Tax Planning for Beginners: What It is and How to Start

If the looming tax season has you scrambling to get a hold of your tax situation, this beginner’s guide is where to start.
Last updated Mar 27, 2020 | By Matt Miczulski
Tax Planning for Beginners

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Taxes can be complex, and it’s easy to feel that they’re shrouded in mystery. But if you take some time to understand how taxes work, then you can use certain tax strategies to your advantage — and this can change how much you end up getting back or paying in April.

Here are some essential tax planning concepts to understand before it comes time to file so you can make the most of your financial situation and avoid costly tax mistakes.

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What is tax planning?

Tax planning is the analysis and organization of a person’s financial situation with the goal of ensuring the most “tax-efficient” outcome. In other words, the goal of tax planning is to make sure you are legally paying as little in taxes as possible.

Tax planning is something that should happen all year long, not just when it comes time to file your tax return. What you do in the beginning of the year and throughout has a direct impact on the taxes you owe or the tax refund you expect when you file.

Tax planning strategies can aim for more than just reducing your taxable income. In some cases, tax strategies can also benefit you by offsetting future costs for health care or providing for your retirement. Employing effective tax planning strategies can free up more money to save, invest, or even spend how you please.

Tax strategies may encompass both short-term and long-term objectives. Short-term tax planning is end-of-year planning, meaning the things you can do at the end of the income year to reduce taxable income. This can include making extra contributions to an IRA or pre-tax retirement savings like a 401(k), prepaying tuition, contributing to a 529 college savings plan, or maxing out charitable contributions.

You can also use the end of each year as a time to learn lessons for longer-term tax planning. Whether it’s identifying tax credits you missed out on this time around, readjusting your withholding for the coming year, or maxing out your retirement contributions over the course of the year so you aren’t scrambling before your next filing, tax planning can keep you organized and keep your finances in order.

Hiring a tax professional vs doing tax planning yourself

Determining who will be planning your taxes is an important element in your overall tax strategy. There are instances when hiring a tax professional makes more sense than doing it yourself, but also situations where you might feel as though you can personally handle things. Depending on the complexities of your tax situation, hiring a tax professional might be the best way to ensure your plan is as tax efficient as possible.

If you decide to hire a tax professional, you’ll need to determine who’s best for your situation. Does hiring a CPA (Certified Public Accountant) make the most sense, or can a tax preparation company handle things? Take a look at some of the pros and cons of these different types of tax preparers to help determine who might be best for your situation:

Tax service Pros Cons Worth it?
Bookkeeper
  • Can be more affordable, depending where you live
  • May not have specialized tax training
Depends on the individual’s training as they may not have in-depth tax planning knowledge
Accountant
  • Has training (likely a college degree) in accounting and can handle bookkeeping tasks
  • May be more familiar with tax planning than a bookkeeper
  • Can be more expensive than a bookkeeper
Depends on the individual’s experience and expertise but can be more affordable than a CPA
Certified Public Accountant (CPA)
  • Expert advice and efficiency
  • May provide audit assistance
  • Licensed and certified professional
  • Can be expensive
If your tax situation is complicated and the value they deliver outweighs the cost, a CPA might be worth it
Certified Financial Planner (CFP)
  • Expert advice and efficiency
  • May provide more value with overall financial planning
  • Certified professional
  • Can be expensive for a comprehensive plan and on-going advice
If you want a professional who can handle tax planning and your overall financial picture, a CFP might be worth it
Tax preparation company (H&R Block, Jackson Hewitt, etc.)
  • May offer in-person and online services
  • May offer competitive pricing
  • May provide audit assistance
  • Services may be of lower quality
  • Can be expensive
  • Tax preparers not guaranteed to have accounting background/certifications
Depends on the company and the branch you work with and expertise of the tax preparers employed there

If your tax situation isn’t complicated, handling your own tax planning is definitely feasible. Even if your tax situation is complex, hiring out could mean you’re missing an opportunity to learn. If you have the time and interest, understanding the entirety of your financial picture can be of great value.

As noted above, hiring a tax professional can be costly. Bookkeepers, accountants, CPAs, and CFPs will all likely charge by the hour. Prices can range from $21 an hour for a bookkeeper and $50 to hundreds per hour for a CPA. A CFP might charge hundreds to a couple thousand for a comprehensive financial plan, and then $50-$300 per month for ongoing advice. National tax preparation companies like H&R Block and Jackson Hewitt may charge varying amounts based on location and services rendered. For any tax professional, it’s best to call to get prices based on the specific services you need.

