Come Christmas or summertime and all are planning a vacation with family and friends; where to go, how much to budget for food and entertainment, checking out when the cheapest flights are, and so on.
When a vacation, which lasts for a short duration, can get so much attention and minute planning, then shouldn’t taxes do too?
What is tax planning?
Making or analyzing a financial plan from a tax perspective is called tax planning.
Tax payments are unavoidable and are compulsory for anyone that falls within the Income Tax bracket of the country. With tax planning, what you can do is make payments or contributions in such a way that you get optimum returns in the future, with minimum risk.
It is important for your financial growth as it reduces your tax liability and leads to tax efficiency. So, when a proper tax plan is executed, you increase your ability to make contributions for an uncertain future or your future after retirement.
There are various factors involved in tax planning, like the size of your income, the timing of your income, your filing status, the investments you have chosen, and the retirement plan that you have chosen.
What should I know before I begin?
- Your tax bracket – Make sure you know which tax bracket you fall in. As of this year, there are seven different tax brackets – 10%, 12%, 22%, 24%, 32%, 35% and 37%.
- Keep a record- Make sure you keep all tax-related documents carefully – all the forms you receive from your employer or forms you give out. It will make the process just easier and hassle-free if all the information that you need to know is in one place.
- Deductions and tax credits available to you – Hardly anyone has to pay the tax rate on their entire income. Some deductions and credits come into the picture that essentially lowers your tax bill.
- Standardizing and itemizing deductions – Choosing one out of the two is very crucial as it plays a big role in determining what your final tax bill will be. For some, itemizing deductions lead to a lower tax bill, but it takes a longer time to do the taxes. There are many deductions and credits available – like child tax credit, deductions on charitable contributions- and each comes with its own set of rules and eligibility.
Deductions and credits can reduce your tax bill, but they do not give any returns in the future. It is applicable only for the present.
What are some general tax planning strategies that will help me in the future?
- Make changes in your W-4 – A W-4 lets your employer know how much money he has to withhold from your paycheck and give to the IRS. If you received a huge tax bill last year, you can edit your W-4 such that more money is withheld, and your tax bill post-filing will be lesser.
- 401 (k) – Employers usually sponsor a 401(k), which is a retirement plan. If you are self-employed, you can open your own 401(k). It is a type of savings and investment plan where you can divert money from your paycheck into a 401(k) which you can use post-retirement. The employer has to match the contribution made by you. The IRS does not directly tax the money when it is diverted or contributed. It is taxed only when it is distributed.
You need to also be able to choose wisely as to which 401(k) to go with since there are a few types like traditional 401(k) plans, safe harbor 401(k) plans, and SIMPLE 401(k) plans. There are also different rules and limits for deferrals for each type. For the year 2022, it is $20,500 for traditional and safe harbor plans and $14,000 for SIMPLE 401(k). For the years 2021 and 2020, it was $19,500 for traditional and safe harbor plans and $13,500 for SIMPLE 401(k). Since they are subject to change and are not fixed, it is necessary that you keep yourself informed of the limits for each type and each year.
- IRA–IRA stands for Individual Retirement Account. Apart from a 401(k), you can also have an IRA (subject to some conditions and eligibility criteria). There are two types here- Traditional IRA and Roth IRA. For tax years 2021 and 2022, the limits for both traditional and Roth IRA are $6,000 per year and a catch-up contribution of $1,000 for those aged 50 and older. A traditional IRA allows you to take deductions, but if you have a 401(k) as well, then you may not be eligible for deductions.
- Health savings accounts (HSA) –They are tax-exempt accounts i.e. the contributions are tax-deductible and withdrawals are tax-free as long as they are used for medical expenses. There are separate limits for individual contribution and family contribution. For individual contributions, the limit was $3,600 in 2021 and has gone up to $3,650 for the tax year 2022. For family contribution, the limit was $7,300 in 2021 and is $7,400 for 2022.
These are just a few of the myriad ways that you can reduce your tax liability and increase your savings for your future.
What can I do towards the end of the year to reduce my liability and increase my savings?
- Check withholdings- If you have witnessed a major change in your life in that tax year, like a change in job, or a promotion at work, then the amount of money withheld could change and be different than you expected it to be. If your W-4 wasn’t updated in accordance with that, then you may end up having to pay a huge tax bill.
You may also ask your employer to increase the withholding of state and local taxes. But they are limited to only $10,000 a year.
- Itemizing deductions – itemizing at the federal level leads to a similar benefit at the state level for a few states. Depending on your state of residence, you may get benefits at the state level also.
- Charitable contributions– In light of the pandemic, making charitable donations is a great way to reduce your tax bill. Earlier you had to itemize your deductions to claim the benefits. But with the passage of the amendment in the CARES Act, even those who do not itemize can claim deductions! The limits vary according to your filing status. You also need to make sure that the organization you are donating to is considered Qualified.
- Postponing Income – Married couples who have children and an Adjusted Gross Income of $150,000 can lower their AGI by postponing their income so that they can take advantage of the expanded Child Tax Credit and missed stimulus checks. Even those who are expecting to fall under a lower tax bracket the next tax year can postpone their income.
- Retirement contributions – Maximize your retirement contributions in your 401(k). Check if you have reached your limit for contributions. If not, use it to the fullest. Anyone enrolled in their employer’s retirement plan generally can make a maximum contribution of $20,500 per year.
For every dollar you contribute, you get a certain percentage from your employer; sometimes you get a dollar-for-dollar match. Use this wisely to reduce your tax liability and increase your retirement income.
- Required minimum distribution – If you are over the age of 72, then RMD is the minimum amount you must take out of your retirement account to avoid a huge tax bill. You are allowed to go over it. If you have multiple retirement accounts, then you need to take an amount out from each such account. You can make a charitable contribution directly from your retirement account, and even that would go towards satisfying your RMD.
- Health Savings accounts – Similar to a retirement account, you can also make sure you maximize your contribution in the HAS
- Long-term assets – If you hold some long-term assets, whose value has appreciated, then consider selling a few of them so you can fall in the 0% bracket of Long-term capital gains tax.
- Disaster Insurance – If you live in an area that was declared a “disaster area” by the federal government, you need to settle your insurance claim to maximize your casualty loss deduction.
- Annual tax-free gift – Every year, you are allowed to give an amount to an individual or multiple individuals without having to pay any gift tax. People with children and grandchildren are suggested to use this benefit. The limit was $15,000 in 2021 and is $16,000 for the tax year 2022. And this exclusion is per recipient, not the sum of all gifts.
These, again, are just a few ways in which you can reduce your tax liability and tax bill. Every year there are new limits; sometimes new deductions, new credits. You must take the help of a CFO consulting service to make sure you exercise the best permutation of all the deductions available to you.