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Taxes Introduction


There are a few certainties in life; things you will inevitably experience. One is birth, another is that you will die, and still another is that you will pay taxes. Taxes are a way that governments lay claim to portions of your income in order to finance their operations.

There are a variety of taxes that you pay as you go about your life. You may pay sales tax each time you buy a product. You may pay an inheritance tax when you inherit property from a deceased relative. You may pay income tax on the money you earn from your employment.

Taxes are mandatory. You must pay income taxes owed, or face stiff financial and legal penalties. However, income taxes are a little different than other forms of taxes like sales tax, in that, if you are careful, learn a little about how the tax code works, and work with a tax professional (like an accountant), you can minimize the amount of income taxes you owe in any given year.

Income Tax Planning

Employing good tax planning strategies will allow you to minimize the amount of your income that is subject to taxes, allowing you to keep more of your income for yourself. There are various ways of accomplishing this, but the most common ways involve: finding ways to reduce your taxable income (e.g., reducing the portion of your income upon which taxes are due), increase your allowable annual deductions (e.g., increasing that portion of your income which is not taxed), and maximizing available tax credits.

Income reduction does not mean that you should actually look for ways to earn less money. Rather, you should look for ways to reduce the amount of income that is taxable each year. You can do this quite readily by participating in a 401(k) or other qualified retirement plan. Contributions you make to these types of retirement accounts are not counted towards your taxable income for each year. This means that after making a retirement contribution, on paper, your income is less than it would have been if you had not made any contribution. Because your taxable income is lower, the amount of income tax you will pay is less. Thus, you can save for retirement and pay less tax at the same time with this simple strategy.

Other than an off-the-top income reduction, you can also lessen your taxable income by increasing your deductions. A deduction is generally an expense you have incurred during the year that you are allowed to deduct from your taxable income, making that portion of your income which is taxable smaller. A number of deductions are allowed:

  • Mortgage interest payments
  • Student loan interest payments and other education related costs
  • Health care expenses
  • State and local and real estate taxes
  • Charitable contributions
  • Tax preparation costs

You will need documentation verifying that you actually had each expense before you are allowed to deduct such expenses. Each deduction is listed on an itemized form which is part of the tax return filed with the government each year. The itemized form allows you to categorize and list each expense.

There is an alternative to itemizing each deduction, and that is to opt for a standard deduction and a personal deduction. These two deductions are standardized in size and one-size-fits all (adjusted for your income and dependents). They are offered to most everyone who files income taxes. It is easier to take the standardized deductions when you file, as they involve far less work. However, most people will benefit more if they take the time to file an itemized deduction

After claiming your applicable deductions, you can further reduce the amount of tax you owe by checking to see if you are eligible to take advantage of any tax credits. Tax credits do not affect the size of the income you are required to pay taxes on. Instead, they directly affect the amount of tax you are required to pay. There are tax credits for retirement expenses, child care, adoption, certain home improvements, certain purchases, and for college expenses. Additionally, there is a special tax credit that is not applied to the amount of tax you owe. It is called the Earned Income Credit (EIC), and it is treated like a payment. This means that you can receive a tax refund even if you have reduced your taxes to zero. There are strict income limits for the EIC however. Check with a tax preparation expert to see if you qualify for EIC.