The term “tax planning” refers to activity associated with creating a financial plan that reduces a person’s tax bill. In general, income tax is a percentage of a person’s earnings that goes to the government. However, the government offers deductions and exclusions from income for certain types of activities and expenses that affect how a peron’s tax bill is calculated. They can be used to decrease a person’s tax liability and increase their tax refund.
Tax planning is especially important for major life events such as starting a business, estate planning, and divorce.
Some common planning techniques are discussed below.:
Figure Out Current Tax Bracket
The first step is for a person to identify their current federal tax bracket. The U.S. has a progressive tax system, which means that people with higher taxable incomes are subject to higher tax rates. People with lower incomes are taxed at lower tax rates. The seven federal income tax brackets are: 10%, 12%, 22%, 24%, 32%, 35% and 37%.
A person usually does not pay one rate on their entire income for two reasons:
- Everyone is allowed to subtract tax deductions from their gross income to arrive at their taxable income; the income that is taxed usually is not the same as their entire salary or total income.
- The federal Internal Revenue Service (IRS) divides a person’s taxable income into chunks and then taxes each chunk at the applicable rate; taxable income is a person’s total income minus any legal deductions and exclusions have been applied.
For example, suppose a person files as a single person with a taxable income of $32,000. This income places the person in the 12% tax bracket in 2020. This person does not pay 12% on all $32,000 of their taxable income. Rather, they pay only 10% on the first $9,875; then 12% on the rest. If the person had $50,000 of taxable income, they would pay 10% on the first $9,875 and 12% on their income between $9,876 and $40,125. And they would then pay 22% on the remainder, because some of their $50,000 of taxable income falls into the 22% tax bracket
Review Available Tax Deductions
Tax deductions and tax credits may be the most helpful part of preparing a tax return. Both reduce the amount of tax a person owes, but in different ways. Understanding deductions, credits and exclusions leads to some effective strategies for reducing a person’s tax liability.
- Tax deductions are specific expenses that can be subtracted from a person’s taxable income. They reduce a person’s taxable income and in this way, reduce a person’s tax liability;
- Tax credits are amounts that are subtracted from your tax liability directly; so, after a person has calculated the amount of tax they owe in a given year, if the person has a credit, the credit is directly subtracted from the amount of tax owed.
- Exclusions are types of income that do not have to be included in taxable income; for example, in some cases, income realized in a foreign country on which a person pays taxes in a foreign country may not have to be included in taxable income in the U.S.
The government offers deductions from income for certain uses of the income, such as money spent on education in certain circumstances and savings for retirement deposited in 401(k) or 403(b) accounts, among others. For example, a person can choose to save money through salary deductions in an employer-sponsored 401(k) account early on that will save on their tax liability in the long run.
Some of the more commonly-used deductions are the following:
- Adoption credit: the cost of adopting a dependent can be deducted from income;]
- Capital loss deduction: losses realized from the sale of capital assets, e.g. stock, can offset capital gains;
- Charitable contributions: contributions that a person makes to qualified charities;
- Child Tax Credit: a credit that goes to parents of minor children;
- Medical expenses: with certain limitations, medical expenses can be deducted;
- Property taxes: taxes paid to local authorities as property tax on a resident can be deducted from a person’s federal taxable income.
There are also a number of deductions for saving for purposes other than retirement. For example, the following type of accounts allow a person to save money and deduct it from their income:
- The 529 account: Offered by most states and some educational institutions these accounts help people save for college. The savings are not deductible on federal income taxes, but possibly on a person’s state tax returns.
- The Flexible Spending Account (FSA): If offered by a person’s employer, a person can deduct money from their paycheck into an FSA and use it for medical and dental expenses as well as everyday health-care-related expenses such as bandages and pregnancy related medical equipment;
- Dependent Care Flexible Spending Accounts (DCFSA): Again, if a person’s employer offers it, this account allows a person to exclude as much as $10,500 of their pay from taxable income. The money is diverted to a DCFSA, from which it can then be used for after-school care, day care, preschool and day camps and other dependent care expenses. Expenses for elder care may be allowed also.
- Health Savings Accounts (HSAs): These accounts are tax-exempt accounts that can be used to pay medical expenses; contributions to HSAs are tax-deductible, and the withdrawals are tax-free, but only they are used for qualified medical expenses; this can help a person who has a high-deductible health insurance coverage; An HSA may be offered by an employer, but a person can set up their own account at a bank.
Each of these deductions has limitations and qualifications. However, it can pay in the form of a lower tax liability for a person to be aware of exclusions, deductions and credits. In addition, there are a number of business deductions, such as travel expenses, the expense of maintaining a home office or depreciation, that may affect a person’s taxes over the course of many years for a person who is a sole proprietor of a business.
Apply Tax Credits
The government also offers personal tax credits for certain activities, including child care credits, education credits, and healthcare credits. Depending on a person’s situation, they may qualify for these tax credits. Again, knowing about these credits can affect a person’s financial planning in general and their tax planning specifically.
Use Employer Withholdings
A person also wants to be sure that the correct amount is being withheld from their paycheck for taxes. A person may also ask their employer to withhold more money from their check in order to get a larger tax refund at the end of the year. Saving the refund instead of spending it could be a useful strategy for saving money, which can be challenging.
Do I Need an Attorney to Help Me with My Tax Problems?
Tax laws are complex and ever-changing. There is tax preparation software on the market that can help with tax preparation. An experienced tax attorney can help with tax planning. They can help you review your current situation, plans for your financial future and help you figure out how some tax planning might play a positive role in your financial and tax situations.