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Ways To Reduce The Impact of Your Income

Defer more income into retirement. 

Contributing to a 401(k) and/or traditional IRA is a great way to lower your taxable income. Contributions are deducted from your income before taxes. For 2013, you can put up to $17,500 into your 401(k), $5,500 into your IRA (subject to income limitations), and more if you are over 50. You save on taxes now, shelter the money from tax as it grows, and contribute to your retirement wealth.

Start a Roth IRA.

Your present income tax will not be reduced by a Roth contribution, but if you follow the rules, your Roth contribution of up to $5,500 ($6,500 if over 50) and its earnings will be removed from taxation forever. 

Use your flexible spending account.  

A medical reimbursement account is funded with pretax dollars, so you reduce the impact of your income. You save income tax and Social Security/Medicare dollars with each contribution. If you haven't signed up for this awesome tax saving tool, you should consider doing so. A review of last year's medical expenditures can help you determine the amount to set aside.  

If you have children in child care, you can set aside up to $5,000 in a pretax child care ac- count. This money also escapes both income and Social Security/Medicare taxes, and in most cases, provides better tax savings than the Child Care Credit.  

If your income is over $200,000 (single) or $250,000 (married/joint), you may be subject to the new .9% surtax on earned income for 2013. The above mentioned pretax accounts can lessen the blow of these new taxes.

Start a college plan.

You have two options: 

  • 529 plans are college saving programs set up by states. They will not save current tax dollars, but the money contributed saves future dollars because they grow tax-free and can be cashed in with no tax liability when used for qualifying post secondary school expenses. These plans were made permanent by Congress, so their future tax-free status is assured.
  • Coverdell IRAs are self-directed education accounts. Contributions to these are more limited, but they also grow tax-free and proceeds can be used for education at any level from kindergarten to college.

Rebalance your portfolio.

  • Do you have any losers? You can sell stocks at a loss and offset all of your present gains plus $3,000 of other income.
  • If you have stock gains instead of losses, take advantage of the lower taxes on long term capital gains by keeping your stocks longer than a year. If you are in the 15% tax bracket or lower, you can sell assets held long term at a gain and pay no federal tax. State taxes may apply, however. If your in- come including the gain is under $46,250 (single), $92,500 (married-joint), or even higher if you can itemize, you are a candidate for a free sale.
  • Dividends are also taxed at lower rates than interest, so consider exchanging some interest bearing securities for those that pay dividends.
  • Investing in tax efficient or index mutual funds can keep your tax bill at a minimum. If you desire more control over your portfolio, buy and hold individual stocks which pay low or no dividends that you expect to increase in value. No gain will be realized until you decide to sell.
  • Invest in municipal bonds for tax-free inter- est. If your tax bracket is high enough, the tax savings will outweigh the lower rate of interest you receive. If your income is over $200,000 (single) or $250,000 (married/joint), you can escape some of the new 3.8%surtax on investment income by buying municipals.

Plan for your required minimum distribution. (RMD)

  • You must begin taking distributions from IRAs and other retirement plans by April 1 of the year after you turn 70½. If you wait until that date, you will have to withdraw two years of distributions in one year.
  • If your income is variable, consider a con- version of money from a traditional IRA to a Roth IRA in a year when your income is low. By doing this, you are creating taxable in- come, but you reduce the amount that must be distributed from the traditional IRA when you turn 70½, and you will remove the money from future taxation.

Use your home as a tax shelter.

You can reap tax-free profits of up to $500,000 ($250,000 if single) upon the sale of your home if you have lived in it for at least two years. There is no limit to the number of times you can do this. This means that you can buy "fixer-uppers," rehab them, and sell them after two years occupancy.

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