Tax Planning Basics—Don't Pay More Than You Have To
It's all about reducing your taxable income as much as possible
The idea of tax planning is to arrange your financial affairs so you ultimately end up owing as little in taxes as possible. You can do this in three basic ways: You can reduce your income, increase your deductions, and take advantage of tax credits. These options aren't mutually exclusive. You can do all three for the best possible result.
How to Reduce Taxable Income
Your adjusted gross income (AGI) is the key element in determining your taxes. It's the starting number for calculations, and your tax rate and various tax credits depend upon it. You won't be able to qualify for certain tax credits if it's too high.
Your AGI can even impact your financial life outside of taxes. Banks, mortgage lenders, and college financial aid programs all routinely ask for your adjusted gross income. This is a key measure of your finances.
The more money you make, the higher your AGI will be and the more you'll pay in taxes. Conversely, you'll pay less in taxes if you earn less. That's the way the American tax system is set up. And it all begins with that magic number—your AGI.
How Do You Find Your AGI?
Your AGI is your income from all sources plus and/or minus any adjustments to income you might qualify for. Adjustments can increase or decrease income, depending on the type of adjustment. They are not the same as deductions, so you don't have to itemize to claim them. Instead, you take them on Schedule 1 of your 1040, and the total of Schedule 1 can reduce—or even increase your adjusted gross income.
Schedule 1 not only reports your adjustments to income but additional sources of income as well. Your AGI will go up if you have only additional income and don't qualify for any adjustments. The flip side is that your AGI will shrink if you have adjustments but no additional sources of income.
Additional sources of income include but aren't limited to:
- Taxable state tax refunds
- Alimony, although only through the end of 2018
- Income from self-employment
- Capital gains
- Unemployment compensation
As of 2020, adjustments to income include but aren't limited to:
- Contributions you made to a traditional IRA
- Student loan interest paid
- Alimony paid—at least through 2018
- Classroom-related expenses paid by educators
- Some business expenses paid by performing artists, certain government officials, and reservists
- Contributions to health savings accounts
- Moving expenses for certain members of the Armed Forces
- A portion of the self-employment tax, as well as self-employed health insurance
These adjustments appear on lines 23 through 35 of Schedule 1, a form that didn't exist in tax years 2017 or earlier. Schedule 1—and numerous other schedules—were introduced in 2018 when the IRS redesigned the old Form 1040.
Increase Your Tax Deductions
Your taxable income is what remains after you've determined your AGI. You have a choice here: You can either claim the standard deduction for your filing status, or you can itemize your qualifying deductions. But you can't do both.
Itemized deductions include:
- Expenses for health care that exceed 7.5% of your AGI
- The total sum of state and local income taxes, real estate taxes, and personal property taxes (such as car registration fees) up to $10,000, or $5,000 if you're married and file a separate return. You can substitute sales taxes you paid for income taxes if this is more beneficial for you, but you cannot include both sales and income taxes—you must choose one or the other.
- Interest on mortgages taken out after Dec. 15, 2017 of up to $750,000, or $375,000 if you're married filing jointly, or $375,000 if you're married and filing separately, provided that the funds are used to "purchase, construct, or make substantial improvements" to your primary or secondary residence. The maximum amount for mortgages originated on or before December 15, 2017 is $1,000,000, or $500,000 for married filing separately.
- Gifts to charity. Cash donations are limited to 60% of your AGI.
- Casualty and theft losses that result from a nationally declared disaster
One key tax planning strategy is to keep track of your itemized expenses throughout the year using a spreadsheet or personal finance program. You can then quickly compare your itemized expenses with your standard deduction. You should always take the higher of your standard deduction or your itemized deduction to avoid paying taxes on more income than you have to.
- $12,400 for single filers
- $12,400 for married taxpayers filing separate returns
- $18,650 for heads of household
- $24,800 for married taxpayers filing joint returns
A single taxpayer who has $13,000 in itemized deductions would do better to itemize than to claim the standard deduction. That's an additional $800 off his taxable income, the difference between $13,000 and $12,200. But a taxpayer who has only $9,000 in itemized deductions would end up paying taxes on $3,200 more in income if she itemizes rather than claims the standard deduction for her single filing status.
Take Advantage of Tax Credits
Tax credits don't just reduce your taxable income—they're better than that. They subtract directly from any tax debt you end up owing the IRS after you take all the adjustments to income and tax deductions you're entitled to.
There are tax credits for college expenses, for saving for retirement, for adopting children, and for childcare expenses, you might pay so you can go to work. The Child Tax Credit is worth up to $2,000 for each of your children under age 17 subject to income restrictions, and the Earned Income Credit (EITC) can put some money back into the pockets of lower-income taxpayers.
Tax credits are credited to your IRS as payments, just as though you had written the IRS a check for money owed. Most of them can only reduce your tax debt, but the EITC can result in the IRS issuing a tax refund for any balance left over after your tax obligation has been reduced to zero. Again, income restrictions apply. You won't qualify for this tax credit if you earn too much.
Avoid Additional Taxes
If at all possible, avoid taking early withdrawals from an IRA or 401(k) retirement plan before you reach age 59 1/2. The amount you withdraw will become part of your taxable income, and you'll additionally pay a 10% tax penalty.
Things Have Changed
The Tax Cuts and Jobs Act (TCJA) upended tax rules to a significant extent when it went into effect in 2018. The Internal Revenue Code used to provide for personal exemptions that could further decrease your taxable income, but the TCJA eliminated these exemptions from the tax code. The rules for deductions, adjustments to income, and tax credits cited here are applicable beginning in the tax year 2018 and going forward. They do not necessarily apply to tax years 2017 and earlier.
Internal Revenue Service (IRS). "IRS Provides Tax Inflation Adjustments for Tax Year 2020." Accessed Feb. 25, 2020.
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Internal Revenue Service (IRS). "About Form 1040, U.S. Individual Tax Return." Accessed Feb. 25, 2020.
Internal Revenue Service (IRS). "Schedule 1: Additional Income and Adjustments to Income." Accessed Feb. 25, 2020.
Internal Revenue Service (IRS). "Topic No. 450 Adjustments to Income." Accessed Feb. 25, 2020.
Internal Revenue Service (IRS). "Credits and Deductions for Individuals." Accessed Feb. 25, 2020.
Internal Revenue Service (IRS). "Topic No. 501 Should I Itemize?" Accessed Feb. 25, 2020.
Internal Revenue Service (IRS). "Topic No. 500 Itemized Deductions." Accessed Feb. 25, 2020.
Internal Revenue Service (IRS). "Publication 972 (2019), Child Tax Credit and Credit for Other Dependents." Accessed Feb. 25, 2020.
Internal Revenue Service (IRS). "Publication 596 (2019), Earned Income Credit (EIC)." Accessed Feb. 25, 2020.
Internal Revenue Service (IRS). "IRA FAQs - Distributions (Withdrawals)." Accessed Feb. 25, 2020.