Time to Think About Taxes, Again!

Yes, I know we're just past last year's tax season, but good tax planning works only if we start early enough for the current year. Having last year's tax return still fresh in memory gives us a great start for next year's tax planning.

Understand how your income is being taxed
Do you know what your effective tax rate is? Do you have more than one income source? Do you know how each of your income sources is taxed? Income can be broadly classified as:

  • Ordinary — Income from a regular job, self-employment and freelancing; interest income and non-qualified dividends.
  • Capital — Qualified dividends, income from the sale of an asset (stock, real estate, etc.)
  • Passive — Income from sources like real estate and business investments where participation is not required.

Each of these types of income is taxed at a different rate. A tax-savvy individual minimizes the income from the highest taxed source and moves his earnings toward the lowest taxed source. Before you dismiss this advice thinking you can't quit your job, think of other ways you can achieve the goal.

  • If you have a large amount of money sitting in a savings account that you won't require for at least 5 years, can you move it to dividend-paying stocks?
  • If you paid the higher rate for selling a stock too soon, can you plan better on when you buy and sell stocks to pay the capital gains rate instead of the ordinary rate?
  • If you don't have more than one source of income, especially if your job is your only source of income, consider diversifying by earning income on the side.

Are you leaving any money on the table?
For each deduction you took this year, is there a better way to save money?

For example, if you had dependents and paid for child care, have you looked at your employer's benefits to see if they offer a dependent care account? A lot of employers also offer discounts toward a variety of businesses. One of my past employers offered a discount and extended hours at a nearby day care, but no one knew about it because it was only mentioned in an online benefits brochure which didn't get many views.

Did you contribute at least enough to your retirement plan to get the employer match?

Can you optimize your deductions?
Did you itemize or take the standard deduction? What is the difference in your return when choosing between itemized and standard deduction? If you donated to charity and the difference between your standard and itemized deductions was small, you might want to consider donating every other year. Here is an example to explain this better:

Let's say you donated $12,000 to charity in 2012 and again in 2013. Let's additionally assume that both years you opted to take itemized deductions. The total deduction for 2012 and 2013 is $24,000.

Now, instead, let's assume you set aside $1,000 each month in 2012 and donated the entire $24,000 in 2013. You take the standard deduction for 2012 ($11,900 if you are married and filing jointly) and itemized deduction for 2013 ($24,000). This makes the total deductions for 2012 and 2013 a whopping $35,900. You can deduct an extra $11,900, which, depending on your tax bracket, can be a substantial saving.

Of course, this is an over-simplified illustration; there are other deductions like state taxes and property taxes to consider. These cannot be skipped every other year, but it is definitely worth doing the calculations both ways to determine which is more beneficial.

Are you placing your investments in a tax-smart vehicle?
Taxes should not be the only concern for any investment; you should evaluate your risk tolerance and do careful asset allocation. After you have made your investment decision, it is essential to choose the right vehicle to make it tax efficient. Should you invest in a taxable account or a tax-sheltered account? For example, if you are going to hold a stock for a very long time, it can be in a taxable account as it will be taxed as capital gains; but if you are going to be generating a lot of short-term gains, it might be better to place it in a tax-sheltered account.

Have a strategy in place
After going over your tax return with the goal of planning for next year, is there anything you can do now to make next year's return more efficient and less time-consuming? Think of all the potential expenses this year and figure out if any of them are deductible. For example, if you are planning to send your kids to summer camp, it might be a deductible expense. Knowing what you are going to deduct this year will make it easier to save the receipts and will also make sure you won't miss it due to last-minute lapses in memory.

Set up a system for next year's deductions
Receipts, receipts and more receipts. Anything that can be deducted, file it. Set up a system that works for you whether it's a folder for each month or a folder for each category or alternatively scanning the receipt and recording it in Excel. Pick a system and work on it throughout the year.

Get help
I wanted to have an accountant prepare my taxes for 2013; but I procrastinated and, by the time I contacted potential accountants, they were all too busy to take new clients. This year, I am looking for an accountant right now. Finding the right person can also be a time-consuming process. I want to get referrals, talk to the accountant, and develop a relationship. Doing it now, when the accountant is not drowning in client files, will help me find the best accountant for my situation.

What is your tax-planning strategy?

This article Time to Think About Taxes, Again! originally appeared on Fivecentnickel.com.

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