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Dear SoFi, How do I reduce my tax burden?
(submitted by Michelle Maria Nicholas, a member of SoFi’s Ambition Club on Facebook)
Dear Michelle,
That’s a great question. And you’re in good company looking for ways to save on your tax bill. Over half of people in a Pew Research poll reported being frustrated by the complexity of the federal tax code (frankly, we’re surprised it’s not even higher.) And an increasing share of Americans — 56% in 2023 — think they’re paying more than their fair share of taxes, considering what they get from the federal government in return.
If you’re strategic, however, your taxable income (which determines what you owe in taxes) can be a lot lower than your total income. You might even discover you’ve been paying tax on things you don’t have to (like medical or childcare bills.)
Here are some of the most common ways to lower your tax burden:
Max Out Your 401(k) or Traditional IRA
Every dollar you put into these types of retirement plans lowers your tax bill, assuming you make pre-tax or tax-deductible contributions. You can contribute up to $23,500 ($31,000 if you’re over 50) to a 401(k) or similar workplace retirement plan this year. With a traditional IRA, the limit is $7,000 ($8,000 if you’re 50 or over.)
You will have to pay taxes on whatever you withdraw when you retire, but for now, you’re lowering your tax burden and building financial security.
Max Out Your HSA
If there ever was a tax-saving secret, it’s the Health Savings Account, or HSA. Unlike just about any other type of account, an HSA offers a triple tax advantage: Your contributions are tax-deductible, you don’t pay taxes on any earnings you make from investing those funds, and withdrawals — as long as they’re for qualifying healthcare expenses — are also tax-free.
The catch is you have to be covered by a high-deductible healthcare plan to contribute to an HSA, but that’s definitely worth considering if you have choices.
You can set aside up to $4,300 this year in an HSA ($8,550 for family plans.) You’ll pay tax and a penalty if you don’t use it for qualifying medical expenses, but after you turn 65, the penalty goes away. Spoiler alert: You’ll probably have plenty of healthcare expenses in retirement anyway.
Note: Even if you’re fit as a fiddle, consider using an HSA as a retirement savings tool. It goes with you wherever you go (even if you change jobs and your health insurance changes,) and unlike a Flexible Spending Account, you don’t lose money you don’t use.
Don’t Forget FSAs
A Flexible Spending Account, or FSA, works similarly to an HSA, but you don’t need to have a high-deductible healthcare plan to have one. By setting aside pre-tax money in an FSA, you’ll lower your taxable income.
There is one huge difference, however: You have to gauge exactly what you’ll spend in a given year, since you’ll lose any unspent funds. FSAs can be used for medical expenses or dependent care (even summer camp!) The 2025 contribution limit is $3,300 or in the case of dependent care, $5,000 per household.
Make Sure You’re Not Better Off Itemizing
The IRS lets us subtract a certain amount from our taxable income each year. We can either take the “standard deduction” for our tax filing status — a predetermined amount that is reset each year (and nearly doubled in 2018 because of The Tax Cuts and Jobs Act) — or we can add up tax-deductible expenses like mortgage interest, student loan interest, business expenses, state income taxes and anything else that qualifies. (Here’s a list.) While most of us are better off taking the standard deduction, make sure your individual deductible items wouldn’t add up to more.
Make Sure You’re Getting All the Tax Credits You’re Owed
Tax credits will often lower your tax bill dollar-for-dollar, whereas deductions shrink the amount of overall income you owe taxes on. So it’s worth looking at the IRS’s list of credits to make sure you’re claiming everything you can. Think of it like a menu for tax savings. Have children? That’s a credit of up to $2,000 per child. Buy a new electric car? It could be worth a credit of up to $7,500.
Consider Tax-Loss Harvesting
If you make money from investing, in the stock market or otherwise, you have to pay long- or short-term capital gains tax. But there’s often a way to reduce that bill through what’s known as tax-loss harvesting. This involves selling assets that have dropped in value (to trigger an investment loss) in order to offset the capital gains tax you owe from profiting on other investments.
If an investor has a net capital loss in a given year, they can deduct up to $3,000.
Here’s a brief example: You have shares in two mutual funds. One has been performing well, the other has lost value. You decide to sell your shares in the better-performing one for $3,000 more than you paid, but that means you’ve got to pay capital gains tax on that profit.
In order to mitigate that burden, you decide to sell your shares in the other mutual fund for $1,000 less than you paid. Now you only have to pay capital gains tax on your net capital gain of $2,000, not $3,000. And then you can buy shares of a substantially similar mutual fund, so your money is still invested in basically the same way.
Keep in mind using this strategy can get pretty involved, so you may want to seek professional help.
Choose Investments That Pay Out Less Frequently
Selling your investments for a profit isn’t the only way to make money from them. But since interest and dividends are taxable income, it’s worth paying attention to which types of investments you’re making. Some pay out more frequently than others, like REITs, certain bond funds, and actively managed funds where the manager makes a lot of trades.
On the flipside, things like index funds and municipal bonds won’t trigger a tax bill as often.
Make Sure You’ve Chosen the Best Filing Status
Finally, don’t overlook your tax filing status. Most couples save money by filing jointly, though there may be situations when filing separately is more advantageous.
With thousands of pages in the tax code, it’s hard not to wonder if you’re leaving money on the table when you file your return. But once you understand some of the basic mechanics — things like deductions, credits and capital gains — things do start to make more sense.
That said, you can always get help from an accountant or tax preparer. They should be able to guide you through the tax savings you’re eligible for now, and help you plan strategies to save even more money down the road.
In financial health,
Brian Walsh
PhD, CERTIFIED FINANCIAL PLANNER®
SoFi Head of Advice & Planning
Image Credit: Bernie Pesko/SoFi
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