Income tax planning is a fundamental part of financial planning. The less money you pay for income taxes, the more money you have working toward achieving other financial goals. Below is an overview of many of the techniques currently available that can be used to minimize your current and future taxes.
Deferring income means reducing your current taxes by postponing the taxability of income until a future year. One easy way to defer income is by maximizing contributions to company retirement savings plans, such as a 401(k) plan, as well as by using other tax-advantaged savings vehicles, including IRAs, annuities, and cash value life insurance. Some contributions to retirement savings plans can be made on a pre-tax basis where you defer income tax on the monies going into the plan. In this case, your contributions won't be taxed until you make withdrawals in the future. The income you earn on these accounts accumulates tax-deferred, which means the earnings on your money are not taxed until you make a withdrawal. Roth IRAs present the opportunity to receive distributions tax-free.
Maximizing Itemized Deductions
Individuals should itemize deductions if their total itemized deductions exceed the federal standard deduction which has been increased in 2019 from $12,000 to $12,200 for single filers and from $24,000 to $24,400 for married couples filing jointly. Deductions reduce the amount of your income that is subject to tax. The following are categories of itemized deductions:
Casualty and theft losses: Nonbusiness casualty losses not covered by insurance are deductible to the extent they exceed 10% of your adjusted gross income. People can only claim casualty losses if they have been affected by an official national disaster. Business casualty and theft losses are fully deductible with certain limits applied.
Flexible Spending Accounts
Many companies provide employees with a variety of benefits such as medical and dental insurance, life insurance, long-term disability, and other health and welfare benefits. To obtain these benefits, employees usually have to pay some portion of the premiums. Flexible spending accounts allow you to pay for certain eligible benefits, such as health insurance, and pay for certain eligible expenses, such as unreimbursed medical expenses and daycare expenses, with pre-tax dollars. If you pay the premiums on a pre-tax basis, your cost is reduced since the money you pay is not subject to federal income tax or Social Security tax. At the end of the year, any unused balances are forfeited.
Health Savings Accounts
IMPORTANT NOTE: The Health Savings Account (HSA) permits eligible individuals who are not enrolled in Medicare to save for "qualified" medical health expenses on a tax-free basis. Note that over-the-counter (OTC) drugs unless prescribed are not a qualifying expense. These accounts may be offered through employers. However, any insurance company or bank can offer HSAs to eligible individuals as well.
These plans are only available to individuals with high-deductible health plans, i.e., plans with a deductible in 2019 of at least $1,350 (same as in 2018) for individuals and $2,700 (same as in 2018) for families. Contributions are limited to $3,500 in 2019 ($3,450 in 2018) for individuals and $7,000 in 2019 ($6,8900 in 2018) for families, regardless of income, and additional "catch-up" contributions may be available to those age 55 or older. Contributions are tax-deductible, and distributions, when used for a qualified medical expense, are tax-free. If expenses are not qualified, then the distribution may be treated as taxable income, and a penalty may also apply.
However, when used as intended, HSAs can grow tax-free, and unused balances can roll over from year to year. These accounts are also portable, and may be used across different jobs. These are all potential advantages of using the Health Savings Account when compared with the Flexible Spending Account.
There are additional details and restrictions that must be considered. Check with your financial professional or account sponsor regarding your eligibility to use the HSA. For more information, see the section Health Savings Accounts.
Tax credits, unlike deductions, reduce tax liability dollar for dollar by the amount of the available credit. There are various tax credits benefiting many different types of taxpayers, including families with young children, the elderly, the disabled, and those with students attending college. Some examples are shown below. Consult your tax professional to determine which credits may be available to you.
Education Tax Incentives
Two income tax credits, the American Opportunity Credit (AOC) and the Lifetime Learning credit are provided to help defray qualified tuition and fees (not room and board).
