How to Make the Tax Code Work for You
Taxes are a part of nearly every financial decision, from earning income and saving for retirement to investing, giving to charity, and planning for the future.
While you can't control the tax laws, understanding how they work may help you make more informed decisions. Two concepts are especially important: tax deductions and tax credits.
Tax Credits: A Direct Reduction
A tax credit generally reduces your tax liability directly.
For example, if you owe $5,000 in federal income tax and qualify for a $1,000 tax credit, that credit could reduce your tax liability to $4,000.
Depending on your circumstances, tax credits may be available for areas such as:
Education expenses
Qualifying childcare or dependent-care expenses
Certain energy-related improvements
Families with qualifying children or dependents
Other eligible expenses or activities
Eligibility requirements and credit amounts vary, so it's important to determine which credits may apply to your specific situation.
Tax Deductions: Reducing Taxable Income
A tax deduction works differently. Rather than directly reducing the tax you owe, a deduction generally reduces the amount of income subject to tax.
Potential deductions may relate to areas such as:
Certain charitable contributions
Eligible mortgage interest
Qualified retirement contributions
Certain medical and dental expenses
Other expenses permitted under current tax law
Whether a deduction is available—and whether you benefit from taking it—depends on your individual circumstances.
Credits and Deductions Aren't the Same
One of the easiest ways to understand the difference is:
Tax deduction: May reduce the income on which you are taxed.
Tax credit: May reduce the amount of tax you owe.
Both can be valuable, but they work in different ways. Understanding that distinction can help you have more productive conversations with your tax professional.
Think Beyond Tax Season
Tax planning doesn't have to begin when it's time to file your return.
Throughout the year, financial decisions can create tax consequences. For example, you may want to consider the tax implications of:
Increasing retirement contributions
Choosing between traditional and Roth retirement strategies
Selling investments that have appreciated
Managing capital gains and losses
Making charitable gifts
Taking distributions from retirement accounts
Buying or selling a business
Planning for future retirement income
The goal isn't necessarily to pay the least amount of tax possible today. Sometimes a decision that creates a tax benefit now may have different consequences in the future.
Look at the Bigger Picture
A tax-efficient decision should fit within your broader financial strategy.
For example, retirement planning may involve balancing current deductions with future taxable income. Investment decisions may involve considering both potential returns and the tax treatment of those returns. Estate and charitable planning can also have tax considerations.
That's why tax planning can be more effective when it is coordinated with your investment, retirement, estate, and overall financial plan.
Keep Your Strategy Current
Tax laws can change, and a strategy that made sense in one year may not be appropriate the next.
Major life events—such as a new job, marriage, divorce, business sale, inheritance, retirement, or significant change in income—can also affect your tax situation.
Reviewing your strategy regularly can help you identify opportunities and potential surprises before they become problems.
Make Tax Planning Part of Your Financial Plan
The tax code can be complex, but you don't have to navigate it in isolation.
A qualified tax professional can help you understand your tax return and current tax rules, while a financial professional can help you consider how tax decisions fit into your broader financial goals.
Educational Disclaimer: This material is provided for general educational purposes and is not intended to provide tax, legal, or financial advice. Tax laws and individual circumstances vary and may change. Consult with qualified tax, legal, and financial professionals regarding your specific situation.
