Your Taxes Are Done! Time to Start on Your Taxes
A collective sigh of relieve was heard today as millions of tax filers sent in their taxes. Most also mistakenly think tax season is over. But savvy people know the best time to start on next year’s taxes is the beginning of this year. If you are one of those who understands the benefits of filing your taxes early, continue that positive habit by starting your taxes early as well.
The following will help you understand your planning options as well as give you a concise list of things which may qualify for a tax deduction. Keeping records and documents of any expenses related to potential deductions will help your tax preparer to maximize your actual deductions.
A History or A Plan
When a CPA prepares your tax return, they have little ability to actually impact your taxes. The reason is your tax return is a historical document about what happened last year. Since you can’t change history, any true tax planning strategies are lost. Next year, however, hasn’t happened yet. As a result, you have complete control over the tax planning environment and can make truly substantive planning decisions.
If your tax preparer never explained this to you, don’t be upset with them. Accountants (including CPAs) are historians by their nature. Their job is to identify how they can make what happened in the past year fit into the extremely complex tax law in the most beneficial way possible for you. Financial planners and tax planners, on the other hand, focus on the future and strategizing how you can use the different elements of your financial plan to make your finances more tax-efficient. They are two very important but very different skill sets.
Plan to Substantiate Your Deductions/Credits
The most powerful tools you have in your tax plan are your tax deductions and tax credits. In order to take deductions and credits, however, the IRS requires you to substantiate them. Substantiation means keeping a document trail which can be used in tax court to prove you are entitled to the deduction or the credit.
Although the law is vague about what constitutes ‘substantiation,’ the IRS and the tax court use a fair amount of common sense when determining if a tax payer has substantiated their claim. If the deduction is well-documented by paperwork which was not generated by the tax payer, it is usually considered substantiated.
If the documents are vague, unofficial, or generated by the tax payer themselves, then they will hold less value as a means of substantiation. And, of course, if the documents have nothing to do with the deduction/credit you are claiming, then they are irrelevant.
Deductions vs. Credits
Although the terms tax deductions and tax credits are sometimes used interchangeably, there is a world of difference between these two. Most are familiar with the concept that both reduce your tax burden and can increase your tax refund if you have overpaid your taxes. Deductions and credits, however, take on completely different characteristics on your tax return.
A deduction reduces your income in the eyes of the IRS; i.e. it deducts money from your gross income. As a result, the benefit you receive is equal to your highest marginal tax bracket times the deduction.
An Example: Say you make $60,000 per year and are in the 20% tax bracket. You would owe $12,000 in taxes ($60k x 20%). If, however, you gave $5,000 to charity, resulting in a tax deduction, your income would be reduced in the eyes of the IRS to only $55,000 ($60k - $5k). The new tax bill is $11,000 ($55k x 20%) instead of the original $12,000. The $5,000 deduction gave you $1,000 in tax savings.
Tax credits on the other hand are when the IRS pretends you paid taxes you actually didn’t pay; i.e. it credits your paid in taxes amount. As a result, the benefit you receive is equal to the actual dollar value of the tax credit.
An Example: You gain make the same $60,000 and are in the 20% bracket. This time, however, your get a tax credit worth $5,000. You still owe $12,000 in taxes ($60k x 20%), but now the IRS pretends you already paid $5,000 in taxes due to the credit. The credit would lower your tax bill to just $7,000 ($12k - $5k). The $5,000 credit gave you $5,000 in tax savings.
As a general rule, tax credits are more valuable than deductions, but there aren’t that many of them.
Start Collecting Possible Deductions and Credits
Since you are not a tax professionals, you may not know what constitutes a tax deduction or a tax credit for your return. Instead of spending hours trying to figure this out, start collecting, organizing, and filing any and all documents related to possible tax deductions and credits. When tax time comes, your tax professional will be able to determine which deductions and credits you qualify for. Only now they will have all the documentation they need to give you the maximum benefit.
Without an organized filing system of all your possible deductions, you will leave money on the table and pay more for the tax preparation. To get the greatest benefit, use a filing cabinet and create folders for each of the following categories. Begin saving receipts, confirmation letters, and other documents for any expense related to any of the categories in their respective folders. Each of the below areas can potentially earn you a tax deduction or tax credit.
Career Expense
Since your income tax is taxed on your...well...income, many expenses which are required for your job may be tax deductible. The new tax code has eliminated many of these deductions for regular employees, but a tax preparer may still be able to use them as self-employment expenses if you have a side-gig. While you may not have a side-gig now, you may end up working freelance at some point in the future. Having good documents of career-related expenses can help a tax preparer maximize your deductions next year.
This includes union or professional dues, work-related expenses, professional development, and even job search expenses. Receipts and documents for any expenses you incur related to your career should be organized and filed in case you qualify for these deductions.
