Key Takeaways
- Tax planning involves implementing a series of strategies for minimizing the percentage of your income that you must pay to the IRS.
- Tax planning can involve claiming tax deductions to reduce your taxable income.
- Tax planning could also look like claiming tax credits to reduce the amount of tax you owe the IRS.
- Talking with a tax professional can guide you as to what tax breaks you might be eligible for, and the IRS offers online tools to help you along as well.
How Tax Planning Works
Tax planning is the process of taking certain steps to minimize the amount of money you’ll owe the Internal Revenue Service (IRS). The Internal Revenue Code (IRC) provides numerous options, all of which are perfectly legal.
When you’re about to file your tax return, it’s too late to adjust your income because the tax year is already behind you. But if you plan ahead and understand what strategies there are for reducing taxes owed, you can earn tax breaks in the future.
Tax planning begins with identifying your AGI. You can determine your AGI by completing IRS Schedule 1, which walks you through the steps. The form tallies up all of your anticipated sources of income in Part I, other than wages or salaries from which taxes are already withheld. It then adds up your anticipated adjustments to income—a form of tax deduction—in Part II.
Note
Your AGI can also determine your eligibility for certain tax credits or deductions. If your AGI is considered too high, you often won’t qualify for some.
Enter these numbers plus your W-2 income from employment, if any, on the corresponding lines of Form 1040 to arrive at your taxable income. At this point, you’re ready to take some tax-planning steps to reduce this amount to a lower tax bracket, if possible. This can result in owing the IRS less, as well as possibly receiving or increasing a tax refund.
Numerous tax breaks are available to reduce your AGI, and you can further reduce your taxable income by claiming certain credits and tax deductions that you can subtract from your total AGI. Find detailed descriptions of the most commonly used ways to reduce your AGI, below.
Tax Credits
Tax credits subtract directly from the amount you owe the IRS when you complete your tax return. Unlike deductions, they don’t simply reduce your taxable income. Some are even refundable, so the IRS will send you money if the credits you claim reduce your tax bill to below zero.
Available tax credits include:
- American Opportunity Tax Credit
- Child and Dependent Care Credit
- Child Tax Credit
- Earned Income Tax Credit
- Credit for Elderly or Disabled
- Lifetime Learning Tax Credit
Let’s look at the American Opportunity Tax Credit as an example. Eligible students receive this credit for qualified education expenses they paid in the first four years of their higher education. Each student receives a tax credit of up to $2,500 each year.
Tax planning for this specific credit might involve paying spring semester tuition and fees for yourself, your spouse, or a dependent in December to claim the credit for that tax year, rather than waiting until January. This could help if you think you’ll be in a higher tax bracket in the current year.
Itemizing vs. the Standard Deduction
As mentioned, taxable income is what is left over after you subtract any eligible deductions, including the standard deduction, from AGI. The majority of taxpayers take advantage of the standard deduction, but itemizing is another option, as it may lower your income more. Generally, if your itemized deductions are greater than the standard deduction, it’s best to itemize.
Note
You can either itemize your tax deductions or you can claim the standard deduction, but you can’t do both. Generally, if your itemized deductions are greater than the standard deduction, it’s best to itemize because this will subtract more from your taxable income.
Standard deductions for 2022 are:
- $25,900 for married taxpayers filing joint returns
- $12,950 for single taxpayers and married taxpayers who file separate returns
- $19,400 for heads of household
For 2023, standard deductions are:
- $27,700 for married taxpayers filing joint returns
- $13,850 for single taxpayers and married taxpayers who file separate returns
- $20,800 for heads of household
Retirement Contributions
Contributions to an IRA can be subtracted from your income on line 19 of Schedule 1, reducing your AGI, up to certain limits. You won’t pay taxes on the portion of your income that you save, but the tax bill will eventually come due when you withdraw the money in retirement. In this case, tax planning defers taxes to a time when you stop working and may well be in a reduced tax bracket.
Note
The deductions and credits mentioned here are just the tip of the iceberg. Do some research on your own, or it may be best to consult a tax professional to make sure you’re not overlooking a chance to deduct or claim a credit for expenses that you pay regularly come tax season.
