How to Reduce Your Income Taxes - Knowledge is the Key

Americans have a love-hate relationship with taxes... Okay, mostly "hate." But of course, our taxes go to fund the infrastructure, roads, social programs, and national security efforts that keep us safe, free, and prosperous. Along with voting, paying taxes is part of our patriotic duty as American citizens. But as one person famously noted, "I'm proud to pay taxes in America, but I could but just as proud for about half as much money."

Private consumption and investment fuels the economy, so you are not being unpatriotic by seeking to legally reduce your tax burden. In fact, even the IRS says that it is every citizen's right to avoid taxes as much as possible - but not to evade them. What's the difference between tax avoidance and tax evasion? About 10-20 years in the federal pen, that's what!

Tax avoidance is legal, ethical, and smart. Tax evasion is criminal, and especially where the IRS is concerned, crime rarely pays. Every person's individual circumstances are unique, so instead of offering personalized tips that may or may not apply to you, this article's purpose is to fill you in on the basics of taxes so that you will have the knowledge necessary to avoid as much taxation as possible.

Some Important Terminology

In order to save on taxes, you need to know what's what. For starters, two terms used in this article are personal exemption and standard deduction. The personal exemption is an amount of income that Uncle Sam is generous enough to not tax you on. Currently, it is $3,400 for every adult and $850 for every dependent. The standard deduction can be used in place of itemized deductions, at the taxpayer's discretion. Like the personal exemption, it reduces the amount of income on which income tax can be assessed. Currently, it is $5,350.

Some people do not use the standard deduction, and instead, they itemize their deductions. This is normally for people who give a lot of money to charity, since charitable contributions are deductible. Also, home mortgage interest is deductible, but only if you exceed the standard deduction. Some deductions, such as student loan interest, can be taken in addition to the standard deduction.

Income Tax Basics

First, let's deal with federal income taxes. Along with FICA (discussed later), these make up the bulk of most people's tax bills. State income taxes, sales taxes, and a variety of other fees and excises also take a bite out of your wallet, but since everyone in all fifty states pays federal income taxes and FICA, we will deal with them in this article.

Personal federal income taxes are assessed to "earned income." This includes wages, salaries, and business profits for unincorporated businesses. Interest income, and other forms of "passive" income (income for which you did not have to work, directly), are also assessed federal income taxes, but they are not assessed FICA.

Most Americans pay their federal income taxes through withholding with each paycheck. Others, like small business owners and self-employed people, may pay their taxes four times a year, or just once every April 15. Regardless, you are required to make sure you are square with Uncle Sam by April 15, file a tax return, and make up for any taxes due if you underpaid. If you overpaid - like most Americans - you get a refund check from the U.S. Treasury Department. But should you be happy about this?

Don't Give an Interest-Free Loan to the Government

Julian and Denise thought that they were savvy planners. A young couple in their twenties, they purposely had more taxes than necessary taken out of each of their paychecks so that they could receive a big refund every April. Meanwhile, they ran up credit card bills all year long, paying only the minimum payments each month, until finally paying off their balances when they received their tax refunds. Then they started all over again.J

ulian and Denise thought that their plan was smart. It took the pain out of paying their monthly credit card bills, and they believed they were getting the stuff they put on their credit cards - movie tickets, dinners out, iTunes downloads, etc. - almost like they were free. In fact, Julian and Denise thought their plan was so ingenious, that they almost felt guilty. That is, until they brought it up to one of their friends at poker night.

"What you're doing is giving the government an interest-free loan all year," Dino said. Julian and Denise were confused. "And even worse, you're going into the hole by racking up interest payments all year long," Dino continued.

Julian and Denise didn't understand, so Dino pulled out a pen and pad. "Look here," he said. "You're giving Uncle Sam $690 every payday when he only wants $600. You're loaning him $90 every two weeks and he isn't paying you any interest." Julian understood, but Denise remained unconvinced. "Then you're putting $40 a week on your credit cards all year long and running up over $500 in interest each year," Dino continued. "You see, Denise," Julian chimed in. "We'd be better off to have only $600 held back from our checks and to use our own money, instead of the credit cards, to buy our goodies all year long. We'd save $500 a year."

The important lesson in this story is to realize that if you get a tax refund, you're not making financially savvy decisions. You are giving an interest-free loan to the government, when instead, you could be investing your money in an interest-bearing account, or just spending it on the things you love. It makes no sense to have more money held out of your check than necessary.

Know Your Filing Status

Worse yet, Julian and Denise were married, but since they both had jobs, they had elected the tax status of "married filing separately." After Dino took a closer look at their tax returns, he found out that Julian and Denise could save more than $550 in taxes by simply switching to "married filing jointly.""

"You see here, Julian," Dino said to his friend. "Your individual income of $53,000 last year - after your personal exemption and standard deduction - puts you in the 25% marginal tax bracket. But if you combine your income with Denise's $28,000, then your joint income - after exemptions and deductions - qualifies for the 15% marginal tax rate. You could save more than $550 a year by switching to 'married filing jointly'."

"Jeez," Julian said. "That's almost $1,100 that we're wasting each year, in addition to giving an interest-free loan to the government."

"That's right," Dino replied. "And there's probably a ton of other things you could do to legally cut your tax bill. We're just getting started."

There are four filing statuses to choose from. Single, married filing jointly, married filing separately, and head of household. Single and married filing separately are essentially the same. Head of household is for unmarried taxpayers who live with dependents (usually their children). Most married couples are better off to file jointly,  as demonstrated in the example above. The only reason you should file separately is if you've spent a lot of money, out of pocket, on health care. There is a special tax deduction for this, and it is easier to meet the necessary threshold if you don't file jointly.

Social Security and Medicare Taxes

FICA - named for the Federal Insurance Contribution Act - is the tax assessed on wages and salaries that goes to pay Social Security and Medicare benefits. Social Security tax is 6.2%, and Medicare is 1.45%. Unlike federal income taxes, exemptions and deductions do not apply to FICA taxes. They are assessed on the very first dollar of income, up to a cap of $93,000 for Social Security. There is no cap on Medicare taxes.

Luckily for Julian and Denise, the onerous tax bills that they've been paying have included FICA. Although they are listed separately on your paycheck and dealt with differently from income taxes, the IRS handles both.

Now You Know...

Now that you're armed with the income tax basics, you can really begin to understand the tax tips offered at this and other websites. The important thing is for you to take an active role in your own financial planning, and that cannot be done if you don't understand the fundamentals. With this article under your belt, you will have much more confidence when approaching a tax specialist or other advisor. You may even be able to help some misguided friends like Julian and Denise. Taxes - like death - are one of life's most unpleasant certainties - but saving as much as you're legally able can be one of life's greatest joys.

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