Financial Learning Center
Income tax planning is a fundamental part of financial planning. The less money you pay for income taxes, the more money you have working toward achieving other financial goals. Below is an overview of many of the techniques currently available that can be used to minimize your current and future taxes.
Deferring income means reducing your current taxes by postponing the taxability of income until a future year. One easy way to defer income is by maximizing contributions to company retirement savings plans, such as a 401(k) plan, as well as by using other tax-advantaged savings vehicles, including IRAs, annuities, and cash value life insurance. Some contributions to retirement savings plans can be made on a pre-tax basis where you defer income tax on the monies going into the plan. In this case, your contributions won't be taxed until you make withdrawals in the future. The income you earn on these accounts accumulates tax-deferred, which means the earnings on your money are not taxed until you make a withdrawal. Roth IRAs present the opportunity to receive distributions tax-free.
Maximizing Itemized Deductions
Individuals should itemize deductions if their total itemized deductions exceed the federal standard deduction which has been increased in 2019 from $12,000 to $12,200 for single filers and from $24,000 to $24,400 for married couples filing jointly. Deductions reduce the amount of your income that is subject to tax. The following are categories of itemized deductions:
- Medical and dental expenses: This category should include the amount of unreimbursed medical and dental expenses (including prescriptions) not paid by insurance or reimbursed through a flexible spending account. Medical and dental expenses are deductible to the extent they exceed 10% of your adjusted gross income. You can also include transportation costs when traveling for medical purposes, including mileage at 20 cents per mile in 2019 (18 cents in 2018), tolls, and the cost of public transportation.
- State and local taxes: The amount of state and local income taxes you paid in the current year may be deducted on your federal income tax return up to a limit of $10,000 in 2019 (same as in 2018). This includes amounts withheld, estimated payments made in the current year, and any balance due on your prior year's state income tax return paid in the current year. Other deductible taxes include real estate taxes and certain personal property taxes.
- Interest expense: Deductible interest includes home mortgage interest, investment interest, qualified student loan interest, and trade or business interest. Certain restrictions apply.
- Charitable contributions: You may deduct contributions and gifts to qualified charities. Contributions may be in cash, property, or out-of pocket expenses (including mileage at 14 cents per mile in 2019 same in 2018) for volunteer work for qualified charities. No deduction is allowed for single contributions of $250 or more to any one organization unless you have a written receipt from the organization.
- Miscellaneous deduction expenses: Cost of safe deposit box, etc. are deductible to the extent they exceed 2% of your adjusted gross income.
Casualty and theft losses: Nonbusiness casualty losses not covered by insurance are deductible to the extent they exceed 10% of your adjusted gross income. People can only claim casualty losses if they have been affected by an official national disaster. Business casualty and theft losses are fully deductible with certain limits applied.
Flexible Spending Accounts
Many companies provide employees with a variety of benefits such as medical and dental insurance, life insurance, long-term disability, and other health and welfare benefits. To obtain these benefits, employees usually have to pay some portion of the premiums. Flexible spending accounts allow you to pay for certain eligible benefits, such as health insurance, and pay for certain eligible expenses, such as unreimbursed medical expenses and daycare expenses, with pre-tax dollars. If you pay the premiums on a pre-tax basis, your cost is reduced since the money you pay is not subject to federal income tax or Social Security tax. At the end of the year, any unused balances are forfeited.
Health Savings Accounts
IMPORTANT NOTE: The Health Savings Account (HSA) permits eligible individuals who are not enrolled in Medicare to save for "qualified" medical health expenses on a tax-free basis. Note that over-the-counter (OTC) drugs unless prescribed are not a qualifying expense. These accounts may be offered through employers. However, any insurance company or bank can offer HSAs to eligible individuals as well.
