One cannot avoid taxes in the US. Moreover, evading taxes is a crime that could lead to severe penalties and punishments. However, over 18.6 million taxpayers in the US still owed more than 300 billion tax dollars to the IRS (Internal Revenue Service) in overdue taxes in 2022. It just highlights the importance of tax planning.
However, many individuals lack the expertise and skills to plan taxes effectively to reduce the tax burden. Nonetheless, the good thing is that you can seek help from professionals, like a Long Island CPA, to help you reduce the tax you owe. Along with saving money, it will also enable you to achieve financial stability.
Tax concepts one should know
Tax planning is a comprehensive process that takes various financial aspects into account to find ways to reduce the tax burden effectively. However, it is not possible to create an effective tax plan without understanding the following concepts.
- Tax bracket: Tax planning starts with understanding your tax bracket. Based on your annual income, you may have to pay 10%, 12%, 22%, 24%, 32%, 35%, or 37% income tax. It is needless to mention that higher incomes are subjected to higher rates of tax. However, your income is not subjected to a single tax bracket. Instead, your income is broken down into different chunks of income slabs and taxed at the corresponding rate.
- Tax deduction vs tax credit: A tax deduction is an expense that has already been incurred and can be subtracted from your taxable income. Hence, tax deductions can reduce your overall taxable income. On the other hand, tax deductions provide you with a dollar-to-dollar reduction in the tax amount; for example, a $100 tax credit will reduce your tax bill by $100.
- Understand the importance of documentation: The IRS can audit your return within three years of filing. Therefore, it is essential to keep your tax-related documents for at least three years. In some cases, the IRS may audit your return even after three years.
- Tweak your W-4: A W-4 allows your employer to withhold tax amount from your paycheck. So, if you increase your withholding, it will help you owe less tax the next time you file. On the other hand, if you get a huge refund last year, you can reduce your withholding to receive the amount throughout the year in your paycheck.
Top tax optimization strategies to adopt
Individual filers can employ various strategies to reduce the tax burden without violating any tax law or regulation. Following are some of the most common ways to reduce your tax burden.
- Filing status: Your filing status plays a significant role in determining how much tax exemption you can claim on different investments and expenditures. Major life events like birth, death, and marriage can have a significant impact on your tax filing status. You can file taxes as a single filer, head of the household, a married couple filing separately, a married couple filing jointly, or a qualified widow(er).
- Deductions: You can choose a standard or itemized deduction to reduce your taxable income. Depending on your filing status, the standard deduction limit can vary between $14,600 to $29,200. However, in some cases, itemizing your deductions can provide you with an increased deduction limit.
- Retirement contributions: Your contributions to a retirement account, whether employer-sponsored or not, can significantly lower your taxable income. You can contribute to a 401(k), 403(b), or different kinds of Individual Retirement Accounts (IRA). Contributions to retirement accounts are usually made pre-tax, resulting in a reduced taxable income.
- HSA (Health Savings Account) contribution: Contributions to a Health Savings Account are tax-free. However, your employer must offer a high-deductible health plan, and you mustn’t be enrolled in Medicare. Examples of qualified HSA expenses include prescription drugs for vision, dental exams, etc.
- Flexible spending accounts (FSA) and dependent care flexible spending accounts (DCFSA): Flexible spending accounts and dependent care flexible spending accounts are used to pay health care expenses for oneself and one’s dependents. The money goes pre-tax in FSA and DCFSA, which reduces your taxable income.
Final thoughts
Tax planning plays a significant role in effectively reducing your tax burden by utilizing tax credits and tax deductions. It not only helps you be tax compliant, it also enables you to achieve financial stability and financial goals and effectively manage cash flow. However, if you feel confused or do not know how to create an effective tax plan, it is always advisable to hire a professional for help.
