Tax planning is looking at your finances to determine how to pay minor taxes. Having a tax-efficient plan means that you will pay less in taxes. It is essential for anyone who wants to be successful financially. It would help if you thought about reducing your tax liability and maximizing how much money you can save for retirement.
- Tax planning involves looking at your finances and making decisions that will help you pay as little tax as possible.
- The timing of income, amount, purchase timeliness, and planning for expenses are all factors to consider when it comes to tax planning.
- Individuals and businesses can set money aside in an IRA or engage in tax gain-loss harvesting.
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Understanding Tax Planning
Tax planning includes considering when you will get your income, how much money you will make when you buy things, and other things you might spend money on. You also need to consider the types of investments you make and the kind of retirement plans you have. All of this must work well with your tax filing status and the deductions you can take.
Contributing to a retirement plan is a popular way to reduce your taxes. Suppose you contribute money to a traditional IRA. In that case, you can minimize the money the government takes from you. For 2021 and 2022, if you meet all the qualifications, you can contribute up to $6,000 if you are younger than 50 or $7,000 if you are 50.
For instance, if a 52-year-old man with a $50,000 yearly salary contributed $7,000 to a traditional IRA and now has an adjusted gross income of $43,000, the $7,000 contribution will continue to grow tax-free until retirement.
An individual can use a variety of various retirement programs to increase their savings. Larger businesses with lots of employees frequently use 401(k) plans. Participants in the program can defer income from their paycheck directly into the company’s 401(k) plan. The most significant difference is that the contribution limit dollar amount is much higher than that of an IRA.
The older person can contribute up to $26,000 into their 401(k). For 2021, if they are under 50 years old, 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 they are aged 50 or older due to the allowed additional $6,500 catch-up contribution.
Tax Planning vs. Tax Gain-Loss Harvesting
Tax gain-loss harvesting is a way to manage your taxes related to your investments. It can be helpful because it uses losses from investments to offset any overall capital gains. According to the IRS, capital gains of the same kind must be offset first by short-term and long-term losses. In other words, long-term losses cancel out long-term profits, then short-term gains, etc. The exact rate of taxation applies to short-term capital gains as to ordinary income.
Long-term capital gains are subject to the following taxes as of 2021:
- Suppose your income is less than $40,400 ($80,800 if married filing jointly or a qualifying widow(er), $54,100 for the head of the household, or $40,400 for married filing separately). You won’t be required to pay taxes in that situation.
- Suppose your income is more than $40,401 but less than $445,850 ($501,600 if married filing jointly or a qualifying widow(er), $473,750 for the head of the household, or $250,800 for married filing separately). You’ll be subject to a 15% tax in that situation.
- If your yearly income is more than what is listed for the 15% tax, you will have to pay 20%.
In 2022, long-term capital gain limits will be increasing to the following:
- Suppose your annual 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). In that case, you won’t have to pay taxes.
- If your income is more than $41,675 but less than $459,750, you will have to pay a 15% tax. It is called the ‘tax brackets.’ For example, if you earn $517,200 as a married couple or widow(er), you will have to pay this percentage over $459,750.
- If your income exceeds the cap for the 15 percent tax, you will be compelled to pay 20 percent tax.
For example, if a single investor who makes $100,000 has $10,000 in long-term capital gains, they would have to pay $1,500 in taxes. If the same investor sold investments that didn’t do well and had $10,000 in long-term capital losses, the losses would cancel out the gains, meaning they wouldn’t have to pay any taxes. If they wanted to repurchase those investments within 30 days of selling them, they would have to wait at least 30 days, so they don’t incur a ‘wash sale.’
The IRS says that if your losses from selling investments are more than your gains, you can only claim $3,000 of the difference on your taxes. It is called a “net loss.” You would report this on line 21 of Schedule D (Form 1040 or 1040-SR).
For example, if the 52-year-old investor had $3,000 in net capital losses for the year, the $50,000 income will be reduced to $47,000. The remaining capital losses can be carried over and used to offset future capital gains.
