Sunday, January 15, 2012

Increase your Income Tax Refund by Proper Timing

Lower your Taxes by Deferring Income and Maximizing Deductions

Using discretion when recognizing income and paying expenses can help reduce payouts and maximize refunds on United States income taxes.

Taxpayers who use the cash basis of accounting can reduce their United States federal tax burden by adjusting when income is received and expenses are incurred. Sometimes the effect will only be temporary, but in other cases permanent savings will be generated.

Cash basis accounting is a different method from accrual accounting. In cash basis, income and expense are recorded when they are paid. Accrual accounting recognizes these when they are incurred.

The following examples relate to the taxpayer using cash basis accounting.

Effect of Timing on Income

The simplest example of timing is in delaying taxable income until the next year. If there is any ability to defer taxes until after the end of the tax period (usually January 1), money received will not be taxed until the next year.

If the taxpayer falls into a lower tax bracket in the next year, this will result in actual savings. Alternatively, it may actually be better to move taxes into the current year if income (and the resulting tax rate) is low.

This is the principle being 401Ks and IRAs, which defer taxable income until after retirement. This is not true for Roth IRAs, which do not feature tax deferral.

It may be rare to find a circumstance where income can be deferred, but if the situation applies, it is smart to take advantage of it. In cases where the alternative minimum tax situation applies, consulting with a tax professional may be appropriate.

Effect of Timing on Deductions

There is much greater flexibility in determining the timing of expenses for deductions. Expenses are recorded when paid.

Generally, paid means when the funds leave the taxpayer’s possession. Checks that are mailed are based on the postmark date. Credit card transactions are considered to be as of when the charge is made, not when the balance is paid off.

Why is this important? Creating deductions before the end of the year lowers taxes in that year. Paying real estate taxes, estimated state taxes, or employee expenses early can defer taxes for the cash basis taxpayer.

There are other opportunities for real savings, not deferrals, built into the tax code. Deductions from federal tax can be used two ways:
  • The Standard Deduction
  • Itemized Deductions
The taxpayer is entitled to take the greater of these two. It is legal and smart to consider whether tax can be reduced by combining as many deductions in one year to maximize itemized deductions, and then claiming the standard deduction in the alternate year.

For example, a taxpayer may have $5,000 in deductions in each of two years, but has the option of prepaying $1,500 in real estate taxes in year one.

If the standard deduction is $6,000, it makes financial sense to pay the taxes early. Then the itemized deduction of $6,500 can be taken in year one. In year two, the standard deduction of $6,000 is greater than the remaining $3,500 of itemized deductions.

Other savings can be garnered from areas where there are limitations. Medical deductions have to exceed 7.5% of adjusted gross income (AGI) to be deductible.

The taxpayer with high medical costs will benefit by maximizing payment in one year, even the amounts exceed the threshold. Similarly, the category of other deductions must exceed 2% of AGI.

Although taxpayers are obligated to pay the appropriate amount due to the Internal Revenue Service, the tax code has provisions that enable honest taxpayers to reduce their burden by the effective use of timing. Always consult a tax professional for specific questions on your situation.

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