Introduction

To figure out which tax-saving strategies will work best for you, you’ll need a basic understanding of how the income tax system works. Cheer up! This isn’t as bad as it sounds. In fact, you may even find it fun to learn about taxes, particularly when you see how much money you can save with a little knowledge and planning.

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What Can Tax Planning Do for You?

Tax planning means figuring out ways to minimize the taxes you have to pay each year. It’s perfectly legal and makes sense for anyone who pays taxes.

This isn’t tax evasion, which means cheating—for example, not reporting all your income to the IRS. Tax evasion is illegal, and people who are caught at it must pay all the taxes they owe, plus interest and penalties. Some even go to jail. Look at what happened to the winner of the first Survivor television series, Richard Hatch. He was sentenced to 51 months in federal prison for tax evasion after he failed to report his $1 million winnings to the IRS.

But you probably don’t have $1 million to hide. In fact, you might be wondering whether tax planning isn’t just for rich people who were looking for an excuse to sail to the Cayman Islands anyway. The answer is no. People with modest incomes can benefit from tax planning. And they often can do it themselves, without high-priced accountants and tax pros.

There are many easy-to-understand ways to lower your taxes you can implement yourself—for example, opening an IRA or hiring your children to work in your business. Others are more complex and may require the help of a tax professional, such as tax-free exchanges of business property. We’ll focus on the ones that are easier to understand and let you know when you might need professional help.

Income Tax 101: How the System Works

First, a little background (we promise to keep it short). As the name implies, with income tax, you are paying tax on your income—for example, your salary from a job or the interest on your savings account. However, you don’t have to pay income tax on all your income—not by a long shot. That’s largely because not all income is considered “taxable income.” The idea behind tax planning is to use all legal means available to keep your taxable income as low as possible.

To do this, you must go through a step-by-step calculation that will ultimately tell you how much you owe; it goes something like this.

• Start with all your income. First, you add up all the income you earn or receive each year, regardless of the source—salary, interest, net business income, investment income, and anything else. If you’re married and file jointly (as the great majority of married couples do), include your spouse’s income as well.
• All Income – Exclusions = Gross Income. Next, you get to exclude certain items from your income, to arrive at your gross income. (It’s not called gross because it’s disgusting; here, gross means the totality of your income, minus some important exclusions.) These exclusions include such things as gifts, life insurance proceeds, up to $500,000 in profits from the sale of your home if certain requirements are met, interest earned on municipal bonds, and other items. (Exclusions are covered in Chapter 2.)
• Gross Income – Adjustments to Income = Adjusted Gross Income. Hey, more subtractions! You get to adjust your income downward for things like contributions to deductible IRAs and self-employed retirement plans, contributions to health savings accounts, your health insurance payments if you’re self-employed, moving expenses if you change jobs, and more. The resulting number is your adjusted gross income (AG I). (These adjustments are often called “above-the-line deductions,” because they go before the line for AG I on your tax return.)
• Adjusted Gross Income – Deductions and Exemptions = Taxable Income. Now you can subtract out (1) any deductions you’re claiming, and (2) your tax exemptions. The result is your taxable income. You’ll choose between taking either a specified standard deduction or itemizing (listing) your deductions one by one. If you itemize, you can deduct expenses for such things as mortgage interest, state and local taxes, charitable contributions, and unreimbursed employee expenses (covered in Chapter 5). These are often called “below-the-line deductions” because they go after the AG I line on your tax return. Your exemptions consist of specified amounts you may deduct for yourself, your spouse, and your dependents (if any). (Exemptions are covered in Chapter 8.)
• Taxable Income × Tax Rates = Tax Liability. By multiplying the amount of your taxable income by the tax rates set forth in IRS tax tables or schedules, you’ll find out your tax liability. The tax rates vary according to the amount of your taxable income, from a low of 10% to a high of 35%. (These brackets are listed in Chapter 6.)
• Tax Liability – Tax Credits = Tax Due. Wait, you’ve got one last chance to lower your tax bill. You can subtract any tax credits you’re entitled to, for such things as buying a hybrid car, paying for higher education or child care expenses, or making your home more energy efficient. (Tax credits are covered in Chapter 3.) The total remaining is the amount you owe the IRS.

