Tax planning helps a taxpayer find his or her way through a maze of paperwork and tax codes. There are a number of resources available to help taxpayers prepare their annual reports to local, state and federal revenue agencies. By exploring these aspects of tax planning and preparation, the reader will better understand both the planning schemes and the environments of tax policy and reporting. A synopsis of the number of ways tax planning may take place in the course of preparing an income tax return is provided.
Keywords: Adjusted Gross Income (AGI); Certified Public Accountant (CPA); Deductions; Earned Income Tax Credit (EITC); E-Filing; Tax Liability; Tax Software
The iconic economist, John Maynard Keynes, once quipped, "The avoidance of taxes is the only intellectual pursuit that carries any reward"
(http://www.quotationspage.com/subjects/taxes/). Paradoxically, taxes are simultaneously one of the most loathed and most invaluable components of any political system. They are despised in popular circles because they draw away from our personal incomes, add cost to the goods and services we buy and are imposed on our personal belongings such as cars and property. At the same time, taxes fund local, state and federal coffers, which are in turn drawn upon to pay for schools and roadway repairs, social services and national security. One of the contributing factors to the public's distrust of taxation is the amount of paperwork, details and bureaucracy that any American filing a tax return must endure throughout the process. Tax planning helps a taxpayer find his or her way through this maze of paperwork.
Indeed, there are a number of resources in use to help taxpayers prepare their annual reports to local, state and federal revenue agencies. By exploring these aspects of tax planning, the reader will better understand both the planning schemes and the environments of tax policy and reporting.
Very few industrialized countries operate without heavy reliance on tax revenues. Oman, for example, levies no income tax on its residents, but that revenue is compensated by a significant tax on businesses, particularly those in the oil industry. Without taxes, countries simply cannot operate unless an alternative form of revenue is located. Roads, education, social services, national security and other government operations depend on taxation.
While the value of tax revenues cannot be discounted, most people lament the taxes taken from personal income or which are assessed on the purchase of a candy bar. Indeed, taxes seem to be imposed on every aspect of life — income, business, home ownership, retail, lodging, restaurants, alcohol, fuel and personal property are among the various forms of taxation that is in place on the federal, state and local levels in the United States. Many other countries have a similar, diverse collection of taxes, often at even higher rates.
In light of the myriad of taxes that are prevalent in the U.S., reporting them to the federal and state governments is often an arduous affair for the uninitiated as well as those who understand it thoroughly. For this reason, a sizable percentage of the population turns to certified public accountants to assemble their returns. According to Harris Interactive, 47 percent of American men and 33 percent of women turn to computer software that helps them walk through each aspect of their returns step by step. The minority of people either prepare their taxes themselves, using paper forms, or turn to family members and friends to help file their taxes for them (Harris Interactive, 2006). While taxation is a fact of life for hardworking Americans, it is also a common fact that of the 91 percent of Americans paying their taxes, about 37 percent of them do not take steps to minimize their liability.
Reducing Tax Liability
Central to the issue of tax planning and preparation is the need for individuals to generate yearly tax reports that are accurate and incur the least amount of tax liability. Since people who earn more income pay more in taxes, the first way for individuals to reduce their tax liability is by reducing their income. Of course, they need not take a pay cut from their jobs in order to do so. Tax liability is determined by assessing the individual's Adjusted Gross Income (AGI), which is the aggregate of all income sources less any adjustments to income. If an individual, rather than applying all income to a deposit account, invests part of his or her income in a 401(k) or similar retirement account, that modification signals a reduction in taxable income. Similarly, a taxpayer who reports deductions to account for student loan payments, alimony or other expenses is also documenting an adjustment in income, thereby reducing tax liability (Perez, 2009).
Another important vehicle for reducing AGI is the deduction. There are a myriad of deductions an individual may report on his or her tax return, each of which must be itemized. In general terms, the IRS allows 11 types of deductions:
- Automobile registration fees,
- Real estate expenses,
- Charitable contributions,
- Investment expenses,
- Casualty and theft losses,
- Job-related books and publications,
- Professional organization and government dues and fees,
- Education and research,
- Business use of an individual's home computer and Internet service, and
- Job search expenses (Robson, 2009).
In addition to deductions and adjustments, taxpayers may also see their tax liability decrease by taking advantage of available tax credits. There are a number of such credits, including incentives offered for a dependent's college education and another to encourage parents to adopt. For lower and middle income taxpayers, there is the Earned Income Tax Credit (EITC), which is designed to help those people who have full-time jobs but are not making very much in salary. The EITC helps qualified taxpayers reduce their tax liability and even see a refund despite receiving a relatively low paycheck (Internal Revenue Service, 2009).
Another vehicle for reduction of an individual taxpayer's tax liability is by increasing the withholding amount in that person's paycheck (Financial Web, 2009). Withholding is usually established when an individual begins his or her employment, but the modification can be made at any point thereafter. Increased withholding will result in a reduction in income but can also help generate a larger refund after April 15.
The greatest challenge for a taxpayer who is filing a return is to know about and take advantage of the myriad of vehicles that can help reduce tax liability by reducing one's AGI. This issue is the central point of tax planning — taxpayers would prefer to avoid losing tax refund monies by exploring every available resource.
Do It Yourself
Most people are not tax professionals. As such, the notion of filing an individual tax return that takes into account the extreme complexity of relevant tax laws is often intimidating. Then again, there are advantages that many Americans see to preparing their own tax returns. About 45 percent of Americans file their own taxes. The rationale is three-fold. First, many taxpayers see this avenue (as opposed to using an accountant or other tax service) as cost-effective. A tax preparation service may charge between $125...
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