97 – How to Prepare for Taxes

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Episode Overview:

Tax Season is soon upon us, with many eligible to file taxes already. Ken walks you through some considerations that will allow you to properly and legally leverage the system. No list of forms needed for this episode, just your 2019 filing. What type of deduction did you use and what bracket do you fall in? Do you use itemized or standard deductions? There are ways to leverage both, depending on your situation. Ken briefly defines these terms and then guides you to an optimal filing.

Transcriptions are auto-generated, please excuse grammar/spelling!

Happy day to you. This is Ken Kaufman, and I’m thrilled you’re here for Episode 97, How to Prepare for Taxes. Now, I want to warn you right upfront, this is not going to be a podcast of a list of documents that you need to pull out and get ready to go talk to your tax person about. I’m not gonna go through that. What I would recommend you do is you pull out last year’s tax return and I want you to look at two things. I want you to look at did you use the standard deduction or did you itemize, and the second is I want you to look at what your effective tax bracket was.

And the reason why is because these two things, from my experience, ends up helping to educate about where the best opportunities are to try to optimize how much taxes you’re paying. This isn’t about avoiding taxes or doing anything illegal, but there are clear strategies that can be deployed relative to the income you have coming in and deductible expenses that you have going out, that can help you get ahead in terms of the amount of taxes that you need to pay. And by get ahead, I mean, optimize.

So when you look at last year’s tax return and then you’ll want to compare it to what this year’s tax return. And when I say last year’s it’s 2019’s tax returns that were filed in 2020. And we’re gonna talk about that and then we’re gonna talk about what the year 2020 is going to look like when you file your taxes. Basically from today on, I think you’re you’ll be eligible to jump in and file taxes. And these two things are very, very critical.

The first element here is the standard deduction. And for the year 2020, the standard deduction for a single person is $12,400. For a married filing jointly couple, it’s $24,800. What that means is that the first $12,400 or $24,800 of income that you have in a year, if you’re single or married filing jointly. And I’m just gonna run with the married filing jointly number, the $24,800, the first $24,800 that you earn in 2020 is tax-free. It doesn’t count as taxable income. That money comes into you and you’re not paying taxes on that.

On the other side of the standard deduction is what’s called an itemized deduction. And with the most recent tax law changes, a lot of people now don’t qualify for an itemized deduction, but I want to bring up this point so that you can be thinking about maybe there’s a way that you could maximize the amount of itemized deduction and standard deductions you get from year to year.

So the things that count as itemized deductions are mortgage interest up to a certain amount, charitable contributions, property taxes paid, medical expenses, I believe, if they exceed 7.5% of your adjusted gross income, and there are a few others. When you are doing your taxes, one of the most critical decisions is, “Do I utilize the standard deduction, the $24,800 or are my itemized deductions greater and I want to use that instead?” Because if your itemized deductions are $30,000, then what that means is the first $30,000 of your income is not taxed, not just 24,800.

And so what I’ve seen a lot of people do over time, and I guess there’s really two strategies that I want to throw out for you to be thinking about and considering. What I’ve seen some people do, where they have some control over those itemized deductions and when they pay them, is that in one year, they’ll go ahead and take the standard deduction of $24,800, and then in the next year, they’ll double pay charitable contributions. They’ll double pay property taxes. They’ll time when they’re actually paying for things and it will allow them in one year to take $24,800 and then another year, maybe $30,000, or $35,000, or some number higher than that just depending on, you know, everything that’s happening with their financial situation.

And, you know, to plan for this, you’ve got to have somewhat stable income, and you’ve got to have cash flow to be able to pay things in advance, and you’ve got to be able to think through all of that and get it planned. But what it means is, is that the standard deduction is a leverage point that can allow you to figure out how to potentially save money on the amount of taxes that you’re paying from year to year.

And you may decide in one year you’ll take that standard deduction and then the next year is when you’re going to actually spend money on the controllable elements of what makes up the itemized deduction and you’re gonna then take the advantage to get even a little bit more versus if you had just lived life normal, you would have gotten the $24,800 one year and then 24,800, the next year. Maybe you could get $24,800 this year, and with a little bit of planning, you could get $30,000 or $40,000 the next year, and then you go back to the standard deduction the next.

So that’s one really interesting strategy. I’ve seen it used, and I’ve seen it used very effectively and it’s, you know, completely within the bounds of what or how the taxation system works.

The second element of the standard deduction that’s very important to remember is besides yourself and your spouse, if you have other people around you that have standard deductions and they’re not using them, there could be a way to leverage that so that you can get the benefit of it.

