When it comes to lowering your taxes, there is no simple path. The tax code is highly complex and voluminous. What works for one person might not work for someone else. However breaking down how individual taxpayers can lower their taxes can be simplified by knowing and understanding a few fundamental concepts.
Taxes are reduced in one of two ways through deductions and/or credits. A deduction reduces taxable income thereby lowering the amount that would be subject to tax while a credit reduces your taxes directly dollar for dollar. For this reason, tax credits are more effective in lowering taxes.
Below, we outline four broad tax tips that all taxpayers should know regardless of whether or not they prepare their own tax return. It is important to note that most deductions and credits are subject to income limitations. This means that while you may qualify for a specific credit or deduction you might not be able to take advantage because your income is too high. The majority of credits and deduction phase out as well, which means that you could qualify for a partial deduction or credit. Each credit and deduction have different limitation levels and phase-outs. This is important to know before you make financial decisions with tax motivations.
Tip #1: Know Your Filing Status – Head of Household
Taxpayers receive a standard deduction based on their filing status. Filing statuses include married filing joint, married filing separate and single. The standard deduction reduces income and the amount of the deduction varies by filing status. Married filing joint taxpayers receive $11,900 of deduction while single and married filing separate taxpayers receive 5,950 of deduction. Additionally, filing status dictates tax bracket thresholds as well.
There is a unique filing status titled Head of Household. Taxpayers claiming the Head of Household filing status benefit from a higher standard deduction (2012 – $8700) and lower tax rates compared to the single filing status. Taxpayers qualify for Head of Household filing status if unmarried, and must maintain the household of a qualifying individual for more than one-half of the tax year for their principal place of residence. The taxpayer is also entitled to a dependency deduction (2012- $3,800) for the qualifying individual in addition to the standard deduction.
Tip #2: Know Your Itemized Deductions
Itemized deductions directly reduce taxable income. Itemized deductions are reported on Schedule A. Taxpayers qualify to file a Schedule A when their itemized deductions are greater than their standard deduction.
The most common itemized deductions are highlighted by the following:
- State taxes paid
- Mortgage interest
- Property taxes
- Charitable donations
If the total of these items is greater than the standard deduction then you would receive income reduction equal to total itemized deductions in lieu of the standard deduction. There are additional itemized deductions not listed above and itemized deductions are subject to limitation when income goes above certain thresholds.
Tip #3: Know Your Individual Tax Credits
There are several individual credits that can reduce your tax bill and increase your refund. Tax credits provide greater tax benefit than tax deductions because they directly lower taxes as opposed to lowering the amount taxable. We highlight only the best of the bunch below:
- Education Tax Credits: Education credits are available for qualified tuition and/or related expenses of the taxpayer, the taxpayer’s spouse or a dependent of the taxpayer claimed on the taxpayer’s return. There are two credits available: the American Opportunity Credit and the Lifetime Learning Credit. The maximum credit is $2,500 per student (100% of the first $2,000 of eligible expenses and 25% of the next $2,000 of expenses) with the American Opportunity Credit and 40% of the credit is refundable. The lifetime learning credit is a nonrefundable tax credit of 20% of up to $10,000 of qualified tuition and fees paid during the tax year. Maximum credit is $2,000. A taxpayer may not claim both an American opportunity credit and a lifetime learning credit for the same student in the same year. It is important to note that this credit is subject to income limitations and phases out completely based on higher income levels.
- Residential Energy Efficient Property: Taxpayers can claim a tax credit for residential energy efficient property placed in service in 2012. The credit is equal to 30% of the cost of the following property: Solar energy systems (water heating and electricity), fuel cells, small wind energy systems, and geothermal heat pumps. There is no limit on the credit amount except in the case of fuel cells.
- Child and Dependent Care Credit: Taxpayers can claim a nonrefundable credit for a percentage of their dependent care expenses that enable them to work. The credit offsets regular tax. Maximum qualifying expenses for the child and dependent care credit is $3,000 for taxpayers with one qualifying individual and $6,000 for taxpayers with two or more qualifying individuals. The credit percentage ranges from 20% to 35% with a maximum credit of 20% of qualified expenses for taxpayers with adjusted gross income over $43,000.
Tax Tip #4: Know Your Retirement Tax Savings Options
Traditional Deductible IRAs
Taxpayers may claim an above-the-line deduction for contributions to a traditional individual retirement account (IRA). Brokers’ commissions are treated as contributions by the taxpayer and are also deductible as an adjustment to gross income. For 2012, IRA contributions cannot exceed the lesser of $5,000 or compensation.
For taxpayers age 50 or older as of year-end, an additional catch-up contribution of up to $1,000 is allowed. Thus, the 2012 contribution limit for these taxpayers is the lesser of $6,000 or compensation.
In addition, taxpayer’s can make their annual contribution up to the April 15 tax deadline to be included in the tax return for the prior calendar year. It is important to note that the IRA contribution deduction is subject to limitation and phases out completely at higher levels of income.
Employer-Sponsored Retirement Plans
There are several types of plans (SIMPLE, 401K) that fall under this category and each has their own distinct features for which we will not get into detail. The important thing to remember is that as an employee, any contributions made directly by the employee reduce current year income because you can’t include them in taxable wages. It is also important to note that some plans have an employer matching contribution feature. It is always advisable to max out on the matching amount.
We hope our tax tips have provided you with some basic background information that will help guide you in developing your tax knowledge and reducing your taxes. Tax professionals are a valuable resource in your quest to lower your taxes. We recommend speaking with a tax professional to gain further insight, if you have not done so already, and depending on your specific circumstances and the complexity of your financial situation it would be advisable to engage the services of someone you trust. Please feel free to contact us for more information or to discuss your specific tax situation in greater detail.
Patrick Finkelstein is a member of Dawson & Associates, a full service accounting firm serving small to mid-sized businesses and their owners. Dawson & Associates through my virtual accounting office, myvao.com, offers local and cloud based scalable accounting services and commercial QuickBooks hosting. Go to dawsoncpa.com and myvao.com for more info.