How The Tax System Works

Even Einstein didn’t understand how taxes work.  He is famously quoted as saying “The hardest thing in the world to understand is the income tax”.

So, in a nutshell, here is how it all works…

1. Add taxable income from all sources to figure total income.  This includes investments, wages, jury duty, business income, royalties, etc.
2. Then subtract allowed “adjustments to income” to determine adjusted gross income (AGI).
3. Subtract standard or itemized deductions and personal exemptions to determine taxable income.
4. Look up taxes owed in table.
5. Subtract allowable credits to determine final tax bill.

That is how the Form 1040 works.  Items 1 and 2 are on the first page, items 3-5 are on the 2nd page.  The trick in reducing taxes is knowing the opportunities available in each of the aforementioned categories and which forms to use to capture those opportunities.

3 of the main strategies for reducing taxes then are:

1. Earn as much nontaxable income as you can.  You have more control over business or investment income than other income.  For instance, there are ways to shift some personal expenses under the business umbrella to reduce taxable income.  As for investments, that income can be accessed in a number of tax-advantaged ways if set up properly.
2. Make the most of adjustments to income, deductions and credits.  Adjustments to income and deductions both reduce taxable income.  Credits reduce taxes owed and are thus generally more valuable than deductions.   The size of credits can depend on income.  Knowing the thresholds, breakpoints, etc. can help reduce taxes.  Sometimes credits can be shifted from one taxpayer to another to increase their size.
3. Shift income to other taxpayers and other tax years.  Delaying income to a future tax year or bunching deductions in a current year would be examples of this.  Shifting income to a lower tax bracket taxpayer, such as a parent or child, can save more.  For example, if you have a business, hire your child.  Money that you are already providing them could be paid in a wage, if done properly.  Their tax bracket is typically much lower than yours or non-existent and the money you are paying out becomes deductible, reducing your taxes.

A good tax preparer recognizes opportunities in your personal situation that could be applied to each section of the tax form and helps you use them to reduce taxes.   This generally takes years of experience and continuous training as tax laws change.

We at AFS have been doing this since 2004, and we do it at a much lower cost than the vast majority of our competition.  Save on your tax preparation and save on your tax liability.

CALL US TODAY for your tax needs.  303-745-3962