|Tax Planning for Income
You don't want to pay more in federal income tax than you have to. With that in mind, here are five things to consider when it comes to keeping more of your income.
1. Postpone your income to minimize your current income
By deferring (postponing) income to a later year, you may be
able to minimize your current income tax liability and invest the money that
you'd otherwise use to pay income taxes. And when you eventually report the
income, it's possible that you'll be in a lower income tax bracket.
Certain retirement plans can help you postpone the
payment of taxes on your earned income. With a traditional 401(k) plan, for example, you
contribute part of your salary into the plan, paying income tax only when you
later withdraw money from the plan (withdrawals before age 59½ may be subject to a 10
percent penalty tax in addition to regular income tax, unless an exception applies). This allows you to postpone tax on part of your
salary and take advantage of the tax-deferred growth of any investment
There are many other ways to postpone your taxable income.
For instance, you can contribute to a traditional IRA, buy permanent life
insurance (the cash value part grows tax deferred), or invest in certain
savings bonds. You may want to speak with a tax professional about your tax
2. Shift income to family members to lower the
overall family tax burden
You may also be able to minimize your federal income taxes by shifting some
income to family members who are in a lower tax bracket. For example, if you
own stock that produces dividend income, one option might be to gift the
stock to your children. After you've made the gift, the dividends will
represent income to them rather than to you, potentially lowering your family's overall tax burden.
Keep in mind that you can make a tax-free gift of up to $15,000 (in 2018, $14,000 in 2017, and could increase in future years)
per year per recipient without incurring federal gift tax.
However, look out for the kiddie tax rules. Under these
rules, for children under age 18, or children under age 19 (or full-time students
under age 24) who don't earn more than one-half of their financial support, any
unearned income over $2,100 (in 2018) is taxed using the trust and estate income tax brackets; any
unearned income over $2,100 (in 2017) was taxed at the parent's marginal tax rate.
Also, be sure to check the laws of your state before giving securities to
Other ways of shifting income include hiring a family member
for the family business and creating a family limited partnership. Be sure to investigate
all of your options carefully before acting.
3. Deduction planning involves proper timing and control
over your income
Part of minimizing federal income tax is about taking advantage of all deductions to
which you are entitled, and timing them in the most beneficial manner.
As a starting point, you'll have to decide whether to
itemize your deductions or take the standard deduction. Generally, you'll
choose whichever method lowers your taxes the most. If you itemize, be aware
that some deductions (for example, medical expenses) are allowed only to the extent the deduction exceeds some percentage of your adjusted gross income
(AGI). In cases where your deductions are affected by your AGI, you might look at ways to potentially increase your allowable deductions by reducing your AGI.
To lower your AGI for
the year, you can defer part of your income to next year, buy investments that
generate tax-exempt income, and contribute as much as you can to qualified
Because you can sometimes control whether a deductible
expense falls into the current tax year or the next, you may have some control
over the timing of your deduction. If you're in a higher federal income tax
bracket this year than you expect to be in next year, you'll want to consider accelerating deductions into the current year. You can accelerate deductions by paying
deductible expenses and making charitable contributions this year instead of
waiting until next.
4. Investment tax planning uses timing strategies and
focuses on your after-tax return
You can also minimize tax by making tax-conscious investment choices. Potential
strategies can include the use of tax-exempt
securities and intentionally timing the sale of capital assets for maximum tax
Although income is generally taxable, certain investments
generate income that's exempt from tax at the federal or state level. For
example, if you meet specific requirements and income limits, the interest on
certain Series EE bonds (these may also be called Patriot bonds) used for
education may be exempt from federal, state, and local income taxes. Also, you
can exclude the interest on certain municipal bonds from your income
(tax-exempt status applies to income generated from the bond; a capital gain or
loss realized on the sale of a municipal bond is treated like a gain or loss from
any other bond for federal tax purposes). And if you earn interest on
tax-exempt bonds issued in your home state, the interest will generally be
exempt from state and local tax as well. Keep in mind that although the
interest on municipal bonds is generally tax exempt, certain municipal bond
income may be subject to the federal alternative minimum tax. When comparing
taxable and tax-exempt investment options, you'll want to focus on those
choices that maximize your after-tax return.
In most cases, long-term capital gain tax rates are lower
than ordinary income tax rates. That means that the amount of time you hold an
asset before selling it can make a big tax difference. Since long-term capital
gain rates generally apply when an asset has been held for more than a year,
you may find it makes good tax-sense to hold off a little longer on selling an
asset that you've held for only 11 months. Timing the sale of a capital asset
(such as stock) can help in other ways as well. For example, if you expect to
be in a lower income tax bracket next year, you might consider waiting until
then to sell your stock. You might want to accelerate income into this year by
selling assets, though, if you have capital losses this year that you can use
to offset the resulting gain.
You should not decide which investment
options are appropriate for you based on tax considerations alone. Nor should
you decide when (or if) to sell an asset solely based on the tax consequence. A
financial or tax professional can help you decide what choices are right for
your specific situation.
5. Year-end planning focuses on your marginal income tax
Year-end tax planning, as you might expect, typically takes
place in October, November, and December. At its most basic level, year-end tax
planning generally looks at ways to time income and deductions to give you the
best possible tax result. This may mean trying to postpone income to the
following year (thus postponing the payment of tax on that income) and
accelerate deductions into the current year. For example, assume it's December
and you know that you're in a higher tax bracket this year than you will be in
next year. If you're able to postpone the receipt of income until the following
year, you may be able to pay less overall tax on that income. Similarly, if you
have major dental work scheduled for the beginning of next year, you might
consider trying to reschedule for December to take advantage of the deduction
this year. The right year-end tax planning moves for you will depend on your