Time to Think About Taxes, Again!

Starting early can mean larger returns.

May 4, 2014 at 2:00PM

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.

Take advantage of this little-known tax "loophole"
Recent tax increases have affected nearly every American taxpayer. But with the right planning, you can take steps to take control of your taxes and potentially even lower your tax bill. In our brand-new special report "The IRS Is Daring You to Make This Investment Now!," you'll learn about the simple strategy to take advantage of a little-known IRS rule. Don't miss out on advice that could help you cut taxes for decades to come. Click here to learn more.

You may also enjoy these financial articles:

How your life is changing in a Heartbleed

Parents' attitudes toward money and kids

Worst-case-scenario playbook

Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

1 Key Step to Get Rich

Our mission at The Motley Fool is to help the world invest better. Whether that’s helping people overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we can help.

Feb 1, 2016 at 4:54PM

To be perfectly clear, this is not a get-rich action that my Foolish colleagues and I came up with. But we wouldn't argue with the approach.

A 2015 Business Insider article titled, "11 websites to bookmark if you want to get rich" rated The Motley Fool as the #1 place online to get smarter about investing.

"The Motley Fool aims to build a strong investment community, which it does by providing a variety of resources: the website, books, a newspaper column, a radio [show], and [newsletters]," wrote (the clearly insightful and talented) money reporter Kathleen Elkins. "This site has something for every type of investor, from basic lessons for beginners to investing commentary on mutual funds, stock sectors, and value for the more advanced."

Our mission at The Motley Fool is to help the world invest better, so it's nice to receive that kind of recognition. It lets us know we're doing our job.

Whether that's helping the entirely uninitiated overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we want to provide our readers with a boost to the next step on their journey to financial independence.

Articles and beyond

As Business Insider wrote, there are a number of resources available from the Fool for investors of all levels and styles.

In addition to the dozens of free articles we publish every day on our website, I want to highlight two must-see spots in your tour of fool.com.

For the beginning investor

Investing can seem like a Big Deal to those who have yet to buy their first stock. Many investment professionals try to infuse the conversation with jargon in order to deter individual investors from tackling it on their own (and to justify their often sky-high fees).

But the individual investor can beat the market. The real secret to investing is that it doesn't take tons of money, endless hours, or super-secret formulas that only experts possess.

That's why we created a best-selling guide that walks investors-to-be through everything they need to know to get started. And because we're so dedicated to our mission, we've made that available for free.

If you're just starting out (or want to help out someone who is), go to www.fool.com/beginners, drop in your email address, and you'll be able to instantly access the quick-read guide ... for free.

For the listener

Whether it's on the stationary exercise bike or during my daily commute, I spend a lot of time going nowhere. But I've found a way to make that time benefit me.

The Motley Fool offers five podcasts that I refer to as "binge-worthy financial information."

Motley Fool Money features a team of our analysts discussing the week's top business and investing stories, interviews, and an inside look at the stocks on our radar. It's also featured on several dozen radio stations across the country.

The hosts of Motley Fool Answers challenge the conventional wisdom on life's biggest financial issues to reveal what you really need to know to make smart money moves.

David Gardner, co-founder of The Motley Fool, is among the most respected and trusted sources on investing. And he's the host of Rule Breaker Investing, in which he shares his insights into today's most innovative and disruptive companies ... and how to profit from them.

Market Foolery is our daily look at stocks in the news, as well as the top business and investing stories.

And Industry Focus offers a deeper dive into a specific industry and the stories making headlines. Healthcare, technology, energy, consumer goods, and other industries take turns in the spotlight.

They're all informative, entertaining, and eminently listenable ... and I don't say that simply because the hosts all sit within a Nerf-gun shot of my desk. Rule Breaker Investing and Answers contain timeless advice, so you might want to go back to the beginning with those. The other three take their cues from the market, so you'll want to listen to the most recent first. All are available at www.fool.com/podcasts.

But wait, there's more

The book and the podcasts – both free ... both awesome – also come with an ongoing benefit. If you download the book, or if you enter your email address in the magical box at the podcasts page, you'll get ongoing market coverage sent straight to your inbox.

Investor Insights is valuable and enjoyable coverage of everything from macroeconomic events to investing strategies to our analyst's travels around the world to find the next big thing. Also free.

Get the book. Listen to a podcast. Sign up for Investor Insights. I'm not saying that any of those things will make you rich ... but Business Insider seems to think so.


Compare Brokers