Everyone needs a basic understanding of what tax planning is. At the very least, you need to know what your tax bracket is, what records to keep, and basic strategies to lower your taxes. Here’s a primer on what you need to know.
What is tax planning?
Tax planning is an analysis of your financial and economic affairs to make sure that all elements work together so you pay the lowest taxes possible. 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:
- Filing your taxes.
- 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. Unfortunately, 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 save money on taxes.
What is the purpose of tax planning?
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. 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.
Strategies to reduce your tax bill
A common way to reduce your tax liability is to claim all the tax deductions and credits you are eligible for. Here is an in-depth review of the most common tax deductions and credits. 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-advantaged ways to reduce your tax liability, and they are available from most employers:
- A 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 Accounts allow you to save tax-free 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.
- A Transportation Spending Account (TSA) is a deduction that 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 a pre-tax deduction from each paycheck for your retirement.
Popular tax credits
An important way to take advantage of tax savings is looking into 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 a qualifying dependent and $6,000 for two dependents or more.
- Child Tax Credit allows you to receive credit from the IRS for dependent children under 17.
- Elderly/Disabled Credit is a credit for low-income individuals and spouses who meet specific criteria laid out by the IRS.
What happens to your tax liability with proper financial planning?
You can minimize your tax liability with proper financial planning. It all starts with understanding what your tax bracket is. As of 2021, 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 by reducing your taxable income without breaking the law or incurring tax penalties.
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 missed or underpaid one or more quarters, consider adjusting (i.e., overpaying) for the remainder of the year. This can help ensure that you come out even in the end.
Include 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, 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 in the lowest two tax brackets. Taxpayers 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 come tax time.
Tax planning for retirement
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 to consider.
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.
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. With a Roth IRA, you contribute after-tax dollars. Your money grows tax-free, and you typically can withdraw money without incurring a penalty after age 59½. Traditional IRAs allow you to contribute both pre- or after-tax dollars. The money grows tax-deferred, and withdrawals are taxed as current income after age 59½. 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 the 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 $1 million. A $1 million in a 401(k) may be worth $800k or even $600k, depending on your tax rate at retirement. The 401(k)s get all the publicity because they lower your taxable income, which is great. 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 and IRS audits
Because the IRS doesn’t have the resources to audit everybody, it targets taxpayers most likely to cheat on their taxes. Your tax planning, or lack thereof, can increase or lower your likelihood of getting audited. Here are a few tax audit tips 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)
Keep good records of your income, expenses, and deductions
It is very important to keep detailed records of the documents you used to file your taxes. The IRS usually requires taxpayers to keep three years of records, but they can ask for six years-worth of records if you underreported your income by more than 25 percent. There is no limit on how far back they can ask for records if you are accused of tax fraud.
You will also need to have records if you decide to file an amendment of a tax return to claim additional credits or deductions.
Here is a list of some of the most common records you may want to keep:
|W-2 form(s).||Receipts.||Closing statements.||Form 5498 (IRA contributions).|
|Bank statements.||Invoices.||Purchase and sales invoices.||Form 8606 (nondeductible IRA contributions).|
|1099-MISC.||Alimony paid.||Insurance records.||401(k) statements.|
|1099-INT.||Statements from charities.||Property tax assessments.||Distribution records.|
|1099-DIV.||Gambling losses.||Annual statements.|
|Brokerage statements.||Transaction data.|
Estate tax planning
Estate tax planning preserves your wealth for future generations. Start your estate tax planning by considering these 9 steps:
- Make a list of all your valuables (include everything worth over $100).
- Make a list of all your non-physical assets (including stocks, bonds, IRAs).
- Make a list of all your debt with or without balances (home loan, credit cards, lines of credit).
- Review accounts to ensure they have up-to-date beneficiary information.
- Select someone as your estate administrator (family or friend).
- Create a will (free online tools 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).
Planning for this Tax Year
Now that you know the basics of tax planning, it is time to use your “informed taxpayer” status to start saving some money this tax season.
- If you owe taxes, get a free consultation with a tax relief expert and ask about the tax relief strategies available to you.
- Be aware of the tax due date and set money aside if you owe money to the IRS.
- 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 to determine which tax preparation programs provide the best support and results.
Andrew is the Content Director for SuperMoney, a Certified Financial Planner®, 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.