Tax Planning for Newbies: 6 Strategies and Concepts to Know
Know your tax bracket, how essential tax concepts operate, what records to preserve, and fundamental strategies to reduce your tax liability.
Tax planning is analyzing and arranging a person’s financial condition to maximize tax advantages and reduce tax liabilities legally and efficiently.
The amount you wind up paying (or receiving) in taxes (or receiving back) might be affected by the amount of time you invest in understanding and applying tax laws. Here are some essential tax planning and tax strategy concepts to comprehend before making your next financial move.
1. Tax Planning Begins With Knowing One’s Tax Bracket
You cannot truly plan for the future if you are unaware of your current situation. Therefore, the first advice for tax preparation is to determine your federal tax bracket.
The United States’ tax system is progressive. Therefore, those with higher taxable incomes are subject to higher tax rates. In comparison, individuals with lower taxable incomes are subject to lower tax rates. There are seven income tax brackets at the federal level: 10%, 12%, 22%, 24%, 33%, 35%, and 37%.
Regardless of your tax bracket, you will likely not pay that rate on your whole income. There are two main factors:
- To determine your taxable income, you can deduct tax deductions. Therefore your taxable income is typically not the same as your wage or total income.
- Simply multiplying your tax bracket by your taxable income is insufficient. Instead, the government apportions your taxable income and taxes each component at the applicable rate.
Suppose, for instance, you are a single taxpayer with a taxable income of $32,000. This places you at the tax rate of 12 percent in 2021. But do you pay 12 percent on all $32,000? No. You pay 10 percent on the first $9,950 and 12 percent on the remainder. If you earned a taxable income of $50,000, you would pay 10% on the first $9,950 and 12% on the portion between $9,951 and $40,525. Because a portion of your $50,000 taxable income falls into the 22 percent tax bracket, you would then pay 22 percent on the remaining amount.
2. What Distinguishes Tax Deductions From Tax Credits
Deductions and tax credits may be the most enjoyable aspect of tax preparation. Both decrease your tax liability, but in very distinct ways. Understanding the distinction between deductions and credits can lead to highly successful tax solutions that decrease your tax liability.
- Tax deductions are deductible costs you can deduct from your taxable income. They reduce the portion of your income liable to taxation.
- Tax credits are even better because they reduce your tax bill dollar for dollar. For example, a $1,000 tax credit reduces your tax liability by $1,000.
3. Taking the Standard Deduction Vs. Itemizing
Choosing between itemizing and using the standard deduction is a crucial aspect of tax preparation, as the decision can significantly impact your tax liability.
What Is the Standard Deduction?
It is essentially a dollar-for-dollar, no-questions-asked tax deduction. Taking the standard deduction expedites tax preparation, likely a major reason why so many choose it over itemizing.
Congress determines the standard deduction amount, normally modified annually for inflation. The standard deduction you are eligible for depends on your filing status, as shown in the table below.
- 2021 tax year / $12,550
- 2022 tax year / $12,950
Married, filing jointly
- 2021 tax year / $25,100
- 2022 tax year / $25,900
Married, filing separately
- 2021 tax year / $12,550
- 2022 tax year / $12,950
Head of household
- 2021 tax year / $18,800
- 2022 tax year / $19,400
What Does ‘itemize’ Mean?
You can itemize your tax return instead of claiming the standard deduction, which involves claiming each individual tax deduction for which you are eligible.
- In general, individuals itemize if their itemized deductions exceed the basic deduction. A crucial aspect of their tax preparation is keeping track of their deductions throughout the year.
- It takes longer to do your taxes when you itemize, and you must be able to substantiate that you are eligible for your deductions.
- Schedule A of the IRS is used to claim itemized deductions.
- Some tax tactics may make itemization more appealing. Suppose you own a home, for instance. In that case, your itemized mortgage interest and property tax deductions may quickly exceed the standard deduction. This could help you save money.
- You may be allowed to itemize your state tax return deductions even if you claim the basic federal deduction.