Regardless of whether you use a professional to help or not, there are still things you need to understand about your taxes. Understanding your financial situation and your options can ensure you have the best chance at taking the tax strategy that’s most advantageous to you. So let’s walk through the tax forms you may encounter, as well as some terminology that is frequently confused.

Basic tax forms you need to understand

Depending on your situation, taxes can require a lot of paperwork. Let’s start with defining some of the forms you’re likely to see:

  • W-2 form: Also known as the Wage and Tax Statement, this document is required to be sent to employees and the IRS at the end of the year. It reports your annual wages and the amount of taxes withheld from your paychecks.
  • W-4 form: You file a W-4 form before starting employment so your employer knows how much federal income tax to withhold from each paycheck.
  • 1099 form: A series of documents known as “information returns.” There are a number of different 1099 forms that report various types of income other than your employment salary. This includes independent contractor income, interest and dividends, and withdrawals from a retirement account among others.
  • 1098-E form: If you paid more than $600 in interest in any given year, you’ll receive a form 1098-E from your student loan servicer.
  • 1098-T form: Also known as the Tuition Statement, this form reports expenses you paid for college tuition that may entitle you to a tax credit or an adjustment to income.
  • Form 5498: This form is used for reporting your IRA contributions to the IRS when you save for retirement.
  • Form 1040: This is the standard federal income tax form used to report your income, claim tax deductions and credits, and calculate the amount of your tax refund or tax bill
  • Form 8962: Use to figure out the amount of your premium tax credit (PTC), if you’re eligible to receive one.

Tax deductions vs tax credits

As you start your tax planning, you will need to know the difference between tax deductions and tax credits.

A tax deduction is an amount of money that you can deduct (or subtract) from your taxable income. Doing so lowers your taxable income and thus lowers your tax liability. There are two types of tax deductions: the standard deduction and itemized deductions. While both types of deductions reduce your tax liability, they do so in different ways.

When you take the standard deduction, you subtract a flat amount that is specified by the government from your income. Itemized deductions, on the other hand, are a variety of eligible expenditures that can be subtracted from your adjusted gross income (AGI) to reduce your tax bill.

Common tax deductions

  • Medical and dental expenses
  • State and local income, sales, and property taxes
  • Home equity loan interest (restrictions apply)
  • Charitable contributions
  • Business use of your home
  • Business use of your car
  • Casualty, disaster, and theft losses
  • Work-related education expenses

A tax credit directly reduces the amount of taxes owed, as opposed to simply reducing your taxable income like a tax deduction. There are two types of tax credits as well: nonrefundable and refundable.

The savings from a nonrefundable tax credit can’t be used to increase your tax refund or to create a tax refund if you weren’t supposed to originally get one. You get a refund only up to the amount you owe. A refundable tax credit can result in a refund when the tax credits are greater than the amount of tax you owe.

Common tax credits

  • Earned Income Tax Credit
  • Child and Dependent Care Credit
  • Adoption Credit
  • Child Tax Credit
  • Residential Energy Efficient Property Credit
  • American Opportunity Credit and Lifetime Learning Credit
  • Premium Tax Credit (Affordable Care Act)

Standard deduction vs itemized deduction

Let’s get a little bit more into the differences between the standard deduction and itemized deductions now, as knowing which is best for you to choose will be part of your tax strategy.

The standard deduction is a flat amount you’re allowed to subtract to reduce your taxable income. This ensures every taxpayer has at least some portion of their income that is not subject to federal income tax. In general, the amount you can deduct is adjusted each year for inflation and the amount you deduct is determined by the government.

The amount of the standard deduction you can claim will vary according to your filing status, whether someone else claims you as a dependent, and whether you’re 65 or older and/or blind. If you’re 65 or older at the end of the tax year or are blind on the last day of the tax year, you’re entitled to an additional deduction. This additional amount will also depend on your filing status.

Filing status 2019 tax year 2020 tax year
Single $12,200 $12,400
Head of Household $18,350 $18,650
Married Filing Separately $12,200 $12,400
Married Filing Jointly $24,400 $24,800

Even though the standard deduction may sound simple, that doesn’t mean everyone can opt for it. According to the IRS, taxpayers in the following situations can’t use the standard deduction:

  • If you’re married filing as “married filing separately” and your spouse itemizes deductions
  • If you were a nonresident alien or dual-status alien during the year (exceptions apply)
  • If you file a return for a time period of less than 12 months due to a change in your annual accounting period (calendar year)
  • If you’re filing on behalf of an estate or trust, common trust fund, or partnership

If you choose not to take the flat amount of the standard deduction or you are not allowed to take the standard deduction, the other option is to itemize your deductions. Essentially you are doing what the word indicates, you are listing out all the items you are deducting from your income. In general, you should itemize if the total of your itemized deductions will be greater than the standard deduction.

