The only things certain in life are death and taxes. The good news is, you can financially plan for both. By careful planning during each tax year and clear understanding of the forms as you file, you can minimize the tax you pay each year while complying with all tax laws.
Planning for Taxes During the Tax Year
It would be a mistake to ignore the reality of taxes until April. By the time you file, most of the decisions that affect your taxes are already made. Your income and financial decisions can drastically change your tax liability.
The first essential component of your tax picture is your income. The United States has a progressive tax rate, meaning that the more income you make, the more income tax you will pay. However, your income is divided into brackets: the first $9,950 you make (if you are single in 2021) will be taxed at a 10% rate, the next $30,575 at 12%, and so on. So if you get a raise this year that bumps you into a higher bracket, only the amount of income over the bracket limit will be taxed at that higher rate.
Next, consider your withholding. This is the amount your employer deducts from each paycheck throughout the year. Your withholding doesn’t actually change the amount of tax you pay, but it determines whether you get a refund in April or have to pay more. So, if you got a large refund last year, that means you had more withheld than was necessary—you could have had that money all year instead of receiving it when you filed. You may want to decrease your withholding. On the other hand, if you owed money at filing last year, you should increase your withholding. You can easily change your withholding by filing a new W-4 with your employer.
If you’re self-employed or a contractor, you should do your own withholding: set aside some money every month so that when your taxes come due, you already have money ready to pay them.
The last important consideration is your deductions. The IRS allows dozens of possible deductions, in part to incentivize certain financial choices. There are deductions for adopting a child, for giving to charity, for being a parent, for medical expenses, for saving for your retirement or for college, and for losses on your investments. If you want to take advantage of these deductions, you have to make sure the things you do qualify for them. You’ll also need to make good records.
A few examples of actions you could take to increase the deductions you will be able to take next year:
- Donating to a 501(c)(3) nonprofit or a church
- Putting money in a 401(k)
- Saving money in a 529 fund for your child’s college education
- Spend money making your home more energy efficient
- Selling investments at a loss (tax loss harvesting)
Minimizing Taxes When You File
Once the tax year is over, it’s too late to change your income or what deductible expenses you have. But there are still strategies you can use to improve your total tax picture.
The first important decision to make is whether to take the standard deduction or itemize your deductions. The standard deduction, which is $12,550 for a single person in 2021, is a guaranteed minimum deduction everyone is allowed to claim. It’s an easy way to deduct something without having to make a list of everything you can deduct.
However, if you have more than the standard deduction worth of deductible expenses, it’s worth it to itemize. That means you will have to list every single deduction you can make. You will need documentation of each. It’s more work, but if you have a large amount of deductible expenses, it’s definitely worth the trouble.
The other important decision you can make at tax time is who prepares your taxes. You can do it yourself, especially if your tax picture is simple—you’re employed at one job, in one state, that gives you a W-2; and you’re planning to take the standard deduction.
But if it’s likely to be complicated, you may need some help. You can use software to help you, like TurboTax, or hire a professional. These days, many accountants and tax preparers will work with you virtually so you don’t even have to leave the house. Even if you do hire someone, though, you’ll still have work to do gathering the documents.
Another person to have on your team is your financial advisor. Unlike an accountant, your financial advisor helps you make strategic decisions all year long.
Tax Planning Help
Need help planning your financial decisions this year to lower your taxes? Still trying to decide how to file your taxes this year? Contact us to be connected with a financial planner who knows how to shrink your tax liability and give you peace of mind.