1. Make sure you aren’t missing out on any deductions. This new tax law signed in January extended a number of tax breaks that had expired at the end of 2011 or 2012. Some of these tax breaks could affect your 2012 tax return, which you will be filing in the coming months. Be sure not to overlook these tax deductions when preparing your income tax return this year:
- The optional deduction for state and local sales taxes in lieu of deducting state and local income taxes.
- The above-the-line deduction for up to $4,000 for qualified tuition and related expenses.
- The above-the-line deduction for up to $250 for classroom supplies purchased by teachers.
- The deduction for mortgage insurance premiums.
- The exclusion from income for cancellation of mortgage debt of up to $2 million on a principal residence.
The good news is there are tons of possible deductions out there just like these, including deductions based on mortgage and loan interest, investment interest, and more.
2. File an amended return for missed tax deductions and credits. If you missed any tax deductions or credits you were entitled to over the past few years, it’s not too late to correct that mistake by filing an amended return. Say you discover after filing that you have not taken advantage of several deductions or tax credits that you were entitled to. Don’t beat yourself up: You can file an amended return to claim an additional refund. Generally, the statute of limitations is three years from the date you filed your tax return. Therefore, you can file a claim or refund for the last three years of tax returns if you uncover a recurring error.
This is a great way to improve your cash flow, and it’s a great example of why you should meet with your tax advisor throughout the year. I can’t stress that enough. Again, there’s no better way to ensure you’re taking advantage of the deductions that apply to you than to get the help of a tax planner!
3. Be smart about when you make certain payments. Many people aren’t aware that you may be able to shift income and deductions to the tax year that will result in lower taxes. For instance (depending on your circumstances), if your estimated city and/or state income tax payments are due in January, you can pay them before December 31 and reduce your federal income tax liability by as much as 39.6 percent of the early payment. This is assuming you are not subject to alternative minimum tax.
Likewise (again, depending on circumstances), prepaying your January mortgage payment in December and paying your first quarter real estate taxes before December 31 can help you to obtain tax breaks. Or you may also be able to shift income among family members to take full advantage of their lower tax brackets.
4. Make full use of tax-deferred accounts. These include IRAs, 401(k)s, annuities, and some life insurance contracts. The government allows you to postpone taxes on this income because they want to encourage you to be responsible and prepared for retirement. The Internal Revenue Code is a mechanism by which the government can influence taxpayers’ behavior by giving them incentives to do or not do certain things. It views tax-deferred accounts as a way of helping taxpayers save money for the long-term and build a secure, comfortable, and sustainable retirement for themselves.
Of course, you will eventually have to pay taxes on that deferred income when you withdraw it from those accounts. But that’s okay—this is still one of the methods to achieve financial independence in a tax-advantaged way. I recommend deferring taxes as long as possible, because every year your income is in an IRA, for example, the entire principal, including the money you would have had to pay in taxes plus earnings, will continue to compound. In essence, the government is giving you a tax-free loan that you can utilize to help maximize your savings. You’re earning money on your funds and the tax dollars you didn’t give up to the government.
Another benefit of deferring income is that, most likely, you’ll be paying into these accounts during your higher-earning years when your tax bracket is higher. If you draw the money out during retirement, you may be subject to a lower tax rate.
5. Take full advantage of work expenses to maximize your tax-free income. One way to increase your tax-free income is to make sure your employer reimburses you for all expenses you paid that are within the guidelines set by your employer and the IRS.
For instance, you can be reimbursed for business travel, meals and entertainment, expenses for a work vehicle, or continuing education. If you have any job-related expenses that aren’t reimbursed by your employer, for example, union dues, job search expenses, and some classroom supplies for teachers, you may be able to get a tax deduction for the amount that exceeds 2 percent of your adjusted gross income (AGI). Ultimately, though, getting reimbursed will always result in your paying less in taxes.
6. Understand gift and estate tax changes. In technical terms, an estate tax is an excise tax levied on the right to pass property at death. It covers everything from real estate to cars to jewelry to investments and more, and is imposed by most state governments, as well as the federal government.
Estate tax changes are often in flux. For instance, before the end of 2012, a wealthy individual could give gifts to his or her family members throughout his or her lifetime and receive an exemption for the first $5.12 million and avoid the gift tax and possibly the estate tax after death. However, the American Taxpayer Relief Act permanently changed the exemption to $5.25 million for 2013 and will also be indexed for inflation annually going forward. As you can see, it’s important to stay abreast of estate tax changes so that you can take advantage of them when the opportunity arises and prevent costly mistakes! As always, be sure that you’re working closely with a trusted tax advisor.
