Income Tax Planning strategies
Income tax planning is a process that helps you reduce your tax liability by taking advantage of deductions and credits while timing income and expenses. Income tax planning involves analyzing your financial situation as well as the IRS tax code so you can minimize your tax liability. There are many ways to minimize your income taxes, such as postponing income and accelerating deductions, or controlling when income is recognized. While tax planning is an ongoing process, the goal is to minimize your income tax. By taking advantage of income tax planning strategies presented here, you can reduce your taxes and keep more money from what you make.
Why is income tax planning important?
Income tax planning is an essential part of any financial plan for individuals and families. Proper income tax planning allows you to reduce or defer your income, increase your deductions, maximize your tax credits, and structure your investments for tax efficiency. Income tax planning is important because it helps you reduce your tax liability. By taking advantage of deductions and credits, and by timing income and expenses, you can minimize your income tax. Tax planning might seem complicated and overwhelming, but a good CPA Tax Advisor or Tax Attorney would guide you through the process, so you don't pay more than what is required by the law. Income tax planning is vital for the preservation of your wealth.
When should I start income tax planning?
Ideally, you should start income tax planning as early as possible in the year. This will give you the most time to take advantage of opportunities to reduce your taxes. However, it is never too late to start planning. Even if you are already in the middle of a tax year, there are still strategies that you can use to reduce your taxes. Although tax planning should start as early as possible, it is often done near the end of the year. Year-end tax planning allows you to take advantage of deductions and credits that may expire at the end of the year. It also allows you to control when income is recognized, which can impact your tax liability. By considering income tax planning as an ongoing process, you can ensure that you get the best possible result in minimizing your taxes.
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Income Tax Bracket
Income tax planning starts with an understanding of your income tax bracket. Currently, there are seven tax brackets to compute your income tax: 10 percent, 12 percent, 22 percent, 24 percent, 32 percent, 35 percent, and 37 percent. Your tax bracket is the rate you pay on the "last dollar" you earn. However, as a percentage of your income, your effective tax rate is generally less than that. That's because the first dollars you earn are taxed at a lower rate than your last dollars. To calculate your effective income tax rate, divide your total taxes by your income.
The United States has a progressive tax system. This means that people with higher taxable incomes are subject to higher tax rates, while people with lower taxable incomes are subject to lower tax rates.
Common Income Tax Planning Strategies
Income tax planning should be incorporated into your day-to-day activities, but most people don't think about their taxes until it is time to file their returns, at which time income tax planning may be too late. Tax planning is something that should be done all year long. Income tax planning is vital for the preservation of your wealth. In this article, you will find various tax planning strategies for you to consider so you can lower your income tax.
Reducing income: The first step in tax planning is to reduce your taxable income by investing in tax-free vehicles such as municipal bonds, maximizing your retirement contributions, deferring capital gains, selling properties in installments, and arranging for like-kind exchanges. These and many other strategies explained here will reduce your taxable income.
Increasing tax deductions: Many people pay more tax every year than they are legally obligated to pay because they miss out on many tax deductions. Make sure that your tax advisor is taking advantage of all the tax deductions that you are eligible for. This includes knowing what expenses you can deduct, such as business expenses, and investment expenses, as well as knowing when to itemize your deductions instead of taking the standard deduction.
Maximizing tax credits: There are many different tax credits available, such as the child tax credit, the earned income tax credit, the education tax credit, the energy tax credit, and many others. By taking advantage of these credits, you can reduce your taxes.
Timing income and deductions: Another important tax planning strategy is to try to minimize your tax liability by timing your income and deductions so that you are in a lower tax bracket. For example, if you know you will be in a lower tax bracket next year, you may want to defer some income into the following year. Alternatively, if you are in a higher tax bracket this year, you may want to accelerate some deductions into this year.
Restructuring investments for tax efficiency: While your current investment structure may have made sense in the past, it may not be the case anymore due to changes in tax laws or changes in your personal circumstances. For example, you can incorporate your business to take advantage of the low corporate tax rate, or you can change the holding of your real estate investment from a corporation to a limited liability company to avoid double taxation. You can also hold investments in a tax-deferred account if it is more advantageous than holding them in a taxable account.