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Example: Ron and Rachel are a married couple, with two young children, who file a joint income tax return. In 2008, Ron earned $70,000 in salary from his job, Rachel earned $20,000 from a part-time home business and they earned $5,000 in interest income. Their total itemized deductions are $12,000, which exceeds their $10,900 standard deduction, making it worthwhile for them to itemize. Here’s how they compute their taxes:

[Ron and Rachel's tax computation chart] omitted for online sample chapter

Could Ron and Rachel have reduced their income tax by using one or more of the tax-planning strategies discussed in this book? C’mon, do you really need to ask? Here are just a few ways they could have reduced their tax:

• Deferred taxes. The couple could have deferred part of their income taxes to future years by opening an IRA and contributing the $10,000 maximum. Rachel could have put off collecting part of her business income until next year—$8,000 for example.
• Taken advantage of tax credits. The family could have purchased a hybrid car, and shaved thousands of dollars off their tax bill.
• Maximized tax deductions. Ron and Rachel could have increased their tax deductions by making a $1,000 contribution to their favorite charity.

Had they done these things, here’s what Ron and Rachel’s taxes would have looked like:

[Ron and Rachel's corrected tax computation] omitted for online sample chapter

Too bad Ron and Rachel didn’t buy and read this book. They could have paid $4,698 in taxes instead of $9,938.

How Low Can You Go? Stopped by the AMT Stealth Tax

Before you start dreaming of reducing your tax bill to zero, realize that Congress tried to put a stop to that, with something called the Alternative Minimum Tax, or AMT. The AMT is designed to force taxpayers to pay a minimum amount of tax, even if they’d be required to pay less, or no tax at all, under the regular tax system. If you’re required to pay the AMT, you pay it in addition to your regular income taxes.

But not everyone falls prey to the AMT. You’re most likely to be subject to it if you have a high income (over $100,000 for singles and $150,000 for married couples) and have many exemptions and deductions that the AMT rules don’t allow. You might owe the AMT if you:

• have lots of children—each one provides a $3,500 dependency exemption not allowed with the AMT
• live in a state with high income taxes, like New York or California
• have substantial miscellaneous itemized deductions, such as unreimbursed employee expenses or investment expenses
• have a very large medical expense deduction
• pay substantial interest on a home equity loan and didn’t use the money to improve your home or buy or improve a second home, or
• receive stock options from your employer.

Unfortunately, if you are subject to the AMT, this book can’t help you—it’s a highly complicated system, and many of the tax-planning techniques we cover here simply won’t work. The IRS has an AMT Assistant on its website (www.irs.gov) that you can use to see if you might be subject to the AMT.

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Tax software like TurboTax can be a big help; but, if you’re facing a substantial AMT liability you should see a tax pro. You might also wish to consult The Alternative Minimum Tax, by Harold S. Peckron (Sphinx Publishing).

Most States Have Income Taxes, Too

This book focuses on the federal income tax—the tax administered by the Internal Revenue Service (IRS). However, 43 states have their own income taxes. Many of these track federal law, so the tax-planning techniques covered in this book will probably help lower your state income taxes as well. Two states—Tennessee and New Hampshire—tax only dividend and interest income.

The seven states with no income tax are Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. Even if you owe state income taxes, they’re likely to be much lower than your federal taxes (for a list of all state income tax rates, go to www.taxadmin.org/FTA / rate/ind_inc.html).

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Resource: For more information on state income taxes: Refer to your state tax department’s website. A handy directory of links to these sites can be found at www.taxsites.com/state.html.

When to Start Tax Planning

People often wait until December to start thinking about ways to reduce their taxes for the year (if they think about it at all). This is too little, too late. If you really want to save some cash, start your tax planning no later than the beginning of the fourth quarter of the year—that is, October. But earlier in the year is usually better. For example, the best time to establish and contribute to tax-deferred accounts is at the beginning of the year, because you’ll get a whole year’s worth of tax-deferred income.

Start by making a simple projection of how much you’ll owe in taxes this year without implementing any of the steps outlined in this book. (You’ll need to estimate your income and expenses for the rest of the year based on how much you’ve earned and spent so far.) This can be done easily with tax preparation software such as TurboTax. There are also several online calculators you can use (www.hrblock.com/taxes, for example), but they don’t provide as much information. If you like hard work, you can do it yourself with paper and pencil.

If you’re happy with your projected tax bill, you don’t need to do any more tax planning. But, if you want to reduce your taxes, keep reading.