The ultimate goal of tax planning, overall, is to end up owing as little in taxes as possible, by arranging your financial affairs, appropriately. This may be accomplished in three ways: by taking advantage of any (and all) applicable tax credits, increasing tax deductions, or reducing your overall income. It is also possible to use all of these three options together for the best result, as they aren’t exclusive.
Applicable Tax Credits
Because tax credits go beyond reducing your taxable income, they directly subtract tax debt that you may owe to the IRS after adjustments have been made. These may include, but not limited to, tax credits for childcare expenses, college expenses, retirement savings or by adopting children. The Child Tax Credit alone is worth up to $2,000 per child (under the age of 17) – dependent upon various income restrictions. Additionally, the Earned Income Credit (EITC) returns money, thereby benefiting many lower-income taxpayers.
Because tax credits apply directly to your IRS as payments, most tax credits aid by only reducing tax debt, while the EITC results in tax refunds issued directly from the IRS (once your tax debt balance is zeroed out). Income restrictions apply to all tax credits, and some individuals will find they don’t qualify for every single credit, due to the fact that they have earned too much income.
Increasing your Tax Deductions
Taxable income is the leftover amount, once you have configured your Adjustable Gross Income (AGI). While you can’t do both, you are left with two choices, including: itemizing all qualifying deductions, or claim the standard deduction for your given filing status.
What qualifies as an itemized deduction?
- Health Care Expenses (exceeding 10% of your AGI)
- Property Taxes
- Personal Property Taxes (car registration fees, etc.)
- State and Local Taxes (up to $10,000, or $5,000 if married filing separately)
- Casualty and Theft Losses (resulting from a nationally declared disaster)
- Charitable Gifts (including cash donations limited to 60% of your AGI)
- Mortgage Interest (up to $750,000, or $375,000 if married filing separately)
Beginning, and maintaining an annual list of itemized expenses is the key to any good tax planning strategy, particularly by utilizing simple spreadsheets or personal finance software. You should take the higher of your standard deduction (or itemized deduction) in order to avoid paying taxes on more income than required. This “list” method allows you to quickly compare your expenses with your standard deduction.
What are the standard deductions for the 2020 tax year?
- $24,800 for Married Taxpayers (filing jointly)
- $18,650 for Head of Household
- $12,400 for Married Taxpayers (filing separately)
- $12,400 for Single Filers
Reducing your Overall Taxable Income
Your Adjusted Gross Income (AGI) increases when you earn larger amounts of money, which results in paying more taxes. Alternatively, if you earn less, you also end up paying less in taxes – this is how the American tax system is laid out. It all begins with this magic number, known as your AGI. The key to determining your taxes lies in your AGI and, if it’s too high, you won’t qualify for various income tax credits. Your tax rate, as well as certain tax credits, depend upon your AGI alone as the starting point for calculations.
How to Best Determine your Personal AGI
When you take your overall income (from all sources), and subtract any qualifying adjustments to your income, you are left with your AGI. Adjustments come in the form of deductions, but you aren’t required to itemize in order to claim any. Rather, on your 1040, take them on Schedule 1. The total of Schedule 1 can either reduce or increase your AGI.
Schedule 1 reports both additional sources of income, as well as adjustments to income. If you only have additional income, and are unable to qualify for adjustments, your AGI will increase. On the other hand, if you have adjustments without additional income sources, your AGI will decrease.
What is an Additional Source of Income?
- Taxable State Tax Refunds
- Self-Employment Income
- Unemployment Compensation
- Taxable State Tax Refunds
- Alimony (only through 2018)
- Capital Gains
Adjustments to income, as of 2020, include (but are not limited to):
- Paid Student Loan Interest
- Contributions to IRA
- Classroom Related Expenses (paid by teachers)
- Moving Expenses (various members of the Armed Forces)
- Health Savings Account Contributions
- Alimony Paid (through 2018)
- Various Business Expenses (paid by reservists, certain government officials, etc.)
- Portions of Self-Employed Tax (including self-employed health insurance)
Additional Taxes you should Avoid
There are various ways in which you may avoid paying additional undue taxes. One easy way is to avoid making early withdrawals from your IRA (or 401(k) retirement plan) before reaching 59 ½ years of age. Any amount withdrawn early, not only becomes part of taxable income, but is also subjected to an additional 10% in tax penalties. If you have further tax planning questions, please call us at (855) 749-2859.