Improving your tax knowledge: One of the most basic tax planning strategies you can do is to understand the tax concepts that can give you the biggest tax deductions. Knowing which areas of your tax laws you can work around, which areas save you money, and knowing what tax records to keep, would help you reduce your taxes without getting in trouble with the government.
Working with tax professionals: You should also work with tax professionals (CPAs or Tax Attorneys) to keep you informed of the ongoing tax law changes and how they impact you.
Potential Planning Opportunities
Here are some of the most common income tax planning strategies used to minimize taxes. Some of these strategies may or may not work for you, but we can guarantee you that if you go over these strategies with your CPA Tax Advisor or Tax Attorney, you will be able to find ways to lower your taxes.
Deferring (postponing) income to future years
One way to defer income tax is to postpone income from one year to a later year. This can be done by holding off on receiving income until a later year. When you defer income, you also postpone the payment of taxes on that income. By transferring income to the next year, you minimize your current year's taxable income. Transferring income from one tax year to the next year can lower your federal income taxes if you are in a high tax bracket this year, but you are in a lower tax bracket next year.
You can defer income by contributing to a registered retirement savings plan (RRSP) or a deferred profit-sharing plan (DPSP). You can also postpone income by investing in growth stocks that pay little or no dividends. The stock price will increase over time, but you won't receive any income until you sell the shares. Another way to transfer income to future years is by using a family trust. You can set up a trust so that the income earned by the trust is taxed in the hands of your children or other beneficiaries. It is important to notice that most of the time you cannot defer income indefinitely – there is usually a time limit for how long you can delay reporting income.
Income shifting strategy - high to low tax bracket
Income shifting is a well-known income tax planning strategy that transfers income from high to low-tax bracket taxpayers. You may be able to minimize your federal income tax by shifting income to family members who are in a lower tax bracket. For example, if you own a business and your kids help you with the business, you can pay them salaries or wages for their work. The income will be taxed in their hands at their lower tax rate, instead of being taxed in your hands at your higher tax rate. This is a legal way to reduce your family federal income taxes. Another example is if you own stock that produces dividend income. One option might be to gift the stock to your children. After you've made the gift, the dividends will represent income to them rather than to you, potentially lowering your family's overall tax burden.
Splitting income with the use of a trust
This strategy involves transferring income-producing assets to family members who are in a lower tax bracket via a trust. By doing this, you can reduce your overall tax liability. The trust can be used to transfer income-producing assets to family members or charitable organizations. This can help minimize your federal income tax and provide financial security for your loved ones. However, trusts can be complex and expensive to set up, so you should consult with an estate planning attorney to see if this strategy is right for you. In most cases, the tax benefit of setting up a trust outweighs the costs associated with the trust.
Capital loss harvesting strategy
Capital loss harvesting is a strategy to lower current capital gains tax by deliberately incurring capital losses to offset capital gains. If you have capital losses, you can use those losses to offset any capital gains you have in the same year. If you have more capital losses than capital gains, you can use up to $3,000 of your capital losses to offset other types of income, such as ordinary income. Capital losses can also be carried forward and used to offset capital gains in future years. Tax-loss harvesting allows you to sell investments that are down, replace them with reasonably similar investments, and then offset a realized capital gain. As part of your year-end income tax planning, you should consider a capital loss harvesting strategy.
Shooting for long-term capital gains
As part of your income tax planning, you should aim to achieve long-term capital gains. If you purchase and hold capital assets (such as real estate, stock, mutual funds, bonds, and other capital assets) for more than one year, they will qualify for lower long-term capital gain rates when you sell those capital assets. Long-term capital gains are taxed at a lower tax rate than short-term capital gains. The federal income tax laws provide a preferential long-term capital gain tax rate of either 0%, 15%, or 20%, depending on your overall income. If you sell the capital assets before qualifying for the long-term preferential tax rate, you have a short-term capital gain subject to the ordinary income rates which could be as high as 37%. Remember, it is always best to sell your capital assets after one year of your acquisition to qualify for long-term capital gain treatment.
