Friday, April 26, 2013

Tax Planning for 2013 Begins Now

Just because tax season is over doesn’t mean your tax planning is done.  Whether you owed the IRS money or got money back, tax planning is something you can do all year.  Consider these tax tips:

Did you get money back?

If so, you may have had too much income tax withheld from each paycheck.  Some taxpayers don’t mind getting a tax refund because they treat it as a forced savings account. They look forward to getting their refund each year to pay off credit card debt, take a vacation, or just to get caught up on late bills. Others resent the idea of letting the IRS have free access to their money that they could be getting throughout the year.

If you like the idea of getting an annual tax refund, then perhaps you can leave well enough alone, but if the idea of foregoing a tax refund for a larger paycheck is music to your ears, then consider adjusting your tax withholding. It sounds simple, and it is.  If you prefer more money in your paycheck, increase the number of allowances you claim on your W-4 and have less income tax withheld from each paycheck.

The IRS offers this nifty calculator to help you determine the right number of allowances based on your situation.  If you run the calculator midyear, be sure to run it again at the beginning of next year.  Otherwise, you could end up increasing your allowances too much, which could result in owing the IRS on your 2014 return.

Did you owe?

If so, you may have had too little income tax withheld from each paycheck.  This sometimes happens when there is another source of income, such as rental income, that is not subject to withholding. This can be remedied by decreasing the number of allowances on the W-4, requesting additional tax withholding on the W-4, and by making quarterly estimated tax payments to the IRS.

Here are some other ways to reduce your taxes:

Contribute to a Roth retirement account.

If you can live off of your current paycheck and don’t mind paying taxes today for the benefit of tax-free money in the future, consider funding a Roth IRA or 401(k).  Roth accounts are funded with after-tax money, and if you have a Roth account for at least five years and wait until age 59 ½ or older before you withdraw money, the distributions are tax free.

Contribute to a traditional retirement account.

In contrast to the Roth, contributions to a traditional retirement account may be tax deductible, thus reducing your taxable income and subsequently the amount of tax you owe.  There are no income limits to the traditional 401(k), but the IRS does impose income limits on deductible contributions to a traditional IRA.

Maximize tax deductions, exemptions, and credits.

Deductible expenses and exemptions lower the amount of taxable income and thus reduce a taxpayer’s liability.  Some deductions are taken above the line (as adjustments to income) and some are taken below the line (as reported on the Schedule A).

Credits, unlike deductions and exemptions, do not reduce the amount of taxable income, but they offset your tax liability dollar-for-dollar.  Commonly used credits include the Saver’s credit, the Earned Income credit, energy credits, credits for parents, and credits for education.

Reallocate investments.

Certain investments held in taxable accounts may be working against you, since interest, earnings and dividends are generally taxable.  Consider placing ordinary income investments like corporate bonds, high dividend paying stocks, and REITs in tax-advantaged accounts like IRAs.

Capital assets, such as growth stocks, mutual funds, and real estate, may generate little if any taxable income while held, and are subject to preferential long-term capital gains tax rates when held for longer than a year.  Taxable accounts are also appropriate for municipal bonds, which pay interest that is generally tax free at the federal level, and possibly the state level if you live in the issuing municipality (although municipal bond interest is considered a preference item for purposes of calculating AMT).

Contribute to a 529 college savings program.

Similar to Roth accounts, 529 plans are also funded with after-tax money.  As long as the funds are used for qualified education expenses, distributions are generally tax free.  As an added benefit, some states give residents a state income tax deduction for their contributions to the state’s plan.

A final word about tax planning

Whether you prepared your taxes using tax preparation software or with the help of a tax preparer, you should look over your return (at least the 1040) and make a note of anything on the return that you don’t understand.  Make it a goal to learn more about these specific items.  Chances are, the more familiar you become with what goes on your tax return, the better you can plan to minimize your taxes.