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Five Ways to Reduce Your Tax Bill

Reducing taxes should be a key component of any financial plan. Here are five ways to keep more money in your pockets.

1. Contribute to retirement plans.

Consider contributing as much as you can afford to your employer's retirement plan. Your contributions are pre-tax and, therefore, reduce your taxable income. You get other long-term tax benefits, too, since earnings grow tax-deferred inside the plan until withdrawn.

You may be able to contribute to a traditional IRA. Eligibility to deduct your contribution depends on your income and whether or not you or your spouse has access to a retirement plan through work. Like a 401(k) plan, an IRA also provides the long-term benefit of tax-deferred growth.

You have until April 15 to make a contribution for the previous tax year. See IRS Publication 590, Individual Retirement Arrangements, for more information.

2. Contribute to flexible spending accounts.

A flexible spending account (FSA) allows you to put aside money from your paycheck to cover either qualified health or dependent care expenses throughout the year. (Your employer may offer one type of FSA or both.) Because the funds are deducted from your paycheck before taxes are calculated, you reduce your taxable income for the year.

One thing to be aware of: Generally, you have to use all the money in your FSA by the end of the plan year, though some plans allow for up to a two and a half month extension. To find out the details of your specific plan, contact your Human Resources or Benefits department. In all cases, what you don't use, you lose!

3. Take advantage of favorable capital gains tax rates.

Long-term capital gains tax rates apply to investments you have owned for more than one year when you sell. If you have held an investment for 12 months or less when you sell, you pay ordinary income taxes on any profit you make. Since the capital gains tax rate is significantly lower than ordinary income tax rates, consider your holding period before selling an investment. Here is an example of how holding your investments at least 12 months can help you pocket more.

Let's suppose you buy 1000 shares of XYZ Corporation for $10 on Sept. 1, 2009.

Tax Rate 28% (Short Term)
Sell on June 1, 2010 for $25 per share
Tax Rate 15% (Long Term)
Sell on November 1, 2010 for $25 per share
Sales Price $25,000 Sales Price $25,000
Cost Basis (10,000) Cost Basis (10,000)
Gross Profit 15,000 Gross Profit 15,000
Federal Tax (4,200) Federal Tax (2,250)
Net after tax profit $10,800 Net after tax profit $12,750

For those taxpayers in the 10 or 15 percent tax brackets, the capital gains rate has been reduced to 0% in 2010. For more information on capital gains, see IRS Publication 544, Sales and Other Dispositions of Assets.

If you sell your main home, you may be able to exclude up to $250,000 of gain ($500,000 for married taxpayers filing jointly) from your federal tax return. This exclusion is allowed each time you sell your main home, but generally no more than once every two years. If you and your spouse file a joint return for the year of the sale, you can exclude the applicable gain if either of you qualify for the exclusion. But both of you would have to meet the use test to claim the $500,000 combined maximum amount.

For more information, refer to IRS Publication 523, Selling Your Home. You can avoid paying capital gains taxes on appreciated assets that you've owned for more than one year by donating them to a qualified charity. You may also get a charitable deduction for the full fair market value of the asset, but only if you itemize deductions. IRS Publication 526, Charitable Contributions, has more information.

4. Maximize your deductions.

You might benefit from itemizing personal deductions on IRS Form 1040 Schedule A instead of taking the standard deduction. The following are some of the expenses that may be deductible when you itemize:

  • State and local income taxes.
  • Mortgage interest and points, and property taxes.
  • Medical and dental expenses that exceed 7.5 percent of your adjusted gross income (AGI).
  • Charitable contributions.
  • Unreimbursed employee expenses that, in total, exceed 2 percent of your AGI.

For more information, see IRS Publication 501, Exemptions, Standard Deduction, and Filing Information.

5. Consider tax-efficient investments.

If you're in one of the higher tax brackets, taxes can take a big bite out of your investment earnings. Fortunately, there are strategies for investors seeking to reduce their tax bill.

For example, tax-efficient mutual funds seek to provide the best possible returns while keeping taxable fund income down and maintaining low turnover rates (to avoid short-term capital gains).

Investing in bond funds is another move worth considering. Under most circumstances, municipal bond funds generate tax-free interest.

If you prefer to buy individual stocks, you can narrow your choices to those stocks that pay no, or low, dividends.

All these investment options might be good moves for you, but don't let the tax tail wag the dog. Missing out on overall performance just to avoid taxes may be missing the point.

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