Tax planning is a very important part of budgeting and financial success. Listed below are 6 tips provided by Nerd Wallet, in order to prepare yourself financially for tax season and beyond.
- 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.
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.
- Be aware of popular tax deductions and credits
There are hundreds of possible deductions and credits out there, and they all have their own rules about who’s allowed to take them. Here are some big ones (click on the links to learn more).
- Adoption credit
- Costs of adopting a child
- American Opportunity credit
- College education costs
- Capital loss deduction
- Losses on stock sales (to offset capital gains)
- Charitable contributions
- Giving money, cars, art, investments, household items or other things to charity
- Child and dependent care credit
- Day care and similar costs
- Child tax credit
- Being a parent
- Credit for the Elderly or the Disabled
- For people or their spouses who retired on permanent and total disability
- Earned Income Tax Credit
- Money for people below certain adjusted gross incomes
- Home office expenses
- A portion of your mortgage or rent; property taxes; utilities, repairs and maintenance; and similar expenses if you work from home
- Lifetime Learning credit
- Undergraduate, graduate or even non-degree courses at accredited institutions
- Medical expenses
- Unreimbursed medical costs over a certain threshold
- Mortgage interest
- The interest portion of mortgage payments on a primary home
- Property taxes
- Property taxes on real estate
- Residential energy tax credits
- Installing things that make a home energy-efficient
- Saver’s credit
- Contributions to an IRA for people with incomes below certain thresholds
- Know what tax records to keep
Keeping tax returns and the documents you used to complete them is critical if you’re ever audited. Typically, the IRS has three years to decide whether to audit your return, so keep your records for at least that long. You also should hang onto tax records for three years if you file a claim for a credit or refund after you filed your original return.
Keep records longer in certain cases — if any of these circumstances apply, the IRS has a longer limit on auditing you:
- Six years: If you underreported your income by more than 25%.
- Seven years: If you wrote off the loss from a “worthless security.”
- Indefinitely: If you committed tax fraud or you didn’t file a tax return.
- Tax strategies to shelter income or cut your tax bill
Deductions and credits are a great way to cut your tax bill, but there are other tax planning strategies that can help keep the IRS’ hands off your money. Here are some popular tax planning strategies.
Tweak your W-4
A W-4 tells your employer how much tax to withhold from your paycheck. Your employer remits that tax to the IRS on your behalf.
Generally, the more allowances you claim on your W-4, the less money will be taken out of your pay to go toward taxes. Claim fewer allowances on your W-4, and more of your pay should appear on your check.
Here’s how to use the W-4 for tax planning.
If you got a huge tax bill when you filed and don’t want to relive that pain, you may want to increase your withholding. That could help you owe less (or nothing) next time you file.
If you got a huge refund last year and would rather have that money in your paycheck throughout the year, do the opposite and reduce your withholding.
You probably filled out a W-4 when you started your job, but you can change your W-4 any time. Just download it from the IRS website, fill it out and give it to your human resources or payroll team at work.
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King Financial Services Inc
610 S Industrial Blvd. Suite 140
Euless, TX 76040
Phone: (800) 503-1343
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