Tax planning is all about one thing: reducing the money you pay in taxes. Let’s consider the three best ways to do this:
Reduce Your Adjusted Gross Income
Adjusted Gross Income (AGI) is a key element in determining your personal income taxes. Your tax rate and tax credits rely on this AGI figure. Your AGI impacts your daily financial affairs in such areas as banking, securing a mortgage, getting college financial aid for your children (or yourself).
Begin your tax planning by taking steps to reduce your AGI.
AGI is calculated by taking your total income from all sources and subtracting any adjustments to that income. The best way to reduce the amount of money you have to pay out in taxes is to decrease the income you make.
One way to reduce your income is to invest in yourself and your financial future by contributing to an approved retirement plan. Investigate any programs your employer offers and/or available 401(K) programs. Your contributions will reduce your reported income and lower your annual tax bill.
Other adjustments to income include interest paid on a student loan, payment of alimony and classroom related expenses for teachers. (See lines 23-34 on the IRS form 1040 for a complete list of potential adjustments you may be able to take to reduce your income.) One of the best adjustments to your annual income is to contribute to a traditional IRA (Individual Retirement Account).
Please note: Roth IRAs tax the money as you put it in, rather than taxing you as you take it out — so this type of IRA won’t reduce your current income or your tax burden.
Increase Your Tax Deductions
Increasing the tax deductions you can claim will reduce the amount of taxable income you have each year. Taxable income is what’s left over after you have reduced your AGI by your deductions and exemptions. Almost everyone can take a standard deduction, but some people are better served by itemizing their deductions.
Itemized deductions include:
- Health care expenses (if 7.5% of AGI or more)
- State and local taxes
- Personal property taxes (such as car registration fees)
- Mortgage interest paid
- Charitable gifts
- Required job-related expenses (that are not reimbursed by your employer)
- Tax preparation fees
- Investment-related expenses
If your annual itemized expenses are greater than the standard deduction, you should itemize. Use a spreadsheet or a simple financial program to make quick end-of-the-year comparisons. Your standard deduction and personal exemptions depend on your filing status and how many dependents you have.
Take Advantage of Tax Credits
Tax credits reduce your tax liability. There are tax credits for college expenses, child care expenses, retirement savings, costs associated with adoptions, and Earned Income Credit (EIC) for some low-income earners.
Some of the most generous tax credits for higher income individuals are for adoption and college expenses. There are two education-related tax credits. The Hope Credit is for students in their first two years of college. The Lifetime Learning Credit is for anyone taking college classes and those classes do not have to be related to your career. Unlike other tax credits, the EIC is credited to your account as a payment. And that means the EIC often results in a tax refund even if the total tax has been reduced to zero.
Please note: If at all possible, avoid early withdrawals from an IRA or 401(k) retirement plan. The amount you withdraw will become part of your taxable income and there will be additional penalties to pay if you withdraw funds early.
For more information on how to reduce the taxes you will have to pay, based on your individual circumstances, contact us.