How The Tax System Works

“The hardest thing in the world to understand is the income tax.”

– Albert Einstein

The bad news is, the tax code is so complicated Albert Einstein can’t understand it. The good news is you don’t have to be Einstein to cut your taxes. You just have to know how the system works for you – your job or business, your investments, and your family.  Here is an overview of how the tax system works:

  1. Add taxable income from all sources to figure total income.
  2. Subtract “adjustments to income” to determine “adjusted gross income” (AGI).
  3. Subtract standard or itemized deductions and personal exemptions to determine taxable income.
  4. Consult table of tax brackets to figure your tax.
  5. Subtract any available credits to figure your final bill.

That’s really most of what you need to know. The real issue isn’t the numbers. It’s what you have to include in your income, what you get to deduct from that income, and where you invest to avoid reporting income at all. Having said that, there are three main strategies for cutting your tax:

  1. Earn as much nontaxable income as possible. You have more control over business and investment income than any other income you earn. You can draw income from your business in the form of tax-deferred and tax-free benefits. And you can grow and draw income from your portfolio in all sorts of tax-advantaged ways.
  2. Make the most of adjustments to income, deductions, and credits. Adjustments to income and deductions save by cutting your taxable income. Tax credits save by cutting your actual tax. There’s no magic to using them, other than knowing what you can deduct.
  3. Shift income to other taxpayers and other tax years. Shifting income from today to tomorrow cuts today’s tax—plus it squeezes another day’s use out of today’s tax dollar. And shifting income from you to a lower-bracket taxpayer, such as a retired parent or child, saves even more.
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