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The goal of tax planning is to arrange your financial affairs so as to minimize your taxes. There are three basic ways to reduce your taxes, and each basic method might have several variations. You can reduce your taxable income, increase your deductions, and take advantage of tax credits.

 

Reducing Taxable Income

Adjusted Gross Income (AGI) is a key element in determining your taxes. Lots of other things depend on your AGI (or modifications to your AGI)-- such as your tax rate and various tax credits. AGI even impacts your financial life outside of taxes: banks, mortgage lenders, and college financial aid programs all routinely ask for your adjusted gross income. This is a key measure of your finances.

 

Itemized deductions include expenses for health care, state and local taxes, personal property taxes (such as car registration fees), mortgage interest, gifts to charity, job-related expenses, tax preparation fees, and investment-related expenses. One key tax planning strategy is to keep track of your itemized expenses throughout the year using a spreadsheet or personal finance program. You can then quickly compare your itemized expenses with your standard deduction. You should always take the higher of your standard deduction or your itemized deduction.

 

 

Take Advantage of Tax Credits

Once we've tweaked our taxable income, we are ready to focus our attention on various tax credits. Tax credits reduce your tax. There are tax credits for college expenses, for saving for retirement, and for adopting children.

 

The best tax credits are for adoption and college expenses. Not everyone is in a position to adopt a child, but everyone could take some college classes. There are two education-related tax credits. The Hope Credit is for students in their first two years of college. The Lifetime Learning Credit is for anyone taking college classes. The classes do not have to be related to your career.


You may also want to avoid additional taxes. If at all possible, avoid early withdrawals from an IRA or 401(k) retirement plan. The amount you withdraw will become part of your taxable income, and on top of that there will be additional taxes to pay on the early withdrawal.

 

One of the best, and most abused, tax credit is the Earned Income Credit (EIC). Unlike other tax credits, the EIC is credited to your account as a payment. And that means the EIC often results in a tax refund even if the total tax has been reduced to zero. You may be eligible to claim the earned income credit if you earn less than a certain amount.

  

Increase Your Withholding

You can avoid owing at the end of the year by increasing your withholding. More money will be taken out of your paycheck throughout the year, but you will get bigger refund when you file your taxes.

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