You can substantially reduce or eliminate your income tax by saving for retirement, owning a home, sending your kids to college. Here's how it worked for one client.

As we were preparing the tax return for a married couple, I realized that they had the ideal tax strategy. You get everything you really want in life: lower taxes, owning a modest home, putting the kids through college, and saving for retirement. Sounds perfect, but how do the numbers work out?

Tax Strategy 1: Save in a 401k Plan
Let's start with their profile. The couple are filing a joint tax return and have three kids: two in college and one in high school. Between the both of them, they earn $76,500 in wages. Each puts away $5,000 in their 401k retirement savings plans, which reduces their taxable wages by $10,000. Now, the couple is taxed only on $66,500. (This is their adjusted gross income.)

Tax Strategy 2: Buy a House & Itemize Your Deductions
Because they own a house, the couple is eligible to itemize their deductions. Besides mortgage interest of $16,000, the couple also has real estate taxes (another $5,000), donations to their church (about $3,700), and let's not forget the state income taxes that were withheld on their paychecks ($2,500). Their itemized deductions totalled up to $27,200. This in turn reduces their AGI from $66,500 to $39,300.

The clients can reduce their taxable income by $15,500 because of their five personal exemptions. So their taxable income is $23,800. This gives them an income tax of $2,859.

Tax Strategy 3: Use Tax Credits to Eliminate Your Taxes
Here's where the fun really begins. Two of their children go to college. Their eldest daughter is a senior at a state university, and they spent $15,000 in tuition for her classes. This gives the couple the maximum Lifetime Learning Tax Credit of $2,000 for their daughter's education. Additionally, their son, the second oldest, was a freshman at another state university and qualifies for the Hope Tax Credit of $1,500.

Together, these two education tax credits total up to $3,500, which is more than the couple's tax liability of $2,859. The education credits therefore reduce the couple's tax to $0. Tax Credits are non-refundable, which means the couple does not get the excess tax credits refunded to them. Instead, the tax credits (at most) reduce the tax to zero, which is still a good deal!

Tax Strategy 4: Adjust Your Withholding & Spend Your Tax Refund Wisely
So, the couple gets a full refund of all their withholding. They decided to use part of their refund to open Roth IRAs for both the husband and the wife (up to $3,000 each), and to put the rest in several bank certificates of deposit for their youngest daughter's college fund.

As you can see, sometimes tax breaks are a very good thing. By owning a house, putting their kids through college, and saving for retirement, this couple has managed to eliminate their tax bill. Now that's what I call living the American Dream!