Itemized deductions may include amounts you paid for the following:

  • State and local income or sales taxes
  • Real estate taxes
  • Personal property taxes
  • Mortgage interest
  • Disaster losses from a federally declared disaster
  • Charitable donations
  • Medical and dental expenses
  • Business use of your home
  • Business use of your car
  • Work-related education expenses

If the total of your itemized deductions is not greater, choosing the standard deduction is often a much simpler process and requires less paperwork on your part. The standard deduction increased with the passing of the Tax Cuts and Jobs Act of 2017, so many people who once itemized may be better off taking the standard deduction. So make sure you double check the numbers before you determine your tax strategy.

Whether you choose to itemize your deductions or take the standard deduction depends on your situation, but whichever reduces your taxable income the most is generally the best way to go.

Reduce your tax burden with an IRA contribution

Another thing to consider in your tax planning, or to ask your tax professional about when choosing your tax strategy, is how you plan to save for retirement.

A traditional IRA is a kind of account that allows you to save for retirement, and contributions to your IRA can reduce your tax burden. Generally, contributions made to a traditional IRA may be fully or partially deductible from your income depending on your situation.

If you earn a lot of money you may not be able to deduct the full amount of your contributions. If and how much you can deduct will be based on your filing status and whether or not you’re covered by a retirement plan at work.

If you are eligible to deduct your IRA contributions, be aware that they are deductible in the year they were paid. So if you contributed $2,000 to your IRA in 2019, then you can deduct up to that amount when you file in April of 2020.

Just because you don’t pay taxes on this money in the year you contributed it, does not mean you never pay taxes on it, though. The money in your traditional IRA (including earnings — the money you earned above the amount you contributed — and gains — the profit from the sale of an investment) will be taxed when you take a distribution, typically after you’ve actually retired.

If your adjusted gross income is higher when you retire and withdraw that money than it is now when you’re saving that money, then you’ll be taxed at that higher tax rate. Typically traditional IRAs are a good idea for someone who plans on having a lower income in retirement, but again this is where getting the advice of a professional tax planner can come into play.

If you decide that contributing to a traditional IRA will be part of your tax strategies, you should know that the annual contribution limit in 2020 for all your IRAs (traditional and Roth) is $6,000 — $7,000 if you’re age 50 or older — and you have until April of 2021 to put this money into an IRA.

Other strategies to reduce your tax burden

If you have children, you can further reduce your tax burden by contributing to a 529 college savings plan. While this won’t reduce your federal tax bill, it can reduce how much you owe in state taxes. Many states will give you a full or partial state income tax deduction for your contributions to the state’s 529 plan. More than 30 states offer such a deduction.

Another option for reducing your tax burden is to make contributions to a health savings account (HSA). An HSA is a savings account designed specifically for medical expenses and is available to taxpayers enrolled in a high-deductible health plan (HDPP). The money you put into an HSA is untaxed and can be used to pay for deductibles, copayments, coinsurance, and some other expenses.

Keeping your tax records: what and for how long?

Unfortunately, your tax planning for any given year doesn’t end once you file the paperwork. You should keep that paperwork and all associated documentation, receipts, etc. for 3-7 years or until the period of limitations for that tax return runs out. The IRS can audit you for this long, if:

  • 6 years: If you underreported income by more than 25% of the gross income shown on your return
  • 7 years: If you wrote off a loss from a “worthless security” or bad debt reduction
  • Indefinitely: If you committed tax fraud or didn’t file a return

You can get a breakdown of the full period of limitations on the IRS website.

Bottom line on tax planning and tax strategies

Tax planning is safe and smart; it’s not tax evasion. Whether you do it yourself or hire a tax professional, tax planning can potentially save you time, anxiety, and money. And each year that you put effort into tax planning, it will get easier and better.

Sound complicated? It doesn’t have to be. Getting started with tax planning for next year could be as simple as adjusting the allowances on your W4 if your tax withholding turned out to be off (as in, you owed a bunch of taxes or you got a big refund).

Tax planning recap

  • Tax planning is the analysis and organization of a person’s financial situation or plan with the goal of ensuring the most tax-efficient outcome
  • In addition to reducing your taxable income, tax planning can also can benefit you by offsetting future costs for health care or providing for retirement.
  • You can do it yourself, or hire a tax professional to handle your tax planning
  • Being familiar with the various tax forms will help you
  • Tax deductions lower your taxable income and therefore your tax liability
  • You can reduce your tax burden with things like contributions to an IRA, HSA, and/or 529 college savings plan
  • It’s important to maintain your tax records
  • You can start planning now for next year

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