Tax planning is a crucial process that helps individuals and businesses slash their tax bills by making the best use of all available tax deductions, credits, and exemptions.
Understanding tax planning can lead to significant savings while maintaining compliance with tax law.
While everyone’s tax situation is different, strategic tax planning must be part of everyone’s approach – not just at tax time – but year-round.
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What is Tax Planning?
According to Cornell Law School’s Legal Information Institute, tax planning is “when a taxpayer makes use of the tax law to pay the least amount of taxes possible.”
It involves analyzing your financial situation to pay the lowest legal amount of tax. Typically, this means maintaining a certain tax bracket to reduce the amount of taxes to be paid. You can accomplish this through:
- Maximizing tax deductions and credits
- Manipulating income timing and purchases
- Selecting and contributing to retirement plans
- Making tax-efficient investments
Tax planning is about controlling changing your financial facts to reduce your tax. It’s not about tax evasion or falsifying information (tax fraud) to save money.
Types of Tax Planning
There are various reasons for undergoing tax planning. Tax planning can be:
This kind of tax planning involves taking full legal advantage of all available incentives, credits, and deductions to lower your tax bill. This includes child tax credits, retirement contribution deductions, etc.
This involves strategically structuring your financial decisions to reduce your tax burden. For instance, you may consider placing assets into a trust to minimize estate taxes.
These decisions will influence your tax return in the coming year. You often take steps at the end of the year to save money on taxes. Examples include increasing charitable contributions or purchasing new business equipment near the end of your fiscal year.
These decisions will influence your future tax returns, allowing you to maximize savings later. Prime examples include retirement savings or college savings plans.
Benefits of Strategic Tax Planning
The primary purpose of strategic tax planning is to reduce your tax liability.
Proper planning can help you save significant money that would otherwise be paid to the government in taxes.
Planning ensures you follow all tax laws to avoid penalties or legal issues.
Saving on taxes allows you to invest more in other areas that will provide financial security in the future. For example, you can invest more in retirement, insurance policies, or income-generating rental properties.
Key Components of Effective Tax Planning
Tax planning isn’t just about reducing the tax you pay. It’s about making wise decisions that align with your overall financial goals. As such, your strategy should involve:
Understanding Your Federal Tax Bracket
In the United States, income tax is progressive. This means your tax rate increases alongside your income. Knowing the tax bracket you fall into can help determine your tax liability and allow you to plan accordingly.
The current federal income tax brackets are:
Regardless of the bracket you fall into, you’re not likely to pay that rate on your full income.
You can subtract deductions from your total income to determine your taxable income. That’s why you see a difference between your actual income and taxable income.
Calculating your tax bill isn’t as simple as finding your tax bracket and multiplying your total income by that amount. The IRS divides your taxable income into pieces and then applies the appropriate tax rate to each piece.
For instance, you’re a single (or married filing separately) taxpayer with $35,000 in taxable income. At that income and filing status, you’re in the 12% tax bracket for 2022 (the taxes you file in 2023.)
Instead of paying 12% on all $35,000, you’d pay 10% of the first $10,275 and 12% on the remainder because that portion of your income lands in the next bracket.
If you’re married and filing jointly, you’d pay 10% on the first $20,550, then 12% on the remainder.
If you’re eligible to file as Head of Household, you’d pay 10% on the first $14,650 and then 12% on the rest.
Maximizing Deductions and Credits
Tax deductions are expenses you’ve incurred that can be subtracted from your taxable income. This reduces the amount of income you pay taxes on.
Tax credits are better because they give you a matching dollar amount toward what you owe. A $1,000 tax credit takes $1,000 off your total tax bill.
|Tax Deduction||Tax Credit|
|Your Adjusted Gross Income (AGI)||$100,000||$100,000|
|Less Tax Deduction||($10,000)|
|Tax Rate* (example)||25%||25%|
|Less: Tax Credit||($10,000)|
|Your Tax Bill||$22,500||$15,000|
There are several business credits and deductions you may be eligible for, such as:
- Opportunity Zones: An economic development tool designed to support investment and growth in distressed areas, investments made in these places allow you to defer tax on eligible gains.
- Plug-In Electric Drive Vehicle Credit: Whether you use one vehicle for business or operate a fleet, upgrading them to qualified plug-in electric vehicles can save you money on taxes.
- Energy Efficient Home Credit: Eligible contractors can claim credit for each qualified energy efficient home leased or sold to another person during the tax year. The credit amount is based on the home’s energy savings requirements, and is part of the general business credit.
- Research Credit: Eligible researchers and field examiners may be able to receive tax credits for their work.
Deducting All Ordinary and Necessary Expenses
According to 26 U.S. Code 162 – Trade or Business Expenses, you can deduct everything you spend in the course of business. This includes:
- Marketing and advertising
- Office expenses supplies
- Continuing education
- Bank fees
- Employee Benefit Programs
- Maintenance and repairs
- Legal and professional fees
- Telephone and utilities
- Postage and shipping
- Additional staff to support your business growth
To learn the best tax deductions for businesses, read our list of the 34 Best Small Business Tax Deductions.
Optimizing Individual Deductions: Standard vs. Itemized Deductions
The IRS annually issues a standard deduction amount based on taxpayer filing status. This amount automatically reduces your taxable income.
