For a lot of young people, especially those who are beginning to get a handle on their finances, tax filing can be a dreaded task, and strategic tax planning may seem like a major undertaking.
Year-end is typically when many people start thinking about taxes. But waiting until the year is over may result in a scramble or the inability to implement certain time-sensitive strategies, which can make tax planning less effective. Often, people look back on the previous years’ filings and think of all the things that could have been done differently to help lessen their tax bill.
Taking a proactive approach by planning for any income tax burdens throughout the year could be the key to lessening some of those tax-related anxieties. Doing so may also be the key to lowering tax bills and generating significant tax savings—catapulting many into a more stable financial future.
Why tax planning is important
Many young adults are on the cusp of pivotal milestones in life—such as graduating from college, entering the workforce and building careers, starting to save and invest, buying their first homes, getting married and having children. Navigating these major life events is not easy, especially in an uncertain financial and economic environment. In addition, tax laws can be complicated, which is why it is especially important for young professionals to understand the potentially fluid nature of their circumstances and the possible impact on their tax obligations.
It’s easy to overlook important deductions or credits that could make a big difference in how much is owed or how much someone can get back when it’s time to file.
This article clarifies some fundamental things young professionals should be aware of when preparing their tax returns.
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Types of taxable income
There are two types of income: earned and unearned. Earned income includes wages from an employer or income received from self-employment, as well as tips, unemployment benefits and sick pay. Unearned income includes interest, dividends, royalties and capital gains from the sale of assets. Income at the federal level doesn’t include gifts or inheritances.
The amount of tax owed is based on how much you earn. To determine your tax rate, the Internal Revenue Service (IRS) uses a series of ranges, also known as brackets, that represent incrementally higher amounts of income. The tax system is designed to be progressive so that people who earn more pay a higher percentage. However, taking advantage of various tax benefits may reduce tax liabilities.
Standard vs. itemized deductions
Tax deductions lower one’s income, so taxes are paid on less earnings. The IRS allows employees to claim the standard deduction, which is a fixed amount based on their filing status. Professionals may also itemize their deductions, which means selecting various deductions allowed by the IRS, including charitable contributions, mortgage loan interest, some medical and education expenses, as well as business-related expenses, though there are limitations on the ability to deduct in all of these categories.
The Tax Cuts and Jobs Act of 2017 increased the standard deduction and made itemizing tax deductions less beneficial for many taxpayers. But if an individual has the ability to itemize his or her deductions, it can make a significant difference on their tax liability.
Maxing out tax credits
While deductions are subtracted from one’s income and lower the amount that they are taxed, tax credits reduce what is owed. After all deductions have been claimed, some people may still owe taxes. However, it is possible to reduce the amount owed or even erase tax debt with tax credits.
Nonrefundable tax credits are only valid in the current reporting year and cannot be carried over to future years. A nonrefundable tax credit can reduce tax liability to zero, but cannot be used to provide a tax refund. Examples of nonrefundable tax credits include credits for adoption, the lifetime learning credit, the child and dependent care credit, the saver’s tax credit for funding retirement accounts, and the mortgage interest credit.
Refundable tax credits entitle taxpayers to the full amount of the credit. If the refundable tax credit reduces the tax liability to zero, the taxpayer will receive a refund for the credit. Examples of refundable tax credits include the Earned Income Tax Credit for low- to moderate-income taxpayers who meet certain criteria based on income and number of family members, and the premium tax credit, which helps individuals and families cover the cost of purchasing health insurance through the health insurance marketplace.
With a partially refundable tax credit, if a taxpayer has a zero tax liability before using the entire amount of the tax credit, the remainder may be taken as a refundable credit, up to a certain amount. An example of a partially refundable tax credit is the American opportunity tax credit for post-secondary education expenses.
A note about student loan interest
Subject to certain income phase outs and limitations, student loan interest may be deducted, regardless of whether the taxpayer itemizes their deductions or chooses the standard deduction.
Getting the most from tax-advantaged retirement and health savings accounts
Funding a retirement account with pre-tax dollars lowers taxable income, so if an employee is not participating in an employer’s 401(k) plan or depositing money into an individual retirement account, he or she are likely missing out on some key tax advantages.
Another recommendation is to consider a Health Savings Account (HSA) if it is an option with an employer’s insurance plan. Any amount deposited into an HSA is deductible and does not have to be itemized in order to take advantage of this tax break.
A good strategy is key
Having a good tax strategy can reduce tax liability and related anxieties. For help with tax planning, consider working with a financial advisor—someone who can explain deductions, qualified credits, and tax-advantage accounts that are most beneficial for particular financial situations.
CIBC Private Wealth’s Wealth Your Way podcast series is an educational offering for clients and their children, and demonstrates our commitment to developing the rising generation. You can listen to the podcast on income tax here.