Getting through your current year’s tax return can be quite the stressful process. The last thing you may want to do is add to that difficulty level by implementing tax planning, but it is a great way to plan for your financial future. There are several elements when it comes to understanding tax planning, but the basic premise is to reduce your tax liability across your lifetime to save you money and further your financial goals.

By understanding the bones of your tax return and taking advantage of strategies that the law affords you to reduce your tax liabilities, you can put more money in your pocket over the long term.

How Tax Brackets Work

Before you can begin tax planning, you must understand how your tax bracket works. The United States has a progressive system, which means different “steps” take you into new brackets as your taxable income increases.

When you enter a new bracket, the taxation on the money earned before that does not change. If you move into the 32% bracket, for example, your next dollar of ordinary income will be taxed at 32%, but your income up to the 32% bracket will remain taxed at 10%, 12%, 22%, and 24% as the income fits into each threshold.

Understanding your tax bracket will help you to determine the impact of deductions or credits you may take.

Deductions and Credits: An Important Distinction

Another important point to tax planning is knowing the difference between tax deductions and tax credits.

Tax deductions will yield you savings as a formula of your marginal tax rate. For example, if you’re in the 22% bracket and contribute $6,000 to a deductible IRA, your tax savings will be 22% x $6K, or $1,320.

A tax credit, on the other hand, is a dollar-for-dollar reduction in tax due. If you have $30 of foreign tax credit, then your tax due is reduced by $30, not $30 times your marginal bracket.

Consider Strategies to Reduce Taxable Income

Implementing strategies to lower your adjusted gross income (AGI) and your taxable income can qualify you for various credits, such as the Premium Tax Credit, American Opportunity Credit, and Child Tax Credit.

Lowering your AGI may also allow you to contribute to retirement accounts like IRAs and Roth IRAs. Contributing to health savings accounts (HSAs), employer retirement plans, and flexible spending accounts are great ways to decrease your AGI and taxable income.

Keep track of potential itemized deductions like charitable contributions, medical expenses, mortgage interest, and property taxes to determine if you would be better off itemizing or taking the standard deduction. These deductions decrease your taxable income.

Sometimes Having More Taxes Is the Right Strategy

Some ways to plan for the future may seem counterintuitive as they involve accelerating income (and therefore, sometimes, taxes due) into a current year. We know no one likes to pay taxes, and your goal each year is probably to have the smallest tax bill possible. Still, there are situations, especially in low-income years, where strategies such as Roth conversions or capital gains harvesting are appropriate.

The goal with Roth conversions is to get money out of a traditional IRA, which has taxable distributions, and into a Roth IRA, which has tax-free distributions. You will pay income tax on the amount converted in the current year in order to have tax-free growth in the Roth account for all years to come.

If you are in the 0% capital gains bracket, you may opt to sell some of your positions and then reinvest the money so that your basis increases. Then, when you need the money and go to sell in the future, the gain that is taxed has decreased.

Take a Look at Your W-4

Another planning opportunity we often come across has less of an impact on your overall taxes due, but it does leave you with less of a shock when it comes to filing time and can allow you to better plan out your cash flow throughout the year.

If you find yourself owing a large balance when you file your return, it may be time to contact your HR to adjust your W-4. You may owe penalties for underpaying your tax liability throughout the year, and if you weren’t planning for a large expense, owing can come as quite the surprise.

On the other hand, if you receive a large refund, you may want to decrease your withholdings. Tax refunds are essentially a tax-free loan to the government that you could have been setting aside on your own throughout the year via increased paychecks.

Consider a Financial Advisor

The points I discussed here only touch on many of the important elements of tax planning. While almost everything involving taxes is convoluted, many opportunities for tax breaks and savings exist. You just have to understand how to utilize them.

A financial advisor may help you incorporate tax planning into your overall financial plan. Our Bethesda, MD fee-only financial planning firm helps clients evaluate their current tax planning strategy and make adjustments to better serve their goals for both the present and future.

Discuss your situation with a fee-only financial advisor.

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