One of the most reliable ways to maximize income is with a tax strategy that takes advantage of available deductions and credits. Reducing taxable income goes beyond taking the standard deduction and requires organization and thoughtful financial decisions.
If you were caught off-guard by owed taxes in your last filing, it’s time to get organized by making a plan. Minimizing risk this way prevents surprises and keeps your income where it belongs—in your wallet.
The key to making your strategy work is to stick to it year-round and follow the guidelines below. Included in our step-by-step strategy are additional opportunities to minimize taxable income.
Step 1: Assess Your Tax Bracket
Your income is taxed in separate chunks, per the Federal progressive tax rate. As your income increases, so does the tax rate, but not on the net income. For example, the first chunk of your income might be taxed at 10 percent, while the next chunk is taxed at 12 percent.
The IRS adjusts the tax brackets each year, so check the IRS website for news regarding the most recent tax items, or use the TurboTax bracket calculator. With a clear understanding of your bracket, you can begin tax planning.
Step 2: Using Tax Deductions and Credits
Deductions are subtracted from net income, minimizing your tax bracket. Taking the 2021 standard deduction for an individual filer subtracts $12,550 from the total taxable income, which can leave you in a lower tax bracket. The standard deduction increases if individuals are married and file jointly.
For individuals who own property or operate a small business, a more effective strategy might be taking the itemized deduction. Property value, depreciating assets, business trips, and more can go to reducing your overall tax bracket.
Credits are a dollar-for-dollar subtraction from taxes that you would pay. Having a child under 17 automatically subtracts $3000 (per 2021 rate) from the actual taxes you pay. There are credits for a variety of situations, from home office upgrades to taking care of an elderly family member.
Some people ask whether they should go for deductions or credits, and that’s an easy answer: Strategize for both deductions and credits and you’ll maximize your income significantly. For the full list of these items, see the IRS page.
Step 3: Saving Beyond Deductions
The IRS offers many avenues of reducing taxes besides the traditional methods. Investing in your future via 401(k) and IRAs help individuals save money for retirement without taxing those investments up to a certain limit. While this strategy does not pay off in the short term, your future self will be grateful for thinking ahead.
Here are the basics:
Money saved inside a 401(k) is not taxed when directly deposited from your paycheck. Your contribution to a traditional IRA is tax-deductible, but withdrawals are taxed. Roth IRAs benefit from pre-taxed income, but contributions are not deductible, but when you use the money in retirement, it will not be taxed.
In summation, use investments to offset your taxes now or later down the road. Self-employed individuals can add a 401(k) or other retirement plans to their business to maximize tax savings.
Health-related tax savings include Flexible Spending Accounts (FSAs), Dependent Care Flexible Spending Accounts (DCFSAs), and Health Savings Accounts (HSAs). These are typically employer-related benefits that allow employees to funnel tax-free income into accounts that can only be used for healthcare or related spending.
This strategy can save you money if there’s a hefty medical bill down the road, whether that expense is something predictable like dental care or surgery. See your employer for details on this tax strategy.
Step 4: Implement Your Plan
Once you know your bracket, you can calculate the predictable deductions and credits. Factor in any investment-related benefits and you can accurately estimate taxes owed. Use this estimate to save appropriately throughout the year until tax filing begins. Organize your expenses in a spreadsheet, keep all receipts, and stay diligent with all finances.
Review your W-4 claims and adjust if necessary. It’s far better to pay taxes accurately than receive a higher-than-expected tax bill. Similarly, a hefty tax refund feels like a gift, but that money didn’t have to go to the IRS first–it could have been in your bank account already.
In today’s digital age, the number of available financial tools simplifies the process of tax planning. Applications like Mint or Simplifi digitally organize your spending, benefiting those who like to run a tight budget. Many banking apps do the same. Specifically for tax planning, TurboTax and H&R Block offer software that can automate many tax planning functions.
One of the best ways to save money, even with a fee, is to use a tax professional. While word-of-mouth is often the best way to find a CPA who suits your needs, you can check your state’s CPA board for recommendations. These individuals take away the hassle of maximizing your income.
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