Unfortunately, paying income taxes is an inevitable part of our lives. However, that doesn't mean there's nothing you can do to reduce your share of what you are contributing to the government. It's quite possible to reduce your tax obligations in many ways that are legal and ethical.
Tax laws change frequently, as does your financial situation. Therefore, don't waste money by not practicing regular income-tax planning. Every dollar you save through your tax planning can be used to fund your lifestyle and other financial goals.
An important first step in sound tax planning is understanding how the tax rules work. Almost every financial decision you make has some kind of tax implication. It's unfortunate that most people choose to focus on taxes only when they prepare their tax returns, which is after the fact. By doing so, they miss many opportunities to adjust their financial situation to their advantage before making decisions in that arena.
Almost all of life's financial events can be improved with some attention to the tax implications before the events occur.
Selling your house
Refinancing your mortgage
Capital gain/loss through stock sales
Paying medical expenses
Marriage or divorce
Changing jobs or becoming self-employed
A birth or death in the family
Taking a withdrawal from a retirement plan
Basically, there are only two methods of lowering the amount of income taxes you pay:
Increase deductible expenses and credits
Reduce taxable income
Successful tax planning operates on the principles of deferral, tax bracket timing and the use of available deductions and credits. The following are some strategies to consider:
INCREASING TAX CREDITS & DEDUCTIBLE EXPENSES
Don't miss out on your deductions:
Medical costs, if they exceed 7.5 percent of your Adjusted Gross Income (AGI)
Certain taxes, such as state and local income taxes and property taxes
Certain interest expenses, such as home mortgage interest
Certain charitable contributions
Casualty and theft losses, in excess of 10 percent of AGI
Certain fees and expenses related to taxes and investment advice, as well as unreimbursed business expenses, that exceed 2 percent of your AGI
If your AGI exceeds specific levels, you must reduce certain itemized deductions by 3 percent of the excess amount. In 2008, this limitation applies only if your adjusted gross income is greater than $159,950, and $79,975 if married filing separately. Check IRS Publication 505 for additional details.
Under certain circumstances, you may be better off grouping deductions every other year. The idea is to accelerate deductions for a year in which you're in a higher tax bracket and postpone deductions for years you're in lower tax brackets.
Accelerate deductions by using the following:
Pay next year's property taxes before year end
Pay your fourth-quarter state income tax estimate in December instead of January
Pay your January mortgage payment in December
Make two annual charitable contributions in the accelerated year.
REDUCE TAXABLE INCOME
By deferring taxable income, you can shift income from one taxable year to the next. This strategy can be used if you are going to be in a lower tax bracket next year. By delaying receipt of income, you get to hold on to your tax dollars longer. Here are some techniques to do this:
Delay the sale of capital gain property
Delay receipt of year-end bonuses until next year (if you can avoid constructive receipt rules)
Purchase a CD or Treasury bill that matures next year (interest will be taxed next year)
If next year you're going to be in a higher tax bracket, income also can be accelerated and expenses postponed by using the opposite of the preceding techniques.
EMPLOYMENT TAX ADVANTAGES
As a full-time employee, you may be well-positioned to improve your tax status.
Most employees have access to tax-free or favorably taxed benefits. Consider the options available to you.
Does your employer offer a 401(k) plan? Or flexible spending plans such as "cafeteria" or salary-reduction plans? Refer to your employee benefits handbook or talk to your benefits manager or financial adviser to discover other benefits you may be overlooking.
This is the 12th feature in a series outlining the Your Financial Partner Personal Financial Management System. Next, we'll focus on insurance planning to protect your family and your assets.
REVIEW YOUR GOALS: The overriding objective for most people is simple: Pay no more income taxes than is legally necessary. Those involved with advanced financial planning may have more complex goals, such as to offset the capital gains tax following the sale of stocks or to determine the tax implications of refinancing a mortgage.
GATHER DATA: Make sure you have all available information so you can outline your current year's taxable income and deductible expenses. Use last year's tax return as a guide and adjust your income and deductions as projected for the current year.
ANALYZE YOUR SITUATION: Income tax planning starts with a tax calculation -- a projection of your tax liability based on your current tax situation. It is essential that you know where you stand and where you're going. If you are not comfortable with preparing a tax calculation manually or with tax software, seek professional advice. It is usually a good idea to have your tax preparer provide you with current-year tax calculations while preparing last year's tax returns.
DEVELOP YOUR STRATEGIES: Carefully consider the options available to lessen your tax burden. This is the essence of tax planning. There usually is more than one solution to reducing income taxes. Consult with your tax preparer/adviser to develop or verify your own strategies to reduce taxable income, increase deductible expenses, shift income between family members, defer or accelerate income and deductions between years to lower tax brackets, and determine tax credits.
IMPLEMENT YOUR PLAN: Once you have identified what needs to be done, it's time to do it. Good tax planning usually is the result of a combination of maneuvers, not buying into a single "tax shelter."
TRACK AND MONITOR YOUR PROGRESS: If you have variable or unpredictable income and expenses, this should be done on a quarterly basis and when faced with a financial or life event that involves tax consequences. If you qualify to use itemized deductions and/or have variable income, make sure to review your current year income tax calculations in April, September and December. If your income and deductions are stable and predictable, review your income tax calculations in April and December.
To assist you with your tax planning, you are invited to e-mail us at email@example.com and we'll e-mail you a complimentary copy of the Your Financial Partner "Tax Planner" in Excel.