The maximum amount of the American Opportunity Credit (AOC) is $2,500 per student. For 2019 the credit is phased out if your modified adjusted gross income (MAGI) is between $80,000 and $90,000 for single filers ($160,000 and $180,000, if you file a joint return). The phase-out is the same as in 2018.
The credit can be claimed for the first four years of post-secondary education.
Generally, 40% of the AOC is now a refundable credit for most taxpayers, which means that you can receive up to $1,000 even if you owe no taxes
The term "qualified tuition and related expenses" includes expenditures for "course materials". For this purpose, the term "course materials" means books, supplies, and equipment needed for a course of study whether or not the materials must be purchased from the educational institution as a condition of enrollment or attendance. The Lifetime Learning credit equals 20% of the first $10,000 of qualified education expense. The Lifetime Learning credit is calculated on a per-family (taxpayer and his or her dependents) rather than a per-student basis, making the maximum 2019 family credit $2,000 (same in 2018). In 2019, to claim the full credit, your modified adjusted gross income (MAGI) must be $67,000 or less or $134,000 or less if you are married and filing jointly. If your MAGI is between $57,000 and $67,000 (between $114,000 and $134,000 for married filing jointly), you receive a reduced amount of the credit. If your MAGI is over $67,000 ($134,000 for joint filers), you cannot claim the credit. These income amounts will be annually adjusted for inflation.
The Lifetime Learning credit is available for any course work at a qualified education institution that improves job skills. Eligible taxpayers may elect to exclude from income amounts withdrawn from an Education Savings Account that are used to pay qualified education expenses for a student. American Opportunity and Lifetime Learning tax credits can be claimed in the same year as Education Savings Account distributions, as long as the ESA distribution is not used to pay for the same costs used to claim the education credit.
In constructing the income-generating portion of your portfolio, investing in tax-exempt vehicles (such as municipal bonds) can be used as a tax-saving strategy. When evaluating investments, you should compare the after-tax yields you are earning. You must look at a taxable investment on an after-tax basis in order to compare it with a tax-exempt obligation. You may also need to factor in state taxes when making your investment decisions.
If you decide to utilize tax-exempt investments, keep the following points in mind:
Business Owner Tax Considerations
Self-employed individuals may establish tax-advantaged retirement plans with contributions based on net earnings from self-employment. Tax-advantaged plans include Keogh plans, Simplified Employee Pensions (SEPs), and Savings Incentive Match Plan for Employees—SIMPLE Plans. See your tax professional for information on retirement plans and other tax-savings retirement vehicles.
Self-employed individuals are currently entitled to deduct up to 100% of the amount paid for health insurance coverage for themselves, their spouses, and dependents during the tax year if they choose to itemize deductions. The deduction is limited to the net earnings from the trade or business for which the insurance coverage was established, minus the deduction for one-half of the self-employment tax and any Keogh, SIMPLE, and SEP deductions.
IMPORTANT NOTE: You cannot take a self-employed health insurance deduction for any month or part of a month that you were eligible to participate in an employer-sponsored health plan.
Other tax issues to keep in mind for a self-employed individual include:
*The self-employment tax is a Social Security and Medicare tax. It is similar to the Social Security and Medicare taxes that are withheld from the pay of most wage earners. For 2019, the tax rate is 15.3% (same in 2018) on the first $132,900 ($128,400 in 2018) of combined wages, tips, and net earnings, and 2.9% on earnings above this limit.
Consult your tax professional for tax issues relating to self-employed business owners.
Withholding and Estimated Taxes
Paying too much or too little in taxes during the year can make budgeting difficult. If you received a large tax refund last year, this money could have been invested instead, helping you achieve your financial goals during the year. Project how much tax you expect to owe and be sure to have at least 90% of that amount withheld during the year. Another option is to consider using one of the safe harbor methods of making estimated federal income tax payments. You should consult with a financial professional to determine which tax payment methods are most advantageous to you, and to consider any state requirements that may apply.
IMPORTANT NOTE: Overpayments of tax are basically interest-free loans to the government.