Managing your taxes can be stressful and with Tax Day (April 15th) being right around the corner, it is never to early to get yourself organized!
Written by BALANCE
What is “smart tax management”? It’s a combination of timely filing and taking advantage of everything that can reduce the amount of money you pay in taxes. While tax management does take a bit of planning, organization, and know-how, the overall financial benefit is strong.
Maximize retirement savings plans
If you have an employer-sponsored retirement savings plan (such as a 401(k), 403(b), or 457) available to you, it makes sense to use it. Since you make contributions with pre-tax dollars, your taxable income and possibly your tax rate will be lowered. Investments grow on a tax-deferred basis, so when you retire and take the money out the earnings will be taxed on your new, and usually lower, tax rate.
IRAs are part of good tax management too. Contributions to a traditional IRA are tax-deductible, and account earnings aren’t taxed until you withdraw that money at age 59.5. There are income restrictions, though, and if you’re an active participant in an employer-sponsored retirement savings plan you can’t deduct your contributions. While contributions to a Roth IRA are always non-deductible, the earnings are tax-free.
Use your employee benefits
If you are an employee, your company may offer benefits that can reduce your taxable income and therefore your tax liability (the amount you owe):
Flexible Spending Accounts (FSAs). Medical FSAs allow you to set aside money for common health-related costs, and dependent care accounts let you to save for work-related child or dependent care expenses. For both, the money is taken out through payroll deductions on a pretax basis.
Transportation plans. These plans allow you to use pretax dollars (and reduce your taxable income) to pay for public transit, vanpooling, or parking.
Pay the right amount
You know you are paying the correct amount of taxes if you neither owe taxes nor receive a large tax refund. While a refund may seem positive, it is really not making the most of your income during the year. For example, a $2,000 tax refund translates into $166 that you don’t have in your pocket every month. On the other hand, if you owe and can’t pay the entire sum, you’ll have to pay interest and possibly penalties, which will only add to your tax debt.
Make the most of your adjustments, deductions and credits
Tax adjustments and deduction are expenses that you can subtract from your income, resulting in a lower taxable income. Common examples of these are:
- An exemption amount for you, your spouse, each child, and any other qualified dependents, and certain disabilities
- Mortgage interest paid on your primary residence
- Equity loan or line of credit interest
- Charitable contributions to eligible organizations
- Certain business expenses
- Union and professional dues
- Some medical expenses
- The cost of tax advice, software, and books
- Depreciation of business assets
- Some work uniforms and clothing
- Moving expenses, in some cases
- Some educational expenses
A tax credit is a dollar-for-dollar reduction in what you would owe for taxes. For example, if you qualify for a tax credit of $1000, you would be able to subtract that amount from your total tax liability. Common examples of tax credits are:
- Earned income credit. This credit reduces the tax burden for lower-income taxpayers.
- Education-related credits. The American Opportunity credit can be used for the expenses that you incur in the first four years of higher education. The Lifetime Learning credit applies to tuition costs for undergraduates, graduates, and those improving job skills through a training program.
- Child-related credits. These include credit for child and dependent care expenses, the child tax credit, and the adoption credit.
File on time – whether you have the money or not
Filing your tax return by April 15 (or August 15 if you file an extension) is important. The drawbacks of not filing include:
- Your tax bill could increase by 25%, due to penalties, or interest charges on balances owed.
- Additional penalties and/or criminal prosecution if you continue to not file (considered tax evasion).
- Losing the refund, if there’s one due (typically after 3 years).
Even if you don’t have the money to pay, file anyway. Programs are available to help you avoid many of the harsher penalties.
Properly managing your taxes can greatly reduce the amount of money you pay in taxes and put more money into your pocket. After all, why pay more if you don’t have to?