retain a qualified professional to help you.
The 10%, 15%, 25%, 28%, 33% and 35% tax brackets that we’ve seen may be replaced with a simple fair tax rate, but don’t count on it. Congress seems to like making the tax code complex. At least it keeps the tax accountants and lawyers employed.
Tax planning requires finding out where you stand now with regard to your tax liability and how that will change as a result of your financial transactions. Then you need a plan of action to reduce, eliminate or postpone that tax liability. Knowing the effects of taxable events beforehand enables you to make better decisions regarding timing of purchases or sales as well as whether or to defer income or accelerate deductions in any given year.
Determine You Tax Liability
Fortunately determining your tax liability is not that difficult for most of us. A simple formula would be to answer the question, “How much did you make? Fine sent it in.” But seriously, a 100% tax rate would never work. So you have to determine not only how much did you earn, but what can lawfully be taken as a deduction from income before you figure out how much you will pay in taxes.
Here is a simple formula:
1 Gross Taxable Income, minus
2 Adjustments to Your gross, equals
3 Adjusted Gross Income, minus
4 Itemized Deductions (or standard deduction) and minus
5 Exemptions, equals
6 Taxable Income, minus any
7 Tax credits, minus
8 Taxes paid, equals
9 Taxes due (or refund owed).
Now the devil is in the details.
Gross Taxable Income - This includes all taxable income: salary, wages, tips, dividends, taxable pensions, farm income, interest income, partnership income, taxable social security and all other taxable income.
Adjustments - Subtract adjustments from your gross income to arrive at Adjusted Gross Income or AGI. Adjustable items can change from time to time, based on what Congress wants to allow you to include. They include things like: IRA contributions (with limits), Keogh contributions, self-employed medical insurance premiums and alimony paid.
Itemized Deductions - Special rules govern these deductions and sometimes you may only qualify for the standard deduction. Currently itemized deductions include: medical expenses, taxes paid (State & Local), mortgage interest, charitable contributions, casualty loses, employee business expense and moving expenses. Some of these deductions are subject to income limits, so you might need to study these carefully to see what you can take as deductions and which ones don’t work in your situation.
If you do not itemize, use the standard deductions. A higher standard deduction is allowed for those over 65 and the blind.
Exemptions and Credits - In order to arrive at your actual taxable income, you also get the personal exemptions as a deduction, before you determine taxable income. Now most of might think we are finished, just calculate the taxes owed on your taxable income, but Uncle Sam and Congress likes provide a number of different tax credits which work just like tax payments. It would be best to review all of the current tax credits available and subtract any credits from the taxes due. Credits are attractive because they reduce your tax liability dollar for dollar.
Additional taxes - Whew it would be nice if we were done, but there might be one more tax that can increase you taxes owed, the Alternative Minimum Tax. The AMT came into being with the Tax Reform Act of 1969. Its purpose was to target a small number of high-income taxpayers who could claim so many deductions they owed little or no income tax. A growing number of middle-income taxpayers are discovering they are subject to the AMT. Fortunately the IRS has provided on its web site the AMT Assistant, an easy-to-use worksheet to see if you need to pay the additional tax. Generally this only applies if you have taken a number of the credits available, have a higher income or have used special deductions to reduce your tax liability. After all we all should be paying some taxes.
Organizing Your Taxes
Paying taxes doesn’t rank high on anyone’s list of “favorite things to do”, but the job can be made a lot easier if you plan and organize you tax records, which we will discuss next.
The easiest way to organize your records is to set up a series of files in which you place all of your monthly income and expense receipts. Try to avoid just tossing your financial information into an old shoebox. Keep a file for your major purchases, as they may be deductible. Also keep track of any unusual expenditures. Most people need files for receipts and bills in the following areas:
Expenses
1 Mortgage payments
2 Loan payments
3 utility bills
4 auto expenses and repairs
5 Insurance (Life, health, auto and homeowners)
6 Medical bills
7 Education expenses
8 Child care
9 Donations and contributions
10 Property taxes
11 IRA contributions (and/or other retirement accounts)
Income
1 Paycheck stubs
2 payments received from interest or Dividends (keep the 1099 forms at the end of the year)
3 Mutual fund statements
4 Rental property
5 Other Income
You will also want to keep files for moving expenses, business expenses, casualty losses, and anything that is included in your income or expenses.
These receipts will provide you and your tax preparer/accountant valuable information as your tax returns are being prepared. Your tax advisor may ask you a number of questions, having receipts at hand will make finding the supporting information that much easier and potentially increase your tax returns.
At the end of the year, after you have received your completed tax return from your tax advisor, gather your receipts together and place them with copies of your tax return in a new file marked “Income Tax Records for Year ____.” Keep your income tax records for at least seven years. The IRS may call for an audit on only the last three years, but depending on your tax situation there may be a tax credit or other deduction that gets carried forward from year to year and you may need to access that information.
Other Records To Keep
It’s very important to retain all of your receipts, work orders, cancelled checks and other documents related to the purchase and improvement of your home and other real estate. You will need to these records