These plans are only available to individuals with high-deductible health plans, i.e., plans with a deductible in 2019 of at least $1,350 (same as in 2018) for individuals and $2,700 (same as in 2018) for families. Contributions are limited to $3,500 in 2019 ($3,450 in 2018) for individuals and $7,000 in 2019 ($6,8900 in 2018) for families, regardless of income, and additional "catch-up" contributions may be available to those age 55 or older. Contributions are tax-deductible, and distributions, when used for a qualified medical expense, are tax-free. If expenses are not qualified, then the distribution may be treated as taxable income, and a penalty may also apply.
However, when used as intended, HSAs can grow tax-free, and unused balances can roll over from year to year. These accounts are also portable, and may be used across different jobs. These are all potential advantages of using the Health Savings Account when compared with the Flexible Spending Account.
There are additional details and restrictions that must be considered. Check with your financial professional or account sponsor regarding your eligibility to use the HSA. For more information, see the section Health Savings Accounts.
Tax credits, unlike deductions, reduce tax liability dollar for dollar by the amount of the available credit. There are various tax credits benefiting many different types of taxpayers, including families with young children, the elderly, the disabled, and those with students attending college. Some examples are shown below. Consult your tax professional to determine which credits may be available to you.
- Child and dependent care credit: A credit is allowed for a portion of qualified child or dependent care expenses that are paid in order for the taxpayer to work. The maximum amount of child care expenses that can be considered is $3,000 for one child or dependent, or $6,000 for two or more. The credit ranges from 20% to 35% of eligible child care expenses. Taxpayers may claim a $500 temporary credit for non-child dependents. This can apply to a number of people adults support, such as children over age 17, elderly parents or adult children with a disability.
- Earned income credit: A credit is available to certain low-income taxpayers who have earned income. The maximum credit in 2019 is up to $529 ($519 in 2018) for a taxpayer with no children and who has earned income less than $15,570, or $21,370 for joint filers ($15,270 for single filers and $20,950 for joint filers in 2018), and $3,526 ($3,461 in 2018) for a taxpayer with one child and earned income less than $41,094 or $46,884 for joint filers ($40,320 for single filers and $46,010 for joint filers in 2018). For a taxpayer with two children and earned income less than $46,703, or $52,493 for joint filers ($45,802 for single filers and $51,492 for joint filers in 2018), the maximum 2019 credit is $5,828 ($5,716 in 2018). For 3 or more children, higher limits apply.
- Saver's Credit: This credit is available to certain taxpayers who contribute to their employer's retirement plans and who have adjusted gross income levels under $64,000 in 2019 ($63,000 in 2018) for joint filing, $48,000 in 2019 ($47,250 in 2018) for head of household, or $32,000 ($31,500 in 2018) for all other filing (i.e. single, married filing separately, and qualifying widow(er)). The maximum credit available is $2,000 (same in 2018). For married couples, the maximum credit available in 2019 is $4,000 (same in 2018). By contributing to a retirement plan and claiming this credit, the taxpayer reduces the amount of tax due to the IRS.
Education Tax Incentives
Two income tax credits, the American Opportunity Credit (AOC) and the Lifetime Learning credit are provided to help defray qualified tuition and fees (not room and board).
The maximum amount of the American Opportunity Credit (AOC) is $2,500 per student. For 2019 the credit is phased out if your modified adjusted gross income (MAGI) is between $80,000 and $90,000 for single filers ($160,000 and $180,000, if you file a joint return). The phase-out is the same as in 2018.
The credit can be claimed for the first four years of post-secondary education.
