Plan to Reduce This Year's Taxes

The vast majority of people worry about the wrong problem: how do I reduce last year's taxes? Think about it for a second. After the year has ended, the options you have for reducing your taxes are very limited. You can dig up tax-deductible expenses, contribute to a tax-deductible IRA, and double-check all your math. That's pretty much the routine most people go through every April.

But there's a better way.

You can plan ahead to reduce your taxes. I have two clients who have completely eliminated their federal income taxes. How did they do it? They planned ahead using four very simple tax strategies.

Strategy #1: Plan to contribute as much as you can afford to a tax-deferred retirement plan.

You read that right -- reducing income is the best way to reduce your taxes. That does not mean you need to give yourself a pay check or quit your job. It means you need to reduce your taxable income. By far the best way to do this is to save money through a 401(K) retirement plan. 401K contributions are deducted from your paycheck before any taxes are calculated. And the savings grow tax-deferred until the funds are withdrawn in retirement. So it's a two-for-one tax deal: you reduce this year's taxes and defer taxes on the investment gains. If your employer doesn't offer a 401K plan, you should take a look at tax-deductible Traditional IRAs. Self-employed people (a.k.a. freelancers and independent contractors) should look into SEP-IRAs to save for retirement.

Strategy #2: Take advantage of tax deductions.

There are a wide variety of tax deductions that you can take advantage of. These deductions require that you spend money in order to save money on your taxes. The most popular tax deductions involve buying a house. Homeowners can deduct mortgage interest paid to banks and real estate taxes paid to the county. Together these two itemized deductions can go a long way to eliminating your tax bill. However, you don't need to be a homeowner to get a tax break. There are tax deductions for performing artists, for purchasing Health Savings Accounts, and for moving expenses because you changed jobs, or for interest you are paying on a student loan.

Many tax deductions need to be itemized. That means, you tally up all your deductions on Schedule A, and see if your total deductions exceed your standard deduction. (You can find standard deduction amounts at Quick Tax Facts 2006.) If your itemized deductions are less than your standard deduction, you are better off taking the standard amount. However, some tax deductions don't need to be itemized. These are called above-the-line deductions or adjustments to income.

Strategy #3: Take advantage of tax credits.

Tax credits are powerful tax breaks. Deductions reduce your taxable income, but credits reduce your tax liability. If you are in teh 25% tax bracket, every $1 in tax credits is worth $4 in tax deductions. So generally speaking, you'll want to take advantage of every tax credit you are eligible for.

The most popular tax credits include the Earned Income Credit and the Child Tax Credit. But there's a new tax credit for 2006 that sound very appealing. You can slash you tax bill by as much as $3,400 if you purchase a new hybrid car or truck. The hybrid tax credit will have a very short life-span before it is completely phased out.

Strategy #4: Review your paystubs and adjust your withholding.

You should review the level of income tax withholding on your paychecks at least once a year. You should compare your withholding to your estimated tax liability for 2006, and use a paycheck tax calculator to help you figure out if you are withholding too little or too much. You should fill out a new Form W-4 to adjust your level of withholding. If too much taxes are taken out during the year, you will have a huge refund on your tax return. If too little taxes are taken out, you'll end up owing tax at the end of the year. And no one really looks forward to paying that bill.

But, you ask, how do I estimate my tax liability for 2006? Easy, get out a copy of your 2005 tax return and a blank Form 1040. (Here's a collection downloadable federal tax forms). Copy over amounts from your 2005 return, making adjustments for what you think your income and expenses will be for 2006. If you got a raise, increase your wages. If you plan to buy a hybrid, make sure to note the tax credit amount. Use 2006 tax figures (instead of the 2005 numbers shown on Form 1040), and calculate your tax using 2006 tax rates. This should give you a good idea of what your tax liability will be for 2006. Then compare your tax bill to your level of withholding.

Voila! You have just planned ahead for your 2006 tax return. If your tax bill is too high, you have plenty of time to search for tax credits and deductions to lower your taxes. How long will this process take? I would spend no more than an hour reviewing your tax plan. If you get stuck, or are looking for more ways to super-charge your tax strategies, you could find a tax professional and ask them to review your tax situation and make recommendations. When people ask me to create a tax plan for them, the first thing I ask them is what they love doing. And then we start search for tax deductions and credits that fit their lifestyle. So my number one tax tip: browse around for tax breaks that sound appealing to you and learn more about them.