Basic Tax Strategy Using Deductions and Tax Credits

A simple strategy can go a long way to minimize taxes

1099 tax form and golden egg in a nest
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You can substantially reduce your income tax by saving for retirement, owning a home, or sending your kids to college. Here's how it worked for one client.

Several years ago when I was preparing the tax return for a married couple for the 2012 tax year, I realized that they had the ideal tax strategy. They were able to lower their federal income taxes by owning a modest home, putting the kids through college, and saving for retirement. Sounds perfect, but how do the numbers work out? Using the 2012 tax year IRS limits and tax rates that were applicable at the time, here's how we reduced their taxable income.

To see how these strategies might work for you, be sure to consult the IRS website for the most up to date federal income tax rates. 

Tax Strategy 1: Save in a 401k Plan

Let's start with their profile. The couple is filing a joint tax return and have three kids: two in college and one in high school. Between the both of them, they earn $76,500 in wages. Each puts away $5,000 in their 401k retirement savings plans, which reduces their taxable wages by $10,000. Now, the couple is taxed only on $66,500. (This also happens to be their adjusted gross income.)

Tax Strategy 2: Buy a House & Itemize Your Deductions

Because they own a house, the couple is eligible to itemize their deductions. Besides a mortgage interest of $16,000, the couple also has real estate taxes (another $5,000), donations to their church (about $3,700), and let's not forget the state income taxes that were withheld on their paychecks ($2,500). Their itemized deductions totaled up to $27,200. This, in turn, reduces their AGI from $66,500 to $39,300.

The clients can reduce their taxable income by $19,000 because of their five personal exemptions. Personal exemptions are a standard amount for each taxpayer and dependent shown on the tax return. For 2012, the personal exemption amount is $3,800, times five persons (husband, wife, and three dependents) equals $19,000. Personal exemptions function like a deduction in that this reduces the couple's taxable income.

After subtracting their personal exemptions, the couple's taxable income is $20,300. This is the amount on which federal income tax is calculated. Using 2012 tax rates gives them an income tax of $2,175. We notice that the couple falls in the 15% tax bracket based on their taxable income for married couples filing jointly. For 2012, the first $17,400 of taxable income is taxed at a rate of 10%. The 15% tax bracket applies to taxable income above $17,400 up to $70,700. However the couple's taxable income is only $20,300, So the 15% rate applies only to the amount by which their taxable income exceeds $17,400, which is the end of the lower 10% bracket.

The amount taxed at the 15% rate is $2,900, resulting in $435 in tax being calculated. Combining the amounts from the 10% and 15% tax rates, this couple has a federal income tax of $2,175. 

Tax Strategy 3: Use Tax Credits to Eliminate Your Taxes

Two of their children go to college. Their eldest daughter is a senior at a state university, and their son, the second oldest, was a freshman at another state university. For 2012, they have the option of deciding between the Lifetime Learning Credit or the American Opportunity Credit. The couple spent $15,000 on the daughter's tuition and $5,000 on their son's tuition for the year. The couple could choose between a Lifetime Learning Credit worth 20% of the first $10,000 of tuition expenses (for a maximum credit of $2,000) or the American Opportunity Credit worth up to $2,500 on the first $4,000 of qualifying educational expenses, which includes course materials as well as tuition.

Either combination of tax credits for higher education would fully eliminate the couple's $2,175 in federal income tax. But in their case, the American Opportunity Credit worked out better, since 40% that tax credit is refundable. With two American Opportunity credits at the maximum $2,500 amount, that's $5,000 in tax credits. Sixty percent of that amount, or $3000, offsets their federal income tax of $2,175. This portion of the American Opportunity credit is non-refundable, so this portion of the tax credit reduces their federal income tax to zero, but not below zero.

Forty percent of their American Opportunity credit was refundable, so $2,000 of that credit was treated as if it were a tax payment. Refundable credits function just like withholding and other tax payments, and any excess amount above the federal income tax liability is refunded by the IRS. For this couple, they received a tax refund that was $2,000 higher than the amount of tax they had paid in through withholding.

Tax Strategy 4: Adjust Your Withholding & Spend Your Tax Refund Wisely

So, the couple gets a full refund of all their withholding, plus an additional amount from the refundable portion of the American Opportunity Credit. They decided to use part of their refund to open Roth IRAs for both the husband and the wife (up to $5,000 each for the year 2012), and to put the rest in several bank certificates of deposit for their youngest daughter's college fund.

As you can see, sometimes tax breaks are a very good thing. By owning a house, putting their kids through college, and saving for retirement, this couple has managed to eliminate their tax bill.