With tax season having come to a close, I wanted to give you a glimpse into tax insights for next year. As a client, we just prepared your taxes. But here at FPFoCo, tax season is year-round for me! With us taking the heavy lifting off of your plate, you might be wondering what goes into tax planning ahead of next year’s tax preparation season. If you’re wondering how the sausage is made, I’ll make the whole process a little less mysterious and easier for you to wrap your head around. 

Let’s start with the basics. The federal income tax serves two purposes:

1. Raise revenue for the United States Treasury.
2. Shape and encourage certain taxpayer behaviors.

That first purpose is pretty self-explanatory. So let’s take a closer look at tax deductions and credits to add perspective on what that second purpose means for you and how tax planning plays a role.

What is tax planning and why is it important?

The majority of U.S. citizens can’t escape taxes — and haven’t been able to historically. After all, Benjamin Franklin once said, “In this world nothing can be said to be certain, except death and taxes.” That makes it especially important to plan. But what does tax planning do, exactly? It’s all about reducing or even eliminating taxes.

Basic tax planning begins with the goal of getting to either side of $1,000 on your federal tax return. That means a balance due of less than $1,000 or a refund of less than $1.000. A refund sure can be nice. But by overpaying income taxes throughout the year, you’re giving Uncle Sam an interest-free loan that the IRS repays to you via a tax refund. On the flipside, tax planning can help you avoid the shock of a large bill by ensuring you’re paying enough throughout the year. The latter can also help you avoid penalties for underpayment.

It’s all about striking the right balance. Overall, a little tax planning strategy can help you keep more money from each of your paychecks in your pocket — and your high-yield savings account. It can also give you a better idea of your financial picture and enhance your ability to plan for your financial future.

Tax code incentives and how to reduce your taxable income

Part of planning that future is understanding what actions the tax system rewards via tax incentives. Don’t worry, I’ll get to the actual planning shortly.

• Incentives exist for saving and investing, generally for the long term.
• Numerous deductions and preferences for adding money to accounts like 401(k)s or IRAs encourages saving for retirement.
• The same is true for saving for health care expenses and using a health savings account (HSA).
• You can gain tax-free interest on municipal bonds to invest in your local community. The interest from these bonds is typically exempt from federal, state, and local taxes.
• The U.S. government continues to encourage investing capital for the long term through lower tax rates on dividends and the gains realized when selling capital investments for cash.

A tax credit — a dollar-for-dollar offset of tax due — provides even more incentive to do what you may not otherwise. Think about credits for …

• Installing solar panels or devices for other renewable energy production.
• Buying a plug-in electric vehicle.
• Raising members of society who’ll make future taxable income for the government: The child tax credit provides a credit of up to $2,000 per child under age 17.

Tax credits and other incentives can vary based on income and often change year to year, which makes tax planning all the more crucial.

Tax planning tips for the upcoming tax year

With that in mind, there’s no better time to do a little tax planning than the present. With the previous tax year fresh in your mind — or at least relatively fresh if you were an early bird — you’ll be well-positioned to make meaningful changes. Plus, you’ve got a nice runway ahead of you with eight and a half months left in this tax year.

When it comes to tax planning for the near future, the overarching theme is to analyze what you think will happen by starting with what you already know. There’s no sense in reinventing the wheel, so always use your prior year return to give you a head start, and add or subtract what is likely to change. The best place to begin is by considering any changes to your tax situation this year as changes can not only shift your tax responsibility but also your filing status. 

