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.
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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
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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It’s also a good idea to avoid additional taxes by not taking 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 itself.
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 it often results in a tax refund, even if the total tax has been reduced to zero. You may be eligible to claim the EIC if you earn less than a certain annual amount.Increase your withholdings.
You can use extra withholdings on one type of income – such as wages – to avoid paying estimated taxes on another type of income – such as interest, dividends or capital gains. And there’s a special benefit to this approach: extra withholdings that come late in the year are treated the same as if they were spread evenly throughout the year. Money will be taken out of your paycheck throughout the year, but you will get a bigger refund when you file your taxes.
To increase the amount of federal income tax withheld from your paycheck, file a new Form W-4 with your employer. There are two ways to increase your withholding on this form: reduce the number of allowances you claim or request an “additional amount” to be withheld from your paycheck, on line six of the form.
For answers to your tax questions, visit, http://www.irs.gov/uac/Help-With-Tax-Questions-2.