10 Tax Planning Tips
Here are ten tax planning tips to help you make the most of your money.
1. Learn to Work With “What Ifs”
The most important planning tool is the ability to project your tax bill for the year and to understand how your tax bill will change based on actions that you take. The process is greatly facilitated by use of the PC and one of the inexpensive tax preparation packages such as Turbo-Tax. By simply storing a “normalized” version of your tax data for the year, you can change factors one at a time or in combination to see what results.
This ability to project accurately is critical to taxpayers who are subject to the Alternative Minimum Tax or who need to figure quarterly estimated tax amounts. If you have a total phobia about tax preparation, then rely on your tax preparer to handle this analysis for you. Advise your preparer during the year as circumstances change.
2. Don’t Over-Withhold
Is it really so great to file for a refund each April? In reality, a large tax refund is nothing more than a tax-free loan to the government. Your ability to handle what-ifs will allow you to adjust your withholding with a targeted balance of zero.
3. Timing Your Deductions
If your income varies from one year to the next, there may be opportunity to load up on deductions when your tax bracket is high by moving the deductions from years when your tax bracket is low. Even if your tax rate doesn’t vary, there is advantage to moving deductions from a later year to an earlier year. The time value of money states very clearly that saving a tax dollar this year is better than saving a tax dollar next year.
Apply the following technique: list the different types of deductible expenditures you make each year. Determine which expenditures are flexible and can be moved between years. Examples include mortgage interest (limited to short time span), equipment purchases that will qualify for a Section 179 or special (bonus) depreciation deduction, medical expenses, state income taxes that will be due in April, etc. Then work through your what-if exercise to determine the best result.
One critical point to consider in this exercise is the need to accelerate state income tax payments from April to December in a high-income year. Failure to pay the state income tax early can not only delay an income tax deduction, it can cause a nasty Alternative Minimum Tax (AMT) problem in the next year if income is down. For the same reason, you may want to defer paying state income taxes if you are subject to AMT in the current year.
4. Bunching Deductions
Certain deductions do you no good because of income thresholds. Examples are medical expenses and miscellaneous itemized deductions. Medical expenses are only deductible to the extent they exceed 7.5% of your adjusted gross income. Miscellaneous itemized deductions, which include employee business expenses, investment expenses and tax preparation costs, are subject to a 2.0% floor. If these expenses in total are just over or just under the threshold, there may be opportunity to forego a deduction in one year in favor of a much higher deduction in the next by bunching your expenditures in one year or the other. If, for example, you have several thousand dollars in medical expenses to pay this winter, you should consider paying them all in December or all in January rather than splitting the payments between the years. The optimum result would be to take expenditures that would otherwise be under the floor and make them deductible.
5. Deferring Income
One of the key points to remember is that when collection is within your control, you will be deemed to have collected the income. That point limits the ability for an employee to instruct his employer to delay a salary check. For the self-employed person, however, there is some degree of flexibility in timing the collection of cash from customers. While you don’t want to put collection at risk just to defer taxes, you may see some benefit by delaying the billing cycle to reputable, paying customers by a few weeks so that collection of revenues falls into the next year.
6. Save for Retirement
Whether it’s a traditional IRA, 401(k), SEP plan, SIMPLE plan, or a Keogh plan, stash away the maximum amount into qualified retirement plans. You get a full dollar for dollar tax deduction, and you defer taxes on any income earned within the plan. Best of all, it’s still your money and you haven’t spent a dime. Remember the following for timing purposes:
- IRA contributions can be made until the earlier of April 15 or the date you file your return.
- 401(k) and SIMPLE contributions must be taken as a percentage of each paycheck, limiting the extent to which you can “catch-up” late in the year.
- SEP contributions can be made up until the extended due date of your tax return. Also, you can set up a SEP for any year as late as the due date (including extensions) of your tax return for that year.
- Keogh contributions can be made up until the extended due date of your tax return, but the plan must have been established before year-end.
7. Consider Tax-Exempt Investments
The higher your marginal tax bracket, the greater your advantage from tax-exempt income. For example, if a taxpayer is in the 35% Federal tax bracket, a municipal bond paying 5% would be equivalent to a taxable yield of nearly 7.7%. If the bond is from your home state, the income is likely to also be exempt from state income tax.
8. Take Advantage of Employer Provided Benefits
Many employers offer optional tax advantaged benefits. In addition to traditional health and life insurance packages, there are now pre-tax deductions for dependent care and non-insured medical costs. Check out these programs and consider whether they are advantageous in your specific circumstances.
9. Keep Your Receipts
A $10 lunch for a prospective client, $8 for parking at a business meeting, $7 for a presentation folder, $1.50 for a highway toll, and on and on and on. These amounts may seem incidental, but over the course of a year they add up. Our recommendation is that you prepare an expense report each month recapping the business expenditure and attaching the receipts. Then reimburse yourself from the cash of the business. This will serve to document the expenditure and put the amounts on record.
10. Take Advantage of Inexpensive Labor
Your least expensive labor source may be your own children. By using your children to do routine tasks, you keep the money in the family. Plus the wages paid to your children are deductible to you and taxed at the lower brackets of your children, or perhaps not taxed at all if less than the standard deduction amount. Also, if your child is under 18 and employed by your unincorporated business (a sole proprietorship or a partnership owned solely by you and your spouse), the wages are not subject to Social Security or Medicare taxes. The resulting 15.3% savings are significant.
Related: [eBook] Home Office Tax Deductions