Invest in municipal bonds
If you are in a high tax bracket, you should consider investing in municipal bonds. When it comes to income tax planning, one of the best things you can do is invest in municipal bonds. Municipal bonds are debt securities issued by state and local governments to finance public projects such as building roads, bridges, and schools. The interest earned on municipal bonds is exempt from federal taxes and state and local taxes. You will, however, have to report this income when filing your taxes. The tax-free nature of these bonds makes them an attractive investment for high-income taxpayers. When shopping for municipal bonds, you should look for bonds that are rated by a reputable rating agency such as Standard & Poor's or Moody's.
Incorporation income tax strategy
High-income individuals can save on income taxes by incorporating their businesses. By doing so, they can shift income from their tax return to the corporate income tax return. This can be done by forming a regular corporation or a limited liability company (LLC) and treating the LLC as a corporation for income tax purposes. The biggest benefit of incorporating is the lower corporate tax rate of 21%, which is less than the higher individual tax rate of 37%. There are also significant tax deferral opportunities, and depending on the nature of the business, a significant exclusion of gain from qualified business stock (QSBS). International Revenue Code Sec. 1202 generally permits a non-corporate taxpayer who holds QSBS for more than five years to exclude up to 100% of any gain on the sale or exchange of the stock. In order to benefit from this exclusion, a few requirements must be met. There are a few disadvantages of incorporating that you should be aware of. These include the need to file corporate tax returns, which can be complex, and the double taxation of dividends paid to shareholders.
Max out your 401(k)-retirement account
If you have not yet maxed out your retirement contributions for the year, consider doing so before the end of the year. The 401(k) is a powerful retirement tax saving tool to minimize your income and your income taxes. You should try to max out your 401(k) every year to take advantage of the tax savings as well as any match your employer offers. In addition, if you are age 50 or over, you may be able to make additional "catch-up" contributions to your retirement plan. You should consider putting in as much money as allowed by the tax law into your retirement account to ensure you will live out your retirement years in comfort. Contributions made to your retirement accounts lower your income tax in the year of the contributions and the income earned on these accounts is not taxable until you take distributions from your retirement account. This is not only good income tax advice but good financial planning advice.
Max out your 529 plans
The 529 plans are a type of college savings plan that allows you to save money for your child's education. Contributions to these plans are not tax-deductible, but the money contributed to these plans grows tax-free and withdrawals for qualified education expenses are also tax-free. This makes 529 plans a great way to save for college. You can contribute as much money as you want to the plan, and if you need to, you can even take out money penalty-free. If you are expecting to be in a high tax bracket in retirement, it may make more sense to contribute to a 529 plan to save for college, rather than contributing to a retirement plan. This is because distributions from retirement plans are taxed as ordinary income, whereas distributions from 529 plans are tax-free. It should be noted that you can only use funds from a 529 plan for tuition, room and board, books, and other required supplies. You cannot use the funds for computers, cars, or other nonessential educational items.
Max out your health savings account (HSA)
If you are a high earner, you may be able to take advantage of a health savings account (HSA) for tax reduction. An HSA is a special account that allows you to save money for medical expenses. Contributions to an HSA are not taxable, and the money grows tax-free. This makes HSAs a great way to save on medical expenses. You can contribute as much money as you want to the account and, if you need to, you can even take out money penalty-free. If you are expecting a large tax bill in retirement, it may make sense to use an HSA to save for medical expenses rather than contribute to a retirement plan. This is because distributions from retirement plans are taxed as ordinary income, whereas distributions from HSAs are tax-free. Another thing to keep in mind is that you can only use funds from an HSA for medical expenses.
Increase your tax deductions - standard deductions vs itemized deductions
As a way to reduce your income tax burden, you must take advantage of any tax deduction that you are entitled to. You can start by deciding whether you should itemize or go for standard deductions. Typically, the simplest way to lower your tax bill is to go with the standard deduction. However, if you have a lot of expenses that qualify as deductions, it may make sense to itemize.
