Tax Planning: What You Should Know

Keys

Tax planning starts with understanding 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.

The difference between 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.
Would you rather have:
A $10,000 tax deduction……or a $10,000 tax credit
Your AGI$100,000$100,000
Less: tax deduction($10,000)
Taxable income$90,000$100,000
Tax rate*25%25%
Calculated tax$22,500$25,000
Less: tax credit($10,000)
Your tax bill$22,500$15,000

Taking the 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.

Filing Status2021 tax year2022 tax year
Single$12,550$12,950
Married, filing jointly$25,100$25,900
Married, filing separately$12,550$12,950
Head of household$18,800$19,400

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: 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.

Be aware of 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.

Tax breakWhat it’s generally for
Adoption creditCosts of adopting a child
American Opportunity creditCollege education costs
Capital loss deductionLosses on stock sales (to offset capital gains)
Charitable contributionsGiving money, cars, art, investments, household items or other things to charity
Child and dependent care creditDay care and similar costs
Child tax creditBeing a parent
Credit for the Elderly or disabledFor people or their spouses who retired on permanent and total disability
Earned Income Tax CreditMoney for people below certain adjusted gross incomes
Home office expensesA portion of your mortgage or rent; property taxes; utilities, repairs and maintenance; and similar expenses if you work from home
Lifetime Learning creditUndergraduate, graduate or even non-degree courses at accredited institutions
Medical expensesUnreimbursed medical costs over a certain threshold
Mortgage interestThe interest portion of mortgage payments on a primary home
Property taxesProperty taxes on real estate
Residential energy tax creditsInstalling things that make a home energy-efficient
Saver’s creditContributions to an IRA for people with incomes below certain thresholds

Knowing what tax records to keep

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
CategoryItems
IncomeW-2 form(s).
Bank statements.
1099-MISC.
1099-INT.
1099-DIV.
Brokerage statements.
Alimony received.
K-1 form(s).
Expenses & deductionsReceipts.
Invoices.
Alimony paid.
Statements from charities.
Gambling losses.
HomeClosing statements.
Purchase and sales invoices.
Insurance records.
Property tax assessments.
Retirement accountsForm 5498 (IRA contributions).
Form 8606 (nondeductible IRA contributions).
401(k) statements.
Distribution records.
Annual statements.
Other investmentsTransaction data (including individual purchase or sale receipts).
Annual statements.

Author: Tina Orem
Article Title: Tax Planning for Beginners: 6 Tax Strategies & Concepts to Know
Publisher: NerdWallet
Date: June 2021
URL: https://www.nerdwallet.com/article/taxes/tax-planning

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