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How I Plan on Reducing My Taxes

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Yesterday I wrote about how to take advantage of some year end tax moves to save money on your taxes when you file them next year. My wife and I had a few changes to our financial situation this year that will affect our taxes, and because of these changes we need to take advantage of some of the year end tax moves I outlined.

My Tax Situation and How I Will Reduce My Taxes

I think I will owe a lot of money on next year’s taxes. My wife and I earned more money than I thought we would earn. I know this is a problem most people would like to have, and I am not complaining!

I started a better paying job in March. My small business income was also more than I predicted it would be for the year. The net result of these changes is that we had more income than I anticipated and we will need to reduce our taxable income or pay extra money in April when we file our taxes. I don’t want to pay the taxes, so I need to find methods of reducing our taxable income.

Day job income

My salary at my new day job is higher than my previous job, which means I will owe more taxes. When I started my job back in March I was also beginning to earn a little more with my business, so I decided I should increase the withholding amount on my W-4. I used the formula on my W-4 to determine how much should be withheld from my day job each check, then I added a couple hundred dollars as a safety precaution. I’m very glad I did this. Had I not done so, I may have been subjected to an underpayment penalty from the IRS.

Self employment income, estimated taxes, underpayment penalty, and safe harbor rule

Self employment income and estimated taxes. The US tax system is a pay as you go system, meaning you need to pay your taxes as you earn your income. When you have self-employment income, you should generally pay quarterly estimated taxes to cover your tax obligations. You don’t pay estimated taxes with your day job because your taxes are usually withheld from your paycheck. I didn’t pay estimated taxes on my self-employment income, though now I think I may have been better off had I done so.

Underpayment penalty. The IRS has an underpayment penalty for people who underpay their taxes. Generally, most taxpayers will have paid enough tax to avoid this penalty if they paid at least 90% of the tax for the current year, or 100% of the tax shown on the return for the prior year, whichever is smaller.

Safe harbor rule. I’m not worried about paying any underpayment penalties to the IRS for not withholding enough income because of the safe harbor rule. The safe harbor rule states that as long as you pay 100% of your previous year’s total tax liability in withholding and/or estimated taxes, you will be exempt from the underpayment penalty regardless of your final tax amount. I easily covered 100% of my previous year’s contributions, but I still think I may owe money on my taxes. So I still need to reduce my earned income.

My plan to reduce taxable income

Tax deferred retirement plan contributions. I’m thankful I started my tax planning soon after starting my new job. In addition to increasing the withholdings on my W-4, I increased my contribution amount to my 401(k) plan to reduce my taxable income. Contributing to a Traditional IRA, Traditional 401k plan, or other tax deferred retirement plan reduces your taxable income. In addition to this, I researched self-employed retirement plans and decided to open a Solo 401k plan with Vanguard so I can contribute more tax deferred money to lower my current tax obligations.

The good news is that a Solo 401k plan must be opened by December 31st, but you can wait to contribute to it up to the tax filing deadline. This will allow me to determine how much money I need to contribute to avoid paying higher taxes.

Roth or Traditional IRA? I did not fully contribute to our IRAs this year because I was waiting to determine what our tax situation would be. While I prefer a Roth IRA over a Traditional IRA, each has its merits. If I need to further reduce my tax obligations this year, I can contribute to a Traditional IRA instead of a Roth IRA. We currently have the funds in a high yield savings account until I know which IRA I should contribute to.

Harvesting losses. I have some index funds in a taxable account which have lost a lot of value in the last few months. While I normally employ a buy and hold strategy, now may actually be a good time for me to sell the equities at a loss. This goes against the buy low, sell high strategy, but locking in these losses will allow me to offset $3,000 of my income. I will turn around and invest the proceeds from the sale of my “losses” into my new Solo 401k plan. As long as I don’t invest the proceeds into the same funds within 30 days, I will avoid the wash rule. I need to rebalance my portfolio anyway and I was heavy in the sector I am selling, so this move works out for me in several ways.

Business expenses. I bought myself a new laptop for my business last week. My old laptop is several years old and is on its last legs. I needed a new laptop anyway, so I bought one before December 31st so I could use it as a tax write off when I file my taxes next year.

Donations. My wife and I held a garage sale in October, and we took several boxes of goods to Goodwill. We have a few more items to donate before December 31st.

Pay my mortgage payment early. I will pay my January mortgage payment in December so I can write off the mortgage interest on my taxes.

This year was a learning experience!

I didn’t expect this year to turn out as it did on many levels, and I allowed myself to get caught off gaurd. As a result, I will do a better job in my tax planning next year. One plan I have is paying estimated taxes, which will make my taxes easier next year and keep me out of trouble with the IRS! I will also contribute to my IRAs and Solo 401k plan as I go, which will make contribution decisions easier.

Overall, my taxes shouldn’t be too bad because I took advantage of several rules to lower my taxable income or defer it for later. These moves should save me from a large tax bill in April.


Published or updated September 14, 2011.
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{ 10 comments… read them below or add one }

1 Craig

The with holding taxes idea is great. The small amount more they take every week doesn’t really matter and you won’t notice it. When you do get that check returned it feels like a bonus you weren’t expecting or planned for.

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2 Donny-invesmint.com

I plan on doing some of these same things to reduce taxes for 2009. It helps tremendous to own your on business because you can write a lot of stuff off.

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3 Ryan

Craig, my goal in doing this was because I knew I would have self-employment income, so I withheld extra from my day job. Otherwise, I probably wouldn’t have done it.

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4 Ryan

Donny, I agree, the write-offs available to small business owners are a nice benefit!

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5 Ryan

StartUp: You are correct; it doesn’t decrease my taxable income, all it did was increase my withholdings from my day job. The reason I did it that way was because I did not pay any estimated taxes on my self-employment income.

The method described in this article is certainly not the best way to go – it just kind of happened that way because I did not have a good idea of how much I would earn from my business in 2008. I plan on changing my W-4 in 2009 and paying estimated taxes as I go. That is a better way to ensure I will pay the proper amount of taxes in 2009.

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6 StartUp

Does increasing your W4 withholding really decrease your taxable income? Doesn’t it just mean you are paying more of your taxes early and are then not able to earn interest on it?

Not trying to be nitpicky. Great post though, lots of good info for people with combined self-employed and standard income.

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7 Sissy

Ryan-
How did it turn out for you? I am looking for a similar strategy since I had sort of a windfall and a raise. Overall I’ll have to claim about 25k more than last year. Can you help?

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8 Ryan

Sissy, it turned out well for me. The Solo 401k allowed me to reduce my income taxes by a fair amount and I was within the safe harbor limits for my estimated taxes. Since I published this article I have been more diligent about calculating my estimated taxes and I have been working with an accountant to better prepare myself for filing deadlines, estimated taxes, and other fun things! I highly recommend working with an accountant if you have a complex tax situation or your income is primarily from contracting or self-employment. Chances are you can save a lot of money by working with a tax pro!

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9 MIKE

Can I increase my witholding amount at my day job to cover my self employment liability from my small part time cleaning business.Since irs wants us to e-file Im leary of giving routing numbers and such.Also working these hours leaves little time to do the quarterly thing.

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10 Ryan

Mike, the IRS looks at is all as one pot of money if you are a sole proprietor, so that could be an effective way to manage your withholding. Be sure to consult with your tax advisor if your situation changes to ensure you are doing the right thing.

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