- Standard deduction: The standard deduction is a set amount that you can subtract from your adjusted gross income. This amount is different for each person and changes each year. If you don't itemize your deductions, you can take the standard deduction.
- Itemized deductions: Itemized deductions are expenses that you can subtract from your adjusted gross income. To itemize, you must have expenses that qualify and that total more than the standard deduction. Some common deductions include medical expenses, interest payments, charitable donations, and state and local taxes. By taking advantage of the itemized deduction, you can lower how much tax you will pay. Consider your itemized deductions during your year-end tax planning.
Medical Expenses: You can deduct medical expenses that you paid for yourself, your spouse, or your dependent. The expenses must be necessary and not just helpful for your overall health. You can deduct the amount of the expense that is more than 7.5% of your adjusted gross income (AGI).
Interest Payments: You can deduct interest payments that you made on your mortgage, student loans, and other debts. The deduction is limited to the interest paid on the first $750,000 of debt.
Charitable Donations: You can deduct charitable donations that you made to qualifying organizations.
State and Local taxes: You can deduct state and local taxes that you paid, including income taxes, sales taxes, and property taxes. The deduction is limited to the amount of tax paid on the first $10,000 of income.
Increasing your giving - charitable deductions
If you are looking for ways to reduce your taxable income, one option is to make charitable donations. You can donate to your favorite charity and reduce your taxable income. In most cases, the amount of charitable contributions taxpayers can deduct as an itemized deduction is limited to a percentage of the taxpayer's adjusted gross income (AGI), see the IRS website for current limitations. You should consider donating appreciated capital assets including your company stocks. You may also want to consider a Donor Adviser Fund. A donor-advised fund (DAF) is a giving vehicle that allows individuals, families, and businesses to make an immediate donation to a public charity and receive an immediate tax deduction.
Bunching deduction is a strategy that involves grouping together several years' worth of deductible expenses into a single year. This allows you to exceed the standard deduction thresholds in that year and get a larger deduction than you would have if you spread the expenses out over several years. For instance, during your year-end tax planning, you should consider whether to give away to your charity this year or next year. By bunching charitable donations into one year, you will exceed the standard deduction in that year, therefore obtaining a better tax benefit for your donations.
Accelerating income tax deductions is a strategy that involves taking advantage of deductions in the current year. It means paying expenses that will generate a tax deduction this year rather than next year. This allows you to get the deduction sooner and can help you save on taxes in the current year. For instance, you may want to buy equipment and supplies for your sole proprietorship this year, instead of next year. Office furniture, computer, and cars are depreciable assets. So, if you buy them before year-end, you can take a large deduction (depreciation), in the current year even if you have not paid for the assets yet.
Maximize your tax credits
Tax credits are even better than deductions because they reduce your tax bill dollar for dollar. This means that a $1,000 tax credit will reduce your tax bill by $1,000. Properly claiming tax credits can reduce income taxes owed or boost refunds. Credits are generally designed to encourage or reward certain types of behavior that are considered beneficial to the economy, the community, the environment or to further any other cause. There are different types of tax credits, and each has its own rules. By taking advantage of available tax credits, you may be able to reduce your taxes owed significantly.
Child and dependent care tax credit: The child and dependent care tax credit is a great way to reduce the cost of childcare. This tax credit can be worth up to 35% of eligible expenses, depending on your income.
American opportunity tax credit: The American opportunity tax credit is a great way to reduce the cost of tuition and other education-related expenses. This tax credit can be worth up to $2,500 per eligible student.
Lifetime learning credit: Lifetime learning credit is another way to reduce the cost of tuition and other education-related expenses. This tax credit can be worth up to $2,000 per eligible student.
Earned income tax credit: The earned income tax credit is a great way to reduce the taxes owed by low and moderate-income taxpayers. This tax credit can be worth a lot of money for taxpayers with three or more qualifying children.
Adoption credit: The adoption credit is a great way to offset the cost of adopting a child. This tax credit can be worth up to $13,460 per child.
