Managing Taxes: a Comprehensive Approach

Written by Monica Sandler

Thursday, 18 September 2008 11:22

Everyone knows taxes. As we start earning, we start paying to Uncle Sam, and, generally, the more we earn, the more we pay. In many cases, a middle-class family can easily end up paying up to 50% of its salary. The burden of taxes seems unavoidable. Or is it?

Sure, you can't eliminate your taxes altogether. But the good news is that there are many, many ways to reduce your taxes. The caveat in managing your taxes is that you want to plan well ahead, and execute your plan throughout the year, not just a week before the well-known deadline date for tax returns April 15th.

Generally speaking, saving money helps. If you did not spend your money, you could use tax deferred accounts to keep them. How does tax deferral work? It allows you to save for your retirement faster. You do not pay taxes until you need this money, and let it grow with interest compounding that is also not taxed. As the money becomes available for your retirement, you pay taxes in a different (usually, lower) income bracket. In the end not only you postpone paying taxes now, generally you end up paying less tax altogether. There are several tax deferred arrangements availible:

IRA
401k or 403b

If you decide to spend your money before you reach the age of 59.5, there might be an additional 10% tax penalty. However, in many cases, such as using this money to purchase your first home, this penalty can be waived. This is an excellent example when careful planning helps you get the most out of a tax program.
Another way to manage taxes is to make a part of your income tax deferred or not taxable at all by using the following options

Roth IRA
Roth 401k
Annuities

These arrangements allow for tax deferred growth, and some of them (such as Roth IRA and 401k) even let you withdraw your money upon reaching the retirement age without paying any taxes. Because you contribute with your after-tax money, these accounts do not provide any immediate tax relief. You will start seeing good tax savings from this strategy only after several years, as your savings grow. As such, this strategy also requires you to clearly understand your goals and carefully plan your financial future.

Building tax free income does not stop at retirement planning. If you wanted to start earning income that is free of federal tax, you could invest in municipal bonds or municipal bond funds. It is true that income earned from such investments is exempt from federal tax, and in some cases even qualifies for state tax exemption.

Another good way of cutting your taxes is purchasing a home. Generally, the interest on mortgage is tax deductible (while principal payments are not). Buying a house is a very big decision for the family so getting a tax break is not the only consideration.

Other, more advanced methods of controlling taxes include purchasing goods that appreciate in time and donating them to charities, or even to your own children who make no money on their own. Under Uniform Transfer to Minors Act and Uniform Gift to Minors Act, once you made a gift, you can not claim it back. The first $700 in your childrens investment earnings are not taxed. If your child is under age of 14, there is a limit of $1,400 that is taxed at your childs rate. All the earnings over that limit are taxable at your tax rate. For kids that are 14 years old and over, there is no such limit.

Considering the entire financial picture and planning ahead are essential in managing your taxes. You do not have to earn more to get more, with a careful planning.