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 behind tax planning is to arrange your financial affairs so you ultimately end up owing as little as possible in taxes. You can do this in three ways: You can reduce your taxable 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 and deductions depend on it. You won't be able to qualify for certain credits or deductions 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 this figure is lower 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, net of any adjustments to income you might qualify for. These aren't the same as deductions when they decrease income, because you don't have to itemize to claim them. You take them on Schedule 1 of your 1040, and the total can reduce—or even increase—your adjusted gross income, depending on the nature of the adjustment.
Schedule 1 reports deductions from gross income and 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, if received under a divorce or separation executed before the end of 2018
- Income from self-employment
- Capital gains
- Unemployment compensation
As of tax year 2020, adjustments to income include but aren't limited to:
- Contributions you made to a traditional IRA
- Student loan interest paid
- Alimony paid under a divorce or legal separation executed before the end of 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 premiums
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.
As of tax year 2020, 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 can't include both sales and income taxes. You must choose one or the other.
- Interest on mortgages taken out after December 15, 2017, of up to $750,000, or $375,000 if you're married and filing a separate tax return, 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 taxpayers filing separately.
- Gifts to charity and cash donations are limited to 60% of your AGI, although this increases to 100% in tax years 2020 under the terms of the CARES Act.
- Casualty and theft losses that result from a nationally declared disaster.
To Itemize or Not to Itemize?
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 deductions to avoid paying taxes on more income than you have to.
The standard deductions for the 2020 tax year are:
- $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
- $24,800 for qualifying widow(er)s
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 $600 off their taxable income, the difference between $13,000 and $12,400. But a taxpayer who has only $9,000 in itemized deductions would end up paying taxes on $3,400 more in income if they were to itemize rather than claim their standard deduction.
Take Advantage of Tax Credits
Tax credits don't reduce your taxable income—they're even better than that. They subtract directly from any tax debt you end up owing the IRS after you complete your tax return and you've taken all the adjustments to income and tax deductions you're entitled to.
There are tax credits for college expenses, saving for retirement, adopting children, and childcare expenses you might pay so you can go to work or attend school. 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.
The Child Tax Credit is worth $3,600 for each child under the age of six, and $3,000 for children from age 6 to 17, in tax year 2021. This is a temporary one-year adjustment provided by the American Rescue Plan Act that was signed into law by President Biden in March 2021.
Tax credits are credited directly to the IRS as payments, just as though you had written a check for money owed. Most of them can only reduce or eliminate your tax debt, but some (i.e., the "refundable") credits can result in the IRS issuing a tax refund for any balance left over after your tax obligation has been reduced to zero.
Avoid Additional Taxes
Avoid taking early withdrawals from an IRA or 401(k) retirement plan before you reach age 59 1/2 if at all possible. The amount you withdraw will become part of your taxable income, and you'll also pay a 10% tax penalty.
Things Have Changed
The TCJA upended tax rules significantly 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 from the tax code, at least through 2025, when the TCJA potentially expires.
The rules for deductions, adjustments to income, and tax credits cited here are applicable in 2020. They do not necessarily apply to tax years 2017 and earlier, and they might not apply to tax year 2021—the return you'd file in 2022.