The vast majority of income tax filers in the United States, regardless of their age, would prefer to minimize their tax burden. How you can go about maximizing deductions will vary based on your assets, income sources and your annual expenses.
There’s no straightforward, one-size-fits-all approach due to the diversity of financial situations among tax filers. Some Phoenix tax filers can afford large charitable contributions while others might have particularly high medical expenses due to a family illness or injury. Both types of tax filers may want to take advantage of itemized deductions to reduce their taxes, but how they go about it may be different.
Although the approach might vary, there are some high-level factors to keep in mind when you begin looking for ways to maximize tax deductions.
Know Your Tax Bracket
If your income fluctuates from year to year, it’s likely a good idea to keep an eye on your tax bracket and be cognizant of how close you may be to reaching a higher or lower marginal tax rate (the rate you’ll pay on your highest dollars of taxable income). Knowing where your income puts you may allow you to strategically plan your income and deductions to potentially decrease your tax rate for the current year or future years.
Have You Maximized Your Retirement Contributions?
Some workers may benefit from maximizing their contributions to pre-tax retirement savings accounts like 401(k)s or traditional IRAs. Contributions to these types of accounts reduce your taxable income, regardless of whether you end up itemizing deductions.
Although Roth IRAs and 401(k)s are not tax deductible and are funded with after-tax dollars, they do offer tax-free growth of invested funds, as well as the potential for tax-free withdrawals in retirement. Those who meet income eligibility requirements and are taking a long-term view on positioning themselves for a reduced tax burden in retirement may want to investigate these types of investments during their working years.
Consider Maximizing Health Savings Account (HSA) Contributions
While maximizing HSA contributions won’t be the best move for everyone, these tax-deductible accounts are similar to Roth retirement savings accounts in that they offer tax-free growth and tax-free withdrawals for any qualifying medical expenses.
How much you or your family will use HSA funds depends on your health insurance and medical needs. These accounts can be a useful way to minimize your taxable income if you know you’ll need to spend money on healthcare expenses, or you just want to make sure you’re prepared for the unforeseen.
Understanding Itemized Deductions
Itemized deductions allow taxpayers to decrease their taxable income, which can potentially allow them to benefit from a lower tax bracket and marginal tax rate. Itemizing deductions is the alternative to the standard deduction, which is a fixed deduction amount that’s based on filing status. Itemized deductions require detailed tracking of eligible expenses throughout the year.
Although there are many potential itemized deductions, some of the more common include:
- Mortgage interest deduction for interest paid on home mortgages (up to specific limits)
- State and Local Taxes (SALT) deductions up to the combined limit
- Medical and dental expense deductions if the expenses exceed 7.5 percent of your adjusted gross income
- Personal casualty and theft loss deductions if your losses can be attributed to a federally declared disaster
You might not know whether to take the standard deduction or itemize until closer to the end of the year, which is why it’s likely in your best interest to track any potential deductions throughout the year. Doing so may make it easier to decide when you start preparing your tax return. Keep in mind that itemizing requires good recordkeeping and organization, as you may need to substantiate your claims to the IRS.
Leveraging Tax Credits
While tax deductions decrease the amount of income subjected to taxes, tax credits reduce the amount of taxes you owe after they have been calculated. They provide a dollar-for-dollar reduction in tax liability in either a refundable or non-refundable form.
A refundable tax credit means that if what you owe goes into the negative, you can get the difference refunded, while non-refundable credits can only reduce your tax liability to zero.
Have an Effective Plan for Capital Gains
Your preferred capital gains tax strategy may vary depending on your income sources, age and financial situation. Every taxpayer is assigned a short-term and long-term capital gains rate based on their income tax bracket. The short-term rate is the higher rate and is applied to any gains on assets sold less than a year after purchase.
Many taxpayers choose to hold onto investments for at least a year before selling to avoid the higher rate, but how you approach capital gains or investment loss harvesting may vary depending on your circumstances.
Get Guidance on Financial Planning, Investment Management and Retirement Planning in Phoenix
If you’re interested in finding ways to minimize your taxes or position yourself for a reduced tax bill in retirement, the financial advisors at Fullerton Financial Planning may be able to help. We make estate planning and long-term tax planning a key component of our comprehensive retirement planning services and are ready to answer your questions and provide solutions. Call us at (623) 974-0300 to get started.
