Tax Planning for Income
Here are a few ideas to consider if you are looking for additional ways to lower your tax bill.
Postpone your income to lower this year's tax bill
If you expect to be in a lower tax bracket next year, then postponing when you earn income when possible can lower the overall taxation of that income. Here's how it works.
Postponement of income is the idea behind some retirement plans. For example, with a pre-tax 401(k) or traditional IRA, you contribute part of your salary into the plan rather than receive it, then pay income taxes on that money when you withdraw in the future. The thought is that you may be in a lower tax bracket than when you earned the money, and therefore lower your lifetime taxes.
In the meantime, as your investments grow, you benefit from deferring the taxes on that as well. (Remember that withdrawals before age 59½ may be subject to a 10 percent penalty and may be taxed as ordinary income in the year you make the withdrawal).
Besides saving into a retirement plan, there are many other ways to postpone your taxable income such as buying permanent life insurance (because the cash value part grows tax deferred), or investing in certain savings bonds. If you are looking for other creative ways to postpone income, it's a good idea to talk to a CPA as well.
Shift income to family members
This idea does mean you have to give some of your income away, but if you're ok with that, here’s an example of how it works: Let's say you own stock that that pays a high dividend and you are in a high tax bracket. One way to lower the taxes you pay on the dividends is to give the stock to your children, who are in a lower bracket, and have them pay taxes on that income.
One caveat to keep in mind though is kiddie tax: If the dividend income is significant, this approach could trigger the kiddie tax, which applies to a child’s unearned income over a certain amount and basically applies the parents' tax rate to the child's investment income. Also, be sure to check the laws of your state before giving securities to minors. You CPA can help you determine if this method would work according to your circumstances.
Other ways of shifting income include hiring a family member for the family business and creating a family limited partnership. Investigate all of your options before making a decision.
Time your deductions
One of the biggest changes to the tax law in 2018 was doubling the standard deduction, while also limiting the amount that itemizers can deduct for state and local taxes paid – many people who used to itemize no longer see the value as the standard deduction exceeds their itemized deductions.
If you're on the cusp, then it might make sense to consider "lumping" your deductions into one year, so that one year you'll have more than enough to itemize, while the following year you take the standard deduction.
If your income fluctuates, then it makes the most sense to take more deductions (and therefore itemize) during the higher earning year, while postponing deductions during the year you'll have lower income.
With investment tax planning, use timing strategies and focus on your after-tax return
Investment tax planning seeks to lower your overall income tax burden through wise investment choices. Strategies include investing in tax-exempt securities and timing the sale of capital assets properly.
While most forms of income are taxable, some investments can generate tax-exempt income. For example, the interest on certain Series EE bonds used for education may be exempt from federal, state, and local income taxes (tax-exempt status applies to income generated from the bond; a capital gain or loss realized on the sale of a municipal bond is treated like any other bond for tax purposes).
You can also exclude the interest you earn on municipal bonds from your federal income, although some municipal bond income may be subject to the federal alternative minimum tax. With tax-exempt bonds issued in your home state, the interest will generally be exempt from state and local tax as well. When comparing taxable and tax-exempt investments, include the benefit of maximizing your after-tax return in your consideration.
Focus year-end planning on your marginal income tax bracket
Year-end tax planning in November or December involves timing your income so that it will be taxed at a lower rate and claiming deductible expenses in years when you are in a higher income tax bracket. This usually means postponing income to a later year and accelerating deductions into the current year. For example, assume it's December and you're entitled to a year-end bonus, but you're in a higher tax bracket this year than you expect to be in next year.
The solution? Ask your employer to pay the bonus in January of next year rather than now so you can postpone the taxable income.
In another situation, say you’re in a high tax bracket this year and are scheduled for major dental work in January. See if you can move the surgery up into this year so you can take the medical expense deduction now (assuming it will exceed 10% of your Adjusted Gross Income). In both cases, the opposite would be true, of course, if you expect to be in a higher tax bracket next year. Long-term capital gains may also be worth accelerating or postponing, depending on your overall tax situation.