Tax Planning | NerdWallet

“You work hard, so it’s important to understand how taxes affect your income and personal finances.”

Tax planning is assessing your financial situation in order to maximize tax breaks and minimize tax liabilities in a legal and efficient manner.

Taxes can have a major impact on your financial future and investing plans. Planning ahead for these costs can make your financial plan much more tax efficient. While many people only think about taxes when they’re filing in the spring, tax planning should be a year-round matter, since all financial and investment decisions you make have a tax impact – even if that impact won’t be felt right away.

Tax rules are complicated, but taking some time to know and use them for your benefit can change how much you end up paying (or getting back) when you file. Here are some key tax planning and tax strategy concepts to understand:

1. Understand your tax bracket

You can’t really plan for the future if you don’t know where you are today. So the first tax planning tip is get a grip on what federal tax bracket you’re in.

The United States has a progressive tax system. That means people with higher taxable incomes are subject to higher tax rates, while people with lower taxable incomes are subject to lower tax rates. There are seven federal income tax brackets: 10%, 12%, 22%, 24%, 32%, 35% and 37%.

No matter which bracket you’re in, you probably won’t pay that rate on your entire income. There are two reasons:

  1. You get to subtract tax deductions to determine your taxable income (that’s why your taxable income usually isn’t the same as your salary or total income).

  2. You don’t just multiply your tax bracket by your taxable income. Instead, the government divides your taxable income into chunks and then taxes each chunk at the corresponding rate.

For example, let’s say you’re a single filer with $32,000 in taxable income. That puts you in the 12% tax bracket in 2020. But do you pay 12% on all $32,000? No. Actually, you pay only 10% on the first $9,875; you pay 12% on the rest. If you had $50,000 of taxable income, you’d pay 10% on that first $9,875 and 12% on the chunk of income between $9,876 and $40,125. And then you’d pay 22% on the rest, because some of your $50,000 of taxable income falls into the 22% tax bracket.

2. Tax deductions and tax credits

Tax deductions and tax credits may be the best part of preparing your tax return. Both reduce your tax bill, but in very different ways. Knowing the difference can create some very effective tax strategies that reduce your tax bill.

  • Tax deductions are specific expenses you’ve incurred that you can subtract from your taxable income. They reduce how much of your income is subject to taxes.

  • Tax credits are even better — they give you a dollar-for-dollar reduction in your tax bill. A tax credit valued at $1,000, for instance, lowers your tax bill by $1,000.

3. Standard deduction vs. itemizing

Deciding whether to itemize or take the standard deduction is a big part of tax planning, because the choice can make a huge difference in your tax bill.

What is the standard deduction?

Basically, it’s a flat-dollar, no-questions-asked tax deduction. Taking the standard deduction makes tax prep go a lot faster, which is probably a big reason why many taxpayers do it instead of itemizing.

Congress sets the amount of the standard deduction, and it’s typically adjusted every year for inflation. The standard deduction that you qualify for depends on your filing status, as the table below shows.

What does ‘itemize’ mean?

Instead of taking the standard deduction, you can itemize your tax return, which means taking all the individual tax deductions that you qualify for, one by one.

  • Generally, people itemize if their itemized deductions add up to more than the standard deduction. A key part of their tax planning is to track their deductions through the year.

  • The drawback to itemizing is that it takes longer to do your taxes, and you have to be able to prove you qualified for your deductions.

  • You use IRS Schedule A to claim your itemized deductions.

  • Some tax strategies may make itemizing especially attractive. If you own a home, for example, your itemized deductions for mortgage interest and property taxes may easily add up to more than the standard deduction. That could save you money.

  • You might be able to itemize on your state tax return even if you take the standard deduction on your federal return.

  • The good news: Tax software or a good tax advisor can help you figure out which deductions you’re eligible for and whether they add up to more than the standard deduction.

4. Popular tax deductions and credits

There are hundreds of possible deductions and credits out there, and they all have their own rules about who’s allowed to take them. Here are some big ones (click on the links to learn more).

Tax break

What it’s generally for

Costs of adopting a child

College education costs

Losses on stock sales (to offset capital gains)

Giving money, cars, art, investments, household items or other things to charity

Day care and similar costs

Being a parent

For people or their spouses who retired on permanent and total disability

Money for people below certain adjusted gross incomes

A portion of your mortgage or rent; property taxes; utilities, repairs and maintenance; and similar expenses if you work from home

Undergraduate, graduate or even non-degree courses at accredited institutions

Unreimbursed medical costs over a certain threshold

The interest portion of mortgage payments on a primary home

Installing things that make a home energy-efficient

Contributions to an IRA for people with incomes below certain thresholds

5. Tax records

Keeping tax returns and the documents you used to complete them is critical if you’re ever audited. Typically, the IRS has three years to decide whether to audit your return, so keep your records for at least that long. You also should hang onto tax records for three years if you file a claim for a credit or refund after you filed your original return.

Keep records longer in certain cases — if any of these circumstances apply, the IRS has a longer limit on auditing you:

  • Six years: If you underreported your income by more than 25%.

  • Seven years: If you wrote off the loss from a “worthless security.”

  • Indefinitely: If you committed tax fraud or you didn’t file a tax return.

Category

Items

Income

Expenses & deductions

  • Receipts.

  • Invoices.

  • Statements from charities.

  • Gambling losses.

Home

Retirement accounts

  • Form 5498 (IRA contributions).

  • Form 8606 (nondeductible IRA contributions).

  • 401(k) statements.

  • Distribution records.

  • Annual statements.

Other investments

  • Transaction data (including individual purchase or sale receipts).

  • Annual statements.

