Who doesn’t love receiving an income tax refund? They’re great. Except, well…while getting one might feel like you’ve hit the jackpot, it’s been your money the entire time. What you’ve just received isn’t a bonus or surprise. It’s payback on a loan you’ve given the federal government for free.
Now consider landing on the other side of the ledger: getting smacked with a tax penalty in the spring. Nobody loves that. It’s the opposite of great, but should come as no big surprise either.
Neither scenario has anything to do with luck, or lack thereof. Both are simply the result of ineffective income tax planning.
By monitoring your income throughout the year and knowing your IADCs, you’ll be able to:
- Track whether or not you’re having enough withheld from your wages
- Determine if you are paying in enough estimated tax payments to stay clear of a penalty
Here are four strategies for tracking, determining and, ultimately, minimizing your federal income tax liability.
1. Postpone income
Deferring (or postponing) your income to a later year minimizes your current income tax liability. You can then invest the money that you'd otherwise use to pay taxes. When the time comes to report the income, you might be in a lower income tax bracket.
Retirement plans, like 401(k)s, are perfect vehicles for postponing income. And not only do they allow you to postpone taxation, they let you take advantage of tax-deferred growth until withdrawal.
2. Shift income
Another strategy for minimizing your tax burden is shifting income to family members in a lower tax bracket. This works if you have kids or a business. You can gift stock to minors (tax-free up to $13,000 per year) or create a family limited partnership by hiring a family member to work for or run your business.
3. Time your deductions
First of all, take all the deductions you’re entitled to. They’re yours for the claiming. But the point of deduction planning is timing them carefully.
Step 1. Decide whether to itemize deductions or take the standard deduction…whichever option lowers your taxes the most.
Step 2. If you choose to itemize, note that some deductions cannot exceed a certain Adjusted Gross Income (AGI) threshold. That being the case, you can lower your AGI by postponing a portion of your income and maximizing your deductions.
Step 3. Decide whether you want a certain deduction to fall in this tax year or the next. If you’re in a higher tax bracket this year than you expect to be in next year, accelerate your deductions this year. Do this by paying deductible expenses and making charitable contributions now.
4. Invest wisely
If you’re in a position to invest any savings, do so in tax-exempt securities and hold off on selling any capital assets until you’re in a lower income tax bracket (we’re talking unemployment or retirement). Generally speaking, long-term capital gain tax rates are lower than income tax rates. That means the longer you are able hold on to an asset* before selling, the bigger the tax difference.
Assets to consider purchasing include:
- Series EE bonds (sometimes called Patriot bonds), which can be used for education down the line and may be exempt from federal, state, and local income taxes.
- Certain tax-exempt municipal bonds
*When purchasing assets like stock, tax should not be the deciding factor when it comes time to sell. Be sure to liaise with your financial professional before making a decision on that front.
5. Wait it out until October, November or December
Year-end planning focuses on your marginal income tax bracket. It’s a way of timing income and deductions to get the best possible tax result. Let’s take a look at a couple of examples:
Example 1: It’s December. You’ve had a good year – a really good year – the kind of year that’s landed you in a higher tax bracket. If you’re in a position to postpone the receipt of any additional income until the following year, do it! It’s a smart way to limit your overall taxes.
Example 2: You’ve decided to go for the Lasik eye surgery or major dental work. Your doctor has penciled you in for the beginning of next year. Reschedule it for December. Why? Combining medical expenses into a single tax year gives you the best opportunity to take advantage of the medical deduction.
Bear in mind that these four income tax-planning strategies depend on your circumstances in the immediate tax year. That’s why it’s essential for you to always be planning – and always be saving for rainy days – in case the forecast for April 18th looks severe.