If you've been hit with a big surprise tax bill in 2020, a financial planner explains how to shrink it in 2021

  • If you got a raise or earned side-gig money in 2020, you may owe more than expected in taxes.
  • This year you’ll have to pay the bill, but for your 2021 taxes, you have some options.
  • Donate to charity, contribute to an HSA or FSA, and update your withholdings.
  • Get a second opinion on your retirement plan from an advisor. Set up a free virtual consultation today »

Around this time of year, many people are processing the shock of finding out they owe the IRS and/or their state more in taxes than they expected or planned for. Those additional taxes due could be the result of a new job with a higher-paying salary. Or maybe because of some additional gig work on top of the 9-to-5 to help make ends meet. Whatever the reason, the good news is you made more money, while the bad news is you owe more in taxes.

In some cases, the additional income is simply a one-time thing, such as an inheritance or winning the lottery. And in those instances, there is not much to do. Your financial life will likely revert back to normal next year and so should your income tax situation. 

However, if you expect your income to stay at this new level, there are a few options available to you to help reduce the amount you will owe in taxes going forward.

Update your withholdings

The IRS rolled out a brand-new Form W4 in November 2020 that was designed to simplify the withholding process for many employees. The form replaced the old system of claiming the appropriate number of allowances and instead allows workers to provide their employer the exact information needed to determine how much to withhold from each paycheck. If you haven’t filled out a W4 in a while, this is a great place to start.

Give more to charity

If you already have a habit of writing a check to support a cause that you care about, consider giving more this year. Since you are going to be giving it away one way or another — either to charity or to the IRS — you might as well send that money somewhere you can feel good about. 

Increase your retirement plan contributions

If the percentage amount you’re currently contributing to your 401(k) or other workplace retirement account is not high enough to hit the cap, this is a great option to consider.

Since contributions to workplace retirement plans grow tax-deferred until the day you begin taking distributions, every additional dollar you are able to get into this account will benefit from compounding without the usual tax drag felt by other investment accounts.

Contribute to a Health Savings Account

Similar to a 401(k) plan, dollars contributed to a Health Savings Account go in pre-tax and do not have to be spent in the year they are contributed. This means that you get to enjoy the tax benefit of your contribution today, while saving its monetary benefit for a future date. 

HSAs also allow you to invest some of the dollars in your account and provide you another way to enjoy tax-deferred growth. Distributions taken from these accounts receive tax-free treatment as long as they are used to cover qualified medical expenses. 

Contribute to a Dependent Care FSA

If you have children younger than 13, consider establishing this account to help cover the costs of activities such as before- and after-school care, preschool, summer camp, and nanny care. 

Those who care for an adult relative who they already claim as a dependent may also use the funds contributed to this account to cover those costs. In most cases, the funds contributed to this account will need to be used in the same calendar year the contributions are made.

Contribute to an Individual Retirement Account

Factors such as overall household income and whether you or your spouse contribute to a workplace retirement plan will determine your eligibility to deduct contributions made to an IRA from your taxable income. And though there are several restrictions and limitations on who is eligible, those who are should consider this option. IRAs are yet another opportunity to receive tax-deferred growth on funds contributed, while only having to pay taxes on the dollars distributed at some point down the line. 

Itemizable deductions, such as gifts to charity, are a great way to reduce your tax burden. However, since those types of transactions are made with after-tax dollars, they are considered “below the line” deductions in the accounting world and are a bit limited in their impact. 

Since contributions to workplace retirement plans, HSAs, IRAs, and Dependent Care FSAs are all made with pre-tax dollars, each one may bring down your taxable income dollar-for-dollar, making them the most impactful of the list above. These types of contributions all receive “above the line” deductions and are a great way to get the maximum bang for your buck.

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