6. Tax strategies to shelter income or cut your tax bill

Deductions and credits are a great way to cut your tax bill, but there are other tax planning strategies that can help keep the IRS’ hands off your money. Here are some popular tax planning strategies.

Tweak your W-4

A W-4 tells your employer how much tax to withhold from your paycheck. Your employer remits that tax to the IRS on your behalf.

Generally, the more allowances you claim on your W-4, the less money will be taken out of your pay to go toward taxes. Claim fewer allowances on your W-4, and more of your pay should appear on your check.

Here’s how to use the W-4 for tax planning.

  • If you got a huge tax bill when you filed and don’t want to relive that pain, you may want to increase your withholding. That could help you owe less (or nothing) next time you file.

  • If you got a huge refund last year and would rather have that money in your paycheck throughout the year, do the opposite and reduce your withholding.

  • You probably filled out a W-4 when you started your job, but you can change your W-4 any time.

Put money in a 401(k)

Your employer might offer a 401(k) savings and investing plan that gives you a tax break on money you set aside for retirement.

  • The IRS doesn’t tax what you divert directly from your paycheck into a 401(k). In 2020 and 2021, you can funnel up to $19,500 per year into an account. If you’re 50 or older, you can contribute up to $26,000.

  • While these retirement accounts are usually sponsored by employee self-employed people can open their own 401(k)s.

  • If your employer matches some or all of your contribution, you’ll get free money to boot.

Put money in an IRA

Outside of an employer-sponsored plan, there are two major types of individual retirement accounts: Roth IRAs and traditional IRAs.

You have until the tax deadline to fund your IRA for the previous tax year, which gives you extra time to do some tax planning and take advantage of this strategy.

  • The tax advantage of a  is that your contributions may be tax-deductible. How much you can deduct depends on whether you or your spouse is covered by a retirement plan at work and how much you make. You pay taxes when you take distributions in retirement (or if you make withdrawals prior to retirement).

  • The tax advantage of a  is that your withdrawals in retirement are not taxed. You pay the taxes upfront; your contributions are not tax-deductible.

  • Earnings on your investments grow tax-free in a Roth and tax-deferred in a traditional IRA.

This table illustrates these accounts in action.

ROTH IRA

TRADITIONAL IRA

Contribution limit

$6,000 in 2020 and 2021 ($7,000 if age 50 or older)

$6,000 in 2020 and 2021 ($7,000 if age 50 or older)

Key pros

  • Qualified withdrawals in retirement are tax-free.

  • Contributions can be withdrawn at any time.

  • If deductible, contributions reduce taxable income in the year they are made.

Key cons

  • No immediate tax benefit for contributing.

  • Ability to contribute is phased out at higher incomes.

  • Deductions may be phased out.

  • Distributions in retirement are taxed as ordinary income.

Early withdrawal rules

  • Contributions can be withdrawn at any time, tax- and penalty-free.

  • Unless you meet an exception, early withdrawals of earnings may be subject to a 10% penalty and income taxes.

  • Unless you meet an exception, early withdrawals of contributions and earnings are taxed and subject to a 10% penalty.

Open a 529 account

These savings accounts, operated by most states and some educational institutions, help people save for college.

  • You can’t deduct contributions on your federal income taxes, but you might be able to on your state return if you’re putting money into your state’s 529 plan.

  • There may be gift-tax consequences if your contributions plus any other gifts to a particular beneficiary exceed $15,000 in 2020.

Fund your flexible spending account (FSA)

If your employer offers a flexible spending account, take advantage of it to lower your tax bill. The IRS lets you funnel tax-free dollars directly from your paycheck into your FSA every year; the limit is $2,750 for 2020 and 2021.

  • You’ll have to use the money during the calendar year for medical and dental expenses, but you can also use it for related everyday items such as bandages, pregnancy test kits, breast pumps and acupuncture for yourself and your qualified dependents. You may lose what you don’t use, so take time to calculate your expected medical and dental expenses for the coming year.

  • Some employers might let you carry over up to $550 to the next year.

Use Dependent Care Flexible Spending Accounts (DCFSAs)

This FSA with a twist is another handy way to reduce your tax bill — if your employer offers it.

  • In 2021, the IRS will exclude up to $10,500 of your pay that you have your employer divert to a Dependent Care FSA account, which means you’ll avoid paying taxes on that money. That can be huge for parents, because before- and after-school care, day care, preschool and day camps usually are allowed uses. Elder care may be included, too.

  • What’s covered can vary among employers, so check out your plan’s documents.

Maximize Health Savings Accounts (HSAs)

Health savings accounts are tax-exempt accounts you can use to pay medical expenses.

  • Contributions to HSAs are tax-deductible, and the withdrawals are tax-free, too, so long as you use them for qualified medical expenses.

  • If you have self-only high-deductible health coverage, you can contribute up to $3,550 in 2020. If you have family high-deductible coverage, you can contribute up to $7,100. For 2021, the individual coverage contribution limit is $3,600 and the family coverage limit is $7,200. If you’re 55 or older, you can put an extra $1,000 in your HSA.

  • Your employer may offer an HSA, but you can also start your own account at a bank or other financial institution

“Filing your taxes can seem overwhelming. But you can tackle tax season one step at a time while you take advantage of money-saving opportunities.”

While many Americans only think about taxes in the weeks before the federal tax deadline, you will need to keep on top of tax planning year-round. By knowing the rules, paying attention to withholdings and keeping an eye out for benefits all year, you’ll be able to maximize benefits and minimize prefiliners errors.


References:

  1. https://www.nerdwallet.com/article/taxes/tax-planning
  2. https://smartasset.com/financial-advisor/tax-planning
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