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Tax planning is an essential process for an individual's financial well-being. It's defined as the process of coming up with a strategic plan that minimizes the number of taxable events that stem from investing, income earned, or purchases. An efficient strategy enables the taxpayer to reduce the tax they eventually pay. This is crucial for an individual that is involved in saving and investing. In addition, those workers looking to save some money for their retirement can benefit from planning.
Trying to build a tax plan is a daunting and stressful process. Navigating this complex process by yourself is not necessary. Reaching out to a professional and exploring the tax planning strategies outlined below with them will help you build a more efficient strategy.
Establishing where you lie in the federal tax bracket system is considered the first step of outlining your tax plan. The system is divided into 7 brackets ranging from 10% to 37%. The higher you earn, the higher you eventually pay. Income eligible for tax considerations is derived from subtracting deductions from your annual income. The Internal Revenue Service then classifies this income into various categories. Finally, these categories are multiplied by a rate to determine the taxes owed.
As mentioned above, tax deductions lower the proportion of your salary that gets taxed. There is, however, a distinction between deductions and credits that can impact your strategy. A tax credit refers to the amount of money you're allowed to deduct (dollar for dollar). An example of this is when a taxpayer owes $100 in federal tax. A tax credit of similar $100 will result in no liability towards the taxpayer. This helps you save more money.
Several deductions exist, all with different rules and regulations. Common ones include:
Sometimes the IRS will audit your filed returns. Therefore, it is best to keep a record whenever you file for the breaks we discussed above. Crucial documents that you should keep handy include but are not limited to bank statements outlining how much you make, W-2 forms, any receipts you might have used in your returns, and 401(k) documents.
This plan is an effective tax planning tool for retirement. This is because these plans are considered tax-deferred accounts. Tax-deferred accounts will record a realizable gain equivalent to your contribution amount. This works similar to deduction of taxes where the income considered for tax reasons is the net difference of how much you make and plan contribution. It ensures that you end up in a much lower bracket when you retire, thus reducing the amount of taxes you have to pay.
One of the other retirement strategies is placing money in an individual retirement account. It's divided into traditional and Roth IRA. A traditional IRA works similarly to a tax-deductible account. The amount deducted is dependent on your salary.
On the other hand, Roth IRA is considered a tax-free retirement account because the taxpayer is avoiding taxes on qualified IRA withdrawals. The tax is usually paid up front. Unlike the traditional IRA, your contributions are not considered tax-deductible.
Health expenses accounts used to cover medical costs are not considered when income is taxed. Maximizing health accounts is a solid strategy in minimizing your tax expense exposure. Contributions to such accounts are also eligible for deductions. Withdrawals don't incur taxes as long as they pay for medical costs. Employers offer these accounts. You also have the option of setting one up by yourself.
As discussed, understanding the various tax laws can be a complicated and stressful process. Always seek out the expertise of a professional financial planner to equip you with the necessary tools and knowledge to build an efficient tax strategy plan. This will prepare you for tax season when you need to file your taxes.