Smart & Legal Tax Savings Strategies

This is a fair question, and every U.S. citizen should be able to answer it. The purpose of taxes is to collect funds to pay for programs and services authorized by state and federal governments. Here are a few examples of what your federal income and state taxes help fund:
Federal taxes help pay for:

• National Defense – Ensuring America's security and protecting its interests abroad.
• Social Security – Providing a reliable system for the protection of elderly Americans.
• Medicare, Medicaid, and CHIP (Children’s Medicaid) – Ensuring access to quality healthcare for low-income families, children, and individuals with disabilities.
• Science and Medical Research – Funding the search for cures and innovations.
• Education – Increasing access to college education through Pell Grants.
• Regulation – Maintaining clean water and air, as well as the safety of products and services.

State taxes help pay for:

• Public Schools – Providing free quality education from K-12 grades.
• State Colleges and Universities – Subsidizing education for residents of the state to promote employment and economic growth.
• Infrastructure – Building and maintaining highways, roads, and bridges.
• Medicaid and CHIP – States also cover part of the healthcare costs for low-income families.
• Public Safety – State and local governments employ police and firefighters, as well as manage prisons.

In short, taxes are the price we pay for living in a society that cares for its elderly and less fortunate members and plays an active role in educating and protecting its citizens. If you feel that state or federal authorities are spending tax dollars irresponsibly, write to your representatives and support candidates who share your values.

If you work for someone else – let’s call it “the employer” – taxes are withheld from each paycheck. When you file your tax return in April, you have the chance to claim deductions and credits that will reduce your overall taxable income. If you reduce it enough, Uncle Sam will owe you part of the money that was withheld throughout the year. This is called a refund!
One way to get a bigger refund is to withhold more money from each paycheck. Talk to your HR representative and ask to reduce the number of allowances on your W-4 form. However, keep in mind that you could likely use that money more wisely than lending it to the tax authorities. They won’t return it with interest. Consider investing the extra income or using it to pay down debt.
Another way to get a larger refund is to claim more deductions and credits on your tax return. Every taxpayer is entitled to the standard deduction, but you could further reduce your taxable income by itemizing deductions. Keep track of deductible items such as mortgage interest, charitable contributions, unreimbursed work expenses, home business expenses, and student loan interest.
If you have significant investments, own rental property, or run your own small business, consider hiring a professional tax specialist. They can help you identify potential losses and expenses that could lead to a larger refund.

If you miss the IRS deadline for filing and paying any taxes owed to the federal government by April 15th, it’s not the end of the world, but you may face some late fees for delayed payment.
The IRS charges two different types of penalties for late filing: for failure to file and for failure to pay. The penalty for failure to file is much higher than for failure to pay — 5% of unpaid taxes per month, versus 0.5% or 1% per month. So, the best advice is to file on time, even if you can't fully pay your tax bill [source: IRS].
Yes, the IRS allows anyone to apply for an automatic six-month filing extension, but read the fine print. The extension gives you an additional six months to prepare and file your tax return, but it does not relieve you of the responsibility to pay taxes on time. When you apply for an extension, you are asked to pay the amount of your unpaid tax bill. If you do not pay at least 90% of the taxes owed by April 15th, the late payment penalty will still apply.

If you work for yourself, pay in cash, have no loans for buying a house or car, don’t have bank accounts, and have never filed or paid income taxes in the past, you might fly under the radar of the IRS. On average, only about 2% of people who don’t file are caught [source: Beam]. However, if you regularly receive a paycheck from an employer, have a mortgage, and keep your savings in a bank rather than in garbage bags buried in your backyard, the IRS will likely catch up with you and impose severe penalties.
Problems arise when IRS computers notice that your Social Security number is linked to wages, loans, and bank accounts but no tax return has been filed. After sending a series of increasingly stern letters, the IRS will file a substitute return, an estimate of your tax liability. Based on these calculations, the IRS will begin applying penalties for failure to file and failure to pay for every month of delay. Both penalties can amount to 25% of your unpaid tax bill [source: IRS].
There is a subculture of tax protestors who use constitutional objections—what the IRS calls "frivolous tax arguments"—to justify not paying taxes. Courts typically reject these arguments as tax fraud or tax evasion. The additional penalty for tax fraud is 75% of the taxes owed, and tax evasion can send you to prison [source: IRS]. Just ask Al Capone.

If you have a modest income and make an honest effort to report your income and expenses accurately, the chances of attracting the attention of an IRS auditor are very low. According to 2011 data, households earning less than $200,000 had only a 1 in 98 chance of being audited. The chances were significantly higher for the very wealthy. If you earned more than $1 million in 2011, you had a 1 in 8 chance of getting the IRS’s attention [source: Cain].
IRS computers are programmed to look for "red flags" of tax fraud. To reduce your chances of being audited, avoid the following mistakes [source: Wicker]:

• Forgetting Income – If you are a salaried worker or self-employed contractor, the IRS receives data about your earnings for the year. If your figures don’t match the IRS’s, that’s a red flag.
• “Business” Expenses – Don’t claim vehicle mileage as a business expense unless you use the car exclusively for business. The same advice applies to home office deductions. And don’t try to write off lavish meals as entertainment expenses unless you can prove that the primary purpose of the meal was to discuss business with clients.
• Huge Charitable Contributions – If you claim tens of thousands of dollars in charitable donations but have a modest income, the IRS will take notice.

