By Michael McDonald, GOBankingRates.com (TNS)
Taxes are an unpleasant fact of life for most people, but planning ahead can make the task a little easier. Addressing each of the following areas can also help you legally minimize your taxes, and leave more money in your pocket.
MINIMIZE TAXABLE INCOME
Taxes are based on the income an individual earns each year, but not all cash a person receives is treated the same way. “There are numerous tax laws that individuals need to take into account when trying to plan the best way to manage their tax liability,” said Bill Rivero, a partner at accounting firm Correia, Rivero and LeFebvre. “An accountant or tax professional can help with this problem.”
One way you can minimize your tax liability is to shift as much income into long-term capital gains as possible. Investment assets held for more than 365 days are generally taxed at a much lower rate than ordinary income or short-term capital gains (those held for less than 365 days). This reality can influence investment choices for many individuals.
Individuals whose income varies from year to year might want to consider shifting some of that income to the next calendar year, to more evenly distribute their income over time. This can help you to avoid paying very high tax rates one year, and then very low tax rates the next year. For instance, salespeople, those working on commission or expecting a bonus can ask their employers to defer a December payment until January. In some cases, waiting a couple extra weeks for a check can mean thousands of dollars in tax savings.
MAXIMIZE 401(k) CONTRIBUTIONS
A 401(k) plan ranks as one of the best ways to manage one’s tax liability, but it requires some advance planning. An individual can contribute up to $18,000 of pretax income to a qualified 401(k) plan each year, and when it’s matched by an employer, the individual gets an automatic 100 percent return on their investment. The catch with 401(k) plans is that since the money is intended for retirement, it can’t be withdrawn until the individual is 59 1/2 years old. Any funds withdrawn before that time face hefty fines and taxes from the IRS.
However, not everyone has access to a 401(k) plan, and some people who do might not take full advantage of it because they want to save more than $18,000 annually. For those facing that dilemma, maximizing deductions is critical. Some of the most important and common tax deductions include those for mortgage interest, student loan interest, charitable contributions, union dues and foreign taxes. Smart planning can help you identify and take advantage of all the deductions for which you’re eligible.
MAXIMIZE TAX CREDITS
Although tax deductions lower one’s taxable income, they do not lower taxes as much as tax credits do. A $100 deduction for a person at the 25 percent rate will lower tax liability by $25. In contrast, a $100 tax credit lowers tax liability by $100. Tax credits vary from year to year, and small business owners can take advantage of several credits not available to most individuals. Still, there are tax credits even the average employee can take advantage of with proper planning.
Common tax credits include the earned income tax credit, the American opportunity tax credit and the child tax credit. Under the child tax credit, individuals are given up to a $1,000 credit for each qualifying child under the age of 17. This credit only applies to individuals with incomes under $110,000 for married couples, and under $75,000 for those filing individually. The earned income tax credit applies to those with low incomes.
Finally, the American opportunity credit is available to people who have college education expenses, and whose modified adjusted gross income is $80,000 or less, or $160,000 or less for married couples filing jointly. The credit can be worth up to $2,500, but the value drops as an individual’s income increases.
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