Tax planning is a fundamental aspect of personal and business tax management that usually gets ignored.
Tax planning is a proactive strategy designed to inform the taxpayer of future tax liabilities, and this allows various options to be utilized to reduce that liability.
In regular people talk, your tax person will estimate what your tax return for the next year will look like based on info you gave them. Based on this estimated return, we can see what you can do to reduce the tax owed.
Understanding the basic premise of what tax planning is, and understanding how tax saving options work and affect the outcome will go a long way in helping you achieve financial success.
Tax Planning Basics
In simplest terms, tax planning is preparing a tax return for the current year before the year is over. You would provide the tax pro certain info they can use to estimate what your total income for the year would be.
As for deductions, we look to previous years (most folks are pretty consistent year to year). We will also interview you for any transactions that are unusual.
The following is a list of info you may need to provide:
- If employed by someone, your most recent paystubs (if married both spouses, and for all jobs).
- If self-employed, year to date financial statements (profit and loss, balance sheet)
- Statements from any investment accounts, like Schwab or TD Ameritrade.
- Has there been any unusual transactions? Vehicle purchase? Refi any real estate?
- Any changes to marital status? New dependants, or any kids going off on their own?
- Any big plans? Sell a house? Buy a house? I have a client that sells collectibles every few years, such as books or artwork. Anything like that?
The only limitation is your ability to remember what has already happened, and any plans you may have later in the year.
Tax Liability Management
The main objective of tax planning is to manage your estimated tax liability. Different kinds of income have different rules. You can’t reduce earned income by taking a huge capital loss (only $3,000 of capital loss can be applied against earned income), So tax planning is identifying the kinds of income earned and the options available to reduce that income.
Timing is IMPORTANT
The timing of our response plays a bigl role in tax planning. Timing plays arole inwhen to recognize income, and conversely when to recognize expense (deductions).
Many times by controlling the timing of these transactions, you can optimize your tax situation. As an example, deferring income to a later year or accelerating deductions can reduce your overall current tax bite.
Understand Deductions and Credits Available
This is the meat of tax planning. We can calculate an estimated tax liability and given the info at hand, we can come up with some potential options you can use to reduce this estimated tax liability.
Without understanding how specific tax reduction strategies affect specific income types, anything you do will be nothing more than a shogun approach to tax planning. Not every strategy works for all types of income.
Portfolio and Retirement Options
Since both are based on saving, I’ll address both here, but bew aware that they don’ have much else in common.
Your portfolio account is a regular investment account like you may have at Schwab or ETrade. The goal of a portfolio is generally to grow in value, but sometimes you pick an investment that refuses. Capital gains can be offset by capital losses in full. For this reason, it may be prudent to look at any of those stubborn investments to possibly use some of its loss against any capital gains you may have.
Retirement investment options are different and I try and get the client to look at these options as nothing more than moving money from one account to another. It’s still your money.
Retirement contributions can also be made by both self-employed taxpayers and those that work for a paycheck. But retirement options really shine when used for self-employed individuals. There are options available for the self-employed which will allow you to contribute tens and hundreds of thousands to your retirement, effectively deferring tax until you withdraw in retirement (hopefully at a lower tax rate).
Tax Planning for Business
I advise everyone who runs their own business to seriously consider tax planning as a part of their accounting process.
Tax planning for a business (even a small business) has a lot more threads, and how to respond to your specific tax planning session WILL affect both your tax liability and the business health at large.
A great example would be the purchase of a truck. If you are someone’s employee, buying a vehicle would have very little impact on your taxes. The registration fee and maybe the sales tax paid would be deductible as an itemized deduction.
But if you buy a truck to be used in your business the deduction will be a lot more, maybe even the entire purchase price! A $50k truck purchased for a business may give you a $50k deduction. If purchased as a individual you only get registration and sales tax to deduct. In California that would be around $5,500.
How Can You Benefit from Tax Planning
Now that you understand what tax planning is, let’s take a look at how you can benefits:
Reduce Your Tax Liability
Duh now. The most apparent benefit is a lower tax bill. Reduce the amount you annually pay in tax, so you can use those funds elsewhere. We all want to save money.
Discretionary Funds Lead To More Opportunity
Paying less in taxes mean more money in your pocket. More money gives you more freedoms. Depending on how much you save, you can put these funds to use in places that improve the quality of your life
Financially Healthy Life
In 40 years of tax practice I can easily state that those who pay attention to issues such as tax planning and investing almos always have better financial health. I know. Stating the obvious.
But it’s a state of mind thing. We are an avoidant society. It’s natural to want to wear a blindfold when it comes to your finances, especially if they are less than pristine. Don’t be afraid.
Decision-Making Strategies
With the additional information tax planning gives us, we can make decisions that affect your quality of life for many years in the future. Save money on taxes and put into a retirement account? This benefits you now AND in the future.
Risk Mitigation
You can reduce any potential penalties and interest by knowing what to expect. If tax planning reveals a potential $20k shortfall at the end of the year, you have the opportunity either reduce the tax owed by spending (like the truck mentioned above) or investing (contributing to a retirement account). You can also simply make additional estimated tax payments to reduce what you will owe next year. All the above could reduce penalty and associated interest charges.
Another area of concern would be being audited. By understanding the whole of your current tax year situation we can conceivably get ahead of any potential audit risks. If you plan on selling your personal residence and taking IRC 121 (that’s the IRS code that allows you to take an exemption from some fo the capital gain realized from the sale of your personal residence), but part of the basis is from remodeling that was done over 20 years, we can advise the client to gather as much documentation about the remodels in anticipation of the IRS having questions.
Tax Planning Conclusion
Tax planning is an indispensable tool for managing your financial world. By understanding the principles and benefits of tax planning, you can better control your finances, only pay the bare minimum due in taxes, and help with your long-term financial prosperity. Consulting with a tax professional can be invaluable in crafting and executing effective tax planning strategies tailored to your specific needs and goals.