What is Tax Planning?
Tax planning is an essential practice that all taxpayers should engage in. However, only a small minority of people consider adopting effective tax planning practices, while the majority prefer to put it off until the last minute.
Effective tax planning can help you draft a tax efficient (a thorough tax-minimization plan) to reduce your tax liability or the amount of tax you’ll have to pay the IRS by the annual due date.
Popular tax planning strategies include accounting for credits and deductibles, understanding which tax bracket you fall into after accounting for reductions in taxable income, and making strategic purchases to minimize tax liability.
If you’re keen on learning what all this means and how you can save up on tax dollars, you’re in the right place!
In this article, we will cover everything you need to know about tax planning strategies, how college students can plan for tax payments, and introduce key concepts and terms related to the tax planning process.
Tax Brackets and Taxable Income
Your tax planning process should start with an attempt to understand which tax bracket you fall within. Tax brackets determine what percentage of your taxable income is to be taxed.
Note: Your taxable income is usually lower than your overall income. This is because the IRS allows you to adjust for certain tax deductions, given that you qualify for them. As a result, the leftover amount counts as taxable income and is lesser than your overall income or salary.
The United States IRS has determined the following seven tax brackets: 10%, 12%, 22%, 24%, 32%, 35%, and 37% of an individual’s income.
Your bracket is directly determined by how much (taxable) money you make—the lesser your taxable income, the lower your tax percentage.
However, things aren’t as straightforward as they may seem. Many people assume the right way to calculate their taxes is by taking out their tax bracket percentage from their taxable income.
However, this is an incorrect method because your income is split into different parts, each with a different threshold.
Interestingly, there’s a high chance you may fall into multiple tax brackets and will have to calculate your taxes accordingly. But don’t worry. This isn’t as complicated as it sounds. Here’s an example to help you understand the system:
Imagine your total taxable income, after-tax deductibles, amounts to $45,000. The 10% tax bracket begins at an income of $0 and ends at $9,875. So, the first $9,875 of your taxable income will be taxed at 10%.
Any income past the standard $9,875 figure will be taxed at 12%, which is the second tax bracket. This percentage will continue until the $40,125 mark, after which any additional income over $40,125 will be taxed in the third tax bracket, which is at 22%.
This system of successive taxation actually helps you cut down on tax expenditure. Isn’t it better to have some of your income taxed at a lower rate of 10% and then at 12% rather than having the entire amount taxed at 22%? (Hint: Yes, it is!)
What Are Tax Credits?
For every tax credit (measured in dollars) you have to your name, you save a dollar’s worth of your taxable income.
So, for example, if you have tax credits amounting to $500, that’s how much you’ll be saving from your final taxes. If your total taxes are amounting to $2500, you’ll only need to pay $2000 after accounting for tax credits.
Note: Tax credits are formally referred to as the Earned Income Tax Credit (EITC).
What Are Tax Deductibles or Deductions?
Tax deductibles help lower the amount you’ll be taxed on. Technically speaking, they reduce your “tax liability.” The system works by reducing your taxable income – we mentioned this point previously, too.
Sales tax also serves as a tax-deductible. While it’s difficult to calculate how much you’ve spent on sales tax when buying smaller things, it’s worth calculating for when you’ve made significant purchases, like a car, jewelry, or indoor gym.
Itemizing your deductions can help you reclaim the amount you’ve already spent as taxes or remove it from your final taxes. Find out more at the IRS’ official website, and use their calculator to help you understand how much you’re saving in deductions.
Health insurance premiums also help you qualify for deductions. Taking your premiums into account is a crucial step in the tax planning process. After all, you’ll be subscribing to health insurance for most, if not all, of your adult life.
Tax Credits vs. Tax Deductibles
The key difference between credits and deductibles is that credits directly reduce the dollars you’ll be paying. In contrast, a deductible reduces your taxable income, which may also impact your tax bracket.
Understanding how tax deductibles and credits work is an essential part of tax planning. Knowing how much you’re potentially saving on tax amounts can help you effectively plan for the future.
Essential Tax Planning Tips and Strategies
Now that we've gone over all the income tax fundamentals, let's explore the most effective tax planning strategies and tips out there.
Understand Your Dependency Status
One can qualify as a dependent child if they are 18 years old or less (under 19) by the end of the tax year. There is an exception for students enrolled at accredited colleges, too. If they are under age 24, they can be considered dependent children, as long as they are younger than the individual filing for tax.
Additionally, the child must be either related to (by blood or marriage) the tax filer or be legally adopted. The term “child” also refers to younger siblings who depend upon their elder tax-filer sibling for support.
The child must have lived with the tax filer for over 6 months (out of the 12 months in a tax year) and have received over half of their child support from the same tax filer.
On the other hand, a dependent relative must have lived with the tax filer for the whole tax year. Their gross annual income (for the same tax year) must not exceed $4,200.
In addition to this, the tax filer must be paying for more than 50% of the relative’s total annual support in order for them to legally qualify as a dependent relative.
Note: Here is a list of IRS-approved ways in which this relative can or must be related to the tax filer for them to qualify as a dependent. They must also be either a U.S. citizen, U.S. national, or a resident alien.
Secure the Appropriate Tax Forms
Securing all the individual tax forms you'll be needing well before the tax-filing deadline can make things significantly easier. In addition, each form will let you know exactly what you need to account for when filing the paperwork.
