Individuals and families may feel helpless when it comes time to pay taxes. The tax code is difficult to understand. However, there are steps consumers can take to lower their tax liability in the coming tax year and in subsequent years.
1. Plan for the future. The government offers several tax-sheltered investments to enable individuals to save for the future and defer paying taxes. These include 401(k) plans through work, IRAs for individuals and simplified employee pension plans (SEPs) for self-employed individuals.
If possible, make contributions to these approved tax shelters throughout the tax year. This lessens tax liability in the contribution year, and it’s easier to make many small payments than it is to make a single large payment at year’s end.
Also, older wage earners are allowed to make larger, “catch-up” contributions to these sheltered investment vehicles. Do your best to make the maximum contribution each year to prepare for a brighter future.
According to Fraser Inouye, a CPA with the Udall CPA Group in Henderson, “There are many different types of pension plans available. Working with knowledgeable advisors when choosing the type of pension plan to implement is extremely important to make sure goals and objectives are being met.”
2. Plan for your child’s education. State 529 tax plans enable you to set aside money, after taxes are paid, to save for approved educational expenses for children, including tuition, books and equipment, room and board, and other expenses associated with higher education.
CPA Bradley Wallace, from Wallace Neumann and Verville, LLC in Las Vegas, states, “There is no tax deduction for putting money into these (529) plans, but they provide tax-free growth if the money in the account is used for higher education.”
So, even if your three-year-old child is toddling around the house, it’s never too early to start a 529 plan to defray education costs and to lower tax liability in the coming years. Wallace offers a suggestion. “The limit on contributions to 529 tax plans is the annual gifting exclusion of $13,000. You have the option of super-funding your plan by using up to five years of the annual gift exclusion, but be prepared to file a gift tax return with the IRS.”
3. Send your child to day camp. Summer months often require parents to arrange day care for children during summer break from school. The cost of day camp may count toward a dependent care tax credit that lowers tax liability. There are rules and regulations associated with this tax credit. Your child must be 13 years old or younger. Overnight camps are not eligible for the tax credit.
Tax credits per child are limited to $3,000. The rate of tax credit ranges from 20% to 35% of expenses depending on your declared income. Discuss this tax break with your tax preparer to make maximum use of this tax credit.
4. Charitable deductions are tax deductible, assuming the recipient is registered as a non-profit agency and is allowed to accept tax-deductible contributions. Not all organizations qualify for this deduction, so ask before contributing to a good cause. Wallace also recommends that you “…be sure to get a written receipt from the charity to support the deduction before you file your tax return.”
5. Dependent exemptions lower your tax liability. Dependents include parents and other relatives who rely on you for living expenses including food, clothing and shelter. Dependents must receive documented support, be American citizens, have little or no income of their own, and must have an approved relationship with the tax payer.
Students, under the age of 24, and attending college or a vocational-technical school, may also qualify as dependents. The “relationship” test, which is somewhat vague according to IRS Tax Code section 151, must be followed to certify a dependent who qualifies under the relationship test to avoid problems with the IRS.
6. Invest in America. Purchase U.S. Savings Bonds to defer tax liability into the future. Interest earned on Savings Bonds is tax deferred until the bonds are cashed in. Savings bonds are available in a range of denominations and length of time the earnings are deferred. The longer the term of the bond, the longer taxes are deferred.
7. Give a gift. Are your children in the market for a home? A new car? The IRS allows tax-free gifts of up to $13,000 annually that can be deducted from your total earnings.
According to Inouye, “With the estate tax exemption scheduled to drop to $1 million beginning in 2013, gifting can be a valuable tool to transfer wealth out of a taxpayer’s estate. Gifts of $13,000 per year (for 2012) can be made under the annual gift tax exclusion. A husband and wife can each take advantage of the $13,000 exclusion. Taxpayers should consult their advisors to identify estate planning opportunities that exist before the end of 2012.
8. Go green. Certain improvements to your home, like solar and wind generation power sources, may deliver tax credits while increasing the value of your home. High-efficiency water heaters and boilers, thermal pane windows and other improvements can not only save on energy costs, they may also save on your tax bill, in some cases, over the course of several years.
9. Buy Munis. The earnings on municipal bonds are often tax-free at both the federal and state levels. While munis don’t pay as much as corporate or other bonds, they can be an excellent means of lowering tax liability and investing in your own community.
10. Consider the tax implications of your investments. Some investments pay dividends and capital gains annually. Others grow in share price to increase the size of your nest egg. Investments that don’t pay annual dividends and interest continue to grow tax-free until these investments are sold. A good example of a low-yield investment is an index mutual fund that tracks popular indices like the Fortune 500. These investments are designed to track market behavior, not to generate income for living expenses. Thus, your net worth increases tax-free until you sell shares of the index fund, at which point capital gains taxes must be paid.
“This strategy is particularly valuable in an environment of higher taxes on dividend income,” according to Wallace.
11. Don’t “buy the dividend.” Many mutual funds and bond funds make quarterly payments, with an annual payment made in the month of December. If you invest in a bond or mutual fund at the end of the year, you receive interest and earnings on the shares you own. You also incur a tax liability for those earnings, despite the fact that you didn’t enjoy wealth appreciation for the full tax year. This is sometimes called “buying the dividend.” You purchase the stock or bond just before the pay date (the date share ownership is determined) and are now faced with an additional tax liability without enjoying the benefit of a full year of growth.
Take advantage of all allowable deductions and seek the advice of a knowledgeable tax advisor to keep more earnings and lower your tax liability in the years ahead. To discover tax strategies that work for you, talk to a tax expert to get the advice and counsel you need to keep more of what you earn.
The information provided is presented for general informational purposes only and does not constitute tax, legal or business advice. Contact a professional for more information or advice.
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