Tax Planning 101

You work hard for your money. You also believe in the idea of living in a free country, which means that by default you have to pay taxes. At least you’re supposed to. But you don’t want to pay more than you have to. So what do you do to make sure that you’re keeping as many of your hard earned dollars in your bank account as possible?

One of the best answers is tax planning. Once you start talking about tax planning you will inevitably start to analyze three primary options to reduce the amount you are taxed. You can 1) reduce your income, 2) increase your deductions, and/or 3) take advantage of tax credits.

But what exactly are these tax planning options?

1) Reducing Income:

A foundational aspect of tax planning is your Adjusted Gross Income (AGI). Your AGI has a number of determining factors that make it up, such as your tax rate and assorted tax credits. Your AGI can also have a direct impact on other areas of your life outside of taxes. It is fairly routine for banks, mortgage lenders, and college financial aid programs to ask for your AGI because it is key to measuring your finances.

So your AGI is a good place to start when tax planning!

You might be asking, “But what is my AGI?”

Your AGI is the total gross income minus specific reductions. There are an assortment of reductions, but when it comes to your taxes, it is important to find out what your AGI is because it will impact a number of taxing aspects.

But generally, the more you make, the higher your AGI will be. And the higher your AGI, the more taxes you will pay. Therefore, one way to reduce your taxes is to reduce your income, and the best way to reduce your income is to contribute money to your 401k or a similar retirement plan. These contributions reduce your taxable income which will decrease the amount of taxes you will pay.

You can also make adjustments to your income on page one of your 1040. These adjustments are things like contributing to your traditional IRA, student loan interest paid, alimony paid, and classroom related expenses. If you want to see a full list of these adjustments you can check out your 1040 on page 1, lines 23 through 34, but contributing to your IRA is the best way to decrease your AGI.

 

2) Increase Tax Deductions:

Income that is taxable is another important element to take a look at when looking at your tax situation. Taxable income is the remaining amount that you have after you have reduced your AGI by your deductions and exemptions. Most people can take a standard deduction which is a flat amount that is not taxed, or they have the option to itemize their deduction which is adding up all of the deductible expenses and then providing evidence of those expenses upon request of the IRS.

Itemized deduction can include things like expenses for health care, state and local taxes, personal property taxes, mortgage interest, gifts to charity, job-related expenses, tax preparation fees, and investment-related expenses.

If you would like to itemize your expenses you must make sure to keep track throughout the year. If you keep track of your expenses you can come to the end of the year and compare your itemized deduction to the standard deduction and choose whichever one will save you the most money.

The best way to reduce your taxable income is to itemize your deductions and the three best ways to do get the greatest deduction is through your mortgage interest, state taxes, and gifts to charity.

3) Tax Credits:

Once you have made adjustments to your taxable income you are ready to look at your tax credits. These tax credits come in the form of college expenses, saving for retirement, and/or for adopting children.

Adopting children and college expenses are the best tax credits. Sometimes neither one of these are options, but more people are able to take college classes than adopt a child. These education tax credits are called The Hope Credit, which is for students in their first two years of college and the Lifetime Learning Credit is for anyone else taking college classes. These classes do not necessarily have to do with your career.
One last option to avoid owing at the end of the year is to increase your withholding from your paychecks. The other benefit of this is you will receive a larger refund at the end of the year.

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