We’re surprisingly almost half way through 2020, isn’t that crazy? With everything going on in the world, the days just seem to keep flying by as we sit in our homes waiting for life to return to normal. To help, I wanted to talk today about something that will never go away and will always be normal, taxes!
I know it’s only May and you don’t want to worry about your taxes, but I want to stress how important it is to have a plan when it comes to your taxes. I’ve never met anyone who hated getting a big tax refund every year, so I want to talk about ways to make it happen.
Even though it is only May, this time of year is so important, because the actions you take in the second half of the year can help you get a bigger tax refund.
Before we move forward, keep in mind, the IRS extended the individual tax filing in 2020 from April 15th to July 15th, so if you haven’t filed yet, file!! But I digress.
First, How Do Taxes Even Work?
Have you ever wondered how your friend’s dad who runs his own company didn’t owe taxes, but yet you, who has a salaried job, ended up owing taxes somehow?
How could that work? That doesn’t seem right. But the fact of the matter is, your friend’s dad did his tax planning and was prepared.
To explain this a little bit, here is how your taxes are generally calculated (this is a very simplified approach, just to get an understanding):
As you can see, you take your total gross income and subtract out deductions and exemptions to arrive at your taxable income. That number is then multiplied by the tax rate to get your Gross Tax. This is the amount of tax you should have paid based on your income, deductions and credits.
From here, you would compare that amount to the actual amount of taxes you paid during the year. This would be the federal taxes taken out of each paycheck. You can find this number in Box 2 of your W-2. When Box 2 is greater than your Gross Tax, meaning you paid more taxes than you needed to, you get a nice refund. Vice versa, if Box 2 is less than your Gross Tax, you didn’t pay enough taxes and need to pay more.
So you’re asking… okay, but what’s the point of this? How can this help me?
In general, if you plan out your deductions and credits, you will be able to lower your taxable income, which will lower your gross tax and give you a bigger tax refund.
With all of that said, let’s dig into 5 ways that you can save on your taxes and get a bigger tax refund this year!
Pay off more student loans
I know, paying off MORE loans? No thanks. I agree with you, they suck. But look at it this way. You can get a credit up to $2,500 worth of student loan interest paid per year.
Around the end of the year, take a look at your most recent student loan interest statement (the bank should send you one every month) and pay off as much student loan interest up to $2,500 as you can. You’ll have to pay off that interest eventually anyways, so you might as well benefit from it.
This is an interesting tax issue because starting in March 2020, the Federal Government ceased all interest on federal loans. If you only have federal loans, you may not be able to get this credit, but that’s completely okay because you are saving the money upfront on paying off a no-interest loan. If you have private student loans with interest, this is your chance to maximize your Student Loan credit. For tips on how to handle your student loan payments during the Coronavirus pandemic, read our post here.
Contribute to a Traditional IRA
If you don’t have an IRA (individual retirement account), I would recommend opening one now. The sooner you begin contributing to one, the better, but that’s a conversation for a different time. For now, let’s focus on the credit you can get for contributing to an IRA. You are able to deduct $6,000 worth of contributions to traditional IRA’s. I bold traditional IRA’s because the deduction is not available for Roth IRA’s. This is a fantastic way to lower your tax liability because not only are you paying less in taxes, the money in your IRA will also grow over time.
With the tax deadline extension to July 15th, you are able to make contributions to your 2019 IRA amounts. Meaning you can contribute towards your 2019 $6,000 cap until July 15th, then you can begin contributing to your 2020 cap. This is just another way to incentivize people to invest their money in their future.
To learn more about the major similarities and differences in Roth and Traditional IRA’s, take a read of this recent blog post.
Use Any Education Credits You May Qualify For
If you are reading this, chances are you are an undergraduate or graduate student. If not, there are multiple other tax savings strategies here for you. But if you plan on going back to school one day, this one is worth noting!
American Opportunity Credit (AOC)
The AOC is a credit restricted to undergraduate students that are enrolled in a two or four year college. You can earn a credit of up to $2,500 annually for qualified education expenses (books, courses, etc.) for four years.
Lifetime Learning Credit
The Lifetime Learning Credit is for students who go back to college for higher education. You are able to use this credit an unlimited amount of years as long as you qualify. The credit is calculated at 20% of qualified education expenses on your first $10,000 expenses. Meaning you can get a maximum $2,000 credit.
Keep in mind you cannot use the Lifetime Learning Credit AND the American Opportunity Credit in the same year.
If you are a teacher for grades kindergarten through 12th grade, you can deduct up to $250 for supplies you purchase for your class. It isn’t much, but it’s something.
Understanding the Difference Between Standard and Itemized Deductions
A standard deduction is a flat rate that the IRS allows you to deduct from your taxable income on your tax return. The 2019 amounts based on filing status are found in the table below: (keep in mind, these will be the same or slightly different for the 2020 tax year)
The standard deduction is automatically given to you unless you itemize your deductions, which is very rare for younger generations and you’ll see why.
Typical itemized deductions include: (you can find Schedule A for itemized deductions here)
- Charitable contributions
- Mortgage interest
- Real estate taxes
- State and local taxes
- Medical expenses
When these amounts total to an amount higher than the standard deduction, you will itemize. This is much more common for older generations just because younger generations may not own a home that comes with mortgage interest or real estate taxes.
If you don’t know if you will itemize, most tax preparation software will automatically calculate this for you. It is good for it to be on your radar of what the difference between the two deductions is.
The 1040 that you file every year is for your federal tax return. You still need to file a tax return for the state you live in as well. Without getting too in-depth on state tax law, know that just as there are federal tax laws, there are also state tax laws.
This means that there are some deductions and credits that you can take for your state tax return that you can’t take on your federal tax return.
For example, in Massachusetts, you can deduct the rent you pay during the year. That is a great deduction that isn’t offered for federal purposes.
You can find these deductions on your state website. Before doing your taxes, make sure to do some research on the deductions available to you through your state.
Taxes aren’t fun. I’ll be the first to admit it, I do them at my day job. But getting a bigger tax refund is fun. As you get older and have more in-depth tax returns, it may be best to consult with a tax professional in order to accurately plan out your taxes. For now, take these five tips and try to implement as many as you can in order to maximize your upcoming 2020 tax refund.