Tax planning is the process of taking certain steps to minimize the amount of money you’ll owe the Internal Revenue Service (IRS) when you complete your tax return for the year. The Internal Revenue Code (IRC) provides numerous options, all of which are perfectly legal.
When you’re about to file your tax return, it’s too late to adjust your income because the tax year is already behind you. But if you plan ahead and understand what strategies there are for reducing taxes owed, you can earn tax breaks in the future.
Definition and Examples of Tax Planning
Tax planning is a series of strategies for minimizing the percentage of your income that you must pay to the IRS. Generally, the higher your adjusted gross income (AGI), the more you pay in taxes. By tax planning, you have the opportunity to make changes during the year that lower your AGI.
The most common methods of tax planning include claiming the most advantageous deductions and credits you’re eligible for, and making sure you’re not hit with a surprise tax bill when you complete your tax return. This can be as simple as double-checking the tax withholding from your paychecks, particularly if you’ve experienced a significant life change such as gaining or losing a dependent.
The IRS provides helpful information for double-checking your tax withholding on its website, guiding you to the types of events that can affect the taxes withheld from your paychecks. There is also a withholding estimator on its website that can help you determine whether you’re having too little or too much tax withheld. You can submit a revised Form W-4 to your employer at any time to change the withholding from your paychecks so it’s as accurate as it can be.
For those who are self-employed or have investment income, you might want to collect income this year rather than next year if you expect that you’ll be in a higher tax bracket going forward, therefore paying a higher percentage in taxes than you are currently. Likewise, you might want to postpone receiving some income if you believe you’ll be in a lower tax bracket next year.
How Tax Planning Works
Tax planning begins with identifying your AGI. You can determine your AGI by completing IRS Schedule 1, which walks you through the steps. The form tallies up all of your anticipated sources of income in Part I, other than wages or salaries from which taxes are already withheld. It then adds up your anticipated adjustments to income—a form of tax deduction—in Part II.
Your AGI can also determine your eligibility for certain tax credits or deductions. If your AGI is considered too high, you often won’t qualify for some.
Enter these numbers plus your W-2 income from employment, if any, on the corresponding lines of Form 1040 to arrive at your taxable income. At this point, you’re ready to take some tax-planning steps to reduce this amount to a lower tax bracket, if possible. This can result in owing the IRS less, as well as possibly receiving or increasing a tax refund.
Numerous tax breaks are available to reduce your AGI, and you can further reduce your taxable income by claiming certain credits and tax deductions that you can subtract from your total AGI. Find detailed descriptions of the most commonly used ways to reduce your AGI, below.
Tax credits subtract directly from the amount you owe the IRS when you complete your tax return. Unlike deductions, they don’t simply reduce your taxable income. Some are even refundable, so the IRS will send you money if the credits you claim reduce your tax bill to below zero.
Available tax credits in 2021 include:
- American Opportunity Tax Credit
- Child and Dependent Care Credit
- Child Tax Credit
- Earned Income Tax Credit
- Credit for Elderly or Disabled
- Lifetime Learning Tax Credit
Let’s look at the American Opportunity Tax Credit as an example. This credit for qualified education expenses is available to eligible students for the first four years of higher education, and up to $1,000 of this credit is refundable.
Tax planning for this specific credit might involve paying spring semester tuition and fees for yourself, your spouse, or a dependent in December to claim the credit for that tax year, rather than waiting until January, if you think you’ll be in a higher tax bracket in the current year.
Itemizing vs. the Standard Deduction
As mentioned, taxable income is what is left over after you subtract any eligible deductions, including the standard deduction, from AGI. The majority of taxpayers take advantage of the standard deduction, but itemizing is another option, as it may lower your income more. Generally, if your itemized deductions are greater than the standard deduction, it’s best to itemize.
You can either itemize your tax deductions or you can claim the standard deduction, but you can’t do both. Generally, if your itemized deductions are greater than the standard deduction, it’s best to itemize because this will subtract more from your taxable income.
The Tax Cuts and Jobs Act (TCJA) increased standard deductions when the law went into effect in 2018. While the TCJA is set to expire at the end of 2025 unless Congress acts to renew some or all of its provisions, the changes continue to have an impact. As of the 2021 tax year, they’re set at:
- $25,100 for married taxpayers filing joint returns
- $12,550 for single taxpayers and married taxpayers who file separate returns
- $18,800 for heads of household
Contributions to an IRA can be subtracted from your income on line 19 of Schedule 1, reducing your AGI, up to certain limits. You won’t pay taxes on the portion of your income that you save, but the tax bill will eventually come due when you withdraw the money in retirement. In this case, tax planning defers taxes to a time when you stop working and may well be in a reduced tax bracket.
The deductions and credits mentioned here are just the tip of the iceberg. Do some research on your own, or it may be best to consult a tax professional to make sure you’re not overlooking a chance to deduct or claim a credit for expenses that you pay regularly come tax season.
What Tax Planning Means for You
The bottom line of tax planning is knowing what deductions and credits are available to you, and whether you meet the rules for claiming them. They all come with detailed, qualifying criteria that you must meet, and these rules can sometimes change from one year to the next. That said, the IRS is set up to help you understand them and keep on top of them.
You can subscribe to IRS Tax Tips to receive emails about tax law changes and for tax-planning suggestions. To sign up, go to IRS.gov or use the mobile app IRS2G0.
- Tax planning involves implementing a series of strategies for minimizing the percentage of your income that you must pay to the IRS.
- Tax planning can involve claiming tax deductions to reduce your taxable income.
- Tax planning can involve claiming tax credits to reduce the amount of tax you owe the IRS.
- Talking with a tax professional can guide you as to what tax breaks you might be eligible for, and the IRS offers online tools to help you along as well.