Tax Planning
Key Points:
• Tax planning is the process whereby an individual analyzes and orients their financial plan to minimize their tax payments.
• There are numerous legal and ethical strategies individuals can employ to achieve this effect, like contributing to certain retirement accounts.
• The U.S.’s progressive tax policy divides taxpayers into seven brackets according to their income, and levies taxes at an increasingly high rate for higher-earning individuals.
• Numerous tax deductions and tax credits are available, all of which have different qualification standards. It behooves taxpayers to know the deductions and credits for which they’re eligible.
• Individuals with highly complex financial circumstances often benefit from working with professional tax planners.
Tax planning is the process whereby an individual analyzes and orients their financial plan in such a way that each of its components work together to ensure that the individual pays the lowest taxes possible. When a financial plan has been successfully oriented thus, it is deemed “tax efficient.” Tax planning incorporates considerations from every dimension of the individual’s financial life, including their income, savings, investments, expenditures, business operations, charitable giving, and whatever other personal decisions may come to bear on their monetary conditions.
There are numerous legal and ethical strategies an individual can employ to reduce their taxes. Depending on an individual’s work situation, marital status, age, and more, there are a host of tax deductions they may employ to reduce their taxable income. In some cases, individuals may be eligible for tax credits, which function as to-the-dollar subtractions from the individual’s overall tax bill. That is, while tax deductions reduce an individual’s total taxable income, tax credits reduce an individual’s tax bill directly, often resulting in a more substantial decrease. Therefore, understanding what deductions and/or credits you may be eligible for is an integral component of tax planning.
Despite the fact that the Internal Revenue Service (IRS) Tax Code totals more than 70,000 pages, it is not sufficiently exhaustive to stamp out all illegal and unethical behavior. When trying to reduce their tax bills, many people resort to unethical and/or illegal means (which Heron Wealth absolutely does not condone). Some people knowingly underreport their income, claim bogus deductions, or otherwise manipulate the letter of the law to reap undue benefits. Because of this, the IRS audits those whose activities it deems potentially unlawful. Anyone can be audited at the IRS’s discretion. So, even for individuals whose tax planning practices are completely above board, keeping thorough tax records is essential.
Indeed, staying organized and keeping highly detailed records is as much a part of tax planning as looking for deductions and credits. Particularly for individuals itemizing many deductions — self-employed people, for example — it is incumbent upon them to retain all receipts, invoices, insurance records, retirement and bank account statements, and more. In general, if a document can be considered official information regarding a person’s financial circumstances, it’s best to err on the side of keeping it in a safe, easily identifiable place for the purposes of tax planning.
Tax planning is a component of a person’s broader financial planning process, and as such, individuals who employ sufficiently qualified financial planners will also receive tax advice from them. Financial planners may also consult specialized tax attorneys, whose job it is to be fully familiar with all 70,000 pages of the IRS tax code, as well as legislative updates made year by year. As with many other specialized financial topics, individuals tend to benefit from professional tax planning help when their financial circumstances are too complex for them to handle alone. Professionals know to make complex tax plans as tax efficient as possible, eliminating an enormous amount of time and stress from the lives of their clients.
Basics of Tax Planning
All who endeavor to create tax plans can benefit by understanding certain rudimentary tax guidelines. At the very least, doing so will make them more prepared to handle tax season when it inevitably rolls around, and at most, it can impact a person’s financial habits in a more positive, holistic way.
