Congratulations, you just made it through another hectic tax season! For many people, tax season seems to sneak up on them, and when they finally make it through, they are happy to forget about it until all of a sudden next year’s tax season rolls around and the last-minute scramble to file your taxes begins again. If you dread this yearly cycle or the feeling of not being prepared for tax season, then tax planning is an easy way to set yourself up for success in next year’s tax season.
Tax planning is the process of examining your current financial situation and creating a strategy to minimize the amount you will pay in taxes at the end of the year. A tax planning strategy is beneficial to everyone regardless of their tax bracket. The key to effective tax planning is understanding you have to be proactive. By the time you file your taxes, it is too late to change your adjusted gross income. At this point, the tax year is already passed; a more suitable way to help ensure you maximize income after tax is to be proactive with your planning.
To be effective at tax planning you have to understand and consider these four key factors that contribute to the amount of money you will owe come next tax season– your tax bracket, tax credits and tax deductions, itemizing vs. standard deductions, and additional ways to reduce tax liability.
#1 Determine Your Tax Bracket
To create and follow through on a successful tax plan, the first thing you need to understand is how tax brackets work and which tax bracket you are in. The parameters of each tax bracket change from year to year. For the most up-to-date information on tax brackets check the IRS website or ask your tax planning professional. For the 2022 tax year, the taxes you’ll be filing in April of 2023, the United States has seven federal income tax brackets, they are:
Tax brackets work as a progressive tax system so people with a higher taxable income pay a higher tax rate compared to people with lower taxable incomes. However, just because you fall in a certain tax bracket does not mean you automatically apply that percentage to your entire income. Instead, the government lumps your income to correspond with the tax brackets and applies the corresponding bracket’s tax rate to that lump of income. So you only owe 10% on the first $10,275 of your income, 12% on the chunk from $10,276 - $41,775, 22% on $41,776 - $89,075, and so on. Understanding how tax brackets work is fundamental to successful tax preparation, so it may be helpful to seek the help of a tax professional to break it down for you.
#2 Know The Difference Between Tax Credits and Tax Deductions
The next step in ensuring effective tax planning is understanding the difference between tax credits and tax deductions. Both are able to reduce what you owe on your tax bill at the end of the year, but they accomplish that goal in different ways. Tax credits directly reduce the amount owed on taxes by granting a dollar-for-dollar reduction on your tax bill. Tax deductions, on the other hand, lower how much of your income is subject to taxes at your highest tax bracket percentage. So a $1,000 tax deduction at the 32% tax bracket will save you $320 on your final tax bill. A $1,000 tax credit, however, will reduce whatever your final bill is by $1,000– saving you that amount dollar for dollar. Once you understand what tax credits and tax deductions are, you can leverage them during your tax preparation by taking advantage of specific credits and deductions you qualify for. The more tax credits and deductions you claim, the less money you will have to spend at the end of the year.
How Do I Find Available Tax Credits and Tax Deductions?
There is a wide range of tax credits and tax deductions available for individuals of all filing statuses. Some are well known and obvious, like the Child or Dependent Care Credit, while others are more obscure and complicated, like the Income in Respect of a Decedent deduction. The IRS keeps a list of available credits and deductions; however, this list is ever-changing, so it is beneficial to seek tax advice from a tax professional who can tell you what individual credits and individual deductions you qualify for.
#3 Do I Itemize Or Opt For The Standard Tax Deduction?
Once you understand which tax deductions you qualified for you can decide whether you itemize your deductions or opt for the standard tax deduction. An itemized deduction consists of a list of all the individual deductions that you qualify for; every individual deduction contributes to the total you get to deduct from your overall income liability. A standard tax deduction is a fixed amount based on your filing status. The standard deduction amount varies depending on your income, age, whether or not you are blind, and filing status and changes each year. The IRS website has tools to help you find what standard deduction amount you qualify for.
Once you know how much your standard deduction would be and how much your itemized deductions would be, you can choose whichever one saves you the most money when you file taxes. Thinking about itemized deductions vs. standard deductions during your tax prep can save you a lot of money each year. Early in your tax planning, talk to a tax professional to determine your standard deduction amount in the upcoming year and what individual tax deductions you should look to qualify for to increase your potential savings by filing for an itemized deduction.
#4 Utilize All Available Methods To Cut Your Tax Bill
After leveraging your tax bracket, tax deduction, and tax credit, some additional tax planning methods may help you reduce your tax liability, like contributing to 401(k)s and IRAs.Tax-deferred 401(k)s, Roth 401(k)s, traditional IRAs, and Roth IRAs all offer a tax advantage, but how and when they save you money on taxes differ.
You may reduce your taxable income by contributing to a tax-deferred 401(k). The money you contribute is set aside in that 401(k) account before taxes are applied, lowering your taxable income. This applies to the year you contribute and saves you money today. Conversely, a Roth 401(k) does not reduce your taxable income upfront, but you will not have to pay taxes on the funds you withdraw when you retire.
When contributing to a traditional IRA, the amount you contribute may be tax-deductible. The amount you can deduct depends on how much you make, if you have a spouse, and whether your spouse has a retirement plan that is covered by their employer. A Roth IRA allows you to withdraw that money tax-free in retirement; however, your contributions to a Roth IRA are not tax-deductible.
Tax season is often a hassle, but through proper tax planning strategies, not only can you make it easier on yourself come next year’s tax season, but you may save yourself money as well. By gaining a better understanding of where you fall on the tax bracket, the difference between tax credits and tax deductions, the benefits of opting for itemized deductions or a standard deduction, and how contributing to a retirement plan may save you money– you potentially set yourself up for financial success. The key to tax planning strategies is to be proactive and start considering ways you can save on your taxes well in advance. There are many different variables to consider, and understanding the different ways you can minimize your tax liability can be a complicated task. That is why it is important to seek the services of a qualified financial and tax professional. The professionals at Benefit & Financial Strategies in Flagstaff, AZ, are experienced tax and financial professionals that can help you with your tax planning strategies.