Many people have no idea how to limit the amount of money Uncle Sam can take away through taxes, and they end up missing out on a few very valuable tax benefits. There are a few easy steps that can help save a lot of money though.
Saving for Retirement and not increasing your Taxes
Traditional 401K’s allow you to set aside up to $17,500 ($23,000 if you are over the age of 50) of your salary before any taxes are taken out. This automatically reduces your income that is shown on paper and therefore reduces your taxes at the end of the year. The money that is set aside can then grow without being taxed until you begin withdrawing the money after age 59 1/2. The idea is that when you begin withdrawing the money, you will be in a lower tax bracket and will therefore pay less money when you withdraw it in the future.
Many employers also have Roth 401K plans available which allow you to put money aside after taxes are already taken out. When the money is withdrawn after 59 1/2, you don’t have to pay taxes on your contributions or your capital gains or dividends. This type of plan does not however reduce your current tax rate or shield your income from the IRS.
Traditional IRA’s are similar to 401K’s but they only allow you to contribute up to $5,500 dollars per year as of 2013. These plans are great if you can’t contribute to an employer plan because they reduce your reportable income by the amount you contribute. The money can then be invested and not taxed until it is withdrawn. If you can contribute to an employer sponsored retirement plan like a 401K however, Traditional IRA’s lose their tax benefits if you make over a certain amount of money.
Roth IRA’s also only allow you to contribute up to $5,500 per year. The contributions you make are not tax deductible though, but they do allow you to shield your future earnings from any taxation. Since your contributions were already taxed, you always have the opportunity to withdraw them without any penalty. If you begin to withdraw your earnings before 59 1/2, however, then you will be receive a tax penalty. These plans are great if you expect your current tax rate to be lower than your tax rate during retirement. Roth IRA’s also have income restrictions, so if you make too much money this plan may not work for you.
For Small Business Owners, Simplified Employee Pension Plans or SEP IRA’s are a great option. Small business owners can contribute 25% of their compensation or $51,000 whichever is less. These contributions shield your compensation from the IRS and are a great way to lower your tax bracket. The money that is set aside is then taxed as ordinary income whenever it is withdrawn and their is no penalty for withdrawing after age 59 1/2.
Mortgage interest
You can also reduce your tax liability when investing in a home purchase. For most people, the biggest tax break from owning a home comes from deducting mortgage interest. You can deduct interest on up to $1 million of debt used to acquire or improve your home.
Your lender will send you Form 1098 in January listing the mortgage interest you paid during the previous year. That is the amount you deduct on Schedule A. Be sure the 1098 includes any interest you paid from the date you closed on the home to the end of that month. This amount is listed on your settlement sheet for the home purchase. You can deduct it even if the lender does not include it on the 1098. f you are in the 25 percent tax bracket, deducting the interest basically means Uncle Sam is paying 25 percent of it for you.
Points
When you buy a house, you may have to pay “points” to the lender in order to get your mortgage. This charge is usually expressed as a percentage of the loan amount. If the loan is secured by your home and the amount of points you pay is typical for your area, the points are deductible as interest as long as the cash you paid at closing via your down payment equals the points.
For example, if you paid two points (2%) on a $300,000 mortgage—$6,000—you can deduct the points as long as you put at least $6,000 of your own cash into the deal. And believe it or not, you get to deduct the points even if you convinced the seller to pay them for you as part of the deal. The deductible amount should be shown on your 1098 form.
Real estate taxes
You can deduct the local property taxes you pay each year, too. The amount may be shown on a form you receive from your lender, if you pay your taxes through an escrow account. If you pay them directly to the municipality, though, check your records or your checkbook registry. In the year you purchased your residence, you probably reimbursed the seller for real estate taxes he or she had prepaid for time you actually owned the home.
If so, that amount will be shown on your settlement sheet. Include this amount in your real estate tax deduction. Note that you can’t deduct payments into your escrow account as real estate taxes. Your deposits are simply money put aside to cover future tax payments. You can deduct only the actual real estate tax amounts paid out of the account during the year.
Private Mortgage Insurance Premiums (PMI)
Buyers who make a down payment of less than 20 percent of a home’s cost usually get stuck paying premiums for Private Mortgage Insurance, which is an extra fee that protects the lender if the borrower fails to repay the loan. For mortgages issued in 2007 or after, home buyers can deduct PMI premiums.
This write-off phases out as adjusted gross income increases above $50,000 on married filing separate returns and above $100,000 on all other returns. (If you’re paying PMI on a mortgage issued before 2007, you’re out of luck on this one.) As it stands now, the PMI write-off is set to expire at the end of 2013, although Congress may extend it.