Mechanics of the U.S.’s Progressive Tax Policy
The U.S. employs a progressive tax policy, whereby lower income earners are generally taxed at a lower rate than higher income earners. The U.S.’s progressive tax policy for single individuals divides earners into seven brackets:
• Bracket 1: Single individuals making $9,875 per year or less are taxed at a rate of 10%
• Bracket 2: Single individuals making between $9,876–$40,125 per year are taxed at a rate of 12%
• Bracket 3: Single individuals making between $40,126–$85,525 per year are taxed at a rate of 22%
• Bracket 4: Single individuals making between $85,526–$163,300 per year are taxed at a rate of 24%
• Bracket 5: Single individuals making between $163,301–$207,350 per year are taxed at a rate of 32%
• Bracket 6: Single individuals making between $207,3351–$518,400 per year are taxed at a rate of 35%
• Bracket 7: Single individuals making people $518,401+ per year are taxed at a rate of 37%
The income requirements for married individuals filing joint returns are roughly 2x the figures included here, and the income requirements for heads of households are slightly higher for the first two brackets, after which they are identical.
It is useful to understand that, if a person makes $50,000 per year, not all of that $50,000 is taxed at 22%. Rather, the first $9,875 is taxed at 10%, the amount between $9,876–$40,125 is taxed at 12%, and the remainder is taxed at 22%.
These figures are also good to be familiar with because, in some situations, receiving sufficient deductions can alter the tax bracket into which an individual falls. Looking out for advantageous circumstances like these is the mark of a proactive tax planner.
Common Tax Deductions and Tax Credits
There are several hundred possible deductions available to taxpayers, all of which have different standards of qualification. When embarking on a tax planning process with the ultimate goal of maximum tax efficiency, it’s useful to have a solid understanding of the ones that could apply to you. Here is a very abridged list of some of the most common tax deductions and credits available to taxpayers:
• American Opportunity Credit — College education costs
• Child Tax Credit — Parenting costs
• Residential Energy Tax Credits — Credit received for installing energy-efficient products
• Home Office Expenses — Mortgage/rent, utilities, office supplies, and more (especially prominent during the COVID-19 era)
• Saver’s Credit — Credit received by people below certain income thresholds upon making contributions to an IRA
Retirement Tax Planning Strategies
Regardless of whether an individual opts to work with a professional tax planner, there are a handful of very simple and user-friendly strategies they can take to begin the process of making their financial circumstances optimally tax efficient. Most commonly, people make regular contributions to retirement accounts — traditional Individual Retirement Accounts (IRAs) or 401(k)s through their employers.
Saving for retirement has myriad upsides. In addition to making steady donations to your “future self,” retirement saving is incentivized by some very favorable tax consequences.
Traditional IRAs
Contributing money to a traditional IRA allows individuals to reduce their gross income by up to $6,000 (if under the age of 50) or $7,000 (if over the age of 50). As stated in an earlier section, reducing gross income by this significant of a quantity each year can carry extreme benefits for a person’s yearly tax payments.
Likewise, until the individual retires, the contributions they make to the traditional IRA grow on a tax-deferred basis. That is, the contributions are taxed only upon withdrawal, never before. The more the traditional IRA grows, the more consequential is this benefit.
401(k)
Whereas IRAs are more commonly utilized by self-employed people, 401(k) are more commonly available to employees of fairly large companies. 401(k) retirement plans often come with the added perk of employer matching — that is, employers will match a certain percentage of the employee’s contributions to their 401(k). That’s basically free money, which makes contributing to these accounts very attractive to employees.
The biggest distinguishing factor between the traditional IRA and the 401(k) from a tax perspective is that the contribution limit for 401(k)s is significantly higher — $19,500 for individuals under 50; $26,000 for individuals over 50. In the most extreme scenario, a 53-year-old making $70,000 could contribute $26,000 to their 401(k) and reduce their gross income to $44,000.
Life’s Certainties
As the saying goes, there are only two certainties in life: death and taxes. For the former issue, refer to our article on estate planning to learn how to prepare for end-of-life care and generational wealth transfers. For taxes, everybody has to pay them at some point, unlawful ex-presidents notwithstanding. Admittedly, paying taxes, and dealing with the complexities they inspire is not an appealing prospect to many, which sometimes brings about the unfortunate unethical/illegal practices mentioned above. The best advice is simply to accept that taxes are a part of life and can be used as an opportunity to plan as proactively and efficiently as possible.