Tax preparers, lawyers, CPAs, and enrolled agents get all the glory by putting out fires during tax season and IRS audits. But most of their heroics wouldn’t be necessary with a little tax planning.
One of the problems with tax planning is that it is such a broad subject. Tax planning has a role to play when:
- Choosing your business structure
- Deciding where to invest your cash
- Buying or renting
- Filing your taxes
- Avoiding or facing an audit successfully
- Retirement planning
It is hard to make useful generalizations on a subject with such a broad scope. Even worse, many people think tax planning is just for the wealthy and don’t give it a second thought. This guide provides a big-picture look at tax planning. We will also provide specific examples of how it can help lower and higher-income taxpayers be more tax efficient.
What is “Tax Planning”
Tax planning is the financial analysis of a situation from a tax perspective. The goal of tax planning is to support a financial plan by guaranteeing long-term tax efficiency. A financial planner may focus exclusively on how to generate the most money on an investment. A tax planner has the same goal but also takes into account the tax consequences of financial decisions. As you can imagine, there is a lot of overlap between financial and tax planning.
Tax planning is essential for a variety of reasons. It’s not only a powerful tool to save money on taxes, which should be more than enough to get anybody’s attention. It can also help you protect your business from bankruptcy; improve the return on your investments, and increase your chances of enjoying a comfortable retirement.
Tax Planning When You Owe Taxes
What? Tax planning when you owe taxes. Isn’t that like applying sunscreen after putting on sunblock after buying insurance after a car accident? Not at all. Although tax planning can help prevent tax debt, medical bills, divorce, and unemployment can put a spoke in the wheel of the most cautious of taxpayers.
So what can you do if you’re facing a huge tax bill you are struggling to pay? If you are behind on your taxes, the IRS has a selection of tax relief programs that can help you lower your tax liability and pay the balance over time. The main tax relief programs are offers in compromise, installment agreements, currently not collectible status, penalty abatement, tax liens removal, levy appeals, innocent spouse relief, tax preparation, and bankruptcy.
Read this “Complete Guide to The IRS Tax Relief” for an in-depth review of the best tax strategies available.
If you owe more than $10,000 or you are being audited by the IRS, it is time for you to consider one of the most powerful tax planning strategies available to taxpayers: tax representation. Tax representation is a right guaranteed by the Taxpayer Bill of Rights. It allows taxpayers to hire an authorized tax representative (tax attorney, CPA, or enrolled agent) to defend their interests and negotiate on their behalf with the IRS.
Tax Planning for Income Taxes
As of 2020, there are seven tax brackets depending on your income, ranging from 10% to 37%. Tax planning involves minimizing the amount you are required to pay without breaking the law or incurring in tax penalties.
Tax laws (and loopholes) are constantly changing, so it makes sense to hire a CPA or professional tax preparer. They can ensure you´re following the latest tax planning guidelines. Here are five tax planning tips to get you started.
Catch Up with Your Estimated Taxes to Avoid Penalties
If you have to pay estimated taxes and you missed or underpaid one or more quarters, consider adjusting (i.e., overpaying) for the remainder of the year. The good news is the IRS considers you have paid your tax withholdings equally throughout the year even if you pay them near the end of the tax year.
Don’t forget bonuses, overtime, and commissions
In some cases, the IRS taxes supplemental wages, such as bonuses, commissions, and overtime, at a flat 25% rate. If this rate is higher than your tax bracket, take it into account when you prepare your estimated taxes. If you’re fortunate enough to receive more than $1 million in supplemental wages, you will be taxed at the highest income tax rate.
Time your compensation and bonuses to minimize taxable income
If you have some control over when and how you are paid commissions and bonuses, consider timing them to minimize tax liability. For example, if one year you receive a particularly high bonus because you killed your sales objectives, try to delay the receipt of the bonus to after December 31st or wait until January to bill for your work. That way you may be able to declare the bonus for that year in the next year’s tax return.
Convert Income into Dividends
Another option is to get your company to pay you in stock, so you are “only” charged ordinary income tax on your supplemental wages. This strategy has the additional benefit of converting income to dividends, which have lower tax rates.
Gift the assets that are most likely to increase in value
If you are interested in transferring wealth to your family, consider giving the assets that are most likely to increase in value as gifts for children who are in the lowest two tax brackets. Taxpayers who are in the lowest two tax brackets: 10% and 15%, have a 0% capital gains tax rate. Taxpayers in the five highest tax brackets, on the other hand, must pay 15% to 20% capital gains rates.
Tax Planning for Retirement
Planning for your retirement is 10% tax planning, 10% financial savviness, and 80% consistent discipline. Okay, I just made up those statistics, but you get the idea. The best financial and tax planning is pointless if you don’t have the discipline to save for retirement consistently. However, smart tax planning can go a long way to improving the return on investment of your savings. Here are three tips you should consider:
Related post: Warren Buffett’s Guide to Investing for Retirement
Max out your employer-sponsored 401(k) plans
The maximum contribution for a 401(k) in 2016 was $18,000 for taxpayers under 50 and $24,000 for those over 50. In most cases, it is smart to pay as much as you can toward your 401(k). Some may consider ignoring their 401(k)s in favor of taxable accounts because of the lower rates on capital gains and dividends. Also, don’t forget employer-sponsored plans are pre-tax, which means they lower your taxable income and could affect your alternative minimum tax calculations. 401(k)s are particularly attractive if your employer offers matching contributions. Don’t say no to “free money.”
Employ your children and max out their Roth IRAs
Taxpayers can contribute their entire taxable compensation or $5,500 (as of 2016), whichever is less, toward a Roth IRA. The interest from a Roth IRA is not taxable. If you have a small business, employ your children and max out their Roth IRAs. You can use that money to pay for their education.