Generally, 40% of the AOC is now a refundable credit for most taxpayers, which means that you can receive up to $1,000 even if you owe no taxes
The term "qualified tuition and related expenses" includes expenditures for "course materials". For this purpose, the term "course materials" means books, supplies, and equipment needed for a course of study whether or not the materials must be purchased from the educational institution as a condition of enrollment or attendance. The Lifetime Learning credit equals 20% of the first $10,000 of qualified education expense. The Lifetime Learning credit is calculated on a per-family (taxpayer and his or her dependents) rather than a per-student basis, making the maximum 2019 family credit $2,000 (same in 2018). In 2019, to claim the full credit, your modified adjusted gross income (MAGI) must be $67,000 or less or $134,000 or less if you are married and filing jointly. If your MAGI is between $57,000 and $67,000 (between $114,000 and $134,000 for married filing jointly), you receive a reduced amount of the credit. If your MAGI is over $67,000 ($134,000 for joint filers), you cannot claim the credit. These income amounts will be annually adjusted for inflation.
The Lifetime Learning credit is available for any course work at a qualified education institution that improves job skills. Eligible taxpayers may elect to exclude from income amounts withdrawn from an Education Savings Account that are used to pay qualified education expenses for a student. American Opportunity and Lifetime Learning tax credits can be claimed in the same year as Education Savings Account distributions, as long as the ESA distribution is not used to pay for the same costs used to claim the education credit.
In constructing the income-generating portion of your portfolio, investing in tax-exempt vehicles (such as municipal bonds) can be used as a tax-saving strategy. When evaluating investments, you should compare the after-tax yields you are earning. You must look at a taxable investment on an after-tax basis in order to compare it with a tax-exempt obligation. You may also need to factor in state taxes when making your investment decisions.
If you decide to utilize tax-exempt investments, keep the following points in mind:
- Due to lower yields, you generally have to be in one of the higher marginal federal income tax brackets for municipals to make sense.
- Don't invest in tax-exempt municipals within a tax-deferred retirement plan. The money in your retirement account is already tax-advantaged.
- Occasionally, municipal funds declare a capital gain, which will be taxable.
Business Owner Tax Considerations
Self-employed individuals may establish tax-advantaged retirement plans with contributions based on net earnings from self-employment. Tax-advantaged plans include Keogh plans, Simplified Employee Pensions (SEPs), and Savings Incentive Match Plan for Employees—SIMPLE Plans. See your tax professional for information on retirement plans and other tax-savings retirement vehicles.
Self-employed individuals are currently entitled to deduct up to 100% of the amount paid for health insurance coverage for themselves, their spouses, and dependents during the tax year if they choose to itemize deductions. The deduction is limited to the net earnings from the trade or business for which the insurance coverage was established, minus the deduction for one-half of the self-employment tax and any Keogh, SIMPLE, and SEP deductions.
IMPORTANT NOTE: You cannot take a self-employed health insurance deduction for any month or part of a month that you were eligible to participate in an employer-sponsored health plan.
Other tax issues to keep in mind for a self-employed individual include:
- If your net earnings from self-employment exceed $400, you will be liable for self-employment taxes. If you make estimated income tax payments, be sure to consider the self-employment tax.*
- If you have employees, you must obtain a separate federal tax identification number and fulfill employment tax responsibilities.
- A deduction may be available for certain expenses incurred in maintaining a portion of your home as an office. You must meet certain restrictive tests for your home office to qualify for deductions.
*The self-employment tax is a Social Security and Medicare tax. It is similar to the Social Security and Medicare taxes that are withheld from the pay of most wage earners. For 2019, the tax rate is 15.3% (same in 2018) on the first $132,900 ($128,400 in 2018) of combined wages, tips, and net earnings, and 2.9% on earnings above this limit.
Consult your tax professional for tax issues relating to self-employed business owners.
Withholding and Estimated Taxes
Paying too much or too little in taxes during the year can make budgeting difficult. If you received a large tax refund last year, this money could have been invested instead, helping you achieve your financial goals during the year. Project how much tax you expect to owe and be sure to have at least 90% of that amount withheld during the year. Another option is to consider using one of the safe harbor methods of making estimated federal income tax payments. You should consult with a financial professional to determine which tax payment methods are most advantageous to you, and to consider any state requirements that may apply.
IMPORTANT NOTE: Overpayments of tax are basically interest-free loans to the government.
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