Tax Planning Basics

The goal of tax planning is to arrange your financial affairs to minimize your taxes. There are three basic ways to reduce your taxes; you can reduce your income, increase your deductions, and take advantage of tax credits. Each basic method might have several variations.

Reducing Income

Adjusted Gross Income (AGI) is a key element in determining your taxes. AGI is your income from all sources minus any adjustments to your income. Lots of other things depend on your AGI (or modifications to your AGI)– such as your tax rate and various tax credits.

AGI even impacts your financial life outside of taxes: banks, mortgage lenders, and college financial aid programs all routinely ask for your adjusted gross income. This is a key measure of your finances.

Because your adjusted gross income is so important, you may want to begin your tax planning there. The higher your total income, the higher your adjusted gross income. As you can guess, the more money you make, the more taxes you will pay. Conversely, the less money you make, the less taxes you will pay. The number one way to reduce taxes is to reduce your income. And the best way to reduce your income is to contribute money to a 401(k) or similar retirement plan at work. Your contribution reduces your wages, and lowers your tax bill.

You can also reduce your Adjusted Gross Income through various adjustments to income. Adjustments include contributions to a traditional IRA, student loan interest paid, alimony paid, and classroom related expenses.

Adjustments are deductions, but you don’t have to itemize them on the Schedule A.  Instead, you take them on page 1 of your 1040, lines 23 through 35.

A full list of adjustments is also found on Form 1040, page 1, lines 23 through 34. The best way to boost your adjustments is to contribute to a traditional IRA.

As you can see, two of the best ways to reduce your taxes is to save for retirement, either through a 401(k) at work or through a traditional IRA plan. Contributions to these retirement plans will lower your taxable income, and lower your taxes.

Increase Your Tax Deductions

Taxable income is another key element in your overall tax situation. Taxable income is what’s left over after you have reduced your AGI by subtracting your deductions and exemptions from your income. Almost everyone can take the standard deduction.

If you don’t want to take the standard deduction, you can itemized your deductions instead. Itemized deductions include expenses for health care, state and local taxes, personal property taxes (such as car registration fees), mortgage interest, gifts to charity, job-related expenses, tax preparation fees, and investment-related expenses. One key tax planning strategy is to keep track of your itemized expenses throughout the year using a spreadsheet or personal finance program. You can then quickly compare your itemized expenses with your standard deduction, so you can decide one to take. You should always take the higher of your standard deduction or your itemized deduction.

Your standard deduction depends on your filing status and how many dependents you have. You can increase your standard deduction and personal exemptions by getting married or having more dependents.

The best strategies for reducing your taxable income is to itemize your deductions, and the three biggest deductions are mortgage interest, state taxes, and gifts to charity.

Take Advantage of Tax Credits

Once you’ve tweaked your taxable income, you are ready to focus your attention on various tax credits. Tax credits reduce your tax. There are tax credits for college expenses, for saving for retirement, and for adopting children. Tax credits will lower your liabilities.

The best tax credits are for adoption and college expenses. Not everyone is in a position to adopt a child, but everyone could take some college classes.

There are two education-related tax credits. The Hope Credit is for students in their first two years of college. The Lifetime Learning Credit is for anyone taking college classes. The classes do not have to be related to your career.

You may also want to avoid additional taxes. If at all possible, avoid early withdrawals from an IRA or 401(k) retirement plan. The amount you withdraw will become part of your taxable income, and on top of that there will be additional taxes to pay on the early withdrawal.

One of the best, and most used, tax credit is the Earned Income Credit (EIC). Unlike other tax credits, the EIC is credited to your account as a payment. And that means the EIC often results in a tax refund even if the total tax has been reduced to zero. You may be eligible to claim the earned income credit if you earn less than a certain amount.

Increase Your Withholding

You can avoid owing at the end of the year by increasing your withholding, increasing the amount of money taken out of your paycheck. More money will be taken out of your paycheck throughout the year, but you will get a bigger refund when you file your taxes.