Tax Planning Strategies Notes
children's investments
A child under 18, or a full-time student under 24, with investment income of more than $2,000 is taxed at the parent's top rate. For investment income under $2,000, the child receives a deduction of $1,000 and the next $1,000 is taxed at his or her own rate, which is probably lower than the parent's rate.
consumer debt
Current tax laws allow homeowners to borrow for consumer purchases. You can deduct interest on loans (of up to $100,000) secured by your primary or secondary home up to the actual dollar amount you have invested in —the difference between the market value of the home and the amount you owe on it. These home equity loans, which are second mortgages, allow you to use that line of credit for various purchases. Some states place restrictions on home equity loans.
health care expenses
Flexible spending accounts (FSAs), also called health savings accounts and expense reimbursement accounts, allow you to reduce your taxable income when paying for medical expenses or child care costs. Workers are allowed to put pretax dollars into these employer-sponsored programs. These "deposits" result in a lower taxable income. Then, the funds in the FSA may be used to pay for various medical expenses and dependent care costs.
Keogh Plan
If you are self-employed and own your own business, you can establish a Keogh plan. This retirement plan, also called an HR10 plan, may combine a profit-sharing plan and a pension plan of other investments purchased by the employee. In general, with a Keogh people may contribute 25 percent of their annual income, up to a maximum of $52,000 (in 2014), to this tax-deferred retirement plan.
tax-exempt investments
Interest income from municipal bonds, which are issued by state and local governments, and other tax-exempt investments is not subject to federal income tax. Although municipal bonds have lower interest rates than other investments, the tax-equivalent income may be higher. For example, if you are in the 35 percent tax bracket, earning $100 of tax-exempt income would be worth more to you than earning $150 in taxable investment income. The $150 would have an after-tax value of $97.50—$150 less $52.50 (35 percent of $150) for taxes.
place of residence
Owning a home is one of the best tax shelters. Both real estate property taxes and interest on the mortgage are deductible (as itemized deductions) and thus reduce your taxable income.
self-employment
Owning your own business can have tax advantages. Self-employed persons may deduct expenses such as health and certain life insurance as business costs. However, business owners have to pay self-employment tax (Social Security) in addition to the regular tax rate.
tax-deferred investments
Although tax-deferred investments, with income taxed at a later date, are less beneficial than tax-exempt investments, they give you the advantage of paying taxes in the future rather than now. Examples of tax-deferred investments include: tax-deferred annuities, Section 529 savings plans (State-run, tax-deferred plans to set aside money for a child's education. The 529 is a savings plan to help families set aside funds for future college costs. The 529 plans differ from state to state.), and retirement plans (such as IRA, Keogh, or 401(k) plans. The next section discusses the tax implications of these plans.).
job-related expenses
As previously mentioned, certain work expenses, such as union dues, some travel and education costs, business tools, and job search expenses (even if you were not successful), may be included as itemized deductions.
capital gains
Profits from the sale of a capital asset such as stocks, bonds, or real estate, are also tax-deferred; you do not have to pay the tax on these profits until the asset is sold. In recent years, long-term capital gains (on investments held more than a year) have been taxed at a lower rate. The sale of an investment for less than its purchase price is, of course, a capital loss. Capital losses can be used to offset capital gains and up to $3,000 of ordinary income. Unused capital losses may be carried forward into future years to offset capital gains or ordinary income up to $3,000 per year.
value-added tax (VAT)
Would add a tax to a product for each stage in the manufacturing process. It is believed that higher-income individuals would pay higher taxes since they are typically the larger consumers of goods. This has been implemented in other countries. That said, the administrative process can be a challenge for each of the companies involved in the process to remit the tax.
529 Plan
The 529 plan is an education savings plan that helps parents save for the college education of their children. Almost every state has a 529 plan available. There is no federal tax deduction, but the earnings grow tax-free and there are no taxes when the money is taken out of the account for qualified education expenses. Many states allow their residents to deduct contributions to their state plans up to a specified maximum.
Roth IRA
The Roth IRA also allows a $5,500 (2014) annual contribution, which is not tax-deductible; however, the earnings on the account are tax-free after five years. The funds from the Roth IRA may be withdrawn before age 59½ if the account owner is disabled, or for the purchase of a first home ($10,000 maximum). Like the regular IRA, the Roth IRA is limited to people with an adjusted gross income under a certain amount. Deductible IRAs provide tax relief up front as contributions reduce current taxes. However, taxes must be paid when the withdrawals are made from the deductible IRA. In contrast, the Roth IRA does not have immediate benefits, but the investment grows in value on a tax-free basis. Withdrawals from the Roth IRA are exempt from federal and state taxes.
401(k) Plan
The part of the tax code called 401(k) authorizes a tax deferred retirement plan sponsored by an employer. This plan allows you to contribute a greater tax-deferred amount ($17,500 in 2014) than you can contribute to an IRA. Older workers, age 50 and over, may be allowed to contribute an additional $5,500 if their employer allows. However, most companies set a limit on your contribution, such as 15 percent of your salary. Some employers provide a matching contribution in their 401(k) plans. For example, a company may contribute 50 cents for each $1 contributed by an employee. This results in an immediate 50 percent return on your investment. Tax planners advise people to contribute as much as possible to a Keogh or 401(k) plan since (1) the increased value of the investment accumulates on a tax-free basis until the funds are withdrawn and (2) contributions reduce your adjusted gross income for computing your current tax liability.
traditional IRA
The regular IRA deduction is available only to people who do not participate in employer-sponsored retirement plans or who have an adjusted gross income under a certain amount. As of 2014, the IRA contribution limit was $5,500. Older workers, age 50 and over, were allowed to contribute up to $6,500 as a "catch up" to make up for lost time saving for retirement. In general, amounts withdrawn from deductible IRAs are included in gross income. An additional 10 percent penalty is usually imposed on withdrawals made before age 59½ unless the withdrawn funds are on account of death or disability, for medical expenses, or for qualified higher education expenses.
tax evasion
The use of illegal actions to reduce one's taxes.
tax avoidance
The use of legitimate methods to reduce one's taxes.
Coverdell Education Savings Account
This account is designed to assist parents in saving for the education of their children. Withdrawals can be used for a variety of educational uses for kindergarten through college-age students. Once again, the annual contribution (limited to $2,000) is not tax-deductible and is limited to taxpayers with an adjusted gross income under a certain amount. However, as with the Roth IRA, the earnings accumulate tax-free.
flat tax
This would require that all taxpayers, regardless of income level and type, pay the same percentage. While seemingly relatively easy to implement, the reality is that this would be an increase in overall tax for quite a few people.