7. Know what the Affordable Care Act means for your taxes. Under the Affordable Care Act, you have limited opportunities to deduct medical costs (including self-paid medical insurance premiums) for you and your family. Starting in 2013, your deduction may be limited to only the amount that exceeds 10 percent (7.5 percent through 2012) of your AGI. With this new threshold for deducting health-related costs, fewer people will be getting this tax break going forward. With that said, establishing a Health Savings Account (HSA) has just become so much more important. With an HSA, if your health insurance plan is considered a high-deductible plan, you can contribute $3,250 as a single individual or $6,450 under a family plan, and an additional $1,000 if you are 55 or older.
Contributing money to an HSA will give you a tax deduction above-the-line in arriving at your adjusted gross income. This means these contributions will reduce your adjusted gross income and taxable income dollar for dollar. If you then withdraw money from these accounts to pay for qualified medical expenses, these withdrawals will not be taxable to you. This is a terrific strategy for paying your medical bills with pre-tax dollars. They are a great way for people who have high-deductible health insurance plans to save money because of the pre-tax benefits, lower premiums, and ability to roll savings over year after year.
8. Know the tax advantages of property ownership. If you sold your home this year, a tax advantage may be in store. Specifically, if you owned and used the home as your principal residence for at least two years out of the five preceding the sale, you might be able to avoid the tax on any profits you made from the sale.
- If you’re single, you may be able to exclude $250,000 of the gain.
- If you’re a married couple filing jointly, you may be able to exclude up to $500,000 of the gain.
This tax-free income is by far one of the most favorable reasons for home ownership.
Also, be aware of the potential benefits that come with owning property used in your business or other income-producing activities, like rental real estate. You will be able to take a depreciation deduction. And even if the property is increasing in value each year, the government allows you to take a write-off for depreciation, which is actually a phantom deduction. You may be able to generate a positive cash flow and pay no tax on this income after deducting depreciation expense.
9. Get smart about education credits. Parents of college students, rejoice: If you paid qualified tuition and fees for an eligible student in the first four years of college or post-secondary institution, you may qualify for the American Opportunity Tax Credit (AOTC) of up to $2,500 for each eligible student (in 2012).
Likewise, if you paid qualified expenses for yourself, your spouse, or your dependents who enrolled in eligible educational institutions during the year, you may be able to claim the Lifetime Learning Credit of up to $2,000. Unlike the AOTC above, this credit does not have a degree or workload requirement. It is not limited to the first four years of post-secondary education, and there is no limit on the number of years it can be claimed.
If your income exceeds the eligibility requirements to take advantage of the two preceding education tax credits, you may elect to forego claiming your child’s exemption on your tax return and instead let your child claim these education credits if he has a tax liability. Calculate your tax bill as well as your children’s and take advantage of the method that provides your family with the greatest tax savings.
10. Don’t give the government an interest-free loan. Your employer provides you with a withholding certificate, Form W-4, in which you indicate your filing status and allowances. The more exemptions you claim, the less tax your employer withholds from your paycheck. Before you start to claim every exemption in sight, though, keep in mind that this is just an estimate of the tax to be paid. Your true tax is calculated when you file your actual income tax return.
You should adjust your exemptions so that you are not overpaying or underpaying the taxes withheld from your paycheck. Although most people like a big tax refund at the end of the year, this simply means you are giving the government an interest-free loan. When you put it in those terms, that check from the IRS doesn’t seem so attractive anymore. Trust me; there is no easier way to improve your cash flow than by adjusting your exemptions so that you are not overpaying your tax with each paycheck.
Make tax planning part of your life. Always ask yourself, Is this the most tax-effective way to handle this financial situation? Viewing your financial decisions through a “tax lens” is, by far, the most efficient way to save money and accumulate wealth, without dramatically altering your lifestyle. Get informed and partner with a tax advisor who can guide you along the way.
About the Author:
John J. Vento is author of Financial Independence (Getting to Point X): An Advisor's Guide to Comprehensive Wealth Management (Wiley, 2013, ISBN: 978-1-1184-6021-4, $40.00, www.ventocpa.com). He has been the president of the New York City-based Certified Public Accounting firm John J. Vento, CPA, P.C., and Comprehensive Wealth Management, Ltd., since 1987. John has been ranked among the most successful advisors of a nationwide investment service firm and has held this distinction since 2008.