Pay attention to tax deductions and tax-advantaged investments, and you’re well on your way to financial independence. Depending on whether you’re an employee or self-employed, some of your choices will differ. I loved the 401k with matching $$ when I was an employee. But the SEP IRA is great for self-employed people, as is the ability to deduct any health insurance premiums I pay. Like we used to say in the early 2000’s: CHA CHING!
When I was still an employee, I was saving almost 50% of my post-tax income. I maxed out my 401K, did an HSA (to which my employee contributed $1,000), maxed out my Roth IRA, and also got a great tax deduction from my mortgage interest. Because of that, even though my income was in the low 6 figures, my tax rate was only about 12% in 2012.
There are a ton of deductions and tax-advantaged ways to save on your next bad-ass federal return. Here are the main ones you should think about:
Mortgage interest: I do NOT have the mortgage on my primary residence paid off, by design. There are a couple great reasons for this, one being the tax deduction for mortgage interest I pay. In most cases, you can deduct all of your home mortgage interest. You can also deduct the amount you paid for mortgage insurance premiums. Sweet! Read, read, read.
Traditional IRA: This is the original IRA. Its great benefit is that in the tax year for which you contribute to this, you don’t pay any federal tax on the amount you put aside. The drag is, when you begin to withdraw money from the IRA, you do pay tax on any withdrawals. It’s a wildcard as to what the tax rate will be at that point.
You can make contributions to a traditional IRA if you received taxable compensation during the year, and you were not age 70½ by the end of the year. If you’re aiming for financial independence, you need to know that you can’t include earnings and profits from property, such as rental income, or interest income and dividend income.
The contribution limits are, not surprisingly, complex and Kafkaesque, but generally, the limit in 2013 is $5,500. If you’re over 50, you can contribute $6,500, but hopefully you’ll be financially independent by then! Read up on the rules.
Roth IRA: With the Roth IRA, you pay taxes on any money you contribute, but when you take distributions during retirement, you get that money tax free. Nice! The contribution limits for this are the same as for a traditional IRA. Read up on the rules.
SEP IRA: A SEP IRA is a type of traditional IRA for self-employed people or small business owners. Any business owner with one or more employees, or anyone with freelance income, can open a SEP IRA. Your contributions are tax-deductible, and go into a traditional IRA. Like a traditional IRA, the money in a SEP IRA is not taxable until withdrawal.
One of the key advantages of a SEP IRA over a traditional or Roth IRA is the high contribution limit. For 2013, contributions to a SEP-IRA are the lesser of 25% of your income, or $51,000. Yup, you can read more about it.
401K: You can invest in a 401K only if you have an employer who sponsors the program. Although it really sucks, you cannot invest in a 401K if you’re self-employed. Tax-wise, this works like a traditional IRA. You can invest up to $17,500 in 2013. Many employers also do some amount of matching, which is great free money. Take it! I always contribute the max to a 401K when I’m working for a company. Read up!
HSA: To be an eligible for an HSA, you must be covered under a high deductible health plan (HDHP). For 2013, if you have self-only HDHP coverage, you can contribute up to $3,250. If you have family HDHP coverage you can contribute up to $6,450. The money you place in your HSA is not taxed. There are other health care related, tax advantaged programs, including MSAs, FSAs, and HRAs. And yes, the IRS tells you all about them.
Health insurance premiums and expenses: If you itemize your deductions on Form 1040, Schedule A, you can deduct the amount of your medical and dental expenses that exceed 10% of your adjusted gross income. And, if you’re self-employed, and have a net profit for the year, you can deduct (as an adjustment to income) the premiums you paid on a health insurance policy covering medical care including a qualified long-term care insurance policy covering medical care. You can’t take this deduction for any month in which you were eligible to participate in any subsidized health plan maintained by your employer, your former employer, your spouse’s employer, or your former spouse’s employer. I love any deductions for self-employed people! Read details here.
That’s the list! Needless to say, if you have dependents, or a home office, or have done energy-saving home updates, or many other things, you can get even more deductions. Call it a kick-back from our free-spending government.