Income tax affects the personal budget, retirement plans, investment choices and financial goals of every individual who earns wages, regardless of income level. Individuals who develop a tax plan find ways to lower the amount of income tax owed to the federal government, and may even find themselves in a lower tax bracket. The rules surrounding income tax are complex, but understanding simple strategies can help you minimize your income tax liability.
Reduce Income through Deductions
A common way to minimize your income tax is through tax deductions, which are used to reduce your taxable income. The Internal Revenue Service allows you to take a standard deduction or to itemize your deductions. If you choose to itemize, some common tax deductions include home mortgage interest, retirement contributions, charitable donations, medical and dental expenses, and student loan interest. Each deduction contains specific guidelines that may or may not fit your particular situation. To avoid owing money to the IRS, you should understand the specific rules of a deduction before including it on your tax return.
Take Tax Credits
Another method to minimize your income tax is to take tax credits that apply to you. While tax deductions reduce your taxable income, tax credits directly reduce your income tax liability or increase your income tax refund, depending on whether they are refundable or nonrefundable. A refundable tax credit allows you to receive a tax refund if you paid more taxes than what you owe. A nonrefunable tax credit simply brings your tax liability to zero and does not allow you to receive a refund. According to the University of California, Los Angeles, some common tax credits include the Lifetime Leaning Credit, Child and Dependent Care Expenses Credit, Child Tax Credit and Earned Income Tax Credit.
Shift Some of Your Income
Shifting your income to members of your family is another method to minimize your income tax. According to Ameriprise Financial, one way to achieve this is by gifting some of your high-dividend stocks to your children. The IRS allows you to give up to $13,000 without the recipient paying income tax on the money received. If you plan to shift some of your income, you should understand kiddie tax rules. The IRS requires income tax to be paid on any unearned income over $1,900 for children under age 19 or full-time students under age 24 who do not earn at least one-half of their financial support.
Earn Tax-Exempt Income
Certain investments allow you to earn tax-exempt income, which minimizes the amount of tax you owe on your earned income. A common method for earning tax-exempt income is investing in municipal bonds. State and local governments issue municipal bonds to raise funds. When you invest in a municipal bond, you lend the agency your money on the promise that it will repay the principal plus interest. Unlike with many other types of bonds, you are not required to pay federal income tax on the interest you earn from municipal bonds.
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- Brigham Young University: Understand How to Minimize Tax Payments for a Given Level of Income
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- Wells Fargo: Common Deductions and Adjustments to Income
- University of California, Los Angeles: Common Tax Credits
- tax forms image by Chad McDermott from Fotolia.com