It's tax season again—the perfect time to explore how you can reduce your tax with clever tax planning and optimization strategies! You're in good hands with P3 Accounting, as we're made up of tax professionals dedicated to helping you maximize your tax benefits. Let's start by discussing some of the most common tax optimization techniques and other tax planning strategies that can help lower your tax bill significantly.
1. Reduce Taxable Income with Income Shifting
Income shifting is the process of redistributing a portion of your income to another family member in a lower tax bracket, meaning they'll pay less in taxes compared to you. This is especially beneficial to high-income earners who wish to pay less income taxes. To officially redistribute part of your earnings to your family members, you'll need to file a gift tax return (Form 709) if the amount goes beyond the annual exclusion limit.
Another form of income shifting is investing in tax-advantaged accounts for family members. When you put some of your earnings into these accounts for someone else (e.g. child dependent or spouse), you can reduce your tax significantly.
2. Use the Capital Gains Tax Exemption
When you sell properties or stocks, you make a profit called a capital gain. There's an exemption for this kind of profit called a capital gains tax exemption. This allows you to avoid paying taxes on a specific amount of these gains. Long-term capital gains (if you hold the investment for more than a year before you decide to sell it) have lower tax rates compared to short-term capital gains (if you sell within a year of purchasing it).
In the US, you're exempted from paying taxes on the first $250,000 ($500,000 for married couples) of capital gains when you sell your primary property or home. So, if you're thinking of selling property soon, make sure you use your capital gains tax exemption to reduce your overall tax liability.
3. Maximize Retirement Accounts
For tax savings, you can maximize your retirement contributions. You can do this by putting money into tax-advantaged retirement accounts such as a 401(k) or a traditional IRA. By doing this, you get a tax break, which reduces your tax payments for the year because the money you put into your retirement accounts is deducted from your overall taxable income for the tax year.
4. Consider Tax Loss Harvesting
Simply put, tax loss harvesting refers to the process of reducing your tax liabilities by selling investments that have lost value. By selling losing investments—investments that are valued much lower than they were when you initially purchased them—you can realize those losses. In turn, you can use these losses to offset capital gains you've made from other investments that have a higher value now. You'll now be paying less taxes on your gains.
5. Reduce Tax Burden by Claiming Deductions
Lower your income tax by claiming tax deductions. This means subtracting specific expenses from your adjusted gross income (AGI), which reduces your overall tax liability. According to tax laws, you can get a tax deduction for eligible expenses like medical and dental expenses, charitable donations, student loan interest, and mortgage interest. By maximizing deductions, you can reduce the tax liabilities you owe this tax season.
6. Leverage Tax Credits for a Lower Tax Bill
Tax credits provide a dollar-for-dollar reduction to your total tax burden. For example, if your tax liability is $2500 and you have a $500 tax credit, you only have to pay $2000. This tax benefit has specific requirements that you need to meet before you can claim any tax credits.
Here are two of the most common tax credits in the US:
Child Tax Credit
A child tax credit basically gives you money back on your taxes (around $2000 per child). When you fill out your tax return, you can claim these tax deductions if you meet the following requirements:
By the end of the tax year, the child must be 17 years old or younger.
The child must be your dependent, meaning they live with you and you cover more than half of the child's financial needs.
Your annual income must not exceed $200,000 or $400,000 for married couples opting for joint tax filing.
The child must be a US citizen, a US national, or a resident alien.
You and your child must have valid Social Security numbers.
Earned Income Tax Credit (EITC)
The earned income tax credit (EITC) is for moderate- to low-income earners who want to reduce their tax bill and keep more of their income. Here are the requirements to claim tax credits:
Your annual income must not exceed $24,000 for those who are single and have no child dependents. The required maximum income is higher for taxpayers who are married and have children.
Your income must come from wages or self-employment earnings. Meanwhile, investment income must not exceed $11,000.
To get the maximum tax credits, your children must meet specific requirements. Those without children can still claim tax credits if their income is low enough.
You and any qualifying children (if applicable) must have valid Social Security numbers.
You must be a US citizen or a resident alien for the entire tax year.
7. Invest in Municipal Bonds
Municipal bonds (munis) are basically loans you give to local governments like cities, counties, and states. Buying a municipal bond means lending a government entity money, and in return, they pay you interest over time. You can calculate the tax-equivalent yield to compare tax-free interest from municipal bonds with the interest from taxable investments. This shows how much a taxable bond would need to earn to be as valuable as the tax-free interest you get from municipal bonds.
Aside from expanding your investment portfolio, the interest income you earn from municipal bonds is usually exempt from federal income taxes. You can also avoid state and local taxes if you reside in the same state where the bond is issued.
In addition to the interest being non-taxable, the money you gain from these bonds doesn't get added to your taxable income, meaning it won't increase your overall tax bill. Municipal bonds are also considered low-risk investments because they're backed by government entities and are therefore safer compared to other investments.
8. Choose the Right Filing Status
Choosing the right filing status is also one of the most useful (and simple) tax optimization strategies you should keep in mind to boost your tax savings. Your filing status—Single, Married Filing Jointly, Married Filing Separately, Head of Household, and Qualifying Widow(er)—dictates your tax rates or tax bracket. It also determines your standard deduction, which refers to the amount deducted from your taxable income. Ultimately, choosing the right filing status can mean paying less taxes.
