Taxes are by far the highest expense for most people and the reason why everyone wants to save on them. When employed, taxes are withheld from your paycheck and automatically sent to the IRS (or other state tax authority.) When self-employed, profits from your business are (or should be) calculated and remitted quarterly.
Taxes are inevitable in either position you play.
But the amount you pay can be greatly reduced. By thousands.
Just like planning for retirement, you should be planning to pay taxes.
Most people know of retirement planning. But not as many consider or develop a tax plan.
Simply put, tax planning is an analysis of a financial situation from a tax perspective in order to reduce tax liability.
Not to be confused with tax evasion, which is illegal and deliberate underpaying of taxes.
Developing a tax plan is not an easy task. Mostly because tax laws tend to be complex in nature. But if you take the time to understand and use them to your advantage, you can greatly save on taxes.
Want to learn more about tax planning and using it to save on taxes?
Here are some tax planning concepts for beginners.
Know the Difference: Tax Planning or Tax Preparation
Many taxpayers don’t know that their accountant is not helping them save on taxes. Instead, the vast majority of tax preparers are only preparing taxes and not tax planning.
But what’s the difference?
Tax preparation is the preparing and filing of tax returns. Tax preparers take information furnished by taxpayers and record it on the appropriate line and form of a tax return.
Tax preparation is what all of us need in order to be compliant with the IRS.
As mentioned earlier, tax planning is the analysis of a financial situation from a tax perspective, in order to reduce tax liability.
Tax planning directly helps you save on taxes. It is what big companies like Apple and Amazon do to legally pay little or no tax.
The fortunate part is that tax planning is not just for big companies or billionaires. Everyone can use tax planning to save on taxes.
It’s important not confuse what your tax preparer does and tax planning. Tax planning is a completely different service. If you haven’t had a clear conversation about tax planning with your accountant, it is highly likely that they are just preparing your returns.
Tax Credit vs. Tax Deduction
Another key distinction you should know when deciding to tax plan is between a tax credit and tax deduction.
Both are helpful when trying to save on taxes, but does so in completely different ways.
Tax credits directly reduce your tax liability. Let’s take an example.
Let’s say, based on your income and tax bracket (discussed later), you owe the IRS $45,000. A $5,000 tax credit would reduce your taxes owed to $40,000.
Tax credits reduce your taxes, dollar for dollar.
On the other hand, a tax deduction indirectly reduces your tax bill. Let’s use the same example but replace the $5,000 credit with a $5,000 deduction.
Let’s say this particular taxpayer is in the 25% tax bracket. The $5,000 deduction would reduce taxes by $1,250 ($5,000 x 25%).
You have to multiply the deduction by your tax rate to get what you would save on taxes.
Sometimes, deductions are referred to as write-offs or business expenses.
It goes without saying, you would much rather have tax credits than deductions. As fate would have it, tax laws have way more tax deductions than credits available.
Here is a list of some common tax credits:
- American opportunity credit
- Child and dependent care credit
- Child tax credit
- Residential energy tax credit
Don’t rely on credits alone. Here are a few common tax deductions:
- Home office expenses
- Mortgage interest
- Medical expenses
- State taxes
Know Your Tax Bracket
Understanding tax brackets can be a little confusing at first. Check out our blog on How Tax Brackets Work for a more detailed explanation.
In general, tax brackets are the ranges of income that are taxed at incremental rates.
Meaning your first $10,000 of income is taxed at a different rate than your last $10,000 of income.
Below are the tax brackets for tax years 2017 and 2018.
|2017 Tax Brackets||2018 Tax Brackets|
|Income Bracket||Tax Rate||Income Bracket||Tax Rate|
|$0 – $9,325||10%||$0 – $9,525||10%|
|$9,325 – $37,950||15%||$9,525 – $38,700||12%|
|$37,950 – $91,900||25%||$38,700 – $82,500||22%|
|$91,900 – $191,650||28%||$82,500 – $157,500||24%|
|$191,650 – $416,700||33%||$157,500 – $200,000||32%|
|$416,700 – $418,400||35%||$200,000 – $500,000||35%|
The difference in tax bracket percentages is the result of the Tax Cuts and Job Act but the methodology remains the same.
As your income increases, your tax rate increases.
Apart of your responsibilities as a taxpayer is to keep proper records. Every year you should keep up with your filed tax returns and any documents used to prepare them.
The IRS requires it, especially in the case of an audit.
Furthermore, if you want to save on taxes, you or your CPA would need to know what you were paying in the first place. It’s starting place for tax planning.
The IRS could audit you for up to 3 tax years so it is wise to keep your documents for 3 years. Longer if possible.
Common Tax Planning Strategies
There are countless ways to save on taxes. Here are some common tax planning strategies to think about.
Itemizing Over the Standard Deduction
If you want to save exponentially in taxes, you should itemize deductions over the standard deduction threshold.
The standard deduction changes from year to year. For tax years 2018 and 2019, it is $12,200 for singles. And doubled for married couples.
If you can instead, itemize deductions on Schedule A over the standard deduction, you’ll have the opportunity to save on taxes.
Some itemized deductions are state income tax, medical expenses, and charitable contributions.
Are you saving towards retirement? Well, you should be. Why not save on taxes too?
Most, if not all, retirement accounts offer some level of tax benefits. For example, if you contribute to a 401k account, your pre-tax income is reduced by your contributions.
And therefore, the income you pay tax on is less.
Also, consider the different Individual Retirement Accounts (IRAs) that are out there.
Keep in mind, there may be contribution limitations or income restrictions that may apply.
Health Saving Accounts
Health Saving Accounts or HSAs are tax-exempt accounts used for medical expenses.
The contributions you make in an HSA are tax deductions and withdraws made are tax-free (as long as they are made for medical purpose).
Everyone wants to save on taxes but may not know where to begin.
The good news is you don’t have to learn the entire tax code and you don’t have to go at it alone.
Consider hiring a CPA or highly trained accountant to help you.
Working with a professional will help you realize the full potential of what you could be saving.
In most instances, the cost to hire a professional will pay for itself with the amount of tax savings you can expect.
Contact us to talk with one of our professionals to develop your personal tax plan and save thousands!