Taxes can eat into your annual earnings. To counter this, tax planning is a legitimate way of reducing your tax liabilities in any given financial year.
It helps you utilise the tax exemptions, deductions, and benefits offered by the authorities in the best possible way to minimise your liability.
The definition of tax planning is quite simple. It is the analysis of one’s financial situation from the tax efficiency point-of-view.
Tax planning is a focal part of financial planning. It ensures savings on taxes while simultaneously conforming to the legal obligations and requirements of the Income Tax Act, 1961.
The primary concept of tax planning is to save money and mitigate one’s tax burden. However, this is not its sole objective.
What is Tax Planning?
Tax planning is the analysis of a financial situation or plan to ensure that all elements work together to allow you to pay the lowest taxes possible. A plan that minimizes how much you pay in taxes is referred to as tax efficient.
Tax planning should be an essential part of an individual investor’s financial plan. Reduction of tax liability and maximizing the ability to contribute to retirement plans are crucial for success.
Tax planning refers to financial planning for tax efficiency. It aims to reduce one’s tax liabilities and optimally utilize tax exemptions, tax rebates, and benefits as much as possible.
Tax planning includes making financial and business decisions to minimize the incidence of tax. This helps you legitimately avail the maximum benefit by using all beneficial provisions under tax laws.
It enables one to think of their finances and taxes at the beginning of the fiscal year, instead of leaving it to the eleventh hour.
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Why do we Need Tax Planning?
There are some fundamental objectives of tax planning. Tax planning diminishes tax liability by saving the assesse the maximum amount of tax by arranging their financial operations according to tax decisions.
It also conforms to the provisions under taxation laws, thereby minimizing any litigation.
One of the biggest benefits of tax planning is that the returns can be directed to investments. It is the most productive way to make smart investments while fully utilizing the resources available due to tax benefits.
Investing tax money generates white money to flow through the economy, aiding in the country’s economic development. Tax planning hence contributes to the economic stability of the individual as well as the country.
Below are the benefits of tax planning:
1. To Minimize Litigation:
To litigate is to resolve tax disputes with local, federal, state, or foreign tax authorities.
There is often friction between tax collectors and taxpayers as the former attempts to extract the maximum amount possible while the latter desires to keep their tax liability to a minimum.
Minimizing litigation saves the taxpayer from legal liabilities.
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2. To Reduce Tax Liabilities:
Every taxpayer wishes to reduce their tax burden and save money for their future.
You can reduce your payable tax by arranging your investments within the various benefits offered under the Income Tax Act, 1961.
The Act offers many tax planning investment schemes that can significantly reduce your tax liability.
3. To Ensure Economic Stability:
Taxpayers’ money is devoted to the betterment of the country. Effective tax planning and management provide a healthy inflow of white money that results in the sound progress of the economy.
This benefits both the citizens and the economy.
4. To Leverage Productivity:
One of the core tax planning objectives is channelising funds from taxable sources to different income-generating plans.
This ensures optimal utilisation of funds for productive causes.
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Basic Tax Planning Strategies
In addition to saving income taxes for the current and future years, effective tax planning can reduce eventual estate taxes, maximize the amount of funds you will have available for retirement, reduce the cost of financing your children’s education, and assist you in managing your cash flow to help you meet your financial objectives.
If you’re ready to start reaping the benefits, it’s important to understand a few basic tax planning strategies first.
These will get you started, and as you continue, you’ll start to learn different variations of these strategies that will help you save more.
1. Know Your Bracket
The first step in your tax planning strategy is to understand which tax bracket you fall in. With the 2018 amendments, your bracket may have changed.
You can find information on the 2019 tax brackets here and if you have any questions, don’t hesitate to contact our accounting firm for help.
2. Reducing Your Income
This is a great place to start with your tax planning strategies, because your adjusted gross income (AGI) is arguably the most important aspect regarding taxes.
Your AGI is essentially the amount of your income that is actually taxable—making it understandably more important than your gross income.
It’s what you have left after you make adjustments such as contributions to your 401(k), IRA accounts, paying off student loan interest, and more.
There is a list of adjustments that can be used on the 1040 form, or you can sit down with an accountant to discuss your specific details further.
Saving for retirement is one of the most common ways to reduce your income. As a bonus, it helps you better prepare for your future.
Keep in mind that when you make a contribution to a 401(k) or IRA retirement plan, your funds are locked in until you reach a certain age—usually around 60.
If you decide to withdraw money before then, whatever you withdraw will be added to your taxable income. Plus, you’ll be hit with additional taxes for early withdraws.
If you make a contribution, keep it there. If you aren’t sure whether or not you’ll need the money, build up your savings before you start adding to a 401(k) or IRA account.
3. Increasing Your Deductions
You can also work on increasing your amount of taxable deductions throughout the year. Depending on your line of work, charitable donations, and a number of expenses, your tax deductions could be substantial.