The first thing to acknowledge is that the so-called "marriage penalty" no longer exists. Prior to 2001, the standard deduction for married couples filing jointly was less than twice that of a single taxpayer. Today, joint filers can claim exactly double the deduction of single or separate filers, so that's no longer a concern. Instead, here’s what you should consider [source: Vient]:
Advantages of Filing Jointly:

• Double Deduction – The standard deduction being twice as large is a compelling reason to file jointly, especially for families with one earner.
• Certain Tax Credits – Only married couples filing jointly (not separately) are eligible for credits like the Earned Income Tax Credit, American Opportunity Tax Credit, Lifetime Learning Credit, Child and Dependent Care Credit, and adoption expense deductions.
• Higher Income Limits – You don’t have to file jointly to receive the Child Tax Credit, but the $1,000 credit gradually phases out at $110,000 for joint filers and only $55,000 for separate filers.

Advantages of Filing Separately:

• Medical Expenses – The IRS allows you to deduct medical expenses exceeding 10% of your income. If your spouse earns significantly more than you, it may be harder to deduct your medical expenses due to their higher income.
• No Shared Liability – When filing jointly, both spouses are legally responsible for any errors or misinformation on the tax return. If one spouse has complicated tax matters, such as business-related issues, it might be wise for the other to file separately to avoid sharing potential liabilities.

You don’t need to file an income tax return if your income for the year is below the established minimum threshold. For example, in 2013, the minimum threshold was $10,000 for single filers, $20,000 for married couples filing jointly, and $3,900 for married individuals filing separately. The minimum filing thresholds are slightly higher if you or your spouse are 65 years old or older [source: IRS]. If you're claimed as a dependent on someone else's tax return, the minimum threshold for filing is $6,100 [source: TurboTax]. These levels increase each year with inflation, so be sure to check the current figures.
However, even if you're not required to file a tax return, there are situations where you still might want to. If your employer withheld taxes from your paycheck, you could be eligible for a refund of some of that money. Additionally, it’s a good practice to file when you're employed full-time or have other income that needs to be reported.

The answer to this question is surprisingly complicated due to the IRS's intricate rules. However, here’s a simplified explanation:
A dependent is anyone who lives with you (except your spouse), and whom you provide more than half of their financial support. Children are the most common dependents, but elderly parents, other relatives, and even unemployed friends who stay at your house could qualify.
There are two main sets of requirements for claiming a dependent: qualifying child and qualifying relative.

1. Requirements for a Qualifying Child:U.S. citizen or legal foreign resident.
2. Younger than you, under 19 years old (or under 24 if a full-time student).
3. A blood relative (son, daughter, niece, nephew, etc.) or an adopted child.
4. Lived with you for at least half the year.
5. You provide more than half of the child's financial support.
6. Requirements for a Qualifying Relative:U.S. citizen or legal foreign resident.
7. Your child doesn’t meet the requirements.
8. Either a relative or someone who lived with you for the entire year (including unemployed friends).
9. Earns less than $3,900.
10. You provide more than half of their financial support.

• Additional Rules:Only one person can claim the same dependent on their tax return.
• You cannot claim someone as a dependent if they are married and filing a joint return with their spouse.

These rules can be tricky, so it's always a good idea to consult the IRS Publication 501 for more detailed guidance on dependents and eligibility.

Oh, that's a good question, because it is a source of much confusion. The U.S. income tax code is called progressive because tax rates increase as income rises. For example, in 2013, income up to $8,925 was taxed at a rate of 10%. Income from $8,926 to $36,250 was taxed at 15%. Income from $36,251 to $87,850 was taxed at 25%. It is said that someone earning $50,000 falls into the "25% tax bracket." Seems pretty simple, right?
Wrong.
When we say someone is in the "25% tax bracket," it sounds like all $50,000 of their income is taxed at 25%, which would result in $12,500 in taxes. But that’s not true. Only the money exceeding $36,250 is taxed at 25%. The rest is taxed at 15% and 10% according to the amounts we just listed [source: Fidelity]. The actual tax owed by someone filing for $50,000 is $8,428.75. The tax rate is 16.8%. (The real rate would be significantly lower after deductions and exemptions.)
The term "tax bracket" is meaningless. The correct term is "marginal tax rate." This is the tax rate applied to the last dollar you earned during the tax year — 25% in our example above. The real rate you pay to the IRS — 16.8% in our example — is called the "average" or "effective" tax rate. The average rate is always lower than the marginal rate unless you earn $8,925 or less, in which case they are equal.

Another great question that deserves closer scrutiny. In 2011, billionaire investor Warren Buffett wrote an article in the New York Times titled "Stop Coddling the Super-Rich," in which he claimed that he paid an effective income tax rate of 17.4%, while other employees in his office paid 36%.
How is that possible? Buffett, like many other extremely wealthy people, earns most of his money from investment income rather than regular wages from employment. Back in 2011, all investment income was taxed at a flat 15% rate. By 2014, this rate had risen to 20% for individuals earning over $400,000. On the other hand, regular income is taxed at 25% once it exceeds $36,250, and from that point, the rates only increase [source: Fidelity].
Regular working people also pay payroll taxes with each paycheck to contribute to Social Security and Medicare/Medicaid trusts. There are no such taxes on investment income.
In the end, people who earn money from money (investors) pay lower effective tax rates than people who earn money from work. However, to pay an effective tax rate of 36% requires an exceptionally generous salary, likely in the millions of dollars, and which is hardly considered "ordinary." For middle-class individuals, their effective tax rates are more likely to be less than 10% after standard deductions and personal exemptions [source: CBPP].