Energy tax credit: The energy tax credit is a great way to reduce the cost of making energy-efficient home improvements. This tax credit can be worth up to 30% of the cost of eligible improvements.
What is the difference between tax deductions and tax credits?
The main difference between tax deductions and tax credits is that tax deductions reduce your taxable income, while tax credits reduce your tax due dollar for dollar. For example, if you have a $1,000 tax credit, it reduces your tax bill by $1,000. However, if you have a $1,000 tax deduction, it reduces your taxable income by $1,000. So, which is better? A tax deduction or tax credit? Most of the time, a tax credit is better than a tax deduction.
Investing in tax-efficient assets
You can also lower your income tax by investing in tax-efficient assets. Some investments are more tax efficient than others. In addition to municipal bonds, you should consider funds that are not actively traded because they generate less short-term capital gains. Actively managed funds, tend to buy and sell security more often, generating more short-term capital gains and therefore more taxes. Examples of tax-efficient investments are index mutual funds and exchange-traded funds (ETFs). Remember, the long-term capital gains tax is lower than the tax on ordinary income or short-term capital gains.
Investing in companies that pay dividends
To lower your income tax, you should also consider investing in companies that pay qualified dividends. Most dividends paid by domestic companies and paid by foreign companies are qualified dividends. Qualified dividends are taxed at a preferential rate. If you want to know why high-net-worth individuals pay lower taxes, the answer could be found in the fact that they invest in companies that pay qualified dividends. Qualified dividends are taxed at long-term capital gain tax rates, which are lower rates than ordinary income tax rates. In addition, dividend payments are a sign that a company is doing well, and that management has positive expectations about the future. Remember, the tax laws favor long-term capital gains and dividends.
Investing in opportunity zones
If you have a capital gain from the sale of an asset, you can reinvest that gain into a qualified opportunity zone and defer paying taxes on the gain until 2026. To qualify for this deferral, the proceeds must be invested within 180 days of the sale, and you must hold the investment for at least 10 years. Investors can improve their return on investment by 40% to 50% if they take advantage of opportunity zone investments. Opportunity zones are economically distressed areas that qualify for preferential tax treatment. By investing in these areas, you are helping your community and at the same time minimizing your taxes. New tax laws like this are passed from time to time by Congress and you should be aware of these tax benefits.
Converting your IRA or 401(k) plans to a Roth
Another good tax planning strategy is to convert your traditional IRA or 401(k) account to a Roth IRA. Converting your traditional IRA or 401(k) account to a Roth IRA is a good tax planning strategy if you think your tax rate will be higher in retirement than it is now. With a Roth IRA, you pay taxes on the money going into the account, but all future withdrawals are tax-free. You can convert your traditional IRA to a Roth IRA by receiving a distribution from a traditional retirement account and contributing it to a Roth IRA within 60 days after the distribution. A conversion to a Roth IRA results in taxation of any untaxed amounts in the traditional IRA. Remember, a traditional IRA contribution is deductible now while a Roth IRA contribution is not because of the benefits of free future tax distributions.
Consider cash-value life insurance
Cash-value life insurance can be a good way to save on income taxes. With this type of policy, a portion of your premium is invested in a cash account that grows tax-deferred. You can use the money in the cash account to pay the premiums or take out loans against the policy. The death benefit is also tax-free. This makes cash-value life insurance a good way to save on income taxes. This is a very popular income tax strategy for high-income earners because large amounts can be invested. This is the typical tax-deferred tax strategy for high earners.
Restructuring your real estate investments
If you own real estate investments, you may want to consider restructuring them into a Limited Liability Company (LLC). An LLC is a business entity that can offer protection from personal liability. This means that if the LLC is sued, the owner's personal assets are protected. You should hire an attorney if you are concerned about asset protection. In addition, an LLC can help to save on taxes by allowing the owner to “pass through” income and losses to the owners. This can help shelter other income from taxes. You may also want to consider converting a Corporation into an LLC to avoid double taxation of current income and potential future capital gains. The internal revenue code favors pass-through entities like LLCs.