Education Expenses
Similarly, education expenses may still be usable if they assist you with earning self-employment income through a side-gig. If you are currently working in your profession, you may be able to deduct student fees, tuition, and even books. You may also be able to deduct certain expenses if you are pursuing a new profession. Additionally, you may qualify for an education-related tax credit, which are even more valuable. Keeping all education-related receipts and documents will help you to substantiate both the deductions and credits you are eligible for.
Housing Expense
The new tax law made some changes to the home mortgage interest deduction, but the changes will not impact the first mortgage interest for the majority of taxpayers. Most people are familiar with the home mortgage interest deduction for income taxes. There are many additional deductions you can take, however, related to your housing. Most charges or fees related to your mortgage are also potentially deductible including late payment fees, prepayment penalties, points, and mortgage insurance premiums.
Home improvements can also be tax deductible. There are numerous deductions and even credits for energy saving home improvements. And costs of most major home improvement project can be deducted from any capital gains when you sell the home in the future. Keep copies of all your home improvement receipts as well as before and after pictures to prove the improvements made to the home.
Child-Related Expenses
Again, almost everyone is familiar with the dependent exemption you are entitled to when you have a child, which acts like a deduction. This exemption has been eliminated in the new tax code, but it has been replaced with a greatly expanded child-tax credit.
There are also, however, tax credits available for both adoption expenses and child-care expenses. If you qualify, these tax credits can significantly lower your tax burden. Maintaining good records of childcare and adoption expenses will help your tax advisor to get the most out of any tax credits you qualify for.
Charitable Giving and Expenses
Again, it is well understand that charitable contributions and activities are tax deductible, but many don’t know the details about how the charitable deductions work. Charitable giving should be well documented including keeping all receipts, thank you letters, and cancelled checks. When you donate property, you should keep not only the documentation from the charity but also pictures of all items donated so you can prove what was donated. There are also some other strange rules for donating property to charity, which you should be aware of.
Taxes Paid
The federal income tax system actually allows you to deduct taxes and expenses related to paying taxes, up to $10,000 for state and local taxes. Many state and municipal taxes qualify as tax deductions. You can also deduct the fees you paid last year to prepare and file your tax returns. Any document you get from your state, county, or city related to taxes or fees should be filed and kept for your tax professional to determine if you can deduct them.
Business Owners
If you own a business, almost all expenses related to the running/growing of your business are tax deductible against the income of your business. Save, organize, and add up all expenses related to your business and provide them to your tax advisor. In order for the expenses to qualify, they must be ordinary, reasonable, and necessary for running the business.
Self-employed & Home Offices
Similar to a business owner, the self-employed and those with a home office can deduct most of the associated expenses. Any costs you incur related to your self-employment and/or your home office should be documented and kept.
Medical Expenses
Once you hit a certain threshold of your income, almost every expense you pay for medical purposes becomes tax deductible. Throughout the year, save all paperwork related to expenses for medical care and provide them to your tax advisor. There are more qualifying expenses than you might think, including things like clarinet lessons for teeth alignment. Generally speaking, if it is prescribed by a doctor or related to health insurance costs, it is potentially tax deductible.
Low Income Families
Two tax credits are available for low and moderate income individuals: the Earned Income Credit and the Savers Tax Credit. Although millions of households qualify for these credits, a small portion of those that qualify actually claim the credit on their taxes. As a result, low income families lose out on thousands of dollars in financial support.
The rules for both are available on your tax forms and on the IRS website. If you don’t understand them, talk to a tax professional. The $50 it costs to get your taxes professionally prepared could result in hundreds or even thousands of dollars in your pocket come tax time.
Other Deductions
The expenses listed above are not an exhaustive list of every deduction you could be eligible for, but they are the most common. Additionally, your income or other circumstances may disqualify you to receive the tax benefit of a deduction. The purpose of this article is to provide you with a foundation to know what receipts and documents you should keep in order to maximize your deductions when filing.
Seeking Professional Help
If you are itemizing your deductions, you should always consult a professional tax advisor before claiming a deduction and filing your tax return. When seeking help, avoid dropping a large box of receipts on their desk. Your tax professional will have no problem entering all of those numbers into a spreadsheet for you because they’ll charge you $100 an hour to do it.
Instead, organize the documents and enter the information into a spreadsheet organized by type of deductions. Then add up the deductions and provide the total for each category along with the spreadsheet and original documents. This will save your tax advisor hours of time and save you hundreds of dollars in tax preparation fees.
Joshua Escalante Troesh is a tenured professor of Business at El Camino College and the founder of Purposeful Finance, a financial literacy organization. He is also the owner of a fiduciary financial planning firm. He can be reached for comment at info@purposefulfinance.org