Online publications typically circulate their tax planning tips at the end of the year. But tax planning can take place all year long; it doesn't matter whether the April filing deadline is 12 months away or just around the corner.
Tax Planning Strategies
Planning strategies really come down to one simplified income tax formula:
Gross Income - Deductible Expenses = Net Taxable Income
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The overall tax-planning objective is to minimize net taxable income. The tactics involved with meeting that objective are twofold: minimizing gross income, while maximizing deductible expenses. The following paragraphs are going to look at each of these tactics separately.
Minimizing Gross Income
No doubt it's possible to minimize taxable income by taking some time off from work, but that's not going to help anyone's lifestyle in the long run. The tax tips discussed in this section include tactics that allow a filer to exclude income from federal income taxes. Therefore, the first tip has to do with retirement planning.
Tax Tip 1: Lowering Gross Income using Retirement Plans
It's no accident this is the first item listed. One of the most effective ways to lower gross income is to have it directed into a 401(k) or 403(b) plan.
The 401(k) rules are quite generous when it comes to lowering income, and they are mirrored by the 403(b) contribution rules. On a pre-tax basis, it's possible to invest up to $19,500 in 2020 and 2021, and employee contributions are often matched by an employer. In 2022 and beyond, these contribution amounts will rise with an index of inflation. That means it's possible to lower taxable income by $19,500, get an instant return on investment, and save for retirement at the same time. It's really a win-win.
Tax Tip 2: Deferring Income
A second way to lower gross taxable income is by deferring it. The objective here is to defer money, or income, to another tax year. Perhaps the best example uses the tax laws to defer stock market gains.
Individuals that have shares of stock that have gone up since they were purchased can defer taking a capital gain and raising their gross income. This is especially desirable if it's possible to offset that capital gain with a capital loss in later years.
Keep in mind the IRS disallows the loss on sales of securities if substantially identical securities are purchased within 30 days, which is called a wash sale.
Maximizing Deductible Expenses
Even though this section has been labeled as deductible expenses, it really includes two items: tax deductions and tax credits. A tax deduction lowers taxable income, while a tax credit is just as the name implies; a credit that's applied to the total tax bill. Tax credits are far more valuable on a dollar-for-dollar basis.
Tax Tip 3: Tax Credits
Admittedly, the qualifying rules for tax credits are typically complex and very specific to each program.
Child Tax Credit: provides a credit of $1,400 per qualifying child under the age of seventeen. In 2020 and 2021, this credit is phased-out for taxpayers with modified adjusted gross incomes (AGI) in excess of $400,000 for married-joint filers, $200,000 for all other taxpayers.
Lifetime Learning Credit: up to $2,500 in credits for each qualifying student enrolled in a qualifying institution of higher education are available through Lifetime Learning Credit program.
Child and Dependent Care Credit: individuals paying a childcare provider for a child under age 13 so they can work, may be able to claim the child and dependent care credit. The credit may be lowered or eliminated for individuals with higher adjusted gross incomes.
Energy Saving Devices: homeowners that install some of the newer energy saving devices such as air conditioners, water heaters, furnaces, boilers or solar panels may be eligible for a tax credit of up to $2,000. Check with local electric or gas utilities to find out which energy saving devices provide tax credits or rebates.
Tax Tip 4: Tax Deductions
This final set of planning tips has to do with tax deductions. While it's certainly possible to buy a new home and deduct mortgage interest and property taxes; that's not the intention of this section. These are actions a taxpayer can take to squeeze out more deductions.
IRA Accounts: Roth IRAs do not provide immediate tax help, although the money removed from these accounts is not considered taxable income. Individuals looking for immediate relief might want to consider funding a Traditional IRA, which can be tax deductible. It's just another way the government provides incentives to save for retirement.
Medical Expenses: no one plans to get sick, but there is one way to use those medical expenses to a taxpayer's advantage. Only medical expenses in excess of 7.5% are allowed as tax deductions. That's where the strategy of grouping medical expenses comes into play. If a family has been hit hard with a lot of medical expenses in a given year, then it may be worthwhile to accelerate additional elective medical payments into the same tax year. This way it's possible to get a tax break on medical expenses, even with the 7.5% threshold.
Homeowner Deductions: it's also possible to accelerate mortgage and property tax deductions merely by changing the timing of certain payments. By writing checks before December 31st, it's possible to claim the interest expense or property taxes in that same tax year.
Business and Personal Expenses: this final tax planning tip has to do with accelerating personal or business-related expenses. By charging some of these costs on a credit card, it's possible to claim the expense in one tax year, and pay for them in the following year.
Prepaying Taxes and Adjusting Withholding
One last suggestion doesn't involve a tax-lowering strategy, but rather the payment of income taxes themselves. For some taxpayers, the April deadline can be financially difficult in terms of paying what is owed on a federal tax return.
There are two actions that can help take the pain out of tax time. The first has to do with prepaying taxes. This is as simple as filling out a tax form, and sending the IRS a check each quarter.
Correct Withholding
The second has to do with adjusting withholding. Neither getting a large tax refund nor sending a large check to the IRS makes a lot of sense. Anyone getting a large refund is lending the federal government money, interest free.
On the other hand, owing a lot of money to the IRS each year is not a good place to be either. In fact, withholding too little in taxes could result in unnecessary penalties.
Anyone in either of these situations should adjust their withholding. This process involves filling out a fairly simple tax form that can be downloaded from the IRS website or obtained from an employer. The W-4 takes about ten minutes to complete and filling out the form now will avoid a big tax bill later on.
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