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Tax Planning for Income

The goal of income tax planning is to minimize your federal income tax liability. You can achieve this in different ways. Typically, though, you'd look at ways to reduce your taxable income, perhaps by deferring your income or shifting income to family members. You should also consider deduction planning, investment tax planning, and year-end planning strategies to lower your overall income tax burden.

Postpone your income to minimize your current income tax liability

By deferring (postponing) income to a later year, you may be able to minimize your current income tax liability and invest the money that you'd otherwise use to pay income taxes. And when you eventually report the income, you may be in a lower income tax bracket.

Certain retirement plans can help you to postpone the payment of taxes on your earned income. With a 401(k) plan, for example, you contribute part of your salary into the plan, paying income tax only when you withdraw money from the plan (withdrawals before age 59½ may be subject to a 10 percent penalty). This allows you to postpone the taxation of part of your salary and take advantage of the tax-deferred growth in your investment earnings.

There are many other ways to postpone your taxable income. For instance, you can contribute to a traditional IRA, buy permanent life insurance (the cash value part grows tax deferred), or invest in certain savings bonds. You may want to speak with a tax professional about your tax planning options.

Shift income to your family members to lower the overall family tax burden

You can also minimize your federal income taxes by shifting income to family members who are in a lower tax bracket. For example, if you own stock that produces a great deal of dividend income, consider gifting the stock to your children. After you've made the gift, the dividends will represent income to them rather than to you. This may lower your tax burden.

However, look out for the kiddie tax if your children are under age 14. Also, be sure to check the laws of your state before giving securities to minors.

Other ways of shifting income include hiring a family member for the family business and creating a family limited partnership. Investigate all of your options before making a decision.

Deduction planning involves proper timing and control over your income

Lowering your federal income tax liability through deductions is the goal of deduction planning. You should take all deductions to which you are entitled, and time them in the most efficient manner.

As a starting point, you'll have to decide whether to itemize your deductions or take the standard deduction. Generally, you'll choose whichever method lowers your taxes the most. If you itemize, be aware that some (or all) of your deductions may be disallowed if your adjusted gross income (AGI) reaches a certain threshold figure. If you expect that your AGI might limit your itemized deductions, try to lower your AGI. To lower your AGI for the year, you can defer part of your income to next year, buy investments that generate tax-exempt income, and contribute as much as you can to qualified retirement plans.

Because you can sometimes control whether a deductible expense falls into the current tax year or the next, you may have some control over the timing of your deduction. If you're in a higher federal income tax bracket this year than you expect to be in next year, you'll want to accelerate your deductions into the current year. You can accelerate deductions by paying deductible expenses and making charitable contributions this year instead of waiting until next.

Investment tax planning uses timing strategies and focuses on your after-tax return

Investment tax planning seeks to lower your overall income tax burden through wise investment choices. Several strategies exist. These include investing in tax-exempt securities and timing the sale of capital assets properly.

Although income is usually taxable, several investments can generate tax-exempt income. For example, the interest on certain Series EE bonds (these may also be called Patriot bonds) used for education may be exempt from federal, state, and local income taxes (tax-exempt status applies to income generated from the bond; a capital gain or loss realized on the sale of a municipal bond is treated like any other bond for tax purposes). Also, you can exclude the interest on municipal bonds from your federal income. And if you earn interest on tax-exempt bonds issued in your home state, the interest will generally be exempt from state and local tax as well. Keep in mind that although the interest on municipal bonds is generally tax exempt, certain municipal bond income may be subject to the federal alternative minimum tax. When comparing taxable and tax-exempt investments, you'll want to focus on those vehicles that maximize your after-tax return.

In most cases, long-term capital gains tax rates are lower than ordinary income rates. You may be able to time the sale of your capital assets (such as stock) so as to minimize your income tax liability. For example, if you expect to be in a lower income tax bracket next year, wait until then to sell your stock. You may want to accelerate income into this year, though, if you have capital losses this year and need to offset them with capital gains. Note that capital gains increase your AGI, which in turn may affect the amount of your itemized deductions and personal exemption.

Year-end planning focuses on your marginal income tax bracket

Year-end tax planning, as you might expect, typically takes place in November or December. It involves timing your income so that it will be taxed at a lower rate and claiming deductible expenses in years when you are in a higher income tax bracket. This usually means postponing income to a later year and accelerating deductions into the current year. For example, assume it's December and you're entitled to a year-end bonus. However, you're in a higher tax bracket this year than you expect to be in next year. The solution? Ask your employer to pay it to you in January of next year, rather than now. This will allow you to postpone the taxable income. Also, if you have major dental work scheduled for the beginning of next year, reschedule for December to take advantage of the deduction this year. If you expect to be in a higher tax bracket next year, however, you should accelerate your income into this year and defer your deductions until next year.

In most cases, long-term capital gains tax rates are lower than ordinary income rates. You may be able to time the sale of your capital assets (such as stock) so as to minimize your income tax liability. For example, if you expect to be in a lower income tax bracket next year, wait until then to sell your stock. You may want to accelerate income into this year, though, if you have capital losses this year and need to offset them with capital gains. Note that capital gains increase your AGI, which in turn may affect the amount of your itemized deductions and personal exemption.

Year-end planning focuses on your marginal income tax bracket

Year-end tax planning, as you might expect, typically takes place in November or December. It involves timing your income so that it will be taxed at a lower rate and claiming deductible expenses in years when you are in a higher income tax bracket. This usually means postponing income to a later year and accelerating deductions into the current year. For example, assume it's December and you're entitled to a year-end bonus. However, you're in a higher tax bracket this year than you expect to be in next year. The solution? Ask your employer to pay it to you in January of next year, rather than now. This will allow you to postpone the taxable income. Also, if you have major dental work scheduled for the beginning of next year, reschedule for December to take advantage of the deduction this year. If you expect to be in a higher tax bracket next year, however, you should accelerate your income into this year and defer your deductions until next year.