Reducing Your Tax Liability: The Basics

There are numerous ways that are available to decrease the amount of money that we must pay in April. Some methods are fundamental; others are more esoteric, depending on one’s financial position. They all, however, can be condensed down into one of three basic categories: reducing your income, increasing your deductions, or using tax credits.

One way to minimize taxes is to reduce your income, by lowering your Adjusted Gross Income (AGI). Your AGI is the sum of your income from all sources minus any adjustments, or deductions. Adjustments may include contributions to a traditional IRA, student loan interest that was paid during the year, tuition and expenses, alimony paid, and classroom-related costs for teachers. The AGI is a key element in determining your tax liability. Because adjusted gross income is so important, many people choose to focus much of their reduction-related attention upon it.

Almost everyone can take the standard deduction, and some people are able to itemize their deductions. Itemized deductions include expenses for health care, state and local taxes, personal property taxes (such as car registration fees), mortgage interest, gifts to charity, job-related expenses, tax preparation fees, and investment-related expenses. One effective tax planning strategy is to keep track of your itemized expenses throughout the year using a spreadsheet or personal finance program. You can then quickly compare your itemized expenses with your standard deduction, and use the higher of the two to compute your tax liability.

The mortgage interest deduction is probably the most well-known, and generally the largest, of all the deductions that can be itemized. But not only interest is eligible to be deducted. Loan origination points, when taken in the year that the loan was made, can also be itemized.

The final method for reducing your tax bill is by the utilization of tax credits. Tax credits are dollar-for-dollar reductions subtracted from your tax liability. There are tax credits for college expenses, for retirement savings, even for adopting children. Two very important education-related tax credits are the Hope Credit and the Lifetime Learning Credit. The Hope Credit is for students in their first two years of college. The Lifetime Learning Credit is for anyone else taking college courses.

One of the best, and most abused, tax credits is the Earned Income Credit (EIC). Unlike other tax credits, the EIC is credited to your account as a payment. This means that the credit can often result in a tax refund even if the total tax owed has been reduced to zero. You may be eligible to claim the earned income credit if you earn less than a certain amount and have a qualifying dependent.

It should also be noted that you can avoid owing money to the government in April by increasing your withholding. More money will be taken out of your paycheck throughout the year, but you could possibly receive a larger refund when you file your taxes.

No matter how complicated the deduction or credit, no matter how obscure the source, all attempts at reducing your tax bill will eventually fall into one of these three basic categories. For more comprehensive information about how to lower your tax liability, visit the Internal Revenue Service’s website at www.IRS.gov.