Penalty-free IRA payouts for first-time buyers
As a further incentive to homebuyers, the normal 10 percent penalty for pre-age 59½ withdrawals from traditional IRAs does not apply to first-time home buyers who break into their IRAs to come up with the down payment. This exception to the 10 percent penalty does not apply to withdrawals from 401(k) plans.
At any age you can withdraw up to $10,000 penalty-free from your IRA to help buy or build a first home for yourself, your spouse, your kids, your grandchildren or even your parents. However, the $10,000 limit is a lifetime cap, not an annual one. (If you are married, you and your spouse each have access to $10,000 of IRA money penalty-free.) To qualify, the money must be used to buy or build a first home within 120 days of the time it’s withdrawn.
But get this: You don’t really have to be a first-time homebuyer to qualify. You’re considered a first-timer as long as you haven’t owned a home for two years. Sounds great, but there’s a serious downside. Although the 10 percent penalty is waived, the money would still be taxed in your top bracket (except to the extent it was attributable to nondeductible contributions). That means as much as 40 percent or more of the $10,000 could go to federal and state tax collectors rather than toward a down payment. So you should tap your IRA for a down payment only if it is absolutely necessary.
There’s a Roth IRA corollary to this rule, too. The way the rules work make the Roth IRA a great way to save for a first home. First of all, you can always withdraw your contributions to a Roth IRA tax-free (and usually penalty-free) at any time for any purpose. And once the account has been open for at least five years, you can also withdraw up to $10,000 of earnings for a qualifying first home purchase without any tax or penalty.
Home improvements
Save receipts and records for all improvements you make to your home, such as landscaping, storm windows, fences, a new energy-efficient furnace and any additions.
You can’t deduct these expenses now, but when you sell your home the cost of the improvements is added to the purchase price of your home to determine the cost basis in your home for tax purposes. Although most home-sale profit is now tax-free, it’s possible for the IRS to demand part of your profit when you sell. Keeping track of your basis will help limit the potential tax bill.
Energy credits
Some energy-saving home improvements to your principal residence can earn you an additional tax break in the form of an energy tax credit worth up to $500. A tax credit is more valuable than a tax deduction because a credit reduces your tax bill dollar-for-dollar.
You can get a credit for up to 10 percent of the cost of qualifying energy-efficient skylights, outside doors and windows, insulation systems, and roofs, as well as qualifying central air conditioners, heat pumps, furnaces, water heaters, and water boilers.
There is a completely separate credit equal to 30 percent of the cost of more expensive and exotic energy-efficient equipment, including qualifying solar-powered generators and water heaters. In most cases there is no dollar cap on this credit.
Tax-free profit on sale
Another major benefit of owning a home is that the tax law allows you to shelter a large amount of profit from tax if certain conditions are met. If you are single and you owned and lived in the house for at least two of the five years before the sale, then up to $250,000 of profit is tax-free. If you’re married and file a joint return, up to $500,000 of the profit is tax-free if one spouse (or both) owned the house as a primary home for two of the five years before the sale, and both husband and wife lived there for two of the five years before the sale.
Thus, in most cases, taxpayers don’t owe any tax on the home-sale profit. (If you sell for a loss, you cannot take a deduction for the loss.)
You can use this exclusion more than once. In fact, you can use it every time you sell a primary home, as long as you owned and lived in it for two of the five years leading up to the sale and have not used the exclusion for another home in the last two years. If your profit exceeds the $250,000/$500,000 limit, the excess is reported as a capital gain on Schedule D.
In certain cases, you can treat part or all of your profit as tax-free even if you don’t pass the two-out-of-five-year tests. A partial exclusion is available if you sell your home “early” because of a change of employment, a change of health, or because of other unforeseen circumstances, such as a divorce or multiple births from a single pregnancy.
A partial exclusion means you get part of the $250,000/$500,000 exclusion. If you qualify under one of the exceptions and have lived in the house for one of the five years before the sale, for example, you can exclude up to $125,000 of profit if you’re single or $250,000 if you’re married—50 percent of the exclusion of those who meet the two-out-of-five-year test.
Home equity loans
When you build up enough equity in your home, you may want to borrow against it to finance an addition, buy a car or help pay your child’s college tuition. As a general rule you can deduct interest on up to $100,000 of home-equity debt as mortgage interest, no matter how you use the money.
Adjusting your withholding
If your new home will increase the size of your mortgage interest deduction or make you an itemizer for the first time, you don’t have to wait until you file your tax return to see the savings. You can start collecting the savings right away by adjusting your federal income tax withholding at work, which will boost your take-home pay. Get a W-4 form and its instructions from your employer or go towww.irs.gov.
Related articles
- Should I Use My 401K for Real Estate Investing? (gayleschofieldrealtor.wordpress.com)
- Roth IRAs: To convert or not to convert? (heritageretirementincomeplanners.com)