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The goal of tax planning is to arrange your financial affairs so that you pay as few taxes as possible, and so the taxes you do pay are as low as possible. Here are four basic ways to reduce your taxes.
Reduce your income.
Your adjusted gross income (AGI) is a key element in determining how high your taxes will be. Several 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. It is a key measure of your finances.
[RELATED: Year-End Tax Planning Tips]
Because your AGI is so important, you may want to begin your tax planning here. What goes into your AGI? Your income from all sources minus any adjustments to your income. The higher your total income, the higher your AGI. As you can guess, the more money you make, the more taxes you will pay. The number one way to reduce the amount of taxes you pay is to reduce your income. And the best way to reduce your income is to contribute money to a 401(k) or a similar retirement plan at work. Your contribution reduces your wages and lowers your tax bill.
You can also reduce your AGI through various adjustments to your income. Adjustments are deductions, but you don’t have to itemize them on the Schedule A tax form. Instead, you take them on page one of your 1040 tax form. Adjustments include contributions to a traditional IRA, student loan interest paid, alimony paid, and classroom-related expenses. A full list of adjustments can be found on Form 1040, page one, lines 23 through 34.
The best way to boost your adjustments is to contribute to a traditional IRA. Two of the best ways to reduce your taxes are to save for retirement through a 401(k) at work or through a traditional IRA. Contributions to these retirement plans will lower your taxable income and, subsequently, 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 with deductions and exemptions. Almost everyone can take a standard deduction, and some people are able to itemize their deductions.
Itemized deductions include expenses for healthcare, 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 the two.
Your standard deduction and personal exemptions depend 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. But the best strategies for reducing your taxable income are to itemize your deductions, and the three biggest deductions are mortgage interest, state taxes, and gifts to charity.
Take advantage of tax credits.
Once you’ve adjusted your taxable income, you can focus on various tax credits. There are tax credits for college expenses, saving for retirement, and adopting children.
The best tax credits are for adoption and college expenses. Not everyone is in a position to adopt a child, but most people can arrange to take a college course or two. 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. And the classes do not have to be related to your career.
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