What are the three basic strategies to use in planning for taxes?
Tax planning or tax-effective investing is a way of structuring your finances to reduce your tax liability and make some savings on tax. Tax planning can benefit both individuals and companies when it is carried out within the confines of the stipulated tax law. There are three basic ways you can plan your finances to minimise your tax burden; read on to discover these ways:
Taxable Income (ATI).
One of the critical elements used to determine the amount you owe in tax is your Adjusted Taxable Income (ATI). Various tax credits and tax rates are usually dependent on your ATI. Even mortgage lenders and banks will often ask for an individual’s ATI before making any lending commitment with them—hence, the importance of Adjusted Taxable Income.
Given the importance of the ATI, your tax planning should probably start by defining your ATI. Your Adjustable Taxable Income is the calculation of all your income minus the adjustments you can make to your income. For instance, if you pay for a retirement plan, then this subsequently reduces your wages, thus lowering your taxable income: This means you can reduce or deduct your retirement plan payments from your overall income. Other adjustments you can make on your taxable income include superannuation contributions, child support payments and spousal maintenance payments.
Increase your tax deductions
Another tax planning strategy is to take advantage of tax deductions. Once you have calculated your ATI (having made the necessary tax adjustments), you will be left with taxable income. You can now make a standard deduction or an itemized deduction on your taxable income. For instance, you can deduct the expenses used for health care, mortgage interest and state taxes.
If you want to utilize deductions fully, you should consider making an itemised list of all your annual expenses in a spreadsheet. This will help you compare your standard deduction versus your itemised expense deduction. Two of the biggest tax deductions you can take advantage of are on state taxes and mortgage interest.
Utilize Tax Credits
Taking advantage of tax credits and tax incentives can reduce your tax. For instance, you might be eligible for a tax credit if you pay medical expenses relating to disability aids or aged care. You can also get tax credits for child care benefits and spouse maintenance.
Tax planning can be difficult to comprehend, especially if you have little financial knowledge. It is, therefore, wise to seek the services of a reputable tax accountant to help you safely implement the above mentioned tax-effective investing strategies.
Tax Planning for Beginners: Tax Strategy Concepts to Know
Tax planning is the analysis and arrangement of a person’s financial situation in order to maximize tax breaks and minimize tax liabilities in a legal and efficient manner.
Tax rules can be complicated, but taking some time to know and use them for your benefit can change how much you end up paying (or getting back) in April. Here are some key tax planning and tax strategy concepts to understand before you make your next money move.
Tax planning starts with understanding your tax bracket
You can’t really plan for the future if you don’t know where you are today. So the first tax planning tip is get a grip on what federal tax bracket you’re in.
The United States has a progressive tax system. That means people with higher taxable incomes are subject to higher tax rates, while people with lower taxable incomes are subject to lower tax rates. There are seven federal income tax brackets: 10%, 12%, 22%, 24%, 32%, 35% and 37%.
No matter which bracket you’re in, you probably won’t pay that rate on your entire income. There are two reasons:
You get to subtract tax deductions to determine your taxable income (that’s why your taxable income usually isn’t the same as your salary or total income).
You don’t just multiply your tax bracket by your taxable income. Instead, the government divides your taxable income into chunks and then taxes each chunk at the corresponding rate.
For example, let’s say you’re a single filer with $32,000 in taxable income. That puts you in the 12% tax bracket in 2020. But do you pay 12% on all $32,000? No. Actually, you pay only 10% on the first $9,875; you pay 12% on the rest. If you had $50,000 of taxable income, you’d pay 10% on that first $9,875 and 12% on the chunk of income between $9,876 and $40,125. And then you’d pay 22% on the rest, because some of your $50,000 of taxable income falls into the 22% tax bracket.
The difference between tax deductions and tax credits
Tax deductions and tax credits may be the best part of preparing your tax return. Both reduce your tax bill, but in very different ways. Knowing the difference can create some very effective tax strategies that reduce your tax bill.
Tax deductions are specific expenses you’ve incurred that you can subtract from your taxable income. They reduce how much of your income is subject to taxes.
Tax credits are even better — they give you a dollar-for-dollar reduction in your tax bill. A tax credit valued at $1,000, for instance, lowers your tax bill by $1,000.
Taking the standard deduction vs. itemizing
Deciding whether to itemize or take the standard deduction is a big part of tax planning, because the choice can make a huge difference in your tax bill.
What is the standard deduction?
Basically, it’s a flat-dollar, no-questions-asked tax deduction. Taking the standard deduction makes tax prep go a lot faster, which is probably a big reason why many taxpayers do it instead of itemizing.
Congress sets the amount of the standard deduction, and it’s typically adjusted every year for inflation. The standard deduction that you qualify for depends on your filing status, as the table below shows.
What does ‘itemize’ mean?
Instead of taking the standard deduction, you can itemize your tax return, which means taking all the individual tax deductions that you qualify for, one by one.
- Generally, people itemize if their itemized deductions add up to more than the standard deduction. A key part of their tax planning is to track their deductions through the year.
- The drawback to itemizing is that it takes longer to do your taxes, and you have to be able to prove you qualified for your deductions.
- You use IRS Schedule A to claim your itemized deductions.
- Some tax strategies may make itemizing especially attractive. If you own a home, for example, your itemized deductions for mortgage interest and property taxes may easily add up to more than the standard deduction. That could save you money.
- You might be able to itemize on your state tax return even if you take the standard deduction on your federal return.
- The good news: Tax software or a good tax advisor can help you figure out which deductions you’re eligible for and whether they add up to more than the standard deduction.
Minimize or eliminate the new 3.8% Medicare tax on personal investment income.
You can do this by reducing rent charged to the business for a personally-owned building and equipment, increasing retirement plan and IRA contributions, gifting investment assets to lower bracket family members or charity, investing in tax-free bonds, and reducing capital gains through tax-free exchanges and harvesting capital losses.
Know your options for maximizing retirement plan contributions.
Looking to maximize tax-deductible retirement plan contributions. Entrepreneurs over age 40 with a younger staff can now fund a combined “safe harbor” 40l(k) profit sharing plan (with a 6% match) and cash balance defined benefit pension plan to save thousands in federal and state income taxes with contribution limits of more than $113,000 annually. How about slightly smaller tax-deductible contributions? Entrepreneurs over age 40 with a younger staff should consider a 40l(k) cross-tested profit sharing plan.
Optimize the way your business is structured.
Contact us to determine the payroll tax savings available from electing Subchapter S corporation status. Often business owners will be able to significantly reduce payroll taxes by taking a lower salary, with the remaining profit distributed as a dividend (not subject to payroll taxes). S status can also reduce income and payroll taxes on the sale of your practice, and lower IRS audit risk and exposure. Look for future article explaining entity selection in more detail!