- The good news is that tax software or a competent tax counselor can help you determine which deductions you qualify for and if they exceed the standard deduction.
4. Observe Prevalent Tax Deductions and Credits
Countless deductions and credits are available, each with its eligibility requirements.
Tax break / What it’s generally for
- Costs of adopting a child / Adoption Credit
- The American Opportunity Credit and the Cost of College
- Capital loss deductions / Stock sales losses (to offset capital gains)
- Charitable gifts / Donating money, cars, art, investments, household items, or other things to charity
- Child and Dependent Care Credit/Daycare Costs and Similar Costs
- Tax credit for children/Being a parent
- Help for the elderly and disabilities / For persons who have retired with a permanent and total handicap or their spouses
- The earned income tax credit / Money for people with adjusted gross incomes less than a certain amount
- If you work from home, a part of your mortgage or rent, property taxes, utilities, repairs, maintenance, and other costs.
- Credit for learning for life / You can take undergraduate, graduate, or even non-degree courses at accredited schools.
- Medical costs or unpaid medical costs that go over a certain limit
- Mortgage interest is the part of a mortgage payment that covers the interest on a primary home.
- Taxes on real estate / Taxes on real estate
- Residential energy tax credits / Putting in things that save energy in a home
- Credit for savers People with incomes below certain levels can put money into an IRA.
5. Know What Tax Records to Keep
If you are ever audited, keeping your tax returns and the documentation you used to complete them is crucial. Typically, the IRS has three years to evaluate whether or not to audit a tax return, so you should maintain your documents for at least that long. If you file a claim for a credit or refund after filing your original tax return, you must retain your tax records for three years.
Keep records longer in certain instances – if any of the following apply, the IRS has a longer audit window:
- Six years: If your income was underreported by more than 25 percent.
- Seven years: If the loss from a “worthless security” was written off.
- Indefinitely: If you committed tax fraud or didn’t file a tax return.
6. Tax Strategies to Shelter Income or Cut Your Tax Bill
Deductions and credits are fantastic ways to reduce your tax liability. Still, additional tax planning tactics can help keep your money out of the IRS’s hands. Here are some prevalent tax planning techniques.
Tweak Your W-4
A W-4 instructs your employer on how much tax to deduct from your paycheck. This tax is remitted by your employer to the IRS on your behalf.
Here’s how to utilize the W-4 to arrange your taxes.
- You might wish to boost your withholding if you received a hefty tax bill when you filed and wish to avoid a repeat. This could help you owe less (or nothing) on your next tax return.
- If you received a large tax refund the previous year and would prefer to have that money in your paycheck throughout the year, reduce your withholding.
- You most likely filled out a W-4 when you started your work, but you can modify it anytime. Simply download the form from the IRS website, complete it, and submit it to your employer’s human resources or payroll department.
Put Money in a 401(K)
Your employer may offer a 401(k) savings and investment plan with a tax deduction on retirement funds.
- The IRS does not tax contributions made straight from a paycheck to a 401(k) (k). In 2022, you can deposit up to $20,500 per year. If you are at least 50 years old, you can contribute up to $27,000.
- 401(k)s are typically sponsored by businesses, but self-employed individuals can form their own accounts.
- You will get extra money if your employer matches some of your money.
Frequently Asked Questions About Tax Planning
Tax planning means reducing how much tax you have to pay. You can do this by using exemptions, deductions, and benefits. In India, some rules let you reduce your tax bill each year.
Tax planning is a way to ensure you are meeting your tax obligations in a planned and organized manner. It considers your current financial situation, including your age, financial goals, how much risk you are willing to take, and how long you plan to invest.
You can reduce your tax burden or get a bigger refund if you do your taxes right. It would help if you planned for your taxes when making your financial plan. That way, you won’t miss any benefits and will pay the right amount.
Tax planning is essential. It can help you to save money on your income taxes. This cash can be set aside and applied to future expenses.
There are many things to consider when planning your taxes. Some factors include the location of your business, the size and nature of your business, the form of organization and ownership, specific management decisions like buying or leasing property, and more.