An asset is any resource with economic value that is expected to provide a future benefit to its holder. An asset may be differentiated from income by this distinction: income is money that is being received, whereas an asset is something–typically money or property–that a person is already in possession of. The Internal Revenue Service (IRS) considers most types of income taxable. There are few exceptions to this; any income that is not taxable, or tax-exempt, is clearly delineated in the Internal Revenue Code (IRC).
- An asset is any resource with economic value that is expected to provide a future benefit to its holder.
- An asset may be differentiated from income by this distinction: income is money that is being received, whereas an asset is something–typically money or property–that a person is already in possession of.
- The Internal Revenue Service (IRS) considers most types of income taxable; any income that is not taxable, or tax-exempt, is clearly delineated in the Internal Revenue Code (IRC).
- Some taxpayers employ legal strategies investing and financial planning strategies with the goal of lowering their annual income tax liability.
Taxable Income vs. Tax-Exempt Income
Taxable income includes wages, salaries, bonuses, and tips, as well as unearned income. Unearned income is any income received from investments and other sources unrelated to employment. Examples of unearned income include interest from savings accounts, bond interest, alimony, and dividends from stock. In some situations, tax refunds that taxpayers are eligible for may be counted as taxable income. However, this is typically only the case if a taxpayer claimed a deduction for state and local taxes in the prior tax year. If that is the case, a taxpayer may be required to report any tax refunds on line 1 of Schedule A of Form 1040. This rule is in place to prevent taxpayers from claiming a deduction for their state income taxes and then later, also receiving a tax-free refund.
Of those items that the IRC delineates as not taxable (or tax-exempt), inheritances, child support payments, welfare payments, manufacturer rebates, and adoption expense reimbursements are generally not taxed. Gains in tax-deferred accounts are protected from taxation under specific conditions, although they may be taxed at a later date (as opposed to annually like other sources of income). Tax-deferred accounts are savings accounts that typically do not require taxpayers to claim the income earned inside of the account on their annual tax return. Some examples of tax-deferred accounts include individual retirement accounts (IRAs), employer-sponsored retirement plans (such as 401(k), 457 or 403(b) plans), and tax-deferred annuities. However, gains in tax-deferred accounts may be taxed if special conditions are violated (such as an early withdrawal of the monies or illegal usage of the funds in the account).
Financial Planning Strategies That Reduce Taxable Income
Taxpayers sometimes employ different investment strategies that are meant to reduce their total tax liability. A tax-minimization strategy may try to take advantage of different types of investments that get different tax treatments; in particular, a financial planning and investment strategy that aims to reduce taxes may maximize the use of tax-deferred accounts.
However, investors using an investment strategy that aims to reduce taxable income tend to hold some of their investments in taxable accounts. For this strategy, it's typically recommended that tax-friendly stocks, volatile stocks, and index funds are held in taxable accounts, whereas taxable bonds, real estate investment trusts (REITs), and mutual funds should be held in tax-deferred accounts.
Take Advantage of Deductions and Credits to Reduce Taxable Income
Other legal ways of reducing your taxable assets are to take advantage of all available tax deductions and tax credits. Whereas a tax deduction reduces the income you're taxed on (which can mean a lower tax bill), a tax credit actually cuts your tax bill directly. With a tax deduction, a taxpayer can subtract the amount of the tax deduction from their income, thus making their taxable income lower: the lower your taxable income, the lower your tax bill. On the other hand, a tax credit is a dollar-for-dollar reduction in your actual yearly tax bill.
There are two options for claiming a tax deduction; you can either claim the standard deduction or itemize your deductions. Choosing to itemize deductions or opt for the standard deduction will impact a taxpayer's total liability, so it is worthwhile to compare tax liability under both options before filing.
The standard deduction lowers your taxable income by one fixed amount. If the standard deduction that a taxpayer qualifies for (based on their age, income, and filing status) is greater than the sum of the itemized deductions they qualify for, it is generally recommended that they elect the standard deduction.
For taxpayers who elect to itemize their deductions, their goal is also to reduce their taxable income. Some common itemized deductions include unreimbursed medical and dental expenses, interest expenses, and qualified charitable donations.
Tax credits can further reduce your liability. Sometimes tax credits even result in a refund for the taxpayer. Some of the most common tax credits that taxpayers are eligible for include the American Opportunity Tax Credit (AOTC), Child Tax Credit, Adoption Credit, and the Lifetime Learning Credit.