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.
Planning strategies really come down to one simplified income tax formula:
Gross Income - Deductible Expenses = Net Taxable Income
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.
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.
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 $18,500 in 2018 and $19,000 in 2019, and employee contributions are often matched by an employer. In 2020 and beyond, these contribution amounts will rise with an index of inflation. That means it's possible to lower taxable income by $19,000, get an instant return on investment, and save for retirement at the same time. It's really a win-win.
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.
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.
Admittedly, the qualifying rules for tax credits are typically complex and very specific to each program.
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.
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.
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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