Income tax planning involves strategies that help reduce a taxpayer's liability by legally utilizing provisions within the tax code. There are three basic ways to minimize your income tax burden: (1) convert your income from one type to another, (2) shift your income from one pocket (or place) to another, and (3) shift your income from one time period to another. Here is a breakdown of each strategy:
1. Convert Income from One Type to Another
This strategy focuses on changing the type or source of income to a form taxed at a lower rate. Since different types of income have different tax rates, shifting income between types helps reduce your overall tax burden. Some common techniques are:
- Convert ordinary income to capital gains: You can reduce taxes by holding assets for more than a year to qualify for long-term capital gains treatment. Long-term capital gains are often taxed at a lower rate than ordinary income (such as wages, interest, or short-term capital gains).
- Convert interest income to dividends: Qualified dividends are usually taxed at a lower rate than interest income. Thus, some investors might prefer investments that generate dividend income rather than interest income.
- Use tax-advantaged accounts: Contributing to retirement accounts like 401(k)s or IRAs allows you to convert taxable income into tax-deferred income (as with traditional IRAs) or tax-free growth (as with Roth IRAs).
2. Shift Income from One Pocket (or Place) to Another
This strategy involves moving income from one taxpayer to another or from one location to another to lower the overall tax burden. Here are some examples:
- Shift income to family members in lower tax brackets: You can gift income-producing assets to your children or other family members in lower tax brackets, so the income is taxed at their lower rate instead of your higher rate.
- Establish trusts or partnerships: You can shift income to a trust or partnership that allows you to distribute income among multiple beneficiaries or partners, potentially lowering the overall tax burden if those individuals are in lower tax brackets.
- Shift income geographically: You can move income-producing assets to states or countries with lower tax rates to reduce your tax liability. For example, some people may move to states with no income tax.
3. Shift Income from One Time Period to Another
This strategy aims to defer income to a later period or accelerate income to an earlier period, depending on your situation and anticipated tax rates. Shifting income between tax years allows you to take advantage of changes in tax rates, deductions, or other provisions. Some examples include:
- Defer income to a future year: If you are in a high tax bracket now, you can defer income to a year when your tax rate may be lower (e.g., during a year with lower income).
- Accelerate income into the current year: If you expect tax rates to increase in the future, you might choose to accelerate income into the current year (e.g., realize capital gains, convert some or all of a traditional IRA into a Roth IRA, etc.) to take advantage of lower tax rates.
- Maximize deductions in high-income years: You can also shift deductions (such as charitable donations) into a year when you have higher income to reduce your tax liability in that year.
By utilizing these three basic types of income tax planning, individuals and businesses can strategically minimize their overall tax burden.