Personal income tax is a direct tax levied on your earned income either from employment or owning a business. A person could be an individual, ordinary partnership, non-juridical entity, or an undivided estate. As a general requirement, an individual must compute his tax liability, file his tax return and pay tax on a calendar basis, a period beginning January 1 and ending on December 31.
Tax planning is commonly defined as the manner of forecasting your tax liability and creating circumstances and ways to reduce it. Tax planning involves the analysis of your financial situation from a tax perspective with the end view of tax efficiency. Every year, American tax law changes, and keeping up with the latest updates can prevent you from paying the government more than you need to.
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.
Your adjusted gross income (AGI) is the key element in determining your taxes. It's the starting number for calculations, and your tax rate and various tax credits depend upon it. You won't be able to qualify for certain tax credits if it's too high.
The more money you make, the higher your AGI will be and the more you'll pay in taxes. Conversely, you'll pay less in taxes if you earn less. That's the way the American tax system is set up. And it all begins with that magic number—your AGI.
Your AGI is your income from all sources minus any adjustments to income you might qualify for. As of 2019, adjustments to income include but aren't limited to:
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.
No matter which bracket you’re in, you probably won’t pay that rate on your entire income. You get to subtract tax deductions to determine your taxable income. Your taxable income is what's leftover after you've determined your AGI. You have a choice here: You can either claim the standard deduction for your filing status, or you can itemize your qualifying deductions. But you can't do both.
Itemized deductions include:
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 to avoid paying taxes on more income than you need to.
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.
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.
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.
Don't overlook the Tax Credit for the Elderly. This special tax credit can be claimed by taxpayers who are age 65 or older, but qualifying for it requires careful retirement tax planning—your AGI must fall beneath certain limits.
A special thing about the earned income tax credit is that even if you don't owe anything in taxes, you can still get the credit amount back from the IRS in the form of a refund.
As you can imagine from the chart, a credit of several thousand dollars for workers earning less than $55,000 -- in some cases, much less -- can make a big financial difference for families struggling to make ends meet. No credit is available to those earning above the top amounts, as the Saver's credit is generally intended for low- to middle-income taxpayers.
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:
Keeping tax returns and the documents 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. It is always recommended that you save your tax documents for seven years in case of an audit.
Retirement tax planning
Retirees have some control over their tax situations because they can decide how much they want or need to withdraw from their various retirement plans.
Retirees can coordinate their taxable retirement distributions with their mortgage interest on loans of up to $750,000, real estate taxes up to $10,000 in most cases, and medical expenses over 10% of your adjusted gross income (AGI) as of 2019. These are all available itemized deductions.
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.
In the old days with paper forms, instructions, and calculator in hand, one became immersed in the math and logical relationships of how the schedules were connected and what they meant. This if nothing else spurred the quest for the opportunity, as one puzzled the relationships and pondered the possible.
These days, it can be far too easy to miss checking a box – or misinterpret the dumbed-down software guidance of what the box means and does – and so generate lots of missed tax savings opportunities.
Traditionally, as a year winds down, it’s a good time to think about these and other tax planning strategies, and review and update your plan. However, if you have never looked at tax planning strategies, you don’t have to wait until year end.
Be sure to talk to your tax professional to determine which are best for you. Get in touch with Leeward Wealth and set an appointment for a tax-strategy consultation today!