Tax Planning : How To Start?
Hiring a Tax Professional VS Doing Tax Planning Yourself
Deciding who will plan your taxes is an important part of your overall tax strategy. Sometimes it makes more sense to hire a tax professional instead of doing it yourself, while other times you might feel capable of handling it on your own. Depending on how complex your tax situation is, hiring a tax advisor could be a wise financial choice to ensure you make the most of your tax efficiency. Even the best tax software cannot provide the same level of advice as a professional.
If you choose to hire a tax professional, you need to figure out who is best suited for your situation. Should you hire a Certified Public Accountant (CPA), or can a tax preparation company handle it? Explore the advantages and disadvantages of these different types of tax preparers before making your final decisions.
If your tax situation is not complicated, it is definitely possible to handle your tax planning yourself. Even if it is complex, outsourcing the work may cause you to miss an opportunity to learn. Understanding your entire financial situation can be highly valuable if you have the time and interest.
As mentioned earlier, hiring a tax professional can be expensive. Bookkeepers, accountants, CPAs, and CFPs typically charge by the hour. Prices can range from $21 per hour for a bookkeeper to $50 to hundreds of dollars per hour for a CPA. A CFP may charge hundreds or even thousands of dollars for a comprehensive financial plan, with ongoing advice costing $50 to $300 per month. It is best to call and inquire about prices based on your specific needs.
Regardless of whether you seek professional help or not, there are still important things you need to understand about your taxes. Being familiar with your financial situation and options ensures that you have the best chance of adopting the most advantageous tax strategy. So let's go through the tax forms you are likely to encounter, as well as some commonly confused terminology.
Here are some basic tax forms you need to understand:
W-2 form: Also known as the Wage and Tax Statement, this form reports your annual wages and the amount of taxes withheld from your paychecks. It is required to be sent to employees and the IRS at the end of the year.
W-4 form: You fill out a W-4 form before starting employment to inform your employer about how much federal income tax should be withheld from each paycheck.
1099 form: This series of documents, known as "information returns," reports various types of income other than your salary. It includes independent contractor income, interest and dividends, and withdrawals from a retirement account, among others.
1098-E form: If you paid more than $600 in interest on your student loan in a year, your student loan servicer will send you a Form 1098-E.
1098-T form: Also called the Tuition Statement, this form reports college tuition expenses that may entitle you to a tax credit or an adjustment to income.
Form 5498: This form is used to report your contributions to an individual retirement account (IRA) to the IRS when you save for retirement.
Form 1040: This is the standard federal income tax form used to report your income, claim tax deductions and credits, and calculate your tax refund or tax bill.
Form 8962: This form helps you calculate the amount of your premium tax credit (PTC) if you are eligible to receive one.
When starting your tax planning, it is important to understand the difference between tax deductions and tax credits. While both can provide tax breaks, they work differently.
A tax deduction allows you to subtract a certain amount of money from your taxable income within your tax bracket, reducing your tax liability. There are two types of tax deductions: the standard deduction and itemized deductions. While both deductions lower your tax liability, they work differently.
The standard deduction is a fixed amount specified by the government that you can subtract from your income. On the other hand, itemized deductions consist of eligible expenses that can be subtracted from your adjusted gross income (AGI) to reduce your tax bill.
Common tax deductions include:
Medical and dental expenses
State and local taxes
Home equity loan interest
Charitable contributions
Business use of your home and car
Casualty losses
Work-related education expenses
Unlike tax deductions, tax credits directly reduce the amount of taxes owed. There are two types of tax credits: nonrefundable and refundable. Nonrefundable tax credits can't increase your tax refund or create a refund if you weren't originally eligible. They can only refund up to the amount you owe. Refundable tax credits, however, can result in a refund when the credits exceed your tax liability.
Common tax credits include :
Earned Income Tax Credit
Child and Dependent Care Credit
Adoption Credit
Child Tax Credit
Residential Energy Efficient Property Credit
American Opportunity Credit
Lifetime Learning Credit
Premium Tax Credit (Affordable Care Act).
When choosing between the standard deduction and itemized deductions, consider your tax strategy. The standard deduction is a flat amount that reduces your taxable income, ensuring everyone has a portion not subject to federal income tax. The amount you can deduct varies based on factors such as filing status, dependency status, age, and blindness. However, there are situations where the standard deduction cannot be used.
If you can't take the standard deduction, you have the option to itemize deductions by listing out individual tax items to deduct from your income. Itemized deductions may include state and local taxes, mortgage interest, charitable donations, medical expenses, and work-related expenses. If your total itemized deductions are greater than the standard deduction, itemizing is usually the better choice.
Consider reducing your tax burden through an Individual Retirement Account (IRA) contribution. Contributions to a traditional IRA can lower your tax burden, as they may be fully or partially deductible from your income depending on your circumstances. However, taxes on the IRA funds, including investment income and gains, are typically paid when you make withdrawals in retirement.
Other strategies to reduce your tax burden include contributing to a 529 college savings plan if you have children, as it can lower your state tax liability. Additionally, contributing to a health savings account (HSA) can provide untaxed funds for medical expenses if you have a high-deductible health insurance plan.
It's important to keep your tax records and associated documentation for 3-7 years or until the period of limitations for that tax return expires. The IRS can audit you for a specific duration depending on the circumstances, such as underreported income, loss write-offs, tax fraud, or failure to file a return. Refer to the IRS website for a breakdown of the full period of limitations.