Single: For unmarried individuals.
Married Filing Jointly: For married couples. You get a larger standard deduction (twice the amount of what a single filer gets). Filing jointly often means you fall into lower tax brackets and that you're eligible for more tax credits,
Married Filing Separately: For married individuals. You get a lower standard deduction (half the amount of what joint filers get). You also get higher tax rates and limited tax credits. However, filing separately can be beneficial if your spouse has significant medical expenses or other deductions tied to income, as this can lead to a higher deduction threshold.
Head of Household: For unmarried individuals who have child dependents. You get a higher standard deduction than single filers.
Qualifying Widow(er): For individuals whose spouse has passed away. You can still utilize some of the benefits of Married Filing Jointly for a specific amount of time.
9. Bunching Deductions
One way to maximize deductions is by bunching deductions. Taxpayers can choose between taking the standard deduction (a fixed deduction amount for all) or opting for itemized deductions (listing specific expenses to deduct from your taxable income, like property taxes, mortgage interest, charitable donations, and qualified medical expenses).
Now, many taxpayers choose the standard deduction because it's simpler and more straightforward. However, it's more beneficial to itemize deductions if your total itemized expenses exceed the standard deduction amount, as this means you enjoy more tax savings. One way to do this is by bunching deductions.
As the name suggests, bunching deductions is when you "bunch" your deductions or make more purchases in one year that can count toward your itemized deductions. Basically, the goal is to make your itemized deductions exceed the standard deduction amount for a lower tax bill. For example, rather than making one charitable donation per year, you can "bunch" several donations into a single year. As a result, your itemized deductions will add up to be higher than the standard deduction, which means you'll have a lower taxable income for that year.
10. Plan Capital Gains and Losses
Tax planning and tax optimization involve managing capital gains and losses to keep more of your money. Capital gains are the profits you make from selling investments (e.g. properties and stocks) on top of the original amount you purchased the investment for. Meanwhile, capital losses refer to the money you lose when you sell an investment for less than you paid for it. You can offset capital gains with losses.
For example, if you earned $10,000 in gains but had $3000 in losses, you only need to pay taxes on the $7000 difference between the gains and losses. Now, if your total capital losses are higher than your gains, you can use those excess losses to offset other income types (e.g. wages). If you have remaining losses, those can be carried forward to the following tax years.
11. Allocate Money for Health Insurance Premiums
If you itemize deductions, you can avoid paying taxes on the money you allocate for health insurance premiums as they may be considered tax-deductible. This means you'll have lower tax liabilities since you'll have a lower taxable income.
12. Contribute to Health Savings Accounts (HSAs)
A health savings account (HSA) is a savings account you can use to cover qualified medical expenses. Contributing to an HSA is a form of tax optimization because the money you allocate for the account can be deducted from your taxable income, which means a lower tax burden. The interest income you get from an HSA is also non-taxable. Additionally, you can have tax-free withdrawals when you use the money in your account for qualified medical expenses.
13. Look into Tax-Free Withdrawals
There are specific accounts where you don't have to pay taxes on the money you withdraw. Roth IRA and Roth 401(k) provide tax-free withdrawals, but you need to be at least 59 and a half years old. You also need to have had the account for a minimum of five years so you can withdraw your contributions and any income without being taxed.
14. Adjust Tax Withholding
Another tax optimization strategy is to adjust your tax withholding. Tax withholding is the money your employer automatically deducts from your paycheck to cover your income tax. So, what's the importance of adjusting it? If your tax withholding amount is higher than what you actually owe, you get a refund at the end of the year. While the refund returns the money you overpaid, you're still at a disadvantage because you could've used or invested that money rather than practically giving the government an interest-free loan. On the other hand, if your tax withholding is lower than what you actually owe, you'll have to resolve it with the Internal Revenue Service (IRS) eventually alongside added penalties and interest.
To adjust your tax withholding, use the IRS Tax Withholding Estimator to determine your exact tax bill. Afterward, you'll have to fill out Form W-4 again to inform your employer of the changes.
15. Utilize Flexible Spending Accounts (FSAs)
A flexible spending account is where you put money straight from your paycheck before taxes. This means you'll have a lower overall taxable income. The money in the account is spent on qualified expenses like medical bills, doctor visits, and prescription medications.
However, while you avoid paying taxes on the money in the account, you have to use that money within the year or there's the possibility of losing it. If you're going to open an FSA, plan your expenses well and manage your money properly to make the most out of the benefits and avoid the possible disadvantages.
16. Consider Income Deferral
When you defer income, it means you're choosing to receive your income at a later date. Income deferral is a tax optimization strategy because it can lower your taxable income for the year. For example, you can choose to delay receipt of your income for now and receive it when you expect to be in a lower tax bracket, thus leading to reduced tax liabilities. Alternatively, income deferral can also be done by contributing to your retirement accounts to avoid paying taxes on them.
Learn More Tax Optimization Strategies With P3 Accounting
When it comes to tax law and financial advice, P3 Accounting is among the best accounting firms you can rely on. With P3 Accounting services, tax optimization strategies are only some of the ways we help you manage your finances effectively.
We're looking forward to discussing how we can best assist you. Give us a call at 405-265-8383 today!
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