Source: Wikimedia Commons.
Every year, Americans have to handle the unpleasant task of preparing their tax returns. As if that weren't bad enough, for many people, the reward for all that hard work is the news that you owe a considerable amount of tax to the government.
Fortunately, there are a number of ways you can handle your finances to reduce your tax bill, and they tend to fall into several broad categories. Knowing what counts as taxable income can make you aware when you earn it and think twice about the consequences of certain things you do. Many expenses you pay can qualify as deductions on your tax return, and there are also many tax credits you can use to reduce your liability. In particular, investors need to keep in mind the tax impact of various transactions and other financial moves, including the tax advantages of certain types of retirement accounts and different tax rates on various types of income.
Below, we'll provide a bit more detail on these broad categories. Then, you'll also see links to more in-depth articles on particular topics related to that category. That way, you can get the specific information you need to cut your tax bill.
What taxable income is and how you can control it
The IRS is happy to tax income from nearly every source, including wages, investment income, business income, and gains on the sale of property you own. Often, trying to reduce taxable income is counterproductive, as you don't want to avoid earning an extra dollar just to avoid paying a portion of it in taxes. What you can control, though, is the timing of taxable income, and by being smart about when you do things to make your income taxable, you can sometimes reduce your overall tax liability.
In addition, some types of income aren't treated as taxable. Provisions like tax-exempt municipal bond interest, foreign income from an overseas job, and tax-free treatment for income from a college savings plan that's used for educational expenses are just a couple examples of how you can produce income that avoids tax. Taking advantage of these provisions can also leave you paying less to Uncle Sam.
Tax deductions and credits
Just about every taxpayer is entitled to some tax breaks, and most people have a lot of different deductions and credits to choose from.
It's important to understand the difference between deductions and credits. A deduction reduces your taxable income, which in turn cuts your eventual tax bill by an amount that depends on the tax rate that you have to pay. By contrast, a credit reduces your actual bill directly, and so a tax credit of $1 is always worth more than a $1 deduction.
The most popular deduction is the standard deduction, which most people can choose in lieu of itemizing specific deductions. For those who itemize, money you spend on mortgage interest, state and local taxes, charitable donations, and medical expenses can often reduce your taxable income.
Among credits, the most popular provisions include the Earned Income Credit for low- and middle-income workers, educational credits for college expenses, and credits for children and the child care expenses families have to pay.
Even though these are the most common tax breaks, an exhaustive list would be too long to put here. By doing some digging, you can often unearth deductions and credits that can produce big tax savings from things you're already doing anyway.
Investing and taxes
Investing involves a number of big tax issues, but a couple of things stand out as being particularly important. First, the type of income you earn can get taxed at different rates. Second, using special types of investment accounts for certain purposes can give you tax advantages.
Most income gets taxed at ordinary rates according to your overall bracket. The major exceptions are certain dividends and long-term capital gains, which get taxed at preferential rates and for some taxpayers go untaxed entirely. In addition, as mentioned above, municipal bonds pay income that's free from federal tax.
Also, the tax laws include provisions that give tax breaks for certain types of saving. IRAs and 401(k) plans offer tax breaks for retirement saving, while 529 plans let you save for college tax-free if you qualify. Knowing these provisions can save you a bundle at tax time.
Taxes can be a hassle, but they don't have to be overwhelming. With the resources you'll find here, you can get a handle on your taxes and figure out how to pay as little in tax as possible both now and in the years to come.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors based in the Foolsaurus. Pop on over there to learn more about our Wiki and how you can be involved in helping the world invest, better! If you see any issues with this page, please email us at [email protected]. Thanks -- and Fool on!
