Planning ahead can go a long way toward keeping your taxes as manageable as possible, especially for those who have reached their retirement years. It can be a bit of a challenge, however, if you don't understand or even know about all the options available to you.
It is helpful to have a good grasp on income tax laws and their impact on how much you will have to pay the government. Effective tax planning can go a long way toward helping you accomplish your financial goals.
The idea of tax planning is to arrange your financial affairs so you ultimately end up owing as little in taxes as possible. You can do this in three basic ways: You can reduce your income, increase your deductions, and take advantage of tax credits. These options aren't mutually exclusive.
You can do all three for the best possible result.
Understanding your tax bracket
The United States has a progressive tax system.
That means people with higher taxable incomes are subject to higher tax rates.
People with lower taxable incomes are subject to lower tax rates.
However, you receive the benefit of lower tax rates for certain parts of your income, in a graduated manner.
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 2019. But actually, you pay 10% on the first $9,700; then you pay 12% on the rest.
The standard deductions for the 2021 tax year are:
A single taxpayer who has $13,000 in itemized deductions would do better to itemize than to claim the standard deduction. That's an additional $800 off his taxable income, the difference between $13,000 and $12,200.
But a taxpayer who has only $9,000 in itemized deductions would end up paying taxes on $3,200 more in income if she itemizes rather than claims the standard deduction for her single filing status.
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 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.
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.
Good tax software or a good tax advisor can help you figure out which deductions you’re eligible for and whether they add up to more than the standard deduction.
Take Advantage of Tax Credits
Tax credits don't just reduce your taxable income—they're better than that.
They subtract directly from any tax debt you end up owing the IRS after you take all the adjustments to income and tax deductions you're entitled to.
Tax credits are credited to your IRS as payments, just as though you had written the IRS a check for money owed.
Most of them can only reduce your tax debt, but the EITC (Earned income Tax Credit) can result in the IRS issuing a tax refund for any balance left over after your tax obligation has been reduced to zero.
Again, income restrictions apply. You won't qualify for this tax credit if you earn too much.
Managing retirement accounts is an important part of tax planning.
Not only do some retirement plan contributions earn you valuable deductions right now, but you also get a chance to put off paying taxes on the income produced by your retirement savings for years until you withdraw the money in retirement.
Most people would only do their taxes in March or April when the deadline for settling tax returns is fast approaching.
Tax planning should start earlier to give you more time to make a good estimate of your investment gains or losses and income.
The Facts About Income Tax
