More than 160 million individuals file tax returns every year in the US. However, many of these people do not know they can further reduce their tax burden with effective tax planning and the right strategies. While avoiding taxes is illegal, some legal and permitted ways exist to minimize the tax without violating any law.
However, it is pertinent to mention that tax planning is not easy and requires significant research and understanding of the tax brackets, laws, and investment instruments that can save you taxes. Therefore, hiring an accountant in Allentown, Pennsylvania, is advisable to ensure that you are not missing any potential tax benefits.
Different types of tax planning
Tax planning can be categorized into different types based on various criteria. Some of the most common ones are as follows.
- Long-term tax planning: When you take actions to reduce the tax burden over a long period, that is, seven years or more, it is called long-term tax planning. A long-term tax plan includes strategies like estate planning, investment planning, and retirement planning.
- Short-term tax planning: When an individual takes measures to reduce the tax burden for the current assessment year, it is called short-term tax planning. Short-term tax planning involves reducing tax burden by accelerating deductions, deferring income, etc.
- Permissive tax planning: The IRS offers various breaks and incentives to taxpayers, which can reduce a filer’s tax liability. Tax deductions and credits are the best examples of such rebates. Considerating such options while planning for taxes is called permissive tax planning.
- Marginal tax planning: This involves analyzing the impact of additional deductions and income on the marginal tax rate to identify the optimal deductions or income to minimize taxes.
- Purposive tax planning: It involves arranging financial investments or transactions in a way that tends to reduce your tax liability is purposive tax planning. It involves manipulative tax loopholes and shelters to reduce tax liability in a legal way.
Top strategies for income tax optimization
Various investments and expenses can effectively reduce the tax you owe to the IRS. However, the following are some of the most widely used strategies to reduce the tax burden.
- Retirement account contributions: Individuals can contribute up to $23,000 to an employer-sponsored retirement plan like a 401(k) and an extra $7,500 if they are over 50. The contributions to such a plan are tax deductible. If you do not have an employer-sponsored retirement plan, you can contribute to an individual retirement account (IRA) and claim similar tax benefits.
- Tax credits: Tax deductions reduce the overall taxable income, whereas the tax credits reduce your tax liability dollar-for-dollar. You can earn child tax credits, earned income tax credits (EITC), and other tax credits by meeting the requisite criteria.
- Start a business: Apart from being an excellent means to earn some extra dollars, you can deduct expenses incurred towards business expenses from your income to reduce the taxable income.
- Health savings account (HSA): You can use a health savings account to reduce your taxable income, as the employees’ contributions towards a high-deductible health insurance plan are tax-deductible. Moreover, employers can also opt to match an employee’s contributions towards HSA.
- Long-term capital gains: Short-term capital gains (those earned within a year) are taxed at ordinary rates. However, the long-term capital gains tax rate is 0%, 15%, or 20%, so holding on to a capital asset for more than a year can offer you significant tax benefits.
- Municipal bonds: Municipal bonds are one of the primary sources of income for local governments. You can buy municipal bonds to help your local administration while earning interest on your investment. Moreover, the interest you earn on the municipal bond grows tax-free.
An effective tax strategy can significantly reduce your tax liability without violating any law. Moreover, effective tax planning ensures compliance with regulations and timely tax filing.