You can find a complete list of tax forms on the IRS’ official website.
Consider Which Tax Records to Save
If the IRS ever reaches out to you for auditing, you should be well prepared with the appropriate tax records. Failure to present these records when asked can result in serious punishments, including jail time.
In most cases, the IRS will only ask you for tax records pertaining to the past 3 years. However, if you’ve ever engaged in unlawful behavior, you should try and keep your tax records forever, or at least significantly longer than just 3 years.
The IRS can audit you for underreported income (of 25% or more) for up to 6 years after you filed related taxes. If you’ve ever written off a “worthless security loss,” the IRS can check your records from the past 7 years.
In the rare case that you’ve ever engaged in tax fraud or failed to file a tax return, the IRS has the right to check your accounts for auditing at any time, regardless of how many years it’s been since the event.
In such cases, it’s best to ensure you keep all your tax records, regardless of how old they are – they might come in handy if you ever get caught in a sticky situation.
Below are some popular examples of tax-related paperwork you should have on you lest the IRS asks for them:
- W-2 form (if employed)
- Bank statement
- 1099 MISC, INT, and DIV forms
- K-1 form
- Alimony payments or receiving receipts
- Invoices and receipts for significant transactions, like jewelry or car purchase
- Insurance papers
- Documents relating to gambling losses
- Closing statements
- Property tax papers
- Documents related to retirement savings, including Form 5498, Form 8606, and your 401(k) statement
- Papers related to taxes paid on investments, if any
Ask Your Employer to Directly Transfer Money to Your 401(k) Retirement Account
Some employers offer direct payments to your 401(k) account. These payments will, of course, be snipped from your paycheck.
Interestingly, the IRS won’t deduct taxes from payments made by an employer to their employee’s 401(k). So, if you have a 401(k) account and regularly add to it, check to see if your employer is comfortable making direct transfers to the retirement account instead of to your personal account.
If you first have your paycheck money credited to your account and then forward it to your 401(k), the amount will count as taxable income, and you may need to pay tax on it.
Of course, there is a limit to how much money you can send to your 401(k) per year. If you’re under 50, this amounts to a maximum of $19,500. If you’re over 50, the limit increases to $26,000.
Talk to a Professional CPA
A qualified accountant can guide you towards effective bookkeeping practices and help you plan your taxes in a way that minimized tax liabilities.
If this is your first time trying your hand at tax planning, you should consider speaking to an accountant or professional who can map your taxes through specialized tax planning software, as well as help you make beneficial financial decisions that lower your taxable income and liability.
Tax Planning for College Students
Below is a list of credit and deductible schemes offered by the IRS for college students:
Look into American Opportunity Tax Credit (AOTC)
The AOTC program can grant you a tax credit worth $2500 – meaning that you’ll be paying $2500 less than what your total tax amount adds up to.
If a student’s tax payment is below $2500, they can successfully secure 40% of the remaining credit from the $2500, as long as this amounts to $1000 or less. However, certain terms and conditions do apply, so be sure to look into those before calculating your overall college costs.
The AOTC system cannot be availed for more than 4 years per student.
Lifetime Learning Credit (LLC)
Unlike the AOTC system, the LLC program won’t give you any cash reimbursements. However, it does allow tax liability reimbursements for tuition fees and related educational expenses, amounting to $2000 or less.
Benefits offered by the LLC can be claimed at any time. There is no age or time limit, unlike with the AOTC system.
IRS Tuition and Fee Deduction
According to the IRS official website, students can claim up to $4000 in deductibles as long as they are enrolled in a recognized educational institute. This deduction applies to taxable income earned by an employed student and will help them compensate for tuition and fees.
Students who don’t owe any taxes are not eligible for this program.
Student Loan Deduction (Interest Reimbursement)
Depending on who is paying for college student loans, a student or their legal guardian can deduct up to $2500 from student loan interest payments made within the same tax year.
While it’s true that annual taxes can amount to quite a significant amount, there are many excellent IRS-supported tax-relief schemes to help you get through your tax payments with ease!
Apart from these, you can also employ the practices noted in this article to reduce your taxable income and take advantage of credits and deductibles.
Of course, planning ahead of time can help ensure you maximize your benefits and minimize your tax liability. So, before filing your taxes this year, be sure to consider tax planning instead of diving headfirst into the filing process!
Final Thoughts from the Hall Accounting Team
If any of the information provided above made you feel confused, don’t stress because you are not alone. There are many other businesses that have faced similar problems in the past. However, with time, they have fared well with just a little help.
If you are struggling or just don't have the time to keep up with it, it may be time to have Hall Accounting take over and invest with accurate accounting records and financial reports. The Hall Accounting team will manage your records from start to finish and make sure all adjustments are timely recorded. This option is also feasible for small businesses because it is cheap and hassle-free, at a fixed monthly rate. If you are interested, please feel free to email us at email@example.com and we will get you a free quote!
4/18/22 TAXES WERE DUE!
Deadline to file individual tax returns for 2021
First-quarter estimated tax payments due for 2022
Deadline to contribute to HSA for 2021
Deadline to contribute to IRA for 2021
Estimated tax payment for 2nd quarter of 2022 (Form 1040-ES)