The goal of tax planning is to arrange your financial affairs so as to
minimize your taxes. There are three basic ways to reduce your taxes,
and each basic method might have several variations. You can reduce
your income, increase your deductions, and take advantage of tax
credits.
Reducing Income
Adjusted Gross Income (AGI) is a key element in determining your taxes.
Lots of other things depend on your AGI (or modifications to your
AGI)-- such as your tax rate and various tax credits. AGI even impacts
your financial life outside of taxes: banks, mortgage lenders, and
college financial aid programs all routinely ask for your adjusted
gross income. This is a key measure of your finances.
Because your adjusted gross income is so important, you may want to
begin your tax planning here. What goes into your adjusted gross
income? AGI is your income from all sources minus any adjustments to
your income. The higher your total income, the higher your adjusted
gross income. As you can guess, the more money you make, the more taxes
you will pay. Conversely, the less money you make, the less taxes you
will pay. The number one way to reduce taxes is to reduce your income.
And the best way to reduce your income is to contribute money to a
401(k) or similar retirement plan at work. Your contribution reduces
your wages, and lowers your tax bill.
You can also reduce your Adjusted Gross Income through various
adjustments to income. Adjustments are deductions, but you don't have
to itemize them on the Schedule A. Instead, you take them on page 1 of
your 1040 and they reduce your Adjusted Gross Income. Adjustments
include contributions to a traditional IRA, student loan interest paid,
alimony paid, and classroom related expenses. A full list of
adjustments are found on Form 1040, page 1, lines 23 through 34. The
best way to boost your adjustments is to contribute to a traditional
IRA.
As you can see, two of the best ways to reduce your taxes is to save
for retirement, either through a 401(k) at work or through a
traditional IRA plan. Contributions to these retirement plans will
lower your taxable income, and lower your taxes.
Increase Your Tax Deductions
Taxable income is another key element in your overall tax situation.
Taxable income is what's left over after you have reduced your AGI by
your deductions and exemptions. Almost everyone can take a standard
deduction, and some people are able to itemize their deductions.
Itemized deductions include expenses for health care, state and local
taxes, personal property taxes (such as car registration fees),
mortgage interest, gifts to charity, job-related expenses, tax
preparation fees, and investment-related expenses. One key tax planning
strategy is to keep track of your itemized expenses throughout the year
using a spreadsheet or personal finance program. You can then quickly
compare your itemized expenses with your standard deduction. You should
always take the higher of your standard deduction or your itemized
deduction.
Your standard deduction and personal exemptions depends on your filing
status and how many dependents you have. You can increase your standard
deduction and personal exemptions by getting married or having more
dependents.
The best strategies for reducing your taxable income is to itemize your
deductions, and the three biggest deductions are mortgage interest,
state taxes, and gifts to charity.
Take Advantage of Tax Credits
Once we've tweaked our taxable income, we are ready to focus our
attention on various tax credits. Tax credits reduce your tax. There
are tax credits for college expenses, for saving for retirement, and
for adopting children.
The best tax credits are for adoption and college expenses. Not
everyone is in a position to adopt a child, but everyone could take
some college classes. There are two education-related tax credits. The
Hope Credit is for students in their first two years of college. The
Lifetime Learning Credit is for anyone taking college classes. The
classes do not have to be related to your career.
You may also want to avoid additional taxes. If at all possible, avoid
early withdrawals from an IRA or 401(k) retirement plan. The amount you
withdraw will become part of your taxable income, and on top of that
there will be additional taxes to pay on the early withdrawal.
One of the best, and most abused, tax credit is the Earned Income
Credit (EIC). Unlike other tax credits, the EIC is credited to your
account as a payment. And that means the EIC often results in a tax
refund even if the total tax has been reduced to zero. You may be
eligible to claim the earned income credit if you earn less than a
certain amount.
Increase Your Withholding
You can avoid owing at the end of the year by increasing your
withholding. More money will be taken out of your paycheck throughout
the year, but you will get bigger refund when you file your taxes.