an Effective Income Tax Strategy
Taking steps now can
help keep your 2015 and future tax liabilities as low as possible. Most
income tax planning centers on a few basic concepts:
- Delaying taxation
- Taking advantage
of tax favored treatments on some types of income.
- Taking maximum
advantage of the marginal rate structure of the tax code.
- Getting the most
from your itemized deductions.
- Being aware of
Why delay taxation?
The answer is simple - the time value of money and tax-deferred compounding.
If you can control when you take an item of income, delaying the recognition
until after year-end will delay paying the tax until April 15th of the
The most common instance
where this applies is deciding to take a capital gain on a stock in December
or January. Delaying until January can let you earn interest on the amount
you will pay in tax for an additional 11 or 12 months. IRAs and qualified
retirement plans are other tools that let you defer taxation and earn
extra money on what you would have otherwise paid in taxes until you withdraw
Tax favored treatment
Wages, interest and most other types of income are taxed at normal rates.
However, the tax law has special provisions for long-term capital gains
and interest on bonds issued by state and local municipalities.
For taxpayers in the
10% and 15% brackets, qualifying dividends and long term capital gains
(assets held for more than a year) will be taxed at 0%. For those in 25%,
28%, 33% and 35% tax brackets, the tax rate on dividends and long term
capital gains is 15%. For those in the top 39.6% bracket, the tax rate
Stocks have other
risks and you should not let the hope of saving some taxes unduly influence
any decisions to sell stocks. Be sure to review your portfolio carefully,
especially at year-end, to understand how your positions stand relative
to the one-year holding period. Net capital losses for a year can only
be used up to $3000. Net losses in excess of $3000 can be carried forward
to offset gains in future years.
Interest on bonds
issued by municipalities and states are generally exempt from federal
income tax. These bonds usually pay lower interest rates than comparable
taxable bonds. To determine if tax-free bonds make sense for you, compare
the after-tax returns of the two types. The higher your income (and marginal
tax bracket), the more likely you may find tax-free bonds to be to your
tax rate structure
Our income tax laws are built around a marginal rate structure. This means
that income at lower levels is taxed at lower rates and income at higher
levels is taxed more heavily. The current rates start at 10% and rise
If your income varies
greatly from year to year, consider steps that even it out so you get
the maximum benefit of the lower rates each year. Individuals that control
portions of their income like bonuses and commissions are the ones most
likely to be able to apply this.
The other way to deal
with marginal rates is to take full advantage of lower rates for each
member of your family. It used to be common for parents to give money
to children so the earnings would be taxed at the child's lower rates.
However, the rules were changed and now this is most practical after the
child has turned 14. Children under age 14 get a small "exemption,"
but have most of their unearned income (dividends, interest and other
investment income) taxed at their parents' highest rates.
You are able to reduce your taxable income for certain types of expenses.
These itemized deductions are mostly for state and local taxes (income
and property), mortgage interest, charitable contributions and certain
expenses if they exceed a percentage of your adjusted gross income. Medical
expenses can also be deductible if they are large relative to your income.
If your itemized deductions are not large, the tax tables have a standard
deduction built into them.
To get the most benefit
for your deductions, consider the timing of when you pay them. For example,
you may want to make your last quarterly estimated state income tax payment
in December rather than January (if your state has a January due date)
or carefully choose when you make charitable contributions.
Avoiding the pitfalls
The income tax laws can be very complex. If your income is high or you
have a "complicated" tax situation, getting professional help
may save you money and reduce the stress and anxiety of dealing with your
taxes. Another factor for some is the alternative minimum tax (AMT). This
additional tax was instituted many years ago to make sure that high-income
individuals did not take unfair advantage of the tax laws to avoid or
reduce their taxes. If your income is high, you have relatively large
amounts of itemized deductions or you have stock options, you should probably
consult with a qualified tax advisor to at least understand the AMT may
apply to you.
No one likes to pay more tax than is absolutely necessary and there are
completely legal ways to manage your taxes to some extent. However, cheating
on your taxes or letting the idea of saving taxes cause you to make unwise
financial decisions should not be parts of your strategy.