A CPA walks into a bar…what, did you think that CPAs are funny? I’ll be funny later, but for the next five hundred words or so (and I’ll keep track on my calculator), let me talk about tax planning.
Over the many tax seasons that I’ve been through, there have been countless times when I’ve had to tell first time clients about the enormous balances due on their tax returns. Once they’ve had the chance to pick their jaws up from the floor, the first two questions invariably are “why?” and “what can I do to not have this happen again?” The short answer to the first question is lack of tax planning, and the short answer to the second question is…you guessed it, tax planning.
I’ve had a number of client consultations recently with people who have had “life changes” (marriage and switching from W-2 employee to 1099 independent contractor are two common ones), and they want to know what they can do to minimize their tax bite and not have surprises on April 15th. Being proactive and thinking about this stuff (i.e. tax planning) while there’s still time to make adjustments before year end is a smart thing to do.
Much as I may like to think that I’m the great and powerful Oz (making tax miracles happen from behind a curtain), in reality there isn’t a lot of mystery behind tax planning. When I look at a tax return, I look at the dollar amounts on the various lines of the 1040 form (and also the blank lines) and think “what can be done on these lines that will save taxes?” For example, if you’re a W-2 employee, you get your paycheck every other week and that’s that. Not much you can do there. But do you get a bonus at the end of the year? If you do, perhaps you can defer it until next year, which will push the tax on that income off a year. Alternatively, you can use some of that bonus to max out on your 401k deduction (if you haven’t yet done that); that’ll knock your taxable income down. Also, are you taking advantage of all of the pre-tax or nontaxable benefits that your employer is offering? These would include flex spending and health savings accounts, and dependent care benefits, among others. These can all help reduce taxable income.
Another area to consider is investment income, such as interest, dividends, and capital gains. Remember that interest and short-term (under a year) capital gains are generally taxed at your top (marginal) tax rate, which can be as high as 39.6%. Municipal bond interest is federal tax free and possibly state tax free, so changing your source of interest income could save money. Qualified dividends and long-term capital gains are generally taxed at 15%, so if you’re holding a security that you’re thinking of selling at a gain, hold it for at least a year and a day to get the long-term tax rate and not your marginal (up to 39.6%) rate. The other thing to consider with investment income is that if your adjusted gross income is above $200K single/$250K married filing jointly, there’s an additional “net investment income tax” of 3.8% to pay on that investment income. With proper planning, your investment income can be shifted around to minimize both income and net investment income taxes.
I could write a couple of thousand words about tax planning, and I just barely scratched the surface here. One of the basic tax planning tenets is to accelerate deductions and defer income (when possible), so when you’re giving your 1040 a top to bottom scan, think of what you can do to accomplish that. There are plenty of ways to keep a few extra tax bucks in your pocket!
Why did the CPA cross the road? To count the chickens on the other side. See, that’s why lawyer jokes are so much more fun!
Practice safe tax every day!