• Have you had a significant change in income this year? Whether it was a big bonus, equity compensation event, large raise, or even transition into retirement, you may be looking at a much larger or smaller taxable income.
• Has your family situation changed? Marriage, divorce, birth or adoption, and reaching a certain age can all impact available standard deductions. 
• Of course, if you itemize — or you think you will itemize — deductions, make adjustments to and considerations for those amounts accordingly.
• After considering deductions, look into possible adjustments to your income, like those for student loan interest paid and for your HSA as well as traditional IRA and 401(k) contributions.
• Then take credits into account, like the child tax credit for those with dependents age 16 and younger, earned income credit for individuals in lower tax brackets, education credits if you’re taking classes or attending university, as well as child and dependent care credits for kids. If you’ve made updates to your home or vehicle in the last year, you may also consider green energy credits. And, due to tax law changes, you may want to review any new credits available for this tax year.
• Have you sold or will you be selling assets at gain — or a loss — this year? If you’re thinking of selling off stocks that aren’t performing as well as you’d hoped or want to sell at a gain, consider and plan how to strategically use these capital gains or losses — or offset them against one another. Expecting more losses than gains? You can offset up to $3,000 in ordinary income with capital losses. If your losses add up to more than $3,000, you can carry them forward into future tax years.
• Take advantage of employer-sponsored benefits paid with pretax dollars (remember my love for HSAs?). When you pay with pretax dollars, you can get more bang for your buck while reducing your tax liability. If you’re wondering about the order in which you may want to fund these accounts, you can refer to my contribution infographic.
• Take a look at your most recent “normal” pay stub. Review your income as well as the tax you’ve paid already. Extrapolate it out through the rest of the year, then adjust withholding as necessary so you can land on either side of the $1,000 mark come tax time.
• For workers who joined team self-employed this year, making quarterly estimated tax payments may be necessary. The same is true for those who have income other than their salaries, whether it’s from passive business ownership, dividends, interest, or gains from selling stocks or bonds. Paying these quarterly estimated taxes on time can help avoid penalties.
• Last but certainly not least, in general, avoid taking money from your retirement accounts before age 59½ to stay away from the 10% early withdrawal penalty tax as well as the taxable addition to income such a withdrawal can create.

If any of these circumstances apply to you, send us your most recent pay stub or income statement along with notes on significant changes in other areas. We’ll review them and let you know if your tax withholding is on track as-is or follow up with an updated W-4. We’ll also let you know if we recommend you schedule a tax planning consultation.

Tax planning strategies for the future

When we’re building or refreshing your financial plan or working on tax planning recommendations for you, we’re not just looking at the current year. We’re considering your taxes over your lifetime and the tax optimization strategies that will work best long-term. 

Compared to your shorter-term tax planning, the big theme with longer-term planning is understanding how your income changes as you age. Consider the average career arc. Most adults go from income acceleration in their 20s, 30s, and 40s to a peak earning period in their 50s. As folks retire, they tend to move to a pretty significant drop in their 60s and beyond when income begins to match expenses.

• You may consider timing your larger purchases and donations for the ability to lump itemized deductions, like charitable contributions, into the same tax year for a greater benefit. This is especially important when considering the relatively large standard deductions in effect today.
• Remember your capital loss carryforwards and understand when and where you can leverage those amounts for a greater benefit.
• Deferring taxes until retirement via qualified retirement plans on an ongoing basis can not only reduce your taxable income in the short term but also set you up for success in retirement.
• Life insurance and/or annuities can also help you defer a portion of your income and reduce what you’ll owe in taxes. The added benefits: Providing for your loved ones when you pass away or cashing your policy out during retirement when you’re in a lower tax bracket. The drawbacks: They’re not for everyone and are generally relatively expensive.
• Asset ownership usually comes with its tax perks. For example, buying a home as opposed to renting means you could deduct your mortgage interest and property taxes from your taxable income. Plus, if you meet certain qualifications, you can sell your home with no or little taxable capital gain.
• For those on the verge of moving into a higher marginal tax bracket over the coming years, especially those entering their peak earning periods, reducing taxable income via deductions and adjustments can also reduce tax liability. Deferring income is another way to manage your marginal tax rate.

Tax planning impact

Ready to put the work in throughout the tax year in preparation for that next April 15 deadline? By approximating your amount due or your refund — especially early in the year — you can also keep your finances in check. In turn, you’ll likely be better able to plan for your other expenses — and your goals. The bottom line? You have more control over your cash — plus you’re able to save money and may even be able to legally hand less over to the IRS. 

To quote Ben again, “an ounce of prevention is worth a pound of cure.” 

Happy tax planning!