Deductions include personal property taxes, any interest that is paid on your mortgage, charitable donations or gifts, and expenses that are directly related to your job, expenses from investments, state taxes, and more.
Over the year, these deductions add up. That’s why you need to keep an itemized list of your expenses throughout the year along with any receipts.
You can use something online or offline. We recommend setting up a simple spreadsheet and adding line items every time you have a deduction.
4. Make Affordable Annual Commitments
Insurance salesmen and agents can be very persuasive. And when they come to you in February, telling you how much tax you will save by buying an insurance or a pension product, chances are that you’ll leap at the opportunity.
But resist the temptation to sign a cheque immediately and ask yourself if you really need the product.
If you don’t need it, but are still willing to buy it for the tax advantage, check your finances and your budget to see if you can afford to sustain this investment.
There are various types of Tax Planning that we have treated in another content. You need to read this to make certain decisions
How Does Tax Planning Work?
Tax planning covers several considerations. Considerations include timing of income, size, the timing of purchases, and planning for other expenditures.
Also, the selection of investments and types of retirement plans must complement the tax filing status and deductions to create the best possible outcome.
Saving via a retirement plan is a popular way to efficiently reduce taxes. Contributing money to a traditional IRA can minimize gross income by the amount contributed.
For 2021 and 2022, if meeting all qualifications, a filer under age 50 can contribute a maximum of $6,000 to their IRA and $7,000 if age 50 or older.1
For example, if a 52-year-old male with an annual income of $50,000 who made a $7,000 contribution to a traditional IRA has an adjusted gross income of $43,000, the $7,000 contribution would grow tax-deferred until retirement.
There are several other retirement plans that an individual may use to help reduce tax liability. 401(k) plans are popular with larger companies that have many employees.
Participants in the plan can defer income from their paycheck directly into the company’s 401(k) plan. The greatest difference is that the contribution limit dollar amount is much higher than that of an IRA.
Using the same example as above, the 52-year-old could contribute up to $26,000 into their 401(k). For 2021, if under age 50, the salary contribution can be up to $19,500 ($20,500 for 2022), or up to $26,000 for 2021 ($27,000 for 2022) if age 50 or older due to the allowed additional $6,500 catch-up contribution.
Tax Planning vsTax Gain-Loss Harvesting
Tax gain-loss harvesting is another form of tax planning or management relating to investments. It is helpful because it can use a portfolio’s losses to offset overall capital gains.
According to the IRS, short and long-term capital losses must first be used to offset capital gains of the same type.
In other words, long-term losses offset long-term gains before offsetting short-term gains. Short-term capital gains, or earnings from assets owned for less than one year, are taxed at ordinary income rates.
In 2022, long-term capital gain limits will be increasing to the following:
- 0% for taxpayers whose income is less than $41,675 ($83,350 in the case of a joint return or widow(er), $55,800 in the case of an individual who is head of household, $41,675 in the case of any other individual)
- 15% tax for taxpayers whose income is more than $41,675 but less than $459,750 ($517,200 in the case of a joint return or widow(er), $488,500 in the case of an individual who is the head of a household, or $459,750 in the case of any other individual)
- 20% tax for those whose income is higher than listed for the 15% tax4
For example, if a single investor whose income was $100,000 had $10,000 in long-term capital gains, there would be a tax liability of $1,500.
If the same investor sold underperforming investments carrying $10,000 in long-term capital losses, the losses would offset the gains, resulting in a tax liability of 0.
If the same losing investment were brought back, then a minimum of 30 days would have to pass to avoid incurring a wash sale.
Tax planning involves a variety of considerations. Several factors are taken into consideration, such as the timing of income, the size and timing of purchases, and planning for other expenses.
It is also important to select investments and types of retirement plans that complement a person’s tax filing status and deductions.
Without a sound tax plan, you might be surprised by unexpected tax liability. Thus, it is always better to take a proactive approach to your taxes and get them out of the way before the end of the financial year.
Trying to evade taxes is not an option you want to consider. It can lead you into some serious trouble and result in penalties.
What are the limitations of tax planning?
The main disadvantages are that it is more complex than the cash basis, and that income taxes may be owed on revenue before payment is actually received. However, the accrual basis may yield favorable tax results for companies that have few receivables and large current liabilities.
What are the factors that are helpful for effective tax planning?
- Reducing Taxable Income
- Deduction planning.
- Investment in tax planning.
- Year-end planning strategies
Is tax planning illegal?
Tax planning,, is perfectly legal assuming they have orchestrated it in a compliant manner. It’s the process of reducing your tax liability in accordance with the law.
Is Tax Planning ethical?
It is this method that constitutes ‘tax avoidance. The focus of both legislature and taxpayer is on rules, not on ethical behavior.
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