As we are now approaching the official tax return deadline within the next two weeks, we wanted to share some pertinent information regarding income tax planning.
You don’t want to pay more in federal income tax than you have to. With that in mind, here are a few key points to consider when it comes to keeping more of your income.
Postponing your income to minimize your current income tax liability.
By deferring (postponing) income to a later year, you may be able to minimize your current income tax liability and invest the money that you’d otherwise use to pay income taxes. And when you eventually report the income, it’s possible that you’ll be in a lower income tax bracket.
Certain retirement plans can help you postpone the payment of taxes on your earned income. With a traditional 401(k) plan, for example, you contribute part of your salary into the plan, paying income tax only when you later withdraw money from the plan (withdrawals before age 59½ may be subject to a 10 percent penalty tax in addition to regular income tax, unless an exception applies). This allows you to postpone tax on part of your salary and take advantage of the tax-deferred growth of any investment earnings.
There are many other ways to postpone your taxable income. For instance, you can contribute to a traditional IRA, buy permanent life insurance (the cash value part grows tax deferred), or invest in certain savings bonds. You may want to speak with a tax professional about your tax planning options.
Deduction planning involves proper timing and control over your income.
Part of minimizing federal income tax is about taking advantage of all deductions to which you are entitled, and timing them in the most beneficial manner.
As a starting point, you’ll have to decide whether to itemize your deductions or take the standard deduction. Generally, you’ll choose whichever method lowers your taxes the most. If you itemize, be aware that some deductions (for example, medical expenses) are allowed only to the extent the deduction exceeds some percentage of your adjusted gross income (AGI). In cases where your deductions are affected by your AGI, you might look at ways to potentially increase your allowable deductions by reducing your AGI. To lower your AGI for the year, you can defer part of your income to next year, buy investments that generate tax-exempt income, and contribute as much as you can to qualified retirement plans.
Because you can sometimes control whether a deductible expense falls into the current tax year or the next, you may have some control over the timing of your deduction. If you’re in a higher federal income tax bracket this year than you expect to be in next year, you’ll want to consider accelerating deductions into the current year. You can accelerate deductions by paying deductible expenses and making charitable contributions this year instead of waiting until next.
Investment tax planning uses timing strategies and focuses on your after-tax return.
You can also minimize tax by making tax-conscious investment choices. Potential strategies can include the use of tax-exempt securities and intentionally timing the sale of capital assets for maximum tax benefit.
In most cases, long-term capital gain tax rates are lower than ordinary income tax rates. That means that the amount of time you hold an asset before selling it can make a big tax difference. Since long-term capital gain rates generally apply when an asset has been held for more than a year, you may find it makes good tax-sense to hold off a little longer on selling an asset that you’ve held for only 11 months. Timing the sale of a capital asset (such as stock) can help in other ways as well. For example, if you expect to be in a lower income tax bracket next year, you might consider waiting until then to sell your stock. You might want to accelerate income into this year by selling assets, though, if you have capital losses this year that you can use to offset the resulting gain.
Note:You should not decide which investment options are appropriate for you based on tax considerations alone. Nor should you decide when (or if) to sell an asset solely based on the tax consequence. A financial or tax professional can help you decide what choices are right for your specific situation.
Year-end planning focuses on your marginal income tax bracket.
Year-end tax planning, as you might expect, typically takes place in October, November, and December. At its most basic level, year-end tax planning generally looks at ways to time income and deductions to give you the best possible tax result. This may mean trying to postpone income to the following year (thus postponing the payment of tax on that income) and accelerate deductions into the current year. For example, assume it’s December and you know that you’re in a higher tax bracket this year than you will be in next year. If you’re able to postpone the receipt of income until the following year, you may be able to pay less overall tax on that income. Similarly, if you have major dental work scheduled for the beginning of next year, you might consider trying to reschedule for December to take advantage of the deduction this year. The right year-end tax planning moves for you will depend on your individual circumstances.
As always, you can contact our office for tailored advice regarding you or your family’s tax picture.