For most people, this amount is sufficient enough to save without needing to itemize deductions. It’s a way to make your tax preparation go a lot faster, too.
|Filing Status||Standard Deduction 2022||Standard Deduction 2023|
|Married, filing jointly||$25,900||$27,700|
|Married, filing separately||$12,950||$13,850|
|Head of household||$19,400||$20,800|
With itemized deductions, you skip the “one-size-fits-all” approach and individually take each of the deductions you qualify for. This is only advantageous for people with itemized deductions exceeding the standard filing status deduction.
You must also have adequate records to support all the deductions you’re claiming.
For homeowners or the chronically ill, the mortgage interest, property tax deductions, or medical expenses deduction may be enough to make itemizing worth it.
A qualified tax advisor can help guide you through the deductions you qualify for and help you decide if it’s better to itemize or stick with the standard deduction.
Depreciating Your Income
Investments can be depreciated to account for wear and tear, deterioration, or obsolescence. This applies to both personal and business investments – property, inventory, home office, etc. You can accelerate the rate of depreciation you take, which may completely wipe your taxable income.
For instance, let’s say you purchase production machines for $500,000. To record the depreciation, accountants estimate the machinery’s life expectancy to be five years, and at that point in time, expect the machinery value to be $150,000, known as the salvage value.
Using the straight line method, the annual depreciation is $70,000 – at a rate of 20% depreciation per year. You arrive at this number by taking the total asset cost, subtracting the salvage value, and then dividing that number by its useful life.
Deferring Your Income
You can push income from one year to the future, simply by moving the money to another tax deductible account. There are several ways to do this, including:
- Retirement contributions (more on that later)
- Certain types of life insurance
- Health Savings Accounts (HSAs)
HSAs are great because contributions are tax-deductible, and when funds are spent on qualifying medical expenses, the withdrawals are tax-free.
In 2023, you can contribute up to $3,850 if you have self-only high-deductible health coverage. That limit goes to $7,750 with high-deductible family coverage. And if you’re 55+, you can add another $1,000.
You can open an account independently with many financial institutions, and offer HSAs to your employees to provide them with a tax-deferral vehicle, while also writing off the expense as part of your employee benefit program.
Contributing to Retirement
As a business owner, you’re a self-employed individual, so you can take advantage of retirement savings from the employer and the employee perspective. Take a look at some of your options:
- Simplified Employee Pension (SEP): Contribute up to 25% of your net self-employment earnings – up to $66,000 for 2023.
- 401(k): Annual salary deferrals up to $22,500 in 2023; contribute up to an additional 25% of your net self employment earnings for up to $66,000 for 2023. Plus, you can tailor your plans to access your account balance through hardship distributions or loans. You can have a one-participant 401(k), also known as a solo-401(k) or individual 401(k), if there are no other employees besides your spouse who work for the company.
- Savings Incentive Match Plan for Employees (SIMPLE IRA Plan): You can contribute up to $15,500 in 2023, or all of your net earnings from self-employment into the plan.
These limits are much higher than you’d have as an individual employee, helping you to further reduce your tax liability.
Investing for Tax Efficiency
Your investment income may greatly influence your taxes. Long-term investments are generally taxed at a lower rate than short-term ones. Certain types of investments may also be exempt from taxes. Understanding the implications of your investments is a crucial part of your tax planning strategy.
You can get a tax deduction for investing, as long as you invest in ways the government wants you to. This includes investing in: real estate, starting and growing businesses to create jobs, and oil and gas to fuel vehicles so that people can go to and from work.
Planning for Major Life Events
Getting married, having a baby/adopting a child, buying a home, or entering retirement can significantly impact your taxes. Getting married could move you into a higher tax bracket, but expanding your family could qualify you for additional tax credits.
Adequate planning can help you prepare for the tax implications and take advantage of any tax breaks.
Common Mistakes in Strategic Business Tax Planning
When done correctly, you can save significantly on your federal income tax return. However, poor or inadequate planning can severely limit or even eliminate the tax benefits at your disposal.
Waiting until the last minute to start your tax planning strategy can lead to missed deductions, credits, or errors in your tax filing. The sooner you start planning, the better.
Ignorance of Law
Tax laws are complex and may even change from year to year. Not understanding the law can result in paying more tax than you need to or even creating legal issues.
Not Keeping Adequate Records
In the event of an IRS audit, you must have the required documentation to support all the income, deductions, and credits you reported.
Generally, the IRS has three years to decide whether or not you’ll be audited, so you’ll need to keep records for at least that long. You’ll need to hold onto them for at least that long if you file claims for a credit or refund after you file the original return.
The IRS can go back six years if you underreported your income by more than 25%. They can go back seven years if you wrote off a loss from a “worthless security.”
They can go back indefinitely if they have reason to believe you’ve committed tax fraud or didn’t file a return at all when you should have.
Not Seeking Professional Help
Qualified tax professionals can help provide valuable guidance to ensure you’re maximizing your possible tax savings. They must be up-to-date with the latest tax laws and regulations.
Let Us Help You Save with Proper Tax Planning
You don’t have to figure out your tax liability alone. Here at MyCPA Coach, our tax planning services will ensure you’re legally paying as little taxes as possible so you can invest the savings into your financial future.