you use exclusively for work (in terms of square footage). Then, calculate what percent of the total square footage that area represents. From there, you can multiply that ratio by the totals of bills like rent, utilities, etc. for the months you worked at home. The resulting figures can usually be deducted.
One important note, though: If you own your home, you can already deduct mortgage interest, so be careful not to double-deduct part of your mortgage payments. But you can still deduct things like utility payments or portions of home maintenance costs.
2. Unreimbursed work expenses
Even if you don’t have a home office, you can still deduct any expenses that you incur for work (your own company or not) that aren’t reimbursed by your employer.
So, if you had to travel for work or buy your own equipment out of pocket, you can probably deduct those expenses. Did you have to buy a new computer so that you could work from home? If you bought new software to help support your new role, that’s probably deductible, too.
Just make sure you have receipts.
3. Retirement account contributions
If you have a full-time job that offers a 401(k), then a lot of this won’t apply to you. But, if you’re self-employed or don’t have a retirement plan through your work, you can contribute to a retirement account of your own even up to your tax-filing deadline (April 15 or, if you file for an extension, October 15).
So, if you are eligible for your own retirement plan, consider setting up an IRA, SEP IRA, or Solo 401(k) so you can contribute even after January 1.
Depending on the type of account you have, these contributions can be pretty large — in the case of Solo 401(k)s, for instance, you can contribute up to $57,000 (or 100% of your income, whichever is higher).
But again, in order to use your own retirement account, you can’t qualify for a retirement plan offered by an employer. So, even if you have a side hustle — even a super-profitable one — in addition to a full-time job at a company, you may not be able to set up your own separate retirement plan to shield income.
If you have a high-deductible health insurance plan (health insurance that has a deductible over $1,400 for individual coverage for $2,800 for a family), you’re eligible to contribute to a health savings account (HSA). This is an account similar to an IRA that allows you to make tax-deductible contributions that can be used later to pay for medical expenses. The Individual contribution limit for 2020 is $3,550, or $7,100 if you have family coverage.
Once you contribute to an HSA, you can use funds in your account to cover medical expenses, including paying your deductible, buying medicine, or even preventative care. And, distributions aren’t taxable if used for qualifying medical expenses.
Also note that you can only CONTRIBUTE to HSA if you have a high-deductible plan, but you can still keep the account if you change plans later — and, you can still use funds in your account.
Plus, many HSA providers actually allow you to invest a portion of your account to grow balance faster, and if you don't end up using the funds for medical expenses, you can withdraw them tax-free in retirement!
If you own commercial property or have certain types of side hustles, you may have assets that can be depreciated over time to help offset part of your income over several years. However, there are several different types of depreciation, such as straight-line, declining balance, and units of production.
So, if you think you may have assets that can be depreciated to help reduce your tax liability, consult an accountant to decide which strategy is right for you. This will be based on the type of asset you own, how it’s being used, and how much income it’s generated for you.
6. Medical expenses
If you paid out of pocket medical expenses, you can probably deduct those on your taxes.
If you paid for them out of an HSA, then you obviously can’t claim them as deductions, because the contributions to the HSA were deductible in the first place — so you were already paying the expenses with before-tax dollars.
But, any expenses you paid out of pocket are likely deductible, even for test or preventative care.
Things you CAN’T do
While these are some strategies that can help you reduce your bill this tax season, it’s just as important to know about some potential missteps to avoid. Some of these can drastically raise your chances of being audited and even lead to big fines and penalties if you’re found to have misreported your income.
Some things you should definitely avoid include:
- Misstating income - Most income is reported to the IRS on either W2 or 1099s. And, even if a lot of your income is in the form of cash, the IRS can still conduct audits to determine whether you’re living above your means, based on your declared income. Misstating your income is something people try to do all the time, and it can be a very costly mistake.
- Overstating charity contributions - If you give some money to charity each year, that’s awesome, but don’t try to take advantage by overstating how much you’ve given. This can be a tempting way to reduce your tax liability, but it’s a big no-no. In fact, you shouldn’t even deduct valid charitable contributions if you don’t have proper documentation such as receipts and proof that the organization is a registered 501(c)3.
And, most importantly:
- Deducting non-deductible expenses - If you had valid business expenses in 2020, then by all means deduct them from your taxes. Uncovering and documenting those expenses is a great way to reduce your tax liability. But, trying to claim deductions that don’t qualify can cause you big headaches later on, so don’t do it.
How to make tax season easier on yourself
Reviewing a full year of finances to spot potential savings is an arduous process; and it’s even more complicated if you have businesses or side hustles that you also need to review. If you don’t set yourself up for success, it’s very difficult to identify ways to lower your tax liability when you’re preparing your tax return.
Two big things you can do that will make it a lot easier to identify deductions and potential tax savings later on are:
- Maintain separate business accounts - This is something you should do anyway in order to lower liability from your business operations. Using the same account(s) for business and personal finances can leave you exposed to liability — if someone gets hurt as a result of your business, you can be sued and be held personally liable. So, set up separate accounts, and keep separate statements so that you can easily track what income and expenses were personal and which related to business activities.
- Use accounting software - Accounting software is pretty cheap and it lets you track income and expenses throughout the year, so you can identify deductions and things quickly. And, if you decide to use an accountant later, having accounting software will make it easy to share all of your records for the year, so they can give you guidance.
- Use tax preparation software. The major tax preparation software options like Turbo Tax, H&R Block, and Credit Karma Tax all have the ability to search for last-minute deductions on your behalf.
It’s a lot easier to reduce your tax liability in the tax year you’re trying to reduce (i.e. before December 31 of a particular year). But, even after a tax year has ended, there are plenty of things you can do to reduce your tax liability at the last minute. So, before you file your taxes, be sure to review the list items above and make sure you’re taking advantage of all the things you can do to lower your tax bill this year.
This article is provided strictly for informational purposes. This information is not provided as legal counsel or tax advisement services, and we encourage you to contact a professional about your particular tax scenario.