Invest in a Cost Segregation Study
Cost segregation is the method of identifying and re-classifying parts of your real estate from real property to personal property. This process allows the assets to be depreciated on a 5-, 7-, or 15-year schedule, compared to the traditional 27.5- or 39-year depreciation schedule of real property. This is true with various components of a building, such as wiring, plumbing, and HVAC (to name a few). When done correctly, a cost segregation study will accelerate your depreciation deduction and reduce your current income tax obligation. Naturally, this translates into a substantial increase in cash flow — typically 5%-10% of the building's value.
Using real estate exemption or rollover
If you have a gain on the sale of your principal residence, you may be able to exclude all or part of that gain from income if you meet the ownership and use tests. To qualify for the exclusion, you must have owned and used your home as your main home for at least two of the last five years before the date of sale. In addition, you can only exclude the gain once every two years. If you don't meet the qualifications for the exclusion, you may be able to use the home sale proceeds to buy a new principal residence within two years of the sale and defer paying taxes on the gain. This is often referred to as a 1031 exchange or a like-kind exchange.
Selling inherited real estate
If you sell inherited real estate, you may not have to pay income tax if you sell the property quickly. If you inherited a property from your parents, your cost on the property for purpose of calculating your capital gain is the FMV of the property as of the day of your parent's death. This is what is known as a step-up basis. It is also important to note that your parents should not sell the property and give you the money. They should transfer the property to you at death so you can take advantage of the step-up on a basis. For example, if your parents bought their house for $250,000 and the property FMV is $750,000. By selling the property before death, the capital gain is $500,000 (FMV $750,000 - Basis-cost $250,000). However, if you sell the property after their death, your capital gains is $0 (FMV $750,000 - Stepped-up basis $750,000). In this case, by implementing this strategy, you will save about $50,000 in taxes.
Consider tax residency planning
Tax residency planning is a strategy used to minimize tax liability by changing an individual's tax residency. There are several ways to change your tax residency, such as moving to a new state with a lower tax rate or setting up a business in a new state. Income tax rates vary from state to state. Some states have lower income tax rates than other states and other states have no state income tax at all. This is a more drastic income tax planning strategy, but it should be considered. Recently, we have seen many people changing their tax residency by moving for most of the year from NY to Florida and from California to Texas because of the high-income tax rates in NY and California, and because Florida and Texas have no individual income tax.
Keep good tax records
As part of your planning, you must keep good records. By establishing a good record-keeping policy, you can simplify the income tax preparation process and be ready to provide answers if the IRS selects your return for examination. You must keep records, such as receipts, canceled checks, and other documents that support an item of income, a deduction, or a credit appearing on a return until the period of limitations expires for your income tax return. The following are the period of limitations:
3 years - For assessment of tax you owe, this period is generally 3 years from the date you filed the return. Returns filed before the due date are treated as filed on the due date.
6 years - If you don't report income that you should have reported, and it's more than 25% of the gross income shown on the return, or it's attributable to foreign financial assets and is more than $5,000, the time to assess tax is 6 years from the date you filed the return.
No limit - There's no period of limitations to assess tax when you file a fraudulent return or when you don't file a return.
Taking a proactive tax-planning approach can help you minimize your taxes. The Internal Revenue Service (IRS) tax code is full of legal ways for you to minimize your income taxes. Income tax planning is a process used to minimize your taxes and maximize your tax refund. There are several strategies that you can use to reduce your taxes, and it's important to be familiar with all of them. The most important thing is to start planning early and to stay organized. Keep good records of all your income and expenses, and work with CPA Tax Advisors to help you navigate the complexity of the US income tax system.
H&CO's bilingual trusted CPA Tax Advisors have been doing income tax planning for high-net-worth individuals with significant income, business owners, investors, global families, and foreign individuals with complex tax needs, for over 30 years. You can talk to our CPAs in one of our offices near you in Miami, Coral Gables, Aventura, or Fort Lauderdale.
Make income tax planning an integral part of your financial planning.