Set up a Keogh plan
Keogh plans are highly flexible investment plans, particularly for self-employed (sole proprietors) and partnerships. They allow you to make contributions until the tax due date (and that includes extensions). They also allow self-employed workers to pay up to $53,000 or 100% of their self-employed income to a defined contribution Keogh plan. This limit is reduced to 20% of net self-employment income in the case of self-employed workers with no employees.
Don’t forget Roth IRAs or Roth 401(k)
Paying into a Roth IRA is smart, particularly if you think your tax rate will be higher at retirement. A $1 million in a Roth IRA is worth a $1 million. A $1 million in a 401(k) may be worth $800k or even $600k depending on your tax rate at retirement. 401(k)s get all the publicity because they lower your taxable income, which is great. The thing is you do have to pay taxes on them eventually. Granted, it will probably be at a much lower tax rate. Another benefit of Roth IRAs is you can continue making contributions after reaching 70, and you don’t have to start minimum distributions.
Tax Planning to Avoid IRS Audits
As big and scary as the IRS is, it doesn’t have the funds or resources to police all taxpayers effectively. That is why only 0.7 percent of all returns were audited in 2015. (Source)
Related post: 15 Flags the IRS Uses to Profile Taxpayers
Because the IRS doesn’t have the resources to audit everybody, it targets the taxpayers that are most likely to cheat on their taxes. Your tax planning, or lack thereof, can increase or lower your likelihood of getting audited. There are too many tax audit tips to include in this guide, but here are a few to give you an idea.
Reduce your taxable income
Find ways to redistribute or reduce your taxable income (legally). The IRS has limited resources, so it focuses on the taxpayers and businesses with the most money. Two key thresholds are $1 million and $10 million. If you have a total positive return of more than $1 million, you have a 1 in 10 chance of being audited. Make more than $10 million, and you have a 1 in 6 chance of being audited.
Choose the right business structure
The IRS profiles companies by their business structure. In some cases, being a sole proprietor can triple your chances of being audited. To illustrate, a sole proprietor that made $200k in 2015 had a 2.9% chance of being audited. A small corporation with the same income has a 0.8% chance of being audited. (Source)
Don’t pad your deductions or expenses
Avoid the temptation of inflating deductions and expenses when preparing your tax return. The IRS uses automatic systems to spot taxpayers who overstate charitable contributions, pad business expenses or claim for tax credits they don’t qualify for, such as the Child Tax Credit or the Earned Income Tax Credit.
If you’re caught, you will be audited and face penalties of 20% the disallowed amount. The penalty is $5,000 if the IRS determines you filed a “frivolous tax return.” And 75% of the amount owed if you underpaid taxes because of tax fraud.
Plan to Pay Lower Taxes
Do you want to keep your taxes to a bare minimum? Hire a tax professional to guarantee you are taking advantage of all the tax deductions and credits you qualify for.
Here are five tax-advantaged ways to reduce your tax liability, and they are available from most employers:
- Flexible Spending Account (FSA) saves pre-tax dollars from each paycheck for your own or your dependents’ health care expenses. However, beware that you lose it if you don’t spend it, so plan wisely
- Dependent Care Account allows you to save pre-tax dollars from each paycheck to pay for child or disabled spouse care
- 529 Plan saves pre-tax dollars for education, often called a qualified tuition plan, available in all 50 states and the District of Columbia
- Transportation Spending Account (TSA) allows you to save pre-tax dollars for transportation costs, such as parking and bus rides, related to your work
- 401k or 403(b) Plans save pre-tax dollars for your retirement
Plan to Receive Tax Credits
An important way to take advantage of tax savings is by taking advantage of the tax credits available to you as a taxpayer.
Here are five tax credits currently available to many Americans:
- Federal Earned Income Tax Credit (EITC) is a refundable income tax credit from the IRS for low- to moderate-income workers
- Overpaid Social Security Tax Credit is available to individuals who had more than one employer and earned over $106,400, thereby paying too much into Social Security
- Dependent Care Credit is a credit of 20% to 35% of qualifying expenses, depending on your adjusted gross income (AGI). As of 2016, the limits are $3,000 for the care on qualifying dependent and $6,000 for two or more.
- Child Tax Credit allows you to receive credit (currently $1000 per child) from the IRS for dependent children under the age of 17
- Elderly/Disabled Credit is a credit for low-income individuals and spouses who meet specific criteria as laid out by the IRS
Estate Tax Planning
Estate tax planning is important. It preserves your wealth for future generations. Start your estate tax planning by taking these ten steps:
- Make a list of all your valuables (include everything worth over $100)
- Make a list of all your non-physical assets (include stocks, bonds, IRAs)
- Make a list of all your debts with or without balances (home loan, credit cards, lines of credit)
- Make a list of charitable organizations you support
- Review accounts to ensure they have up-to-date beneficiary information
- Select someone as your estate administrator (family or friend)
- Create a will (there are several online tools that can help)
- Provide copies of your lists and will to your estate administrator
- Create a power of attorney and assign guardianship for your children and pets
- Appoint a health care surrogate and create a living will (also known as an advance health care directive)
What should you do next?
Now you know the basics of tax planning, it is time to use your “informed taxpayer” status to start saving some money.
- If you owe taxes, get a free consultation with a tax relief expert and ask about the tax relief strategies available to you.
- If you own a business, talk to your CPA or tax attorney and make sure they are using all the tax planning strategies available.
- If you prepare your own taxes, click here find out which tax preparation programs provide the best support and results.
Andrew is the managing editor for SuperMoney and a certified personal finance counselor. He loves to geek out on financial data and translate it into actionable insights everyone can understand. His work is often cited by major publications and institutions, such as Forbes, U.S. News, Fox Business, SFGate, Realtor, Deloitte, and Business Insider.