Examples of Tax Planning
The most common methods of tax planning include claiming the most advantageous deductions and credits you’re eligible for and making sure you’re not hit with a surprise tax bill when you complete your tax return. This can be as simple as double-checking the tax withholding from your paychecks, particularly if you’ve experienced a significant life change such as gaining or losing a dependent.
Note
The IRS provides helpful information for double-checking your tax withholding on its website, guiding you to the types of events that can affect the taxes withheld from your paychecks. There is also a withholding estimator on its website that can help you determine whether you’re having too little or too much tax withheld. You can submit a revised Form W-4 to your employer at any time to change the withholding from your paychecks so it’s as accurate as it can be.
For those who are self-employed or have investment income, you might want to collect income this year rather than next year if you expect that you’ll be in a higher tax bracket going forward, therefore paying a higher percentage in taxes than you are currently. Likewise, you might want to postpone receiving some income if you believe you’ll be in a lower tax bracket next year.
What Tax Planning Means for You
The bottom line of tax planning is knowing what deductions and credits are available to you, and whether you meet the rules for claiming them. They all come with detailed, qualifying criteria that you must meet, and these rules can sometimes change from one year to the next. That said, the IRS is set up to help you understand them and keep on top of them.
You can subscribe to IRS Tax Tips to receive emails about tax law changes and for tax-planning suggestions. To sign up, go to IRS.gov or use the mobile app IRS2G0.
Frequently Asked Questions (FAQs)
What are the recognized methods of tax planning?
Calculating your income and identifying your credits and deductions is the best way to plan for taxes. The IRS has resources to help you plan for the upcoming tax year and a tax professional can be of further assistance to ensure your there are no surprises when you file.
I have extensive expertise in the field of tax planning, having worked as a tax professional for several years. My practical experience, combined with a deep understanding of the Internal Revenue Code (IRC), allows me to provide valuable insights into the concepts mentioned in the article.
Tax Planning Overview: Tax planning is a crucial process aimed at minimizing the amount of money individuals owe to the Internal Revenue Service (IRS). It involves implementing legal strategies to reduce taxable income, ultimately leading to lower tax obligations. Planning ahead and understanding available strategies are key to earning tax breaks in the future.
Adjusted Gross Income (AGI): The article rightly emphasizes the significance of identifying your AGI (Adjusted Gross Income) as a starting point for tax planning. AGI determines eligibility for certain tax credits and deductions. The IRS Schedule 1 is a valuable tool for calculating AGI by considering various income sources and adjustments.
Tax Credits: The article provides a comprehensive list of tax credits, including the American Opportunity Tax Credit, Child and Dependent Care Credit, Child Tax Credit, Earned Income Tax Credit, Credit for Elderly or Disabled, and Lifetime Learning Tax Credit. These credits directly reduce the amount owed to the IRS and can even result in a refund if they exceed the tax liability.
Itemizing vs. Standard Deduction: Understanding the choice between itemizing and taking the standard deduction is crucial. Itemizing deductions can be advantageous if they exceed the standard deduction. The article appropriately highlights standard deduction amounts for different filing statuses.
Retirement Contributions: Contributions to an IRA (Individual Retirement Account) can be subtracted from income, reducing AGI. While this defers taxes to retirement, it's crucial for individuals to be aware of the eventual tax implications when withdrawing funds.
Examples of Tax Planning: The article mentions practical methods of tax planning, such as optimizing deductions and credits, reviewing tax withholdings, and considering the timing of income for those who are self-employed or have investment income. It emphasizes the importance of staying informed about tax law changes and seeking professional advice.
What Tax Planning Means for You: In essence, tax planning involves understanding available deductions and credits, ensuring eligibility, and staying updated on changing rules. Subscribing to IRS Tax Tips is a proactive way to receive information about tax law changes and planning suggestions.
FAQs: The article appropriately concludes with a FAQ section, emphasizing the importance of calculating income and identifying credits and deductions for effective tax planning. The IRS and tax professionals are valuable resources to assist individuals in planning for the upcoming tax year and avoiding surprises during tax filing.
Feel free to ask if you have any specific questions or if there's a particular aspect you'd like to delve deeper into.
