Arthur Godfrey once said, “I’m proud to pay taxes in the United States, but I’d be just as proud for half the money.”
Early in our careers we probably learned that taxes often constitute our largest single, annual expense. As recently as two years ago, the average income tax Americans paid was $10,649. However, that doesn’t have to be the case. If we can manage our tax burden while working and even in retirement, the funds we’ll need to cover unexpected medical expenses, pay for tuition, or travel are more likely to be available.
Given the number of taxes that are imposed in the US, it’s difficult to reduce them without doing some careful research.
What is tax planning?
Tax planning begins with understanding your current tax bracket. A simplified look at what determines your bracket is your annual net income. By adding income from your job to income from any investments and subtracting allowable deductions, you’ll get a rough idea of the net amount that is currently subject to tax.
Going forward, one of the keys to managing your liability will be increasing your knowledge of what kind of income counts towards taxable income, what expenses and investments are deductible, and structuring your investments to manage taxes.
Tax accounting: Standard deduction vs. itemized deduction
For the tax year 2022, if you are married and filing jointly, or are a qualified window(er), you get a standard deduction of $25,900, without further itemization. You can take this deduction even if you don’t have expenses that would otherwise justify it.
If you have expenses that exceed the standard deduction available to you, you should itemize your deductions. Often, taxpayers itemize mortgage interest and property taxes. Other commonly itemized expenses are medical and dental expenses, charitable gifts, and casualty and theft losses.
If you are evaluating whether or not to itemize, you need to be aware of limitations on some expenses. For example, there is a limit of $10,000 on deductions for state and local taxes.
The determination of whether to use the standard deduction or itemize can be complicated. If in doubt, consult with a tax professional.
Here are some other tax-savvy strategies that can manage your tax burden if you plan ahead:
- Hold capital assets (like stock, businesses, and real estate) for more than a year.
You will be taxed at the lower long-term capital gains rate (0%-20%) rather than the higher short-term rate (up to 37%).
- Delay the sale of capital assets, if possible, to a year when you and your spouse, filing jointly, are earning less than $80,800 (including your capital gains profits).
Your taxable rate will be reduced to 0%.
- Benefit from the tax rules for sales of your primary residence.
If you have lived in your primary residence for two of the five years before the sale, and are filing jointly, $500,000 of your gain on the sale of your home ($250,000 for single filers) is tax-free.
- Use retirement plans to reduce taxable income.
The money you contribute to a 401(k) plan is not included in your taxable income. In 2022, you could invest up to $20,500 in a 401(k) plan. If you are over 50, the maximum increases to $27,500.
- Invest in a Roth IRA.
Contributions to a Roth IRA are made with after-tax dollars. Qualified withdrawals are not subject to taxation.
- Open a flexible spending account.
In 2022, you can put $2,850 in an employer sponsored flexible savings account. You do not pay taxes on this money. You can spend FSA contributions for certain medical and dental expenses for you, your spouse if you’re married, and your dependents.
- Open a health savings account.
Check to see if you are eligible to open a health savings account. You can find eligibility rules here. If you qualify, you can use funds in this account to pay uncovered medical expenses. Unused funds roll over every year.Contributions to a health savings account are tax deductible. Maximum contribution limits for 2022 are $3,650 for individuals and $7300 for families. There is an annual “catch-up” contribution amount for individuals age 55 or older of $1000.There are many other tax planning strategies available, ranging from the basic ones described above to very sophisticated ones involving charitable planning, estate tax planning, and Roth conversions. Your financial advisor and tax professional are excellent resources to determine which ones are appropriate for you.
Focus on the long-term
If your idea of tax planning is focused only on minimizing the amount of wealth you’ll lose to taxes this year, you could be setting yourself up for increased tax liability later. A longer-range element in effective tax planning that is just as important is the evaluation of investments that can generate tax-free income.
Know more about how tax planning can help secure your future through Allied Integrated Wealth.