Saturday, February 11, 2012

Tax Strategies

Now you should know whether or not you should file your own tax forms, but before learning about the forms themselves, it may be good to learn a little bit about tax strategies to minimize your bill to Uncle Sam and maximize how much in cash you take home from your hard work.  There is a way you should approach your taxes so as to maximize the cash that reaches your pocket and it is good to learn these early so that they can work to your advantage for they ears to come.  I also go over some of the basics in an earlier post on taxes.

First of all, what is tax strategy?  Tax strategy is how to manage your income and expenses to minimize how much you have to pay in taxes or defer paying taxes for the longest period of time possible.  I am going to focus on federal taxes but you should look into your own state and local taxes as well.  I talked about the time value of money in an earlier post, but as a quick refresher, the main idea is that if given the choice between $1 today and $1 in the future, $1 today would be more valuable.  Similarly, if given the choice of paying $1 in taxes today and $1 in taxes in the future, you would much rather pay it in the future because it has a lower effective cost to you.  My earlier post on taking end of the year losses to decrease your tax bill is one example of a tax strategy.

Like I mentioned earlier, one of the primary ways to save on taxes is to defer them until a later date.  Another tax strategy is to try to move income from higher taxed sources to lower taxed sources (generally this requires a bit of planning beforehand).  For example, taxes from long-term capital gains and dividends are currently taxed at the same rates but this may change in the future.  It can be very important for you to pay attention to these taxes as they will largely affect your after-tax return.  It is important to be aware of what activities get subsidized by the government through tax credits and deductions.

You want to make sure you get the most tax credits as possible as well as the highest amount of deductions from your taxable income when filing your taxes. You generally prefer tax credit to a deduction to taxable income since given the same dollar value, the tax credit is worth more.  For example, if you can get a $100 tax credit, you get $100 in savings.  If you get a $100 deductible, you get to save taxes on $100 worth of income which would be $100 * your tax rate (i.e. $100 * 35% = $35).  Some more common tax credits include the AMT credit (if you have previously paid taxes under the alternative minimum tax), foreign tax credits, dependent child credit, and American Opportunity and Lifetime Learning credit.  Some common deductions include out-of-pocket charity contributions, job-hunting costs, interest on student loans, and the cost of relocating for your first job.  I will detail these credits and deductions more in detail in a future post.

Make sure you also make the most use of your individual retirement accounts and employer sponsored retirement plans to maximize your tax savings.  Contributions to a traditional IRA, for example, are deductible from your taxable income.  And earnings that grow in a Roth IRA will be tax-free when you withdraw the money (although you have to wait until you are at retirement age to do so).  When/if you are a parent, you can open a 529 college savings account for your children which provide special tax benefits for the savings you put aside for your child's education.  I will also go more in depth on special tax-advantaged accounts in another post.

There are a lot of fine details when looking at taxes, especially with consistently changing tax laws to encourage particular behaviors.  Although the specific rules may change from time to time, the overall strategy of minimizing your tax bill legally through special accounts and taking deductions will stay for the rest of our lives.  The sooner you learn about this, the more you can save on your tax bill come April and better prepare for your future.

1 comment:

  1. Indeed, a smart tax strategy can save you a lot, but it varies depending on the individual’s standing and the state’s law. So, before you do anything, you have to understand the inner workings of tax planning. Take time to think what the best strategy to reduce your tax is. Better yet, consult your tax advisor and accountant and ask them what the possible ways are to reduce your tax payments.

    (Parris Moretti)