There’s more to taxes than filing returns annually. By keeping good records and thinking about tax implications of financial transactions, you can make tax planning a key ingredient of your overall personal financial planning. The overriding objective of effective tax planning is to maximize total after-tax income by reducing, shifting, and deferring taxes to as low a level as legally possible. Keep in mind that avoiding taxes is one thing, but evading them is another matter altogether. By all means, don’t confuse tax avoidance with tax evasion, which includes such illegal activities as omitting income or overstating deductions. Tax evasion, in effect, involves a failure to accurately report income or deductions and, in extreme cases, a failure to pay taxes altogether. Persons found guilty of tax evasion are subject to severe financial penalties and even prison terms. Tax avoidance, in contrast, focuses on reducing taxes in ways that are legal and compatible with the intent of Congress.
Fundamental Objectives of Tax Planning
Tax planning basically involves the use of various investment vehicles, retirement programs, and estate distribution procedures to (1) reduce, (2) shift, and (3) defer taxes. You can reduce taxes, for instance, by using techniques that create tax deductions or credits, or that receive preferential tax treatment such as investments that produce depreciation (such as real estate) or that generate tax-free income (such as municipal bonds). You can shift taxes by using gifts or trusts to transfer some of your income to other family members who are in lower tax brackets and to whom you intend to provide some level of support anyway, such as a retired, elderly parent. The idea behind deferring taxes is to reduce or eliminate your taxes today by postponing them to some time in the future when you may be in a lower tax bracket.
Perhaps more important, deferring taxes gives you use of the money that would otherwise go to taxes thereby allowing you to invest it to make even more money. Deferring taxes is usually done through various types of retirement plans, such as IRAs, or by investing in certain types of annuities, variable life insurance policies, or even Series EE bonds (U.S. savings bonds). The fundamentals of tax planning include making sure that you take all the deductions to which you’re entitled and also take full advantage of the various tax provisions that will minimize your tax liability. Thus, comprehensive tax planning is an ongoing activity with both an immediate and a long-term perspective. It plays a key role in personal financial planning in fact, a major component of a comprehensive personal financial plan is a summary of the potential tax impacts of various recommended financial strategies. Tax planning is closely interrelated with many financial planning activities, including investment, retirement, and estate planning.
Fundamental Objectives of Tax Planning
Tax planning basically involves the use of various investment vehicles, retirement programs, and estate distribution procedures to (1) reduce, (2) shift, and (3) defer taxes. You can reduce taxes, for instance, by using techniques that create tax deductions or credits, or that receive preferential tax treatment such as investments that produce depreciation (such as real estate) or that generate tax-free income (such as municipal bonds). You can shift taxes by using gifts or trusts to transfer some of your income to other family members who are in lower tax brackets and to whom you intend to provide some level of support anyway, such as a retired, elderly parent. The idea behind deferring taxes is to reduce or eliminate your taxes today by postponing them to some time in the future when you may be in a lower tax bracket.
Perhaps more important, deferring taxes gives you use of the money that would otherwise go to taxes thereby allowing you to invest it to make even more money. Deferring taxes is usually done through various types of retirement plans, such as IRAs, or by investing in certain types of annuities, variable life insurance policies, or even Series EE bonds (U.S. savings bonds). The fundamentals of tax planning include making sure that you take all the deductions to which you’re entitled and also take full advantage of the various tax provisions that will minimize your tax liability. Thus, comprehensive tax planning is an ongoing activity with both an immediate and a long-term perspective. It plays a key role in personal financial planning in fact, a major component of a comprehensive personal financial plan is a summary of the potential tax impacts of various recommended financial strategies. Tax planning is closely interrelated with many financial planning activities, including investment, retirement, and estate planning.
Some Popular Tax Strategies
Managing your taxes is a year-round activity. Because Congress considers tax law changes throughout the year, you may not know all the applicable regulations until the middle of the year or later. Like other financial goals, tax strategies require review and adjustment when regulations and personal circumstances change. Tax planning can become complex at times and may involve rather sophisticated investment strategies. In such cases, especially those involving large amounts of money, you should seek professional help. Many tax strategies are fairly simple and straightforward and can be used by the average middle-income taxpayer. You certainly don’t have to be in the top income bracket to enjoy the benefits of many tax-saving ideas and procedures. For example, the interest income on Series EE bonds is free from state income tax, and the holder can elect to delay payment of federal taxes until (1) the year the bonds are redeemed for cash or (2) the year in which they finally mature, whichever occurs first. This feature makes Series EE bonds an excellent vehicle for earning tax-deferred income.
There are other strategies that can cut your tax bill. Accelerating or bunching deductions into a single year may permit itemizing deductions. Shifting income from one year to another is one way to cut your tax liability. If you expect to be in the same or a higher income tax bracket this year than you will be next year, defer income until next year and shift expenses to this year so you can accelerate your deductions and reduce taxes this year.
Maximizing Deductions
Review a comprehensive list of possible deductions for ideas, because even small deductions can add up to big tax savings. Accelerate or bunch deductions into one tax year if this allows you to itemize rather than take the standard deduction. For example, make your fourth-quarter estimated state tax payment before December 31 rather than on January 15 to deduct it in the current taxable year. Group miscellaneous expenses and schedule unreimbursed elective medical procedures to fall into one tax year so that they exceed the required “floor” for deductions (2% of AGI for miscellaneous expenses; 7.5% of AGI for medical expenses). Increase discretionary deductions such as charitable contributions.
