10 Ways to Lower Your Taxes

Make these moves now to help you shrink your tax liability next spring.

I have discovered only three ways to cut my taxes: reduce income, give more to charity and incur major medical expenses. Is there anything else I can do?

You have the right idea: Anything that reduces your income or maximizes your credits and deductions will lower your tax bill. And now is the perfect time of year to make some moves that can help you shrink your tax liability for 2009 -- and make key decisions about your employee benefits that can cut your taxes for 2010. Here are ten ways to lower your taxes:

1. Boost your 401(k) contributions. Any money you contribute to a 401(k) lowers your taxable income. You can contribute up to $16,500 to a 401(k) in 2009 (plus an extra $5,500 if you're 50 or older). You still have a few months to boost your regular contributions, or you can add any year-end bonus you receive to help max out your contributions before 2009 is over.

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2. Make the most of your flexible spending account. Contributions to a flexible spending account avoid income tax and Social Security tax, which can save you 35% or more compared with spending after-tax money. Most employers require you to use your FSA money by December 31 or by March 15 of the following year, so make sure you're on track to spend the money in your account before the deadline (otherwise it disappears). See 25 Ways to Spend Your Flex Account for more information. You'll be making key decisions about next year's FSA account over the next few months, and you may want to boost your contributions if your employer is increasing your out-of-pocket health-care costs for next year -- as many of them are (see Employer-Sponsored Health Coverage Costs Rising).

The maximum contribution limits vary by employer, but many let you set aside $3,000 a year in pretax money for a health-care flexible spending account and up to $5,000 in a dependent-care FSA. Use our How Much Should I Put in My Flexible Spending Account? calculator for help deciding how much to contribute.

3. Buy a house. The economic-stimulus plan provides a tax credit of up to $8,000 for purchasing a first home between January 1 and November 30, 2009. You're considered a first-time home buyer if you (and your spouse, if you're married) haven't owned a home in the past three years. The credit begins to phase out if your modified adjusted gross income tops $75,000 (or $150,000 if married filing jointly), and it disappears if your income exceeds $95,000 if you're single (or $170,000 if married filing jointly).

A special rule lets you receive the money quickly: After you close on the house, you can claim the credit for the 2009 purchase on an amended 2008 tax return. But unlike the 2008 version of the tax break, you don't have to pay back the credit, as long as you live in your home for at least three years. See Take Advantage of These Stimulus Breaks Soon for more information.

4. Buy a car. The stimulus plan also provides a tax break for new-car buyers. If you buy a new car between February 17 and December 31, 2009, then you can deduct state and local sales taxes and excise taxes paid on up to $49,500 of the cost of the car. If you live in a state that doesn't have a sales tax, you still get a tax break if your state imposes a flat fee on the purchase of vehicles or a fee based on the price you pay.

The tax break applies to new (not used) cars, light trucks, motor homes and motorcycles. To qualify, your modified adjusted gross income must be less than $135,000 if you're single, or $260,000 if married filing jointly (the deduction starts to phase out if you earn more than $125,000 if single, or $250,000 if married filing jointly).

5. Sell losing investments. Capital losses are first used to offset capital gains, and then up to $3,000 of the net loss can be deducted against income, such as your salary. Any excess loss is carried forward to future years. See Investor Tax Tips for more information.

6. Maximize your tax credits and deductions. Tax credits can lower your tax bill dollar for dollar. If you contribute to a 401(k), IRA or other retirement-savings plan, you may qualify for the retirement savers' tax credit, which can trim your tax bill by up to $1,000 per person (see Qualifying for the Retirement Saver's Tax Credit for more information).

The dependent-care tax credit is also valuable -- and often overlooked -- if you pay someone to care for your child while you work. Keep in mind that even summer day camp counts if your child is younger than 13 and you or your spouse work. See A Tax Break for Sending the Kids to Camp for more information.

And tax deductions are valuable, too, which lower your taxable income and in turn reduce your tax bill. See The 11 Most Overlooked Deductions for more information.

7. Pay college bills. The stimulus also improved the tax breaks for paying college bills. The new American Opportunity credit replaces the Hope credit for 2009 and 2010 and increases the size of the maximum credit from $1,800 to $2,500. The income limits to qualify have increased, too - from $58,000 to $90,000 if you're single and from $116,000 to $180,000 if you're married filing jointly.

You can claim the American Opportunity credit in the first four years of college (not just the first two years, as was the case with the Hope credit). Money you use to pay for college from a 529 or Coverdell education-savings account (both of which can already be used tax-free for college bills) doesn't count toward the American Opportunity credit. You need to pay at least $4,000 in tuition, fees and course materials, such as textbooks, from a source other than a 529 or Coverdell to qualify for the full credit.

8. Give to a charity. You can write off charitable contributions if you itemize your deductions. But people often scramble in late December to decide which organizations to support. Now is a good time to start thinking about who should benefit from your largess.

When tallying up your charitable contributions for the year, don't forget to count gifts of cash as well as appreciated stock and noncash donations. You can also include out-of-pocket costs to help a charity, such as 14 cents a mile in transportation costs to do charitable work or the cost of ingredients for a casserole you make for a nonprofit's soup kitchen. For more information about what you can deduct, see Deducting Charitable Contributions.

9. Max out tax breaks for the self-employed. If you're self-employed or have just a little freelance income, be sure to make the most of the tax breaks. You'll be able to deduct the cost of equipment you use in your business, such as a computer, printer, fax machine and copier, as well as a dedicated phone line, office supplies, business travel and advertising. You may even be able to deduct a portion of your rent or mortgage, homeowners insurance and utilities if you have a qualified home office.

You can also make tax-deductible contributions to a retirement plan for the self-employed, such as a Simplified Employee Pension or a solo 401(k), and can deduct your health-insurance premiums if you aren't eligible for health insurance from an employer or your spouse's employer. (You can't deduct more than the net income of your business.) For more information about what you can deduct and what forms you need to file, see Tax Toolkit for the Self-Employed.

10. Keep track of medical expenses. As you mentioned, incurring big medical expenses can result in a lower tax bill. But it can be tough to get much of a break for medical costs. You qualify for the tax break only if you itemize your deductions, and you can write off expenses only if they exceed 7.5% of your adjusted gross income. That means if you're earning $50,000 per year, you can deduct out-of-pocket medical expenses beyond $3,750. If you have $5,000 of qualified costs, you're left with a deduction of just $1,250. But even that partial deduction can make a difference. If you're in the 25% bracket, a $1,250 deduction can lower your tax bill by $313.

It's worthwhile to keep the receipts of money spent on medical bills in your tax file throughout the year because you could end up with a surprisingly large deduction if you have a medical emergency or a major expense that isn't covered by insurance, such as fertility treatments, orthodontia, laser eye surgery, or any experimental medical procedures that your insurer won't cover. For more information about medical expenses that are eligible for the deduction, see IRS Publication 502, Medical and Dental Expenses.

Kimberly Lankford
Contributing Editor, Kiplinger's Personal Finance

As the "Ask Kim" columnist for Kiplinger's Personal Finance, Lankford receives hundreds of personal finance questions from readers every month. She is the author of Rescue Your Financial Life (McGraw-Hill, 2003), The Insurance Maze: How You Can Save Money on Insurance -- and Still Get the Coverage You Need (Kaplan, 2006), Kiplinger's Ask Kim for Money Smart Solutions (Kaplan, 2007) and The Kiplinger/BBB Personal Finance Guide for Military Families. She is frequently featured as a financial expert on television and radio, including NBC's Today Show, CNN, CNBC and National Public Radio.