I’ll give you one example. Either you or your spouse are self-employed, or you have some form of self-employed income coming in. And you have children, and some of those children are old enough to where they can work and do things to help you with this business that you have, whether it’s your primary source of income, or it’s a side hustle, or whatever that situation is. You can choose, if you desire, to hire one or more of your children into the business, and then you can pay them for the work that they do.

And here’s the interesting thing. If let’s say that you are in a 22% tax bracket and all the income coming into that business is taxed at 22%, plus, there’s the self-employment taxes and just depending on your situation and what you do or don’t pay, if you’re above cap or below, there’s some detail to this to get it right but you could elect to pay one or more of your children to help you inside your business.

Now, it has to be legitimate. First of all, the child must be old enough to be able to do whatever tasks it is that you’re assigning to them and perform them at a reasonable level. And then when you pay them, the interesting thing is, you can pay them up to the $12,400 standard deduction and they don’t pay any taxes.

And my understanding is I don’t know exactly how this part works, but I think if they’re 16 or younger, you also don’t have to withhold Social Security or Medicare tax. So literally all of those dollars would flow straight over to them and as long as it’s below that standard deduction, it’s a way to move that money out of your tax bracket and move it over into theirs and leverage that $12,400 standard deduction.

So two ways here to use the standard deduction. One is if you can legitimately and have good business reason and good business purpose to do this, transfer some of your income over to another person’s standard deduction, generally, that would live in your same household, phenomenal benefit.

And then those dollars could be used to if you’re going…I mean, actually, they’d have an earned income now so you could fund a Roth IRA for them, you could put that money aside and have it be saved for their schooling in the future or a mission or, you know, any number of things.

In essence, what I’m trying to say is if it’s a family member like that, you could benefit from it in the sense that you would have possibly needed to pay or help pay for some of those things in the future anyway. And then obviously, the other part of the standard deduction is possibly leveraging, switching back and forth from year to year going itemized in standard and actually getting more bang for the buck out of what the IRS gives us as tools in terms of optimizing our taxes.

The other part to think about is what is your tax bracket. Now, I have it pulled up here, I just need to open it up. The 2021 tax brackets…or the 2020 tax brackets. And this is why I want you to look at your 2019 return and I want you to look at what was your effective income tax bracket. And when I say effective, because we’re in a progressive tax system that says the first roughly $20,000 of your income is taxed at 10%. And by the way, that’s income above your standard deduction or itemized deduction.

The next let’s see from about 20,000 I’m rounding here and this is married filing jointly about $20,000 to $80,000 of income, or when you’re at $20,000 to $80,000 of your income, now you move into a 12% bracket. And then in between $80,000 to $171,000 you’re in a 22% bracket.

So there’s some big jumps there. Look at that from $80,000. If you cross over the $80,000 number and I’m approximating this, I’m just taking a rounded number, but every dollar that you earn over that you’re now paying not 12% but 22%. So your tax rate on those dollars goes up 10% from where it was before.

And so there are often things you can do from an income perspective and especially if you have some visibility to what your income is going to be in future years to leverage how much of your income can stay in that 12% bracket, and not trip over into the 22% bracket. Again, there are some strategies you can do with that but the most important thing is know what your tax bracket is, know how close you are to the bottom or top of that bracket, and then understand what your income is going to be in the future.

And this is where having a great tax CPA helps. They can help by the way on utilizing or maximizing your standard versus itemized deduction. They can also help on helping you plan based on when your incomes coming in how you can try to leverage these tax brackets so that the maximum amount of dollars coming through can be taxed at the lowest possible rate over time.

Now, again, there’s a lot of nuances here and strategies to work with here, but the key thing is, when you’re preparing for taxes, this should not be a one-time event. Preparing for taxes should be something you’re thinking about and working on throughout the year and actually throughout your life. And having a good tax person that can give you some consulting, give you some direction and advice can actually help you really optimize how much tax you pay and try to minimize it from year to year over time, paying your fair share, but not anything more than that.

And so, again, this podcast was not about making a list of what documents you need. Just go google “how do I prepare for taxes” and you’ll find all kinds of information about what documents and all those things. I’m saying look at your return last year, look at standard versus itemized and how far you are away if you were standard, how far were you away from getting the itemized. Look at other standard deductions that are available to you within your circle of influence and look at your tax bracket and then track those every year. And look and see where some of those opportunities are going to be, engage your tax professional to help you optimize your situation.

Many, many thanks to you for joining today. This is a wrap for Episode 97. Happy day.

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About the Podcast

Join Chief Financial Officer Ken Kaufman as he helps you track and hack your net worth. For those seeking financial independence, your net worth is one of the most significant measurements of success. Using his two decades of financial experience, Ken Kaufman helps you overcome your financial obstacles and look onward towards a better, brighter financial future.

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