Income Shifting
One way of reducing income taxes is to use a technique known as income shifting. Here the taxpayer shifts a portion of his or her income, and thus taxes, to relatives in lower tax brackets. This can be done by creating trusts or custodial accounts or by making outright gifts of income-producing property to family members. For instance, parents with $125,000 of taxable income (28% marginal tax rate) and $18,000 in corporate bonds paying $2,000 in annual interest might give the bonds to their 15-year-old child with the understanding that such income is to be used ultimately for the child’s college education. The $2,000 would then belong to the child, who would probably be assumed to be able to pay $110 (0.10 × [$2,000 $900 minimum standard deduction for a dependent]) in taxes on this income, and the parents’ taxable income would be reduced by $2,000, reducing their taxes by $560 (0.28 × $2,000).
Tax-Free and Tax-Deferred Income
Some investments provide tax-free income; in most cases, however, the tax on the income is only deferred (or delayed) to a later day. Although there aren’t many forms of tax-free investments left today, probably the best example would be the interest income earned on municipal bonds. Such income is free from federal income tax and possibly state income taxes. No matter how much municipal bond interest income you earn, you don’t have to pay any federal taxes on it.
Most any wage earner can open an IRA and contribute up to $5,000 (or possibly $6,000, depending on an age qualification) each year to the account (in 2008). Of course, as noted earlier in this chapter, although any employed person can contribute to an IRA, only those people meeting certain pension and/or income constraints can deduct the annual contributions from their tax returns. If you fail to meet these restrictions, you can still have an IRA, but you can’t deduct the $5,000 annual contribution from your income. So why have an IRA? Because all the income you earn in your IRA accumulates tax free. This is a tax-deferred investment, so you’ll eventually have to pay taxes on these earnings, but not until you start drawing down your account. Roth IRAs provide a way for people with AGI below a given level to contribute after-tax dollars. Not only do earnings grow tax free, but so do withdrawals if the account has been open for 5 or more years and the individual is over 591⁄2. In addition to IRAs, tax-deferred income can also be obtained from other types of pension and retirement plans and annuities.
Managing your taxes is a year-round activity. Because Congress considers tax law changes throughout the year, you may not know all the applicable regulations until the middle of the year or later. Like other financial goals, tax strategies require review and adjustment when regulations and personal circumstances change. Tax planning can become complex at times and may involve rather sophisticated investment strategies. In such cases, especially those involving large amounts of money, you should seek professional help. Many tax strategies are fairly simple and straightforward and can be used by the average middle-income taxpayer. You certainly don’t have to be in the top income bracket to enjoy the benefits of many tax-saving ideas and procedures. For example, the interest income on Series EE bonds is free from state income tax, and the holder can elect to delay payment of federal taxes until (1) the year the bonds are redeemed for cash or (2) the year in which they finally mature, whichever occurs first. This feature makes Series EE bonds an excellent vehicle for earning tax-deferred income.
There are other strategies that can cut your tax bill. Accelerating or bunching deductions into a single year may permit itemizing deductions. Shifting income from one year to another is one way to cut your tax liability. If you expect to be in the same or a higher income tax bracket this year than you will be next year, defer income until next year and shift expenses to this year so you can accelerate your deductions and reduce taxes this year.
Maximizing Deductions
Review a comprehensive list of possible deductions for ideas, because even small deductions can add up to big tax savings. Accelerate or bunch deductions into one tax year if this allows you to itemize rather than take the standard deduction. For example, make your fourth-quarter estimated state tax payment before December 31 rather than on January 15 to deduct it in the current taxable year. Group miscellaneous expenses and schedule unreimbursed elective medical procedures to fall into one tax year so that they exceed the required “floor” for deductions (2% of AGI for miscellaneous expenses; 7.5% of AGI for medical expenses). Increase discretionary deductions such as charitable contributions.
Income Shifting
One way of reducing income taxes is to use a technique known as income shifting. Here the taxpayer shifts a portion of his or her income, and thus taxes, to relatives in lower tax brackets. This can be done by creating trusts or custodial accounts or by making outright gifts of income-producing property to family members. For instance, parents with $125,000 of taxable income (28% marginal tax rate) and $18,000 in corporate bonds paying $2,000 in annual interest might give the bonds to their 15-year-old child with the understanding that such income is to be used ultimately for the child’s college education. The $2,000 would then belong to the child, who would probably be assumed to be able to pay $110 (0.10 × [$2,000 $900 minimum standard deduction for a dependent]) in taxes on this income, and the parents’ taxable income would be reduced by $2,000, reducing their taxes by $560 (0.28 × $2,000).
Tax-Free and Tax-Deferred Income
Some investments provide tax-free income; in most cases, however, the tax on the income is only deferred (or delayed) to a later day. Although there aren’t many forms of tax-free investments left today, probably the best example would be the interest income earned on municipal bonds. Such income is free from federal income tax and possibly state income taxes. No matter how much municipal bond interest income you earn, you don’t have to pay any federal taxes on it.
Most any wage earner can open an IRA and contribute up to $5,000 (or possibly $6,000, depending on an age qualification) each year to the account (in 2008). Of course, as noted earlier in this chapter, although any employed person can contribute to an IRA, only those people meeting certain pension and/or income constraints can deduct the annual contributions from their tax returns. If you fail to meet these restrictions, you can still have an IRA, but you can’t deduct the $5,000 annual contribution from your income. So why have an IRA? Because all the income you earn in your IRA accumulates tax free. This is a tax-deferred investment, so you’ll eventually have to pay taxes on these earnings, but not until you start drawing down your account. Roth IRAs provide a way for people with AGI below a given level to contribute after-tax dollars. Not only do earnings grow tax free, but so do withdrawals if the account has been open for 5 or more years and the individual is over 591⁄2. In addition to IRAs, tax-deferred income can also be obtained from other types of pension and retirement plans and annuities.
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